1. ©2001 West Legal Studies in Business. All Rights Reserved. 1 Chapter 29: Securities Regulation and Investor Protection

2. ©2001 West Legal Studies in Business. All Rights Reserved. 2 Historical Background of Securities Regulation A security is a document evidencing ownership (stock) or debt (bond) in a corporate entity. 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. Congress passed the Securities Act of 1933 and Securities Exchange Act of 1934 which created the Securities Exchange Commission to regulate securities.

3. ©2001 West Legal Studies in Business. All Rights Reserved. 3 §1: Corporate Financing Securities evidence the obligation to pay money or the right to participate in earnings the distribution of corporate assets. Corporations are financed by the sale of securities: –Bonds. –Stocks.

4. ©2001 West Legal Studies in Business. All Rights Reserved. 4 Bonds Bonds are debt instruments (like a loan) issued by a governmental or corporate entity to finance business activities. Bonds have a maturity date when the debt must be paid back with interest to the bond- holder.

5. ©2001 West Legal Studies in Business. All Rights Reserved. 5 Bonds [2] TypeDefinition DebenturesNo specific corporate assets are pledged as collateral. Backed by corporation’s general credit rating. MortgagesPledge specific real estate. If corporation defaults, bondholders can foreclose. ConvertibleConditions trigger bonds to convert to corporate stock. CallableCan be “called in” by principal and repaid according to bond conditions.

6. ©2001 West Legal Studies in Business. All Rights Reserved. 6 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.

7. ©2001 West Legal Studies in Business. All Rights Reserved. 7 § 2: The Securities and Exchange Commission SEC is an independent federal agency created by the 1934 Act. Responsibilities: administer the 1933 and 1934 Acts: –Make rules to implement the 1933-34 Acts. –Investigate and enforce SEC laws against those who violate rules. –Adjudicates offenses with appeal into the court system.

8. ©2001 West Legal Studies in Business. All Rights Reserved. 8 Expanded Powers of the SEC Securities Enforcement Remedies and Penny Stock Reform Act of 1990. Securities Acts Amendments of 1990. Market Reform Act of 1990. –National Securities Markets Improvement Act of 1996 exempts certain persons, securities and transactions from securities laws.

9. ©2001 West Legal Studies in Business. All Rights Reserved. 9 § 3: The Securities Act of 1933 SEA of 1933 designed to prohibit fraud and require certain essential information so that investors can make informed business decisions. 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

10. ©2001 West Legal Studies in Business. All Rights Reserved. 10 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 SEC and state (see Texas) securities agencies before offered to the public.Texas Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.

11. ©2001 West Legal Studies in Business. All Rights Reserved. 11 Contents of Registration Statement Description of the significant provisions of the registrant’s “offering” and how the registrant intends to use the proceeds from the sale. [Today, many “dot com” companies are registering Initial Public Offerings (IPO’s)].Initial Public Offerings (IPO’s Description of the registrant’s properties and business.

12. ©2001 West Legal Studies in Business. All Rights Reserved. 12 Contents of Registration Statement [2] 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.

13. ©2001 West Legal Studies in Business. All Rights Reserved. 13 Exemptions to Registration Bank securities sold before 1933. 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.

14. ©2001 West Legal Studies in Business. All Rights Reserved. 14 Exemptions to Registration [2] 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).

15. ©2001 West Legal Studies in Business. All Rights Reserved. 15 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. –Intrastate Offerings (Rule 147).

16. ©2001 West Legal Studies in Business. All Rights Reserved. 16 Exempt Transactions [2] Rule 147 Intrastate Sales Broker/Dealer Transactions. Casual Sales. Resales of Restricted Securities by “Control Persons” under Rule 144 and 144(a).

17. ©2001 West Legal Studies in Business. All Rights Reserved. 17 Violations of the 1933 Act Violation of the Securities Act means to intentionally or negligently defraud investors by misrepresenting or omitting material facts in the registration statement and/prospectus.

18. ©2001 West Legal Studies in Business. All Rights Reserved. 18 Securities Act Defenses & Penalties 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.

19. ©2001 West Legal Studies in Business. All Rights Reserved. 19 §4: The 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 (Section 12 companies or 1934 companies).

20. ©2001 West Legal Studies in Business. All Rights Reserved. 20 Section 10(b) and Rule 10b(5) Section 10(b) prohibits the use of any manipu- lative or deceptive device or contrivance in contravention of rules and regulations of SEC, including “insider trading.” –Case 29.1: Diamond v. Oramuno (1969). Disclosure Requirements. Rule 10b(5) prohibits the commission of fraud in the connection with the purchase or sale of any security. –Case 29.2: SEC v. Texas Gulf Sulphur Co. (1968).

21. ©2001 West Legal Studies in Business. All Rights Reserved. 21 Applicability of Rule 10b(5) Insider trading prohibited –10b(5) “Insiders”. –10b(5) “Outsiders”. »Tipper/tippee theory--insider’s fiduciary duty must be breached Case 29.3: SEC v. Warde (1998).SEC v. Warde »Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance. Case 29.4: U.S. v. O’Hagan (1997).U.S. v. O’Hagan

22. ©2001 West Legal Studies in Business. All Rights Reserved. 22 Insider Reporting and Trading under Section 16(b) Officers, directors and large stockholders of Section 12 corporations are required by SEC to file reports concerning their ownership and trading of their stocks. Section 16(b) requires the “recapture” of certain profits made by these types of shareholders. –Case 29.5: Medtox v. Morgan Capital (1999).

23. ©2001 West Legal Studies in Business. All Rights Reserved. 23 Proxy Statements Section 14(a) regulates the contents of proxy statements, which are statements sent to shareholders by managers who are requesting authority to vote on behalf of the shareholder. Whoever solicits a proxy must fully disclose any material information the shareholder should know pursuant to SEC antifraud rules.

24. ©2001 West Legal Studies in Business. All Rights Reserved. 24 Violations of the 1934 Act 10b violation for insider trading—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) violators are strictly liable—no fault or scienter required– for civil violations of the rules.

25. ©2001 West Legal Studies in Business. All Rights Reserved. 25 The Insider Trading Sanctions Act of 1984 SEC can bring suit in federal court against anyone violating or aiding in a violation of the 1934 act or SEC rules by purchasing or selling a security while in the possession of material non-public information Must be a public sale (triple profits awardable). –Emerging Trends in Technology.Emerging Trends in Technology

26. ©2001 West Legal Studies in Business. All Rights Reserved. 26 Insider Trading and Securities Fraud Enforcement Act of 1988 Enlarged class of person who may be liable under insider-trading rules. SEC can award a bounty to informers. SEC got more power to prevent insider trading. Criminal penalties were increased to 10 years and $2.5 million.

27. ©2001 West Legal Studies in Business. All Rights Reserved. 27 § 5: Regulation of Investment Companies Investment companies act on behalf of smaller shareholders by buying large portfolios of securities and managing them professionally. An example is a “mutual fund.” Investment companies must register with the SEC and file annual reports with the SEC. Security must be held in the custody of a bank or stock exchange member who in turn must follow strict procedures set by the SEC.

28. ©2001 West Legal Studies in Business. All Rights Reserved. 28 Investment Companies [2] No dividends may be paid except from accumulated, undistributed net income. Restrictions on investment activities—IC’s may not purchase on a margin, sell short, participate in joint trading accounts. National Securities Markets Improvement Act of 1996 gave regulation to federal government, restricted state regulation.

29. ©2001 West Legal Studies in Business. All Rights Reserved. 29 § 6: State Securities Laws States securities laws are also known as “Blue Sky Laws.” States laws typically require: –Certain disclosures and compliance with antifraud provisions, –Registration or qualification of securities to be sold, –Regulation of securities brokers and dealers.

30. ©2001 West Legal Studies in Business. All Rights Reserved. 30 Focus on Ethics and Government Regulation Environmental Law. –Economic Productivity vs. Environmental Protection. –Superfund and Toxic Waste. Fair Debt Collection. Antitrust Law and Consumer Protection. Insider Trading. Eminent Domain: Balancing Public and Private Rights.

31. ©2001 West Legal Studies in Business. All Rights Reserved. 31 Law on the Web SEC’s Edgar database.SEC’s Edgar database Center for Corporate Law at University of Cincinnati School of Law.Center for Corporate Law at University of Cincinnati School of Law Securities Act of 1933.Securities Act of 1933 Securities Act of 1934.Securities Act of 1934 Information on Investor Protection.Information on Investor Protection Legal Research Exercises on the Web

32. ©2001 West Legal Studies in Business. All Rights Reserved. 32 Emerging Trends First Public Offering over the Internet in 1996. SEC has begun to regulate sale of securities on the internet. SEC’s fraud site.SECfraud There are dozens of “IPO’s” offered via internet brokers such as E-trade.com.E-trade.com Virtually all major corporations have on-line financial statements, “forward-looking” information. RETURN