Securities Regulation Sachs Fall 2014
I. Introduction
A. Federal Securities Laws
(1) Goals of Securities Laws
· (a) Encourage Full Disclosure
o Who does this protect?
§ Consumers and Investors – more information, better informed decisions
§ Shareholders – the more information, the more control they have over Boards
§ Non-investors – if less information, investors lose confidence, stop investing and market suffers
o Effects?
§ Affects Substantive Behavior – “if you have to undress in public, you watch your weight”
§ Increases Market Efficiency – investors have the information to allocate to company that will use best
o Disclosure Requirement Result In:
§ All companies providing information (not just those who would anyway) and in a timely manner
§ Uniformity of disclosures, which makes it easier for investors to compare investments (efficiency)
§ Decrease of favoritism to insiders
· (b) Deter and Prevent Fraud
o Effects?
§ Adds credibility to disclosures – companies are subject to enforcement actions by the SEC and DOJ
§ Enhances investor confidence – there is knowledge that errors will result in penalties
§ Ensures accuracy of disclosures – laws have teeth
o Why the need for national fraud laws?
§ Uniformity of enforcement – some states had hyper technical fraud laws
§ Mechanism of National Service of Process – No International Shoe in 1933
(2) Sources of Federal Securities Law
· (a) Securities Exchange Act of 1934
o Regulates secondary market transactions and the professionals that facilitate such transactions
§ Primary Protections are Disclosure Requirements:
ú Annual Reports – 10-K
ú Quarterly Reports – 10-Q
ú Major Event Disclosures – 8-K
§ Anti-Fraud Protections – Rule 10b-5
· (b) Securities Act of 1933
o Regulates primary market transactions
§ (1) Mandatory Disclosure Documents – Registration Statement and Prospectus
§ (2) Gun Jumping Rules – ensure prospectus is widely distributed and received before other information
§ (3) Anti-Fraud Liability – material misstatement sin public offering documents
o Exempts some offerings
· (c) Other Later Acts
o Sarbanes-Oxley
o Dodd-Frank
o JOBS Act
· (d) Other Sources of Regulation
o SEC Rules – SEC authorized by Congress to adopt supplemental rules
o SEC Interpretive Releases – practical force of law (but not technically)
o No-Action Letters – Issued by the SEC
§ Limited to the specific facts of the case at hand
(3) Efficient Capital Markets Hypothesis
· (a) Hypothesis
o The securities market price of an actively traded security will incorporate information related to the security
· (b) Versions:
o (i) Weak:
§ The current market price of a security reflects the information found in all past prices for that security
ú If true, investors cannot earn greater than normal returns by trading on a security’s past price patterns
ú Past information is cheap and widely available
o (ii) Semi-Strong:
§ The stock market price of an actively traded company’s stock will reflect all relevant publically available information
ú Information is acquired so quickly that no one can systematically beat the market
ú Requires:
· Company that is publically traded
· On an efficient market
o Need institutional investors that make big enough trades that the market will notice
o Must not be any fraud-on-the-market that renders market inefficient
§ Paradox
ú If all investors were convinced that the market was completely efficient, there would be no incentive to invest
ú Theory is that some investors can capture information that the market has not incorporated that will allow them to profit
o (iii) Strong Form:
§ The stock market price of a company incorporates all information, whether public or private
ú Not believed to be accurate; would be no need to regulate securities trading; no insiders
· (c) An efficient market requires the following:
o (i) Informationally Efficient
§ When new information comes down the pipe, the market incorporates it
§ Might attach too much importance or too little (and over/under react)
ú But will still be incorporated into the market prices
o (ii) Functionally Efficient
§ Suggests that there is a totally rational behavior by the market
ú All price differences can be explained
· (d) ECMH upheld by Halliburton II
o “…[defendant] has not identified the fundamental shift in economic theory that would justify overruling precedent on the theory that it is misunderstood or overtaken by economic realities.”
II. Definition of a Security
A. Background
· In order for the Securities Laws to apply, the threshold question is whether there is a security
· Definitions:
o § 2(a)(1) “Security”
§ Note, stock, treasury stock, security future, security-based swap, bond, debenture, … etc.
§ “Unless the context otherwise requires”
ú The context may be interpreted differently from case to case
o Less clear are investment contracts and instruments commonly known as a security
§ This is the Act’s “catch-all” provision
B. Investment Contracts
· There is no such thing as an investment contract in the commercial world – judicial term of art
o When it is not a classic stock, run through the Howey analysis
o EX: interest in a profit sharing relationship, Co-op
· If you are aware that what you are offering is an investment contract, and thus a security, you should:
o Register the offering; OR
o Find an Exemption from registration
§ (however, this only applies to registration, will not be exempt from fraud provisions)
(1) Test for an Investment Contract
· (a) Howey (p. 102) – Citrus grove owner sold tracks of land in grove which were then leased back to his service company under service contracts. Service company would tend the grove for a fee plus the cost of labor and materials. Land investments were marketed through hotel that Howey owned in area. Did not file with SEC. Found to be in violation of §5 as these were investment Ks.
o RULE: Investment contract exists where there is an investment of money due to an expectation of profits arising from a common enterprise which depends solely on the efforts of a promoter or third party.
· (b) Taken separately, the warranty deed to the land and the service contract would not be a security; however, when combined, this constitutes and investment contract and must be registered or qualify for an exemption from registration
o Does not matter than some investors did not accept the service contract – Act prohibits the offering of a security
(2) “A Person Invests His Money”
· Daniel (p. 107) – compulsory, noncontributory pension plan for truck drivers did not constitute a security, thus no 10b-5 action
o The employee did not have a choice to contribute to the plan; paid f
ve to argue
· How long did you live there? Less time might indicate goal was to make money
ú Real estate can be a security: see p. 126
· (b) Edwards (p. 127) – pay-phone sale leaseback program; found to be a security
o Fixed Rate of Return does not preclude the finding that something is an investment contract
§ There is no appreciation requirement in the expectation of profits prong
(5) “Solely From the Efforts of the Promoter or a Third Party”
· (a) Solely simply requires that the efforts of others be those that are managerial and entrepreneurial (Forman)
o If the promoters efforts are merely ministerial or administrative, cuts against being an investment contact
§ See Life Partners ruled that because the investment depends solely on the mortality of the insured, there are little post-purchase managerial or entrepreneurial efforts
· (b) Mutual Benefits Corp. (p. 143) – viatical settlement provider (sale of life insurance benefits by terminally ill); security
o However, here court held that managerial efforts made prior to the investment contract are not excluded from Howey analysis; significant efforts are needed pre-purchase requiring the expertise of the promoter in selecting and negotiating the price of an asset
§ Key to this inquiry is the expertise of the promoter; if information is needed to evaluate the expertise of the promoter, it will likely be deemed to require securities law protections
C. Stock
(1) Traditional Stock is a security
· (a) No need for Howey Test
o However, form (naming something a stock) is insufficient (See Forman)
· (b) Qualities of a Traditional Stock:
o (i) Right to receive dividends contingent upon an apportionment of profits
o (ii) Negotiability
o (iii) The ability to be pledged or hypothecated
o (iv) Conferring of voting rights in proportion to the number of shares owned
o (v) Capacity to appreciate in value
(2) Sale of Corporation
· Landreth (p. 148) – Lumber mills sold through stock sale; held to be traditional stock and thus a security.
o D’s argue this was not security, and didn’t have to register, b/c fail Howey test.
o Court holds that if you’re selling stock, and the stock looks like actual stock then no Howey test
§ These are just securities outright – look to the qualities of a stock
ú This not like the shares in Forman which weren’t really stock
§ However, a sale of assets is NOT a security – but be careful how it is structured
o In doing so, Court rejects the Sale of Business Doctrine
§ When you sell stock in a business, you are not selling a protected security
ú There is no dependence relationship (now your business)
ú Opportunity to bargain, and is in control at the end of the day
§ Can’t contract around Securities Laws
