Chapter 45 – Securities Regulation
CHAPTER 45
SECURITIES REGULATION
I. OBJECTIVES
The purpose of this chapter is to familiarize students with the complexity of securities regulation
and the important rules that will enable them and their clients to avoid an inadvertent violation of
the securities laws. After reading this chapter and attending class, a student should know:
A. What a security is.
B. When offers and sales of securities may be made and how they may be made.
C. How to avoid a registration of securities under the Securities Act of 1933.
D. How to avoid liability for defective 1933 Act registration statements.
E. The reporting requirements of the Securities Exchange Act of 1934.
F. SEC regulation of proxy solicitations and shareholder proposals.
G. The limits of liability under SEC Rule 10b-5.
H. When a person may be liable for trading on confidential corporate (inside) information.
I. The proscriptions of Regulation FD
J. The nature and purposes of tender offer regulation.
K. The requirements and proscriptions of the Foreign Corrupt Practices Act.
L. The importance of state securities regulation.
II. ANSWER TO INTRODUCTORY PROBLEM
A. The PPPs are securities, because they meet the Howey test’s definition of an investment
contract. There is an investment of money by the purchasers, contributing $200,000 with an
investment objective, to receive a return on their investment in the form of 3% of profits.
There is a common enterprise, with horizontal commonality proved by all the investors’
money being pooled to finance the construction of the mall and each sharing in the mall’s
profits and with vertical commonality proved by all the investors being similarly affected by
the efforts of L’Malle in building and running the mall. Finally, the investors have an
expectation of profits solely from efforts of persons other than the investors, because L’Malle,
not the investors, is the exclusive manager and makes all decisions regarding its construction
and operation.
B. We refer you to the table on pages 1198-1199 for the details on each exemption, but let’s
examine which exemptions will work well under the facts here. Rule 504 is out, because the
$4,400,000 amount exceeds the rule’s $1 million limit. Rule 505 can work, because the
amount is less than $5 million and the number of unaccredited investors is 35 or less (only 16
at most, since the two insurance companies and four mutual funds are accredited investors).
Rule 506 will also work, because there is no dollar limit and it has the same limit on the
number of purchasers. Rule 506, however, requires that L’Malle have reason to believe that
each unaccredited purchaser alone or with her purchaser representative has such knowledge
and experience in business and financial matters to be capable of evaluating the merits and
risks of the investment. Both Rule 505 and 506 require audited financial statements: if
L’Malle is not a public issuer, the most recent balance sheet, income statement, and statement
of changes in financial position must be audited. Both rules require restrictions on resale.
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Chapter 45 – Securities Regulation
The best rule is Regulation A, because L’Malle is not a public company. Reg. A has a $5
million limit, allows sales to unlimited purchasers who do not have to meet any sophistication
requirement, does not restrict resale, and does not require audited financial statements, unless
L’Malle is otherwise required to have audited statements.
C. As CEO participating in the sales effort, your student has a risk of liability under Section
12(a)(2). This is a distribution of securities covered by the section. If you assigned the
material in Chapter 46 on this section, you may point out that while the CEO is not a seller
(L’Malle is), the CEO is actively soliciting a sale and if she has a financial interest in the sale
(the offering will enable L’Malle to build the mall which should increase its profits and likely
increase the CEO’s compensation), the privity requirement of Section 12(a)(2) is met.
However, there is no liability if the CEO proves she was not negligent.
Rule 10b-5 liability is unlikely. Although Rule 10b-5 applies to any communication in
connection with a securities transaction and the CEO is primarily responsible for the
statements she makes when visiting investors and answering questions, liability under this
rule is imposed only on those who act with scienter, that is, intent to defraud or gross
recklessness. If your students are CEOs, they are unlikely to act with scienter. You’re too
good a teacher to allow them to act that way.
D. Under the SEC’s new gun-jumping rules that became effective in December 2005, during the
period more than 30-day prior to the filing date, L’Malle may release any information about
itself provided it does not mention the prospective offering (Rule 163A). At all times during
the pre-filing period, waiting period, and post-effective period, L’Malle may release regularly
released factual business information (Rule 169). Since L’Malle is not a public company, it is
not allowed to release forward looking information.
E. During the waiting period, L’Malle may conduct a road show if it is a live show viewed by a
live audience. Since L’Malle is not a public issuer, if the road show is not viewed by a live
audience, such as a previously recorded road show that is posted at a website, the road show
must meet the requirements of a free-writing prospectus, which requires that each viewer
have received a copy of a prospectus or an email with a hyperlink to the prospectus.
F. L’Malle may post its preliminary prospectus during the waiting period. The FAQ page is OK
if it meets the requirements of a free-writing prospectus, which since L’Malle is not a public
issuer, requires that each FAQ-page viewer have received a copy of a prospectus or an email
with a hyperlink to the prospectus. L’Malle may require investors to download the
prospectus from the offering website before they can access the FAQ page.
G. L’Malle may confirm sales only if investors have received a copy of the final prospectus.
H. Since L’Malle’s corporate website has free writings that probably do not meet the
requirements of a free-writing prospectus, investors may be directed to it only after they have
received the final prospectus. L’Malle may require investors to download the final prospectus
from the offering website before they are directed to the corporate website.
III. SUGGESTIONS FOR LECTURE PREPARATION
A. Introduction
1. Note that federal securities regulation was a response to the stock market crash of 1929
(evidence that law is a reaction to an historical context).
2. Describe the choices of regulatory schemes facing Congress: merit registration versus
disclosure.
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Chapter 45 – Securities Regulation
3. Note why Congress chose disclosure as the basis of federal securities regulation: such a
scheme did not greatly trample upon the economic freedom of security issuers and
investors.
4. Explain briefly the Securities Act of 1933 and the Securities Exchange Act of 1934. Note
that the 1933 Act is primarily concerned with protecting purchasers during the period
during which securities are being sold by the issuer to public investors. The 1934 Act is
primarily concerned with protecting investors after the securities have reached the hands
of public investors. That is, the 1933 Act primarily regulates the primary market for
securities. The 1934 Act primarily regulates the secondary market for securities.
5. Log On (p. 1184): This is the easiest way to find the federal securities laws.
6. Note the role of the Securities and Exchange Commission. You may want to mention the
role of the SEC under the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010
at this time. You’ll find materials on Sarbox and Dodd-Frank in this chapter, as well as
Chapters 4, 43, and 46.
7. Log On (p. 1184): Note the extensive resources at the SEC’s website.
B. What Is a Security?
1. List the common examples of securities: common shares, preferred shares, debentures,
bonds, notes payable, warrants, rights, pre-incorporation subscriptions, post-
incorporation subscriptions, and limited partnership interests.
2. Howey test: Carefully review the definition of an investment contract. Note that the
Howey test requires that the profits be solely from the efforts of others, but there is
significant authority that the investors may expend some effort provided fithe efforts
made by those other than the investors are the undeniably significant ones, those essential
managerial efforts which affect the failure or success of the enterprise.” SEC v. Glenn W.
Turner Enterprises, Inc., 474 F.2d 476, 482 (9th Cir. 1973); SEC v. Koscott
Interplanetary, Inc., 497 F.2d 473, 483 (5th Cir. 1974).
Example: Chapter Introductory Problem (p. 1182).
3. SEC v. Edwards (p. 1185). The Supreme Court held that the opportunities to buy
payphone packages were securities even though they promised a set return on investment,
because they met the Howey test.
Points for Discussion: Make sure your students understand what the investors were doing
here. They were providing the capital necessary for ETS to purchase and install public
payphones. What did the investors get for their $7,000 infusion of capital? They got an
agreement for ETS to lease the payphones from the investors, to do all the work to make
sure the payphones were installed and operational. And each investor got $85 per month
under the lease, not a variable amount, but a set contractual amount.
Go through each element of the Howey test. The court didn’t do this very well, so you
will have to help the students. It is easy to find an investment of money, because each
investor put in $7,000 per payphone with the intent to get a return in the form of lease
payments. They did not buy the payphones to make their own phone calls, so there was
no consumption motive, but an investment motive. There was a common scheme or
enterprise, because all the contributions were pooled, that is, received by the same
person, ETS, proving horizontal commonality. Point out that even if the money had been
designated for an individual payphone owned by a single investor, vertical commonality
was proved, because each payphone investor was similarly affected by ETS’s efforts in
selecting the location of payphones, installing them, and maintaining them. The last
factor of the Howey test was that the profits were derived solely from the efforts of the
promoter, ETS. The court didn’t point out much direct evidence on this. The court states
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Chapter 45 – Securities Regulation
that investors were attracted fiby ETS’s invitation to watch the profits add up.” What the
court could have written was that ETS did all the work to determine whether the
payphones were profitable, including choosing good sites, installing attractive and
functioning equipment, and properly maintaining the phones. While ETS also collected
the coins, that was purely a ministerial duty that did not determine whether payphone
would be profitable and whether ETS would be able to make the lease payments to the
investors. ETS also controlled its expenses and cash inflows and outflows, which would
and did determine whether ETS could make the lease payments.
Additional Points for Discussion: The court spent most of its opinion dealing with ETS’s
argument that the fixed return should prove that no security existed. That was because
that was the issue on appeal. The court noted that investors in securities are often
attracted by promises of fixed returns, and it pointed to authorities that did not justify a
distinction between variable and fixed returns. The court could also have pointed out that
typical securities such as debentures and bonds have fixed returns (set interest rates) and
that the fixed return does not guarantee returns if the business is not profitable, as was the
case here. Therefore, investors need to know information about the issuer to decide
whether to take the risk whether they will receive fixed returns by investing.
Additional Examples:
a. Problem Cases ## 1 and 2.
b. A developer’s sale of a condominium in a resort community in conjunction with a
contract to rent the condo for the owner has been held to be an investment contract.
The most difficult element to prove here is a common enterprise. If all the
condominium owners are treated separately, there is no common enterprise. But if all
the rent from all the condos is pooled and then shared by all condo owners, or if
tenants are allocated to the condos proportionately, then there is a common
enterprise, since all the owners are similarly affected by the efforts of the rental
agents.
4. Economic realities, sale of business, and family resemblance tests
While the Howey test remains the predominant test for determining whether a security
exists, the economic realities test is important. Under the economic realities test, a court
disregards the name given to a contract and examines the characteristics of the contract.
If the contract possesses the typical characteristics of a security (bears a family
resemblance to a typical security), then the contract is a security. If it bears none of the
typical characteristics of a security, then it is not a security, unless the Howey test is met.
After the Forman case was decided, there was some doubt about the importance of a
finding that a contract possessed the typical characteristics of a security. Some
commentators argued that such a contract may still not be a security, if it failed to meet
the Howey test. This view was repudiated partly by the Supreme Court when it rejected
the sale-of-business doctrine in May of 1985. In two cases decided the same day, the
court held that when a contract is called stock and possesses the typical characteristics of
stock, it is a security, regardless whether the contract is sold in a transaction that causes
the contract to fail to satisfy the Howey test. Landreth Timber Co. v. Landreth, 471 U.S.
681 (U.S. Sup. Ct. 1985); Gould v. Ruefenacht, 471 U.S. 701 (U.S. Sup. Ct. 1985). These
decisions are consistent with Forman, in which the Court pointed out that the use of the
traditional name may lead a purchaser justifiably to assume that the federal securities
laws apply. In Forman, the Court stated that the purchasers of the stock in the housing
corporation were not likely to believe they were purchasing securities. In the
sale-of-business cases, the court stated that the purchasers believed that they were
transacting in securities. The Court specifically reserved the question whether notes or
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Chapter 45 – Securities Regulation
bonds or some other category of instruments listed in the definition of a security might
not be a security because it failed to meet the Howey test. Ask your students how they
would structure a sale of business transaction to avoid the application of the securities
laws: sell the business to the purchaser, not the shares.
In 1990, the Supreme Court reiterated its reliance on an investment possessing the
characteristics of a typical security, adopting the family resemblance test for notes. Note
that a mortgage note issued by a business to a bank to evidence the business’s obligation
to repay a bank loan used to buy land is not a security. While there are recognized
markets for mortgage notes, the note is not one of a series of notes, the bank does not
need or expect the protection of the securities laws, and the bank’s intent is commercial
lending, not investment.
On the other hand, if a corporation repurchases common shares from its public
shareholders by issuing 10,000,000 identical notes that are traded on the New York Bond
Exchange, all the factors in the family resemblance test point to the notes being
securities.
C. Registered Offerings under the 1933 Act.
1. Note the purpose of requiring registered securities offerings: to ensure that investors have
the information they need to make intelligent investment decisions.
2. Review the mechanics of a registered offering, describing the various types of
underwriting. Note the functions of the registration statement and the prospectus.
3. Carefully review the proscriptions of Section 5.
a. Slowly go through the concept review at page 1191. Note that the preliminary
prospectus is often called a fired herring” prospectus, because it includes a statement
in red ink on its cover stating that the securities may not yet be sold and cannot be
sold until the registration statement is effective. The emergence of the Internet has
eased the prospectus delivery requirement, increased the availability of information
about offerings, and increased the number of people to whom IPOs can be made.
Example: Log On: GoPro Preliminary Prospectus (p. 1188): See online the GoPro
prospectus used when GoPro went public in 2014. It is increasingly difficult to find
hard copies of prospectuses because of the lower expense of electronic copies.
b. Note especially the new safe harbors that the SEC passed in 2005. Some of those
safe harbors codify what the SEC allowed in no-action letters, but some of the safe
harbors reflect an interest in rejecting previously constrained thinking that limiting
information was good. They also reflect the modern world in which the Internet
allows everyone to have access to the same information simultaneously. The new
rules now allow much more information to be received by investors in many more
ways. They should result in more informed investment decisions. By the way, the
SEC release covering the new rules is almost 500 pages and is not a model in
lucidity. Good luck reading it and understanding it.
Example: Introductory Chapter Problem (p. 1182).
Additional Example: Problem Case # 3.
Additional Example: Figure 1: Rule 134 Tombstone Ad (p. 1190). Students enjoy
our pointing out the features of Google’s tombstone ad used during Google’s second
public offering.
4. Ethics in Action (p. 1200): Although this ethics box is placed after the section on
exemptions, we usually cover the material in this ethics box at the end of the materials on
section 5, which we usually cover in class after we cover exempted offerings. Whichever
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Chapter 45 – Securities Regulation
sequence you choose, we suggest covering this ethics material after you have covered
both registered offerings and exemptions from registration.
Some of the questions posed in this ethics box answer themselves. Let’s cover the ones
that don’t. One of the constant criticisms of securities regulation, and especially section
5, is its paternalistic philosophy which proposes that investors can’t judge the quality of
information received from issuers and that therefore constrains issuers from giving
investors information that has real value to them, instead requiring issuers to give
investors a long, complex, and often irrelevant prospectus that few read and fewer
understand. Your students who have studied portfolio theory may argue that an investor
should diversify alpha risk (the risk of an individual security) and that, therefore, the only
information an investor needs is a security’s beta (its risk relative to the market). By
knowing a security’s beta, an investor can create a portfolio of securities that matches the
risk preference of the investor.
Why not create a free market of securities information? A rights theorist may elevate an
issuer’s right to speak truthfully about itself over the right of an investor to be protected
from speech that touts the issuer’s securities. Shouldn’t an investor be able to protect
himself from fraud by requiring more information and refusing to purchase a security
unless he receives that information? A profit maximizer would come to that conclusion,
especially since untruthful statements are banned under the liability rules of the common
law and securities law. A profit maximizer would prefer such a market system that
punishes fraudulent issuers and rewards honest issuers.
Presumptively, justice theory would suggest the protection of investors who can’t protect
themselves. Yet most investment comes from investors who are wealthy or in the
business of investment and can protect themselves. Even in the modern American society
in which 60% of Americans invest in the stock market, those who cannot protect
themselves can hire advisers or invest in mutual funds that are managed by competent
managers.
Fortunately, the SEC’s new gun jumping safe harbors that became effective in December
2005 increase the ability of issuers to provide information about themselves and the
offering. They are a step in the right direction toward a fully informed securities offering
market.
D. Exemptions from a 1933 Act Registration
1. In class, we usually cover the registration exemptions prior to covering registered
offerings. For our purposes, it makes more sense to do that, because we examine the law
in the context of a growing company that first raises capital privately and then years later
goes public. Some teachers, however, prefer to cover registered offerings first, which
makes it easier for some students to understand why a registration is to be avoided when
possible.
2. Review the reasons why an exemption is desirable from an issuer’s point of view: less
burdensome, less time, less expense.
3. Stress the rule that EVERY TRANSACTION IN SECURITIES MUST BE
REGISTERED OR BE EXEMPT FROM REGISTRATION. Note that this rule applies
to everyone, not just issuers of securities.
4. Securities exemptions. Briefly list and explain the securities exemptions, giving the
rationales for each. Note that these exemptions stay with the securities, making them
exempt whenever they are resold.
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Chapter 45 – Securities Regulation
5. Transaction exemptions. Note that these exemptions are only for the transaction in which
the securities are sold. If the securities are resold, another exemption must be found for
that resale transaction.
a. Transaction exemptions for issuers. List each exemption and its accompanying SEC
rule. Note especially the limits on the amount sold, limits on the number of
purchasers or offerees, and disclosure requirements. Refer to the concept review on
pages 1198-1199.
1) Intrastate offering: Rule 147
a) No limit on the amount of offering.
b) No limit on the number of offerees or purchasers.
c) No investor sophistication requirement.
d) No disclosure requirement.
e) All offerees and purchasers must reside in same state as the issuer.
f) Issuer must be resident and organized in the same state as the offerees and
purchasers.
g) Issuer has 80% of its gross revenues and assets and uses 80% of the proceeds
of the offering in the same state.
h) Resale restricted to within the state for 9 months.
Example: Banner Corp., organized and doing all its business in Wyoming,
intends to make an offering to its employees, the proceeds of which offering
will be used only in Wyoming. Although all the employees work in
Wyoming, some reside in Colorado. The intrastate offering exemption is not
available, since not all the offerees are resident in Wyoming.
Additional Example: Problem Case # 6.
2) Private offering: Rule 506
a) No limit on the amount sold.
b) No more than 35 unaccredited purchasers. Unlimited accredited purchasers.
c) The seller must have reason to believe that each purchaser is either
accredited or alone or with his purchaser representative (broker or financial
adviser) has such knowledge and experience in business and financial
matters to be able to evaluate the risks and merits of the prospective
investment. The way an issuer complies with this requirement is to use what
is called an fiinvestment letter” or fisuitability letter,” prepared by the issuer
and addressed from the investor to the issuer, in which the investor checks
off items that are true about the investor. For example, the letter will state, fiI
represent that I have annual income of more than $200,000.” If the investor
checks that item, then she is an accredited investor. Or the letter will state, fiI
represent that alone or with my purchaser representative I have such
knowledge and experience in business and financial matters to be capable of
evaluating the merits and risk of this investment.” If the investor is
unaccredited but checks that item, the issuer has reason to believe the
investor meets the Rule 506 sophistication test. The issuer in the Mark case
on page 1194 used investment letters, but never read them when the investors
returned them, so the issuer could not have a reasonable belief that the
purchasers met the purchaser qualifications of Rule 506.
d) Each investor is furnished or has access to the information he needs to make
an informed investment decision. Note the audited financial statement
requirements of the rule.
e) No general solicitations are permitted, unless sales are made only to
accredited purchasers.
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Chapter 45 – Securities Regulation
f) Resale restricted. Note that the SEC recently reduced the resale restriction to
six months and one year.
g) Mark v. FSC Securities Corp. (p. 1194). Malaga failed to meet the
requirements of either section 4(2) or Rule 506.
Points for Discussion: Why did Malaga fail to meet the requirements of
section 4(2)? There were too many offerees, who did not have a sufficiently
close relationship to Malaga to ensure that they had access to investment
information. Why did the court conclude that there were too many offerees?
Although there were only 28 purchasers, there were offering memoranda
numbered up to 477. Note that courts generally consider 25 to be the limit
for the number of offerees under section 4(2).
Why did Malaga fail to meet the requirements of Rule 506? The number of
purchasers (28) was under the 35 purchaser limit, but Malaga failed to prove
that it believed each unaccredited purchaser was sophisticated. Note that
Malaga used documents from which it could determine the sophistication of
its purchasers, but it had failed to review the documents. This is a case in
which Malaga used form documents drafted by its lawyers, which would
allow Malaga to comply with Rule 506, but Malaga failed to use the
documents in the proper way.
h) Example: Problem Case # 4.
3) Small offering: Rule 504
a) Available to only nonpublic issuers
b) $1,000,000 limitation in 12 months.
c) No limit on number of purchasers or offerees.
d) No investor sophistication requirement.
e) No disclosure required.
f) General solicitations permitted, in limited circumstances.
g) No restrictions on resale of the securities, in limited circumstances.
Example: Problem Case # 5.
4) Small offering: Rule 505
a) $5,000,000 limitation in 12 months.
b) No more than 35 unaccredited purchasers.
c) No investor sophistication requirement.
d) Disclosure required same as under Rule 506.
e) No general solicitations permitted.
f) Resale restricted.
5) Small offering: Regulation A
a) May be used by nonpublic issuers only.
b) $5,000,000 limitation in one year.
c) No limit on number of purchasers or offerees.
d) No investor sophistication requirement.
e) Offering circular required. The offering circular must contain a balance sheet
that is less than 90 days old and income statements, cash flows statements,
and statements of shareholder equity for each of the last two years. These
financial statements need not be audited unless the issuer is otherwise
required to have audited financial statements, which is unlikely because the
issuer must be a nonpublic issuer.
f) General solicitations permitted; after the offering circular is filed with the
SEC, oral offers and offers by use of the offering circular are permitted.
After the passage of 20 days after the filing, the securities may be sold.
g) Resale not restricted.
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Chapter 45 – Securities Regulation
h) Note that Regulation A is the best of the exemptions for small issuers,
because it allows sales to unlimited investors regardless of their
sophistication and does not restrict them from reselling their shares.
6) Internet Exempt Offerings
Note that Regulation A is a particularly good exemption for an Internet offering
because it permits general solicitations.
7) Ethics in Action: JOBS Act: SEC Proposal on Crowdfunding (p. 1197): There is
enough information in this lengthy ethics box to generate class discussion. You
will want to stay abreast of the SEC’s progress toward adopting JOBS Act rules.
b. Transaction exemptions for nonissuers: Rule 144
1) Note that most investors do not need to comply with Rule 144, because they do
not own restricted securities. Securities purchased on an exchange are already
publicly traded, so that a resale by an investor does not aid in the distribution of
the securities: the securities have already been distributed (i.e., sold to the general
public). Rule 144 applies only when securities are purchased pursuant to a Rule
504 (sometimes), 505, or 506 transaction exemption (as well as section 4(a)(2)).
2) Elements to be deemed not an underwriter:
a) Six-month to one-year holding period. Note the rationale for requiring
investors to hold onto restricted securities for at least six months: to prevent
the issuer from circumventing the 1933 Act registration requirements.
b) Limitation on amount sold: In any three-month period, the greater of:
* 1% of the outstanding securities of that class, or
* the average weekly volume of trading of the securities for the previous
four weeks.
Indicate the purpose of this limitation: to ensure that the market can absorb
the shares without any selling effort being made by the seller.
c) No solicitations permitted. Essentially, the seller must not create a market
for the shares, although she may contact buyers who have indicated a prior
interest in buying the shares.
d) Public availability of information about the issuer. This ensures that there is
information to support a public market for the securities.
e) File Form 144 with the SEC.
f) There is no limitation on the amount that may be resold and no public-
availability-of-information requirement if the seller is not an affiliate of the
issuer (not an insider) and has held the securities for six month for a public
company or one year for nonpublic issuer. If the seller is an affiliate, the
affiliate will be subject to the amount and disclosure limitations indefinitely,
until the issuer becomes a public issuer.
E. 1933 Act Liability Provisions
1. Briefly cover the liability provisions other than Section 11. Also review the standard of
conduct and penalty for criminal violations of the Act. You may want to cover Section
12(a)(2) in more detail than this chapter does. If so, the material on pages 1248-1249 of
Chapter 46 should be assigned.
2. Section 11 liability
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Chapter 45 – Securities Regulation
a. Note how extraordinary this liability section was at the time it was enacted; in fact, it
remains extraordinary.
1) Privity is not required. A purchaser may sue any of the listed defendants. A
person need only have purchased the securities. She need not have purchased
them during the issuer’s offering. She could have been the 15th owner of the
securities and could have purchased them on the New York Stock Exchange.
The statute of limitations provides an effective limitation upon the number of
purchasers who may sue under Section 11. The action must be brought within
one year after the misstatement or omission should have been discovered and no
more than three years after the security was first offered to the public [courts hold
that the three-year period starts when the securities are first delivered]. Note that
the Sarbanes-Oxley Act of 2002 may have changed the Section 11 statutes of
limitations to two-year and five-year periods. It is not clear whether SOA’s
limitations section was intended to apply and does apply to Section 11.
2) Reliance is not ordinarily required. Reliance is required if a purchaser bought the
securities after the issuer has released publicly an annual earnings statement for a
year beginning after the effective date of the registration statement. Note also
that if a purchaser knew of the misstatement or omission yet bought the
securities, the purchaser cannot sue under Section 11.
3) The purchaser need not prove that the defendants were negligent. Instead, the
defendants must disprove their negligence by establishing due diligence. Review
the due diligence defense for each type of defendant for the expertised and
nonexpertised portions of the registration statement. Go over the Concept
Review on page 1201.
4) To review the requirements of Section 11, especially in the accounting and
securities professional context, refer to page 1248 and the concept review on
pages 1254-1255 of the professionals’ liability chapter (46).
b. When the 1933 Act was enacted, critics attacked Section 11 as a section that would
spell the doom of the securities industry, subjecting underwriters and others to
inescapable liability. Instead, Section 11 has strengthened the securities industry.
Securities professionals have performed their due diligence duty almost without
exception, promoting greater investor confidence in the securities markets and
increasing the level of investment in securities. Litigation under Section 11 is rare:
the only two authoritative cases on Section 11 are the BarChris case on page 1202
and Feit v. Leasco Data Processing Equipment Corp., 332 F.Supp. 544 (E.D.N.Y.
1971). Both are federal district court opinions.
c. Note that the misstatement or omission must be of a material fact. A fact is material
if would be important to an investors decision whether to purchase the securities.
Example: Problem Cases ## 7 and 8.
d. Escott v. BarChris Construction Corp. (p. 1202). This is the most important case in
the history of Section 11. This case deserves careful treatment in class. We spend
almost an entire class period on it.
Points for Discussion: Ask your students why they think the court found the
misstated and omitted facts to be material to a purchaser of the BarChris debentures.
Current assets were overstated by a great amount, 15.6%. Current assets are
important to a debenture holder, because they indicate liquidity–the ability of
BarChris to pay its debts as they come due. Contingent liabilities were understated
by 42.8%. Contingent liabilities affect future liquidity and profitability. Gross profit
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Chapter 45 – Securities Regulation
and sales were overstated. Both of these affect net profit, which directly affects the
value of a business. Backlog was overstated by 186%. Backlog relates to future
sales and, therefore, future profits. Officer loans to the corporation were material as
an indication of BarChris’s liquidity problems. The use of the proceeds to pay old
debts also indicated liquidity problems. The existence and extent of potential liability
to factors affected future liquidity and profitability. BarChris’s operation of bowling
alleys affected its business risk and indicated liquidity problems due to customer
defaults.
Review each defendant’s ability to meet his due diligence defense. First consider
Trilling. Trilling knew of some errors in the registration statement. Other errors he
should have known about because of his position (controller) within BarChris, which
provided access to information proving the errors. In addition, he failed to make a
reasonable investigation into the accuracy of the unaudited financial statements. As a
result, he failed to meet his due diligence defense as to the audited financial
statements (expertised portions), because he had reason to believe that the financial
statements were untrue. He failed to meet his due diligence defense for the
nonexpertised portions for two reasons: he failed to make a reasonable investigation,
instead relying on others to investigate; without a reasonable investigation, he had no
reasonable grounds to believe that the registration statement was true.
Auslander must be pitied, for only unfortunate timing imposed liability on him. He
was an outside director, so he did not have access to the information to which Trilling
had access. He was not experienced in accounting, so he was not as likely to
discover that the audited statements were wrong. Thus, he was not liable for errors in
the audited financial statements (expertised portions), because he had no reason to
believe that the financial statements were untrue. He was entitled to rely on his faith
in Peat Marwick absent some evidence to the contrary. As to the nonexpertised
portions, the analysis is different. Here he had a duty to investigate. He could not
merely rely upon Peat, Marwick. Why was his checking with Dun & Bradstreet, the
bank, and Talcott not enough? Because that was merely a general credit check that
did not relate to the information in the registration statement. Was he entitled to rely
upon Vitolo and Russo? No, because they were comparative strangers to him, whom
he had no reason to trust. Did the court reduce his duty to inquire on the grounds that
he was a new director? No. The court held him to the standard of a prudent person.
Note that Auslander, as a director, is liable even if he did not sign the amendment.
Trilling as an officer, had to sign to become liable; however, as a controller, Trilling
was required to sign. [See Securities Act Section 6.]
Additional Points for Discussion: Note that Peat, Marwick is liable for the audited
financial statements, the portion of the registration statement that it provided as an
expert. Therefore, it must make a reasonable investigation. PM made two
investigations: the 1960 audit and the S-1 review. Berardi did most of the 1960 audit.
Note that Berardi was not a CPA and that this was his first job as a senior accountant.
Berardi failed to discover that Capitol Lanes had not been sold. Why? Because he
did not realize that Heavenly Lanes and Capitol Lanes were two names for the same
bowling alley. [As Heavenly Lanes, the alley had been recorded as sold and put in
sales. As Capitol Lanes, it was treated as backlog, a future sale. In fact, BarChris was
operating the alley through a subsidiary.] The court held that he should have
discovered the dual names. Why? He had read minutes of a board of directors
meeting that BarChris’s chairman recommended that BarChris operate Capitol Lanes.
He also knew that Capitol Lanes was paying rentals to Talcott and that it held
insurance policies. Berardi investigated these red flags, but the court didn’t think he
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Chapter 45 – Securities Regulation
did enough to disabuse himself of a reasonable belief that Capitol Lanes had not been
built. While Berardi believed that Capitol Lanes had not been built yet and that the
rental payments were being made on vacant land, the court found he had the red flags
(insurance payments and the board minutes recommending the operation of Capitol
Lanes) that indicated that Capitol Lanes existed and was being operated by BarChris.
Insurance is not usually maintained on vacant land, because there is nothing to insure.
Also one job cost ledger card and two accounts receivable cards showed names of
both Capitol and Heavenly on them. Berardi’s said he didn’t look at these cards.
Although GAAS doesn’t require an auditor to look at every accounting record, and
though the court said it was a close question regarding the reasonableness of
Berardi’s investigation, the court found he had not complied with PM’s due diligence
defense under Section 11.
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.