final paper legal environment

Federal Securities and Antitrust Laws 31

Now that you have studied corporations and are familiar with the concept of stock (see Chap-ter 30), this chapter turns to the study of some of the rules that govern the sale and purchase of such stock (also called securities) and the issuance of stock, as well as the preservation of free economic markets. The first half of this chapter examines the major laws governing securities and the stock exchanges, and the second half reviews the legislative efforts to keep competition fair and unfettered under antitrust laws.

31.1 Securities Laws

The Securities Act of 1933 applies only to initial public offerings (IPOs). Issuance refers to listing the stock on a public stock exchange, such as the New York Stock Exchange, thereby making the stock available for purchase by anyone. Listing and selling stock on public stock exchanges is heavily regulated by both federal and state governments. In the aftermath of the stock market crash of 1929, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934. These landmark acts regulate the original issuance of securities and the sub- sequent trading of securities in the sec- ondary markets, respectively. These acts, as amended, require companies to pro- vide investors with accurate information about their finances and set forth penalties for fraudulent and deceptive activities in the issuance and sale of securities. In these ways, the government seeks to keep the markets free from illegal and deceptive activities that might take advantage of the average investor on the street.

This federal law requires that securities be registered before being offered for sale for the first time. Registration means that the corporation that plans to sell the stock must file paperwork with the Securities and Exchange Commission (SEC), a fed- eral agency that oversees public sales of securities. The paperwork that is filed must meet the precise requirements of the law, whose purpose is to protect the public by requiring that companies file detailed information about their companies. In that way, initial investors can make an intelligent decision about whether or not to invest in the securities offered by the company. The act defines securities broadly to include a range of instruments such as stocks, bonds, debentures, evidence

Listing and selling stock on public stock exchanges, such as the New York Stock Exchange, is heavily regulated by both federal and state governments.

John Moore/Getty Images

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of indebtedness, voting trust certificates, investment contracts, and fractional undivided interests in oil, gas, or mineral rights. In SEC v. W. J. Howey Co. (328 U.S. 293), the U.S. Supreme Court held that an investment contract constitutes a security under the act. Affectionately called the “Howey test,” an investment contract is defined as any transac- tion in which a person:

• Invests • In a common enterprise • Reasonably expecting profits that are • Derived primarily or substantially from the managerial or entrepreneurial efforts

of others.

Registration

Before any new security can be offered to the public through the mails or through any interstate commerce facility (such as a stock exchange or the Internet), the issuer must file a registration statement with the SEC. The registration statement must be written in plain language and include all of the following elements:

• A description of the significant provisions of the security offered for sale that includes the relationship between the security and other capital securities of the company;

• A description of the company’s properties and business; • A description of the company’s management that includes information on the

management’s security holdings, compensation, and benefits; • A financial statement certified by an independent public accounting firm; and • A description of pending lawsuits involving the company.

Before filing for registration with the SEC (the prefiling period), a company must avoid publicity about the new security and may not sell or offer to sell the security to anyone. Once the company files the registration statement with the SEC and its approval is pend- ing (the waiting period), the company may still not sell the security, but may begin to offer it for sale through limited advertisements in ads that tell prospective investors where they may request a prospectus for the new security (see Figure 31.1 for a sample).

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Figure 31.1: A sample prospectus

SUMMARY OF PROSPECTUS

The following is a summary of certain information contained in this Prospectus, and prospective investors are

referred to the more detailed information contained in the other portions of this Prospectus.

THE COMPANY

DeLorean Motor Company, a Michigan corporation formed in October 1975, to engage in the business of develop-

ing, manufacturing, and selling a new automobile.

THE OFFERING

Up to 2,000,000 shares of Common Stock, $.01 par value, to be purchased by Dealers or Dealer Associates who

also apply to become, and are accepted by the Company as, authorized dealers for the Company’s Automobile and

products. The offering will be terminated if 150 or more Dealers have not been appointed by the Company by Decem-

ber 31, 1977, and the Company will not appoint more than approximately 100 Dealers within the United States. In order

to become an authorized dealer for the Company, a Dealer and/or its Dealer Associates must purchase a minimum of

5,000 shares of Common Stock, for a minimum total investment in Common Stock of $25,000. See “Cover Page,” “plan

of Distribution,” “Summary of Terms of Dealer Sales Agreement,” “Business Plan—Sales and Dealer Organization,”

and “Description of the Company’s Common Stock” herein.

The price of the Common Stock has been determined arbitrarily by the Company and bears no relationship to the

tangible assets or performance of the Company. Based upon such price, the value of presently outstanding Common

Stock, Options, and Conversion rights held by management and others is $63,249,500.

BUSINESS PLAN

To manufacture and sell a new automobile, code-named the DMC-12, through a network of dealers distributed

throughout the United States. See “High Risk Factors,” “Financing Requirements and Use of Proceeds,” and “Business

Plan” herein.

USE OF PROCEEDS

To perform production engineering and vehicle development and develop a dealer network for the DMC-12, and

to pay administrative expenses and overhead, including salaries. In order to complete the Company’s program,

substantial additional financing will be required. See “Financing Requirements and Use of Proceeds” and “Business

Plan” herein.

At this point, a company may make available a preliminary prospectus to investors that does not include the price of the security. Once the SEC declares the registration effective and prospective buyers are given a final prospectus (the posteffective period), the com- pany may finally offer and sell the new security.

Securities Exempt From Registration

As noted previously, there are some limited exemptions to the requirement that new secu- rities be registered with the SEC prior to their being offered to the public. According to the Securities Act of 1933, the following securities are exempt from registration:

• All bank securities sold prior to July 27, 1933; • Commercial paper (such as checks, drafts, notes, and certificates of deposit) with

a maturity date of not more than nine months;

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• Government-issued securities; • Securities issued by nonprofit religious, charitable, educational, benevolent, or

fraternal organizations; • Securities issued by a bank or savings and loan; • Securities issued by common carriers regulated by the Interstate Commerce

Commission; and • An insurance policy or an annuity contract.

Under Rule 147, securities offered for sale solely in one state by a company that does at least 80% of its business in the state are also exempt from filing. State securities regula- tions, however, may require the company to file with the SEC. Resale of these securities is also restricted to residents of the state for nine months following the initial sale. In addi- tion to the intrastate sales and security exemptions noted above, the act allows several exemptions involving small securities offerings:

• Rule 506 of Regulation D: Exempts private offerings to accredited investors (expert investors such as banks, executive officers, directors, and partners of the business issuing the security and wealthy investors) and limited offerings to not more than 35 nonaccredited investors (e.g., regular, nonexpert investors).

• Rule 504 of Regulation D: Nonpublic issuers may sell up to $1 million of securi- ties in a 12-month period to any purchaser. General advertising of the issue is permitted, as long as the dollar limit of the issue is not exceeded.

• Rule 505 of Regulation D: Any issuer may sell up to $5 million of securities in a 12-month period to fewer than 35 nonaccredited investors and to an unlimited number of accredited investors. However, general advertising of the issue is not permitted.

• Regulation A: Any nonpublic issuer may sell up to $5 million of securities in a one-year period with no limit on the number of purchasers and no purchaser sophistication requirement. The offering circular is considered the disclosure document for such a filing and must be filed with the SEC, but registration of the offering itself is not required.

Securities purchased under Rules 504, 505, and 506 must generally be held for one year prior to resale, or the seller may be subject to penalties as an underwriter of an unregis- tered security.

Sanctions Under the Securities Act of 1933

Section 12(a)(2) of the Securities Act of 1933 prohibits misstatements or omissions of material fact in any written or oral communication in connection with the general distri- bution of any security by an issuer. Section 17(a) of the Securities Act of 1933 prohibits the use of any device or artifice to defraud, or the use of any untrue or misleading state- ment, in connection with the offer or sale of any security.

The act provides for civil and criminal sanctions for willful and negligent violations. It gives the SEC the power to investigate and bring civil enforcement proceedings under the act and allows the SEC to seek injunctive relief against violators of the act. Section 11 of the Securities Act of 1933 provides civil liability for damages when a registration statement misstates or omits a material fact on its effective date. A purchaser may file suit

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for damages caused by misstatement or omission. The purchaser does not have to prove reliance on the misstatement or omission in purchasing the securities or prove that the defendant negligently or intentionally misstated or omitted a material fact. However, a defendant can escape liability by proving that the purchaser knew of the misstatement or omission when the security was purchased. In addition, defendants can successfully assert the defense of due diligence and escape liability if they can establish that after a reasonable investigation, they had reasonable grounds to believe, and did believe, that the registration statement was true and contained no omission of material fact.

Section 24 of the Securities Act of 1933 provides for criminal liability for any person who willfully violates the act or its rules and regulations. Violators are subject to fines of up to $10,000 and/or imprisonment for up to five years for each criminal violation of the act, which are prosecuted by the Department of Justice.

Securities Exchange Act of 1934

Unlike the disclosure requirements of the Securities Act of 1933, which apply only to the IPO of a security, the Securities Exchange Act of 1934 regulates the trading of securities after their original public offering. The act also regulates securities brokers, dealers, secu- rities exchanges, and national securities associations. In addition, the act created the SEC and empowered it to enforce the securities laws under the 1933 and 1934 acts.

Scope Under the Securities Exchange Act of 1934, companies whose securities are traded on any public securities exchange, and companies whose assets exceed $10 million whose stock is owned by 500 or more shareholders, are required to file information on an annual and quarterly basis with the SEC. Companies are also required to provide the SEC with noti- fication of material changes when they occur by means of a monthly report. The reported information is then made available to prospective investors and to the general public through the Electronic Data Gathering Analysis and Retrieval (EDGAR) database main- tained by the SEC. EDGAR is available online at http://www.sec.gov/edgar.shtml.

The act also requires company insiders (defined as corporate officers, directors, and any- one who controls 10% or more of any company’s class of equity securities) to disclose their holdings and transactions in company securities. Proxy solicitations, which are attempts by a group of shareholders to garner votes from other shareholders on specific issues, are also regulated under the act.

Violations of the Securities Exchange Act of 1934 Both civil and criminal sanctions are available under the act. These include the following:

• Section 18 imposes liability on any person responsible for a false or misleading statement of a material fact in any filing under the act. Anyone who relies on the false or misleading statement may sue for damages without the need to prove that the defendant was negligent in providing the false or misleading informa- tion to the SEC. However, a defendant may avoid liability by proving that the false or misleading information was provided in good faith.

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• Section 10(b) prohibits the use of manipulative or deceptive devices through misstatement or omission of a material fact in the sale of securities. A material fact can be defined as any information where there is substantial likelihood that a reasonable investor would consider it important in making the decision to purchase the security. A seller is not liable under section 10(b) unless he or she acts with scienter (the mental state embracing the intent to deceive, manipulate, or defraud). The prohibition is made applicable to all transactions in securities under Rule 10(b)(5), whether or not the securities need to be registered with the SEC under the 1933 or 1934 acts.

• Section 32 provides criminal liability for violations of the act of up to $5 million in fines and imprisonment for up to 20 years for willful violations of the act. Busi- nesses may be fined up to $25 million for violations of the act.

Sarbanes–Oxley: The Public Company Accounting Reform and Investor Protection Act of 2002

One of the most important pieces of legislation with which you need to be familiar as a business manager is the Sarbanes–Oxley Act of 2002 (SOX). The highly publicized man- agement and accounting scandals involving Enron, Tyco International, WorldCom, Arthur Andersen, and other companies in the recent past led Congress to adopt this law in 2002, with near unanimity in both the House of Representatives and the Senate. The legislation established new or enhanced standards for the boards of all U.S. publicly traded compa- nies, their management, and all public accounting firms. It imposed criminal penalties for certain violations of the act and charged the SEC with implementing rules for complying with the provisions of the act. SOX created a new agency: the Public Company Account- ing Oversight Board (PCAOB), which it charged with the oversight, inspection, regula- tion, and disciplining of accounting firms in their roles as auditors of public companies. Its website can be found at http://pcaobus.org/Pages/default.aspx.

Key provisions of the act include:

• Section 906 requires chief executive officers (CEOs) and chief financial officers (CFOs) of most publicly traded companies to certify the accuracy of financial statements filed with the SEC.

• Section 302 requires both quarterly and annual statements to be certified by the chief executive officer (CEO) and chief financial officer (CFO) of reporting companies as having been reviewed by a signing officer of the company and to contain no factual errors to the best knowledge of the signing officer. The signing officer must also certify the existence of an internal control system to identify all material information that must be reported by the company.

• Section 806 provides protection for employees who report securities violations (whistleblower protection), preventing employers from firing or taking other retal- iatory action against such employees.

• Enhanced penalties, including fines of up to $5 million and/or up to 20 years in jail for criminal violations of the Section 906 certification requirements.

For an interesting and comprehensive look at the Enron scandal, go to “Behind the Enron Scandal” at http://www.time.com/time/specials/packages/0,28757,2021097,00.html. See Chapter 4, Business Ethics, for more on this topic.

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Securities Regulation by the States

Federal securities regulation does not preempt the states from also regulating the sale of securities within their borders. In cases where the issuance or sale of securities is not cov- ered by the federal acts (such as in the case of intrastate offerings), states impose their own regulatory requirements on issuers under what are often referred to as blue sky laws. Every state has its own regulatory scheme covering the issuance and sale of securities. In most states, securities regulation is patterned after the federal acts.

31.2 Federal Antitrust Law

The integrity of our economic system depends not only on regulating the stock mar-kets but also on maintaining a system that allows for free and fair competition. But the system can be undermined if companies are allowed to engage in anticom- petitive practices that artificially manipulate prices, restrict the availability of products, or fix prices by agreements that undermine basic market forces. While the states and the federal government both regulate and punish anticompetitive practices, it is the federal government that regulates anticompetitive practices that can impact interstate commerce, primarily through the Sherman Antitrust Act of 1890 and the Clayton Act of 1914 as amended. In this section, we will focus on these two acts and examine the basic tenets of federal antitrust law.

Sherman Antitrust Act of 1890

As noted above, the U.S. economy depends on a fluid exchange and needs unfettered and fair competition to flourish. Trusts and monopolies are arrangements among competi- tors that destroy competition and regulate pricing. Thus, the courts have determined that trusts defeat competition and should be outlawed. The act also prohibits cartels, which involve the collusion of companies in the same industry to fix prices. While restricted in the United States under the Sherman Antitrust Act, cartels are still allowed to some extent in Europe. For example, in 1999, Hoffman–La Roche pleaded guilty to a worldwide con- spiracy involving international cartels to fix the price of vitamins and paid a $500 million fine.

Violations of the Sherman Act Section 1 of the Sherman Antitrust Act (15 U.S.C. § 1), as amended, declares illegal every “contract, combination in the form of trust or otherwise, or conspiracy, in restraint of trade or commerce among the several States, or with foreign nations.” Violation of the act is punishable as a felony and carries a maximum penalty of $10 million if the violator is a corporation and a maximum fine of $350,000 and/or imprisonment of up to three years if the violator is an individual. Because contracts and conspiracies require the participa- tion of two or more persons, Section 1 of the act applies only to concerted efforts by two or more persons or entities to restrain trade or commerce. (Section 3 of the act extends the same prohibition and penalties for conduct in restraint of trade affecting Washington, D.C., and U.S. territories.)

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Section 2 of the act (15 U.S.C. § 2) makes it a felony to “monopolize . . . or conspire with any other person or persons, to monopolize any part of the trade or commerce among the several States, or with foreign nations.” The maximum penalty for persons or corpora- tions found guilty of violating Section 2 of the act is the same as for violations of Section 1: namely, a maximum fine of $10 million for corporations and $350,000 and/or imprison- ment for up to three years for individuals. Under this section, individual and concerted action to artificially create a monopoly is criminalized. Note that monopolies as such are not prohibited; rather, it is the effort to artificially create a monopoly by restraining trade that is criminalized.

To successfully prosecute individuals or companies for a conspiracy to monopolize, the prosecutor must establish that the defendants planned a course of action with the intent to destroy competition in order to create a monopoly and that they engaged in some overt act to carry out that plan.

In addition to the criminal penalties discussed above, Section 4 of the act (15 U.S.C. § 4) gives U.S. Attorneys, under the direction of the U.S. Attorney General, the power to obtain injunctive relief (such as cease and desist orders) in federal district courts against viola- tors of the act.

The Sherman Act also provides civil penalties to individuals or companies harmed by those who violate the act that include treble damages (triple the amount of actual damages suffered by a plaintiff due to a defendant’s violation of the act).

An individual or corporation may in theory create and maintain a monopoly as long as it is done without engaging in illegal anticompetitive activity. Thus, if an inventor were to invent an engine that runs on tap water, the inventor could patent the invention and be guaranteed a manufacturing monopoly for a period of 20 years from the date that the patent application was filed, once the patent was issued. Likewise, if a corporation dis- covered a new process for genetically engineering a bacterium that ingests waste products and excretes crude oil, it could either patent the new organism or protect its manufactur- ing as a trade secret and thereby guarantee for itself a monopoly without violating the Sherman Antitrust Act (see Chapter 20, Intellectual Property, for more on patents and trademarks). In other words, dominating a market by producing a superior product or service at a lower price than the competition does not violate the act.

The overwhelming majority of suits against violators of the Sherman Act have come from private parties. For an example of a recent case involving the Sherman Act, see U.S. v. Microsoft, Civil Action No. 98-1232, at http://www.microsoft.com/en-us/news/down load/legal/RemediesTrial/PubIntDeterm11-1.pdf.

Legal Standards The courts apply a “rule of reason” test, first announced by the U.S. Supreme Court in Standard Oil Co. v. United States (221 U.S. 1 (1911)), to determine whether specific actions that may arguably result in restraint of trade under the act are illegal. Under the rule of reason test, conspiracies in restraint of trade are held to be illegal under the Sherman Act only if they constitute undue or unreasonable restraints of trade and unreasonable attempts to monopolize. Therefore, only contracts or actions that unduly restrict trade are deemed to violate the act.

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Some types of agreements are so harmful to free competition that they are held to be per se violations of the Sherman Act and punishable in themselves without having to be examined for their reasonableness or potential restraint on commerce. Common exam- ples of per se violations of the act include agreements among competitors to fix prices or limit the availability of commodities, group boycotts in which groups of sellers refuse to deal with a specific company or person, and agreements by competitors to carve out geo- graphic areas in which they will not compete with one another. The following examples will illustrate:

• Three book publishers conspire to fix the price of e-books. This is a price- fixing agreement and a per se violation of Section 1 of the Sherman Antitrust Act (for more information on the actual case, see “Settlements in e-book price-fixing suit” at http://www.upi.com/Business_News/2012/08/30/ Settlements-in-e-book-price-fixing-suit/UPI-12161346368728/).

• Slick’s Lube Works and Do-Em-Fast Oil Changes, two national competing chains specializing in oil changes and related automotive services, agree to divide areas of each state in which they do business so that only one of the companies does business in any given city or town in each state. This agreement, intended to lessen competition and increase the profitability of each franchise for both com- panies, is a per se violation of the act.

• Three major food retailers, ABC Corp., DEF Corp., and GHI Corp., agree not to purchase produce from JKL Corp., a produce wholesaler, until JKL makes major price concessions to each company. This is an illegal boycott and a per se violation of the act.

Clayton Act of 1914

The Clayton Act modifies and strengthens the antitrust provisions of the Sherman Act in a number of significant ways. We’ll explore some of these next.

Prohibition on Price Discrimination Section 2 of the Clayton Act (15 U.S.C. § 13) prohibits sellers from charging different com- petitive buyers different prices for “commodities of like grade and quality.” Temporary price reductions are permitted if made in a good-faith effort to meet a competitor’s price reductions. Different prices may also be charged to reflect higher shipping costs when delivering commodities to buyers in different geographic areas. Quantity discounts are also allowable, provided they are available to all buyers who purchase similar quantities of goods. Giving and soliciting discriminatory pricing are punished equally under the act. Schools, colleges, universities, public libraries, churches, hospitals, and not-for-profit charitable institutions are not subject to the provisions of this section of the act. Violation of this section of the act is punishable by fines of not more than $5,000 and/or imprison- ment for not more than one year.

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Prohibition on Sale and Lease Contracts That Prevent the Buyer From Purchasing Commodities From the Seller’s Competitors Section 3 of the Clayton Act (15 U.S.C. § 14) makes it illegal for sellers of commodities involved in commerce to enter into sale or lease contracts that restrict the ability of buyers to purchase the goods or services of the seller’s competitors when the effect is to lessen competition or tend to create a monopoly in any line of commerce. The effect of this sec- tion is to prohibit exclusive dealing contracts and tie-in sales arrangements in which a buyer must agree to purchase one or more product lines as a precondition to being able to purchase what is typically a highly desirable product line with limited availability.

Antitrust Laws Inapplicable to Labor Organizations Section 6 of the Clayton Act (15 U.S.C. § 17) exempts labor organizations from coverage under antitrust laws, stating that “[t]he labor of a human being is not a commodity or article of commerce” and that the lawful activities of unions cannot be “held or construed to be illegal combinations or conspiracies in restraint of trade, under the antitrust laws.”

Acquisition by One Corporation of the Stock of Another Section 7 of the Clayton Act (15 U.S.C. § 18) generally prohibits the acquisition of one company’s stock by another company when “the effect of such acquisition may be sub- stantially to lessen competition, or to tend to create a monopoly.” Corporations may, how- ever, expand their operations through subsidiaries and purchase the stock of subsidiary companies when the effect is not to substantially lessen competition.

Premerger Notification Section 7A of the Clayton Act (15 U.S.C. § 18a) requires premerger notification by the companies involved. Such notice must be given to the Federal Trade Commission (FTC) and the Assistant Attorney General in Charge of the Antitrust Division of the Department of Justice prior to the acquisition of voting securities when the acquisition would leave the acquirer with voting securities and aggregate assets in the company whose securi- ties are being acquired of $200 million or more. In certain circumstances, the threshold amount is set at $50 million. The amounts are adjusted annually and, as of February 27, 2012, were raised to $272.8 million and $68.2 million, respectively. A waiting period of 30 days (15 days for cash tender offers) is imposed prior to the consummation of acquisi- tions requiring notification of the FTC and Department of Justice, with the waiting period starting on the day that the notification is received by the FTC. In 2011, AT&T attempted a merger with T-Mobile. The Justice Department sued under the act, claiming that the merger would constitute a violation of the antitrust laws, and in 2012 AT&T dropped its attempt at the acquisition. See “AT & T Ends $39 Million Bid for T-Mobile” at http://deal book.nytimes.com/2011/12/19/att-withdraws-39-bid-for-t-mobile/.

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Prohibition on Officers and Directors Serving Competing Companies Section 8 of the Clayton Act (15 U.S.C. § 19) prohibits interlocking directorates and officers serving competing companies if both companies have aggregate capital, surplus, and undivided profits of $10 million or more each. (The amount is also adjusted annually by the FTC on September 30 and was $27.784 million as adjusted for 2012.) Directors and officers serving two companies that meet the minimum capital amount may still lawfully serve both companies as long as one of the following conditions is met:

1. The competitive sales of either company are less than $1,000,000 ($2,778,400 as adjusted for 2012);

2. The competitive sales of either corporation are less than 2% of that corporation’s total sales; or

3. The competitive sales of each corporation are less than 4% of that corporation’s total sales.

Directors and officers of banks, banking associations, and trust companies are exempt from the provisions of this section.

Violations of the Clayton Act The Department of Justice through the Assistant Attorney General in Charge of the Anti- trust Division, state attorneys general, and the FTC all have jurisdiction over violations of the act. The federal and state attorneys general may seek injunctive relief, such as cease and desist orders, in federal district courts. The act also provides treble damages and reasonable attorney’s fee reimbursement in private actions against violators of the act. As with the Sherman Act, the overwhelming majority of suits against violators have come from private parties.

Key Terms

accredited investors Expert investors such as banks, executive officers, directors, and partners of the business issuing the secu- rity and wealthy investors.

blue sky laws State laws that regulate the issuers and sellers of securities; often mod- eled after federal laws.

cartels Prohibited by the Sherman Anti- trust Act, cartels involve the collusion of companies in the same industry to fix prices. While restricted in the United States, cartels are allowed to some extent in Europe.

cease and desist order A type of injunctive relief or court order wherein the person or entity must refrain from undertaking or continuing a certain type of conduct.

due diligence A level of care in which a business takes reasonable care to investi- gate all facts, repercussions, and legal and financial aspects of making a decision.

Electronic Data Gathering Analysis and Retrieval (EDGAR) database Electronic data gathering analysis and retrieval database maintained by the Securities and Exchange Commission.

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exempt from registration Refers to securi- ties that do not have to be registered with the Securities and Exchange Commission prior to becoming public offerings.

Federal Trade Commission (FTC) The federal agency that has jurisdiction over business practices that are anticompetitive, deceptive, or unfair to consumers.

Howey test The test developed by the U.S. Supreme Court in SEC v. W. J. Howey Co. to determine whether paper (an investment contract) is in fact a security.

initial public offering (IPO) The first time a stock is offered for sale on a stock exchange to the public.

insiders Corporate officers, directors, and anyone who controls 10% or more of any company’s class of equity securities.

interlocking directorates Under the Clayton Act, an officer or director of one corporation is prohibited from serving as an officer or director of another competing corporation if each corporation has capital, surplus, and undivided profits aggregating to more than $10 million.

issuance Listing of stock on a public stock exchange, such as the New York Stock Exchange, thereby making the stock avail- able for purchase by the public.

per se violations of the Sherman Act Types of agreements that are so harmful to free competition that they are punishable in themselves without having to be examined for their reasonableness or potential restraint on commerce.

posteffective period Period in which the SEC declares the registration effective and prospective buyers are given a final prospectus, after which the company may finally offer and sell the new security.

prefiling period Period before the filing for registration with the Securities and Exchange Commission, when a company must avoid publicity about the new secu- rity and may not sell or offer to sell the security to anyone.

prospectus A booklet of information pro- vided by a corporation for buyers to read so that they may determine whether the stock is a good investment.

proxy solicitation Prior to the annual meeting, a mailing to shareholders by the corporation giving each shareholder an option to vote on corporate matters via a proxy card, that is, giving their voting rights over to a group who will vote on the issues on their behalf rather than the shareholder voting individually.

Public Company Accounting Oversight Board (PCAOB) A new agency created by the Sarbanes–Oxley Act of 2002, charged with the oversight, inspection, regulation, and disciplining of accounting firms in their roles as auditors of public companies.

registration The filing of paperwork with the Securities and Exchange Commission by a corporation that plans to sell stock.

registration statement Initial paperwork filed with the Securities and Exchange Commission that must be approved by the SEC before stock can be issued.

Regulation A Any nonpublic issuer may sell up to $5 million of securities in a one- year period with no limit on the number of purchasers and no purchaser sophistica- tion requirement.

Rule 147 of the Securities Act of 1933 Securities offered for sale solely in one state by a company that does at least 80% of its business in the state are also exempt from filing. State securities regulations, however, may require the company to file with the Securities and Exchange Commission.

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Rule 504 of Regulation D Nonpublic issu- ers may sell up to $1 million of securities in a 12-month period to any purchaser.

Rule 505 of Regulation D Any issuer may sell up to $5 million of securities in a 12-month period to fewer than 35 unac- credited investors and to an unlimited number of accredited investors.

Rule 506 of Regulation D Exempts private offerings to accredited investors and limited offerings to not more than 35 nonaccredited investors (e.g., regular, non- expert investors).

“rule of reason” test A test employed by the courts to determine whether an action is a restraint of trade contracts or action unduly restrictive.

scienter The mental state embracing the intent to deceive, manipulate, or defraud.

Section 2 of the Clayton Act (15 U.S.C. § 13) Prohibits sellers from charging differ- ent competitive buyers different prices for “commodities of like grade and quality.”

Section 3 of the Clayton Act (15 U.S.C. § 14) Makes it illegal for sellers of com- modities involved in commerce to enter into sale or lease contracts that restrict the ability of buyers to purchase the goods or services of the seller’s competitors when the effect is to lessen competition or tend to create a monopoly in any line of commerce.

Section 6 of the Clayton Act (15 U.S.C. § 17) Exempts labor organizations from coverage under antitrust laws.

Section 7 of the Clayton Act (15 U.S.C. § 18) Prohibits the acquisition of one com- pany’s stock by another company when “the effect of such acquisition may be sub- stantially to lessen competition, or to tend to create a monopoly.”

Section 7a of the Clayton Act (15 U.S.C. § 18a) Requires notification of the Fed- eral Trade Commission and the Assistant Attorney General in charge of the Antitrust Division of the Department of Justice prior to the acquisition of voting securities when the acquisition would leave the acquirer with voting securities and aggregate assets in the company whose securities are being acquired of $200 million or more.

Section 8 of the Clayton Act (15 U.S.C. § 19) Prohibits interlocking directorates and officers serving competing companies if both companies have aggregate capital, surplus, and undivided profits of $10 mil- lion or more each.

Section 10(b) of the Securities Exchange Act of 1934 Prohibits the use of manipula- tive or deceptive devices through misstate- ment or omission of a material fact in the sale of securities.

Section 11 of the Securities Act of 1933 Provides civil liability for damages when a registration statement misstates or omits a material fact on its effective date.

Section 12(a)(2) of the Securities Act of 1933 Prohibits misstatements or omissions of material fact in any written or oral com- munication in connection with the general distribution of any security by an issuer.

Section 17(a) of the Securities Act of 1933 Prohibits the use of any device or artifice to defraud, or the use of any untrue or misleading statement, in connection with the offer or sale of any security.

Section 18 of the Securities Exchange Act of 1934 Imposes liability on any person responsible for a false or misleading state- ment of a material fact in any filing under the act.

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Key Terms CHAPTER 31

Section 24 of the Securities Act of 1933 Provides for criminal liability for any person who willfully violates the act or its rules and regulations. Violators are subject to fines of up to $10,000 and/or imprison- ment for up to five years for each criminal violation.

Section 32 of the Securities Exchange Act of 1934 Provides criminal liability for will- ful violations of the act of up to $5 million in fines and imprisonment for up to 20 years.

securities A range of instruments such as stocks, bonds, debentures, evidence of indebtedness, voting trust certificates, investment contracts, and fractional undivided interests in oil, gas, or mineral rights.

Securities Act of 1933 Federal law gov- erning initial public offerings (IPOs) of securities. Requires that investors receive financial and other significant informa- tion concerning securities being offered for public sale; prohibits deceit, misrepre- sentations, and other fraud in the sale of securities.

Securities and Exchange Commission (SEC) Federal agency that regulates the securities markets. Created by the Securi- ties Exchange Act of 1934.

Securities Exchange Act of 1934 Created the Securities and Exchange Commission (SEC), which it empowers with broad authority over all aspects of the securities industry, including brokerage firms and the various securities exchanges; oversees, identifies, and prohibits certain types of conduct in the markets; and empowers the SEC to require periodic reporting of infor- mation by companies with publicly traded securities.

Sherman Antitrust Act of 1890 Federal law that prohibits monopolies or other devices that restrain free trade.

trusts and monopolies Arrangements among competitors that destroy competi- tion and regulate pricing.

waiting period Once the company files the registration statement with the Securi- ties and Exchange Commission and its approval is pending, the company may still not sell the security, but may begin to offer the security for sale through limited advertisements in ads that tell prospective investors where they may request a pro- spectus for the new security.

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Critical Thinking and Discussion Questions CHAPTER 31

Critical Thinking and Discussion Questions

1. Under the Securities Act of 1933, when must securities be registered with the SEC? What types of securities are covered under the 1933 act?

2. What is the definition of an investment contract under the Howey test? 3. What kinds of securities are exempt from registration under the 1933 act? What

are the maximum penalties for violating the Securities Act of 1933? 4. What is the threshold for registering securities under the 1934 act and having to

file periodic reports about these securities? What is the maximum criminal pen- alty available under the 1934 act?

5. What is the function of the Public Company Accounting Oversight Board (PCAOB) created by Sarbanes–Oxley? What is the maximum criminal penalty for violating the certification requirements of Sarbanes–Oxley?

6. What are interlocking directorates? When are directors and officers of corpora- tions forbidden from working for or serving on the boards of competitors?

7. Private University, a private nonprofit educational institution located in Califor- nia, decides to issue “Shares in Learning” certificates in a one-time offering to the public. These shares will be sold for $500 each and entitle the bearer to redeem each certificate for two undergraduate or one graduate college credit in any of its schools at any time in the future. The shares may also be resold without restric- tion by the initial purchaser. The offering will be made via the Internet.

a. Assuming that the “Shares in Learning” are securities for purposes of the Securities Act of 1933, will the issue need to be registered with the SEC under the act? Explain.

b. Assume that the “Shares in Learning” are issued by Private College, a proprietary for-profit institution licensed to do business in California. Will the securities need to be registered with the SEC if the college does business only in California, the securities are advertised and sold only to California residents via telephone solicitation, and 5 of the 500 current students are from out of state? Explain fully.

c. If State University is a proprietary, for-profit institution that does business in all 50 states and around the world by offering its degrees online, will the securities offering come under the 1933 act?

8. Carlos is the owner of a small business that specializes in refurbishing and sell- ing used laptops for under $300 each. His business has been doing well, and he decides to expand his operation by purchasing 10 similar small businesses from around the country and consolidating them under his brand name of Under $300 Laptops, Inc.

a. Assuming that all the businesses purchased by Carlos were closely held corporations, that he purchased the entire voting shares for these, and that the total assets of each business were under $10 million, would these purchases require FTC notification?

b. Given the niche market in which Carlos operates, if the acquisitions left him with 70% of the laptop refurbishing and resale market and if he had a 5% interest in that market prior to the acquisitions, is Carlos likely to be in violation of the Sherman or Clayton Act?

c. If Carlos provides used laptops to schools at cost, is Carlos guilty of illegal price discrimination under the Clayton Act?

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