CHAPTER 23
Securities Laws
The Securities Act of 1933 (the 1933 Act) and the Securities Exchange Act of 1934 (the 1934 Act) are the two most important securities laws.
What Is a Security?
A security is any transaction in which the buye
1. invests money in a common enterprise and
2. expects to earn a profit predominantly from the efforts of others.
This definition includes investments that are not necessarily called securities. Besides the obvious stocks or bonds, the definition of security can even include items such as orange trees. W. J. Howey Co. owned large citrus groves in Florida. It sold these trees to investors, most of whom were from out of state and knew nothing about farming. Purchasers were expected to hire someone to take care of their trees. Someone like Howey-in-the-Hills, Inc., a related company that just happened to be in the service business. Customers were free to hire any service company, but most of the acreage was covered by service contracts with Howey-in-the-Hills. The court held that Howey was selling a security (no matter how orange or tart) because the purchaser was investing in a common enterprise (the orange grove) expecting to earn a profit from Howey’s farm work.
Other courts have interpreted the term security to include animal
eeding a
angements (chinchillas, silver foxes, or beavers, take your pick), condominium purchases in which the developer promises the owner a certain level of income from rentals, and even athletes. In these deals, investors make a lump sum payment now, in return for a share of the athlete’s future earnings.
Securities Act of 1933
Securities Act of 1933
The 1933 Act requires that before offering or selling securities in a public offering, the issuer must register them with the Securities and Exchange Commission (SEC). An issuer is a company that sells its own stock.
The guiding principle of federal securities laws is that investors can make a reasonable decision on whether to buy or sell securities if they have full and accurate information about a company and the security it is selling. Given clear information, the responsibility is on the buyer to evaluate the quality of the investment. The SEC does not, itself, evaluate or investigate the quality of any offering; it simply ascertains that, on the surface, the company has disclosed all required information about itself and the security it is selling. Permission from the SEC to sell securities does not mean that the company has a good product or will be successful.
When the Green Bay Packers football team sold an offering of stock to finance stadium improvements, the prospectus admitted:
IT IS VIRTUALLY IMPOSSIBLE that any investor will ever make a profit on the stock purchase. The company will pay no dividends, and the shares cannot be sold.
This does not sound like a stock you want in your retirement fund; on the other hand, the SEC will not prevent Green Bay from selling it, or you from buying it, as long as you understand what the risks are.
Liability
Under the 1933 Act, the seller of a security is liable for making any material misstatement or omission, either oral or written, in connection with the offer or sale of a security. Material means important enough to affect an investor’s decision. Anyone who issues fraudulent securities is in violation of the 1933 Act, whether or not the securities are registered. Both the SEC and any purchasers of the stock can sue for damages and the Department of Justice (DOJ) can prosecute.
Public Offerings
A company’s first public sale of securities is called an initial public offering or an IPO. Any subsequent public sale is called a secondary offering.
This is the process an issuer follows for either an IPO or a secondary offering:
· Registration statement. To make a public offering, the company must file a registration statement with the SEC. The registration statement has two purposes: to notify the SEC that a sale of securities is pending and to disclose information of interest to prospective purchasers. The registration statement must include detailed information about the issuer and its business, a description of the stock, the proposed use of the proceeds from the offering, and three years of audited financial statements. Preparing for an IPO is neither fast nor cheap. A typical IPO can cost $10 million; an exceptional one as much as $40 million.
· Prospectus. All investors must receive a copy of the prospectus before purchasing the stock. (It is included in the registration statement that is sent to the SEC.) The prospectus includes all of the important disclosures about the company and the security that is to be sold, while the registration statement includes additional information that is of interest to the SEC but not to the typical investor, such as the names and addresses of the lawyers for the issuer and underwriter.
· Sales effort. Even before the final registration statement and prospectus are completed, the investment bank representing the issuer begins its sales effort. As part of this effort, company executives and the investment bankers conduct a road show; that is, they travel around the country making presentations to potential investors. The investment bank cannot actually make sales during this period, but it can solicit offers. The SEC closely regulates an issuer’s sales effort to ensure that it does not hype the stock by making public statements about the company before the stock is sold. The SEC delayed an offering of stock by Google, Inc., after Playboy magazine published an interview with its founders.
· Going effective. Once the SEC finishes its review of the registration statement, it sends the issuer a comment letter listing required changes. Remember that the SEC does not assess the value of the stock or the merit of the investment. Its role is to ensure that the company has disclosed enough information to enable investors to make an informed decision. After the SEC has approved a final registration statement (which includes, of course, the final prospectus), the issuer and underwriter agree on a price for the stock and the date to go effective, that is, to begin the sale.
Private Offerings
Registering securities with the SEC for a public offering is very time consuming and expensive, but the 1933 Act also permits issuers to sell stock in a private offering, which is much faster and cheaper. Issuers provide less disclosure in return for selling less stock, to fewer (often wealthier) investors. Thousands of private offerings take place each year, in contrast to only about 150 IPOs.
Regulation D
The most common and important type of private offering is under Regulation D (often refe
ed to as Reg D). The rules of Reg D control:
· How much stock can be sold,
· How many and what type of purchaser can buy the stock,
· How the issuer can advertise,
· What the issuer must disclose, and
· When the securities can be resold.
Under some provisions of Reg D, the issuer can sell to an unlimited number of accredited investors, but to only 35 unaccredited investors. Accredited investors are institutions (such as banks and insurance companies) or individuals (with a net worth of more than $1 million, not counting their homes, or an annual income of more than $200,000).
Crowdfunding
Regulation Crowdfunding permits privately held companies to sell up to $1 million in securities in any 12-month period, provided that they:
· Sell the securities through only one online platform that is operated by a
oker-dealer or a funding portal (e.g., a website) that has registered with the SEC,
· File an offering statement and annual reports with the SEC,
· Limit investments by individuals to either 5 or 10 percent of their income or net worth (depending on their wealth),
· Limit any advertising outside of the funding portal, and
· Prohibit resale of the stock for one year (except to the company, accredited investors, family members, or as part of a registered offering).
Note that Regulation Crowdfunding provides for little oversight. The SEC does not review these companies to ensure that they are complying with the law. Indeed, one study found that half the offering companies were in violation.
As we remember from our discussion of the business judgment rule in Chapter 21, managers have wide latitude in how they spend any funds they raise. Investors have little recourse for off-plan expenditures. Since few of these companies ever go public, investors have limited opportunities to sell their stock or realize any return on their investment.
Securities Exchange Act of 1934
Securities Exchange Act of 1934
Registration
Most buyers do not purchase new securities from the issuer in an IPO. Rather, they buy stock that is publicly traded in the open market. This stock is, in a sense, secondhand because other people—perhaps many others—have already owned it. The purpose of the 1934 Act is to provide investors with ongoing information about public companies (i.e., companies with publicly traded stock).
Under the 1934 Act, an issuer must register with the SEC if:
· It completes a public offering under the 1933 Act, o
· Its securities are traded on a national exchange (such as the New York Stock Exchange), o
· It has at least 2,000 shareholders (or 500 who are unaccredited investors) and total assets that exceed $10 million.
The 1934 Act requires public companies to file the following documents:
· Annual reports on Form 10-K, containing audited financial statements, a detailed analysis of the company’s performance, and information about officers and directors. A public company must also deliver its annual report to shareholders.
· Quarterly reports on Form 10-Q, which are less detailed than 10-Ks and contain unaudited financials.
· Form 8-K to report any significant developments, such as a change in control, the resignation of a director over a policy dispute, or a change in auditing firms.
A company’s CEO and CFO must certify that:
· The information in the quarterly and annual reports is true,
· The company has effective internal controls, and
· The officers have informed the company’s audit committee and its auditors of any concerns that they have about the internal control system.
Liability
Section 10(b) (and Rule 10b-5) prohibit fraud in connection with the purchase and sale of any security, whether or not the security is registered under the 1934 Act. Under these rules, anyone who fails to disclose material information or makes incomplete or inaccurate disclosure is liable, provided that the statement or omission was made with scienter. This legal term means that someone has acted with the intent to deceive or with deliberate recklessness as to the possibility of misleading investors. Negligence is not enough to create liability. Thus, an accounting firm that certified financials in a company’s annual report, knowing that it had not in fact adequately audited the firm’s books, is acting with scienter and would be liable under §10(b).
In the following case, Hewlett-Packard (HP) and its executives made inaccurate statements. But did they have scienter? You be the judge.
Insider Trading
Why is insider trading a crime? Who is harmed? Insider trading is illegal because:
· It undermines the integrity of stock markets. Investors will be unwilling to buy in