the securities and exchange act of 1934 created the sec, an independent federal regulatory agency...

The Securities and Exchange The Securities and Exchange Act of 1934 created the SEC, Act of 1934 created the SEC, an independent federal an independent federal regulatory agency that regulatory agency that administers federal securities administers federal securities laws. laws.

© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 2

SEC basic functions:SEC basic functions:1. Interprets federal securities laws

and investigates securities law violations.

2. Issues new rules and amends existing rules.

3. Oversees the inspection of securities firms, brokers, investment advisers, and ratings agencies.


SEC basic functions:SEC basic functions:4. Oversees private regulatory

organizations in the securities, accounting, and auditing fields.

5. Coordinates U.S. securities regulation with federal, state, and foreign authorities


Updating the Regulatory Updating the Regulatory Process.Process.

SEC’s Expanding Powers.SEC’s Expanding Powers.Securities Enforcement Remedies

and Penny Stock Reform Act of 1990.

Securities Acts Amendments of 1990.

Market Reform Act of 1990. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 5

The SEC’s Expanding Powers The SEC’s Expanding Powers (cont’d).(cont’d).National Securities Markets Improvement Act of 1996.

The Sarbanes-Oxley Act of 2002 (discussed later in the chapter).


Securities Act of 1933 Securities Act of 1933 regulates solicitation, buying regulates solicitation, buying and selling of securities: and selling of securities: stocks and bonds. stocks and bonds.

Designed to prohibit fraud Designed to prohibit fraud and stabilize securities and stabilize securities industry.industry.

Main purpose: full disclosure.Main purpose: full disclosure.


1.1. Instruments and interests Instruments and interests commonly known as commonly known as securities, such as preferred securities, such as preferred and common stocks, and common stocks, treasury stocks, bonds, treasury stocks, bonds, debentures, and stock debentures, and stock warrants. warrants.


2. 2. Any interests commonly known Any interests commonly known as securities, such as stock as securities, such as stock options, puts, calls, or other types options, puts, calls, or other types of privilege on a security or on of privilege on a security or on the right to purchase a security or the right to purchase a security or a group of securities in a national a group of securities in a national security exchange. security exchange.


3. Notes, instruments, or other 3. Notes, instruments, or other evidence of indebtedness, evidence of indebtedness, including certificates of including certificates of interest in a profit-sharing interest in a profit-sharing agreement and certificates of agreement and certificates of deposit. deposit.


4. Any fractional undivided 4. Any fractional undivided interest in oil, gas, or other interest in oil, gas, or other mineral rights. mineral rights.

5. Investment contracts, which 5. Investment contracts, which include interests in limited include interests in limited partnerships and other partnerships and other investment schemes. investment schemes.


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.


Unless exempt, an offering Unless exempt, an offering must be registered before must be registered before offered to the public.offered to the public.

Issuing corporation must file a Issuing corporation must file a registration statement and registration statement and prospectus with the SEC.prospectus with the SEC.

ProspectusProspectus is later distributed is later distributed to investors.to investors.


Contents:Contents:1. The securities being offered for

sale, including their relationship to the registrant’s other capital securities.

2. The corporation’s properties and business (including a financial statement certified by an independent public accounting firm).


Contents:Contents:3. Management of the corporation,

including all benefits, and any interests of directors or officers in any material transactions.

4. How the corporation intends to use the proceeds of the sale.

5. Any pending lawsuits or special risk factors.


Registration Process.Registration Process.Waiting Period: securities can be

offered but not sold. All issuers can distribute a red herring prospectus, advertise with a tombstone ad, and a free-writing prospectus.

Posteffective Period: securities can now be sold.

Registration Process Review.


Registration Process.Registration Process.Restrictions Relaxed for Well-Known

Seasoned Issuers. In 2005, SEC revised the registration process and created new categories of issuers based on size and market presence. A WKSI has issued $1 billion in securities during last 3 years, or $700 million outstanding stock in public hands.


Regulation A Regulation A Offerings.Offerings.Up to $5 million in any twelve

month period. Issuer must file a notice and

offering circular with SEC.Companies can “test the waters”

without actually selling.Can be sold online.


Regulation DRegulation D Offerings. Offerings.Rule 504: up to $1M during 12

months to accredited investors only.

Rule 505: up to $5M during 12 months to both accredited and unaccredited investors.


Regulation DRegulation D Offerings. Offerings.Rule 506: unlimited if no general

solicitation and notice to SEC. Max of 35 unaccredited investors.

Resales and Safe Harbor Resales and Safe Harbor Rules.Rules.Generally, most securities can be

resold without registration.


Resales and Safe Harbor Rules.Resales and Safe Harbor Rules.Rule 144: Rule 505 or 506

securities trigger registration requirements unless the sale complies with all of Rule 144’s conditions (pages 818-819).

Rule 144A: allows sale only to a qualified institutional buyer.


Intentional or negligent Intentional or negligent defrauding of investors by defrauding of investors by misrepresenting or omitting misrepresenting or omitting material information in the material information in the registration statement or registration statement or prospectus. Provides for criminal prospectus. Provides for criminal penalties, and civil sanctions. penalties, and civil sanctions.


DefensesDefenses: : Statement left out Statement left out was not material; Plaintiff knew was not material; Plaintiff knew about fraud and purchased about fraud and purchased stock; Registrant believed stock; Registrant believed statements were true.statements were true.


Provides for registration of Provides for registration of securities exchanges, brokers, securities exchanges, brokers, dealers, and national securities dealers, and national securities exchanges and associations. exchanges and associations. Applies to companies with $10

million in assets and 500 or more shareholders .


Introduction:Introduction:Section 10(b) prohibits use of any

manipulative or deceptive device or contrivance in violation of SEC rules and regulations.

SEC Rule 10b(5) prohibits fraud in connection with the purchase or sale of any security.


Applicability of SEC Rule Applicability of SEC Rule 10b(5).10b(5).Virtually all cases concerning the

trading of securities, whether on exchanges, OTC, or private.


Insider Trading.Insider Trading.Goal is to prevent purchase or sale

of securities on basis of information that is not available to the public.

Applies to corporate directors, officers, and others with “inside” information, or anyone who has access to or receives nonpublic information.


Disclosure Under SEC 10b(5):Disclosure Under SEC 10b(5):Any material omission or

misrepresentation in connection with the sale or purchase of security may violate Section 10(b) or SEC Rule 10b-5.

Examples of materials facts in disclosure: Fraudulent trading by broker.


Disclosure Under SEC 10b-5Disclosure Under SEC 10b-5Examples (cont’d):

Dividend Change. Contract for sale of corporate assets.

New discovery, process, or product. Significant change in firms financial condition.

Potential litigation against the company.


Disclosure Under SEC 10b-5 Disclosure Under SEC 10b-5 (cont’d)(cont’d)CASE 29.1 SEC v. Texas Gulf Sulphur Co. (1968). Who were the insiders in this case and what should they have done differently?


Disclosure Under SEC 10b-5 Disclosure Under SEC 10b-5 (cont’d):(cont’d):Private Securities Litigation

Reform Act: provides a “safe harbor” for publicly-held companies making forward-looking statements.

Securities Litigation Uniform Standards Act.


Outsiders and SEC Rule 10b-5.Outsiders and SEC Rule 10b-5.Tipper/Tippee Theory--insider’s

fiduciary duty must be breachedMisappropriation Theory -- one

wrongfully obtains inside info and trades on it. Courts still require fiduciary duty be breached, e.g., to employer.


Requires recapture of all Requires recapture of all short-swing profits by short-swing profits by insiders (those owning 10% insiders (those owning 10% of equities) to corporation.of equities) to corporation.Applies to stocks, warrants,

options, and securities.


Section 14(1) of the 1934 Act Section 14(1) of the 1934 Act regulates the sale of proxies regulates the sale of proxies from shareholders of Section from shareholders of Section 12 companies.12 companies.

Remedies for violations Remedies for violations include injunctions to include injunctions to damages.damages.


ScienterScienter or intent is required to or intent is required to prove civil or criminal penalties prove civil or criminal penalties under 10(b) and Rule 10b-5.under 10(b) and Rule 10b-5.

Violator must have had intent Violator must have had intent to defraud (false statements or to defraud (false statements or wrongfully failed to disclose wrongfully failed to disclose material facts). material facts).


CASE 29.2 Gebhart v. SEC (2010). What factors did the court analyze to determine if scienter was present?

Criminal Penalties. 10(b) and Rule 10b-5, a person faces $5

million and 20 years in prison, $25 million for partnership or corporation.

Sarbanes-Oxley provides for 25 years in prison if willful.


Civil Sanctions: Both SEC and Private Parties Can Bring Actions Against Violators under the Insider Trading and Securities Fraud Enforcement Act. Private parties may bring action for violations of 10(b) and Rule 10b-5.


CASE 29.3 Stark Trading v. Falconbridge, Ltd. (2009). If an investor is aware of misrepresentations, can he still recover?


State securities laws are called State securities laws are called “blue sky” laws.“blue sky” laws.

RequirementsRequirements: : Issuers must comply Issuers must comply with federal and state securities laws with federal and state securities laws and states do not allow the same and states do not allow the same exemptions as federal government.exemptions as federal government.

Concurrent RegulationConcurrent Regulation: : Uniform Uniform Securities Act has been adopted in Securities Act has been adopted in part by many states.part by many states.


Relationship between a Relationship between a corporation and its corporation and its shareholdersshareholders. .

Attempts at Alignment between Attempts at Alignment between Officers and Shareholders.Officers and Shareholders.Stock Options?

Goal is to Promote Goal is to Promote Accountability. Accountability.


Corporate governanceCorporate governance involves:involves:(1) The audited reporting of

financial conditions to evaluate managers.

(2) Legal protections for shareholders so that violators can be punished and victims can recover losses.


Board of Directors: Board of Directors: responsible responsible to ensure all corporate officers to ensure all corporate officers are operating in best interests of are operating in best interests of shareholders.shareholders.

Compensation Committee: Compensation Committee: assess performance and design assess performance and design fair compensation systems.fair compensation systems.


Sarb-Ox attempts to increase Sarb-Ox attempts to increase corporate accountability by corporate accountability by imposing strict disclosure imposing strict disclosure requirements and harsh requirements and harsh penalties for securities penalties for securities violations. violations.

Applies to all public Applies to all public companies. companies.


Requires CEO’s to take responsibility for accuracy of financial statements filed with SEC.

Requires independent auditor report except for smaller companies of less than $75 million market capitalization (2010 exemption).


Other Provisions: Other Provisions: Public Company Accounting

Oversight Board regulates public accounting firms.

Internal Controls and Internal Controls and Accountability: Accountability: Direct federal Direct federal corporate governance requirements. corporate governance requirements. High-level managers must maintain High-level managers must maintain internal controls and disclosures.internal controls and disclosures.


The SEC is aggressively The SEC is aggressively prosecuting internet fraud prosecuting internet fraud using traditional laws.using traditional laws.

Investment Scams.Investment Scams. Online Investment Online Investment

Newsletters and Forums.Newsletters and Forums. Ponzi Schemes. Ponzi Schemes. (e.g., Bernie (e.g., Bernie

Madoff)Madoff)© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 48

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