chapter 24 chapter 24 public and private offerings of securities

CHAPTER 24 CHAPTER 24 Public and Private Offerings

of Securities

INTRODUCTION INTRODUCTION

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

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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

investments—only 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.

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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.

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DEFINITION OF TERMS

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.

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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).

DEFINITION OF TERMS

DEFINITION OF TERMS

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INVESTMENT CONTRACT 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.

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FAMILY RESEMBLANCE TEST

FAMILY RESEMBLANCE TEST

Case 24.2 Synopsis. Reves v. Ernst & YoungA 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? HELD:Yes. The Supreme Court ruled that these demand notes were securities.

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PUBLIC OFFERING 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.

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.


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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).


Prospectus - disclosure and marketing tool to prospective purchasers.

Due Diligence - company has to be able to back up every claim in the registration statement.


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Form S–1 Offering Form SB–1 Offering Form SB–2 Offering

Amount of offering No limit Up to $10 million in any fiscal year

No limit

Type of issuer Any issuer Must be a nonreporting or a transitional small business issuer

Must be a small business issuer

Type of offering No limitations No limitations No limitations

Type of disclosure required

S–1 basic registration form for most offerings. S–1 items referenced in Regulation S–K.

Simplified Form SB–2. SB–2 items referenced in Regulation S–B, a simplified version of Regulation S–K.

Offering statement with three models: 1. Q&A, Form U–7 2. Form 1–A, old form 3. Form SB–2, part I.


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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.


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.


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Day 1 Decide upon a public offering of securities to raise capital, and choose a securities underwriting firm

Day 30-60 With the aid of the underwriter, prepare the forms and prospectus for the registration statement.

Day 60-90 File the registration statement with the SEC for review, and submit any amendments to the filing.

Day 90-120 During the quiet period, the underwriter can assemble selling groups, distribute copies of the preliminary prospectus, and solicit offers to sell the securities.

Day 120 + Once the offering is declared effective and the pricing amendment is filed, sales of the company’s securities may begin.


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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.


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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.

EXEMPTIONS FOR OFFERINGS

BY THE ISSUER


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.


BY THE ISSUER


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.


BY THE ISSUER


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.


BY THE ISSUER


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.


BY THE ISSUER


BY THE ISSUER

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EXEMPTIONS FOR SECONDARY OFFERINGS

EXEMPTIONS FOR SECONDARY OFFERINGS

Section 4(1) Exemption - 1933 Act; secondary offerings are exempt.

Rule 144 - criteria deciding if someone is an underwriter

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RULE 144A AND REG S 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.

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VIEW FROM CYBERSPACE: OFFERINGS ON THE

INTERNET

VIEW FROM CYBERSPACE: OFFERINGS ON THE

INTERNET SEC’s 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.

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REPORTING REQUIREMENTS OF

PUBLIC COMPANIES


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.

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 issuer’s 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.


PUBLIC COMPANIES


PUBLIC COMPANIES

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SELECTIVE DISCLOSURE AND REGULATION FD (FAIR

DISCLOSURE)

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

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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

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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.





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.

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.



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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.



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.



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DUE DILIGENCEDUE DILIGENCECase 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.

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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.

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.



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 Point’s claim was dismissed.



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LIABILITY OF CONTROLLING PERSONS

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.

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CRIMINAL PENALTIES CRIMINAL PENALTIES

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

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THE RESPONSIBLE MANAGER

THE RESPONSIBLE MANAGER

Complying with Registration RequirementsAny 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.

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REVIEWREVIEW

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?

chapter 24 chapter 24 public and private offerings of securities

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security regulations

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