Securities Regulation Outline

Securities Regulations                                                                                                           Professor Molitor
 
I.    Overview of Securities Laws
a.   Federal Laws
1.   Securities Act of 1933
i.    If you have something that is a security, you have two choices if you want to offer or sell it to someone:
a.   Register the securities with the SEC
b.   Find an exemption
2.   Securities Exchange Act of 1934
b.   State Laws
c.  Sources of Securities Law
1.   Statutes, SEC Rules, Other SEC Materials (Releases; No-action letters)
II. What is a Security?
a.   Section 2(a)(1) of the 1933 Securities Act – Definition of Security
1.   Unless the context otherwise requires… “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, pre-organization 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.
b.   Investment Contract – Security under Section 2(a)(1)
1.   SEC v. Howey – transaction involved the offering of small parcels of land in a citrus grove in Florida, coupled with a service contract for cultivating and marketing the produce. The prospective purchasers were informed that the venture was not economically feasible without arranging for a service contract.
i.    Investment Contract – an investment of money in a common enterprise with profits to come solely from the efforts of others. 
ii.   The court held that the instrument offered was an investment contract, hence a security. 
iii. Here the farm took money from people to invest in trees. The common enterprise was that all the fruit was grown together and the profits were split at the end of the season. People that gave money did this to make a profit. The investors make a profit off the efforts of the howey company because they did all of the leg work to grow and maintain the citrus
iv. Does it matter that only some of the investor bought land? No because the howey company was still offering the potential for an investment contract. So that would be a violation as well.
v.   Howey Test – ONLY applies to an investment contract NOT for other securities under 2(a)(1)
a.       Investment of Money
1.   The investment, which can be of cash or noncash consideration, is expected to produce income or profit; the investor is not buying a consumable commodity or service.
b.      In a common Enterprise (“Commonality”)
1.   Multiple investors have interrelated interests in a common scheme (horizontal); or if a single investor has a common interest with the manager of the investment (vertical)
c.       With the expectation of Profit
1.   The expected return must come from earnings of the enterprise, not merely additional contributions, and this return (whether fixed or variable) must be the principal motivation for the investment.
d.      Solely from the Efforts of Others
1.   Profits must be derived “solely” from the efforts of others; however, lower courts have accepted that the investor’s efforts in the common enterprise may contribute to the profits. The efforts of the managers must predominate; the investors must be mostly passive.
2.   United Housing v. Forman – Expectation of Profits
i.    United Housing (UHF) created low income housing. UHF organized Riverbay to own and operate the low income housing. To acquire an apartment, a prospective purchaser must buy 18 shares of stock in Riverbay for each room desired at a cost of $25/share. The sole purpose of acquiring these shares is to allow the purchaser to occupy the apartment. The shares, in effect, are a recoverable deposit on an apartment. The shares are explicitly tied to the apartment: they can’t be transferred to a non-tenant; can’t be pledged or encumbered. No voting rights attach to the shares. Participation in the affairs of the building are based on your tenancy, not on the number of shares, only get one vote. Any tenant that wanted to terminate their tenancy must offer his shares to Riverbay at the initial price of $25/share. If Riverbay doesn’t want the share back, the tenant cannot sell for more than purchased for.
ii.   Court held that the shares were not securities
iii. Court assessed the “economic realities” of the transaction: the shares purchased didn’t confer rights that normally accompany stock (they weren’t transferable to non-tenant, couldn’t pledge, carried no voting rights in relation to shares owned, and had to sell back at the initial purchase price)
iv. Court rejected the liberal approach that a stock is a security just because it contained the word stock. Court stressed that “economic reality”, not form should control.
v.   Court failed to label this as an “investment contract” because securities law don’t apply when the purchaser is motivated by a desire to use or consume the item purchased, rather than by the anticipation of receiving a return on his investment. Here the purchasers of stock sought adequate and affordable housing to live.
vi. Two forms of “profits” that meet the Howey Test:
a.       Capital appreciation resulting from the development of the initial investment
1.   The value of your investment will go up so when you sell it to someone later at a higher price
b.      A participation in earnings resulting from the use of investor funds (Dividends from earnings)
3.   SEC v. Edwards – Expectation of Profits
i.    Edwards owned and controlled ETS Payphones, which sold “payphone packages.” Packages included a payphone, a leasing agreement with ETS and an agreement for ETS to repurchase the payphone at buyer’s request. An investor purchased a payphone from ETS which ETS then leased from the investor for 5 years at a return of 14% to the investor.
ii.   Court held that a contractual entitlement to a fixed (rather than variable) rate of return in a payphone package investment satisfied the “expectation of profit” element of Howey.
iii. Expanded on the Forman examples of profits to include dividends, other periodic payments, or the increased value of the investment (here a contractual entitlement to a fixed return meets the expectation of profit).
iv.    Court also held that a contractual entitlement to a fixed return met the element “solely from the efforts of others.” Court said that the fact that investors have bargained for a return on their investment does not mean that the return is not also expected to come solely from the efforts of others. ETS says the returns come to the investor no mater how hard they work to provide a return. Investors aren’t doing anything.
4.   Teamster v. Daniels – Investment of Money(Pension Plans) “Economic Realty”
i.    A pension plan was created for the local teamster district. The plan was compulsory & noncontributory. Employees had no choice as to the participation in the plan, and didn’t have the option of demanding that the employer’s contribution be paid directly to them as a substitute for pension eligibility. Employees paid nothing into the plan. In order to receive a pension, an employee was required to have 20 years on continuous service. Daniels was denied a pension because it was determined he had a break in service.
ii.   Court held that an interest in noncontributory, compulsory pension plan is not an investment contract. In this type of plan, the employer contributes the necessary payments, not the employee who ultimately benefits from the plan. Court said that the employee is selling his labor primarily to obtain a livelihood, not to make an investment (“investment of money not satisfied).
iii. Moreover, the employer’s contributions to the fund were not equivalent to an investment by the employee because no fixed relationship existed between the employer’s contributions to the funds and the employee’s potential benefits. The employee’s benefit depended not so much on the plan’s investment returns as on the employee becoming eligible under the plan.
iv. Court said the pension fund’s assets didn’t depend on profits yielded by the efforts of others. In contrast, the vast majority of the income generated came from the employer’s contributions and thus was independent from the efforts of the fund’s managers. In addition, actual receipt of benefits from the funds depended on whether employees met certain individual eligibility requirements, not on the financial successes of the fund itself.
v.   If you have a contributory and noncompulsory plan, the SEC states that it is an investment contract. Although a pension may be a security, they are usually regulation by another federal statute
5.   SEC v. Koscot Interplanetary – Common enterprise and solely from efforts of others (Pyramid Scheme)
i.    Pyramid scheme was used to lure into a multi-level network of independent distributors selling cosmetics. At the lowest level a “beauty advisor” whose income is derived from retail sales gets a large discount on supplies. The second level (supervisor or manger) can invest $1000 for a greater discount to sell to consumers or distributors. If a supervisor introduces a new member they get a commission. Investors solicit prospects to attend their seminars where they introduce the scheme. The meeting is conducted in conformity with the scripts from Koscot. If a prospect comes to a meeting, an investor is not required to take additional steps.
ii.   To determine whether the element of “solely from the efforts of others” is met the court looks at 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.
a.   Whether the investor has meaningfully participated in the management of the venture in which it has invested such that it has more than minimal control over the investment’s performance.
b.   The court held that bringing people to the meetings was an effort, but once they got to the meeting, the script that was required to be read word for word was not a large enough effort.
iii. Common Enterprise Tests – There must be some FIXED relationship
a.   Horizontal (accepted by all courts) – looks at the relationship which exists between an individual investor and the pool of other investors.
1.   Pooling of the interests of the investors is essential to finding the existence of an investment contract. No horizontal common enterprise can exist unless there exists between the investors themselves some relationship which ties the fortunes of each investor to the success of the overall venture.
2.   You will have multiple investors that are similarly situated getting the same return on investment
b.   Vertical – the relationship between