CHAPTER 37

1. CHAPTER 37 Securities Regulation

2. Securities and Exchange Commission (SEC) • Created in 1934 to regulate the securities industry: • Rules – to fill in gaps left by state securities statutes. • Releases – informal pronouncements on current issues, particularly proposed changes in the rules. • No-Action Letters – the answer to a question; states that the SEC will take no action (meaning that they approve of the transaction in question.)

3. What is a Security? • A security is any transaction in which the buyer: • (1) invests money in a common enterprise and, • (2) expects to earn a profit predominately from the efforts of others.

4. Securities Act of 1933 • The 1933 Act requires that, before offering or selling securities, the issuer must register the securities with the SEC, unless the securities qualify for an exemption. • When an issuer registers securities, the SEC does not investigate the quality of the offering. • The 1933 Act prohibits fraud in any securities transaction.

5. 1933 Act -- Exemptions • General Exemption – those made by the SEC “for the public interest.” • Exempt Securities • Government securities, Blank securities, Short-term notes, Non-profit issues, Insurance policies and annuity contracts • Regulation D covers private offerings; Regulation A covers “small” public offerings.

6. 1933 Act -- Exemptions • Exempt Transactions • Section 4(2) of the 1933 Act exempts from registration “transactions by an issuer not involving any public offerings.” • Under SEC Rule 147, an issuer is not required to register securities that are offered and sold only to residents of the state in which the issuer is incorporated and does business.

7. 1933 Act -- Exemptions • Regulation D • Rule 504 – allows up to $1 million in securities sold in 12-month period; may advertise if transaction is registered and limited to accredited investors. (Sales that don’t meet this limit are restricted stock and cannot be resold in less than one year.) • Rule 505 – may sell up to $5 million in 12-month period; may not advertise; may have unlimited accredited investors and 35 unaccredited investors. • Rule 506 – like Rule 505 except amount is unlimited and unaccredited investors who cannot evaluate the risk for themselves must have a purchaser representative.

8. Public Offerings • Direct Public Offerings – stock sold directly by the company, without going through a broker. • This option is cheaper and may increase loyalty among customers, but.. • It can be expensive to mail disclosure statements and to set up trading systems. • A company’s first public sale of securities is called its initial public offering (IPO).

9. Public Offerings (cont’d) • A company selling stock may hire an investment bank to serve as the underwriter. • In a firm commitment underwriting, the bank buys the stock, then resells it. Risk of loss is borne by the bank. • In a best efforts underwriting, the bank acts as the agent, selling the stock for the company, which bears the risk of loss.

10. Public Offerings (cont’d) • A registration statement is required for a company preparing to sell stock. Its purpose is: • To notify the SEC that a sale of securities is pending, and • To disclose information to purchasers. • A prospectus is a portion of the registration statement which must be given to prospective purchasers.

11. Public Offerings (cont’d) • The company’s sales effort is restricted during the pre-filing and waiting periods. • The quiet period begins when an underwriter is hired and ends 25 days after the IPO. Company officers must not “hype” their stock during this time. • The waiting period is after the registration statement is filed, but before the SEC approves it. A simple ad can be published, and indications of interest are gathered, but no sales can be made. • A road show may take place, where representatives from the company visit stockbrokers and potential investors to present information and determine interest.

12. Going Effective • The SEC may require changes to the registration statement before allowing the stock to go effective (begin to be sold). • Before going effective, the company and underwriter together decide on the opening price of stock. • Setting the price too low causes the company to not earn what it could. • Setting the price too high and everyone loses.

13. Sales of Restricted Securities • Rule 144 limits the resale of two types of securities: control securities and restricted securities. • A control security is one held by any shareholder who owns more than 10 percent of a class of stock or by any officer or director. • A restricted security is any stock purchased from the issuer in a private offering.

14. Liability Under the 1933 Act • Liability is imposed on anyone selling unregistered and non-exempt securities. • Fraud imposes liability on the seller if any interstate commerce is used (such as U.S. mail, telephone, banks – which includes practically every transaction!)

15. Liability (cont’d) • Criminal liability is imposed on anyone who willfully violates the Act of 1933. • If a final registration statement contains a material misstatement or omission, the purchaser of the security can recover from everyone who signed the registration statement.

16. Securities Exchange Act of 1934 • Registration – an issuer must register with the SEC if: • It completes a public offering under the 1933 Act, • Its securities are traded on a national exchange, or • It has at least 500 shareholders and its assets exceed $10 million. • A company can deregister if its number of shareholders falls below 300 or if it has fewer than 500 shareholders and assets of less than $10 million.

17. Securities Exchange Act of 1934 (cont’d) • Section 13 requires companies to file the following documents: • An initial, detailed information statement when the company first registers. • Annual reports on Form 10-K, containing a detailed analysis of the company’s performance, and information about officers and directors. • Quarterly reports on Form 10-Q, which are less detailed than 10-Ks. • Form 8-Ks to report any significant developments or changes.

18. Securities Exchange Act of 1934 (cont’d) • Proxy Requirements - Section 14 – allows shareholders to vote without attending the meeting. • Short-Swing Trading - Section 16 – prevents insiders from manipulating the market using inside information; this section limits insiders from buying and then selling (or selling then buying) company stock within a 6 month period.

19. Liability Under the 1934 Act • Section 18 holds liable those who make a false or misleading statement in a filing. • Section 10(b) prohibits fraud in the purchase and sale of any security whether or not it is registered under the 1934 Act. Applies to: • Misstatement or omission of material fact that was relied upon • Scienter (willful misstatement) • Either purchasers or sellers • Injured party must have relied on the fraudulent statement and must have suffered economic loss that was caused by the statement.

20. The Private Securities Litigation Reform Act of 1995 • Insider Trading • Someone who trades on inside information is liable only if he has a fiduciary duty to the company whose stock he has traded. • Fiduciaries • A fiduciary violates Rule 10b-5 if she trades stock of her company while in possession of nonpublic material information.

21. Reform Act of 1995 (cont’d) • Tippers -- Insiders who pass on non-public, material information are liable under Rule 10b-5, even if they do not trade themselves, as long as: • (1) they know the information is confidential and, • (2) they expect some personal gain (this term is loosely defined, and can even include the pleasure of giving a “gift” to a friend.)

22. Reform Act of 1995 (cont’d) • Tippees --Those who receive tips are liable for trading on inside information, even if they do not have a fiduciary relationship to the company, as long as: • (1) they know the information is confidential, • (2) they know it came from an insider who was violating his fiduciary duty, and • (3) the insider expected some personal gain.

23. Reform Act of 1995 (cont’d) • Takeovers • This rule prohibits trading on inside information during a tender offer if the trader knows the information was obtained from either the bidder or the target company. • Misappropriation • A person is liable if he trades in securities (1) for personal profit, (2) using confidential information, and (3) in breach of a fiduciary duty to the source of the information.

24. Foreign Corrupt Practices Act • Under the Foreign Corrupt Practices Act, it is a crime for any American company (whether reporting under the 1934 Act or not) to make or promise to make payments or gifts to foreign officials, political candidates, or parties in order to influence a governmental decision, even if the payment is legal under local law.

25. Blue Sky Laws • State statutes regulating securities are called blue sky laws (because crooks were willing to sell investors “a piece of the great blue sky”). • All the states and the District of Columbia have blue sky laws. • The National Securities Markets Improvement Act of 1996 restricts state regulation of securities that are: • Traded on a national exchange, • Exempt under Rule 506, or • Sold to “qualified purchasers.”

26. Blue Sky Laws • Any securities not covered by NSMIA must comply with state security laws. • Typically, states take one of the following approaches: • Registration by notification • Registration by coordination • Registration by qualification

27. Blue Sky Laws • Three options ease the process of complying with state requirements. • Coordinated Equity Review – issuer deals with only one state, which coordinates comments from all other states. • Small Company Offering Registration – for use in offerings of up to $1 million over any 12 month period; relatively simple form; designed to be used with Rule 147, Rule 504 and Regulation A. • Uniform Limited Offering Exemption – most states largely exempt from registration any offerings under Rule 505.

28. “Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934 to ensure that the country never suffers through another economic crisis as catastrophic as the Great Depression. It is in no small part owing to these laws that the United States has enjoyed so many years of economic stability.”