LEGAL & ETHICAL ENVIRONMENT OF BUSINESS
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Cohen_PPT_Chapter8Securities2.pptxChapter Eight: Securities Law
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Chapter Eight: Securities Law
Securities Regulation
Definition of Security
Federal Securities Laws
State Blue Sky Laws
SEC
Chapter Eight: Securities Law
Fundraising: Why do we have securities? As a mechanism to raise money and show proof of ownership in a company. Bootstrapping: The effort to grow a business using only revenue generated by the business. This is extremely hard and very rare today.
Securities Regulation – Why do we have securities regulation?
Blue Sky? Don’t we like blue skies or no?
1929 Market Crash
Fraud
Greed
Protect the little investor.
Chapter Eight: Securities Law
Securities Regulation
Two major federal acts
Securities Act of 1933 (1933 Act) – Regulates original issuance
Securities Exchange Act of 1934 (1934 Act) – Regulates the securities in the secondary market and regulates the market.
Note: The 1934 Act was the enabling statue for the Securities and Exchange Commission As amended through P.L. 112-158 Sec. 4 (a) Securities and Exchange Commission: “There is herby established a Securities and Exchange Commission (hereinafter referred to as the “Commission”) to be composed of five commissioners to be appointed by the President by and with the advice and consent of the Senate. Note more than three of such commissioners shall be members of the same political party, and in making appointment members of different political parties shall be appointed alternately as nearly as may be practicable….” What does this tell you about the nature of independent agencies?
Chapter Eight: Securities Law
Definition of a Security?
Common law definition – is it even relevant?
Statutory law definition (1933 Act)
Promise to repay debt;
Ownership certificate in a company;
Debt in a company (bond);
Debentures in a company (debt in a company as well);
Warrants (right to buy stock in a company);
Subscriptions (agreement to buy stock in a company);
Voting trusts;
Rights to oil, gas and minerals; and,
Limited Partnership interests.
Supreme Court Definition: SEC v. W.J. Howey Co., 328 U.S. 293 (1946) “(a security is) a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of a promoter or a third party…...The test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the offer, the plan of distribution, and the economic inducements held out to the prospect.”
Chapter Eight: Securities Law
State Law Definition of Security:
Majority of States: Howey
Minority of States: Howey plus the Risk Capital Test (Ohio is a risk capital test)
Silver Hills Country Club v. Sobieski, 55 Cal.2d 811 (1961)
Risk capital test, the Court explained that if these criteria were met, then it’s a security: 1) are the funds raised for a business venture or enterprise; 2) is the offering to the public at large; 3) do investors have the power to affect the success of the enterprise; and 4) is the investor’s money is substantially at risk because it is not secured. Why is an investment into a country club before its built a security even though you are not buying ownership in the country club?
Chapter Eight: Securities Law
1993 Act – Regulates “primary offerings…”
1934 Act – Regulates stock sold in the “secondary markets.”
SEC promulgates regulations under both pieces of legislation.
1933 Act - First time securities are offered by the issuer to the public, often referred to as an IPO.
Proper filings
Audited financial statements
Costly
Loss of control
Loss of privacy
Litigation
Performance pressure
Investor headaches
Dynamic world and environment
Chapter Eight: Securities Law
1933 Act
Exempt Securities
Government securities
Commercial paper, short term unsecured notes, issued by company with maturity dates less than 9 months
Securities issued by banks, Saving and Loans and certain charitable organizations including religious organizations
Annuities
Life Insurance policies
Common carrier securities
Stock dividends and splits
Charitable bonds
Chapter Eight: Securities Law
Exempt Transactions
The Intrastate Offering Exemption (offeror and offeree all from same state)
At least 80% of the entities assets must be located in the state;
At least 80% of the entities income must be earned from operations within the state; and,
At least 80% of the proceeds from the sale must be used on operations within the state
A nine-month transfer restriction where securities can only be transferred between state residents also applies.
Small-Offering Exemption: Regulation A
This applies to security issues up to $5,000,000 dollars during any 12-month period. The investment cap goes up to $50,000,000 if the offering company has audited financial statements.
Small-Offering Exemption: Regulation D
501 Accredited Investor –
Individual with $200,000 income 2 years back to back or joint with spouse of $300,000, or net worth of $1mm not including primary residence.
Banks, insurance companies, registered investment companies, business development companies or small business investment companies. Businesses where all owners are accredited investors;
Charitable organizations with greater than $1,000,000 in assets;
Directors and officers, or general partners of the company selling the securities;
ERISA employee benefit plan if the plan has a bank, insurance company, or registered investment adviser making investment decisions or if the plan has total assets greater than $5,000,000;
Under JOBS, certain types of offerings under Regulation D provide accredited status for investors with net worth or income of $100,000 to invest up to five percent ($2,000 max) and those worth or earning more than $100,000 up to 10 % ($100,000 max); and,
Certain trusts with assets in excess of million, not formed to acquire the securities offered, and under the direction of a sophisticated investor.
Chapter Eight: Securities Law
Exempt Transactions
Small-Offering Exemption: Regulation D Continued
502 Crowdfunding –
Under $1mm in a year.
503 Requires Form D
504 applies to offerings up to an including $1,000,000 (during any 12-month period). Sales of securities to insiders such as directors, officers, and employees are not included in the $1,000,000 million limit. Up to $2mm when registered under state blue sky laws
A Rule 505 exemption covers sales of securities up to $5,000,000, with a cap of 35 (expanded definition) non-accredited investors. Like Rule 504, the Rule 505 sale can go as high at $7,500,000 with a state registration
A Rule 506 exemption has no dollar limit, but investor type and numbers are limited. Non-accredited investors are capped at 35.
Private Placement Exemption: The Shares have not been registered under the Securities Act of 1933, and the Company is not subject to the reporting and information requirements of the Securities Exchange Act of 1934, as amended. Therefore, information about the Company is not publicly available. Investors are asked suitability questions and essentially warned about the highly risky nature of the investment.
Chapter Eight: Securities Law
Filing requirements: If securities are not exempt or the transaction is not exempt, then the following must be filed in a registration statement with the SEC:
A description of the offering such as types of securities being offered, why the securities are being offered, how the securities will fit into the business’s existing capital structure, and how the proceeds will be used in a sources and uses of funds statement;
Audited financial statements by an independent third party auditor utilizing both GAAP and FASB standards, usually more than one year;
A list of all corporate assets as well as corresponding liabilities
A description of the issuers business and relevant activities
A capitalization table that includes all the ownership vested in management as well as board members
Other relevant and material information, such as pending lawsuits, potential exposure to economic weakness or technology threats or the like
Companies will advertise the issuance through a tombstone ad (in WSJ) or a Red Herring prospectus…
Chapter Eight: Securities Law
1933 Act Violations
Must be material (what is material mean?);
Investor cannot have knowledge of the material mistake when the investment is made;
Due diligence – defendant acted prudently and with diligence to make the registration statement correct…
Escott v. BarChris Construction Corporation, 283 F. Supp. 643 (S.D.N.Y 1968). This is considered a seminal case on the requirements and application of due diligence related to a sale of securities under the 1933 Act. BarChris, a builder of bowling alleys, offered debentures for sale. The company was under dire financial straights and did not disclose this in its prospectus. Even though the lead underwriter performed due diligence on the company and hired outside legal counsel to review the company as, the underwriter was held liable for its failure to adequately conduct due diligence. The intent of the law was to protect investors from misrepresentations and omissions by the issuer. The underwriter signed the registration statement and missed the fraud so it was held liable. Why do you think the underwriter was held liable when it performed “due diligence.”
Penalties imposed for a Section 11 violation are $10,000 per violation as well as potentially up to 5 years in jail. The SEC can also enjoin the company through an injunction and force them to cease and desist the alleged behavior.
Section 12 violations care the same criminal penalties as Section 11 violations for the following offenses: 1) Selling securities without a registration as required (without an exemption); 2) Selling securities before the effective date of the registration statement, or 3) Selling securities using false information in the prospectus.
Chapter Eight: Securities Law
1934 Act Violation
Registration. The main requirement of this law is that all securities traded on public platforms need to be registered, which includes required quarterly filings. And as amended, any company with over $10,000,000 in assets and 500 unaccredited investors or 2,000 shareholders total must register.
Reporting. The periodic reporting requirements include the 10-Q, 10-K and 8-K forms, all of which can be found on Edgar online at www.sec.gov.com. These are quarterly, annual and unusual event filings. The CEO and CFO must sign and certify under Sarbanes Oxley requirements which requires them reading the report, that the report is true to their knowledge with no misleading statements, that the financial statements fairly represent the financial condition of the company and that financial controls are in place to guarantee that future reporting will be accurate. If the certifying officer fails in his/her duty, then penalties are up to 20 years in jail and $10,000,000 in fines and or penalties.
Violations. 10(b) Anti-fraud provisions, application and proof really focus on fraud or misrepresentation in the sale of securities. The application of the law applies to all firms provided they are in interstate commerce. Proof of Section 10(b) could come in several forms but mainly hinge on a failure to disclose either bad or good information or giving overly optimistic or pessimistic information. So the company must disclose when it’s in merger discussions or when a buyout offer has been provided. Unpredicted swings in quarterly earnings, potential litigation or other areas impact the company’s current ability to perform should be disclosed.
Evidence. The general proof required for a 10(b) violation might be insiders or tippees trading securities too soon before information is disseminated, or passing along inside information to those who then trade on this information. These are essentially insider trading cases.
Since 2000, the SEC, under Rule 10b5-1, defines insider trading as any securities transaction made where a person involved in the trade is aware of nonpublic material information and that person has a duty to maintain confidentiality of this knowledge. This activity is a violation of the law and can lead to civil and criminal prosecution. This does not apply to all individuals with such knowledge who engage in the sale of securities btw.
Chapter Eight: Securities Law
Insider Trading
Misappropriation theory/Classical Theory:
In United States v. O’Hagen, 521 U.S. 657 (1997)
“The classical theory applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of a corporation. See Dirks v SEC, 463 U.S. 646, 655, n. 14 (1983).”
“misappropriation theory” holds that a person commits fraud “in connection with” a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.”
When a person expresses agreement to maintain confidentiality (lawyer);
Past interactions show mutual confidentiality; and,
When a person hears information from a spouse, parent, child or sibling whom they know to have a duty.
Duty to keep the information confidential
Tippee v. Tipper
Shareholder Voting – William’s Act – in mergers, acquisitions, buyouts etc…
State Blue Sky Laws: Avoid companies that register to sell securities in states that do not require merit review...
