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Prior to beginning work on this discussion,
Assume Ken Hastings (cookout host) and Tim Daniels (Ken’s tennis partner) both bought stock in New World Industries as soon as the market opened on Monday and all profited 30% after the press announcement by Mrs. Chen. Pursuant to their agreement, Tim Daniels paid Ken Hasting 5% of the profit he made on the transaction.
Reference
Prenkert, J.D., Barnes, A.J., Perry, J.E., Haugh, T, & Stemler, A.R. (2022). Business law: The ethical, global, and digital environment (18th ed.). Retrieved from
https://www.vitalsource.com
CHAPTER 45
Securities Regulation
Y
ou are the CEO of L’Malle LLC, a nonpublic company that builds and manages upscale
shopping malls. L’Malle plans to raise $4,400,000 for construction of L’Malle’s newest shopping
center complex, Grande L’Malle Geneva (GLG). In an effort to avoid the application of the
Securities Act of 1933, L’Malle’s CFO has proposed that the company issue 22 profit participation
plans (PPPs) to two insurance companies, four mutual funds, and 16 individual investors. Under
the PPPs, each owner will contribute $200,000 cash to finance the construction of GLG and receive
3 percent of the profits generated by GLG. L’Malle will be the exclusive manager of GLG, making
all decisions regarding its construction and operation, for which L’Malle will receive a fee equal
to 34 percent of GLG’s profits.
• Are the PPPs securities under the Securities Act of 1933?
• If the PPPs are securities, may L’Malle sell them pursuant to a registration exemption from the
Securities Act of 1933 under Regulation A, Rule 504, or Rule 506?
L’Malle decides to sell the PPPs directly to investors by making a Regulation A offering. As CEO,
you will accompany L’Malle’s CFO and communications vice president when they visit
prospective investors. During those visits, you and the other L’Malle executives will present copies
of the offering circular to prospective investors and make oral reports about the offering, GLG,
and L’Malle’s business and prospects. You will also answer the investors’ questions about L’Malle
and GLG.
• Should you be fearful about having liability to the investors under Section 12(a)(2) of the 1933
Act and Rule 10b—5 of the Securities Exchange Act of 1934?
L’Malle decides to make a public offering of its common shares by registering the offering under
the Securities Act of 1933 and complying with the requirements of Section 5 of the 1933 Act. The
shares will be sold by a firm commitment underwriting.
• Under what legal conditions may L’Malle release earnings reports and make other normal
communications with its shareholders and other investors?
• After L’Malle has filed its 1933 Act registration statement with the Securities and Exchange
Commission and before the SEC has declared the registration statement effective, under what
legal conditions may you (the CEO) and L’Malle’s CFO conduct a road show where you pitch
the shares to mutual fund investment managers in several cities?
• During that waiting period, may L’Malle post its preliminary prospectus and have an FAQ
page for prospective investors at the offering’s website?
• After the SEC has declared the registration statement effective, under what legal conditions
may L’Malle confirm the sale of shares to an investor?
• During that post-effective period, under what legal conditions may L’Malle direct prospective
investors from the offering’s website to L’Malle’s corporate website, where investors may
obtain additional information about L’Malle?
page 45-2
LO
LEARNING OBJECTIVES
After studying this chapter, you should be able to:
1.
45-1Understand why and demonstrate how the law regulates issuances and issuers of securities.
2.
45-2Define a security and apply the definition to a variety of contracts.
3.
45-3Comply with the communication rules that apply to a public offering of securities.
4.
45-4List and apply the Securities Act’s exemptions from registration.
5.
45-5Engage in behavior that avoids liability under the federal securities laws.
MODERN SECURITIES REGULATION AROSE from the rubble of the great stock market crash
of October 1929. After the crash, Congress studied its causes and discovered several common
problems in securities transactions, the most important ones being:
1. 1.Investors lacked the necessary information to make intelligent decisions whether to
buy, sell, or hold securities.
2. 2.Disreputable sellers of securities made outlandish claims about the expected
performance of securities and sold securities in nonexistent companies.
Faced with these perceived problems, Congress chose to require securities sellers to disclose the
information that investors need to make intelligent investment decisions. Congress found that
investors are able to make intelligent investment decisions if they are given sufficient information
about the company whose securities they are to buy. This disclosure scheme assumes that
investors need assistance from government in acquiring information but that they need no help in
evaluating information.
Purposes of Securities Regulation
LO45-1
Understand why and demonstrate how the law regulates issuances and issuers of securities.
To implement its disclosure scheme, in the early 1930s Congress passed two major statutes, which
are the hub of federal securities regulation in the United States today. These two statutes,
the Securities Act of 1933 and the Securities Exchange Act of 1934, have three basic purposes:
1. 1.To require the disclosure of meaningful information about a security and its issuer
to allow investors to make intelligent investment decisions.
2. 2.To impose liability on those persons who make inadequate and erroneous disclosures
of information.
3. 3.To regulate insiders, professional sellers of securities, securities exchanges, and
other self-regulatory securities organizations.
The crux of the securities acts is to impose on issuers of securities, other sellers of securities,
and selected buyers of securities the affirmative duty to disclose important information, even if
they are not asked by investors to make the disclosures. By requiring disclosure, Congress hoped
to restore investor confidence in the securities markets. Congress wanted to bolster investor
confidence in the honesty of the stock market and thus encourage more investors to invest in
securities. Building investor confidence would increase capital formation and, it was hoped, help
the American economy emerge from the Great Depression of the 1930s.
Congress has reaffirmed the purposes of the securities law many times since the 1930s by
passing laws that expand investor protections. Most recent are the enactments of the Sarbanes—
Oxley Act of 2002 and the Dodd—Frank Wall Street Reform and Consumer Protection Act of
2010. The Sarbanes—Oxley Act was a response to widespread misstatements and omissions in
corporate financial statements, which led to accounting fraud scandals at high-profile public
companies. Many public investors lost their life savings in the collapses of firms like Enron and
WorldCom, while insiders profited. As we learned in Chapters 4 and 43 and will learn in this
chapter and Chapter 46, the Sarbanes—Oxley Act imposes duties on corporations, their officers,
and their auditors and provides for a Public Company Accounting Oversight Board to establish
auditing standards.
The Dodd—Frank Act, enacted in the wake of the financial crisis of 2007, mostly regulates
banks and consumer credit institutions. While this subject matter is outside the scope of the
chapter, what is covered here and in Chapters 43 and 46 are the Dodd—Frank Act’s provisions
that impose new powers and responsibilities on the Securities and Exchange Commission, increase
regulation of brokers and investment advisers, regulate asset-backed securities, require shareholder
approval of executive compensation, and strengthen shareholder rights in director elections.
page 45-3
Securities and Exchange Commission
The Securities and Exchange Commission (SEC) was created by the 1934 Act. Its
responsibility is to administer the 1933 Act, 1934 Act, and other securities statutes. Like
other federal administrative agencies, the SEC has legislative, executive, and judicial
functions. Its legislative branch promulgates rules and regulations; its executive branch
brings enforcement actions against alleged violators of the securities statutes and their
rules and regulations; its judicial branch decides whether a person has violated the
securities laws.
SEC Actions The SEC is empowered to investigate violations of the 1933 Act and 1934 Act and
to hold hearings to determine whether the acts have been violated. Such hearings are held before
an administrative law judge (ALJ), who is an employee of the SEC. The administrative law judge
is a finder of both fact and law. Decisions of the ALJ are reviewed by the commissioners of the
SEC. Decisions of the commissioners are appealed to the U.S. Court of Appeals. Most SEC actions
are not litigated. Instead, the SEC issues consent orders, by which the defendant promises not to
violate the securities laws in the future but does not admit to having violated them in the past.
The SEC has the power to impose civil penalties (fines) up to $500,000 and to issue cease and
desist orders. A cease and desist order directs a defendant to stop violating the securities laws and
to desist from future violations. Nonetheless, the SEC does not have the power to issue injunctions;
only courts may issue injunctions. The 1933 Act and the 1934 Act empower the SEC only to ask
federal district courts for injunctions against persons who have violated or are about to violate
either act. The SEC may also ask the courts to grant ancillary relief, a remedy in addition to an
injunction. Ancillary relief may include, for example, the disgorgement of profits that a defendant
has made in a fraudulent sale or in an illegal insider trading transaction. In recent years, the SEC’s
disgorgement remedy has been limited, however. The Supreme Court ruled in Kokesh v. SEC1 that
disgorgement is a penalty subject to a five-year statute of limitations. And the Court also held
in Liu v. SEC2 that when disgorgement is sought as equitable relief, it may not exceeding the
wrongdoer’s net profits.
Figure 45.1 A Note on Lucia v. SEC
In 2018, the Supreme Court heard a case, Lucia v. SEC, 138 S. Ct. 2044 (2018), that challenged the very nature of the SEC’s
functions. Six years prior, the SEC charged Raymond Lucia with violating the antifraud provisions of the Investment Advisers Act
and other SEC rules. It was alleged that Lucia, an investment professional, misled potential investors in roughly 40 different
retirement-planning seminars. The case was assigned to one of the SEC’s five ALJs, who was appointed by SEC staff. The ALJ
heard nine days of testimony, ultimately finding that Lucia had violated the Act; he recommended Lucia pay a $300,000 fine and
be barred for life from the investment industry. On appeal to the SEC, Lucia argued not only that the decision was wrong on the
merits, but that the ALJ was invalidly appointed and therefore lacked authority to convene a hearing, much less issue a binding
decision, in his case. The question became whether the SEC’s five ALJs were “Officers of the United States” or “mere employees”;
if they were officers, their appointment was subject to the Appointments Clause of the Constitution and they could not be validly
appointed by SEC staff.
Justice Kagan, writing for the 6-3 majority, found that the ALJs were officers. “Far from serving temporarily or episodically,
SEC ALJs ‘receive[] a career appointment.’ And that appointment is to a position created by statute, down to its ‘duties, salary,
and means of appointment.’” Justice Kagan further stated that “ALJs exercise the same ‘significant discretion’ when carrying out
the same ‘important functions’ as [special trial judges in tax court, which were found to be officers under Freytag v.
Commissioner, 501 U.S. 868 (1991)].” Accordingly, Lucia’s case was remanded for a rehearing by a validly appointed ALJ. More
importantly, the Court’s ruling called into question the appointment of some 1,900 ALJs across various federal agencies, who have
collectively heard hundreds of thousands of cases. The SEC, though, made a quick fix—it reappointed its ALJs itself (as opposed
to staff doing it) and thus solved the Appointments Clause issue. What long-term effects the Lucia decision will have beyond the
SEC remains to be seen.
page 45-4
To reduce the risk that a securities issuer’s or other person’s behavior will violate the securities
law and result in an SEC action, anyone may contact the SEC’s staff in advance, propose a
transaction or course of action, and ask the SEC to issue a no-action letter. In the no-action letter,
the SEC’s staff states it will take no legal action against the issuer or other person if the issuer or
other person acts as indicated in the no-action letter. Issuers often seek no-action letters before
making exempted offerings of securities and excluding shareholder proposals from their proxy
statements, issues we discuss later in the chapter. Because a no-action letter is issued by the SEC’s
staff and not the commissioners, it is not binding on the commissioners. Nonetheless, issuers that
comply with no-action letters rarely face SEC action.
What Is a Security?
LO45-2
Define a security and apply the definition to a variety of contracts.
The first issue in securities regulation is the definition of a security. If a transaction
involves no security, then the law of securities regulation does not apply. The 1933 Act
defines the term security broadly:
Unless the context otherwise requires the term “security” means any note, stock, treasury stock, security future, security-based
swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, . . .
preorganization certificate or subscription, . . . investment contract, voting trust certificate, . . . fractional undivided interest in oil,
gas, or mineral rights, any put, call, straddle, option, or privilege on any security, . . . or, in general, any interest or instrument
commonly known as a “security” . . . or warrant or right to subscribe to or purchase, any of the foregoing.
The 1934 Act definition of security is similar but excludes notes and drafts that mature
not more than nine months from the date of issuance.
While typical securities like common shares, preferred shares, bonds, and
debentures are defined as securities, the definition of a security also includes many
contracts that the general public may believe are not securities. This is because the
term investment contract is broadly defined by the courts. The Supreme Court’s threepart test for an investment contract, called the Howey test, has been the guiding beacon
in the area for more than 50 years.3 The Howey test states that an investment contract is
an investment of money in a common enterprise with an expectation of profits solely
from the efforts of others.
In the Howey case, the sales of plots in an orange grove along with a management
contract were held to be sales of securities. The purchasers had investment motives
(they intended to make a profit from, not to consume, the oranges produced by the
trees). There was a common enterprise because the investors provided the capital to
finance the orange grove business and shared in its earnings. The sellers, not the buyers,
did all of the work needed to make the plots profitable.
In other cases, sales of limited partnership interests, Scotch whisky receipts, and
restaurant franchises have been held to constitute investment contracts and, therefore,
securities. Even partnership interests in an ordinary partnership have been held to be
securities, when the partner is a passive investor with no meaningful control over the
management of the partnership.4
Courts define in two ways the common enterprise element of the Howey test. All
courts permit horizontal commonality to satisfy the common enterprise requirement.
Horizontal commonality requires that investors’ funds be pooled and that profits of the
enterprise be shared pro rata by investors. Some courts accept vertical commonality, in
which the investors are similarly affected by the efforts of the person who is promoting
the investment.
Courts have used the Howey test to hold that some contracts with names of typical
securities are not securities. The courts point out that some of these contracts possess
few of the characteristics of a security. For example, in United Housing Foundation,
Inc. v. Forman,5 the Supreme Court held that although tenants in a cooperative
apartment building purchased contracts labeled as stock, the contracts were not
securities. The “stock” possessed few of the typical characteristics of stock and the
economic realities of the transaction bore few similarities to those of the typical stock
sale: The stock gave tenants no dividend rights or voting rights in proportion to the
number of shares owned, it was not negotiable, and it could not appreciate in value.
More important, tenants bought the stock not for the purpose of investment but to
acquire suitable living space.
However, when investors are misled to believe that the securities laws apply
because a seller sold a contract bearing both the name of a typical security and
significant characteristics of that security, the securities laws do apply to the sale of the
security. The application of this doctrine page 45-5 led to the Supreme Court’s rejection
of the sale-of-business doctrine, which had held that the sale of 100 percent of the shares
of a corporation to a single purchaser who would manage the corporation was not a
security. The rationale for the sale-of-business doctrine was that the purchaser failed to
meet the third element of the Howey test because he expected to make a profit from his
own efforts in managing the business. Today, when a business sale is affected by the
sale of stock, the transaction is covered by the securities acts if the stock possesses the
characteristics of stock.
In 1990, the Supreme Court further extended this rationale in Reves v. Ernst &
Young,6 adopting the family resemblance test to determine whether promissory notes
were securities. The Supreme Court held that it is inappropriate to apply the Howey test
to notes. Instead, applying the family resemblance test, the Court held that notes are
presumed to be securities unless they bear a “strong family resemblance” to a type of
note that is not a security.
The five characteristics of notes that are not securities are:
1.
2.
3.
4.
5.
1.There is no recognized market for the notes.
2.The note is not part of a series of notes.
3.The buyer of the note does not need the protection of the securities laws.
4.The buyer of the note has no investment intent.
5.The buyer has no expectation that the securities laws apply to the sale of
the note.
Types of notes that are not securities include consumer notes, mortgage notes,
short-term notes secured by a lien on a small business, short-term notes secured by
accounts receivable, and notes evidencing loans by commercial banks for current
operations.
In the following case, the Supreme Court applied the family resemblance test.
Nye Capital Appreciation Partners, L.L.C. v. Nemchik
483 F. App’x 1 (6th Cir. 2012)
In the mid-1990s, the Nyes began making equity investments in ProPaint Plus Automobile Repairs, Systems & Services Inc.
(ProPaint), a company founded by James Johnson and Jackie Nemchik. Between December 1996 and January 1997, Nemchik
hired Roy Malkin as ProPaint’s chief operating officer and president. In May 1997, Randy Nye became a member of ProPaint’s
board of directors.
After Malkin was hired, ProPaint determined it needed capital to make the company viable and to continue business
operations. Malkin, Joseph Carney, and members of ProPaint’s board of directors prepared a private placement memorandum
(PPM) in order to produce new investors. The PPM failed to produce new investors by March 1998, so the Nyes offered to provide
an $800,000 capital infusion to ProPaint in exchange for 40 percent of ProPaint’s total stock in a form substantially the same as
that being offered through PPM. Pursuant to this agreement, the Nyes agreed to sell shares in Nye Capital Appreciation Partners,
L.L.C. (Nye Capital), an entity the Nyes created to gather investors to make equity payments in ProPaint, and use the capital raised
to invest in ProPaint. ProPaint agreed to repay the Nyes $800,000 and used the remaining capital for business activities. Between
March and October 1998, the Nyes, in the name of Nye Financial Group Inc. (Nye Financial), transferred a $607,000 “loan” to
ProPaint. In October 1998, the Nyes raised $223,000 through Nye Capital and invested it in shares of ProPaint stock.
ProPaint continued to suffer losses through the fall of 1998. On November 15, 1998, Malkin submitted his resignation. On
December 4, 1998, Randy Nye became ProPaint’s chairman and senior executive and became more involved in the day-to-day
operations of ProPaint. Through his involvement, Randy Nye became aware of alleged misconduct by Malkin, and shortly after,
ProPaint ceased operations and filed for bankruptcy.
The Nyes filed a complaint that asserted various claims arising out of alleged fraudulent misrepresentations that led to the
loss of the money they provided ProPaint. Malkin, Nemchik, and the Johnsons then filed a motion for summary judgment to dismiss,
asserting that the Nyes’ claims involved the sale of securities and were time-barred. In response, the Nyes filed an opposition to
the summary judgment motions. They contended that the transfer of $607,000 to ProPaint constituted a loan, not a purchase or
sale of securities. They argued that the claims were not time-barred because they were subject to a longer statute of limitations
applicable to common law tort claims. page 45-6 However, the district court granted the motions for summary judgment of the
complaint on the ground that these claims were intertwined with the sale of securities and were, therefore, time-barred by the
applicable statutes of limitations and repose.
On appeal, the Nyes contended that the district court erred in determining that their claims were intertwined with the
purchase or sale of securities. They argued that their $607,000 cash infusion constituted “the mere making of a loan and an
issuance of a promissory note.”
Alarcón, Judge
To determine whether a “note” is a security, this court applies the “family resemblance” test articulated by the United States
Supreme Court in Reves v. Ernst & Young, 494 U.S. 56, 110 S. Ct. 945 (1990). Under this test, every note is presumed to be a
security, unless it falls into one of the few enumerated categories. Reves, 494 U.S. at 65. It is undisputed that the $607,000 loan
does not fall within an enumerated category that rebuts the presumption that a note is a security.
If a note does not bear a strong resemblance to one of the enumerated categories, then courts may still weigh the following
four factors to determine whether a note should be added to the list of categories of non-securities: (1) “the motivations that would
prompt a reasonable seller and buyer to enter into the transaction”; (2) “the ‘plan of distribution’ of the instrument”; (3) “the
reasonable expectations of the investing public”; and (4) “whether some factor such as the existence of another regulatory scheme
significantly reduces the risk of the instrument, thereby rendering application of the Securities Acts unnecessary.” Id. at 66—67.
With respect to the first factor, “if the seller’s purpose is to raise money for the general use of a business enterprise or to
finance substantial investments and the buyer is interested primarily in the profit the note is expected to generate, the instrument is
likely to be a ‘security.’” The Appellees sought the cash infusion to enable ProPaint to continue operating its business. The Nyes
transferred the money to acquire stock in ProPaint and to generate profit by selling stock to outside investors. Accordingly, the
district court did not err in determining that the first factor weighs in favor of characterizing the loan as a security.
In applying the second factor, we look to the record to “determine whether it is an instrument in which there is ‘common
trading for speculation or investment.’” Id. However, even if an instrument is not commonly distributed, “it is clear that
paradigmatic securities, such as stocks, can be offered and sold to a single person, while yet remaining securities.” Bass v. Janney
Montgomery Scott, Inc., 210 F.3d 577, 585 (6th Cir. 2000). Here, the Appellees used the PPM to generate equity interest from the
Nyes. The PPM explicitly stated that the “investment in ProPaint is speculative and should be considered only by those persons
who are able to bear the economic risk and could afford a complete loss of their investment.” Despite the absence of common
trading for speculation or investment, this solicitation of capital in exchange for stock also weighs in favor of characterizing the
Nyes’ loans as securities.
The record also demonstrates that the third Reves factor is satisfied. The Nyes referred to the $607,000 transfer to ProPaint
as a “loan” but expected to receive stock in ProPaint in exchange and to convert their “loan” into an equity investment. Randy Nye
wrote to Nemchik stating that the Nyes’ $800,000 capital infusion to ProPaint will “initially take the form of notes and that in
exchange for this funding the investment partnership or LLC will receive 40% of ProPaint.” Carney also stated in a May 14, 1998
letter to Randy Nye and others, that “if ProPaint were flush with funds, we could skip the loan step and proceed directly to the
investment.” He laid out the steps involved in converting the loans to equity investments and added “the sooner we get equity
issued the better for ProPaint.”
We reject the Nyes’ assertion that the district court erroneously “relied upon an interpretation of the evidence” in determining
that their loan was intended as an equity investment. The district court properly reviewed the evidence on the record and “looked
to the actual nature or subject matter of the case, rather than to the form in which the action was plead.” The district court did not
err in determining that the nature of the transaction was a sale of security and that the investing public would have reasonably
perceived it as such.
The final Reves factor is also inapplicable because the Nyes’ loan in exchange for stock in ProPaint was not collaterized or
insured. The PPM warns prospective investors that their investment would be subject to financial risks, indicating the absence of
any security measures. Additionally, the Nyes have not disputed Malkin’s allegation that “the notes at issue here were not protected
by any other regulatory scheme and were uninsured and uncollateralized.” Absent a risk-reducing factor, the fourth factor supports
the characterization of the Nyes’ “loans” as securities.
The balance of the four factors identified in Reves does not support the creation of a new category of non-securities to
encompass the $607,000 loan. The district court did not err in determining that the Nyes’ loans were securities and that the Nyes’
claims were inextricably intertwined with the sale of securities.
Judgment AFFIRMED.
page 45-7
Securities Act of 1933
The Securities Act of 1933 (1933 Act) is concerned primarily with public distributions of
securities. That is, the 1933 Act regulates the sale of securities while they are passing from the
hands of the issuer into the hands of public investors. An issuer selling securities publicly must
make necessary disclosures at the time the issuer sells the securities to the public.
The 1933 Act has two principal regulatory components: (1) registration provisions and (2)
liability provisions. The registration requirements of the 1933 Act are designed to give investors
the information they need to make intelligent decisions whether to purchase securities when an
issuer sells its securities to the public. The various liability provisions in the 1933 Act impose
liability on sellers of securities for misstating or omitting facts of material significance to investors.
Registration of Securities under the 1933 Act
The Securities Act of 1933 is primarily concerned with protecting investors when securities are
sold by an issuer to investors. That is, the 1933 Act regulates the process during which issuers
offer and sell their securities to investors, primarily public investors.
Therefore, the 1933 Act requires that every offering of securities be registered with the SEC
prior to any offer or sale of the securities, unless the offering or the securities are exempt from
registration. That is, an issuer and its underwriters may not offer or sell securities unless the
securities are registered with the SEC or exempt from registration. Over the next few pages, we
will cover the registration process. Then the exemptions from registration will be addressed.
LO45-3
Comply with the communication rules that apply to a public offering of securities.
Mechanics of a Registered Offering
When an issuer makes a decision to raise money by a public offering of securities, the issuer needs
to obtain the assistance of securities market professionals. The issuer will contact a managing
underwriter, the primary person assisting the issuer in selling the securities. The managing
underwriter will review the issuer’s operations and financial statements and reach an agreement
with the issuer regarding the type of securities to sell, the offering price, and the compensation to
be paid to the underwriters. The issuer and the managing underwriter will determine what type of
underwriting to use.
In a standby underwriting, the underwriters obtain subscriptions from prospective investors,
but the issuer sells the securities only if there is sufficient investor interest in the securities. The
underwriters receive warrants—options to purchase the issuer’s securities at a bargain price—as
compensation for their efforts. The standby underwriting is typically used only to sell common
shares to existing shareholders pursuant to a preemptive rights offering.
With a best efforts underwriting, the underwriters are merely agents making their best efforts
to sell the issuer’s securities. The underwriters receive a commission for their selling efforts. The
best efforts underwriting is used when an issuer is not well established and the underwriter is
unwilling to risk being unable to sell the securities.
The classic underwriting arrangement is a firm commitment underwriting. Here, the
managing underwriter forms an underwriting group and a selling group. The underwriting group
agrees to purchase the securities from the issuer at a discount from the public offering price—for
example, 25 cents per share below the offering price. The selling group agrees to buy the securities
from the underwriters also at a discount—for example, 12½ cents per share below the offering
price. Consequently, the underwriting and selling groups bear much of the risk with a firm
commitment underwriting, but they also stand to make the most profit under such an arrangement.
Securities Offerings on the Internet Increasingly, issuers are using the Internet to make public
securities offerings, especially initial public offerings (IPOs) of companies’ securities. The Internet
provides issuers and underwriters the advantage of making direct offerings to all investors
simultaneously—that is, selling directly to investors without the need for a selling group. The first
Internet securities offering that was approved by the SEC was a firm commitment underwriting.
Internet offerings have increased dramatically since 1998. The Internet is likely to become the
dominant medium for marketing securities directly to investors.
Registration Statement and Prospectus The 1933 Act requires the issuer of securities to
register the securities with the SEC before the issuer or underwriters may offer or sell the securities.
Registration requires filing a registration statement with the SEC. Historical page 45-8 and current
data about the issuer, its business lines and the competition it faces, the material risks of the
business, material litigation, its officers’ and directors’ experience and compensation, a description
of the securities to be offered, the amount and price of the securities, the manner in which the
securities will be sold, the underwriter’s compensation for assisting in the sale of the securities,
and the issuer’s use of the proceeds of the issuance, among other information, must be included in
the registration statement prepared by the issuer of the securities with the assistance of the
managing underwriter, securities lawyers, and independent accountants. Generally, the registration
statement must include audited balance sheets as of the end of each of the two most recent fiscal
years, in addition to audited income statements and audited statements of changes in financial
position for each of the last three fiscal years.
The registration statement becomes effective after it has been reviewed by the SEC. The 1933
Act provides that the registration statement becomes effective automatically on the 20th day after
its filing, unless the SEC delays or advances the effective date.
The prospectus is the basic selling document of an offering registered under the 1933 Act.
Almost all of the information in the registration statement must be included in the prospectus. It
must be furnished to every purchaser of the registered security prior to or concurrently with the
sale of the security to the purchaser. The prospectus enables an investor to base her investment
decision on all of the relevant data concerning the issuer, not merely on the favorable information
that the issuer may be inclined to disclose voluntarily.
Although some prospectuses are delivered in person or by mail, most issuers now transmit
prospectuses through their own or the SEC’s website.
LOG ON
Facebook Preliminary Prospectus
To see an example of a preliminary prospectus, a draft registration statement nicknamed a “red herring” because the
SEC requires companies to print in red ink that indicates its preliminary nature, log on to the SEC’s website and find
the 2012 prospectus of Facebook, Inc.
https://www.sec.gov/Archives/edgar/data/1326801/000119312512034517/d287954ds1.htm
Section 5: Timing, Manner, and Content of Offers and Sales The 1933 Act restricts the
issuer’s and underwriter’s ability to communicate with prospective purchasers of the securities.
Section 5 of the 1933 Act states the basic rules regarding the timing, manner, and content of offers
and sales. It creates three important periods of time in the life of a securities offering: (1) the prefiling period, (2) the waiting period, and (3) the post-effective period.
The Pre-filing Period Prior to the filing of the registration statement (the pre-filing period), the
issuer and any other person may not offer or sell the securities to be registered. The purpose of the
pre-filing period is to prevent premature communications about an issuer and its securities, which
may encourage an investor to make a decision to purchase the security before all the information
she needs is available. The pre-filing period also marks the start of what is sometimes called
the quiet period, which continues for the full duration of the securities offering. A prospective
issuer, its directors and officers, and its underwriters must avoid publicity about the issuer and the
prospective issuance of securities during the pre-filing period and the rest of the quiet period.
Generally, statements made within 30 days of filing a registration statement are considered an
attempt to presell securities during the quiet period. Such “gun jumping” is a violation of Section
5 and may result in liability to the issuer for violating securities laws, a delay of the public offering
by the SEC, and a required disclosure in the prospectus of the potential securities law violations.
Examples of gun jumping include press interviews, participation in investment banker—sponsored
conferences, or new advertising campaigns; all are discouraged during the pre-filing period.
However, the SEC has created a number of safe harbors that allow issuers about to make
public offerings to continue to release information to the public yet not violate Section 5. For
example, under Rule 163A, an issuer can communicate any information about itself so long as it
is more than 30 days prior to the filing of a registration statement and two conditions are met: (1)
the issuer does not reference the upcoming securities offering and (2) the issuer takes reasonable
steps to prevent dissemination of the information during the 30-day period before the registration
statement is filed.
Rule 135 permits the issuer to publish a notice about a prospective offering during the prefiling period. The notice may contain only basic information, such as the name of the issuer, the
amount of the securities offered, a basic description of the securities and the offering, and the
anticipated timing of the offering. It may not name the underwriters or state the price at which the
securities will be offered. A Rule 135 notice is often referred to as a “tombstone” ad. See Figure
45.2.
page 45-9
Figure 45.2 Rule 134 Tombstone Ad
page 45-10
Under Rule 169, nonpublic issuers may release only factual business information
of the type they have previously released, and the information must not be intended for
investors or potential investors. The released information can only be intended for
customers, suppliers, or other individuals, but not in their capacities as investors. The
SEC will review the timing, manner, and form of the release of the factual information
to ensure that it is consistent with prior practices of the issuing company.
Also, the Jumpstart Our Business Startups Act of 2012 (JOBS Act) created a host
of new processes and disclosures for public offerings of “emerging growth companies,”
or EGCs. An EGC is defined as a company with total annual gross revenues of less than
$1 billion during its most recently completed fiscal year. The JOBS Act is discussed in
later parts of this chapter, but its disclosure safe harbors for EGCs in particular are
significant.
Section 105(c) of the Act allows EGCs to “test the waters” for a registered offering
by communicating with qualified institutional buyers and certain institutional investors
to gauge their interest in a proposed offering. In order to be considered a qualified
institutional buyer, one must own and invest $100 million of securities; to be an
institutional accredited investor, one must have a minimum of $5 million in assets. So
long as no securities are sold unless accompanied by a prospectus, EGCs can
communicate without restrictions with these groups, and they do not have to notify the
SEC.
The Waiting Period The waiting, or pre-effective, period is the time between the filing
date and the effective date of the registration statement, when the issuer is waiting for
the SEC to declare the registration statement effective. During the waiting period,
Section 5 permits the securities to be offered but not sold. This distinction may sound
odd, but think of it as the period when the securities are marketed. SEC rules allow only
certain offerings to be made. Face-to-face oral offers (including personal phone calls)
are allowed during the waiting period. However, written offers may be made only by a
statutory prospectus, usually a preliminary prospectus, or a free-writing prospectus.
During the waiting period, the preliminary prospectus omits the price of the securities
and the underwriter’s compensation. (A final prospectus will be available after the
registration statement becomes effective. It will contain the price of the securities and
the underwriter’s compensation.) The idea is to prohibit inappropriate “hyping” of the
security before all investors have access to publicly available information so that they
can make an informed investment decision.
The waiting period is part of the quiet period, but, as seen above, many safe harbors
apply. Rule 169’s protections are available during the waiting period, as is Section 105
of the JOBS Act for EGCs. Under Rule 168, public issuers are permitted to continue to
release regularly released factual business and forward-looking information. The type
of information, as well as the timing, manner, and form, must be similar to past releases
by the public issuer. This safe harbor only applies to the release of such information by
employees of the company who are historically responsible for providing such
information to persons other than investors.
Rule 134 permits the issuer to communicate limited factual information about the
offering after the preliminary prospectus is filed. A Rule 134 communication allows
disclosure of the same information as that of Rule 135, plus the general business of the
issuer, the price of the securities, and the names of the underwriters who are helping the
issuer to sell the securities. In addition, Rule 134 requires the tombstone ad to state
where a hard copy of a prospectus may be obtained or downloaded.
Finally, Section 105(a) of the JOBS Act eliminates restrictions on publishing
analyst research while offerings are in progress. Under prior law, research reports by
analysts, especially those participating in the underwriting of the issuer, could be
deemed to be “offers” of those securities and could not be issued prior to the offer’s
completion. Section105(a) allows publication of research reports about an EGC that is
the subject of a proposed public offering of its securities, even if the broker or dealer
that publishes the research is participating as an underwriter. Research is defined as any
information, opinion, or recommendation about a company, made orally or in writing.
No prospectus need accompany the research. As such, research providers are free to say
just about anything they want to about an issuer, subject to the SEC’s antifraud
provisions.
Issuers making public offerings will typically send their CEOs and other top
officers on the road to talk to securities analysts and institutional investors during the
waiting period. These road shows are permissible, whether an investor attends in person
or watches a webcast, provided it is a live, real-time road show to a live audience.
Road shows that are not viewed live in real time by a live audience are considered
written offers but are permitted during the waiting period if they meet the requirements
of what are known as free-writing prospectuses. That means that issuers other than
well-known seasoned issuers, those issuers with at least $700 million in public float
(the value of its common shares held by nonaffiliates of the issuer), must provide a
prospectus to investors who view an electronic road show that is not live. Such issuers
must also make a copy of the electronic road show available to any investor or file a
copy of the electronic road show with the SEC.
page 45-11
Communications and Information That an Issuer or Underwriter May Provide to
the Public or to Investors during a Registered Offering
page 45-12
Figure 45.3 Google’s Gun Jumping
A well-known example of a gun-jumping violation of Section 5 was committed by Google, Inc. Sometime prior to the company’s
IPO of August 13, 2004, Google’s founders Sergey Brin and Larry Page gave an interview to Playboy magazine. The interview
was published in the September 2004 issue under the title “Playboy Interview: Google Guys.” Not surprisingly, Brin and Page
made favorable comments about their company but included no mention of the offering or the sale of securities. In fact, the
statements the founders made about the tech company were innocuous, such as “people use Google because they trust us.”
Nevertheless, the SEC found the interview was gun jumping under Section 5 for violating the quiet period. Although Google
could have been required to buy back shares sold to investors in the IPO at the original purchase price for a period of one year
following the violation, ultimately the company had to take three remedial actions: (1) revise its prospectus to include a risk factor
warning that the Playboy interview violated Section 5, (2) include the full text of the article in the prospectus; and (3) address
discrepancies between statistics reported in the article and the prospectus.
Note: More recently, Salesforce.com Inc. was forced to delay its IPO after the company and its CEO Marc Benioff were
featured in a flattering New York Times article. The article drew SEC attention because it included statements from Benioff about
his company that were not included in its registration statement.
The waiting period is an important part of the regulatory scheme of the 1933 Act. It provides
an investor with adequate time to judge the wisdom of buying the security during a period when
he cannot be pressured to buy it. Not even a contract to buy the security may be made during the
waiting period.
The Post-effective Period After the effective date (the date on which the SEC declares the
registration effective), Section 5 permits the security to be offered and also to be sold, provided
that the buyer has received a final prospectus (a preliminary prospectus is not acceptable for this
purpose). Road shows and free-writing prospectuses may continue to be used. Other written offers
not previously allowed are permitted during the post-effective period, but only if the offeree has
received a final prospectus. During the post-effective period, the safe harbors of Rules 134, 135,
and 168 and Section 105 of the JOBS Act continue to apply. The Concept Review provides a
comparison of the three important periods of time in the life of a securities offering, as well as
some of the applicable safe harbors.
Liability for Violating Section 5 Section 12(a)(1) of the 1933 Act imposes liability on any person
who violates the provisions of Section 5. Liability extends to any purchaser to whom an illegal
offer or sale was made. The purchaser’s remedy is rescission of the purchase or damages if the
purchaser has already resold the securities.
Exemptions from the Registration Requirements of the 1933
Act
LO45-4
List and apply the Securities Act’s exemptions from registration.
Complying with the registration requirements of the 1933 Act, including the restrictions of Section
5, is a burdensome, time-consuming, and expensive process. Planning and executing an issuer’s
first public offering may consume months and cost millions of dollars. Consequently, some issuers
prefer to avoid registration when they sell securities. There are two types of exemptions from the
registration requirements of the 1933 Act: securities exemptions and transaction exemptions.
Securities Exemptions
Exempt securities never need to be registered, regardless who sells the securities, how they are
sold, or to whom they are sold. The following are the most important securities exemptions.7
page 45-13
1. 1.Securities issued or guaranteed by any government in the United States and its
territories.
2. 2.A note or draft that has a maturity date not more than nine months after its date of
issuance.
3. 3.A security issued by a nonprofit religious, charitable, educational, benevolent, or
fraternal organization.
4. 4.Securities issued by banks and by savings and loan associations.
5. 5.An insurance policy or an annuity contract.
Although the types of securities listed above are exempt from the registration provisions of the
1933 Act, they are not exempt from the general antifraud provisions of the securities acts. For
example, any fraud committed in the course of selling such securities can be attacked by the SEC
and by the persons who were defrauded under Section 17(a) and Section 12(a)(2) of the 1933 Act
and Section 10(b) of the 1934 Act.
Transaction Exemptions
The most important 1933 Act registration exemptions are the transaction exemptions. If a security
is sold pursuant to a transaction exemption, that sale is exempt from registration. Subsequent sales,
however, are not automatically exempt. Future sales must be made pursuant to a registration or
another exemption.
The transaction exemptions are exemptions from the registration provisions. The general
antifraud provisions of the 1933 Act and the 1934 Act apply to exempted and nonexempted
transactions.
The most important transaction exemptions are those available to issuers of securities. These
exemptions are the intrastate offering exemption, the private offering exemption, and the small
offering exemptions.
Intrastate Offering Exemption
Under Section 3(a)(11), an offering of securities solely to investors in one state by an issuer
resident and doing business in that state is exempt from the 1933 Act’s registration requirements.
The reason for the exemption is that there is little federal government interest in an offering that
occurs in only one state. Although the offering may be exempt from SEC regulation, state
securities law may require a registration. The expectation is that state securities regulation will
adequately protect investors.
The SEC has defined the intrastate offering exemption more precisely in Rule 147 and Rule
147A. Under Rule 147, an issuer must be organized and have its principal place of business in the
state where it offers and sells securities, and those securities can only be offered and sold to instate residents. Resale of the securities is limited to persons within the state for six months.
Rule 147A is almost identical to Rule 147 except that it allows offers to be accessible to outof-state residents, so long as sales are only made to those in-state and the company has its principal
place of business in-state.
Private Offering Exemption
Section 4(a)(2) of the 1933 Act provides that the registration requirements of the 1933
Act “shall not apply to transactions by an issuer not involving any public offering.” A
private offering is an offering to a small number of purchasers who can protect
themselves because they are wealthy or because they are sophisticated in investment
matters and have access to the information that they need to make intelligent investment
decisions.
To create greater certainty about what a private offering is, the SEC adopted Rule
506. Although an issuer may exempt a private offering under either the courts’
interpretation of Section 4(a)(2) or Rule 506, the SEC tends to treat Rule 506 as the
exclusive way to obtain the exemption.
Rule 506 Under Rule 506, which is part of Securities Act Regulation D, investors must
be qualified to purchase the securities. The issuer must reasonably believe that each
purchaser is either (a) an accredited investor or (b) an unaccredited investor who “has
such knowledge and experience in financial and business matters that he is capable of
evaluating the merits and risks of the prospective investment.” Accredited investors
include institutional investors (such as banks and mutual funds), wealthy investors, and
high-level insiders of the issuer (such as executive officers, directors, and partners).
Issuers should have purchasers sign an investment letter or suitability letter verifying
that they are qualified.
An issuer may sell to no more than 35 unaccredited purchasers who have sufficient
investment knowledge and experience; it may sell to an unlimited number of accredited
purchasers, regardless of their investment sophistication.
Each purchaser must be given or have access to the information she needs to make
an informed investment decision. For a public company making a nonpublic offering
under Rule 506 (such as General Motors selling $5 billion of its notes to 25 mutual
funds plus 5 other, unaccredited investors), purchasers must receive information in a
form required by the 1934 Act, such as a 10-K or annual report. The issuer must provide
the following audited financial statements: two years’ balance sheets, three years’
income statements, and three years’ statements of changes in financial position.
For a nonpublic company making a nonpublic offering under Rule 506, the issuer
must provide much of the same page 45-14 nonfinancial information required in a
registered offering. A nonpublic company may, however, obtain some relief from the
burden of providing audited financial statements to investors. When the amount of the
issuance is $2 million or less, only one year’s balance sheet need be audited. If the
amount issued exceeds $2 million but not $7.5 million, only one year’s balance sheet,
one year’s income statement, and one year’s statement of changes in financial position
need be audited. When the amount issued exceeds $7.5 million, the issuer must provide
two years’ balance sheets, three years’ income statements, and three years’ statements
of changes in financial position. In any offering of any amount by a nonpublic issuer,
when auditing would involve unreasonable effort or expense, only an audited balance
sheet is needed. When a limited partnership issuer finds that auditing involves
unreasonable effort or expense, the limited partnership may use financial statements
prepared by an independent accountant in conformance with the requirements of federal
tax law.
Rule 506 prohibits the issuer from making any general public selling effort, unless
all the purchasers are accredited, preventing the issuer from using the radio,
newspapers, and television. However, offers to an individual one-on-one are permitted.
In addition, the issuer must take reasonable steps to ensure that the purchasers do
not resell the securities in a manner that makes the issuance a public distribution rather
than a private one. Usually, the investor must hold the security for a minimum of six
months.
In the Mark case, the issuer failed to prove it was entitled to a private offering
exemption under Rule 506. The case features the improper use of an investment or
suitability letter.
Mark v. FSC Securities Corp.870 F.2d 331 (6th Cir. 1989)
FSC Securities Corp., a securities brokerage, sold limited partnership interests in the Malaga Arabian Limited Partnership to Mr.
and Mrs. Mark. A total of 28 investors purchased limited partnership interests in Malaga. All investors were asked to execute
subscription documents, including a suitability or investment letter in which the purchaser stated his income level, that he had an
opportunity to obtain relevant information, and that he had sufficient knowledge and experience in business affairs to evaluate the
risks of the investment.
When the value of the limited partnership interests fell, the Marks sued FSC to rescind their purchase on the grounds that
FSC sold unregistered securities in violation of the Securities Act of 1933. The jury held that the offering was exempt as an offering
not involving a public offering. The Marks appealed.
Simpson, Judge
Section 4(2) [now 4(2)] of the Securities Act exempts from registration with the SEC “transactions by an issuer not involving any
public offering.” There are no hard and fast rules for determining whether a securities offering is exempt from registration under
the general language of Section 4(2).
However, the “safe harbor” provision of Regulation D, Rule 506, deems certain transactions to be not involving any public
offering within the meaning of Section 4(2). FSC had to prove that certain objective tests were met. These conditions include the
general conditions not in dispute here, and the following specific conditions:
(i) Limitation on number of purchasers. The issuer shall reasonably believe that there are no more than thirty-five purchasers
of securities in any offering under this Section.
(ii) Nature of purchasers. The issuer shall reasonably believe immediately prior to making any sale that each purchaser who
is not an accredited investor either alone or with his purchaser representative(s) has such knowledge and experience in financial
and business matters that he is capable of evaluating the merits and risks of the prospective investment.
In this case, we take the issuer to be the general partners of Malaga. FSC is required to offer evidence of the issuer’s reasonable
belief as to the nature of each purchaser. The only testimony at trial competent to establish the issuer’s belief as to the nature of the
purchasers was that of Laurence Leafer, a general partner in Malaga. By his own admission, he had no knowledge about any
purchaser, much less any belief, reasonable or not, as to the purchasers’ knowledge and experience in financial and business matters.
Q: What was done to determine if investors were, in fact, reasonably sophisticated?
A: Well, there were two things. Number one, we had investor suitability standards that had to be met. You had to have a
certain income, be in a certain tax bracket, this kind of thing. Then in the subscription documents themselves, they, when they sign
it, supposedly represented that they had received information necessary to make an informed investment decision, and that they
were sophisticated. And if they were not, they relied on an offering representative who was.
Q: Did you review the subscription documents that came in for the Malaga offering?
A: No.
page 45-15 Q: So do you know whether all of the investors in the Malaga offering met the suitability and sophistication
requirements?
A: I don’t.
FSC also offered as evidence the Marks’ executed subscription documents, as well as a set of documents in blank, to establish
the procedure it followed in the Malaga sales offering. Although the Marks’ executed documents may have been sufficient to
establish the reasonableness of any belief the issuer may have had as to the Marks’ particular qualifications, that does not satisfy
Rule 506. The documents offered no evidence from which a jury could conclude the issuer reasonably believed each purchaser was
suitable. Instead, all that was proved was the sale of 28 limited partnership interests, and the circumstances under which those sales
were intended to have been made. The blank subscription documents simply do not amount to probative evidence, when it is the
answers and information received from purchasers that determine whether the conditions of Rule 506 have been met.
Having concluded that the Malaga limited-partnership offering did not meet the registration exemption requirement of Rule 506 of
Regulation D, we conclude that the Marks are entitled to the remedy of rescission.
Judgment reversed in favor of the Marks; remanded to the trial court.
Small Offering Exemptions
For example, several SEC rules and regulations permit an issuer to sell small amounts of securities
and avoid registration. Section 3(b)(1) of the 1933 Act permits the SEC to exempt from registration
any offering by an issuer not exceeding $5 million. The Jumpstart Our Business Startups Act
(JOBS Act) amended the 1933 Act in Sections 3(b)(2) and 4(a)(6) to permit the SEC to exempt
offerings up to $1 million, under some conditions. The rationale for these exemptions is that the
dollar amount of the securities offered or the number of purchasers is too small for the federal
government to be concerned with registration. State securities law may require registration,
however.
Rule 504 SEC Rule 504 of Regulation D allows a nonpublic issuer to sell up to $5 million of
securities in a 12-month period and avoid registration. Rule 504 sets no limits on the number of
offerees or purchasers. The purchasers need not be sophisticated in investment matters, and the
issuer need disclose information only as required by state securities law. Rule 504 permits general
selling efforts, and purchasers are free to resell the securities at any time but only if the issuer
either registers the securities under state securities law or sells only to accredited investors pursuant
to a state securities law exemption.
Regulation A Regulation A allows issuers to offer and sell securities to the public, but with more
limited disclosure requirements than generally required. The motivation behind the exemption is
that smaller issuers in earlier stages of development may be able to raise money more costeffectively.
Under Regulation A, issuers can raise money under two different tiers. Issuers are required to
indicate the tier under which the offering is being conducted. Tier 1 issuers can raise up to $20
million in any 12-month period, but their offering circular must be filed with the SEC and securities
regulators in the states where the offering is being conducted. The financial statements disclosed
are not required to be audited. There are no limitations on who can invest or how much under Tier
1.
Tier 2 issuers can offer up to $50 million in any 12-month period, and their offering is subject
to review and qualification only by the SEC, but financial statements disclosed must be
independently audited. Tier 2 also limits those who can purchase securities and in what amounts.
Accredited investors are not limited. Unaccredited entities are limited based on annual revenues
and net assets. Unaccredited individual investors can invest up to no more than 10% of the greater
of their annual income or net worth (excluding the value of the person’s primary residence and any
loans secured by the residence).
Regulation A’s disclosure requirements also differ depending on the tier. Issuers relying on
Tier 1 do not have ongoing reporting obligations other than filing a final report on the status of the
offering. Tier 2 issuers have detailed ongoing reporting obligations for various disclosure forms.
For example, an issuer must file an annual report within 120 days after the end of the fiscal year
that includes audited financial statements for the year, a discussion of the company’s financial
results for the year, and information about the company’s business and management, related-party
transactions, and share ownership. Issuers that already publicly report, such as companies that are
listed on a stock exchange, will be deemed to have met their Regulation A disclosure obligations
by remaining current in their disclosures.
page 45-16
The JOBS Act and Regulation Crowdfunding The JOBS Act authorizes the SEC to exempt
from 1933 Act registration the use of crowdfunding to offer and sell securities. The intent of the
JOBS Act is to make it easier for startups and small businesses to raise capital from a wider range
of potential investors and to provide more investment opportunities for investors. The JOBS Act
restricts crowdfunding to emerging growth companies, that is, those with less than $1 billion in
total annual gross revenues. Investment companies, non-U.S. companies, and companies already
required to file reports under the 1934 Act are not eligible to use the JOBS Act exemptions.
The JOBS Act established the foundation for a regulatory structure that would permit
emerging growth companies to use crowdfunding and directed the SEC to write rules
implementing the exemption. It also created a new entity—a funding portal—to allow Internetbased platforms or intermediaries to facilitate the offer and sale of securities without having to
register with the SEC as brokers.
Under Regulation Crowdfunding, the regulation flowing from the JOBS Act, an issuer is
limited in the amount of money it can raise to a maximum of $1 million in a 12-month period.
Although there are no limits on the number of investors, individuals are only permitted over the
course of a 12-month period to invest
• $2,000 or 5 percent of their annual income or net worth, whichever is greater, if both their
annual income and net worth are less than $100,000 or
• 10 percent of their annual income or net worth, whichever is greater, if either their annual
income or net worth is equal to or more than $100,000. During the 12-month period, these
investors would not be able to purchase more than $100,000 of securities through
crowdfunding.
Regulation Crowdfunding requires an issuer to file certain information with the SEC, provide
it to investors and the broker-dealers or portals facilitating the crowdfunding offering, and make it
available to potential investors. In its offering documents, the issuer must disclose the following:
• A description of the issuer’s business and the use of the proceeds from the offering.
• Information about the issuer’s officers and directors as well as owners of 20 percent or more
of the issuer’s equity securities.
• The price to the public of the securities being offered, the target offering amount, the deadline
to reach the target offering amount, and whether the issuer will accept investments in excess
of the target offering amount.
• A description of the financial condition of the issuer.
• Financial statements of the issuer that, depending on the amount offered and sold during a 12month period, would have to be accompanied by a copy of the issuer’s tax returns or reviewed
or audited by an independent public accountant or auditor.
One of the key investor protections of the JOBS Act is the requirement that crowdfunding
transactions take place through an SEC-registered intermediary: either a broker-dealer or a funding
portal. Under Regulation Crowdfunding, the offerings occur exclusively online through a platform
operated by a registered broker or a funding portal. These intermediaries, then, must
• Provide investors with educational materials.
• Take measures to reduce the risk of fraud.
• Make available information about the issuer and the offering.
• Provide communication channels to permit discussions about offerings on the platform.
• Facilitate the offer and sale of crowdfunded securities.
The regulation prohibits funding portals from offering investment advice or making
recommendations, soliciting purchases or sales of securities on its website, and holding or
processing investor assets. Regulation Crowdfunding also imposes certain restrictions on
compensating people for solicitations but does allow issuers to make general solicitations to
prospective investors.
Transaction Exemptions for Nonissuers Although it is true that the registration provisions
apply primarily to issuers and those who help issuers sell their securities publicly, the 1933 Act
states that every person who sells a security is potentially subject to Section 5’s restrictions on the
timing of offers and sales. This highlights the most important rule of the 1933 Act: Every
transaction in securities must be registered with the SEC or be exempt from registration.
This rule applies to every person, including the small investor who, through the New York
Stock Exchange, sells securities that may have been registered by the issuer 15 years earlier. The
small investor must either have the issuer register her sale of securities or find an exemption from
registration that applies to the situation. Fortunately, most small investors who resell securities will
have an exemption from the registration requirements of the 1933 Act. The transaction ordinarily
used by these resellers is Section 4(a)(1) of the 1933 Act. It provides an exemption for
“transactions by any person other than an issuer, underwriter, or dealer.”
For example, if you buy GM common shares on the New York Stock Exchange, you may
freely resell them without a page 45-17 registration. You are not an issuer (GM is). You are not a
dealer (because you are not in the business of selling securities). And you are not an underwriter
(because you are not helping GM distribute the shares to the public).
Application of this exemption when an investor sells shares that are already publicly traded is
easy; however, it is more difficult to determine whether an investor can use this exemption when
the investor sells restricted securities.
Sale of Restricted Securities Restricted securities are securities issued pursuant to
regulations that limit their resale. Restricted securities are supposed to be held by a
purchaser unaffiliated with the issuer for at least six months if the issuer is a public
company and one year if the issuer is not public. If they are sold earlier, the investor
may be deemed an underwriter who has assisted the issuer in selling the securities to
the general public. Consequently, both the issuer and the investor may have violated
Section 5 of the 1933 Act by selling nonexempted securities prior to a registration of
the securities with the SEC. As a result, all investors who purchased securities from the
issuer in the exempted offering may have the remedy of rescission under Section
12(a)(1), resulting in the issuer being required to return to investors all the proceeds of
the issuance.
For example, an investor buys 10,000 common shares issued by Arcom Corporation
pursuant to a Rule 506 private offering exemption. One month later, the investor sells
the securities to 40 other investors. The original investor has acted as an underwriter
because he has helped Arcom distribute the shares to the public. The original investor
may not use the issuer’s private offering exemption because it exempted only the
issuer’s sale to him. As a result, both the original investor and Arcom have violated
Section 5. The 40 investors who purchased the securities from the original investor—
and all other investors who purchased common shares from the issuer in the Rule 506
offering—may rescind their purchases under Section 12(a)(1) of the 1933 Act,
receiving from their seller the return of their investment.
Ethics and Compliance in Action
JOBS Act: Ethics of Crowdfunding
While the intent of the JOBS Act seems laudatory—to make it easier for startups and small businesses to raise capital from a wider
range of potential investors—it is not without its detractors. Critics charge that unless Congress reforms or repeals the law, securities
crowdfunding is destined to do little more than separate mom-and-pop investors from their savings. Here’s why:
From an investor’s perspective, crowdfunding operates most like angel investing. Yet most crowdfunding investors will not
act like successful angel investors, who invest in industries they know, exercise due diligence, spend time mentoring the companies
they invest in, and diversify their investments. Even so, the majority of angel investments fail. Angel investors earn a profit only
because the small percentage of successful companies make enough money to offset failures.
Moreover, crowdfunding’s extensive registration and disclosure requirements not only poorly protect investors but also
heavily regulate businesses. The SEC estimates that it would cost $39,000 in fees to accountants, lawyers, and the funding portal
to raise just $100,000 and more than $150,000 to raise $1 million. Those capital costs are so high that companies would be better
off financing their operations with a MasterCard or VISA. For comparison, consider that underwriting fees for large public offerings
are usually under 4 percent.
Compared to the registration exemptions under Regulation D, crowdfunding is a poor alternative. Not only are Regulations
D’s disclosure requirements limited, but it also lets a company raise an unlimited amount of capital from an unlimited number of
investors, provided those investors are accredited. That leaves only desperate companies using the crowdfunding rules, ones that
cannot use better and cheaper exemptions from the registration provisions of the 1933 Act.
Against these criticisms, proponents of the JOBS Act point to the following: 8
•
Women have traditionally received venture capital funding at lower rates than men. One goal of the JOBS Act was to increase
opportunities for female-led companies to raise capital. In a recent study, 28 percent of crowdfunding companies have a woman
on their executive team, which is approximately double the percentage found in the traditional venture capital world.
•
An additional goal of the JOBS Act was to geographically diversify entrepreneurs by providing them a way to seek venture
capital without relocating to Silicon Valley. Some data show that companies from 44 different states participated in equity
crowdfunding campaigns in recent years, suggesting that crowdfunding is living up to its promise of overcoming geographic
constraints.
•
Small and young startup companies were a particular focus of the JOBS Act. Data indicate that many crowdfunding companies
were founded very recently (40 percent were under one year old at the time of key filings), and the median age of a crowdfunding
company was 1.5 years. Crowdfunding companies are also very small, with a majority (55 percent) having three or fewer
employees.
Given these competing perspectives, do you see the JOBS Act as overall positive or negative?
Would you use crowdfunding to raise equity capital for your business?
Would you invest your own money through crowdfunding?
If you were an investment adviser, would you recommend that a client invest through crowdfunding?
page 45-18
CONCEPT REVIEW
Issuer’s Exemptions from the Registration Requirements of the Securities Act of
1933
Ethics and Compliance in Action
Section 5 of the 1933 Act and many of the exemptions from registration put severe limits on an issuer’s ability to inform
prospective investors during a registered or exempted offering. For example, during the quiet period of a registered offering, the
SEC takes a dim view of an issuer’s attempt to publicize itself and its business. Rule 506(b) of Regulation D prohibits general
solicitations.
•
Are those limitations consistent with the principles of a country that has a market-based economy and elevates freedom of speech
to a constitutional right? Would a rights theorist support American securities law? How about a profit maximizer?
•
Might a believer in justice theory view be more likely to support American law regulating issuances of securities? Whom would
a justice theorist want to see protected?
•
Who is the typical securities purchaser? Is it not someone from the wealthier classes of citizens? Is securities regulation welfare
for the wealthy?
Note that Section 5 of the 1933 Act does not require that investors receive a preliminary prospectus during the waiting period.
In fact, an issuer can completely avoid giving investors a prospectus until a sale is confirmed during the post-effective period. That
means an investor may not receive a prospectus until he has made his purchase decision. Moreover, many investors find the
prospectus overwhelming to read, and if they do read it, it is often couched in legalese that is difficult to understand. Finally, the
prospectus mostly comprises historical information. It is more correctly a “retrospectus,” not a prospectus, and contains information
that is already in the marketplace. Yet professionals like auditors and investment bankers make millions of dollars by being involved
in the preparation of the prospectus, which is not received by investors at the right time, not read, not readable, and not relevant to
investment decisions.
•
Is it ethical for professionals to profit enormously from their role of putting together a prospectus that provides little real value
to investors?
SEC Rule 144 allows purchasers of restricted securities to resell the securities and not be
deemed underwriters. The resellers must hold the securities for at least six months if the securities
issuer is a public company and for one year if the issuer is nonpublic, after which the investors
may sell all or part of the restricted securities. After the passage of those time periods, investors
not affiliated with the issuer may sell all or part of the restricted securities they hold. For investors
affiliated with the issuers, such as an officer or director, the rules are more complex. In any threemonth period, the affiliated reseller may sell only a limited number of securities—the greater of 1
percent of the outstanding securities or the average weekly volume of trading. The reseller must
file a notice (Form 144) with the SEC.
Consequence of Obtaining a Securities or Transaction Exemption When an issuer has
obtained an exemption from the registration provisions of the 1933 Act, the Section 5 limits on
when and how offers and sales may be made do not apply. Consequently, Section 12(a)(1)’s
remedy of rescission or damages is unavailable to an investor who has purchased securities in an
exempt offering.
When an issuer has attempted to comply with a registration exemption and has failed to do
so, any offer or sale of securities by the issuer may violate Section 5. Because the issuer has offered
or sold nonexempted securities prior to filing a registration statement with the SEC, any purchaser
may sue the issuer under Section 12(a)(1) of the 1933 Act.
Although the registration provisions of the 1933 Act do not apply to an exempt offering, the
antifraud provisions of the 1933 Act and 1934 Act, which are discussed later, are applicable. For
example, when an issuer gives false information to a purchaser in a Rule 504 offering, the issuer
may have violated the antifraud provisions of the two acts. The purchaser may obtain damages
from the issuer under the antifraud rules even though the transaction is exempt from registration.
Liability Provisions of the 1933 Act
LO45-5
Engage in behavior that avoids liability under the federal securities laws.
To deter fraud, deception, and manipulation and to provide remedies to the victims of such
practices, Congress included a number of liability provisions in the Securities Act of 1933.
page 45-21
Liability for Defective Registration Statements Section 11 of the 1933 Act provides civil
liabilities for damages when a 1933 Act registration statement on its effective date misstates or
omits a material fact. A purchaser of securities issued pursuant to the defective registration
statement may sue certain classes of persons that are listed in Section 11—the issuer, its chief
executive officer, its chief accounting officer, its chief financial officer, the directors, other signers
of the registration statement, the underwriter, and experts who contributed to the registration
statement (such as auditors who issued opinions regarding the financial statements or lawyers who
issued an opinion concerning the tax aspects of a limited partnership). The purchaser’s remedy
under Section 11 is for damages caused by the misstatement or omission. Damages are presumed
to be equal to the difference between the purchase price of the securities less the price of the
securities at the time of the lawsuit.
Section 11 is a radical liability section for three reasons. First, reliance is usually not required;
that is, the purchaser need not show that she relied on the misstatement or omission in the
registration statement. In fact, the purchaser need not have read the registration statement or have
seen it. Second, privity is not required; that is, the purchaser need not prove that she purchased the
securities from the defendant. All she has to prove is that the defendant is in one of the classes of
persons liable under Section 11. Third, the purchaser need not prove that the defendant negligently
or intentionally misstated or omitted a material fact. In other words, investors are not required to
show scienter. However, defendant who otherwise would be liable under Section 11 may escape
liability by proving that he exercised due diligence.
Section 11 Defenses A defendant can escape liability under Section 11 by proving that the
purchaser knew of the misstatement or omission when she purchased the security. In addition, a
defendant may raise the due diligence defense. It is the more important of the two defenses.
Any defendant except the issuer may escape liability under Section 11 by proving that he acted
with due diligence in determining the accuracy of the registration statement. The due diligence
defense basically requires the defendant to prove that he was not negligent. The exact defense
varies, however, according to the class of defendant and the portion of the registration statement
that is defective. Most defendants must prove that after a reasonable investigation they
had reasonable grounds to believe and did believe that the registration statement was true and
contained no omission of material fact.
page 45-22
CONCEPT REVIEW
Due Diligence Defenses under Section 11 of the 1933 Act
For Expertised Portion of the
Registration Statement
For Nonexpertised Portion of the
Registration Statement
Expert
Liable only for the
expertised portion of
the registration
statement contributed
by the expert.
Examples:
Auditor that issues an
audit opinion regarding
financial statements
Geologist that issues an
opinion regarding
mineral reserves
Lawyer that issues a tax
opinion regarding the
tax deductibility of
losses
After a reasonable investigation, had
reason to believe and did believe that
there were no misstatements or
omissions of material fact in the
expertised portion of the registration
statement contributed by the expert.
Not liable for this portion of the
registration statement.
Had no reason to believe and did not
believe that there were any
misstatements or omissions of material
fact in the expertised portions of the
registration statement.
After a reasonable investigation, had
reason to believe and did believe that
there were no misstatements or
omissions of material fact in the
nonexpertised portion of the
registration statement.
Nonexpert
Liable for the entire
registration statement.
Examples:
Directors of the issuer
CEO, CFO, and CAO
of the issuer
Underwriters who
assist in the sale of the
securities and help
prepare the registration
statement
Experts need to prove due diligence only in respect to the parts that they have contributed. For
example, independent auditors must prove due diligence in ascertaining the accuracy of financial
statements for which they issue opinions. Due diligence requires that an auditor at least comply
with generally accepted auditing standards (GAAS). Experts are those who issue an opinion
regarding information in the registration statement. For example, auditors of financial statements
are experts under Section 11 because they issue opinions regarding the ability of the financial
statements to present fairly the financial position of the companies they have audited. A geologist
who issues an opinion regarding the amount of oil reserves held by an energy company is a Section
11 expert if her opinion is included in a registration statement filed by the limited partnership.
Nonexperts meet their due diligence defense for parts contributed by experts if they had no
reason to believe and did not believe that the expertised parts misstated or omitted any material
fact. This defense does not require the nonexpert to investigate the accuracy of expertised portions,
unless something alerted the nonexpert to problems with the expertised portions.
Due Diligence Meeting Officers, directors, underwriters, accountants, and other experts attempt
to reduce their Section 11 liability by holding a due diligence meeting at the end of the waiting
period, just prior to the effective date of a registration statement. At the due diligence meeting, the
participants obtain assurances and demand proof from each other that the registration statement
contains no misstatements or omissions of material fact. If it appears from the meeting that there
are inadequacies in the investigation of the information in the registration statement, the issuer will
delay the effective date until an appropriate investigation is undertaken.
The BarChris case is the most famous case construing the due diligence defense of Section
11.
Escott v. BarChris Construction Corp.283 F. Supp. 643 (S.D.N.Y. 1968)
BarChris Construction Corporation was in the business of constructing bowling centers. With the introduction of automatic
pinsetters in 1952, there was a rapid growth in the popularity of bowling, and BarChris’s sales increased from $800,000 in 1956
to more than $9 million in 1960. By 1960, it was building about 3 percent of the lanes constructed, while Brunswick Corporation
and AMF were building 97 percent. BarChris contracted with its customers to construct and equip bowling alleys for them. Under
the contracts, a customer was required to make a small down payment in cash. After the alleys were constructed, customers gave
BarChris promissory notes for the balance of the purchase price. BarChris discounted the notes with a “factor,” an intermediary
agent that finances receivables. The factor kept part of the face value of the notes as a reserve until the customer paid the notes.
BarChris was obligated to repurchase the notes if the customer defaulted.
In 1960, BarChris offered its customers an alternative financing method in which BarChris sold the interior of a bowling
alley to a factor, James Talcott Inc. Talcott then leased the alley either to a BarChris customer (Type A financing) or to a BarChris
subsidiary that then subleased to the customer (Type B financing). Under Type A financing, BarChris guaranteed 25 percent of the
customer’s obligation under the lease. With Type B financing, BarChris guaranteed 100 percent of its subsidiary’s lease
obligations. Under either financing method, BarChris made substantial expenditures before receiving payment from customers
and, therefore, experienced a constant need of cash.
In early 1961, BarChris decided to issue debentures and to use part of the proceeds to help its cash position. In March 1961,
BarChris filed with the SEC a registration statement covering the debentures. The registration statement became effective on May
16. The proceeds of the offering were received by BarChris on May 24, 1961. By that time, BarChris had difficulty collecting from
some of its customers, and other customers were in arrears on their payments to the factors of the discounted notes. Due to
overexpansion in the bowling alley industry, many BarChris customers failed. On October 29, 1962, BarChris filed a petition for
bankruptcy. On November 1, it defaulted on the payment of interest on the debentures.
Escott and other purchasers of the debentures sued BarChris and its officers, directors, and auditors, among others, under
Section 11 of the Securities Act of 1933. BarChris’s registration statement contained material misstatements and omitted material
facts. It overstated current assets by $609,689 (15.6 percent), sales by $653,900 (7.7 percent), and earnings per share by 10 cents
(15.4 percent) in the 1960 balance sheet and income statement audited by Peat, Marwick, Mitchell & Co. The registration statement
also understated BarChris’s contingent liabilities by $618,853 (42.8 percent) as of April 30, 1961. It overstated gross profit for the
first quarter of 1961 by $230,755 (92 percent) and sales for the first quarter of 1961 by $519,810 (32.1 percent). The March 31,
1961, backlog was overstated by $4,490,000 (186 percent). The 1961 figures were not audited by Peat, Marwick.
page 45-23
In addition, the registration statement reported that prior loans from officers had been repaid but failed to disclose that
officers had made new loans to BarChris totaling $386,615. BarChris had used $1,160,000 of the proceeds of the debentures to
pay old debts, a use not disclosed in the registration statement. BarChris’s potential liability of $1,350,000 to factors due to
customer delinquencies on factored notes was not disclosed. The registration statement represented BarChris’s contingent liability
on Type B financings as 25 percent instead of 100 percent. It misrepresented the nature of BarChris’s business by failing to disclose
that BarChris was already engaged and was about to become more heavily engaged in the operation of bowling alleys, including
one called Capitol Lanes, as a way of minimizing its losses from customer defaults.
Trilling, BarChris’s controller, signed the registration statement. Auslander, a director, signed the registration statement.
Peat, Marwick consented to being named as an expert in the registration statement. All three would be liable to Escott unless they
could meet the due diligence defense of Section 11.
McLean, District Judge
The question is whether Trilling, Auslander, and Peat, Marwick have proved their due diligence defenses. The position of each
defendant will be separately considered.
Trilling
Trilling was BarChris’s controller. He signed the registration statement in that capacity. Trilling entered BarChris’s employ in
October 1960. He was Kircher’s [BarChris’s treasurer] subordinate. When Kircher asked him for information, he furnished it.
Trilling was not a member of the executive committee. He was a comparatively minor figure in BarChris. The description of
BarChris’s management in the prospectus does not mention him. He was not considered to be an executive officer.
Trilling may well have been unaware of several of the inaccuracies in the prospectus. But he must have known of some of
them. As a financial officer, he was familiar with BarChris’s finances and with its books of account. He knew that part of the cash
on deposit on December 31, 1960, had been procured temporarily by Russo [BarChris’s executive vice president] for windowdressing purposes. He knew that BarChris was operating Capitol Lanes in 1960. He should have known, although perhaps through
carelessness he did not know at the time, that BarChris’s contingent liability on Type B lease transactions was greater than the
prospectus stated. In the light of these facts, I cannot find that Trilling believed the entire prospectus to be true.
But even if he did, he still did not establish his due diligence defenses. He did not prove that as to the parts of the prospectus
expertised by Peat, Marwick he had no reasonable ground to believe that it was untrue. He also failed to prove, as to the parts of
the prospectus not expertised by Peat, Marwick, that he made a reasonable investigation which afforded him a reasonable ground
to believe that it was true. As far as appears, he made no investigation. He did what was asked of him and assumed that others
would properly take care of supplying accurate data as to the other aspects of the company’s business. This would have been well
enough but for the fact that he signed the registration statement. As a signer, he could not avoid responsibility by leaving it up to
others to make it accurate. Trilling did not sustain the burden of proving his due diligence defenses.
Auslander
Auslander was an outside director, i.e., one who was not an officer of BarChris. He was chairman of the board of Valley Stream
National Bank in Valley Stream, Long Island. In February 1961, Vitolo [BarChris’s president] asked him to become a director of
BarChris. In February and early March 1961, before accepting Vitolo’s invitation, Auslander made some investigation of BarChris.
He obtained Dun & Bradstreet reports that contained sales and earnings figures for periods earlier than December 31, 1960. He
caused inquiry to be made of certain of BarChris’s banks and was advised that they regarded BarChris favorably. He was informed
that inquiry of Talcott had also produced a favorable response.
On March 3, 1961, Auslander indicated his willingness to accept a place on the board. Shortly thereafter, on March 14,
Kircher sent him a copy of BarChris’s annual report for 1960. Auslander observed that BarChris’s auditors were Peat, Marwick.
They were also the auditors for the Valley Stream National Bank. He thought well of them.
Auslander was elected a director on April 17, 1961. The registration statement in its original form had already been filed, of
course without his signature. On May 10, 1961, he signed a signature page for the first amendment to the registration statement
which was filed on May 11, 1961. This was a separate sheet without any document attached. Auslander did not know that it was a
signature page for a registration statement. He vaguely understood that it was something “for the SEC.”
At the May 15 directors’ meeting, however, Auslander did realize that what he was signing was a signature sheet to a
registration statement. This was the first time that he had appreciated the fact. A copy of the registration statement in its earlier
form as amended on May 11, 1961, was passed around at the meeting. Auslander glanced at it briefly. He did not read it thoroughly.
At the May 15 meeting, Russo and Vitolo stated that everything was in order and that the prospectus was correct. Auslander
believed this statement.
page 45-24
In considering Auslander’s due diligence defenses, a distinction must be drawn between the expertised and nonexpertised
portions of the prospectus. As to the former, Auslander knew that Peat, Marwick had audited the 1960 figures. He believed them
to be correct because he had confidence in Peat, Marwick. He had no reasonable ground to believe otherwise.
As to the nonexpertised portions, however, Auslander is in a different position. He seems to have been under the impression
that Peat, Marwick was responsible for all the figures. This impression was not correct, as he would have realized if he had read
the prospectus carefully. Auslander made no investigation of the accuracy of the prospectus. He relied on the assurance of Vitolo
and Russo, and upon the information he had received in answer to his inquiries back in February and early March. These inquiries
were general ones, in the nature of a credit check. The information which he received in answer to them was also general, without
specific reference to the statements in the prospectus, which was not prepared until some time thereafter.
It is true that Auslander became a director on the eve of the financing. He had little opportunity to familiarize himself with
the company’s affairs. The question is whether, under such circumstances, Auslander did enough to establish his due diligence.
Section 11 imposes liability upon a director, no matter how new he is. He is presumed to know his responsibility when he
becomes a director. He can escape liability only by using that reasonable care to investigate the facts that a prudent man would
employ in the management of his own property. In my opinion, a prudent man would not act in an important matter without any
knowledge of the relevant facts, in sole reliance upon general information which does not purport to cover the particular case. To
say that such minimal conduct measures up to the statutory standard would, to all intents and purposes, absolve new directors from
responsibility merely because they are new. This is not a sensible construction of Section 11, when one bears in mind its
fundamental purpose of requiring full and truthful disclosure for the protection of investors.
Auslander has not established his due diligence defense with respect to the misstatements and omissions in those portions of
the prospectus other than the audited 1960 figures.
Peat, Marwick
The part of the registration statement purporting to be made upon the authority of Peat, Marwick as an expert was the 1960 figures.
But because the statute requires the court to determine Peat, Marwick’s belief, and the grounds thereof, “at the time such part of
the registration statement became effective,” for the purposes of this affirmative defense, the matter must be viewed as of May 16,
1961, and the question is whether at that time Peat, Marwick, after reasonable investigation, had reasonable ground to believe and
did believe that the 1960 figures were true and that no material fact had been omitted from the registration statement which should
have been included in order to make the 1960 figures not misleading. In deciding this issue, the court must consider not only what
Peat, Marwick did in its 1960 audit, but also what it did in its subsequent S—1 review. The proper scope of that review must also
be determined.
The 1960 Audit
Peat, Marwick’s work was in general charge of a member of the firm, Cummings, and more immediately in charge of Peat,
Marwick’s manager, Logan. Most of the actual work was performed by a senior accountant, Berardi, who had junior assistants,
one of whom was Kennedy.
Berardi was then about 30 years old. He was not yet a CPA. He had had no previous experience with the bowling industry.
This was his first job as a senior accountant. He could hardly have been given a more difficult assignment.
It is unnecessary to recount everything that Berardi did in the course of the audit. We are concerned only with the evidence
relating to what Berardi did or did not do with respect to those items which I have found to have been incorrectly reported in the
1960 figures in the prospectus. More narrowly, we are directly concerned only with such of those items as I have found to be
material.
First and foremost is Berardi’s failure to discover that Capitol Lanes had not been sold. This error affected both the sales
figure and the liability side of the balance sheet. Fundamentally, the error stemmed from the fact that Berardi never realized that
Heavenly Lanes and Capitol were two different names for the same alley. Berardi assumed that Heavenly was to be treated like
any other completed job.
Berardi read the minutes of the board of directors meeting of November 22, 1960, which recited that “the Chairman
recommended that the Corporation operate Capitol Lanes.” Berardi knew from various BarChris records that Capitol Lanes, Inc.,
was paying rentals to Talcott. Also, a Peat, Marwick work paper bearing Kennedy’s initials recorded that Capitol Lanes, Inc., held
certain insurance policies.
Berardi testified that he inquired of Russo about Capitol Lanes and that Russo told him that Capitol Lanes, Inc., was going
to operate an alley someday but as yet it had no alley. Berardi testified that he understood that the alley had not been built and that
he believed that the rental payments were on vacant land.
I am not satisfied with this testimony. If Berardi did hold this belief, he should not have held it. The entries as to insurance
and as to “operation of alley” should have alerted him to the fact that an alley existed. He should have made further inquiry on the
subject. It is apparent that Berardi did not understand this transaction.
He never identified this mysterious Capitol with the Heavenly Lanes which he had included in his sales and profit figures.
The vital question is whether he failed to make a reasonable investigation which, if he had made it, would have revealed the truth.
Certain accounting records of BarChris, which Berardi testified he did not see, would have put him on inquiry. One was a
job cost ledger card for job no. 6036, the job number which Berardi put on his own sheet for Heavenly Lanes. This card read
“Capitol Theatre (Heavenly).” In addition, two accounts receivable cards each showed both names on the same card, Capitol and
Heavenly. Berardi testified that he looked at the accounts receivable records but that he did not see these particular cards. He
testified that he did not look on the job cost ledger cards because he took the costs from another record, the costs register.
The burden of proof on this issue is on Peat, Marwick. Although the question is a rather close one, I find that Peat, Marwick
has not sustained that burden. Peat, Marwick has not proved that Berardi made a reasonable investigation as far as Capitol Lanes
was concerned and that his ignorance of the true facts was justified.
I turn now to the errors in the current assets. As to cash, Berardi properly obtained a confirmation from the ba…
