© 2005 West Legal Studies in Business A Division of Thomson Learning CHAPTER 21 Financing, Investor Protecting, Online Securities Offerings

© 2005 West Legal Studies in Business A Division of Thomson Learning 2 What is meant by the term securities?What is meant by the term securities? What are the two major statutes regulating the securities industry? When was the SEC created, and what are its major purposes and functions?What are the two major statutes regulating the securities industry? When was the SEC created, and what are its major purposes and functions? What is insider trading? Why is it prohibited?What is insider trading? Why is it prohibited? What are some of the features of state securities laws?What are some of the features of state securities laws? How are securities laws being applied in the online environment?How are securities laws being applied in the online environment? Learning Objectives

© 2005 West Legal Studies in Business A Division of Thomson Learning 3 Introduction The stock market crash of 1929 showed the need for:The stock market crash of 1929 showed the need for: –More disclosure from issuers. –Prohibition of deceptive, unfair and manipulative practices in the purchase and sale of securities.

© 2005 West Legal Studies in Business A Division of Thomson Learning 4 Introduction The Securities Act of 1933 and Securities Exchange Act of 1934 are designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities.The Securities Act of 1933 and Securities Exchange Act of 1934 are designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities. Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt.Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt.

© 2005 West Legal Studies in Business A Division of Thomson Learning 5 Corporate Financing Bonds vs. Stocks Stocks DebtOwnership/equity Fixed ROI Dividends (variable) No votes Vote for Management OptionalRequired Priority over stock Paid last

© 2005 West Legal Studies in Business A Division of Thomson Learning 6 Bonds TypeDefinition Debentures No specific corporate assets are pledged as collateral. Backed by corporation’s general credit rating. Mortgages Pledge specific real estate. If corporation defaults, bondholders can foreclose. Convertible Conditions trigger bonds to convert to corporate stock. Callable Can be “called in” by principal and repaid according to bond conditions.

© 2005 West Legal Studies in Business A Division of Thomson Learning 7 Stocks Common Stock: represents true ownership of a corporation. Provides pro-rata (proportional) ownership interest reflected in control, earnings and assets.Common Stock: represents true ownership of a corporation. Provides pro-rata (proportional) ownership interest reflected in control, earnings and assets. Preferred Stock: has preferences over common stock.Preferred Stock: has preferences over common stock. –Cumulative Preferred. –Participating Preferred. –Convertible Preferred. –Redeemable or Callable Preferred.

© 2005 West Legal Studies in Business A Division of Thomson Learning 8 Sarbanes-Oxley Act of 2002 Attempts to increase corporate responsibility by:Attempts to increase corporate responsibility by: –Stricter disclosure requirements. –Harsher penalties for legal violations. –Corporate officers take responsibility for financial statements and SEC reports. –CEO’s and CFO’s must personally certify reports. Oversight by Public Company Accounting Oversight Board.Oversight by Public Company Accounting Oversight Board. Protections for Whistleblowers.Protections for Whistleblowers. Enhanced Penalties.Enhanced Penalties.

© 2005 West Legal Studies in Business A Division of Thomson Learning 9 Securities Act of 1933 Securities Act of 1933 regulates solicitation, buying and selling of securities.Securities Act of 1933 regulates solicitation, buying and selling of securities. In SEC v. Howey (1946), the U.S. Supreme Court held that a security exists in any transaction in which a person: (1) invests (2) in a common enterprise (3) reasonably expecting profits (4) derived primarily from others’ managerial or entrepreneurial efforts.In SEC v. Howey (1946), the U.S. Supreme Court held that a security exists in any transaction in which a person: (1) invests (2) in a common enterprise (3) reasonably expecting profits (4) derived primarily from others’ managerial or entrepreneurial efforts. SEC v. Alpha Telcom, Inc. (2002).SEC v. Alpha Telcom, Inc. (2002).

© 2005 West Legal Studies in Business A Division of Thomson Learning 10 Registration Statement If a security does not qualify for an exemption under §5 of the Securities Act of 1933, the security must be registered with the Securities Exchange Commission ( and state securities agencies before offered to the public.If a security does not qualify for an exemption under §5 of the Securities Act of 1933, the security must be registered with the Securities Exchange Commission ( and state securities agencies before offered to the public. Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.

© 2005 West Legal Studies in Business A Division of Thomson Learning 11 Registration Statement Description of the significant provisions of the registrant’s “offering” and how the registrant intends to use the proceeds from the sale.Description of the significant provisions of the registrant’s “offering” and how the registrant intends to use the proceeds from the sale. Description of the registrant’s properties and business.Description of the registrant’s properties and business.

© 2005 West Legal Studies in Business A Division of Thomson Learning 12 Registration Statement Description of the management of the registrant, remuneration, pension, stock offerings, executive interests and compensation.Description of the management of the registrant, remuneration, pension, stock offerings, executive interests and compensation. Financial statement certified by and independent accounting firm.Financial statement certified by and independent accounting firm. Description of pending lawsuits.Description of pending lawsuits.

© 2005 West Legal Studies in Business A Division of Thomson Learning 13 Exempt Securities Bank securities sold before 1933.Bank securities sold before Commercial paper if maturity date does not exceed 9 months.Commercial paper if maturity date does not exceed 9 months. Charitable organization securities.Charitable organization securities. Securities issued to existing securities holders resulting from reorganization, bankruptcy.Securities issued to existing securities holders resulting from reorganization, bankruptcy. Securities issued to finance railroad equipment.Securities issued to finance railroad equipment.

© 2005 West Legal Studies in Business A Division of Thomson Learning 14 Exempt Securities Any insurance, endowment, annuity contract or government-issued securities.Any insurance, endowment, annuity contract or government-issued securities. Securities issued by banks, savings and loan association, farmers' cooperatives.Securities issued by banks, savings and loan association, farmers' cooperatives. Regulation A, small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular.Regulation A, small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular. Securities issued to existing securities holders, stock split, dividend (really a transaction exemption).Securities issued to existing securities holders, stock split, dividend (really a transaction exemption).

© 2005 West Legal Studies in Business A Division of Thomson Learning 15 Exempt Transactions Small “Reg D” OfferingsSmall “Reg D” Offerings –Rule 504: up to $1M in 12 months to accredited investors only. –Rule 504a: up to $500K but no ads. –Rule 505: up to $5M during 12 months to both accredited and unaccredited investors. –Section 4(6): up to $5M solely to accredited investors.

© 2005 West Legal Studies in Business A Division of Thomson Learning 16 Violations of the 1933 Act Intentional or negligent fraud of investors by misrepresenting or omitting material facts in the registration statement and/prospectus.Intentional or negligent fraud of investors by misrepresenting or omitting material facts in the registration statement and/prospectus. Defenses: Statement left out was not material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true.Defenses: Statement left out was not material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true. Penalties :Penalties : –Criminal: up to 5 years in prison and $10,000 fine. –Civil: damages, refund of investment, injunction.

© 2005 West Legal Studies in Business A Division of Thomson Learning 17 Registration of securities exchanges, brokers, dealers, and national securities exchanges and associations.Registration of securities exchanges, brokers, dealers, and national securities exchanges and associations. Requires continuous disclosure system for corporations with securities sold on national exchanges or assets in excess of $5 million and 500 or more shareholders (Sec. 12 companies or 1934 companies).Requires continuous disclosure system for corporations with securities sold on national exchanges or assets in excess of $5 million and 500 or more shareholders (Sec. 12 companies or 1934 companies). Securities Exchange Act of 1934

© 2005 West Legal Studies in Business A Division of Thomson Learning 18 Section 10(b) and Rule 10b(5) & Insider Trading Section 10(b) prohibits the use of any manipulative or deceptive device or contrivance in contravention of rules and regulations of SEC.Section 10(b) prohibits the use of any manipulative or deceptive device or contrivance in contravention of rules and regulations of SEC. Rule 10b(5) prohibits the commission of fraud in the connection with the purchase or sale of any security.Rule 10b(5) prohibits the commission of fraud in the connection with the purchase or sale of any security. SEC v. Texas Gulf Sulphur Co. (1968).SEC v. Texas Gulf Sulphur Co. (1968).

© 2005 West Legal Studies in Business A Division of Thomson Learning 19 Insider TradingInsider Trading –Advance information available to corporate officers and directors that can affect future value of stock. Insider trading prohibited:Insider trading prohibited: –10b(5) “Insiders” (Officers, Executives and Directors). –10b(5) “Outsiders”. Tipper/tippee theory--insider’s fiduciary duty must be breached.Tipper/tippee theory--insider’s fiduciary duty must be breached. Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance.Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance. Section 10(b) and Rule 10b(5) & Insider Trading

© 2005 West Legal Studies in Business A Division of Thomson Learning 20 Insider Reporting and Trading Section 16(b).Section 16(b). Recapture by corporation of profits during previous six months gained by insider trading.Recapture by corporation of profits during previous six months gained by insider trading. Applies to stocks, warrants, options and convertible securities.Applies to stocks, warrants, options and convertible securities.

© 2005 West Legal Studies in Business A Division of Thomson Learning 21 Penalties for Violations of the 1934 Act 10b violation—scienter or intent is required to prove criminal penalties.10b violation—scienter or intent is required to prove criminal penalties. –Imprisonment up to 10 years, fines up to $1 million, $2.5 for partnership or corporation. 16(b) -- strict liability -- no fault or scienter required -- civil penalties.16(b) -- strict liability -- no fault or scienter required -- civil penalties. United States v. Stewart (2004).United States v. Stewart (2004).

© 2005 West Legal Studies in Business A Division of Thomson Learning 22 Regulation of Investment Companies Act on behalf of many smaller shareholders by buying stock and professionally managing the “portfolio.” (MUTUAL FUNDS.)Act on behalf of many smaller shareholders by buying stock and professionally managing the “portfolio.” (MUTUAL FUNDS.) To safeguard company assets, all securities must be held by a bank or stock exchange member.To safeguard company assets, all securities must be held by a bank or stock exchange member. No dividends paid except from undistributed net income.No dividends paid except from undistributed net income.

© 2005 West Legal Studies in Business A Division of Thomson Learning 23 State Securities Laws State securities laws are called “blue sky” laws.State securities laws are called “blue sky” laws. Issuers must comply with federal and state securities laws and states do not allow the same exemptions as federal government.Issuers must comply with federal and state securities laws and states do not allow the same exemptions as federal government. States could require registration or qualification.States could require registration or qualification. Uniform Securities Act has been adopted in part by many states.Uniform Securities Act has been adopted in part by many states.

© 2005 West Legal Studies in Business A Division of Thomson Learning 24 Online Securities Offerings Landmark Online IPO (1996): Spring Street Brewing Company.Landmark Online IPO (1996): Spring Street Brewing Company. Regulations for online offerings.Regulations for online offerings. –SEC October 1995 “use of electronic media should be at least an equal alternative to paper- based media.” Downloadable prospectus is permissible.

© 2005 West Legal Studies in Business A Division of Thomson Learning 25 Online Securities Offerings Online IPO’s may deliver a prospectus by:Online IPO’s may deliver a prospectus by: –Giving timely and adequate notice ( s). –Making the online communication system readily accessible. –Requiring evidence of delivery ( return receipt).

© 2005 West Legal Studies in Business A Division of Thomson Learning 26 Online Securities Offerings Online offers should not link to other sites in prospectus.Online offers should not link to other sites in prospectus. Problems with status of investors on a general website. For example, Reg D offerings can only be made to “accredited investors”.Problems with status of investors on a general website. For example, Reg D offerings can only be made to “accredited investors”. –Perhaps use password protected website.

© 2005 West Legal Studies in Business A Division of Thomson Learning 27 Online Securities Fraud SEC tries to enforce anti-fraud provisions of Securities Laws.SEC tries to enforce anti-fraud provisions of Securities Laws. Use and abuse of internet chat rooms.Use and abuse of internet chat rooms. –Where is the line between free speech and fraud? –Pumping and Dumping: buyer pumps the stock and after it rises, he dumps it, selling at a higher price. Selling unregistered securities by unregistered stock brokers is a problem.Selling unregistered securities by unregistered stock brokers is a problem.