SECURITIES REGULATION McCLANE
Investors and Information
What Makes Securities Different from Other Commodities:
intangible, informational problems – provide value to stockholders by conferring intangible rights to company cash flow
value of intangible rights (i.e. expected return) turns on inside information – so outsiders are at an informational disadvantage
similar preferences – purchasers’ preferences regarding securities are more similar than those for goods or services (all investors want returns)
means that all investors want relatively homogenous info (return, risk)
collective action problem – all investors would benefit from having the info but no single investor would receive the full benefit of that info
so no single investor would perform the research/diligence in obtaining the info
the necessary collective action can only be achieved if companies are induced to provide investors with the info they need
lead to irrational behavior – potential for people to put their entire life savings in, irrational greed
is this something regulators should watch out for?
centrality – capital market determines where as a society funding goes
raised as a reason to justify more stringent regulations, to make sure prices in the market place is an accurate signal of the value of the business
How Do People Value Investments?:
technical analysis – observe patterns in stock prices to gain a sense of what will happen in the future
fundamental analysis – value + risk
PDV (today’s value) = expected payment/(1 + r)x
r = discount rate; x = # of periods
why is a dollar today worth more than a dollar in the future?
people are impatient – esp. b/c we only live for so long
most currencies suffer from inflation – erodes the currencies real purchasing power
not all promises are kept
What Information Would Investors Want to Know if Purchasing Stock:
(1) properties and lines of business, (2) expected growth rate in its businesses, (3) management plans for capital expenditures and other expenses, (4) past financial performance, (5) existing capital stock and investor base, (6) regulatory environment, (7) competitors and competitive environment, (8) management and directors, (9) executive compensation
Types of Securities
common stock
have voting rights
owed a fiduciary duty by directors and officers of the corporation
no fixed monetary claim on the corp’s cash flows – residual and discretionary
weakest claim on corporate assets in liquidation
preferred stock
issued in 2 situations:
new startups issuing to outside investors providing capital (esp. venture capital firms)
older, more established companies that need an infusion of cash
contingent voting rights if dividend is not paid for a certain # of quarters
fixed and discretionary dividend
medium liquidation rights – often receive cumulated, unpaid dividends + a contracted-for share of any remaining assets before common stockholders receive any payment in liquidation
bonds – loan by investors to the corporation
notes – shorter-term debt of a maturity period < 10 years
indentures – longer-term bonds
have a fixed term and the principal invested is repaid at a specified maturity date – pay periodic interest or could be a zero coupon bond
greater financial security for investors than equity investments – hold priority in case of liquidation
options
2 principle varieties:
call options – K right to buy a security, typically common stock, at a certain price for a specified period of time
put options – corresponding K right to sell a security
Securities Market Transactions
primary markets
issuer offers and sells own securities to investors, taking proceeds into its funds
IPOs
secondary markets
one investor resells securities of the issuer to another investor - the issuer does not participate in the transaction and no money goes to issuer
organized marketplace provides liquidity (buyers/sellers can quickly locate counterparties) and price transparency
Traditional Securities Exchanges
NYSE, American SE (AMEX), Boston SE, Pacific SE, Philadelphia SE, London SE, Tokyo SE
characterized by the presence of a physical trading floor
NASDAQ
no physical trading floor, consists of a network of interlinked computers connecting a multitude of securities dealers to one another
Federal Securities Laws
Securities Act of 1933
regulates primary market transactions
Securities Exchange Act of 1934
primarily regulates secondary market transactions and the market professionals and institutions that facilitate such transactions
protects investors thru disclosures, antifraud liability, ant-manipulation provisions, proxy solicitations
Disclosures
disclosures matter under the semi-strong ECMH
all information, both public and private, including disclosures, become incorporated into the market price
allowing investors to fend for themselves to determine inside info has 3 weaknesses
costly – more costly for investors to discover inside info than for company to disclose it
self-interest – investors will only focus on their own interests, will not distribute the info to others
duplicative costs – investors who do pursue research may duplicate another’s research
issuers have an incentive to give voluntary disclosures
investors will discount the price of issuers’ securities if issuers fail to disclose the info investors need to ascertain the investment’s risk and return
but companies still may not willingly disclose the info that i
is material, pick income – if D, want to say something is immaterial, pick revenue
even a small % could be significant
consider an opposite rule of thumb: large magnitude items are presumptively material – e.g. > 20% of a company’s revenues is presumptively material
SEC Staff Accounting Bulletin No. 99
SEC cautions against exclusive reliance on rules of thumb
qualitative factors that may rise to the level of materiality:
if the misstatement masks a change in earnings or other trends
if the misstatement hides a failure to meet analysts’ consensus expectations for the enterprise
if the misstatement has the effect of increasing management’s compensation (for ex. by satisfying requirements for the award of bonuses or other forms of incentive compensation)
if the misstatement involves concealment of an unlawful transaction
market response (event studies)
for freely tradable stock, look at market reaction to public release of info
a significant response in the stock-market price can be seen as evidence that the market considered the info material
decision-maker is the investors, rather than a formula and therefore, tracks what a reasonable investor does more accurately
but there are lots of decisions that need to be made by a judge to apply an event study – and there is underlying assumption that the markets is efficient
but Q of what period to look at – when did the market first learn about the truth?
judge needs to decide this
date of disclosure = when all the pieces are out there such that the analysts can figure it out themselves (Merck)
In re Merck & Co. (3d Cir. 2005)
Merck discloses that it books co-payments to pharmacies as revenue on form S-1 on 4/17 but does not disclose magnitude
WSJ article reveals magnitude on 6/21 – stock price drops
when did the truth first come out?
Court says it first came out w/Form S-1, WSJ reporter did the calculations but the pieces were all available in the Form S-1 and that represents the date of disclosure
but how many calculations are too many to not count as disclosure, how detailed does disclosure need to be to count
other factors that may undermine the probative value of stock price reaction:
confounding events
info leakage
