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Securities Regulation

Professor Bradford

Spring 2010

Exam Answer Outline

The following answer outlines are not intended to be model answers, nor are they intended to include every issue students discussed. They merely attempt to identify the major issues in each question and some of the problems or questions arising under each issue. They should provide a pretty good idea of the kinds of things I was looking for. If you have any questions about the exam or your performance on the exam, feel free to contact me to talk about it.

I graded each question separately. Those grades appear on your printed exam. To determine your overall average, each question was then weighted in accordance with the time allocated to that question. The following distribution will give you some idea how you did in comparison to the rest of the class:

Question 1: Range 4-9; Average = 6.75

Question 2: Range 3-9; Average = 6.35

Question 3: Range 3-8; Average = 6.35

Question 4: Range 0-8; Average = 5.95

Question 5: Range 3-8; Average = 6.05

Total (of unadjusted exam scores, not final grades): Range 3.60-7.90; Average = 6.29

Question 1

The Potential Section 5 Violation

Prior to filing its registration statement, Newbie may not “offer to sell” the common stock. Securities Act § 5(c). An offer to sale is any attempt to dispose of or solicitation of an offer to buy the security, for value. Securities Act § 2(a)(3). Neither the ad nor the brochure actually asked anyone to purchase Newbie’s common stock, but the SEC has indicated that any attempt to condition the market—to arouse public interest in the issuer or its securities—can be an offer to sell, even if there’s no specific solicitation. However, the SEC has also adopted several safe harbors providing that specific communications are not offers to sell.

Rules Clearly Not Available

Rule 163 is not available to Newbie because it is not a well-known seasoned issuer; it is not even a reporting company. See Rule 163(a). Rule 163A is not available because these communications do not occur more than 30 days prior to the filing of the registration statement. See Rule 163A(a). Newbie expects to file on May 15 and the communications were on April 25 and May 1. Rule 168 is not available to Newbie because it is not a reporting company under the Exchange Act. See Rule 168(a)(1).

Rule 169

Rule 169 cannot be used for the newspaper and magazine ad. Rule 169(c) specifically excludes any communication containing information about the registered offering, and the ad discusses the offering. In addition, the communication must be intended for use by persons other than in their capacity as investors, and this ad seems to be aimed at investors. Rule 169(d)(3). But Rule 169 might cover the brochure.

Rule 169 is only available for communications “by or on behalf of the issuer.” Rule 169(a). The brochure meets this requirement as it is released by Newbie itself. See Rule 169(b)(2).

Registered investment companies and business development companies may not use Rule 169, Rule 169(d)(4), but Newbie does not appear to be either; the question indicates it is a manufacturer.

To use Rule 169, Newbie must have previously released information of this type in the ordinary course of its business. Rule 169(d)(1). And the timing, manner, and form of this brochure must be consistent with those past releases. Rule 169(d)(2). The question doesn’t specify whether Newbie has previously sent similar brochures to its customers or, if so, whether the timing, manner, or form of the current brochure is consistent with past brochures.

Rule 169 is available only for communications to people such as customers or suppliers, who are not contacted in their capacities as investors. Rule 169(d)(3). That appears to be the case here; the brochure was sent to customers and its purpose appears to have been to solicit additional orders.

Finally, Rule 169 is limited to “factual business information.” Rule 169(a). This includes “factual information about the issuer, its business or financial developments, or other aspects of the business;” and “advertisements of, or other information about, the issuer’s products or services.” Rule 169(b)(1). Rule 169 does not allow the issuer to communicate forward-looking information: projections or statements about future plans or objectives. Compare 169(b)(1) to 168(b)(1), (2).

Most of what Newbie included in the brochure is current, factual business information—even the statement about breaking ground on the new facility. But the statement that the new facility will double Newbie’s production capacity is arguably forward-looking, as the facility has not yet been completed. It’s not speculative information of the sort described in Rule 168(b)(2); arguably, it’s merely a present statement of what the architectural plans indicate, so Rule 169 might arguably apply, if the other conditions are met.

Rule 135

The only possible safe harbor for the ad is Rule 135, which allows limited notices by the issuer concerning the offering itself. Newbie’s ad falls within Rule 135 only if it includes the legend required by Rule 135(a)(1) and contains only the information allowed by Rule 135(a)(2).

The statement that “We are not offering the stock for sale at this time” meets the requirement of Rule 135(a)(1).

Rule 135 allows Newbie to indicate it is selling 200,000 shares of common stock. Rule 135(a)(2)(ii). Rule 135 doesn’t specifically say you can mention the price of the stock. That might arguably come within “basic terms of the securities being offered,” Rule 135(a)(2)(ii), but note that, in a situation not applicable here, the rule specifically mentions price as “additional information” that might be provided. Rule 135(a)(2)(viii)(B)(3). This would seem to indicate that price may not be included in the usual Rule 135 notice.

Rule 135(a)(2)(v) allows a brief statement of the purpose of the offering. The question is whether the “state-of-the-art” language and the indication that it will double Newbie’s production capacity goes beyond a bare-bones statement of purpose and into conditioning the market. Rule 135(a)(2)(iv) allows Newbie to indicate the expected selling date.

Rule 135 doesn’t say anything about providing a URL. However, if the ad itself falls within Rule 135, and if the Rule 135 notice may itself be on a web page (Rule 135(a)-“any medium”), it is axiomatic that a URL connecting only to that same ad would also fall within Rule 135.

The Web Page

The problem, for purposes of both Rule 169 and Rule 135, is the web page containing both the ad and the brochure. Neither Rule 135 nor Rule 169 would allow the information in the two documents to be in a single document. Rule 169 would not allow the offering-related material and Rule 135 would not allow the information about Newbie’s products. Tying offering-related information to promotional information creates serious conditioning-the-market concerns.

Putting the two documents together on the same web page arguably makes them a single document, just as linking to another URL incorporates it into the issuer’s web site. See Rule 433(e). Thus, even if each of the documents separately would be acceptable, linking them together on the Notices web page may result in a violation.

Question 2

There are two possible issues: (1) integration and (2) whether the offering exceeds the allowable aggregate offering price for either Regulation A or Rule 505.

Integration

Integration is not a problem. Regulation A says that a Regulation A offering will not be integrated with any prior offers and sales of securities. Rule 251(c). And Rule 502(a) says that a Regulation D offering will not be integrated with offers and sales more than six months before or after the Regulation D offering, provided that there are no offers and sales of the same or a similar class of securities during that six-month period. The July 3 offering was more than six months ago and there have been no intervening offers or sales, so Rule 502(a) protects both the current Rule 505 offering and the prior Rule 505 offering from integration with each other.

Aggregate Offering Price

Calculation

The aggregate offering price of this offering is $1.2 million. When securities are being offered for cash and non-cash consideration, the aggregate offering price is based on “the price at which the securities are offered for cash.” Rule 251(b), Note; Rule 501(c). Since 1,000 shares were sold for $600,000 cash, the aggregate offering price for Larry’s shares will also be $600,000, not the $400,000 appraised value of the land. As a result of this valuation rule, the aggregate offering price is $1.2 million.

Regulation A

The current offering clearly comes within the aggregate offering price limit of Regulation A. The Regulation A limit is $5 million, reduced by the price of all securities sold during the past 12 months “in reliance upon Regulation A.” Rule 251(b). The July 3 offering was within the past 12 months, but it was not in reliance on Regulation A, so it does not reduce the Regulation A limit. The limit is the full $5 million, so a $1.2 million offering is clearly acceptable.

Rule 505

Rule 505 also has a $5 million limit, but that amount is reduced by the aggregate offering price for securities sold within 12 months before the start of the Rule 505 offering pursuant to any exemption under section 3(b). Rule 505(b)(2)(i). Rule 505 is a section 3(b) exemption, and the July 3 offering is within 12 months of the start of the current offering, so the limit under Rule 505 must be reduced by $4 million, to $1 million. The $1.2 million aggregate offering price of the current offering exceeds this limit, so Rule 505 is not available. If Alpha wants to use Rule 505, it must wait until after July 3, when the full $5 million limit will be available.

Other Possible Issues

Regulation A is not available to reporting companies or to companies that aren’t incorporated in the United States or Canada. Rule 251(a)(1),(2). The question doesn’t indicate if Alpha meets these requirements.

Rule 505 has a 35-purchaser limit, Rule 505(b)(2)(ii), but that’s not an issue because there are only two purchasers in this offering. In addition, an issuer in a Rule 505 offering may not engage in general solicitation. Rule 502(c). The SEC staff has interpreted this to require that the issuer have a preexisting relationship with the offerees; that requirement appears to be met here since both purchasers are existing shareholders of Alpha.


Question 3

Mouth clearly made a misleading statement: he indicated that the EPA investigation would not have a significant impact on the company at a time that the company knew the investigation was more serious than that. But he nevertheless might not be liable under Rule 10b-5.

Materiality

The first issue is whether the misstatement was material. A statement is material if there is a substantial likelihood that a reasonable investor would consider it important. TSC Industries. Where, as here, the statement relates to a probabilistic future event—whether Smokestack will have any significant liability to the EPA—that test is applied using the Basic probability and magnitude standard. This test is uncertain, but the misstatement is probably material.

According to Lawyer, at the time of the statements, there was a 50% or greater chance that Smokestack would have to pay fines in the $10-$15 million range. That’s a moderately high probability. In the context of a $450 million company with annual income of $45 million a year, the magnitude of a one-time charge of $10-15 million is moderate to moderately high. In addition, there’s a low probability of a very high magnitude event—temporarily shutting down the plant. Basic says the two must be weighed together to determine materiality. The combination of this magnitude and this probability is probably enough to make this material.

Materiality must be judged with reference to the total mix of information available to investors. In addition to Mouth’s statements, there are also rumors about substantial liability. However, corroboration from the company is much more important to investors than unsubstantiated rumors, and this is supported by the market reaction to the announcements: the price rose from $20 to $22 a share.

Mouth might argue that his statements were mere puffery; he’s a public relations flack and everyone expects them to sugar-coat things. A reasonable investor therefore would not consider his statement important. See Eisenstadt. But even public relations specialists don’t have carte blanche to lie freely without violating Rule 10b-5; reasonable investors expect the company to put a positive spin on things, but they don’t completely discount everything said.

Scienter

The second issue is whether Mouth acted with scienter. At the time of his statements, he did not actually know that what he was saying was untrue. He was merely repeating what Prez told him. Thus, he did not intentionally deceive anyone. However, most lower courts have held that recklessness satisfies the scienter requirement, and it’s probable that Mouth acted recklessly here, especially in the last two press conferences. Lawyer’s statement put Mouth on notice that what he was saying was probably false. Continuing to say the same thing without checking further shows a total lack of concern with whether the statements were true or not, and that’s sufficient to establish recklessness.

Primary Violator?/Reliance/Fraud on the Market

The third issue is whether Mouth can be liable as a primary violator under Rule 10b-5. In an action by private investors, there is no aiding and abetting liability, Central Bank, so Mouth is liable only if he himself committed securities fraud. Two elements are necessary for one to be a primary violator: a misstatement communicated to the plaintiffs and reliance. Stoneridge. Mouth’s statement was public. Even if the plaintiffs weren’t aware of Mouth’s statement, Smokestack is a publicly traded company and the market was aware of it. And, even if the plaintiffs can’t show direct reliance, they can use fraud-on-the-market as a substitute for reliance. Basic. Smokestack’s stock is traded on the New York Stock Exchange, so the market for Smokestack’s stock is efficient. Therefore, there’s a presumption that the investors relied on the integrity of the market price. The rumors aren’t enough to rebut that presumption; as far as we know, no one knew Mouth’s statements were untrue.