1. Corporations: Securities and Investor Protection
Chapter 41
Chapter 41: Corporations: Securities and Investor Protection
Corporations: Securities and Investor Protection
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2. Overview LO41-1: What is a security?
LO41-2: What requirements are imposed by the Securities Act of 1933?
LO41-3: How does the Securities Exchange Act of 1934 regulate the trading of securities?
LO41-4: How are investment companies regulated?
LO41-5: How do states regulate securities?

3. Chapter 41 Hypothetical Case 1
As this chapter indicates, although the Securities and Exchange Commission (SEC) requires the registration of securities, the SEC does not approve these securities. In other words, the SEC does not make any judgment about the worth of securities. Instead, it simply enforces the requirement that issuers provide certain information to potential buyers, including: (1) a description of the securities offered for sale; (2) an explanation of how proceeds from the sale of the securities will be used; (3) a description of the registrant's business and properties; (4) information about the management of the company; (5) a description of any pending lawsuits in which the registrant is involved; and (6) financial statements certified by an independent public accountant.
As the federal administrative agency with primary responsibility for regulating the United States securities market, should the Securities and Exchange Commission formulate a judgment regarding the worth of soon-to-be-issued securities and inform potential investors of that judgment? Does the SEC have an ethical obligation to potential investors to make and publicize such valuation judgments?
Chapter 41 Hypothetical Case 1: As this chapter indicates, although the Securities and Exchange Commission (SEC) requires the registration of securities, the SEC does not approve these securities. In other words, the SEC does not make any judgment about the worth of securities. Instead, it simply enforces the requirement that issuers provide certain information to potential buyers, including: (1) a description of the securities offered for sale; (2) an explanation of how proceeds from the sale of the securities will be used; (3) a description of the registrant's business and properties; (4) information about the management of the company; (5) a description of any pending lawsuits in which the registrant is involved; and (6) financial statements certified by an independent public accountant.
As the federal administrative agency with primary responsibility for regulating the United States securities market, should the Securities and Exchange Commission formulate a judgment regarding the worth of soon-to-be-issued securities and inform potential investors of that judgment? Does the SEC have an ethical obligation to potential investors to make and publicize such valuation judgments?
[Instructor: See Securities Regulation in Chapter 41]

4. Chapter 41 Hypothetical Case 2
Thomas Abramson is a quality control manager for Capitol-IZE Pharmaceutical Company, Inc. The company is headquartered and has its principal production facility in Indianapolis, Indiana. For several years, Capitol-IZE Pharmaceutical has been engaged in the research and development of a new cancer drug, Izerion. As part of the federal regulatory procedure for mass-marketing a new drug, Capitol-IZE Pharmaceutical applied to the Food and Drug Administration (FDA) for final approval of Izerion.
Yesterday, Abramson's supervisor informed him in somber fashion that the FDA had rejected the company's application for final approval of Izerion. Apparently, the FDA was concerned about serious side effects that manifested during the drug's clinical trials. Abramson's supervisor further advised him that next Monday Capitol-IZE Pharmaceutical is scheduled to go public with a press release concerning the FDA's rejection of Izerion.
Chapter 41 Hypothetical Case 2: Thomas Abramson is a quality control manager for Capitol-IZE Pharmaceutical Company, Inc. The company is headquartered and has its principal production facility in Indianapolis, Indiana. For several years, Capitol-IZE Pharmaceutical has been engaged in the research and development of a new cancer drug, Izerion. As part of the federal regulatory procedure for mass-marketing a new drug, Capitol-IZE Pharmaceutical applied to the Food and Drug Administration (FDA) for final approval of Izerion.
Yesterday, Abramson's supervisor informed him in somber fashion that the FDA had rejected the company's application for final approval of Izerion. Apparently, the FDA was concerned about serious side effects that manifested during the drug's clinical trials. Abramson's supervisor further advised him that next Monday Capitol-IZE Pharmaceutical is scheduled to go public with a press release concerning the FDA's rejection of Izerion.
[Instructor: See The Securities Exchange Act of 1934 in Chapter 41]

5. Chapter 41 Hypothetical Case 2 (cont'd)
Abramson is frantic. He owns approximately 6,000 shares of Capitol-IZE Pharmaceutical stock, and he knows that news of the FDA's rejection of Izerion will be disastrous to the company, its employees, and its shareholders. Capitol-IZE Pharmaceutical stock is currently valued at $47.50 per share, and news of the FDA's disapproval of Izerion will likely drive the stock down to one-half of its current value.
Abramson quickly runs the numbers on his calculator. A reduction of 50% of the stock's value would represent a personal loss of $142,500. Abramson's Capitol-IZE Pharmaceutical stock is his only retirement plan, aside from a modest pension he will receive from the company (assuming the company survives the announcement).
Abramson has a plan. Today, he will instruct his financial planner to immediately sell all 6,000 shares of his Capitol-IZE Pharmaceutical Company, Inc. stock. Abramson rationalizes his decision by assuring himself that anyone else in his position would do the same thing.
Is Thomas Abramson's plan legal? Is it ethical?
Chapter 41 Hypothetical Case 2 (cont'd): Abramson is frantic. He owns approximately 6,000 shares of Capitol-IZE Pharmaceutical stock, and he knows that news of the FDA's rejection of Izerion will be disastrous to the company, its employees, and its shareholders. Capitol-IZE Pharmaceutical stock is currently valued at $47.50 per share, and news of the FDA's disapproval of Izerion will likely drive the stock down to one-half of its current value.
Abramson quickly runs the numbers on his calculator. A reduction of 50% of the stock's value would represent a personal loss of $142,500. Abramson's Capitol-IZE Pharmaceutical stock is his only retirement plan, aside from a modest pension he will receive from the company (assuming the company survives the announcement).
Abramson has a plan. Today, he will instruct his financial planner to immediately sell all 6,000 shares of his Capitol-IZE Pharmaceutical Company, Inc. stock. Abramson rationalizes his decision by assuring himself that anyone else in his position would do the same thing.
Is Thomas Abramson's plan legal? Is it ethical?
[Instructor: See The Securities Exchange Act of 1934 in Chapter 41]

6. Securities and the SEC
Security: Investment in a common enterprise with the reasonable expectation of profit gained predominantly from others' efforts
Securities and Exchange Commission: Created in 1934 to:
Enforce securities laws
Interpret provisions of securities acts
Regulate the trade of securities
Regulate the activities of securities brokers, dealers, and advisers
A security is an investment in a common enterprise, with a reasonable expectation of profit gained predominantly from others' efforts.
The Securities and Exchange Commission, or SEC, was created in 1934 to enforce securities laws, interpret provisions of securities acts, regulate the trade of securities, and regulate the activities of securities brokers, dealers, and advisers.

7. Expansion of SEC Powers in the 1990s
Securities Enforcement Remedies and Penny Stock Reform Act of 1990
Market Reform Act of 1990
Securities Acts Amendments of 1990
National Securities Markets Improvement Act of 1996
Sarbanes-Oxley Act of 2002
During the 1990s, SEC Powers were expanded by way of supplemental legislation, including the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, the Market Reform Act of 1990, the Securities Acts Amendments of 1990, the National Securities Markets Improvement Act of 1996, and the Sarbanes-Oxley Act of 2002.

8. Securities Act of 1933 Requirements: Registration Statement
Securities Act of 1933: Passed to legitimize security transactions by requiring registration of securities
Registration statement is document containing:
Description of securities offered
Explanation of how proceeds from sale will be used
Description of registrant's business and properties
Information about management of company
Description of pending lawsuits
Certified financial statements
Congress passed the Securities Act of 1933 in reaction to the mistrust of securities transactions before the Great Depression. Thus, a function of the act was to legitimize security transactions by requiring the registration of securities offered to the public. Through the registration process, investors have more information to make better-informed decisions about their securities purchases.
Required from securities issuers by the Securities Act of 1933, a registration statement is a document containing a description of the securities offered, an explanation of how proceeds from the sale will be used, a description of the registrant's business and properties, information about company management, a description of pending lawsuits, and certified financial statements.

9. Securities Act of 1933: Terminology, Rules, and Procedures
Prospectus: Written document similar to registration statement, used as a selling tool to attract potential investors
Periods of the registration statement and prospectus filing process:
Prefiling period
Waiting period
Posteffective period
Exempt transactions: Securities exempt from standard SEC registration requirements
Limited offers: Involve small amounts of money, or are offered only to sophisticated investors
Private placement exemption: Exempts private offerings of securities
Rule 505: States that private offerings may not exceed $5 million in a 12-month period, and firms do not have to believe that investors have a reasonable ability to evaluate risk
Rule 504: Exempts noninvestment firms that offer no more that $1 million in securities in a 12-month period
Section 4(6): Exempts securities offered only to accredited investors for amount less than $5 million
A prospectus is a written document similar to a registration statement, used as a selling tool to attract potential investors.
Periods of the registration statement and prospectus filing process include the prefiling period, the waiting period, and the posteffective period.
Exempt transactions are securities exempt from standard SEC registration requirements. These include limited offers, which involve only small amounts of money, or are offered only to sophisticated investors.
A private placement exemption also exempts private offerings of securities from standard SEC registration requirements. In terms of pertinent rules set forth in the Securities Act of 1933 pertaining to the exemption of securities from standard SEC registration requirements, Rule 505 states that private offerings may not exceed $5 million in a 12-month period, and firms do not have to believe that investors have a reasonable ability to evaluate the risk. Rule 504 exempts noninvestment firms that offer no more that $1 million in securities in a 12-month period. Section 4(6) exempts securities offered only to accredited investors for an amount less than $5 million.

10. Securities Act of 1933: Terminology, Rules, and Procedures (cont'd)
Intrastate issues: Exempt local investors in local businesses
Resales of securities: Exempt transactions by any person other than an issuer, underwriter, or dealer
Restricted securities: Securities acquired under Rule 505, 506, or Section 4(6) that must be registered for resale, unless investor follows Rule 144 or 144(a)
Violations may result in:
Administrative action
Injunctive action
Criminal prosecution
Intrastate issues exempt local investors in local businesses, and resales of securities by any person other than an issuer, underwriter, or dealer are also exempt from standard SEC registration requirements.
Restricted securities are securities acquired under Rule 505, 506, or Section 4(6) of The Securities Act of 1933 that must be registered for resale, unless the investor follows Rule 144 or 144(a). Violations may result in administrative action, injunctive action, and/or criminal prosecution.

11. Securities Exchange Act of 1934
Section 10(b): Prohibits use of manipulative and deceptive devices to bypass SEC rules
Insider trading: Trading in which company employee or executive uses material inside information to make profit
Misappropriation theory: Individual who wrongly acquires and uses inside information for profit is liable for insider trading
Section 10(b) of The Securities Exchange Act of 1934 prohibits the use of manipulative and deceptive devices to bypass SEC rules. Insider trading is trading in which a company employee or executive uses material inside information to make a profit. According to misappropriation theory, any individual who wrongly acquires and uses inside information to generate profit is liable for insider trading.

12. Securities Exchange Act of 1934: Terms, Rules, and Procedures
Tipper/tippee theory: Individual who receives material inside information as a result of insider's breach of duty is guilty of insider trading
Statutory insiders: Certain stockholders, executive officers, and directors who must file reports detailing their ownership and trading of the corporation's securities
Short-swing profits: Profits made from sale of company stock within any six-month period by statutory insider; per Section 16(b), these profits must be returned to company
According to the tipper/tippee theory, an individual who receives material inside information as the result of an insider's breach of duty is guilty of insider trading. Statutory insiders include certain stockholders, executive officers, and directors, who must file reports detailing their ownership and trading of the corporation's securities. Short-swing profits are profits made from the sale of company stock within any six-month period by a statutory insider. Per Section 16(b) of The Securities Exchange Act of 1934, these profits must be returned to the company.

13. Securities Exchange Act of 1934: Terms, Rules, and Procedures (cont'd)
Proxy: Document that authorizes an individual to vote shareholder's share of stocks at a shareholders' meeting
Proxy solicitation: Process of obtaining authority to vote on behalf of shareholder
Violations of Securities Exchange Act of 1934 may result in:
Criminal penalties
Civil penalties
Suits against those involved in insider trading under Insider Trading Sanctions Act of 1984
A proxy is a document that authorizes an individual to vote a shareholder's share of stocks at a shareholders' meeting. A proxy solicitation is the process of obtaining the authority to vote on behalf of a shareholder. Violations of The Securities Exchange Act of 1934 may result in criminal penalties, civil penalties, and suits against those involved in insider trading.

14. State Securities Regulation
Blue-sky laws: Regulate the offering and sale of securities within the state only
Some laws exempt from federal securities regulation may be subject to state laws
Often similar to federal securities laws
Uniform Securities Act: Most states have adopted
State securities laws include blue-sky laws, which regulate the offering and sale of securities within the state only. Hence, although certain securities are exempt from federal securities regulation, they may be subject to state securities laws.
Many state securities laws serve functions similar to those of federal securities laws. For example, many states have laws requiring registration of securities issued within the state and requiring disclosure of certain information. Moreover, state laws regulate securities brokers and dealers. Although the purposes of state and federal securities regulations overlap, the specific regulations differ. Consequently, to encourage greater coordination between federal and state securities laws, most states have adopted the Uniform Securities Act.

15. Chapter 41 Hypothetical Case 3
Although the Securities and Exchange Commission has existed as a federal administrative agency for over 70 years (the Commission was created in 1934), some critics question the need for its continued existence, or alternatively argue for significant deregulation of stock trades. According to critics, there is arguably no need for significant federal regulation of publicly-traded securities, since market conditions dictate legitimacy and honesty in securities transactions; after all, for how long could a corporation exist if it does not strive to ensure the integrity of its stock?
How do you respond to this line of reasoning, that the free market will dictate fair and honest stock trades? In your answer, consider the history and mission of the Securities and Exchange Commission. Reference: About the SEC: What We Do
Chapter 41 Hypothetical Case 3: Although the Securities and Exchange Commission has existed as a federal administrative agency for over 70 years (the Commission was created in 1934), some critics question the need for its continued existence, or alternatively argue for significant deregulation of stock trades. According to critics, there is arguably no need for significant federal regulation of publicly-traded securities, since market conditions dictate legitimacy and honesty in securities transactions; after all, for how long could a corporation exist if it does not strive to ensure the integrity of its stock?
How do you respond to this line of reasoning, that the free market will dictate fair and honest stock trades? In your answer, consider the history and mission of the Securities and Exchange Commission.
[Instructor: See Securities Regulation in Chapter 41]

16. Chapter 41 Hypothetical Case 4
A new tech start-up, Tolumetrix, is planning to go public in an initial public offering (IPO). One of the company's executives, Richard Columbus, is charged with preparing the company's registration statement and prospectus, which are required.
Columbus is unfamiliar with the process of creating and filing these documents and with securities in general; a programmer by trade, he is new to the entire process of running a successful company. He decides to use the documents provided by a similar company as a template.
Columbus files the forms to the SEC and immediately begins making oral offers to sell the company's stock. He sends a copy of the prospectus identical to the one that has been submitted to the SEC. He does not send a follow-up version of the prospectus after many changes are requested and made and the final approval has come from the SEC.
Has Columbus—and Tolumetrix—violated the 1933 Securities Act? Explain your answer.
Chapter 41 Hypothetical Case 4: A new tech start-up, Tolumetrix, is planning to go public in an initial public offering (IPO). One of the company's executives, Richard Columbus, is charged with preparing the company's registration statement and prospectus, which are required.
Columbus is unfamiliar with the process of creating and filing these documents and with securities in general; a programmer by trade, he is new to the entire process of running a successful company. He decides to use the documents provided by a similar company as a template.
Columbus files the forms to the SEC and immediately begins making oral offers to sell the company's stock. He sends a copy of the prospectus identical to the one that has been submitted to the SEC. He does not send a follow-up version of the prospectus after many changes are requested and made and the final approval has come from the SEC.
Has Columbus—and Tolumetrix—violated the 1933 Securities Act? Explain your answer.
[Instructor: See The Securities Act of 1933 in Chapter 41]