Notes Securities regulation [second book] - Securities regulation R. Chapter 1: Introduction to - Studeersnel (2024)

Studiejaar: 2017/2018

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Securities regulation R. Chapter 1: Introduction to securities markets and regulations Securities regulation wants to protect the investor, mandatory disclosure, liability for fraud and regulation of securities intermediaries. You buy shares in the primary market for the first time, and you trade them in the secondary market. There are private placements in the private market (venture capitalists e.) and public offerings in het public market (selling debt and equity securities 1). There are two markets in the US for the public trade of securities: Exchange (auction) markets: centralized markets where specialists match buyers and sellers, e. New York Stock Exchange (dealer) markets (OTC): securities firms as intermediaries buy and sell, e. NASDAQ Electronic communication networks (ECN): trade directly The functions of security markets are matching supply and demand for capital, the possibility to sell your investment (liquidity), and diversification (risk management). If you want to buy shares of General Electric, you call a broker (or use an online broker) to buy shares. become the beneficial owner of the shares and you can vote, but will not receive share certificates. The brokerage firm will act as the nominee, and they have the shares of GE. difficult to buy corporate bonds, because they start from However, you can buy shares of mutual funds. To become a venture capitalist (buy a minority of in a there are several conditions. You can protect your portfolio against a falling dollar buying a currency future. If the exchange rates fall and hurt the value of your portfolio, the value of the currency futures rises to offset the loss in your securities portfolio. If the interest rates raise, the value of equity securities decline. What to do if you want to sell them, because then the prices declines even more? You sell an index future, which is a contract in which the seller promises to sell in the future at a specified price a block of stocks that represent a stock index (typically the Standard Almost all of the time too late if you read information about shares in Wall Street, because the professional analysts have already found it and adjusted the price. typical for IPOs that the price rises significantly just after the IPO, but on average the IPO underperforms the market. The Securities Act 1933 was the first step in a comprehensive scheme of federal securities regulation, with the issuance of securities and the prospectus. The second step was the Securities Exchange Act 1934, with creation of the SEC, disclosure requirements and regulation about insider trading. In the (now repealed) Act commercial banking (accepting of deposits and making loans) was separated from investment banking (securities). However, the securities are still regulated the SEC, the banking activities federal or state bank regulators. 1 Including the initial public offering (IPO): raising capital from the public for the first time. 1 The Act 2002: there is more disclosure to prevent fraud, as a result of the fraud of Enron, e. reporting current expenses as assets. The Act 2010 aimed to reform the U. financial and banking system, and introduced reforms aimed at greater shareholder voting rights and oversight of executive compensation in public companies. The NSMIA (National Securities Markets Improvement Act) 1996 allocates regulatory responsibility for particular securities offerings exclusively to the federal government (i. government of the whole U.). Vocabulary Debenture unsecured bond Derivative financial instrument which price is derived from prices of underlying securities, to lock in investment gains and set a floor on investment loss. You can reduce risk with them. Mutual fund broad category of stocks, and someone else manages it for you Put option a promise the option seller to purchase your stock on a specified date for a specified price, even if the market price is lower. A call option is the converse, then you can buy stock. Futures contract an agreement to buy or sell at a fixed price on a specified date in the future, so you can hedge against a falling market Hedge a contract entered into as a protection against possible financial loss SEC Securities and Exchange Commission, a US governmental agency that monitors trading in securities and company takeovers. This was the Federal Trade Commission (FTC). The SEC is an alert watchdog. CFTC Commodities Futures Trading Commission IP index participation, a contract in which the seller promises to pay the buyer the value of a stock index, this is a futures contract and the CFTC has jurisdiction Proxy the authority to represent someone else, especially in voting 2 Security transaction: Buying stock, especially if there are dividend rights, liquidity rights 4, proportional voting powers and appreciation potential5. Buying citrus trees and get a service offer, i. the combined offer of real estate and management (i. the Howey case and the Howey test). plans could be securities. arrangement (where all rents are pooled) with or without a formal relation to the management company, because profits are derived from the efforts of the rental manager. a package of the condo and the agreement. Stock of even if they the business. Unsecured promissory notes to the members of the payable on demand and variable rates of interest: proceeds from the notes were for general business purposes, widely offered and advertised as investments. Buying a block of football seats can be a security with someone else to resell them, because you have agency costs, however a football fan seek financial return but a club membership. Purchase life insurances from persons with terminal disease so they get cash, because of the activities of the intermediary that makes it successful. Sale of a restaurant: a sale of assets is not a securities transaction, a sale of shares is, even though in both situations the restaurant is managed another. Multiple investors with a pooled account for trading securities or commodities (the account is the enterprise), even when the fee is tied to the performance. With a flat fee, probably also a security. A partnership investment (joint venture) if you lack control over your investment. Limited partnership interests, unless you can veto any material actions of the general partner. A partnership that in economic reality is not a because someone else operates everything. No security transaction: 4 5 Buying a farm together and contract a local farmer to take care of it, because control and ownership are still together. One investor invests money in a discretionary trade account, because there is horizontal commonality. It would be a security under the vertical commonality if the fee is tied to the performance (a minority of the courts). With a flat fee, it is not a security. Separate option to rent or use the condo for yourself, i. no and therefore no horizontal communality and therefore no security. Purchase of resort residence with community dues for services, because profits does not depend on the effort of others. If you have the full partnership rights and powers at the time of the investment, even if you fail to exercise them. A promissory note to repay the loan in 36 months, and the note is secured the bike, because a note given in a consumer transaction has no attributes of a typical investment. Possiblity to sell the shares. Increase in the value of an asset. 4 Buying (combined) services is no security, because you invest money from which you expect profits. The sale of a franchise, because the profits depend on the efforts of the one who bought the franchise (the franchisee). Vocabulary Note a promise to repay a debt (extension of credit) and this note represents the investment in the borrower. Securities Act 1933, Section 2(a) (a) used in this title, unless the context otherwise (1) The term means any note, stock, treasury stock, security future, swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any agreement, certificate, preorganization certificate or subscription, transferable share, investment contract, certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. Exchange Act 1934, Section 3(10)(a) SEC. 3. (a) When used in this title, unless the context otherwise (10) The term means any note, stock, treasury stock, security future, swap, bond, debenture, certificate of interest or participation in any agreement or in any oil, gas, or other mineral royalty or lease, any certificate, preorganization certificate or subscription, transferable share, investment contract, votingtrust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the but shall not include currency or any note, draft, bill of exchange, or acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited. 5 Examples Agreement between CEOs to work toward a business alliance, but there is not yet agreed on price or design of the alliance. Duty to disclosure current negotiations: Federal securities law: no, disclosure is only required if mandated statute or SECrule. This include pending merger discussions. State corporate codes: no, disclosure duties only arise from fiduciary duties Stock exchange or securities industry law: no, there is an exception for proper business reasons If the agreement is material, is it fraudulent to withhold the information: Under Rule Exchange Act: this rule prohibits fraud, but not silence if there is no duty to speak Under state corporate law: no, this is a matter of discretion protected under business judgment rule. If the negotiations are material, then if the CEO speaks, he must speak truthful and complete. Or say because silence is not objectionable under Rule As a CEO, you give strategic misinformation (white lie) even if it helps your shareholders, as long as the information about the negotiations are material. The negotiations are probably material, because of the hiring of investment bankers and lawyers to work on the deal and negotiations among managers (see test). If a year ago a press release was issued that the company was not engaged in merger negotiations, and this agreement with the other company for the merger is material, do you need to update this earlier press release? Probably not: the duty to update lasts only as long as the prior incorrect information continues to affect prices in the market. When the company deals in its own stock while in possession of material information, the company has a duty to disclose. The company has no duty to respond to market rumours, unless the company is responsible for these rumours. Even if a made statement is technically true, if the statement implies something else, you violate Rule If the market is not efficient, so if trading nonprofessional traders can affect the price of the stock, any information to their trading becomes material (i. the nonprofessional trader becomes reasonable If the directors of the company approve the merger because price is fair to the but they actually approve because of personal reasons (i. misleading opinion), this is probably material information, if there is also objective evidence that the board did not actually believe its stated opinion. The predictions come out. There is immunization from liability if: SEC safe harbour: documents filed with the SEC, and the statement is made in good faith and with a reasonable basis. Statutory safe harbour: a statement, accompanied meaningful cautions and it identifies important facts that could cause actual results to differ materially from those in the statement. doctrine: add cautionary language The Statutory safe harbour and Bespeaks do not focus on the of the directors, but on the objective statements to investors. The SEC safe harbour, however, does need of the directors. 7 Vocabulary management discussion and analysis PSLRA Private Securities Litigation Reform Act, with safe harbours for the disclosure of forwardlooking information. Exchange Act 1934, Section 10(b)(5) Employment of Manipulative and Deceptive Practices It shall be unlawful for any person, directly or indirectly, the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circ*mstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. 8 In a public offering, the underwriters cannot only sell to restricted persons in the securities industry, and flipping is also forbidden under the Underwriters in an IPO will typically ask for an (i. Green Shoe) option so they can sell up to 15 percent more shares than agreed with the issuer. Underwriters and members of the selling group cannot sell at a discount, so a system. In of the Securities Act, the registration process is divided into three time periods: 1. Prefiling period: preparing for the offering 2. Waiting period: registration statement is filed with the SEC but not yet effective 3. Post effective period: registration statement is effective, sale can start Sales in private placements and government securities are exempted from There are various forms for the registration statements (i. sets of disclosure instructions): Form most detailed set of instructions, for nonreporting or small issuers. It contains the prospectus and information about the company. Form for large reporting companies. It contains only the prospectus. Other forms: merger or acquisition employee stock purchase plan real estate companies Special forms for smaller reporting companies to reduce the administrative burden Special rules for emerging growth companies. The registration statement becomes automatically effective 20 days after its filing (with every amendment a new period starts). In the filing you include a delaying amendment so the SEC has enough time. After the filing, the SEC has ten days to review the registration statement for incomplete or misleading disclosure, and can give a refusal order so the statement become effective. The SEC can also issue a stop order after the registration is effective, if there is a defect in the disclosure. If a seasoned issuer (WKSI), you can easily sell shares from the shelf. You can also withdraw your registration, e. because you want to do a private offering. If you have made any sales yet, you can wait thirty days and the withdrawal is complete. There is also state securities law (i. blue sky laws). State securities law apply to so there is no registration, notice filings, or filing fees required. Covered securities are: 1. 2. 3. 4. 5. securities: New York Stock Exchange, American Stock Exchange, NASDAQ Securities issued registered investment companies: mutual funds Securities sold to Securities offered and sold pursuant to a exemption Securities offered and sold pursuant to a exemption Smaller and local offerings remain subject to state blue sky laws, e. requiring registration before securities may be offered or sold in the state. There are three registrations possible: coordination (file a copy of the federal registration statement), notification filing) and qualification (rigorous). Examples In preparation for the IPO, there has to be a corporate amending the Articles to authorize additional shares for the offering, a stock split so the prise will be per share, 10 antitakeover provisions. You also have to conform to the accounting requirements of the integrated disclosure system, which are pretty rigorous. For the registration statement, you can use the registration statements other companies to describe the competitive conditions and risks in the markets. Senior executives can sell some of their stocks, if they are (1) registered under the Securities Act or (2) sold pursuant to Rule 144, i. the stocks have been held for at least six month and are sold a broker in limited quantities. Indemnification of Securities Act liability is against public policy and is unenforceable. The indemnification of underwriters is allowed. If you comply with the suggestions of the SEC, they accelerate the effectiveness of the registration, so then stuck. After the SEC declares the registration effective, you can close the deal and sell to the underwriters. You also need to file a prospectus supplement that contains the information of the new price. The issuer and selling shareholders are prohibited to buy securities to lift the price. If the distribution of the securities is completed the underwriters, there are no more limitations for the issuer and selling shareholders (Regulation M). If the possibility of stabilization is disclosed in the prospectus, the underwriter can do so (i. placing a bid with market makers to buy at the offering price). If you are a WKSI, the registration statement becomes effective immediately upon filing. The registration statement is effective for three years, and this can be extended another three years (etc.) filing another registration statement. The registration of shares for future sale results in the drop of the market price (i. shelf overhang), because of the dilution of existing shareholders or because of the fact that managers only issue shares when the market is overvalued. For an emerging growth firm, the underwriter can contact investors to see if interested, for the usual rules apply. A draft of the registration statement can be submitted for confidential review of the SEC. Violations of of the Securities Act are known as e. you cannot make offers until a registration statement is filed with the SEC, once the registration statement is filed you cannot use a prospectus unless it contains specified information. There are four types of issuers: 1. Nonreporting issuers: not required to file under the Exchange Act, e. IPO 2. Unseasoned reporting issuers: required to file but not eligible for Form 3. Seasoned reporting issuers: reporting companies eligible for Form (more than one year since going public and a million public float) 4. seasoned reporting issuers: seasoned reporting issuers that have either million worldwide public float of billion in debt issues in the last three years. There are three periods: 1. During the prefiling period: no sales of deliveries of securities and no offer to buy or sell. 2. During the waiting period: no sales or deliveries of securities and no prospectuses. Oral offers and a preliminary prospectus (without information about the price and the underwriters) are allowed. 3. During the post effective period: no prospectus unless it is the final prospectus, and no deliveries unless accompanied final prospectus. 11 Examples The registration statement is not yet filed. You make an offer, and an offer is attempt to of securities, i. any activity that conditions the securities market. There is a safe harbour if you issue communications more than 30 days before the filing of the registration statement, if you mention the offering. Or safe harbour if you make a cautionary statement, e. the offering will be made only means of a prospectus. Preliminary negotiations between an issuer and underwriters is allowed, because this is exempted from the definition of The underwriter can also send a letter of intent. An offer to buy or to sell (e. telling your housekeeper and your housekeeper wants to buy) is prohibited. Regularly released factual information is excluded from the definition of Asking other securities firms to act as underwriters is allowed. However, seeking participation as a retailer dealer is prohibited. Nonparticipating securities firms can issue research reports (e. a newsletter) about nonreporting companies, but if you as a securities firm plan to participate in the offering, it is prohibited. A press release Goldman Sachs about the upcoming offering (even without mentioning the offering price) is prohibited because it can arouse interest in the securities. No safe harbour, because the safe harbour is limited to announcements the issuer, and the underwriters were named. The registration statement is filed, and the preliminary prospect states the anticipated price. Running a ad stating that is the industry in a business magazine (as opposed to a computer publication) is prohibited, because it is directed at potential investors. mail to employees that the company will sell shares against a certain price, is also prohibited. There is no exception applicable, because there is no mention of how to obtain a prospectus, and no legend or preliminary prospectus attached, and the price is not unmentioned. The could be a free writing prospectus if it included an accompanying prospectus and was filed with the SEC on the day it was sent. A banner about the prospectus and offering on the site is allowed, if the banner is filed with the SEC. If Goldman Sachs places an ad in The Wall Street Journal with announcement is neither an offer to sell nor a solicitation of an offer to buy securities. The offering is made only it is allowed, because this is a classic tombstone ad. Oral sales efforts are not prohibited during the waiting period. If a forwardlooking statement, it is subject to antifraud rules. You need to add a caution to oral, forwardlooking statements. If a newspaper article quotes the press interview with Bill Gates, this article has to be filed within four days after becoming aware of this. The posting of road shows on the company website is exempt, as well as handouts of PowerPoint these fall under the writing If a sales rep of Goldman Sachs strongly recommends someone to buy Microsoft and sends an with a link to the prospectus, that is allowed. However, if you put a note in the looks really it is prohibited. The message has to include the legend, and a link to the preliminary prospectus instead of the prospectus. The broker is prohibited to accept the check: you make sales during the waiting period. What is allowed, is asking a customer to back how many shares the customer wants to purchase, if the sent has a hyperlink to the preliminary prospectus, and offer to buy and no commitment to buy 13 Oral offers to buy are possible during the waiting period, but you have to send a preliminary prospectus. The creation of a selling group (i. Goldman Sachs offering a company the possibility to sell shares) is permitted during the waiting period, if the underwriters make no binding commitments and the communications are oral. The agreement among underwriters is a preliminary negotiation or agreement, and this is allowed. The common stock is registered under the Exchange Act. Sending an to the employees with the sold shares and the increasing price is a violation, because it indicates that Microsoft is a hot IPO. An ad in Business Week is probably also a violation, because it arises investor interest. As long as the issuer is still in registration, it is prohibited (that is 25 days after the initial offering date). If a participating securities firm adds a link on its website to a wire story that reports on the success of the offering and later sends with the final prospectus, this will form a violation. The wire report has to include a link to the final prospectus. Goldman Sachs emails confirmations to customers who have had a preliminary having access to the final prospectus is enough if the issuer filed the final prospectus: access equals delivery. If there is a major omission in the final prospectus, the issuer has to sticker the prospectus and file it within five business days. Any prospectus used more than nine months after the effective date may not have financial information that is more than 16 months old (unaudited information is fine). Vocabulary Flipping buying the IPO, and sell it after the first day of trading, to make a big profit Penalty bid a penalty on individual brokers if their clients sold an IPO within a certain time, to discourage flipping. Spinning allocating IPO shares preferentially to corporate executives in the hope of garnering future business from their companies Laddering requiring customers who received IPO allocations to purchase additional shares in the aftermarket at prices FINRA Financial Industry Regulatory Authority, and this is the largest independent regulator for all securities firm doing business in the US. Public float all the shares outstanding that can be publicly traded Seasoned if the security has been traded for over a year with a good payment track record. Unseasoned if the security has been traded for less than a year Shelf registration registration of securities for later sale Collateral pledge assets that are used to secure a loan the illegal practice of soliciting orders to buy a new issue before registration of the IPO has been approved the SEC Blank check company company in a development stage with no specific business plan or purpose Penny stock issuer company that issues stock at less than per share and has few net tangible assets and minimal revenue 14 Most of the time Rule 506 is used, because the blue sky state laws are preempted. The SEC intention was that smaller issuers would use Rule 504 million cap), issuers Rule 505 or Reg A (both million cap) and large issuers Rule 506 (no dollar cap). Crowdfunding, asking for donations, or rewards if you invest, are not securities because they promise future financial returns. The state blue sky exemptions (exemption for the state securities laws): Offerings of government, bank and insurance (but not charities) Resales Private placements Crowdfundings Reg State exemptions largely follow those of the federal Securities Act. Examples exemption Is the issuer qualified for the intrastate exemption? The issuer and the offering have to be subject to the state jurisdiction. Even though he sells to buyers, the activities are done in the state. And the of Rule 147 safe says that if a majority of the employees live in the state, the company is deemed to be doing business in that state. The state securities authorities should have jurisdiction over the use of the offering, i. invest in something that is in the state. The Safe harbour Rule 147 safes, because most of the employees live in the state, even if the building is going to another state. Are the investors qualified for the intrastate exemption? The underwriter can come from another state (i. but has to use an branch office. The purchasers have to be residents. sellers are not permitted, so branch office. You even make an offer to so sending an offering circular to the customers with instate addresses is dangerous, because you know if they have domiciliary intent. (Rule 147A permits intrastate offerings as long as only intrastate sales are made.) You cannot sell at the same time to a separate investor only if you do that before the interstate or six months afterward, because you cannot divide a financing effort: every part of the issue has to comply, i. in the Are resales permitted for the intrastate exemption? The resident purchaser has to keep the shares for at least six months (Rule 147 and 147A). The company has to notify all investors of the resale restrictions. Private placement Are the investors qualified? Limited partner interests: The investor is qualified if there is investor sophistication and information access, and this is no problem because he is an insider with a lot of experience. 16 Is disclosure sufficient? A well sophisticated investor who has access to information and has a lot of experience in such companies need to be an insider or receive a prospectus, to have sufficient disclosure. For unsophisticated investors a is not enough, because you miss the SECreview and due diligence. Even if they have a lot of money won in the lottery, money buy sophistication. An investor would seem able to fend for himself if he gets the right investment advice and assistance, because then he has (1) investor sophistication and (2) access to information. The critical test is investor sophistication. Even if you get the requested information, if you think you have enough information it is fine. The issuer must show that each offeree and each purchaser meet the sliding scales, otherwise the entire exemption is destroyed. The statutory exemption does not permit the issuer to rely on a about the sophistication after a signed investment letter (unlike Rule 506 of Reg D). Reg D problems: raise million in a common stock offering, 50 investors, no formal disclosure document Rule 504: million cap, widely marketed offering is not allowed without disclosure document Rule 506: no dollar cap, but general solicitations are not allowed, nonaccredited investors have to receive a disclosure document and receive investment advice Under Rule 506 there are actor but a pending administrative review of nonregistered sales is not included. Problem: the accountant has never performed an audit, and the audited balance sheet is needed for nonaccredited investors. Accredited investors necessarily need information, but it is advisable to prevent Rule liability Secondary distributions control persons (broker) are not possible under Reg D, so you have to look for another exemption. Rule 506 offering Problem: there is a maximum of 35 nonaccredited investors, so you can only add accredited investors (they count for the number 35. According to Reg D a person with net worth of million is an accredited investor, but you know if the illiquid assets are worth million. If they are (and there are no debts), it matter that she is personal incapable. Spouses with joint income above are also accredited investors. Rule 506 offering, unaccredited investor gets advice If the former husband (who is an experienced stock broker) gives advice and X acknowledges that he is the purchaser representative, it is okay. Insiders cannot be purchaser representatives. A person with a material relationship with the issuer cannot act as a purchaser representative, unless he discloses the relationship (there is a relationship if he invested). He must reveal material information about the company, because he acts for the purchaser. Rule 506, unaccredited investors 17 Investors in a crowdfunding must hold for 12 months. 19 Chapter 6: Securities Act Liability The Securities Act imposes heightened standards of liability on those who offer and sell securities. 1. Common law deceit (fraud) I. intentionally making a material misrepresentation, with the result that you are liable for the losses caused the justifiable reliance. Elements of common law deceit: Misrepresentation of material fact Scienter, i. culpable. matter.) Reliance, i. there is justifiably relied on the misrepresentation Causation Damages, including consequential damages and punitive damages Cancellation of the contract is also possible elements of common law rescission: Material misrepresentation or fraudulent misrepresentation (one of the two) Reliance Damages, not including consequential damages and punitive damages 2. Section 12(a)(1): violations of This is a private remedy to enforce the requirements of the purchaser may cancel the transaction and gets his money back. If there is a violation of later compliance does not cure this violation. Any person who offers or sells a security in violation of is liable to the person purchasing that security from him. The statutory seller includes the person who passes title, but also any person who solicits security sales, but not persons who give gratuitous advice (i. not for his own or for the sellers interests). The action must be brought within one year after the violation. 3. Section 11: misrepresentations in registration statement This is a civil remedy for purchases in a registered offering if they can point to a material misrepresentation or omission in the registration statement. Culpability, reliance and causation are presumed. It is limited to actual purchasers, so not for other securities of the issuer. Defendants are signers, directors, underwriters and experts. The defendants have to defend their nonculpability the defense. There is expertised information (e. information audited an accountant) and nonexpertised information (i. not prepared an expert). The expert that writes the expertised information has to reasonably believe, after reasonable investigation that the information is the same for a nonexpert who writes nonexpertised information. The expert is never liable for nonexpertised information (he wrote that), and the nonexpert is not liable for expertised information if he has no reason to believe that the information is false. Due diligence varies (case BarChris): (1) The access to inside company information and (2) The position as a company insider or as a nonemployee outsider 20