Management Chapter 21 Howey Established Three Criteria For Determining Whether

Chapter Twenty-One

Public and Private Offerings of Securities

A MANAGER’S DILEMMA: PUTTING IT INTO PRACTICE

To IPO or Not to IPO

Issue Presented: Under what circumstances should a company go public? When can counsel

for a company receive compensation in the form of equity as opposed to hourly fees?

Especially during a “hot IPO market,” managers and directors considering taking a

company public should exercise restraint. They should carefully consider the factors that are

traditionally necessary for a successful IPO and be sure to disclose all pertinent information to

investors. Going public is an expensive and time-consuming proposition that may not be in the

Compensating outside counsel with a 5% equity share in lieu of traditional hourly fees

raises significant problems regarding the independence of counsel. These issues are discussed

at length in Anthony T. Jacono, Rush to Riches: The Rules of Ethics and Greed Control in the Dot.com

World, 2 MINN. INTELL. PROP. REV. 51 (2001). Jacono discusses the hypothetical case of Tom, a

At this point, Tom realizes that this entire dilemma stems from the fact that he is not

receiving hourly compensation and that his financial interests are tied to the success of the IPO.

He is therefore no longer a truly independent counsel:

Such incentive problems arise whenever outside counsel is offered equity compensation.

This is particularly true in a hot IPO environment when companies are selling high-risk

securities. Jacono points out that this scenario is “fraught with ethical pitfalls.” He continues:

“This type of transaction may expose a lawyer to malpractice liability and sanctions from an

ethics board, in addition to invalidation of the transaction. Having an equity stake in a client

can compromise a lawyer’s independent judgment and strain a longstanding rapport with the

client.”

For example, an attorney has a duty to include any material negative information to

investors regardless of his or her personal economic incentives. In other words, the attorney

must “subordinat[e] any economic incentive” and “maintain the requisite professional

independence.” In the extreme case, where revealing negative investment information to

potential investors would result in a significant financial loss to the attorney, the attorney is not

permitted to continue representing the client even if the client consents.

QUESTIONS AND CASE PROBLEMS

Question 1

Issue Presented: Are fractional interests in a pool of terminal patients’ life insurance benefits

(viatical settlements) securities?

In Securities and Exchange Commission v. Life Partners, Inc., 87 F.3d 536 (D.C. Cir. 1996), the

U.S. Court of Appeals for the D.C. Circuit held that viatical settlements are not exempt from the

securities laws as insurance contracts. However, applying the three-part test articulated in SEC

v. Howey, 328 U.S. 293 (1946), the court concluded that Life Partners’ contracts were not subject

to the securities laws because the profits from their purchase did not derive predominantly

from the efforts of others.

Turning to the common enterprise requirement, the court concluded that pooling was in

practice an essential ingredient of the program, i.e., any individual investor would find that the

profitability, if not the completion of his or her purchase, depends upon the completion of the

larger deal. In addition, profits or losses accrue to all investors in proportion to the amount

invested. Thus, the three elements of horizontal commonality—pooling, profit sharing, and loss

sharing—were present.

The court conceded that application of the 1933 Act might increase the quantity and

quality of information available to the investor prior to closing, but stated that “the securities

laws [are not] a broad federal remedy for all fraud,” quoting Marine Bank v. Weaver, 455 U.S. 551

(1982). While doubting that pre-purchase services should ever count for much, the court limited

its opinion to hold that pre-purchase services cannot by themselves suffice to make the profits

of an investment arise predominantly from the efforts of others, and that ministerial functions

should receive a good deal less weight than entrepreneurial activities.

The U.S. Court of Appeals for the Eleventh Circuit reached the opposite result in

Securities and Exchange Commission v. Mutual Benefits Corp., 408 F.3d 737 (11th Cir. 2005), and

We decline to adopt the test established by the Life Partners court. We are not

convinced that either Howey or Edwards [540 U.S. 389 (2004) (Case 21.1)] require

such a clean distinction between a promoter’s activities prior to his having use of

an investor’s money and his activities thereafter. The rule set forth in Howey and

reiterated in Edwards directs us to broadly apply the Security Acts of 1993 and

1994 to all “schemes devised by those who seek the use of the money of others on

the promise of profits.”

Furthermore, while the “solely on the efforts of the promoter or a third party”

prong of the Howey test may not be met where an investment relies

predominantly on market speculation, that is not the case here. The investors’

expectations of profits in this case relied heavily on the pre-and post-payment

the chances increased that the investors would realize less of a profit, or no profit

at all. And, investors had no ability to assess the accuracy of representations

being made by MBC or the accuracy of the life-expectancy evaluations. They

could not, by reference to market trends, independently assess the prospective

value of their investments in MBC’s viatical settlement contracts. There were

important post-purchase managerial efforts of MBC as well. Often, life-

Question 2

Issues Presented: (a) Does an acquiring company planning to issue common stock in

connection with a merger have to register the stock that will finance the takeover? (b) Can

affiliates of the acquired company freely resell the shares they receive in the merger?

(a) Under Rule 145, adopted by the SEC, the protections of the 1933 Act extend to

certain types of business reorganizations and combinations. Transactions that fall within the

guidelines specified in Rule 145 must be registered with the SEC in a combined registration

(b) Under amended Rule 145, the officers, directors, and controlling shareholders of the

acquired company are subject to the same restrictions on resale of the acquirer’s stock as

nonaffiliates of the target. Because Flintstone will not be an affiliate of Rock Quarry, as long as

Question 3

Issue Presented: Under what conditions may a director of a corporation who owns 15% of its

stock sell shares received in a merger in exchange for stock issued pursuant to Section 4(2)?

Susan Newton may not sell any of her EBM Corporation stock pursuant to the public

pursuant to Rule 144(k) because she is an affiliate of EBM (both as a director and as a person

Question 4

Issue Presented: If a company’s registration statement includes an overappraisal of a key

asset, will Section 11 of the Securities Act of 1933 support claims against the company’s

controller and outside directors, as well as the company and its auditors?

Under Section 11, the company is strictly liable for any material misstatements or

omissions in its registration statement. An overappraisal of a key asset by $150 million in the

company’s registration statement is clearly material: the company will be strictly liable for this

The company will probably claim that the plaintiffs have failed to prove causation. The

defendants will argue that the drop in the price of the stock was a result of the announcement

that its competitor plans to double its paper production capacity. Even if the plaintiffs

successfully establish causation, the effect of the competitor’s announcement on the company’s

stock will be relevant to the issue of damages.

Question 5

Issue Presented: Do the failures to include information concerning a deteriorating inventory-

to-sales ratio relative to competing firms and to disclose insider transactions that increase a

company’s operating costs constitute material omissions giving rise to liability under Section

11 of the Securities Act of 1933?

The company’s deteriorating inventory–to-sales ratio relative to competing firms may

well be material. Although the company did not misstate its own inventory-to-sales ratio, its

failure to evaluate this ratio in an industry-wide context could alter the total mix of information

available to a reasonable investor. The result will depend in part on what the market already

The strongest defense available to the various defendants in the present case is probably

no causation. If the company’s stock has fallen because of an unexpectedly weakening

economy, the omissions in the registration statement would not have caused the plaintiffs any

damage.

Question 6

Issue Presented: Do virtual shares in an enterprise existing only in cyberspace constitute

securities?

In this case, the Securities and Exchange Commission brought a suit against SG Ltd. for

operating its virtual stock exchange in violation of the registration and antifraud provisions of

the federal securities laws. SG claimed that “the virtual shares were part of a fantasy

Quoting William Shakespeare, “A rose by any other name would smell as sweet,” the

First Circuit ruled that SG had sold securities. The First Circuit explained:

Howey established three criteria for determining whether a financial instrument

constitutes an investment contract (and thus a security): (1) the investment of money (2) in a

common enterprise (3) with an expectation of profits to be derived solely from the efforts of the

promoter or a third party. The First Circuit explained:

The appeals court also noted that in Reves v. Ernst Young, 494 U.S. 56 (1990), the Supreme

Court established “that the ‘commercial world’ to which the Howey Court alluded encompasses

the total universe of financial instruments available to investors, rather than the subset of

financial instruments envisioned by the district court.”

The court rejected SG’s claim that “individuals who purchased shares in the privileged

company were not so much investing money in return for rights in the virtual shares as paying

for an entertainment commodity. . . .” The court considered whether the primary motivation of

the participants was a “perceived investment opportunity” or “the visceral excitement of

playing a game.” The court cited SG’s statements that participants could “firmly expect a 10%

profit monthly” and concluded that participants who invested substantial amounts of money in

exchange for virtual shares in the privileged company likely did so in anticipation of investment

gains.

Here, the pooling element of horizontal commonality jumps off the screen. The

defendants’ website stated that: “The players’ money is accumulated on the SG

current account and is not invested anywhere, because no investment, not even

the most profitable one, could possibly fully compensate for the lack of

sufficiency in settling accounts with players, which lack would otherwise be

more likely.” Thus, as the SEC’s complaint suggests, SG unambiguously

represented to its clientele that the participants’ funds were pooled in a single

account used to settle participants’ on-line transactions. Therefore, pooling is

established.

With respect to the third factor, the expectation of profits, this exists when there is either

(1) capital appreciation from the original investment, or (2) participation in earnings resulting

from the use of investors’ funds. The SEC argued that “SG’s guarantees created a reasonable

expectancy of profit from investments in the privileged company,” while SG responded that

In Forman, the apartment was the principal attraction for prospective buyers, the

purchase of shares was merely incidental, and the combination of the two did

not add up to an investment contract. . . . Seen in this light, SG’s persistent

representations of substantial pecuniary gains for privileged company

shareholders distinguish its StockGeneration website from the Information

Bulletin circulated to prospective purchasers in Forman. While SG’s use of

gaming language is roughly analogous to the cooperative’s emphasis on the

The First Circuit also agreed that SG had misrepresented “the nature of the enterprise by

concealing the fact that the supply of new participants inevitably would be exhausted, causing

the scheme to implode and all existing participants to lose their money.” The SEC’s complaint

plausibly characterized SG’s flat guarantee of a 10% monthly return on the privileged

company’s shares and its assurances that it would support those shares as another material

misrepresentation of fact. Finally, the SEC had alleged that SG deceived participants by failing

to disclose its intent to keep investor money for itself.

Question 7

Issue Presented: Would an issuer have any basis for suing the lead underwriters in its initial

public offering (IPO), if post-IPO, it learned that the underwriters had signaled to potential

purchasers that they would be allocated shares in high-demand IPOs only if they were

willing to buy additional shares in the aftermarket? How would the issuer prove damages as

a result of such an undisclosed arrangement? If the arrangement had been disclosed to the

issuer, would purchasers in the aftermarket have any claims against the issuer and its

officers and directors or against the lead underwriters and their officers and directors?

This behavior is referred to as “tie–in agreements” or “laddering,” and it is illegal under

securities laws. By requiring customers to agree to buy additional shares of the issuer in the

aftermarket as a condition for receiving IPO stock, the underwriters created an artificial demand

In the case In re Initial Public Offering Securities Litigation, 241 F. Supp. 2d 281 (S.D.N.Y.

2003), on which this hypothetical is based, the court characterized the alleged actions of 55

underwriters, 309 issuers, and thousands of individual defendants as a “vast scheme to defraud

the investing public,” writing:

The defendants moved to dismiss the case, arguing that the complaints failed to comply

with the pleading requirements of the Federal Rules of Civil Procedure and the Private

Securities Litigation Reform Act of 1995 (the Reform Act). The Reform Act requires the plaintiff

to specify each statement that is misleading or omitted and the reason it is misleading.

Plaintiffs must also show that the defendant acted with intent to defraud or with the requisite

state of mind.

The court rejected the defendant’s claim that the Reform Act supported their motion to

dismiss:

The court then analyzed the plaintiffs’ claims under Sections 11 and 15 of the 1933 Act

and Sections 10(b) and 20 of the 1934 Act. The court ruled that failure to disclose the tie-in

agreements and the undisclosed compensation in the registration statement or prospectus was a

material omission in violation of Section 11. The Section 15 claims, which did not require proof

of intent, were also upheld. Moreover, on the secondary offerings, the registration statements

also failed to disclose “that the analyst reports were prepared by analysts employed by the

Plaintiffs have successfully pled that all of the Underwriters (both Allocating and

Non-Allocating) made material misstatements and omissions, which they had a

The court pointed out that the plaintiffs could establish intent to defraud by presenting

evidence that the defendants reaped a financial gain from the missatements and omissions:

“Specifically, when an Issuer exploited the inflated value of the company to engage in a merger

or acquisition, or to raise even more money through further stock offerings, the intent

requirement has been satisfied. Likewise, when an Individual Defendant sold large amounts of

her shares at a significant profit relatively close in time to the IPO, the requisite intent has been

demonstrated.” In all other instances, the pleading of intent to defraud was deemed inadequate

Section 20 of the 1934 Act provides joint liability for defendants that controlled a person

or entity that violated Section 10(b) and does not require proof of scienter or fraud. For the

defendants for whom the plaintiffs proved control, the Section 20 claims survived. The Section

20 claims against the other defendants were dismissed. But see Kalin v. Xanboo, Inc., 526 F. Supp.

2d 392 (S.D.N.Y. 2007).

Credit Suisse argued that the plaintiffs’ claims and related requests for documents were

based on “pure speculation,” but the court disagreed:

Question 8

Issue Presented: Are either the Section 4(1) or Section 4(2) exemptions available to exempt the

sale of shares by a privately held corporation to a consulting firm that then sold them to the

public?

Platforms and Martin alleged that (1) the transfer of ownership from Intermedia to

Draper and Benefit Consultants qualified for an exemption under Section 4(1) of the 1933 Act,

because Intermedia was not an “affiliate” of Platforms as defined in Rule 144(a)(1), and (2) even

if Intermedia was an affiliate of Platforms, the issuance of shares by Platforms was exempt

under Section 4(2), because they took reasonable care to assure that Intermedia was not an

Section 4(1). Section 4(1) of the 1933 Act exempts from registration “transactions by any

person other than an issuer, underwriter, or dealer.” Because Platforms was an “issuer,” it could

not rely on this exemption. Even though Intermedia, Draper, and Benefit Consultants were not

“issuers” or “dealers,” the court concluded that all three were “underwriters,” making Section

4(1) unavailable.

If a transaction complies with the requirements of Rule 144, then the parties involved are

deemed not to fall within the statutory definition of underwriters for purposes of the

transaction, making Section 4(1) potentially available. Rule 144(k) permits a person to resell

securities without restriction under certain circumstances if that person was not an “affiliate” of

the issuer at the time of the sale or within the three months preceding the sale. An “affiliate” is

“a person that directly, or indirectly through one or more intermediaries, controls, or is

controlled by, or is under common control with, such issuer.”

The court also rejected the assertion that the opinion letters from Platforms’ general

counsel stating that Intermedia was not an affiliate of Platforms raised a genuine issue of fact on

control. Because these letters were premised on the information provided by the defendants,

they did not bear on the issue of Intermedia’s affiliate status. Because Intermedia was an

affiliate of Platforms at the time of the transactions, the transactions do not qualify for the Rule

144(k) safe harbor.

The court explained that this result was consistent with the public policies underlying

the 1933 Act:

Although failure to qualify for the Rule 144 safe harbor does not automatically prevent a

transaction from qualifying for the broader Section 4(1) exemption, the court concluded that

Intermedia’s affiliate status made it an “issuer” for the limited purpose of defining underwriters

Section 4(2). Section 4(2) of the 1933 Act exempts from registration “transactions by an

issuer not involving any public offering.” The court explained that “a limited distribution to

highly sophisticated investors, rather than a general distribution to the public, is not a public

offering.”

Regulation D creates a safe harbor within this exemption by defining certain

transactions as non-public offerings. For a transaction to be eligible, the issuer must comply

with Rule 502(d) and “exercise reasonable care to assure that the purchasers of the securities are

not underwriters within the meaning of section 2(11) of the Act.” Martin and Platforms

conceded that they took none of the three actions explicitly enumerated in Rule 502(d), but they

argued that they could reasonably rely on the opinion letter stating that Intermedia was not an

affiliate of Platforms. The court rejected this assertion, stating:

Second, whether or not Intermedia was in fact a statutory underwriter does not

bear on whether defendants exercised reasonable care under Rule 502(d). . . . By

its plain terms, Rule 502(d) required Platforms and Martin to “exercise”

reasonable care to “assure” that Intermedia was not an underwriter, having

thereby “demonstrated” reasonable care through their “actions.” . . . Persons

with access to material nonpublic information about Platforms sold 17.45 million