SECURITIES REGULATION — GADINIS — FALL 2009
I. Introduction
A. What is Securities Liability?
Securities Liability= compromise between caveat emptor and risk of markets.
Companies disclose all relevant information to investors
Investors choose which securities to buy and at what price
Companies are liable only for misstatements/omissions in disclosure, not for poor business decisions
So the question becomes not whether a particular business decision was wise, but whether it was properly disclosed (e.g.: executive bonuses)
Role of securities regulators is to ensure that information is available to investors so that they can make informed decisions
B. Key Statutes
Securities Act of 1933
Transactional focus: offering and sale of securities
Purpose: disclosure to investors through registration and prospectus
Provides public and private remedies
Securities Exchange Act of 1934
SEC (not covered)
Stock exchanges, broker-dealers, SROs (not covered)
Requires continuous disclosure for reporting companies
’33 Act is thus focused on individual transactions, and ’34 Act is focused on continual reporting. Challenge of securities law since then has been to bring these two things together.
C. Market Efficiency
A market is efficient when the prices fully reflect available information
1. Three formulations:
(1) Weak: current prices reflect fully only past stock prices and returns (i.e., backwards looking only). Thus, we cannot make predictions about the future, but only claim that current prices efficiently reflect past performance. The result is that stock prices appear random (a random walk)
(2) Semi-strong: Market prices reflect all publicly available information. The moment that information becomes public it is reflected in price.
(3) Strong: Market prices reflect all information, even private information. While information is not available to all, once someone who has the information acts on it, it effectively becomes public.
Semi-strong approach is the most widely studied, and also the weak one. By 1970s market efficiency was a widely accepted view.
2. Critiques:
(1) Rationality
Investors, both professional and amateur, are not rational
People are influenced by other factors besides available information, including external needs (i.e. need to sell stock to buy a house) or irrational psychological biases (e.g. risk aversion, a tendency to see patterns where none exist)
(2) Noise Traders: Random or Not?
Efficient market argument: Noise traders (i.e. irrational traders) act randomly, and so cancel each other out, leaving the markets in an efficient equilibrium
But, in fact there are systematic patterns among noise traders, both individuals and institutions
(3) Arbitrage:
Efficient market argument: Even when some people act irrationally to inflate or deflate a stock price, arbitrageurs will buy or sell identical or extremely similar stocks which are differently valued (either more or less) to make a profit. This will produce market efficiency overall.
E.g.: short selling: the arbitrageur thinks a stock is going down, so she sells the stock at a high price (without actually having it) for later delivery, and then when the stock price falls she buys the stocks for delivery. The arbitrageur reaps the profit from the difference.
But, there are limits to arbitrage. There is a limited availability of substitutes and risk, especially when an entire market is overvalued.
If everyone believes that the market is going up all the time, the rational investor will buy, and not sell, because there is no way to know when the bubble will burst. Thus arbitrage may not work under these conditions.
Conclusion: Markets are certainly not fully rational, but they are probably rational to some degree. But we don’t know to what degree.
II. What is a Security?
§2(a)(1) of Securities Act:
The term “security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege in any security, certificate of deposit, or group or index of securities,… in general, any interest or instrument commonly known as a “security,”…
§3(a)(10) of Exchange Act:
The term “security” means any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security,… or in general, any interest or instrument commonly known as a “security,”…
but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months…
Statutory Definitions:
§2(a)(1) of Securities Act is very vague
§3(a)(10) of Exchange Act is similarly vague, but includes some more specific exemptions
SCOTUS has interpreted these two definitions along similar lines
Ways in which something not included may be considered a security:
Howey “investment contract” test
Ways in which something included in the list might not be a security:
If their goal is consumption under Forman
A. Definition of a Security: The Howey Test (and Forman)
1. Investment Contracts: SEC v. W.J. Howey (p. 21)
Key issue: What counts as an “investment contract” under §2(1) of Securities Act?
Howey test: An investment contract… means a contract, transaction or scheme whereby
A person invests his money
In a common enterprise
Is led to expect profits (see Forman for discussion of “profits”)
Solely from the efforts of others
Underlying policy rationale: securities laws are designed to protect investors (i.e. owners) who are divorced from control.
Is risk a key element of the definition of a security?
Circuit court thought so
Supreme Court: it is immaterial whether the enterprise is speculative or non-speculative
Unique one-on-one agreements are not securities
cf. Marine Bank v. Weaver (
ey had to get sub-franchisees.
§ These franchisees are therefore more like the buyers in Howey, in that they are merely owners, and do not really participate in the business. This makes them more like investors
o So, the fact that there is a franchise does not automatically mean that it is not a security. It depends on the actual economic arrangements.
Pre-purchase efforts are not securities: SEC v. Life Partners (p. 43)
Terminally ill person is interested in cashing in her life insurance policy at a discount
Life Partners identifies patients, identifies their medical condition, and finds investors and negotiates a price for the purchase of the life insurance policy
After sale, Life Partners only monitors the details of the policies
D.C. Cir.: Because all efforts of Life Partners occur at the pre-purchase stage, the price already reflects them and the sale fails the Howey test, i.e. profits are not dependent on the efforts of others.
This decision was controversial. 11th Cir. declined to follow Life Partners in SEC v. Mutual Benefits: definition of a security should “encompass virtually every instrument that may be sold as an investment.” (SEC v. Edwards)
· Open question: Investment in an operation that guarantees a minimum price. Is this speculative, due to option to make profit on falling price? Or is it not speculative, since there is a guaranteed floor?
o Courts are split on this question.
B. Sale of Business: Landreth Timber v. Landreth (p. 45)
· Q: Should Howey test apply to all possible securities, or only to investment Ks?
o If Howey was applied here, then it would not be a security, because it would not meet the “efforts of others” test. But perhaps the transaction here is still a security, but just of a different sort.
o Thus, Howey test applies only to investment Ks
· Instead of Howey, SCOTUS applies Forman characteristics of what constitutes a stock:
Right to receive dividends contingent upon an profits
Negotiability (i.e. transferability)
Ability to be pledged or hypothecated
Voting rights in proportion to the number of shares owned
Capacity to appreciate in value
· Thus, the sale of a controlling stake in a business is really a stock (regardless of its name), and is therefore covered by the Securities Act. There is no “sale of business” exemption for stock transactions.
· So, Howey was intended only to apply to investment Ks, and is not a general test for what constitutes a security. It is possible (and was the case here) that something that does not meet the Howey test may still meet the Forman test of what constitutes a stock, and will thus be considered a security.
