Investor Protection and Securities Transactions
INVESTOR Protection
Ch. 17
Business Judgment Rule
The Business Judgment Rule is a legal principle that protects the directors of a corporation from liability when making decisions if the following conditions are met:
The decision was made in good faith.
The directors employed the care that an ordinary prudent person in a similar position would exercise.
The action was taken in a manner that the directors reasonably believe to be in the best interest of the corporation and its shareholders.
Due Diligence
Due Diligence refers to the investigation and evaluation conducted prior to significant business decisions such as:
Purchasing property.
Launching a new business.
Conducting adequate investigations into securities purchases.
It serves as a defense for broker-dealers accused of insufficiently disclosing material information related to securities purchases. Under the Securities Act of 1933, brokers and dealers are protected from liability if they exercised due diligence when investigating the entities whose securities they sell, and if they fully disclosed their findings to investors, provided no undiscovered information was omitted from disclosure.
Regulatory Framework of Securities Markets
Pre-1920s and 1930s
Before the 1920s and 1930s, there was little to no federal regulation regarding the sale of securities.
Securities were often issued and sold with minimal disclosure, leading to widespread fraud in transactions.
Post-1929 Market Crash
Following the stock market crash of 1929, federal law began regulating securities markets.
The introduction of securities laws aimed to ensure proper disclosure of information to investors and to prevent acts of fraud.
New Laws Enacted (1933 & 1934)
In response to the market crash, Congress passed significant federal securities statutes in 1933 and 1934, which include:
The Securities Act of 1933: Aims to require disclosure of information to investors and establishes a registration process.
The Securities Exchange Act of 1934: Focuses on the regulation of securities and fraud prevention in subsequent trading.
Definitions of Securities
What is a Security?
Securities are defined as investments that can be traded in a secondary market, with examples including:
Equity Securities: Involves shares of a corporation, with their secondary market on the stock market.
Debt Securities: Consist of loans, referred to as bonds, made to corporations or countries.
Derivative Securities: Financial instruments whose value is derived from other underlying assets such as stocks or bonds, providing potentially higher returns than directly purchasing the asset itself (example: stock options or put options).
IPO (Initial Public Offering)
An IPO refers to the process where a private company issues stock to the public for the first time, thereby becoming publicly traded.
It raises capital for the company and generally requires around four months for completion prior to listing on a stock exchange.
Securities Act of 1933
The Securities Act of 1933 primarily governs the issuance of securities by various entities including corporations and partnerships.
It applies to initial issues of securities, including IPOs and the issuance of new securities by established firms, including online securities issued.
Its purpose is to ensure full and honest disclosure of information to investors to allow informed investment decisions.
Impact of Securities on the Economy
Securities aid in connecting those with capital to those in need of investment, enhancing market efficiency.
They facilitate clarity regarding which companies are performing well, influencing the allocation of funds to growing enterprises, thereby rewarding performance and prompting growth.
Negative Aspects of Securities
The ease of purchasing securities can result in impulsive buying, leading to uninformed investment decisions.
Significant downturns in stock prices may jeopardize investors' entire savings (example: Black Thursday contributing to the Great Depression).
Volatility can be exacerbated by derivatives, which are complex investment instruments.
An example of this is CDOs (collateralized debt obligations) that contributed to the Global Financial Crisis of 2008.
Understanding Derivatives
Definition of a Derivative
A Derivative is a security or contract that derives its value from its relationship to another asset or cash flow stream.
Call Option: A contract that allows the purchase of an underlying asset at a specified price.
Example: If a call option's strike price is $37 and the underlying stock trades at $45, the option is considered in the money (ITM), with intrinsic value equal to the difference between the current price and the strike price.
Put Option: A contract that anticipates a decrease in the underlying asset's price.
If the underlying stock trades at $37, the put option becomes profitable when the stock price drops below $37.
The option is at the money (ATM) when the strike price equals the underlying asset's price.
Time Value: The period available for exercising the option affects its intrinsic value, hence influencing its market price.
Legislative Updates
Dodd-Frank Act 2010
Following earlier reforms, the Dodd-Frank Act was enacted in 2010 to regulate hedge funds, derivatives, and prevent abusive practices in the securities industry post-2008 financial crisis.
It aimed to enhance transparency within securities markets, continuing the agenda that began with the Sarbanes-Oxley Act of 2002, which developed measures to prevent conflicts of interest.
Definition of a Security (continued)
Common types of securities include:
Common and preferred stocks.
Bonds, debentures, and warrants.
Statutorily Defined Securities: Explicitly mentioned in securities acts, such as interests in oil and gas.
Investment Contracts: Defined under the Howey test as involving an investment of money in a common enterprise, expecting profits primarily from the efforts of others.
Securities and Exchange Commission (SEC)
The SEC is a federal agency responsible for administering federal securities laws.
It adopts rules and regulations for interpreting and enforcing these laws, investigates allegations of violations, and enforces compliance.
The SEC regulates the activities of brokers and advisors involved in securities transactions and oversees initial public offerings under the Securities Act of 1933.
Going Public
The Process of Going Public
Going public refers to a business or issuer selling securities to the public for the first time through an IPO.
Many issuers engage investment banks for the resale of their securities, paying a fee for this service.
Prior to becoming an issuer, a written registration statement must be filed with the SEC.
Registration Statement
Issuers must submit this written statement to the SEC prior to securities sales, providing essential information about the issuer and the securities involved.
The SEC reviews this statement to confirm compliance with disclosure requirements but does not assess the merits of the securities itself.
Prospectus
A prospectus is a disclosure document that accompanies the registration statement submitted to the SEC.
It serves as a sales aid for the issuer and a means for prospective investors to gauge investment risks.
It must include a warning, prominently stating: "These securities have not been approved or disapproved by the SEC …"
Prefiling Period
This period begins when the issuer considers offering securities and concludes when the registration statement is filed.
During this waiting time, the issuer cannot engage in market manipulating activities or conduct a public relations campaign leading up to the filing.
Sale of Unregistered Securities
Selling securities that should have been registered but were not constitutes a violation of the Securities Act of 1933.
Investors affected may rescind their purchase and claim damages.
Criminal penalties can also be imposed by the U.S. government.
Exempt transactions include:
Nonissuer Exemption: Sales of previously purchased securities.
Intrastate Offering Exemption: Limited to local businesses selling to local investors for local economies.
Private Placement Exemption: Raising capital from accredited investors without registering.
Small Offering Exemption: Securities sales under $1,000,000 in a 12-month period.
Transactions Exempt from Registration
Certain transactions need not register with the SEC but must still comply with antifraud provisions of federal securities laws, necessitating adequate information for investors such as annual reports and financial statements.
DOJ Actions for Violations of 1933 Act
The Department of Justice may instigate criminal prosecutions for violations, leading to possible fines or imprisonment.
Sarbanes-Oxley Act
This act establishes barriers between investment bankers and securities analysts to prevent conflicts of interest, ensuring analysts act independently from investment pressures.
Securities Exchange Act of 1934
Intended to thwart fraud in subsequent security trading, this act oversees securities exchanges, brokers, and dealers.
It mandates ongoing reporting to investors and the SEC, requiring annual and quarterly reports to ensure transparency.
Section 10(b)
This section prohibits manipulative or deceptive devices in the sale or purchase of securities against SEC rules.
Rule 10b-5
Clarifies Section 10(b) obligations, stating that making untrue statements or omitting material facts constitutes fraud, focusing on intentional misconduct (scienter).
It applies to all securities transactions, including stock exchanges and private sales.
Violations of 1934 Act
Private Actions: Courts have recognized a private right of action for violations under Section 10(b) and Rule 10b-5, allowing plaintiffs to seek rescission or damages, including profits gained from illegal trades.
Insider Trading
Insider trading is prohibited under Section 10(b) and Rule 10b-5, which aims to prevent individuals from profiting by trading based on material nonpublic information.
Notable Case: United States v. Bhagat (2006): Bhagat faced conviction for insider trading after purchasing Nvidia shares based on nonpublic information about a contract with Microsoft.
United States v. Kluger (2013)
Kluger, a lawyer, was implicated in a conspiracy involving insider trading that resulted in over $47 million in profits over 17 years.
Ultimately, the court upheld his 12-year sentence due to the extensive and historic conspiracy.
Chiarella v. United States (1980)
Chiarella, who traded based on inside information about impending takeover bids, was acquitted of liability under SEC regulations, establishing that a duty to disclose arises only with fiduciary relationships.
Definition of Insiders
Insiders are individuals within the company holding fiduciary relationships, including officers, directors, employees, and certain agents such as lawyers and consultants who owe the company a duty.
Tippee-Tipper Liability
Tipper: A person who provides non-public material information to another.
Tippee: The recipient of such information who acts on it.
Both can face civil and criminal liabilities for insider trading activities.
Others Liable for Securities Fraud
Individuals who misappropriate information or abet fraud may also incur liability.
Aiders and abettors who knowingly assist in fraudulent activities face potential criminal charges, though no private action can be made against them.
SEC v. Texas Gulf Sulphur (1968)
The SEC sued Texas Gulf Sulphur after its employees profited from undisclosed, positive mining results.
The case highlighted the significance of material information in trading involving inside knowledge and confirmed the importance of the duty to disclose before securities transactions.
Materiality Test Established
The court affirmed that inside information is material to shareholders, justifying adherence to disclosure protocols.
Trading on undisclosed material information warrants legal repercussions.
Short-Swing Profits
Section 16(a)
Defines statutory insiders as executive officers, directors, or significant shareholders who must disclose trading in company securities.
Section 16(b)
This provision criminalizes profits made from trades executed within a 6-month window, enabling corporations to seek recovery without needing proof of insider trading.
State Securities Laws
Most states have established Blue-sky laws, regulating the issuance and trading of securities, often mirroring federal laws for coordination.
The Uniform Securities Act serves as a model statute adopted by numerous states.