purchasing without a view to further distribution or resale to nonresidents, may not in due course be resold by such persons, whether directly or through dealers or brokers, to nonresidents without in any way affecting the exemption. The relevance of any such resales consists only of the evidentiary light which they might cast upon the factual question whether the securities had in fact come to rest in the hands of resident investors. If the securities are resold but a short time after their acquisition to a nonresident this fact, although not conclusive, might support an inference that the original offering had not come to rest in the state, and that the resale therefore constituted a part of the process of primary distribution; a stronger inference would arise if the purchaser involved were a security dealer. It may be noted that the nonresidence of the underwriter or dealer is not pertinent so long as the ultimate distribution is solely to residents of the state.

Use of the mails and facilities of interstate commerce

The intrastate exemption is not dependent upon non-use of the mails or instruments of interstate commerce in the distribution. Securities issued in a transaction properly exempt under this provision may be offered and sold without registration through the mails or by use of any instruments of transportation or communication in interstate commerce, may be made the subject of general newspaper advertisement (provided the advertisement is appropriately limited to indicate that offers to purchase are solicited only from, and sales will be made only to, residents of the particular state involved), and may even be delivered by means of transportation and communication used in interstate commerce, to the purchasers. Similarly, securities issued in a transaction exempt under section 3 (a) (11) may be offered without compliance with the formal prospectus requirements applicable to registered securities. Exemption under section 3 (a) (11), if in fact available, removes the distribution from the operation of the registration and prospectus requirements of section 5 of the Act. It should be emphasized, however, that the civil

liability and anti-fraud provisions of sections 12(2) and 17 of the Act nevertheless apply and may give rise to civil liabilities and to other sanctions applicable to violations of the statute.

CONCLUSION

In conclusion, the fact should be stressed that section 3 (a) (11) is designed to apply only to distributions genuinely local in character. From a practical point of view, the provisions of that section can exempt only issues which in reality represent local financing by local industries, carried out through local investment. Any distribution not of this type raises a serious question as to the availability of section 3 (a) (11). Consequently, any dealer proposing to participate in the distribution of an issue claimed to be exempt under section 3(a) (11) should examine the character of the transaction and the proposed or actual manner of its execution by all persons concerned with it with the greatest care to satisfy himself that the distribution will not, or did not, exceed the limitations of the exemption. Otherwise the dealer, even though his own sales may be carefully confined to resident purchasers, may subject himself to serious risk of civil liability under section 12(1) of the Act for selling without prior registration a security not in fact entitled to exemption from registration. In Release No. 4386, we noted that the quick commencement of trading and prompt resale of portions of the issue to nonresidents raises a serious question whether the entire issue has, in fact, come to rest in the hands of investors resident in the state of the initial offering.

The Securities Act is a remedial statute, and the terms of an exemption must be strictly construed against one seeking to rely on it. S.E.C. v. Sunbeam Gold Mining Co., 95 F. 2d 699, 701 (C.A. 9, 1938). The courts have held that he has the burden of proving its availability. Gilligan, Will & Co. v. S.E.C., 267 F. 2d 461, 466 (C.A. 2, 1959); S.E.C. v. Ralston Purina Co., 346 U.S. 119, 126 (1954); S.E.C. v. Culpepper, 270 F. 2d 241, 246 (C.A. 2, 1959).

SECURITIES ACT OF 1933

Recent decision of the courts and of the Securities and Exchange Commission have raised important questions concerning the standards of conduct expected of a registered brokerdealer in connection with the distribution to the public of substantial blocks of unregistered securities, particularly in situations where the securities are those of relatively obscure and unseasoned companies and where all of the circumstances surrounding the proposed distribution are not known to the broker-dealer.1 Particularly significant are the following: What steps the broker-dealer should take to make sure that he is not participating in an illegal distribution in violation of section 5 of the Securites Act of 1933? What investigation he should make concerning the issuer in order to avoid violations of the anti-fraud provisions of the Federal securities laws in the course of the distribution, and particularly section 17 of the Securities Act and section 10(b) of the Securities Exchange Act and Rule 10b-5 thereunder?

In view of certain apparent misconceptions with regard to the responsibilities of a brokerdealer under these circumstances, it seems appropriate to set forth for the guidance of the industry and the Bar certain standards that the Commission believes applicable.

With regard to the registration requirements of the Securities Act of 1933, certain basic principles should be borne in mind. In the first place, section 5 of the Securities Act of 1933 broadly prohibits the use of the mails or facilities of interstate commerce to sell a

1 United States v. Francis Peter Crosby, 294 F. 2d 928 (C.A. 2, 1961); S.E.C. v. Culpepper, 270 F. 2d 241 (C.A. 2, 1959); Gilligan, Will & Co. v. S.E.C., 257 F. 2d 461 (C.A. 2, 1959); S.E.C. v. MonoKearsarge, et al, 167 F. Supp. 248 (D. Utah, 1958); Barnett & Co., Securities Exchange Act Rel. 6310; Best Securities, Securities Exchange Act Rel. 6282.

security unless a registration statement is in effect. A dealer or other person claiming the benefit of an exemption from this requirement has the burden of proving entitlement to it." Where unregistered securities are offered to a dealer for distribution, exemption is commonly claimed under the first and third clauses of section 4(1)3 of the Securities Act which, speaking generally, exempt transactions not involving any distribution by, or for an issuer or for a person controlling, controlled by, or under common control with the issuer. Consequently, in order for this exemption to be available, a dealer must not be participating directly or indirectly in any such distribution. He may become such a participant even if he has no direct contractual relationship or privity with an issuer or person in a control relationship if he, in fact, engaged in steps necessary to such a distribution. Section 4(1) exempts trading transactions between individual investors with respect to securities already issued. It does not exempt distributions by issuers or control persons or acts of other individuals who engage in steps necessary to such distributions. Consequently, a dealer who offers to sell, or is asked to sell a substantial amount of securities must take whatever steps are necessary to be sure that this is a transaction not involving an issuer, person in a control relationship with an issuer or an underwriter. For this purpose, it is not sufficient for him merely to accept "self-serving statements of his sellers

2 S.E.C. v. Ralston Purina, 346 U.S. 119 (1953); Gilligan, Will & Co. v. S.E.C., supra note 1; S.E.C. v. Culpepper, supra note 1; and Edwards v. United States. 312 U.S. 473 (1941).

3 First and third clauses of section 4(1) are now section 4(1) and 4(3) respectively, as amended Aug. 20, 1964.

S.E.C. v. Culpepper, supra note 1.

5 S.E.C. v. Chinese Consolidated Benevolent Association, 120 F. 2d 738 (1941), cert. denied, 314 U.S. 618; S.E.C. v. Culpepper, supra note 1.

and their counsel without reasonably exploring the possibility of contrary facts." 1

The amount of inquiry called for necessarily varies with the circumstances of particular cases. A dealer who is offered a modest amount of a widely traded security by a responsible customer, whose lack of relationship to the issuer is well known to him, may ordinarily proceed with considerable confidence. On the other hand, when a dealer is offered a substantial block of a little-known security, either by persons who appear reluctant to disclose exactly where the securities came from, or where the surrounding circumstances raise a question as to whether or not the ostensible sellers may be merely intermediaries for controlling persons or statutory underwriters, then searching inquiry is called for.

The problem becomes particularly acute where substantial amounts of a previously little known security appear in the trading markets within a fairly short period of time and without the benefit of registration under the Securities Act of 1933. In such situations, it must be assumed that these securities emanate from the issuer or from persons controlling the issuer, unless some other source is known and the fact that the certificates may be registered in the names of various individuals could merely indicate that those responsible for the distribution are attempting to cover their tracks.

2

In United States v. Crosby, the court found persuasive the contention of defendant dealers that, in selling large blocks of unregistered stock of Texas-Adams Oil Co., Inc., in reliance on a legal opinion based upon incomplete facts, they were "doing business as usual" and, to their best knowledge, according to acceptable standards. The court perhaps found this argument persuasive in the context of that criminal conspiracy trial, since no evidence to the contrary was before it. The experience of the Commission, however, clearly demonstrates

1 S.E.C. v. Culpepper, supra note 1 p. 44. See also S.E.C. v. MonoKearsarge Consolidate Mining Company, supra note 1 p. 44. 2 Supra note 1 p. 44.

3 Ralston-Purina supra note 2. Gilligan, Will, supra note 1 p. 44; S.E.C. v. Culpepper, supra note 1 p. 44.

The seller turned out to be a nominee for the controlling group and the brother-in-law of one of them.

that the conduct of these dealers did not meet acceptable standards. Not only did the transactions in fact violate section 5 of the Securities Act, as the court found, but the surrounding circumstances made such violations altogether likely. Shortly after the transfer of control of Texas-Adams to a small group of related persons, large blocks of unregistered stock commenced to appear in the market, accompanied by a drumfire of optimistic publicity from the management, obviously designed to keep the price of the stock up. In such situations, responsible dealers, aware that they have the burden of proving the availability of an exemption,3-and confronted with both an absolute liability to buyers under section 12(1) of the Securities Act, and with the possibility of civil, administrative, or criminal proceedings -proceed with far more caution than was displayed in the Texas-Adams case, and the Commission expects, and will continue to expect, all dealers to do so. It was up to these dealers to make an appropriate investigation as to who their seller was and not simply to rely upon the opinion of the seller's attorney that no control relationship existed.

There have been a number of cases in which dealers have unsuccessfully sought to justify a claim to exemption under section 4(1) of the Securities Act simply by securing from the sellers, actual or ostensible, representations that such persons are neither officers, directors, nor large stockholders of the issuer, and submitting such representations to an attorney who then gives an opinion to the effect that, assuming the correctness of such representations, exemption under section 4(1) is available. Obviously, an attorney's opinion based upon hypothetical facts is worthless if the facts are not as specified, or if unspecified but vital facts are not considered. Because of this, it is the practice of responsible counsel not to furnish an opinion concerning the availability of an exemption from registration under the Securities Act for a contemplated distribution unless such counsel have themselves carefully examined all of the relevant circumstances and satisfied themselves, to the extent possible, that the contemplated transaction is, in fact, not a part

of an unlawful distribution. Indeed, if an attorney furnishes an opinion based solely upon hypothetical facts which he has made no effort to verify, and if he knows that his opinion will be relied upon as the basis for a substantial distribution of unregistered securities, a serious question arises as to the propriety of his professional conduct.1

A broker-dealer undertaking the sale of a block of securities under the circumstances referred to herein has the further problem of avoiding conduct which will violate the antifraud provisions of the Federal securities laws. In making such a distribution, he will probably find it necessary, or at least desirable, to recommend purchase of the security by his customers. The Commission has, however, repeatedly held that it is a violation of the anti-fraud provisions for a broker-dealer to recommend a security unless there is an adequate and reasonable basis for the recommendations2 and, further, that such recommendations should not be made without disclosure of facts known or reasonably ascertainable, bearing upon the justification for the recommendation. As indicated, the making of recommendations for the purchase of a security implies that the dealer has a reasonable basis for such recommendations which, in turn, requires that, as a prerequisite, he shall have made a reasonable investigation. In addition, if such a dealer lacks essential information about the issuer, such as knowledge of its financial condition, he must disclose this lack of knowledge and caution.

customers as to the risk involved in purchasing the securities without it."

In view of the foregoing principles, it would appear that if a dealer undertakes the retail distribution of a block of securities without obtaining reliable information concerning the issuer, there is a substantial risk that he will violate the anti-fraud provisions of the securities laws, either by making recommendations without an adequate basis or by failing to disclose the absence of available information. Indeed, a serious question arises as to whether a dealer who undertakes an aggressive retail distribution to individuals of an obscure, unregistered security, with regard to which reliable information is not readily available, can meet his obligation to treat customers fairly and in accordance with the standards of the profession. The mere fact that a security may allegedly be exempt from the registration requirements of the Securities Act of 1933 does not relieve a dealer of these obligations. On the contrary, it may increase his responsibilities, since neither he nor his customers receive the protection which registration under the Securities Act is designed to provide.

1 In United States v. Crosby, supra note 1 p. 44, the court appears to have regarded the giving of such opinions as significant evidence supporting a jury finding that an attorney was guilty as COconspirator.

2 Leonard Burton, Securities Exchange Act Release 5798; Barnett & Co., supra note 1 p. 44. MacRobbins & Co., Securities Exchange Act Release 6462; Midland Securities Inc., Securities Exchange Act Release 6524.

3 Leonard Burton, supra note 2; Best Securities, supra note 1 p. 44.

MacRobbins & Co., Inc., supra note 2. 5 Best Securities, supra note 1 p. 44.

SECURITIES ACT OF 1933

The Securities and Exchange Commission today announced that it has adopted Rule 155 under the Securities Act of 1933. The new rule relates to the application of the exemption afforded by section 4(1) with respect to public offerings of convertible securities by or

on behalf of any person who purchased such securities directly or indirectly from the issuer in a nonpublic transaction, or to a public offering of the securities received upon conversion of the securities so placed. Of course, where there is an initial public offering of

convertible securities immediate registration is required, in the absence of some exemption, and the rule has no application to such a situation.

A preliminary draft of the rule was published for comment December 2, 1959, in Securities Act Release No. 4162. A number of comments were received in regard to this draft and were carefully reviewed. A revised draft of the rule was published for comment on July 14, 1960, in Securities Act Release No. 4248. The comments received in regard to this draft were also considered and the proposed rule was adopted with certain minor clarifying amendments. Reference is made to those releases for a statement of reasons for the rule and its application to various situations.

The new rule defines the phrase "transactions by an issuer not involving any public offering," in section 4(1)1 of the Act as not including within the provisions of that exemption certain public offerings of convertible securities or of securities received upon such a conversion. The rule excludes from the quoted exemption two types of public offerings. The first is a public offering of a security, which is immediately convertible into another security of the same issuer, by or on behalf of any person or persons who purchased the convertible security directly or indirectly from the issuer in a nonpublic transaction. The other type of offering excluded from the quoted exemption is one by or on behalf of any such person or persons of the security acquired upon conversion, unless the person or persons making the public offering are not underwriters within the meaning of that term as defined in section 2(11) of the Act. In determining whether any such person is an underwriter, the usual statutory tests are to be applied, as in other situations.

In order that intermediate persons who are not connected with any public offering of such securities may not be treated as underwriters, the rule provides that any such intermediate holder of the convertible security or of the underlying security who has not acquired it

1 Now section 4(2), as amended Aug. 20, 1964.

with a view to its distribution and is not instrumental in making or arranging a public offering is not to be deemed an underwriter for the purpose of the rule. Of course, even though a person is instrumental in making or arranging a public offering of the underlying security, the rule does not apply if the acquisition, retention and disposition of such security are such that the person is not an underwriter within the meaning of the term as defined in section 2(11) of the Act.

Inasmuch as the rule is intended to have only prospective application, provision is made that it shall apply only with respect to convertible securities issued after the effective date of the rule.

The text of the rule, which was adopted pursuant to the Securities Act of 1933, particularly section 19 (a) thereof, reads as follows: Rule 155. Definition of "Transactions by an Issuer Not Involving Any Public Offering" in Section 4(1)1 of the Act for Certain Transactions with Respect to Convertible Securities

(a) The phrase "transactions by an issuer not involving any public offering" in section 4(1)1 of the Act shall not include (1) any public offering of a convertible security (which at the time of such offering is immediately convertible into another security of the same issuer) by or on behalf of any person or persons who purchased the convertible security directly or indirectly from an issuer as part of a nonpublic offering of such security, or (2) any public offering by or on behalf of any such person or persons of the security acquired on conversion of a convertible security, unless the security so acquired was acquired under such circumstances that such person or persons are not underwriters within the meaning of section 2(11) of the Act.

(b) The phrase "transactions by any person other than an... underwriter" in section 4(1) 1 of the Act shall, in the situations covered in paragraph (a), be deemed to include transactions by the initial, and any intermediate, holder of the convertible security or of the underlying security who (1) has not acquired