1. INVESTOR PROTECTION AND ONLINE SECURITIES TRANSACTIONS
CHAPTER 41
INVESTOR PROTECTION AND ONLINE SECURITIES TRANSACTIONS
© 2010 Pearson Education, Inc., publishing as Prentice-Hall

2. Federal law began to regulate securities markets after stock market crash of 1929.
Securities laws require disclosure of information to investors and seek to prevent fraud.

3. Securities Act of 1933
Primarily regulates the issuance of securities by a corporation, a general or limited partnership, an unincorporated association, or an individual.
Applies to initial issue of securities, including IPOs and sales of new securities by established companies. Includes issue of securities online.
Purpose: require full and honest disclosure of information to investors.

4. Definition of a Security
Common securities
E.g., common and preferred stocks, bonds, debentures, warrants.
Statutorily defined securities
Instruments expressly mentioned in securities acts.
E.g., interests in oil and gas.
Investment contracts
Investment of money by investor in common enterprise and investor expects to make profit based on sole or substantial efforts of promoter or others. (Howey test.)

5. Securities and Exchange Commission (SEC)
Federal administrative agency empowered to administer federal securities laws.
Adopts rules and regulations to interpret and implement federal securities laws.
Investigates alleged securities violations and brings enforcement actions.
Regulates activities of securities brokers and advisors.

6. Transactions Exempt from Registration
Need not register with SEC.
Still subject to antifraud provisions of the federal securities laws.
Issuer must provide investors with adequate information.
E.g., annual and quarterly reports, proxy statements, financial statements, etc.

7. Private Transactions Exempt from Registration (continued)
Nonissuer Exemption
Intrastate Offering Exemption
Private Placement Exemption
Small Offering Exemption 3

8. Non-issuer Exemption
Non-issuer reselling securities previously purchased, need not register transaction with SEC.
E.g., average investor.

9. Intrastate Offering Exemption
Local businesses may raise capital from local investors to be used in the local economy without registering with the SEC.
Requirements:
Issuer must be resident of state.
Corporation is resident of state in which incorporated.
Issuer must be doing business in state.
80 percent rule.
Purchasers must all be residents of state.

10. Private Placement Exemption
Issuers may raise capital from an unlimited number of accredited investors without registering the offering with the SEC.
Wealthy individuals (as defined), institutional investors such as banks or investment companies, or insiders of the issuers.
No more that 35 non-accredited investors may purchase.
E.g., friends and family. May not advertise to public.

11. Small Offering Exemption
Sale of securities not exceeding $1 million during a 12-month period need not be registered with SEC.
Sold to unlimited number of accredited or unaccredited investors.
May not sell to general public.
Buyers must hold for at least 1 year; limited sales permitted in second year.

12. Securities Exempt from Registration
Government-issued securities.
E.g., municipal bonds.
Short-term notes and drafts with maturity date not exceeding 9 months.
E.g., certain commercial paper issued by corporation.
Securities Issued by nonprofit issuers.
E.g., religious institutions, colleges.

13. Registration Statement
Covered issuer of must file written registration statement with SEC.
Contains required information about the issuer and the securities to be issued.
SEC does not pass upon the merits of the registered securities.
Decides only whether the issuer has met the disclosure requirements.

14. Prospectus
A written disclosure document submitted to SEC with the registration statement.
Used as selling tool by issuer.
Provided to prospective investors to enable them to evaluate the financial risk of the investment.
Must contain prescribed, boldface caveat: “These securities have not been approved or disproved by the SEC …”

15. Prefiling Period
Begins when issuer contemplates offering securities and ends when registration statement is filed.
During waiting period, issuer cannot condition the market.
Offer to sell or sell during this period.
Engage in public relations campaign.

16. Sale of Unregistered Securities
Sales of securities that should have been registered but were not violates Securities Act of 1933.
Investors can rescind and recover damages.
U.S. government may impose criminal penalties.

17. Regulation A Offerings
Regulation A permits issuer to sell securities pursuant to a simplified registration process.
Issuers may sell up to $5 million of securities in 12-month period.
May have an unlimited number of purchasers.
They do not have to be accredited investors.
There are no resale restrictions on the securities.
Small Corporate Offering Registration form eases filing for domestic businesses seeking to raise $1 million or less.

18. Private Actions for Violations of 1933 Act
Act imposes civil liability on anyone violating Section 5.
E.g., by selling securities pursuant to unwarranted exemption, or making misrepresentations about securities.
All defendants except issuer may assert due diligence defense—after reasonable investigation, believed statements to be true.
Purchaser may rescind purchase or seek damages.

19. SEC Actions for Violations of 1933 Act
SEC may:
Issue consent order.
Defendant agrees not to violate securities law in future but does not admit violation.
Bring an action for an injunction.
Request ancillary relief.
E.g., disgorgement of profits.

20. DOJ Actions for Violations of 1933 Act
Department of Justice may pursue criminal charges.
Fines or imprisonment.

21. Sarbanes-Oxley Act
Erects wall between investment bankers and securities analysts.
Fear that analysts, who provide investment advice to investors, would be pressured to give high marks to companies being assisted by firm’s investment bankers.
To avoid conflicts, protects analysts from review, pressure, and oversight by investment bankers. Any potential conflicts must be disclosed.

22. Securities Exchange Act of 1934
Designed to prevent fraud in subsequent trading of securities.
E.g., insider trading.
Regulates securities exchanges, brokers, and dealers.
Requires continuous reporting to investors and SEC.
Annual, quarterly, and other reports.

23. Section 10(b)
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.

24. Rule 10b-5
Clarifies the reach of Section 10(b) against deceptive and fraudulent activities in the purchase and sale of securities.
E.g., it is fraudulent to make an untrue statement or to omit a material fact.
Only intentional conduct (involving scienter) is a violation.
All transfers of securities subject to this rule.
Stock exchange, over-the-counter, private sale, merger.

25. Violations of 1934 Act Private Actions
The courts have implied private right of action under Section 10(b) and Rule 10b-5.
Plaintiff may seek rescission of the securities contract or recover damages (e.g., disgorgement of illegal profits).

26. Violations of 1934 Act (continued)
SEC Actions
Enter consent order with defendant.
Issue order prohibiting defendant from serving as officer or director of public company.
Seek injunction.
Seek court order for disgorgement of profits.
Under Insider Trading Sanctions Act, may seek civil penalty of 3 times profits or losses avoided.

27. Violations of 1934 Act (continued)
Criminal Liability
Section 32 imposes criminal liability on any person who willfully violates the act or regulations.
Under Sarbanes-Oxley Act:
Individuals can be fined up to $5 million and/or imprisoned for up to 25 years.
Corporations can be fined up to $2.5 million.

28. Insider Trading Section 10(b) and Rule 10b-5 prohibit insider trading.
When an insider makes a profit by personally purchasing shares of the corporation prior to public release of favorable information, or
By selling shares of the corporation prior to the disclosure of unfavorable information.

29. Insiders
Defined as:
Officers, directors, and employees at all levels of the company
Lawyers, accountants, consultants, and other agents and representatives who are hired by the company on a temporary and nonemployee status to provide services or work to the company
Others who owe a fiduciary duty to the company.

30. Tipper – Tippee Liability
Tipper - A person who discloses material non-public information to another person.
Tippee - The person who receives and acts on material non-public information from a tipper.
Both tipper and tippee may be held civilly and criminally liable for insider trading.

31. Others Liable for Securities Fraud
Those who misappropriate information.
May be outsider who obtains inside information.
Aiders and Abettors.
Those who knowingly assist in fraud.
Aiders and abettors may be criminally liable, but no private cause of action exists against them.

32. Short-Swing Profits
Section 16(a) of 1934 Act defines any person who is an executive officer, a director, or a 10-percent shareholder of an equity security of a reporting company as a statutory insider for Section 16 purposes.
Officer must have policy-making role.
Must file reports disclosing ownership and trading in company securities.

33. Section 16(b)
Short-Swing Profits – Profits made by statutory insiders on trades that occur within 6 months of each other.
Excludes involuntary transactions.
Excludes transactions that occur within 6 months before becoming an insider.
Corporation may bring legal action to recover these short-swing profits.
No need to show that statutory insider traded on inside information.

34. State Securities Laws
Most states have enacted securities laws that regulate the issuance and trading of securities.
“Blue-sky laws.”
These acts are often patterned after, and are designed to coordinate with, federal securities laws.
The Uniform Securities Act (a model state statute) has been adopted by many states.