Chapter 17 Financing, Investor Protection and Online Securities Offerings

 What is meant by the term securities?  What are the two major statutes regulating the securities industry?  What is insider trading ? Why is it prohibited?  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 is insider trading ? Why is it prohibited?  What are some of the features of state securities laws?  How are securities laws being applied in the online environment? Learning Objectives

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.

Corporate Financing Bonds vs. Stocks DebtOwnership/equity Fixed ROIDividends (variable) No votesVote for Management OptionalRequired Priority over stockPaid last

Bonds TypeDefinition Debentures No specific corporate assets are pledged as collateral. Backed by corporation’s general credit rating. Mortgages Pledge specific real estate. If corporation defaults, bondholders can foreclose. Convertible Conditions trigger bonds to convert to corporate stock. Callable Can be “called in” by principal and repaid according to bond conditions.

Stocks  Common Stock: represents true ownership of a corporation. Provides pro- rata (proportional) ownership interest reflected in control, earnings and assets.  Preferred Stock: has preferences over common stock. Cumulative Preferred. Participating Preferred. Convertible Preferred. Redeemable or Callable Preferred.  Common Stock: represents true ownership of a corporation. Provides pro- rata (proportional) ownership interest reflected in control, earnings and assets.  Preferred Stock: has preferences over common stock. Cumulative Preferred. Participating Preferred. Convertible Preferred. Redeemable or Callable Preferred.

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.  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.

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.

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.

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.

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.

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).

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.

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.

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).

Section 10(b), SEC 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.

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.

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.

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.

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.

Online Securities Offerings  Landmark Online IPO (1996): Spring Street Brewing Company.  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.  Landmark Online IPO (1996): Spring Street Brewing Company.  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.

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

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.

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.