19 - 138 - 1 © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman Chapter 41 Investor Protection and Online Securities Transactions

© 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman 19 - 138 - 1

Chapter 41Investor Protection and Online

Securities Transactions


Federal law did not Federal law did not regulate the securities regulate the securities markets until after the markets until after the stock market crash of stock market crash of 1929.1929.

Securities laws are Securities laws are designed to help prevent designed to help prevent a similar crash today.a similar crash today.


The Securities and Exchange Commission (SEC)

• Federal administrative agency that is empowered to administer federal securities laws.– Can adopt rules and regulations to

interpret and implement federal securities laws.

– Investigates alleged securities violations.

– Brings enforcement actions.– Regulates activities of securities

brokers and advisors.


Definition of a Security• A security must exist before

securities laws apply.• Securities are:

– Any interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant.

– An interest or instrument that is expressly mentioned in securities acts.

– An investment contract.


The Securities Act of 1933

• Primarily regulates the issuance of securities by a corporation, a general or limited partnership, an unincorporated association, or an individual.

• Section 5 of the Act requires securities offered to the public through the use of the mails or any facility of interstate commerce to be registered with the SEC.


Registration Statement• Covered issuer of securities must

file a written registration statement with the SEC.

• Contains required information about the issuer and the securities to be issued.

• The SEC does not pass upon the merits of the registered securities.

• Decides only whether the issuer has met the disclosure requirements.


Prospectus• A written disclosure document

that must be submitted to the SEC along with the registration statement.

• It is provided to prospective investors to enable them to evaluate the financial risk of the investment.


Limitations on Activities During the Registration Process

The Prefiling PeriodThe Prefiling Period

The Waiting PeriodThe Waiting Period

The Posteffective The Posteffective PeriodPeriod


Prefiling Period• Begins when issuer

contemplates offering securities and ends when registration statement is filed.

• Issuer cannot:– Offer to sell or sell during this

period.– Condition the market.– Engage in public relations

campaign.


Waiting Period• Begins when registration

papers filed and continues until declared effective.

• Issuer can:– Condition the market.– Distribute preliminary

prospectus and summary prospectus.

– Publish tombstone ads.


Posteffective Period• Begins when registration

becomes effective and runs until securities are all sold or withdrawn from market.

• Issuer can:– Sell securities.

• Must deliver a final prospectus before confirming sale.

– Run tombstone ads.


Sale of Unregistered Securities

• Sales of securities that should have been registered but were not violates the Securities Act of 1933.– Investors can rescind and

recover damages.– U.S. government may impose

criminal penalties.


Regulation A Offerings

• A regulation that permits the issuer to sell securities pursuant to a simplified registration process.– Issuers may sell up to $6 million of

securities in twelve-month period.– May have an unlimited number of

purchasers.– They do not have to be accredited

investors.– There are no resale restrictions on

the securities.


Violations of Securities Act of 1933

• Private actions– Act imposes civil liability

• For anyone violating Section 5– Rescission of purchase or

damages

• For damages when registration statement misstates or omits material fact


Violations of Securities Act of 1933 (continued)

• SEC actions– The SEC may:

• Issue consent order• Bring an action for an injunction• Request ancillary relief


Transactions Exempt from Registration

• Exempt transactions are subject to the antifraud provisions of the federal securities laws.

• The issuer must provide investors with adequate information.


Transactions Exempt from Registration (continued)

Nonissuer Nonissuer ExemptionExemption

Intrastate Intrastate Offering Offering

ExemptionExemption

Private Private Placement Placement ExemptionExemption

Small Small Offering Offering

ExemptionExemption


Nonissuer Exemption

• Nonissuers do not have to file a registration statement prior to reselling securities they have purchased.


Intrastate Offerings• Exemption that permits local

businesses to raise capital from local investors to be used in the local economy without the need to register with the SEC.– Issuer must be resident of state.– Issuer must be doing business

instate.• 80 percent rule

– Purchasers must be residents of state.


Private Placements• An exemption from

registration that permits issuers to raise capital from an unlimited number of accredited investors and no more that 35 non-accredited investors without have to register the offering with the SEC.


Accredited Investors• Accredited investors may

be:– Natural person with net worth

of at least $1 million.– Natural persons who had

annual income of at least $200,00 for last two years, and expects same this year.

– Any corporation, partnership, or business trust with total assets of at least $5 million.

– Insiders of the issuers.– Certain institutional investors.


Small Offerings

• Small offering exemptions under Rule 504:– Sale of securities not exceeding the

$1 million during a 12-month period.– Sold to unlimited number of

accredited or unaccredited investors.

– No general selling efforts to public allowed.


Resale Restrictions• Certain resale restrictions are

placed on securities issued pursuant to exemptions from registration.

• Cannot be resold for a limited period after initial issue.– Rule 147 covers intrastate sales.

– Rule 144 covers private placement or small offerings.

• Investors must sign affidavit that they are aware of restricted transferability.


Rule 144A• Rule adopted by the SEC to

increase the liquidity of the registered securities.

• The rule permits “qualified institutional investors” to buy unregistered securities without being subject to the holding periods of Rule 144.


Securities Exempt from Registration (1 of 2)

1. Securities issued by any government n the U.S.

2. Short-term notes and drafts that have a maturity date that does not exceed nine months.

3. Securities issued by nonprofit issuers.

4. Securities of financial institutions that are regulated by the appropriate banking authorities.


Securities Exempt from Registration (2 of 2)

5. Securities issued by common carriers.

6. Insurance and annuity contracts issued by insurance companies

7. Stock dividends and stock splits8. Securities issued in a corporate

reorganization where one security is exchanged for another security.


The Securities Exchange Act of 1934

• Federal statute that primarily regulates the trading in securities.

• It provides for the regulation of– Securities exchanges– Brokers– Dealers

• Contains provisions that assess civil and criminal liability on violators of the act.


Section 10(b)• A provision of the Securities

Exchange Act of 1934.• Prohibits the use of manipulative

and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations prescribed by the SEC.


Rule 10b-5• A rule adopted by the SEC to

clarify the reach of Section 10(b) against deceptive and fraudulent activities in the purchase and sale of securities.

• All transfers of securities are subject to this rule.– Stock exchange, over-the-

counter, private sale, merger


Insider Trading• One of the most important

purposes of Section 10(b) and Rule 10b-5 is to prevent insider trading.– When an insider makes a profit

by personally purchasing shares of the corporation prior to public release of favorable information, or

– By selling shares of the corporation prior to the disclosure of unfavorable information


Insiders• Insiders are defined as:

– Officers, directors, and employees at all levels of the company

– Lawyers, accountants, consultants, and other agents and representatives who are hired by the company on a temporary and non-employee status to provide services or work to the company

– Others who owe a fiduciary duty to the company.


Tipper – Tippee Liability

• Tipper- A person who discloses material non-public information to another person.

• Tippee- The person who receives material non-public information from a tipper.


Violations of the Securities Exchange Act of 1934

• Private Actions – The courts have implied

private right of action under Section 10(b) and Rule 10b-5.

– Plaintiff may seek rescission of the securities contract or recover damages.


Violations of the Securities Exchange Act of 1934 (continued)

• SEC Actions – Consent order– Injunction– Seek court orders– Insider trading sanctions

• Criminal penalty of three time profits or losses avoided


Violations of the Securities Exchange Act of 1934 (continued)

• Criminal Liability – Section 32 imposes criminal

liability on any person who willfully violates the act or regulations .

– Under Sarbanes-Oxley• Individuals can be fined up to $5

million and imprisoned for up to 25 years.

• Corporations can be fined up to $2.5 million.


Short-Swing Profits

• Section 16(a) of the 1934 act – defines any person who is an executive officer, a director, or a 10 percent shareholder of an equity security of a reporting company as a statutory insider for Section 16 purposes.


Section 16(b)

• Short-Swing Profits – Profits made by statutory insiders on trades involving equity securities that occur within six months of each other.

• Section 16(b) – A provision of the 1934 act that requires that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation.


State Securities Laws• Most states have enacted

securities laws that regulate the issuance and trading of securities.

• These acts are often patterned after, and are designed to coordinate with, federal securities laws.

• The Uniform Securities Act (a model state statute) has been adopted by many states.

Documents

19 - 138 - 1 © 2007 Prentice Hall, Business Law, sixth edition, Henry R. Cheeseman Chapter 41 Investor Protection and Online Securities Transactions