SECURITIES REGULATION
PROFESSOR PRITCHARD – FALL 2010
Chapter 1: Introduction to Securities Markets
I. The Basics
Origins and Purposes of Federal Securities Law: 1930s Great Depression.
§ Primary goal to protect investors considering putting capital into the country’s financial markets from abuses by company insiders and m arket professionals.
– Perception that the common law was ill-equipped to stop insider trading, thus Congress/FDR wanted to pass some legislation (’33 Act and ’34 Act)
§ Secondary goal to discourage speculative frenzies among investors
Categories of Securities Transactions:
§ “Primary” transaction: a company (the issuer) offers and sells its own securities to investors
§ “Secondary” transaction: one investor resells securities of the issuer to another investor
Statutes:
§ Securities Act of 1933: focuses on primary transactions by an issuing company selling securities to investors
o Drafted in 3 days by Justice Frankfurter and others
o Registration statement must be filed with FTC (now SEC)
o Mandates the dissemination of a disclosure document called the prospectus
o Created a complex liability scheme for misinformation in the registration statement, prospectus, or during distribution of new securities to public investors
§ Securities Exchange Act of 1934: deals with secondary transactions between investors, and regulates market intermediaries including broker-dealers and securities exchanges;
o Established the SEC (§4)
o Regulation of the securities industry, namely, the stock exchanges (§6) and securities firms (§15)
o Requirement of periodic disclosure by public companies (§§12, 13)
o Regulation of proxy voting by shareholders in public companies (§14)
o Regulation of insider trading (§16)
II. Types of Securities
Typical Characteristics of the Three Basic Types of Securities
Type of Security
Cash Flow Rights
Liquidation Rights
Voting Rights
Common
Residual and discretionary dividend
Residual
Yes
Preferred
Fixed and discretionary dividend
Medium
Contingent (e.g., if dividend not paid for certain number of quarters)
Debt
Fixed and certain interest payment
Highest
None
A. Common Stock
Equity stake in a company with voting power
B. Preferred Stock
Used primarily in two situations: relatively new startup companies issue it to outside investors providing capital; or by older, more established companies needing an infusion of cash (e.g. as Buffet provides).
Participating preferred allows holders the right to residual distributions as if they held an equivalent number of common shares, but still entitled to preference over common shareholders in getting investment back upon liquidation
Preferred stockholders have no protection from directors fiduciary duty but instead must look to their contract to protect their rights
Assorted possible contractual provisions: e.g., conversion rights that allow preferred stock to become a specified number of common shares.
C. Bonds
Zero coupon bonds – no interest but sold at discount; give issuers more financial flexibility
Absolute priority rule exception under federal bankruptcy: allows equity to be paid even if debt not fully paid, if company has few assets left to distribute. Protection against this through negotiated bond covenants (contractual provisions), e.g. restrictions on dividend payments, sale of specific assets, or exceeding a specified debt-equity ratio.
III. Why Do we need information on securities?
Securities are intangible and endemic (broad based, affecting a lot of people)
IV. The Capital Market
A. Primary Market Transactions
Underwriters – take the financial risk that the offering will not sell to investors, usually provided by investment banks, or a syndicate of investment banks; compensation for them is the “spread” (difference between the discounted price they pay the issuer and the price paid by the investing public)
Attorneys – take the lead role in drafting disclosures to be filed with the SEC
Accounting firms – audited financial statements ensure that historical information is accurate, which helps determine the value of the investment
Institutional investors – e.g. mutual funds, pension funds, and insurance companies; dominant force in today’s securities markets; sophisticated investors arguably requiring less protection, but also may cut “sweetheart” deals with issuers or underwriters
1. Types
a. Private placements
b. Initial public offering (greatest regulation)
c. Subsequent public offierings (Less regulation, bc information already exists)
d. Other offerings
B. Secondary Market Transactions
1. Traditional Securities Exchanges.
NYSE : $16.9 trillion total listedmarketvaluation (aka an Exchange Market)
E.g., inside the U.S., NYSE, AMEX, Boston S.E., Pacific S.E., Philadelphia S.E.
E.g., outside the U.S., London S.E., the Deutsche Bourse, Tokyo S.E.
Floor brokers may execute trades with other brokers on the floor seeking the opposite transaction
The specialist for a particular stock plays a central role in maintaining liquidity for that stock
2. The NASDAQ Market, $4.1 trillion total listed market valuation. (aka Over the Counter—OTC—markets)
Actually three markets: Global Select, Global, and Capital
Market makers hold themselves out as continuously willing to purchase shares at bid price and sell shares at the ask price (and they make money on the bid-ask spread)
3. Electronic Communication Networks (E.g., Archipelago, now owned by NYSE; Brut, now owned by Nasdaq); PTSs –
C. Go Betweens
1. Broker-Dealers broker investments between issuers and investors (primary market transactions) or between investors (secondary market transactions)
2. E.g. investment banks and securities analysts
V. Investment Decisions
A. Present Discount Valuation
1. Interest
o Risk to our ability to consume posed by death (deferred consumption)
o Inflation may erode purchasing power of cash
o Uncertainty of actually receiving the payment in the future
2. Present Value
B. What Risks Matter
– Diversification can help reduce “unsystemic risk” (e.g. rain/shine for ice cream shop/ umbrella stand)
o Capital Asset Pricing Model: R = R(f) + beta(R(m) – R(f)), where R(f) = Risk-free rate and R(m) = Entire stock market rate
o Low beta is lower volatility, and higher beta indicates greater systemic risk
§ Investor Information Exercise (CE
ry Organizations (SROs)
1. E.G. NASD, NYSE
2. Exchanges have incentives to increase number of traders on their exchanges, thus they must make investors believe it is safe to invest
3. SROs are supervised by the SEC as well
D. Investors as regulators
1. Permitted to bring private causes of action
Chapter 2: Materiality
I. What Matters to Investors?
Materiality – 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.” TSC Industries, Inc. v. Northway (1976). (in the proxy-solicitation context)
Issues:
§ Who is the reasonable investor?
§ What is considered significant?
§ What constitutes the total mix of information? (Means, for one thing, that this is a fact specific inquiry.)
II. Forward-looking Information
Basic Inc. v. Levinson (1988) (Blackmun) (adopting the TSC Industries in the §10(b) and Rule 10b-5 context; establishing fact-intensive probability-magnitude approach to balance indicated probability of the event and the anticipated magnitude of the event in the totality of company activity)
§ Facts: Combustion had interest in acquiring Basic from about 1965 (first appeared in 1976 strategic plan), but in 1977 and 1978, Basic made 3 public statements denying it was engaged in merger negotiations. In Dec. 1978, trading was suspended, Basic endorsed and approved Combustion’s offer.
§ Procedure: sued by former Basic shareholders who sold stock after Basic’s first public denial and before the suspension of trading.
– District Court granted summary judgment for defendants because negotiations not “destined, with reasonable certainty, to become merger agreement.”
– Sixth Circuit reversed and remanded calling the statements misleading, holding that “once a statement is made denying the existence of any discussions, even discussions that might not have been material in absence of the denial are material because they make the statement made untrue.”
§ Holding:
– Adopted neither the Sixth Circuit’s reasoning nor a Third Circuit test that decided merger discussions would be material only when “agreement in principle” as to the price and structure of the transaction.
– “a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.” SEC v. Texas Gulf Sulphur Co., SEC v. Geon Industries (2d Cir. 1976) (Friendly).
o Ex-post reasoning concern – who knows the magnitude of the event ex ante?
o Counter to the business judgment rule (but here is against the backdrop of congressional policy of disclosure)
§ What constitutes a reasonable investor?
§ Safe Harbors for forward-looking information: SA Rule 175 and EA Rule 3b-6
Statements must be made “with reaso
