# Lecture 1 - 9.3.2014

Capital Markets

Introduction

The capital market is formed by connecting those who need capital to grow, expand, start-up and those

who want to invest (investors) or banks.

The long-run reason why the SEC has to regulate this market is that it is very conducive to the

sustainability, growth in economics, and taxes made to the government.

Participants in the capital markets

Corporation: Securities

Holding securities endows upon you rights, like voting rights, rights to assets in liquidation (absolute

priority). Two primary types of securities: (1) equity, which is common stock. Preferred stock is a bit

different and (2) debt securities, mainly corporate bonds.

Common Stock: an ownership interest and voting rights (whether for selecting people who run the

corporation or on major transactions). Common stock holders don’t have a fixed right to cash flows, but if

a dividend is paid they have the right to get it. If the stock appreciates, I can sell my stock for more. The

bad news is that they are last in the absolute priority (liquidation line). Benefit from fiduciary duties from

the board of directors.

Corporate Bonds A bond is a loan (exchange of money) that will be paid back plus interest. A bond

holder does not have any rights beyond getting his money back. Very little voting rights – only in some

cases. If the company grows this doesn’t affect him (appreciation). A bond holder takes precedence over

stock holder in liquidation.

Preferred Shares it’s like common, it does give the same rights, but has debt symbols, it’s typically a fixed

dividend and takes precedence over other common stock holder in absolute priority (usually non-voting

rights).

Investors: In a security offerings, there are:

1. Issuer (registrar = the company selling), 2. Investor.3. Intermediaries (underwriters, broker-dealers).4. Other people involved in the transactions: lawyers, accountants (auditors) - hired to check

the financial filing of the company.

Equity vs. debt: With equity, companies do not have to pay money but give up ownership rights.

Two types of securities offerings (transactions): 1. Primary offering: direct offering between a company that issues shares and an investor.2. Secondary trading transactions: buying/selling between existing shareholders (often

through a broker); corporation is not involved in those secondary transactions. Distinct regulatory structures; distinct statutes.

Financial Markets Secondary markets provide liquidity. Initially, there were: (1) physical exchanges, and (2) OTC: computerized.Today everything is computerized but the different types of exchanges still exist. They are more or less regulated; the quality of the companies that are traded may be different.

What can go wrong on a market? A company goes to an underwriter (a facilitator who helps to sell the shares). Underwriters have relationship with broker-dealers. A broker-dealer sells to investors. The underwriter gets commission from the company. Investors pay broker-dealers.

Conflicts of interests that may exist1. Corporation incentive: get as much capital at the lowest possible price. Corporations are

over-optimistic. They might even be fraudulent. 2. Management: similar interests as the corporation, but conflicts can be worse, because

corporation have reputation concerns while management may not have such concerns. 3. Sometimes lawyers and auditors can have conflicts of interests: they might be afraid to

lose the client.4. Underwriter: need to make sure the company is happy, but he has a relationship with the

broker-dealers. However, generally investors are easy to find. Companies who are willing to hire to sell securities are harder to find.

5. Broker-dealers have closer relationship with the investors, but the relationship between the broker-dealer and the underwriter exist because they are in good terms. The broker-dealer want to make sure the underwriter will continue to do business with him.

6. Investors (retail): greedy, lazy, not smart enough to understand.

Merit-based regulation (government telling the people in what security to invest) vs. disclosure-based system (provide all information to make an investment decision).

# Lecture 2 - 9.10.2014

Definition of Securities

The federal system is a disclosure system. Not a merit system (in which the government determines which

security can be distributed). In a disclosure system, any company can sell securities to the public as long

as it provides disclosure.

The 1933 registers transactions, not securities. The 1934 registers classes of securities.

1933: every time there’s a security transaction you have to think of the 33’ requirements. Every offering

and sale of securities is a transaction and the 33’ comes into the picture. It imposes disclosure

requirements to the transaction. The 34’ focuses on classes of securities. It says if you have a class of

securities widely held and are likely to be transferred back and forth across many investors, you have to

comply with 34’. A class of securities is for instance common shares or preferred shares, etc. Registration

is a mechanical process. It’s important because that’s what triggers the disclosure requirements, and then

as part of this the issuer has to file the several documents.

A security: if you don’t have a security then you shouldn’t worry about the 33’ act. Like selling a cow for

instance. 33’ section 2(a)(1) is very broad, but like all statutes the definition is a starting point.

1. Stocks/Shares

It identifies stock (common and preferred), common is the most typical, as a general rule a common stock

is most probably a security (but not 100%).

United housing foundation v. Forman: you gotta look at the underline economics, even if it’s called a

stock or a housing stock. It was not a financial investment (no expectation of profit), people were buying

it to secure a housing.

Landreth Timber v. Landreth: if you give it all the rights and attributes a common stock has (right to

dividend, voting rights, appreciation potential, negotiability) then you really don’t have to go any further.

SC: stock is stock corporate form dictates.

SEC vs. Howey (Investment contracts): Courts use this concept when unusual schemes are involved. The

test is that an investment vehicle will be a security when a “(1) person invests his money (not cash only)

in (2) a common enterprise expectedly to (3) get profits (4) solely (predominantly) by the

management and control of others”. It focuses on the investor’s reliance on the promoter’s efforts.

They speak about a horizontal commonality when there are many people investing in the pool (collective

action). A vertical commonality depends on the manager of his investment. He has to expect profits and

someone has to do the work for you (agent agency costs that require the protection of the securities

laws).

* Int’l Brotherhood v. Daniel – SC: money = not cash only.

In limited partnerships, there are two types of partners: general partners and limited partners. If I buy a

limited partnership share:

- I am hoping to get profit

- I am reliant on the general partner.

If we apply the Howey test, the share will be a security subject to ’33 Act.

In a general partnership, I will have equal rights, I will rely on my own efforts => the ’33 Act does not

apply.

Williamson v. Tucker test:

Even general partners can be found to hold securities if the investor shows either:

- no legal control, or

- no capacity to control (the partner is inexperienced and unknowledgeable in business affairs), or

- no practical control (the partner is dependent on the unique managerial ability of the promoter)

Members of a manager-managed LLC are more likely to be passive investors in need of the protections

afforded by the federal securities laws. By the same token, members of member-managed LLCs who are

able to actively participate in the management affairs of the entity are less likely to need such protections.

But even these characteristics may differ based on the economic realities and facts of each case, making it

difficult to establish bright line rules in this area.

2. Debt

Notes, bonds and debentures.

A note evidences a borrower’s promise to repay a debt (extension of credit) and, as such, represents the

creditor’s investment in the borrower.

Notes that have a maturity of less than 9 months are exempt from registration requirements.

On top of that, courts have said that not every note is a security. Courts have generally recognized that

notes issued on a commercial or consumer contracts are not securities. Consumer finance notes (for

mortgage, for commercial purposes, loans by bets) are not securities. They usually involve a direct

negotiation between the buyer and the lender (banks) who is/are financially sound – in large

denominations.

Reves v. Ersnt and Young - the “family resemblance test”

PP: a note is presumed to be a security unless it has the characteristics of something that is not security.

Test:

1. Motivation: if it is for commercial purposes (e.g. to buy consumer goods), it is more likely not to be a

security; if a buyer looks to raise capital for general business purposes, it is likely to be security.

2. Distribution: is it widely distributed (security) or a one-to-one negotiation (probably not security).

3. Expectations: do I consider it as an investment.

4. Are there other regulatory schemes? Example: banks are already regulated – not security. If unregulated

somewhere else and uncollateralized/uninsured security.

See interpretative guidance of the SEC on the Reves case.

Also example 5 on p.67

Materiality

Not all information has to be disclosed. If the disclosure is too costly, companies will be discouraged.

If there is too much information, the investors might not be able to identify the important information.

No information is also risky, investors will lose confidence.

Rule 405: Information is material if there is “substantial likelihood that a reasonable investor would

consider it important.”

TSC v. Northway:

1. If there is substantial likelihood for a reasonable investor to consider it important when making securities-

related decision;

2. If substantial likelihood that the disclosure of the omitted information would have been viewed by a

reasonable investor as having significantly altered the total mix of information.

“Substantial likelihood”: more than just possible, more probable than not

“Reasonable investor”:

a. If there is an efficient market, courts have found that the reasonable investor is the sophisticated

investor who is looking at the information because he will understand this information and is going

to price the stock based on this information; unsophisticated investors will benefit from the pricing

made by the sophisticated investor.

b. If the market is not efficient, then the reasonable investor will be the unsophisticated investor.

“Total mix of information”:

a. Information must be considered in the context of everything else that is provided;

b. Another way of looking at the information: if there is an efficient market, courts have found that

information may not be material if the market already knows about it;

c. Yet another way to look at the information: ask the question whether the information affects the

whole picture (not only the investment decision). Example: my company sells umbrellas, if I do not

say where I sell umbrellas and I am only selling them in the desert, it may be important, but if I also

sell them throughout the whole country, this is probably not that important.

Basic v. Levinson

The court focused on the probability that the event will happen in relation with the magnitude of the

event.

1) How probable is the event?

2) How big is the event?

Based on these two elements, we determine whether information is material. Example: if there is a small

chance that something happens but the magnitude is enormous, this is probably material (and vice versa).

* The SEC considers some pieces of information as material per se. Example: age of the executive

officers.

There are other elements of information for which we still need to make an analysis. Example: “litigation

that would have material impact on the company”. The SEC requires this information, but the lawyers

have to determine whether the litigation is material (on the basis of the probability of the outcome of the

decision and the potential impact on the company).

# Lecture 3 - 9.17.2014

Recap of last class:

We spoke very broadly about 33’ Act and 34’ Act and what constitutes a “security”.

Remember if there isn’t an offer or sale of security then you don’t need to worry about the 33’ Act.

Definition of ‘security’ is important – because every time you have an offer or sale of a security you

need to consider the 33’ Act. BUT not every security is subject to the registration and disclosure

requirements of the 33 Act.

Lecture 3:

“Interstate commerce” – in this class we will assume that any transaction is interstate commerce and so it

is within the scope of 1933 Act. The concept of “interstate commerce” has been interpreted very broadly.

The reason the concept is used is so that the federal regulation has jurisdiction (it has to be attached to the

Commercial Clause provision).

When an offer and sale IS subject to the registration requirements – then section 5 places very strict

requirements.

Registration is the threshold to the disclosure requirements.

What triggers registration under section 5 of the 33’ Act is the offer and sale of a security.

Starting point: every offer and sale of a security MUST be registered under the 33 Act unless there

is an exemption.

Three specific sections of the 33 Act – 3, 4, and 5. Section 5 – registration and sections 3 and 4 identify

the exemptions.

Section 5

How does section5 work: a company can only offer or sell a security if there is a registration

statement on file.

What does section5 require: filing a registration statement and dissemination of information (i.e.

disclosure of what securities are being sold).

Need to know what is an “offer” and what is a “sale” (i.e. when does a sale occur)

Section 2(a)3

“Sale” or “sell”: includes every contract of sale or disposition of a security or interest in a security,

for value.

“Offer to sell”/”offer for sale”/”offer” – every attempt or offer to dispose of, or solicitation of an

offer to buy, a security or interest in a security, for value.

And the subsection continues to elaborate on the definition.

OFFER: Any attempt to condition the market may constitute an “offer” basically any

communication can be an offer of a security, which will be subject to 33 Act. But you really need to

look at the facts and circumstances.

There are certain facts and circumstances that are always going to constitute an “offer”. Example: if

you discuss the price in a communication of a particular security – then it will be deemed an offer.

The price may create an interest in the security Offer.

SALE: sale is more straightforward than an offer. Sale isn’t just about cash – it is BROADER than

that. It is about value and value can take many forms. Value is about benefit – and so with the internet

company concept where they were giving free stock if those people gave them confidential

information this is of value to the internet company. DON’T get tripped on the “for value” – a

lot of things can be “for value” to a company, not just cash.

SECTION 5

Pre-filing Period

Waiting Period Post-Effectiveness Period

5(c) Oral Offers OK 5(a)No Offers Written Ok with

restrictions5(b)(2) 10(a)

No Sales No Sales 5(b)(1)Release 33-5180 5(b)(1) Offers OKRule 135 Rule 134 Sales OKRule 168-169 Rules 168-169Rule 163A 5(d)Rule 163

Section 5 sets forth the registration requirements and outlines what an issuer can do during the 3

periods: (1) Pre Filing (2) Waiting Period and (3) Post Effective.

Section 5 registers t ransactions . You cannot offer a security until that transaction is filed. And can’t

sell the security until the registration is “effective” (post effective stage).

The players in this game are the (1) issuer (entity offering the security), (2) the offeree (person you

are offering the security too), and (3) the underwriter.

Firm-commitment offer: the underwriter agrees to buy the securities from the issuer and then the

underwriter will resell the securities to public investors.

When does section5 come into play: when an issuer is offering or selling a security and no exemption

applies (don’t need to worry about section5 if you’re not offering or selling a security). As soon as

you’re starting to contemplate an offer – then that’s when section5 comes into play! This pre-filing

section starts.

The focus of section5 is on issuer communication, in other words, what the issuer can say/do when

offering securities.

S5(c) – prohibits any offers prior to filing (category 1).

S5(a) – no sale prior to effectiveness (category 3).

S5(b)(2) – prohibits the delivery of security after sale unless a company files a prospectus.

S5(b)(2): “It shall be unlawful for any person, directly or indirectly: to carry or cause to be carried

through the mails or in interstate commerce any such security for the purpose of sale or for delivery

after sale, unless accompanied or preceded by a prospectus that meets the requirements of subsection

(a) of section 10”.

S5(b)(1) – most important provision – prohibits the use of any prospectus relating to any security

with respect to which a registration statement has been filed unless the prospectus meets the

informational requirements of section10.

S5(b)(1) “It shall be unlawful for any person, directly or indirectly—to make use of any means or

instruments of transportation or communication in interstate commerce or of the mails to carry or

transmit any prospectus relating to any security with respect to which a registration statement has

been filed under this title, unless such prospectus meets the requirements of section 10”.

I can’t make an offer before I file (a prospectus) – but upon making a prospectus you have to make

sure it complies with s10. S5(b)(1) + definition of prospectus = you can’t deliver without prospectus

that has to meet section 10.

So section 5(b)(1) really govern how written offers can be made to the public. There are different

rules for oral offers – but we are focused on written offers.

S2(a)(10) The term ‘‘prospectus’’ means any prospectus, notice, circular, advertisement, letter, or

communication, written or by radio or television, which offers any security for sale or confirms the

sale of any security; except that (a) a communication sent or given after the effective date of the

registration statement (other than a prospectus permitted under subsection (b) of section 10) shall not

be deemed a prospectus if it is proved that prior to or at the same time with such communication a

written prospectus meeting the requirements of subsection (a) of section 10 at the time of such

communication was sent or given to the person to whom the communication was made, and (b) a

notice, circular, advertisement, letter, or communication in respect of a security shall not be deemed

to be a prospectus if it states from whom a written prospectus meeting the requirements of section 10

may be obtained and, in addition, does no more than identify the security, state the price thereof, state

by whom orders will be executed, and contain such other information as the Commission, by rules or

regulations deemed necessary or appropriate in the public interest and for the protection of investors,

and subject to such terms and conditions as may be prescribed therein, may permit.

What constitutes an offer?

Broadly – any communication can be an offer. But we need more specifics. We will focus on the

“Pre-filing” period (category 1) – which is when offers are PROHIBITED. If you are making offers

before filing a registration then this is prohibited. Gun jumping – refers to making an offer before

filing a registration - this is illegal and in violation of s5.

To figure out whether something is an offer you need to start by looking at the context.

When does pre-filing start? It is an important concept to understand because once you’re in the

“pre-filing” period you can’t make any offers. During this pre-filing phase all communication is

going to be scrutinized by the SEC to ensure that this communication doesn’t constitute an offer.

Once a company is thinking of an IPO, the company needs to start thinking about s5. (a board

meeting is a good indication).

As soon as a company starts thinking about starting the process of offering and selling shares – then

the company needs to think about the registration process.

Let’s assume that we are in the “pre-filing” phase – what communication constitutes an offer? What

communications are lawful and not lawful?

Release 33-5180 (1971)

Available through Westlaw. It’s from 1971 but it is an operative guidance. Focus on the practicalities

of running a business – what we mean by this is that businesses need to communicate in order to run

their businesses. So this release explains what businesses can do without violating s5.

The Release says that when you’re in the pre-filing period and you can’t make offers – you can still

go ahead and make factual statements, do routine advertising etc. – this is okay. BUT what you

can’t do is make communications that are designed to have the effect of conditioning the market

regarding an offer (i.e. can’t have communication that will induce people to buy securities – can’t

promote the business by encouraging people to purchase shares in the business)

When something is purely FACTUAL – then this shouldn’t be a problem under Release 5180. BUT

as soon as you get beyond FACTUAL, HISTORICAL, ROUTINE ADVERTISEMENT,

REQUIRED STATEMENTS BY 34’ then there will be a problem (i.e. any communication that

props up the company, mentions prices of securities etc.)

The release also says that it would seem anomalous that a company planning an offering could

condition the market so long as it has not found a managing UW, hence concrete steps by the issuer

are enough.

What happens if your client is still working on their registration statement + prospectus – and they

know they can’t make any “offers” – but they still want to make a general statement to the world

about their offer – what can the client do?

Rule 135: “limited public announcement” - Certain communications that are announced pre-filing won’t breach the “offer” violation. The announcement’s disclosure shall not be an offer, it’s an invitation. This announcement can’t discuss the price, underwriters, or pump up the company, etc.Conditions:(1) Legend. The notice includes a statement to the effect that it does not constitute an offer of any securities for sale; and(2) Limited notice content: (Name of the issuer; the title, amount and basic terms of the securities offered; the amount of the offering; the anticipated timing of the offering; a brief statement of the manner and the purpose of the offering, without naming the underwriters; whether the issuer is directing its offering to only a particular class of purchasers; any statements or legends required by the laws; and a bit more)

Recap: you can’t make offers pre-filing. But there are some things you can do:

(1) Make factual statements as per release 33-1580.

(2) Can make an announcement as per rule 135 – applicable only to issuer.

Securities Offering Form 33-8591 – don’t have to read it, but it’s very informative (maybe released in

2005).

Rule 168: (safe harbor) applicable only to reporting issuers (issuers that are already subject to 34’ Act]

See page 160.

Exempts from section 5(c): It allows the issuer to continue (something that started in the past) publishing

or disseminating “regularly released factual business and forward-looking information,” even around the

time of a registered offering. This safe harbor is designed to permit ongoing communications with the

market, such as press releases, earnings releases, conference calls, earnings guidance, and other

information released in accordance with an issuer’s past practices, but cannot contain information

about a potential offering. (only as part of ordinary business)

Conditions:

(1) The issuer has previously released or disseminated information of the type described in this section in

the ordinary course of its business;

(2) The timing, manner, and form in which the information is released or disseminated is consistent in

material respects with similar past releases or disseminations; and

(3) The issuer is not an investment company registered under the Investment Company Act of 1940 or a

business development company as defined in section 2(a)(48) of the same Act.

Rule 169: applies to ALL issuers but doesn’t allow FORWARD looking statements, and must be

intended for non-investors.

Pre-filing Stage

What exactly is pre-filing and how far does it go? Does this have an impact on whether communication in

advance of filing is an offer?

Violating 5(c) is a bad thing and can cost the firm a significant amount of money.

RULE 163A – (Bright line test)

Rule 163A defined pre-filing as 30 days (see pg 159). The statement shall not mention/reference the

proposed offering. Some communications are not exempt have to check if our case falls within them.

* ALSO, it only applies to the issuers and NOT to the underwriters/dealers.

RULE 163 carved out a huge exemption for WKSIs.

If a company is a WKSI – don’t have to worry about s5(c) – subject to a few conditions:

o There must be a legend (where to get a copy of prospectus and instructions to read).

o Only applies to the issuers – not other participants.

o Company must file the written communication with the SEC.

o And there is some liability for it – it will still be a FWP and a prospectus s10.

So RULE 163 eliminates s5(c) for WKSIs.

Rule 405 defines WKSIs: these are the largest companies that have a public float (value of the shares that

are held by non affiliates) of more than $700 million or has issued $1B in debt over the past 3 years.

Rationale: these companies are so large and are heavily followed by analysts – all information is already

available to the public and is already reflected in the price. Therefore, investors already know all the

information (no need to protect investors) and there is no harm in WKSIs offering securities because they

won’t be in violation of s5(c).

Recent statutory change that impacted pre-filing

JOBS Act 2012: relaxed the offering process and disclosure requirements for emerging growth

companies – small companies with less than $1B and started up after 2007.

BUT big change is that they added section 5(d).

09/24/2014

Guidance/release: gives factors but not a clear path to compliance, while safe harbors are very concrete.

Waiting period

5(b)(1)

No restrictions on oral offers;

No use of prospectus unless the prospectus meets the requirements of section 10. Any written document

that offers a security is a prospectus (including any ad on TV or radio).

Information required by section 10

- 10 (a) prospectus: all the information set forth in schedule A.

- 10 (b) prospectus: less than the 10(a). The Commission can permit, under certain circumstances, the

use of prospectus that contains less than 10(a).

As a practical matter, no one uses a 10(a) prospectus during the waiting period, because there has to be a

price.

Historically (before 2005), there were only 2 documents that were used during the waiting period:

1. The preliminary prospectus (10(b) prospectus): no price (a “red herring” - because there used to

be a legend in red that said that no sales could be made effectively).

2. Tombstone ad (allowed by rule 134): rule 134 defines certain documents that are not prospectus

(a corollary to Rule 135) - originally, brief notices that the company was going to do a market;

then expanded - information that can be included; there has to be a legend; price (or method of

determination or a price range).

However, if used during the pre-filing period, it will constitute a violation.

Rules 168-169: if you follow the safe harbor, the written communication will not be a prospectus.

Information previously released in the ordinary course of business. Facts and circumstances - consistence

with prior practices. What if the company is new?

Offer/Sale of Security

1st question: is there a security?

If yes, think about the filing restrictions (what stage; oral or written offer; is it a prospectus)?

If there is a communication

1st we see at which stage.

If we are in the pre-filing, see what we can argue to show that the statement was not an offer.

* Section 5 violation cannot be cured.

Free Writing Prospectus (FWP):

Aims to remedy the lack of flexibility and allows taking advantage of new technologies.

Very limited (almost no) content requirement.

405 definition : any written offer, including graphic communication, or a written solicitation of an

offer to buy, that is not a final 10(a) prospectus, a valid 10(b) prospectus, or sales literature.

Any written communication that is not one of the 3 such as: press release, email, interview

on TV.

FWP is subject to the same liability.

Need to understand the definition of FWP and why the FWP is relevant.

Conditions

Set under 163, 164 and 433.

The conditions vary depending on the issuer’s size and extent to which it is publicly traded.

Rule 164 + 433: you can use FWP only after filing a registration statement (unless you’re a WKSI) and, if

the issuer is involved with the communication, it has to be preceded or accompanied with a preliminary

prospectus that includes a price range (unless you’re a WKSI or a seasoned issuer).

* There is one exception: a media FWP, 433(f) - (the communication that ends up to be an offer and

hence a violation); can be turned into a 10(b) prospectus within 4 days.

Example: if the CEO had given interview, talking about how great the company is and how excited he

was about the future prospects; if the interview is later published in a newspaper, it becomes a violation.

The Commission tried to address such “technical” unintended violations.

SEC: if that happens, the article can be filed within 4 days after.

Filing conditions

1. Seasoned issuers: you have to have a registration in file, but no need to accompany or precede the

FWP with a preliminary prospectus.

2. Unseasoned or IPO: the big condition is “accompanied or preceded” by a prospectus (can be

interesting in the digital world where the prospectus is attached but the communication only

contains the FWP. For IPOs: PP has to include a price range.

3. Issuers and underwriters: issuers have to file it the 1st time they use it; underwriters do not need

to file it, just to retain it.

4. There cannot be information that is not in the registration statement (it cannot conflict with the

registration statement or other reporting the company has filed).

5. File the FWP and it has to have a legend. If you forget to add a legend or delayed the filing you

can argue under the “good faith and reasonable effort” (164) provision no violation of s5.

After meeting the conditions FWP will be deemed as 10(b) prospectus complies with §5(b)(1).

When can I use it?

If I am a WKSI, even before filing, otherwise, only after registration.

§ 10(b) and FWP

When does the FWP comply with §10(b)? The answer will be ‘yes’ if the FWP complies with all the

conditions outlined below (that depend on the nature of the company).

Does a Reg. Stat. have to be filed?

Accompanied or preceded with a PP?

Do they have to file the FWP with the

SEC?

Does the FWP have

to contain a legend?

WKSIsWKSIs, unlike other issuers, can use FWPs before filing and after filing under Rule 163.

No No Yes Yes

Seasoned issuers (have a public float of greater than $75M + 1 year public). They have to look to Rule 164 for FWP and there are conditions that have to be met in order for the FWP to satisfy §10(b).

Yes No Yes Yes

Unseasoned issuers or IPOs They have to look to Rule 164 for FWP and then there are conditions that have to be met in order for the FWP to satisfy §10(b).

*This group has the most conditions because it’s assumed that there isn’t a lot info available in the market about these companies and therefore more disclosure is required.

Yes Yes With a §10(b) that (for IPOs must have a price range!) can be attached via a hyperlink(send an email which highlights key facts and attach hyperlink)

Yes Yes

Do they have to file the FWP with the SEC?

Does the FWP have to contain a legend?

Exceptions Media FWP exception - Rule 433(f): The purpose of the media FWP exception is to give some issuers a form of protection when they give interviews when part of the interview is subsequently published in the media. Under Rule 433(f), these media releases are considered FWPs the FWP is considered a §10(b) prospectus it complies with a §5(b)(1). BUT, the FWP must be filed to the SEC within 4 days

Media FWP exception - Rule 433(f): The issuer must, within 4 days of becoming aware of the FWP, file it with a legend.

of becoming aware of the media release.

Note: this media FWP exception is important because without this exception the media release will be considered a “written offering” violating §5.

* 433(d)(8)(2) a FWP in a road show is exempt from filing for reporting issuers, not exempt for non-reporting

issuers unless at least one version of a bona fide electronic road show available without restriction by means

of graphic communication to any person. (if it’s available on the web)

* For media FWP, no need to file PP.

Lecture 5 – 10.1.2014

Pre-filing Period§5(c), §5(a)

Waiting Period§5(b)(1), §5(a)

Post-Effective Period§5(a), §5(b)(2), §5(b)(1)

No offers before filing RSNo sales before filing RS

Do we have an “offer” (of a security)? If yes, then you have just violated §5.

Rule 135: offer announcement. Allows notice of public offering but limited info. Applicable only to issuer and can’t name underwriter, mentioning price only if offering to employees. Has to have a legend: “this isn’t an offer, an offer will be made only by means of a prospectus”.

Rule 168: regular communication (reporting issuers): permits regularly released factual info and SEC filed FLI, provided timing, manner, and form are similar to past releases; may not mention offering.

Rule 169: regular communication (new issuers): permits regular released factual info, but not FLI; may not mention offering; must be intended only for non-investors (i.e. customers, suppliers, etc. NOT shareholders).

Release 33-5180: can’t initiate publicity, but can continue to advertise products and services, to make periodic and other

Sales are prohibitedWritten offers ok but restrict

Oral offers unrestricted

*an oral FLS must be accompanied with a caution that results could differ materially – 1995 Reform Act.

§5(b)(1): a prospectus (written offer) has to comply with §10 if/when used.§10(a) must include the price.§10(b) has everything but price, more common (430 - 431).

Legend: (who is selling and where to get prospectus).Tombstone ≠ prospectus under 2(a)(10).

Rule 134: identifying statement = expanded TS + legend. Info about issuer, UW, price range, and offering, pursuant to 2005 reforms.* 134 options ≠ prospectus no need to comply with §10.

Exemptions(1) 134, (2) 135, or (3) investor’s interests + PP + no commitment, (4) or a PP + legend (red herring).

Written offers are ok but with restrictions: No

Sales are okOffers are ok but rare

Offers: may be made in underwriting situations that are based on “best efforts” rather than “firm commitments”. They must comply with §5(b)(1).

Sales literature §2(a)(10): are not a prospectus no need to comply with §10.

5(b)(2) – must deliver a prospectus with or before the security. (So when you deliver the final security after sale then the issuer must deliver a 10(a) prospectus to the investor.

disclosures required by the 34’ Act, to issue routine factual business statements or press announcements, and to respond to regular inquiries – all while avoiding future-looking statements and valuation opinions.

Rule 163A: bright line test for when an issuer is “in registration” and hence “offers” are prohibited. Communications by issuers are permitted when made more than 30 days before the registration statement is filed, but cannot mention proposed offering. Safe harbor for issuers (but not underwriters/others).

Rule 163: FWPs available only to WKSIs during pre-filing period (but not underwriters, unless the issuer approves).

5(d): This section was created under the JOBS Act and applies to emerging growth companies (EGC) “test the waters” with QIBs only.

prospectus unless it complies with §10. The definition of “prospectus” is broad: includes any written document, radio, TV, etc.

Rule 168 + 169: safe harbor for written communication ≠ prospectus.

5(d): This section was created under the JOBS Act and applies to emerging growth companies (EGC). “test the waters” with QIBs only.

Release 33-5180: see there.

FWP: under the conditions:(1) Can’t conflict with RS but could be beyond prospectus.(2) Must be filed with SEC, on usage, some exceptions.(3) For IPOs and unseasoned, a FWP must be accompanied or preceded by PP. For IPOs, PP has to include a price range.(4) Legend (where to get a prospectus and how to read it).

* The SEC authorized by 10(b) has made rules 430 and 431 aka preliminary prospectus or “red herring”.

* Anything beyond 135 (and probably 134), must comply with FWP and Reg FD requirements (unless

company is non-reporting and it’s oral for reg. offerings).

How do we know that we’re before registration?The board of directors made a decision or the mere fact that a lawyer is approached about registration. Reaching an understanding with a managing underwriter is a good sign but could be too late.

If the company says they want to pronounce an ad, what would you consider to make determinations whether these ads make an offer or not?168/169

What if according to these you see that you don’t need these?- 33-5180: you can make routine factual statements.- 163A- 163- 5 (d)

Post-Effective Period

You can make sales in the post effective period.

Work out step:

1. First determine if you have a “security”.2. Then work out if you have an “offer”. The fact that they said there will be an IPO suffices.3. If there is an offer, see if there is an “exemption” from registration.4. If no exemption from registration then you have to register your security – so look at the fact that

you can’t have any offers prior to the filing and can’t have any sales until the effectiveness of the registration.

Hypothetical

B & S want to start a coffee company; they need money and are going to sell common stock, they are going to sell 100 million dollars shares in common case.

1) do we have a security? We have recognized that the common stock is a security.2) is there going to be an offer? B & S are going to sell => there will be an offering. 3) for now, assume that no exemption is available.=> they have to comply with section 5.

B & S call Morgan Stanley and call a law firm. Is there an issue? Negotiations… S decides to start an advertisement content: a picture with a lady, drinking coffee, says “best

coffee ever” - is this an offer ?- is this 30 days before (they have already talked to MS and lawyers, so they are already in registration)168 and 169 – regular public information here this safe harbor probably won’t apply.

5180 – look at this release and see if this applies and argue this is just a regular release.

Not satisfied with just advertising – and want to let suppliers know how we’re doing financially

and so send suppliers a quarterly report (which you send all the time).

Ask yourself now if there is a problem here Look at 168 (reporting company – so if you’re a start-up

you can’t use it) and 169 for all companies (communication ≠ offer). Look to see if it’s the same

form/style/type/TIMING of info that you have sent to your customers/suppliers in the past. Rule 169 has

another requirement: the info is only intended for NON-INVESTORS, so you can send to

customers/suppliers etc. BUT NOT shareholders, because shareholders = investors. Also rule 169 does

not allow FORWARD LOOKING STATEMENTS, such as expected results. So in the hypothetical

because he’s just sending out past historical info this is okay, but if the hypothetical said past and

predicted future results then THIS IS NOT ALLOWED.

What if you want to announce to shareholders/customers that you’re going to do an IPO? Can

you do this pre-filing (e.g. tweet to all shareholders about it).

Rule 135: there can be no info about the price, underwriter, etc. think about the requirements of the

rules with what the facts say.

If EGC, you can test the waters – §5(d) – you can make offers to institutional buyers/investors in the

facts he didn’t give us enough facts to determine whether we are an EGC but discuss this.

In every cup of coffee we are going to give the right to buy 10 shares at the IPO price. here no offers are permitted. Need to make an argument as to why this is an offer. Is this communication any offer? And here you’ll most likely conclude that this is an offer – and because you are in the pre-filing period offers are NOT allowed. In pre filing period you cannot do ANY SORT of offers – and it doesn’t matter if it’s oral or written offers.

Registration has now happened – and Barry makes comments at a conference and then it’s

published in NY times. Issues:

Work out if there’s an “offer: oral allowed. Then assuming it’s a written offer go through the steps – here argue media FWP – and here it’s permitted

– but the article has to be filed within 4 days.

If 10 days later you find out about this press release – is this a problem that you haven’t filed it

yet?

No, because you only need to file it within 4 days of becoming aware of the article (and remember to file

it with a legend!!).

Find out if there is a ‘reasonable’ element in the rules. If article in Wall Street Journal then you must file

it because this is a popular magazine and you should reasonably see this article. But if in a small town

Ohio magazine – probably reasonable to not see and so maybe okay to not file it. But if a national well-

respected media outlet you should reasonably see it become aware of it file it within 4 days. This is

really easy to cure because you just file it within 4 days with a legend.

Barry goes to a road show and explains to potential investors what the deal looks like - hands out

red herring prospectus (10(b) – includes everything but price) and hands out 10 hot tips about the

company.

Then look at the hot tips and ask yourself is this a written offer. If it’s an offer then ask yourself if it

complies with FWP and its conditions. Here, we are a non-seasoned issuer go through conditions. The

top 10 list CANNOT conflict with anything that’s in the prospectus need to separate the prospectus

from the coffee beans. So you need to discuss whether both comply with prospectus.

Mechanics of filing:

Used to all be done on paper. People will just bring in copies of the registration statement and then

SEC would make comments and send it to the company which in turn will then rewrite the registration statement.

Now, companies submit electronically registration statements to EDGAR. Once filed with SEC, SEC has attorneys and accountants that look at the registration statement

check whether it satisfies rules, accounting standards, etc. They will come up with a list of comments and the SEC will send written comments to the company and the company will revise the document to address comments from the staff and add in any new/additional material that is now available but wasn’t available at the time of first filing. So the company includes an amendment of the registration statement.

SEC staff then reviews everything again and look to see if the company resolved the comments, if they didn’t then SEC re-ask the comments and etc.

Once everything is ok, then company will talk to underwriters and work out if good time to price an offer and determine whether this is a good time to actually make offers.

For any media releases, coffee bags, etc. the info is sent to SEC (just the text is sent to SEC and not the coffee beans)

One of the final amendments to the registration statement is the price range (SEC has rules as to how much of a window the price can range from, e.g. $16-$20 per share)

Company is ready to go effective and the underwriters submit a letter and specify a date: (Thursday, 2 October at 4pm).

Then at the time, someone at the SEC will put in the document that this Registration Statement is going effective on Thursday 2 October at 4pm.

Once Registration Statement has gone effective then the company/issuer can make SALES!!!!

DEFINITION OF SEC FORM S-1:

The initial registration form for new securities required by the (SEC) for public companies. Any security

that meets the criteria must have an S-1 filing before shares can be listed on a national exchange.

Form S-1 requires companies to provide information on the planned use of capital proceeds, detail the

current business model and competition, and provide a brief prospectus of the planned security itself,

offering price methodology, and any dilution that will occur to other listed securities. The SEC also

requires the disclosure of any material business dealings between the company and its directors and

outside counsel.

Form S-1 is also known as the "Registration Statement Under the Securities Exchange Act of 1933".

SEC. 7. (a) INFORMATION REQUIRED IN REGISTRATION STATEMENT

(1) IN GENERAL — The registration statement, when relating to a security other than a security issued by a foreign government, or political subdivision thereof, shall contain the information, and be accompanied by the documents, specified in Schedule A, and when relating to a security issued by a foreign government, or political subdivision thereof, shall contain the information, and be accompanied by the documents, specified in Schedule B; except that the Commission may by rules or regulations provide that any such information or document need not be included in respect of any class of issuers or securities if it finds that the requirement of such information or document is inapplicable to such class and that disclosure fully adequate for the protection of investors is otherwise required to be included within the registration statement. If any accountant, engineer, or appraiser, or any person whose profession gives authority to a statement made by him, is named as having prepared or certified any part of the registration statement, or is named as having prepared or certified a report or valuation for use in connection with the registration statement, the written consent of such person shall be filed with the registration statement. If any such person is named as having prepared or certified a report or valuation (other than a public official document or statement) which is used in connection with the registration statement, but is not named as having prepared or certified such report or valuation for use in connection with the registration statement, the written consent of such person shall be filed with the registration statement un- less the Commission dispenses with such filing as impracticable or as involving undue hardship on the person filing the registration statement. Any such registration statement shall contain such other information, and be accompanied by such other documents, as the Commission may by rules or regulations require as being necessary or appropriate in the public interest or for the protection of investors.

(2) TREATMENT OF EMERGING GROWTH COMPANIES — An emerging growth company—(A) need not present more than 2 years of audited financial statements in order

for the registration statement of such emerging growth company with respect to an initial public offering of its common equity securities to be effective, and in any other registration statement to be filed with the Commission, an emerging growth company need not present selected financial data in accordance with section 229.301 of title 17, Code of Federal Regulations, for any period prior to the earliest audited period presented in connection with its initial public offering; and

(B) may not be required to comply with any new or revised financial accounting standard until such date that a company that is not an issuer (as defined under section 2(a) of the Sarbanes-Oxley Act of 2002 (15 U.S.C. 7201(a))) is required to comply with such new or revised accounting standard, if such standard applies to companies that are not issuers.

Lecture 6 - 10.8.2014

Sales literature: it’s a written offer that is not a prospectus. Allowed only post effectiveness.

Is a written document sent by the company to its shareholders a prospectus? All it talked about was the

transaction, it turned out that this was a company that had a problem with a transaction? we went through

the process through all the sections to see whether it falls within one of the exemptions.

Our system

We are in a disclosure-based system, where any company can sell securities as long as it complies with

the procedure. It is helpful to think about different types of disclosure we require.

1) Prescriptive approach: a government will tell companies what they have to disclose. It’s cheaper for the

government. Advantages: it’s homogenous among different companies, no need to guess what should be

disclosed. Disadvantages: (a) putting the entire burden on the government to discern all the topics to be

disclosed. (b) Moreover, great variety of companies doesn’t suit a one-size-fits-all system.

2) Principles-based approach: you just delineate what is supposed to be disclosed with no specific things

(only guidelines) and the company has to know what to disclose. Advantages: you avoid some risks

mentioned above, because each company will shape it to itself and match the unique circumstances.

Disadvantages: (a) company might not fully understand the requirements and have bad actors that can

exploit this leeway. (b) Moreover, there’s no uniformity, where each company is doing its thing.

What do we do as federal securities laws: we try to get the better of the two worlds. We gave a

prescriptive approach as a base and then added up some customized (principles-based approach) like

when it comes to materiality. For instance: in litigation, the company can exercise judgment for what’s

important and relevant to disclose.

Disclosures and Forms

Section 5 requires all transactions to be registered unless they’re exempt.

Section 7 of the 1933, establishes what disclosure has to be made. It specifies in schedule A what are the

stuff to be disclosed. What the commission has done by rule, it established specific forms to disclose

certain information. The primary form we’re going to talk about is form S-1, it’s also called the “long”

form or the “default” form. Any registrant can always use a form S-1 for all transactions. It’s a form that

you have to use when there is no other form available. Form S-1 has 17 specific disclosure items, like the

companies business, who runs it, financial information, historical performance, exhibits about the

company and contracts, being audited by an independent auditor. If we will, we will test you about form

S-1. Form S-3 has very specific requirements; it’s shorter and requires less because it incorporates info

from other forms. No need to repeat info found somewhere else. It’s limited to public reporting

companies. Another form is S-4 designed for very specific transactions like mergers. There’s an S-8

offering securities to employees under stock options. There’s a form for real estate companies.

Integrated Disclosure

Let’s get into these requirements, but before let’s talk about the integrated disclosure regulation S-K and

S-X. All items on S-1 will refer you to these to regulations. The history of it was that each form had its

own disclosure requirements and some forms had overlapping requirements. Integrated disclosure was a

way to come up with a consistent body for all disclosures. Reg S-K (all the business general info) and S-

X (all the financial). Those are menus for info and you’d just go to any of these forms and take what you

want.

Reg S-K

Reg S-K, there’s a lot of items in it and you don’t need to memorize it. First section is describing the

business, the properties, legal proceedings, securities, market price, dividends, and financial info, like

MD&A (a narrative that companies take financial analysis and translate them into words).

Materiality: for instance I’m a mid-sized company and I signed a contract to produce products that are

five times bigger than my average operations (this is material). What is the material info that is supposed

to be disclosed? It’s not a mechanical process to go down the S-K form.

Rule 408 complicates the requirement with respect to materiality. This rule says: “In addition to the

information expressly required to be included in a registration statement, there shall be added such further

material information, if any, as may be necessary to make the required statements, in the light of the

circumstances under which they are made, not misleading”. Does that mean that company has to include

all info related to the topic? No. It says you have to include all material info necessary to make the

required disclosure not misleading. When you go thru through the S-K items, you have to ask yourself

whether there is something else that if I don’t include will make my disclosure misleading! It’s always

based on facts and circumstances.

Examples:

1. We have a drug company that makes a nose spray and the company is soaring in sales. They wanna go

public. You put in form S-1 stuff about the product how good it is. The next day you get a letter from the

FDA saying that this nose spray has caused severe headaches and people losing their sense of smell. The

FDA did a study that confirmed these results and issue a “voluntary recall”. The company gets shocked,

because S-K doesn’t say anything about the FDA, they say ok we’ve been operating for 10 years and

that’s one or two complaints out of thousands of users. If this info will be put in the prospectus no one

will buy the stock. The S-K doesn’t ask to put stuff like the FDA’s letter. But 408 says: you know about

the FDA’s study. Is this material info? The SC said: it was material because materiality isn’t just

quantitative analysis, but it’s the nature the complaint will have impact on the market. Do the investors

wanna know this info upon buying their stock? The accountants like to say that it’s only 10% of

revenues/income/assets, but the SC says this is not the only factor to make it significant or material

enough or not.

2. Company files an S-1 and identifies its CEO as John Dow. It lists his name on the form. S-1 doesn’t

say that Mrs. Dow has just filed for divorce. Shall we disclose? Mrs. Dow comes to the door and says that

securities laws require disclosure about material events that might affect the company. Assuming they

live in a state with strong divorce stocks, no prenup agreements... Let’s check the risk factor: how

important is the CEO or his divorce will be on the company. That’s how 408 works, it’s on a case-by-case

basis.

Section 5(b)(2)

The problem is that we’re required to deliver the prospectus at the time or before the time we deliver

the shares for our buyers. That would make the investment decision precede the looking into the

prospectus, meaning that the prospectus is more like “retrospectus”. So under Rule 430, the SEC tries to

encourage companies to deliver the prospectus ahead of time (during the waiting period). Moreover,

Section 15c2-8 (1934), in section (b), it’s said that the issuer or a broker or a dealer will be delivering the

prospectus at least 48 hours prior to sending the confirmation of sale, this is only happening to non-

reporting companies, hence IPOs. If the companies are reporting then the companies aren’t required.

How do we deliver a prospectus: In 2005 the SEC adopted Rule 172 (access=delivery of a prospectus).

Section (b) says that you can satisfy a requirement to deliver a prospectus if you have an effective

registration statement with a final prospectus that satisfies 10(a). We’re talking about final prospectus.

Exempt offerings

Congress main objective was to provide full disclosure to investors, in 1933 the house of reps said that

there were certain types of securities where there is no need to make a disclosure.

Exemptions are from section 5, but the antifraud laws in the act will always apply to exempt offerings.

There are certain types of investors that are deemed not to need these laws, like sophisticated ones. Or

certain small amounts that don’t need the securities laws.

Section 3 (exempted securities)

It’s the nature of the securities themselves that actually provide the basis for the exemption. Hence,

exemption for these kinds of securities can carry on to all rounds of selling and reselling, because the

exemption is not for the specific transaction but rather for the security itself.

* Section 3 does have some exempt transactions in it.

Section 3(a)(2) deals with securities issued by state or federal gov’t. They’re not there to defraud the

investor, just to raise money. No need for all the registration process because it’s the gov’t itself.

Section 3(a)(3) selling commercial paper for 9 months or less for maturity. Like the repo market for

instance.

NPOs are another example - financial institutions for the community.

Lecture 7 – 10.15.2014

Exempt Transactions

Last class we went through exempt securities (which is different than exempt transaction). We identified

different classes that do not need to register, as the investors do not need the protection.

Today we’re going to focus on exempt transactions (not all of them).

Congress could’ve made it easy for us, but they did not put all exempt transactions under one section. All

these transactions relate to primary offers exemptions. In specifically section 3a(9) - we’re not going to

spend time on it. But I wanted to make you aware that all exemptions we talk about today are about

raising capital, although there are some transactions where there is no raising capital but exchanging

securities.

Section 3(a)(11): This is an exemption. The SEC promulgated rule 147 which is a safe harbor under 3(a)

(11). These rules provide clarity about when the exemption applies. Most issuers that are looking to use

the exemption rely on rule 147 because if you comply with this, the SEC tells that you comply with the

exemption, however, section 3(a)(12) is less certain.

Rule 147 is a very narrow exemption to cover situations in which an offering or sale happen within the

borders of a state. The SEC leaves it to the state to regulate the transaction. It has to be one particular

state. In addition, the issuer has to be incorporated in this state, 80% of his revenues and assets have to

come from within this state and 80% of the use of proceeds has to be in the state. It is a very limited

exemption. The limitation is that your general solicitation and advertising has to be limited within the

state itself, you cannot make any offer to anyone out of the state. In reality rule 147 wasn’t popular until

recently, the main issue was that within some states it was hard to find investors. But recently, there has

been a push at the state level to create the equivalent of crowd funding type offerings (which was created

by the JOBS act, yet not finalized yet at the SEC). This has created a buzz for peeps on the web to invest

in nascent start-ups. Since the SEC hasn’t finished the rules this has created tension on state level

legislators to imitate the same idea within the state. Many states are creating the same concept. They are

still subject to all limitations within the state, the problem is when you use the internet it’s hard to limit

the target community to the boundaries of the state. The SEC has provided some guidelines about the

topic.

Section 3(b): Provides an exemption for limited offers (dollar amount or the nature of the offer itself).

This is an exemption of Section 5. Situations that are not necessary to register, but the commission has

made a determination that it’s not important because of the amount of money involved or the limited

nature of the offer itself. While in section 3a(11), the congress crafted an exemption (and SEC clarified it

through a rule), in Section 3(b) the commission was enumerated by congress to get the power to create

exemptions. The SEC used this power to create Reg D (Rules 504 and 505).

In 1980 the congress allowed the SEC to create exemptions up to $5M, hence under Reg D the max is

$5M. Reg A is limited to $5M, so as rule 505. None of these exemptions could exceed $5M.

The two key rules are Reg A and Reg D (504 and 505).

Reg A: Rules number 251-263 (who can qualify, what is required, when is he able to use the exemption,

etc). This exemption is available for companies that are not reporting. In addition, the company has to be

Canadian or American only, and other limitations that we won’t cover. Total amount raised is $5M in

12 month period. This exemption is not widely used because many issuers consider its burden to

outweigh the benefit. Reg A is being referred to as the mini-IPO. A company using Reg A has to file an

offering document (very simple); the SEC will review it, give comments, etc. In addition, the company

will have to file an offering document in each state where the company is planning to conduct an offering.

No restrictions after vesting, no reporting obligations. Every state will give its comments. Because of

that, many issuers decided that Reg A is expensive and not worth it. A successful Reg A offering was a

company that’s offering interest in a property on H St. In Reg A, General solicitation is OK after filing

with the SEC and you can sell to any investor, they don’t have to be sophisticated, rich, etc. The

company sold interest and limited their offerings to persons buying form VA, MD, or DC, but they still

had to clear comments with the SEC and all 2 states. In reality, there have been only 11 offerings through

Reg A in the past 3 years.

Reg D: also is a result of the SEC power enumerated by congress. We’re talking about Rule 504 and 505.

Reg D is huge. Reg D is responsible for $600B of offerings.

Rule 501 defines the terms. The most important of which is “accredited investor”: certain purchasers who

don’t need the protection of the registration because they can fend for themselves. Individuals who make

more than annual $200,000 (or $300,000 with a spouse) for the last two years and will probably make the

same this year. Or those whose net worth exceeds $1M excluding the value of the primary residence.

Rule 504 and 505 the definitions under 501 apply to them.

Rule 504 is called the “seed capital” rule. For early start-ups to get their initial funding, General

solicitation is allowed only in limited circumstances, like accredited investors. No limit on the

number of purchasers. There are situations where you have non-accredited investors but you can’t

do general solicitation unless the state law department permits you to do so. Don’t need to file any

specific disclosure document. Limited to $1M and still has to comply by the requirements of state

law.

Rule 505: up to $5M. You cannot advertise the fact that you’re doing an offering - no General

Solicitation. Finding investors from previous relationships from the past. No ads on websites or

newspapers. Unlimited number of accredited, if not accredited then can be up to 35 non-accredited

investors. And the issuer has to provide some info to the non-accredited about the company and financial

statements. Most companies shy away from non-accredited investors. You still have to comply with all

state level laws, in every state. So (1) dealing with states and (2) the limitation on the offering amount -

have resulted in that the only people who use it don’t know the securities laws well. Other sections are

better.

While Reg D includes 504 505 506, the authority for the SEC to come up with these varies. 504 and 505

were under the powers given by 3(b), but 506 comes from somewhere else - section 4(a)(2).

Rule 506 (Section 4(a)2): In Ralston Purina in 1953 the Supreme Court formulates a standard for who

doesn’t need the protection of the SEC (by registration) those who can fend for themselves or have

access to info. The standard is very fact-intensive. Section 4(a)(2) deals with transactions not involving a

public offering, it is the second most important exemption (following 4(a)(1)). It is like section 3a(11),

there is an exemption in the statute itself, not created by the SEC, for transactions by an issuer not

involving any public offering. Public offering is not defined, this is one uncertainty. There are no

expressions. It’s always facts and circumstances analysis. This is risky. No objective conditions, but all

decided by the courts. Safe Harbor for Section 4(a)(2) is Rule 506(b) (it became b after coming up with

rule 506c). Rule 506 covers 96% of the cases. It’s popular because comparatively to the other exemptions

it has (1) no limit on the amount of money raised, (2) no limitations who the issuers can be (reporting or

not). Conditions: (1) No general solicitation and advertising. (2) Up to 35 non-accredited investors,

but they have to be sophisticated (having a purchaser rep that is sophisticated) and provide disclosure to

the investors.

One big difference between 506 and the rest: while in all others you have to go to the specific state, in

506 the state is preempted and cannot review or comment on transactions. Meaning the state is not able to

put requirements. This is a huge difference and that’s why people love 506. It’s noteworthy: the states can

still pursue fraud provisions.

When the JOBS act came in when banks suffered tremendous losses and small businesses claimed that

there’s no way to get capital, the congress wanted to facilitate the process. Start-ups argue that with the

absence of General Solicitation, only the hedge funds and other similar industries were able to raise

capital. Especially those located in the accredited investors’ hub like Boston, NY, and the Silicon Valley.

The JOBS act came up with 3 major changes. They’re big because they have reshaped the way we look at

exemptions themselves.

Title 2: (506(c)) mandated that the SEC lift the ban on General Solicitation that existed under 506(b).

This is done by creating a new exemption under 506(c) where the authority comes directly from the JOBS

act and not from 4(a)(2).

Rule 506(c) allows these companies to make offers to anyone so long as sales are made only to

accredited investors and the issuer takes reasonable steps to verify this. There’s no limit on the amount

raised and General Solicitation is ok. And the states are preempted. The biggest difference between 506

(b) and (c) is that (b) could always go back to 4a(2) while (c) can’t, and the thing about GS. Only 10% of

the amount raised were under (c) while the rest under (b).

Title 3: Section 4(a)(6)/crowdfunding:

Kickstarter and Indigogo are reward-based crowdfunding, they’re getting something out of it and they’re

customers more than investors. This is not securities. None of the exemptions existed fitted with the

concept of crowdfunding.

The company will be able to raise up to $1M, regardless to the type of investor, the rules require certain

disclosure to be filed with the SEC, the transactions take place thru an intermediary registered with the

SEC. Think about a website which all parties use as intermediary to communicate between start-ups and

investors (both unsophisticated). This intermediary is the gatekeeper; make sure issuers comply with their

exemptions, etc. It’s still not available.

Title 4: (Section 3b) amended section (b) and hence Reg A+. Amended the amount raised up to $50M.

(a) The SEC has to consider additional disclosure requirements, (b) requirement to provide audited

financial statements, and (c) also allow the SEC define certain purchasers that don’t have to be under state

level.

Exemptio

n Nature of Issuer

Size of

offering

Purchaser

requirements

Informationa

l

requirement

s Manner of offering

Filing

requiremen

t

Resale

status of

securities

3(a)(11)

Principle Office in

State

-80% of gross

revenues, assets, use

of proceeds in state

No limit In state None

Offers in state.

General solicitation

and advertising OK.

None

9 month

safe

harbor

Section

4(a)(2)

No limitation No

specific

limits, but

courts

might

consider

the size of

the

offering

and the

number of

units

Must be

sophisticated

enough to be

able to “fend for

themselves”;

number not

determinative,

but courts might

consider it

Offerees

must “have

access to the

kind of

information

which

registration

would

disclose”

No general

solicitation or

advertising

None Restricted

securities

offered

Rule 504

Not available to

Exchange Act

reporting companies,

investment

companies, or “blank

check” companies

Up to $1

million in

any 12-

month

period

None None

No general

solicitation or

advertising unless (1)

registered in a state

requiring filing and

delivery of a

substantive

disclosure document;

or (2) sold only to

accredited investors

pursuant to state

exemption that

permits general

solicitation

Form D

required

but not a

condition to

the

exemption

Restricted

securities

unless

issued in a

manner

under

which

general

solicitatio

n is

permitted

Rule 505

Not available to

investment companies

or to certain

companies described

in Rule 262

Up to $5

million in

any 12-

month

period

Any number of

accredited

investors + up to

35 non-

accredited

investors

Rule 502(b)

information

must be

provided to

non-

accredited

investors

No general

solicitation or

advertising

Form D

required

but not a

condition to

the

exemption

Restricted

securities

Rule

506(b)No limitation No limit

Any number of

accredited

investors + up to

35 non-

accredited

investors - but

non-accredited

investors must

be sophisticated

or use a

purchaser

representative

who is

sophisticated

Rule 502(b)

information

must be

provided to

non-

accredited

investors

No general

solicitation or

advertising

Form D

required

but not a

condition to

the

exemption

Restricted

securities

Rule

506(c)No limitation No limit

Any number of

accredited

investors. Issuer

must verify that

the investors

are accredited.

NoneGeneral solicitation

and advertising OK

Form D

required

but not a

condition to

the

exemption

Restricted

securities

Reg. A Non-reporting Up to $5 Offering Offering No offers until File offering Not

Companies organized

in the U.S. or Canada.

Not available to

Exchange Act

reporting companies,

investment

companies, “blank

check” companies or

issuers of oil, gas or

mineral rights

million in

any 12-

month

period,

including

no more

than $1.5

million

offered by

all selling

security

holders

document

in each state

statement

must be filed

with SEC –

analogous to

a

registration

statement

but less

rigorous (e.g.

financials

not required

to be

audited)

offering statement

filed, and no sales

until the offering

statement qualified

and an offering

circular is delivered.

“Test the waters”

exception in Rule

254. Subject to

conditions, an issuer

may obtain

indications of interest

prior to filing an

offering statement.

statement

and “test

the waters”

materials

restricted

securities

Source Issuer State Laws Amount GS Investors3(a)(110/147Safe Harbor

3(a)(11) Everything incorp. inside

the state

Only within state

In state

Reg A non-reporting +

US/Canadian

$5M in 12 months

OK everyone

504 3(b) non-reporting yes $1M if sale are made to

accredited

everyone

505 3(b) everyone yes $5M no Up to 35 non-accredited,

unlimited accredited506(b)/4(a)

(2)Safe Harbor

4(a)(2) everyone no unlimited no Up to 35 sophisticated non-

accredited, unlimited accredited

506(c) JOBS Act everyone no unlimited OK Only accreditedReg A+

Is it in effect?JOBS Act non-reporting

+ US/Canadian

Mostly $50M Ok? Everyone?

Lecture 8 – 10.22.2014

If I own shares of IBM and I wanna sell them to someone. Do I need to comply with the SEC laws upon

selling these shares to another person? I will have to find an exemption, if not I’ll have to register.

4(a)(1): This is a very important exemption because if I, average Joe, will have to register my securities, I

will have to go through all the process that the issuer goes through. It will be terribly expensive, lawyers,

underwriters, etc. The markets won’t work! That’s why section 4(a)(1) is that important.

It’s pretty straight forward; it provides an exemption for the registration requirement for any transaction

not involving an issuer, underwriter, or a dealer. But in reality it gets complicated. The problem with the

definition is to discern when does the sale by an issuer finish and the sale becomes to be “by an

individual”.

Example: you have a company owned by friend. He’s willing to offer $100,000,000 shares of stock. But

since it’s expensive, many companies use the exemption to sell to accredited investors. So I’m gonna use

506(b) to sell shares up to 35 non-accredited investors and unlimited accredited investors who will in turn

sell these shares in the market. Bypassing! So Section 4(a)(1) excluding transactions by an issuer,

underwriter, or a dealer. And the definition of these guys here is important. Question: is the individual

selling the sales an underwriter? Which is defined in section 2(a)(11), broadly to cover any person who

has purchased from the issuer with a view to offer or sale to any individual, or participates in the indirect

or direct underwriting. This accredited investor will be deemed to be an underwriter with the intent to

sell these shares. Many situations will be harder, the person maybe be buying and selling but not

distributing. Example: what if my friend comes to me and says that he needs to sell some shares, I’m an

accredited investor. 6 months later I get into financial trouble and I need to sell these shares, in that case,

am I an underwriter or can I use section 4(a)(1)? Proving intention is very hard. What if I get into

financial trouble 5 days after?

The commission came up with a safe harbor. If you meet the criteria you’ll be OK; Rule 144.

Rule 144

This is complicated. (1) If there’s a restrictive legend or (2) the securities are held by a “control person”

(defined in Rule 405) like a CEO for instance, or the chairman of the board, or a controlling shareholder

as well. How does it work?

Rule 144 sets 5 conditions if met the seller is not an underwriter. If you’re an underwriter you can’t meet

it of course. (1) The rule in general contains a holding period (6 months for reporting or 12 for non-

reporting). (2) The issuer met his disclosure requirements regarding the historical performance. (3) With

respect to certain types of persons (affiliates), in certain instances, the rule limits the number of shares a

person will be able to sell over time (up to 1% shares outstanding). (4) All the normal trading conditions

have been met. (5) If more than 500 shares or more than $10,000 – a form must be filed with the SEC.

Question 1: I wanna sell shares, to do that I email my brothers and cousins who live in DC so as me and

my company, and my dad who lives in Seattle. I don’t give them any info, everyone buys except my dad

and none is an accredited investor.

Even in the exam we don’t need to elaborate too much about the “offer of a security” because it’s

obvious. Usually we’re supposed to start from here.

Section 3(a)(11) and rule 147 don’t work because all offerees have to be in the same state. If there’s not

enough info, we have to check all possibilities.

Reg A doesn’t limit the number or types of offerees or the number of states involved, but limits the

amount (up to $5M), however, General Solicitation is OK (after filing that document with the SEC).

Rule 505 and 506: 505 has a limit and no GS allowed, 506b has no limit and also GS isn’t allowed. 506c

won’t work, it allows offering to anyone (GS is OK) but they have to be accredited and you have to verify

he is accredited.

Section 4(a)(2) the last option: make an argument that applies. Limited number of people who got

offered, we are all related, they know me beforehand but we need to know more about them and the level

of sophistication, i.e. to argue under Ralston Purina that they can fend for themselves.

Question 2: You’re a lawyer, your client has a corporation and want to know what is the easiest way to

solicit, using email and the website, investments of up to $1M of stock?

Start: am I offering or selling a security?

Tips: usage of internet implies general solicitation:

1. Section 3(a)(11)? No, because internet has no particular state.

2. Reg A: $1M is below the $5M threshold and GS is allowed.

3. Rule 504: you have to be in a state that requires the disclosure of a document through which you can do

that solicitation. Not sure if this is the easiest.

4. 506b: unlimited accredited investors, unlimited amount, but no general solicitation.

5. 506c: General Solicitation but only accredited investors.

In the end, we check section 4(a)(2). But doesn’t allow general solicitation.

Liability

We spoke about the disclosure system, because of which someone could violate the securities laws.

We don’t want the penalties to be so harsh to paralyze the capital markets.

He’s going to give us a 1 page that includes many important facts. And then we’re going to analyze 4

provisions:

Section 11 12a2 10b 12(a)(1)

Liability

Trigger

If any part of RS,

when became

effective,

contained

untrue

statement of

material fact or

omitted material

fact required to

be stated in the

RS or necessary

to make RS not

misleading.

Any person who

[publicly—SC] offers or

sells a security

[primary] … by means

of a prospectus or oral

communication, which

includes an untrue

statement of a

material fact or

material omission…

*Measure at time of

investment decision

P must prove D: 1) made a

false statement or omission

of material fact, 2) with

scienter (includes

recklessness), 3) in

connection w/ purchase or

sale of a security, 4) upon

which P justifiably relied and

5) which proximately caused

6) Ps economic loss.

Any person that

offers a security in

violation of Section

5 is liable to the

person who

purchases the

security.

--prove

scienter

No (not

negligence

required either)

No Yes No

--silence Yes No—but once say

anything can’t omit

No—unless DUTY to speak Yes

Plaintiff -Any person

acquiring

securities

covered by a

registration

statement may

sue.

-NOT SEC or DOJ

Purchaser from D. Purchaser (or seller). SC

upholds private right of

action.

- YES SEC or DOJ

Purchaser of

security

offered/sold TO

SUCH PERSON in

violation of Section

5

--Reliance No No-but some courts

hold that “by means

of” language requires

at least a weak causal

link (not reliance)

between prospectus

Yes

-rebuttable presumption

that material omission relied

upon.

-“Fraud on the market

theory”: show that 1) D

No

and losses made material public

misrepresentations, 2)

securities traded on efficient

market (exchange, market

cap, analyst coverage), 3) P

bought shares between time

misreps made and time

truth revealed.

-Presumption can be

rebutted: market didn’t

react to info or P didn’t

consider price when bought.

--privity No (but only

relevant in IPO;

can’t trace)

Yes, transferee of title

or successfully and

actively solicit the sale

(see below)

No See 12(a)(2).

Defendants every person

who signed the

registration

statement (i.e.

issuer, CEO, CFO

and principal

accounting

officer),

directors (all),

consenting

experts (but only

for expertized

portion), every

underwriter [not

covering

“controlling

persons”].

Sellers: Pinter v. Dahl:

Person transferring

title to securities or

any person actively

soliciting purchases for

own financial interest

or that of the seller.

Direct communication

required, though

courts have concluded

that prospectuses and

RS are sales docs and

hold signatories liable

as sellers. Also see

Rule 159A making

issuers statutory seller

for 12(a)(2) in initial

distribution.

No privity—so any person

making statement that

satisfies “in connection

with…” requirement.

Company statements

covered if foreseeable will

impact trading. No aiding

and abetting.

See 12(a)(2)—but

159A does not

apply to 12(a)(1).

Defenses Yes, see below Yes No SOL

and noisy

withdrawal:

cease

involvement in

RS and notify the

SEC

Section 11 12a2 10b 12(a)(1)

--P

knowledge

Yes (no standing

to sue)

Yes Implicit in reliance NA

--SOL Yes. Claim must

be made the

lesser of 1 year

after

misstatement

discovered or

should have

been discovered

and 3 years after

security bona

fide offered.

Same as Section 11. 2 years after discovery, 5

years after violation.

Yes—1 year

--Diligence Yes, except

company. No

reason to

believe and did

not believe

misstatement.

Yes (including

company)

NA NA

----

reasonable

investigatio

n required

-Non-experts:

Yes, except for

expertized

portions (but

beware red

flags). “After

reasonable

investigation

had reason to

Yes—standard close to

that of Section 11;

though SEC position is

standard is lower.

NA

believe…”

-experts: Yes for

expertized

portion

-standard:

prudent man in

own affairs

Damages Difference

between

amount paid

(not to exceed

public offering

price) and value

of securities at

time of suit or

price plaintiff

sold at before

bringing suit.

Recission or

rescissionary

damages.” Thus not

limited to “offering”

price” like for Section

11.

Courts differ but generally

out of pocket: difference

between value paid and

value worth assuming

violation was known.

One year recission

right. If don’t own

get damages for

difference between

what you paid and

got on sale.

--joint and

several

Yes, but 1) no

underwriter

(except

managing) may

be liable for

more than

amount

underwritten; 2)

outside directors

only have

proportional

liability (for

percentage of

responsibility)

unless

determined to

have knowingly

NA Generally joint and several.

But PLSRA provides for

proportional liability (among

all persons, not just

defendants) in case of

reckless behavior.

NA

committed

violation.

--loss

causation

Yes—D must

prove

Yes—D must prove Yes—P must prove

proximate cause of loss

NA !!!!! This

distinguishes

damages from

recission.

1933 Act protects only the purchasers. 1934 protects both the purchaser and the seller. In particular

section 10b (antifraud) are virtually cited in all cases of liability – the most important.

We’re talking about private liability: Section 10b and rule 10b-5 of 1934, sections: 11, 12a(1), and 12(a)2

of 1933.

Section 10b and rule 10b-5 allow both the SEC and a private party to take action. Sec 10b prohibited

manipulative and deceptive devices. Sec 10b requires the SEC to prescribe rules pursuant to it. It is a

general antifraud rule. 10b-5: The use of means of interstate commerce that employ any device or scheme

to defraud, make material misstatements or omission, or engage in any course of business that is fraud.

In order to prevail under these a plaintiff has to prove that the defendant has (1) made a false statement or

omission of a material fact, (2) had scienter/knowledge, (3) in connection of the purchase of the sale of a

security, and (4) the plaintiff has to rely and that reliance has to be enough to (5) be the proximate cause

of (6) the plaintiffs economic loss.

The 3 triggers/misconduct to 10b-5:

1. The plain vanilla fraud: face to face transactions like lying. Between sellers, purchasers, or a broker-

dealer lying to accomplish the sale.

2. False or misleading facts: most corporations sued under this had to do with false or misleading.

3. Insider trading:

Section 11 and section 12(a)(2):

Basic private liabilities under the securities laws. It’s good to compare them to each other. Both under

1933, so they don’t protect a seller – only buyers. The biggest difference between them is: (1) with

respect to damages: Section 11 allows the plaintiff to look who’s responsible and seek damages. All

purchasers are eligible to seek damages. Section 12(a)(2) allows the purchaser to rescind/undo the

transaction (broader than 11) if the seller has used false prospectus or misleading info. Section 11 allows

purchasers to bring an action. It deals in essence with the wholesellers (issuers, underwriters and experts)

while section 12 deals with the retailers, those who have privity with the seller, and allows rescission as a

remedy.

Lecture 9 - 10.29.2014

To reiterate the key points of section 4(1)

It’s the most popular exemption and used on a daily basis. It covers transactions that don’t involve an

issuer, underwriter, or a dealer. The problem is with the definition of an underwriter, hence 144 - a safe

harbor for the definition of an underwriter. On a daily basis, millions and millions of sales through

brokers don’t fall within the definition of underwriter.

Back to liability

Last class we talked about section 10b of the Exchange act that includes a general antifraud rule so they

came up with 10b-5 (the most powerful antifraud rule). In order to have a claim for rule 10b-5 the

plaintiff has to prove that (1) the defendant made a misstatement/misconduct, (2) scienter, (3) connection,

(4) reliance, (5) causation, (6) economic loss.

Section 11 vs. 12a(1)

Comparison between section 11 and section 12a(1). These are basic private liability provisions, very

similar, but some core distinctions exist. They protect only the buyers not the sellers.

Difference:

1. Privity: in section 11, no need to show privity - all purchasers regardless from whom they bought will

be able to bring suits. While section 12a(1) requires privity; there has to be a connection between the

purchaser and the seller.

2. Remedies: section 11 – damages. Section 12a(1) – rescission.

* Directors who sign the registration statement are potential defendants on section 11, if you sign a

registration statement you are on the hook. A director withdraws so as not to take liability. Section 11(b):

a director resigning before signing a statement has to advise the commission on the reason why he’s

resigning. It will also take him off the hook from earlier versions of the statement if he informs the SEC

before the later version.

* These sections are not mutually exclusive.??

Section 11 vs. 12a(2)

1. Coverage: Section 11 applies only to registration statements. While section 12a(2) covers any public

offer including written or oral disclosures (doesn’t have to be material mistake in the reg. statement, it’s

much broader).

2. Scope: Section 12a(2) is broader in scope to whom you can sue. If you’re a dealer you’re not a

defendant under 11 but potentially under 12a(2). People actively soliciting purchasers are also subject to

12a(2).

3. Privity: 12a(2) requires privity, while section 11 doesn’t.

4. Strict liability: for the issuer in section 11 and due diligence for others. In 12a(2) every defendant gets

a due diligence defense.

5. Timing: section 11 – measured at the time of effectiveness. Section 12a(2) – measured at the time of

investment decision. For instance: an oral conversation is off the hook in section 11, while under 12a(2) it

isn’t. 12a(2) covers communication with solicitors.

* the SEC doesn’t do criminal, but can help the DoJ to get someone into jail.

Due diligence defense

Who is it available to: defendant (section 11 excludes issuers here) that didn’t know that the disclosure

was false and basically wasn’t negligent in connection of making the statement.

1. Burden: must be proven by the defendant.

2. Knowledge: the defendant can’t know of the misstatement or the omission. It depends whether you’re

an expert or not and whether the decision is expertised or not.

Example: Audited financial statements and consent from auditors to use the opinion in the reg. statement

(experts + expertised).

- If you’re an expert , you have to demonstrate a reasonable investigation on expertise stuff. An auditor

will have to demonstrate this and based on this he believes that the expertise section was accurate. If it

was a non-expertised section, the experts will not be a section 11 defendant in that case, in other words

the expert is not responsible.

- If you’re not an expert : if it’s expertise, they have to show that they had no reason to believe that the

omission was material. If it’s non-expertised, you’re going have to show a reasonable investigation.

Due Diligence Expertised Non-expertisedExpert reasonable investigation not responsible

Not Expert reasonable ground for immateriality reasonable investigation* In section 11 an issuer doesn’t have a due diligence defense.

Rule 176: specifies what should be taken into account for the due diligence: (type of issuer, security,

person, etc.)

Escott vs. BarChris Const. Corp

This case lays out all the potential defendants.

The auditor: he had to show reasonable investigation. He’d be sued only for the section that is expertised.

In this case, the auditor was a bit sympathetic, he didn’t understand one of the transactions and he didn’t

do any investigation to check if there was anything misleading. Even if an expert is not responsible for the

non-expertised section, the court said you can’t put blinders on and just disregard everything else. As long

as this stuff is affecting your expertise stuff then you will become liable for the expertised section. He

should’ve done a reasonable investigation.

The CEO: had knowledge, hence the defense is not available to him.

The CFO: the court said that he had financial knowledge (CPA), he had connection with the company, he

was aware of the fact that there were misstated facts, and was involved in the registration statement. The

court: you signed the reg. statement and had the affirmative obligation to check it and cannot say that you

relied on experts; you should’ve asked better questions.

The young in-house lawyer: seems very inexperienced, but became the in-house attorney. The court:

liable not just because he was a lawyer, but he happened to be a director. Maybe he’s not an expert, but he

should’ve made a reasonable investigation. Hence, due diligence defense isn’t successful for him.

Outside director: he did investigation but not regarding the reg. statement, he didn’t even read it, he just

signed it. The court stated that he’s a gatekeeper but didn’t do his job.

Outside counsel: his role in drafting the reg. statement made him expectedly responsible but he didn’t live

up to this. He wasn’t expected to check every fact in it, but to do at least a reasonable investigation and

look at some of it (non-expert and non-expertised).

Underwriter: he hired a law firm to do the work for him, but he’d still be on the hook.

Sub underwriter: it’s ok to rely on the due diligence of the main underwriter but you’d still be on the

hook.

WorldCom

One of the biggest frauds in American history. CEO and senior managers were all involved in the fraud.

They’ve done all these fake entries off-balance sheets and the company went bankrupt. But the

underwriters are the deep pocket so they got sued. Why sue the CEO and the directors when they have

liability insurance? Because the insurance company will have to pay for their liability. The underwriter

hired Cravath (big law firm) to do the due diligence and received a comfort letter. It’s a standard letter

issued by an auditor and makes you feel good about yourself. The court: the auditor is an expert but the

underwriters aren’t experts. The underwriters argued that the unaudited financial statements should be

treated as expertise because it contains a comfort letter. The court: unaudited financial statements are

unexpertised. So non-experts at non-expertised section have to show reasonable investigation. The court

said a comfort letter is not necessarily a reasonable investigation, It was an important evidence but

insufficient by itself to establish a due diligence defense. In this case the comfort letter was not enough

because of many red flags. The auditors issued the comfort letter but dropped words in it that should’ve

been a red flag for the underwriters. A change in this magnitude should’ve raised a red flag.

Insider trading

The basis of this is found in 10b-5. Three basic facts:

1. The insider trades for himself.

2. An insider tells somebody about material nonpublic info, who goes and trades on it.

3. The employee of a financial company helps the acquirer to buy or sell. The duty is between the

employee and the firm, but the person trades with the securities of another firm.

Section 16: as a plaintiff you don’t have to demonstrate that he had material non-public information.

Lecture 10 – 11.5.2014

I would think that many investors if told that they can buy these shares but can’t pass it along will act

differently. So the importance of providing disclosure protection not only benefits the investors but

benefits the whole capital raising process.

Becoming subject to 1934 Act

So how does a company become subject to the 1934 Act? The 1933 is enough to have a security offered

for sale. Keep in mind that the purpose of the 1934 is to provide disclosure for shares that are widely

traded in the market.

1. 12(b): requires any issuer which has a class of securities (equity or debt) traded on a national stock

exchange to register with the SEC. The timing (section 12a) says that you have to register under 12(b)

before you trade.

2. 12(g): (only to equity) focuses on the nature of the class of security. If the company exceeds the

threshold asset limits it has to register under 12(g). Companies can also voluntarily register under 12(g).

Thresholds: any issuer with $10M in assets and a class of shares with either (1) 2000+ shareholders, or

(2) 500+ non-accredited investors - has to register, excluding those under compensation plan or through

crowdfunding.

3. 15(d): It imposes certain reporting requirements for a company that registers under 1933 Act and sells

shares publicly (after an IPO it goes automatically for one year and after that it will hold if they have

above than 300 shareholders, meaning that if a year passed and the number dwindles to 299 they won’t be

under 15d), if 12(b) and 12(g) don’t apply. The reporting obligation is less than 12(b) and 12(g).

What are the mechanics of this:

Once you have to file a registration statement

In section 13(a) (the source of the disclosure requirements): every company must file..

Registration process:

When any of the abovementioned triggers meet, the company has to file a 1934 registration statement.

Except for 15(d), you don’t need to file the following forms but rather your reporting requirements kicks

in automatically.

There are two forms for domestic issuers: (1) Form 10 (the long form), and (2) Form 8A (the short form).

Form 10 is used more often, because the short is restricted sometimes for usage. Complete disclosure

about the securities, financial statements, and etc.

Form 8A is easier for companies to use. Usage: (1) Either when it’s already a reporting company. You hit

12(g) threshold (file Form 10) and at some point start issuing another class that reaches the threshold, so

you can use the 8A to copy all info from 10. OR (2) when you file the 1933 S-1 IPO file with all info and

then just file 8A in reliance on S-1.

Start-ups: they start slowly selling shares to the 3Fs and then they become subject to 12(g) and file Form

10.

Disclosure requirement

10K is filed annually and 10Q quarterly. 10K is the cornerstone of the reporting requirement.

* The larger the company is the faster they have to report their 10K and 10Q.

Form 8-K used to notify investors of any material event that is important to shareholders or the SEC. It

used to be 15 days and it’s a lot of time to file the info, but then it went to 4 business days (with all these

triggers events) and the definition of materiality. We don’t need to memorize the 8K requirements but we

should read through them because the test might touch on them. Sections:

1. Business operations:

1.1 Entry into a Material Definitive Agreement (financially material to the registrant not the other party).

1.2 Termination of a material Definitive Agreement.

1.3 Bankruptcy or Receivership.

1.4 Mine Safety – Reporting of Shutdowns and Patterns of Violations.

2. Financial info

2.1 Completion of Acquisition or Disposition of Asset.

2.2 Results of Operations and Financial Condition.

2.3 Direct Financial Obligation or Off-balance sheet stuff.

2.4 Material Impairment.

3. Securities and Trading Markets

4. Changing your accountant

4.2

Rule 12b-20 is rule 408 of the 1934 Act. It says that you have to provide any other material info to make

those [required] statements not misleading.

Regulation FD

This deals with selective disclosure. Reg FD is not insider trading. A key requirement of an insider

trading is a breach of a duty. Not giving info to the public is not breaching a duty.

Being an investor without the same chance as an insider is just not cool. If I know that my Financial

Statements are gonna be amazing in the next 10Q, do I have to disclose it? No, you only have to disclose

quarterly and annually (past) or when something very material happens then use 8K. For example:

projections (forward looking) are not required to be disclosed.

If investors think that the game is not fair no one will participate in that market.

Reg FD

If an issuer or a person acting on his behalf discloses material non-public info to certain enumerated

persons then he has to make public disclosure of that info either simultaneously (if it was intentional) or

promptly (if it was non-intentional).

Acting on his behalf: senior management or the “mouth” of a company. It doesn’t cover anyone giving

this info.

Material non-public info:

Enumerated persons: analysts, advising companies, investment companies, mutual funds, hedge funds,

etc.

Public disclosure: Rule 101 defines the public disclosure by Form 8K or any method or a combination of

methods that are designed to disclose blablabla.

Promptly: within 24 hours or before the commencement of next day’s trading on NYSE.

* It’s when those whose their job is to disclose but don’t disclose correctly. You have to give to

either nobody or everybody.

Putting on the website, is that enough disclosure? SEC came up with a release saying that it depends, is

the company website a recognized channel of distribution, how long was the thing posted, etc. The other

side of the coin: Is putting on the website curing the broad dissemination obligation.

Netflix case

CEO of Netflix posts material non-public info on his public FB page and didn’t file 8K. Hastings (the

CEO) said that we don’t use social media as a means to disseminate info. SEC: Netflix had an FD

problem, you have to get it out to the world at large, especially when you make it clear that you don’t use

this as a means to communicate with the world.

Tesla

Musk the CEO tweeted about sales rising and reaching a record high worldwide and in fact the shares

climbed after WSJ said that prices will decline.

What we have to do is to ask him whether he made people know that Twitter is one of the channels to

announce material info.

Lecture 11 – 11.12.2014

Insider Trading

It’s quite a norm for the SEC to bring Insider Trading cases.

Insider Trading, while based on the antifraud rule (particularly 10b-5), is not that clear and was developed

based on the SEC’s and courts work. Some courts believe that it’s their role to do it, while the SEC

believes that they have the parameters to develop it because it’s based on 10b-5. The book describes the 3

different doctrines very well. It’s hard to prove Insider Trading because it’s based on non-public info and

trading on that while breaching some duty. The technology has been helping the SEC immensely

identifying Insider Trading, specially the stock exchanges because they can track the changes in stock

price and trading volume at and before specific dates. Even if someone is trading from an account that is

new or uncommon in the market. It raises a lot of red flags. The irony is while all this is available, many

Insider Traders are sophisticated. In 2013, there was a senior employee at NASDAQ who got access to

info and used it.

The doctrines

1. The classic: an insider that trades the securities of the company while in possession of material non public

info (because of their corporate position – directors, officers, employees, controlling shareholders). The

court developed 3 conditions to meet:

a. person who buys or sells securities.

b. to a person to whom he owes a duty of trust or confidence (the insider owes duty to the current

and prospective investor)

c. without disclosing to that person about the material nonpublic info.

2. Tipper-tippee: An individual who obtains material nonpublic info from the insider and uses it to trade.

This individual owes an abstain-or-disclose duty that has originated from the insider’s duty to the

shareholders.

Supreme Court: breach of duty: the insider has to receive some kind of personal benefit, including any

benefit like a friendship.

3. Misappropriation theory: developed by the court (unclassic) because there isn’t a duty between the insider

to the shareholders or a duty that is transferred to the trader. But there’s a person who misappropriates

info from someone/some company to who he owes a certain duty and would use this info to trade on

stocks of another company, hence the person owns duty to the source of info.

The court:

a. material non public information.

b. that info is entrusted to a person/company who owes a duty of trust.

c. that person buys or sells a security.

d. without first disclosing the intention to trade to the source.

In the classic doctrine, the duty is owed by the insider to the shareholders; here it’s a duty of trust that

comes out of the source’s duty to the shareholders.

Example: September 16, 2014: SEC charges a senior IT at a law firm with insider trading. This person at

the law firm owes no duty whatsoever to the shareholder of the client company. But the law firm was

hired by the company and this person breached the law firm’s duty.

16(a) (Exchange Act): Requirements for insiders of the company or those holding more than 10%

shareholders to file a form with the SEC in which they report every buy/sale, how many, and what price.

16(b): sets forward a provision that provides a case of action that will get the executive director or owner

of more than 10% to return any profit they made in purchase within 6 months period. Some people say

that this is overbroad, because if you’re an executive of a company and execute a few transactions within

6 months period where you lose and win money – any purchase/sell combination of these transactions

could be captured by this section. Meaning, that other transactions that were “clean” could be captured. I

bought 200 and sold at 50 then bought at 300 and sold at 250.

* In light of this, insiders enter stock tracking plan and hire brokers to keep records and check if there’s a

situation like this where we have two transactions within 6 months.

Government’s role in the securities laws

Rule-making:

Section 8(a) of 33’ Act: deals with effectiveness of reg. statements. The Reg. Stat. automatically becomes

effective in 20 days. But 20 days is not enough.

Rule 473: Registrants can file a delay amendment 20 days period won’t apply until the commission

accelerates the effectiveness and declares it effective. Also allows companies can change their mind and

start the clock again. The purpose is to give the SEC and underwriters time to do their job.

8(b) a refusal order: the commission can issue an order refusing effectiveness. The commission has to

make a hearing within 10 days. Very rare.

8(d) a stop order: Very rare.

8(e) investigation order: the commission can get an order of investigation.

Enforcement actions: they get hundreds of tips, info from the exchange, monitor the news, filing

companies, notice problematic stuff, and start working on it, and then they get a formal order of

investigation. Then type of action, injunction, taking profits.

Criminal actions: SEC’s authority is civil but they’d help the DoJ in criminal stuff.

SEC review process (corp fin): you have all these companies filing all the docs, proxies, etc.

Dodd-Frank and JOBS act

They were both congressional reactions to specific economic and political concerns, it’s somewhat

predictable because this is how we start the class by talking about the 33’ act and when something bad

happens to the economy the public gets angry and congressmen put laws.

Dodd-Frank 2010

Derivatives, CDS, changes in definition for accredited investors. Created an office to focus on municipal

securities. General interest disclosures.

JOBS Act

It wanted to help small business and start-ups that will in turn help the economy. Congress comes in

micromanaging the party of the players very specifically.

Changes for the EGC where they can file confidentially. They added section 5(d): make offers to

Quibs under “testing the waters”.

12(g): you can stay a private company as long as you don’t have more than 500 unaccredited

investors. So you can grow more before having to pay for going public.

1940 Act

Mutual funds and money management. Big impact in the financial markets. NASDAQ and NYSE are

Self-Regulatory Organizations (SROs).

Electronic offerings

1. Written offers: impact of technology on written offers. How to distinguish oral from written: what

about a website or a PPT or a DVD? SEC: added new term “graphic communication” defined under

rule 405 that includes all methods of communication except oral. If it’s “live” in real time to audience it’s

not graphic communication as well.

In a road show: live presentations are live but when recorded it’s not live anymore and becomes graphic

communication. So graphic = FWP. So the SEC relaxed the filing requirements for FWP in a road show,

you do not have to file it unless you’re doing IPO, and when you are doing IPO, you don’t have to file it

if this PPT is made available on an unrestricted basis no later than the first time it was transmitted.

2. Electronic delivery prospectus: section 5(b)(2) requires prospectus delivery but access = delivery (so

the issue goes away). The problem is FWP that requires to be accompanied or preceded with a 10(b)

prospectus (unseasoned issuer). Or if there’s sales literature it’s a problem because it’s a written offer that

is not a prospectus. It’s a problem at 15c(2)-8 which requires prospectus to be delivered at the time you’re

seeking info from the person that is willing to buy the shares (more than 48 hours delivery). You can send

it electronically and “bypass” all other shit if you meet: (1) provide access, (2) notice about that, (3) seek

the consent of the investor to receive it electronically, (4) proof of delivery. Can I include a hyperlink:

yes! (as long as it’s a live hyperlink). Posting on the website under access = delivery is not OK unless

we’re dealing with 5(b)(1). Only for 5(b)(1).

3. Almost every issuer has a website. Is the info in the website deemed to be an offer? Issuers have to be

aware of what’s posted on their website and review the website upon making an offer. The term offer has

been defined broadly by the court! If there’s no offering but filing 34’ reports, info on the website could

subject the company to liability. What if they have a hyperlink on the website to another website? (1) the

entanglement theory: it depends on the level of involvement of the issuer. Did he participate or prepare

that info on that website? Case-by-case analysis. The more the issuer entangled, the more likely he will be

subject to liability. (2) the adoption theory: depends on the extent to which the issuer has

endorsed/approved this info in a manner to be looked upon that it’s his info.

11.19.2014

Shelf Registration

Big companies didn’t like the timeline, where marketing and staff review are slow etc. Their complaint

was that they’re big companies followed by analysts, they file reports, and there’s a lot of info about them

out there. Moreover, the volatility of the market: interest rates can jump a lot and upon raising capital

could be affected and become risky. So they wanted a fast route which is less susceptible to the market. If

they file and have to wait for all the procedures, in 20 or 30 days they’d lose a lot of money and might

miss the window. So large companies started going public offshore quickly. iBanks in the US didn’t like,

the thing came to the SEC and adopted Rule 58: a delayed offering. You go ahead and register the

transaction now but do it at some point in the future by getting the registration out of the way, you’ll be

free to go whenever you want. If you want to update the registration statement, you can do this in the

future without the whole process.

Requirements: (1) Companies have to be reporting for one year and (2) their public float have to be

$75M. (3) Have a class already registered under the 1934 act.

These requirements are based on the EMH: investors have efficient info about the market and is already

absorbed into the market.

Based on that S-3 form was created to address the problems of waiting and market volatility. A key thing

in this form is that you refer to info filed in previous forms. Prospectus will be filed with S-3. The best

part is that this form allows forward incorporation of future filed forms. All the 10Qs and 10Ks between

the effectiveness of the registration and the day they decide to “take down” the shares. How does it work?

The basics don’t change. What changes: when the RS is filed and when it goes effective. It is filed right

after the company decided to sell securities. It goes effective very soon after filing and before hiring

UWs. They approach the UW when they are ready, he will take a few days to do marketing. If the

company wanna sell immediately the UW will get stressed but he wanna take the business companies

will squeeze him otherwise someone else will take it. UWs hate this because he won’t have time to do

due diligence.

Forward Looking Info:

Assuming efficient market, what is it going to take to change the price of the stock? Past info has been

already absorbed, what about future info?

Companies have a lot of info and management has to have a good estimation of the future. If all this info

is material, they have to disclose everything. Many obstacles for info disclosure: confidentiality, certainty,

etc.

The SEC: let’s disclose facts. Investors might not understand that this is a projection and get mislead.

They’re unreliable. Don’t disclose FLS. 1973 SEC: encourage but not require projections. Companies

don’t disclose projections in SEC filings only outside of SEC filings; part of this is related to section 11 –

they want to be off the hook. They are liable under 10b-5 but it’s much harder to prove.

Item 303 of S-K under MD&A the company is required to disclose a description of the financial

statements. You have to disclose anything that makes historical results not indicative of future results.

The disclosure here is facts-based. If you know that your sales are not going up, maybe you have to point

it out.

Hypotheticals about liability

1. The train company example that will be powered by solar energy. A misstatement in the prospectus.

12(a)(1): if they don’t qualify for the exemption.

12(a)(2): misrepresentation.

10b-5: have to prove scienter, etc.

11: not available, it doesn’t relate to a RS.

If 12(a)(1) is not relevant because it’s exempt section 11 is not relevant! Because it’s about

problems with the RS.