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Securities Regulation
SUNY Buffalo Law School
Westbrook, Amy Deen

Securities Regulation
Wednesday, June 13, 2007
3:57 PM
1.       History and Basics of Securities Regulations
a.       Pre 1929 Crash
                                        i.            State by State – now call blue sky laws
1.       Varied
2.       Many merit based: what kinds of securities could be offered
3.       Obviously didn’t do so well
b.      Great Depression
                                        i.            People lost faith in the system and were reluctant to put money back in
c.       Feds step in to change things
                                        i.            FDR wants a better system
                                      ii.            Investor protection through information and disclosure
1.       Allows investors to make informed decisions
2.       Brandeis – Other People’s Money –  All you have to do is shine light on what is going on to make an informed decision. Give the investor information in language they can understand, and they will make a decision.
3.       New federal laws were enacted on top of the state Blue Sky laws
a.       1933 Act – Securities Act
b.      1934 Securities Exchange Act
d.      1933 Securities Act: A micromanaging act “Truth in Securities Law”
                                        i.            Makes companies give information
                                      ii.            Prohibits fraud and deceit
1.       Allowed investors to get all the information they needed to make a decision of whether or not to buy, and if the info was wrong then the company would be in big trouble
2.       Accomplished through a registration process
a.       Everybody had to register their securities unless they had an exemption
e.      1934 Securities Exchange Act
                                        i.            Set up the Securities Exchange Commission (SEC)
1.       A whole crew of micro managers so it is not as detailed as the 1933 act
2.       Requires periodic reporting of companies who have already registered their securities
a.       Financial Statements
b.      Big Events
3.       Beefed up fraud provisions
a.       Ex. Insider Trading
4.       Regulated Market Participants – Actors in the Market
f.        Sarbanes Oxley 2002
                                        i.            Amended the 1933 and 1934 Acts
                                      ii.            Added other stand alone regulations
g.       Other Laws
                                        i.            Public Utility Holding Company Act
                                      ii.            Trust Indenture Act 1939: Regulates Debt instruments
                                     iii.            Investment Company Act: Regulates Mutual Funds
                                    iv.            Investment Advisor’s Act: Regulates Advisors
h.      Congress Enacts these laws and then gives authority to an agency to make the will of Congress happens through rules and regulations pursuant to the statute passed by Congress
                                        i.            Ex. SEC
                                      ii.            Agency enforces the rules and regulations with the help of the department of justice
i.         Basics and Vocabulary
                                        i.            Issuer: The company that issues the securities
                                      ii.            Types of Securities
1.       Equity: Gives some ownership in the company
a.       Common Stock: Gets some voting control
b.      Preferred Stock: Can look however the company wants it to look
                                                                                              i.            More contractual in nature
                                                                                            ii.            Can be convertible
                                                                                           iii.            Usually Non Voting
                                                                                          iv.            Investors may want more control
                                                                                            v.            Can look more like common stock sharing in dividends
2.       Debt: An IOU paid back at a fixed rate
a.       Secured get paid first
b.      Unsecured get paid after secured
                                     iii.            Primary Transaction: The first time the securities are issued
1.       The issuer gets the money for the security
                                    iv.            Secondary Transaction: The securities get resold after the primary transaction
1.       This transaction does not involve the issuer
2.       The seller gets the money and the buyer gets the security
j.        Ex. Extreme Company – Pg 1 in Casebook
                                        i.            Common stock trades at $20
                                      ii.            Has a “Buy” analyst recommendation
1.       Millionaire investor is thinking about buying
a.       Liquid and traded on the NYSE: She can sell it if she doesn’t want it anymore
b.      The price may go up, so she might make some money in the short term by reselling
c.       It is 20 years old/not brand new
d.      There is more than one analyst/advisor looking at the company
                                     iii.            Extreme wants more capital to expand into Asia and is going to issue unsecured debt at 15%
1.       If Extreme sells debt instead of equity
a.       Not selling ownership so it will not dilute ownership
b.      Will not create more voters or share holders
c.       There may be a tax difference in issuing debt
2.       The only way that issuing debt makes sense is if he gets a return of more than 15% so he can pay off the debt and get to keep the extra
a.       If he doesn’t make more than 15% it is not good for anyone
b.      Probably a high rate because it is unsecured
3.       How can he reduce the interest rate?
a.       He can secure the debt
b.      Contractual provisions
                                                                                              i.            No dividend payments while the debt is issued
                                                                                            ii.            Cut back on other spending
                                    iv.            Extreme wants to sell lottery tickets
1.       The company will make money, but people may not buy them because they don’t give the buyer a right to anything and isn’t worth the $50 bucks to buy them
2.       Some people will buy them irrationally, this is why the securities regulation works so hard to make information available to investors
3.       Extreme would have to inform investors how useless these lotto tickets are and the minimal chances of winning
k.       More Vocabulary
                                        i.            Liquidity: If there is no liquidity an investor might have to sell for a lower price – Key to the secondary market and also somewhat in the primary market
                                      ii.            Price Transparency: How much a security is being sold for in other trades impacts how much a security will sell for in my trade
                                     iii.            Exchanges: Organized resale markets and are generally Self Regulatory Organizations having their own rules and requirements
1.       If resale is available people will pay more for a security the first time in the primary transaction and in secondary transactions
a.       NYSE: A centralized auction market where people meet in a place and trade their securities
                                                                                              i.            Merged with Euronext
                                                                                            ii.            Traditionally you had to buy a seat to go there and trade
b.      NASDAQ: Decentralized and does not take place in a physical market – Pg 15
c.       Archipelago and Instinet – ECN’s: Electronic trading place
2.       Merging with other or foreign stock exchanges gives more liquidity and transparency drawing more listings and trading volumes, this is advantageous to investors and exchanges
                                    iv.            Public vs. Private shares
1.       Maybe a company wants to sell to pension funds etc… (Not to the public “widows and orphans”)
a.       The buyer may be too big and rich to need all of the protections of the securities laws requiring registration etc. This might result in an exemption
2.       Always remember that the Securities Laws only apply if the item is a security. When the securities laws apply then there are strict guidelines pertaining to:
a.       mandatory Disclosure
b.      Antifraud
c.       gets the SEC involved
d.      Is this a security?   This is never a dumb question since the term is broad and vague at the same time.
                                        i.            Securities have unique problems and characteristics.
1.       they are intangible (sometimes have a certificate)
2.       hard to value (how much will someone buy it for?)
                                      ii.            A major problem is information asymmetry where the person selling the security knows more about it than you do. This asymmetry exists the moment the securities are created. 
                                     iii.            securities are connected with the capital markets so people worry about wrecking the economy which is why they get a lot of attention
                                    iv.            the purchasers are disperse so it is hard to come after the fraudulent issuer. A broader definition of a security would help these people get a remedy.
                                      v.            when people buy securities they do not behave rationally so they may need protection.  
3.       Definition of Security: pg. 1 of Securities Reg. Supp. § 2(a)(1) Categories of Securities
a.       Instruments commonly known as securities (like stocks, bonds)
b.      Instruments specified by the Act to be Securities
                                        i.            Fractional undivided interest in oil, gas or other mineral rights
c.       Broad catch-all phrase “investment contract”
                                        i.            Courts determine whether financial instrument is a security.
4.       Investment Contracts
a.       SEC v. W.J. Howey Co., 328 US 293 (1946) pg. 106
                                        i.            Class Notes: 
1.       Howey Test:   To be considered an investment contract, a contract or transaction scheme must include each of the following:
a.       a person invests his money (Daniel)
b.      in a common enterprise (SG Ltd.)
c.       is led to expect profits (Forman, Edwards)
d.      solely from the efforts of the promoter or third party. (Merchant Capital)
2.       The 1st part of the test is easy to understand if you realize that consideration will vary.
a.       Value
b.      Amount
c.       What else it would have been used for (would it have gone into the public capital markets otherwise?)
d.      Investor Choice – chose to invest or forced to invest. Daniel really discusses this issue.
                                        i.            International Brotherhood of Teamsters v. Daniel, 439 U.S. 551 (1979) pg 111
1.       Rational: Powell: Pension plans are not included in the extensive definition of “securities” in the Acts. Based on this the respondent alleges that the shares in the pension plan constitute an investment contract. Applying the Howey Test, this pension plan does not agree with the definition of an investment contract.
a.       The employee does not make an investment into the fund. (He fails the first part of the Howey Test) In every instance where the Supreme Court found a security to exist an investor chose to give up a specific consideration in return for a separable financial interest with the characteristics of a security. “only in the most abstract sense may it be said that an employee “exchanges” some portion of his labor in return for these possible benefits.” Am employee sells his labor primarily to make a living, not an investment. The method that the employer tracks his contributions is done in a way to measure its o

rally defined stock.
1.       Side Note: To avoid the application of the securities laws the seller could have restructured the sale and sold assets as opposed to stock
2.       Side Note: 10 Years after Forman. Justice Powell’s opinion distinguishes Forman in 4 ways:
a.       Says this “stock” has stock- like characteristics
                                                                                             i.            Negotiability
                                                                                           ii.            Ability to be pledged or hypothecated – like negotiability
                                                                                         iii.            Conferring of voting rights in proportion to the number of shares owned
                                                                                          iv.            The capacity to appreciate in value
b.      Context – Is it being bought ands sold in traditional context? Yes
c.       Investor’s Expectations of protection of securities laws
d.      Congressional Purpose of Disclosure – If you call a stock a stock, you get more disclosure which is good
6.       Note
a.       Characteristics of a Note (Like Debt)
                                        i.            Specified Interest Rate
                                      ii.            Principal Amount
                                     iii.            Term
                                    iv.            No Voting Rights
b.      Reves v. Ernst & Young
                                        i.            OVERVIEW: Petitioners, a class of holders of demand notes issued by a farmers’ cooperative (the co-op), filed suit against respondent accounting firm. 
1.       Demand Notes: Give the investors (people who buy the note) the right to demand repayment of their principal at any time. People like them because they can get out of their investment quickly if they need to.
                                      ii.            Petitioners alleged that respondent (auditor) violated the antifraud provisions of the Securities Exchange Act of 1934 (the Act) by failing to follow generally accepted accounting principles in its audit of the co-op.
                                     iii.            The Supreme Court reversed the judgment of the appellate court, which held that the Act’s antifraud provisions did not apply because the demand notes were not “securities” within the meaning of 15 U.S.C.S. § 78c(a)(10)
1.       Court says: Everybody has a different test to decide whether a note is a note (circuits are split and uncertainty is bad), and a decision needs to be made as to which test to use.
a.       Court wants a rule that is specific but not too specific. Not all notes are investments.
b.      Three tests the court looks at
                                                                                              i.            Investment v. Commercial
                                                                                            ii.            Family Resemblance Test (not that different from Investment v. Commercial)
·         Rule: A note is a security UNLESS it is on the family resemblance list , or it was like things on the list (need rules/standard to determine this).
·         This test may get a different outcome than the Howey test. If it is a “stock” or a “note” look at the applicable test FIRST! Don’t go to the Howey test first!
           Howey Test
                       Using the “family resemblance” approach, the Court concluded the notes were “securities.” The Court considered several factors in making its determination.
     Motivation of the Seller and the Buyer
           The co-op sold the notes to raise capital and purchasers bought them to earn a profit in the form of interest.
     Plan of Distribution
           The co-op offered the notes over an extended period to a broad segment of the public.
     Reasonable Expectation of investing public
           The advertisements characterized the note as “investments.” So the public expected them to be securities.
           Finally, there was no risk-reducing factor to suggest the notes were not securities.
     Presence of an alternative regulatory scheme
                 1933 Act 3(a)(3)
                       The provisions of this title shall not apply to…
     Any note, draft, bull of exchange, or banker’s acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace or any renewal thereof the maturity of which is likewise limited
                       Side Note: This meant to apply to commercial paper, we were reading the case to learn the test
     Materiality – What is material?
           Some information that investors want:
                 Future outlook