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Securities RegulationProfessor BradfordSpring 2015

Exam Answer OutlineThe following answer outlines are not intended to be model answers, nor are they intended to include every issue students discussed. They merely attempt to identify the major issues in each question and some of the problems or questions arising under each issue. They should provide a pretty good idea of the kinds of things I was looking for. In some cases, the result is unclear; the position taken by the answer outline is not necessarily the only justifiable conclusion.

I graded each question separately. Those grades appear on your printed exam. To determine your overall average, each question was then weighted in accordance with the time allocated to that question. The following distribution will give you some idea how you did in comparison to the rest of the class:

Question 1: Range 5-9; Average = 6.86Question 2: Range 3-9; Average = 7.57Question 3: Range 3-8; Average = 6.29Question 4: Range 0-9; Average = 5.93Question 5: Range 2-8; Average = 5.21Question 6: Range 2-8; Average = 5.86Question 7: Range 3-9; Average = 6.36

Total (of unadjusted exam scores, not final grades): Range 3.65-7.60; Average = 6.08

All of these grades are on the usual law school scale, with 9 being an A+ and 0 being an F.

If you have any questions about the exam or your performance on the exam, feel free to contact me to talk about it.

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Question OneOrange is offering a security if what it is offering investors is either an investment contract as defined in Howey, or a note as defined in Reves.

I. Investment Contract

Four requirements must be met for something to be an investment contract. There must be (1) an investment of money (2) in a common enterprise (3) with an expectation of profits (4) coming from the efforts of others. Howey. Three of those requirements are met; the fourth is less certain.

1. Investment of money

Assuming it’s an investment (which is related to the expectation of profits question discussed below), people are clearly contributing money, $1000 cash.

2. Common enterprise

This is a common enterprise in the strictest, horizontal sense. There are multiple investors and everyone’s money is being pooled to develop the LifeCam.

3. Expectation of profits

The most difficult question is whether there is an expectation of profits. The Supreme Court has distinguished between investment and consumption; a purchase of a consumption item is not profit, even if that item is obtained at a cheaper price. Forman. If contributors are motivated by a consumption motive—getting a camera—then there clearly isn’t an expectation of profits. But this scheme has a profit element in it because of the expected increase in the value and the establishment of the resale market. It sounds like Orange is marketing this as an investment and even establishing a mechanism by which the investors can receive an investment return. In addition, if the camera is not developed, the investors will receive

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interest, which is clearly profit within the meaning of Howey. SEC v. Edwards. It’s a close case.

4. Efforts of others

The profits, if any, are going to come almost exclusively from the efforts of others. The value of the camera (or, alternatively, the ability to pay the interest) will depend on Orange’s efforts. Investors will not directly participate in the development of the camera. Investors will participate in reselling the cameras, but their ability to earn a profit will depend primarily on how good a camera Orange develops and also on how good a resale market it establishes. Orange’s efforts appear to be the “undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” SEC v. Glenn W. Turner Enterprises.

II. Note

Even if this is not an investment contract, it might be a note within the meaning of Reves. Orange is making a conditional promise to pay investors 3% interest.

Presumption: a security

Notes are presumed to be securities. Reves. Thus, unless the presumption is rebutted, Orange’s promise is a security.

List of non-securities

Reves includes a list of notes that are not securities. Orange’s “note” does not appear to fall into any of the categories on that list. This is a consumer transaction, since Orange is selling cameras, but this is not a note delivered in consumer financing. The producer, Orange, is borrowing the money, not the purchasers of the cameras.

Since this does not fall into any of the categories of non-securities, we must apply the family resemblance test.

Motivations of the parties

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The application of this portion of the test is unclear, primarily because of the contingent nature of the investment. On the one hand, the buyers’ primary motivation is to purchase the camera, not to receive the interest. In the event the camera is not made, the buyers’ secondary motivation is the interest. That’s a securities motivation, Reves, but it does not appear to be the primary motivation.

Orange’s motivation is to raise funds for the general use of its business. That’s a securities motivation. Reves. However, you could also characterize this as merely correcting for Orange’s cash-flow difficulties, a non-securities motivation. Reves. The argument is that Orange is merely bridging the gap between when it has to pay to develop the product and when it will receive payment for the product. However, if you read the cash flow language this broadly, then almost anything would fit within it. Orange probably has a securities motivation.

Plan of distribution

There is no organized trading market to trade these “investments, but the contributions are from a broad segment of the public (1,000 people, if each contributes $1,000), and that’s sufficient to point towards this being a security. Reves.

Reasonable expectations of the investing public

Most people probably see this transaction as involving the purchase of a camera, although the possible resale element could turn even that into an investment motive. This element of the test is most often used to make something a security that would not otherwise be considered a security.

Risk-reducing factors

There are no risk-reducing factors that would make this less likely to be treated as a security. There’s no federal regulation of these investments if they aren’t treated as securities, and they’re not backed by collateral.

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It’s not clear if this would be a security under the Reves analysis. At least three of the factors point in that direction, but the consumer nature of the transaction and the fact that the interest is contingent might be enough to keep this from being treated as a security.

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Question TwoIt is unlawful to offer to sell a security unless a registration statement has been filed. Securities Act § 5(c). Magnum plans to post this information on its web site before the registration statement is filed. This clearly would be an offer to sell, defined as “every attempt or offer to dispose of, or solicitation of an offer to buy.” § 2(a)(3). The post will include the details of the offer and urge people to buy the stock. Thus, unless Magnum has an exemption, this is a violation.

However, this posting could be exempted from section 5(c) by Rule 163. This is an offering by a well-known seasoned issuer that will be registered under the Act. See Rule 163(a). Rule 163 says that an offer by or on behalf of the WKSI is exempt from section 5(c) if two conditions are met. First, the web site posting would have to include the legend provided in Rule 163(b)(1)(i). Second, Magnum must file a copy of this communication with the SEC “promptly upon the filing of the registration statement.” Rule 163(b)(2). If Magnum meets those conditions, the posting will not violate the Act. (Even if Magnum doesn’t meet these conditions, there are protections for “immaterial or unintentional failures. Rule 163(b)(1)(iii), (b)(2)(iii).)

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Question ThreeA.

Rule 505. The maximum offering amount is $5 million, less the aggregate offering price of securities sold within twelve months before the start of the current offering “in reliance on any exemption under section 3(b).” Rule 505(b)(2)(i). Rule 505 is a 3(b) exemption, Rule 505(a), and the earlier sales were within the last twelve months. After those earlier sales are subtracted, the remaining amount is zero.

Rule 504. Rule 505 has a $1 million cap, subject to the same reduction, Rule 504(b)(2), so the available aggregate offering price for the current offering is zero.

B.

Regulation A. Rule 262(a)(3) disqualifies an issuer from using the rule if, within 5 years, it has been convicted of any felony or misdemeanor in connection with the purchase or sale of any security.

Rule 505. Rule 505(b)(2)(iii) disqualifies any issuer described in Rule 262 of Regulation A, so the same disqualification applies.

Rule 506(b) and Rule 506(c). Rule 506(d)(i)(A) disqualifies any issuer that has been convicted within the past 5 years of any felony or misdemeanor in connection with the purchase or sale of any security.

C.

Rule 506(b). Each purchaser who is not an accredited investor must meet a sophistication test. Rule 506(b)(2)(ii). Sales to non-accredited, unsophisticated purchasers are prohibited.

Rule 506(c). The issuer must verify that all purchasers are accredited investors, Rule 506(c)(2)(ii), and may sell only to purchasers who are accredited investors. Rule 506(c)(2)

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(i). Sales to the 30 non-accredited investors would be prohibited.

D.

Rule 147. The securities may not be sold to non-residents for nine months after the last sale. Rule 147(e).

Rules 504, 505, 506(b), and 506(d). The securities are restricted and may not be resold without an exemption. Rule 502(d). For Rule 504 offerings, that requirement does not apply if the Rule 504(b)(1) exception applies. The exception applies if the securities are sold pursuant to state disclosure requirements that require a disclosure document or pursuant to a state exemption that permits sales only to accredited investors. See Rule 504(b)(1)(i)-(iii).

E.

Regulation A. Regulation A requires the filing and qualification of a disclosure document known as an offering statement. Rule 251(d)(1); Rule 252. A portion of that filing known as the offering circular must be provided to investors. Rule 251(d)(2)(i)(B),(C).

Rules 505; 506(b). Rule 502(b)(1) requires mandatory disclosure when offers are made to non-accredited investors pursuant to Rule 505 or 506(b).

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Question FourAn issuer may not register an offering of securities unless (1) it expects to sell all of those securities immediately after the registration statement becomes effective, or (2) the offering falls within the shelf registration rule, Rule 415. Thus, this offering will be lawful only if it meets the conditions of Rule 415.

Rule 415

Only the offerings listed in Rule 415(a)(1) are eligible for shelf registration. The only possibility here is subsection (a)(1)(x) because this is an at the market offering of equity securities by the registrant. Issuer is selling equity securities (common stock) into an existing trading market (the NYSE) at other than a fixed price (the market price at the time). Rule 415(a)(4). An at-the-market offering must come within subsection (a)(1)(x). Id.

To qualify, Issuer’s offering must be registered (or qualified to be registered on Form S-3. Rule 415(a)(1)(x). The other requirements of subsection (a)(x) are clearly met: the offering is by the registrant, Issuer, and the securities will be sold on an “immediate, continuous, or delayed” basis.

The only other condition Issuer would have to meet for this offering is the requirement in (a)(3) that it furnish the undertakings required by Item 512(a) of Reg. S-K. Rule 415(a)(3). Issuer’s Rule 415 shelf registration will be effective for only three years, Rule 415(a)(5), but that’s not a problem because Issuer expects to sell all of the stock over the next three years.

Eligibility for Form S-3

To qualify for Form S-3, the issuer must meet the registrant requirements of I.A. of the Form S-3’s instructions and the offering must meet the transaction requirements in I.B. Form S-3 Instructions, ¶ I.

Registrant requirements

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A.1. Issuer is organized under the law of a U.S. state (Delaware) and its principal business operations are in the United States (Nebraska).

A.2. Issuer is an Exchange Act reporting company.

A.3. Issuer has been subject to the reporting requirements for more than 12 months (10 years) and it has filed all the required reports in a timely fashion.

The facts of the question don’t raise any issues under the rest of I.A, but we would need to verify that Issuer does not have a default covered by ¶ I.A.4.

Transaction requirements

The offering must fit into one of the categories in Instruction I.B. The only possibilities are ¶¶ B.1 and B.6.

This does not fit into ¶ B.1. Although it’s an offering for cash by the registrant, the aggregate market value of equity held by non-affiliates is only $60 million, so it doesn’t meet the $75 million requirement.

¶ B.6. does, however, appear to apply, assuming Issuer has not sold any other securities during the past 12 months. The market value of the stock to be sold is only $10 million, and that’s no more than 1/3 of the existing aggregate market value of $60 million. As far as we know, Issuer is not a shell company, and its common stock is registered on the NYSE, a national securities exchange.

Since Issuer meets both the transaction requirements and the issuer requirements, it is eligible to use S-3 and the offering therefore fits within Rule 415(a)(x).

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Question FiveSection 4A(c) raises several questions with respect to the liability of Webstock.

1. Is Webstock an “Issuer”?

First, 4A(c)(1)(A) and 4A(c)(2) only make an “issuer” liable to purchasers. Webstock will not be the actual issuer of the securities being sold on its web site. However, 4A(c)(3) defines issuer to include, among other people, “any person who offers or sells the security in such offering.” (It includes other people, but none of those would cover Webstock.)

2. Is Webstock Offering or Selling the Securities Listed?

To be an issuer, and thus potentially liable, Webstock must be “offering or selling” the securities sold on its site. Pinter v. Dahl defined similar language in section 12(a)(2) of the Securities Act. It held that an “offeror” for purposes of this language is either (1) the person who passes title to the security or (2) a person who solicits the purchaser either to serve its own financial interests or those of the title-passing seller.

Webstock would clearly not be a seller within the first category; it will never hold title to the securities listed on its site. Title would pass directly from the issuers to purchasers.

Webstock could be a seller under the second category, but it’s uncertain. Webstock is posting this material to serve its own financial interest. It receives a commission if the securities are sold. But it is unclear that Webstock is actually soliciting anyone. Webstock is not recommending any of these securities to investors; it is merely posting the issuers’ materials. Webstock’s role is arguably only ministerial; like a messenger, it is merely conveying the issuer’s message to investors. However, Webstock is actively involved in drafting the issuer’s message, which may be enough to make the solicitation its own.

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3. Is Webstock “Making” False Statements?

Even if Webstock is an issuer, liability is imposed only if the issuer “makes an untrue statement of a material fact or omits to state a material fact necessary to make the statements made not misleading. Janus interpreted almost identical language in Rule 10b-5 and held that one “makes” a statement only if one has ultimate authority over the statement, including its content and whether and how to communicate it. The issuers, not Webstock, have that ultimate authority in this case, since the fraud would be in the issuers’ documents. Under Janus, one who assists in the drafting of another’s statement or helps disseminate that statement is not a maker.

However, one possible interpretation of § 4A(c)(2)(A) would cover Webstock, even though it’s not a maker. Subsection 2 says an “issuer” shall be liable if “the issuer” makes a misleading statement. Since the term “issuer is defined to include several different people, it’s possible that this could be read to mean that one issuer, such as one who offers or sells the security, can be liable if any issuer, including the company actually issuing the security, makes a misleading statement. The question is whether the same person must be the issuer in both occurrences of the term.

4. Would Webstock Have a Reasonable Care Defense?

Webstock’s lack of knowledge of the fraud doesn’t prevent it from being liable. Nothing in subsections (c)(1) and (2) requires scienter. However, Webstock can avoid liability if it proves that it “did not know, and in the exercise of reasonable care could not have known” of the fraud.” § 4A(c)(2)(B).

Webstock will not post any offering where it has actual knowledge of the fraud, so the question is what it has to do to establish reasonable care. This language is exactly the same as that in section 12(a)(2), and the courts have disagreed about whether reasonable care in that context requires an investigation or just that the person have no reasonable basis to believe there was a problem. Webstock

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intends to investigate offerings only if it is aware of red flags indicating possible fraud. If reasonable care requires an investigation in all cases, Webstock will not be able to establish a reasonable care defense. If reasonable care requires an investigation only if there are red flags, Webstock will be able to establish the defense.

5. Webstock Would Have a Negative Causation Defense

Section 4A(c) includes a negative causation defense. Section 4A(c)(1)(B) says the action is subject to § 12(b) as if brought under § 12(a)(2). Thus, Webstock can avoid liability to the extent it can prove that any portion of the investor’s loss resulted from something other than the fraud, such as a general market drop. See § 12(b).

6. Would Webstock be Liable to Aiding and Abetting an Issuer’s Fraud?

Congress in section 4A(c)(3) specifically listed the defendants liable and said nothing about aiding and abetting. Therefore, Webstock will probably not be liable to private plaintiffs for aiding and abetting issuers’ violations of section 4A(c). See Central Bank.

However, section 15(b) of the Securities Act authorizes the SEC to bring an action against any person who “knowingly or recklessly provides substantial assistance” to another’s violation of the Act. Webstock would clearly be providing substantial assistance by helping fraudulent issuers draft their disclosure and posting the offerings on the web site. However, Webstock would probably not be acting “knowingly or recklessly.” It will not knowingly post any fraudulent offerings and investigating when it becomes aware of any red flags is probably enough to bar a finding a recklessness. There is, however, at least an argument that posting offerings without investigating them at all is reckless.

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Question SixThe report could possibly violate § 5(b)(1) of the Securities Act, which makes it unlawful to transmit a “prospectus” for a security with respect to which a registration statement has been filed, unless that prospectus meets the requirements of § 10.

Is the Report a Prospectus?

Seller’s registration statement has been filed, so § 5(b)(1) applies. And the May 27 report could be a prospectus. A prospectus is, among other things, a written offer to sell. § 2(a)(10).

Written

The report is written. Rule 405 defines “written communication” to include “graphic communication” and it defines “graphic communication” to include electronic mail.

Offer to sell

An offer to sell is any attempt to dispose of or solicitation of an offer to buy a security, § 2(a)(3), and the SEC has indicated that anything that conditions the public to be interested in the security can be an offer to sell. Broker’s distribution of information about the company, coupled with the statement about the offering, could potentially generate interest among potential buyers. And Broker, as a participant in the offering, clearly has an interest to condition the market.

Research reports about emerging growth companies

Research reports by brokers about emerging growth companies are excepted from the definition of “offer to sell,” but only with respect to “a proposed public offering of the common equity securities” of such an issuer. § 2(a)(3). Seller appears to be an emerging growth company, § 2(a)(19), but this is an offering of preferred stock, so the exception does not apply.

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Section 2(a)(10)(a)

A communication is excepted from the definition of prospectus if it is sent after the effective date and a final prospectus is sent prior to it or at the same time. § 2(a)(10)(a). That exception does not apply because a prospectus was not included in the email or sent prior to the email.

Possible Exemptions

The SEC has promulgated a couple of safe harbors that allow brokers to distribute reports without running afoul of section 5.

Rule 137

Rule 137 does not help Broker because it only applies to non-participants in the offering. Rule 137(a).

Rule 138

Rule 138 is available to participants. Rule 138(a). Seller is offering non-convertible preferred stock, so Rule 138 would protect the report if the report “relates solely to the issuer’s common stock.” Rule 138(a)(1)(i). That requirement is not met because the report clearly specifically discusses the preferred stock offering.

In addition, Rule 138 is only available if the issuer has been a reporting company for at least 12 months. Rule 138(a)(2)(i). At the time of the offering, Seller had only been a reporting company for nine months.

Rule 139

Rule 139 provides that two types of reports are not offers to sell, and thus not prospectuses: (1) issuer-specific research reports and (2) industry reports. This is definitely a “research report.” See Rule 139(d).

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Rule 139(a)(1), dealing with issuer-specific reports is not available. The issuer must meet the registrant requirements of Form S-3, Rule 139(a)(1)(i)(A)(1), and Seller does not because it hasn’t been a reporting company for at least a year. Form S-3, Instruction IA(3). In any event, this is not an issuer-specific report.

Rule 139(a)(2) is not limited to issuers eligible to use Form S-3. Seller must be a reporting company, (a)(2)(i), but the one-year requirement doesn’t apply. Seller may not be a blank check company, a shell company, or an issuer of penny stock, 139(a)(2)(ii), but it does not appear to be.

Broker must distribute this report in the regular course of its business, (a)(2)(v), but that appears to be true. It’s not regularly distributed; it’s sporadic. But it is in the regular course of business.

Broker’s report, to qualify, must include similar information about a substantial number of issuer in the industry or sub-industry or contain a comprehensive list of securities currently recommended by Broker. Rule 139(a)(2)(iii). Broker’s report probably does not meet this requirement. Each of the two reports only includes information about three companies out of twelve. That is probably not a “substantial number” of issuers in the industry.

At the time this report is distributed, Broker must also be “including similar information about the issuer or its securities in similar reports.” Rule 139(a)(2)(v). Seller was also included in the January report, but information about the offering was not included, because it had not begun at the time. Broker does include information about offerings when they occur, but is that enough to meet (a)(2)(v)?

Other safe harbors

No other safe harbor is available.

A Rule 433 communication involving an unseasoned issuer like this must be accompanied or preceded by a prospectus, Rule 433(b)(2)(i), and include a legend.

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Rule 433(c)(2)(i). The question indicates that nothing else was included with the report.

The information included, particularly the financial information, goes beyond what’s allowed by Rule 134. See Rule 134(a).

Most of the other safe harbors, such as Rule 168, 169, and 135, are only available for communications by or on behalf of the issuer. Broker’s communication would not qualify.

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Question SevenThese are restricted securities. Rule 506(b) is a safe harbor for section 4(a)(2), so they were acquired in a chain of transactions not involving a public offering. Rule 144(a)(3)(i). They are also subject to the resale restrictions in Rule 502(d). Rule 144(a)(3)(ii).

To determine whether Sam can fit his resales within Rule 144, we need to know whether Sam is an affiliate. See Rule 144(a)(1). There is no information in the question to indicate whether or not Sam is an affiliate.

If Sam is Not an Affiliate

If Sam is not an affiliate, subsection (b)(1)(i) applies, because Alpha has been a reporting company for several years. Sam is subject only to the conditions of Rule 144(c)(1) and Rule 144(d). Rule 144(b)(1)(i).

Subsection (c)(1): Current public information

To meet the requirement in subsection (c)(1), Alpha must have filed all required reports during the past 12 months, other than Form 8-Ks. Rule 144(c)(1)(i).

However, a non-affiliate is not subject to the (c)(1) condition “provided a period of one year has elapsed since the later of the date the securities were acquired from the issuer for from an affiliate of the issuer.” Rule 144(b)(1)(i). Sam’s stock clearly has been out of the hands of the issuer, Alpha, for more than a year. Alpha sold the stock 17 months ago. The question is whether Jones, from whom Sam acquired the securities, is an affiliate. If Jones is not an affiliate, then more than a year has elapsed since the securities were acquired from the issuer or an affiliate, and the (c)(1) condition would not apply. If Jones is an affiliate, then the (c)(1) requirement still applies since it hasn’t been 12 months since the securities were acquired form an affiliate.

Subsection (d): Holding period

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In the case of a reporting company such as Alpha, since these are restricted securities, a minimum of six months must elapse between “the late of the date of the acquisition of the securities from the issuer, or from an affiliate of the issuer” and the resale. Rule 144(d).

Six months has clearly elapsed since the securities were first acquired from the issuer, Alpha. Six months have not elapsed since Sam acquired the securities from Jones. If Jones is not an affiliate, that doesn’t matter; the question is not how long Sam has owned the securities. But, if Jones is an affiliate, six months must have elapsed since the securities left Jones’s hands; that is not the case, so this requirement would not be met.

If Sam is an Affiliate

If Sam is an affiliate of Alpha, then he must comply with all of the requirements of Rule 144. Rule 144(b)(2).

Subsection (c)(1): Current public information

To meet the requirement in subsection (c)(1), Alpha must have filed all required reports during the past 12 months, other than Form 8-Ks. Rule 144(c)(1)(i). If Sam is an affiliate, this condition would apply no matter how long he’s held the stock.

Subsection (d): Holding period

The analysis would be the same as if Sam were not an affiliate. This requirement would be met only if Jones is not an affiliate.

Subsection (e): Limitation on the amount sold

The amount Sam could sell within any three-month period would be limited to the greater of the average weekly trading volume of Alpha’s shares or 1% of the total of this class of common shares outstanding. Rule 144(e)(1). We need additional information to know if this requirement is met.

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Subsection (f): Manner of sale

The securities must be sold in brokers’ transactions. Rule 144(f)(i). That requirement seems to be met. Sam used a broker and that broker did not solicit anyone. See Rule 144(f)(2),(g).

Subsection (h): Notice of sale

Sam must file a Form 144 notice of the sale, because the amount sold exceeds $50,000. Rule 144(h)(1).