chp 18

SECURITIES REGULATION

Chapter 18

Meiners, Ringleb and Edwards

The Legal Environment of Business, 13th Edition

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Corporate Finance Security  May be debt (debt securities) of certain form Note or bond that can be traded

 May be equity (equity financing) Most famous are common stocks traded on New York Stock

Exchange, NASDAQ, etc.

 Securities provide capital for business operations

 Securities represented by Pieces of paper More commonly now, just electronic records

 Represent value in something real

Debt and Equity

Debt When bonds are sold, there is an

issue of a certain amount

Bonds when traded are securities

Debt financing may also occur by borrowing from large lenders (e.g., insurance companies)

Instrument usually specifies: Amount of debt Length of period Repayment method Rate of interest charged

Equity

• Equity financing is raising funds through sale of company stock

• Sale of company stock to purchasers – (shareholders)

• Shareholders have claim to future profits of company

• Company is not obligated to repay shareholders

• If openly traded, are securities

Origins of Securities Regulation

States began with blue sky laws to deter fraudulent securities sales.

Most important Federal laws are:  Securities Act of 1933 Regulates initial public offerings of securities

 Securities Exchange Act of 1934 Regulates trading in existing securities, disclosure

requirements, securities markets and professionals

Securities and Exchange Commission  Agency responsible for enforcement and administration of

federal securities laws

What Is A Security?

Merely calling something a security does not make it one

Have higher regulatory controls for securities

Four basic elements (Howey Test):  Investment of money  In a common enterprise  With an expectation of profits  Generated by efforts of persons other than the investors

Securities Exempt from Regulation

Securities issued or guaranteed by government Federal, state or local

Securities issued by banks

Securities issued by religious and charitable organizations

Insurance policies

Annuity contracts

Offering Securities to Investors

1933 Act requires full disclosure of all material information on security, issuers, and intended use of money before sale to public.

Material information is relevant information an investor would want to know:  Background  Executives  Plan of operation (use of money raised) Despite regulations, a lot of bogus securities are sold, Latta case provides example.

Latta v. Rainey

From 2001 - 2004, Mobile Billboards of America (MBA) sold mobile billboard “investments” in U.S. Investors given “offering circular” to seemingly comply with federal and state regulations. Billboard units were $20,000. Leased the unit for 7 years to Outdoor

Media Industries (OMI), a shell company run by MBA’s principals. Investors promised average return of 13.49% per year. After 7 years,

MBA would buy back the billboards & return investment. MBA claimed it had a Reserve Guaranty Trust (RGT) – $5,000 of each $20,000 would be placed in RGT. Investors received a certificate to receive share of money earned by

funds invested in RGT, plus the right to the $20,000 investment. Latta, terminally ill, wanted a secure investment. Rainey, “Certified

Senior Advisor” with MBA said Billboards was a “safe company – “absolutely no risk”. Latta invested $100,000.

Latta v. Rainey Rainey received a commission of 16-20%. Lattas received “lease

payments” from OMI the first year. This was classic Ponzi Scheme. Secretary of State of North Carolina investigated. MBA ordered to cease

and desist from sales. Rainey collected Latta’s final investment. Latta and others sued. Rainey filed for bankruptcy; Mr. Latta died. Trial Court Held: MBA billboard sales were unregistered securities –

violation of federal and state law. Also breach of fiduciary duty by Rainey to Latta, fraudulent concealment, securities fraud and conversion. Jury awarded Mrs. Latta $95,503.40, plus $750,000 punitive damages.

Court reduced punitive damages to $286,510. Rainey appealed. HELD: Affirmed. Elements of fraud: (1) False Representation or Omission of Material Fact,

(2) Intent to Deceive, (3) Reasonable Reliance (by Lattas) All elements were present here.

Registration Statement • Prospectus (SEC Schedule A)

• First version of prospectus not yet approved by SEC: Called red herring – traditionally red ink on 1st page

• Provides material information about: • Issuer’s finances and business • Purpose of the offering • Plans for funds collected • Risks involved • Promoter’s managerial experience and financial compensation • Financial statements certified by independent CPA

The Registration Statement Regulation S-K

 More detailed disclosure than in prospectus reported to SEC  Used by investment analysts  Available for public inspection

Review by SEC  Doesn’t rule on merits (likelihood of success)  Can require issuers to indicate high-risk factors to buyers  Registration effective 20 days after filing, but SEC can issue deficiency letter and

issuer will need time to amend the filing  Can issue stop order to prevent sale until examiners are happy

Costs of Registration  Expensive: Need securities attorney, CPA, printer, and underwriter (i.e. investment

banker)

Exemptions From Registration • Some securities, while subject to securities laws, are exempt from

registration requirements: • Government Bonds • Private Placements

• Not offered to the public • Usually placed with institutional investors (pension plans or

insurance companies) • Regulation D specifies what will qualify as a private placement

exemption • Made to accredited investors – presumed sophisticated and

wealthy – complex rules • Common Reg. D offerings are called Small Corporate Offering

Registration (SCOR) • Rule 144A sale of bonds or stocks to qualified institutional buyers

(QIBs) investors w/portfolio of at least $100M

Well-Known Seasoned Issuers (WKSIs)

• Securities issued by WKSIs: • Issuers that have issued at least $1 billion in securities

previously OR have public-equity market capitalization of at least $700 million

• They can file registration statements (Form S-3) the day new offering is announced rather than submitting for SEC staff review beforehand

• Can continuously update information – via Website • Securities are under shelf registration – once announced

and registered, they may be sold at any time over next 3 years.

Crowdfunding Since 2016, possible for non-accredited investors to invest in securities sold

by crowdfunding—up to $1 million over 12 mos. Idea is to make equity funding possible for small businesses due to high

cost of Initial Public Offering registration Lets investors who do not meet traditional definition of being accredited

have a chance to invest in new small companies. Anyone can invest $2000 or 5% of net worth or income which ever is less Method called the 12g Rule; variation of traditional Rule 504 Must provide financial background info to investors Must register fact that offering is occurring with SEC Complicated disclosure requirements make it unlikely these small offering

will be common.

Regulation of Securities Trading If registered under ‘33 Act, must register under ‘34 Act;

If exempt under ‘33 Act, must register

If traded on an exchange or OTC market and have >$5M assets and 500+ shareholders company is public

Publicly Held Company

Publicly traded stock Most traded OTC Must file 10-K annual report

Privately Held Company

Less than 500 shareholders

Not openly traded

Proxies and Tender Offers • Regulation FD (Fair Disclosure) in 2002 tried to create a

“level playing field,” requiring public companies to release information to the public rather than selective revealing of information

• Proxies • Permission by shareholders given to someone else to

vote their shares in the manner they instruct • Tender Offers

• When one company attempts to take over another • Target company’s owners offered stock in acquiring

company or cash in exchange for their stock

Securities Fraud Investors may have trouble proving common-law fraud so sually rely on

antifraud provisions of ‘33 and ‘34 Act for statutory fraud

‘33 Act: Misleading statements or material omissions in original registration materials

Rule 10b-5

Basis for Securities Fraud; used more than other Act sections

Civil liability for misstatements

Unlawful to:  Employ device, scheme to defraud

 Make untrue statement of material fact

 Engage in act or practice which operates a fraud in connection with purchase/sale of security

To Succeed on Claim of Securities Fraud • Court of Appeals explained in order to proceed, plaintiff

must establish

• 1. A false statement of omission of material fact

• 2. Made with scienter

• 3. Upon which plaintiff justifiably relied

• 4. That proximately caused plaintiff’s injury

Liability for Securities Law Violations

Can sue parties who prepared disclosure docs or other important info about securities

Can also sue directors of company, CEO, CFO and accounting officers, accountants, lawyers

SEC may also act against them with civil penalties and criminal charges Have liability for misstatements or omissions about

financial status of business with publicly traded securities

Liability for Misstatements

Safe Harbor

oSecurities Litigation Reform Act of 1995

oAllows companies to predict profits and likely success as long as forecasts are accompanied by “meaningful cautionary statements” that identify “important factors that could cause actual results to differ materially from those in the forward-looking statement.”

oGives immunity from liability

Federal Exclusivity

oSecurities Litigation Uniform Standards Act of 1998

oRequires securities suits that involve nationally traded securities to be brought “exclusively” in federal court under federal law.

City of Livonia Employees Retirement System v. Boeing Company

Class action suit for all who bought Boeing stock between May 4 and June 22, 2009. Allegation: Boeing was overly optimistic about ability to get new 787 into service. Technical problems known after test flight; official first flight delayed. Stock fell 10% on June 23. Suit claimed company executives made false statements about when plane

would be in service and therefore committed securities fraud. District Court dismissed suit. Plaintiffs appealed. HELD: Affirmed. Case dismissed. Private Securities Litigation Reform Act of 1995

changed securities fraud litigation. (1) Requires plaintiff complaining about “forward looking” statements

(predictions or speculations about the future) to prove “actual knowledge” of falsity on part of defendant (2) Complaint must “state with particularity facts giving rise to a strong

inference that the defendant acted with the required state of mind” • This is rather than mere inference. • “Required state of mind” is “scienter.” • Use “a reasonable person test”

City of Livonia employees Retirement System v. Boeing Company

There is no securities fraud by hindsight. Law does not require public disclosure of mere risks of

failure. No predictions have a 100% probability of being correct. Future is uncertain Market debut may be delayed or even abandoned. Purchasers of 787s protected themselves by reserving the

right to cancel their orders. If top executives knew statements were false, that is one

thing~ here no evidence that executives made statements they

knew to be false.

Sarbanes-Oxley Act Requirements

 CEO and CFO of companies with publicly traded stock must personally certify that financial reports comply with SEC rules.

 Knowing misstatements have criminal fines and imprisonment.

 Protection provided for corporate whistleblowers.

 Established Public Company Accounting Oversight Board to discipline CPAs for misconduct & set accounting standards.

 Sarbanes-Oxley has forced firms to expand and standardize procedures and accounting.

Insider Trading

•Most controversial application of 10b-5 is prohibiting insider trading

•Insiders have access to info not available to public

•May be liable to SEC for profits from such transactions; possibility of prison term

U.S. v. Salman

• Maher Kara worked for Citgroup’s investment banking group. • He frequently discussed details of his work with his brother, Michael

Kara. Michael began to trade in stocks based on Maher’s information about upcoming mergers and other activities.

• Maher became engaged to Salman’s sister. He and Salman became good friends.

• Michael encouraged Salman to make trades like he was doing based on Maher’s information. Two of them made identical trades.

• Salman’s account grew from $400,000 to $2.1 million. • Investigators figured out what was going on. • Michael confessed to government about activities – pled guilty. • Salman, as tippee, was convicted on 5 criminal counts, included trading

inside information. He contended the evidence was insufficient to find that either Maher disclosed information to Michael in exchange for personal benefit, or, if he did, that Salman knew of such benefit. He appealed.

U.S. v. Salman

• Affirmed. “Personal benefit” requirement for tippee liability comes from the Supreme Court. Not only are insiders forbidden by fiduciary relationship from personally using undisclosed corporate info to their advantage, they “may not give such information to an outsider . . for their personal gain.”

• Test: “Whether the insider personally will benefit, directly or indirectly, from his disclosure.” Then there is a breach of fiduciary duty.

• Tippee is usually liable if “the tippee knows or should know that there has been a breach.”

• Personal benefit Includes pecuniary gain or reputational benefit that will translate to future earnings.

• Here was a “gift of confidential information to a trading relative.” Jury had enough facts to infer that when Michael received inside info, and Maher knew Michael would trade on it. As part of the “close-knit Kara clan,” Salman must have known that there was an intention to benefit a close relative.

Insider Trading Acts

∗Insider Trading Sanctions Acts of 1984

∗Gives SEC authority to bring enforcement actions.

∗The law was strengthened by the Insider Trading and Securities Fraud Enforcement Act. ∗Increased the maximum fine to persons to $1 million

per action and set maximum prison term to 10 years per violation. ∗Corporate fines were raised to $5 million per willful

violations. Up to $25 million for non-willful violations.

The Investment Company Act

Regulates Investment Companies Three types

Face-amount certificate companies – issue debt securities paying fixed rate of return Unit investment trusts – offer

fixed portfolio of securities Management companies –

most important type

Regulates Mutual Funds ∗ Open-end Company (Mutual Fund)

∗ No specific number of shares; expand as long as new investments

∗ Invested in portfolio of securities ∗ Two kinds of mutual funds:

∗ Load: Sold through securities dealer; have commissions (load) of some % of price

∗ No-Load: Sold directly to public through mail or Internet; no sales commissions

Regulation of Investment Companies • Must register with SEC • State operational policy and provide financial information • Annual reports • Capital requirements • Payment of dividends

• Registration and Disclosure • Securities registered • Disclosure requirement of the SEC for publicly-traded securities

• Limiting Conflicts of Interest • Restrictions on who may be on Board of Directors • At least 70% must be outsiders • Invested funds cannot be used for deals with persons affiliated with company. All deals

must be “arm’s length”

The Investment Advisers Act

• Investment Adviser is a “person who, for compensation, engages in the business of advising others . . . as to the advisability of investing in, purchasing or selling securities”

• Hired by investment companies • Registered with SEC • Manages operations • “Deemed to have a fiduciary duty with respect to receipt of

compensation for services” rendered to company.

Professional Responsibility to Clients

Brokers  Affect transactions for

the account of others Dealers  Buy and sell securities

for own account Advisers  Charge fees for

investment advice

• Must be registered with SEC • Cannot churn

• Excessive buying and selling of client’s account to get commissions

• Cannot scalp • Buy stocks for personal

benefit then urge clients to buy so price goes up

Stock Market Regulation New York Stock Exchange and other exchanges are “self-regulated.”

Governed by FINRA, the Financial Industry Regulatory Authority, an independent authority overseen by SEC. FINRA has 3,600 employees, mostly in New York and Washington, D.C. FINRA:

Sets rules of behavior for brokers and handles most disputes.

Oversees more that 4,000 securities firm that employ more than 600,000 registered brokers.

Handles more than 1,000 disciplinary actions/year Imposes about $200 million a year in fines Expels or suspends hundred of securities professionals annually

ACAP Financial v. SEC • Greyfield Capital was defunct Canadian company. A couple of con men

got their hands on a signature stamp belonging to company’s former president. They used the stamp to:

• Appoint themselves corporate offices • Issue millions of unregistered shares in their names • Embark on a penny stock pump-and-dump scheme

• Issued press releases touting Greyfield as a “premium automobile dealership” experiencing “explosive growth” and “quickly becoming the largest . . . in western Canada.”

• Stocks’ price rose and con men made out selling their shares to the public. • When truth came out, stock collapsed, and authorities stepped in. • Besides the con men, regulators looked for those who helped facilitate

sale of unregistered shares.

ACAP Financial v. SEC • Hume was head trader and compliance manager for ACAP – a brokerage

firm in Salt Lake. He let Greyfield schemers keep accounts at ACAP and sell shares through it.

• FINRA investigated – unregistered securities being sold. • ACAP was fined $100,000 and Hume fined $25,000 and suspended from

securities industry for 6 months. • SEC reviewed; approved penalties. • ACAP and Hume petitioned for review of penalties. Denied. • Court can only “interfere with” a sanctioned imposed by SEC only if its

statutory authority is “beyond the law,” “unsupported factually,” or is “completely lacking reasonableness such that it is an abuse of the SECs discretion.”

• Hume’s “egregious” conduct denotes intentional or knowing violation of a regulatory duty or breach of a fiduciary duty.

Arbitration of Disputes

Usually investors with investment firms sign a standard form indicating disputes must be arbitrated, not litigated.

SEC rules govern the arbitration process.

The Supreme Court upholds the binding nature of arbitration agreements.

Dodd-Frank Wall Street Reform and Consumer Protection Act

• Dodd-Frank Wall Street Reform Act (2010). • Established new regulatory authority in the consumer credit area and

broader financial market oversight. • Regulators oversee general market conditions – prepared to act in case of

crisis. • Oversight of “systemic risk” – market-wide problem. • Example: Financial meltdown in 2007-08 • Regulators can intervene in financial institution in case of trouble. • Trading of derivatives also open to greater regulatory oversight.