45-1 Copyright © 2013 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

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10• History and Nature of Corporations

• Organization and Financial Structure of Corporations

• Management of Corporations• Shareholders’ Rights and Liabilities

• Securities Regulation• Legal and Professional Responsibilities

of Auditors, Consultants, and Securities Professionals

Corporations

PART

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Securities Regulation

PA ET RHC 45Quality, at its broadest and most basic level, is the protection of the investor interest. This principle reaffirms a simple and salient truth – markets exist by the grace of investors.

Arthur Levitt, Jr., former SEC chairman, Sept. 23, 1999

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Learning Objectives

• Define “security” and explain how issuances and issuers of securities are regulated

• Describe communication rules for a public offering of securities

• List the Securities Act’s exemptions from registration

• Discuss liability for securities

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• In general, security means any investment of money in a common enterprise with an expectation of profits solely from efforts of others, including but not limited to: – A short-term note, stock, treasury stock,

security future, bond, debenture, investment contract, participation in any profit-sharing agreement, or fractional undivided interest in oil, gas, or mineral rights

What is a Security?

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• Securities Act of 1933 and Securities Exchange Act of 1934 have 3 purposes:

1. Require disclosure of meaningful information about a security and its issuer to allow investors to make intelligent investment decisions

2. Impose liability on those who make inadequate and erroneous disclosures of information

3. Regulate insiders, professional sellers of securities, securities exchanges, and other self-regulatory securities organizations

The Disclosure Laws

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• The 1934 Act created the Securities and Exchange Commission (SEC)

• Empowered to investigate violations of securities laws and hold hearings to determine whether laws have been violated, the SEC has legislative, executive, and judicial functions

– Most SEC actions are resolved through consent orders rather than litigation

The SEC

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• In SEC v. W. J. Howey Co., the court held that sales of plots in an orange grove plus a management contract were sales of securities because the investment contract was an investment of money in a common enterprise with an expectation of profits solely from the efforts of others– Known as the Howey test

Defining The Security

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• 1933 Act regulates the sale of securities while they pass from the hands of the issuer into hands of public investors

• Two principal regulatory components: 1. Registration provisions 2. Liability provisions

Securities Act of 1933

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• Under the 1933 Act, an issuer may not offer to sell or sell securities unless the securities are registered with the SEC or exempt from registration

• Registration requires underwriting by securities market professionals

• Registration requires filing a registration statement with the SEC

Registration of Securities

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• The prospectus is the sales document of an offering registered under the 1933 Act

• Most of the information in the registration statement must be in the prospectus

• A prospectus allows a potential investor to base an investment decision on all relevant data about the issuing company, not simply favorable information

Prospectus

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• Three important periods of time in the life of a securities offering:

1. Prefiling period 2. Waiting period3. Post-effective period

The Securities Offering Timeline

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• Two types of exemptions from the registration requirements of the1933 Act:

1. Securities exemptions• Exempt securities never need to be

registered

2. Transaction exemptions• Requirement to register depends upon

the type of transaction

Exemptions to Registration

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• Government-issued securities• Short-term note or draft (< 9 months to

maturity)• Security issued by a nonprofit religious,

charitable, educational, benevolent, or fraternal organization

• Securities issued by a bank or savings and loan• Securities issued by common carriers regulated

by the Interstate Commerce Commission• An insurance policy or an annuity contract

1933 Act Securities Exemptions

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• Intrastate (Rule 147): Offering securities solely to investors in one state by an issuer resident and doing 80% of firm’s business in that state

• Private Offering (Rule 506 of Regulation D):

• Rule 506, Regulation D: Private offering to less than 35 unaccredited purchasers with sufficient investment knowledge and an unlimited accredited investor-purchasers

Transaction Exemptions – Intrastate and Private

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• Rule 504, Regulation D: Nonpublic issuer may sell up to $1 million of securities in a 12-month period to any purchaser

• Rule 505, Regulation D: Any issuer may sell up to $5 million of securities in a 12-month period to less than 35 unaccredited investors (unlimited accredited investors)

• Regulation A: Nonpublic issuer may sell up to $5 million of securities in one year period

Transaction Exemptions – Small Offerings

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• Section 11: civil liabilities for damages when a registration statement misstates or omits a material fact on its effective date– Purchaser may file suit for damages

caused by misstatement or omission• Reliance and privity usually not required• Purchaser need not prove that defendant

negligently or intentionally misstated or omitted a material fact

1933 Act Liability Provisions

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• Defendant can escape liability by proving the purchaser knew of misstatement or omission when security was purchased

• Defendant may raise due diligence defense:– Defendant must prove that after reasonable

investigation they had reasonable grounds to believe and did believe that the registration statement was true and contained no omission of material fact

Section 11 Defenses

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Other 1933 Act Provisions

• Section 12(a)(2) prohibits misstatements or omissions of material fact in any written or oral communication in connection with general distribution of any security by issuer

• Section 17(a) prohibits the use of any device or artifice to defraud, or the use of any untrue or misleading statement, in connection with the offer or sale of any security

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• Two subsections of Section 17(a) require that defendant merely act negligently, while a third subsection requires proof of scienter– Scienter: intent to deceive, manipulate, or

defraud the purchaser (may include recklessness)

• Section 24 of the 1933 Act provides for criminal liability for any person who willfully violates the act or its rules and regulations– Maximum penalty: $10,000 fine, or five

years’ imprisonment, or both

Other 1933 Act Provisions

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Securities Exchange Act of 1934

• 1934 Act requires periodic disclosure of material information by issuers with publicly held equity securities

• Purpose is to protect investors after the issuer becomes a public company– Compare to 1933 Act, which primarily is a

onetime disclosure statute• 1934 Act also regulates insiders’

transactions in securities, proxy solicitations, tender offers, brokers and dealers, and securities exchanges

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Registration Under 1934 Act

• Issuers must file a 1934 Act Registration Statement for classes of securities which remain registered until the issuer acts to deregister the securities– Compare to 1933 Act which requires

issuers to register only for the term of an issuance of securities

• Result: Issuer must disclose information about itself to its owners and the SEC

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Periodic Reporting

• Issuers that also register securities under the 1934 Act must file several periodic reports:– Annual report (Form 10-K), quarterly report

(Form 10-Q), and a monthly report (Form 8-K) when material events occur

– Comparable reports must be sent to shareholders

• Issuers who must disclose under 1934 Act due to registered offering under 1933 Act must file same reports, but need not provide annual report to shareholders

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Insider Holdings & Tradings

• Section 16(a): statutory insiders must disclose ownership of their firm’s securities within 10 days of becoming owners and report subsequent transactions within 2 business days after a trade

• Statutory insider is any one of the following: 1. An officer of a corporation having equity securities

registered under the 1934 Act2. A director of such a corporation3. An owner of more than 10 percent of a class of

equity securities registered under the 1934 Act

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1934 Act Liability Provisions

• Section 18 is the 1934 Act counterpart to Section 11 of 1933 Act; imposes liability on any person responsible for false or misleading statement of material fact in any filing under 1934 Act– Person who relies on false or misleading

statement in a filing may sue for damages– Need not prove defendant’s fault

• Defendant may raise defense of good faith -- no knowledge (no scienter) that the statement was false or misleading

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Section 10(b) & Rule 10b-5

• Section 10(b) broadly prohibits the use of any manipulative or deceptive device in contravention of any SEC rules prescribed as “necessary or appropriate in the public interest or for the protection of investors”

• Rule 10b-5 specifies the elements of the prohibition and applies to all transactions in all securities, whether or not registered under 1933 or 1934 acts

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Insider Trading

• Rule 10b–5 prohibits a person with inside information (nonpublic, confidential) from using the information when trading securities with a person without the information– Insider: anyone with confidential corporate

information for a corporate purpose– Disclose-or-refrain rule: insider must either

disclose the information before trading or refrain from trading

– Tippees receive inside information

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• Reg. FD (fair disclosure) states that when an issuer or person acting for the issuer discloses material nonpublic information to securities market professionals and holders of the issuer’s securities, it must make public disclosure of that information– File or furnish Form 8-K or use other

method designed to effect broad, nonselective disclosure to the public

Regulation FD

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• Section 32: – Individuals may

be fined up to $5 million and imprisoned up to 20 years for willful violations

– Businesses may be fined up to $25 million

1934 Act Criminal Liability

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• A tender offer is a public offer by a bidder to purchase a subject company’s equity securities directly from shareholders at a specified price (generally well above market) for a fixed period of time– Hostile tender offers: opposition from subject

company’s management • Williams Act amendments to the 1934 Act:

bidders & subject companies must provide relevant information to shareholders

Tender Offer Regulation

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• State securities laws often called blue sky laws, since early state securities laws were to protect investors from promoters and security salespersons who would “sell building lots in the blue sky”

• Most state securities statutes have a registration scheme much like 1933 Act

• All state statutes have a limited number of exemptions

State Securities Laws

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Thought Question

• Alan Greenspan stated: Private capital markets are the fundamental building block of the capitalist system…Such markets can function properly only if investors bear the costs of their bad decisions and bad luck and reap the benefits of their good decisions and good luck. – Speech by Former Federal Reserve Chairman to the Financial Crisis Conference on July 12, 2000

• Do you agree with his statement?