Understanding Securities Law: Investor Protection Insights

1. Chapter 33Investor Protection andOnline Securities Offerings

2. Learning Objectives • What is meant by the term securities? • What are the two major statutes regulating the securities industry? • What federal laws specifically regulate investment companies? • What are some of the features of state securities laws? • How are securities laws being applied in the online environment?

3. Introduction • The 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.

4. Introduction • 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.

5. Securities Act of 1933 • Securities Act of 1933 regulates solicitation, buying and selling of securities. • 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.

6. 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 Securities Exchange Commission (http://www.sec.gov) and state securities agencies before offered to the public. • Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.

7. Registration Statement • Description of the significant provisions of the registrant’s “offering” and how the registrant intends to use the proceeds from the sale. • Description of the registrant’s properties and business.

8. Registration Statement • 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.

9. Exempt Securities • 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.

10. Exempt Securities • 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).

11. 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.

12. Violations of the 1933 Act • Intentional or negligent fraud of investors by misrepresenting or omitting material facts in the registration statement and/prospectus. • 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.

13. 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 (Sec. 12 companies or 1934 companies).

14. Section 10(b) and Rule 10b(5) & Insider Trading • 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.

15. Section 10(b) and Rule 10b(5) & Insider Trading • Insider Trading • Advance information available to corporate officers and directors that can affect future value of stock. • Insider trading prohibited: • 10b(5) “Insiders” (Officers, Executives and Directors) • 10b(5) “Outsiders” • Tipper/tippee theory--insider’s fiduciary duty must be breached • Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance.

16. Violations 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.

17. Regulation of 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.

18. 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.

19. Online Securities Offerings • Spring Street Brewing Company (1996): Landmark Online IPO • Regulations for online offerings. • SEC October 1995 “use of electronic media should be at least an equal alternative to paper-based media.” Downloadable prospectus is permissible.

20. Online Securities Offerings • Online IPO’s may deliver a prospectus by: • Giving timely and adequate notice (e-mails) • Making the online communication system readily accessible. • Requiring evidence of delivery (email return receipt).

21. Online Securities Offerings • Online offers should not link to other sites in prospectus. • Problems with status of investors on a general website. For example, Reg D offerings can only be made to “accredited investors”. • Perhaps use password protected.

22. Online Securities Fraud • SEC tries to enforce anti-fraud provisions of Securities Laws. • Use and abuse of internet chat rooms. • Where is the line between free speech and fraud? • Pumping and Dumping: buyer pumps the stock and after it rises, he dumps it, selling at a higher price. • Selling unregistered securities by unregistered stock brokers is a problem.