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Securities Regulation
University of South Carolina School of Law
McWilliams, Martin C.

Securities Regulation

Fall 2012, Professor McWilliams

Securities Markets


1. Trying to create an efficient market

2. US Regulation trying to provide time & information to make efficient decisions

3. Regulations need to strike a balance between capital formation, efficient low cost, & protection of markets & investors.

33 Act focuses more on protecting investors by giving time & information to make decision. 34 Act is more concerned about market transactions

Market used to be a physical space to buy & sell stock. An aggregate of negotiated face-to-face exchanges.

· Negotiated exchanges- are private law arrangements whereby each party ends up with something they value more highly than the thing they exchanged

· Lower transaction costs- a transaction cost is the cost of doing a transaction. May include playing a stockbroker to help you, acquiring information, and other business expenses. A market lowers transaction costs because it allows for the price to take in account all available information

· Impounded in Price- as soon as information becomes public it is taken into account in purchasing the stock

Private Market

· These are exchanges that occur off an exchange.

· Trades happen through direct negotiation between sophisticated parties. The largest volume of trades are done in private transactions.

· Normally self regulation

· i.e. insurance companies, institutional investors, & pension funds

Anonymous Auction Market

· Principals do not come to the market. They engage brokers to represent them. Buyer who is willing to pay the highest price wins the deal. Buyers & Sellers don’t know each other.

· No negotiated disclosure- impossible to negotiate towards information symmetry

o Information symmetry- occurs when each party has full information

o Anonymous auction market rely on public information

§ Gives investors the time & information to make an informed investment decision. This helps make the market efficient.

· Markets are regulated by government- information cost is normally high and must use present information to anticipate future change. Manipulating information will manipulate the price

· US Markets/Exchanges (NYSE)- is a resale market. To be listed on the exchange, you have to have certain number of shareholders, sound financials

o Being listed on an exchange makes your security more liquid***

Over the Counter Market

Formerly known as the pink sheet market. These are smaller companies. Do not have specialists but have market-makers aka broker-dealers who stand ready to make a market in the OTC stock.

Efficient Market Hypothesis

If material risk information is made on a timely basis to the entire market, this information will be reflected in price.

· Trades reflect the urgency to buy based on fresh information

· Trades will push the price of the security to a new, more correct level relative to the pricing of other securities

· DISCLOSURE- helps investors make an informed decision and makes the market efficient

o Have to determine if gathering information becomes more costly than the potential return on the investment.

· Investing- to justify an investment, investor needs to be able to minimize the sum of transaction costs and the cost of making bad decisions.

o Higher the information cost, the more quickly the cap on efficiency is reached.

PRICE- an allocation of risk that is based upon the various opportunities that buyers of securities have in the entire market.

· Price is relative to what the buyer is willing to play. Will see if this is the best use of their money in comparison to other investments available.

More About Markets & Their Efficiency

Markets are subject to regulation rather protecting individual investors. Individual investor is more of the focus in state regulation

NY Stock Exchange

An anonymous auction market. Participants in the market bid what they are willing to buy or sell for. But anonymous because you don’t know who is on the other side of your trade.

Specialists- a financial enterprise with a duty to be a buyer or sell of last resort. For some reason if no one is in the market who is buying the security you want to sell then the specialist will buy it from you. Get a lot of business but it is extremely risky to be one in a collapsing market

· Post- where the specialist is located on the market floor of the NYSE. Exchange trades in a security take place there.

Market-makers- similar job as specialist. They make the market for over the counter stocks by buying and selling.

Dealer- person who actually takes title of something then they offer it to someone else.

Broker- doesn’t actually take title but is a middle man for buying and selling

Broker-Dealer- all market professional b/c hardly anyone is just one or the other.

Block Trading- takes place off the formal markets. Very large trades between institutional investors.

· 30-40% of trades on NYSE take place in block trades off the exchange.

· Institutional investors often don’t use a broker-dealer

Bond Market

No exchange but normally a dealer takes title to the bonds and then offers them for resale.

· Why do corporation prefer bonds compared to selling stock?

o Don’t want to dilute control or ownership of the stock

o Costly to get money into the hands of investors

§ Dividends are paid out of tax income & company has to pay tax first. Corporations are forbidden for giving dividends if don’t pass the balance sheet test

o Investors/Corporations like bonds b/c its steadier market and cheaper to the get money into the hands of investors b/c interest is tax deductible.


Trading in securities is all about passive investment that will lead to personal wealth by using presently existing information to predict future value then discount that future value back to present value, which is what is reflected in the market price.

Two types of trading: Issuer Transactions & After Market Transactions

Issuer Transactions

Private Placement or Public Offering. These are used to raise capital for the issuer.

Private Placement

· Private Placement is selling securities to a single purchaser or small group of purchasers where the buyer can negotiate face-to-face with the issuer. Naturally regulating because they want to get information & have the sophistication and leverage to get the information.

· This is the most expedient form of issuer transaction

o Lower transaction costs and often no registration requirement

· Not as regulated as public offerings. Able to deliver information that levels out asymmetry of information. Investors are able to self protect.

· This preferable to a public offering b/c of the lower transaction costs.

o Not as much red tape to go through.

Public Offering

· Offering made to members of the public at large or a number of people with whom the issuer has no previous relationship. Regulations look to whether the people being offered have adequate information & ability to fend for themselves.

· Must be registered with the SEC and astrictly regulated especially if IPO

· Reasons to do a Public Offering:

o Enhances the public market in the security, Makes it more liquid

o Allows the issuer to have control

o Gives a corporation that is growing prestige and publicity

· Two Types of Public Offerings:

o Primary Distribution- where the issuer itself makes an offering to a wide group of people.

o Secondary Distribution- when an investor holds enough of a security and it is selling widely enough that regulators think it needs protections of a public offering

§ Look at amount of shares, amount of offerees, & who is doing the offering

· Regulated by the Securities Act of 1933

Aftermarket Transactions

These are essentially trading transaction. Sales not from an issuer. These often are transactions that take place on an exchange. However, if resales are sufficient to support a public offering, then may be considered a secondary distribution

· Market for resale is regulated by Securities Exchange of 1934

o Created the Securities & Exchange Commission

o Helps keel level of information available by requiring continuous disclosures

Global Certificate

The trading of equity securities without actually issuing individual certificates. Print one global certificate for a million shares and deliver it to a clear agency. Also when shares are issued to big investment banks they get interest in the global certificate.

Laws Governing Securities

Congress has passed several acts governing securities and their sales in order to protect the public.

Securities Act of 1933 (’33 Act or Securities Act)

· Governs the issuance of securities. Registration covers transactions not individual securities

· This is a remedial statute***

o One that was enacted to regulate and remedy a persistent pattern of bad acts. These statutes are read broadly in order to correct the problems that it was enacted to fix

· Act is designed to be disclosure based to alleviate information asymmetry

· Important Sections of the Act:

o Primary Tool***: Section 5 which states every OFFER or SALE of a security that uses instrumentalities of interstate commerce must be registered with SEC or qualify for exemption.

§ 1. Offer or Sale of Securities

§ 2. Uses Instrumentalities of Interstate Commerce- Jurisdictional Hook

§ 3. Registered or Qualify for exemption

o Section 3- exempts securities

o Section 4- exempts transactions

o Section 12- makes it unlawful to sell or offer securities in violation of Section 5

o Section 11- anti-fraud- full and complete disclosure and makes silence actionable


Registration is process of meeting the requirements of information disclosure set by the SEC.

· Register a TRANSACTION not the SECURITIES****

o This is important because even if you purchase a security through an exemption. You must qualify for an exemption or register if you want to resell that security. Possible to destroy the exemption for the entire transaction if not done correctly.

· Registration Statement- must be filed in order to make a public offering. Registration statement is a basic disclosure document. Level of information to be disclosed depends on the issuer & SEC.

o Registration Statement Contains:

§ Description of Issuer’s Business- both financial & operations

§ Extensive Financial Disclosures- including certified & audited financial statements

· Must be prepared in accordance with Regulation S-X (SEC account principles)

§ Management Discussion & Analysis (D&A)- an analysis of issuer’s solvency, performance of operations, variations in success, & discussion of issuer’s future

§ Type of Security being offered- i.e. common or preferred stock? Debt or Equity? Voting rights?

§ Description of the Offering- how many shares, who is selling the shares (underwriters, broker-dealers), how much are they getting paid

§ Use of Proceeds- what are the proceeds going to be used for.

§ RISK FACTORS- must “undress” itself and reveal everything and emphasize all potential risks. Have to point out the bad things that could happen. Clients will want to try to tone it down but needs to be complete and correct.

§ EVERY THING MATERIAL must be disclosed

· Material- information that would be important/significant to an investor in making an investment decision

o Unlawful to make an offering that is accompanied by false or misleading statements

· PROSPECTUS- this is part of the reg

· FINRA- financial industry regulatory authority

· NYSE & Other Major Exchanges- are also self regulating

What is a Security?

In order for the securities laws to be relevant, you must be dealing with a security. The definition is broad. Securities do not give you the right to something tangible many times. If you are buying equity shares then you are getting equity in the company and have no right to your money back if company goes downhill. If investing in debt then the right to get your money back is contractual. However, the securities laws allow you to rescind these deals if they violate the law.

· Comes into play in most business setting because every corporation must issue at least one share of stock.


· Section 2(1) of the 33 Act and the 34 Act define a “security” almost identically. Lists instrument that constitute securities including:

o Stocks

o Bonds

o Notes

o Investment Contracts (example of remedial basket)

o Certificates of Deposits

o Debentures

o Certificates of interest in profit sharing agreements

o Interests commonly known as securities

o Remedial Baskets

§ People try to invent something not on the list and in order to capture these Congress put “basket” that capture a lot of things i.e. “investment contracts”

· When considering whether something is a security have to take into account the broad remedial policy behind the securities laws. Don’t want people to easily get around it

o Courts often interpret the definition of security and these remedial baskets differently. Heavily litigated.

· In SEC v. Joiner Leasing Corp., the court stated that the reach of the act does not stop with the obvious and commonplace. Novel, uncommon, or irregular devices, whatever they appear to be, are also reached if it be proved as a matter of fact that they were widely offered or deal in udner terms or courses of dealing which established their character in commerce as investment contracts or as any interest or instrument commonly known as a security.

Investment Contract (Howey Test)

This often the term in the securities definition that courts will try to bring something that may not look like a security within the scope of the securities laws.

Howey TEST FOR INVESTMENT CONTRACT (Not applied to stock w/ normal attributes of stock or to notes**):

1. Investment of Money

2. In a common enterprise

a. Vertical Commonality;

i. Broad- efforts are required by a promoter that lead to success & loss of investor

ii. Strict- Risk of the enterprise is shared by the promoter; promoter also takes risk

b. Horizontal Commonality – requires a pooling of investor funds. Investors take a common risk. May presuppose multiple investors but 7th circuit has said one investor can satisfy.

3. Expecting Profits

a. Profits are financial returns on investment. Capital Appreciation or a participation in earnings.

i. May be fixed or variable as long as based on risk of enterprise success.

4. Solely by the efforts of others

a. Forman says you should look to the economic realities and whether you are depending on someone else.


b. Critical inquiry: whether the efforts made by those other than the investor are undeniably significant ones, those essential managerial efforts which affect the failure or success of the enterprise.

c. Level of Control- Williamson says not sufficient control in a partnership if:

i. An agreement among the parties that leaves little power in the hands of the partner; the agreement distributes power as would a limited partnership

ii. The partner is inexperienced in business affairs and incapable of intelligently exercising his partnership powers; OR

iii. The partner is so dependent on some unique entrepreneurial ability of the promoter that he cannot replace the manager.

d. So if you buy something with promise they’ll buy it back if you don’t like then taking risk in what you are buying and in person who says they’ll buy it back.

5. Consider Other Factors:

a. Passive Nature of the Investment: actually operating or having control in what is being purchased or invested

i. Look to factual circumstance surrounding investment and look at post formation activities if involves an LLC or business entity.***

b. Was it individually negotiated in face-to-face transaction with a sophisticated person. Investment does not always = security

UHF v. Forman: The touchstone is a presence of an investment in a common venture premised on a reasonable expectation of profits to be derived from the entrepreneurial or managerial efforts of others.