Question

One of your firm's clients, Fancy Fashions Inc., is a highly successful, rapidly expanding entity. It is owned predominantly by the Munster family and key corporate officials. Although additional funds would be available on a short-term basis from its bankers, they would represent only a temporary solution to the entity's need for capital to finance its expansion plans. In addition, the interest rates being charged are not appealing. Therefore, Chris Munster, Fancy's chairman of the board, in consultation with the other shareholders, has decided to explore the possibility of raising additional equity capital of approximately $15 million to $16 million. This will be Fancy's first public offering. At a meeting of Fancy's major shareholders, its attorneys and a member of your firm spoke about the advantages and disadvantages of "going public" and registering a stock offering. One of the shareholders suggested that Regulation D under the Securities Act of 1933 might be a preferable alternative. Required: Assume that Fancy makes a public offering for $16 million and, as a result, more than 1,000 persons own shares of the entity. Following the public offering, what are the implications with respect to the Securities Exchange Act of 1934? (Hint: You can identify the thresholds for being subject to the reporting requirements of the Securities Exchange Act of 1934 through reference to the SEC's website, www.sec.gov.)

What federal civil and criminal liabilities under the Securities Act of 1933 could apply if Fancy sells the securities without registration and a registration exemption is not available?

Using the SEC's website (www.sec.gov) as a reference, define "accredited investor" and discuss the exemption applicable to offerings made under Regulation D for accredited investors. Your written response paper should be 3-4 pages in length.

Answer 1

The Securities Litigation Uniform Standards Act of 1998 (“SLUSA”) amended portions of the Securities Act and the Exchange Act to preempt certain class actions that allege fraud under state law. Specifically, SLUSA precludes a private party from bringing a “covered class action” in federal or state court based on state law alleging a “misrepresentation or omission of a material fact” or the use of “any manipulative or deceptive device or contrivance in connection with the purchase or sale of a covered security.” 15 U.S.C. § 78bb(f)(1); see also § 77p(b). “Generally, a ‘covered class action’ involves common questions of law or fact brought on behalf of more than 50 persons or an action brought on behalf of one or more unnamed parties.” Prager v. Knight/Trimark Grp., Inc., 124 F. Supp. 2d 229, 231 (D.N.J. 2000) (citing 15 U.S.C. § 78bb(f)(5)(B)); see also 15 U.S.C. § 77p(f)(2)(A). SLUSA effectively makes federal court the exclusive venue for nearly all securities fraud class actions.

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”), Pub. L. No. 111-203, 124 Stat. 1376 (2010), enacted in response to the financial crisis of 2008-2009. While this law primarily addresses financial regulations and corporate governance issues, it does contain provisions affecting securities law liability, such as increasing exposure to liability under the federal securities laws of credit ratings agencies and establishing new incentives and protections for whistleblowers. With respect to the specific provisions of the federal securities laws covered by this post, Dodd-Frank amended § 20(e) of the Exchange Act to augment the SEC’s authority to pursue civil enforcement actions alleging aiding and abetting of Exchange Act violations by modifying the requisite state of mind to encompass “reckless,” in addition to “knowing,” acts, and adding § 15(b) to the Securities Act to empower the SEC to pursue actions premised on knowingly or recklessly aiding or abetting violations of that act (and adding similar provisions to the Investment Company Act of 1940 and the Investment Advisers Act of 1940). Dodd-Frank §§ 929M, 929N, 929O.

The Securities Act was Congress's opening shot in the war on securities fraud with Congress primarily targeting the issuers of securities. Prior to the Securities Act, states were largely responsible for regulating securities. Companies which issue securities (called issuers) seek to raise money to fund new projects or investments or to expand. These companies need to invest potential investors to invest, and thus the companies have an incentive to present the company in a way that is attractive to investors. The Securities Act serves the dual purpose of ensuring that issuers selling securities to the public disclose material information to investors, and that any securities transactions are not based on fraudulent information or practices. In this context, "material" means information that would affect a reasonable investor's evaluation of the company's stock. The goal is to provide investors with accurate information so that they can make informed investment decisions.

Mandatory Disclosures

The Securities Act effectuates disclosure through a mandatory registration process in any sale of any securities. In reality, due to a number of exemptions for trading on the secondary market and small offerings, the Act is mainly applied to primary market offerings by issuers. Under Section 5 of the Securities Act, all issuers must register non-exempt securities with the Securities and Exchange Commission (SEC). Section 5 regulates the timeline and distribution process for issuers who offer securities for sale. The actual registration process is laid out in Section 6, under which registration entails two parts:  

1. First, the issuer must submit information that will form the basis of the prospectus, to be provided to prospective investors.
2. Second, the issuer must submit additional information that does not go into the prospectus but is accessible to the public.

The SEC rules dictate the appropriate registration form, which depends on the type of issuer and the securities offered. Section 7 gives the SEC full authority to determine what information issuers must submit, but generally included are information about the issuer and the terms of the offered securities that would help investors form a reasoned opinion about the investment. The requirements are extensive, and include descriptions of the issuer's business, past business performance, information about the issuer's officers and managers, audited financial statements of past business performance, executive compensation, risks of the business, tax and legal status, and the terms and information about the securities issued. Often, the issuer will submit the prospectus with the registration statement. All of this information becomes public soon after filing with the SEC, through the SEC's online EDGAR system.

The SEC reviews registration statements to ensure that all required disclosures have been made. Barring glaring deficiencies or omissions, the registration statement is effective within 20 days, per Section 8. The SEC does substantively evaluate the registration statement and prospectus, and can issue "deficiency letters" suggesting changes. Thus, the SEC can aid in shaping disclosure to meet investor needs. Companies tend to comply because the SEC has the power to accelerate the effective date, which allows the company to sell its stock and raise capital earlier. The registration process protects investors in two ways. Issuers cannot offer to sell securities without disclosing information about the company, and developing and delivering a prospectus that the SEC has reviewed. In addition, issuers are liable for any material misstatements or omissions in the prospectus or registration statement, providing a way to enforce truth in disclosure.

Enforcing the Securities Act

SEC actions are the main mechanism for enforcing federal securities laws. The SEC can prosecute issuers and sellers who sell unregistered securities, and under Section 20(b) can seek injunctions if the Securities Act has been violated, or if a violation is imminent. Section 8A also allows the SEC to issue orders to issuers to cease and desist from certain activities, and bar officers and directors who have violated the Securities Act's anti-fraud provisions. Additionally, the SEC can seek civil penalties under Section 20(d) if a party violated the Securities Act, an SEC rule, or a cease-and-desist order.

The SEC may not bring actions on behalf of individual investors, but the Securities Act allows individual investors to bring civil actions under several provisions:

• Section 11 makes issuers liable for registration statements that contain "an untrue statement of a material fact or omit to state a material fact required...to make the statements there in no misleading." Under this provision, a purchaser of the security can bring suit under Section 11, even if he bought the security after the initial offering, on the secondary markets. As long as the purchaser can trace the purchase back to the initial offering and is within the statute of limitations, he can sue - there is no need to prove causation or reliance on the misstatements or omissions. Damages are limited to the difference between the offering price and value of the securities at the time of the lawsuit. Although the purchaser can sue the issuer, underwriter, or subsequent seller, all defendants but the issuer have a "due diligence" defense that they had no grounds to believe the statement had a misstatement or omission.
• Section 5 and Section 12(a)(1) allow purchasers to sue sellers for offering or selling a non-exempt security without registering it. As long as the purchaser can prove a direct link between the purchaser and the seller, and the suit is within the statute of limitations, the purchaser may obtain rescission with interest, or damages if the investor sold his securities for less than he purchased them.
• Section 12(a)(2) creates liability for any person who offers or sells a security through a prospectus or an oral communication containing a material misstatement or omission, is liable to the purchaser for rescission of the purchase or damages, provided that the purchaser did not know about the misstatement or omission at the time of the purchase. Court holdings imply that the cause of action only applies to purchasers in the initial offering, not secondary purchases, but this is not settled law yet. Investors suing under 12(a)(2) can only recover from sellers.
• Section 15 aids investors by making "control persons," or persons who "control" defendants liable under Sections 11 and 12 by owning stock or under agency principals, jointly and severally liable. This helps investors collect damages in cases where the defendant is insolvent or does not have enough money to pay the investor, a frequent situation in securities litigation (most investors sue after their investment has soured).
• Section 17(a) is a key anti-fraud provision in the Securities Act. It provides for liability for fraudulent sales of securities. Some courts have found an implied right of private action under this provision, though this is becoming a less favored position. However, some courts continue to accept private suits under this provision. Section 17(a) makes it unlawful to "employ any device, scheme, or artifice to defraud", "obtain money or property" by using material misstatements or omissions, or to "engage in any transaction, practice, or course of business which operates or would operate as a fraud or deceit upon the purchaser." This provision is closely tracked by Section 10b of the Securities Exchange Act and Rule 10b-5, which is used more widely by investors suing for fraud.
• An accredited investor is a person or entity that can deal with securities not registered with financial authorities by satisfying one of the requirements regarding income, net worth, asset size, governance status or professional experience.

• Because raising capital entails costly regulatory filings, many companies offer securities to accredited investors, exempting the companies from registering securities with the SEC. Regulatory authorities verify that an individual or entity possesses necessary financial means or knowledge to take investment risks in unregistered securities, before he is considered an accredited investor.

  Accredited Investor Requirements

  To be an accredited investor, a person must demonstrate an annual income of $200,000, or $300,000 for joint income, for the last two years with expectation of earning the same or higher income. An individual must have earned income above the thresholds either alone or with a spouse over the last three years. The income test cannot be satisfied by showing one year of an individual's income and the next two years of joint income with a spouse. The exception to this rule is when a person is married within the period of conducting a test. A person is also considered an accredited investor if he has a net worth exceeding $1 million, either individually or jointly with his spouse. The SEC also considers a person to be an accredited investor if he is a general partner, executive officer, director or a related combination thereof for the issuer of unregistered securities.

  An entity is an accredited investor if it is a private business development company or an organization with assets exceeding $5 million. An organization cannot be formed with a sole purpose of purchasing specific securities. Also, if an entity consists of equity owners who are accredited investors, the entity itself is an accredited investor.

  In 2016, the U.S. Congress modified the definition of an accredited investor to include registered brokers and investment advisors. Also, if a person can demonstrate sufficient education or job experience showing his professional knowledge of unregistered securities, he is also considered an accredited investor.

  Purpose of Accredited Investor Requirements

  The SEC has adopted requirements for accredited investors to protect those who may be unable to sustain economic risks of investing in unregistered securities. When a company or individual engages in an unregistered securities offering, it bypasses registering valuable information with the SEC, which may mask certain risks inherent in these investments. Participants in these private placements are vulnerable to losing their entire investment.

• Under the federal securities laws, a company that offers or sells its securities must register the securities with the SEC or find an exemption from the registration requirements. The federal securities laws provide companies with a number of exemptions. For some of the exemptions, such as Rule 506 of Regulation D, a company may sell its securities to what are known as accredited investors. The term accredited investor is defined in Rule 501 of Regulation D.