Select Page

Securities Regulation
Rutgers University, Newark School of Law
Garten, Helen A.

SECURITIES REGULATION – SPRING 2011 (GARTEN)
 
1: Background (Chapter 1)
1)     Policy Considerations
a)       Purpose of Sec Reg?
i.         Informing investors (PRIMARY PURPOSE)
·         Information asymmetry: want to make sure insiders/big banks aren’t keep all info for themselves.
·         Collective action: hard to get bunch of investors together to demand what they all want.
·         Good for company to have as much info out as possible (avoid suspicious discounting by investors)
·         Efficient Market Hypothesis: more info → price more accurately reflects value of stock.
¨        Affects the allocation of capital → facilitates economic growth
ii.        Why not disclose everything?
·         Very expensive. Will cause companies to go public to avoid onerous disclosure costs.
·         Some things shouldn’t be disclosed (e.g., trade secrets).
·         Investors will drown in too much information
iii.      Benefits of mandatory disclosure
·         Standardizes method of disclosure
·         Reduces duplicative research (by analysts)
·         Reduces costs b/c companies are repeat players
iv.      Class Actions – primarily concerned about frivolous/vexatious suits
·         Companies have strong incentives to settle before discovery – very, very few suits are actually litigated
·         Agency problem: who are the attorney’s really after?
·         Is it circular? Are SHs filing suits just to end up ultimately paying for the settlement indirectly?
¨        WRT current company, this depends on whether SH’s retain shares after suing. But can also be the case that over the long run SHs end up paying out for a lot of vexatious suits.
b)       Assumptions about investors reflected by policies
i.         Something about investments makes people act irrationally.
·         Is there a difference between institutional investors and Joe the retiree from Iowa?
ii.        Investments tend to be relatively important to people (contrast to  candy bars)
iii.      Intangible investments harder for individuals to value on their own
c)        How to deal with capital markets
i.         Self-help: investors just buy more if happy, don’t if not.
·         Reputation matters. But this is not infallible: e.g., Arthur Anderson helped ENRON despite reputational cost.
ii.        Self-regulation: e.g., NYSE
iii.      Private regulation – IBs review. Favors companies w/more money, and IBs don’t necessarily have aligned interests w/investors.
iv.      Mandatory disclosure:
·         Cheap for large companies but expensive for small ones.
·         Gun jumping rules are supposed to encourage investors to read prospectuses.
v.        Process rules: e.g., gun jumping rules
·         Paternalistic – raises question about how we think investors act (in the heat of the moment, or calculatedly)
vi.      Merit regulation – licensing: only licensed goods/securities may be sold.
·         Paternalistic – raises question about how we think investors act (in the heat of the moment, or calculatedly)
·         Problem: what criteria do we use?
2)       Introduction to Sec Reg
a)        Basics: Congress enacted securities laws to protect investors in 1930s.
i.         Two acts:
·         Securities Act of 1933: primary transactions (issuer offers to investors)
¨        Requires issuers to file mandatory disclosures that include important info when making public offering.
¨        Gun-jumping rules (procedural)
¨        Heightened antifraud liability (above and beyond common law)
·         Exchange Act of 1934: secondary transactions (investor sells to other investors; also, regulated intermediaries (e.g., BD’s)).
¨        Requires disclosure
¨        Provides antifraud liability the most powerful of which is 10b-5.
¨        Anti-manipulation provision
ii.        Three pillars of Sec Reg: (1) disclosure, (2) antifraud liab (greater scope than common law fraud), (3) gun-jumping rules governing public offering process.
b)       Types of securities
i.         Common Stock: residual and discretionary dividend; residual liquidation rights; (usually) voting rights.
ii.        Preferred Stock: fixed and discretionary dividends that accrue in unpaid; medium liquidation rights; contingent voting rights if dividends in arrears.
iii.      Debt: fixed and certain interest pmt; highest liquidation rights; no voting rights.
c)        Valuation:
i.         Two types of analysis: (1) Technical (i.e., magical chart reading); (2) Fundamental (discounted cash flows).
ii.        Two types of risk: (1) systemic (BETA); (2) diversifiable
2: Materiality (Chapter 2)
1)       What Matters To Investors
a)        Materiality is an element in several key provisions
i.         SEA Rule 10b-5: it shall be unlawful for any person…(b) To make any untrue statement a material fact or to omit to state a material fact necessary in order to make the statements made, in the light the circumstances under which they were made, not misleading… In connection with the purchase or sale of any security.
ii.        SA Rule 408 and SEA Rule 12b-20: in addition to the information expressly required to be included in a statement or report, there shall be added such further material information, if any, as may be necessary to make the required statements, in the light of the circumstances under which they are made, not misleading.
iii.      Item 101(a) of Regulation S-K: describe the general development of the business of the registrant…during the past five years…. Information shall be disclosed for earlier periods if material to an understanding of the general development of the business.
b)       Division between affirmative misstatements and omissions:
i.         Affirmative misstatements → materiality is threshold concept.
ii.        Omissions → materiality is necessary, but so too is DUTY TO DISCLOSE
·         “no comment” vs. lying? Big difference. No comment doesn’t taint other disclosures, but lies do.
2)       The Materiality Standard
a)       Overriding concern: certainty. If materiality standard is too uncertain, it will limit voluntary disclosure, harming
b)       Possible approaches:
i.         “I know it when I see it” (not easy to figure out ex ante)
ii.        Probability*magnitude (pretty tough to figure out either of these things ex ante or ex post)
iii.      Rule of thumb (e.g., 5% of revenue; gives predictable rule, but may be too arbitrary)
iv.      Stock price change (more objective than “I know it when I see it,” but still leaves a lot up to the judge and experts).
c)        TSC materiality standard [1976]: information is material if there is a (1) substantial likelihood that the disclosure…would have been viewed by the (2) reasonable investor as having (3) significantly altered the (4) total mix of information made available.
i.         Prompts questions: who is a reasonable investor? What information would he deem significant? What constitutes the total mix of info?
d)       Forward looking information: [Probability x Magnitude] i.         Basic v. Levinson [seminal SCOTUS case][1988]: while Basic was in talks w/potential acquirer, it several times denied that it was engaged in merger negotiations. Eventually, though, the merger went through. Π class comprised those who sold Basic stock after the first denial and before the merger was officially announced.  Π alleged SEA Rule 10b-5 violation. At issue was materiality.
·         6th Cir: no duty to disclose, but once you make an affirmative statement, you’re liable (regardless of materiality) if it is so incomplete as to be misleading. [SCOTUS REJECTS] ·         3rd Cir: special rule for mergers. Statements about merger not material until you’ve reached an “agreement in principle.” [SCOTUS REJECTS: we shouldn’t attribute to investors a “child like simplicity”—they’re more than capable of dealing with disclosed uncertainty] ·         SCOTUS: adopts TSC in 10b-5 context. Announces materiality standard in merger context that depends on probability that event will occur * magnitude of event in light of company activity.
¨        IMPORTANTLY: no actual threshold announced. Rule of thumb is 5%, but is this really just “I know it when I see it”?
e)        Historical facts: [Probability = 1 → test = Magnitude] i.         Bright line approach (adopted by some) → if misstatement < rule of thumb, not material. Some circuits use this std. ·         Notice that could be less objectionable if just use as a s

“Security” → federal securities regime applies (disclosure, filings, antifraud provisions, gun jumping rules, SEC enforcement, federal consequences (including nationwide service of process)). Otherwise it doesn’t.
b)       Why should some things be securities and others not?
i.         Intangibility?
ii.        High stakes
iii.      Investor irrationality
iv.      Homogeneity of information disclosure → efficiency of scale
v.        Maybe there are other regimes that we need to make sure the securities regime doesn’t conflict with.
c)        What is the law and does the legal doctrine match our intuition?
2)       Definition
a)        §2(a)(1) of securities act of ’33:  UNLESS THE CONTEXT OTHERWISE REQUIRES, the term security means…
·         Instruments commonly known as securities (e.g., stocks, bonds, options)
·         Instruments specified by act to be securities (e.g., fractional undivided interest in oil, gas, or other mineral rights)
·         Broad, catch-all phrase “investment contract”: courts determine whether financial instrument is an investment contract and therefore fits within the definition of security.
ii.        “Unless the context otherwise requires” = safety valve.
b)       §3(a)(10) of exchange act of ’34 is more or less the same.
c)        What are Investment Contracts?
i.         Policy: here we talk about a lot things that don’t look like traditional securities. Why? If we did not have the investment K catchall, companies seeking to evade the regulatory regime would enter into arrangements whose form varied from that of a security but whose function remained the same (e.g., divide factory into strips and sell interests that are accompanied by mandatory service K’s)
ii.        Howey Test [CONJUNCTIVE]:
·         (1) Investment of money in a
·         (2) common enterprise, where there is an
·         (3) expectation of profits* to be derived
¨        After SEC v. Edwards, many courts collapse into investment element
·         (4) purely through the efforts of others
iii.      W.J. Howey Co. [Seminal SCOTUS case]: company owns tracts of citrus groves. Offers prospective customers a sales K for a tract of land and a service K.  85% of customers take the service K b/c company says it’s superior AND has economy of scale advantage over competitors who would service grove. Service K specifies that customer CANNOT enter land w/out consent of company. Purchasers are predominantly business and professional people who lack agricultural experience. Issue is whether this arrangement = “investment contract” under §2(a)(1) of the securities act of ’33; if so, would be liable for failing to met registration req’s under §5(a).
·         Court considers substance over form. Rejects COA argument that no investment K exists where there is no speculative or promotional element.
·         Finds that customers are interested in investment not acquisition of land, that transfer of rights is purely incidental to the arrangement.
·         Enumerates Howey test
¨        (1) Investment of money in a – [CHECK] ¨        (2) common enterprise, where there is an  – [CHECK] ¨        (3) expectation of profits to be derived – [CHECK] ¨        (4) purely through the efforts of others  – [Here it’s important that mere offer of service K is  enough, b/c the character of the arrangement ensured that the majority of customers would opt in]