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Ken Hastings is hosting a backyard cookout for some of his neighbors. One of the invitees is Steve Chen, whose wife, Judith Chen, is the CEO of New World Industries. During the cookout, Steve received a call from his wife, who is out of town on business.
Upon returning to the barbecue after the call, Steve’s demeanor has clearly changed and he seems unusually happy. Ken and Tim Daniels listen to what Steve reports. Steve tells his neighbors that Judith was out of town working on a very important settlement, and that her efforts have paid off.
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.
1
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.Investors lacked the necessary information to make intelligent decisions whether to buy,
sell, or hold securities.
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
LO45-1Understand 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.To require the disclosure of meaningful information about a security and its issuer to allow
investors to make intelligent investment decisions.
2.To impose liability on those persons who make inadequate and erroneous disclosures of
information.
3.To regulate insiders, professional sellers of securities, securities exchanges, and other selfregulatory 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.
2
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
LOG ON
https://lawblogs.uc.edu/sld/
The Securities Lawyer’s Deskbook is maintained by the Robert S. Marx Law Library at the
University of Cincinnati College of Law. You can find the text of all the federal securities
statutes and SEC regulations.
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.
3
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
4
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 noaction 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?
LO45-2Define 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.
5
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 three-part 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 45-5led
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
6
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.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
7
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 456However, 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, timebarred 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
8
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
9
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.
Securities Act of 1933
LO45-1Understand why and demonstrate how the law regulates issuances and issuers of securities.
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.
LO45-3Comply 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
10
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 45-8and 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
11
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 pre-filing 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 prefiling period is to prevent premature communications about an issuer and its securities, which may
12
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 pre-filing
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.
Securities Act of 1933
LO45-1Understand why and demonstrate how the law regulates issuances and issuers of securities.
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.
13
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.
LO45-3Comply 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.
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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 45-8and 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
15
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 pre-filing 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 prefiling 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 pre-filing
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.
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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.
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Exemptions from the Registration Requirements of the 1933 Act
LO45-4List 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.Securities issued or guaranteed by any government in the United States and its territories.
2.A note or draft that has a maturity date not more than nine months after its date of issuance.
3.A security issued by a nonprofit religious, charitable, educational, benevolent, or fraternal
organization.
4.Securities issued by banks and by savings and loan associations.
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.
18
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 in-state
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 out-of-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
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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 45-14nonfinancial 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.
mall Offering Exemptions
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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
21
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 Internet-based 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.
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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 45-17registration. 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).
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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.
