Chapter 18

S

ECURITIES

R

EGULATION

Chapter 18

Meiners, Ringleb & Edwards

The Legal Environment of Business, 12 th Edition

©2015 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.

C

ORPORATE

F

INANCE

 Securities

 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

 Securities provide capital for business operations

 Securities represented by



Pieces of paper or records in computers

 Represent value in something real


D

EBT AND

E

QUITY

Debt

 When bonds are sold, there is often an issue of a certain amount

 Bonds usually traded on securities market, so are securities

 Debt financing may also occur by borrowing money from large lenders (banks, insurance companies)

 Instrument usually specifies:





Amount of debt

Length of period





Repayment method

Rate of interest charged

 Handled by professionals who earn commissions



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

 Can usually be traded


O

RIGINS OF

S

ECURITIES

R

EGULATION

 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


W

HAT

I

S A

S

ECURITY

?

 Merely calling something a security does not make it so

 Have higher legal standards 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


S

ECURITIES

E

XEMPT FROM

R

EGULATION

 Issued or guaranteed by government

 Federal, state or local

 Issued by banks

 Issued by religious and charitable organizations

 Insurance policies

 Annuity contracts



See Issue Spotter “What Are You Selling?”


O

FFERING

S

ECURITIES TO

I

NVESTORS



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

 Material information is all relevant information an investor would want to know:

 Background

 Executives



 Plan of operation

See “Securities Offering on the Web”


C

ASE

L ATTA V . R AINEY

 From 2001 - 2004, Mobile Billboards of America (MBA) sold mobile billboard “investments” in U.S. Investors given “offering circular” to 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” owned/operated 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 (of North Carolina) said

Billboards was a “safe company – “absolutely no risk”.

Latta invested $100,000.

(Continued)


C

ASE

L ATTA V . R AINEY

 Rainey received a commission of 1620%. 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.


T

HE

R

EGISTRATION

S

TATEMENT

 Prospectus (SEC Schedule A)

 First version of prospectus not yet approved by SEC:

Called red herring – red ink on 1 st 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 public accountants


T

HE

R

EGISTRATION

S

TATEMENT

 Regulation S-K





More detailed disclosure than in prospectus

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, underwriter, etc.

Need to hire an underwriter (i.e. investment banker)


E

XEMPTIONS FROM

R

EGISTRATION

 Some securities, while subject to securities laws, are exempt from registration requirements:





Government Bonds

Private Placements



Not offered to the public



Usually placed w/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


WKSI

S

 Well-Known Seasoned Issuers

 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

 Includes most well-known securities firms

 They can file registration statements the day new offering is announced rather than submitting for SEC staff review beforehand

 Can continuously update information – even on Website

 Securities are under shelf registration – once announced and registered, they may be sold at any time over next 3 years.


R

EGULATION OF

S

ECURITIES

T

RADING



If registered under ‘33 Act, must register under ‘34 Act;



If exempt under ‘33 Act, must register

 If traded on an exchange or over the counter (OTC) and has >$5M assets and 500+ shareholders

 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


P

ROXIES AND

T

ENDER

O

FFERS

 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 stock owners are offered stock in the acquiring company or cash in exchange for their stock


S

ECURITIES

F

RAUD







Investors may have trouble proving common-law fraud

Usually rely on antifraud provisions of ‘33 and ‘34 Act for statutory fraud

‘33 Act: Misleading statements or material omissions on 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


L IABILITY FOR S ECURITIES L AW V IOLATIONS

 Can sue parties who prepared disclosure docs or other impt. 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


L

IABILITY FOR

M

ISSTATEMENTS

Safe Harbor o Securities Litigation Reform Act of 1995 o Allows companies to predict profits and their likely success as long as forecasts are accompanied by “ meaningful cautionary statements ” that ID

“important factors that could cause actual results to differ materially from those in the forward-looking statement .” o Gives immunity from liability

Federal Exclusivity o Securities Litigation Uniform

Standards Act of 1998 o Requires securities suits that involve nationally traded securities to be brought

“exclusively” in federal court under federal law.


C

ASE

C ITY OF L IVONIA EMPLOYEES R ETIREMENT S YSTEM

V . B OEING C OMPANY













Class action suit for all who bought Boeing stock between May 4 and

June22, 2009. Key allegation: Boeing was overly optimistic about ability to get new 787 Dreamliner 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”

(Continued)


C

ASE

C ITY OF L IVONIA EMPLOYEES R ETIREMENT S YSTEM

V . B OEING C OMPANY

 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 Dreamliner 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.


S

ARBANES

-O

XLEY

A

CT

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

o Knowing misstatements have criminal fines and imprisonment.

o Protection also for corporate whistleblowers .

o Established Public Company Accounting Oversight

Board to discipline CPAs for misconduct & also sets accounting standards.

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


I

NSIDER

T

RADING

 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



See “London, New York and Sarbanes Oxley Act”


C

ASE

U.S. SEC V . G INSBURG

 Scott Ginsburg, CEO of Evergreen, owned radio stations; met with CEO of EZ Communication to discuss “strategic alternatives.” Ginsburg called his brother, Mark, and his father Jordan. Next day, Mark bought 3,800 shares of EZ stock; Jordan bought 20,000.

 Day after, Evergreen and EZ began confidential merger discussions. Cell phone calls were made from Scott to Mark and Jordan. Large purchases of EZ stock followed.



EZ’s stock rose 30% -- Mark made $413,000 and Jordan made $664,000.

 SEC brought civil actions against Ginsburg for securities violation – communicating material nonpublic information to brother and father.

C

ASE

U.S. SEC

V

. G

INSBURG

 Jury: Found he violated rule against insider trading ; $1 million in penalties.

 Trial court set aside verdict; said evidence insufficient that

Ginsberg tipped off his brother and father; SEC appealed.

 HELD: Reversed and remanded with instructions for court to reinstate $1,000,000 penalty and enjoin Ginsburg from future violation of securities laws.

 SEC must prove violations by “preponderance of evidence.” May use direct or circumstantial evidence.

 Telephone call/trade pattern , coupled with jury’s right to disbelieve “innocent explanations”, are enough to support the verdict.


I

NSIDER

T

RADING

A

CTS

 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.



See Issue Spotter “Can You Exploit the Gossip?”


T

HE

I

NVESTMENT

C

OMPANY

A

CT

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

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


R

EGULATION OF

I

NVESTMENT

C

OMPANIES

 Register with SEC

 State 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 74% must be outsiders

Invested funds can’t be used for deals with persons affiliated with company’

All deals “arm’s length”


T

HE

I

NVESTMENT

A

DVISERS

A

CT

 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

 Manage operations



“Deemed to have a fiduciary duty with respect to receipt of compensation for services” rendered to company.

 See “ European Approaches to Insider Trading”


P ROFESSIONAL R ESPONSIBILITY TO C LIENTS

 Brokers

 Effecting transactions for the account of others

 Dealers

 Buying and selling securities for own account

 Advisers

 Charging fees for investment advice

 Must be registered with

SEC



Can’t churn

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



Can’t scalp

 Buy stocks for personal benefit then urge clients to buy so price goes up


S

TOCK

M

ARKET

R

EGULATION

 New York Stock Exchange and other exchanges governed by the

Financial Industry Regulatory Authority (FINRA)

 An independent regulatory authority that sets rules of behavior for its traders and handles most disputes by arbitration; also oversees brokerage firms and employees

 Self-Regulation of Securities Markets

 SEC has power to monitor stock markets

 Regulation of Securities Transactions

 Regulates actions of securities

 Professionals who do actual trading



Professionals can’t trade for their own benefit ahead of customers

 Penalties: Include suspension or expulsion


A

RBITRATION OF

D

ISPUTES

 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.


D

ODD

-F

RANK

W

ALL

S

TREET

R

EFORM

AND

C

ONSUMER

P

ROTECTION

A

CT

 Dodd-Frank Wall Street Reform Act (2010)

 Established new regulatory authority in consumer credit area

 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 by the Financial

Stability Oversight Council

 Regulators can intervene in financial institution in case of trouble

 Trading of derivatives also open to greater regulatory oversight

 Greater desire for transparency
