Public and Private Offerings of Securities

1
CHAPTER 24

• Public and Private Offerings of Securities

2
INTRODUCTION

• This chapter explores security regulations,
  registration and reporting requirements, and
  violations of the requirements.

2
3
FEDERAL STATUTORY SCHEME

• 1933 Act.
• Covers original distribution of securities.
• Requires promoters to register securities with
  the SEC, and a prospectus to be given to
  prospective purchasers.
• Investors are not protected from highly
  speculative investmentsonly advised of all
  material facts.
• 1934 Act.
• Builds upon 1933 Act with continuous disclosure
  for publicly traded securities.
• Contains the first anti-fraud provisions.
• Requires regular reporting to SEC.

3
4
FEDERAL STATUTORY SCHEME

• Private Securities Litigation Reform Act of 1995.
• Designed to correct perceived abuses in private
  securities litigation, particularly in class
  actions that coerced settlements thereby
  increasing the costs raising capital and correct
  the chilling of corporate disclosures to
  investors.
• Limited fishing expeditions during discovery.
• Generally eliminates joint and several liability.
• SEC Rules and Regulations.
• Blue Sky Laws state regulatory statues.

4
5
DEFINITION OF TERMS

• Security - very broad definition not just
  stocks, bonds and investment contracts but not
  real estate.
• Investment Contract investment of money in
  common enterprise with profits to come solely
  form the efforts of others.
• Family Resemblance Test - promissory notes may be
  a security, depending on the circumstances.

5
6
DEFINITION OF TERMS

• Offer - the 1933 Act definition is every attempt
  to dispose of, or solicitation of an offer to
  buy, a security or interest in a security, for
  value. Much broader than contract law.
• Sale - every contract for sale or its
  disposition of a security or interest in a
  security, for value (cash, property or
  compensation for past services).

7
INVESTMENT CONTRACT

• Case 24.1 Synopsis. SEC v. W. J. Howey Co.
• Howey owned large tracts of citrus groves in
  Florida, financed in part by the sale of strips
  of land containing citrus trees to people
  throughout the United States. Along with the sale
  of the land came an optional service contract to
  care for the trees and fruit. ISSUE Does the
  offer and sale of parcels of land bearing citrus
  trees, coupled with optional management contracts
  pursuant to which the promoter cares for the
  trees, constitute an investment contract and
  hence a security under Section 2(1) of the 1933
  Act? HELD YES. The Supreme Court held that this
  transaction clearly was an investment contract (a
  security) because the person invested money in a
  common enterprise and expected profits solely
  from the efforts of the promoter or third party.

7
8
FAMILY RESEMBLANCE TEST

• Case 24.2 Synopsis. Reves v. Ernst Young
• A farmers co-op with about 23,000 members
  raised money to support its general business
  operations by selling demand notes. The notes
  were not collateralized and were uninsured, and
  paid a variable interest rate that was higher
  than financial institutions. The co-op offered
  these notes to members and non-members of the
  co-op as an investment program. ISSUE Are demand
  notes issued by a farmers cooperative to its
  members securities? HELDYes. The Supreme Court
  ruled that these demand notes were securities.

8
9
PUBLIC OFFERING

• Assuming investment is a security, it must be
  registered.
• Registration of Securities - Section 5 of the
  1933 Act requires registration of all securities
  with SEC offered and sold in the United States
  unless exempt.

9
10
PUBLIC OFFERING

• Role of the Underwriter - public offerings
  usually underwritten by one or more
  broker-dealer(s) or investment banker(s).
• Firm Commitment Underwriting - underwriter buys
  the entire offering and re-sells.
• Best-Efforts Underwriting - underwriters do not
  buy the offering, but use their best efforts to
  find buyers.

11
PUBLIC OFFERING

• The Registration Statement - Sections 7 and 10
  contain the guidelines.
• Forms - initial public offerings use Form S-1
  Form S-2 allows previous filers a streamlined
  form and a way to incorporate previous filings by
  reference Form S-3 is for previous filers with a
  widespread following in the marketplace the SEC
  also has adopted two forms for small business
  (SB-1 and SB-2).

11
12
PUBLIC OFFERING

• Prospectus - disclosure and marketing tool to
  prospective purchasers.
• Due Diligence - company has to be able to back up
  every claim in the registration statement.

13
PUBLIC OFFERING
13
14
PUBLIC OFFERING

• Registration Procedure - Section 8 of the 1933
  act provides registration automatically becomes
  effective on the 20th day after filing each
  amendment starts a new 20-day period.

14
15
PUBLIC OFFERING

• Review - first time registrants receive a
  complete SEC review. Comments from SEC in a
  Letter of Comment.
• Waiting Period (or quiet period) - the time
  between the filing of the registration statement
  and its becoming effective. Red Herring
  preliminary prospectus.
• Going Effective - once an offering is declared
  effective, sales of securities may be made.

16
PUBLIC OFFERING
16
17
PUBLIC OFFERING

• Shelf Registration - Rule 415 of the 1933 act
  allows registration of a number of shares at one
  time for later issuance.
• Reorganizations and Combinations - certain types
  fall under Rule 145 and are filed on Form S-4.
• Secondary Offerings - subsequent offering by a
  person other than the issuer must be registered
  with the SEC or be exempt.

17
18
EXEMPTIONS FOR OFFERINGS BY THE ISSUER

• Difference between exempt securities (such as
  federal and state issues) and exempt transactions
  (such as private offerings).
• Private Offerings - non-public offering to
  selected qualified investors.

18
19
EXEMPTIONS FOR OFFERINGS BY THE ISSUER

• Regulation D Safe-Harbor Exemptions for Private
  Offerings.
• Accredited Investors - Rule 501 exempts
  sophisticated investors.
• Integration of Sales - successive sales within a
  limited time period.
• Rule 504 - offerings of up to one million dollars
  within twelve months to an unlimited number of
  purchasers.
• Rule 505 - offerings up to five million dollars
  within twelve months to 35 or fewer unaccredited
  investors.
• Rule 506 - offerings to no more than 35
  unaccredited investors and an unlimited number of
  accredited investors.

20
EXEMPTIONS FOR OFFERINGS BY THE ISSUER

• Case 24.3 Synopsis. SEC v. Ralston Purina Co.
•   Ralston Purina offered stock for market prices
  to its employees, regardless of job
  classification. Between 1947 and 1951 Ralston
  Purina sold 2 million worth of stock to 2,000
  employees throughout the United States. ISSUE
  Does the determination of whether a transaction
  is public or private offering depend primarily on
  the number of offerees or the sophistication of
  the offerees? HELD NO. The Supreme Court ruled
  that these sales were not exempt from
  registration as a private sale. It is not merely
  numbers of employees, but the sophistication of
  them due to access to information.

21
EXEMPTIONS FOR OFFERINGS BY THE ISSUER

• Section 4(6) Exemption - from the 1933 act - like
  Regulation D requirements.
• Regulation A - testing the waters provisions
  which permits issuers to solicit indications of
  interest before filing.
• Size of Offering and Eligible Companies.
• Testing the Waters - checking interest in the
  proposed offering pre-offer.

22
EXEMPTIONS FOR OFFERINGS BY THE ISSUER

• Offerings to Employees - Rule 701 exemption of
  certain offers and sales of securities.
• The Private Placement Memorandum - private
  offering counterpart to the prospectus. Both
  selling and disclosure document.

23
EXEMPTIONS FOR SECONDARY OFFERINGS 

• Section 4(1) Exemption - 1933 Act secondary
  offerings are exempt.
• Rule 144 - criteria deciding if someone is an
  underwriter

23
24
RULE 144A AND REG S

• Rule 144A - permits resale of unregistered
  securities to qualified institutional buyers,
  i.e., institutional investors holding and
  managing 100 million or more of securities, if
  the securities are not of the same class as any
  listed securities.
• Regulation S - offers and sales must be made
  offshore so they are not subject to U.S. federal
  registration requirements.

24
25
VIEW FROM CYBERSPACE OFFERINGS ON THE INTERNET

• SECs position is that offerings on the net
  violate the general solicitation ban unless the
  offering materials are restricted to
  pre-qualified investors, usually only done by
  password protected files after completing of a
  questionnaire. NETROADSHOW.COM.
• SEC has ruled that any hyper-linked information
  contained in an on-line prospectus becomes part
  of the prospectus itself.

25
26
REPORTING REQUIREMENTS OF PUBLIC COMPANIES

• Section 12 - issuers in interstate commerce and
  having total assets exceeding 5 million must
  register with the SEC each non-exempt class of
  security that is listed on a national exchange or
  is an equity security held by at least 500
  persons.

26
27
REPORTING REQUIREMENTS OF PUBLIC COMPANIES

• Other Sections of the 1934 Act.
• Proxy Solicitations - Section 14.
• Insider Trading - must disclose securities
  holdings of officers, directors, and 10 or more
  shareholders of the issuers equity securities
  and any changes in the holdings.
• Tender Offers - Section 14 rules.
• Schedule 13D - acquirers of 5 or more of shares
  must file one within ten days of acquisition.

28
SELECTIVE DISCLOSURE AND REGULATION FD (FAIR
DISCLOSURE)
In October, 2000, SEC adopted prohibition of
selective disclosure of material information to
analysts before making it available to the
general public
28
29
VIOLATION OF THE REGISTRATION AND
PROSPECTUS-DELIVERY REQUIREMENTS OF THE 1933 ACT
SECTION 12(1)

• Elements of Liability - strict liability for sale
  or offered securities without effective
  registration statement, or non-complying
  prospectus, through the use of interstate
  transportation or communication.
• Damages - if the plaintiff has not sold - rescind
  the sale if sold - damages.
• Who May Be Sued - definitely the insurer.
• Who May Sue - anyone who purchased shares issued
  in violation of the registration requirements

29
30
VIOLATION OF THE REGISTRATION AND
PROSPECTUS-DELIVERY REQUIREMENTS OF THE 1933 ACT
SECTION 12(1)
Case 24.4 Synopsis. Pinter v. Dahl (1988).  Dahl
purchased unregistered securities in the form of
oil and gas interests from Pinter, an oil and gas
producer and registered securities dealer in
Texas. Dahl got his friends and family to also
purchase securities from Pinter. When the
investment failed, they all sued Pinter for a
violation of Section 12(1) of the 1933 Act.
Pinter claimed Dahl was a seller under Section
12(1) because he substantially encouraged his
friends and family to purchase the shares.
ISSUE Is a person with no financial interests
in an offering of unregistered securities a
seller under Section 12(1) of the 1933 Act?
HELD The Supreme Court remanded the case to
determine if Dahl made the recommendations to
further a goal of Dahl or Pinter, or for the
benefit of the friends and family who were the
buyers. The Court said that Congress did not
intend to impose liability on one who gave advice
solely for the benefit of the buyer.
30
31
SECTION 11 OF THE 1933 ACT

• Sale pursuant to a misleading registration
  statement.
• Who May Sue - anyone who acquired a registered
  security.
• Tracing Requirements - tie purchase to misleading
  statement.
• Class Actions - typically done.

32
SECTION 11 OF THE 1933 ACT

• Who May Be Sued - Section 11 lists who may be
  sued.
• Controlling Persons - Section 15 imposes
  liability on anyone who controls any person under
  Section 11 or 12 control is not defined in the
  1933 Act.
• Elements of Liability - plaintiff must show when
  the registration statement became effective it
  contained a false or misleading statement
  concerning a material term.

33
SECTION 11 OF THE 1933 ACT

• Defenses
• No Reliance - investor knew of misstatement or
  omission.
• No Causation - plaintiff suffered no loss.
• Due Diligence - defendant conducted a reasonable
  investigation and it reasonably believed the
  statements made were true and there were no
  omissions which made the statements misleading.

33
34
SECTION 11 OF THE 1933 ACT

• Bespeaks Caution Doctrine - can negate
  misrepresentations and omissions in prospectus.
• Reform Act Safe Harbor for Forward-Looking
  Statements.
• Damages - for sale and no sale of the securities.

35
DUE DILIGENCE

• Case 24.5 Synopsis. Escott v. BarChris
  Construction Corp. (1968). BarChris built
  bowling alleys with capital raised through public
  offerings. It obtained money in May 1961, but due
  to financial problems, filed for bankruptcy
  protection in October of 1962. A class action
  suit was filed alleging Section 11 claims against
  the company, its officers and directors, and
  underwriters. The court found that only the
  outside directors could rely on the due diligence
  defense because of their knowledge of the
  company. The defendants were held liable for
  misleading statements on the registration
  statements.

35
36
SECTION 12(2) OF THE 1933 ACT

• Remedy for purchaser of any security by means of
  a misleading prospectus or oral communication.
• Who May Be Sued - anyone who offers or sells a
  security by means of a misleading prospectus.
• Reasonable Care Defense - defendant is not liable
  if the defendant can show he or she did not know
  and could not have known (using due care) about
  the misrepresentation and omissions.

36
37
SECTION 12(2) OF THE 1933 ACT

• Case 24.6 Synopsis. Gustafson v. Alloyd Co. 
• Three individuals own all the stock in Alloyd, a
  manufacturing corporation. They all agreed to
  enter a stock purchase agreement to sell their
  shares to Wind Point, an investment partnership.
  The individuals made a misrepresentation about
  the value of the company based on the inventory
  and financial statements.

38
SECTION 12(2) OF THE 1933 ACT

• When a year-end audit disclosed this difference,
  Wind Point sued, alleging a material
  misrepresentation in the purchase agreement,
  which Wind Point characterized as a prospectus.
  ISSUE Does Section 12(2) apply to
  misrepresentations in a stock-purchase agreement
  in connection with a private offering of stock?
  HELD The Supreme Court ruled that Section
  12(2) does not apply to private offerings as
  here, but only to public offerings. Wind Points
  claim was dismissed.

39
LIABILITY OF CONTROLLING PERSONS

• Courts do not agree
• Some courts hold that liability attaches when
  defendant had power to control the general
  affairs of the company.
• Other courts require participation in the
  securities violation.
• Controlling person is officer, director or major
  shareholder of the company.
• Section 15 No strict liability knowledge
  required.

39
40
CRIMINAL PENALTIES

• Not more than 10,000 fine and/or five years in
  prison.

40
41
THE RESPONSIBLE MANAGER

• Complying with Registration Requirements
• Any person offering securities must comply with
  the registration requirements of the 1933 Act as
  well as any applicable blue sky laws. This
  includes start-up companies, as well as large,
  publicly traded companies. Failure to comply
  gives the purchaser of the security the right to
  keep the proceeds if the investment is successful
  or to return the security to the seller if the
  investment does not turn out as hoped.

41
42
REVIEW

• 1. Why do states need blue sky laws?
• 2. Are securities laws pro-active or reactive?
  Why?
• 3. Why is the securities area so highly
  regulated?
• 4. Should there be special rules for sale of
  stocks on the internet?

42