Chapter 9 Sale of Securities and Investor Protection

Thursday, September 21, 2017 11:17 PM

Chapter Objectives
1. To know the role and purpose of the Securities and Exchange Commission in regulating securities
transactions in the United States
2. To know the purpose of the Securities Act of 1933 and understand how it helps protect investors
3. To know the purpose of the Securities Exchange Act of 1934 and understand its impact on publicly
held companies
4. To understand the law, ethical issues, and consequences of insider trading
5. To understand the ethical obligations of corporate boards, executives, and traders in protecting
investors and the public
6. To know the major provisions of the Sarbanes-Oxley Act of 2002
State Securities Laws
• State securities laws are common rules and regulations that apply to all companies offering
securities to the public in the United States
○ Blue Sky Laws: each state has its own set of securities laws and regulations
 A company must follow both federal and state securities laws
What is a Security?
• Securities are not limited to stocks and bonds
• An investment contract is any transaction in which a person:
a. Invest
b. In a common enterprise
c. Reasonable expecting profits
d. Derived primarily or substantially from others' managerial or entrepreneurial efforts
○ This is called the Howey test
The Securities and Exchange Commission (SEC)
• After the Great Depression of 1929, Congress focused on developing new laws, regulations, and
agencies to ensure that it never happen again
a. The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC):
i. Plays a critical role in protecting private and institutional investors
ii. Help minimize the risk of investing in companies by reviewing and monitoring the
information companies are required to generate and disseminate to the general
public
iii. Help control the various stock markets
b. Mission of the SEC
i. Protect investors
ii. Maintain fair, orderly, and efficient markets
iii. Facilitate capital formation
• Helps provide a well-controlled stock market and instill confidence in the investing public
The Securities Act of 1933 (Securities Act)
• The Securities Act of 1933 covers the purchase and sale of securities in the U.S, which helps
protect investors and assist companies in offering its securities for sale to the public
○ The act has 2 objectives:
i. To help ensure that private and institutional investors receive accurate, complete, and
valid information about publicly held companies
ii. To minimize the likelihood of a company engaging in fraud or deceit when offering
securities for sale to the public
• Registration with the Securities and Exchange Commission
1. Make securities available to the general public is to make a public offering (first offering is
called Initial Public Offering - IPO)
 The Securities Act of 1933 requires a company to provide information about itself, the

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  The Securities Act of 1933 requires a company to provide information about itself, the
type of securities being offered, and similar kinds of information
□ Companies need to complete a 2-part registration process with the SEC in order
to provide them the information
a) Complete a prospectus, which describes the mission and objectives of a
business along with details about a company's business operations
i) A prospectus explains the major risks and opportunities associated
with a business
ii) A prospectus is sometimes referred to as a "selling document"
iii) Companies need to include mission and objectives, business
operations, financial information (audited financial statements),
management team, major risks and benefits
iv) Companies must distribute a prospectus to all parties interested in
buying the company's stock and to those who presently own the
company's stock
b) Company must provide confidential information (recent sales of
unregistered securities, copies of significant contracts, etc.)
□ Once registered, the SEC assigns staff members to review the information
provided in a registration statement
a) The review ensures that the content of the registration statement
conform to applicable rules and regulations
2. Exemptions from the Registration Process
 Several types of offerings may qualify for exemption from registration:
□ Private placement offerings - securities are offered only to people who
understand the risks, appreciate the risks, and can bear the risks of the
investment
□ Offerings limited in size
□ Offerings confined to a single state, often referred to as intrastate offerings
(issuers and purchaser are from the same state)
□ Offerings of municipal and state governments, and the federal government
 Companies must satisfy the following 3 criteria in order to fall under the private
placement exemption (most commonly used exemption)
□ Section 4(a)(2) of the Securities Act exempts from registration "transactions by
an issuer not involving any public offering"
□ Section 4(a)(2) requires:
◊ The purchasers of the private securities must be sophisticated investors
(someone who has the educational background and professional
experience sufficient to allow the investor to assess the risks and merits of
the private offering)
◊ The purchasers must have access to all the information normally provided
in a prospectus for registered securities
◊ The purchasers must agree in advance of any purchase not to sell or
otherwise distribute the purchased shares to members of the general
public
 A number of federal securities laws continue to apply to companies that are exempt
from the registration process
□ Antifraud provisions (the corporation itself along with its officers and directors
are responsible for any false, deceiving, or otherwise misleading information
disseminated by the company to shareholders or members of the general
public)
• Violations of the 1933 Act
○ Misrepresenting or omitting facts in the registration statement or prospectus
○ Selling securities before the registration statement becomes effective
Utilizing an exemption that is not applicable

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 ○ Utilizing an exemption that is not applicable
○ Criminal violations prosecuted by Dept. of Justice
○ Fine of up to $10,000 up to 5 year imprisonment, or both
○ SEC can also seek civil sanctions
• Defenses to a '33 Act claim
○ Statement or omission was not material
○ Plaintiff knew about the misrepresentation at the time of purchasing the stock
○ Defendant exercised due diligence in preparing the registration and reasonably believed at
the time that the registration was true
• Benefits and Burdens of "Going Public"
Benefits of Going Burdens of Going Public
Public
• Enhance the • The founders of the company may lose control of the company
credibility of the they started
company and its
products/services • A public offering takes time and money to accomplish

• A company assumes significant new obligations, such as filing SEC

• Increase a company's reports and keeping shareholders and the market informed
access to cash to about its business operations, financial condition, and
finance present and management practices, which consumes a significant amount of
future projects time and adds to the cost of the operations

• Attract talented
officers and
managers by offering • A company may lose flexibility in managing company affairs
stock options
• Information such as financial statements and disclosures about
material contracts, customers, and suppliers, becomes available
• Expand brand to the general public (including competitors)
awareness

• Jumpstart Our Business Startup Act

○ Jumpstart Our Business Startup Act (JOBS Act) focuses on streamlining the registration
process
 Aims to facilitate the process of capital formation and make the registration process
much easier for small businesses
□ Requires the SEC to develop rules and amend existing rules to make it easier for
companies to raise capital without going through the formal registration process
Securities Exchange Act of 1934
• The Securities Act of 1933 and the Securities Exchange Act of 1934 are distinctive acts:
○ Thus, a company may be exempt from registering under the Securities Act, but may
nonetheless be subject to the reporting requirements of the Securities Exchange Act
• Reporting Requirements
○ The Securities Exchange Act of 1934 requires registered companies to report information
regularly to the SEC about their business operations, financial condition, and management
practices
 The information sent to the SEC is public because they are meant to provide investors
with as much information as possible about a registered company

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 with as much information as possible about a registered company
○ Full disclosure and transparency underlie the reporting objectives
○ Rationale: if publicly held companies provide a regular flow of pertinent information about
themselves in a consistent and understandable format, investors will have equal access to
the information they need to make informed decisions
• Securities Exchange Act of 1934 Illegal Activities
○ Section 10b-5 of the Exchange Act provides that "it shall be unlawful for any person, directly
or indirectly, by the use of any means or instrumentality of interstate commerce, or of the
mails or of any facility of any national security exchange:
 To employ any device, scheme, or artifice to defraud
 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 circumstances
under which they were made, not misleading
 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
• Registration under the Securities Exchange Act of 1934
○ Section 12(g) of the Exchange Act requires a company to register its securities with the SEC if
the following conditions are met:
i. The company has more than $10 million in total assets and a class of equity securities,
such as common stock, held by either (1) 2,000 or more persons, or (2) 500 or more
nonaccredited investors
ii. The company lists its securities on a U.S. stock exchange
Insider Trading
• Insider trading occurs when material nonpublic information is used by a person inside the
company in the trading of a company's stock
• An insider:
○ A person who owes a fiduciary duty to the company, including employees, and uses material
nonpublic information when trading in the shares of stock of the company
○ A person who has knowledge or facts about a company that are not available to the general
public
○ A person who operates "outside" the company and receives "insider" information through
the normal course of providing professional services for the company, such as members of
the company's accounting firm
○ A stock broker or financial adviser who receives information, often in the form of a tip, from
someone who has access to inside information because of a fiduciary relationship with the
company
• What is Inside Information?
○ Inside information is any information about a company's strategic and financial plans or
current operations, such as planned mergers and acquisitions, research and development,
and new product launches obtained from "inside" the company
 Examples: planned mergers, planned acquisitions, research and development, new
product launches
• What Are the Penalties for Insider Trading
○ The civil penalties for insider trading consists of a violator being disgorged of any profit
made or loss avoided as a result of using insider information
 SEC (Section 21A), a violator may be fined up to 3 times the amount of the profit
earned or the loss avoided
 Sanctions may also include restrictions on the types of activities the violator may
engage in, such as not serving in certain types of position in the future
 Examples:
□ A business person who obtained confidential information from the CEO of an oil
and gas company that was about to secure a huge investment
□ A partner in a major accounting firm who obtained nonpublic information while

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 □ A partner in a major accounting firm who obtained nonpublic information while
serving as the partner in charge of a regional audit practice
□ A portfolio manager who traded on the basis of inside information ahead of the
quarterly earnings announcement of a major public company
○ The criminal penalties for insider trading involve the Department of Justice through the
local U.S. attorney's office, and not the SEC
 Violators may face up to 20 years in prison for criminal securities fraud and a fine up
to $5 million for each "willful" violation of the act
 Only fines, not imprisonment if the defendant can demonstrate "no knowledge" of
the rule or regulation that was violated
 Corporations face penalties of up to $25 million
Legislative Initiatives of the Twenty-First Century
• Sarbanes-Oxley act of 2002
○ After the financial collapse of Enron Corporation in 2001, Congress passed the Sarbanes-
Oxley Act of 2002
○ Most significant securities legislative acts since the Securities Act and the Securities
Exchange Act
○ Emphasizes a company's financial and corporate management practices
 The act increases corporate responsibility and mandates higher levels of financial
disclosures
 Created a new public oversight board (The Public Company Accounting Oversight
Board which oversees the activities of the public accounting profession relative to the
audits of publicly held companies)
 Focuses on a company's financial and corporate management practices that aims to
hold corporate officers and directors accountable for the accuracy, completeness, and
validity of a company's financial reports
○ Major provisions of the Sarbanes-Oxley Act of 2002
 Section 203: Corporate Responsibility for Financial Reports
□ Requires management to make assertions about the overall accuracy,
completeness, and validity of the financial reports signed by the company's CEO
and CFO
□ Places a company's system of internal control in the forefront of management's
reporting requirements
 Section 401: Disclosures in Periodic Reports
□ Increases the disclosure requirements of a company's financial reports
□ Requires publicly traded companies to make complete disclosure of the use of
any device
 Section 404: Management Assessment of Internal Controls
□ Requires management to include a statement in the annual report about the
quality and integrity of the company's system of internal control
□ Requires the accounting firm that audits a company's financial statements to
corroborate management's assertion about the effectiveness of the company's
internal control system
□ Management must assume responsibility for designing, implementing, and
maintaining an adequate system of internal controls
 Section 409: Real-Time issuer Disclosures
□ Requires companies to report information on a "real-time" basis
□ Companies must disclose to the public on a rapid and current basis, in plain
English, information concerning material changes in the financial condition or
operations of the company
 Section 802: Criminal Penalties for Altering Documents
□ Imposes significant criminal sanctions on offenders who violate provisions of the
Sarbanes-Oxley Act
□ For the first time, external auditors may face criminal sanctions for knowingly

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 □ For the first time, external auditors may face criminal sanctions for knowingly
and willfully violating the requirements of maintaining audit work papers for the
required period of five years
• Dodd-Frank Wall Street Reform and Consumer Protection Act
○ The Dodd-Frank Wall Street Reform and Consumer Protection Act focuses on consumer
protection, trading restrictions, credit ratings, regulation of financial products, corporate
governance, disclosure, and transparency
○ Requires the SEC to create an Office of the Whistleblower
 Whistleblower protection laws encourage employees to report inappropriate
corporate activities to government officials, and they prevent companies from
discharging or disciplining employees who report improper corporate activities
Global Perspective: International Securities Law
• Mary Jo White's (Chairman of the SEC) speech on the topic of "Regulation in a Global Financial
System" reflects a growing recognition that securities laws and regulations are no longer the
exclusive domain of one country
○ As we move increasingly into a global economy, the markets and securities laws of the
various countries must reflect this global transformation

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