Ch 37 - Securities Regulation

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The SEC creates law in three different ways:

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1. Rules. The securities statutes are often little more than general guides. Through its rules, the SEC fills in the crucial details.
2. Releases. These are informal pronouncements from the SEC on current issues. Releases often operate as two0way communication. When the SEC issues a release to announce a proposed change in the rules, it also asks for comments on the proposal.
3. No-Action Letters. Anyone who is in doubt about whether a particular transaction complies with the securities laws can ask the SEC directly. The response is called a no-action letter because it states that "the staff will recumbent that the Commission take no action" if the transaction is done in a specified manner.

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Security

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Any transaction in which the buyer (1) invests money in a common enterprise and (2) expects to earn a profit predominantly from the efforts of others.

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The 1933 Securities Act:

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Requires that, before offering or selling securities, the issuer must register the securities with the SEC, unless the securities qualify for an exemption. When an issuer registers securities, the SEC does not investigate the quality of the offering. The 1933 Act also prohibits fraud in any securities transaction.

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Issuer:

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The company that issues the stock.

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Exempt Securities:

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The 1933 act exempts some types of securities from registration because they (1) are inherently low risk, (2) are regulated by other statutes, or (3) are not really investments.

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Securities that are exempt from Registration:

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1. Government Securities, which include any security issued or guaranteed by federal or state government.
2. Bank securities, which include any security issued or guaranteed by a bank.
3. Short-term notes, which are high-quality negotiable notes or drafts that are due within nine months of issuance and are not sold to the general public.
4. Nonprofit issues, which include any security issued by a nonprofit religious, educational, or charitable organization.
5. Insurance policies and annuity contracts, which are governed by insurance regulations.

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Exempt Transactions:

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Section 4(2) of the exempts from registration "transactions by an issuer not involving any public offering."

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Intrastate Offering Exemption:

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Under SEC Rule 147, an issuer is not required to register securities that are offered and sold only to residents of the state in which the issuer is incorporated and does business.

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The different types of private offerings can be made under Regulation D (often referred to as Reg D):

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Rule 504, 505, and 506

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Rule 504 - Under this rule (know as the "seed capital" rule), a company:

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1. May sell up to $1 million in securities during each 12-month period.
2. May advertise the stock and solicit an unlimited number of investors if:
1. The transaction is registered under a state law with disclosure requirements
2. Sales are limited to accredited investors.

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Accredited Investors:

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Institutions )such as banks and insurance companies) or wealthy individuals (with a net worth of more than $1 million or an annual income of more than $200,000).

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restricted Stock

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Must be purchased for investment purposes.

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Rule 505 - This rule permits a company to sell up to $5 million of stock during each 12-month period, subject to the following restrictions:

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1. The company may not advertise the stock publicly.
2. The issuer can sell to as many accredited investors as it wants, but is limited to only 35 unaccredited investors.
3. The company need not provide information to accredited investors but must make some disclosure to unaccredited investors. This requirement provides issuers with a serious incentive to avoid unaccredited investors because the disclosure requirements, although less demanding that for a public offering, are nonetheless burdensome.
4. Stock purchased under this rule is restricted.

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Rule 506 - This rule is similar to Rule 505. The differences are that:

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1. there is no limit on the amount of stock a company can sell.
2. If an unaccredited purchaser is unsophisticated, he must have a purchaser representative to help him evaluate the investment.

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Unsophisticated Investor:

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Someone who is unable to assess the risks of the offering himself.

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Regulation A:

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Reg A permits an issuer to sell $5 million of securities publicly in any 12-month period.

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Direct Public Offerings (DPO):

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When a company tries to raise capital for the first time, they may sell stock to the public themselves instead of going through Wall Street. In a DPO, the issuer typically sells shares to its stakeholders: customers, employees, suppliers, or the community.

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The advantages of a DPO are:

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1. It is much cheaper than a regular public offering done through an underwriter.
2. It can be an effective marketing tool - shareholders tend to become even more loyal customers.

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The Downside of a DPO are:

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1. Each investor must receive written information about the company. The cost of this disclosure can be prohibitive when dealing with many small investors. Mailing a $10 disclosure document to hundreds of investors who only want to buy $50 worth of stock each may not be an efficient means of raising money.
2. Although shareholders are warned that they should view their purchases as longterm investments, some will inevitably want to sell their shares, Setting up a system to permit theses trades can be tricky and time consuming.

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Public Offerings:

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When a company wishes to raise significant amounts of capital from a large number of people.

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Initial Public Offering (IPO):

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A company's first public sale of securities.

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Underwriting:

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Usually an investment bank serves as underwriters.

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Firm Commitment Underwriting:

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The underwriter buys the stock from the issuer and resells it to the public.

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Best Efforts Underwriting:

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The underwriter does not buy the stock but instead acts as the company's agent in selling it.

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Registration Statement:

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A statement that notifies the SEC that a sale of securities is pending and to disclose information to prospective purchasers.

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Red Herring:

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The preliminary draft of the registration statement. Called a red herring because it contains a notice in red ink warning that the securities cannot yet be sold.

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Prospectus:

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Under the Securities Act of 1933, an issuer must provide this document to anyone who purchases a security in a public transaction. The prospectus contains detailed information about the issuer and its business, a description of the stock, and audited financial statements.

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Quiet Period:

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begins when a company hires an underwriter and ends 25 days after the stock is first sold to the public.

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Waiting Period:

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The time after the registration statement has been filed but before the SEC has approved it.

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Road Show:

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The cross-country road trip to convince traders to buy the stock.

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Comment Letter:

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The letter sent from the SEC listing changes that must be made to the registration statement.

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Going Effective:

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The date that the stock begins to sell.

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Rule 144:

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Limits the resale of two types of securities: Control securities and restricted securities.

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Control Security:

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Stock held by any shareholder who owns more than 10 percent of a class of stock or by any officer or director.

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Restricted Security:

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Any stock purchased from the issuer in a private offering (such as Reg D)

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Liability:

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1. Liability for Unregistered Securities. Section 12(a)(1) of the 1933 Act imposes liability on anyone who sells a security that is not register and not exempt.
2. Fraud. Section 12(a)(2) states the seller of a security is liable for making any material misstatement or omission, either oral or written, in connection with the offer or sale of a security.
3. Criminal Liability. Under Section 24 of the Act, the Justice Department can prosecute anyone who willfully violates the Act.
4. Liability for the Registration Statement. Section 11 of the Act establishes the penalties for any error in a registration statement. If a final registration statement contains a material misstatement or omission, the purchaser of the security can recover from everyone who signed the registration statement.
1. Damages. To prevail under Section 11, the plaintiff need only prove that there was a material misstatement or omission and that she lost money.
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Liability Continued

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1. Material: important enough to affect an investor's decision.
2. Due Diligence. How the people who signed the registration statement can avoid liability by showing that he investigated the registration statement as thoroughly as a "prudent person in the management of own property."

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Securities exchange Act of 1934:

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To maintain the integrity of the secondary market.

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Reporting Companies:

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Companies that are required to register under the 1934 Act.

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Section 13 requires reporting companies to file the following documents:

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1. An initial, detailed information statement when the company first registers
2. Annual reports on Form 10-K, containing audited financial statements, a detailed analysis of the company's performance, and information about officers and directors
3. Quarterly reports on Form 10-Q, which are less detailed than 10-Ks and contain unaudited financials
4. Form 8-Ks to report any significant developments, such as bankruptcy, a change in control, a purchase or sale of significant assets, the resignation of a director as a result of policy dispute, or a change in auditing firms.

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The Sarbanes-Oxley Act of 2002 requires each company's CEO and CFO to certify that:

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1. The information in the quarterly and annual reports is true
2. The company has effective internal controls
3. the officers have informed the company's audit committee and its auditors of any concerns that they have about the internal control system.

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Section 16:

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1. Insiders must report their trades within two business days. This report must also reveal their total stock holdings in the company.
2. Insiders must turn over to the corporation any profits they make from the purchase and sale or sale and purchase of company securities in a six-month period.

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Section 18:

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Anyone who makes a false or misleading statement in a filing under the 1934 Act is liable to buyers or sellers who (1) acted in reliance on the statement and (2) can prove that the price at which they bought or sold was affected by the false filling.

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Section 10(b):

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Prohibits fraud in connection with the purchase and sale of any security, whether or not the security is registered under the 1934 Act.

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Rule 10b-5:

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Adopted by the SEC to clarify section 10(b).

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Courts have generally interpreted Rule 10b-5 to require:

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1. A Misstatement or Omission of a Material Fact. Anyone who fails to disclose material information, or makes incomplete or inaccurate disclosure, is liable.
2. Scienter. this is a legal term meaning willfully, knowingly, or recklessly. To be liable under Rule 10b-5, the defendant must have (1) known that the statement was inaccurate and (2) intend for the plaintiff to rely on the statement.
3. Purchases or Sale. Rule 10b-5 covers both buyers and sellers.
4. Reliance. To bring suit, a plaintiff must show that she relied on the misstatement or omission.
5. Economic Loss. The plaintiffs must suffer a loss in the value of their investment.
6. Loss Causation. The economic loss must have been caused by the misstatement of a material fact.

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The Private Securities Litigation Reform Act of 1995:

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An amendment to the 1934 Act intended to discourage fraud suits by shareholders.

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Insider Trading:

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A crime punishable by fines and imprisonment. The guilty part may also be forced to turn over to the SEC three times the profit made.

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Insider Trading is illegal because:

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1. If offends our fundamental sense of fairness.
2. Investors will lose confidence in the market if they feel that insiders have an unfair advantage.
3. Investment banks typically "make a market" in stocks, meaning that they hold extra shares so that orders can be filled smoothly.

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The current rules on insider trading are as follows:

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1. Strangers. The Supreme Court has held that someone who trades on inside information is liable only if he has a fiduciary duty to the company whose stock he had traded.
2. Fiduciaries. Anyone who works for a company is a fiduciary. A fiduciary violates Rule 10b-5 if she trades stock of her company while in possession of nonpublic material information. This rule applies not only to employees who work for the company, but also to constructive insiders - others who have an indirect employment relationship, such as employees of the company's auditors or law firm.
3. Possession versus use of information. Rule 10b5-1 provides that an insider violates Rule 10b-5 if she trades while in possession of material, nonpublic information, unless she has committed in advance to a plan to sell those securities.
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The current rules on insider trading are as follows: continued

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4. Tippers. Insiders who pass on nonpublic, material information are liable under Rule 10b-5 even if they do not trade themselves, as long as (1) they know the information is confidential and (2) they expect some personal gain.
5. Tippees. Those who receive tips. Tippees are liable for trading on inside information, even if they do not have a fiduciary relationship to the company, as long as (1) they know the information is confidential, (2) they know it came from an insider who was violating his fiduciary duty, and (3) the insider expected some personal gain.
6. Takeovers. Rule 14e-3 prohibits trading on inside information during a tender offer if the trader knows the information was obtained from either the bidder or the target company.
7. Misappropriation. A person is liable if he trades in securities (1) for a personal profit, (2) using confidential information, and (3) in breach of a fiduciary duty to the source of the information.

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Foreign Corrupt Practices Act:

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Under this Act, it is a crime for any American company (whether reporting under the 1934 Act or not) to make or promise to make payments or gifts to foreign officials, political candidates, or parties in order to influence a governmental decision, even if the payment is legal under local law.

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Blue Sky Laws:

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Statutes in place to regulate the sale of securities.

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National Securities Markets Improvement Act of 1996 (NSMIA):

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Passed by Congress to make life easier for issuers of stock.

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The NSMIA makes it so states may no longer regulate offerings of securities that are:

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1. Traded on a national exchange
2. Exempt under Rule 506
3. sold to qualified purchasers.

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State Regulation
States take one of the following approaches to securities offerings:

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1. Registration by notification. Some states permit issuers with an established track record simply to file a notice before offering their securities.
2. Registration by coordination. some states permit issuers that have registered with the SEC simply to file copies of the federal registration statement with the state.
3. Registration by qualification. Some states require issuers to undergo a full-blown registration, complete with a merit review.

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Coordinated Equity Review (CER):

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the issuer deals with only one state, which takes responsibility for coordinating the comments from all other states.

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Small Company Offering Registration (SCOR):

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Used in offerings of up to $1 million over any 12-month period. the issuer has the right to advertise publicly and can sell any amount of securities to any number of investors. SCOR registration is designed to be used with Rule 147, Rule 504 and Regulation A.

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Uniform Limited Offering Exemption:

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Under this Act, most states largely exempt from registration any offerings under Rule 505.

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Chapter Conclusion:

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the 1929 stock market crash and the Great Depression that followed were an economic catastrophe for the US. The Securities Act of 1933 and the Securities Exchange Act of 1934 were designed to prevent such disasters from ever occurring again. This country had enjoyed years of prosperity that is based, at least in part, on reliable and honest securities market. The securities laws deserve some of the credit for that stability.

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Chapter Review #1

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A security is any transaction in which the buyer invests money in a common enterprise and expects to earn a profit predominantly from the efforts of others.

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Chapter Review #2

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Before any offer or sale, an issuer must register securities with the SEC, unless the securities qualify for an exemption.

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Chapter Review #3

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These securities are exempt from the registration requirement: government securities, bank securities, short-term notes, nonprofit issues, insurance policies, and annuity contracts.

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Chapter Review #4

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If a final registration statement contains a material misstatement or omission, the purchaser of a security offered under that statement can recover from everyone who signed it.

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Chapter Review #5

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The 1934 Act requires public companies to make regular filings with the SEC.

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Chapter Review #6

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Under §16, insiders who buy and sell or sell and buy company stock within a six-month period must turn over to the corporation any profits from the trades. They must also disclose any trades they make in company stock.

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Chapter Review #7

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Section 10(b) prohibits fraud in connection with the purchase and sale of any security, whether or not the issuer is registered under the 1934 Act.

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Chapter Review #8

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Section 10(b) also prohibits insider trading.

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Chapter Review #9

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Under the Foreign Corrupt Practices Act, it is a crime for any U.S. company to make payments to foreign officials to influence a government decision. This statute also requires reporting companies to keep accurate records.

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Chapter Review #10

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The NSMIA prohibits states from regulating securities offerings that are:
1. Traded on a national exchange
2. Exempt under Rule 506, or
3. Sold to “qualified purchasers.”

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Chapter Review #11

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Any securities offerings not covered by the NSMIA must comply with state securities laws, which are varied and complex.

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Practice Test #1

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Christopher Stenger bought 12 Impressionist paintings from R. H. Love Galleries for $1.5 million. Love told Stenger that art investment would produce a safe profit. The two men agreed that Stenger could exchange any painting within five years for any one or two other paintings with the same or greater value. When Stenger's paintings did not increase in value, he sued Love, arguing that the right to trade paintings made them securities. Is Stenger correct?

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Practice Test #2

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CPA QUESTION When a common stock offering requires registration under the Securities Act of 1933:
a. The registration statement is automatically effective when filed with the SEC
b. The issuer would act unlawfully if it were to sell the common stock without providing the investor with a prospectus
c. The SEC will determine the investment value of the common stock before approving the offering
d. The issuer may make sales 10 days after filing the registration statement

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Practice Test #3

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Fluor, an engineering and construction company, was awarded a $1 billion project to build a coal gasification plant in South Africa. Fluor signed an agreement with a South African client that prohibited them both from announcing the agreement until March 10. Accordingly, Fluor denied all rumors that a major transaction was pending. Between March 3 and March 6, the State Teachers Retirement Board pension fund sold 288,257 shares of Fluor stock. After the contract was announced, the stock price went up. Did Fluor violate Rule 10b-5?

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Practice Test #4

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CPA QUESTION Hamilton Corp. makes a $4.5 million securities offering under Rule 505 of Regulation D of the Securities Act of 1933. Under this regulation, Hamilton is:
a. Required to provide full financial information to accredited investors only
b. Allowed to make the offering through a general solicitation
c. Limited to selling to no more than 35 nonaccredited investors
d. Allowed to sell to an unlimited number of investors both accredited and nonaccredited

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Practice Test #5

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Does this excerpt from the Boston Globe reveal any potential securities law problems?
Berkshire Ice Cream's down-home investment strategy is paying off for more than 100 people who last year put up $800 to $1,000 to “own” a company cow. Last month, the company sent out about $32,000 to investors who bought a total of 110 cows a year ago, with the expectation of a 20 percent annual return on their money. [I]nitially, there were 63 investors who agreed to finance the purchase of a cow—which the company then cares for—in return for a piece of the company's profits.

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Practice Test #6

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ETHICS ETS Payphones, Inc., sold pay phones to the public. The company then leased back the pay phones from the purchaser, promising a fixed 14 percent annual return on their investment. Although ETS's marketing materials trumpeted the “incomparable pay phone” as “an exciting business opportunity,” the pay phones did not generate enough revenue for ETS to make the required payments, so the company depended on funds from new investors to meet its obligations to its existing customers. After ETS filed for bankruptcy protection, the SEC sued, alleging that ETS had been selling unregistered securities. Were the pay phone contracts securities under the 1933 Act? ETS advertised this investment as low risk (offering a “guaranteed” fixed return). These sorts of advertisements are particularly attractive to individuals more vulnerable to investment fraud, including older and less sophisticated investors. Continued on next card...

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Practice Test #6 Continued

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Whether or not the pay phone contracts were securities, was it ethical to pitch what was, in fact, a high risk investment to vulnerable investors who were unable to accurately assess the risks? Were these actions right? How would the CEO of ETS have felt if someone had sold such an investment to his poor, elderly mother?

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Practice Test #7

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CPA QUESTION Pace Corp. previously issued 300,000 shares of its common stock. The shares are now actively traded on a national securities exchange. The original offering was exempt from registration under the Securities Act of 1933. Pace has $2.5 million in assets and 425 shareholders. With regard to the Securities Exchange Act of 1934, Pace is:
a. Required to file a registration statement because its assets exceed $2 million in value
b. Required to file a registration statement even though it has fewer than 500 shareholders
c. Not required to file a registration statement because the original offering of its stock was exempt from registration
d. Not required to file a registration statement unless insiders own at least 5 percent of its outstanding shares of stock

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Practice Test #8

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YOU BE THE JUDGE WRITING PROBLEM World-Wide Coin Investments Ltd. sold rare coins, precious metals, camera equipment, and Coca-Cola collector items. Its stock was registered with the SEC under the 1934 Act. Joseph Hale was the controlling shareholder, chairman of the board, CEO, and president. World-Wide's independent auditor warned Hale that the company's faulty system of accounting procedures was causing problems with inventory control. Furthermore, the auditor could not document transactions, and it had found that the books and records of the company were inaccurate. Is World-Wide in violation of the Foreign Corrupt Practices Act? Argument for the SEC: Without exception, all reporting companies are required to maintain accurate books and records. Argument for World-Wide: This is a small company, and the cost of such an elaborate internal control system would bankrupt it.

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Practice Test #9

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Consider this scenario from the periodical Investor's Business Daily, Inc.:
You're in line at the grocery store when you overhear a stranger say: “That new widget is going to make XYZ Co. a fortune. I can't wait until the product launches tomorrow.”
What do you do? (a) Nothing? (b) Call your broker and buy as much XYZ Co. stock as you possibly can?

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Practice Test #10

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Malaga Arabian Limited Partnership sold investments in the Spanish Arabian horse industry under Rule 506. James E. Mark, who purchased one of the partnership interests, alleged that the partnership violated Rule 506 because it never gave him any disclosure about the risks of the investment. He was not an accredited investor. At trial, the partnership said that it had surveyed investors to ensure that they were either accredited or sophisticated but had not actually read the surveys and did not have them available for the trial court. Is this offering exempt from registration under the 1933 Act?

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Practice Test #11

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CoolCom, Inc., sends notice to all of its shareholders that its annual report and proxy soliciting materials are on its Internet Web site. It provides investors with the Internet location and a telephone number that they may call to request a paper copy. Is CoolCom in compliance with SEC rules?

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Practice Test #12

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ROLE REVERSAL Prepare a multiple-choice question that focuses on an issue involving Rule 504, restricted securities, or insider trading.