May 12, 2011
Federal Securities Law: A Plea for Simplification
It's past time we do something about federal securities law. I don't mean a new exemption or changes to a few rules. I mean a complete rewrite of federal law. First enacted 75+ years ago, the federal securities laws have grown into a complex morass that is totally inaccessible to business people without the intervention of sophisticated securities law specialists.
Federal securities law is based primarily, but not exclusively, on four statutes: the Securities Act of 1933, the Securities Exchange Act of 1934, the Investment Company Act of 1940, and the Investment Advisers Act of 1940. Those statutes cover literally hundreds of pages, and the regulations associated with those statutes are even more extensive. Size alone is an issue; it’s not surprising that someone might get lost in all that detail. But the complexity lies in more than just the magnitude of the enterprise as a whole.
Consider one small, but important, provision, subsection 5(b)(1) of the Securities Act. Section 5(b)(1) says, in its entirety:
It shall be unlawful for any person, directly or indirectly –
(1) to make use of any means or instruments of transportation or communication in interstate commerce or of the mails to carry or transmit any prospectus relating to any security with respect to which a registration statement has been filed under this subchapter, unless such prospectus meets the requirements of section 10 of this Act; . . .
Understanding exactly what this small subsection does and does not prohibit requires a circuitous traipse through the statute and the SEC rules. First, one has to deal with the lengthy interstate commerce language at the beginning of the subsection—what exactly does it mean to “make use of any means or instruments of transportation or communication in interstate commerce or of the mails”? The statute provides little guidance.
But, putting that jurisdictional issue aside, one must next determine what a “prospectus” is. There’s a lengthy definition in section 2(a)(10) of the statute, with two exceptions to that definition which depend on when the communication is made and what the communication includes. The section 2(a)(10) definition and exceptions require statutory side trips into section 2(a)(3) to determine what an “offer” is and to determine exactly what section 10(a) requires. But the journey to define a prospectus is incomplete without looking at the SEC’s view on what constitutes an offer—which, not surprisingly given that it’s the SEC, does not require that one actually ask people to buy a security, or even mention that one is offering securities, for that matter. It’s enough to “condition the market.” And there are a multitude of rules providing that certain communications either are not prospectuses or are not offers at all: Rules 134, 134A, 134B, 135, 135A, 135B, 137, 138, 139, 139A, 167, 168, and 169, although I’m sure I missed a few.
Let’s assume you’ve waded through the rules and cases, and what you’re transmitting is a prospectus. You’re not done yet. It’s not a violation if the prospectus you’re transmitting “meets the requirements of section 10” of the Securities Act. When you look at section 10, you find two things. First, section 10(a) says that a prospectus must include most of the information contained in the registration statement, with a cross-reference to two statutory schedules listing what the registration statement must include. But don’t be misled by that—the SEC has exercised its statutory power to change what must be in the registration statement, so those statutory schedules are obsolete. You have to look at the SEC forms instead.
The SEC has also exercised the power granted in section 10(b) to approve other communications for purposes of section 5(b)(1), so it’s back to the rules. Rule 430 and 431 are relatively straightforward, but God help anyone who stumbles into the Rule 164/433 combination. Whether a communication falls within the Rule 433 safe harbor can depend on, among other things:
(1) whether the issuer has filed a registration statement, Rule 433(a);
(2) characteristics of the company issuing the securities, such as its size and how long it has been a reporting company, Rule 433(b);
(3) the content of the communication, Rule 433(b)(2)(i), (c);
(4) who is making the communication, Rule 433(d), (f);
(5) where the information in the communication originally came from, Rule 433(d)(1)(i)(B), (h)(2);
(6) whether the information in the communication is otherwise available to the general public, Rule 433(d)(8)(ii); and
(7) whether the issuer or anyone else associated with the offering paid for the communication, Rule 433(b)(2)(i), (f)(1)(i).
This is one subsection in one statute—a very important subsection, admittedly, but still only one tiny part of the morass. And most of this comes from the same agency that has chided lawyers for their inability to write in “plain English.”
This is the rule of lawyers, not the rule of law. Anyone who tries to navigate through the Securities Act provisions without a sophisticated securities lawyer, either to register an offering or to avoid registration, will fail. They will violate the law--not “might” but “will.” Only SEC restraint has avoided wholesale prosecution of a large number of entrepreneurs. (The SEC must be too busy investigating and prosecuting insider trading.)
It’s time to have a set of offering and exemption rules that, even if they’re not accessible to the average lay reader, at least are understandable to a reasonably competent lawyer who isn’t versed in securities law. We need rules that entrepreneurs can understand—straightforward answers to the question of what they may or may not do in raising capital. If that means a complete rewrite of the statute, so be it.
"Anyone who tries to navigate through the Securities Act provisions without a sophisticated securities lawyer, either to register an offering or to avoid registration, will fail. They will violate the law--not “might” but “will.” Only SEC restraint has avoided wholesale prosecution of a large number of entrepreneurs. (The SEC must be too busy investigating and prosecuting insider trading.)
It’s time to have a set of offering and exemption rules that, even if they’re not accessible to the average lay reader, at least are understandable to a reasonably competent lawyer who isn’t versed in securities law. We need rules that entrepreneurs can understand—straightforward answers to the question of what they may or may not do in raising capital. If that means a complete rewrite of the statute, so be it."
Is there any reason that this should be done by people other than sophisticated securities lawyers? As your post makes clear, the rules of clear, just not simple, and scholars like Professor Mulligan, for example, have made a good case, that this is the most important matter.
For attorneys who do not represent people in public offerings (which are almost always handled by investment banks that are well counseled), far less is relevant. The take away less from Section 5 of the Securities Act is that it is illegal to offer to sell unregistered securities to the public unless an exemption applies (one that produces take down notices from securities regulators directed to would be Craig's List offerors almost every week). Regulation D provides the vast majority of the information needed to use the most common exemptions to registration. It is almost impossible, in practice, to end up with a corporation subject to the '34 Act without first conducting a public offering under the '33 Act.
Moreover, it is not necessary for a competent non-specialist lawyer to master every available exemption to registration. Mastery of two or three safe harbors is enough to escape client liability.
The only component of the federal securities act that has broad application to private offerings of securities (other than the requirements for not being subject to it) is Rule 10b-5, which closely tracks common law fraud liability.
The costs of a public offering does in a workmanlike manner runs to the hundreds of thousands of dollars even for a relatively straightforward offering, which is more than enough to cover fees for a sophisticated securities lawyer, as opposed to a non-specialist lawyer or lay person.
In practice, mastery of these tiny pieces of the federal securities laws is quite sufficient for a private attorney who represents small and medium sized businesses, affluent individuals, and closely held large businesses to know without being dangerous. Investment banks and entities that are public held, are normally represented by large law firms that have sophisticated securities lawyers on retainer.
Posted by: ohwilleke | May 12, 2011 11:00:31 AM
I disagree with you on a number of points.
1. The rules are neither clear nor simple. They are remarkably unclear in many areas, even to sophisticated securities lawyers.
2. It is one thing to have complex rules. It is another thing entirely to have unnecessarily complex rules. Because of the way the system has developed--using rules to change the basic statutory process without amending the statute, it's a regulatory minefield.
3. Not everyone subject to these rules is doing a multimillion dollar public offering. People raising relatively small amounts for startup businesses are violating these rules every day without even knowing it. That leaves far too much discretion to the SEC to decide who to ignore and who to prosecute. If there were an exemption for all offerings below a certain dollar amount, with no additional requirements, I would be less worried about the complexity of the rules. But Rule 504 no longer provides such an exemption.
4. Extra legal fees, to most non-attorneys, are not a good thing. The fact that companies doing public offerings might be able to afford it is irrelevant. Anything that can reduce legal costs for anyone, no matter the size of their company, is a good thing.
5. I picked section 5 as an example, but the problem persists in many other areas where people might be caught unaware, not even realizing there's a potential problem--the definition of broker, for example.
Posted by: Steve Bradford | May 12, 2011 12:47:06 PM