Chapter 45: Securities Regulation
I. Purposes of Securities Regulation
A. Require the disclosure of meaningful information about a security and its issuer, permitting investors to make intelligent decisions
B. Impose liability on persons who make inadequate and incorrect disclosures of information
C. Regulate insiders, professional sellers of securities, securities exchanges, and other self-regulator securities organizations
II. Securities and Exchange Commission (SEC)
A. Created by Securities Act of 1934 (1934 Act)
B. Responsible for administering the Securities Act of 1933 (1933 Act), 1934 Act and other statutes
C. Actions
1. Empowered to investigate violations
2. Hold hearings to determine violations
a. Before an Administrative Law Judge
b. Finder of both fact and law
c. Decisions reviewed by commissioners of the SEC, which can then be appealed to the U.S. Court of Appeals
3. Most actions not litigated; rather, the SEC issues consent orders, where the defendant promises no future violations
4. Authorized to
a. Impose civil penalties up to $500,000; and
b. Issue cease and desist orders: directs a defendant to stop violating securities laws and refrain from future violations
5. May not issue injunctions
6. No Action Letter
a. SEC’s staff indicates that it will not take legal action against an issuer or other person who has proposed a transaction
b. Not binding on the commissioners
III. What Is a Security?
A. Defined by 1933 Act and 1934 Act as including any
1. Note
a. Use Family Resemblance Test
b. Presumed to be a security unless it bears a “strong family resemblance” to a type of note that is not a security
i. No recognized market
ii. Not party of a series of notes
iii. Buyer does not need securities law protection
iv. No investment intent
v. No expectation that securities laws apply
2. Stock
3. Treasury stock
4. Security Future
5. Bond
6. Debenture
7. Investment contract
a. Broadly defined by courts
b. Howey Test
i. Investment of money
ii. In a common enterprise
a) Horizontal commonality: funds pooled and profits shared pro rata by investors
b) Vertical commonality: investors are similarly affected by efforts of person promoting the investment
iii. Expectation of profits solely from others’ efforts
a) SEC v. Edwards: no reason to distinguish between promises of fixed returns and promises of variable returns
8. Any instrument commonly known as a security
B. Securities laws will also apply where investors are misled to believe that they apply due to a contract bearing the name and significant characteristics of a security
IV. 1933 Act
A. Concerned mostly with public distributions of securities
B. Issuer must make necessary disclosures at the time he or she sells to the public
C. Two principal regulatory components
1. Registration provisions
a. Act requires that every offering of securities be registered prior to any offer or sale, unless exempt
b. Statement and Prospectus
i. Registration statement
a) Must file with SEC before offer or sale
1) Historical and current data about the issuer and business
2) Full details about the securities to be offered
3) Use of the proceeds
4) Audited balance sheets
5) Audited income statements
6) Audited statements of changes in financial position
b) Effective after
1) Reviewed by the SEC
2) Automatically on the 20th day after its filing unless delayed or advanced by SEC
ii. Prospectus
a) Basic selling document of registered offering
b) Includes most of the information found in the registration statement
c) Must be provided to every purchaser before or at the same time as the sale of security
c. Section 5: Timing, Manner, and Content of Offers and Sales
i. Pre-filing period
a) Before the registration statement has been filed
b) May not offer to sell the securities to be registered
c) Start of the quiet period: must avoid publicity about the issuer and prospective issuance of securities for full duration of offering
ii. The Waiting Period
a) Time between the filing date and the effective date of registration
b) Securities may be offered but not sold
1) Face to face offers permitted
2) Written offers may be made only by a statutory prospectus
c) Part of the quiet period
iii. Post-effective Period
a) After the effective date of registration
b) May offer and sell securities if buyer has received a final prospectus
d. Exemptions
i. Securities Exemptions
a) Issued or guaranteed by a government in the U.S. and its territories
b) Note or draft with a maturity date not more than 9 months after issuance date
c) Issued by a non-profit religious, charitable, educational, benevolent, or fraternal organization
d) Issued by banks and by savings and loans associations
e) Issued by railroads and trucking companies regulated by the Interstate Commerce Commission
f) Insurance policy or annuity contract
ii. Transaction Exemptions
a) Intrastate Offering Exemption: rule 147
1) 80% of gross revenues in state
2) 80% of assets in state
3) Use 80% of proceeds in state
4) Resale is limited to persons within the state for 9 months
b) Private Offering Exemption: rule 506
1) Issuer must reasonably believe each purchaser is either an
a. Accredited investor; or
b. Unaccredited investor who has such knowledge and experience in financial and business matters that he or she is capable of evaluating the merits and risks of prospective investment
2) May sell to
a. No more than 35 unaccredited purchases
b. An unlimited number of accredited purchasers
3) Mark v. FSC Securities Corp.: issuer failed to show that he qualified for exemption due to lack of knowledge about any purchaser
iii. Small Offering Exemptions
a) Rule 504
1) Non-public issuer may sell up to $1 million in securities in a 12 month period
2) No limits on number of offerees or purchasers
3) Purchasers are free to resell at any time
b) Rule 505
1) Any issuer may sell up to $5 million of securities in a 12 month period
2) No general selling efforts allowed
3) May not resell for at least one year
4) May sell to no more than 35 unaccredited purchasers
c) Regulation A
1) Non-public issuer may sell up to $5 million of securities in a one-year period
2) No limit on number of purchasers
3) No purchaser sophistication requirement
4) No resale restriction
iv. Transaction Exemptions for Nonissuers
a) Section 4(1) provides an exemption for “transactions by any person other than an issuer, underwriter or dealer”
v. Sale of Restricted Securities
a) Issued under Rules 504, 505 and 506
b) Supposed to be held by purchaser for at least one year
c) May resell only a limited number in any 3-month period
d) After holding for two years, may sell unlimited amounts
2. Liability provisions
a. Defective Registration Statements
i. Civil liabilities for damages when statement misstates or omits a material fact on its effective date
ii. Purchaser may sue the following for damages equal to the difference between the purchase price less the price of the securities at the time of the suit
a) Issuer
b) CEO
c) Chief Accounting Officer
d) CFO
e) Directors
f) Other signers of registration statement
g) Underwriter
h) Experts
iii. Does not require
a) Reliance
b) Privity
c) Negligence or Intent
iv. Defenses
a) Purchaser knew of the misstatement or omission at time of purchase
b) Due diligence
1) No negligence
2) After a reasonable investigation, had reasonable grounds to believe and did believe that the registration statement was true and contained no omission of material fact
3) Escott v. BarChris Construction Corp.
4) Due Diligence Meeting: participants obtain assurances and demand proof from each other that the registration statement contains no misstatements or omissions of material fact
c) Statute of Limitations
1) Defendant has liability for a limited period of time
2) Must be sued
a. Within one year after the misstatement or omission was or should have been discovered by the purchaser
b. Not more than three years after securities were offered to the public
b. Other Liability Provisions
i. Section 12(a)(2) bars misstatements or omissions of material fact in any written or oral communication in connection with the general distribution of a security by an issuer
ii. Section 17(a): bars 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
c. Criminal Liability
i. Section 24: any person who willfully violates the Act or its rules and regulations
ii. Maximum penality: $10,000 fine and 5 years imprisonment
V. 1934 Act
A. Requires periodic disclosures by issuers with publicly held securities
1. Must report annual to shareholders
2. Must submit annual and quarterly reports to the SEC
3. Material information must be disclosed upon receipt absent a valid business purpose
B. Registration of Securities
1. Registration Requirement
a. Two types of issuers must register
i. Total assets exceed $10 million and 500 holders of a class of equity securities traded in interstate commerce
ii. Traded on a national security exchange
b. Must file a 1934 Act registration statement with SEC
2. Termination of Registration permitted if
a. Issuer has less than 300 shareholders in class
b. Issuer has less than 500 shareholders in class and assets of no more than $10 million for each of last three years
3. Periodic Reporting Requirement if
a. Total assets exceed $10 million and 500 holders of a class of equity securities traded in interstate commerce
b. Traded on a national security exchange
c. Made a registered offering under 1933 Act
4. Suspension of Duty to File Reports
a. Issuer has less than 300 shareholders in class
b. Issuer has less than 500 shareholders in class and assets of no more than $10 million
C. Holdings and Trading by Insiders
1. Section 16(a): requires insiders to disclose ownership of securities within 10 days of becoming owners
2. Also must report any subsequent transaction within 2 days
3. Insiders include
a. Officer of a corporation having equity securities registered under 1934 Act
b. Director of such a corporation
c. Owner of more than 10 percent of a class of equity securities registered under 1934 Act
4. Section 16(b): prevents an insider from profiting from short-swing trading
5. Any profit is recoverable if it was the result of purchase and sale or sale and purchase of any class of equity securities within less than a 6-month period
D. Proxy Solicitation Regulation
1. 14A requires any person soliciting proxies to furnish each holder of securities under 1934 Act with a proxy statement
2. 14a-9 prohibits misstatements or omissions of material fact during proxy solicitation
3. Proxy contest
a. Shareholder may solicit proxies in competition with management
b. Corporation must furnish a shareholder list or mail the competing proxy material
E. Shareholder Proposals
1. Rule 14a-8: Corporation must include a shareholder’s proposal in its proxy statement if, among other things, the shareholder owns at least 1% or $2000 of securities to be voted at meeting
2. Management may exclude proposals if
a. Deal with the ordinary business operations of the corporation
b. Relate to operations that account for less than 5% of total assets and not otherwise significantly related to business
c. Require the issuer to violate a state or federal law
d. Relate to a personal claim or grievance
F. Liability Provisions
1. False Statements in Filed Documents
a. Section 18
b. Defense for good faith actions without knowledge (no scienter)
2. Section 10(b) and Rule 10b-5
a. Prohibits the use of any manipulative or deceptive device in contravention of any rules that the SEC imposes as “necessary or appropriate in the public interest or for the protection of investors”
b. Elements
i. Misstatement or Omission
ii. Of Material Fact
a) Any information likely to have an impact on the price of a security in the market
b) Substantial likelihood that a reasonable investor would consider it important to the decision
iii. With Scienter
a) Intent to deceive, manipulate or defraud
b) Probably includes gross recklessness
iv. To plaintiffs seeking damages who were actual purchasers or sellers
v. And who relied on the statements or omissions
a) Carr v. Cigna Securities, Inc.: competent adult could not maintain action for fraud when written documents disclosed information
b) Fraud-on-the-market theory: an investor’s reliance on the availability of the securities on the market satisfies the reliance requirement because the market is defrauded as to the value
1) Basic, Inc. v. Levinson: permits a court to presume the investor’s reliance merely from the public availability of material misrepresentation
2) Presumption is rebuttable if the investor knew the market price was incorrect
vi. Which were the cause of the Investor’s loss
c. Wrongful action must be accomplished by the mails, with any means or instrumentality of interstate commerce, or a national securities exchange
d. Scope
i. Actual fraud
ii. Price manipulation
iii. Continuous Disclosure Obligation
a) Must be immediate and accurate
b) Basic, Inc. v. Levinson: materiality of merger negotiations is determined on a case-by-case basis, depending on the probability that the transaction will be consummated and on its significance to the issuer of the securities
c) Not required to disclose merger negotiations if
1) Did not make any prior disclosures
2) Not compelled by other SEC rules
3) Would jeopardize completion of the transaction
iv. Trading on Inside Information
a) 10b-5’s disclose or refrain rule: insider must either disclose information before trading or refrain from trading
b) Duty to disclose arises when one party has information that the other party is entitled to know because of a fiduciary or similar relation of trust and confidence between them
c) Insiders include