Ch27 Investor Protection and Online Securities Transactions.docx

Chapter 27 INVESTOR PROTECTION AND ONLINE SECURITIES TRANSACTIONS What’s wrong with insider trading? I. Overview Assume a sporting event were to be contested under the following conditions: 1. All the players were well trained. 2. The rules of the game were fully explained to the players. 3. Those rules are fairly and evenhandedly applied to all participants. 4. An even playing field is used as a site for the contest. With all these suppositions in place, can you rest assured your team will win? Or can you, at best, hope that, win or lose, your team was engaged in a fair contest? In the broadest sense, the buying and selling of securities is indeed similar to an athletic event. Each participant goes into the game with his or her own self-interest in mind. And all the fair rules in world will not change one essential truth of these or any other contests--there will be winners and there will be losers. That reality must always be kept in mind from the outset by anyone seeking to make his or her fortune through the sale or purchase of securities. Risk is inherent to the nature of this activity, and anyone who fails to appreciate that simple fact should not be there in the first place. It is most difficult for professionals to master the ins and outs of the financial markets, let alone the casual investor. Yet the lure of playing this game is so strong that every year millions of people invest hard-earned money with nothing more than high hopes and a prayer. Securities law was designed to at least give some substance to those hopes and prayers. That substance is public information upon which investment choices can be rationally made. These laws are not designed to assure a win in this high-risk game, but rather to provide a more even playing field. The great financial stock market crash of 1929 and the ensuing Depression brought on by that calamity brought to the fore the need to create a greater governmental role in securities markets. Prior to that period, the sale of stocks in corporations remained essentially unregulated except for the common law doctrines of fraud and the like. Manipulative and unscrupulous trading practices coupled with a lot of hopes and unrequited prayers all pointed to a need for a better set of ground rules by which this game could be played. The basic rules of the game go back almost seventy years to the Securities Act of 1933 and the Securities Exchange Act of 1934 that created the Securities and Exchange Commission. The approach is simple. Provide all information that is deemed necessary to market operation and be honest while doing it. The 1933 Act covers initial issuances while the 1934 Act deals with subsequent trading. Over the years, the Commission's role has greatly increased with the advent of new technologies like programmed trading and with the need to expand its regulatory framework into the financial services arena. Because of recent scandals in this sector of the economy, a number of new white-collar crimes have been added to the government's arsenal for dealing with abuses in this area. All in all, it has made the specialized practice of securities law or SEC accounting more difficult, yet more challenging, than ever. As future business leaders, you have more than just a self-survival need to stay abreast of these changing rules of the game. As a nation we cannot afford the losses created by the manipulative abuses recently seen in these critical markets. If we do not watch out, 1929 can be revisited upon us, this time only worse. II. Hypothetical Multi-issue Essay Question Mr. Albert Williams was suffering from a common Twenty-First century malaise, working at a good paying job that provided him only with material but not emotional satisfaction. He wanted to break away and engage in his dream occupation – bread making. He has not had any formal training, but he knew what he liked when he tasted it. He decided to start his own chain of bakeries specializing in Italian breads produced from a special family recipe. He could not afford to capitalize the entire operation himself, so he came up with a novel idea. Why not sell the individual bakeries to “partners”? They would each get his expertise in producing the bread as well as having their names on specialty products. Mr. Williams convinced several hundred partners to combine with each other to buy one bakery each for $100,000 and proceeded to start up production of the bread. Unfortunately what he didn't tell his partners was that he didn't know if the recipe would be successful or if it would even work. Having failed to master the art of baking, the bread tasted more like dry dough than Italian bread. His partners are upset and look to see if they can get out of this deal. What results? 1308735160655Purpose of Securities Law Disclosure No Fraud 00Purpose of Securities Law Disclosure No Fraud III. Outline 2908935774700023374357747000 233743588900003137535889000039376358890000 2223135110490 Administered by SEC 00 Administered by SEC Definition of a Security An interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant An interest or instrument that is expressly mentioned in securities acts An investment contract-investment in common enterprise expecting profits from the significant work of others Can be issued over the Internet Securities Act of 1933 A federal statute that primarily regulates the issuance of securities by corporations, partnerships, associations, and individuals. Registration is required unless exempt. Fraud is prohibited whether or not registered. Criminal liability for willful violations, SEC actions or civil liability are all possible violations. Due diligence is a defense for all except issuers for omission or misstatement of a material fact. Liability could be imposed on issuers, officers, directors, signers of registration statement and experts. Burden of proof is on the defense. Private actions are available under Sections 1 & 12. Registration Statement Document that an issuer of securities files with the SEC that contains required information about the issuer, the securities to be issued, and other relevant information. Information includes information on securities, management, industry and risks. Certified financial statements must accompany registration statement as well as a prospectus. Prospectus is like an advertisement. Limitations on Activities During the Registration Process Prefiling Period (issuer contemplation of sale until statement filing) no sale or offer to sell or market conditioning unless normal corporate disclosures. Waiting Period (filing of statement until statement declared effective) time to condition the market. Posteffective Period (statement effective until sale or withdrawal from sale) sales take place. Securities Exempt from Registration under 1933 Act Securities issued by any government in the U.S. Short-term notes and drafts that have a maturity date that does not exceed nine months Securities issued by nonprofit issuers Securities of financial institutions Securities issued by common carriers Insurance and annuity contracts issued by insurance companies Stock dividends and stock splits Securities issued in a corporate reorganization where one security is exchanged for another Security. Exempt Transactions (often resale is restricted) Nonissuers or average investor. Intrastate Offering – almost all activity within a single state. Private Placements if sold to unlimited accredited investors and no more than 35 unaccredited but sophisticated investors. Accredited investors have sufficient funds and/or special expertise. Sophisticated investors have gained knowledge through experience or education. Small Offerings not exceeding $1million in a 12 month period but not to general public. Regulation A permitting sale up to $5million in a 12 month period, often with substitute information. Over $100,000 requires an “offering statement”. Preventing Transfer of Restricted Securities To protect the nontransferability of restricted securities, the issuer must Require the investors to sign an affidavit stating that they are buying the securities for investment, acknowledging that they are purchasing restricted securities, and promising not to transfer the shares in violation of the restriction Place a legend on the stock certificate describing the restriction Notify the transfer agent not to record a transfer of the securities that would violate the restriction Securities Exchange Act of 1934 A federal statute that primarily regulates the trading in securities. Registration and continuous filing is required. The Act also regulates exchanges, brokers, and dealers. Strong anti-fraud provisions are included. Issuers must file if assets are greater than $5million and at least 500 shareholders, equity is traded on a national exchange or registered under 1933 Act. Continuous filing includes: 10K annual reports with certified financial statements 10Q quarterly reports 8K material changes Officers, directors and owners of 10% or more of an equity security (insiders) must show changes. Anyone acquiring over 5% must report. Manipulation and deception are prohibited under Section 10b. Rule 10b-5 prohibits use of interstate commerce, mails or a national exchange to defraud, make or omit material untrue statements or other fraud. Scienter or intentional conduct is required as is reliance by injured party. Insider trading or trading on nonpublic information is prohibited. The rule applies to insiders (officers, directors, employees, relevant professionals or those owing a fiduciary duty). It also applies to tippers and tippees with some exceptions. Tipper A person who discloses material nonpublic information to another person Tippee The person who receives material nonpublic information from a tipper Section 16(b) makes insiders liable to the corporations for short-swing profits or profits made in a 6 month period whether or not there was actual use of inside information. Officers are those who perform policymaking functions. 6 months before become an insider do not count. Other civil and criminal penalties and SEC actions may apply. Civil penalties could be up to three times under the Insider Trading Sanctions Act of 1984. Other Federal Securities Laws Racketeer Influenced and Corrupt Organizations Act—pattern of racketeering Private Securities Litigation Reform Act—safe harbor for appropriate forward-looking statements Regulation FD—prohibits leaking information to securities professionals prior to issuing to the public Sarbanes-Oxley Act – SEC may issue order prohibiting any person who has committed securities fraud from acting as an officer or director of a public company. State laws—Blue Sky Laws IV. Objective Questions Terms: 1. Two federal statutes designed to require disclosure of information to investors and prevent fraud are known as the _______________ _______________ _______________ _______________ and the _______________ _______________ ________________ _______________ _______________. 2. Generally, a _______________ is present when an investor invests money in a common enterprise with the expectation of making a profit from the significant efforts of others. 3. The federal administrative agency empowered to administer federal securities laws is called the _______________ _______________ _______________ ________________. 4. A written document used as a selling tool by the issuer, which enables prospective purchasers of securities to evaluate certain risks of a particular investment, is known as the _______________. 5. When an issuer engages in public relations campaigns that tout the prospects of the company and an upcoming securities offering, this is called ________________ _______________ _______________. 6. The time between when a registration statement is filed with the SEC and when the registration statement becomes effective is called the _______________ period. 7. The document which must be delivered to investors at the time of confirming a sale or when sending a security to a purchaser is known as the _______________ prospectus. 8. Each state is entitled to enact its own laws, known as _______________ _______________ laws, regulating the offer and sale of securities within its borders. 9. In certain situations, employees and advisors of an issuer of securities use material, nonpublic information to make a profit by buying or selling securities of the issuer. This practice is known as _______________ _______________. 10. When certain insiders buy and sell securities within a six-month period of time, any gains realized are called _______________ ________________ profits. True/False: 1. ____ During the prefiling period, the issuer is permitted to offer, but not to sell, securities of the proposed offering. 2. ____ During the waiting period, the issuer may distribute a preliminary prospectus and publish tombstone ads that, in effect, condition the market for the upcoming issuance of securities. 3. ____ Certain transactions in securities are exempt from the registration requirements of the federal securities laws as are certain types of securities. 4. ____ During the posteffective period, the issuer may close the transactions solicited previously, but may not solicit any new transactions. 5. ____ Securities issued by colleges and universities are typically exempt from the registration requirements of the federal securities laws. 6. ____ Securities issued using a private placement exemption may only be sold to 35 investors. 7. ____ Violation of the federal securities laws can result in civil and criminal actions by the SEC as well as private civil actions by individual investors. 8. ____ Certain individuals associated with a securities offering can avoid liability by proving that, after reasonable investigation, they had reasonable grounds to believe, and did believe that at the time the registration statement became effective, the statements therein were true and that there was no omission of a material fact. 9. ____ An insider who trades on public information is subject to prosecution for violating the federal securities laws. 10. ____ If an insider provides nonpublic information to another who knows the information is not public information and who trades the related securities in reliance on that information, both the insider and the trading party have committed violations of the federal securities laws. Multiple Choice: 1. In general, which of the following is least likely to be considered a security under the Securities Act of 1933? A. General partnership interests. B. Warrants. C. Limited partnership interests. D. Treasury stock. 2. Under the Securities Act of 1933, the registration of securities that are offered to the public in interstate commerce is: A. Directed toward preventing the marketing of securities which pose serious financial risks to the prospective investor. B. Not required unless the issuer is a corporation. C. Mandatory unless the cost to the issuer is prohibitive as defined in the SEC regulation. D. Required unless there is an applicable exemption. 3. Which of the following is subject to the registration requirements of the Securities Act of 1933? A. Public sale of its bonds by a municipality. B. Public sale by a corporation of its negotiable five year notes. Public sale of stock issued by a common carrier regulated by the Interstate Commerce Commission. D. Issuance of stock by a corporation to its existing stockholders pursuant to a stock split. 4. The principle purpose of the registration requirements of the Securities Act of 1933 is to: Prevent public offerings of securities in which management fraud or unethical conduct is suspected. Provide the SEC with the information necessary to determine the accuracy of facts presented in the financial statements. C. Assure that investors have adequate information upon which to base investment decisions. Provide the SEC with the information necessary to evaluate the financial merits of the securities being offered. 5. Shadee Corporation wishes to sell securities to raise $850,000 for the purpose of financing several corporate expansion projects. The issuance is considered a small offering. Which of the following statements is correct with respect to the transaction? The transaction cannot be completed without registration because Rule 504 only allows the issuance of $750,000 of securities. B. The securities can be sold to accredited investors only. The securities can be sold to an unlimited number of accredited investors and to 35 unaccredited investors. D. The securities can be sold to an unlimited number of accredited unaccredited investors. 6. Ricky Risktaker was of the theory that to make it big, he had to take big risks in his investments. He took a huge risk in buying stock in Worthless Corporation. He is now suing the CPA firm that audited the financial statements including in the registration statement in an attempt to recover his investment. Which of the following statements is correct? A. The CPA firm is not liable if it can prove that it acted with due diligence in conducting its audit. B. The CPA firm is strictly liable for any material defects in the registration statement. C. Ricky must prove that he relied on the registration statement before he will be entitled to recover. D. None of the above. 7. Drink-Rite Corporation, a corporation whose shares are publicly traded, was having a phenomenal year. Profits were rolling in because rolls were coming off of its customers. However, the fun is about to end. The Food and Drug Administration has notified the president of Drink-Rite that the corporation will be forced to stop selling its product because of a recent discovery of significant health risks created by the product. The president immediately sells his shares and calls his father who also sells his shares. In addition, the president's father calls a friend who also sells his shares. Who has made an illegal sale in this situation? A. The president. B. The president's father. C. The friend of the president's father. D. A and B. E. All of the above. 8. Hometown Corporation, a Colorado corporation, hopes to raise capital by issuing new securities. Which of the following facts would prevent the issuance of securities pursuant to an intrastate offering exemption? A. The principal office of Hometown is located in Omaha, Nebraska. The securities are offered to several residents of New Mexico, but ultimately purchased by only Colorado residents. C. Hometown earns 30 percent of its gross revenues in Wyoming. D. A and C. E. All of the above. 9. Assume the same facts as in question 8, except that Hometown hopes to issue the securities using a Small Offering Exemption. Which of the following facts would prevent the issuance of securities pursuant to a Rule 505 Small Offering Exemption? A. Securities totaling $4,500,000 are sold in the transaction. B. The securities are sold to 37 accredited investors. C. The securities are offered in newspapers and magazines throughout the region. D. The securities are sold to investors whom the issuer knows will transfer the securities within three years of purchase. E. C and D. 10. Which of the following statements about a private placement not involving a public offering of securities is incorrect? A. Resale of such securities is restricted. B. General solicitations of purchasers is prohibited. C. Securities may only be offered to corporations and partnerships. D. None of the above. V. Answers to Objective Questions Terms: 1. Securities Act of 1933; Securities Exchange Act of 1934. These laws are the two keystones of today’s securities law system. 2. Security. The definition of securities has expanded to cover more and more sorts of ventures, including some limited partnership offerings. 3. Securities and Exchange Commission or SEC. This is the securities equivalent of the IRS. 4. Prospectus. Note that this is not a contract per se. 5. Conditioning the market. There are limitations on this practice. 6. Waiting. This period is designed to give time to act if someone may want to object. 7. Final prospectus. There is time to act based on this information. 8. Blue-sky laws. This is nicknamed after fraudulent sales of securities that had no underlying value beneath the "Blue Sky." 9. Insider trading. Much needed reforms have come based on recent scandals. 10. Short-swing. These transactions are now targeted by reforms to securities laws. True/False: 1. False. During the prefiling period, the issuer is not permitted to offer or sell securities. 2. True. Although actual sales are prohibited during the waiting period, the issuer may engage in certain offering activities. 3. True. Congress took cost considerations into account when these exemptions were allowed. 4. False. During the posteffective period, the issuer may close the transactions arranged previously and solicit new offers and sales. 5. True. Securities issued by nonprofit institutions, such a colleges and universities, are exempt from registration. 6. False. Securities sold using a private placement exemption may be sold to an unlimited number of accredited investors, but may only be sold to 35 nonaccredited investors. 7. True. Depending on the violation, a particular action could result in all of the mentioned actions. 8. True. Such a due diligence defense is available to a nonexpert with respect to that portion of a registration statement prepared by nonexperts. 9. False. If the information is truly "public" in nature, then an insider is free to trade without committing any violations. 10. True. Unfortunately, much of this still goes on. Multiple Choice: 1. A. Under the Howey test, a security exists where the investor invests money in a common enterprise with the expectation of making a profit from the significant efforts of others. A general partnership interest would result in profits from the efforts of each general partner including the partner’s own efforts as coowner of the enterprise.. 2. D. Unless a security or transaction qualifies for an exemption, Section 5 of the Securities Act of 1933 requires securities offered to the public through the use of the mails or any facility of interstate commerce to be registered with the SEC by means of a registration statement and an accompanying prospectus. This rule is designed to afford maximum coverage of the 1933 Act. 3. B. Unless a security or the transaction is exempt, the issuance and sale must be registered. Answer B is not an exempt security because commercial paper of a corporation must have a maturity of nine months or less to qualify as an exempt security. A and C are examples of exempt securities. In answer D, there is no offer or sale of a security because the securities are received in a stock split and not for value given in exchange. 4. C. The primary purpose of the Securities Act of 1933 is to assure that securities issuers provide potential investors with full and fair disclosure of all material information needed to make a prudent investment decision. The Act does not assure that the investor will make a profit on his or her investment. 5. D. The small offering exemption exempts the sale of up to $1 million of securities during a 12-month period from registration. The securities may be sold to an unlimited number of accredited and unaccredited investors, but general selling efforts to the public are not permitted. 6. A. To be shielded from liability, the CPA firm only needs to prove that it acted with due diligence with respect to the portions of the registration statement it prepared, i.e., only the financial statements. 7. E. All three parties have made illegal sales in this situation because all knew that they were trading on material nonpublic information. 8. E. To qualify for the intrastate offering exemption, the issuer must be a resident of the state in which the exemption is sought. In addition, the issuer must be doing business in that state, i.e., earn 80 percent of its gross revenues in that state. Finally, the shares may not be offered or sold to a resident of another state. 9. D. To qualify for a Small Offering Exemption, general selling efforts, such as advertising in a newspaper or magazine, are forbidden. 10. C. Securities may be sold to an unlimited number of accredited investors and to 35 unaccredited investors. VI. Answers to Essay Question: Mr. Williams may have a barrel full of real problems on his hands. He must now worry about possibly having run afoul of the Securities and Exchange Commission. Under the 1933 Act, newly issued securities must comply with the registration requirements of the Act unless they fall into specific exemptions. The first issue revolves around the definition of security for purposes of the 1933 Act. Under the court decision of S.E.C. v. Howey, any contract that calls for an investment with the expectation of income from the efforts of a promoter or third person may be deemed to be a security. Here the most likely interpretation is that the sales contracts for bakeries would be declared a security. Next, look to see how this security was sold. If there is use of any facility of interstate commerce or the mail, it may be covered under the 1933 Act. Here with sales to several hundred people, lawyers would indicate a very likely use of the mail for purposes of selling the securities. Then decide if any of the exemptions from registration apply. The securities themselves do not fall into any of the exempt categories. It is not a nonprofit organization, nor is this a sale by a governmental entity. It is not a reorganization or stock split. In addition, it does not appear that any of the transaction exemptions apply. It is not stated as only an intrastate offering. Nor does it appear that Mr. Williams tried to qualify the sales as a private placement or a small offering under either Section 504 or 505. Because he failed to comply with the 1933 Act, he may now be subject to both civil and criminal sanctions by the government. In addition, the private parties hurt by these violations may sue him. In addition to the problems raised by the 1933 Act, there are problems that may arise under the 1934 Act if Mr. Williams engaged in subsequent trading of his partnership interests after they had first been issued. This is particularly a problem for him under Rules 10(b) and 10(b)-5 that are designed to go after fraudulent transfers of securities. These violations could lead to both civil and criminal sanctions against him by both the government and private parties. Mr. Williams may be liable under the RICO statute or one or more of the newer federal securities laws recently passed as a result of scandals in the securities markets.