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Securities Regulation Outline Manns Spring 2011

I. Basic Principles and Policies A. Rationale: Why should we regulate securities? Issues with Regulation and Mandating Disclosure (1) Extremely Costly Creates Transaction Costs The larger the regulated pool, the less costly per unit it is Securities make up a huge pool If smaller market, not national scalecase to regulate is worse (2) Regulation is easier if there is a goal in mind, but not easy to come up with a goal With a clear goal/consensus on why, better reason However, with lack of clear goal, regulation may lead beyond initial reasonspreading it too thin, wasting resources, and getting involved in things without reason (3) Amount consumers have a stake is relative Potential harm with securities is vast (4) Too much regulation may reduce our welfare Where is the line drawn to avoid over/under regulation Companies leaving the Public Market Overregulation Leads to: Capital Markets drying up going private transactions leaving country Chills Best People from entering that industry/public companies Chills risk taking, if liability ensues (5) Cost/Benefit of It: We may mandate many disclosures, but in reality, they may actually hurt shareholders See 10-K mandates and financial costs to shareholders

Why should we regulate Securities: (1) Intangible: Provide Value By: Give right to (1) Cash Flow, (2) Assets in Liquidation, and (3) Voting Rights The Stock, for instance, itself is valueless It gets value from something else We should provide information of what that something else is Paternalistic (2) Different than Tangible Goods: A. Greater Chance of Fraud: Because there is much $ involved, they offer better forum for greed Moral Hazard: That investors interest may not be in line with promoters interests B. Greater Danger to Capital Markets: Capital Markets are more important to Economy then others In an efficient market, poorly made goods get eliminated while Securities in Capital markets are vital to the economy Need to preserve their viability Consumers have large amount at stake justifying Regulation C. Collective Action Problem: Market, made up of large groups of people who want similar information But cost/effort of getting information will only lead to temporary advantagenot worth effort Therefore, collectively, Market will not engage in action that would have benefitted all and information is vital to securities D. Information Asymmetry (3) On a National Scale Therefore, not as costly to regulate per unit Goal is easier to develop Stake Market has is larger the normal goods Just determine amount of regulation Overall Distinctive Features of Securities and their Markets (1) Capital Markets and investing are important to Economy; Vital (2) Investments effect many decisions (Life, home, kids, day to day events) (3) Investing may make people act irrationally (Emotion rather then reason) (4) Collective Action problems exist and Information Asymmetry (5) Intangible and hard to value Should Securities Laws be Optional Opt In (See discussion, infra on Voluntary or Mandatory Disclosure): Yes: If company didnt, its price would be adequately discounted Easier to use Bright Line Rule Easier for SEC to govern Private Body may emerge No: Collective Action issue Lack of Standardized System would exacerbate collective action issues Information Asymmetry Issue Effects On Capital Markets: Chilling of investing as not all information available (Caveat Emptor)

B. Capital Markets, Securities and Participants: 1. Primary and Secondary Markets Primary: Issuer sells securities to raise capital 1933 Securities Act applies SEC oversees Intermediaries in Primary Market: Effect: Reputation of intermediary enhances the transaction Eases Market Concern Legitimacy added to transaction, that IPO may not otherwise have Underwriter: Investment Banks that provide advice, expertise to Issuers of securities Syndicate Disperses Risk taken Leverages abilities of all Anti-trust issues Types of Underwriting: Firm Commitment Offering Underwriter commits to purchasing securities at discount Guarantees sale of certain number Underwriter resells at higher price Makes the Spread Best Efforts Offering Underwriter commits to trying his best to sell shares No guarantee Attorneys: Assure Regulatory Compliance Reputation is key Accountants: Certify the statements are accurate Reputation is key Institutional Investors: Mutual Funds, Pension Funds, Insurance Companies Purchase large amounts of IPOs Adds Liquidity Adds Legitimacy and reassurance Secondary: Resale of security to other investors Issuer gets no benefit, and are not involved 1934 Securities Exchange Act applies SEC oversees Intermediaries in the Secondary Market: Block Transactions: Huge amounts of trade typically done by Institutional Investors Brokers: Facilitate trading for smaller, more typical investors Market Order or Limit Order Because Limit Order is automated, off fluctuations may trigger automated limit order Trading Forums: Type of Self Regulatory Organization, or SRO Exchanges will have their own rules that further regulate securities Rules on Capitalization Requirements, Voting Requirements and BOD Traditional: NYSE, AMSE Physical trading and electronic trading Floor Brokers with Specialist per security Specialist maintains liquidity and a market for the security If need be, will make trades from his own account to meet supply and demand NASDAQ Electronic market Market Maker: Dealers who buy and sell securities to create market Promotes liquidity Make $ through the Bid and Ask spread Electronic Communications Network, or ECN: Solely electronic market Simply link up buyers and sellers through computer Promote liquidity but not necessarily price transparency Liquidity and Price Transparency These issues are vital to having an efficient, and working secondary market Liquidity: Ability of an investor who desires to buy or sell to do both, quickly, finding opposite position at market price Liquidity maintains prices and promotes stability Avoids Volatility Price Transparency: Ability of investors seeking to transact to observe the price of transaction, and bid/ask offers across markets Market Participants need immediate access to this information Shows what stock is worth that second Information which gives ability to make decisions

2. Types of Securities: Differentiated by: Voting Rights Cash Flow Rights Liquidation Rights 1. Common Stock: Voting Rights Based on risk taken, and last in line in bankruptcy, shareholders are given ability to vote to control Business Are not secured, like debtors, so compensated for risk with Vote Owed Fiduciary Duty of Care and Loyalty Residual Liquidation Rights Absolute Priority Rule They are last in hierarchy of priority But, can be nuisance in holding up bankruptcy proceedings Residual and Discretionary Dividend Not mandated they get one and if they do it is after interest on debt and dividend to preferred shareholders 2. Preferred Stock: Fixed and Discretionary Dividend Dividend set in contract, but discretion to pay one out or not Cumulative Dividend accumulates unpaid ones They must be paid prior to CS getting anything Participating Adds potential to earn with earnings of company Medium Liquidation Rights Prior to CS but Post Debt May have voting rights Right of Election: May contract to contingent vote if missed dividend Convertibility Contract is controlling 3. Debt: Fixed, certain interest payments Highest Liquidation Rights Equity Cushion may be required to protect creditor Contract will specify, and if breached may Accelerate Payment No Voting Rights Their protection for risk profile is in the contract and priority in bankruptcy Contract is controlling

3. How should we Regulate Securities? A. Generally: Above, we conclude that, ok, securities need to be regulated What should the regulation entail and should it be Voluntary or Mandatory? B. Value of Information: There are basic things we would want to know to alleviate the concerns Securities bring (discussed infra) The Security is intangible, but what about that something else that gives it value Financial Statements Detail of past data, projections Management Members, experience and compensation Business Strategy Industry Competition, Barriers to Entry Regulation Tax Risk and Regulatory Risk Risk Note: With a Primary Market (IPO) transaction, we want more information (the reputation of underwriter will help), but with Secondary Market, we still want information, but the track-record will certainly help How Information Helps Investors Investors can do Self Help While investors could read it, analyze itnot very common Prohibitive cost, time and ability Inability to get same access to same information as larger investors Butjust because individuals dont actually look at directly, they are still benefited Indirect Access Filtering Mechanisms, like newspapers, magazines, brokers, will read the reports and break down Financial manager will make decisions for them (Mutual Fund) benefiting individual Institutional, and Large investors will use Efficient Market Hypothesis then takes over Efficient Capital Market Hypothesis The idea that information is priced into the security, almost immediately Weak Form: Only past information is incorporated into price Semi-Strong: All Publicly available information is incorporated into price **Strongest argument Idea that even if self help doesnt happen, sophisticated filters and players do, so price changesb. Strong: All information, public or private is in price Doesnt make as much sense, given that profit can be made off of insider trading Combining the Two: The indirect access + ECMH means that the individual investors share is affected by the information But Should it be Voluntary or Mandatory?

A. The Argument for Private Sector (Voluntary) Regulation: Private sector could regulate itself: Companies have an incentive to voluntarily disclose information The Market would view non-disclosure as something is wrong and would discount price of stock Investors value info, and Company would see that disclosing increases share price Voluntary disclosure positively influences share price EG: Telling what earnings will be = higher price Incentive to Continue disclosure If issuer needs to go back to capital markets, incentive would be to continue disclosure so as not to depress share price That way, when he goes back, prices are still up and Market is receptive to sale Disclosure by few creates pressure for others to disclose Investors would discount those who had less information Other business would see this, and begin to disclose too 3rd Party Added Reputation is Private Sectors method of legitimacy 3rd party lawyers, accountants, and IBs establish credibility Analysts research and interpret information provided Once information was given by few, who had incentive to, analysts would validate Methods to make it viable: Anti Fraud Liability Creating a floor of anti-fraid liability could help ensure accuracy ContractSelf Regulation The market may begin to regulate itself, through contract of covenants of accuracy and anti-fraud Even if Anti-fraud liability would voluntary, the market would discount those firms who did not opt into it May create its own centralized authority to create standardization The Problems with Private Sector (Voluntary) Regulation: Firms may not issue securities If no securities were trading, no incentive to disclose as market wont determine value of shares Anti-Fraud liability doesnt necessarily mean credibility Managers may profit from less then total disclosure and informed Market/Agency Costs Engage in insider trading, if no mandated disclosure Bias would be towards the firm Firms would not disclose certain things to avoid Competition Would lack standardization/Coordination Problem Without mandated system, disclosures would be different and would be difficult to compare apples to apples Firms may issue duplicative research, and investors would also compete for duplicative information A Mandatory system reduces waste, and gets information from the source

B. The Argument for Mandatory Disclosure Generally: We see above that, theoretically, the private sector could regulate itself, but the problems associated with that are quite vast and could be avoided with mandatory disclosure Mandatory disclosure improves marketplace, investor welfare Mandatory Disclosure is Best 1. The more wrong with Voluntary disclosure, better argument for Mandated See supra, issues with voluntary 2. Overcomes Collective Action problems meeting investors needs Because the Securities Market is large, and efficient, arguably, if one party does all the work to discover information, all will benefit while 1 will bear all the cost There is a general problem of Collective Actionthat no one will do the work Standardized disclosure makes comparisons and coordination issues end Better decisions because standard disclosure (EG: The 10-K) Mandatory disclosure sustains standardization Collective Action creates issue that all will not combine to make 1 system (Effort and Cost v. Benefit) If it were voluntary, the issuer would benefit The more people use the standard, better and more valued it is 3. Agency Costs Mandatory disclosure allows stockholders to control costs of management If it were voluntary, management would disclose that which was pro-management Keeps managers accountable If voluntary, they may wait to disclose negative information or hide altogether Promotes accurate ability to vote 4. Federal or State Although corporate law is traditionally state, race to bottom concern is evident 5. Positive Externalities By mandating disclosure Investors are helped but so are competitors If it were voluntary, firms would not disclose due to competitors finding out So while Competitors get free-rideall do and Investors are benefited by disclosure, and information to make decision based on accurate information 6. Reduces Duplicative Research By mandating disclosure, from the source, the law reduces the duplicative effort of many parties If voluntary, the first to find out about info wins But as second party tries, market has already incorporate and his effort is wasted Mandated disclosure serves to eliminate wasteful efforts by giving standard information to all at same time Reduces waste of temporary gains 7. Reduces Information Asymmetry

Issues with Mandatory Disclosure 1. More disclosure is not always better The proper balance is not easy to ascertain If too much, firms may go private, leave country Best candidates for jobs leave which puts us worse off By requiring too much information, we actually get less because companies go private If too little, under informs investor 2. Government may not adapt to new needs EG: derivatives If government too slow to respond, perhaps private sector would have been faster? EG: The derivatives market has regulated itself, creating standard documents, and a central system The Regulators have been slow to respond, only responding after financial meltdown 3. Private sector may know better what it values Is more in tune then Fed, as to what market needs 4. Regulatory Capture With lobby, there is risk that regulator will be influenced by regulates If so, benefit will be to SEC person who gets job later or to industry Investor, the beneficiary of disclosure, actually would bear the cost How Does US regulate Securities: (1) Mandatory Disclosure Promotes Efficient Market Allowing investors to make their own decisions Effects: Cures many of issues with Securities Decreases Moral Hazard By mandating certain things be disclosed, disclosures align the interests of the investors and promoters (2) Anti Fraud Liability (3) Gun-Jumping rules avoiding advantage (in IPO) Note: The procedural nature of our rules, and non-merit regulation We do not Merit Regulate or tell investors what is good or bad Merit Regulation risks governments poor choice and excluding certain things that may be beneficial Non-Merit Regulation, provides certain informations to the Market allowing Market to decide Government does not educatebut is Paternalistic in that it requires information Effect of our System: 1. Promotes the Free Market Capitalism that is Efficient Market 2. Cures issues with securities 3. Avoids Moral Hazard 4. Certainty in Marketplace 5. Enhances overall capital markets

II. Materiality A. Generally: Above, we determined that (a) Securities need to be regulated and (b) There should be Mandatory Regulation We also determined that information is what is needed What is Material: The type of information we want Valuable to investors TSC Industries Definition: Information is material if there is substantial likelihood that the reasonable investor would find information significant given the total mix of information The Reasonable Investor One could argue that investors are not reasonable, and that the unreasonable investors should be focused on Many lack capability Over-confidentwithout reason for acting Why dont we focus on Unreasonable Investor (they need paternalistic protection): If they are unreasonable, and stinkmore disclosure or rules for them wont help With so many ailments, difficult to craft Regulations to help each need With irrational investors, tough to craft Regulations to help So, Presuming reasonable is easiest, most efficient way to operate Regulatory Regime

B. Policy Arguments for Why Material Information Generally: These are the reasons we want to restrict disclosure to material information and not have exhaustive disclosure (1) Disclosure is costly we dont want to impose too high a cost, as some information isnt worth the cost (2) Disclosure expands legal liability we want information for investors, but too much creates liability which is negative for issuers and investors Weed out frivolous litigation Increases costs, distracts, and poor reputation (3) Flood/Burried Too much information is confusing and not helpful Easy to bury important things within the flood of information (4) Competitive Disadvantage some information investors dont want out, as it puts firm at disadvantage May lead to companies leaving public market May lead to chilling of innovationas if work was simply given to competitorsno incentive (5) Subversion Requirement of too much information may lead to the chilling of keeping records (6) Privacy Too much disclosure, for instance of Managers personal date may lead to the flight from public companies This would have negative effect on Markets, Society, and investorswe want the best to manage

C. The Duty to Disclose There is no general duty to disclose all material information Absent some mandate, an omission (no statement) does not make you liable (per 10-b 5 anti-fraud)But: See 8-K, and discussion of why no general mandate to disclose all (logistics, inaccuracyetc) The Duty to Disclose Arises when: (1) Enumerated Mandates of Securities Laws The law will specify what needs to be disclosed (may not be material) Mandated Disclosures: May require disclosure of material and non-material information (1) Registration StatementRule 408 Those who issue Securities in Public Offering must Register with SEC Information on Securities offered Use of proceeds Business Financials Managers and Compensation (2) Periodic Reports Publicly held companies (34 Act) must file periodic reports with SEC (10-K, 10-Q, 8-K) What is required in forms is in Regulation S-K (3) Regulation S-K In addition to what it mandates, it also requires disclosure of material information (4) Affirmative Statements must be materially accurate and complete Rule 408 (Registration)no truths 12-b 20 (Periodic Reports) No Material Misstatements or omissions Note: If mandated duty to disclose certain things, the affirmative statement duty also arises to perhaps disclose more.if what was disclosed is not complete Allways must be materially accurate and complete (5) Anti-Fraud Provisions Once a company begins to disclose, duty to not make material omission 10-b 5 (6) Insider Trading Insiders must either disclose inside information or abstain from trading, based on that information (2) Affirmative Statement If made, must be (1) Materially Accurate (2) Complete No material misstatements or omissions So, you may not have to talk, but if you doshould be complete and materially accurate Duty to Correct: If statement made, or mandated statement of SEC madeduty kicks in If statement is not both, Duty to disclose whole truth arises for material information (10-b 5) If not may be liable for making misstatement or omission of material fact for which you had duty to disclose

D. Forward Looking Information: Generally: The general standard for Materiality, defined in TSC, is applied uniquely to forward looking statementsevents that may or may not occurthat are contingent Merger, Sale, etc Future events do affect total mix by measuring the magnitude of information, in context and discounting probable future events into price Basic, Inc. v. Levinson (US 1988): F: Combustion Corp wanted to buy Basic. Basic, who was in discussions, and made several statements denying the merger, that it was unaware of why stock was trading at high volume. I: Was affirmative complete, and materially accurate, or did it trigger duty to disclose more? R: 1. Duty Triggered: Was not complete or Materially Accurate Because of that Affirmative Statement duty to disclose arose But again, note that if SilentOmission is not enoughso staying silent is viable (if no specific duty) 2. Dislikes Bright Line when agreement in principle Rule: While more certain, and avoids too much information being given to an investor who may not understand it is over and under-inclusivemay not include fact-specific issues which are material Is too paternalisticMerely requires disclosure of material information, but not to protect/paternalize shareholdersnot good policy argument 3. Dislikes Idea that All information Affirmatively given is material Not all false, incomplete statements are significant to total mixwe want to limit liability 10-b 5 specifically says, that only applies to material information Test of Forward Looking Information: Whether there is substantial likelihood that reasonable investor would find information significant given the total mix in Forward looking statements depends on Balance the Probability of event x Magnitude Fact specific Inquiry that varies case-by-case Examples of Probability: indicia of interest by highest levels, involvement of bankers, negotiations Examples of Mag: size, premiums, etc Policy Issues with Basic Test: Hard to be objective Very much relies on what each judge, attorney, and jury thinks goes into this equation Dont know which facts are important Looking back on what happened will taint the ex-ante interpretation (Hindsight Bias) So as Court evaluates the equation, it will look at what happened, rather then at that point in time, ex ante, what would happen Could argue that it may actually be Bright Line Rule that was rejected While this is fact-specific, it may look at a fact as controlling.which in essence is the bright line rule For instance, if agreement in principle is weightierthat is basically the rule Ormay be so difficult, and courts may say mergers are materialthat is also a bright line rule E. Historical Facts: Generally: Facts that have already been given, such as accounting issues, may become material Because the affirmative statement was made, historical material facts may need to be corrected to assure they are complete, but how do we determine if they are material? 1. Numerical Guideposts Ganino v. Citizens Utilities Company: F: Citizens hadnt missed earnings for 50 years, but was about to. So, they entered contract with HTCC and consulted in exchange for fees. It received them in 1996, but recognized them in 1997 as income. Without disclosing that these fees were extraordinary and not from operations, it said that it attributed growth to profitable operations. Finally, it missed earnings and disclosed this issue. I: Did the duty to disclose kick in to make complete and materially accurate statementsAnti Fraud Liability? R: 1. Court rejects any numerical bright line rule of thumb to determine what is material Per TSC, materiality is a question of fact 2. Standard to Dismiss for lack of Materiality No dismissal, unless the omitted facts are so obviously unimportant to reasonable investor that reasonable minds could not differ on question of importance 3. SEC Staff Bulletin 99 (p. 61) Materiality as to historic facts evaluates: Qualitative and Quantitative Facts No specified Numerical value is controlling, although can be used to begin the inquiry If Company chooses a number as a rule of thumb to make it material: Lawyers should come up with a paper trail of qualitative data for why it is material or below that chosen % is not material But SEC says no specified number is dispositive Lists Qualitative Factors on p. 61 A small $ amount can be material if qualitative facts surrounding make it so EG: intending to meet analysts by fudging number just a bit A larger $ amount can be immaterial if qualitative facts surrounding make it so Note: A Qualitative factor can make a large number (quantitative data) less material Look at a 1-time occurrence, or a Recurring event to weigh qualitative factor Look at effect on integrity

Evaluate to determine if significant to reasonable investor as substantially altering total mix Here: The quantitative portion represented large percentage (17%) of income Qualitative portion showed that misstatement was intended to mask the failure to meet earnings estimates Rejection of bright line rule: (1) The court rejects, again, a bright line numerical rule because the qualitative factors may in fact make small quantities material The small quantitative fudging may be used in times needed most Shows the qualitative reasoning for small numerical shifts (2) Also, numbers can be calculated in many different ways Not easy to determine what we should look at: Assets, Income, revenueetc 2. Courts use of Market Reaction to determine Materiality: Generally: In determining the materiality of historical data, and if a duty to disclose more to make materially accurate and complete kicks in, we see above that numerical rules of thumb apply Here: we look at if a reasonable investor would consider information material by evaluating the reaction of the market once an announcement is made about some historical issue Market shows what is material In Re Merck: F: Merk owned Medco. Medcos sales included revenue that did not belong to it. Merck disclosed this on April 17, but did not disclose the $ amount it was affected bystock price rose .03 cents. Then, on June 21 a WSJ report came out and it stated that the deal was worth $4.2 Billion. The stock price dropped about 20%. I: Did Merks initial statement require additional statement to disclose material accuracy, or was information immaterial? R: Efficient Capital Market Hypothesis Analysis of Materiality: *Court looks to the period immediately following the disclosure Here: Mercks initial statement actually raised stock price a small bit. Not Material, based on semi-strong ECMH Petitioner Argues that disclosure made was not complete, and therefore the second market reaction shows it was material Argument is that Merck, in effect, failed to disclose enough information for market to determine No: There were many analysts following the stock who easily could have done this type of math WSJ did a quick calculation Even if the $ amounts were not clearly indicated, they were there to be foundand Merck did disclose them This means that Market did not think they were material Issues with Analyst Standard: (1) The public/non-analysts may be able to do thisbut takes more time and workunlikely (2) Even if analysts could do thisthe trickle down effect of information is similar to the burried rationale for material informationwe dont want such information buried, requiring it to be extracted This is contrary to the idea of materiality and disclosure (3) Reasonable Investor is the standard set by SCOTUS Although Analyst may be reasonable investor, reasonable investor not necessarily analyst Counter Argument: Individuals get their information through intermediaries, so it is feasible view Issues with Focus on Stock Price Movement to determine Materiality: (1) If initial disclosure only has limited information, stock price may not reflect it immediately which is what court looked at (2) Market may be a bit inefficient with processing new information even if the market is efficient, it may not be immediate that most accurate price is adopted The courts time frame may be offslow to react Idea of disclosure is that company gives information to us to avoid collective action problem (3) Company may disclose a lot of good news and a small amount of bad news This, in effect, buries the material information, albeit disclosed (4) Ok, market response on day of disclosure is plausible But market may overreact optimistically or pessimistically If overreaction doesnt necessarily mean material More time to consider, makes more accurate price evaluation (5) General market trends may cause stock to fluctuate, rather then the disclosure Note on Practice: Expert witnesses will be called in to created Event Study A window, around the event of the disclosure is made The past performance, and expected return of that window is calculated using historic data The expected return is subtracted from what actual return of that window was Determination of if it was abnormal or not F. The Total Mix Generally: A key part of the Basic cases definition of Materiality Has been used by Courts to dismiss suits that they consider weak Meaning: If information is already in the total mix, or in the public markets, its failure to be in a disclosure is, in context, not a misstatement or omission It is already out there While it may be material, it is not a misstatement or omissionlook at context of total mix

Methods to determine the total mix: 1. SEC disclosures they are part of the total mix Incorporate by Reference Allows companies to simply reference past disclosed information from prior filings Feeds into idea of mix as past information is relevant 2. Brokers/Financial Advisors Whatever information they look at is part That is because they advise investor decisions Whatever they reasonably look at 3. Anything else that plausibly affects stock price Longman v. Food Lion: F: Food lion made statements regarding its employees happiness, being well paid, and the cleanliness of its stores. Its annual reports continued these statements. In 1992, ABC aired a program documenting the poor quality of the food and employment issues they had had with the Union. Following the program, shares fell 11%. Prior to the ABC program, Food Lion had acknowledged allegations of employee issues, and investigated. I: Shareholders allege that affirmative statements failed to disclose complete and materially accurate information. Were there misstatements or omissions? R: 1. Employment Practice A. If the information is available to the public Food Lion had already acknowledged the complaint, and complaint was public information Market already had opportunity to evaluate these claimsso omission was not material B. Quantitative: Settlement was a few cents a share experts found immaterial C. Qualitative: Quantitative versus Qualitative was only 1 time occurrence D. Stock price was unaffected Overall, the employment information was not material given the total mix 2. Unsanitary Practices Puffery or Opinion is not something the reasonable investor would find in the total mix Puffery is language that investors realize is opinion and is not reliable A type of opinion, without any fact that is not actionable These types of statements cannot be factually accurate or completeso they are not material Not the type of affirmative statement that duty to disclose emanates from Puffery is not a materially misleading statement that gives rise to Anti-Fraud Liability Fact versus Puff The more closely something gets to fact/numerical valuethe more likely it is reliable Stay away from Numbers/Concreteness Analysts or Investors: Analysts: Tend to be able to view a bigger total mix, and have more ability to determine This seems to coincide with the intermediary theory, and potential that securities laws have Investors: Are not as able, and unlikely to read certain information The total mix may be smaller G. Management and Materiality: Generally: One of the controlling intentions of Congress was the idea that disclosure would reduce Agency Coststhat is, make management more accountable to shareholders Promotes Managerial Integrity Promotes Managerial Competence Regulation S-K: This regulation mandates certain information be disclosed regarding management 1. 401: Past business experience within last 5 years 2. Managements past performance, as shown by comprehensive financial and other disclosure 3. 401: Potential conflicts of interest with Duty of Loyalty 4. 401: Remuneration and other benefits paid to management 5. 404: Material Transactions between corporation and its officers, directors Note: Because these are mandated affirmative statements, material corrections to make them materially accurate and complete may be needed Stockholder reaction to Managerial Discslosure: If the disclosure reveals troubling information, what are your responses: 1. Sell Shares 2. Mobilize Shareholders to vote out Directors 3. File derivative suit on behalf of shareholders claiming damages In Re Franchard Corporation: F: Glickman was a big time investor. He formed Franchard Corporation and had voting control of the stock outstanding. Through a public offering, affirmative statement was made that Glickman was controlling shareholder and that he loaned the corporation money. However, he eventually began loaning himself money from the corporation, and pledging his shares as collateral in exchange for loans from other sources. He eventually resigned. I: Did Glickman make affirmative statements that were materially inaccurate and incomplete? R: Yesduty arises from mandatory and duty to correct 1. The Quality of Management is vitally important to shareholders Disclosure shows financial ability of manager Integrity Potential incentive to operate undesirably Change of Control potential from pledging of shares Mangements ability is vitally important, especially when the Managers unique reputation is large reason for investment Note an Evaluation of the Quantitative and Qualitative factors Although small amounts of $, the qualitative aspectthat it was recurring and that it showed poor integrity weighed heavily to make it material Because of Qualitative factors, small quantitative is not controlling Loss of Control, also, due to his reputation was key 2. The SEC is not empowered to determine the standard of care exhibited by a Board of Directors There was no material omission of fact because the performance of the BOD is protected by the Business Judgment Rule A Function of State Lawnot the place of securities laws Note: Disclosure may become method of enforcing a federal standard of business conducteventually overriding State law on the matterduty of care and business judgment rule Policy: At what point does disclosure reveal Personal Facts, and Should there be a limit: 1. Potential to scare off talented managers 2.Your in Public, you should expect disclosure Note: Franchard holds that what facts need to be disclosed stems from a Materiality analysisthat is the only limit on what may or may not be disclosed Goes back to very factual analysis EG: Steve Jobs may need to disclose more then a typical CEO. His reputation, and connection to apple is uniquewith only few others resembling. The standard is malleable to accommodate it So, based on an affirmative statement that is misleading or incomplete or a mandated discslosure, materiality is relative 3. See Supra, discussion of why we limit information disclosed to Material Information H. Duty to Disclose and Criminal Liability: Generally: The 5th amendment privilege cannot form the basis for non-disclosure of security law violations Except (SEC v. Fehn): 1. Whether the disclosure targets a highly selective group inherently suspect of criminal activity rather then public 2. Whether disclosure covers an area covered by criminal statute, rather than essential non-criminal regulation 3. Whether compliance would compel disclosure of information that surely would prove link to evidence establishing guilt Mandatory Disclosure of Criminality: 1. 401: Management must disclose formal indictment 2. Must disclose conviction of violation of securities laws, bankruptcy, or past role in bankruptcy 3. Must disclose criminal cases, and adjudications during past 5 years and earlier cases if material to understand disclosed information 4. Must disclose self-dealing 5. Note: Unadjudicated civil cases against officer or director does not require disclosure, unless material due to integrity of management *And, as always, must disclose all material information to make affirmative statement complete and accurate!

III. What is a Security: 2 (a) 1 of Securities Act of 1933 An Inquiry into, do the securities laws apply? Threshold inquiry Policy Implications: We want to define a security sufficiently broadly to allow to include new, potential schemes to be included within that law Basicallyit allows for inclusion of things that have same issues as Security, discussed infra (1) Information Asymmetry: Because less information available, we want more things in definition of security to mandate disclosure (2) Importance to Capital Markets: We want to include enough things into the definition to protect our Capital Markets (3) Collective Action Problems: People are unable to secure enough information regarding something; we want our definition to include those things that are similar to a security, with similar issues it poses (infra) (4) Unsophisticated Investors: Substantial Sums of $ invested; because people often invest themselves, and are financially illiterate, we want to protect them in some wayPaternalism. Including something in the definition then, mandates certain things (5) Risk: ties into protection of overall economy (6) Anti-Fraud (7) Intangible (8) National Scale (9) Effect on Daily Decisions (10) Protects overall economy If it does apply, regulation has implications: Negative: Costly to regulatee Positive: Gives legitimacy to you, as anti-fraud provisions kick in Gives Access to Capital Markets The Basics: 3 basic components make up definition of a Security: 1. Something is excluded from being a security if the context otherwise requires Gives discretion to SEC to exclude certain things Prevents from law overreaching, extending securities laws too far away from effects on capital markets 2. Lists many things that are securities Stocks, bonds, etc 3. Investment Contract Purpose: Is a term that gives SEC discretion to include something as a security Provides a malleable, broadly construed term that may or may not include something Allows for SEC to include new things, reacting to issues in the market place and putting them within purview of federal regulationespecially the latest scheme to defraud people Evlautes Substance of Economic Reality over Form: In using Investment Contract the economic reality, or substance of the issue will be considered over the form it takes Policy Applies Here in Defining Investment Contract: Substance of something includes collective action issues, unsophistication of investors, effect on marketsall the rationales of regulating securities So, simply because something is formed one way does not mean the underlying policy rationales of a security do not exist Overall: We want a definition(s) that effectuates these Policy Rationales for why securities need regulation in the first place A. Investment Contract: Generally: Apply the Prongs Look at Economic Realities Argue policy points of why we need to regulate a security and how the thing at issue fits in or does not 1. SEC v. Howey, Co.: F: Howey owned citrus plots, and sold them to people who visited a resort. In addition to selling them the plot of land, he also sold them a service contract, which gave Howey and his business the right to fully control the land, and maintain it. All the oranges were pooled together, sold, and proceeds return pro-rata. I: Is this scheme an Investment Contract, and thus a security within the purview of Federal Regulation? R: 4 Prong Investment Contract Test: 1. Investment of Money 2. In a Common Enterprise 3. With the Expectation of Profits 4. Solely from the efforts of the promoter/3P/Other Party Evaluate the economic realities and substance over the form Here: It is an IC The Service contract brought this above and beyond a real-estate deal EG: Real Estate alone is not an IC Not Common Enterprise Not solely from the efforts of others While theoretically, the value of your land is largely affected by others, it is not solely affected by othersand you can alter value Here, the Service contract is solely from efforts of others Note: The Optional Service If the service is optional and not chosen, it may lack solely from efforts of others although it may have been offered, even if not sold But, if the purchaser can make economically viable use Less likely to be Investment Contract Note: The sophistication of investors Is not part of the Howey Test May be an indirect, policy argument for the economic realities and policy reasons of Securities Law Note: The intrinsic value, for instance land, that alleged investment already has is not part of Howey Test Policy of Investment Contract Approach: 1. Provides broad enough test to allow argument, but malleable to exclude things that are not within purview Allows for quick reaction to new, potentially fraudulent schemes that implicate all that is unique about securities which we discussed, infra, as reason for their being Federally Regulated 2. Could argue that allows SEC too much discretion, to include things that simply are not securities Counter Argument: Court will evaluate economic realities, and because no factor is more weighty, or prescribed in exactly what it meansvery subjective to Court interpretation, which eats away at the SEC discretion somewhat 3. Unless context otherwise requires also acts as limitfor instance, if other Regulatory Scheme applies

4. Why dont we allow Opt-In/out of Regulation? Label instead of having to determine if security or not? Arguably: People would opt in to get legitimacy and avoid discounting Goes back to voluntary system rather then mandatory system and attributes of a Security If dont Opt in, or decide to opt outall issues with a security are still thereunregulated Investment Contract allows malleable approach to regulating those who wish to get out of regulation SEC has limited resources Economic Realities 5. The Investment Contract Test Focuses on Capital Markets If the type of transaction would have otherwise affected the Public Capital Markets Focuses the SECs efforts, rather then wasting them on things that may not have effected Capital Markets So, another way to limit something that may seem like and Investment Contract Note: See Expectation of Profits prong as indicative of effecting Capital Markets 1. An Investment of Money Policy standpoints of a security this prong includes: 1. Lack of Sophistication 2. Risk 3. Effect on Capital Markets Intl Brotherhood of Teamsters v. Daniel: F: Employer had a compulsory, non-contributory pension plan for Employeeswhere eligibility occurred after 20 continuous years of service. When employee was denied, he argued that material misstatements about the pension had been made, in violation of Federal Securities Lawsand that this was an investment contract security. R: 1. Investment of Money: The giving up of some specific consideration in return for separable financial interest with the characteristics of a security $ is not only considerationcan also be other thing of value Labor, goods and services may apply Note: If labor is compensated for with some type of risky asset, more likely to be IC 2. Context Clause If there is another regulatory scheme that may apply to the issue at hand, covering the thing, the context clause unless context otherwise provides may be used to declare something a non-security So take note, that if another regulation exists, securities may not apply Here: Labor was done for the pay check, not pension Employers contribution was not out of his paycheck Not an investment of money He had no choice in matter, of $ invested or whereNo giving up of consideration for separate interest Note: The larger the Pension, the more likely the money contributed would have gone to capital markets? Effect of Choice: The larger the $ involved, and more likely the pension, or fund will effect or be injected into the capital markets, the better policy argument there is for the thing to be an Investment Contract, subject to the regulation and protection of the Securities Laws Policy: *Effect on Capital Markets: Consideration may be deemed an investment of money for purposes of the Howey test, if that consideration would have otherwise been invested or have affected the Capital Markets Per the Policy rationale justifying regulation of securities Evaluate Economic Realities Effect of Risk in Investment: Risk goes back to initial idea of regulation a Security they are risky and effect the capital markets and many individuals decisionsvast implications require regulation and paternalism Something with Less risk, may be even more enticing to public Public needs protection, in addition to the allegedly less-risky asset having larger implications for Capital Markets and economy as a whole EG: Money Market funds are made up of Commercial Paper. If, even though market as less risky, turned out there was rumor of fraud, run on the bank may occur, money removed from money market account, and then Corporations lack commercial paper needed to run day to day Although not an element, plays into general policy of including something as a Security or not Lack of Sophistication: People may not appreciate the risk of investment

2. In a Common Enterprise Policy standpoints of a security this prong includes: 1. Collective Action 2. Economic Realities/Substance 2 Broad Forms: 1. Horizontal Commonality: When returns of all investors are (1) pooled together and (2) share risk (Pro-rated distribution) 2. Vertical Commonality: Connection between investor and promoter Broad: The promoters efforts affect the individual investors collectively (Even if no pooling) Different investors may receive differing returns Promoter does not necessarily have to share risk with investors Narrow: Same as Broad And, promoter takes risk of investment going up or down with each investor Evaluate the contribution of the promoter and the control the investor gets Note: The types of commonality are not mutually exclusive In fact, they will often times overlap, or both be evident Look for Horizontal, however, as it offers best argument Policy Purpose of Commonality Prong 1. A common enterprise exhibits the issue of collective action In Horizontal Commonality, all benefit together, and lose togetherbut if 1 investor works harder, or acquires more information, then all benefit while he bears all the costs So, no one investor will do this Requiring a Common Enterprise implicates a basic tenet of securities law then Where there is a collective action problem, Securities Regulation should applythat way, information is not hidden, but instead given up front This is seen in Horizontal Commonality But, the greater role you have in the process, and more likely you are to personally benefit from your efforts, the less need for securities lawNo Collective Action Issue 2. The strongest case for securities regulation is horizontal Weaker Case: Broad Vertical: if each individual investor gets different return, then they may have incentive to act on their own behalfnot as much collective action problem Weakest Case: Narrow Vertical: if each individual bears risk with the promoter, promoter has incentive to see it succeed Not as much need for disclosure, paternalism 3. In Economic Reality many actually, legally compliant funds have Horizontal Commonality So, the more something resembles a real fund, it should be treated like a security

SEC v. SG: F: Website set up what it considered a game. People could buy shares, received 10%, and advocated it had no risk. When issues arose of players not getting money back, SEC filed suit alleging there was violation of required registration. I: Was this an investment Contract, creating Federal subject matter jurisdiction? R: 1. Economic Realities, and substance govern. Not the Form Here: Considering it a game was not dispositive, but rather it resembled an investment in substance May argue that the money wouldnt have otherwise gone into the capital markets, and thus no need to regulatebut, it resembles the substance of an investment and for the reasons above, needs to be regulated 2. Common Enterprise Horizontal the court accepted the horizontal approach because (1) It is the Majority view (2) is easy, ascertainable, and predictable in what is a security and what is not Here: All monies were pooled together, with all investors risking together. Ponzi / Pyarmid schemes will generally meet horizontal commonality, as the investors bear risk together, if no new people sign upall lose

3. Led to the Expectation of Profit Policy standpoints of a security this prong includes: 1. Effect on Capital Markets a. Redundancy if doesnt effect capital markets with alternative regulatory scheme like consumer protection Thus context may provide otherwise b. If effects capital markets, legitimate use of SEC resources 2. Risk 3. Lack of Sophistication General Policy: If something is an investment, one does expect profit Thus, this is more closely connected with the idea of the capital markets which is within purview of SEC Focus is on the Capital Markets, and the thing in questions relation to it If something is not an investment and no expectation of profit exists, then it likely doesnt resemble a security, effect the Capital Markets, and is being undertaken for some other reason (Use/Consumption) Waste of SEC resources Rule: Look at Motivation: A. If Attracted for return/profit Security Profit/Return: Capital Appreciation from development of initial investment or Participation in the earnings resulting from the use of the investors funds B. However, if motivated for other desire, such as use or consumption of the item purchased not security

United Housing Foundation v. Forman: F: Housing project was being built. shares were sold in it at a fixed cost, with no appreciation, no dividend, and a right to vote per apartment. The shares did not appreciate even if the complex made money. Buying these shares gave you the right to that apartment. In initial advertisement the price was declared $25, but as costs grew the price changed to $36. Suit is brought under Exchange Act anti-fraud provision alleging the initial advertisement was materially misleading or had omission. I: is it a security, to create subject matter jurisdiction? Was there an expectation of Profit? R: The Primary purpose of Securities Law is to protect Capital Markets 1. Title is not dispositive: Look at Economic Realities and Substance over form Although stock is used in listed securities, this does not resemble same stock Act referred to Doesnt have same features as typical stockso court did not consider it a stock Economic Realities were that it was in fact not a stock See Lander (infra) and section discussing stock test Note: Court used Economic Substance Test of Howey to check stock Arguably, such a test should not be used on a constant basis Creates uncertainty While it is ok to use the Investment Contract/Economic Substance test to those instruments that are borderline, using a fact-inquiry determination on everything creates a lot of uncertainty as to whether one needs to comply with Securities Laws or not While used here in particular situation, best left to those cases that are clearly questionable rather then all 2. There was no Expectation of Profit Attracted for return/profit, or consumption and use? Here: The buyers of the stock were not attracted for a return, which arguably they could not have gotten anyway Rather, they bought them to be able to rent the apartmentconsume/use SEC v. Edwards: F: Pay phone ponzi scheme was developed, where management contract was created and people bought the phone. The company managed, and paid a fixed rate of 14%, or $82 a month. I: Does expectation of profit include both fixed and variable return? R: 1. There is no reason to distinguish Risk: 1. Although Risk is not part of the Howey Test, those low risk investments are actually more attractive to investorsso from policy perspective, that money could have gone to Capital Markets and does resemble the markets Risk goes back to initial idea of regulation a Security they are risky and effect the capital markets and many individuals decisionsvast implications require regulation and paternalism Economic Realities: This resembles an investment like those in the Capital Markets. The money otherwise invested may have gone to a fixed income asset in those capital markets Forman Test of Expecation of Profit: Attracted for the return of investmentso passes Forman test Return/Proft does occur Would create a loophole otherwise, which was not intended Fixed Return and Commonality: May be less likely to be Horizontal Commonality, as the group does not benefit together However unless guaranteed (USA), which most likely isnt, that fixed interest rate is not risk free If the company goes bankrupt, then all investors do lose together Also Collective Action issuebecause fixed, there is no incentive to get information

4. Solely from the Efforts of Others Policy standpoints of a security this prong includes: 1. Information Asymmetry 2. Risk 3. Capital Markets 4. Collective Action issue If it is solely from others efforts, your effort will have no effect, so no incentive to acquire information Perpetuates information asymmetry Policy of Prong: Evaluate the degree investors have in managerial control A Question of Spectrum The Spectrum: Investor Minimum control by investor will not negate finding of Investment Contract Promoter Per Life Partners, minimum control by promoter in investment wont create Investment Contract The greater managerial control the investor has: The less there is a need to find a security Expands securities laws too far away from Capital Markets The more these unusual schemes appear, the further away we get from true Capital Markets The more involved you are the more disclosure and anti-fraud provisions impose excessive transaction costs Overall: The more or less control, the more or less information asymmetry exists and Capital market connection exists A. Generally: Solely is not read literally Generally read as primarily, predominately, or, disproportionate managerial control by promoter B. Alternative Entities and Investment Contracts: SEC v. Merchant Capital, LLC: F: Merchant was formed, and was in factoringbuying uncollectable accounts. To create a pool of funds, it began to solicit limited partners from the general public. 28 RLLPs were created. Pooled $ bought uncollectable accounts. I: Whether a LP meets the solely prong of the Howey Test? R: 1. Focus on the dependency of the investor on the entrepreneurial or managerial skills of promoter Overall it is a Totality of Circumstancesfactual inquiry of the economic realities 2. Limited Partnerships are presumed securities

3. General Partnerships are presumed non-investment contracts, and not securities Rebuttable presumption However, if one of the following factors is met Prong Met Determined at the time interest sold but look to actual operation Totality of Circumstances looks at Williamson Test: 1. Agreement leaves so little power in hands of Partners 2. Partner is so inexperienced in business that he cannot exercise powers given - Inexperience looked at of investors in the particular business in question - Not in their overall, general business sense and skills 3. Partner cannot replace the manager of enterprise, and is reliant on him Here: While in form on paper was significant power, in substance not Had no experience of this type of business Were, in essence, reliant on the managers Note: Alleged control given to LPs may be to bypass securities laws, while in substance not really giving them controlWilliamson Test does away with this Investor Expectations: In Merchant, the court focuses on investor expectations at time sold, in addition to facts of actual operation While freedom to contract, and waiver of security may lead to show investors expectations The reality of the investment may not be what was agreed to Substance over Form So focus on investor expectations may fail to answer policy protections securities laws offer

D. Efforts: SEC v. Life Partners: F: Company sells interests in viaticle settlementbuying life insurance of Aids patient, at discount, and when they die you get the proceeds. SEC argues that these are securities, sold without registration under Securities Act. I: Were the efforts solely of others. R: 1. Post-Sale, A promoters purely ministerial acts are not enough to meet this prong The promoter here could not influence the return at allpurely reliant on patient dying We only look to the managerial/entrepreneurial efforts of the promoter of the investment Ministerial acts are no entrepreneurial or managerial effortsnot efforts intended Cannot effect investment at all Would be too broad a reading Policy of Why: Information Asymmetry and lack of post-sale efforts: Disclosure post-sale would not help Promoter cannot do anything to effect return, so disclosure of what they are doing is meaninglesslack of information asymmetry Not informational superiority, as cannot effect returns, so the fact that all or most efforts are pre-sale raises policy issue that Securities Laws wont help Effect of Pre-Sale Efforts: Pre-sale efforts cannot alone count as efforts of others

Note on Franchise Agreements: There is a chance that a Franchise Agreement can fit into the definition of an Investment Contract 1. There is an investment of $ 2. Commonality exists, in the broad-vertical formthe promoters efforts effect the investors, although dont share same risk 3. There is an expectation of profits 4. Solely from efforts of others There is a potential that, if franchisor mandates all that franchisee has to dopolicies, etcit may be solely from efforts of others Generally franchise agreements will not fit into the definition of an investment contract But, may go back to a spectrum of the degree of effort/control the investor or promoter puts in B. Stock: Generally: One of the specifically enumerated securities listed in 2(a) 1 Unlike the Howey Investment Contract analysis, stock analysis is generally not fact-specific Promotes Certainty, and ability to expect the securities laws to apply Because so common a security, uncertainty would pose potential issue with Capital Markets Landreth Timber Co. v. Landreth: F: Dennis eventually purchased Timber company in an all stock transaction. There were issues when he bought the company, such as the rebuilding of the saw-mill, but he bought anyway expecting them to be fixed. When they were not, and he sold for a loss, he filed a suit saying that the stock sale was a security, and was not registeredsought disgorgement. I: What is a stock? R: 1. If the instrument possess the characteristics associate with a stock and the title of stock, it will be treated as a stock and a security If the Title and Characteristics are that of a stock, justified in assuming security laws apply Characteristics: Dividends Residual value at liquidation after all other Voting Rights Ability to appreciate in value Note: There is flexibility, as some shares dont possess all these characteristics 2. When an instrument qualifies as a stockinvestment contract analysis is not needed A. The investment contract analysiseconomic substance and factual evaluationis only used in an investment contract analysis Forman evaluated stock because of the characteristics, not based on the Howey test B. Investment contract analysis is used for unusual items, or unclear instrumentsnot always Used as a safety valve, to include potential unusual schemes/items Howey limited to Investment Contract Landreth limited to Stock Bringing the uncertainty of the analysis into each, fact specific inquiry of stock is dangerous to markets Would make language of investment contract and Stock superfluous Purpose of IC is a safety valve, catch all

3. The Sale of Business Doctrine is RejectedCertainty in Markets is Important Doctrine is the idea that sophisticated investors, who buy an entire company dont apply to Securities Laws Sophisticated Investors: Not as much information asymmetry or collective action issue Can negotiate better However: The Securities Laws already apply to sophisticated investors in Private placements, anti-fraud, tender offers This implies that Congress intended to regulate them as well as passive/unsophisticated investors Sophistication, alone, is not sufficient to exempt The laws apply to securitiesnot particular investors, although used in general to protect investors Still chance, on back end, that these securities are sold to unsophisticated investors The Securities still exhibit characteristics which need regulation Would lead to uncertainty in stock markets Maintaining Certainty in Market is Important Goal: Line-drawing between sophisticated and unsophisticated is not easy Uncertainty in stock-markets of application of securities laws may have negative effect Arguments for and against Landreth: Against: 1. Sophisticated purchaser can negotiate information, less concern with collective action 2. Sophistication 3. Less concern with information asymmetry 4. Waste of SEC time and resources to focus on such a small company, when large frauds occurring in public markets For: 1. Original owner kept as manager, so still asymmetric information 2. Once exception made based on sophistication or other, line drawing is uncertain 3. Maintain consistency with market, and investor expectations long thought of that stock is regulated If some is and some isnt, may create uncertainty and lack of consistency 4. Protect passive investors 5. Securities are regulated to protect investors Securities still bear unique characteristics and arguments for regulation even if sophisticated investors exist (i.e., intangible, lack of all information, risk, capital market effect) 6. Even if there are ways around stock purchase (asset purchase), thats irrelevant as it does not deal with securitieswhich (for arguments infra) need to be regulated C. Note: Generally: An enumerated security in 2 (a) 1 of the Securities Act There are many variations of notes, but have typical characteristics: 1. Fixed, periodic interest payment 2. Fixed maturity Date 3. No Voting Rights 4. Get payment of interest, and face value back at maturation Reeves v. Ernst & Young: F: Co-op issued promissory notes, payable on demand. With variable interest rate kept above bank rate, issuer eventually went bankrupt. Accountant had represented the Co-op as successful and viable, however suit brought alleging the auditor failed to adequately audit, and violated anti-fraud provisions of the security act. I: Whether a demand not is a security? R: 1. Stock is different then note Note is a broader category with much more divergent characteristics, as not all are investments must be understood in context of why Congress included it Potential for Private Negotiations: Like Landreth, here investors may contract for added information and thus securities laws in some contexts may simply not add anything but transaction costs But, not surplusage in statute 2. The Family Resemblance Test: 1. Presumed that all notes with a maturity of greater then 9 months are securities (per exemption in statute) 2. Rebuttable if bears a strong resemblance to one of the listed exemptions, utilizing factors a. Motivations of Transaction Investment profit versus Commercial/Consumption b. Reasonable Expectations of Investors c. Plan of distribution Common trading platform, speculation, investment to common public? Offering to public is enough d. Presence of an alternative regulatory regime that reduces risk making application of securities laws unnecessary? 3. If does not bear strong resemblance, can utilize these factors to convince court to add to the list of notes that are not securities Notes that are not Securities: Consumer Financing Mortgage note Short term business note Commercial paper note The more investment like, the more likely to be security Here: Sold to general public, marketed as investments, and no alternative regulatory regime

Policy Of Note: In Commercial Sense: If the securities laws overapplied to notes in consumer and commercial nature, the effect may be to chill those activitiesno wanted The laws may apply by the definition, but the policy reasons for regulating a security may not be as warranted Courts are warranted to demonstrate judicial restraint due to importance of debt markets Dont want to oppressively regulate them Potential for Private Negotiations: Like Landreth, here investors may contract for added information and thus securities laws in some contexts may simply not add anything but transaction costs Due to perhaps increased negotiation, Collective Action, and information asymmetry may not be existentetc In Investment Sense: Creates same attributes that all securities manifest Investors generally lack same ability as commercial users of notes to get information But, not a clear distinction So use Reeves Test to determine intention Difference between Reeves and Howey: 1. Motivation Focus Reeves: Focuses not only on motivation of lender, but also on borrower This is due to note being debt-instrument, using contractso both parties evaluated Howey: Only looks to expectation of investor of profit 2. Scope of Distribution Reeves: Focuses on plan Howey: Focuses on common enterprise, which is more limited 3. Expectations Reeves: Focuses on reasonable expectations of investors Howey: Focuses on particular investors expectation of profit Effect on Capital Markets or not 4. Multi-Factor versus All-Factor Reeves: Provides a balancing test of the factors listed Howey: Requires all factors be met for a security to exist D. Securitization: What is it: Securitizing something is pooling together assets, and then selling the rights to the proceeds of that asset to certain parties Effects: 1. Liquidity: selling securitized assets gives seller liquidity for what may be, taken alone, illiquid asset 2. Diversification: risk of individual assets is now spread out, with other risks balancing it out Policy Ramifications: 1. Moral Hazard: By providing liquidity, and selling security, people dont care as much once sold That carelessness spreads into creating it, so you create poorly functioning securitized things, and sell them 2. Expectations Heightened: high yields led to increased demand for them However, as they began to fail, demand stopped 3. Illiquidity Issue: froze the market 4. Created National debt crisis: By Federal Government bailing out Securitization and Securities: Securitizing something may turn a non-security into a security, potentially: May meet investment contract test: 1. Investment of Money 2. Commonality: investors, whose money is pooled together, or if all depend on promoters success 3. Expectation of profits: Whether fixed or variable 4. Dependent on predominate efforts of promoter Security Wrap Up: Investment Contract Howey Test (Economic Substance Test) Stock Landreth Test (Traditional Characteristics Test) Note Reeves Test (Family Resemblance Test) Effect of Being Security: Once considered a security, federal securities laws apply Anti-fraud provisions apply 1933 Act Registration applies 1934 Act Disclosures Apply

IV. Disclosures and Their Accuracy Generally: Congress created the 1934 Securities Exchange Act to create disclosure requirements It delegated the specifics of the disclosure mandated to the SEC The SEC has in turn developed and mandated specific items be disclosed A. The 1934 Exchange Act: 1. Generally: 1. Determines Public Company and Anti-Fraud Requirements 2. Creates substance of periodic filing and disclosure requirements for these Public Companies 3. Regulation F-D When an issuer discloses material non-public information to certain individuals or entities (Analysts, Holders, etc) The issuer has a duty to make a public disclosure of that information 4. Mandates certain mechanisms that exist to ensure that mandatory disclosures are accurate 2. Policy of Disclosure: Smaller Scale Contract: On a smaller, private scale, investors may be able to contract for certain rights, such as what information they may get Trust: Also, on smaller scale, parties may know each other and trust each other in process On Bigger, Public Scale: Solves Issues of why securities are unique, and why disclosure will help (infra) The ability to contract and trust really dont exist Information Asymmetry Collective Action Problem Federal Securities Laws, the 1934 Act provide a fix to these issues (discussed infra) Takes into account: 1. The Scale of the Enterprise In $ amount The Amount of people Both of these have implications for capital markets 3. Three Ways a Company Becomes Public : 1. 12 (a): Companies listed on a National Securities Exchange it is illegal for a broker-dealer to trade in securities listed on a national exchange unless registered 12 (b) is registration Policy Reasons: Open to the Public Capital Markets Information Asymmetry and Collective Action issues Disclosure helps these people Anti-Fraud liability The laws applying make the Exchange and traders feel more secure 2. 12 (g) Companies with >500 Shareholders and at least $10M in assets Policy Reasons: The size of people exacerbates the collective action issue and information asymmetry While 500 is somewhat arbitrary, it is a number used to exemplify these issues that plague securities Amount of $, while too arbitrary, is possibly used to exemplify the ability to pay for the disclosure 3. 15(d) Companies that have filed a 1933 Securities Act registration Statement to make Public Offering General: Typically occurs now with debt offerings This is largely in part because those companies filing to make a public offering will be listed on an exchange, or have the threshold Assets and Shareholdersthus they will register under 12(a) or 12(g) Do not have to comply with 14 Proxy Rules 4. Ways to Avoid Public Company Status: Purpose: 1. Expensive: 1934 Act compliance and disclosure requirements are very costly 2. Exposure to Excess Liability 3. Public Scrutiny: some companies and managers may simply not want to deal with it Duties to be materially Accurate Negative Externalities of giving competitors your information Methods: 1. To Avoid 12(a): Delist from Stock Exchange Note: Even if one does delist from an exchange, and 12 (a) no longer applies, typically the company will be of sufficient size to have to report under 12 (g), or under 15(d) So, have to check those rules too 2. Deregistration under 12 (g): Either: 1. Certify that you have less then 300 shareholders (if assets >$10M) or Purpose: The even less shareholders is there as a prophylactic rule Provides excess cushion in case inadvertently cross the 500 mark Inadvertent public company is avoided 2. Certify that you have less then 500 shareholders and Benefit occur? Reduce Redundancy of internal controls to avoid Cost>Benefit Possible Methods: 1. Information Systems: track the expenditures and sales per unit, 2. Internal Auditing 3. Segregate Duties require multiple parties to sign checks, maximum allowance before permission to do so 4. Policies and Procedures Design a system of clear policy and procedure to avoid this 5. Training 6. Company Code of Ethics and Policy Goes back to disclosure of it, or disclosure of why you dont have it Oil States International: F: Oil States owned a subsidiary in Venzuela. The subsidiary was dealing with a consultant to contact it with the local government and a local government owned company. The local company began overcharging, and the consultant participated. Kick backs were occurring, and eventually Oil States figured out it was losing money in its Venezuela projects. Oil States corrected its books, strengthened records. I: Whether Oil States is liable under 13(b) 2(a) or (b)? R: 21(c) action broughtcease and desist Violation of 13(b)2 (a) because its books were not accurate and fair in reasonable detail Violation of 13(b)2 (b) for failing to maintain adequate controls Why were they liable?? The 21 Reputational sanction was available because 13(b)2(a) is strict liability Even though they decided to voluntarily disclosestill liable FCPA May allow bribery of non-government official: The FCPA specifically prohibits the bribing of government officials Government Official: any officer, employee of a foreign government, or any department, agency, or instrumentality thereof, or any person acting on the behalf of a government So: Will need to argue neither employee or working on behalf FCPA Policy: 1. The FCPA may disadvantage US Companies that operate internationally Other countries dont have this restraint Competitive disadvantage But: US may be able to point to FCPA, avoiding extortion issues 2. The Costs of compliance with internal controls has effect on Corporations Audit Policies and Practices 3. The Benefits of compliance with internal controls is questionable The more regulation, the less a business focuses on the task at hand---the business All that effort, and still not a complete fix Redundancy is an issue too with any internal control scheme Could, after these costs hurt shareholders wallet

E. Use of 3rd Party Reputation as Gatekeeper to Disclosure: Reason: Gate keeping Function Ensures accuracy of most important Financial Statements Info Asymmetry and Collective Action issues eased as information flows through intermediaries to SH Key Issue: In all, we are worried that 3rd parties will be Capturedno longer independent, making disclosure useless So: With Rules, we focus on independency 1. The Independent Auditor: General Function: A. Rule 13a-1 requires a public company to be audited by an independent accounting auditor B. Accountants are the gatekeeper of ensuring financial disclosure and integrity Their accuracy and good job is key to maximizing the benefit that disclosure offersi.e., remedying unique issues with securitiesand the ability for intermediaries to funnel the information down the pipeline Post Sarbanes Oxley: A. Auditors must be independent 1. 10A(g): Auditors are prohibited from performing other non-audit services for a client 2. 10A(j): Partners must be rotated from account to account every 5 years or less Policy: Benefit Avoidance of Capture Cost May be very costly to the auditing firm, and may instead merely pass along a shiester auditor to another company May potentially hurt oversight, as best partners have to move on 3. 10A(l): Auditor cannot audit a company if the CEO or CFO worked for that auditor within last year 4. Public Certified Accounting Oversight Board Created by SOX, the PCAOB creates new rules and standards that Auditors must comply with 5. Auditor Standards and Sanctions: 1. Cannot engage in intentional, knowing or reckless conduct that results in violation 2. 4 (c): May be barred from practice in front of SEC

B. Audit Committee As a result of SOX, the auditors who annually audit a company are supervised by the audit committee of target companys Board of Directors Policy: Helps in the process that the most important portion of disclosurefinancialsare taken care of Membership: Members must be independent directors, who only get salary for directorship NYSE and exchanges require more strict rules, that all members be financially literate What must occur: 1. Auditor Compensation the committee is responsible for developing the retention, compensation and oversight 2. Auditor must Report critical policies Disclose any alternative treatments of information discussed with management Disclose material communications between auditor and management Must report on the internal control and evaluate them Auditors also must use their practices and skills in an attempt to detect illegal acts If foundreport to Committee, and if need be to SEC C. Potential Issues Remain with Auditors: While the above fixes have helped audits become more independent, accurate, and beneficial of overall disclosure, there are issues 1. Oligopoly Problem Because of The Big 4 there is no incentive to compete with each otherrather, sharing the wealth will benefit all However, there is incentive to squeeze the market so that no one can enter 2. Partners may seek profits: Even with the rules available, greed may fuel fraud Thus, the reputation and gate keeping function of the auditor is bypassed 3. There is always potential for Capture 4. The issue that disclosure of Auditors leaving, it is in the best interest of the company and auditor to spin the story (see, infra, discussion on 8-K disclosures)

2. The Securities Lawyer: General Function: Lawyers expertise and assistance allow for accurate disclosure and compliance with the securities laws They enforce and assist in the process Gate keeping Mandates: Benefits: A. Lawyers understand the process the best B. Is more Cost efficient and thus the benefits are maximized by using lawyers for enforcement and compliance in addition to auditors Issues: A. The Cost of lawyers is high This is passed onto the corporation, and in turn the shareholder B. Lawyers are less likely to be privately liable C. There is conflict between lawyers gate keeping and representation of corporate client D. Capture What Lawyer Must Do: 1. Withdrawal Duty: Lawyers confronted with fraud are required to withdraw from representing the client 2. Whisteblowing: Lawyers must report material violations of state or federal securities law to company, or GC If not satisfied with the response, lawyer must report to audit committee If not satisfied with response, lawyer may go to SEC Whistleblowing Function: How are lawyers Sanctioned: 1. Injunction 2. Bar Pursuant to 4(c), Lawyer may not be permitted to practice in front of the SEC This means virtually any filing Note:a. Potential to end a securities lawyer career as can be for period of time or indefinitely

V. Rule 10b-5 Anti Fraud The Rule: 10b SEC has authority to adopt rules governing any manipulative or deceptive device in connection with purchase or sale of security 10b-5 Prohibits: 1. Fraudulent Devices or Schemes 2. Misstatements or Omissions of Material Facts or 3. Act or practice that is fraudulent or deceptive in connection with purchase or sale of any security Elements: Misstatement of Fact or Omission (Deception) Materiality Scienter Reliance Causation Damages

A. General Policy of Fraud 1. Why We Regulate Fraud: 1. Fraud has negative ramifications for Securities Markets Effect: Negatively influences how capital is used by investors, as overvalued prices eventually lose $ Waste of Resources as $ could be better used elsewhere Undeserving business that should go bankrupt is continued Prices Discounted Shareholder is hurt by Agency Costs Securities are intangible and susceptible to fraud 2. Investor Discounting Problem Fraud is priced into stocks with slight discount As Fraud Continued 1. Honest Companies Punished due to lower IPO prices 2. Lemons Problem: Truthful Companies would be forced to leave markets due to lower capital raising capability 3. Fraudulent Companies would remain, as discounting continued 3. Unsophisticated Investors Taken Advantage Of Typical, everyday investors are more vulnerable As irrational investors buy securities, the fraud, and overvalue of them leads to losses 4. Increases Accuracy of Disclosure Another method we use in our securities regulation regime to increase accuracy 2. How do We Regulate Fraud: 1. Audit 2. 3rd Party Reputation Auditors, Underwriters, Investment Bankers, Lawyers Concerned with Capture 3. Process Controlled with 13(b)2(b) 4. Rating Agencies 5. Enforcement 6. 10b-5 Liability Note: An overall blanket, like 10b-5 is most likely more efficient, rather then having investors go through other options to determine if 3rd party is reputable, track record, etc Cheaper B. The Use of the Class Action Lawsuit Generally: A Key Policy Issue of 10b-5 being broader or narrower While 10b-5 allows for an interpreted private cause of action, with a small company of relatively few shareholders it may be feasible and justified Benefits> Costs Collective Action Issues: However, as the company gets bigger, the costs of doing so to go through the process are huge, and impossible to do while the shareholder only gets pro-rata portion of the recovery Costs> Benefits The Class Action allows for the aggregation of all shareholder interests

A. Issues with Target Company and Plaintiffs Bar: 1. Distinguishing Fraud from merely bad business decision is not easy 2. s Bar: Cons: Like business, s attorneys speculate and essentially lend (contingency fee) to shareholder to recover later Settlement/Strike Suit Incentive to bring settlement suit for huge pecuniary value; nefarious purposes Benefits: They may be necessary evil, to have trained representation of shareholders, however

3. Settlement Usage of SuitFrivolous versus meritorious suit If attorneys can get past motion to dismiss, they will seek to get past for settlement value Company has incentives to settle: 1. They have insurance to use 2. Attorneys fees in the massive process are high 3. Makes business look bad 4. Quicker to settle, lower the cost 5. Massive amount of Fishing for documents 6. Long time 7. Distracts business from its key purpose Frivolous Law Suits: Extortion value, nuisance value, brought without belief there is evidence, costs10% of net worth, if net worth is costs Ratcheting this % up may be a good thing Offsetts costs of chane of never being hired again 3. 20A Standing to Contemporaneous Trading Shareholders who traded around the same time may sue individual trading on material non-public information

D. Section 16: Provides for a 3 Pronged approach to addressing insider trading 1. 16(a) Required Reporting within 2 days of Trades By: 1. Directors or Officers of the Issuer 2. Shareholders with > 10% of any class of securities (stock, option) File Form 4 Policy Effect of 16a: 1. Curb Take-Over As a party who is gradually acquiring stock for a potential takeover, 16 may deter you Negative Externality of Disclosing Lead to price increases Pay more for takeover Leads to competition and putting the target in play 2. Function as an Anti-Takeover Scheme Negative: Leads target to continued inefficient operation 2. 16(b) Short Swing Profits 1. Requires disgorgement of profits made in transaction of purchase and sale that occurs within 6 months Policy: Attempts to bar trading where insider is pursing short-term gains, presumably on inside information with the companys stock Misappropriation of corporate property Avoids officers from changing policies and practices in pursuance of short term profits Exception: Stock option conversions Policy: Recognition that options are used as compensation Thus, not a surprise that insiders will exercise options to increase compensation But, unlike options, taking short term positions in stocks is not aligned with incentives, especially considering that options are usually out of the money and take time to earn income off of them Standing to Bring Suit: 1. Corporation 2. Shareholder acting in derivative suit Strict Liability No scienter is required 3. 16(c) Bars short sales of the companys stock by: All insiders (Directors, Officers, and 10% more shareholders) Policy: Misaligns incentives of directors and officers of company They are in position to easily profit off of short sale Disincentive to tank corporation to their benefit

VII. Public Offerings: A. Corporate Finance Background: 1. Basics 1. Capital Needs of the Business Immediate, long term 2. Types of Financing Financing has many different forms that can be selected Effect of over regulation: Change of Behavior: By over regulating certain form of financing, companies can shift financing choice Public to private equity as a replacement Examples: 1. Internal Financing: Includes plowback of retained earnings Assumes there are cash flows that can be reinvested Organic financing may not be available for startups 2. Financing from Current Owners Venture Capital Maintains control of the company 3. Bank Financing possible, but risk will need assurance of repayment With newer companies, unlikely to lend due to lack of records, income, capital, or collateral 4. Private Placements 5. Public Offering Issues: High costs to enter Dilution of existing owners Disclosure, and securities regulation compliance Negative Externalities of competitive disadvantage Short term focus of meeting analysts predictions quarter to quarter Loss of control Non-Economic reasons to Publicly Offer: 1. Public offering creates liquid secondary market for company allows insiders to sell allows for secondary offering to occur for added financing allows for more sure source of capital for secondary offering 2. Publicity and Investor Excitement May assist company in financing later Legitimacy of company Promotes products and corporations attributes 3. Types of Securities Debt, Common stock, Preferred stock Why do we have 3 elements of capital structure: 1. Each fulfills different need of corporation WACC at optimal level Allows for Flexibility Options 2. Fulfills different needs of Investors, who have Differing Risk Profiles and Preferences Investors are where company gets financing from More options of capital structure allows a company to tap into each investors risk preference 2. Public Offering Process The Underwriter The main player in the process Role and Key Attributes: 1. Starting point to determine potential of offering 2. Skill Advice and experience of structuring offerings 3. Reputation and Connections: Marketing: Source of many contacts with large institutional investors and 4. Financing Overall: while skill is one thing the reputation and connections are the biggest factor Almost guarantees success of the offering and $ to corporate issuer Underwriter Legal Documents: 1. Letter of Intent Intent to sell Size of spread Option to purchase more shares and sell them if demand is available 2. Underwriter Syndicate Agreement How syndicate will divide up spread Who is responsible for what If Liability ensues: Proportionate liability is easy to determine Simply look to the % allocation of the profit of the issuance and that will show % allocation of liability 3. Underwriting Agreement: Formal Agreement that lays out terms of offering Total Shares, price, gross spread, over-allotment option Representations and Warranties FINRA Requirements: That UW Fees be reasonable Is a 7% Continent Fee Reasonable: UW based on sale occurring Exude large efforts and sophisticated analysis to correctly do so attorneys make 30% UW are different than Attorneys: UW are not successful if the IPO does not go through An hourly approach to paying them is irrelevant if the IPO fails Thus, the contingent fee is in line with the task at hand Attorneys, however, should be paid by the hour Otherwise, they may abdicate their duty to get the deal through, where their duty is to make sure it complies with the applicable laws, not whether its successful or not (partially)

Types of Offerings: 1. Firm Commitment: Process: The UW, or UW syndicate commits to purchasing securities They purchase a discount of worth, guarantee sale, sell for worth and pocket the spread All risk on UW, then, to resell so they take on average 7% EG: UW buys an issuance of 55M for 53M, and sells for 55M Benefit: Issuer is guaranteed return, they know exactly how much they will get They may plan accordingly 2. Best Efforts Offering: Process: Underwriter commits to trying his best to sell the shares No guarantee Receives a commission from shares sold rather then spread Less risk for UW, but less return to UW Syndicate of UW to spread risk of offering flopping Issue: Without reputation and, for instance, backing of Goldman Sachs reputation, may not be as likely Red Flag to market that UW did not commit to the offering

Policy Concern: Firm Commitment versus Best Efforts The Underwriter wants to use firm commitment to get return While he does take on all the risk, underpricing the issuance and purchasing it lower than perhaps is capable, almost guarantees him the higher return Therefore: UW and the UW syndicate may be able to influence decision to go with Firm Commitment Oligopoly issue May implicitly act, or enga