Securities Regulation Outline

 
SECURITIES REGULATION
HILLMAN
SPRING 2014
 
 
INTRODUCTION
Framework
·         Primary transaction: First transaction in life of securities distribution. Issuer and investors negotiate terms of public offerings or private placements.
·         Secondary transaction (resale): First investor sells to next investor
·         ’33 Act: Regulates both primary and secondary transactions in interstate commerce
o    Regulates disclosures and substantive procedures
o    Regulates securities professionals
·         ’34 Act: Protects secondary market trading
o    Created the SEC
§  Independent
·         Overseen by 5 commissioners, no more than three from same political party
·         Staggered terms, appointed by president
§  Divisions: Market regulation, enforcement, corporate finance
§  Communications: Rules & Regulations (force of law), Releases (don’t have force of law), No Action Letters (interpretative opinions and non-binding)
 
THE DEFINITION OF A SECURITY
Securities Acts
·         ’33 Act: Issuance of a security triggers registration requirement
o    §2(1): “unless the context otherwise requires…security means… investment contracts … or, in general, any interest or instrument commonly known as a security”
§  If instrument is specifically listed, then it’s a security. If not, might be investment K.
·         ’34 Act: If transaction involves security, triggers fraud provisions 10(b) and 10(b)(5)
Investment Contracts
·         SEC v. Howey (1946)
o    Issue: Are the land and service Ks for the citrus grove considered investment contracts within 2(1) of the ’33 Act?
§  Held: Yes, these are investment contracts and are securities.
o    Rule: A contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of others.
§  Service Ks were the problem here. It brought Howey back into the picture to work the orange grove and the work determined the profits.
§  §5: It is unlawful to offer security before registration statement is filed and unlawful to sell before RS is effective.
§  Risk is irrelevant under Howey, but states still use it as analysis (i.e. CA)
·         Risk-Capital Test from Silver Hills Country Club: The greater the risk the more likely it will be a security.
·         Proposed Reformulation: Investment of money that is not meaningfully controlled by the investor and is subject to a significant degree of risk.
o    If investor fully secured, court less likely to say this is investment K
o    But under Howey, being secured is irrelevant.
Howey Applied
·         United Housing Foundation v. Forman (1975) – Investment vs. consumption (no longer good law)
o    Issue: Are shares of “stock” in apartment co-op considered securities?
§  Held: No, name of instrument not determinative of it being a security.
o    Rule: There is no investment if one purchases a commodity for personal consumption (ex. living quarters), and not parting with money in hopes of receiving profits.
§  Not stock within meaning of securities act – No voting rights, no dividends, not transferable, not investing for profit, etc.
§  Court drops “solely” and uses “reasonable expectation of profits test.
·         SEC v. Edwards (2004) – Common Enterprise
o    Issue: Can investment that pays fixed, rather than variable return, be considered an investment contract?
§  Held: Yes, profits don’t need to be varied.
o    Rule: An investment contract can have profits of fixed return. Profits defined as financial return on investment (no matter fixed or variable).
·         Common Enterprise – Courts typically accept 1-2 of approaches; Rarely accepts all 3.
o    Broad Vertical Commonality: Requires the fortunes of the investors to be dependent on the activities of the promoters (easy to satisfy)
o    Strict Vertical Commonality: Investor and promoter share risk and rewards together
o    Horizontal Commonality: Look at relationship among investors and if there is pooling of profits or funds
§  What if there is a single investor? Courts dodge this issue and don’t say if there can be a security with only one investor.
·         Profits from Efforts of Others
o    Almost all circuits interpreted “solely” to mean largely from efforts of others and not sole efforts determinative of profits.
§  Important aspect: Someone else manages your $ and you are dependent on them.
§  Outside market forces is not “efforts of other”
o    Franchises not investment Ks because franchisee is active on site and overseeing operations. Profits not solely dependent on efforts of other.
Associational Formalities: Does form of business affect stock as security?
·         Sale of Business Doctrine (now defunct): If it is closely held corporation, the purchase of all or substantially all stocks doesn’t involve securities transaction
·         Landreth (1985): Sale of stock is selling of securities as long as it holds normal attributes of stock.
o    Gets rid of Forman suggestion that “stock” doesn’t mean it is stock.
o    Howey case defines investment contract (one type of security), but doesn’t identify stock (another type of security).
·         Can structure transactions so that the securities laws do not apply
o    Sale of assets doesn’t involve securities, but sale of stock involves securities.
·         General Partnerships: Ass’n of two or more person to carry along business for profit.
o    Problem is partners are active and can’t have efforts solely by others.
o    Majority of courts hold that partnerships are NOT securities.
§  Exceptions: One or more general partner is dependent on efforts of other partners to generate business or profits, then these partnership interests may be investment Ks.
o    Two approaches to determine if partnership interest is security
§  (1) Four Corners Test: Look at partnership agreement and evaluate status of each partner under the agreement.
§  (2) Pragmatic Test: Look at actual operation of partnership to see how business was really conducted.
·         Limited Partnerships: Limited partners look to general partner for management
o    Presumption that limited partnership interests are investment Ks
o    Exception is if limited partner had a lot of power in the partnership
·         LLC Interests
o    Member-managed LLCs (like general partnership) à Less like investment K
o    Manager-managed LLCs (like limited partnership) à More like investment K
o    US v. Leonard (2d Cir. 2008)
§  Rule: If realities of member positions show there was not “reasonable expectation of significant investor control,” then investment K is a security.
·         Need to look at TOC to determine if investors were active or passive.
Real Estate: Simple real estate transaction is not a security, but resort condos and RPAs might be.
·         Hocking v. Dubois (9th Cir. 1989)
o    Rule: Condo investment coupled with rental pool arrangement (RPA) could be investment Ks
§  Apply Howey: Investment of $, common enterprise (horizontal), profits solely from efforts of others
§  But who do you sue – broker or seller?
o    Need to look at how condo was promoted to investor and investor’s intentions and expectations as communicated to the broker is relevant in determining what investment package was actually offered.
Notes as Securities
·         ’33 Act: Notes are defined as securities under §2(1), but §3(a) exempts short-term notes with maturities at time of issuance to be less than 9 months (short-term notes under act but exempt)
·         ’34 Act: §3(a)(10) includes any note other than short-term notes (short-term notes not under the act)
·         Reves v. Ernst & Young (1990) – Family Resemblance Test
o    Issue: Are demand notes considered securities?
§  Held: Yes. Even though demand note is ambiguous as to its term (it can be “on demand” and less than 9 months or exceed 9 month term), interpret demand note in context of Congressional purpose of regulating investments to prevent fraud/abuse.
o    Rule: Apply the family resemblance test where you presume note with term of more than 9 months is a security. Then issuer can rebut presumption through a 4-factor test by showing note “bears strong resemblance” to an item of judicially crafted exemptions or convinces the court to add a new instrument to the list.
§  (1) Why was the money borrowed?
·         Business investment are securities. Commercial or corporate borrowings are not securities.
§  (2) What is the plan of distribution?
·         The greater the public participation, the more likely the note is a security.
§  (3) What are the reasonable expectations of note holders? (objective standard)
·         Do the people regard the purchase as an investment and expect a return?
§  (4) Is there presence of risk reduction factor?
·         Is there a regulatory system protecting note holders, or collateral securing the investment, that reduces risk and rebuts the presumption that this is a security?
 
UNDERSTANDING INVESTORS
Efficient Capital Market Hypothesis – Markets react quickly to available info and reflect it in stock pricing.
Strong Form: All info (public and private/illegal and legal) is reflected in securities pricing
Semi Strong Form: Markets only reflect all public information
Under this form, public disclosure is especially important.
Market efficiency = informational efficiency.
This isn’t fundamental efficiency where we look at whether market is accuratel