Securities & Market Regulation
Introduction to the Securities Market & Securities Regulation
Types of Securities
Different types of securities are defined through cash flow rights, liquidation rights, and voting rights. There are three general types of stock corporations can issue: common stock, preferred stock, and debt.
Common stock and preferred stock are equity securities, while bonds are debt securities.
Common stockholders enjoy residual cash flow rights, meaning they are paid out of whatever remains after the preferred and bond stockholders are paid out. Corporations’ decisions to issue dividends to common stockholders is also purely discretionary.
Boards usually only issue common stock dividends if there is no other use for the profits. The business judgment rule usually protects board decisions in regards to dividends.
However, there are tax consequences for dividends, as corporations pay another tax on dividends.
Common stockholders typically receive all of the voting rights to the board of directors; shareholder passivity and dispersion usually protects directors’ board seats.
Common stockholders also have lowest priority in liquidation rights, according to the absolute priority rule.
Preferred stock is contractually negotiated with each investor, and the terms can vary greatly between investors. Contractual stock agreements usually provide investors with downside protection and upside return, usually through options that allow for the preferred stock to be converted into common stock.
Issuers usually issue preferred stock in two situations: when the startup issuers look to venture capitalists for capital infusions, and when established companies need cash for new ventures.
Preferred stockholders enjoy no cash flow rights, and instead must rely on their preferred stock contracts to protect any negotiated cash flow rights.
However, preferred stockholders are entitled to fixed dividend payments before common stockholders are paid out. Additionally, unpaid dividend payments to preferred stockholders can cumulate over time, and this accumulation must be paid out before dividends are issued to common stockholders.
In liquidation, preferred stock comes before common stock.
Unlike equity securities, bonds are fixed-term loans. Bonds can be short-term (notes) or long-term (indentures).
Bondholders are owed periodic interest payments until the maturity date of the bond, when the principal is due. Zero coupon bonds have no periodic interest payments; instead, the bonds are sold at a discount and there is an implicit interest payment in the principal due.
Bondholders are generally the most protected—they have senior rights in liquidation and bondholders usually negotiate bond covenants to ensure that corporations keep equity cushions to make bond interest payments.
Many consider bonds to be the safest form of securities because they are generally secured (whereas equity securities are not) and the absolute priority rule dictates that bondholders are paid first.
Consider also pecking-order theory, which dictates that investors look (in order) to cash holdings, debt, preferred stock, and then common stock. This theory helps explain why the market generally looks upon common stock issuance as a risky investment.
Consider also the Modigliani-Miller hypothesis, which posits that the capital structure of a company does not matter to investors—rather overall cash flow dominates investment decisions.
The Capital Market
Investment banks assist issuers in making public offerings by providing expert advice as well as assuming an underwriting role. As underwriters, investment banks assume the risk of the issuer’s securities not selling.
In firm commitment offerings, the underwriters take on the full risk of not selling the securities. As such, the investment banks are entitled to a discount rate of the issuer’s securities (and profit from the spread).
Attorneys typically take the lead in drafting the disclosure documents needed for a public offering.
Accounting firms audit the issuer’s financial statements to provide the market with accurate information.
Institutional investors are the primary purchasers of securities in primary transactions. As sophisticated investors, they usually do not need the protection of the securities laws and can cut sweetheart deals with underwriters to increase their profits from the securities.
A well-functioning secondary market is both liquid and transparent. A liquid market allows for quick reselling of securities, while a transparent market reflects the best possible prices for securities.
Without a strong secondary market for securities, investors often demand illiquidity discounts on securities purchased in primary transactions.
Traditional securities markets, most notably the New York Stock Exchange (NYSE), help maintain liquidity by requiring floor brokers for particular stocks (specialists) to trade their own inventory of securities to halt short-term imbalances.
The Nasdaq market employs a slightly different approach—market makers set a bid-ask spread for particular securities, not knowing how investors will react. In this way, the spread compensates the market maker for creating liquidity (i.e. if the market maker prices too high, investors will sell).
Critically, NYSE and Nasdaq, as self-regulating organizations (SROs), impose listing requirements for all listed companies. Broker-dealer floor traders are also regulated by the Financial Industry Regulatory Authority (FINRA).
Alternative Trading Systems (ATSs)
ATSs eliminate the third-party intermediaries by allowing investors to directly purchase or sell from other investors by placing limit orders, whereby an investor places an order for securities at a desired quantity and price. The ATS then transacts the order upon finding a match, or records the order until a match is found.
Present Discount Value
Interest is paid on money for three reasons: (1) people are impatient and would rather spend money today then wait to spend it tomorrow; (2) inflation can erode the future purchasing power of money; and (3) future investments face the uncertainty of return.
To account for the differential between present value and future value of money, investors must guess what the future return on an investment will be and discount the time value of money.
Thus, PDV = Cash Flow / (1 + Discount Rate)t, where t = the number of years of the investment.
What Risks Matter
Investors face many risks from investment and prefer to hedge those bets by diversifying their investments.
may not want to disclose to help competitors.
Voluntary disclosure can also lead to duplicative research as multiple entities race to research the same security or firm to try to get an edge over the other.
Costs of Mandatory Disclosure
Still, mandatory disclosure is not a panacea. Regulators’ behavioral biases and mistakes may undermine the credibility of the disclosure regime.
Likewise, the problem of agency capture, where the regulators fall under the sway of the market participants, also undermines the credibility of the system.
How Does Disclosure Matter?
Some may wonder how disclosure matters when the vast majority of investors do not read the information that is disclosed. Disclosure serves the market by filtering the information that indirectly reaches investors and by incorporating the information into a corporation’s stock price.
Filtering agents, such as brokers and mutual funds, do the research on behalf of investors and invest on those investors’ behalves.
Problems of agency cost still exist here, however, as “boiler room” brokers can offer unscrupulous deals and fund managers may overcharge for comparatively cheap information.
The Efficient Capital Markets Hypothesis (ECMH)
The ECMH posits that the market price of an actively traded security will reflect all of the market information related to the security.
With weak ECMH, the market price of securities reflects all the information found in past prices for that security. Under such a model, investors cannot safely invest as any information they invest in is random. This fact is because past performance cannot help predict future returns.
With semi-strong ECMH, the stock price reflects all publicly available information. The implication is that investors cannot expect to profit by studying available information because the market has already incorporated the information into the price.
But consider the paradox of efficiency—why would market analysts compete to find out information that the market has already incorporated?
The Court adopted the semi-strong ECMH view through the “fraud-on-the-market” theory in Basic Inc. v. Levinson, see infra Section II.B, at p. 7.
However, behavioral economists have recently derided the ECMH theory, focusing on noise trading and the irrational exuberance of investors. These types of trades lead to market bubbles, which are not accurately priced and do not reflect the information in the market.
With strong ECMH, the stock price reflects all information, regardless of whether it is outside or inside. It is generally agreed that strong ECMH is false because insiders earn systematically higher returns than outsiders.