Federal Securities Law

Question 1

Issuer

Answer 1

An issuer is a company offering its securities for sale to raise capital.

They make a financial commitment to provide a return in the form of (1) dividends, (2) interest payments, (3) appreciation and/or (4) liquidation rights

Question 2

Financial Intermediaries

Answer 2

They bring issuers and investors together; they come in various forms:
(1) Dealer (2) Broker (3) Underwriter

Question 3

Underwriter

Answer 3

They are the firm that helps a company sell securities through an offering registered under the 1933 Act
-Issuer enters into a contract with an underwriter to sell shares to the public –> Underwriter then approaches investors with offers to sell these shares

Question 4

Primary Market

Answer 4

It’s the sale of securities to investors by issuers seeking to raise capital for their businesses.
-IPO’s = Initial Public Offering: First sale of a corporation’s securities to public investors

Question 5

Secondary Market

Answer 5

Buy-sell transaction among investors of already-issued securities. Issuer NOT involved

• These sales can be in public markets or private placements in negotiated transactions
• DO NOT raise capital for issuer - This is investors cashing out and liquidating their investments by selling to other investors in privately negotiated transactions or continuous public trading (stock exchange)

Question 6

Two Examples of Secondary Markets

Answer 6

NYSE and NASDAQ

Question 7

Function of Securities Markets

Answer 7

(1) capital formation: bringing together investors and businesses through the issuance of equity and debt;
(2) liquidity: the ability to readily sell an investment instrument- providing an exit strategy; and
(3) risk management: permits diversification and hedging of investments

Question 8

Securities Regulations Purpose

Answer 8

Designed to protect investors through:

(1) mandatory disclosure [Make sure that investors have all the information they need to make informed decisions] and
(2) anti fraud liability will equip securities investors and securities markets with non fraudulent information to move capital to its optimal uses.

Question 9

What market does the 1933 Act regulate?

Answer 9

Regulates the sale of securities to the public - primary market
-Gist: Unless there is an exemption available for the security itself, or the way you are selling it, you have to register the securities with the SEC if you want to offer it to the public or sell it in interstate or foreign commerce or through the mails.

Question 10

Selling securities under the securities act of 1933 (Section 5)

Answer 10

§ 5 prohibits the offer and sale of “securities” through the mail or via interstate commerce without filing a disclosure document called a registration statement with the SEC;
§ 5 requires that the securities can’t be sold until the registration statement is declared effective by the SEC; and
§ 5 requires the delivery of a prospectus to everyone who actually buys the securities, as well as to anyone just offered the securities.

Question 11

What market does the 1934 Act regulate?

Answer 11

Secondary market activity

• Sets up mandatory disclosure system that requires largely publicly traded companies (the companies subject to section 16(b)) (those companies that have more than $10 million in assets and more than 500 SH or those companies that trade on a national exchange - NYSE OR DAQ) to disclose information regularly
• Requires these listed companies to have an audit committee and that that committee is comprised solely of independent directors. At least one member must qualify as a “financial expert”

Question 12

State Blue Sky Laws

Answer 12

(1) anti-fraud provisions
(2) disclosure provisions
(3) licensing and registration provisions for securities and brokers and dealers of the securities

Question 13

Definition of Security

Answer 13

Definition of a Security § 2(a)(1): “The term ‘security’ means any note, stock, … bond, debenture, … investment contract … or, in general, any interest or instrument commonly known as a ‘security’.”

Question 14

What is an investment contract?

SEC v. Howey

Answer 14

A transaction constitutes an investment contract, triggering the federal securities laws if (1) a person invests money; (2) in a common enterprise; (3) with the expectation of profits solely from the efforts of others [promoter or some third party].

Question 15

Prong 2 of Howey (Common Enterprise): Horizontal Commonality

Answer 15

Look to the relationship between the individual investor and other investors who put money into the scheme
-Requires investors to share the risk of the enterprise, usually through pooling of their funds (shareholders of a corporation)

Question 16

Prong 3 of Howey: Expectation of profit from the efforts of others

Answer 16

Howey says that the profits must be SOLELY from the efforts of others; lower courts wrestle with whether “solely” means only or predominantly or substantially.

Critical Inquiry: “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise”

Can the investor exercise “meaningful control” over the investment (Robinson v. Glynn)

Question 17

Prospectus

Answer 17

The page summarizing the offering

Question 18

Timeline of Selling Securities

Answer 18

(1) No selling activity
(2) Registration filed with SEC
- Offers permitted but no sales
- SEC review: adequacy of disclosure, not merits
(3) Registration statement effective
- Sales allowed
- Prospective must be delivered

Question 19

Two ways to avoid the registration process

Answer 19

(1) Exempt securities

(2) Exempt transactions

Question 20

Burden of proving exemption

Answer 20

is on the person claiming the exemption; if the burden is not met, the exemption is lost, and if they were counting on the exemption, they have probably now violated §5 which requires registration with automatic liability for selling unregistered securities under §12(a)(1).

Question 21

Exempt Securities

Answer 21

ALWAYS exempt from registration, both when issued and later when traded.

• Remain subject to the anti-fraud provisions
• Just because a security is exempt under FEDERAL registration requirements doesn’t necessarily mean it is exempt from state blue sky registration

Examples: (1) Gov. securities (2) Commercial paper (with a maturity of less than 9 months) (3) Securities issued by banks (4) insurance policies and annuity contracts issued by state regulated insurance companies (5) Securities issued by not for profit issuers

Question 22

Exempt Transactions

Answer 22

One-time exemptions based on the way you sell the security

Question 23

Market trading exemption

Answer 23

Exemption for person other than issuer, underwriter, or dealer for ordinary trading transactions like on stock exchanges between investors

Question 24

Private placement exemption

Answer 24

exempts from registration any offering “by an issuer not involving a public offering” – of course the laws don’t define “public offering.” 
-The application of this exemption turns on whether the particular class of persons affected needed the protection of the Act

Question 25

Regulation D

Answer 25

Provides issuers with safe harbor to conduct 4(2) private placements.
-Exemptions are available only to the issuer, and the issuer must file an informational noticed called a Form D with the SEC within 15 days of first sale

Question 26

Private Placement Test: Four Factors

Answer 26

Number of offerees and relationship to issuer (The relationship must be that the offeree is furnished with or has acess to information about the issuer that a registration would have disclosed)
Number of units offered
Size of the offering
Manner of offering (no public offering/advertisement)

Question 27

Express right of action under the 1993 Act

Answer 27

Provides an express right of action for securities purchasers when:

(1) They bought a registered security in an offering (OR a post offering trading market as long as they can show the securities were part of the block sold in the offering)
(2) There was a material misrepresentation in the registration statement

Question 28

Who are the possible defendants when a registration statement contains untrue statements of material facts or omissions?

Answer 28

This section imposes express liability on everyone who prepares or signs the registration statement [§6 tells us who has to sign][issuer, CEO, CFO, chief accounting officer]; all directors [even those who didn’t sign the registration statement]; underwriters, and experts like lawyers, accountants, investment bankers who have consented to be named as experts – their liability is limited to the information prepared or certified by them, and certainly, most of them would prefer not to have any liability.
(They have the burden to show that its misconduct did NOT cause plaintiff’s damages)

Question 29

Defenses for Issuers when there has been a material misrepresentation or omission in a registration statement

Answer 29

are strictly liable unless they can show one of these affirmative defenses:

(1) the purchaser knew of the untruth or omission when they bought the security; OR
(2) the untruth or omission is not material; OR
(3) the statute of limitations has run.

Question 30

Non-issuers Defenses when there has been a material misrepresentation or omission in a registration statement

Answer 30

Get same defenses as issue and in addition:

(1) resign or take steps to resign and tell the issuer and the SEC in writing that they have done so, and disclaiming all responsibility for the relevant sections of the registration statement;
(2) if the registration statement has already gone effective, written notice to the SEC and reasonable public notice; and
(3) due diligence/reasonable investigation defense – absolves defendants from liability if after reasonable investigation, they had reasonable grounds for believing and did believe that there was no omission or material misstatement

Question 31

Due Diligence Defense

Answer 31

(The level of care that a prudent person would exercise if his or her own money were at stake)

The court will look at the defendant’s knowledge, expertise and status with regard to the issuer, its affiliates and underwriters, and the degree of participation by the defendant in the actual registration process and preparation of the materials.

Question 32

Liability for Selling Securities Without Registering

Answer 32

Civil Liability on those who sell securities in violation of Section 5
-Purchase just needs to show that (1) he bought the security from defendant (2) It was unregistered

Question 33

Forms (10-K, 10-Q, 8-K)

Answer 33

10-K comprehensive summary of a company’s financial performance
10-Q: quarterly report of the first three quarters of the year
8-K: Unusual important events that cannot wait for the 10-K or 10-Q (Filed within 15 days of a big event to inform the market)