978-1285860381 Chapter 37 Solution Manual Part 1

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Suggested Additional Assignments

Research: Direct Public Offerings

The Web site http://www.dfdpo.com is a useful source of information about direct public offerings. Ask

students to think of a business idea that would pass the “Screen Test” at this site.

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. All SEC filings are also available on the Internet through its EDGAR system at

http://www.sec.gov/edgar/searchedgar/webusers.htm. 1 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?

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.

Quote of the Day

“Definition of insider trading: Stealing too fast.” –Calvin Trillin (b. 1935), essayist.

Introduction

The Securities and Exchange Commission

The Securities and Exchange Commission, or SEC, is the federal agency that enforces securities laws. It

can bring cease and desist orders against those who violate the securities laws, and it can also levy fines

or confiscate profits from illegal transactions. Those accused of wrongdoing can appeal these sanctions to

the courts. The SEC does not have the authority to bring a criminal action; it refers criminal cases to the

Justice Department.

What Is a Security?

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. An issuer is the company that sells the stock

initially.

1 EDGAR is an acronym for Electronic Data Gathering Analysis and Retrieval.

Exempt Securities

The following securities are exempt from registration:

Government securities: any security issued or guaranteed by federal or state government

Bank securities: any security issued or guaranteed by a bank

Short-term notes: high-quality negotiable notes or drafts that are due within nine months of

issuance and are not sold to the general public

Nonprofit issues: any security issued by a nonprofit religious, educational, or charitable

organization

Insurance policies and annuity contracts: policies and contracts governed by insurance

regulations

Exempt Transactions

Section 4(2) of the 1933 Act exempts from registration “transactions by an issuer not involving any public

offering.” In private offerings, investors have enough experience to make good decisions or are so

wealthy that they can afford a loss. And the amount at stake is too small to justify the heavy expense of a

public offering.

Intrastate Offering Exemption

Under SEC Rule 147, an issuer is not required to register securities that are offered and sold only to

residents of the state in which the issuer is incorporated and does business

Regulation D

Any offering that meets the requirements of Regulation D qualifies as a private offering under the 1933

Act.

Regulation A

Although an offering under Regulation A is called a private offering, it really is a small public offering.

There are two types of Regulation A offerings:

Tier 1: An issuer may sell publicly up to $5 million of securities in any 12-month period, with no

limit on the maximum amount an investor may buy. After the offering, the issuer is not required

to make ongoing reports to the SEC.

Tier 2: An issuer may sell publicly up to $50 million of securities in any 12-month period.

Investors may not buy stock that costs more than the greater of 10% of their annual income or net

worth.

Crowdfunding

Congress recently passed the Jumpstart Our Business Startups (JOBS) Act, which permits crowdfunding.

Additional Case: SEC v. InterLink 2

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?

Answer: No, because it:

Sold to more than 35 unaccredited investors,

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:

21993 U.S. Dist. LEXIS 20163 (1993).

Direct Public Offerings

In a DPO, companies sell stock themselves under Regulation A or Rule 504. Both of these rules permit

public offerings of stock without registration.

Research: Direct Public Offerings

If students completed this suggested assignment, ask them to answer these questions:

Question: What is a direct public offering?

Answer: It is a way to raise small amounts of capital without registration.

Question: What rules apply to DPOs?

Answer: A company can engage in a DPO under either:

Rule 504, which permits a company to sell up to $1 million in securities in 12 months. The company may

advertise and sell stock to an unlimited number of investors if:

The transaction is registered under a state law with disclosure requirements, or

Sales are limited to accredited investors.

Regulation A, which permits a company to sell up to $5 million of securities in 12 months. The company

must provide each investor with an offering circular.

Question: From the company’s perspective, what are the advantages of a DPO?

Answer: With a DPO, companies can raise capital with very little regulation by the SEC.

Question: Are there any disadvantages for the company?

Answer: As the text (p. 897) and the DPO Web site reveal, selling stock this way can require a lot of

effort and ingenuity on the part of 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

involved may be small to a company or to the SEC, but can be a lot to an individual investor. There

is some concern that these offerings may be a great opportunity for fraud.

Question: Did students think of a business idea that would pass the “Screen Test” at

http://www.dfdpo.com?

Answer: These are the components of the Screen Test:

1. The business would excite prospective investors, making them want to share its future.

Public Offerings

When a company wishes to raise significant amounts of capital from a large number of people, it

has to do a public offering. This is the process an issuer follows for either an IPO or a secondary

offering:Underwriting: For a public offering, companies hire an investment bank to serve as

underwriter.

Registration Statement: The registration statement has two purposes: to notify the SEC that a

sale of securities is pending and to disclose information to prospective purchasers.

Prospectus: Typically, buyers never see the entire registration statement; they are given the

prospectus instead The prospectus is a document that provides potential investors with

information about a security.

Sales Effort: Even before the final registration statement and prospectus are completed, the

investment bank begins its sales effort. As part of this effort, company executives and the

investment bankers conduct a road show. As part of the IPO sales process, company executives

and investment bankers make presentations to potential investors.

Going Effective: Once its review of the preliminary registration statement is complete, the SEC

sends the issuer a comment letter, listing changes that must be made to the registration statement.

Research: IP0s

If students completed the suggested research assignment on IPOs, ask them to present their findings.

ETHICS When going public, companies rely on their investment bankers to guide them and represent

their interests. Their trust may sometimes be misplaced because investment banks have a conflict of

interest. Companies want the banks to pay the highest possible price for their shares; the banks prefer to

pay a low price so that they can be sure to sell the stock quickly and profitably.

When Goldman Sachs took eToys public, it agreed to purchase the shares at a price of $18.65, for resale

to the public at $20. But the first day, the stock closed at $77. As the saying goes, eToys left a lot of

money on the table. Money it could very much have used—the company ultimately ran out of cash and

went bankrupt.

eToys’ creditors sued Goldman, alleging that it had made side deals with other clients, allowing them to

purchase shares in eToys’ offering in exchange for kickbacks to Goldman of a portion of their profits on

the stock. Such an arrangement would virtually require Goldman to underprice the stock. During

discovery, eToys found damning evidence to support their claims. There was even evidence that the

Goldman executive in charge of the deal, bet her colleagues that the eToys price would reach $80 on the

first day.3 Goldman ultimately settled the case by paying $7.5 million, a small percentage of the more than

$400 million that eToys would have received had the IPO been properly priced.

How might the Goldman people have rationalized this behavior? What other ethics traps did they face?

Emerging Growth Companies

An emerging growth company (EGC) is an issuer with annual gross revenues of less than $1 billion

(indexed for inflation).

Sales of Restricted Securities

Rule 144 limits the resale of two types of securities issued by public companies: control securities and

restricted securities.

Any stock purchased from the issuer in a private offering (such as Regulation D) is a restricted security. A

control security is stock held by any shareholder who owns more than 10 percent of a class of stock or by

any officer or director of the company.

Liability under the 1933 Act

Liability for Selling Unregistered Securities: Section 12(a)(1) of the 1933 Act imposes liability on

anyone who sells a security that is neither registered nor exempt.

Fraud: Under Section 12(a)(2) of 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.

Criminal Liability: Under Section 24 of the 1933 Act, the Justice Department can prosecute anyone who

willfully violates the Act.

Liability for Registration Statement

If a final registration statement contains a material misstatement or omission, the purchaser of the security

can recover from everyone who signed the registration statement.

33 Joe Nocera, “Rigging the I.P.O. Game,” The New York Times, March 9, 2013.

Additional Case: Rombach v. Chang3

Facts: Family Golf Centers, Inc., a public company that owned and operated 119 golf courses nationwide,

sold shares in a second public offering to raise funds to acquire more courses. Within two years of the

second offering Family Golf Center’s earnings declined, its stock price fell by 43%, and the company

filed for bankruptcy protection.

The plaintiffs purchased stock from the company in the second public offering. They sued the

company’s officers and underwriters, alleging that the registration statement contained misrepresentations

about Family Golf’s financial performance and projected income. The district court granted defendants’

motion to dismiss and the plaintiffs appealed.

Issue: Did the defendants violate §11 by issuing a false or misleading registration statement?

Holding: Judgment for defendants affirmed. Plaintiffs complained that the registration statement should

have disclosed that the (1) the company’s creditors had pressured it to complete a public offering, (2) it

was running out of cash and (3) it was experiencing problems in operating its new golf courses.

However, the registration statement did contain many warnings, including that the company was

losing money, running out of cash, needed additional capital, and might not be able to repay its debt. In

short, the registration statement was not misleading.

Question: What is the goal of a registration statement?

Question: Is a registration statement by definition defective if the investment turns out to be

worthless?

Answer: Some investors feel that way, but the answer is “no.” All investments involve risk. The

Question: Why did the plaintiffs’ file suit in this case?

Question: Did the court agree?

Answer: No. Because the registration statement did include many warnings, including that the

Question: What is the moral of this story?

Securities Exchange Act of 1934

Registration Requirements

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.

3 355 F.3d 164; 2004 U.S. App. LEXIS 778 United States Court of Appeals for the Second Circuit, 2004

Disclosure Requirement—Section 13

Like the 1933 Act, the 1934 Act focuses on disclosure. The difference is that the 1933 Act requires

onetime disclosure when a company sells stock to the public. The 1934 Act requires ongoing, regular

disclosure for any company with a class of stock that is publicly traded. Companies that register funder

the 1934 Act are called reporting companies.

In 2012, the Jumpstart Our Business Startups Act (or JOBS Act) is a law intended to encourage funding of

small businesses by easing certain securities regulations

(http://www.gpo.gov/fdsys/pkg/BILLS-112hr3606enr/pdf/BILLS-112hr3606enr.pdf).

Liability Under the 1934 Act

Section 18

Under Section 18, anyone who makes a false or misleading statement in a filing under the 1934 Act is

liable to buyers or sellers who (1) acted in reliance on the statement and (2) can prove that the price at

which they bought or sold was affected by the false filing.

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. Siracusano4

Facts: Zicam Cold Remedy was a nasal spray (or gel) that accounted for 70% 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). Then it learned for the first time that some

studies had linked the use of zinc sulfate to the loss of smell.

A year later, Matrixx 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

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. Matrixx issued a press release stating:

“Matrixx believes statements alleging that Zicam products caused anosmia (loss of smell) are completely

unfounded and misleading. In no clinical trial of zinc gluconate gel products has there been a single report

of lost or diminished olfactory function (sense of smell). A multitude of environmental and biologic

influences are known to affect the sense of smell. Chief among them is the common cold. As a result, the

population most likely to use cold remedy products is already at increased risk of developing anosmia.”

4 2011 U.S. LEXIS 2416, SUPREME COURT OF THE UNITED STATES, 2011.

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 §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: Was Matrixx required to disclose allegations of harm for which there was not statistical

correlation? Did Matrixx violate §10(b) and Rule 10b-5?

Excerpts from Justice Sotomayor’s Decision: To prevail on a §10(b) claim, a plaintiff must show that

the defendant made a statement that was misleading as to a material fact. [T]his materiality requirement is

satisfied when there is a substantial likelihood that the disclosure of the omitted fact would have been

viewed by the reasonable investor as having significantly altered the “total mix” of information made

available.

[M]edical researchers consider multiple factors in assessing causation. A lack of statistically significant

data does not mean that medical experts have no reliable basis for inferring a causal link between a drug

and adverse events. Not only does the FDA rely on a wide range of evidence of causation, it sometimes

acts on the basis of evidence that suggests, but does not prove, causation. For example, the FDA requires

manufacturers of over-the-counter drugs to revise their labeling to include a warning as soon as there is

reasonable evidence of an association of a serious hazard with a drug; a causal relationship need not have

been proved.

Given that medical professionals and regulators act on the basis of evidence of causation that is not

statistically significant, it stands to reason that in certain cases reasonable investors would as well. As a

result, assessing the materiality of adverse event reports is a fact-specific inquiry that requires

consideration of the source, content, and context of the reports.

Application of [the] “total mix” standard does not mean that pharmaceutical manufacturers must disclose

all reports of adverse events. Adverse event reports are daily events in the pharmaceutical industry. The

fact that a user of a drug has suffered an adverse event, standing alone, does not mean that the drug

caused that event. Something more is needed, but that something more is not limited to statistical

significance.

Moreover, it bears emphasis that §10(b) and Rule 10b-5(b) do not create an affirmative duty to disclose

any and all material information. Disclosure is required under these provisions only when necessary to

make statements made, in the light of the circumstances under which they were made, not misleading.

Even with respect to information that a reasonable investor might consider material, companies can

control what they have to disclose under these provisions by controlling what they say to the market.

[W]e conclude that respondents have adequately pleaded materiality. Matrixx received information that

plausibly indicated a reliable causal link between Zicam and anosmia. Importantly, Zicam Cold Remedy

accounted for 70 percent of Matrixx’s sales.

It is substantially likely that a reasonable investor would have viewed this information as having

significantly altered the “total mix” of information made available. Matrixx told the market that revenues

were going to rise 50 and then 80 percent. [H]owever, Matrixx had information indicating a significant

risk to its leading revenue-generating product.

For the reasons stated, the judgment of the Court of Appeals for the Ninth Circuit is Affirmed.

ETHICS Matrixx learned that its products were potentially causing a loss of smell, which is no minor

matter. People with anosmia cannot properly taste food so often lose interest in eating, which can lead to

malnutrition and depression. Did the company have an ethical obligation to alert the public to this issue?

What about its obligation to its shareholders?

Question: What was the holding?

Answer: The plaintiffs have stated a claim for securities fraud under § 10(b) of the Securities and

Question: What does this mean?

Answer: A drug company’s failure to make reports of adverse drug reactions public may constitute