Business Associations Class Notes 6/10/04


We’re entering “crunch time”!  The exam will have 5-7 problem-type questions.  You’ll want to spend about 30 minutes per question.


Rule 504


So Rule 504 is the “mom ‘n’ pop” exception.  In Ohio, you’ll use R.C. 1707.03(O).  Whenever you can use .03(O) instead of .03(Q), do so, because (O) is easier to satisfy.  § 1707.03(O) is limited to equity securities of a corporation or a limited liability company.  What’s an equity security?  It’s a stock, warrant, or debt convertible into stock.  What is the counterpart in Ohio to pure debt?  Look for the .02 regulations in a section dealing with commercial paper.  There are two sets of .02 regulations.  The first one, about 30 years old, says that despite the wording of the section, it is limited to debt sold to insiders/affiliates.  But in the 1990’s, the commissioner expanded .02, saying that if something is a pure debt security and if it would meet .03(O) if it were an equity security then it will meet that particular regulation.  Another set of Ohio regulations that are crucial are the regulations under .03(V).  There are some “nice” exemptions there, including one for certain employee stock purchase plans and employee stock options.


Federally, Rules 701-703T of the Securities Act of 1933 provide a similar exemption for non-public companies up to a certain dollar limit.  The rules under 701-703T say that you need not integrate what you sell under these rules with Regulation D.  Regulation D makes the same statement.  Integration makes your hair go gray in this area!  Why is it restricted to non-public companies?  For non-public companies, the SEC has a short form, the S-8, for employee stock purchase plans and options.  It’s an easy form to use.  Later on we’ll see that employee stock options and purchase plans are a lot more valuable for public companies than for private companies.  Beginning 25 years ago, executives could make tens of millions of dollars through these plans.  In the 1990’s, this expanded to up to $1 billion.  Jack Welch has a net worth of around half a billion dollars.  So corporate executives can pull a lot of money!


Rule 506


This rule was first adopted in the 1970’s and revised several times since then.  It’s kind of at the other end of the scale from Rule 504.


1.          This Rule falls under Securities Act of 1933 § 4(2), which has no dollar limit.  Thus, this Rule has no dollar limit either.  Rule 504 is under § 3(b) which has a dollar limit, and 504 has an even smaller dollar limit imposed upon it.

2.          Rule 506 also applies to all types of issuers, including corporations, partnerships, LLCs, LLPs, not-for-profit organizations, and general partnerships issuing debt: it is broad.

3.          Like Rule 504, Rule 506 also applies to all types of securities.

4.          Like Rule 504, you must always file the proper reports with the commission on time.  The report is the Form D, and you’ll find it set out in the CCH Federal Securities Reporter.  Many, if not most exemptions have a precondition of a proper notice filing either with the SEC or the states or both.

5.          A precondition to Regulation D, Rule 504 and Rule 506 is no general advertising.  That’s also a precondition to § 4(2).

6.          Like Rule 504, there is an integration test.  As a rule of thumb, lawyers will tend to look one year back and one year forward, though Shipman is not sure that it really goes that far.  If different securities are issued for very different purposes, there will be no integration.

7.          Both as to Rule 504 and Rule 506, the securities must be legended upon delivery.  The sales agreement and private placement memorandum must prominently, in advance warn investors of this.  This deals with the “come to rest” test.

8.          For Rule 504 there is no advance disclosure precondition.  You still have to comply with the civil liability section.  Regulation D has an elaborate twist: if every purchaser is an accredited investor as defined in the rule, there is no advance disclosure requirement.  In big offerings, everyone will be accredited investors.  But there are caveats:

a.      One or more of the people are going to request a lot of stuff and the rule itself tells you: what you provide to one, provide to all.

b.     To protect yourself under the civil liability provision, you will always put together a decent private placement memorandum.  Note that a prospectus is only with a registered public offering.  The memorandum will be numbered and you will get receipts from everyone and make them sign a form that they won’t circulate or distribute them to anyone except their own lawyers, investment bankers and accountants for advice.  We do this because of the no general advertising provision.  Careful lawyers also get, in advance, signed and dated investment letters under Rule 504 because someone will try to purchase for 40 friends and they are going to screw up a Rule 506 because they won’t be accredited investors.

9.          Even if all of your investors are accredited and they’re all sharp, there must be a due diligence meeting where the lawyer, management, and CPA make them available for questions before people are going to buy.

10.      What part of the “fend for themselves” test goes into Rule 506?  Shipman says this is subtle: if all purchasers are accredited investors, the test does not apply because if you read the rule carefully, there is a built-in, implied statement that accredited investors are conclusively presumed as a matter of law to be able to fend for themselves.  Is it true?  Maybe, maybe not.  If all purchasers are accredited investors, the issuer does not have to appoint a purchaser representative.  But if one or more purchasers is not an accredited investor, then this is the rule: if one of these purchasers is not a financial sophisticate, the issuer must hire, out of its own pocket, an independent investment banker aside from the one it uses to advise as to the suitability of the investment.

11.      Rule 504 has no limit on the number of purchasers because it is a 3(b) rule, that is, it covers limited public offerings as well as private offerings.  But Rule 506 is a 4(2) rule, and the SEC does have a limit on number of purchasers.  This is after integration and “come to rest” are applied.  The number of purchasers in an offering, so defined, may not exceed 35.  If you sell 1,000 shares to Mr. Jones and 1,000 shares to his wife, Ms. Smith, that counts as two purchasers.  It’s not tenancy in common or joint tenancy with right of survivorship.  The rule tells us that we use the old view of marriage!  The two are one even if the stock is separately titled and separately paid for by each spouse!  The counting rule is quite liberal.  But that’s not all!  What else does the commission have to help?  Each accredited investor counts as zero investors!  In other words, you could have 80 accredited investors plus 20 other people.  This counting rule ties in to 3(c)(1) of the Investment Company Act of 1940, which was the fifth federal securities statute passed.  If you’re an investment company, there is an extra strong burdensome level of registration.  The commission was aiming at mutual funds.  However, the definition of investment company is much broader.  Lawyers are concerned about inadvertently becoming an investment company.  But if you’re a bona fide commercial bank, you’re exempt.  If you’re a bona fide insurance company, you’re exempt.  If you’re a pension or profit-sharing trust for employees, you’re exempt.  If you’re a bona fide charitable trust, you’re exempt.  There is also an exemption for a company that invests in real estate mortgage notes.  In Ohio, you may have to file as a bond investment company.  The big exemption from this Act is 3(c)(1).  This section says that if a company has fewer than 100 holders and it’s not presently making a public offering, then it’s exempt.  Therefore, if you set up a partnership that has mainly financial instruments in it, and there are only 80 partners then if you’re not presently making a public offering, you’ll be exempt.  This directly ties in with Rule 506 because a 506 offering is not a public offering even if there are 70 accredited investors buying.


If you have purchasers who are not accredited investors, you work through Rules 501-503 and find that, for a big offering, you will have to put together a private placement memorandum that contains just about what a prospectus would contain for a public offering.



What about the Ohio situation?  For an offering exempt either under § 4(2) or under Rule 506, you can get an exemption for the Ohio portion if you make timely filing and a $100 fee.  Each filing is only good for 60 days.  If you go for the whole year, you’ll have to make seven different filings.  In the real world, many exemptions are lost because they’re not careful in getting the filing there on time.  Make sure you have a stamped copy before the final due date that you can put in your file.  In Ohio, R.C. 1701.39 and .391 will allow you, in limited circumstances, to file lateTexas has an even more advanced scheme.  Federally and generally under state law, if you miss the deadline you’re dead, and you get strict liability and malpractice.


What if the private offering crosses state lines?  You must make the filings in all states on time.  If it’s an ongoing offering, you’ll have to make several different filings during the year.  If it’s really important that a form be filed on time, send someone there in person.


As of 1994 and 1995, the high-tech companies in California, Seattle, Texas and Massachusetts were using Rule 506 heavily.  They were finding that the various states were questioning their disclosure and were trying to impose substantive fairness tests.  The big problem was that the suggestions of the various states were contradictory; you couldn’t please everyone.  So there is a lot of political dispersion.  As a reaction, a part of NSMIA provides as follows: this applies only as to Rule 506 offerings, and not to § 4(2).  Rule 506 is much safer than § 4(2)!  Rule 504 is safer still!  In Ohio, always use .03(O) in preference to .03(Q) because it is a lot simpler.  NSMIA says that states can continue to require (1) notice filing, (2) a filing fee, (3) application of broker-dealer rules, (4) application of fraud law, and (5) application of criminal law.  But the states shall not, as a matter of routine, question the disclosure in a Rule 506 transaction or use their anti-fraud powers to impose substantive fairness tests.  This has worked, and though Shipman is in favor of state regulation, he thought state variation had gotten out of hand.  Another part of NSMIA dealt with broker-dealer rules.  It said that a federally registered broker-dealer can continue to be forced to register under state law.  There can be filing fees.  Criminal, fraud and injunctive provisions can be used.  But in applying selling practice and other rules, such as net capital, the states can only enforce the federal rules.  But can federal courts enforce Ohio broker-dealer rules?  The Ohio Supreme Court has held that federal and state regulation must work together closely in this area.


If the Martin Act in the 1920’s had just far-reaching powers, why didn’t people avoid New York as a place for doing business?  First, in many financial transactions there is no way you can avoid New York.  It has been the world’s financial capital since 1914.  Second, the provisions of the Martin Act weren’t actually enforced until four years ago.


The hypothetical


But I didn’t have a chance to get the hypothetical down.


How do we approach a problem?  Rule things out.  First consider the ultra vires/1701.13 problem.  The corporate charter must have an “all lawful business” clause.  If there is an ultra vires problem, you go to 1701.69-.72.  There must be a charter amendment and it will likely create appraisal rights.  What about 1701.14 preemptive rights?  Under .14 and the common law, if you’re issuing stock for non-cash property, there is an exception.  What about fiduciary duties under 1701.59?  Due diligence must be done concerning a transaction.  You must get financial statements.  Rule 10b-5 applies to a securities offering.  The U.S. Supreme Court, in Gustafson in the 1980’s, held that 12(a)(2) doesn’t apply to unregistered private offerings.  § 14(e) deals with tender offers for any security, public or private, but it must be a tender offer.  The big worries of the guy are going to be §§ 1707.38-.45 and .29.  The criminal mens rea test in Ohio is ordinary negligence.  Plus .38-.45 state a negligence test and say that if the company is liable, the directors are liable unless they were non-negligent.  If there is no directors’ and officers’ insurance policy, the guy should resign.  Otherwise, what’s in it for the guy?


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