Business Associations Class Notes 6/9/04


There is a hypothetical here for tomorrow that I’m missing because I was several minutes late.  At least I managed to write down tomorrow’s assignment.


More on exemptions


Ralton Purina established, among other things, that with all exemptions the burden of pleading and proof in every detailed respect falls upon the claimant of the exemption.  R.C. 1707.38-.45 establishes the same thing in Ohio.  Keep in mind these points:


1.     Both federally and in Ohio, the fact that you’re exempt from registration doesn’t exempt you from implied or express civil liabilities.  For example, R.C. 1707.38-.45 apply equally as to registered transactions as they do to exempt transactions.

2.     State law is often more demanding than federal law.  For example, R.C. 1707.29 and .44-.45, in a criminal case, make a defendant far more vulnerable than in a federal criminal prosecution.  The major case on the subject is State v. Warner out of the Ohio Supreme Court from the 1980’s.  The court held that R.C. 1707.29 means what it says: the mens rea element in a criminal prosecution under R.C. 1707.29 is simply ordinary negligence.  Federally, the mens rea element is willfulness, which has been construed as a very high burden on the federal government.

3.     How much does federal law preempt state law?  The short answer is some but not much.  In the 1990’s, there were three big federal statutes.

a.      First, in 1996, there was NSMIA, or the National Securities Markets Improvements Act.  This Act has several preemptive provisions.

                                                              i.      As to investment advisors, the federal government takes over primary regulation of the big ones and the states take over primary regulation of the little ones.  As a result, in the 1990’s, Ohio passed an investment advisors act that covers financial planners.

                                                            ii.      NSMIA also says that if a company is listed on a major exchange or on the national market system of the NASD, no state can require registration of the issuance of securities by that company.  It reads just like R.C. 1707.02(E) in Ohio.  Before this federal Act, several states like Florida did not exempt nationally-listed corporations from registration.

                                                          iii.      Only the state of incorporation can deal with alleged securities and fiduciary duty violations.

                                                         iv.      As to mutual funds, certain things were reserved to the SEC, while the states can do certain other things.

                                                           v.      We’ll later discuss the provision dealing with Rule 506.

b.     In 1998, an act was passed that says with respect to certain fraud and other suits they will become subject to the 1995 federal act (which was very pro-defendant).  If they are in state court, they are to be removed to federal court where the defendant advantages of the 1995 Act apply.  There is a big exception, though.  In an action for breach of fiduciary duty under the law of the state of incorporation, the 1998 Act doesn’t apply, and if the plaintiff’s lawyer is careful in drafting, you can avoid the 1995 Act.

c.     In CTS from the U.S. Supreme Court in the 1980’s, the Court said that regulation of tender offers by the states must be reasonable and limited and if they are not reasonable and limited then they will be preempted.


So there is some federal preemption but not a heck of a lot.  Common law remedies are not displaced by federal or state securities laws.  When would common law remedies be the best?  It’s more often than you think!  In a recent big Ohio case out of Cleveland, a discount broker then known as Olde & Co.  This firm was a member of the NYSE.  The issue involved suitability.  Under the federal securities laws, a securities broker must avoid recommending unsuitable securities to purchasers.  There is a remedy under Rule 10(b)(5).  Under 10(b)(5), it is only if the customer proves that the recommendation was made with scienter.  That’s hardcore.  In the case, a Cleveland resident was recommended certain securities by Olde, and they went south.  The customer said that given his precarious financial position, they should not have recommended a speculative security.  If he had sued under 10(b)(5), it would have had to go to federal court because the Securities Exchange Act of 1934 says that all actions under the Act must be in federal court (which is different from the other federal securities statutes).  Why is that significant?  Over the last 25 years, many federal judges have become more anti-plaintiff on securities cases.  The state courts have remained more neutral.  So the guy wanted to sue in county common pleas court.


The plaintiff argued that Olde & Co. is a member of the NYSE and that one of the rules of the NYSE says that every member must “know thy customer”.  The primary purpose of the rule is to protect the member firm.  If a customer doesn’t buy up after he buys, the member firm is responsible to the party on the other side of the transaction.  The court held that under Ohio common law this created a statutory tort for a negligent failure to observe suitability, and the plaintiff won!  Shipman says that the plaintiff’s attorneys were very smart.


We don’t know why this case didn’t go to arbitration.  Usually, broker-dealers will force customers to sign arbitration clauses up front, and usually the broker-dealer insists on arbitration.  We don’t know why they didn’t do so here!  In arbitration, suitability claims under 10(b)(5) require scienter, at least in theory.  But in practice, arbitrators will often give recovery for mere negligence on the part of the broker-dealer firm regarding suitability.  On the other hand, studies of all massive arbitration system, like the securities system, indicate that arbitrators tend not to give lavish or large awards.  They cut down on the amount.  They’re more liberal in giving the plaintiff something, but the dollar amounts are smaller.


Lastly, Shipman argues that securities laws are one of America’s first consumer laws.  He was at the SEC in the 1960’s.  Johnson wrote a letter asking the SEC’s views on a consumer protection bill.  Shipman’s friend was asked to draft a reply.  He basically said: “We regulate securities, and that’s not consumer law!”  The chairman kicked his ass!


Attorney General Spitzer in New York has gone faster than the SEC in enforcing consumer protection.  New York’s “Blue Sky” law, the Martin Act, was passed in the 1920’s.  What’s the deal with the Martin Act?  Under the federal securities laws, the courts and some statutes have said that the SEC can get disgorgement for misconduct, but nearly all of the federal provisions on disgorgement require proof of scienter.  The Martin Act provides no private right of action, but rather says that the Attorney General can go into court and get disgorgement.  He can probably get it upon a proof of negligence or bad faith.  He doesn’t have to prove scienter.  Because of that power, Spitzer has been the main person pushing through settlements in the past 18 months.  He is unpopular with certain segments of the financial world.  The talk is that he wants to run for governor.  There are many investors in New York State and he doesn’t care.  He figures he is building a constituency.



Some examples of exemptions


Around 93% of all transactions are exempt.  Let’s go over some of the important ones.


4(1) says that if you’re not an issuer or an underwriter or an affiliate of the company, stock which you purchase through the organized trading markets will be exempt.  For example, I’m contacted by Johnson in Dayton who is a physician.  Three months ago, he bought GM stock, registered in his own name, through the NYSE.  He is not a director or officer of GM.  Neither is his wife or any other relative.  He doesn’t meet the 10% rule, which is the third way you can be an affiliate.  If you add up the GM stock all of his family owns, it’s still well under 10% of the shares outstanding.  Insofar as the Securities Act of 1933 is concerned, he has a 4(1) exemption.  Insofar as Ohio law is concerned, R.C. 1707.02(E) exempts him.


To sell the stock, he will have to sell it through a broker, but he had to have a brokerage account in order to buy the stock in the first place.  If you are an affiliate as defined in Rule 405, you must construe 4(1) with 2(11), which gets tricky.  2(11) defines “underwriter” in terms of a person taking with a view to distribution.  In United States v. Wolfson out of the Second Circuit, the court held that in a criminal case the last sentence of 2(11) applies not only to the first sentence of 2(11) but also to 4(1), meaning that an affiliate owning stock can sell only in one of only three ways:


1.     The company files a registration statement for him.  This happens only once in 10,000 times because it’s very expensive.

2.     As to public companies, Rule 144 provides a limited, specified exemption that is widely used.

3.     He can make a non-distribution.  Look at 2(11)’s first sentence, and you’ll find the word “distribution”.  The SEC concedes that if an affiliate makes a non-distribution, 4(1) applies to him.


Let’s say an affiliate bought the stock on the NYSE and he now wants to sell.  He can sell under Rule 144 on the stock exchange (but there’s a lot of paperwork).  He will get market price for his stock on the exchange.  Can he legally make a non-distribution?  Yes, in theory.  The SEC says that the term “distribution” in 2(11) equals “non-public offering” in 4(2) as defined by Ralston Purina.  He could sell the stock to a big mutual fund with a legend saying that the taker is buying for investment and not distribution.  The taker cannot sell for one year.  If there is full and fair disclosure to the mutual fund up-front, that would be perfectly legal.  However, he won’t do that because he’ll have to sell at a 15-40% discount.  So he’ll go to the internal general counsel to get the paperwork going to sell and he’ll sell under Rule 144 at the full market price.  So to construe 4(1) you must construe it with 2(11), United States v. Wolfson, and Rule 144.


This accounts for the fact that in the United States, many major investors elect not to sit on the board of a company that they own a lot of stock in.  If they sit on the board of the company, they will be subject to the restrictions of Rule 144 and Rule 10(b)(5).  On the other hand, let’s say a rich guy in New York wants to buy 4.5% of GM.  He can go to his bank and the bank can purchase in “street name”, and as long as he stays under 5%, he doesn’t even have to surface under 13(d).  He will prefer to remain anonymous because if that is his only connection to GM and his family owns no GM stock and he acquired the stock over one year ago on the NYSE, then he can sell it at any time!  If, on the other hand, he’s on the board, he has all the Rule 144 limits plus, if there is material, undisclosed and unfavorable information about the company, 10(b)(5) absolutely precludes him from selling.  In Europe, the big companies all have the big investors on their board.  But in this country, a lot of the people who are big investors prefer to stay off the board.  As long as they’re under 10% including family holdings and as long as they don’t seek out or get inside info, they can sell when they want to and they can buy when they want to.


Another person that cannot use 4(1) is someone who has purchased stock in an exemption and sells before it has come to rest.  That is why under Regulation D securities sold under that exemption must be legended.  In the public trading markets, delivery to your broker of a legended security is per se bad delivery!  Therefore, if you buy in a 506 offering and get legended securities, then even if the company is a public company you’ll be unable to sell the securities until you get the company to issue you a “squeaky-clean” certificate.


Can a person be both an affiliate and also not meet the “come to rest” period?  Yes.  What’s the “come to rest” period?  At common law, it is two years.  Under United States v. Sherwood out of the Southern District of New York in the 1950’s, under Rule 144 for a public company the period is cut to one year.  Public companies are treated better under the securities laws in about eight ways.


The SEC introduction to Regulation D talks about “come to rest” and integration.  Rule 504 is the “mom and pop” exemption.  This exemption cannot be used by a public company or investment company.  There is a dollar limit of $1,000,000.  Under all of Regulation D, there can be no general advertising.  The same is true under 4(2).  If you’re an Ohio entrepreneur and you’re getting in the car and dropping in on 80 bankers that you don’t know, that would be construed as general advertising.  But if you hire an Ohio company as your general agent and they deal with these banks all the time and they send out a fax to them, then it’s okay.


Is Rule 504 a 4(2) rule?  That is, is it adopted under 4(2)?  No, it’s adopted under 3(b) of the Securities Act of 1933 which gives the commission power to adopt exemptions for (1) private offerings and (2) limited public offerings below a certain number of dollars (currently $5-$7.5 million).  Rule 504 is broader in the sense that it can cover limited public offerings just as R.C. 1707.03(O) can.


What about 3(a)(11)?  Generally don’t use the 85% rules in Rule 147.  85% of the assets must be in Ohio.  85% of the revenue and profit have to be from Ohio.  Only 1 out of 50 times will you meet that.  If you’re organizing a company in Ohio with its principal place of business in Ohio but half the business will be done in Kentucky.  In that case, don’t use 3(a)(11).  Also, like 4(2), 3(a)(11) counts offerees not purchasers, and if there is a single rotten offeree, either 4(2) or 3(a)(11) is lost forever.  This is Draconian!  It’s a financial trap and snare and sinkhole!  Rules 504 and 506 concentrate, in the main, on purchasers, who you can more easily keep account of.  Under 504, there is no limit on the purchasers because it is a limited public offering rule.  In 506, there is a limit on purchasers, but that limit is pretty liberal.  But under Regulation D, there is no general advertising.  That is true in all of the rules under Regulation D.  That’s a trap!


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