Select Page

Securities Regulation
University of North Carolina School of Law
Hazen, Thomas Lee

Introduction to Securities Regulation

Professor Hazen

Spring 2017

UNC Law

Regulatory System

Securities transactions are subject to both federal and state law

Federal securities laws apply to transactions that use mails or facilities of interstate commerce—broadly defined, interstate phone call suffices.

National Securities Markets Improvement Act of 1996:

Federal securities laws were amended to preempt state regulation of certain classes of securities and transactions
Old regime – concurrent state and federal regulation,
New regime – narrowed state law via preemptions in many areas of securities regulation, including:

Registration and reporting requirements
State regulation of broker-dealers and investment advisers

Blue Sky laws – state laws regulating transactions in securities.

Most contain one or more of three provisions:

Prohibitions against fraud in the sale of securities;
Requirements for registration of brokers and dealers; and
Requirements for registration of securities to be sold in the state.

Uniform Securities Act

4 major parts:

Antifraud provisions;
Broker-dealer registration provisions;
Security registration provisions; and
Definitions, exemptions, and administrative and liability provisions.

Most states have adopted most or some of the provisions.

6 Major Statutes of Federal Securities Law:

Securities Act of 1933
Securities Exchange Act of 1934
Trust Indenture Act of 1939
Investment Company Act of 1940
Investment Advisers Act of 1940
Securities Investor Protection Act of 1970

All securities rules are codified in 17 CFR
Securities Act of 1933

Regulates public offerings of securities

Requires registration of a transaction, but once they are public 1933 no longer applies

Disclosure approach to regulation (Brandeis: “Sunlight is the best disinfectant”)
§ 2: defines terms in the act
§ 3&4: exempt various kinds of securities and transactions from its registration requirements
§ 5: prohibits offers and sales of securities, which are not registered with the SEC.
§ 6 & 8: specify the procedure for registration
§ 7, 10 & Schedule A: prescribe the contents of the registration statement and prospectus
§ 11 & 12: specify civil liabilities for false or misleading statements
§ 17 prohibits fraudulent or deceptive practices in the sale of securities
§ 27 & 27A: restrictions on class action litigation under the Act, created a safe harbor for projections and other forward-looking statements.

Securities Exchange Act of 1934

Extended federal regulation to trading in securities which are already issued and outstanding
§ 4: established the SEC, transferred responsibility for administering the 1933 Act by Title II.
§ 12, 13, 14 & 16: impose disclosure and other requirements on publicly traded companies.

Disclosure every quarter (10Q) and year (10k)

§ 12: issuers of class of stock trading on a national securities exchange must register w/ SEC.

§12(a) traded on a national exchange = must register & follow reporting requirements
§12(g) companies with total assets >$10M and a class of equity securities ≥ 500 shareholders must register w/ SEC

§ 13: periodic filing w/ SEC for companies registered under §12
§ 14: regulates the solicitation of proxies from holders of such securities
§ 16: officers, directors and 10% owners must report purchases & sales, must disgorge short swing profits.
§ 9 & 10 prohibit various kinds of manipulative or deceptive devices or contrivances.
Also regulates broker-dealer industries, broker-dealers must register, transfer agents, rating agencies, etc.

Trust Indenture Act of 1939

Applies generally to public issues of debt securities in excess of $1M.
Such issues are registered under the 1933 Act, but must also qualify under this Act, which imposes standards of independence and responsibility on the indenture trustee and requires other provisions for the protection of the security holders.
Statute not limited to disclosure, regulates the merits as well

Investment Company Act of 1940

Gives the SEC regulatory authority over publicly-owned companies which are engaged primarily in the business of investing and trading in securities.
Regulates the composition of the management of investment companies, their capital structure, approval of their advisory contracts and changes in investment policy, and requires SEC approval for any transactions by such companies.
1970 amendments impose additional controls on management compensation and sales charges.

Investment Advisers Act of 1940

Amended in 1960
Established a scheme of registration and regulation of investment advisers comparable to §15 of the 1934 Act with respect to brokers
1996 Amendments preempt state regulation of investment advisers with > $25M of assets under management, exempts from the Act advisers <$25M under management that are regulated by their home states.
Broker-dealers and bankers are exempt from this act! But broker-dealer exemption is being reigned in by SEC

Securities Investor Protection Act of 1970

Passed after the industry urged Congress following the failure of a number of large securities firms in the financial crisis of 1969-70.

Crisis created the risk of massive defaults on obligations to customers, leading to a loss of public confidence in securities firms.

Created a non-profit membership corporation – Securities Investor Protection Corporation (SIPC) – every broker-dealer must belong to.
SIPC has a 7-director board, chosen by the Feds from different segments of the industry.
Funded by assessments on its members and a $1B line of credit from the Treasury.
If SIPC determines that a member firm is in danger of failing, it may apply to a court for a decree that the firm’s customers need the protection of the Act, and the appointment of a trustee to liquidate the firm.

If the assets are insufficient to pay all claims, SIPC must advance to the trustee sufficient funds to satisfy all claims up to $100,000 for each customer but not more than $40,000 in respect of claims for cash.

2002 Sarbanes-Oxley Act

amended or expanded existing securities laws (added a few new ones)
requires CEO and CFO to certify SEC filings are true, complete, and fairly represented

Dodd-Frank Act

Enacted after 2008 financial crisis
Mostly bank regulation
Also partially amended the 1933 and 1934 acts

JOBS Act

Facilitate capital raising for small business

Easing regulation for smaller companies.

FINRA

regulatory arms of NASD & NYSE merged to form FINRA
All broker-dealers must be registered w/ SEC and be a member of a Self-Regulatory Organization (SRO). SRO rules subject to SEC approval

The SEC

5 members appointed by the President for five-year terms, staggered expirations, not more than 3 from the same political party.
4 divisions:

Division of Corporate Finance – reviewing and processing various disclosure documents
Division of Enforcement – responsible for investigations of alleged violations and for the conduct of administrative and court proceedings against alleged violators
Division of Trading and Markets – assist the Commission in developing its regulatory policies over the securities markets and broker-dealer firms
Division of Investment Management – assist the Commission in developing its regulatory policies over Investment managers

Office of the General Counsel

Responsible for advising the SEC and its Divisions on questions of law
Responsible for representing the SEC in its district and appellate court proceedings
Prepares the SEC’s legislative proposals and comments on legislation proposed by others

Office of the Chief Accountant

Key role in developing the SEC’s position on accounting questions and in presenting the SEC’s position in deliberations of the standard-setting bodies in the accounting profession.

National Association of Securities Dealers (NASD)

Authorized by §15A of the 1934 Act, added by the Maloney Act in 1938.
Exercises self-regulation over dealings in the over-the-counter market.

2007 – the regulatory arm of NASD merged with the regulatory arm of the NYSE to form the Financial Industry Regulatory Authority (FINRA).

Definition of Security

1933 Act § 2(a)(1): defines as a security any: Note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement, collateral-trust certificate, preorganization certification 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 on any security, certificate of deposit, or group or index of securities . . . [and] any interest or instrument commonly known as a security.”
1934 Act § 3(a)(10): “(10) The term ‘‘security’’ means any note, stock, treasury stock, security future, security-based swap, 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, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a ‘‘security’’; or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to

on v Forman)

Fixed-Rate Returns: No reason to distinguish btwn a fixed-rate return and a variable rate return for purposes of the Howey test (SEC v Edwards)

A note is a security, which is a fixed return security

Sale-leaseback: typically not a security, can be investment K under Howey (Edwards)
License schemes: can be investment K = not so much what you market, but how you market it (Aqua-Sonic case) (licensing right to sell products w/o active role in business or management)
Return must come from earnings of the enterprise or appreciation of the investment based on anticipated earnings, but not merely from additional contributions

Element #4: Solely from the efforts of others

Undeniably significant test: Solely is satisfied if the efforts made by those other than the investor are the undeniably significant ones, those essential managerial efforts which effect the failure or success of the enterprise (SEC v Glenn Turner Enterprises)

The word “solely” should be not be read as a strict or literal limitation on the definition of an investment contract
Purchaser may have to contribute something other than $, still ok

Franchises aren’t a security generally, because the efforts of the franchisee are determinative of the success of the business (select employees, location, etc.)
Retirement plan that employees had to contribute to = not investment K (Daniel case)

Examples of Investment Contracts / Not ICs:

Sale of real estate + service contract (mgmt.) = IC (SEC v. Joiner Leasing Corp.)
Options: security if the typical investor who was being solicited would be expected under all the circumstances to accept the option

Remains passive and derives profits from the efforts of others
Economic reality is that the investors were not going to make their own efforts

Partnership Interests: can be investment contract only when the partners are so dependent on a particular manager that they cannot replace him or otherwise exercise ultimate control (e.g., limited partnership)

Partnership is generally not a security
Whether the powers possessed by the general partner in the partnership agreement were so significant that, regardless of the degree to which such powers were exercised, investments could not have been premised on a reasonable expectation of profits to be derived from the management efforts

Retirement Plans that employees voluntarily contribute to (Uselton) c.f. (Teamsters v. Daniel, noncontributory, compulsory pension plan not an IC, no expected profit from plan)
Individually managed commodities trading account = not an IC (Brodt v. Bach, broker making investment decisions)
Shares in a housing cooperative = not an IC, primary motivation was housing (Foreman)
Distributorship of dental products = IC, investors dependent on sales team (SEC v. Aqua-Sonic)

Partnership Interests as Securities

Partnership Interests: can be investment contract only when the partners are so dependent on a particular manager that they cannot replace him or otherwise exercise ultimate control (e.g., limited partnership)

Partnership is generally not a security
Whether the powers possessed by the general partner in the partnership agreement were so significant that, regardless of the degree to which such powers were exercised, investments could not have been premised on a reasonable expectation of profits to be derived from the management efforts

General Partnerships not securities b/c management powers are granted to partners by UPA
Limited Partnership interests will typically be a security = no managerial powers
LLC Memberships: When the owners of a LLC are not expected to exercise control over the day-to-day business operations, interests in LLC companies should be classified as investment contracts

Member-managed LLC most likely not a security
Nonmember-managed LLC most likely will be a security

LLP – passive investors are typically securities, active partners don’t have securities.