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Securities Regulation
University of San Diego School of Law
Krause, James

Securities Regulation – Prof. Krause – Fall 2009
Chapter Topic
1)      Major subsection
a)      Subsection
i)        Minor subsection
ii)      Case
iii)    Statute
The Capital Markets: An Overview
1)      The Goals of Securities Regulation
a)      Generally
i)        The securities laws require affirmative disclosure in connection with the issuance of securities and establish a detailed and mandatory system of continuing, periodic disclosure with which “public” companies must comply.
(1)   The requirement of affirmative disclosure in connection with the issuance of securities focuses on the primary market in which issuers sell securities to investors.
(2)   The continuing disclosure system focuses on the secondary market, in which investors trade with each other.
b)      Consumer protection
i)        Bases for the Securities Acts: (1) Investors were vulnerable in a manipulated marketplace and had been misled during the 1920s; and (2) others suffered when investors disinvested in the market.
ii)      Securities Exchange Act of 1934, § 2 (15 U.S.C. § 78b): “[T]ransactions in securities as commonly conducted upon securities exchanges and over-the-counter markets are affected with a national public interest which makes it necessary to provide for regulation and control of such transactions and of practices and matters related thereto . . . .”
iii)    N.B.: Investor protection rationale applies with less force in the debt markets because the participants in these markets tend to be sophisticated financial institutions.
c)      The informational needs of investors
i)        It is impossible for a typical investor to “examine” an issuer.
ii)      The Securities Acts—through a regime of mandatory disclosure—provide investors with access to information about, inter alia, an issuer’s financial condition, its likely future earnings, its competitive position, the status of its products in their own marketplaces, its prospective contingent liabilities, and the competence of its management—all in a relatively standardized form to facilitate comparison among securities.
d)     Inadequate incentives to disclose
i)        Managers may resist disclosure of adverse information about their firm—even if it is in the long-term best interest of the firm—out of fear that revelation of adverse information could lead to the managers’ ouster or cause proprietary injury to their firm by alerting competitors and investors to important developments.
(1)   Conceivably, individual securities markets could obviate the need for governmental intervention in the securities market by adopting minimum listing standards for securities traded on them.
e)      Allocative efficiency
i)        Mandatory disclosure serves to further the goal of ensuring that stock prices reflect the fundamental value of the companies traded. 
(1)   The efficient markets hypothesis theorizes that information quickly permeates the market, and therefore, prices in the market reflect that information.
ii)      Critics believe that the goal of “accuracy enhancement” must be balanced against the issuer’s interest in confidentiality. Their primary fear is that excessively high disclosure standards will result in disclosures that the firm’s competitors can exploit.
f)       Corporate governance and “agency costs”
i)        Mandatory disclosure permits shareholders to gain greater control over corporate managers by reducing the shareholders’ cost of monitoring their agents.
g)      Financial stability
i)        The Securities and Exchange Commission (SEC), in addition to enforcing the securities laws, acts as the financial overseer of those financial institutions that register with it as broker-dealers. The SEC is responsible for overseeing these broker-dealers’ capital adequacy and monitoring their safety and soundness and risk management practices.
(1)   The collapse of a financial institution can produce externalities that can destabilize the economy as a whole.
h)      Economic growth, innovation, and access to capital
i)        Economies that are organized around securities markets tend to favor new entrants, in particular start-up and venture capital companies that convince the market that a new technology developed by them merits equity capital.
ii)      A legal system that facilitates and encourages an active and efficient securities market may also promote a more decentralized economy and a faster pace of technological innovation.
i)        Maintaining a competitive market and the relative cost of capital
i)        In a global economy, investors can select the market in which they want to participate. If regulatory costs are lower in one market than another, issuers will predictably prefer the lower cost market—unless that market has a higher cost of capital.
(1)   The cost of capital rises as investors face greater uncertainty and therefore demand a correspondingly higher rate of return to compensate them for bearing increased risk. Thus, markets must balance regulatory costs and benefits.
ii)      N.B.: The question of regulatory costs and benefits has become more acute in the wake of the passage of Section 404 of the Sarbanes-Oxley Act of 2002 (SOx), which requires a costly annual audit of internal controls. These costs have caused foreign issuers to leave, or not enter, U.S. Securities Markets.
2)      An Overview of the Financial Markets
a)      Generally
i)        Financial markets are in direct competition. Which market an issuer will choose to enter depends on:
(1)   The relative cost of capital in the different markets;
(2)   The time necessary to effect a transaction in the different markets;
(3)   The degree of regulatory supervision and legal liability the issuer exposes itself to by entering a particular market.
ii)      The line between securities markets and other capital markets has become increasingly uncertain.
(1)   E.g., The securities markets sell options on securities, and the commodities (futures) market sells futures contracts on individual securities and securities indexes.
iii)    Consequences of a financial instrument being deemed a security:
(1)   A mandatory disclosure system applies to the same and trading of the instrument;
(2)   Stiff federal antifraud rules apply that are considerably more favorable to plaintiffs than common-law fraud rules;
(3)   The financial intermediaries who handle transactions in the market for the instrument are subject to substantive regulation by the SEC.
b)      An overview of the non-equity markets
i)        Functions:
(1)   Match lenders and other investors with businesses seeking financing, enabling those with surplus funds to earn a favorable return while permitting those unable to finance their operations with internally generated funds to obtain capital;
(2)   Permit investors to reduce their exposure to risk through various strategies, including portfolio diversification and hedg

wn payments.
(b)   Because their purchases were financed entirely by debt, borrowers had greater incentive to abandon their collateral if interest rates rose or housing prices fell.
(c)    Accordingly, when housing prices fell, SPEs were left holding risky financial assets backed by collateral worth less than the financial assets themselves.
vii) Derivative product markets: Markets that, instead of providing capital for issuers, allow corporations to engage in side bets to protect themselves against adverse changes in interest rates, currency values, or price levels through investment in derivatives.
(1)   Derivatives: Instruments that derive their value from the values of underlying instruments or commodities on which they are based.
(a)    Traded options: Options to buy shares of stock, stock indexes, or other financial assets in the future at a price agreed upon on the issue date.
(i)     Options are created on standardized terms by the Options Clearing Corporation and traded in secondary markets including the Chicago Board Options Exchange and the American Stock Exchange.
(b)   Futures: Contracts to buy or sell financial assets or commodities at a fixed price on a future date.
(i)     Stock index futures, in contrast to stock index options, create an obligation to deliver or receive the cash equivalent to a portfolio of stock. The most popular stock index future is the Standard & Poors 500 (S&P 500).
(c)    Differences between equity options and futures:
(i)     On stock exchanges—but not futures exchanges—a “specialist” is under a legal obligation to ensure an orderly market by buying and selling against the direction of the market when there is an order imbalance. And short selling—the sale of borrowed stock—is restricted on stock exchanges when it would lead to downward price movement, but no similar restriction exists on futures exchanges. Accordingly, futures exchanges are apt to exhibit greater volatility than stock exchanges.
(ii)   Equity securities and equity options are regulated by the SEC, whereas future and futures on stock indexes are regulated by the Commodities Futures Trading Commission (CFTC).
(d)   Swaps: Contractual agreements to pass risk onto a better risk-bearer for a fee.
(i)     E.g., A corporation that has borrowed at a floating rate can enter into an swap transaction with a commercial bank whereby the corporation agrees to pay a fixed rate—typically a fraction above the current floating rate—for the life of the note, while the bank agrees to pay the floating rate. If the floating rate exceeds the fixed rate, the corporation “wins,” and vice versa.
Credit-default swaps (CDSs): Contractual agreements which permit a party to purchase insurance on bonds or other obligations. The purchaser of a CDS need