Chapter 37: Corporations—Securities Regulation and Investor Protection

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Chapter 37: Chapter 37: Corporations—Securities Corporations—Securities Regulation and Investor Regulation and Investor

ProtectionProtection

Chapter 37: Chapter 37: Corporations—Securities Corporations—Securities Regulation and Investor Regulation and Investor

ProtectionProtection


IntroductionIntroductionIntroductionIntroduction

• Historical Background: 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.


IntroductionIntroductionIntroductionIntroduction

• The Securities Act of 1933 and Securities Exchange Act of 1934 are designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities.

• Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt.


§ 1: The SEC§ 1: The SEC§ 1: The SEC§ 1: The SEC• The Securities and Exchange Commission is an

independent federal regulatory agency that enforces federal securities laws. The SEC :– Regulates disclosure of facts in offerings made

through national securities exchanges (e.g., NASDAQ, NYSE).

– Investigates and prosecutes securities fraud.– Registration and regulation of securities brokers,

dealers and investment advisors.– Securities Regulations.


Expanded Powers of the SECExpanded 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.


§ 2: The Securities Act of 1933§ 2: The Securities Act of 1933§ 2: The Securities Act of 1933§ 2: The Securities Act of 1933

• Securities Act of 1933 regulates solicitation, buying and selling of securities: stocks and bonds.

• 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 StatementRegistration StatementRegistration StatementRegistration 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.

• Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.


Contents of Contents of Registration StatementRegistration Statement

Contents of Contents of Registration StatementRegistration 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)].

• Description of the registrant’s properties and business.


Contents of Contents of Registration Statement Registration Statement [2][2]

Contents of Contents of Registration Statement Registration Statement [2][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.


Exemptions to RegistrationExemptions to RegistrationExemptions to RegistrationExemptions 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.


Exemptions to Registration Exemptions to Registration [2][2]Exemptions to Registration Exemptions to Registration [2][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).


Securities Act Securities Act Exempt Exempt TransactionsTransactions

Securities Act Securities Act Exempt Exempt TransactionsTransactions

• 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.– (Also Regulation A)


Securities Act Securities Act Exempt Exempt Transactions Transactions [2][2]

Securities Act Securities Act Exempt Exempt Transactions Transactions [2][2]

• Rule 147 Intrastate Sales.

• Broker/Dealer Transactions.

• Casual Sales .

• Resales of Restricted Securities by “Control Persons.”– Rule 144 and 144(a).


Securities Act ViolationsSecurities Act ViolationsSecurities Act ViolationsSecurities Act Violations

• Violation of the Securities Act to intentionally or negligently defraud investors by misrepresenting or omitting material facts in the registration statement and/prospectus.


Securities Act Securities Act Defenses & PenaltiesDefenses & Penalties

Securities Act Securities Act Defenses & PenaltiesDefenses & 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.


§3: The §3: The Securities Securities Exchange Act of 1934Exchange Act of 1934

§3: The §3: The Securities Securities Exchange Act of 1934Exchange 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).


Purposes of 1934 ActPurposes of 1934 Act [2][2]Purposes of 1934 ActPurposes of 1934 Act [2][2]

• Rule 14(a) proxy regulations.

• Market surveillance by SEC.

• Rule 10(b) prohibits fraud with insider trading and disclosure regulations.

• Rule 16(b) insider reporting and trading.

• Rule 13 tender offer regulations.


Section 10(b) and Rule 10b(5)Section 10(b) and Rule 10b(5)Section 10(b) and Rule 10b(5)Section 10(b) and Rule 10b(5)• 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.

• Case 37.1: Diamond v. Oramuno (1969).• Case 37.2: SEC v. Texas Gulf Sulphur (1968).


Section 10(b) and Rule 10b-5 Section 10(b) and Rule 10b-5 [2][2]Section 10(b) and Rule 10b-5 Section 10(b) and Rule 10b-5 [2][2]

• Insider trading prohibited:– 10b(5) “Insiders”.– 10b(5) “Outsiders”.

• Tipper/tippee theory--insider’s fiduciary duty must be breached Case 37.3: SEC v. Warde (1998).

• Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance. Case 37.4: U.S. v. O’Hagan (1997).

• Case 37.5: Medtox v. Morgan Capital (1999).


Violations of the 1934 ActViolations of the 1934 ActViolations of the 1934 ActViolations 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.


Section 16 (a) & (b): Section 16 (a) & (b): Section 16 (a) & (b): Section 16 (a) & (b):

• 16(a): Stockholders who become owners of 10 or more of the classes of equity stock must report their ownership to the SEC.

• 16(b): Profits realized by the insider on any purchase and sale, or sale and purchase, of the corporation's stock within any six-month period must be forfeited to the corporation.

• Also applicable to warrants and options and securities convertible into stock.


Insider Trading Sanctions Insider Trading Sanctions Act of 1984Act of 1984

Insider Trading Sanctions Insider Trading Sanctions Act of 1984Act 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.


Insider Trading and Securities Insider Trading and Securities Fraud Enforcement Act of 1988Fraud Enforcement Act of 1988Insider Trading and Securities Insider Trading and Securities Fraud Enforcement Act of 1988Fraud 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.


§4: Investment Companies§4: Investment Companies§4: Investment Companies§4: 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.


§5 State Securities Laws §5 State Securities Laws §5 State Securities Laws §5 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.


Law on the WebLaw on the WebLaw on the WebLaw on the Web

• SEC’s Edgar database.

• Center for Corporate Law at University of Cincinnati School of Law.

• Securities Act of 1933.

• Securities Act of 1934.

• Information on Investor Protection.


Emerging TrendsEmerging TrendsEmerging TrendsEmerging Trends

• First Public Offering over the Internet 1996.• SEC has begun to regulate sale of securities

on the internet. • There are dozens of “IPO’s” offered via

internet brokers such as E-trade.com .• Virtually all major corporations have on-

line financial statements, “forward-looking” information.

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Chapter 37: Corporations—Securities Regulation and Investor Protection

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