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Securities Regulation
University of Dayton School of Law
Chaffee, Eric C.

·         Securities Act=transactional; Exchange Act=periodic reporting
·         The Securities Act was intended to prevent frauds in the sale of securities by providing full and fair disclosure in the context of the public offerings of securities.
·         The Exchange Act was enacted to regulate brokers and dealers and securities markets.
·         The framework of the Securities Act was transaction oriented, i.e., the focus was upon the public offering of securities by any company.
·         The framework of the Exchange Act was status oriented, i.e., the focus was upon issuers with a class of securities listed and traded on the exchange.
·         Security is defined in §2(a)(1) of the 1933 Act and §3(a)(10) of the 1934 Act
Investment Contract
·         Is undefined by the Securities Act; state courts have broadly construed it so as to afford the investing public the full measure of protection.
o   Howey test as to whether a security is an investment contract:
§  1. Are the investors’ interests interwoven with those of other investors and/or the promoter for a return on their investment (“common enterprise”)?
§  2. Is the interest bought in order to obtain a financial return or for other reasons (“expectation of profits”)?
§  3. Does the investor participate in the venture to such a degree that he is not dependent “solely on the efforts of others” for profits?
·         Ponzi Schemes
o   A fraudulent investment scheme in which money contributed by later investors generates artificially high dividends or returns for the original investors, whose example attracts even larger investments.
·         Question: how strictly should “solely” be construed?
o   Two leading cases are the 5th Circuit’s decision in SEC v. Koscot Interplanetary, Inc. (1974) and 9th Circuit’s decision in SEC v. Glenn W. Turner Enterprises, Inc. (1973)
§  The critical inquiry was defined as: whether the efforts made by those essential managerial efforts which affect the failure or success of the enterprise
§  This Koscot/Turner test rejects a literal interpretation of “solely” and has been widely followed.
§  The Supreme Court appears to have acquiesced to this formulation.
·         In United Housing Foundation, Inc. v. Forman, the Court identified two forms of “profit” that meet the Howey test:
o   1. Capital appreciation resulting from the development of the initial investment, and
o   2. A participation in earnings resulting from the use of investors’ funds
·         More recently in SEC v. Edwards (2004), the Court elaborated that “profit” includes, “for example, dividends, other periodic payments, or the increased value of the investment.”
·         A key point is that the securities laws do not apply where the purchaser is principally motivated by a desire to use or consume the particular item acquired.
·         Generally there are two types of common enterprise: horizontal commonality and vertical commonality
·         Horizontal commonality
o   All courts have held that horizontal commonality is sufficient to meet this aspect of the Howey test.
o   Generally horizontal commonality looks to the relationships which exist between an individual investor and the pool of other investors.
§  Under this standard, the pooling of the inte4rests of the investors is essential to finding the existence of an investment contract.
·         Vertical commonality
o   The lower courts widely disagree on whether vertical commonality satisfies the Howey common enterprise test.
o   a relationship between the investors and the promoter
o   The issue may arise in the context of individual discretionary trading accounts between the stockbroker and his client.
·         Since state law governing the operation of LPs traditionally prohibited limited partners from performing significant managerial functions, courts usually held that these interests met the Howey requirement that profits be derived essentially from the efforts of others.
·         Interests in a limited partnership generally are securities because limited partners ordinarily rely on the general partners to exercise the essential efforts.
·         Since general partnerships do not possess the same restrictions on participation in management as limited partnership interests, they usually fail to satisfy the Howey “from the efforts of others” test.
·         Williams v. Tucker (5th Circuit 1981)
o   A general  partnership in which some agreement among the partners places the controlling power in the hands of certain managing partners may be an investment contract with respect to the other partners.
o   A general partner or joint venturer who lacks the business experience and expertise necessary to intelligently exercise partnership powers may also be dependent on the investment’s promoter or manager.
o   A general partnership or joint venture interest can be designated a security if the investor can establish that:
§  1. An agreement among the parties leaves so little power in the hands of the partner or venturer that the arrangement in fact distributes power as would a limited partnership; OR
§  2. The partner or venturer is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising his partnership powers; OR
§  3. The partner or venturer is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he can’t replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.
·         An alternative to the Howey standard for ascertaining the existence of an investment contract
·         Generally not adopted by federal courts, but has been enacted by statute in several states
·         Generally under the risk capital test:
o   1. There is no horizontal common enterprise required;
o   2. Similar to the Howey line of cases, non-pecuniary benefits are sufficient; and
o   3. The Howey “solely” from the efforts of others standard is relaxed.
·         The Forman Court identified two forms of “profit” which meet the Howey test:
o   1. Capital appreciation resulting from the development of the initial investment; and
o   2. A participation in earnings resulting from the use of the investors’ funds
Other Securities
·         Characteristics traditional associated with common stock: (Landreth)
o   The right to receive dividends contingent upon an apportionment of profits;
o   Negotiability;
o   The ability to be pledged or hypothecated;
o   The conferring of voting rights in proportion to the number of shares owned; and
o   The capacity to appreciate in value
·         Deposits in federally regulated banks are protected by the reserve, reporting, and inspection requirements of the federal banking laws, so it does not need protection under the Securities Acts.  [Marine Bank v. Weaver]  
·         Court in Reves adopts the “Family resemblance test” that was previously adopted by the 2nd Circuit.
o   Notes that are NOT securities:
§  The note delivered in consumer financing;
§  The note secured by a mortgage on a home;
§  The short-term note secured by a lien on a small business or some of its assets;
§  The note evidencing a ‘character’ loan to a bank customer;
§  Short-term notes secured by an assignment of accounts receivable;
§  A note which simply formalizes an open-account debt incurred in the ordinary course of business.
o   Factors the Court applies in deciding whether a transaction involves a “security”:
§  1. Court examines the transaction to access the motivations that would prompt a reasonable seller and buyer to enter into it.
·         If the seller’s purpose is to raise money for the general use of a business enterprise or finance substantial investments, and the buyer is interested primarily in the profit the note is expected to generate, the instrument is likely a security
·         If the note is exchange to facilitate the purchase and sale of a minor asset or consumer good, to correct for the seller’s cash-flow difficulties, or to advance some other commercial or consumer purpose, the note is less sensibly described as a security.
§  2. Court examines the plan of distribution of the instrument to determine whethe

omatic shelf registration to register any offering of securities (other than an offering in connection with a business combination).
§  An issuer that has attained well-seasoned status based on its registered non-convertible securities can register any offering for cash with an automatic shelf registration statement if it is eligible to register primary offerings of securities on Form S-3.
·         The Pre-Filing Period
o   The time period before a registration statement has been filed with the SEC.
o   During this time §5(c) prohibits the use of mails or any means of interstate commerce to offer to sell or offer to buy the securities to be offered.
o   Conditioning the Market (“Gun Jumping”)
§  The publication of information and statements, and publicity efforts, made in advancement of a proposed financing which have the effect of conditioning the public mind or arousing public interest in the issuer or in its securities constitutes an offer in violation of the Act.
§  Four non-exclusive safe harbors from §5 gun-jumping provisions:
·         1. Rule 163; Well-known seasoned issuers are exempt entirely
·         2. Rule 163A; The SEC excludes all communications made by or on behalf of any issuer made more than 30 days prior to the filing of the registration.
·         3. Rule 168 provides a safe harbor by allowing Exchange Act reporting issuers to continue to publish any regularly released factual business information and forward-looking information without restriction.
o   The purpose of this type of communication is to keep the market informed about the subject company’s financial condition rather than to condition the market for new issuances.
·         4. Rule 169, all issuers including non-reporting issuers may continue to publish, prior to the filing of the subject registration statement, any regularly released factual business information intended for use by persons other than in their capacity as investors or potential investors (such as information directed for the use of customers or suppliers).
o   Rules 163 & 163A
§  The safe harbor rules vary depending on the status of the issuer.
§  Under Rule 163, well-known seasoned issuers (e.g., companies that have a public float of $700M and have timely filed their Exchange Act reports for the past 12 months) are completely exempt from restrictions on offers during the pre-filing period.
§  Rule 163A
·         Other issuers remain subject to the gun-jumping prohibitions.
·         Provides protection for these issuers with respect to their communications that occur more than 30 days prior to the filing of the subject registration statement.
·         Rule 163A communication has several stipulations:
o   1. Can’t reference the offering itself;
o   2. Only communications made by or on behalf of the issuer come within the safe harbor; and
o   3. The burden is on the issuer to take reasonable steps to prevent circulation of the communication in the 30 day period leading up to the filing of the registration statement.
o   Effect of Rule 135
§  Rule 135 allows an issuer to make a public announcement relating to a contemplated public offering of its securities.
§  An issuer notice that adheres to Rule 135 is not deemed to constitute an “offer to sell”.
§  Generally, a Rule 135 notice, in addition to containing on certain specified information, must include a legend stating that the notice does not constitute an offer to sell.