INVESTOR PROTECTION (SECURITIES)

BA 333, PROFESSOR SCOTT

AGENDA

1. Review exceptions to limited liability.

2. Cover Chapter 29, investor protection (securities).

3. Break.

4. More Chapter 29.

5. In class writing assignment.

LIMITED LIABILITY COMPANY• Ease of formation: Relatively easy to form (typically

members negotiate operating agreement), but some legal uncertainty may drive up costs or risk.

• Flexibility: Can be member-managed, or manager-managed.

• Liability: Members enjoy limited personal liability, except in cases where the corporate veil is pierced, or they commit a tort.

• Tax treatment: Separate entity from members, but taxed as a partnership unless elects otherwise. (LLC with two or more members can elect to be taxed as a corporation.)

• Raising capital: Can have foreign and corporate investors, partnerships or individual members. Unlimited number of investors.

IN-CLASS ASSIGNMENT #3ORS § 471.565¹

Liability for providing or serving alcoholic beverages to intoxicated person

(1) A patron or guest who voluntarily consumes alcoholic beverages served by a person licensed by the

Oregon Liquor Control Commission, a person holding a permit issued by the commission or a social

host does not have a cause of action, based on statute or common law, against the person serving

the alcoholic beverages, even though the alcoholic beverages are served to the patron or guest

while the patron or guest is visibly intoxicated. The provisions of this subsection apply only to

claims for relief based on injury, death or damages caused by intoxication and do not apply to

claims for relief based on injury, death or damages caused by negligent or intentional acts other

than the service of alcoholic beverages to a visibly intoxicated patron or guest.

(2) A person licensed by the Oregon Liquor Control Commission, person holding a permit issued by the

commission or social host is not liable for damages caused by intoxicated patrons or guests unless

the plaintiff proves by clear and convincing evidence that:

(a) The licensee, permittee or social host served or provided alcoholic beverages to the patron or

guest while the patron or guest was visibly intoxicated; and

(b) The plaintiff did not substantially contribute to the intoxication of the patron or guest by:

(A) Providing or furnishing alcoholic beverages to the patron or guest;

(B) Encouraging the patron or guest to consume or purchase alcoholic beverages or in any other manner; or

(C) Facilitating the consumption of alcoholic beverages by the patron or guest in any manner.

RIDGAWAY V. SILKThe administrator alleged that the patron was served and consumed large quantities of alcoholic beverages, although he was intoxicated. He drove away from the establishments with two passengers, lost control of the car, and drove off the roadway, resulting in injuries to one passenger and death to the patron and the other passenger. The wrongful death action was based on claims of negligent and reckless conduct and included claims against the patron and the establishments. The members of the LLC sought summary judgment. The court found that one individual who merely loaned money to purchase the establishment, and was nothing more than a passive member of the LLC, was entitled to summary judgment because there could be no liability against him under Conn. Gen. Stat. §§ 34-133(a) and -134. However, two other members who admitted to participating in business activities on the night in question could have been liable under a theory of negligent supervision and training of employees. Further, they might have served the patron and been liable under the Dram Shop Act, Conn. Gen. Stat. § 30-102.

In reviewing the operative complaint, it is apparent that the counts against Giordano and Costello do not allege liability based solely upon their status as members of a limited liability company. There are several allegations in negligence and recklessness addressed to a purported failure of these defendants to supervise and train properly their personnel and a failure to monitor their patrons to ensure safety. In the Dram Shop Act count, it is alleged that Mr. Sulls was sold large quantities of alcoholic beverages while he was intoxicated by the defendants or their agents, servants and/or employees.

Giordano and Costello were both present at Silk Stockings on the night in question. They were meeting and greeting people and performing various tasks on a very busy evening with hundreds of patrons on the premises. It is true that Giordano and Costello would not be liable to these plaintiffs solely because they are members of Silk, LLC. "When, however, an agent or officer commits or participates in the commission of a tort, whether or not he acts on behalf of his principal or corporation, he is liable to third persons injured thereby." In the circumstances of this case, given the participation of Giordano and Costello in the operations of the business, there are material issues of fact which preclude the granting of a summary judgment.”

-Ridgaway v. Silk, 2004 Conn. Super. LEXIS 548 (2004)

PIERCING THE CORPORATE VEILThe general rule is that members of an LLC, like shareholders in a corporation, are not liable for the debts of the company.

If enforcing that rule would perpetuate a fraud, or cause a considerable injustice, courts may “pierce the corporate veil.”

In order to do so, the court must find that the individual operating the corporation acted as an individual, or disregarded the corporate form. Some of the factors they may consider (varies by state):

• Inadequate capitalization

• Failure to issue stock

• Failure to observe corporate formalities

• Co-mingling of corporate and personal funds

• ORX Resources v. MBW Exploration, LLC (32 So.3d 931) (2010) (page 405 of the book).

GOALS OF SECURITIES LAWS

Why were these laws passed? • Stock market crash & depression• Intended to give investors more information to help make decisions

Who do they protect? • Intended to protect the average investor, not the professional

Primary goal: substance or disclosure?

WHAT IS A SECURITY?

Securities Act of 1933 and Securities Exchange Act of 1934 define security as:

Any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement…investment contract…option…or in general, any interest or instrument commonly known as a “security”…

An investment contract is:

Any transaction in which a person (1) invests (by purchasing a stock, bond or other security); (2) in a common enterprise; (3) from which she reasonably expects to earn profits; (4) primarily or substantially as a result of the managerial or entrepreneurial efforts of others. SEC v. Howey (1946) (“Howey Test”)

WHAT IS A SECURITY?

Alpha Telcom offered buyers a chance to earn profits from a pay-phone. Buyer would pay for all costs associated with the phone and own the phone outright. Alpha would manage and service the phone. They promised buyers a 14% return.

• “Alpha would select a suitable location for the telephone, install the telephone, maintain the telephone, pay all monthly telephone and utility bills, as well as obtain all regulatory certifications.”

Alpha was actually operating at a loss and borrowed funds to pay investors. Eventually, Alpha filed for bankruptcy.

Was the pay phone program a security?

SEC v. Alpha Telcom, Inc., 187 F.Supp.2d 1250 (2002).

SECURITIES AND EXCHANGE COMMISSIONAn independent regulatory agency, created by the Securities Exchange Act of 1934, empowered to enforce the various federal securities laws and to promulgate regulations to aid their enforcement.

Basic function of the SEC:

• Require disclosure of facts concerning offerings of securities to the public

• Regulating the trade in securities

• Investigating securities fraud

• Registering and regulating the activities of securities brokers, dealers, and investment advisors

• Recommending administrative sanctions, injunctions, and criminal prosecution for violations of federal securities law

SECURITIES ACT OF 1933

• The Securities Act requires companies to give investors "full disclosure" of all "material facts.“

• Material facts: facts investors would find important in making an investment decision.

• Applies to initial sales of securities by business

SECURITIES ACT OF 1933

Requires issuers of securities to file a registration statement:

• Subject to certain exemptions, securities must be registered and declared effective by SEC before offered to the public.

• Company issuing the securities must also file a prospectus with the SEC and provide to potential investors.

• This is a very expensive process – registered public offerings typically cost more than $1 million.

• Before filing registration statement, cannot offer securities.

• After filing registration statement, company must wait for SEC review and approval before securities can be sold (waiting period).

• After approval, registration becomes effective and securities can be sold.

SECURITIES ACT OF 1933

Prospectus: a disclosure document filed with registration statement that describes:

• The security being sold.• The financial operations of the issuing corporation.• The investment or risk attaching to the security.• Delivered to prospective investors electronically or in hard

copy.• Used as a selling tool for prospective investors.

REGISTRATION STATEMENTThe registration statement must describe:

1. Significant characteristics of the offered security, including its relationship to the issuer’s other outstanding securities.

2. Issuer’s properties and business activities, including a financial statement.

3. Issuer’s directors and officers, their compensation, securities holdings, and other benefits, and any interest in any material transactions.

4. How the issuer intends to use the proceeds from the sale of the offered security.

5. Any pending lawsuits or special risk factors.

Can’t sell securities until SEC declares the registration statement to be effective.

EXEMPT SECURITIES & TRANSACTIONSMany securities avoid registration because they are exempt. Important exemptions to know:

• Intrastate offering: Securities offered and sold to persons within a single state by an issuer who is a resident of that state

• Regulation A: $5M in a 12 month period; requires simplified process

• Regulation D: used by most small businesses

• Rule 504: Non-investment company offerings of up to $1M in any 12 month period.

• Rule 505: Non-investment company private offering up to $5M in 12 month period

• Rule 506: Private placement; offerings cannot be advertised or solicited; non-public. Limited to accredited investors and limited number of unaccredited investors, who must possess sufficient knowledge and experience to evaluate the risks involved.

SECURITIES ACT OF 1933

Are thesenew

securities to be issuedby a

company?

Does an exemption

apply?

File a RegistrationStatement

with the SEC

NO

RegistrationStatement

Prospectus

Yes (e.g., Intrastate, private placement)

Investors

SEC

Disclosure to potential investors may still be required.Also Check Federal and State Laws (“Blue Sky Laws”)

SECURITIES ACT: LIABILITY

Violation of the 1933 Securities Act to:

1. Defraud investors by misrepresenting or omitting facts in a registration statement or prospectus.

2. Be negligent in not discovering the fraud.

3. Failing to file a registration statement, claiming an exemption that does not apply, or selling securities prior to registration becoming effective.

Criminal and civil penalties; monetary penalties, imprisonment, disgorge (refund) profits, injunction.

SECURITIES ACT: DEFENSES

Defenses to liability:

• Immateriality: even if the statement or omission was false or misleading, the statement or omission was not material.

• Plaintiff’s knowledge: even if defendant made false or misleading statements, the plaintiff knew about them and bought the stock anyway.

• Due diligence: defendant reasonably believed that the statements were true and there were no omissions of material fact.

SECURITIES EXCHANGE ACT OF 1934

Unlike Securities Act, which requires one-time disclosure, the Exchange Act requires ongoing disclosure of material information to investors.

• Applies to companies who have assets in excess of $10M and 500 or more shareholders.

• Requires annual, quarterly, and even monthly reports filed with SEC.

SECURITIES EXCHANGE ACT OF 1934

Section 10(b), SEC Rules 10b-5:

• Applies in almost all cases of securities trading.

• Prohibits the use of manipulative or deceptive mechanism in violation of SEC rules.

• Prohibits the commission of fraud in connection with the purchase or sale of any security.

• Omission of a material fact, or misrepresentation of a material fact constitutes fraud.

• Prohibits insider trading.

SECURITIES FRAUD: MATERIAL FACT

What is a material fact? A fact that is likely to affect a reasonable party’s decision to buy or sell the securities.

Example:

• Significant changes in the corporation’s financial condition

• Developments, such as a new discovery or the prospect of litigation, that will likely cause significant changes in the corporation’s financial condition.

MATERIAL FACTS

SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (1968), page 636.

• Mining company found evidence of high mineral content in one core sample.

• Results kept secret.

• Unclear what the results would be when mine went into commercial operation.

• Officers and employees made substantial purchases after they heard the news.

• Price of TGS stock rose substantially as a result.

• Was this material information that should have been disclosed to the public?

INSIDER TRADING

Insider trading occurs when persons buy or sell securities on the basis of information that is not available to the public.

• Traditionally applied to “insiders” who have corporate information because of their position, and have a duty not to disclose.

• Also applies to “outsiders” (“tippees”) who have access to or receive information of a nonpublic nature.

• Information must have come from someone violating their fiduciary duty, doing so for personal benefit, and the tippee knows it.

• Sanctions: SEC has broad powers to bring civil suits against insiders and others who use inside information for their own benefit.

EXCHANGE ACT VIOLATIONS

Penalties for violations of the Exchange Act are steep.

Criminal penalties: Individuals can be fined up to $5M, imprisoned up to 20 years, or both. Corporations can be fined up to $25M.

• Must be proof of scientier: defendant knew about the fraud or had intent to defraud.

Civil: can impose up to treble (triple) damages for profits gained or losses avoided.

SARBANES-OXLEY ACT OF 2002

An attempt to restore investor confidence after corporate scandals and improve corporate governance.

• Chief corporate executives personally responsible for financial statements and reports filed with the SEC.

• Stricter disclosure laws.

• Harsher penalties.

• Greater regulation of public accounting firms.