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Securities Regulation
West Virginia University School of Law
Cummings, Andre Douglas Pond

Securities – Outline
I.                   The Framework of Securities Regulation
A.     Securities Transactions
1.      Issuer Transactions – transactions involving the sales of securities by the issuer to investors. The means by which businesses raise capital – to develop, to grow, or to survive.
2.      Trading Transactions – the purchasing and selling of outstanding securities among investors.
B.     Legal Framework of Securities Regulation
1.      Federal Securities Laws
a.       The Securities Act of 1933 – an act of disclosure so that investors can make a knowledgeable decision about a security. Regulates the public offering and sales of securities in interstate commerce. Act requires registration of securities. The registration statement’s information is contained in the prospectus.
1)      Prospectus – designed to provide all material information necessary for investors to fully assess the merits of their purchase of the security.
2)      Section 3 – exempts numerous categories of securities from the Act’s registration requirements.
3)      Section 4 – exempts securities sold in certain types of transactions.
4)      Section 11 – provides a private right of action for materially false statements in the registration statement.
5)      Section 12 – imposes civil liability upon those who sell securities in violation of Section 5’s registration requirement.
b.      The Securities Exchange Act of 1934 – created the SEC to promulgate and enforce rules. Gives strong federal control of the trading markets.
c.       Federal Regulation Beyond Disclosure: Sarbanes-Oxley Act of 2002 – enacted to further protect investors. Sets forth broad prescriptions for corporate governance. Allowed SEC to develop rules for conduct of lawyers. Regulates areas that have been up to the states. Introduced important procedural and substantive requirements for public companies.
d.      Regulation of Investment Advisers and Investment Companies
e.       Organizational Structure of the SEC – SEC is composed of five commissioners appointed by the President to five year terms. Not more than three of the commissioners may be of the same party as the President. 66% of the SEC lawyers are in Washington, D.C. The SEC was once viewed as the model federal agency. With the recent corporate scandals recently, that image has dissipated some what, but it is still viewed as one of the few effective regulatory agencies in D.C. There are several SEC Divisions.
1)      Division of Corporate Finance – disclosure requirements promulgated here and information is reviewed. Way overworked and does not have the resources to review everything it gets.
2)      Division of Market Regulation – oversees the secondary exchange market.
3)      Division of Investment Management – oversees all of the institutional investments.
4)      Enforcement Division – administrative proceeding or criminal proceeding.
f.       Mediums Through Which the SEC Speaks – Provides guidance through its staff’s issuance of no-action letters. These letters do not represent the official view of the cmm’n. A no-action letter describes the viewpoints of the staff of the cmm’n as to how a rule would likely be interpreted or how the cmm’n would rule in a given case. No-action letters have no force in court and are merely guidance. It is a very practical tool for lawyers.
g.       SEC Some Critical Perspectives – SEC walks a tight line between investor protection and allowing businesses to raise capital.
2.      Blue Sky Laws – state securities laws. A difference between federal regulation and some blue-sky laws is the federal system is very disclosure oriented, while some state securities laws are merit regulation where qualification depends on convincing the state blue sky administrator of the substantive merits of the offering.
3.      Self-Regulatory Organizations – NEED TO READ
II.                Definition of a Security
A.     Introduction – if something is deemed to be a security, then the full weight of the securities laws, including registration and prospectus requirements, as well as the anti-fraud provisions, is brought to bear on the transactions underlying it marketing and sale.
1.      Securities that are rather straightforward – Notes, stocks, bonds, debentures, CODs.
2.      Vehicles that may be a security – Investment contract, certificates of interest, or if the context requires otherwise.
3.      Section 2(1) of the Securities Act defines a security.
B.     Development of a Defining an Investment Contract
1.      SEC v. W.J. Howey Co. (U.S. 1946) – court held that a partial interest in a citrus grove was an investment contract and under Section 2(1) a security. Therefore, the investors could rescind their investment b/c Howey failed to register the investment contract as a security. Defining an investment contract is difficult.
1)      Purchaser must give up some tangible and definable consideration in return for an interest – does not have to be cash.
1)      Horizontal commonality – involves the pooling of assets from multiple investors so that all share in the profits and risk of the enterprise (often many investors are needed)
2)      Vertical commonality – less dependent on there being a lot of investors.
                                                                                                                                      i.      Broad – requires the well-being of all investors to be dependent upon the promoter’s efforts/expertise.
                                                                                                                                    ii.      Narrow – requires that the investor’s fortunes be interwoven w/the efforts and success of the promoter.
1)      Capital appreciation from the original investment.
2)      Participation in earnings resulting from the use of investors’ funds.
3)      To meet the expectation of profits under Howey, the profits must not be too far speculative nor insubstantial to bring the transaction w/in the Securities Laws. United Housing Found v. Forman.
4)      There is no reason to distinguish between fixed or variable returns. An expectation of profit is all that is necessary, whether fixed or variable, and all that will be necessary to satisfy “expectation of profit.” SEC v. Edwards.
d.      SOLELY FROM THE EFFORTS OF OTHERS – asks the question of whether or not the investor has to expend any effort to profit from the investment.
1)      “Solely” is not to be given a literal meaning.
2)      Whether the efforts are made by those other than the investor are the “undeniably significant ones.”
3)      “Whether the efforts made by those other than the investor are the undeniably significant ones, thoses essential managerial efforts which affect the failure of success of the enterprise.” Miller v. Central Chincilla Group.
C.     Howey Applied – an agreement, negotiated one-on-one by the parties will likely not be an investment contract. Look to control to determine if the profits can be made solely from the efforts of others. If some of the profits can be made based upon the efforts of the investors, then that will affect the final prong.
1.      Investment v. Consumption
a.       United Housing Found. v. Forman (U.S. 1975) – Characteristics of a stock:
                                                                                                                                      i.      RIGHT TO RECEIVE DIVIDENDS
                                                                                                                                    ii.      NEGOTIABLE
                                                                                                                                  iii.      RIGHT TO BE PLEDGED OR HYPOTHECATED
                                                                                                                                  iv.      CONFERS VOTING RIGHTS IN PROPORTION TO THE NUMBER OF SHARES OWNED
                                                                                                                                    v.      ABILITY TO APPRECIATE IN VALUE
2)      If the investor is motivated by a desire to consume or use the item, then the securities laws do not apply. The investment must be made to make a profit.
3)      Just b/c something called a stock, does not mean that it is a stock. The vehicle must either meet the Five Element Forman test or the Four Element Howey Test.
4)      Primary purpose of the securities laws is to protect investors from bad investments and the underlying economic realities of the purchase.
5)      B/c the “expectation of profit” element of Howey was missing, this vehicle is not an investment contract and need not be registered.
                                                                                                                                      i.      To meet the expectation of profits under Howey, the profits must not be too far speculative nor insubstantial to bring the transaction w/in the Securities Laws.
2.      Common Enterprise and Profits Solely from the Efforts of Others
a.       SEC v. Edwards (U.S. 2004) – investors attracted to a guaranteed 14% return and no work to be done by the investors. Issue was whether a fixed returns fall outside of the expectation of profits prong?
1)      D argue fixed profit = no risk., but this is exactly the type of scheme that would trap the weary, unsophisticated investors who would be more compelled to enter into a fixed return.
b.      Held: There is no reason to distinguish between fixed or variable returns. An expectation of profit is all that is necessary, whether fixed or variable, and all that will be necessary to satisfy “expectation of profit.”
c.       Meaning of Common Enterprise
1)      Vertical commonality – relationship between investors and the promoter, the principal inquiry is whether the activities of the promoter are the controlling factors in the success or failure of the investment, and a common enterprise may exist even though there is no pooling of investors’ fund or interests.
                                                                                                                                      i.      Broad – impact of the promoter and only a connection between the promoter and investors.
2)      It is the character of the investment vehicle, not the presence of multiple investors, that determines whether there is an investment contract. SEC v. Lauer.
3)      Investment contract

                               ii.      Plan of distribution – Offer and sale to a broad segment of the public.
                                                                                                                                  iii.      Reasonable expectations of investor
                                                                                                                                  iv.      Protection by Risk-Reducing factors, such as other regulatory scheme.
G.     Derivative Securities & Synthetic Investments – financial instruments that derive their value from other assets to which their values are linked. Items which are derivatives are:
1.      Options
2.      Futures
3.      Swaps
4.      Synthetic Transactions – a contractual agreement between an investor and a counterparty, often a bank, that gives the investor the economic equivalent of a position in a certain security or option on a security interest w/o the investor actually buying that security option.
5.      Caiola v. Citibank, N.A. (2d Cir. 2002)
H.     Separate Securities and Pass-throughs
III.             Markets and Their Efficiency
A.     Markets and Investors
1.      The Structure of Trading Markets
2.      Globalization
3.      Institutionalization
4.      Derivative Markets
B.     Efficient Market Hypothesis: Implications and Limitations – an efficient market will be the best measure of the “value at the moment,” usually falling between extreme optimism and pessimism. An efficient market focuses on “the relationship between price and information.” The market is fundamentally efficient when prices reflect the security’s intrinsic value. If something is wrong in the market, it will correct itself down the road. Several of the securities regulations are based upon the efficient market hypothesis.
1.      Meaning and Mechanisms of Market Efficiency – there are three levels of market efficiency.
a.       Weak Form – exists when security prices reflect all the information embodied in the “past prices of the security.”
b.      Semi strong – exists if security prices reflect all publicly available information. Stock prices quickly reflect successive pieces of new information as that information becomes available.
c.       Strong form – occurs when security prices reflect all information, whether that information is publicly available or not.
2.      Noise – securities prices are not associated with rational expectations about assets. This theory offers approaches for understanding possible causes and mechanisms of market inefficiency, (i.e. there is an inverse relationship between price and information). The behavioral sciences focus on identifying social and psychological forces that explain stock price movements. Trading occurs b/c of non-information related events, weather, CEO hiring/firings, demand. Under this theory, investing is essentially guessing how others will react to news, then buy or sell accordingly. This is known as “herd” instinct.
a.       In response this noise theory, efficient market theorists would predict that any overreaction or underreaction would create rewarding opportunities b/c any such reaction would be short lived.
C.     Behavioral Economics and Decisions by Individual Investors – most people are over confident in their ability to choose stock, mostly men. “Loss aversion” most people are more willing to take a risk to avoid loss than to pocket a gain.
IV.              The Public Offering
§         An issuer must register its securities offering under Section 5, unless there is an exemption that applies.
            Section 5(a) bars any offer to sell and sales of security w/o a registration statement becoming effective. Until 1933, states regulated all of this, so the interstate commerce is the jurisdictional hook. The registration statement’s purpose is to facilitate informed investment decisions and discourage fraudulent promotion of worthless securities. Objective is to inform all those involved of the material facts bearing the issuer and the security. Material facts include information about the security, information about risks.
            Issuers want to avoid registration b/c of the cost and expenses and hassle of hiring lawyers underwriters and auditors.