SECURITIES REGULATION FALL 2011 FALLONE Kinds of Securities Transactions (2) o (1) Issuer Transactions: Company sells stock

k to first buyer as a way for the company to make money Issued to Public: public offering 1st issue to public: initial public offering (IPO) Regulated by the 1933 Securities Act o (1) Trader Transactions: transactions from person to person (not the first time the securities are being sold Sold on secondary markets Regulated by the 1934 Securities Exchange Act Definition of a Security (provided by 2(a)(1) of the 33 Act and 3(a)(10) of the 34 Act, and although the acts provide different language, the definition is considered the same). IVESTMENT CONTRACTS (the catch all of securities)(as provided in Howey) o (1) there must be an investment of money o (2) in a common enterprise (either horizontal or vertical, but the key is the pooling of money) o (3) where profits are derived solely from the efforts of others SEC v. Howey (p. 29) Investors in orange grove were dissatisfied with their investment and tried to have it rescinded, arguing it was an investment contract (S.Ct. determined it was an investment contract and rescinded the sale.) What is a COMMON ENTERPRISE for purposes of Investment Contracts o HORIZONTAL COMMONALITY: when there are lots of investors with a single promoter (the classic example is the pooling of money for the sharing of profits)(this is more difficult to prove). o VERTICAL COMMONALITY: looking for a commonality between investor and promoter (Look into this more) Foreman case (p. 36) added an additional element to the Howey test o (4) look at the underlying economic reality of the situation (IS THIS THE KIND OF TRANSACTION WHERER THE INVESTORS NEED THE PROTECTION OF THE SECURITIES LAWS?) aka WAS THE TRANSACTION FOR CONSUMPTION OR INVESTMENT, ETC. Problem 2.6 (p. 48) Asset purchase is usually not a security because the profits are not solely derived from the efforts of other o Stock purchase usually is a security though Business Entities as Securities? o General Partnership: Generally not a security because all the partners have co-equal management decisions. However, it can be a security if the partners roles are very limited by the language of the contract. o Limited Partnership: some managing partners with other limited partners that have no active role. This is probably a security but is limited to the partners that have no active role. CHARACTERISTICS OF STOCK AS SECURITY (5) o (1) the right to receive dividends contingent upon apportionment of profits; o (2) negotiability; o (3) the ability to be pledged or hypothecated (used as collateral); o (4) the conferring of voting rights in proportion to the number of shares owned; and o (5) the capacity to appreciate in value

EFFICIENT CAPITAL MARKETS HYPOTHESIS o The idea that stock prices are not dependent on past prices but are dependent on all the present information that is available about a company (there are three theories) (1) Weak Form: the stock reflects past information, but no new information (2) Semi-Strong: the stock reflects past info and all publicly available info (most economists think that this form works) (3) Strong Form: all past and present publicly known info, as well as all privately known info (inside knowledge) is reflected in the stock price In the strong form, insider trading has no advantage, though, because the stock price will not reflect the inside information until it is made public, which would be the semi-strong form then o Noise is irrational trading behavior based on absolutely no knowledge o Price Takers are someone who simply takes the price of a stock but does not move the stock price o Price Makers are financial institutions that buy large blocks of stock and actually move the stock price Limitations of ECMH: research is limited to large companies traded on national markets; it only describes on securities markets not IPO prices (SEE PAGE 107 FOR A DISCUSSION OF THE DIFFERENCE BETWEEN INFORMATIONAL AND ALLOCATIONAL EFFICIENCY) INTRODUCTION TO THE 33 AND 34 ACT o There are ultimately two kinds of q laws: (1) mandatory disclosure and (2) anti-fraud rules o (1) Mandatory Disclosures (2 kinds) Event based rule (tied to the occurrence of an event) Continued reporting EVENT BASED DISCLOSURES o (1) The public offering of securities (when a company wants to raise capital). A public offering triggers disclosure under the 33 Act (REGISTRATION STATEMENT AND PROSPECTUS) REGISTRATION STATEMENT: a company must register the offering with the SEC, then the registration statement becomes a public document. It contains info about the security and the companies financial information. Reg. SX: details about financial information that needs to be included in the registration statement Reg. SK: details about what NON-financial information must be included in the registration statement PROSPECTUS: (like a reg. statement) this is a sales statement o (2) Hostile Takeover is an event that triggers disclosures o (3) Soliciting Proxies: asking shareholders to vote CONTINUOUS REPORTING: from the 34 Sec. Ex. Act o Every company has to file a report every 3 months (10-Q) o Every company has to file an annual report regarding finances, risks, etc. (10-K) o Even if not end of the year, a company will have to file an 8-K if a specific, qualifying event occurs o ALSO regulations SX and SK apply to continuous reporting as well as the registration statement in event based reporting o INCORPORATION BY REFERENCE: A company that has previously filed an annual or quarterly report can reference that report when filing a registration statement AN OVERVIEW OF COMMERCIAL BANKS V. INVESTMENT BANKS (see notebook XX)

1933 SECURITIES ACT (SECTION 5 REGISTRATION) 5 prohibits the sale of securities before a registration statement is filed with the SEC and forbids certain kinds of marketing of the sale. Also, it forbids a final sale to the purchaser without the delivery of a prospectus. 3 & 4 provide exemptions: the types of securities and transactions that are not regulated by 5. 7 & 10 provide the content that must be included in the necessary disclosure documents (these are very bare bone but do point to reg. SX and SK) 11 prohibits material misstatements or omissions in the Registration Statement 12 prohibits material misstatements or omissions in the Prospectus 17 prohibits fraud SECTION 5 REGISTRATION PROCESS The Registration Process is divided into three sections: (1) Pre-filing period (before registration is filed; (2) Waiting period (after the registration is filed but before it becomes effective); and (3) Post-effective period (after registration becomes effective). BASIC RULES OF REGISTRATION UNDER SECTION 5: o (1) Pre-Filing Period: no offer to sell or offer to buy securities can be made o (2) Waiting Period: oral solicitations of offers is permitted but no written offers are allowed until the registration is effective, unless a written solicitation is preceded by, accompanied with a prospectus o (3) Post-Effective Period: no sale can close before the effective date; however, sales can occur and securities can be received so long as they are accompanied with or preceded by a Final Prospectus CONSEQUENCES OF VIOLATING SECTION 5 o If violation occurs during pre-filing: the SEC will send the issuer a Cool-Off Letter o If violation occurs during waiting period: the SEC will send the issuer a Stop Order o If violation occurs during post-effective period: every stock holder can rescind the contract OVERVIEW OF DIFFERENT KINDS OF ISSUING COMPANIES o (1) Non-reporting Company: not required to file disclosure statements with SEC o (2) Reporting Company: THREE WAYS TO BECOME A REPORTING COMPANY (1) Once you file a Registration Statement (however, if the company has fewer than 500 shareholders after it sells all its stock it will drop off list of reporting companies) (2) If your securities are traded on a national market, regardless of the size of the company (3) If you have MORE THAN 500 shareholders and have GREATER THAN $10 MILLION in assets aka everything you own (this is the most significant)(however if the companys shareholders become less than 500 for two consecutive years it will cease to be a reporting company o (3) Seasoned Issuers: reporting companies that can use a FORM S-3 (much shorter form) TWO CRITERIA (1) Must have been a reporting company for AT LEAST 1 YEAR (2) Have to have GREATER THAN $75 MILLION worth of stock held by the public (public float) o (4) WKSIS (WILL COVER THIS IN MORE DEPTH LATER) SEE PROBLEMS 4-1 THROUGH 4-11 P. 165-66. ESPECIALLY 4-6 SAFE HARBORS DURING THE PRE-FILING PERIOD o (1) Rule163A: Communications BY AN ISSUER MORE THAN 30 DAYS BEFORE THE REGISTRATION STATEMENT IS FILED do not violate Section 5. 3

The communication CANNOT REFERENCE THE PUBLIC OFFERING The communication must be done by, or behalf of, an Issuer o (2) Rule 169/Factual Information FOR A NONREPORTING COMPANY: The issuer can issue communications of REGULARLY RELEASED FACTUAL BUSINESS INFO. However, the intended audience cannot be investors, but customers, suppliers, etc. (It will look weird if a technology company places an informational communication in a business/economy magazine). The communication CANNOT REFERNCE THE PUBLIC OFFERING o (3) Section 2(a)(3) of the 1933 Act: provides right in the definition of sale, sell, offer that there is an exception for arrangements with and among underwriters and negotiations. (between issuer and underwriter or between underwriters) o (4) Rule 135: The issuer, and those acting on its behalf, can release certain information including its intent to issue a public offering, the kind of security being offered (but cannot disclose who the underwriters will be or what the price of the security will be). This kind of communication must have a legend explaining that it is not an offer, that there will be a registration statement filed, and that there will be a prospectus forthcoming SAFE HARBORS DURING THE WAITING PERIOD See problems 4-12 through 4-18 o Again, during the Waiting Period, oral solicitations can be made and written offers can be made if accompanied by a preliminary Prospectus that satisfies statutory requirements 2(a)(10) provides that any written communication, or communication on the radio or tv is a prospectus. (see section 5(b)(10) as well, providing that only a prospectus that meets the requirements of section 10 (a final or preliminary prospectus) can be used). Also, 7 & 10 must be satisfied by potential preliminary prospectus Rule 15(c)(2)-(8) provides that a non-reporting company and its underwriters must deliver a preliminary prospectus to any purchaser at least 48 hours prior to the closing of a sale o Rule 134(d) Safe Harbor: this permits a written communication to be sent to any investor asking for an expressed interest in the distribution, asking how many shares, etc. However, this communication must include a legend explaining that the offer is NOT BINDING AND YOU CAN BACK OUT OF IT, AND THAT NO PAYMENT CAN BE RECEIVED UNTIL THE REG. STATEMENT BECOMES EFFECTIVE. o Rule 433 Free Writing (see page 143 of statutory supplement)(FOR NON-REPORTING COMPANY OR UNSEASONED ISSUER): written communications will be allowed as free writing prospectuses that qualifies as a prospectus under section 10 if certain conditions are satisfied: the free writing must be preceded by, or accompanied with a prospectus that satisfies Section 10 (preliminary prospectus) and includes the securities price range. Also, a legend must be included on the free writing explaining where a prospectus is available. Note that some free writings must be filed with the SEC. Also, information included in the free writing cannot be contradictory to information presented in the registration statement Can send email information as long as a hyperlink to the prospectus is included Also, if you provide info that is considered a free writing on your website you better include a legend and a hyperlink to your prospectus o Tombstone Ad as excluded in definition of Prospectus in 2(a)(10): can identify the security, the price, and underwriter if it provides where and from whom a written prospectus can be obtained Overview of Form S-1 and Form S-3 o A form S-1 is used by a Reporting Company

A form S-3 is used by Seasoned Issuers and WKSIs In order to qualify to use a Form S-3 aka become a Seasoned Issuer: (1) Must be a reporting company for more than 1 year and one of the following o (2) in a cash offering, you have greater than $75 Mil public float (money in the hands of the public); or o (3)(a) in a cash offering, (b) in any 12 month period the offering does not exceed 1/3 of public float (dont increase shares by 1/3); (c) issuer has stock listed on public exchange o (4) in a sale of debt securities, issuer must meet one of the following requirements: (a) issued greater than 1 billion in non-convertible debt in prior 3 years (b) issuer has outstanding greater than 75 mil in non-converted securities (already owe that much); Issuer is a subsidiary of a WKSI or issuer is a Real Estate Interest Trust aka REIT. WKSIS OVERVIEW o In a Stock Offering: have to be S-3 Eligible w/ greater than $700 mil in public float aka value of shares held by the public is greater than $700 mil o For a Debt Offering: S-3 Eligible w/ greater than $1 billion worth of non-convertible debt sold over the last 3 years o Stock Offering: have greater than $75 mil in public float and greater than $1 billion in debt over last 3 years WKSI Benefits and Safe Harbors o No rule 163: a wksi can make almost any statement before the registration statement is filed (there is no 30 day rule or no cooling off period/quiet period) The communications must be made by or on behalf of the WKSI, cannot be made by the underwriter all communications must be accompanied with a legend and filed with the SEC o Rule 168: includes the regular release of factual business information or forward looking information; however, it does not protect communications issued by the underwriter or other distribution participants. o Rule 433 Free Writing: there is no requirement that a WKSI deliver a prospectus with a free writing the free writing must just be accompanied by a legend and satisfy SEC filing requirement o The writings just cannot explicitly say buy my securities or the equivalent o SHELF REGISTRATION: (AUTOMATIC FOR WKISS) Rule 415, no registration statement is needed in advance of offering securities, a WKSI can simply offer the securities anytime within 3 years of shelfing Auto. Shelf Regs. A WKSI will file a registration statement and it automatically becomes effective on the filing date (no info about the shares or the price needs to be filed for 2 days after selling of the securities)(basically, WKSIs can sell securities without disclosing info until after the sale) o RESEARCH REPORTS (RULES 137, 138, 139) (p. 189-90 (1) Rule 137:Permits nonparticipating brokers and dealers to publish or distribute, in the regular course of business, information, opinions, and recommendations regarding an issuer in registrations securities. (The dealer and/or broker must not receive compensation from the issuer for the report made). o

(2) RULE 138 FOR REPORTING ISSUERS: A broker or dealer, even if a PARTICIPANT IN THE DISTRIBUTION OF BONDS OFFERING BUT NOT STOCK OFFERING, can publish opinions or recommendations for the registrants common stock. AND VICE VERSA. This exemption is conditioned on the broker or dealer having previously published or distributed in the regular course of its business research reports for similar types of securities. (3) RULE 139 FOCUSED AND INDUSTRY REPORTS: Broker or dealer that is even participating in the distribution of common stock can release reports, opinions, etc. that are solely about the issuer (as long as the issuer is a reporting company). The broker or dealer must have previously issued similar kind of report when relying on this rule. POST EFFECTIVE PERIOD (p. 177) o 5(b)(2) requires that every security delivered be accompanied or preceded by a prospectus that meets the requirements of 10(a) aka a final prospectus o However, now the main rule is Rule 172(b), requiring that a final prospectus need not be delivered as long as access to the final prospectus is provided. o NON-REPORTING CO., pursuant to 15c2-8(b) requires underwriters for non-reporting companies to deliver a preliminary prospectus to buyers at least 48 hours before sending confirmation of sale. o A Rule 433 Free Writing made during the post-effective period is fine as long as it is accompanied with a legend and satisfies the necessary SEC filing requirements AND IT MUST BE ACCOMPANIED OR PRECEDED BY A FINAL PROSPECTUS (Fallone says that access is probably sufficient) EXEMPTIONS FROM REGISTRATION UNDER 5 o Two kinds of exemptions: (1) issuer exemptions and (2) resale exemptions o (1) Issuer Exemptions 3(a)(11) INTRATSTATE OFFERING (Exempting the local raising of capital (found in section 3 of 1933 Act) If entire offering is sold and offered to residents of the same state where the issuer is incorporated and doing business o If even one security is sold to a non-resident, or later transferred under certain conditions to a non-resident, the entire exemption is void. o Doing Business within the state: the performance of substantial business operations in the state of incorporation. ASK YOURSELF, WHERE IS THE INCOME PRODUCING ACTIVITY LOCATED VIA CHAPMAN P. 257 See Rule 147 Safe Harbor Release (p. 262) 80% Rule: 80% of your revenues come from instate, 80% of assets in state, 80% of proceeds from offering are spent in the state (if you satisfy this you are absolutely good). o Residence within the state: mere presence in the state is not sufficient. RESIDENCY MENAS PLACE OF PERMANENT ABODE/ADDRESS FOR PURPOSES OF BUYERS o INTEGRATION (P. 263) basically holding 2 offerings at the same time (and really trying to apply an exemption to both when only 1 would qualify) RULE 147 ON P. 263 PROVIDES THE 6 MONTH 2 WAY INTEGRATION RULE: SO LONG AS THERE IS 6 MONTHS BETWEEN OFFERINGS THEY WILL NOT BE INTEGRATED

5 Integration Factors to Apply if Offerings w/in 6months of each other: (1) are the offerings part of a single plan of financing; (2) do the offerings involve issuance of the same class of security; (3) are the offerings made at or about the same time; (4) is the same type of consideration to be received; (5) are the offerings made for the same general purpose. o RESALE ISSUES: An initial buyer of intrastate securities can screw the whole exemption if he sells to non-resident; however, Rule 147 tells us that IF THE BUYER PURCHASES THE SECURITIES WITH THE INTENT TO INVEST (THE BASIC RULE IS THAT YOU HAVE TO HOLD THE SECURITIES FOR 9 MONTHS AFTER THE CLOSING, BUT THIS IS NOT NECESSARY). You do not need to hold for 9 months if you had an Intent to Invest (just may have to show a change in circumstances (ex. You went bankrupt, you suddenly have new expenses) 4(2) PRIVATE OFFERINGS/PRIVATE PLACEMENTS (transactions not involving a public offering) See Ralston case p. 268 An offeree in a private placement must be SOPHISTICATED AND HAVE ACCESS TO THE SAME KIND OF INFO THAT WOULD APPEAR IN THE REG. STATEMENT o Sophisticated: look at education, relevant experience, net worth, etc. A company could send out a questionnaire asking education/experience questions, trying to pre-certify buyers (look at the difference in sophistication when the securities were offered and when they were purchased) o Access to Info: to be safe you should just release all the same info that would appear in a reg. statement/or your last financial statement If you rely on just access to the info (w/o just providing the info) you should make sure there is some kind of relationship between the issuer and buyer as to make the issuer have to answer questions (leverage). For 4(2) Private Placement you need: (1) SOPHISTICATION and (2) ACTUAL DISCLOSURE (LIKE REG. STATEMENT) or ACCESS (TO PERSON WITH KNOWLEDGE OF REG. STATEMENT INFO). ADDITIONAL STEPS FOR A PRIVATE PLACEMENT: o Factors to consider for private placement (1) The number of offerees and their relationship to each other and to the issuer: the more offerees the more likely the offer will be considered public. Relationship is important because if the offerees are members of class that has special knowledge than more likely private. (Fallone says there is no magic number but that less than 100 people is key)

(2) The number of units offered: large number of cheap securities equal more public/small number of expensive securities equal more private (3) The size of the offering: small offerings were intended (Fallone says millions is ok i.e. 5 mil) (4) The manner of the offering: direct contact is key as opposed to informal advertising (no advertisements, no public distributions, no mass communications). REGULATION D (RULES 504, 505, AND 506) (p. 281) and REGULATION A (p. 319) SEE FALLONE HANDOUT RESALE OF SECURITIES

Basic framework of a transaction: ISSUER ------------------PURCHASER 1----------------PURCHASER 2 (issuer one will have used an exemption from section 5: 3(a)(11), 4(2), Reg. A, or Reg. D.) (purchaser 1 may have to register the securities for resale under 5) EXEMPTIONS FOR RESALE o 4(1) The Mother of All Exemptions This exempts from registration under section 5 any transaction not involving an issuer, underwriter, or dealer We dont want to exempt the resale of unregistered securities or the resale by a Control Person of the issuer o Control Person someone who can dictate policy at the issuer, top official, officer, etc. (someone with lots of shares) 2(a)(11) The Definition of Underwriter: defined broadly so fewer people can use the 4(1) exemption. (1) any person who purchases from an issuer with a view to the distribution of a security; (2) any person who offers or sells for an issuer in connection with a distribution; (3) any person who participates or has direct or indirect participation in the activities covered by 1 or 2 above; (4) any person who participates or has a participation in the direct or indirect underwriting of any such undertaking (under 1 or 2) o For purposes of this definition, the term Issuer shall also mean Control Person / a control person of an issuer is an issuer o For the definition of Under Writer to apply there must be a Distribution How do you not have a Distribution? If the issuer sells via an exemption and then Purchaser 1 resells and also qualifies for the same exemption AND the securities never came to rest with Purchaser 1 (basically like issuer sold directly to Purchaser 2). If the securities CAME TO REST with Purchaser 1, then the issuer is off the hook for any rescinding of the initial sale (if the securities did not come to rest 8

with P1 and P1 resells in a way that is contrary to the original exemption, then it voids the first exemption for the issuer) o COME TO REST: Did Purchaser 1 buy with the intent to invest or with the intent to resell (what is P1s motivation) (if there is an intent to invest then the securities came to rest/if no intent to invest then did not come to rest) o RULE: If P1 owned the securities for greater than 3 years then there is investment intent; if P1 owned for less than 3 years but greater than 2 years there is a challengeable presumption that there was investment intent; if P1 held for less than 2 years there is presumption of no investment intent Even if you hold for less than 3 years you can still show investment intent by showing CHANGED CIRCUMSTANCES (purchasers circumstances) o IT DOES NOT MATTER IF THE SECURITIES CAME TO REST IF THE PURCHASER IS A CONTROL PERSON o There is a 9 month holding period for purchaser of intrastate offering security; then you can sell to anyone. RULE 144: RESTRICTED SECURITIES (see chart on p. 365-366) Restricted Securities: acquired from an issuer in an unregistered offering (private placement, regulation D can both be sold under 144). RULE 4(1 1/2) p. 380-81/384 STATE BLUE SKY LAWS o See packet and notebook pages ENFORCEMENT (PUBLIC ENFORCEMENT AND PRIVATE ENFORCEMENT) o OVERVIEW OF ENFORCEMENT: 11 provides cause of action for material misstatement/omission in reg. statement 12(a)(1) provides cause of action for violation of section 5 i.e. failure to register/failure to jump through 5 requirements 12(a)(2) for a material misstatement/omission in prospectus or oral communication related to prospectus o Section 11 of 1933 Act: Federal cause of action for MATERIAL MISTATEMENTS or OMISSIONS in the Registration Statement. Remedy: rescission and damages in the form of difference between amount paid and the value of security today The requirements are that the statement must have been MATERIAL The Plaintiff cannot have known the truth at the time (truth about the statement) There is no requirement that the Plaintiff/Investor relied on the misstatement/omission UNLESS it has been 12 months and the issuer has put 9

out a new reg. statement (must show you relied on the old statement with the misstatement/omission in it). Do not have to show causation o There is an affirmative defense of Loss Causation, basically if there was an intervening event that caused the stock to tank. SOL is 1-3 years: w/in 1 year of discovery but no later than 3 years after purchase No privity requirement: that means that P2 can sue the issuer directly, doesnt have to be P1 (dont have to show that you bought directly from the Issuer or P1, but if you did not buy from one of them you cannot rescind the contract). TRACING REQUIREMENT: The plaintiff must prove that his securities were sold under the offering in question (this may be impossible). STRICT LIABILITY for the Issuer WHO ELSE CAN BE SUED: Signatories i.e. top officers who signed the reg. statement; every person named as director/partner; every underwriter involved in offering; any experts whose reports were included i.e. accounting firm conducting the audit (this will be discussed in more detail later). POTENTIAL DILIGENCE DEFENSE: for expert and non-expert portions of registration statement o (1) Defense for the Expert Portion: Expert Due Diligence: If after reasonable investigation the defendant did not believe and had no reason to believe there was a misstatement/omission (affirmative conduct req.) Every other Defendant: had no reasonable grounds to believe that there was a misstatement/omission (no required to do anything, just looking for red flags) o (2) Defense for non-expert portion: Expert is not liable for the non-expert portion of a regulation statement Every other Defendant: if after reasonable investigation the defendant did not believe and had no reason to believe there was a misstatement/omission (same affirmative conduct required as expert for expert portion). 12(a)(1) ACTION: suing someone who is a Statutory Seller of securities that violate Section 5 or are not registered under section 5 Who is a STATUTORY SELLER for purposes of 12(a)(1): the key is COMPENSATION (see Pinter v. Dahl p. 515) (if doing it for free or gratuitously then you are fine; but if done for compensation EVEN IF YOU ARENT THE ONE TRANSFERING TITLE) p. 517 Pinter case: every contract of sale or disposition of a security interest in a security, for value offer to sell, offer for sale, offer means every attempt or offer to dispose of, or solicitation of an offer to buy, a security or interest in a security, for value Consequently, Stat. Sellers under 12(a)(1) is not limited to persons who pass title, but includes person who solicit on offer to buy For an action under 12(a)(1) it is STRICT LIABILITY, NO RELIANCE IS REQUIRED, NO INTENT IS NEEDED, AND NO CAUSATION IS NEEDED. However, there is an affirmative defense of LOSS CAUSTION (as discussed later) 12(a)(2) ACTION: suing someone for a material misstatement/omission in Prospectus

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12(a)(2) ONLY APPLIES TO PUBLIC OFFERINGS VIA THE SUPREME COURTS BULLSHIT OPINION IN GUSTAFSON V. ALLOYDCO (p. 521) 12(a)(2) is not available for offerings that do not require a registration statement/A REGISTRATION STATEMENT MUST BE REQUIRED FOR 12(A)(2) TO KICK IN Consequently, private placements and Rule 506 offerings are loop holes. The oral misstatement under 12(a)(2) must be a lie about the prospectus/saying something that is contrary to what is in the prospectus. DUE DILIGENCE DEFENSE: the defendant has the same affirmative defense as in section 11; however, it is a sufficient defense even without a showing of Affirmative Investigation. The defendant just has to show that they did not possess info that raised a red flag. MATERIALITY IN THE CONTEXT OF ENFORCEMENT ACTIONS o Two tests on p. 586 from TSC Industries v. Northway (1) An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote. (2) There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. There is a difference between disclosing something because it is Material and disclosing something pursuant to a Duty TRUTH ON THE MARKET: there will not be an material omission if info is not included but the info was available in the market (when everyone knows the info because it is already in public knowledge) SOFT INFO/HARD INFO: A hard fact is something historical, a soft fact is a risk, something that may happen TEST FOR WHETHER SOFT INFO IS MATERIAL ENOUGH TO DISCLOSE: (p. 595) o Materiality will depend at any given time upon a balancing of both the indicated probability that the event will occur (the soft fact) and the anticipated magnitude of the event in light of the totality of the company activity. ABSENT A DUTY TO DISCLOSE, THE OMISSION OF A MATERIAL FACT IS NOT ACTIONABLE. 10b(5) CAUSE OF ACTION: ANTIFRAUD o See Adam Smiths notes o Elements of a 10b(5) action (8): (1) In connection with (fraud must touch the transaction) (2) the purchase/sale of a security (this is the standing requirement; must be an actual purchase or sale of securities) (3) a material (2 tests: (1) the historical test from TSC Industries; or (2) the soft information balancing test from Basic v. Levingston) (4) misstatement or omission (made by the defendant; silence does not equal fraud unless there is a duty to disclose) (5) upon which the plaintiff relied (in omission cases, there is a presumption of reliance) (6) that was made with scienter (the defendant must have acted with an evil state of mind, or at least with a reckless state of mind) (7) That caused (TRANSACTION CAUSATION AND LOSS CAUSATION) (8) damages or injury 11

LOSS CAUSATION: was the misrepresentation the cause of the harm not just a link in the chain Look at the specific reason that the company lost money, the lie has to be related to why the investment lost value Fallones boat hypo: a company owns 1 single ship that it uses for exporting. It states that the ship can hold 500 ft of cargo, when in fact it can only hold 300 ft of cargo. The ship is not insured and is sunk in a storm. The stock collapses. Is there loss causation? No, because the misstatement, that the boat could hold more than it actually could, was not related to the loss, the boat sinking in a storm. o DAMAGES: the difference between what you paid for the security and what it was worth at the time of the lawsuit, plus interest. Class Actions: damages cannot exceed the mean stock price 90 days prior to FRAUD ON THE MARKET THEORY o All elements are the same from 10b(5) cause of action except reliance (there is a PRESUMPTION OF RELIANCE when there is a misstatement/omission that has an impact on the market price of the stock (the theory is that the purchasers relied on the market price of the stock) (reasons for this presumption (1) problem with proving reliance; (2) reliance req. would hinder use of class actions; (3) the fraud on the market theory is in line with the Efficient Capital Markets Hypothesis.) This is a rebuttable presumption though (can be rebutted by showing) (1) the market price reflected the lie (Truth on the Market)(show that institutional investors knew this was happening) (2) even though the plaintiff relied on the market price, you can prove there was another reason why the plaintiff sold the stock SECONDARY LIABILITY: o There is no aiding and abetting when it comes to secondary liability for 10b5 cause of action o AIDERS AND ABETTORS CAN BE PROSECUTED CRIMINALLY HOWEVER. o SCHEME LIABILITY:

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