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TREATISE, SECURITIES-REGULATION, 3. Definitions 2009, CCH INCORPORATED. All Rights Reserved. A WoltersKluwer Company Definitions a. Security [3(a)(10)] The term security120 is defined as in 2(a)(1) of the Securities Act --which was concurrently amended121 --with a number of variations.122 The phrase evidence of indebtedness does not appear.123 The reference is to "any instrument commonly known as a 'security,'" rather than any interest or instrument. A "guarantee" is not specifically included, although 12(b) authorizes the Commission to require applications for registration of securities to include information with respect to any guarantor as well as the issuer.124 Short term notes of the type that are exempted from registration under the Securities Act by 3(a)(3) are excluded from the definition of "security" in the Exchange Act.125 While the Securities Act definition refers to any "fractional undivided interest in oil, gas, or other mineral rights,"126 the Exchange Act definition uses the language, "certificate of interest or participation ... in any oil, gas, or other mineral royalty or lease."127 It is nevertheless the administrative view that the ordinary oil royalty is a security under the Exchange Act --if not under this portion of the definition, then under the catchall phrases.128 Indeed the Exchange Act definition may well go further than its Securities Act counterpart in the sense that a "certificate of interest ... in any ... lease" is perhaps broad enough to include any portion of an entire leasehold interest, whether or not it is an undivided portion. b. Class Section 12(g)(5) borrowed a special definition from 15(d): For the purposes of this subsection, the term "class" shall include all securities of an issuer which are of substantially similar character and the holders of which enjoy substantially similar rights and privileges. This general problem keeps cropping up in a number of contexts. We have met it in connection with the "new security" question129 and the voluntary exchange exemption;130 and we shall meet it again in connection with 15(d),131 and especially 16, on insider trading, which refers to beneficial holders of more than 10 percent of "any class of any equity security."132 In terms of maximizing the statutory coverage, there is a built-in stress. For purposes of 12(g) and 15(d) --as well as the intrastate and private offering exemptions in 3(a)(11) and 4(2) of the 1933 Act to the extent that different classes constitute separate "issues" or "offerings"133 --it is in the Commission's interest to play down relatively minor difference between "Class A Common" and "Class B Common," or between two formally separate "classes" of convertible debentures, so as to produce one big, widely held "class." So, too, when it is a matter of matching a purchase of Class A against a sale of Class B for purposes of 16(b). But that approach cuts in the opposite direction as far as the 10 percent test in 16 is concerned. Presumably there is some limit to the freedom to give the same term different constructions in different sections of the same statute, particularly since the existence of a single "class" for purposes of 12(g) may be the sole basis for applying 16. Maximization of coverage itself may not be a strong enough solvent. Yet 3(a) of the 1934 Act, like 2(a) of the 1933 Act, introduces all the general definitions with the words, "unless the context otherwise requires." And -more to the point here --the definition of "class" in 12(g)(5) and 15(d) is specifically limited to "the purposes of this subsection." There is not much that has so far emerged in the way of guidelines. As always, of course, "form" must yield to "substance." This means that securities denominated "preferred" and "common"may constitute a single class. The mere fact that one security is convertible into another does not make them one class.134 On the other hand, the result is apt to be different when both securities are of the same basic type, which is to say, common stock, preferred stock, unsecured debt, or secured debt. Convertibility aside, when, for example, two preferred issues differ with respect to one or more of their basic characteristics --voting rights, dividend preference, and preference on liquidation --an approach in terms of the purpose of the differences in the particular case, which would be roughly analogous to the "business purpose" test in tax law, would seem to be superior to the sort of "color matching" approach that Justice Harlan disparaged in his dissenting opinion in the variable annuity case,135 even though the latter approach seems to be invited by the "substantially similar character" language of 12(g)(5). c. Held of Record [Rule 12g5-1] Consistently with the reference in 12(g)(1) to holders "of record," this definitional Rule136 simply supplies a series of explanations and qualifications: (1) "In any case where the records of security holders have not been maintained in accordance with accepted practice, any additional person who would be identified as such an owner on such records if they had been maintained in accordance with accepted practice shall be included as a holder of record."

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(2) "Securities identified as held of record by a corporation, a partnership, a trust whether or not the trustees are named, or other organization shall be included as so held by one person."137 (3) "Securities identified as held of record by one or more persons as trustees, executors, guardians, custodians or in other fiduciary capacities with respect to a single trust, estate or account shall be included as held of record by one person."138 (4) "Securities held by two or more persons as co-owners shall be included as held by one person." It follows from Clauses (3) and (4), for example, that, when John Doe holds some securities in his own name and others as trustee, there are two record holders; that, when John and Mary Doe hold securities as co-owners (whether the type of tenancy is joint or common or by the entirety or unknown) and each of them holds other securities in his or her own name, there is a total of three record holders; and that, when securities are held by John Doe, by Mary Doe, by John and Mary Doe as co-owners, by John Doe as custodian for a minor child, and by John and Mary Doe as trustees, there is a total of five record holders. (5) "Each outstanding unregistered or bearer certificate shall be included as held of record by a separate person, except to the extent that the issuer can establish that, if such securities were registered, they would be held of record, under the provisions of this rule, by a lesser number of persons." Since a convertible bond is defined as an "equity security" by 3(a) (11), this clause applies equally to convertible bonds in bearer form. That is to say, it is simply a matter of counting the number of bonds outstanding, regardless of denomination. (6) "Securities registered in substantially similar names where the issuer has reason to believe because of the address or other indications that such names represent the same person, may be included as held of record by one person." Notwithstanding these six clauses of Rule 12g5-1(a), Rule 12g5-1(b) goes on to provide: (1) "Securities held, to the knowledge of the issuer, subject to a voting trust, deposit agreement or similar arrangement shall be included as held of record by the record holders of the voting trust certificates, certificates of deposit, receipts or similar evidences of interest in such securities: Provided however, That the issuer may rely in good faith on such information as is received in response to its request from a nonaffiliated issuer of the certificates or evidences of interest." Note the limiting words, to the knowledge of the issuer. When that limitation is satisfied, the record holders of the votingtrust certificates or similar securities are counted twice, once to determine the number of holders of the underlying shares and again to determine the number of holders of the votingtrust certificates, which are themselves included within the definition of "equity security" under 3(a)(11). On the other hand, the Rule as adopted does not, as the Commission originally proposed, look through brokers, dealers, banks, or their nominees to include the number of separate customers' accounts. That is to say, the brokerage firm that holds stock in "street name" for 50 customers is counted as a single holder.139 The Commission, apparently assuming that its authority in 12(g)(5) to define "held of record"could be stretched to include beneficial holders in this sense, stated that it had abandoned its original proposal in the interest of simplification but would "determine in the light of experience whether inclusion of these accounts at a future date is necessary or appropriate to prevent circumvention of the Act and to achieve the intended coverage on a uniform and acceptable basis."140 Similar considerations underlay the Commission's decision not to include employees with a direct beneficial interest in securities held by an employee plan.141 (2) "Whole or fractional securities issued by a savings and loan association, building and loan association, cooperative bank, homestead association, or similar institution for the sole purpose of qualifying a borrower for membership in the issuer, and which are to be redeemed or repurchased by the issuer when the borrower's loan is terminated, shall not be included as held of record by any person." This clause corrects an apparent oversight in the drafting of 12(g)(2)(C) of the Act142 that exempts all building and loan securities "other than permanent stock, guaranty stock, permanent reserve stock, or any similar certificate evidencing nonwithdrawable capital." Rule 12g5-1(b)(2), in effect, expands the statutory exemption to include the nontransferable shares (presumably in the nature of "permanent stock" or the like) that some building and loan associations issue solely to qualify borrowers for membership. (3) Finally, we have already noted the safety valve that the Commission preserved by adopting Rule 12g5-1(b)(3): "If the issuer knows or has reason to know that the form of holding securities of record is used primarily to circumvent the provisions of section 12(g) or 15(d) of the Act, the beneficial owners of such securities shall be deemed to be the record owners thereof."143 d. Total Assets [Rule 12g5-2] The assets test in 12(g)(1), too, presents a bit of a dilemma for both the Commission and corporate management. The Commission for its part must balance the conflicting policies of furthering the statutory coverage, which in an inflationary economy would tend to support asset revaluations, and encouraging conservative accounting, which would tend in the opposite direction. Conversely, management now has an incentive to make accounting adjustments downward in order to

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reduce total assets below the $10 million figure and thus avoid registration. As long as the accounting principles followed by the company are supported by substantial authority, are adequately disclosed, do not unfairly portray the company's financial condition, and do not contravene a position expressed in a Commission rule or release, it is difficult to see how the Commission could object to this kind of avoidance. For, consistently with its general approach to accounting principles,144 the Commission has not prescribed detailed rules under 12(g) for valuing assets or computing reserves. Although this may result in some lack of uniformity in the application of the Section, that consideration alone has not persuaded the Commission to undertake the formidable task of choosing between alternative methods of valuation when there is a substantial difference of opinion within the profession. Its definitional Rule145 makes only two points:

(1) The term total assets refers to either the corporate or the consolidated balance sheet, whichever shows the larger figure, as required to be filed on the proper registration form and as prepared in accordance with Regulation S-X. This formula, of course, makes more acute the question whether consolidated statements should be prepared in the first place.146 Clearly the fact that a company may not have prepared consolidated financial statements in the past cannot be determinative for purposes of the $10 million test when generally accepted accounting principles would have dictated consolidated statements. (2) "Where the security is a certificate of deposit, voting trust certificate, or certificate or other evidence of interest in a similar trust or agreement, the 'total assets' of the issuer of the security held under the trust or agreement shall be deemed to be the "total assets" of the issuer of such certificate or evidence of interest." This means that the assets test is met by a voting trust that has half the stock of a company with $10 million of assets. One thing that is clear is that the existence of a capital deficit is irrelevant as long as "total assets" exceed $10 million. On this basis registration might be required even on the part of a company that was insolvent in the bankruptcy sense.
120

The definition of "equity security" is considered infra ch. 6.E.

The definition of "issuer" in 3(a)(8) follows 2(a)(4) of the Securities Act, see supra at 1124-1127. except for a lack of special treatment in connection with oil and gas securities. See supra at 968-969, 980 n. 113. What has been said with respect to the Securities Act definition applies equally here. One question peculiar to the Exchange Act, however, arose by reason of the fact that the issuer and its management were under a continuing duty to report. In certain cases --notably the bonds of railroads whose properties have been leased or purchased by other companies --the issuer for all practical purposes was the owner or lessee of the properties rather than the original issuer of the bonds. The Commission earlier met this problem by adopting a special Rule that in substance made the owner or lessee the issuer: The security was exempted from the registration requirement of 12(a) if the owner or lessee of the property on which the security was a lien filed with the Commission and the exchange a statement complying with the form it would use for the registration of its own securities. The Rule was not limited to railroads, but applied whenever (1) the original owner either had been dissolved or had no assets (other than nominal) except its interest (if any) in the property, and (2) the only means of servicing the security was the payments made by the owner or lessee. Former Rule 12b-2. In 1982, however, the Rule was rescinded because it had become "outdated through the passage of time." Sec. Act Rel. 6414, 25 SEC Dock. 776 (1982) (rescission). The proposal Release added that there were no longer any companies relying on this Rule for exemption from the requirements of 12(a). Sec. Act Rel. 6393, 24 SEC Dock. 1646, 1648 (1982).
121 122

See supra at 923-1138.19.

As noted supra at 924 n. 2, the two definitions are "substantially the same," see S. Rep. No. 792, 73d Cong., 2d Sess. 14 (1934), or "virtually identical." Tcherepnin v. Knight, 389 U.S. 332, 336, 342 (1967).

The Supreme Court considered this omission not to be "of controlling significance" in determining that withdrawable capital shares in a savings and loan association were securities within the 1934 Act. Tcherepnin v. Knight, 389 U.S. 332, 344 (1967); see supra at 958-960.
124

123

This, of course, does not preclude the conclusion that the entire transaction, including the guarantee, is an investment contract. See supra at 1128-1129 n. 437.

125

See supra at 933-934 n. 29; 1205-1219. Section 3(a)(12) of the Exchange Act, which defines "exempted security," see infra at 1784-1792, does not, however, incorporate the "current transaction" requirement found in 3(a)(3) of the Securities Act.
126

See supra at 965-981.

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127 128

Cf. Unif. Sec. Act 401(1), supra at 970-971. Cf. supra at 981.

In Louis Grow, 2 SEC 306 (1937), the Commission revoked the broker-dealer registration of a person engaged in the oil royalty business without specifically discussing the "security" question. The Commission did say, however, that "[t]he Securities Division of the [Massachusetts] Department of Public Utilities appears to have held that oil royalties, working interests, or any undivided fractional interest in oil, gas, or other mineral rights are not 'securities' under the laws of Massachusetts." Id. at 307. This was by way of finding that the respondent had not acted willfully in answering "No" to a question in the SEC application form inquiring with respect to any convictions "involving the purchase or sale of any security." The respondent had been convicted of larceny in Massachusetts in connection with the sale of an oil royalty.
129 130 131 132 133 134

See supra at 1138.21-1138.24. See supra at 1254. See infra at 1868-1879. See infra ch. 6.E. See supra at 1231-1248.

In Plessey Co. PLC v. General Elec. Co. PLC, 628 F. Supp. 477, 488-489 (D.Del. 1986), the court held, for purposes of determining whether a tender offer had been made by one British company to another, that the target's American depositary receipts (convertible to Dollar Ordinary Shares) and those Dollar Shares (convertible to Sterling Ordinary Shares) were all separate classes. But see Chemical Fund, Inc. v. Xerox Corp., 377 F.2d 107 (2d Cir. 1967), where convertible debentures, able to command less than 3 percent of common stock if converted, were held not to be a separate "class" for purposes of 16(b).
135

SEC v. Variable Annuity Life Ins. Co. of Am., 359 U.S. 65, 96 (1959), supra at 1076-1078.

Cf. Fulco v. American Cable Sys. of Fla., 1989-1990 Fed. Sec. L. Rep. (CCH) 94,980 (D.Mass. 1989), deferring to several Commission no-action letters that allowed limited partnerships with similar, but distinct, classes of interests to avoid registration. In each instance "the holders had different rights, notably with respect to profits, losses, and distributions." Id. at 95,489. Cf. also Bear, Stearns & Co., 1982-1983 Fed. Sec. L. Rep. (CCH) 77,343 (avail. Aug. 2, 1982) with Ellerin v. Massachusetts Mut. Life Ins. Co., 270 F.2d 259 (2d Cir. 1959). In the former instance, the Commission staff agreed that in light of differences between Class B and Class C limited partnership interests --a limited guaranty against losses accorded the Class B partners, cash distributions, priority upon liquidation, voting rights and participation in decision making, withdrawal rights, and transferability --the limited partnership interests could be treated as separate classes for purposes of registration under 12(a). In Ellerin, the Second Circuit held that two series of preferred stock were part of a single class in a case arising under 16(b) despite differences in (1) annual dividend rates, (2) redemption prices, (3) sinking fund acceleration rates, (4) dates of issuance registration, listing, and commencement of the payment of dividends, (5) voting rights, and (6) redeemability. Id. at 262. Sec. Ex. Act Rels. 7426 (1964) (proposal), 7492 (1965) (adoption). Rule 12g5-1 was adopted before it became common for securities to be represented by a single certificate, typically in the name of the Depository Trust Company or its nominee, Cede & Co., with the securities registered in book entry form. See infra ch. 7.E.2. The Commission has relied on the "accepted practice" phrase in Rule 12g5-1(a)(1) to view the direct participants in the book entry system, in effect the second tier of the system, as the holders of record. See, e.g., Chevy Chase Sav. Bank, F.S.B., avail. in LEXIS (July 31, 1989); System Energy Resources, Inc., avail. in LEXIS (Mar. 16, 1992). Cf. Valley Nat'l Bank of Ariz., 1990 Fed. Sec. L. Rep. (CCH) 79,461 (avail. Mar. 30, 1990) (Cede & Co. or the Depository Trust Company would not be considered the holder of record). See also GE Capital Pub. Fin., Inc., 1991-1992 Fed. Sec. L. Rep. (CCH) 76,031 (avail. Sept. 25, 1991). See Tankersley v. Albright, 374 F. Supp. 551 (N.D.Ill. 1974), aff'd in part & rev'd in part, 514 F.2d 956, 968-970 (7th Cir. 1975); North Face, 1975-1976 Fed. Sec. L. Rep. (CCH) 80,483 (avail. Apr. 26, 1976).
138 137 136

Industronics, Inc., 1979-1980 Fed. Sec. L. Rep. (CCH) 82,405 at 82,708 (avail. Oct. 9, 1979): Paragraph (a)(3) "aggregates only those beneficial interests 'held of record' by a fiduciary acting solely in that capacity." See also

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Consolidated R. Corp., avail. in LEXIS (June 30, 1980); Perdue Inc., avail. in LEXIS (Apr. 6, 1977). However, when securities are identified as being owned by a person acting as a custodian for individuals and each individual has a separate account, the securities will be deemed "held of record" by each separate account pursuant to Rule 12g5-1(a) (3) and will not be aggregated. Techne Corp., 1988-1989 Fed. Sec. L. Rep. (CCH) 78,887 (avail. Sept. 20, 1988). Similarly when an individual owns securities both as an individual and in the capacity of a joint owner (such as a joint tenant), the securities will be held of record by two different persons for purposes of 12(g). "Rule 12g-5-1(a)(6) ... does not have the effect of aggregating shares 'held of record' by different persons or by the same person acting in different capacities." Id. at 78,457.
139 140 141 142

See Security Am. Corp. v. Meredith, 1981-1982 Fed. Sec. L. Rep. (CCH) 98,448 (N.D.Ill. 1981). Sec. Ex. Act Rel. 7492 (1965). Ibid.

See infra at 1796-1797. See Tcherepnin v. Franz, 461 F.2d 544, 550 (7th Cir. 1972): Withdrawable shares are exempt from registration under 12(g)(2)(C). See also Tcherepnin v. Knight, 371 F.2d 374, 377 (7th Cir. 1967), rev'd on other grounds, 389 U.S. 332 (1967). See supra at 1763-1765. See supra at 724-751. See Sec. Ex. Act Rels. 7426 (1964) (proposal); 7492 (1965) (adoption).

143 144 145 146

Regulation S-X, 3A-01 to 3A-05, governs the consolidation of financial statements. "Generally, registrants shall consolidate entities that are majority owned and shall not consolidate entities that are not majority owned." However, in rare situations consolidations of a majority-owned subsidiary may not result in a fair presentation, because the registrant, in substance, does not have a controlling financial interest (perhaps because of a bankruptcy reorganization, or when control is anticipated to be temporary). In other situations, consolidation of a less than majority-owned subsidiary may be necessary to present fairly the financial results of the registrant because of the existence of a parent-subsidiary relationship by means other than a record ownership of voting stock. 3A-02(a). The Commission also provides guidance for the consolidation of financial statements of a registrant and its subsidiaries when different fiscal periods are employed. See 3A-02(b). There are special rules for bank holding companies, see 3A-02 (c) (no consolidation of subsidiaries subject to the Bank Holding Company Act of 1956 when a decision to divest has been made or there is a substantial likelihood that divestiture will be necessary); foreign subsidiaries, see 3A-02(d); intercompany items and transactions, see 3A-04; and public utility holding companies. See 3A-05.

2009, CCH INCORPORATED. All Rights Reserved. A WoltersKluwer Company

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