PART A
Paul and Thomas Franklin, brothers, are college students and
web designers. While at the University of Megalopolis, a private, for-profit
college in the “Quad State” area, they started an online chat service called
FaceLinked. Paul attended and resided at the college’s campus in the State of
Quadrahenria. Thomas, who was on probation during college
for a low level felony drug conviction, could not be a resident student and
took classes at the campus in the Commonwealth of New Guernsey campus. The chat
service began by putting information from the school’s student
directory online, and offering blog, chat, and message board
features. FaceLinked was such a hit that within a year, the school advised the
brothers that they had to remove FaceLinked from the university’s server as it
was utilizing too many resources. This was not a problem as the
Franklins found advertisers, so they were able to move
FaceLinked to a private server without charging user fees. In fact, FaceLinked
was earning so much revenue that the Franklin brothers were able to pay
themselves and the six friends who helped them start and operate it salaries.
The
Franklin brothers are graduating from the University of
Megalopolis and will be attending separate graduate programs. Paul will attend
Quadrahenria State University, and Thomas the College of New Guernsey. As
FaceLinked is so successful, the brothers not only plan to expand it to the two
new colleges that they are attending, but to as many other
colleges within the four states comprising the “Quad State” area as possible.
They even have hopes of “going national.” As part of their plan to expand to
other campuses, they expect to recruit a student from each of the new
schools “to get them in.” They wish to formalize FaceLinked
by organizing it as a proper business. The brothers would like to maintain a
majority interest in the business, give about 20 percent to the six friends
from their undergraduate days who helped them run the service, and use the
remaining interest in the business to attract other
investors and use employee incentives.
They seek your advice on (a) the form of business they
should use, (b) who might have a claim on the business, and (c) how they might
protect themselves from claims regarding a computerized internet platform?
PART B
FaceLinked has been a phenomenal success for over ten years.
They are now a worldwide social networking phenomenon. Over the years and the
various incarnations of the business enterprise, they are now a corporation
with just under 100 shareholders. In anticipation of a public offering,
they have just completed a private stock offering and
allowed several of the initial equity owners to exercise stock options. The
Franklin brothers each exercised options to purchase 10,000 shares for $5 a
share. Also in anticipation of the public offering, pursuant to the early
intervention
drug plea he made while in college, Thomas Franklin had his
conviction expunged. In addition, FaceLinked sold $10 million in two year
advertising contracts, which would allow the clients to back out for a 90
percent refund. These unusual contracts increased their current revenue by 15%.
As FaceLinked is such a phenomenon, the hype regarding the
public offering has been enormous. Even college students are attempting to buy
the stock. Days before the public offering, the following occurred: (a) a
broker at their underwriter, Silversmith & Baggs, showed a pension fund
director a draft version of the prospectus; (b) Paul sold
1000 shares of the stock that he purchased through the stock option plan for
$45 a share, telling the private investor that the issue price for the public
offering would be at least $60 a share; and (c) several of the people who
bought
stock in the private offering sold it at a nice profit. The
initial public stock offering had many problems. The NASDAQ computer system,
which was implemented pursuant to a recent regulation change by the Securities
And Exchange Commission (SEC), could not keep up with the demand.
The system could not accurately report the price, and many
day traders, including Big Profit Hedge Fund, lost money. Big Profit had
formally filed its opposition to the SEC’s regulation when it was proposed.
After the public offering was completed, FaceLinked stock stabilized at $40 a
share, well below the initial offering price of $70 a share.
In light of the fiasco of the public offering and the bad press that it
generated, users began to drop FaceLinked in favor of a new, upstart rival
service offered by TronCom. Fearful that the new advertisers would back out of
their
contracts, the Franklin brothers sold a great deal of their
stock.
What issues does FaceLinked, its officers, and stockholders
face under (a) state securities law, (b) the Securities Act of 1933, and (c)
the Securities and Exchange Act of 1934? (Points : 60)
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