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Suggested Additional Assignments
Research: IPOs
Ask students to obtain a preliminary or final prospectus from a company that has recently been through an
initial public offering (IPO). To obtain this document, they can call a company directly, a brokerage firm,
or an investment bank. In addition, all SEC filings are available on the Internet through its EDGAR
system (Electronic Data Gathering Analysis and Retrieval) at http://www.sec.gov/ . Students should
prepare answers to the following questions:
Can you tell from reading the prospectus what type of commitment the
underwriters have made—best efforts or firm commitment?
What risk factors did the company disclose? Are they “boilerplate” or do they
specifically relate to the particular company?
Does the SEC consider this stock to be a good investment?
How many shares can company insiders sell under Rule 144?
Are there any questions about the company that the prospectus did not
answer?
Research: Direct Public Offerings
The website http://www.dfdpo.com/ is a useful source of information about direct public offerings. Ask
students to research direct public offerings using the “About DPOs” and “Glossary” links. Then divide
students into teams and have them collaborate on a business idea that would pass the “Screen Test” at the
site.
Research, Read, Debate, and Retain:
Ask students to locate the Securities Act of 1933, Securities Exchange Act of 1934, and Sarbanes Oxley
Act. Students should then read the acts with particular attention to ethical considerations. Students should
then debate the need for legislations as well as the effectiveness of the Acts in minimizing potential for
abuse. Those students who believe the Acts are ineffective should formulate a strategy they would
recommend. Copies of the Acts should be retained in the PRJ for future reference.
Research, Read, and Discuss:
Ask students to do some research into the recent Donald Trump issue with the Seminole Hard Rock
Casino in Hollywood, Florida. After locating the recent material students should briefly summarize the
case facts, and present status. Distinguish issues relevant to only one of the cases, and compare the
similarities. Compare the facts and legal issues in both cases in class discussion including ethical issues
and challenges.
Chapter Overview
Chapter Theme
Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934 to ensure that the
country never suffers through another economic crisis as catastrophic as the Great Depression. It is in no
small part owing to these laws that the United States has enjoyed so many years of economic stability.
Securities Laws
There are two major securities laws: the Securities Act of 1933 (the 1933 Act) and the Securities
Exchange Act of 1934 (the 1934 Act).
What Is a Security?
A security is any transaction in which the buyer (1) invests money in a common enterprise and (2) expects
to earn a profit predominantly from the efforts of others.
Additional Case: SEC v. Life Partners, Inc.1
Facts: Life Partners, Inc. (LPI) bought life insurance policies from AIDS victims at a discount from face
value. It then repackaged these policies and sold them to investors who recovered the full face value of
the policy after the insured died. LPI evaluated the patient’s medical condition, reviewed his insurance
policy, negotiated the purchase price, and prepared the legal documents. Once an investor acquired an
interest in a policy, she could avail herself of LPI’s ongoing administrative services, which included
monitoring the patient’s health, assuring that the policy did not lapse, and arranging for resale of the
investor’s interest if requested.
You Be the Judge: Was Life Partners selling a security?
Holding: The court held for LPI. Before the investment is made, the investors can evaluate LPI for
themselves, so the securities laws do not apply. After the investment is made, profitability depends
predominantly on the life span of the patients, not on LPI’s clerical services. Therefore, investors do not
expect “to earn a profit predominantly from the efforts of others.”
Question: What was Life Partners selling?
Question: What difference does it make whether the policy is a security or not?
Answer: If it is a security, LPI must comply with the disclosure requirements of the 1933 Act and
Question: What two elements are required for a security?
Answer:
Question: Was there a “common enterprise”?
Question: Did they expect to earn a profit predominantly from the efforts of LPI?
Answer: The federal district court said, “Yes.” It held that LPI was offering a security because the
company performed three important functions: it found the AIDS patients, assessed their condition
(and life expectancy), and paid out the proceeds to the group of investors. However, the appeals court
1 87 F.3d 536, 1996 U.S.App. LEXIS 16117.
Question: Does it seem likely that most purchasers evaluated their investments ahead of time? What
might an investor need to do to determine the value of the investment?
Answer: He might, for example, need to make an independent assessment of the life expectancy of
Securities Act of 1933
The 1933 Act requires that, before offering or selling securities, the issuer must register the securities with
the SEC, unless the securities qualify for an exemption. When an issuer registers securities, the SEC does
not investigate the quality of the offering.
Liability
Under the 1933 Act, the seller of a security is liable for making any material misstatement or omission,
either oral or written, in connection with the offer or sale of a security.
Additional Case: SEC v. InterLink2
Michael Gartner founded InterLink “to develop private, fully integrated telecommunication networks and
video phone systems.” InterLink prepared an offering memorandum for a sale of its securities. The
document contained no financial statements or other financial information about the company other than
projections of future operations. Gartner hired more than 80 salespeople to make unsolicited telephone
calls to potential investors across the country. Gartner himself held up a copy of an offering memorandum
during an appearance on TV. The salespeople failed to inquire about investors’ wealth or investment
experience. The company also failed to file a registration statement for its securities because it claimed
that the offering was exempt from registration under Rule 506 of Regulation D. InterLink raised
$3,163,795 through this offering. None of the fiber-optic cable, as described in the offering document,
was ever installed, nor were the video phones manufactured.
Question: What are the requirements for Rule 506 under Reg D?
Answer:
No public solicitation
Question: InterLink sold stock to hundreds of investors. Is that a violation of Rule 506?
Question: Did InterLink comply with Rule 506?
Sold to more than 35 unaccredited investors,
2 1993 U.S. Dist. LEXIS 20163 (1993).
Question: InterLink did not comply with Rule 506. Does that mean it definitely made a public
offering?
Question: Did InterLink have a private offering?
Question: What penalty will InterLink and Gartner face? Under what section of the 1933 Act?
Answer: They have violated the following sections of the 1933 Act:
Public Offerings
A company’s first public sale of securities is called its initial public offering (IPO).
Suggested Additional Assignment
The website http://www.dfdpo.com/ provides additional information about direct public offerings. It also
gives examples of companies that have raised capital in this manner.
Question: What is a direct public offering?
Question: Under what rules? And what is the difference?
Answer: DPOs can be made under either:
Question: From the company’s perspective, what are the advantages of a DPO?
Question: Are there any disadvantages for the company?
Question: Is there any downside to investors?
Answer: The SEC is basically taking a hands-off approach to small offerings. Of course, the amounts
Question: Did students think of a business idea that would pass the “Screen Test” at http://www.
dfdpo.com/?
Answer: The Screen Test is:
1. The business would excite prospective investors, making them want to share its future.
2. There is a history of profitable operations under the company’s present management.
3. The company and management meet standards of honesty, social responsibility, and
competency.
Registration Statement
A company undertaking a public offering of securities must file a registration statement with the SEC and
provide a copy of the prospectus to prospective purchasers.
Additional Case: In Re Donald J. Trump Casino Securities Litigation3
Facts: The Taj Mahal Associates Limited Partnership sold $675 million in bonds to the public. The
partnership used the proceeds from the offering to purchase and complete construction of the Taj Mahal, a
lavish casino/hotel in Atlantic City. After the partnership filed for bankruptcy, the purchasers of the bonds
filed suit, alleging that the bond prospectus contained material misstatements and omissions.
Issue: Did the prospectus contain material misstatements and omissions?
Holding: No. Although the prospectus did state that “[t]he partnership believes that funds generated from
the operation of the Taj Mahal will be sufficient to cover all of its debt service,” it also contained an
abundance of warnings and cautionary language casting doubt on the partnership’s ability to repay the
bonds.
Question: What is the plaintiffs’ allegation in this case?
3 7 F.3d 357, 1993 U.S.App. LEXIS 26691, U.S.Ct. of Appeals, 3d Cir. 1993.
Question: Is that language, by itself, misleading?
Question: What else did the prospectus say to qualify the optimistic language?
Answer:
Question: Even with all this cautionary language, under what circumstances would the partnership be
liable?
Answer: If the cautionary language was buried among glowing praise. However, in this case, the
Question: What is the goal of a prospectus?
Question: Is a prospectus by definition defective if the investment turns out to be worthless?
Private Offerings
Registering securities with the SEC for a public offering is very time-consuming and expensive, but the
1933 Act also permits issuers to sell stock in a private offering, which is much simpler (and cheaper).
Regulation D
Under the 1933 Act, an issuer is not required to register securities that are sold in a private offering, that
is, an offering with a relatively small number of investors or a limited amount of money involved. The
most common and important type of private offering is under Regulation D.
Crowdfunding
In 2010, Congress passed the Jumpstart Our Business Startups (JOBS) Act, which permits privately held
companies to sell up to $1 million in securities in any 12-month period through the pooling of capital,
provided that they follow certain procedures.
Securities Exchange Act of 1934
Under the 1934 Act, an issuer must register with the SEC if (1) it completes a public offering under the
1933 Act, or (2) its securities are traded on a national exchange (such as the New York Stock Exchange),
or (3) it has at least 500 shareholders and total assets that exceed $10 million. A company can deregister if
its number of shareholders falls below 300 or if it has fewer than 500 shareholders and assets of less than
$10 million.
Liability
Section 10(b) (and Rule 10b-5) prohibit fraud in connection with the purchase and sale of any security,
whether or not the security is registered under the 1934 Act.
Section 10(b)
Section 10(b) of the 1934 Act prohibits fraud in connection with the sale of any security, whether or not
registered under the 1934 Act. The SEC adopted Rule 10b-5 to implement Section 10(b). Liability under
Rule 10b-5 requires:
A misstatement or omission of a material fact in connection with a securities
transaction,
Scienter (i.e., willful, knowing, or reckless disregard of the misstatement of
fact),
Purchase or sale of a security,
Reliance on the misstatement or omission,
Economic loss to the plaintiff, and
The loss must have been caused by the misstatement or omission of fact.
Case: Matrixx Initiatives, Inc. v. Siracusano
Facts: Zicam Cold Remedy was a nasal spray (or gel) that accounted for 70 percent of Matrixx’s sales
revenue. Its active ingredient was zinc gluconate. Matrixx began receiving reports that some Zicam users
had developed anosmia (that is, they had lost their sense of smell). The company learned for the first time
that some studies had linked the use of zinc sulfate to the loss of smell.
Matrixx then found out that two doctors were planning to make a presentation at a conference about
patients who had developed anosmia after Zicam use. Matrixx sent them a letter warning them that they
did not have permission to use the name of Matrixx or its products. The doctors deleted references to
Zicam.
Nine people filed suit against Matrixx, alleging that Zicam had damaged their sense of smell. Matrixx
then issued statements that Zicam was poised for growth and that revenues would increase by more than
80 percent. In its 10-Q filing with the SEC, Matrixx warned of the potential “material adverse effect” that
could result from product liability claims, “whether or not proven to be valid.” It did not disclose,
however, that plaintiffs had already sued Matrixx.
After the Food and Drug Administration (FDA) announced that it was investigating Zicam, Matrixx’s
stock price fell. The company issued a press release stating that there are many causes for anosmia,
including the common cold, but Zicam was not one of them.
The day after this press release, Matrixx stock price bounced back. Shortly thereafter, however, the
TV show Good Morning America reported that more than a dozen patients had suffered from anosmia
after using Zicam and that some had filed lawsuits against Matrixx. The company’s stock price
plummeted.
A group of shareholders filed suit, alleging that Matrixx had violated Section 10(b) and Rule 10b-5.
The trial court granted Matrixx’s motion to dismiss on the grounds that, without a statistical correlation
between the use of Zicam and anosmia, the reported incidents were not material. The Court of Appeals
reversed. The Supreme Court granted certiorari.
Issues: Did Matrixx violate §10(b) and Rule 10b-5?
Decision: Yes, Matrixx was in violation.
Reasoning: Information is material if a reasonable investor would view it to be significant. The FDA
sometimes takes action on a product even if the available evidence merely suggests but does not prove
that it causes harm. The FDA does not require statistical correlation; it considers other data as well. If this
other information matters to the FDA, then it will also be important to investors.
However, reports of adverse events are common with all pharmaceuticals, and companies are not
required to report each and every one of these events to investors. Something more is needed, but that
something is less than statistical correlation.
In this case, the “total mix” of information reported by the company was misleading. Matrixx told
investors that revenues were going to rise substantially even though it had information that created a
significant risk to its leading product. That combination – knowledge of adverse events and an upbeat
revenue prediction – created an obligation to report these potential concerns.
Question: Did it matter whether Zicam actually caused anosmia?
Answer: The causal connection between Zicam and loss of the sense of smell had yet to be proved.
Question: Why should Matrixx have to disclose these concerns, given that Matrixx had not been
found liable for the allegations concerning anosmia?
Question: Must an issuer disclose every piece of potentially negative information?
