• Debt• When bonds are sold, there is often an

issue of a certain amount• Bonds usually traded on securities

market, so are securities• Debt financing may also occur by

borrowing money from large lenders (banks, insurance companies)

• Instrument usually specifies:– amount of debt– length of period– repayment method– rate of interest charged

• Handled by professionals who earn commissions

• Equity• Equity financing is raising

funds through sale of company stock

• Sale of company stock to purchasers (shareholders)

• Shareholders have claim to future profits of company

• Company is not obligated to repay shareholders

• Can usually be traded

Securities Regulation• States began with blue sky laws to deter

fraudulent securities sales• Most important Federal laws are:

– Securities Act of 1933• regulates initial public offerings of securities

– Securities Exchange Act of 1934• regulates trading in existing securities, disclosure

requirements, securities markets and professionals

• Securities and Exchange Commission– agency responsible for enforcement and

administration of federal securities laws

What Is A Security?

• Merely calling it a security does not make it so

• Have higher legal protection for securities

• Four basic elements (Howey test):– investment of money

– in a common enterprise

– with an expectation of profits

– generated by efforts of persons other than the investors

Securities Exempt from Regulation

• Issued or guaranteed by government– Federal, state or local

• Issued by banks

• Issued by religious and charitable organizations

• Insurance policies

• Annuity contracts

Offering Securities to Investors

• ‘33 Act requires full disclosure of all material information on security, issuers, and intended use of money before sale to public.

• Material information is all relevant information an investor would want to know:– background– executives– plan of operation

Registration Statement• Prospectus (SEC Schedule A)

• Provides material information about:– issuer’s finances and business– purpose of the offering– plans for funds collected– risks involved– promoter’s managerial

experience and financial compensation

– financial statements certified by independent public accountants

Registration Statement

• Regulation S-K– more detailed disclosure than

in prospectus– used by investment analysts– available for public inspection

• Review by SEC– doesn’t rule on merits

(likelihood of success)– can require issuers to indicate

high-risk factors to buyers– registration effective 20 days

after filing, but SEC can issue deficiency letter and issuer will need time to amend the filing

– can issue stop order to prevent sale until examiners are happy

• Costs of Registration– Expensive!– Need securities

attorney, CPA, printer, underwriter, etc.

– Need to hire an underwriter (i.e. investment banker)

Exemptions From Registration• Some securities, subject to securities laws, are exempt from registration

requirements:– New JOBS law.– Private Placements

• not offered to the public• usually placed w/institutional investors (pension plans or insurance

companies)• Regulation D specifies what will qualify as a private placement exemption

– Made to accredited investors – presumed sophisticated and wealthy – complex rules– Common Reg. D offerings are called Small Corporate Offering Registration (SCOR)

• Rule 144A sale of bonds or stocks to qualified institutional buyers (QIBs) investors w/portfolio of at least $100M

Well-Known Seasoned Issuers (WKSIs)

• Securities issued by WKSIs.• Issuers that have issued at least $1 billion

in securities previously OR• Have public-equity market capitalization of

at least $700 million• Includes most well-known securities firms• They can file registration statements the

day new offering is announced rather than submitting for SEC staff review beforehand

• Can continuously update information – even on Website

• Securities are under shelf registration – once announced and registered, they may be sold at any time over next 3 years.

Regulation of Securities Trading

• If registered under ‘33 Act, must register under ‘34 Act; if exempt under ‘33 Act, must register if traded on an exchange or over the counter (OTC) and has >$5M assets and 500+ shareholders

• Publicly held company– publicly traded stock– most traded OTC– must file 10-K annual

report• Privately held

– less than 500 shareholders

– not openly traded

Proxies and Tender Offers

• Regulation FD (Fair Disclosure) in 2002 tried to create a “level playing field,” requiring public companies to release information to the public rather than selective revealing of information

• Proxies – Permission by shareholders given to someone else to

vote their shares in the manner they instruct• Tender Offers

– When one company attempts to take over another– Target company’s stock owners are offered stock in the

acquiring company or cash in exchange for their stock

Securities Fraud

• Investors often have trouble proving common-law fraud

• Usually rely on antifraud provisions of ‘33 and ‘34 Act for statutory fraud

• ‘33 Act: misleading statements or material omissions

• Rule 10b-5• Basis for Securities Fraud;

used more than other Act sections

• Unlawful to:– employ device, scheme to

defraud– make untrue statement of

material fact– engage in act or practice which

operates a fraud in connection with purchase/sale of security

Liability For Securities Law Violations

• Can sue parties who prepared disclosure docs or other impt. info about securities

• Can also sue:– directors of company, CEO, CFO and

accounting officers, accountants, lawyers

• SEC may also act against them with civil penalties and criminal charges

• Have liability for misstatements or omissions about financial status of business with publicly traded securities

Safe Harbor and Federal Exclusivity

• Safe Harbor– Securities Litigation Reform Act

of 1995

– Allows companies to predict profits and their likely success as long as forecasts are accompanied by “meaningful cautionary statements” that ID “important factors that could cause actual results to differ materially from those in the forward-looking statement.”

– Gives immunity from liability

• Federal Exclusivity– Securities Litigation

Uniform Standards Act of 1998

– Requires securities suits that involve nationally traded securities to be brought “exclusively” in federal court under federal law.

Slayton v. American Express Company

• A group of investors bought American Express (AE) stock between 1999 and 2001 .

• Sued the company & executives for securities fraud for misleading investors.

• Contended that AE over-invested in high-yield debt (junk bonds)– Resulting in loss of hundreds of millions of dollars in 2000 and 2001.

• Investors’ claim was largely based on 10Q report AE filed with SEC in May 2001 .– Report stated that while it lost $182 million from its high-yield debt

investment in the 1st Quarter of 2001, future losses expected lower.

• Company later realized that losses were larger than report said• In July AE announced a further $826 million loss due to write-downs

of the junk bonds.– Caused AE stock to fall. (Continued)

Slayton v. American Express Company, cont.

• Plaintiffs claimed May filing was misleading and AE knew or should have known that losses were worse than reported.

• District court dismissed complaint; investors appealed.• HELD: Affirmed. American Express wins.• Not liable under Private Securities Litigation Reform Act IF

– False or misleading statement is “identified as a forward-looking statement” and has precautionary statement re: important factors that could cause result to be different.

• Form 10-Q warned that forward-looking statement were “subject to risks and uncertainties”.

• AE used words like “believe”, “expect”, “anticipate”, “aim”, etc.• Plaintiffs claim that “forward-Looking Statement” should be specifically

marked that labeled as “forward-looking”. • SEC disagreed. Statements such as “we expect” and we believe” designate

statement as forward-looking. Don’t need separate section. Nor does statute say must be a separate section labeled “forward-looking”.

Sarbanes-Oxley Act (SOX) Requirements

– CEO and CFO of companies with publicly traded stock must personally certify that financial reports comply with SEC rules.

– Knowing misstatements have criminal fines and imprisonment.

– Protection also for corporate whistleblowers.– Established Public Company Accounting

Oversight Board to discipline CPAs for misconduct & also sets accounting standards.

– Sarbanes-Oxley has forced firms to standardize procedures and accounting.

Insider Trading• Most controversial application of 10b-5 is

prohibiting insider trading• Insiders have access to info not available

to public• May be liable to SEC for profits from such

transactions • See “London, New York and Sarbanes

Oxley Act. Compares U.S. & European nations re: impact of Sarbanes-Oxley Act. U.S. competitive position impacted more negatively than London. Firms often choose London’s stock exchange and junior market over New York.

Insider Trading Sanctions Act of 1984

• Gives SEC a statutory basis for prosecuting insider trading.

• The law was strengthened by the Insider Trading and Securities Fraud Enforcement Act.– Increased the maximum fine to $1 million per

action and set maximum prison term to 10 years per violation. Corporate fines were raised to $2.5 million /violation.

• See Issue Spotter: “Can You Exploit the Gossip?”

Investment Company Act• Primarily in the business of investing or trading securities• Three types of Investment Companies

– face-amount certificate companies – issue debt securities paying fixed rate of return

– unit investment trusts – offer fixed portfolio of securities– management companies – most important type

• open-end company known as a mutual fund– no specific number of shares, expand as long as new investments– invested in portfolio of securities

• two kinds of mutual funds: load and no-load– load: sold through securities dealer; have commissions (load) of

some % of price– no-load: Sold directly to public through mail or Internet; no sales

commissions

Investment Advisers Act (IAA) Regulates Securities

Professionals

• Brokers– effecting transactions

for the account of others

• Dealers– buying and selling

securities for own account

• Advisers– charging fees for

investment advice

• Must be registered with SEC

• Can’t churn– excessive buying and

selling of client’s account to get commissions

• Can’t scalp– buy stocks for personal

benefit then urge clients to buy so price goes up

Stock Market Regulation• New York Stock Exchange and other exchanges governed by

the Financial Industry Regulatory Authority (FINRA)

– An independent regulatory authority that sets rules of behavior for its traders

– Handles most disputes

– Helps oversee brokerage firms and employees

• Self-Regulation of Securities Markets

– SEC has power to monitor

– Includes stock exchanges such as NYSE, AMEX, NASDAQ

• Regulation of Securities Transactions

– Regulates actions of securities

professionals who do actual trading

– Professionals can’t trade for their own benefit

ahead of customers

Penalties Include Suspension or Expulsion

Arbitration of Disputes• Usually investors with

investment firms sign a standard form indicating disputes must be arbitrated, not litigated.

• SEC rules govern the arbitration process.

• The Supreme Court upholds the binding nature of arbitration agreements.

The Consumer Financial Protection Bureau

• 2010 Dodd-Frank Act• Established new agency: Consumer Financial Protection Bureau (CFPB)

within the Federal Reserve• Still “getting up to speed”• Attorneys-general have authority to enforce Bureau rules• Instructions from Congress to the CFPB

– Crack down on financial scams/gimmicks aimed at ordinary consumers and debtors

– Ensure terms of financial documents are transparent & can be understood by a reasonable consumer

– Focus on practice of non-bank institutes, i.e. payday lenders, that seem unfair– Look at existing rules i.e. those of the Equal Credit Opportunity Act, and make

sure rules are not in conflict with each other

Dodd-Frank Wall Street Reform and Consumer Protection Act

• Dodd-Frank Wall Street Reform Act (2010).• Established new regulatory authority in consumer credit area.• Focuses on financial markets and oversight in large-scale

financial problems.• Regulators oversee general market conditions – prepared to act

in case of crisis.• Oversight of “systemic risk” – market-wide problem.• Example: Financial meltdown in 2007-08 by the Financial

Stability Oversight Council.• Regulators can intervene in financial institution in case of

trouble.• Trading of derivatives also open to greater regulatory oversight.• Greater desire for transparency.

Latta v. Rainey

• From 2001 through 2004, Mobile Billboards of America (MBA) sold mobile billboard “investments” in U.S.

• Investors given “offering circular” claimed to comply with federal and state regulations.• Each billboard unit was $20,000.• Owner leased the unit for 7 years to Outdoor Media Industries (OMI), a shell company

owned/operated by MBA’s principals.• Investors would receive average return of 13.49%/year.• After 7 years, MBA would buy back the billboards & return investment.• MBA claimed it had a Reserve Guaranty Trust (RGT) – $5,000 of each $20,000 would be

placed in RGT.• Investors received a certificate to receive share of money earned by funds invested in

RGT, plus the right to the $20,000 investment.• Latta, terminally ill, wanted a secure investment.• Rainey, “Certified Senior Advisor” with MBA (of North Caroline) said Billboards was a

“safe company – “absolutely no risk”.• Latta invested $100,000. (Continued)

Latta v. Rainey, cont.

• Rainey received a commission of 16-20%. Lattas received “lease payments” from OMI the first year. This was classic Ponzi scheme.

• Secretary of State of North Carolina, investigated.• MBA ordered to cease and desist from sales.• Rainey collected Latta’s final investment.• Latta and others sued.• Rainey filed for bankruptcy; Mr. Latta died.• Trail court Held MBA billboard sales were unregistered securities – violation of federal and state

law.• Also breach of fiduciary duty by Rainey to Latta, fraudulent concealment, securities fraud and

conversion.• Jury awarded Mrs. Latta $95,503.40, plus $750,000 punitive damages. Court reduced punitive

damages to $286,510. Rainey appealed.• HELD: Affirmed. • Elements of fraud:

– 1) False Representation or Omission of Material Fact

– 2) Intent to Deceive

– 3) Reasonable Reliance (by Lattas)

• All elements were present here