978-1285770178 Lecture Note BL ComLaw 1e IM-Ch07 Part 1

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whole or in part.

ADDITIONAL BACKGROUND—

Organization of the Securities and Exchange Commission

The Securities and Exchange Commission is composed of the following divisions with the stated

responsibilities.

• Corporate Finance: Reviews documents filed by publicly held corporations.

• Market Regulation: Oversees the major securities markets participants.

• Investment Management: Interprets laws affecting investment companies and supervises mutual fund

companies.

• Enforcement: Investigates securities violations, and recommends sanctions, if any, to be pursued and

whether they should be sought in a court or before an administrative law judge.

A. UPDATING THE REGULATORY PROCESS

The SEC now requires companies to—

• File certain information electronically so that it may be available online in the SEC’s EDGAR

(Electronic Data Gathering, Analysis, and Retrieval) database.

• Make disclosures about the potential impacts of climate change on future profitability.

B. THE SEC’S EXPANDING REGULATORY POWERS

The SEC’s authority has increased since the 1930s, most recently through—

* The National Securities Markets Improvement Act of 1996 expanded the power of the SEC to

exempt persons, securities, and transactions from the requirements of the securities laws.

* The Sarbanes-Oxley Act of 2002 required the SEC to adopt new rules relating to corporate

disclosure requirements and created an oversight board to regulate public accounting firms.

* Instruments and interests commonly known as securities (common stock, etc.).

* Interests commonly associated with instruments and interests known as securities (stock options,

etc.).

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whole or in part.

4 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS

whole or in part.

c. Posteffective Period

final prospectus before or at the time they buy the securities.

ADDITIONAL BACKGROUND—

Can a Contract Be a Prospectus in a Private Sale of Securities?

Section 12 of the Securities Act of 1933 imposes liability on those who offer securities “by means of a

prospectus” that contains material misrepresentations or omissions of fact. This section clearly applies to

public offerings. Does it also apply to contracts for private sales of securities? Can the terms of a

private contract be considered a “prospectus”?

These were the questions in Gustafson v. Alloyd Co., 513 U.S. 561, 115 S.Ct. 1061, 131 L.Ed.2d 1

(1995). Arthur Gustafson and the other shareholders of the Alloyd Co. contracted to sell their stock to Wind

Point Partners II, Limited Partnership, and others. The price was based in part on an estimated increase in

the value of Alloyd since the end of the previous year. The contract provided that the price would be adjusted

if, at the end of the current year, an audit showed the actual value to be more or less than the estimate. At the

end of the year, according to the audit, the buyers were entitled to an adjustment. Instead, they filed a suit in a

federal district court against the former shareholders, under Section 12(2) of the Securities Act of 1933, to

rescind the deal. The court issued a judgment in favor of the former shareholders, but the U.S. Court of

Appeals for the Seventh Circuit vacated the judgment. The former shareholders appealed.

The United States Supreme Court reversed the ruling of the appellate court and remanded the case. The

contract between the former and current Alloyd shareholders was not a “prospectus,” as the term is used in

the Securities Act of 1933 “[W]hatever else ‘prospectus’ may mean, the term is confined to a document that *

* * must include the ‘information contained in the registration statement.’ ” The Court pointed out that “only

public offerings * * * require the preparation and filing of registration statements. It follows, we conclude, that a

prospectus * * * is confined to documents related to public offerings.” In this case, the contract was not held

out to the public and thus was not a prospectus “as the term is used in the 1933 Act.” Because the contract

was not a prospectus, Section 12(2) did not apply.

If the Supreme Court had ruled that the contract was a prospectus, what else, if anything, would

have to be shown before it could be rescinded?

ENHANCING YOUR LECTURE—

 WILL INACCURATE INFORMATION IN AN ELECTRONIC

PROSPECTUS INVALIDATE THE REGISTRATION? 

Many companies now submit registration statements, prospectuses, and other information to the

Securities and Exchange Commission (SEC) via the Internet. The SEC’s Electronic Data Gathering, Analysis

and Retrieval (EDGAR) system then posts much of this information online to inform investors about the

CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 5

whole or in part.

corporation, the security being sold, and the risk of investing in that security. Some corporations also send

investors a printed prospectus. Theoretically, a corporation should provide the same information in electronic

form as it does in a printed prospectus, but practical difficulties can arise in transmitting digital information.

THE PROBLEM WITH GRAPHICS

As anyone who is familiar with the Internet knows, the graphics, images, and audio files created by one

computer are not always readable by another computer when they are exchanged online. The SEC has

created Rule 304 to deal with this situation.a The first part of the rule states that if graphic, image, or audio

material in a prospectus cannot be reproduced in an electronic form on EDGAR, the electronic prospectus

must include a fair and accurate narrative description of the omitted data. The second part of Rule 304

provides that the graphic, image, and audio material contained in the version of a document delivered to

investors is deemed to be part of the electronic document filed with the SEC.

As a result, a corporation can have two versions of a prospectus—a print version that contains graphics

and an electronic version that describes the information shown in the graphics. What if the summary

describing the graphics in an electronic prospectus is inaccurate but the investors received an accurate print

version? That was the issue before a federal appellate court in DeMaria v. Andersen.b

THE ELECTRONIC PROSPECTUS CONTAINED INACCURACIES

In anticipation of an initial public offering (IPO), ILife.com, Inc., filed a registration statement and a

prospectus with the SEC via the EDGAR database. ILife.com also distributed a printed version of the

prospectus to the public. The printed prospectus contained a bar graph that provided historical financial

information about the company, while the EDGAR prospectus contained a table that summarized the bar

graph inaccurately (without mentioning losses). Brian DeMaria and other investors filed a suit against officers

of ILife.com. The investors claimed that because of the inaccurate summary, the securities in the IPO were

“unregistered” and thus were sold in violation of the Securities Act of 1933. The lower court dismissed the

case, and DeMaria appealed.

THE REGISTRATION HELD VALID

Despite the inaccurate summary of the bar graph in the electronic prospectus, the appellate court had no

trouble deciding that the securities sold were still registered as required by the securities act. Federal courts

are bound to follow the SEC’s interpretation of its own regulations unless the interpretations are plainly

erroneous. Here, the SEC had filed a brief explaining that because the graphics in the printed prospectus are

deemed to be part of the electronic registration statement, it did not matter that the narrative description was

inaccurate.

FOR CRITICAL ANALYSIS

Does the part of Rule 304 that deems a printed prospectus to be part of a registration statement

completely eliminate liability for any inaccuracies in the electronic materials filed? Why or why not?

a. 17 C.F.R. Section 232.304.

b. 318 F.3d 170 (2d Cir. 2003).

3. Well-Known Seasoned Issuers

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whole or in part.

A well-known seasoned issuer is a firm that has issued at least $1 billion in securities in the

previous three years or has at least $700 million of value of outstanding stock in the public’s hands.

This issuer can offer securities for sale without waiting for SEC review and approval of the

registration statement.

C. EXEMPT SECURITIES

The text lists securities that are exempt from the registration requirements. These include—

1. Government-issued securities.

a bankruptcy proceeding.

8. Securities issued in stock dividends and stock splits.

D. EXEMPT TRANSACTIONS

Securities that can be sold without registration include those sold in tin the following transactions.

a. Testing the Waters

A company can “test the waters” for potential interest before preparing a circular.

b. Using the Internet

Some companies have sold securities on the Web under Regulation A.

is the exemption used by most small businesses.

b. Rule 505

Private, noninvestment company offerings up to $5 million in a twelve-month period are

exempt if—

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If the sale involves any unaccredited investors, all investors must be given material information

about the company, its business, and the securities. The securities cannot be sold by the

buyers for at least a year.

c. Rule 506—Private Placement Exemption

Private—nonpublic and not generally advertised—offerings in unlimited amounts are subject to

essentially the same requirements as Rule 505, except—

• There is no limit on the amount of the offering and

• The issuer must believe that each unaccredited investor has sufficient knowledge or

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Second, until delivery of the final prospectus has been completed, written offers and offers transmitted by

radio and television cannot be made outside of a Section 10 prospectus except in connection with business

combinations. [FN75] After filing the registration statement, two limited exceptions provide some flexibility

to offering participants to publish notices of the offering. [FN76] Following effectiveness, offering

participants may disseminate sales literature and other writings so long as these materials are

accompanied or preceded by a final prospectus. [FN77] Oral offers, in contrast, are permissible as soon as

the registration statement has been filed. Offering participants may use any combination of electronic and

more traditional media, such as paper or the telephone, to communicate with prospective investors,

provided that use of these media is in compliance with the Securities Act.

These key legal principles must underpin the development of appropriate procedures for online offerings.

To date, the Division of Corporation Finance has reviewed numerous procedures in connection with online

distributions of IPOs. The Division also has issued a no-action letter regarding permissible procedures for

the use of the Internet in IPOs. [FN78] We understand, however, that a number of online brokers have

urged that we make additional regulatory accommodations to facilitate online offerings. We appreciate the

benefits that technology brings to the offering process and fully support the need to craft a regulatory

system that maximizes these benefits. We also are mindful of our investor protection mandate and the

fundamental principles established by the Securities Act for the offer and sale of securities. Many of the

procedures urged upon us by online brokers may be properly the subject of regulatory action. Accordingly,

in this release, we do not prescribe any specific procedures that must be followed. Instead, we will continue

to analyze this area as practice, procedures and technology evolve, with a view to possible regulatory

action in the future. Additionally, the Commission staff will continue to review procedures submitted in

connection with online offerings.

[Footnotes:]

FN69. See Division of Corporation Finance no-action letter Wit Capital Corporation (July 14, 1999).

FN70. We are aware that municipal securities issuers and municipal securities underwriters have begun to

evaluate the online offering process and that a limited number of offerings have been conducted over the

Internet. At this time, we are not addressing the implications of online municipal securities offerings, but we

encourage comment on this topic. We remind municipal securities issuers and other municipal securities

market participants, however, of the potential issue that arises if the municipal securities offering also

involves an offering of a separate security that is not being sold pursuant to the exemption from registration

contained in Section 3(a)(2) of the Securities Act, 15 U.S.C. §77c(a)(2). If the municipal securities offering

involves an offering of a separate security that is being sold in reliance on an exemption from registration

contained in Section 4(2) of the Securities Act, 15 U.S.C. §77d(2), or Regulation D, 17 CFR 230.501, et

seq., or in a registered offering, our discussion in Section C.2 below applies. We, therefore, caution

municipal securities offering participants wishing to offer municipal securities online to evaluate carefully

whether any separate security is being sold.

FN71. See Joseph Weber & Peter Elstrom, Transforming the Art of the Deal, Bus. Wk., July 26, 1999, at

96; Shawn Tully, Will the Web Eat Wall Street?, Fortune, Aug. 2, 1999, at 112.

FN72. There also have been numerous reports where investors complained that they did not receive

shares in an online IPO. See Randall Smith, So Far, “E– Underwriting” Gets a Slow Start, Wall St. J., Aug.

16, 1999, at C1. See also Randall Smith, Online Brokers to Form Bank in Bid for IPOs, Wall St. J., Nov. 15,

St. J., Aug. 18, 1999, at A1.

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whole or in part.

FN73. Section 5(a) of the Securities Act, 15 U.S.C. §77e(a).

FN74. Securities Act Rule 134(d), 17 CFR 230.134(d).

FN75. See Sections 2(a)(10) and 5(b) of the Securities Act. Section 5(c) of the Securities Act also

proscribes both oral and written offers before the filing of a registration statement or while the registration

statement is subject to a refusal order, stop order or, before effectiveness, any other public proceeding or

examination under Section 8 of the Securities Act, 15 U.S.C. §77h. For a description of the new rules

regarding communications in a business combination context, see n. 62 above. Mutual funds are permitted

to make written offers before delivery of the final prospectus under Securities Act Rule 482 (permitting

advertisements containing only information “the substance of which” is included in the fund’s prospectus)

and Securities Act Rule 498, 17 CFR 230.498 (permitting the use of a “profile,” a summary disclosure

document). Both Rule 482 advertisements and fund profiles are prospectuses under Section 10(b) of the

Securities Act, which permits a prospectus that omits in part or summarizes information to be used to make

offers before delivery of the final prospectus.

FN76. See Securities Act Rules 134 and 135, n. 68 above.

FN77. See Sections 2(a)(10) and 5(b) of the Securities Act. A confirmation of sale is not deemed a non–

conforming prospectus when sent or given after the effective date of a registration statement if a

prospectus satisfying the requirements of Section 10(a) of the Securities Act is sent or given before or with

the confirmation.

FN78. See Wit Capital Corporation, n. 69 above.

3. Resales

Most securities can be resold without registration. Resales of small offerings [Rule 505] and private

offerings [Rule 506] are exempt from registration if, under the following safe harbor rules—

a. Rule 144

b. Rule 144A

• The securities, on issue, must not have been of the same class as securities listed on a

national securities exchange or a U.S. automated interdealer quotation system.

whole or in part.

Violations include intentionally defrauding investors by misrepresenting or omitting facts in a registration

• The SEC may seek an injunction and an order to refund profits. These who buy securities and

suffer harm through a violation of the 19933 act may file a suit for damages.

2. Defenses

Defenses include—

information was true and there were no material omissions.

CASE SYNOPSIS—

Case 7.1: Litwin v. Blackstone Group, LP

Blackstone Group, LP, manages investments. One of its divisions, or “businesses,” is “Corporate Private

Equity,” which consists of about 40 percent of the assets under management. Before making an initial public

offering (IPO), Blackstone filed a registration statement with the SEC. At the time, Corporate Private Equity’s

investments included FGIC Corp. and Freescale Semiconductor, Inc. In the registration statement, Blackstone

did not mention the impact on its revenue of a substantial drop in value of FGIC and Freescale. Martin Litwin

and others who invested in the IPO filed a suit in a federal district court against Blackstone. The company

filed a motion to dismiss, which the court granted. The plaintiffs appealed.

The U.S. Court of Appeals for the Second Circuit vacated and remanded. The plaintiffs adequately

pleaded that Blackstone omitted material information. The information concerned the extent to which known

events and trends could reasonably be expected to affect Blackstone’s investments and revenue. The

plaintiffs alleged that Blackstone should have disclosed this information. In particular, a reasonable investor

would want to know the expected effect on Corporate Private Equity’s future revenue.

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Notes and Questions

Would the view of materiality asserted by the plaintiffs in this case require companies like

Blackstone to issue enormous collections of information for the scores of companies and other

assets in which they invest? Including all such information would obviously bury material information in a

flood of unnecessary detail. In fact, the securities laws prohibit this result and protect against by requiring that

information must be material and material information must be disclosed. Not every investment is deemed