Chapter 33 Investor Protection and Online Securities Offerings

2  What is meant by the term securities?  What are the two major statutes regulating the securities industry?  What federal laws specifically regulate investment companies?  What are some of the features of state securities laws?  How are securities laws being applied in the online environment?  What is meant by the term securities?  What are the two major statutes regulating the securities industry?  What federal laws specifically regulate investment companies?  What are some of the features of state securities laws?  How are securities laws being applied in the online environment? Learning Objectives

3 Introduction  The stock market crash of 1929 showed the need for: More disclosure from issuers. Prohibition of deceptive, unfair and manipulative practices in the purchase and sale of securities.  The stock market crash of 1929 showed the need for: More disclosure from issuers. Prohibition of deceptive, unfair and manipulative practices in the purchase and sale of securities.

4 Introduction  The Securities Act of 1933 and Securities Exchange Act of 1934 are designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities.  Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt.  The Securities Act of 1933 and Securities Exchange Act of 1934 are designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities.  Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt.

5 Securities Act of 1933  Securities Act of 1933 regulates solicitation, buying and selling of securities.  In SEC v. Howey (1946), the U.S. Supreme Court held that a security exists in any transaction in which a person: (1) invests (2) in a common enterprise (3) reasonably expecting profits (4) derived primarily from others’ managerial or entrepreneurial efforts.SEC v. Howey  Securities Act of 1933 regulates solicitation, buying and selling of securities.  In SEC v. Howey (1946), the U.S. Supreme Court held that a security exists in any transaction in which a person: (1) invests (2) in a common enterprise (3) reasonably expecting profits (4) derived primarily from others’ managerial or entrepreneurial efforts.SEC v. Howey

6 Registration Statement  If a security does not qualify for an exemption under §5 of the Securities Act of 1933, the security must be registered with the Securities Exchange Commission ( and state securities agencies before offered to the public.  Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.  If a security does not qualify for an exemption under §5 of the Securities Act of 1933, the security must be registered with the Securities Exchange Commission ( and state securities agencies before offered to the public.  Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.

7 Registration Statement  Description of the significant provisions of the registrant’s “offering” and how the registrant intends to use the proceeds from the sale.  Description of the registrant’s properties and business.  Description of the significant provisions of the registrant’s “offering” and how the registrant intends to use the proceeds from the sale.  Description of the registrant’s properties and business.

8 Registration Statement  Description of the management of the registrant, remuneration, pension, stock offerings, executive interests and compensation.  Financial statement certified by and independent accounting firm.  Description of pending lawsuits.  Description of the management of the registrant, remuneration, pension, stock offerings, executive interests and compensation.  Financial statement certified by and independent accounting firm.  Description of pending lawsuits.

9 Exempt Securities  Bank securities sold before  Commercial paper if maturity date does not exceed 9 months.  Charitable organization securities.  Securities issued to existing securities holders resulting from reorganization, bankruptcy.  Securities issued to finance railroad equipment.  Bank securities sold before  Commercial paper if maturity date does not exceed 9 months.  Charitable organization securities.  Securities issued to existing securities holders resulting from reorganization, bankruptcy.  Securities issued to finance railroad equipment.

10 Exempt Securities  Any insurance, endowment, annuity contract or government-issued securities.  Securities issued by banks, savings and loan association, farmers' cooperatives.  Regulation A, small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular.  Securities issued to existing securities holders, stock split, dividend (really a transaction exemption).  Any insurance, endowment, annuity contract or government-issued securities.  Securities issued by banks, savings and loan association, farmers' cooperatives.  Regulation A, small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular.  Securities issued to existing securities holders, stock split, dividend (really a transaction exemption).

11 Exempt Transactions  Small “Reg D” Offerings Rule 504: up to $1M during 12 months to accredited investors only. Rule 504a. Rule 505: up to $5M during 12 months to both accredited and unaccredited investors. Section 4(6): up to $5M solely to accredited investors.  Small “Reg D” Offerings Rule 504: up to $1M during 12 months to accredited investors only. Rule 504a. Rule 505: up to $5M during 12 months to both accredited and unaccredited investors. Section 4(6): up to $5M solely to accredited investors.

12 Violations of the 1933 Act  Intentional or negligent fraud of investors by misrepresenting or omitting material facts in the registration statement and/prospectus.  Defenses: Statement left out was not material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true.  Penalties : Criminal: up to 5 years in prison and $10,000 fine. Civil: damages, refund of investment, injunction.  Intentional or negligent fraud of investors by misrepresenting or omitting material facts in the registration statement and/prospectus.  Defenses: Statement left out was not material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true.  Penalties : Criminal: up to 5 years in prison and $10,000 fine. Civil: damages, refund of investment, injunction.

13 Securities Exchange Act of 1934  Registration of securities exchanges, brokers, dealers, and national securities exchanges and associations.  Requires continuous disclosure system for corporations with securities sold on national exchanges or assets in excess of $5 million and 500 or more shareholders (Sec. 12 companies or 1934 companies).  Registration of securities exchanges, brokers, dealers, and national securities exchanges and associations.  Requires continuous disclosure system for corporations with securities sold on national exchanges or assets in excess of $5 million and 500 or more shareholders (Sec. 12 companies or 1934 companies).

14 Section 10(b) and Rule 10b(5) & Insider Trading  Section 10(b) prohibits the use of any manipulative or deceptive device or contrivance in contravention of rules and regulations of SEC.  Rule 10b(5) prohibits the commission of fraud in the connection with the purchase or sale of any security.  Section 10(b) prohibits the use of any manipulative or deceptive device or contrivance in contravention of rules and regulations of SEC.  Rule 10b(5) prohibits the commission of fraud in the connection with the purchase or sale of any security.

15 Section 10(b) and Rule 10b(5) & Insider Trading  Insider Trading Advance information available to corporate officers and directors that can affect future value of stock.  Insider trading prohibited: 10b(5) “Insiders” (Officers, Executives and Directors) 10b(5) “Outsiders” Tipper/tippee theory--insider’s fiduciary duty must be breached Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance.  Insider Trading Advance information available to corporate officers and directors that can affect future value of stock.  Insider trading prohibited: 10b(5) “Insiders” (Officers, Executives and Directors) 10b(5) “Outsiders” Tipper/tippee theory--insider’s fiduciary duty must be breached Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance.

16 Violations of the 1934 Act  10b violation—scienter or intent is required to prove criminal penalties. Imprisonment up to 10 years, fines up to $1 million, $2.5 for partnership or corporation.  16(b) -- strict liability -- no fault or scienter required -- civil penalties.  10b violation—scienter or intent is required to prove criminal penalties. Imprisonment up to 10 years, fines up to $1 million, $2.5 for partnership or corporation.  16(b) -- strict liability -- no fault or scienter required -- civil penalties.

17 Regulation of Investment Companies  Act on behalf of many smaller shareholders by buying stock and professionally managing the “portfolio.” (MUTUAL FUNDS.)  To safeguard company assets, all securities must be held by a bank or stock exchange member.  No dividends paid except from undistributed net income.  Act on behalf of many smaller shareholders by buying stock and professionally managing the “portfolio.” (MUTUAL FUNDS.)  To safeguard company assets, all securities must be held by a bank or stock exchange member.  No dividends paid except from undistributed net income.

18 State Securities Laws  State securities laws are called “blue sky” laws.  Issuers must comply with federal and state securities laws and states do not allow the same exemptions as federal government.  States could require registration or qualification.  Uniform Securities Act has been adopted in part by many states.  State securities laws are called “blue sky” laws.  Issuers must comply with federal and state securities laws and states do not allow the same exemptions as federal government.  States could require registration or qualification.  Uniform Securities Act has been adopted in part by many states.

19 Online Securities Offerings  Spring Street Brewing Company (1996): Landmark Online IPO  Regulations for online offerings. SEC October 1995 “use of electronic media should be at least an equal alternative to paper- based media.” Downloadable prospectus is permissible.  Spring Street Brewing Company (1996): Landmark Online IPO  Regulations for online offerings. SEC October 1995 “use of electronic media should be at least an equal alternative to paper- based media.” Downloadable prospectus is permissible.

20 Online Securities Offerings  Online IPO’s may deliver a prospectus by: Giving timely and adequate notice ( s) Making the online communication system readily accessible. Requiring evidence of delivery ( return receipt).  Online IPO’s may deliver a prospectus by: Giving timely and adequate notice ( s) Making the online communication system readily accessible. Requiring evidence of delivery ( return receipt).

21 Online Securities Offerings  Online offers should not link to other sites in prospectus.  Problems with status of investors on a general website. For example, Reg D offerings can only be made to “accredited investors”. Perhaps use password protected.  Online offers should not link to other sites in prospectus.  Problems with status of investors on a general website. For example, Reg D offerings can only be made to “accredited investors”. Perhaps use password protected.

22 Online Securities Fraud  SEC tries to enforce anti-fraud provisions of Securities Laws.  Use and abuse of internet chat rooms. Where is the line between free speech and fraud? Pumping and Dumping: buyer pumps the stock and after it rises, he dumps it, selling at a higher price.  Selling unregistered securities by unregistered stock brokers is a problem.  SEC tries to enforce anti-fraud provisions of Securities Laws.  Use and abuse of internet chat rooms. Where is the line between free speech and fraud? Pumping and Dumping: buyer pumps the stock and after it rises, he dumps it, selling at a higher price.  Selling unregistered securities by unregistered stock brokers is a problem.