Securities Regulation Outline
Terminology
Private Placement: Offerings by a small business. Usually, do not have the resources to give a large public offering.
Public Offering: Offering by large businesses (usually), who do have the resources to support this method. Public offerings allow stock to be sold in order to raise capital.
Primary Transaction: Involves a direct flow of money from the investors to the issuer i.e. General Motors has a public offering. BUT, these do not happen all that much
Secondary Transaction: Flow of money between investors i.e. one shareholder selling her stock to another investor. This is what happens most commonly in everyday life.
I) Introductions
A) Definition of a security
B) Public Offerings
1) Stock considered a security. After all, it is an investment that carries the expectation of some profitable return. Would a limited edition car that is expected to appreciate be considered a security? (Might depend on the reason why the person purchases the vehicle.)
C) Exempt Transactions (Things that are not public offerings)
1) Exemptions are sought after in order to avoid the obligation to register a security
1) This is especially useful for small companies because they typically cannot afford public offerings
D) Secondary Distributors (ie resales)
1) “Every” transaction must be preceded by a registration statement
2) But there are exemptions for small transactions, meaning that ordinary market players do not have to register.
1) But what about larger transactions involving “control persons?” (like the Bancrofts and Murdoch?)
3) Risk disclosures – how to disclose without really disclosing and minimize the actual information given (don’t want to scare people away)
1) But this also works as an insurance policy against future problems.
E) No Offer to sell securities unless-
1) Registration statement is in effect, or an exemption is available. Fitting into an exemption is the bread and butter of lawyers.
2) Doesn’t say “No Sale,” just “No Offer”
II) Background & History
A) The SEC
1) The 1933 Securities Act seeks disclosure through the preparation of a registration statement. The prospectus is designed to provide all material information necessary for investors to fully assess the merits of their purchase of the security. The ’33 Act is meant to protect investors in primary distributions of securities.
1) This triggers the registration requirements
2) The 1934 Securities Exchange Act set up many things, including the SEC agency. The 1934 act is a “laundry list” of problems, but gives neither the means nor the end objective. The ’34 Act is concerned with trading markets and their participants, and uses continuous disclosure requirements to protect participants.
1) This triggers the fraud protections of transactions in securities
3) The SEC is an independent administrative agency that receives a degree of autonomy. It doesn’t report to the president, and only 3 out of the 5 commissioners may be from one party. The Commissioners serve staggered appointments, and are responsible for setting oversight & policy of the SEC.
4) The SEC Staff receives more contact with actual attorneys. The major SEC divisions are as follows:
1) Market Regulation
a) Regulates secondary trading markets, like stock brokers & dealers
2) Enforcement
a) Investigates & prosecutes civil matters (criminal matters are typically referred out to the DOJ)
3) Corporate Finance
a) Reviews disclosure documents i.e. proxy documents
b) Can stop registration from going forward
5) How the SEC “speaks”
1) Regulations – established under statutes
2) Rules – Not all that much different from regulations, actually
3) Releases – Public statement given by the SEC
a) May be in relation to high profile cases – these are not law, but they do contain important information
b) Sometimes they give background to the rules/regulations that it is about to issue
c) These are meant to be taken very seriously.
4) “No Action” Letters – These are issued by the division of Corporate Finance.
a) Contain the Div. of Corp. Finance’s interpretation of regulations as applied to certain (usually hypothetical) sets of facts
b) These only address certain questions of law
c) The Div. of Corp. Finance will recommend no action, but this is not binding, and does not necessarily reflect policy.
(1) The Enforcement Division is still free to bring charges, but this has not really happened before.
d) Prior “No Action” letters can be helpful to gauge response to current registration statements
(1) But of course, these are not binding.
5) Private statements/articles – have the least of value
III) What is a Security?
A) The term “investment contract” has carried most of the weight in defining what exactly a security is.
B) Securities and Exchange Commission v. W.J. Howey Co.
1) Howey was selling interests in a Florida orange grove adjacent to the resort that was owned and run by Howey. Investors purchased individual strips of real estate, but as an investment. The returns would be generated by sales of the oranges from the land. The real estate was marketed alongside a 10-year service contract to take care of, harvest, and pool the oranges together and then divide up the revenue. The SEC brought suit under §5 (offer and sale of unregistered and non-exempt securities)
1) Note that the service contract was optional, and 10% of investors chose not to purchase it. However §5 applies to offers, not just sales.
2) Also, all the oranges were pooled together, creating an undivided interest
a) If each individual plot were separately accounted for, would this still be a common enterprise?
2) Establishes the initial investment contract framework
1) An investment of money
2) Common Enterprise
3) Expectation of Profits
4) Solely from the efforts of others
a) “Solely” as opposed to “largely” or “principally.” Is a nominal effort ok to avoid falling into the security zone?
5) Risk doesn’t matter. Even something that is minimally risky would be considered a security (at this point).
C) Marine Bank v. Weaver
1) Weavers purchase a $50,000 certificate of deposit from Marine Bank to secure a bank loan to the Columbus packing company, owned by the Piccirillos. In turn, Weavers received a share of Columbus’ net profits as well as pasture rights. The Court concluded that the Weavers had not purchased a security.
2) Columbus defaults, and the Bank then decides to exercise their rights and get back their money.
3) Although initially CDs might be thought to come within the meaning of what a security is, CDs are regulated enough as it is.
4) The Court holds securities are meant to protect large classes of investors. Here, there is no large class, just the Weavers. This is a unique, privately negotiated transaction.
1) The Court points specifically to the pasture privileges. But even without this, this deal was negotiated one on one.
2) Securities protect large classes of investors by making information that is not readily accessible by a large class available to them. A transaction of this size between two parties does not benefit all that much from the registration requirement.
5) Privately Negotiated Transactions
1) None of the securities regulations will apply, not even the anti-fraud protections
2) 1933 Act registration provision is generally useful where investors cannot readily obtain the information on their own.
a) But if that person is defrauded, shouldn’t they have some sort of remedy? A possible remedy would be for the security to be exempt from the registration provision, but still be protected by the anti-fraud provision. But Marine Bank concludes that it is not a security, and doesn’t reach the second part. Hillman thinks that the n
arily by the prospect of acquiring use and not by financial returns on their investment.” This is a very subjective determination of investor’s intent.)
2) p. 34, Problem 2-1 (The limited edition Jaguar that is expected to appreciate)
1) How to determine what people were planning to do with the car? [Really, it is hard to determine after the fact]
2) Investment versus consumption
3) Is this a common enterprise?
a) How to analyze the relationship? That between the community of the investors, that between promoters and investors?
4) Solely from the efforts of others?
a) The price might be determined by the market, but the promoters have a great deal to do with what the price will be via marketing, etc.
b) What about an investment in gold?
(1) The source of profit is the market forces/appreciation
c) Highly contingent on market conditions, state of the economy.
d) May be easier to classify the Jaguar under the Risk Capital framework as opposed to the Howey framework.
5) This problem is meant to illustrate the difficulty in defining what a security is.
F) Common Enterprise and Profits Solely from the Efforts of Others
1) Securities and Exchange Commission v. Edwards
1) Sale and leaseback arrangement; “investors” purchase a phonebooth and then lease it back to the company in exchange for a fixed rate of return
2) 11th Cir. says that this is not a security because the rate of return is fixed rather than variable, so not a profit in terms of the security framework.
a) But really, this is a very speculative investment.
3) The Supreme Court disagrees with the 11th Cir.
a) Profits may be variable or fixed for the purposes of security definitions.
(1) Also, profits refers to the profits that investors seek on their investment, not the profits of the scheme in which they invest.
(1) “… capital appreciation resulting from the development of the initial investment”
(2) “…participation in earnings resulting from the use of investors’ funds.”
2) Approaches to common enterprise
1) Broad Vertical Commonality
a) The fortunes of the investors are connected to the success of the manager in handling the money.
b) “Uniformity of the impact of the promoter and require only a connection between the efforts of the promoter and the collective successes or losses of the investors.”
2) Strict Vertical Commonality
a) Investors and promoter must share the risk
b) “Requires a direct relationship between the success (as opposed to the efforts) of the promoter and that of the investors”
3) Horizontal Commonality
a) Requires a pooling of investors’ funds – undivided interests in the profits of the investment
b) “Emphasizes the common enterprise among investors, rather than the common enterprise between a promoter and investors.”
c) But creates a question ; can there be a single investor under horizontal commonality scheme?
3) Profits from the Managerial Efforts of Others
1) Requirement that profits be derived solely from the efforts of others suggest that promoters may try to circumvent securities laws by requiring some nominal participation.
