Federal Securities Laws

Question 1

How to tell if an Investment Contract is a Security - Howey Test

Answer 1

A transaction constitutes an investment contract if:

(1) A person invests money
(2) In a common enterprise
(3) With the expectation of profits solely from the efforts of others

Question 2

Investment of Money

Answer 2

The investment can be cash or non cash consideration, like checks or money orders or credit

The investment part is satisfied if you put out consideration with the hop of some financial return - producing income or profit

Question 3

Common Enterprise

Answer 3

Focuses on the question of the extent to which the success of the investor’s interest rises and falls with others involved in the enterprise

Majority Rule: Horizontal Commonality

• Looks to the relationship between the individual investor and the other investors who put money into the scheme
• Requires investors share the risk of the enterprise, usually through pooling of their funds (e.g. Shareholders of the corp.)

Question 4

Expectation of Profit from the Efforts of Others

Answer 4

The expected return must come from earnings of the enterprise, not merely additional contributions, and this return must be the principle motivation for the investment

The critical inquiry is “whether the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.”

The investor must not be putting in as much effort as the promoter into the success of the project and to make profits

Question 5

1933 §5

Answer 5

Gun-Jumping Statue

Any sale that occurs before the registration statement if effective is “gun jumping” - the sale of an unregistered security

Securities cannot be sold thru mail or interstate commerce until:

• a registration statement is filed with the SEC
• the registration statement is deemed effective by the SEC
• and everyone who is offered the security receives a prospectus

Question 6

Private Placement Exemption

Answer 6

Exempts from registration any offering “by an issuer not involving a public offering” (the laws don’t define “public offering”)

4 Factor Doran Test:

(1) # of offerees & their relationship to issuer
- r’ship must be such that the offeree is furnished with or has access to information about the issuer that a registration statement would have disclosed
(2) # of units offered
(3) size of offering
(4) manner of offering

Question 7

Liabilities Under 1933 Act

Answer 7

§11

§12

Question 8

§11

Answer 8

Private right of action for investors who bought securities under a materially misleading registration statement

To Prove §11 violation, Investor has to show:

(1) they bough a registered security; AND
(2) the registration statement contained a material misrepresentation or omission

• Don’t have to prove scienter/causation/reliance
• allows suits by those who didn’t purchase in an initial offering, but purchased in a secondary offering

Question 9

Possible Defendants for §11 Claim

Answer 9

• everyone who signed prospectus (§6 requires issuer, CEO, CFO, CFA to sign)
• all directors of company (even if they didn’t sign)
• experts who prepared certain parts (liability is limited to info they prepared or certified)

BOP: on Defendant

Question 10

Defenses for §11 Claim

Answer 10

Issuers: Strict Liability, unless:

(1) purchaser knew of the misstatement when they bought
(2) Misstatement is not material
(3) SOL has run

Non-Issuers: Negligence Std.

(1) resign or take steps to resign & tell issuer & SEC in writing that you have done so, and disclaim all responsibility for the relevant sections of the RS
(2) If RS has already gone effective, written notice to SEC & reasonable notice to public
(3) Due Diligence/Reasonable Investigation
- §11(c) Test: the level of care that a prudent person would exercise if his own money were at stake

Question 11

§12

Answer 11

Civil Liability arising in connection with prospectus & communication

§12(a)(1) imposes liability for those who violate §5
- Purchaser just has to show that they bought an unregistered security from the defendant and they win

Question 12

When are falsities in a registration statement material?

Answer 12

Something is “material” if an average & reasonably prudent investor would like to be informed about it

Question 13

10(b)

Answer 13

It shall be unlawful for any person…
(b) to use or employ, in connection with the purchase or sale of a security (reg. or unreg.) any manipulative or deceptive device or contrivance in contravention of such rules & regulations that the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors

Question 14

Rule 10b-5

Answer 14

It shall be unlawful for any person…

(a) to employ any device, scheme or artifice to defraud
(b) to make any untrue statement of material fact or omit to state a material fact necessary in order to make the statements made, in the light of circumstances under which they were made, misleading, or
(c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

In connection with the purchase or sale of any security

*If one makes an untrue statement of a material fact in connection with the purchase or sale of a security, that person may have committed fraud

Question 15

Elements of 10b-5 Claim

Answer 15

1. Jurisdictional nexus
2. Transactional nexus
3. Material misrep or omission
4. Reliance
5. Causation
6. Scienter

Question 16

10b-5: Transactional Nexus

Answer 16

The rule only applies to those defendants who do the prohibited conduct “in connection with the purchase or sale of any security”
- so only PURCHASERS/SELLERS have standing to sue

Question 17

10b-5: Material Misrep or Omission

Answer 17

The untrue statement must be of a material fact

Plaintiff must show that a reasonable investor would likely consider the misstatement or omissions important

*If a reasonable investor considers something important, that something will necessarily affect the price they will pay for the security

Question 18

10b-5: Reliance

Answer 18

Plaintiff must show that there is a causal connection between a defendant’s misrep and P’s injury

Fraud on the Market is a way to show this - shows that you relied on the efficiency of the market (which was deceived)

FOM invoked when:

(1) alleged misrep was publicly known
(2) and material
(3) the stock traded in a generally efficient market
(4) and P traded the stock between the time the misrep was made and when the truth was revealed to the public

Question 19

10b-5: Causation

Answer 19

Plaintiff must show that the misstatement caused the damage

Question 20

10b-5: Scienter

Answer 20

Plaintiff must show that defendant acted with an intent to deceive, manipulate or defraud.

• Reckless disregard or falsity of statement will satisfy this requirement too
• negligence does not suffice (but some lower court decisions have held that it does)