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Securities Regulation
Temple University School of Law
Ellers, Edward S.

Securities Regulation
Ellers – Fall 2010
I.          Main Elements of Securities Regulation
1.     Disclosure based model – companies must fully disclose all material info to purchasers
2.     Securities Transactions
A.    Primary offering or Secondary Offerings
1.    Issuer Transactions or Primary Transactions
a.    IPO – Co issues securities for 1st time. Co gets $, investors get stock. Can only be 1 IPO.
2.    Secondary Offering – when the company decides to sell more stock publicly
3.    Secondary Transactions – when the investors sell the stock to someone else.
a.    Secondary trading is calling trading transactions
B.    Private – if they are small in number of purchases or amount
C.    Public – where securities are registered with SEC and then traded
3.     What securities regulates (4)
A.    Requires disclosure of material information by issuers in primary or secondary offerings.
B.    Requires public companies (trade on exchange) to disclose material continuous information on a periodic basis. (public companies have continual disclosure of info)
C.    Regulation of people who attempt to use unfair practice
D.    Firms and markets that sell buy and trade securities
II.      About the System
1.     Dual System: both FED (SEC) and State Reg.
2.     State
A.    State system = Blue Sky Laws
B.    States have jurisdiction for those things exempt federally.
1.    Thus, just bc you have a fed exemption doesn’t mean you’re exempt. Must check state
C.    Non-Public Offers – State focuses on nonpublic offers. Exempt from fed law either bc sold w/in 1 state (ie no I/C) or too small either in amount being sold or # of purchasers
D.    “that issue has to be blued skied” = been registered w/ SEC, now fill out paperwork w/ state
E.    Merit Review = Big Difference btwn State and Federal Regulation (FIL)
1.    Fed: SEC does not have merit review. Won’t make a judgment on whether it’s a good or horrible deal. Allows sale of securities once RS contains all required disclosures.
2.    State: Many states, like PA, do have merit review. – if PA securities commission doesn’t like underlying securities deal, they won’t let it be sold in PA no matter what disclosures you make.
a.    When: It’s only for offerings filed in the state. They don’t do it when SEC says it’s okay, but will do it if SEC exempts you.
b.    If state rejects you, go to another state and can’t sell it in state where haven’t been “blue skied.” You prob won’t change the deal.
3.     Federal –
A.    The Legal Framework for Securities Regulation
1.    The Securities Act of 1933 – regulates issuer transactions, whether in the IPO or secondary offerings.
a.    Covers primary or secondary transactions by issuers. All about registration
b.    All about disclosure, created registration process, focus on protecting investors in primary distrib.
c.    Specific goal: the registration of public offerings of securities not otherwise exempt under the Act.
2.    The Securities Exchange Act of 1934 – regulates trading transactions, so everyone but issuer.
a.    Requires continuous & period disclosure of info so investors can make decisions
b.    Section 10 & Rule 10b-5
3.    Sarbanes-Oxley (2002)
a.    says unless you behave in a certain way, we won’t allow you to sell securities, no matter what you disclosure. Directed at changing corporate behavior.
b.    Sets forth broad prescriptions for corporate governance, authorizes the SEC to develop rules for professional conduct for lawyers, and regulates areas that have always been the province of the states, such as loans to officers and directors
4.    Integrated disclosure – ’34 Act can be incorporated by reference to satisfy ’33 Act requirements. Allows to combine some requirements of Securities Act (33) and Exchange Act (34). Greatly reduces delay & cost of registering.
B.    SEC authority: SEC can only injunctive relief. SEC can’t sue for $ damages or bring crim action – DOJ does.
III.     Markets and Their Efficiency [93-108, problems 3-1 & 3-2] 1.     The SEC Today-
A.    Two big shifts – SEC disclosure requirements of not as much utility in light of these shifts:
1.    Shift of ownership of public securities form individual to institutional investors
2.    Growing acceptance of efficient market hypothesis
B.    Given the leverage & influence that wall street investors have, mandatory disclosures are also questionable. How can individuals compete?
2.     The Efficient Market Hypothesis: Implications and Limitations
A.    Def: Theory attempts to describe relationship btwn disclosure of financial info & changes in stock mkt prices
B.    Point of it: Historical info is no longer either valid or necessary to predicting future prices of stock.
C.    *not everybody believes it’s true. Cts starting to rely on it. SEC implicitly accepts it in some disclosure changes
D.    securities prices instantly reflect all public info, so you can’t predict future prices based on presently available info. It’s so efficient that it’s already reflected in that info.
E.    For our purposes: relies on analysts that follow stock and essentially kept the public informed and change the stock price through their analysis and publishing.
3.     Information Costs and Market Efficiency – information costs (costs to acquire info, expense to decipher significance, cost to verify validity).
4.     Informational efficiency – describes the speed with which market prices adjust to new info
5.     Allocation Efficiency – concerns allocation of resources to their best or highest use
6.     Commodity Futures Modernization Act of 2000 – for the first time permits single stock futures & futures on small groups of stocks, with joint regulatory responsibilities over these two activities shared by CFTC and SEC
I. The Definition of a Security
I.         Start on Exam: §2(a)(1) of the ’33 Act contains the definition of security. As it relates to these facts, there are ___ # of items that may cover it: X,Y,Z. (e.g. stock, investment K, participation in a profit sharing agreement).
II.       Under § 5- it’s unlawful to sell a security [in I/C] w/out a RS in effect. Need to figure out if it’s a security.
1.    Under Section 2(3) – a sale means an offer.
2.    As long selling or offering an interest in something and not the actual thing, may have a security.
3.    Anytime $ is invested, loaned, borrowed, by or from third parties, the potential exists that a security has been created. Follow the money.
4.    Which act to look at: ’33 Act when dealing with registration issue or IPO. If dealing w something that arises under ’34 act, look there. The definitions are similar, but can be different for some things. Notes are in both but are different.
5.    Statutory Definition – Section 2(a)(1) of ’33 Act- The term “security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.
6.    To define a security, look at CASES & INTERPRETATIONS. Read index to see if there is an applicable rule.
A. Investment Contracts, Howey,
I.         Investment K is not defined in the act, it’s a catch-all position
II.      Remember – Participation in a Profit Sharing Agreement – Since the same tests are used in determining whether it’s an investment k or participation we can determine it under either one.
III.   Test for Investment K and Participation in a Profit Sharing Agreement– Under Howey, an investment contracts exists where (1) there is an investment of money or a thing of value (2) in a common enterprise; (3) with an expectation of profit; (4) solely from the efforts of others.
1.    Howey Test – 4 Prong Test defines what an investment contract is: Look at it from investor’s POV.
A.  (1) Investment of Money or a Thing of Value
1.    investment can be cash or non-cash value
2.    Investment v. Consumption – United Housing Foundation v. Foreman-when a purchaser is motivated by a desire to use or consume the item purchased – “to occupy the land or to develop it themselves” the securities laws don’t apply. Primary motivation is not investment.
3.    usually not at issue, can dismiss most of the time w/ 1 sentence on exam
4.    if don’t want it to be a security – argue that it’s a capital contribution, not an investment of $ even though $ has changed hands
B.   (2) In Common Enterprise
1.    FIL – horizontal commonality, strict vertical commonality, broad vertical commonality
C.   (3) With an Expectation of Profit
1.    Profit = capital appreciation and a stream of earnings. Nothing else. (Foreman)
2.    Use & Consumption – objective view -Where investor’s primary motive is to use or consume, won’t satisfy profit prong – Foreman (profit must be the principal motivation for the investment, NOT consumption)
3.    expected profits must be from the enterprise, not merely additional contributions
4.    Qualification – is exchange of $ related to the return that expecting OR is it more like the price of admission to something like CART or housing coop or to secure job or opportunity make $ by his own efforts.
D.  (4) Solely From The Efforts of Others
1.    Write – The test is solely from the efforts (Howey). But, it’s been interpreted to mean means significantly, not solely (cite). To the extent the significant efforts to make a profit are going to come from the promoter, then this prong will be satisfied. Alternatively, if the significant efforts will be contributed by the coffee shop owners, then it won’t. We have to look at what efforts predominate. [examine the efforts that will be made-break down & say who is doing what. Don’t go crazy on this element, not a lot of wiggle room] a.    are the efforts of others the predominant/significant/essential managerial efforts?
b.    investors efforts may contribute to the profits, but the managers efforts must be predominant
c.    investors must be mostly passive
d.   Time = FIL – do significant effo

ality. If there is not, then there isn’t. (MCI).
1.    Ex) broker invests money for lady in discretionary account, stock does down, money lost. Woman wants to sue. No fraud, so lawyer tries to say it’s an investment K. even though buying stock, lawyer thinks the security here is the discretionary account. Is the investment in a discretionary account an investment K? Yes to all except lawyer faces hurdle over whether its’ a common enterprise when only between 2. If you accept horizontal commonality as the only way for common enterprise, then NO.
2.    Ex) if multiple investors are buying different debt instruments, but each debt instruments is dependant on being contributed to the same enterprise. Good L will argue no, don’t have horizontal bc don’t have multiple investors buying the same interest under traditional def. To get around it, great L will say it’s their contribution to the larger enterprise that forms the horizontal commonality. Everyone’s interest are being pooled into the larger biz enterprise even though they are diff. one w/out the other and you wouldn’t have an enterprise. Only value that investment has is if contributed to larger pool. (problem 2-2, pg 40).
2.    Strict Vertical Commonality-fortunes of promoter are tied fortunes of each investor, even if there is only 1 investor.
A.    Ex) Classic strict case – In Hiwifi, if store makes money, promoter makes money. Their fortunes are tied together. The promoters are only going to make money if the investors [stores] make money. if the investor [store] is successful and it sells, they all make money.
B.    Ex) In stockbroker, not strict vertical bc the investor wasn’t making money. Investor could be losing and stockbroker could still be getting paid bc he gets a fee for transaction. (getting paid regardless). BUT, if broker instead only getting commissions on profits, it would work.
3.    Broad Vertical Commonality-Connection btwn efforts of promoter and success of venture
A. Just giving advice would be enough. Very few courts accept this.
B. Ex) in Hiwifi, the efforts of the promoter are the advertising, technology, and service. The advertising would probably be enough to establish broad vertical.
2.Expectation of Profit
I.          Set up – The third element requires that the investors had an expectation of profit when they invested. Profit is defined as capital appreciation or investment in a stream of earnings. (Foreman). If investors Primary motive was to use or consume the benefit, it is not a profit. (Foreman). A fixed return can be an expected profit. (Edwards).
II.       Overview
1.    Profit = Capital Appreciation or Investment in a Stream of Earnings. (Foreman)
2.    Name is not determinative
3.    Whose expectation – whoever is contributing money
4.    Profit can be variable or contractually fixed – (Edwards)
5.    Use & Consumption – where their Primary motive is to use or consume, you won’t satisfy the expectation of profit prong of Howey. (foreman)
6.    Substance over form– look at transaction w/ economic realities in mind (Foreman)
7.     United Housing Foundation, Inc. v. Forman (1975) à(1) Def of stock; (2) Use v consumption;(3) Profit test (for a while); (4) Looking at all of these transactions with an economic reality in mind
A.    Facts: developers sold “stock” in a co-op city as a prerequisite for leasing the apt to finance construction. Shares can’t be transferred, explicitly are tied to apt, in essence are recoverable deposit on apt. Point of buying them is to occupy the apt. no voting rights. T moving out must sell back to developer so never will have secondary mkt.
1.    Construction costs went up, rent went up, Ts sued for false rep on who would bear cost of increase. 10b fraud claim. Ps argue- this was a stock, defrauded. D’s argue – duck theory – not stock bc lacks characteristics of stock
B.    Issue:is stock to acquire housing that has no secondary mkt a security? 
C.   Held: No. it’s neiher stock nor an investment K.
D. Rules:
1.    Use & Consumption – Where their Primary motive is to use or consume, you won’t satisfy the expectation of profit prong of Howey test for investment contracts.
a.    Here primary motive was use and consumption – to occupy land themselves.
2.    Defines Profit as Capital Appreciations or Streams of Earnings. Nothing else