Source: http://tollefsenlaw.com/federal-securities-law-overview/
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Federal Securities Law Overview | Tollefsen Law
by John J. Tollefsen | Aug 28, 2011 | Blog, Civil Litigation, Federal Law, Securities US | 0 comments
Federal Securities Law Overview With Commentary by John Tollefsen1The author has served and continues to serve on several securities laws committees of the American Bar Association Business Law and Litigation Sections. He has been a speaker at Continuing Legal Education seminars on securities law. He obtained his Series 27 (Financial Principal), 24 (General Principal), 7 and 63 NASD licenses and founded two securities broker dealers businesses. He also managed a Securities Exchange Commission licensed stock transfer agent. His practice included numerous private placements and several public offering registrations. He was privileged to make quasi-official visits with a team of ABA securities lawyers to ranking members of several international stock exchanges including some in China and the former Soviet Union and Soviet-Bloc countries of Poland, Czechoslovakia, and Hungary. One delegation was headed by the Solicitor General of the SEC. He has been active in the SEC Small Business Forum on Small Business Capital Formation since 1982.
U.S. banking laws3The securities laws are a subset of banking regulation. Banks and broker-dealers were combined except during the Glass-Steagall regime (1933-1999). were written in response to financial crisis. The stock market first crashed in 1792. The first of thirteen major bank panics occurred in 1814.4Charles W. Calomiris, U.S. Bank Deregulation in Historical Perspective, (Cambridge: Cambridge University Press, 200), 98. The Wall Street Crash of 1929 did not trigger a major bank panic. Id. In times of economic stress, it is politically popular to bash the “robber barons of Wall Street” creating a season of “financial reform”. Thus, the Securities Act of 1933 was passed unanimously without debate. More recently the Sarbanes Oxley Act of 2002 originated from the dot.com bubble burst of 2000 and several scandals including Tyco, WorldCom, and Enron. The “Great Recession” that developed after the Lehman Brother bankruptcy in the wake collapse of the housing market2The housing market at the time was experiencing a market bubble built on what proved to be complex and speculative derivatives. produced the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2011.
Trading on public markets
Regulation of market professionals
Dual jurisdiction issues
Reform of the U.S. securities regulation system is very controversial and tends to reflect the conscious or unconscious bias of the commentators. My view is influenced by the historic rise of the capital markets in the U.S. which provided access to capital and wealth to many of those who worked wisely and diligently. Many of the major U.S. companies were founded by entrepreneurs who sold stock at state fairs and any other venue they could find. Even the Pilgrims sold stock to finance their ships and the voyage to New England.5The pilgrims arguably misrepresented their prospects in the new world to their investors and then failed to pay their investors as promised. I favor a just and honest form of capitalism that levels the playing field as much as possible for new entrepreneurs.
The U. S. attracted entrepreneurs from all over the world because it was open to new ideas and capital was available but as the financial scandals wracked the markets and took money from the innocent, the laws changed to keep most small business entrepreneurs from access to the capital markets.6Only Canada among developed countries attempts to provide significant opportunity to entrepreneurs. Europe has not had a history of start-up ventures due to barriers to entry erected by those in power. Venture capital (with the possible exception of the relatively small “angel capital” market) is a cutthroat business unavailable to most small business. Others have unique advantages like successful entrepreneur, Bill Gates, who was so well-born and well-connected he could drop out of Harvard. Securities regulation in the U.S. is primarily a “one-size fits all” system. It assumes that what is good for General Motors shareholders is also good for the shareholders of small business.7There are exceptions like the temporary small business exemption from SOx § 404 but the generalization is still true. As a result, IPOs are only available for the well-connected or irrationally exciting companies (e.g. Facebook) but not for the run of the mill small companies who employ so many Americans.8In the current market, small-cap stocks are struggling and the issuers find it difficult to raise capital. Well-designed securities laws can play a major role in leveling the playing field while protecting investors. This goal seems beyond the reach of both the SEC and Congress.
Justification for financial markets: When healthy, the capital markets create wealth for all participants from the institutions and professionals to the pension plans and retail investors. When the markets rise, consumer sentiment also rises thereby fueling the modern consumer-based economy. When markets fall, the velocity of money declines, reducing liquidity, and people become more cautious. Recessions can result.
The markets are said to run on “fear and greed”.9More politely “fear and greed” is referred to as “fear and enthusiasm”. This pattern results in business cycles of boom and recession. Politicians have a role in fueling the cycle with rhetoric that causes fear. Responsible politicians can provide leadership by limiting “market bashing” during recessions.10An example of failure to recognize the proper role of leaders in times of recession is President Obama’s statement, “There will be time for them to make profits, and there will be time for them to get bonuses — now is not that time. And that’s a message that I intend to send directly to them.” January 30, 2009. The market reaction to this comment reduced the pensions of unions and other investors President Obama did not intend to hurt. Recession is the time for making profits so that people can be put back to work. Politicians as well as business leaders attempt to establish investor confidence and limit the cycles of crash and bubble the United States has experienced through the activities of a strong securities regulator11The United States should eliminate the separation of the commodities markets from other securities markets and having the central bank set separate margin regulations for each. There is too much room for political influence. Once the separate system was established in the U.S., lobbyists have been able to defeat any attempts at reform including Dodd-Frank. and a separate but powerful central bank. It should reenact a “Glass-Steagall” barrier between banks and broker dealers.12In my view, the Glass-Steagall Act of 1933 worked well and its repeal is partially responsible for the crash of 2008. The Act was opposed by banks who argued they needed to expand their business and diversify their risks. Exactly the opposite occurred for many banks after Glass-Steagall was repealed in 1999.
The source of most information regarding securities must come from the issuer because the purchaser has little ability to discover the information needed to evaluate the investment without the assistance of the issuer. Beginning with the Kansas Blue Sky Act of 1911, U.S. securities law put the duty on the seller and purchaser to give full disclosure without material omission as a condition of sale or purchase. Formerly the law followed the maxim caveat emptor.13Central Bank of Denver v, First Interstate Bank, 511 U.S. 164, 171 (1994) (quoting Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151 (1972.)) After the securities laws were enacted, the law imposed the duty of caveat venditor on the seller. The philosophy is called “full disclosure” and is based on the view that “[s]unlight is said to be the best of disinfectants; . . . .”14Louis D. Brandeis, Chapter IV:, New York: Harper’s Weekly (December 20, 1913).
Generally, securities regulation philosophy is viewed as two extremes on a spectrum. On the one side is the extreme “full disclosure” regime. Its extreme version allows any security to be sold if certain material facts are disclosed and material facts are not unlawfully omitted from the disclosure. A Ponzi scheme could be sold so long as there was full disclosure that there was no real business. On the other end of the spectrum is extreme merit review. It includes all of the full disclosure requirements plus it only allows “good deals” or “suitable transactions” be sold to the public. Some classify the U.S. Federal Securities laws as examples of full disclosure and the securities laws of most states as merit review. In reality, the distinction is much more subtle. Many federal regulations include limitations designed to protect investors from themselves even if there is full disclosure. For example, in private placements, “accredited investors” are allowed unlimited access to the offering because they are rich and arguably able to fend for themselves. No disclosure is mandated for accredited investors.15 Regulation D, 17 CFR § 230.502(b). The antifraud rule still applies. In public offerings there are many barriers placed for public protection. For example some people are barred from serving as officers and directors, “shell companies” can face permanent second class status,16Blank check companies (blind pools), shell companies, and penny stock issues are the targets of SEC “merit” review. See Rule 419(a)(2); Rule 405; and Rule 3a51-1 of the Securities Exchange Act of 1934. and there are listing requirements mandating net worth and other requirements.
The real issue with the merit review as practiced by Blue Sky jurisdictions and sometimes the SEC is the unpredictability and subjectivity involved.17President Roosevelt first considered having the Federal Trade Commission decide the securities that would allowed to be sold to the public. Wall Street objected and what was then considered political “liberalism” prevailed. Let the market decide after disclosure was the liberal philosophy (now called conservatism). See Noah Feldman, Scorpions: The Battles and Triumphs of FDR’s Great Supreme Court Justices, New York: Twelve, 2010, 79-80. Often the state examiner is given discretion to condition effectiveness on factors that in the opinion of the examiner protect investors.18There is also much discretion used by SEC examiners. They have been known to issue comment letters on companies they do not like (e.g. “blank check issuers”) expanding the comment period after filing for years and insist on disclosures designed to kill the deal. I have been told by an examiner that when he sees a deal he does not like, he will never run out of comment letters. Even Fortune 500 companies have complained that the SEC examiners are constantly changing comments on filings even though the company may register over 100 transactions per year.
The major difficulty with the full disclosure philosophy is the word “full”. It is impossible to fully disclose anything. The law limits the disclosure obligation to facts that are “material” and that are not otherwise protected. Liability attaches only to the failure to disclose these material facts. “Material facts” are defined as facts that a reasonable investor is substantially likely to consider important in the total mix of information.19Or alter the mix of information. See e.g. Basic Inc. v Levinson, 108 S. Ct. 978, 983(1988) (adopting the standard in TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976). Even though material, disclosure may not be required at that time (e.g. acquisition or restructuring) or perhaps at any time (e.g. proprietary information, trade secrets). The SEC is careful to limit the facts it deems “material”:
“it is clear that the Commission has the authority, pursuant to the various provisions of the securities laws, [citation omitted], to require registrants to disclose “nonmaterial” but economically significant information. . . . . by deeming information “material,” the Commission exposes registrants to potential civil damage suits by investors . . .20Footnote 26, Natural Resources Defense Council, Inc. v. Securities and Exchange, 432 F.Supp. 1190, D.C.D.C. 1977 (Public interest groups sought review of Securities and Exchange Commission’s rulemaking pertaining to disclosure of reporting corporations’ compliance with National Environmental Policy Act as well as disclosure requirements with respect to equal employment opportunities and other matters of social concern).
The SEC believes in exercising its disclosure authority in “contexts related to the objectives of the securities laws” it has to balance investor interest in extensive disclosure on various matters against (1) the danger of “excessive and possibly confusing detail” that might result in disclosures so voluminous that they would be less useful to investors generally, and (2) the cost of such disclosures to registrants, and ultimately to their shareholders.21Securities Release No. 5627, 40 Fed.Reg. at 51,659-60. “Costs” include civil liability. This issue has been controversial and mandatory minimum disclosure (whether material or not) of certain issues that have troubled Congress is required (like management compensation).22Shareholders do not seem to be a troubled by management compensation. Shareholders have rarely voted to reduce salaries of management. Few corporations want a bargain-priced CEO. In addition there are numerous mandatory disclosures for filings with the SEC which may not be material in all circumstances.23E.g. Regulation S-K. The SEC has been careful to avoid limiting “materiality” to a formula like percentage of assets, sales or other numerical tests.24See SEC Staff Accounting Bulletin No 99, August 12, 1999.
Because of the costs and risks involved with registration, issuers will be tempted to disguise securities transactions as non-securities transactions. The scope of the definition of “security” is very broad. It often surprises business people that most promissory notes are securities. The other surprise is the term “investment contract” in the Federal law definition of “security”. An investment contract is “a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party”.25SEC v. W.J. Howey Co., 328 U.S. 293, 298–99, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244 (1946). The word “solely” is not construed narrowly.26“An interest thus does not fall outside the definition of investment contract merely because the purchaser has some nominal involvement with the operation of the business. Rather, ‘‘the focus is on the dependency of the investor on the entrepreneurial or managerial skills of a promoter or other party.’’ Gordon v. Terry, 684 F.2d 736, 741 (11th Cir.1982). See S.E.C. v. Merchant Capital, LLC, 483 F.3d 747, 755 (11th Cir. 2007). States by statute and case law also use the “risk capital” test which in practice has proven superior in some situations to the federal rule. If the essence of the transaction is an investor putting money at risk for a profit, the transaction involves “risk capital” and is a security.27See the seminal case, Silver Hills Country Club v. Sobieski, 55 Cal.2d 811(1961). State law generally looks to the risk capital and Howey tests as alternative tests which are equally applicable.
In the 1920s, teams of stock sellers touted stock which was also being promoted by paid newspaper “journalists” who had call options on the stock. The stock was “pumped” and promoters “dumped” their stock on overly enthusiastic buyers. There was little professional evaluation of the merits of the stock offerings. Investors “bought water and paid for it with wind”.28Robert H. Jackson, “The Bar and the New Deal”, West Virginia Law Quarterly 41 (1935): 103, 105. The Securities Act of 1933 was designed to prevent another major bubble and collapse by controlling the actions of stock promoters selling blue sky to a gullible public. Instead of registering the public company and allowing it to issue securities, the 33 Act required registration of transactions unless an exemption applied.29There have been proposals considered to register companies instead of transactions but they have not gained traction. The length of this paper does not allow discussion of statutory exemptions. The ones that have generated the most litigation are 4(1) and 4(2). An unwritten exemption developed through no action letters is 4(1 ½) which allows a non-issuer to use 4(2) under certain circumstances. If a company has 100 securities transactions in a year, it could be required to register 100 times with the SEC.30“Transactions” are separate, non-integrated offerings of securities by underwriters on behalf of the issuer. There may be numerous buyers of the securities issued in a single transaction.
To avoid “gun jumping”,31“Gun jumping” refers to offers to buy or sell a security before the transaction registration is effective with the SEC. “front running”,32“Front running” is buying before a positive recommendation is made public. It was practiced by broker-dealers and journalists in the 1920s. and “pump and dump” schemes, the 33 Act divides a public offering into three parts: 1) The pre-filing period; 2) the waiting or filing period; and 3) the quiet period or post-effective period. The 33 Act proscribes liability under section 5 for to sell a security using the jurisdictional means through a prospectus33Jurisdiction is using any instrument of interstate commerce (e.g. phone, internet, mail, etc.) The requirement that a prospectus be a “writing” should be reviewed in light of the age of the Internet (e.g. twitter). unless the transaction is registered.34“. . . to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise; . . . . “Sales” include attempts to sell (section 2(a)(3).
During the pre-offering period, the issuer searches for underwriters,35An underwriter is one who purchases with a view of distribution. This definition has created difficulty in interpretation leading to the “come to rest” exception for purchasers who hold for a period of time with investment intent and the offering is not part of another offering (“integrated”; see SEC Release 4552). plans and prepares the offering. There can be no conditioning of the offering during this period. 36E.g. see Rule 163A which provides a safe harbor under section 5 of the 33 Act for communications made by certain issuers more than thirty days prior to filing a registration statement that does not mention the offering or registration and reasonable steps are taken to prevent further distribution or publication. Next is the waiting period which must be a minimum of 20 days.37It is probably impossible to file a registration statement and become effective within 20 day. Normally it takes months to go through two or more comment letters. Oral offers and a preliminary prospectus known as a “Red Herring” are allowed.38Red Herrings are identified by their conspicuous red letter disclaimers on the cover. See Rule 430. Some Free Writing prospectuses are allowed. See Rules 405, 164, and 433. Free Writing prospectus can include a communication given with or after the delivery of the final prospectus. Non-binding orders, underwriting agreements, and selling group agreements are negotiated during the waiting period.39Dealers lose their exemption after the first bona fide offer (Section 4(3)(B, Rule 137). “Tombstone” notices may be publicized under certain conditions.40Rule 134. After the offering becomes effective, the communications that are not unlawful prospectuses during the waiting period may continue. A statutory final prospectus must also be delivered with or before confirmations for after-market sales by dealers (regardless of whether the dealer participated in the public offering) for 25 days following the effective date of an initial public offering (90 days if the securities are not listed). The prospectus must be updated if there is any material post-effective change with a post-effective filing and a “sticker” placed on the original printed prospectuses. The SEC has allowed issuers to prepare an offering in advance. These are known as “shelf offerings”. Shelf offerings are registered41Shelf offerings frequently require price and term amendments but are complete in all other respects. and are kept “evergreen” by filing updates as needed. They are then available to use quickly when the need arises.42See Rules 413(b), 415; 430B.
After the initial public offering, the issuer must comply with the requirements of the 34 Act in order to remain listed on a public market.43There is no reason to separate the provisions of the 33 Act from the 34 Act as in the U.S. This generally involves an annual update to the prospectus material and audited financial statements (10K), unaudited quarterly reports (10Q), and certain material changes throughout the year (8K). Issuers with more than 500 shareholders and $10 million in assets must register under the 34 Act. The states have trading exemptions for most large exchanges so no state filing is required. There remain controversial exemptions for “Pink Sheet” and other stocks in the Blue Sky “manual” exemption.44It was considered sufficient to be identified in Moody’s Manual or other similar publications to allow a public market with the Uniform Securities Act was promulgated.
The U.S. system does not require “real time” reporting of material facts. It was designed prior to television, the internet, or even Federal Express. It limited most disclosures to quarterly reports. Over time, the more frequent interim reports on form 8K have increased their scope to now include e.g. certain restructuring required under Sarbanes Oxley Act. The difficulty with real-time reporting is that the possibility of errors increases due the lack of time for 20-20 hindsight. Often issues are more important or less important than initially thought. Real-time reporting can increase potential civil liability risks depending on the safe harbors provided.45Safe harbors include, forward looking information, timing of disclosure, state of completion of transaction, likelihood of technical success or regulatory approval.
Some securities exchanges have gone public. Therefore, they have a primary interest in increasing profits through trading volume and perhaps volatility. Volatility can increase trading because traders have more opportunity to make profits. Unfortunately all trading information is not publicly available so some have more information on bids than others.46Probably only Canadian exchanges have transparent trading where the public has access to all orders whether in the money or not. Other protections like the short selling uptick rule should be mandated. The current loopholes that allow naked shorting should be abolished. There should be listing requirements tied to the risk of the security. General Motors should have been delisted from the New York Stock Exchange when it became an ongoing concern risk. There should be multiple tiers of listings to reflect more than net worth and number of shareholders.
Trading on public markets is done only by persons licensed and tested by FINRA. There are net capital requirement for the firms which have stringent rules about the value of equity assets.47For example, penny stocks are valued at $0 (100% haircut). The accounts are insured to $500,000 through SIPC.48Securities Investor Protection Corporation. FINRA has no provision for broker-dealers assisting small business financing and actual prohibits (or drastically limits) such financing. FINRA and the SEC should amend their policies and allow its market professionals to assist small business.49At a minimum, the SEC should license “finder broker dealers”, a persistent proposal of small business to the SEC.
Trading on material non-public trading is called “insider trading”. The cases have struggled to find the limits between clever research and wrongful behavior. Early cases held that the information must come from the issuer to be unlawful. Thus a printer who deduces the name of the target of an acquisition by reviewing documents in the print shop along with some additional detective work was not liable for insider trading because he did not obtain his information from the issuer.50Chiarella v U.S, 445 U.S. (1979). Later courts found this result unacceptable and adopted what is known as the misappropriation theory. If there is a breach of fiduciary duty and the person who trades knows or has reason to know of the breach, there is a violation of the restriction against insider trading.51U.S. v O’Hagan, 521 U.S. 642 (1997) (lawyer acquires confidential information about issuer from another lawyer in his firm). It is important to enforce rigid rules against insider trading to maintain confidence in the markets.
The 33 Act, section 4(2), exempts transactions that do not involve a public offering. The Supreme Court interpreted that exemption to include the requirement that the investors have access to the kind of information a registration statement would disclose.52SEC v Ralston Purina Co., 73 U.S. 981, 1985 (1953) (Over 1100 employees bought unregistered company stock for approximately $2 million). In that case, the SEC argued that the number of offerees should be limited but the Supreme Court did not agree. Subsequently, the SEC provided a safe harbor with former Rule 146 and limited the number of offerees to 35. Finally in 1982, the SEC issued Regulation D in three rules. Rule 504 allowed sales up $1 million of free trading stock and provided an easy path to public offerings for small business. This was quickly quashed by state legislation. Rule 505 allowed offerings up to $5 million and Rule 506 was unlimited in dollar amount. Both limited unaccredited investors to 35 and had no limit on accredited investors.53Unaccredited investors are “smart” and can understand the deal. Accredited investor may be dumb but rich. The theory is that accredited investors have the money to fend for themselves. Rule 506 became the rule of choice when it became covered securities exempt from state blue sky laws except for the state antifraud provisions and filing fees.54Section 18(b)(4)(D) of the ’33 Act. In 2010, the Dodd-Frank Act Section 926 put the status of covered securities in question at least for some transactions.
The primary problem for compliance with Regulation D by small business has been the general solicitation rule. The SEC has consistently ruled in no-action letters that the investor must have a substantial pre-existing relationship with the issuer or seller. The small business community continually pushes the SEC to relax the rule because small business first raises money from friends and family (those with whom there is a pre-existing relationship) then turns to Regulation D. Small business lobbied the SEC to provide a substantial compliance safe harbor. When it did, it excluded general solicitation from the safe harbor.55Regulation D, Rule 508. As a consequence, most of small business Regulation D offerings are subject to attack for Section 5 violations.
Resale of private placements, sales by affiliates and control persons: Section 4(1) of the 33 Act does not allow an underwriter to use the standard public market trading exemption. The 33 Act defined “underwriter” as one who purchased with a view toward distribution. Since most investors buy with a view to resell at a profit, the law struggled with the distinction between an ordinary investor and an underwriter. The early cases focused on the length of time the security is held and investor intent. The longer it is held the more likely it has “come to rest” and the investor is not an underwriter. Cases that looked toward the change in investment intent have created law that is difficult to apply. The SEC came to the rescue with Rule 144, a complex rule which allows public resale of restricted and control securities if a number of conditions are met.
Control securities are those held by an affiliate of the issuing company. An affiliate is a person, such as a director or large shareholder, in a relationship of control with the issuer. Control means the power to direct the management and policies of the company in question, whether through the ownership of voting securities, by contract, or otherwise. If the securities are purchased from a controlling person or “affiliate”, they are restricted securities, even if they were not restricted in the affiliate’s hands. An affiliate of an issuer is a person that directly or indirectly, through one or more intermediaries, controls, or is controlled by, or is under common control with the issuer. Directors and senior officers are deemed affiliates.
The restricted security investor almost always will receive a certificate stamped with a “restricted” legend. The legend indicates that the securities may not be resold in the marketplace unless they are registered with the SEC or are exempt from the registration requirements. The conditions of resale vary by the status of the holder but include holding period, adequate current information, trading volume limitations, and the requirement of an ordinary brokerage transaction. A filing of Form 144 with the SEC is required.
Although the SEC generally does not assert jurisdiction over foreign transactions,56The subject is complex. See the “foreign cubed” transaction considered outside the jurisdiction of the courts in Morrison v. National Australia Bank Ltd., 130 S.Ct. 2869 (2010) and the response expanding jurisdiction in the Dodd-Frank Act. it is concerned with the resale into the U.S. of offshore transactions. Regulation S is designed to provide guidance when securities are deemed to come to rest abroad so that the investor is not deemed a statutory underwriter. The safe harbors in the rule are subject to two general conditions: 1) The offer or sale must occur in an “offshore transaction” in which the seller reasonably believes that the buyer is offshore at the time of the offer or sale or the transaction occurs on certain “designated offshore securities markets and the transaction is not pre-arranged with a buyer in the United States. 2) There are no “directed selling efforts” made in the United States by the issuer, a distributor, any of their respective affiliates, or any person acting on their behalf. The SEC attempts to regulate resale of unregistered securities, whether sold in its jurisdiction or abroad, because these transactions can provide opportunities for the unscrupulous to dump stock on the public market without regulatory review.
U.S. securities law provides four primary federal theories for recovery: 1) Section 11 provides an almost strict liability standard for issues of securities registered under the 33 Act for material misstatements or omissions. There is secondary liability for certain aiders and abettors including experts. Its usefulness is limited by the one year statute of limitations (3 year discovery rule). 2) Section 12(a)(1) reaches sellers and control persons who fail to register (section 5 violations). Its usefulness is limited by the one year statute of limitations (3 year discovery rule). 3) Section 12(a)(2) reaches misrepresentations and omissions through use of a prospectus in public offerings. Its usefulness is limited by the one year statute of limitations (3 year discovery rule). 4) The implied cause of action through Rule 10b-5. This has become the most significant theory for federal civil liability. A plaintiff must allege and prove, six elements: (1) material misrepresentation or omission; (2) nexus to the purchase or sale of a security; (3) scienter; (4) reliance; (5) economic loss; and (6) loss causation. Some aspects have been affected by the requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA).57The PSLA codified the right to civil action under 10b-5 but added many restrictions and controls. See Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified as amended in scattered sections of titles 15 & 18 of the U.S. Code). The defendant’s fraudulent conduct must meet the “nexus” requirement, meaning that the conduct must have been “in connection with the purchase or sale” of a security in interstate commerce.58Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 768 (1975) (citing 17 C.F.R. § 240.10b-5). The “fraud-on-the-market” presumption applies if the information at issue is material, the market is sufficiently active, and the misinformation was disseminated publicly.59Basic, Inc. v. Levinson, 485 U.S. 224, 246-47 (1988). In 1968, the Second Circuit Court of Appeals laid the groundwork for the fraud-on-the-market doctrine by determining that privity was not a requirement for Rule 10b-5 liability. Thus, parties other than the issuer could be held liable. SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968) (en banc), cert. denied, 404 U.S. 1005(1971). The Supreme Court’s decisions in Central Bank, Stoneridge, Janus, and other recent cases eliminated liability for secondary actors. There seems to be no valid policy reason for the limitation. As the Supreme Court noted in Central Bank, “[t]he issue . . . is not whether imposing private civil liability on aiders and abettors is good policy but whether aiding and abetting is covered by the statute.” 60511 U.S. at 177. The reasoning is ironic since the cause of action under 10b-5 is implied by the court and not found in the statute. The statute of limitations is two years (5 year discovery rule).
As a result of the limitations imposed by federal law, state law appears to be preferable. Not only is the statute of limitations longer, there is generally aider and abettor liability, no scienter requirement, no reasonable reliance issue, and no loss causation required. In addition, the Sarbanes Oxley Act made securities violations nondischargeable in bankruptcy.6111 U.S.C 523(a)(19).
Federal securities laws should codify civil liability laws and with a focus on the harm to the public. Even negligent misrepresentations can harm the public and should be actionable in some situations. Aiders and abettors should have liability in at lease some circumstances.62The law must balance the needs of the issuers to make disclosure without needing 20-20 hindsight, minimize the punishment inflicted on the corporation and the shareholders for management errors, prevent the formation of law firm class action factories who have the power to “extort” money from issuers, and the right of shareholders to relief from blindly optimistic or dishonest management. More than 15 pages would be needed to develop these ideas.
Even though small business generates a large number of the jobs and growth in the economy, the SEC is hostile to small business capital formation believing that most fraud occurs in this area. Congress recognized the problem and enacted the Small Business Investment Incentive Act of 1980 which mandated annual meetings of small business with the SEC. At every Forum, small business meets and generates a list of requested changes in the securities laws. These have been mostly ignored during the past 29 years. The SEC does not like the process and has reduced the Forum to one day.
Although it is true that some entrepreneurs have used corporate shells to facilitate pump and dump schemes on the public, it is time the SEC learn how to distinguish legitimate small business capital formation from fraud. The SEC has shown some sympathy with small business by special forms and the exemption for small issues from accelerated filing status and compliance with Sarbanes Oxley 404.63The SB forms were replaced in 2008. See “Smaller Reporting Company Regulatory Relief and Simplification”, Release No. 33-8876 (Dec. 19, 2007). There is much that can be done to give small business access to capital but it cannot happen with the type of people the SEC recruits. The SEC should provide better opportunities for its employees to avoid its security regulatory agency serve primarily as a training school for big business law firms.
The U.S. has overlapping system of securities regulation between the fifty states and the federal government. Issuers must often comply with regulator schemes of the SEC and multiple states. It is often like threading a needle to find exemptions that will allow a private placement to proceed. Often, certain states must be avoided to complete a transaction.64An IPO example is Apple Computer which was denied blue sky registration in some states and was purchased by investors in those states for double the offering price later the same day of the IPO. The criticism resulted in NASAA implementation of a high tech exemption from the registration by coordination rules. This system has positive aspects for fraud investigation and sanctions. The SEC does not have the budget or manpower to enforce all the federal securities violations. It selectively choses enforcement cases across the securities law legal spectrum.65Currently insider trading cases are primarily discovered and prepared by FINRA. The SEC only prosecutes a select few due to lack of resources even though the enforcement division claims these are all good cases. Canada has a system of separate provincial securities administrators and no federal agency. The best system would be to have a uniform national system of registration and exemption and limit regional blue sky laws to fraud enforcement.66The regions need to be paid filing fees to fund their agencies. This suggestion assumes that the federal agency is not hostile to small business like the SEC is. Otherwise, the “test the waters” and other provisions assisting small business capital raising in states like California would not exist.
1. ↑ The author has served and continues to serve on several securities laws committees of the American Bar Association Business Law and Litigation Sections. He has been a speaker at Continuing Legal Education seminars on securities law. He obtained his Series 27 (Financial Principal), 24 (General Principal), 7 and 63 NASD licenses and founded two securities broker dealers businesses. He also managed a Securities Exchange Commission licensed stock transfer agent. His practice included numerous private placements and several public offering registrations. He was privileged to make quasi-official visits with a team of ABA securities lawyers to ranking members of several international stock exchanges including some in China and the former Soviet Union and Soviet-Bloc countries of Poland, Czechoslovakia, and Hungary. One delegation was headed by the Solicitor General of the SEC. He has been active in the SEC Small Business Forum on Small Business Capital Formation since 1982.
2. ↑ The housing market at the time was experiencing a market bubble built on what proved to be complex and speculative derivatives.
3. ↑ The securities laws are a subset of banking regulation. Banks and broker-dealers were combined except during the Glass-Steagall regime (1933-1999).
4. ↑ Charles W. Calomiris, U.S. Bank Deregulation in Historical Perspective, (Cambridge: Cambridge University Press, 200), 98. The Wall Street Crash of 1929 did not trigger a major bank panic. Id.
5. ↑ The pilgrims arguably misrepresented their prospects in the new world to their investors and then failed to pay their investors as promised.
6. ↑ Only Canada among developed countries attempts to provide significant opportunity to entrepreneurs. Europe has not had a history of start-up ventures due to barriers to entry erected by those in power. Venture capital (with the possible exception of the relatively small “angel capital” market) is a cutthroat business unavailable to most small business. Others have unique advantages like successful entrepreneur, Bill Gates, who was so well-born and well-connected he could drop out of Harvard.
7. ↑ There are exceptions like the temporary small business exemption from SOx § 404 but the generalization is still true.
8. ↑ In the current market, small-cap stocks are struggling and the issuers find it difficult to raise capital.
9. ↑ More politely “fear and greed” is referred to as “fear and enthusiasm”.
10. ↑ An example of failure to recognize the proper role of leaders in times of recession is President Obama’s statement, “There will be time for them to make profits, and there will be time for them to get bonuses — now is not that time. And that’s a message that I intend to send directly to them.” January 30, 2009. The market reaction to this comment reduced the pensions of unions and other investors President Obama did not intend to hurt. Recession is the time for making profits so that people can be put back to work.
11. ↑ The United States should eliminate the separation of the commodities markets from other securities markets and having the central bank set separate margin regulations for each. There is too much room for political influence. Once the separate system was established in the U.S., lobbyists have been able to defeat any attempts at reform including Dodd-Frank.
12. ↑ In my view, the Glass-Steagall Act of 1933 worked well and its repeal is partially responsible for the crash of 2008. The Act was opposed by banks who argued they needed to expand their business and diversify their risks. Exactly the opposite occurred for many banks after Glass-Steagall was repealed in 1999.
13. ↑ Central Bank of Denver v, First Interstate Bank, 511 U.S. 164, 171 (1994) (quoting Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 151 (1972
14. ↑ Louis D. Brandeis, Chapter IV:, New York: Harper’s Weekly (December 20, 1913).
15. ↑ Regulation D, 17 CFR § 230.502(b). The antifraud rule still applies.
16. ↑ Blank check companies (blind pools), shell companies, and penny stock issues are the targets of SEC “merit” review. See Rule 419(a)(2); Rule 405; and Rule 3a51-1 of the Securities Exchange Act of 1934.
17. ↑ President Roosevelt first considered having the Federal Trade Commission decide the securities that would allowed to be sold to the public. Wall Street objected and what was then considered political “liberalism” prevailed. Let the market decide after disclosure was the liberal philosophy (now called conservatism). See Noah Feldman, Scorpions: The Battles and Triumphs of FDR’s Great Supreme Court Justices, New York: Twelve, 2010, 79-80.
18. ↑ There is also much discretion used by SEC examiners. They have been known to issue comment letters on companies they do not like (e.g. “blank check issuers”) expanding the comment period after filing for years and insist on disclosures designed to kill the deal. I have been told by an examiner that when he sees a deal he does not like, he will never run out of comment letters. Even Fortune 500 companies have complained that the SEC examiners are constantly changing comments on filings even though the company may register over 100 transactions per year.
19. ↑ Or alter the mix of information. See e.g. Basic Inc. v Levinson, 108 S. Ct. 978, 983(1988) (adopting the standard in TSC Indus., Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
20. ↑ Footnote 26, Natural Resources Defense Council, Inc. v. Securities and Exchange, 432 F.Supp. 1190, D.C.D.C. 1977 (Public interest groups sought review of Securities and Exchange Commission’s rulemaking pertaining to disclosure of reporting corporations’ compliance with National Environmental Policy Act as well as disclosure requirements with respect to equal employment opportunities and other matters of social concern).
21. ↑ Securities Release No. 5627, 40 Fed.Reg. at 51,659-60. “Costs” include civil liability.
22. ↑ Shareholders do not seem to be a troubled by management compensation. Shareholders have rarely voted to reduce salaries of management. Few corporations want a bargain-priced CEO.
23. ↑ E.g. Regulation S-K.
24. ↑ See SEC Staff Accounting Bulletin No 99, August 12, 1999.
25. ↑ SEC v. W.J. Howey Co., 328 U.S. 293, 298–99, 66 S.Ct. 1100, 1103, 90 L.Ed. 1244 (1946).
26. ↑ “An interest thus does not fall outside the definition of investment contract merely because the purchaser has some nominal involvement with the operation of the business. Rather, ‘‘the focus is on the dependency of the investor on the entrepreneurial or managerial skills of a promoter or other party.’’ Gordon v. Terry, 684 F.2d 736, 741 (11th Cir.1982). See S.E.C. v. Merchant Capital, LLC, 483 F.3d 747, 755 (11th Cir. 2007).
27. ↑ See the seminal case, Silver Hills Country Club v. Sobieski, 55 Cal.2d 811(1961). State law generally looks to the risk capital and Howey tests as alternative tests which are equally applicable.
28. ↑ Robert H. Jackson, “The Bar and the New Deal”, West Virginia Law Quarterly 41 (1935): 103, 105.
29. ↑ There have been proposals considered to register companies instead of transactions but they have not gained traction. The length of this paper does not allow discussion of statutory exemptions. The ones that have generated the most litigation are 4(1) and 4(2). An unwritten exemption developed through no action letters is 4(1 ½) which allows a non-issuer to use 4(2) under certain circumstances.
30. ↑ “Transactions” are separate, non-integrated offerings of securities by underwriters on behalf of the issuer. There may be numerous buyers of the securities issued in a single transaction.
31. ↑ “Gun jumping” refers to offers to buy or sell a security before the transaction registration is effective with the SEC.
32. ↑ “Front running” is buying before a positive recommendation is made public. It was practiced by broker-dealers and journalists in the 1920s.
33. ↑ Jurisdiction is using any instrument of interstate commerce (e.g. phone, internet, mail, etc.) The requirement that a prospectus be a “writing” should be reviewed in light of the age of the Internet (e.g. twitter).
34. ↑ “. . . to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to sell such security through the use or medium of any prospectus or otherwise; . . . . “Sales” include attempts to sell (section 2(a)(3).
35. ↑ An underwriter is one who purchases with a view of distribution. This definition has created difficulty in interpretation leading to the “come to rest” exception for purchasers who hold for a period of time with investment intent and the offering is not part of another offering (“integrated”; see SEC Release 4552).
36. ↑ E.g. see Rule 163A which provides a safe harbor under section 5 of the 33 Act for communications made by certain issuers more than thirty days prior to filing a registration statement that does not mention the offering or registration and reasonable steps are taken to prevent further distribution or publication.
37. ↑ It is probably impossible to file a registration statement and become effective within 20 day. Normally it takes months to go through two or more comment letters.
38. ↑ Red Herrings are identified by their conspicuous red letter disclaimers on the cover. See Rule 430. Some Free Writing prospectuses are allowed. See Rules 405, 164, and 433. Free Writing prospectus can include a communication given with or after the delivery of the final prospectus.
39. ↑ Dealers lose their exemption after the first bona fide offer (Section 4(3)(B, Rule 137).
40. ↑ Rule 134.
41. ↑ Shelf offerings frequently require price and term amendments but are complete in all other respects.
42. ↑ See Rules 413(b), 415; 430B.
43. ↑ There is no reason to separate the provisions of the 33 Act from the 34 Act as in the U.S.
44. ↑ It was considered sufficient to be identified in Moody’s Manual or other similar publications to allow a public market with the Uniform Securities Act was promulgated.
45. ↑ Safe harbors include, forward looking information, timing of disclosure, state of completion of transaction, likelihood of technical success or regulatory approval.
46. ↑ Probably only Canadian exchanges have transparent trading where the public has access to all orders whether in the money or not. Other protections like the short selling uptick rule should be mandated. The current loopholes that allow naked shorting should be abolished. There should be listing requirements tied to the risk of the security. General Motors should have been delisted from the New York Stock Exchange when it became an ongoing concern risk. There should be multiple tiers of listings to reflect more than net worth and number of shareholders.
47. ↑ For example, penny stocks are valued at $0 (100% haircut).
48. ↑ Securities Investor Protection Corporation.
49. ↑ At a minimum, the SEC should license “finder broker dealers”, a persistent proposal of small business to the SEC.
50. ↑ Chiarella v U.S, 445 U.S. (1979).
51. ↑ U.S. v O’Hagan, 521 U.S. 642 (1997) (lawyer acquires confidential information about issuer from another lawyer in his firm).
52. ↑ SEC v Ralston Purina Co., 73 U.S. 981, 1985 (1953) (Over 1100 employees bought unregistered company stock for approximately $2 million).
53. ↑ Unaccredited investors are “smart” and can understand the deal. Accredited investor may be dumb but rich. The theory is that accredited investors have the money to fend for themselves.
54. ↑ Section 18(b)(4)(D) of the ’33 Act.
55. ↑ Regulation D, Rule 508.
56. ↑ The subject is complex. See the “foreign cubed” transaction considered outside the jurisdiction of the courts in Morrison v. National Australia Bank Ltd., 130 S.Ct. 2869 (2010) and the response expanding jurisdiction in the Dodd-Frank Act.
57. ↑ The PSLA codified the right to civil action under 10b-5 but added many restrictions and controls. See Pub. L. No. 104-67, 109 Stat. 737 (1995) (codified as amended in scattered sections of titles 15 & 18 of the U.S. Code).
58. ↑ Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 768 (1975) (citing 17 C.F.R. § 240.10b-5).
59. ↑ Basic, Inc. v. Levinson, 485 U.S. 224, 246-47 (1988). In 1968, the Second Circuit Court of Appeals laid the groundwork for the fraud-on-the-market doctrine by determining that privity was not a requirement for Rule 10b-5 liability. Thus, parties other than the issuer could be held liable. SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968) (en banc), cert. denied, 404 U.S. 1005(1971).
60. ↑ 511 U.S. at 177. The reasoning is ironic since the cause of action under 10b-5 is implied by the court and not found in the statute.
61. ↑ 11 U.S.C 523(a)(19).
62. ↑ The law must balance the needs of the issuers to make disclosure without needing 20-20 hindsight, minimize the punishment inflicted on the corporation and the shareholders for management errors, prevent the formation of law firm class action factories who have the power to “extort” money from issuers, and the right of shareholders to relief from blindly optimistic or dishonest management. More than 15 pages would be needed to develop these ideas.
63. ↑ The SB forms were replaced in 2008. See “Smaller Reporting Company Regulatory Relief and Simplification”, Release No. 33-8876 (Dec. 19, 2007).
64. ↑ An IPO example is Apple Computer which was denied blue sky registration in some states and was purchased by investors in those states for double the offering price later the same day of the IPO. The criticism resulted in NASAA implementation of a high tech exemption from the registration by coordination rules.
65. ↑ Currently insider trading cases are primarily discovered and prepared by FINRA. The SEC only prosecutes a select few due to lack of resources even though the enforcement division claims these are all good cases.
66. ↑ The regions need to be paid filing fees to fund their agencies. This suggestion assumes that the federal agency is not hostile to small business like the SEC is. Otherwise, the “test the waters” and other provisions assisting small business capital raising in states like California would not exist.