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Securities Regulation
SUNY Buffalo Law School
Halpern, Phillip



For the economy to function what is necessary?
– Credit: used by businesses to finance inventory (liquidity)
– Mortgage: security interest in the house/ property (note)
– Owner’s Equity = assets – liabilities
o Banks used to keep the note on the left side of the balance sheet as an asset
o Banks need to have a positive spread: must make more lending than cost to sell
o Where did the funds come from?
§ Savings
§ Deposits
o There is a limit on the amount that the bank can led and the banks must maintain a cushion (capital case)
– How can a bank get in trouble?
o Lending to the wrong people and firms can caused a loss in assets
o FDIC will step in (provides insurance for deposits) and also has the ability to close the bank

Securitization: does not really have to do with capital markets (long and short term debt markets)
– Idea to access the capital markets to finance home ownership
– Bank would sell the loan to in the early days Fannie Mae, Freddie Mac, and other investment banks like Goldman Sachs
– Then would bundle them together and slice them up and use the pool of mortgages to create mortgage backed securities/ asset backed securities
– Provided liquidity and leverage to the mortgage markets by replenishing the cash flow for lenders to lend again
o The more that was loaned the more fees that are paid

What caused the mortgage crisis?
– Subprime mortgages
o Worked as long as people were able to sell homes when they were able to pay
o Greater availability to get credit increased demand for homes (credit bubble) based on securitization because more liquidity given to lenders
o Credit bubble created an asset bubble
o Credit crunch started and then people were unable to sell (flippers no longer able to offload houses)—homes became worth less than amount left on mortgage
§ People began to walk away from their mortgages
§ Lenders began to get all the houses back and the market was flooded with homes that unable to sell

33 Actà deals with transactions in the primary securities market
– Initial public offering as an example (IPO)
o Develop a secondary market in the stock once the IPO done and the original owners can cash out on the stock which is now in the public market
o Provides the owners with liquidity and all stock can be turned into cash

34 Actà transactions in the secondary market (securities where investors are selling to other investors)
– If you are a founder of the company you enter in the IPO so that a secondary market will exist

Martin Act: allows NYS attorney general to prosecute for securities crimes

How do we regulate securities?
– Mandate of certain disclosures
– Preserve the fairness and integrity of the markets
o Prevention of fraud
o Actively monitor conflicts of interest
o Prohibit certain acts that are unfair such as insider trading

Why regulate securities?
– Impact of securities on the overall economy
– Crash of 1929 as example
o Caused by another credit bubble where credit was allowed to buy stockà purchasing on the margin
o Broker dealer got the money to loan the customer from the bank
o Margin requirements now exist (Glass-Stiegel Act repealed in 1999)
§ Set different standards for investment and commercial banking
§ Separation of institutions for lending purposes
– Idea that the market can regulate itself ingrained in a theory called the ECMH (efficient capital markets hypothesis)
o Markets are efficient and the only role of the regulators is to ensure the free flow of information
o Should prevent bubbles if people are rational
o Received large amount of criticism recently
– Investors need informationà efficient pricing

What are the attributes of a security?
– Everything has to do with the flow of cash
– Preferred v. common stock
o Preferred dividends first
o If there is a liquidation of the corporation preferred will get paid first over the common stock
o Common stockholders typically are the only shareholders able to vote
– Bonds (debt)àpaid before common and preferred stock upon liquidation
o Different classifications of junior and senior bonds

Securities are concerned with the effect on the overall economy as well as the agency problem
– Stock represents a collection of rightsàright to cash flow, dividends, voting
– Need regulation to level the playing field through the distribution of information
– Relative importance to an investor is much higher than the purchase or sale of some other product (produce, consumer goods, etc)

Electronic Communication Networks (ECN)àstocks not traded in a physical place but through an electronic entity.

What do we want from a secondary market?
– Liquidityà the ability to convert assets into cash cheaply
o Spreadà difference between the bid (what willing to pay) and the ask (what willing to sell for) price for the stock
o The smaller the spread, the liquidity that exists in the market
o Want to buy and sell shares without moving the spread of the market and the price of the stock à if selling do not want to lower the price of the stock
– Transparencyà want to know the price (specifically the best price) of the stock
o Price discoveryà want the securities markets to arrive at an accurate price because provides for a more efficient allocation of capital

Debt is far more risky than equity for creating capital
– If dividends are not paid to equity shareholders, there is no recourse
– If interest payments are not paid to bondholders there is the potential that the company can be thrown into bankruptcy, because they will be insolvent

Discounted Cash flowà the method by which we determine the value of an asset
– Based upon the cash that the asset will throw off in the future and any capital appreciation
– Analyze the likely cash that will likely be created
– When will this take place?
– Then need to take those cash flows and apply a discount rate to determine the present value of the future cash flows
o The higher the risk that, the less we are willing to pay which results in a higher discount rate
– Discount rateà return that we are demanding on our investment
o Determined by comparing to other similar investments

Difference Between risk and uncertainty
– Risk is quantifiable (i.e. actuary tables used by insurance companies)
o Can be limited through diversification

– Fundamentally efficientà the prices reflect the underlying present discounted value of the return investors may expect from purchasing a security
– Informationally

f materiality?
– TSC Industries, Inc, v. Northwayàinformation is material if there is a substantial likelihood that the disclosure would have been viewed by the reasonable investor as having significantly altered the total mix of information made available

Forward looking information
Basic, Inc. v. Levinson (merger case)
– Case required court to apply the materiality requirement of §10(b) of the Securities Exchange Act of 1934 and the SEC rule 10b-5 in the context of preliminary discussions (merger discussions)
– Court assumed that the market was informationally efficient and because of the denials the market was artificially low
– “An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote.
o There must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available
– Role of the materiality requirement is to filter out essentially useless information that a reasonable investor would not consider significant, even as part of a larger mix of factor to consider in making his investment decision
– Determination of materiality requires delicate assessments of the inferences a reasonable shareholder would draw from a given set of facts and the significance of those inferences to him
– There is not valid justification for artificially excluding from the definition of materiality information concerning merger discussions which would otherwise be considered significant to the trading decisions of a reasonable investor, merely because agreement in principle as to price and structure has not been reached by the parties or their representatives.
– Whether merger discussions in any particular case are material therefore depends on their facts
o Need the balance the probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity
§ To access the magnitude of the transaction to the issue of the securities allegedly manipulated, a factfinder will need to consider such facts as the size of the two corporate entities and of the potential premiums over market value.
§ No particular event or factor short of closing the transaction need be either necessary or sufficient by itself to render merger discussions material.

Primary duties to disclose:
1. FilingàUnder the rules and regulations of the SEC must do filings
a. Annual filingà10-K
b. Quarterly filingsà 10-Q
Regulation S-K itemizes all the information that must be provided in a