ANSWERS TO PROBLEMS
1. Acme Realty, a real estate development company, is a limited partnership organized in Georgia.
It is planning to develop a 200-acre parcel of land for a regional shopping center and needs to
raise $1,250,000. As part of its financing, Acme plans to offer $1,250,000 worth of limited
partnership interests to about 100 prospective investors in the southeastern United States. It
anticipates that about forty to fifty private investors will purchase the limited partnership
interests.
(a) Must Acme register this offering? Why or why not?
(b) If Acme must register but fails to do so, what are the legal consequences?
Answer: Regulation A. (a) Acme’s offering would be an offering of a security under the 1933 Act as
limited partnership interests are almost always considered securities. So, Acme must register its
offering of limited partnership interests unless exempt. Under these facts Acme could use
2. Bigelow Corporation has total assets of $850,000, sales of $1,350,000, and one class of common
stock with 375 shareholders and a class of preferred stock with 250 shareholders, both of which
are traded over the counter. Which provisions of the Securities Exchange Act of 1934 apply to
Bigelow Corporation?
Answer: 1934 Act: Anti-Fraud Provision. Bigelow is subject to Section 10(b) of the 1934 Act and
the anti-bribery provisions of the Foreign Corrupt Practices Act. Bigelow is not required to
3. Capricorn, Inc., is planning to “go public” by offering its common stock, which previously had
been owned by only three shareholders. The company intends to limit the number of purchasers
to twenty-five persons resident in the state of its incorporation. All of Capricorn’s business and
all of its assets are located in its state of incorporation. Based on these facts, what exemptions
from registration, if any, are available to Capricorn, and what conditions would each of these
available exemptions impose on the terms of the offer?
Answer: Intrastate Issues. (a) Intrastate Exemption. The most likely exemption would be the
intrastate exemption. Rule 147 requires that: (1) the issuer is incorporated or organized in the
state in which the issuance occurs; (2) the issuer is principally doing business in that state, which
sold under this exemption are restricted securities and may be resold only by registration or in a
4. The boards of directors of DuMont Corp. and Epsot, Inc., agreed to enter into a friendly merger,
with DuMont Corp. to be the surviving entity. The stock of both corporations was listed on a
national stock exchange. In connection with the merger, both corporations distributed to their
shareholders proxy statements seeking approval of the proposed merger. The shareholders of both
corporations voted to approve the merger. About three weeks after the merger was consummated,
the price of DuMont stock fell from $25 to $13 as a result of the discovery that Epsot had entered
into several unprofitable long-term contracts two months before the merger had been proposed.
The contracts will result in substantial losses from Epsot’s operations for at least the next four
years. The existence and effect of these contracts, although known to both corporations at the
time of the proposed merger, were not disclosed in the proxy statements of either corporation.
Can the shareholders of DuMont recover in a suit against DuMont under the 1934 Act? Explain.
Answer: Proxy Solicitation. Yes, decision for the shareholders of DuMont Corp. DuMont is
5. Farthing is a director and vice president of Garp, Inc., whose common stock is listed on the New
York Stock Exchange. Farthing engaged in the following transactions in the same calendar year:
on January 1, Farthing sold 500 shares at $30 per share; on January 15, she purchased 300
shares at $30 per share; on February 1, she purchased 200 shares at $45 per share; on March 1,
she purchased 300 shares at $60 per share; on March 15, she sold 200 shares at $55 per share;
and on April 1, she sold 100 shares at $40 per share. Howell brings suit on behalf of Garp,
alleging that Farthing has violated the Securities Act of 1934. Farthing defends on the ground
that she lost money on the transactions in question. Is Farthing liable? If so, under which
provisions and for what amount of money?
Answer: Short-Swing Profits. Decision for Howell on behalf of Garp in the amount of $6,000.
6. Intercontinental Widgets, Inc., had applied for a patent for a new state-of-the-art widget that, if
patented, would significantly increase the value of Intercontinental’s shares. On September 1, the
U.S. Patent and Trademark Office notified Jackson, the attorney for Intercontinental, that the
patent application had been approved. After informing Kingsley, the company’s president, of the
good news, Jackson called his broker and purchased 1,000 shares of Intercontinental at $18 per
share. He also told his partner, Lucas, who immediately proceeded to purchase 500 shares at $19
per share. Lucas then called his brother-in-law, Mammon, and told him the news. On September
3, Mammon bought 4,000 shares at $21 per share. On September 4, Kingsley issued a press
release that accurately reported that a patent had been granted to Intercontinental. On the next
day, Intercontinental’s stock soared to $38 per share. A class action suit is brought against
Jackson, Lucas, Mammon, and Intercontinental for violations of Rule 10b–5. Who, if anyone, is
liable?
Answer: 1934 Act: Antifraud Provision. Jackson, Lucas and Mammon are all liable for violating
Rule 10b-5 by trading on inside information. When any person possesses material information
7. Nova, Inc., sought to sell a new issue of common stock. It registered the issue with the SEC but
included false information in both the registration statement and the prospectus. The issue was
underwritten by Omega & Sons and was sold in its entirety by Periwinkle, Rameses, and
Sheffield, Inc., a securities broker-dealer. Telford, who was unaware of the falsity of this
information, purchased 500 shares at $6 per share. Three months later, the falsity of the
information contained in the prospectus was made public, and the price of the shares fell to $1
per share. The following week, Telford brought suit against Nova, Inc.; Omega & Sons; and
Periwinkle, Rameses, and Sheffield, Inc., under the Securities Act of 1933.
(a) Who, if anyone, is liable under the Act? If liable, under which provisions?
(b) What defenses, if any, are available to the various defendants?
Answer: 1933 Act: Liability. (a) Under Section 11, liability is imposed upon (1) the issuer; (2) all
persons who signed the registration statement; (3) every person who was, or who consents to be
8. Tanaka, a director and officer of Deep Hole Oil Company, telephoned Romani for the purpose of
buying 200 shares of Deep Hole Company stock owned by Romani. During the period of
negotiations, Tanaka concealed his identity and did not disclose the fact that earlier in the day he
had received a report of two rich oil strikes on the oil company’s property. Romani sold his 200
shares to Tanaka for $10 per share. Taking into consideration the new strikes, the fair value of
the stock was approximately $20 per share. Romani sues Tanaka to recover damages. Is Tanaka
liable? If so, under which provisions and for what amount of money?
Answer: 1934 Act: Antifraud Provision. Tanaka is liable for damages to Romani. Section 10(b) of
the act and SEC Rule 10b-5 make it unlawful for any person by use of the mails or facilities of
interstate commerce in connection with the purchase or sale of any security:
9. Venable Corporation has 750,000 shares of common stock outstanding, which are owned by
2,640 shareholders. The assets of Venable Corporation are valued at more than $10 million. In
March, Underhill began purchasing shares of Venable’s common stock in the open market. By
April, he had acquired 40,000 shares at prices ranging from $12 to $14. Upon discovering
Underhill’s activities in late April, the directors of Venable had the corporation purchase the
40,000 shares from Underhill for $18 per share. Which provisions of the 1934 Act, if any, have
been violated?
Answer: Tender Offers. Underhill has violated sections 13 and 14 of the 1934 Act regarding tender
offers. Because Venable has assets in excess of $5 million and a class of equity securities with
10. Dirks was an officer of a New York broker-dealer firm who specialized in providing investment
analysis of insurance company securities to institutional investors. On March 6, Dirks received
information from Ronald Secrist, a former officer of Equity Funding of America. Secrist alleged
that the assets of Equity Funding, a diversified corporation primarily engaged in selling life
insurance and mutual funds, were vastly overstated as the result of fraudulent corporate
practices. Dirks decided to investigate the allegations. He visited Equity Funding’s headquarters
in Los Angeles and interviewed several officers and employees of the corporation. The senior
management denied any wrongdoing, but certain corporation employees corroborated the
charges of fraud. Neither Dirks nor his firm owned or traded any Equity Funding stock, but
throughout his investigation he openly discussed the information he had obtained with a number
of clients and investors. Some of these persons sold their holdings of Equity Funding securities,
including five investment advisers who liquidated holdings of more than $16 million.
While Dirks was in Los Angeles, he was in touch regularly with William Blundell, The Wall Street
Journal’s Los Angeles bureau chief. Dirks urged Blundell to write a story on the fraud
allegations. Blundell did not believe, however, that such a massive fraud could go undetected and
declined to write the story. He feared that publishing such damaging hearsay might be libelous.
During the two-week period in which Dirks pursued his investigation and spread word of
Secrist’s charges, the price of Equity Funding stock fell from $26 per share to less than $15 per
share. This led the New York Stock Exchange to halt trading on March 27. Shortly thereafter,
California insurance authorities impounded Equity Funding’s records and uncovered evidence of
the fraud. Only then did the Securities and Exchange Commission (SEC) file a complaint against
Equity Funding.
The SEC began an investigation into Dirks’s role in the exposure of the fraud. After a hearing by
an administrative law judge, the SEC found that Dirks had aided and abetted violations of
Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b–5 by repeating the
allegations of fraud to members of the investment community who later sold their Equity Funding
stock. Has Dirks violated Section 10(b) and Rule 10b–5? Explain.
Answer: Insider Trading. No, Dirks has not violated either Section 10(b) or Rule 10b–5. Judgment
for Dirks. An insider is liable under Rule 10b-5 for insider trading only when he does not
disclose material, nonpublic information before trading on it and thus makes “secret profits.”
11. Texas Gulf Sulphur Company (TGS) was a corporation engaged in exploring for and mining
certain minerals. A particular tract of Canadian land looked very promising as a source of
desired minerals, and TGS drilled a test hole on November 8. Because the core sample of the hole
contained minerals of amazing quality, TGS began to acquire surrounding tracts of land. Stevens,
the president of TGS, instructed all on-site personnel to keep the find a secret. Because
subsequent test drillings were performed, the amount of activity surrounding the drilling had
resulted in rumors as to the size and quality of the find. To counteract these rumors, Stevens
authorized a press release denying the validity of the rumors and describing them as excessively
optimistic. The release was issued on April 12 of the following year, though drilling continued
through April 15. In the meantime, several officers, directors, and employees had purchased or
accepted options to purchase additional TGS stock on the basis of the information concerning the
drilling. They also recommended similar purchases to outsiders without divulging the inside
information to the public. At 10:00 A.M. on April 16, an accurate report on the find was finally
released to the American financial press. The SEC brought this action against TGS and several of
its officers, directors, and employees to enjoin conduct alleged to violate Section 10(b) of the
Securities Act of 1934 and to compel rescission by the individual defendants of securities
transactions assertedly conducted in violation of Rule 10b–5. Have any of the defendants violated
Section 10(b)? Explain.
Answer: Insider Trading. Judgment for SEC. Where corporate employees learn of information
which is considered material as it relates to the investment market of their corporation’s securities,
12. W. J. Howey Co. and Howey-in-the-Hills Service, Inc., were Florida corporations under direct
common control and management. The Howey Company owned large tracts of citrus acreage in
Florida. The service company cultivated, harvested, and marketed the crops. For several years,
Howey Company offered one-half of its planted acreage to the public to help it “finance
additional development.” Each prospective customer was offered both a land sales contract and
a service contract with Howey-in-the-Hills after being told that it was not feasible to invest in the
grove without a service arrangement. Upon payment of the purchase price, the land was
conveyed by warranty deed. The service company was given full discretion over cultivating and
marketing the crop. The purchaser had no right of entry to market the crop. The service company
also was accountable only for an allocation of the net profits after the companies pooled the
produce. The purchasers were predominantly nonresident businesspersons attracted by the
expectation of substantial profits. Contending that this arrangement was an investment contract
within the coverage of the Securities Act of 1933, the Securities and Exchange Commission
brought an action against the two companies to restrain them from using the mails and
instrumentalities of interstate commerce in the offer and sale of unregistered and nonexempt
securities. Should the SEC succeed?
Answer: Investment Contracts. Judgment for the SEC. The land sale and service contracts
constitute an investment contract within the scope of the Securities Act of 1933. By including
ANSWERS TO “TAKING SIDES” PROBLEMS
Basic, Inc. was a publicly traded company. Combustion Engineering, Inc. and Basic began
discussions concerning the possibility of a merger of the two companies. During the next two years,
Basic made three public statements denying that it was engaged in merger negotiations. In
December of the second year, Basic publicly announced its approval of Combustion’s offer for all its
outstanding shares. Former owners of Basic stock who sold their shares after Basic publicly denied
that it was engaged in merger negotiations brought a class action suit against Basic and its directors
for having released false or misleading information in violation of Section 10(b) of the 1934 Act and
Rule 10b–5. The plaintiffs claimed that they were injured by selling their shares at prices that were
artificially depressed as a consequence of Basic’s misleading public statements. The defendants
claimed that the plaintiffs had not proven that the plaintiffs had, in fact, relied upon the misleading
statements in selling their stock.
(a) What are the arguments that the plaintiffs have satisfied the reliance requirement of Section
10(b) of the 1934 Act and Rule 10b–5?
(b) What are the arguments that the plaintiffs have not satisfied the reliance requirement of
Section 10(b) of the 1934 Act and Rule 10b–5?
(c) Which side should prevail?
ANSWER:
(a) The plaintiffs could argue that they had traded Basic shares in reliance on the integrity of the
price set by the market. Because of the defendants’ material misrepresentations, that price
had been fraudulently depressed. Under the “fraud-on-the-market” theory, in an efficient
