Securities Regulation Outline

Definition of a security
Statutory Definitions
1.       Securities Act §2(a)(1): 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.
·         NOT certificate of deposit itself**
2.       Exchange Act §3(a)(10): Essentially the same as the Securities Act
3.       Distinguish between something that is not within the definition of a security at all and something within the definition, but exemption from some or all of the statute.
4.       Implications: if a transaction is considered involving a security, there will be the required registration and disclosure requirements under §5; liability for selling unregistered securities;
5.       Securities Act § 14; Exchange Act § 29(a): Any condition, stipulation, or provision binding any person acquiring any security to waive compliance with any provision of this Act or of the rules and regulations of the Commission shall be void.
Investment Contracts
1.       Listed under Securities Act §2(a)(1) as “security.” “Investment Contract” is a catchall term
2.       SEC v. Howey Co.
                                -Orange grove-
·         An investment contract for purposes of the SA means 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 the promoter or third party.
·         Investment of Money: Not buying consumable commodity or service under UHF v. Forman
·         In a Common Enterprise: courts struggle with this idea. There are two forms:
                1. Common enterprise between promoter and investor[see below]                 2. Common enterprise between investors themselves: Horizontal [see below] ·         With an Expectation of Profits: investing not for other purposes—a business transaction. In some state tests it matters if there is a risk of losing money. Even if just getting the product, profit of getting cheaper than otherwise would by buying.
·         To come solely from the efforts of others: No way it would be profitable otherwise. “Solely” eventually drops out of this test. “Whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.” Glen W. Turner Enters. Inc.
·         Even if the security is not bought, the offer is also covered by the SA
3.       UHF v. Forman
                -Housing cooperative-
·         “Stock” under SA §2(a)(1): called stock, but substance over form. Can still analyze whether an investment contract.
·         Consumption v. Profit:
                1. Profit could be construed as the difference in $$ you’d otherwise pay for                                                another apartment
                2. Using Investment of Money and Expectation of profits under the Howey                                                factors to determine whether in fact something is an investment contract.
                3. Why are you giving them money? For investment or consumption/use?
4.       SEC v. Edwards
                                -payphone scheme where investors made money by getting other investors involved in                                                         the scheme rather than the business itself-
·         SCOTUS decided that a sale-leaseback arrangement for payphones can constitute an “investment contract” under Howey even when the scheme involves a contractual promise to pay a fixed rate of return. Ct. stated that nothing in the Howey test required that profits be variable or derive from a particular source. The court state that a flexible interpretation of investment contract prevents schemes avoiding the SEC merely by making the payouts constant rather than variable.
5.       Horizontal Commonality: amongst investors there is a common pooling of investor’s funds. Every court accepts this as satisfying the Howey Test, but some courts allow vertical commonality to substitute if no horizontal.
6.       Vertical Commonality: between investor and promoter. Some courts accept; some don’t.
·         Broad: requires only a connection between the efforts of the promoter and the collective successes or losses of the investors. Promoters have to do something in order for you to get your money. PROBLEM: this makes commonality essentially the same as the 4th prong: efforts of others. This essentially reads “common enterprise” out of the test.
·         Strict: requires a direct relationship between the success (as opposed to the efforts) of the promoter and that of the investors; this requires the promoters and investors to share the risks of a venture. This becomes problematic with brokers since they make efforts rather than success for themselves.
7.       Pre-Investment Efforts
·         Open question as to whether they should count under the “efforts of others” test
·         Life Partners, Inc.: shouldn’t look at pre-investment activities because no risk as to whether or not that happens—not “investment” anymore.
Interests in Corporations; Partnerships; LLCs as Securities
1.       Stock as a Security: SA §2(a)(1): stock is listed as part of “security”
2.       Sale of Business Doctrine (Killed by Landreth Timber): If you purchase 100% stock of a business, there is no common enterprise or efforts of others, thus this is not a purchase of a security. Landreth Timber said that “stock” is not an investment contract as defined by Howey, thus not subject to the 4 factors (and most stock wouldn’t meet it anyway). This opens up a problem, though because equivalent transactions in substance can be treated differently depending on how it is conducted (i.e. through stock or investment contract) making it a “security” or not.
3.       The common characteristics of stock are: “(i) the right to receive dividends contingent upon an apportionment of profit; (ii) negotiability; (iii) the ability to be pledged or hypothecated; (iv) the conferring of voting rights in proportion to the number of shares owned; and (v) the capacity to appreciate in value…” Landreth Timber
4.       Partnership Interests:
·         Partnership interests aren’t stockàonly way to get there is by catchall “investment contract”
·         Only real issue is whether the profits derived from the partnership interest is from the efforts of others.
·         General v. limited partnerships:
                1. General: all partners participate in the control of the business (never efforts of                     others)
                2. Limited: limited partners may derive profits from efforts of others depending on how partnership agreement is structured.
                **Substance over form**
·         Steinhardt Group, Inc. v. Citicorp: Holding that limited partner’s interests are not securities if the limited partner can and does exercise pervasive control of the partnership. (Efforts of others test lacking under Howey)
·         Investor Sophistication: Williamson Test: Less Sophistication= more passivity; more passivity=more “from the efforts of others”
5.       LLC Interests:
·         Use Investment Contract Analysis
·         Two management models:
                1. Member managed: all members participate in management (similar to general                  ptshp)
                2. Manager-managed: Managers run the firm (similar to a corp. BOD)
·         “From the efforts of others?”
Notes as Securities
1.       Securities Act sec. 2(a)(1): “any note” [no exception as in EA] 2.       Exchange Act sec. 3(a)(10): “The term “security” means any note, . . .* * *but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.”ànot a security at all!
·         Excludes notes from “security” that at the time of issuance do not exceed 9 month maturity
·         Problem: demand notes are paid whenever issuer asks for payment
·         Majority of courts: “on demand” means that it can be more than 9 mos.àSECURITY
·         Minority of courts: “on demand” means could be payable at less than 9 mosàNOT A SECURITY
·         Demand notes are not within exception, but if parties can show that both sides contemplated that the notes be repaid before 9 mosàNOT A SECURITY
·         Courts/SEC have only allowed in limited circumstances: “Commercial Paper”: institutional investor markets and Prime Quality requirement: high rating from Standard & Poor’s
3.       Securities Act §3(a)(3): Exempt:  “Any note, draft, bill of exchange, or banker’s acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.”àExemption from reporting requirements ONLY
·         “Current transaction” language (not in 3(a)(10))—Reeves debates as to whether         the EA (3)(a)(10)  and SA 3(a)(3)  are really the same.
·         Current operations requirement: the exemption is available only if the proceeds      of the borrowing have been or are to be used for current operations.
·         Courts/SEC have only allowed in limited circumstances: “Commercial Paper”: institutional investor markets and Prime Quality requirement: high rating from Standard & Poor’s
4.       Reeves v. Ernst & Young
·         Starts out with the presumption that “Note” in the statute creates a rebuttable presumption, but not every note is a security. Ct says apply the Family Resemblance Test unless on the 2d Cir. list of Nonsecurities:
·         Family Resemblance Test:
                        1. Motivation of Buyer and Seller: If the issuer of the note uses the proceeds for                              general business purposes or to finance substantial investments and the                                                     buyer is interested primarily in the profit the note is expected to                                                                      generateàSECURITY. If the issuer gives the note to buy consumer                                                                goods or for some “commercial” purpose such as correcting cash flow                                                        difficultiesàNOT A SECURITY. 
                        2. Plan of Distribution: If the notes are widely offered and traded, it is more                                                      likely a security.
                        3. Reasonable Expectation of Investors: If investors generally view the type of                                                notes to be investments, it is more likely a security. This is circular:                                                              using reasonable expectations to determine whether a security when                                                                trying to find out if it is a security. Basically comes down to whether                                                             there is anything that would lead persons to believe the SEC rules apply.
                        4. Risk Reducing Factors: Something that makes the note less risky (less in need                                    of SEC laws). Is there some other Fed REG applicable? Is there collateral                                                 that would protect investors against loss?
                        **Balancing Test: difficult to predict court’s outcome**
·         2d Cir List of Nonsecurities (don’t need to apply Family ResemblanceàNOT A SECURITY):
        1. Consumer Financing
        2. Mortgage on a home
        3. Short-term note secured by a lien on a small business
        4. Short-term notes secured by an assignment of A/R
        5. Character loan to bank customer
        6. Loan that formalized open account debt
Separate Securities and Pass-Throughs
1.       Participation Interests: split one thing among a number of investors
·         Bank holds and services a Note and sells participation interests to investors, still holder of note, but every investor has the right to assert a certain % of the note.
2.       Split a pool among a number of investors
·         Bank holds and services a large number of CDs and splits
3.       Courts have been consistent in treating the bank’s holding and the participation interests as separate for determining whether a security under the Howey test.
4.       Pass-Through Interests
·         Promoter sells investors the instrument and the investors become the owners of the instruments. Investors don’ own part of a pool, but a piece of X.
·         Gary Plastics: If promoter is doing something to provide value to investors (setting up a market; negotiating with parties; monitoring parties it buys the X from), then a significant portion of the customer’s investment depends upon the promoter’s effortsàSECURITY as to what the promoter is offering (CDs + what promoter is doing because of value added)
 
Markets and their efficiency
Markets and Investors
1.       It is clear why the SEC cares about initial distribution market, but less clear why trading market is important because none of that money is going to the business itself.
2.       NASDAQ is a computerized system connecting brokers and dealers around
3.       NYSE began as physical meeting place, but its distinction from NASDAQ is becoming less and less
4.       There are a lot of regional stock exchanges
5.       OTC: everything not traded on an exchange. Exchange Act Companies, but not big enough to be on exchange. Pink Sheets are companies not even Exchange Act Companies.
6.       Who owns?
·         Large institutions
·         But there is a lot of individuals as well
·         Effect on policy of SEC? Different policies depending on sophistication of parties? If different policies, how do you draw the line? If mixed parties, how do you construct a policy that will protect one party, but not over-encumber another?
The Efficiency Hypothesis
1.       Informationally efficient: that prices at any time fully reflect all information available to the public. Particular information in an efficient market affects the market price of a company’s stock as though everyone had the same information at the same time. New information becomes impounded in the stock price so that it is as though all investors simultaneously discovered the information and reached a consensus on a new price. In an efficient market, there are no opportunities for super-profitable trading strategies.
2.       Allocational Efficiency: does the price accurately reflect the value of the company?
 
Public offering
Underwriting and Underwriters
1.       Why use Underwriters?
·         Provide customer base
·         Expertise/knowledge of the market
·         Reputational effects (backed up by liability): good underwriter signals to investors it is a quality security
2.       Process:
·         Letter of intent between issuer to managing underwriter (not a final contract; gets formalized right before public offering)
·         Managing Underwriter manages offering; puts together group of companies involved in sale
·         Managing Underwriter gets together syndicate of underwriters
3.       Types of Underwriting
·         Firm Commitment: underwriters buy from issuer; then resell; least risky to issuer; most risky to underwriter
·         Stand-by Commitment: usually when offering is to existing SHs (rights offering); underwriter agrees to buy if offerees do not
·         Best Efforts Commitment: Underwriter acts only as salesperson; least risky to underwriter; used most often for IPOs
                **Tells investors how risky the venture is depending on the amount of risk underwriter is willing                                     to undertake**
4.       Dealers are basically the salespersons: hired by individual underwriters in the syndicate
5.       “The Spread”: the difference between what underwriters market to buyers and what they give to issuer
Securities Act Disclosure Documents
1.       Registration Statement: filed with the SEC
2.       Prospectus: provided to investors (part of registration statement)
3.       SA §7(a): says that Schedule A contains required information, but SEC has the authority to alter by omission or addition. Don’t bother with Schedule A because SEC has its own forms.
The Registration Statement
1.       S-1
·         Registrant and business (basic info.)
·         Distribution and use of proceeds (about offering itself)
·         Attributes of securities sold (about offering itself)
·         Exhibits/Undertakings (list of stuff and promises to be made to SEC)
·         Prospectus includes everything but exhibits/undertakings
2.       S-3
·         Isn’t available to everyone
·         US Company
·         Registered under EA 12(b)
·         Filed all reports in a timely manner
·         Transaction Requirements: Cash offering; certain registration requirements under B6
·         Allows the incorporation of other filings under S-1  by reference under EA. If material changes—have to disclose; specific information about the particular offering has to be included; Exhibits may be referenced back to S-1
3.       Smaller Companies: SB-1; SB-2; but IRS put special instructions on S-1 and S-3 do not have to file using special forms anymore.
 
4.       EA Rule 405: Smaller reporting company:As used in this part, the term smaller reporting company means an issuer that is not an investment company, an asset-backed issuer (as defined in §229.1101 of this chapter), or a majority-owned subsidiary of a parent that is not a smaller reporting company and that:
                (1) Had a public float of less than $75 million as of the last business day of its most recently                                                completed second fiscal quarter
                (2) In the case of an initial registration statement under the Securities Act or Exchange Act for
                                shares of its common equity, had a public float of less than $75 million as of a date within                   30 days of the date of the filing of the registration statement
                (3) In the case of an issuer whose public float as calculated under paragraph (1) or (2) of this
                                definition was zero, had annual revenues of less than $50 million during the most                                                 recently completed fiscal year
                (4) Determination: Whether or not an iss