Chapter 17

 The federal and state governments have enacted statutes that regulate the issuance and trading of securities  Primary purpose  To promote full disclosure to investors  To prevent fraud in the issuance and trading of securities 17-2 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 The federal administrative agency that is empowered to administer federal securities laws  Created by the Securities Exchange Act of 1934  Major responsibilities  Adopt rules  Investigate alleged securities violations and bring enforcement actions  Bring civil action to recover monetary damages from violators of securities laws  Regulate activities of securities brokers and advisors 17-3 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

17-4 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall. Type of SecurityDefinition Common securitiesInterests or instruments that are commonly known as securities, such as common stock, preferred stock, debentures, and warrants. Statutorily defined securities Interests and instruments that are expressly mentioned in securities acts as being securities, such as interests in oil, gas, and mineral rights. Investment contractsA flexible standard for defining a security. Under the Howey test, a security exists if an investor invests money in a common enterprise and expects to make a profit from the significant efforts of others.

 A test which states  An arrangement is an investment contract if there is an investment of money by an investor in a common enterprise and the investor expects to make profits based on the sole or substantial efforts of the promoter or others 17-5 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Sale of unregistered securities violates the Securities Act of 1933  Investors can rescind their purchase and recover damages  The U.S. government can impose criminal penalties  Regulation A  A regulation that permits an issuer to sell securities pursuant to a simplified registration process ▪ Issuers with offerings exceeding $100,000 must file an offering statement with the SEC 17-6 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 A method for small companies to sell up to $1 million of securities to the public:  By using a question-and-answer disclosure form called Form U-7  The SCOR form is available only to domestic businesses 17-7 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Section 11  A provision of the Securities Act of 1933 that imposes civil liability on persons who ▪ Intentionally defraud investors by making misrepresentations or omissions of material facts in the registration statement ▪ Are negligent for not discovering the fraud  All defendants except the issuer may assert a due diligence defense against the imposition of Section 11 liability 17-8 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 A provision of the Securities Act of 1933 that imposes civil liability on any person who  Violates the provisions of Section 5 of the act  Violations include  Selling securities pursuant to an unwarranted exemption  Making misrepresentations concerning the offer or sale of securities 17-9 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 The SEC may  Issue a consent decree whereby a defendant agrees not to violate securities laws in the future but does not admit to having violated securities laws in the past  Bring an action in U.S. District Court to obtain an injunction to stop challenged conduct  Request the court to grant ancillary relief, such as disgorgement of profits by the defendant Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Section 24  A provision of the Securities Act of 1933 ▪ Imposes criminal liability on any person who willfully violates the 1933 act or the rules or regulations adopted thereunder Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 New York Stock Exchange (NYSE) is operated by NYSE Euronext  NYSE lists the stocks and securities of approximately 3,000 of world’s largest companies for trading  National Association of Securities Dealers Automated Quotation System (NASDAQ)  An electronic stock market  Has the largest trading volume of any securities exchange in the world Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 The electronic data and record system of the Securities and Exchange Commission (SEC)  E-Public offerings  Making electronic initial public offerings (e-IPOs) by selling stock to the public for the first time Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Exempt securities: Securities that are exempt from registration with the SEC  Once a security is exempt, it is exempt forever  Exempt transactions: Transactions in which securities are sold that are exempt from registration with the SEC  If certain requirements are met Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 An exemption from registration which states that securities transactions not made by an issuer, an underwriter, or a dealer do not have to be registered with the SEC  E.g., normal purchases of securities by investors  Intrastate offering exemption  Permits local businesses to raise capital from local investors to be used in the local economy without the need to register with the SEC Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Permits issuers to raise capital from an unlimited number of accredited investors and no more than thirty-five nonaccredited investors  Without having to register the offering with the SEC  Also known as SEC Rule 506  Accredited investor: A person, a corporation, a company, an institution, or an organization that:  Meets the net worth, income, asset, position, and other requirements established by the SEC to qualify as an accredited investor Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 SEC Rule 504  An exemption from registration that permits the sale of securities not exceeding $1 million during a twelve-month period  Restricted securities  SEC Rule 144 states that securities issued pursuant to the private placement exemption or the small offering exemption cannot be resold for ▪ Six months if the issuer is an SEC reporting company ▪ One year if the issuer is not an SEC reporting company Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Section 501  A section of a federal statute that eliminates conflicts of interest by establishing rules for the separation of the investment banking and securities advice functions of securities firms Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Securities Exchange Act of 1934: A federal statute that primarily regulates trading in securities  Section 10(b): A provision of the Securities Exchange Act of 1934 that: ▪ Prohibits the use of manipulative and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations prescribed by the SEC Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Adopted by the SEC to clarify the reach of Section 10(b) against deceptive and fraudulent activities in the purchase and sale of securities  Scienter: Intentional conduct  Scienter is required for there to be a violation of Section 10(b) and Rule 10b Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 An injured private plaintiff may  Bring a civil action  Seek rescission of the securities contract or recover damages  SEC Actions Under the Securities Exchange Act of 1934  Insider Trading Sanctions Act: A federal statute ▪ Permits the SEC to obtain a civil penalty of up to three times the illegal benefits received from insider trading Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Section 32  A provision of the Securities Exchange Act of 1934  Imposes criminal liability on any person who willfully violates the 1934 act or the rules or regulations adopted thereunder Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 A situation in which an insider makes a profit:  By personally purchasing shares of the corporation prior to public release of favorable information  By selling shares of the corporation prior to the public disclosure of unfavorable information Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Officers, directors, and employees at all levels of a company  Lawyers, accountants, consultants, and agents and representatives who are hired by the company on a temporary and nonemployee basis to provide services or work to the company  Others who owe a fiduciary duty to the company Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Tipper: A person who discloses material nonpublic information to another person  Liable for the profits made by the tippee  Tippee: A person who receives material nonpublic information from a tipper  Liable for acting on material information that he or she knew or should have known was not public Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Rule 10b5-1: An SEC rule  Prohibits the trading in the security of any issuer on the basis of material nonpublic information obtained in a breach of duty of trust or confidence owed to the person who is the source of the information  Misappropriation theory: A rule that imposes liability under Section 10(b) and Rule 10b-5 on an outsider who  Misappropriates information about a company, in violation of his or her fiduciary duty, and then trades in the securities of that company Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Parties who knowingly assist principal actors in the commission of securities fraud  The U.S. Supreme Court has held that aiders and abettors are not civilly liable under Section 10(b)-5 and Rule 10b-5.22  They can be held criminally liable Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 Profits that are made by statutory insiders on trades involving equity securities of their corporation that occur within six months of each other  Section 16 statutory insider: A person who is  An executive officer  A director  A 10 percent shareholder of an equity security of a reporting company Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 A section of the Securities Exchange Act of 1934  Requires that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

ElementSection 10(b) and Rule 10b-5 Section 16(b) Covered securitiesAll securities.Securities required to be registered with the SEC under the 1934 act. Inside informationDefendant made a misrepresentation or traded on inside (or perhaps misappropriated) information. Short-swing profits recoverable whether or not they are attributable to misappropriation or inside information. RecoveryBelongs to the injured purchaser or seller. Belongs to the corporation Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

 A 2010 federal statute that:  Regulates hedge funds and derivatives and provides protection to consumers regarding financial products and services  State “blue-sky” laws  State laws that regulate the issuance and trading of securities Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.

17-32 Copyright © 2013 Pearson Education, Inc. Publishing as Prentice Hall.