Federal Securities Regulation
Professor Cleveland
Fall 2009
Cox, Hillman, Langevoort 6th Edition
What is a Security?
The Act applies only to securities – to come within the Act’s registration requirement, the property interest that is offered or sold must be a security. Not a simple question because many instruments that don’t seem to be securities are treated as securities and the opposite.
Section 2(l) — 1933 Act. Sec. 2(a)(l).
The term “security” means any note, stock, treasury stock, security future, bond, debenture . . . investment contract ….
Section 3(a)(l0)–1934 Act. Sec. 3(a)(l0)
The term “security” means any note, stock, treasury stock, security future, bond, debenture . . . investment contract. . . 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
ECMH
Weak – historic info cannot be used to make money today, mkt adjust to information
Semi-strong – mkt fluctuates to info. Paradoxical – doesn’t make sense to research
Strong – all info (public and private) is reflected in stock price. No one thinks this.
MATERIALITY
A. Orthodoxy
The test of materiality depends not upon the literal truth of statements, but upon the ability of reasonable investors to become accurately informed. No bright line test.
Materiality depends on whether the plaintiff can establish “a substantial likelihood that a reasonable shareholder would consider it important.” TSC v. Northway
Fundamental Test – disclosure of the info results in a substantial likelihood that it alters the “total mix” – fundamental purpose of securities acts was to substitute disclosure for the philosophy of caveat emptor
B/c it is a question of fact, materiality should not be decided by SJ
B. Speculative Information
The test of materiality is whether a reasonable investor would have considered the matter significant; it is not necessary to show that the investor would have acted differently. It is not sufficient to show that a shh might have found the info to be of interest. Basic v. Levinson
Silence, absent a duty to disclose is not misleading under Rule 10b-5
Don’t say “no,” say “no comment.”
Speculative info test (talk of merger/acquisition)
The greater the magnitude and the greater the probability of the event, the more likely it is that it will be material.
C. Total Mix of Information and Market Efficiency
1. Truth on the Market
The market adjusts to information.
2. Puffery
General statements of optimism are not actionable.
While a good faith opinion is not material, a statement of opinion made with no belief in its’ truth is actionable.
D. Forward-Looking Information –Rule 175 (p.109-111)
Soft information- management often makes predictions, projections and valuations for the MD&A disclosures
Once a prediction, projection, valuation is made, it must withstand materiality scrutiny if there are any inaccuracies. The mere fact that a projection turns out to be wrong is not sufficient to state a 10b-5 claim.
1. Bespeaks Caution Doctrine
“Meaningful” cautionary language may preclude misstatements from being actionable, this applies to both oral and written “forward looking statements”
In order to be effective the language should not only alert the reader to risk factors, but should briefly summarize them.
Context matters
Boilerplate disclaimers are insufficient
Must be substantive and tailored
2. Statutory Safe Harbor for Forward Looking Statements
21E (34) and 27A (33) In order to be eligible, forward statements must be either:
Identified as forward looking and accompanied by meaningful cautionary language
Be immaterial; or
Not be made with actual knowledge that it was false or misleading (even if plaintiff proves this, the claim will fail if the “bc” doctrine is satisfied)
3. Duty to Disclose Forward-Looking Information
The independent duty to disclose soft info arises from the overall disclosure rule that no half-truths should appear in filings with SEC.
E. The SEC and Corporate Governance
1. Disclosure Beyond the Bottom Line: Management Integrity
Evaluation of management is an important part of any investment decision, thus any facts which may indicate a possible change of management would be material to the reasonable investor
Important to adequately disclose questionable activities by management
Fine line between personal lives and managing ability, but when an exec’s personal dealings affect the issuer’s business (or have a strong potential) the materiality threshold may be reached making disclosure necessary.
2. The interface of Materiality and Corporate Governance
If an officer or director knows or should know that his or her company’s statements concerning particular issues are inadequate or incomplete, he has an obligation to correct that failure. An officer may rely upon company procedures for disclosure only if he has a reasonable basis for believing that those procedures have resulted in full consideration of those issues.
Dissent of Commissioner: “they weren’t lawyers, and were not capable of making fine judgment calls on whether disclosure was sufficient or warranted, and had a right to rely on company procedures”
DEFINITION OF A SECURITY
A. Introduction
Defined 2(a)(1) 33’ and 3(a)(10) 34’
Expansive language, and has been interpreted accordingly
Investors perception/expectation is a significant factor
Sold by security broker –likely a security
Parallel regulatory scheme – securities laws may be unnecessary
B. Framework for Defining Investment Contract
Bottom-line question: Whether the particular investment or instrument involved is one that needs/demands the investor protection of the federal securities laws.
Howey Test – An investment contract means a contract, transaction, or scheme where person:
o Invests his money
§
ties
U.S. v. Leonard (selling interests in LLCs that financed motion picturesà court found to these interests to be securities)
In applying the Howey factors, courts should look to the reality of the situation (not just the contract of the parties) to evaluate whether “the reasonable expectation was one of significant investor control.”
No reasonable expectation of control
Managerial rights were illusory
Take it or leave it basis terms of LLC
Investors had no relative experience
Investors were geographically dispersed (so had to rely on central mgmt.)
No exercise of meaningful control
F. Notes as Securities
Act
Def. of Sec
Exemption
Anti-Fraud
Leg. History
1933
Any note
Except as otherwise provided, 33 does no apply to note w/maturity less than 9 months
-ignore exemption
– protection from fraud
Comm. paper
1934
Any note w/ a maturity less than 9 months
——-
No fraud in sale of security
——-
Reves v. Ernst & Young (variable rate demand note issued by coop was a security)
Family Resemblance Test
Begin with presumption that every note is a security, rebut by following factors
Motivation of buyer/seller
Plan of distribution and evidence of common trading
Reasonable expectations of the public
Existence of other regulatory scheme that reduces risks
One that significantly reduces the risk suffered by investors
Collateralization/securitization may also help
The requirement of ‘profits’ derived solely from efforts of others is inherent in bonds, investor has no managerial responsibility.
Howey
Reves (Family Resemblance Test)
1. An investment of money
1. The motives are investment, not commercial or consumer.
2. in a common enterprise (under the multiple-investor test)
2. The notes are offered and sold to a broad segment of the public.
3. with an expectation of profits
3. The public reasonably expects the notes to be investments.
4. solely from the efforts of others.
4. [This is inherent in notes.]
5. The absence of an alternative regulatory scheme.
5. The absence of an alternative regulatory scheme or other risk-reducing factor.
Reves rejected Howey test for notes.
THE PUBLIC OFFERING
SECURITIES OFFERING REFORM, SEC RELEASE 33-8591
The following chart is a summary of certain aspects of the SEC’s recent overhaul of
