Chapter 41 Investor Protection, E-Securities, and Wall Street Reform Securities and Exchange Commission (SEC) Federal administrative agency empowered to administer federal securities laws Adopts rules and regulations to interpret and implement federal securities laws Investigates alleged securities violations and brings enforcement actions Regulates activities of securities brokers and advisors Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-2 Definition of a Security Common security: Interests or instruments that is common stock, bond, debenture or warrant Statutorily defined security: Interest or instrument mentioned in securities acts Investment contract: Flexible standard for defining a security Howey Test is applied to determine investment contract Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-3 Initial Public Offering: Securities Act of 1933 Primarily regulates the issuance of securities by a corporations, limited partnerships, and associations Initial public offering: sale of securities by an issuer to the public Securities are registered with SEC by means of: Registration statement Prospectus Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-4 Initial Public Offering: Securities Act of 1933 Regulation A: Permits issuer to sell securities pursuant to a simplified registration process Civil liability under Section 11: Imposed on persons who intentionally defraud investors by omitting facts in registration statement Civil liability under Section 12: Imposed on persons who violate provisions of Section 5 Criminal liability: Imposed on persons who willfully violate the act Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-5 Securities Exempt from Registration Securities issued by any government in the U.S. Short-term notes with maturity date not exceeding nine months Securities issued by nonprofit issuers Securities of financial institutions Insurance and annuity contracts Stock dividends and stock splits Securities issued in corporate reorganization Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-6 Transactions Exempt from Registration Nonissuer Exemption Intrastate Offering Exemption Private Placement Exemption Small Offering Exemption Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-7 Transactions Exempt from Registration Nonissuer exemption: Security transactions not made by issuer, do not have to be registered with SEC Intrastate offering exemption: Permits local businesses to raise capital from local investors without registering with SEC Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-8 Transactions Exempt from Registration Private placement exemption: Permits issuers to raise capital from unlimited number of accredited investors without registering with SEC Law permits no more than thirty-five nonaccredited investors to purchase securities Small offering exemption: Permits sale of securities not exceeding $1 million during twelve-month period Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall. 41-9 Sarbanes-Oxley Act Establish rules for separation of investment banking and securities advice functions of securities firms to eliminate conflicts of interest Fear that analysts would be pressured to give high marks to companies being assisted by firms investment bankers Protects analysts from review, pressure, and oversight by investment bankers 41-10 Securities Exchange Act of 1934 Primarily regulates trading in securities Provides for registration of companies with SEC Filing of periodic reports by companies Regulation of security exchanges, brokers, and dealers Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Section 10(b) and Rule 10b-5 Section 10(b): Prohibits use of manipulative and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations of SEC Rule 10b-5: Clarify reach of Section 10(b) against deceptive and fraudulent activities in purchase and sale of securities Only conduct involving scienter (intentional conduct) violates Section 10(b) and Rule 10b-5 Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Violations of 1934 Act Civil liability: Plaintiff may bring civil action and seek rescission of securities contract SEC actions: Enter into consent decrees with defendants Seek injunctions in court Seek court orders requiring defendants to disgorge illegally gained profits Criminal liability: Criminal offence to willfully violate provisions of the act Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Violations of 1934 Act Insider trading: Insider uses material nonpublic information to make a profit by trading in the securities of the company Tipper-tippee liability Tippee is liable for acting on material information Tipper is liable for profits made by tippee Tipper: person who discloses material information Tippee: person who receives material information Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Case 41.1: Insider Trading Case United States v. Bhagat 436 F.3d 1140, Web 2006 U.S. App. Lexis 3008 (2006) United States Court of Appeals for the Ninth Circuit Issue Is Bhagat criminally guilty of insider trading and tipping? Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Violations of 1934 Act Misappropriation theory: Imposed on outsider who misappropriates information about a company, and then trades in securities of the company Aiders and Abettors: Those who knowingly assist in fraud They are criminally liable, but no private cause of action exists against them Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Short-Swing Profits Profits made by statutory insiders on trades involving equity securities that occur within a time period of six months Statutory insider: A person who is an executive officer, a director, or a 10-percent shareholder of an equity security of the company Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Section 16(b) Profits made by statutory insider on transactions involving short-swing profits belong to the corporation SEC Section 16 rules Defines officers to include only executive officers who perform policy-making functions Relieves insiders of liability for transactions that occur within six months before becoming a insider Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall Consumer Protection Act and State Securities Laws Dodd-Frank Wall Street Reform and Consumer Protection Act: Regulates hedge funds and derivatives and provides protection to consumers regarding financial products and services State blue-sky laws: State securities laws that regulate issuance and trading of securities Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall 41-20 Copyright 2013 Pearson Education, Inc. Publishing as Prentice Hall.