Securities Regulation Week 1 Lecture Slides

Electronic copy available at: http://ssrn.com/abstract=2727252

SECURITIES REGULATION WEEK 1:

Introduction

The Good. The Bad. And the Ugly.

Lecture Slides Draft: 02/02/2016

Richard Strasser

Electronic copy available at: http://ssrn.com/abstract=2727252

BC (Before The Crash)

The securities markets of the early 1920s were marked by excess and

speculation—certainly it was a period of “Irrational Exuberance”


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But the party came to an end in

October of 1929.

• The stock markets crashed.

• Securities markets lost over half their value in the crash and subsequent years, sending the world into a global depression.


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There was only one man who could

save us!!!!!!

fear itself.ram


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FDR Made Restoring Confidence in the

Securities Markets a Top Priority

• In 1933, FDR signed into law the Securities Act of 1933, requiring companies to file a registration statement with the feds that discloses in a “prospectus” important information about their businesses.

• Failure to register carried criminal and civil penalties.

• Drafters chose an informed investor model over a “merit regulation” model where government decides where capital should be allocated.


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The Following Year Congress enacted

the Securities Exchange Act of 1934.

• The “Exchange Act,” as it’s called, created the Securities and Exchange Commission, an independent administrative agency tasked with carrying out the ’33 and ’34 Act rules.

• Whereas the primary focus of the ’33 Act is to enhance disclosure by companies before they offer their securities to the public, the ’34 Act focuses on the “secondary market” trading in those securities.

• In other words, it makes the rules for what happens AFTER the IPO.

• It requires, among other things, periodic disclosure by public companies.


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More Exchange Act

The ’34 Act also regulates:

• The stock exchanges, like the New York Stock

Exchange and Nasdaq, as well as FINRA, which

oversees stock brokers and dealers.

• The Exchange Act also imposes rules directly on

brokers and dealers.


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Continuing Story of Excess, Crisis and Response

• Regulation of the securities markets has been likened to a swinging pendulum.

• The austerity of World War I gave way to the excesses of the 1920s, which gave way to the Stock Market Crash of 1929, which gave way to the securities law reforms of the 1930s.

• Likewise, the irrational exuberance of the “DOT COM” era gave way to the scandals typified by companies like Enron, WorldCom, and others (which, ironically, were not technology companies).


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ENRON & BEYOND

• The accounting crisis of the Enron Era gave rise to the most far-reaching overhaul of the securities regulatory scheme since the 1930s—the Sarbanes-Oxley Act of 2002 (“SOX”).

• SOX responded to concerns that the disclosure requirements were not being taken seriously. What companies reported as “earnings” were often misleading estimates or sometimes pure fabrications.

• Investors can tolerate risk as long as they know what the risks are.

• But without reliable disclosure, investors had no way of knowing what a company was really worth. Is GE like Exxon or is it like Enron?

• The entities that were supposed to keep management honest—the Board of Directors and the outside auditor—were taken to task for failing shareholders. Investors lost confidence in the markets.

• To restore confidence, Congress enacted SOX.


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SOX

• SOX identified the weaknesses in the accounting system and sought to address them.

• Created the Public Company Accounting Oversight Board (PCAOB) to establish auditing standards.

• Imposed restrictions to reduce auditor conflicts of interest.

• SOX also gave the SEC expanded powers to sanction auditors, company officers and directors and attorneys.

• Required CEO and CFO to certify that SEC filings are true and accurate and banned certain types of corporate transactions (e.g., personal loans to directors and officers).


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déjà vu all over again

• Even before the ink dried on SOX, business leaders began to complain that SOX unnecessarily hinders business, particularly small businesses. Calls for a relaxation of SOX and the rules adopted under SOX intensified.

• Some have complained that SOX goes beyond disclosure regulation toward “merit regulation,” by dictating actions companies can and cannot take.

• But then the financial system crashed…


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Dodd-Frank and Beyond

• Credit markets crumbled.

• The Federal Government (i.e., U.S. taxpayers) was

forced to bail out (or “help” other institutions) bail

out large financial institutions (e.g., Bear Stearns,

AIG, Fannie Mae, etc.).

• The American people were up in arms.

• Congress adopted Dodd-Frank, the most sweeping

reform of the financial system since…SOX.

• Now that the financial storm has passed, the

financial industry is seeking to weaken Dodd-Frank.Lecture Slides Draft: 02/02/2016

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And now for something completely different.

• Before we dig too deeply into what securities

regulation is, we need to understand better

what law is. And where it comes from.


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A brief introduction to the law.

• In the U.S., it all starts and ends with the

Constitution. It’s the supreme law of the law.

It says so right there in the Constitution.


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The Supremacy Clause

• Article. VI, ¶ 2

• “This Constitution, and the Laws of the United States which shall be made in Pursuance thereof; and all Treaties made, or which shall be made, under the Authority of the United States, shall be the supreme Law of the Land; and the Judges in every State shall be bound thereby, any Thing in the Constitution or Laws of any state to the Contrary notwithstanding.”


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Constitution: A system of checks

and balances

• The Constitution also defines the role and power of Congress and the President.

• Checks and balances keep any one branch of government from becoming too powerful.

• Congress makes the laws. Article I.

• The President enforces the laws. Article II.


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Constitution

• The Supreme Court interprets the laws. Article III; and Marbury v. Madison.

• Each year about 8000 petitions are filed with the Supreme Court. About 100 are granted.

• Most cases in the federal system reach no higher than a U.S. Circuit Court.

• First, a case (usually) must make its way through a federal district court (i.e., a federal trial court) or an administrative agency (e.g., SEC).


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Courts

• The 94 U.S. judicial districts are organized into 12 regional circuits, each has a U.S. court of appeals.

• Appeals courts hear appeals from the district courts located within its circuit, and from federal administrative agencies.

• Federal Circuit has nationwide jurisdiction to hear appeals in specialized cases, (e.g., patent law).


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State Courts

• Each state has a court system similar to the federal system.

• Trials courts, to appeals courts, to state appellate courts.

• Some state appellate courts, like Maryland’s, are referred to as courts of special appeals or superior courts.

• Some state courts of last resort are called Courts of Appeal rather than Supreme Courts.


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More State Courts

• Each state has laws governing securities offerings.

• The laws are made by the legislative body—typically called a general assembly.

• The laws are executed by the state’s chief executive—the governor.


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More State Courts

• States used to play a more significant role in regulating securities offerings than they do today. Some states favored “merit regulation.”

• State laws regulating securities were and are referred to as “blue sky laws.” A disparaging remark referring to the value of securities sold by unscrupulous stock promoters.

• States’ role in securities regulation was greatly diminished (but not eliminated) in 1996, when Congress passed a law that preempted or overrode most state rules in favor of federal regulations.


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State Preemption

• This course will focus primarily on federal regulation of the securities markets—and the federal agency largely responsible for carrying out that regulation—the SEC.

• Nevertheless, like all swinging pendulums, the role of the states has ebbed and flowed over time.

• Over the past decade, certain state Attorney Generals (e.g., NY) have reasserted their authority in cases where federal regulation was seen as slow or weak (e.g., market timing and dark pools).


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Other Federal Agencies

• Moreover, the SEC performs its regulatory function in conjunction with but also often in conflict with other federal agencies with overlapping jurisdictions and influence. These include the FRB, Treasury, CFTC and DOJ. An understanding of these relationships is necessary for full understanding of the regulatory landscape.


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History of SEC

• The SEC was formed in 1934. It is headed by 5 commissioners, one of whom serves as the chairman.

• The first chairman was Joseph Kennedy, a successful businessman and a stock speculator and father of President Kennedy.

• The five commissioners are appointed by the President with the advice and consent of the Senate for a term of five years.

• No more than 3 commissioners shall be from the same political party.

• It’s independent (i.e., not part of the President’s cabinet).• SEC makes the law, enforces the law, and judges alleged

wrong-doers. Checks and balances?


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SEC

• Most of the day-to-day operation of the Commission is conducted by the staff.

• Commission's approximately 3,500 staff are located in Washington and in 11 Regional Offices throughout the country.


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SEC

• It is the responsibility of the Commission to:

• interpret federal securities laws;

• issue new rules and amend existing rules;

• oversee the inspection of securities firms, brokers, investment advisers, and ratings agencies;

• oversee private regulatory organizations in the securities, accounting, and auditing fields; and

• coordinate U.S. securities regulation with federal, state, and foreign authorities.


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SEC

• The Commission convenes regularly at

meetings that are open to the public and the

news media unless the discussion pertains to

confidential subjects, such as whether to

begin an enforcement investigation.


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SEC

• Most securities professionals that have dealings with the SEC deal with the staff.

• The SEC staff is made up of three divisions that oversee particular areas or sections of the securities laws.

• The most visible division is the Division of Enforcement, which enforces the laws and regulations of each of the subject-matter divisions.


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Division of Corporation Finance

• The Division of Corporation Finance (“Corp. Fin.”) assists the Commission regarding corporate disclosure of important information to the investing public.

• Corporations must comply with regulations pertaining to disclosure that must be made when stock is initially sold and then on a continuing and periodic basis.

• The Division's staff reviews the disclosure documents filed by companies and provides companies with assistance interpreting the Commission's rules and recommends to the Commission new rules for adoption.


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Corp. Fin.

• The Division reviews documents that publicly held companies must file with the Commission.

• The documents include:

• registration statements for newly offered securities;

• annual and quarterly filings (Forms 10-K and 10-Q);

• proxy materials sent to shareholders before an annual meeting;

• annual reports to shareholders;

• documents concerning tender offers (i.e., an offer to buy a large number of shares of a corporation, usually at a premium above the current market price); and

• filings related to mergers and acquisitions.


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Corp. Fin.

• These documents disclose information about the companies' financial condition and business practices to help investors make informed investment decisions. In its review the Division checks to see if publicly held companies are meeting their disclosure requirements and seeks to improve the quality of the disclosure.

• To meet the SEC's requirements for disclosure, a company issuing securities or whose securities are publicly traded must make available all information, whether it is positive or negative, that might be relevant to an investor's decision to buy, sell, or hold the security.


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Corp. Fin.

• Corp. Fin. also provides administrative interpretations of the ’33 Act, the ’34 Act, among other areas. It also recommends regulations to implement these statutes.

• With the Office of the Chief Accountant, Corp. Fin. monitors the activities of the accounting profession, particularly the Financial Accounting Standards Board (FASB), that result in the formulation of generally accepted accounting principles (GAAP).

• The Division also monitors the use by U.S. registrants of International Financial Reporting Standards (IFRS), promulgated by the International Accounting Standards Board.


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Corp. Fin.

• Corp. Fin. provides guidance and counseling to registered companies, prospective registrants, and the public to help them comply with the law.

• For example, a company might ask whether the offering of a particular security requires registration with the SEC. Corp. Fin. would share its interpretation of the relevant securities regulations with the company and give it advice on compliance with the appropriate disclosure requirement.

• The Division uses “no-action” letters to issue guidance in a more formal manner.

• A company seeks a no-action letter from the SEC staff when it plans to enter uncharted legal territory in the securities industry.

• For example, if a company wants to sell a new financial product, it can ask the staff to write a letter indicating whether it would or would not recommend that the Commission take action against the company for selling this new product.


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Division of Trading and Markets

• The Division of Trading and Markets (formerly the Division of Market Regulation, and the Division of Trading and Markets) assists the Commission in executing its responsibility for maintaining fair, orderly, and efficient markets.

• The Division provides day-to-day oversight of the major securities market participants: the securities exchanges; securities firms; self-regulatory organizations (SROs) including the Financial Industry Regulatory Authority (FINRA), the Municipal Securities Rulemaking Board (MSRB), clearing agencies (help facilitate trade settlement); transfer agents (maintain records of securities owners); credit rating agencies; and others.


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Trading and Markets

• The Division also oversees the Securities Investor Protection Corporation (SIPC), which insures the securities and cash in customer accounts of member brokerage firms against the failure of those firms.

• The Division's other responsibilities include:

• carrying out the Commission's financial integrity program for broker-dealers;


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Trading and Markets

• reviewing (and sometimes approving, under delegated authority) proposed new rules and proposed changes to existing rules filed by the SROs;

• assisting the Commission in establishing rules and issuing interpretations on matters affecting the operation of the securities markets; and

• surveilling the markets.


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Investment Management

• The Division of Investment Management (“IM”) assists the Commission in overseeing and regulating mutual funds and the professional fund managers who advise them; analysts who research individual assets and asset classes; and investment advisers to individual customers.

• IM focuses on ensuring that disclosures about these investments are useful to retail customers, and that the regulatory costs which consumers must bear are not excessive.


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Investment Management

• The Division's other responsibilities include:

• assisting the Commission in interpreting laws and regulations for the public and SEC inspection and enforcement staff;

• responding to no-action requests and requests for exemptive relief;

• reviewing investment company and investment adviser filings;

• assisting the Commission in enforcement matters involving investment companies and advisers; and

• advising the Commission on adapting SEC rules to new circumstances.


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Enforcement

• First and foremost, the SEC is a law enforcement agency. Walk softly and carry a big stick. The “shotgun behind the door.”

• The Division of Enforcement assists the Commission in executing its law enforcement function by recommending the commencement of investigations of securities law violations, by recommending that the Commission bring civil actions in federal court or before an administrative law judge, and by prosecuting these cases on behalf of the Commission.

• The SEC has civil enforcement authority but not criminal authority. As an adjunct to the SEC's civil enforcement authority, the Division works closely with law enforcement agencies in the U.S. and around the world to bring criminal cases when appropriate.


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Enforcement

• The Division obtains evidence of possible violations of the securities laws from many sources, including market surveillance activities, investor tips and complaints, other Divisions and Offices of the SEC, the SROs and other securities industry sources, and media reports.

• SEC investigations are conducted privately. Facts are developed to the fullest extent possible through informal inquiry, interviewing witnesses, examining brokerage records, reviewing trading data, and other methods.

• Once the Commission issues a formal order of investigation, the Division's staff may compel witnesses by subpoena to testify and produce books, records, and other relevant documents. Following an investigation, SEC staff present their findings to the Commission for its review. The Commission can authorize the staff to file a case in federal court or bring an administrative action. In many cases, the Commission and the party charged decide to settle a matter without trial.


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Enforcement• Whether the Commission brings a case in federal court or within the SEC before an

administrative law judge (ALJ) may depend upon the type of sanction or relief that is being sought.

• For example, the Commission may bar someone from the brokerage industry in an administrative proceeding, but an order barring someone from acting as a corporate officer or director must be obtained in federal court. Often, when the misconduct warrants it, the Commission will bring both proceedings.

• Recently, the SEC has come under scrutiny for bringing most actions before SEC ALJs, which seldom rule against the SEC staff.

• Civil action: The Commission files a complaint with a U.S. District Court and asks the court for a sanction or remedy. Often the Commission asks for a court order, called an injunction, that prohibits any further acts or practices that violate the law or Commission rules. An injunction can also require audits, accounting for frauds, or special supervisory arrangements.

• In addition, the SEC can seek civil monetary penalties, or the return of illegal profits (i.e., disgorgement). The court may also bar or suspend an individual from serving as a corporate officer or director. A person who violates the court's order may be found in contempt and be subject to additional fines or imprisonment.


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Enforcement

• Administrative action: The Commission can seek a variety of sanctions through the administrative proceeding process. Administrative proceedings differ from civil court actions in that they are heard by an ALJ, who is independent of the Commission, although employed by the SEC.

• The ALJ presides over a hearing and considers the evidence presented by the Division staff, as well as any evidence submitted by the subject of the proceeding.

• Following the hearing, the ALJ issues an initial decision that includes findings of fact and legal conclusions. The initial decision also contains a recommended sanction. Both the Division staff and the defendant may appeal all or any portion of the initial decision to the Commission.

• The Commission may affirm the decision of the ALJ, reverse the decision, or remand it for additional hearings. Administrative sanctions include cease and desist orders, suspension or revocation of broker-dealer and investment adviser registrations, censures, bars from association with the securities industry, civil monetary penalties, and disgorgement.


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Other Offices

• In addition to the four main divisions, the SEC also employs several support offices.

• Those with the most contact with the public and securities professionals include:

• The Office of Compliance Inspections and Examinations (“OCIE”) administers the SEC's examination and inspection program for registered SROs, broker-dealers, transfer agents, clearing agencies, investment companies, and investment advisers.

• OCIE conducts inspections to foster compliance with the securities laws, to detect violations of the law, and to keep the Commission informed of developments in the regulated community.

• Among the more important goals of the examination program is the quick and informal correction of compliance problems. When OCIE finds deficiencies, it issues a "deficiency letter" identifying the problems that need to be rectified and monitors the situation until compliance is achieved. Violations that appear too serious for informal correction are referred to the Division of Enforcement.


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Other Offices

• Office of International Affairs (“OIA”) negotiates bilateral and multilateral agreements for Commission approval on such subjects as regulatory cooperation and enforcement assistance, and oversees the implementation of such arrangements. Strong support role with Enforcement Division. OIA also is responsible for advancing the Commission's agenda in international meetings and organizations. OIA also conducts a technical assistance program for countries with emerging securities markets, which includes training both in the United States and in the requesting country.

• Office of Investor Education and Advocacy serves individual investors by seeing to it that their problems and concerns are known throughout the SEC and considered when the agency takes action.

• Most day-to-day regulation is done by internal firm compliance departments or SROs, in compliance with SEC rules and oversight—the SEC is the “shotgun…behind the door.”


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Terminology—Learn to talk the talk

• Certain terms are commonly used in the securities industry.

• Primary Market Transactions

• The “primary market” refers to the sale of securities by the issuer to investment banks or other intermediaries.

• Initial Public Offering (“IPO”) is a term of art. It occurs when the issuer of a security sells stock to the public for the first time.

• Not all offerings are IPOs. If the issuer’s shares already trade in the public market and it does an offering it’s not an IPO.

• Rules for IPOs are typically more stringent than for subsequent offerings because the company and management have not been subjected to public scrutiny before—they are unknown quantities and greater disclosure is warranted.


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More Terminology

• Secondary Market

• After a company’s shares are issued to the public a new cast of characters comes into play in the “secondary market.”

• Secondary market participants with an interest in the issuer (e.g., those who own shares or who are considering ownership such as brokers, mutual funds, hedge funds, individual investors) become the primary players interested in the value of the company at a given time.

• Unlike company management, these players do not have unfettered access to information about the company.

• Instead, they must rely on issuer disclosure to ensure that their investment choices are informed.


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Lingo

• Sell-side: brokers (pros “engaged in the business” of trading for the accounts of others) and dealers (pros “engaged in the business” of trading for their own accounts. Most do both—broker-dealers. (e.g., Goldman Sachs, Merrill Lynch, Morgan Stanley, Charles Schwab). Dodd-Frank restricts investment banks from trading on their own behalf.

• Buy-side: take positions as investments or hedges but not engaged in the business of trading (e.g., mutual funds like Vanguard, Fidelity, T. Rowe, Legg Mason; also insurance companies, pension funds). Hedge funds?


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Market Efficiency

• Whether a particular market is efficient will be assessed by its effectiveness in incorporating info about a company into the price of that company’s stock. What’s the “true value” of the stock at a given time?

• E.g., Facebook issues an earnings warning—how should that information impact the current price of the stock?

• A lot of academic attention to this area—“efficient capital market hypothesis”—comes in three flavors.

• Weak-form Efficiency—stocks incorporate info about historic trading patterns so there’s no way to guess a stock’s direction based on past trading patterns—stocks take a “random walk.”


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More Efficiency

• Semistrong-form Efficiency—stock market incorporates all publicly available info into the stock price—ordinary investors can’t beat the market over time by using public info that affects stock price (e.g., earnings releases, tax policies)—informed investors get the info most quickly and can trade on it before ordinary investors—most pros don’t even beat the market over time.

• Strong-Form Efficiency—not perfect market efficiency—not all info is incorporated into the stock price—insiders have an informational advantage (non-public info) that allows them to reap profits by trading on that information ahead of uninformed investors.

• Efficiency is another word for fairness. Are markets fair to all investors or just to insiders? The more info that is available to the public the less chance that inside info will skew the market in favor of insiders.

• This issue has come into focus recently with respect to high frequency traders, which get and process info faster than other market players.

• Theories help in understanding policy reasons behind enhanced disclosure and penalties against insider trading.


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Documents

Securities Regulation Week 1 Lecture Slides