Securities Act & SEC Regulations

Investor Protection, Insider Trading, and Corporate Governance

• Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934 to regulate securities markets after the stock market crash in 1929.
• The Securities Act of 1933 and the Securities Exchange Act of 1934 were designed to provide investors with more information and prohibit deceptive, unfair, and manipulative practices.
• The Securities and Exchange Commission (SEC) is the main independent regulatory agency that administers the 1933 and 1934 securities acts.

The Securities Act of 1933

• Governs initial sales of stock by businesses.
• Prohibits various forms of fraud.
• Requires investors to receive financial and other significant information concerning the securities being offered for public sale.
• All securities transactions must be registered with the SEC unless specifically exempt.
• Applies to all companies, even private.
• Securities are stocks, bonds, or other items that represent an ownership interest in a corporation or a promise of repayment of debt by a corporation.
• Securities include stocks, bonds, debentures, stock warrants, stock options (puts and calls), notes, instruments, or other evidence of indebtedness, fractional undivided interest in oil, gas, or other mineral rights, and investment contracts.
• The Howey Test determines whether something is an investment contract.

The Howey Test

• A transaction in which a person invests in a common enterprise, reasonably expecting profits that are derived primarily from the efforts of others.

Many Types of Securities

• Almost any stake in the ownership or debt of a company can be considered a security like stocks and bonds.
• Examples of securities: Investment contracts in condominiums, franchises, and limited partnerships in real estate.
• Cryptocurrencies are subject to the Howey test and must be registered with the SEC.
• Any security must be registered before it is offered to the public if that security does not qualify for an exemption.

Registration statement

• Corporations must file registration with SEC and provide all investors with a prospectus.
• Prospectus: A written disclosure document required by securities law when a security is being sold.
• The prospectus describes the security being sold, the financial operations of the issuing corporation, and the investment or risk attaching to the security.

Contents of registration statement

• The securities being offered for sale, including their relationship to the registrant's other securities.
• The corporation's properties and business, including a financial statement certified by an independent public accounting firm.
• The management of the corporation, including managerial compensation, stock options, pensions, and other benefits.
• How the corporation intends to use the proceeds of the sale.
• Any pending lawsuits or special risk factors.
• Registration statements must be filed electronically so that they can be posted on the SEC's EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database

Registration process

• The registration statement is not effective until it has been approved by the SEC, unless filed by a well-known seasoned issuer.
• Prefiling period: the issuer cannot sell or offer to sell the securities.
• Waiting period: after filing but before approval, the securities can be offered for sale but cannot be sold by the issuing corporation.
• All issuers can distribute a preliminary prospectus or free-writing prospectus.
• Post-effective period: after SEC approval, the issuer can offer and sell the securities without restrictions.
• A final prospectus must be provided either before or at the time of purchase of the securities.
• A well-known seasoned issuer (WKSI) is a firm that has issued at least $1 billion in securities in the last 3 years or has outstanding public stock valued at ???.
• Certain types of securities are exempt from the registration requirements of the Securities Act because they are either low-risk investments or are regulated by other statutes.

Exempt securities

• Exempt securities maintain their exempt status forever and can be resold without being registered.
• Examples: Government-issued securities, bank and financial institution securities, short-term notes and drafts (less than nine months to maturity), securities of nonprofit, educational, and charitable organizations, securities issued by common carriers (railroads and trucking companies), insurance policies, endowments, and annuity contracts, securities issued in a corporate reorganization in which one security is exchanged for another or in a bankruptcy proceeding, securities issued in stock dividends and stock splits.
• The Securities Act exempts certain transactions from registration requirements.
• Exemptions allow certain issuers to avoid costs and procedures associated with registration; consider:
  • Limited amount of securities offered in 12 month period
  • Private offerings with small number of investors
  • Securities offered and sold only to residents of state in which issuing firm is incorporated and doing business (Intrastate offerings)
  • Crowdfunding
• Issuers are still subject to anti-fraud provisions even if exempt from registration.

Violations of the 1933 Act

• Violations of the Securities Act resulting in liability:
  • Intentionally defrauding investors by misrepresenting or omitting facts in a registration statement or prospectus.
  • Selling securities before the effective date of the registration statement.
  • Selling securities under an exemption for which it did not qualify.

Remedies for violations of the 1933 Act

• DOJ- Criminal violations are prosecuted by the U.S. Department of Justice.
• Violators may be fined up to $10,000, imprisoned for up to five years, or both.
• SEC- authorized to impose civil sanctions for willful violations.
• The SEC can request an injunction to prevent further sales of the securities involved or ask a court to grant other relief, such as ordering a violator to refund profits.
• Private parties– those who purchase securities and suffer harm as a result of violations may file suit in federal court to recover any losses and damages.

Defenses against the 1933 act

• There are three basic defenses to charges of violations under the 1933 act:
  • The statement or omission was not material.
  • The plaintiff knew about the misrepresentation when the stock was purchased.
  • The defendant exercised due diligence in preparing or reviewing the registration and reasonably believed at the time that the statements were true.
  • This defense is available to an underwriter or subsequent seller but not to the issuer.

The Securities Exchange Act of 1934

• Provides for continuous periodic disclosures by publicly held corporations to enable the SEC to regulate subsequent trading.
• Applies to "Section 12" companies, which have:
  • Assets in excess of $10 million and
  • Five hundred or more shareholders
• Section 12 companies must file annual and quarterly reports with the SEC (monthly if specified events occur, such as a merger).
• The 1934 act also: Authorizes the SEC to engage in market surveillance to deter:
  • Fraud
  • Market manipulation
  • Misrepresentation
• Provides for the SEC's regulation of proxy solicitations for voting

Section 10(b), SEC Rule 10b-5, and Insider Trading

• Section 10(b) of the 1934 Act prohibits the use of any manipulative or deceptive mechanism in violation of SEC rules and regulations.
• SEC Rule 10b-5 prohibits the commission of fraud in connection with the purchase or sale of any security.
• The basic elements of a securities fraud action are:
  • A material misrepresentation (or omission) in connection with the purchase and sale of securities
  • Scienter (intent)
  • Reliance
  • An economic loss
  • Causation

Disclosure under SEC Rule 10b-5

• A material fact is significant enough that it would likely affect an investor's decision as to whether to purchase or sell the company's securities.
• Examples:
  • Fraudulent trading in the company stock by a broker-dealer
  • A dividend change
  • A contract for the sale of corporate assets
  • A new discovery, a new process, or a new product
  • A significant change in the firm's financial condition
  • Potential litigation against the company

Insider Trading SEC Rule 10b-5

• One of the major goals of Section 10(b) and SEC RUle 10b-5 is to prevent:
  • Insider trading: The purchase or sale of securities based on information that has not been made available to the public.

Outsiders and SEC Rule 10b-5

• Increasingly, liability has been extended to include certain "outsiders”-those who trade on inside information acquired indirectly. Two theories:
  • Tipper/tippee theory
  • Misappropriation theory
• Tipper/Tippee theory: Anyone who acquires inside information as a result of a corporate insider's breach of their fiduciary duty can be liable under SEC Rule 10b-5, including:
  • Tippees
  • Remote tippees

Requirements for tippee liability

• There is a breach of duty not to disclose inside information.
• The disclosure is made in exchange for personal benefit, such as reputational benefits that lead to future profits or a gift to a relative or friend.
• The tippee knows (or should know) of this breach and benefits from it.
• Misappropriation theory: holds liable an individual who wrongfully obtains inside information and trades on it for personal gain.

Insider Reporting and Trading—Section 16(b)

• Section 16(b) of the 1934 act provides for recapture by the corporation of all short-swing profits realized by an insider.

• Short-swing profits: Profits earned by a purchase and sale, or sale and purchase, of the same security within a six-month period.

• Insiders: officers, directors, and large stockholders of Section 12 corporations.

• Can recapture without actual fraud or insider trading.

• To discourage insider trading, the SEC requires insiders to file reports concerning their ownership and trading of their corporation's securities.

• Violations of the 1934 Act may lead to both criminal and civil liability.

Scienter Requirement

• For either criminal or civil sanctions to be imposed, scienter must exist.
• Scienter proven by showing either that the defendant had intent to defraud or knowledge of their misconduct, such as showing they:
  • Made false statements or wrongfully failed to disclose material facts or
  • Was conspicuously reckless as to the truth or falsity of their statements
• In a complaint alleging a violation, the plaintiff must state facts giving rise to an inference of scienter.
• Scienter is Not Required for Section 16(b) Violations – Strict Liability!

Criminal Penalties

• For violations of Section 10(b) and Rule 10b-5:
  • An individual may be fined up to $5 million, imprisoned for twenty years, or both.
  • A partnership or a corporation may be fined up to $25 million.
• Under the Sarbanes-Oxley Act, for a willful violation of the 1934 act:
  • The violator can be imprisoned up to twenty-five years and fined.
• Criminal prosecution standard: no reasonable doubt that the defendant was aware of acting wrongfully.

Civil Sanctions

• The SEC can bring a civil action against anyone who purchases or sells a security while in possession of material nonpublic information in violation of the 1934 act or SEC rules.
  • The violation must occur through the use of a national securities exchange or a broker or dealer.
  • Penalties assessed up to triple the profits gained or the loss avoided by the guilty party.
• Private parties may also sue violators of Section 10(b) and Rule 10b-5.
  • A private party can obtain rescission (cancellation) of a contract to buy securities or damages to the extent of the violator's illegal profits.
• Corporations can bring an action to recover the short-swing profits for insider violations of Section 16(b).

State Securities Laws

• Every state has its own corporate securities laws, “blue sky laws”, that regulate the offer and sale of securities within its borders.
• Article 8 of the Uniform Commercial Code (“UCC”), which has been adopted by all of the states, also imposes various requirements.
• State securities laws:
  • Apply mainly to intrastate transactions
  • Typically have disclosure requirements and antifraud provisions, similar to federal laws.
  • Provide for the registration of securities offered or issued for sale within the state
• Most state securities laws also regulate securities brokers and dealers.

Concurrent Regulation

• Since the adoption of the 1933 and 1934 federal securities acts, the state and federal governments have regulated securities concurrently.
  • Issuers must comply with both
  • Exemptions from federal law are not exemptions from state laws
• Uniform Securities Act revised to coordinate state and federal securities regulation and enforcement efforts.

Corporate Governance

• Corporate governance: A set of policies specifying the rights and responsibilities of the various participants in a corporation and spelling out the rules and procedures for making corporate decisions.
• Essential in large corporations because corporate ownership (by shareholders) is separated from corporate control (by officers and managers).
• Some corporations have sought to align the financial interests of their officers with those of the company's shareholders by providing the officers with stock options.

Problems with stock options

• Options have turned out to be an imperfect device for encouraging effective governance.
• Executives tempted to “cook” the company's books in order to keep share prices higher so that they can sell their stock for a profit.
• Executives may “reprice” their options so that they do not suffer from a share price decline.
• Due to problems with stock options, we now see more boards with outside, independent directors.

The Sarbanes-Oxley Act of 2022

• Attempts to increase corporate accountability by imposing strict disclosure requirements and harsh penalties for violations of securities laws
• Created a new entity, called the Public Company Accounting Oversight Board (PCAOB), to regulate and oversee public accounting firms

Certification and Monitoring Requirements

• Requires the CEO and CFO to certify the accuracy of the information in the corporate financial statements.

More Internal Controls and Accountability

• Introduced direct federal corporate governance requirements for publicly traded companies.
• Requires high-level managers to establish and maintain an effective system of internal controls and procedures to: – Ensure that company financial reports are accurate and timely – Document financial results prior to reporting

Independent Auditor Report - Exemptions for Smaller Companies

• The act requires public companies to have an independent auditor file a report with the SEC on management's assessment of internal controls.
• Exemptions exist for smaller public companies with a market capitalization of less than $75 million.

Explore securities regulations, the Securities Act of 1933, and the SEC's role. Understand the Howey Test applicability and the definition of a security. Learn about regulations related to raising capital.