Chapter 33Investor Protection and

Online Securities Offerings

Chapter 33Investor Protection and

Online Securities Offerings

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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?

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?

Learning ObjectivesLearning ObjectivesLearning ObjectivesLearning Objectives

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IntroductionIntroduction

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.

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.

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IntroductionIntroduction

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.

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.

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Securities Act of 1933Securities 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.

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.

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Registration StatementRegistration 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.

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.

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Registration StatementRegistration 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.

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.

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Registration StatementRegistration 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.

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.

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Exempt SecuritiesExempt SecuritiesBank 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.

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.

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Exempt SecuritiesExempt SecuritiesAny 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).

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).

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Exempt TransactionsExempt Transactions

Small “Reg D” OfferingsRule 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.

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Violations of the 1933 ActViolations 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.

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Securities Exchange Act of 1934

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).

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Section 10(b) and Rule 10b(5)

& Insider Trading

Section 10(b) and Rule 10b(5)

& Insider TradingSection 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.

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Section 10(b) and Rule 10b(5)

& Insider Trading

Section 10(b) and Rule 10b(5)

& Insider TradingInsider TradingAdvance 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.

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Violations of the 1934 ActViolations 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.

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Regulation of Investment Companies

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.

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.

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State Securities Laws 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.

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Online Securities Offerings

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.

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.

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Online Securities Offerings

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).

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).

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Online Securities Offerings

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.

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.

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Online Securities FraudOnline 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.

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.