Chapter 41 Corporations: Securities and Investor Protection Copyright © 2017 McGraw-Hill Education All rights reserved No reproduction or distribution without the prior written consent of McGraw-Hill Education Overview • LO41-1: What is a security? • LO41-2: What requirements are imposed by the Securities Act of 1933? • LO41-3: How does the Securities Exchange Act of 1934 regulate the • • trading of securities? LO41-4: How are investment companies regulated? LO41-5: How states regulate securities? 41-2 Chapter 41 Hypothetical Case • As this chapter indicates, although the Securities and Exchange Commission (SEC) requires the registration of securities, the SEC does not approve these securities In other words, the SEC does not make any judgment about the worth of securities Instead, it simply enforces the requirement that issuers provide certain information to potential buyers, including: (1) a description of the securities offered for sale; (2) an explanation of how proceeds from the sale of the securities will be used; (3) a description of the registrant's business and properties; (4) information about the management of the company; (5) a description of any pending lawsuits in which the registrant is involved; and (6) financial statements certified by an independent public accountant • As the federal administrative agency with primary responsibility for regulating the United States securities market, should the Securities and Exchange Commission formulate a judgment regarding the worth of soon-to-be-issued securities and inform potential investors of that judgment? Does the SEC have an ethical obligation to potential investors to make and publicize such valuation judgments? 41-3 Chapter 41 Hypothetical Case • Thomas Abramson is a quality control manager for Capitol-IZE Pharmaceutical Company, Inc The company is headquartered and has its principal production facility in Indianapolis, Indiana For several years, Capitol-IZE Pharmaceutical has been engaged in the research and development of a new cancer drug, Izerion As part of the federal regulatory procedure for mass-marketing a new drug, Capitol-IZE Pharmaceutical applied to the Food and Drug Administration (FDA) for final approval of Izerion • Yesterday, Abramson's supervisor informed him in somber fashion that the FDA had rejected the company's application for final approval of Izerion Apparently, the FDA was concerned about serious side effects that manifested during the drug's clinical trials Abramson's supervisor further advised him that next Monday Capitol-IZE Pharmaceutical is scheduled to go public with a press release concerning the FDA's rejection of Izerion 41-4 Chapter 41 Hypothetical Case (cont'd) • Abramson is frantic He owns approximately 6,000 shares of Capitol-IZE Pharmaceutical stock, and he knows that news of the FDA's rejection of Izerion will be disastrous to the company, its employees, and its shareholders Capitol-IZE Pharmaceutical stock is currently valued at $47.50 per share, and news of the FDA's disapproval of Izerion will likely drive the stock down to one-half of its current value Abramson quickly runs the numbers on his calculator A reduction of 50% of the stock's value would represent a personal loss of $142,500 Abramson's Capitol-IZE Pharmaceutical stock is his only retirement plan, aside from a modest pension he will receive from the company (assuming the company survives the announcement) Abramson has a plan Today, he will instruct his financial planner to immediately sell all 6,000 shares of his Capitol-IZE Pharmaceutical Company, Inc stock Abramson rationalizes his decision by assuring himself that anyone else in his position would the same thing • Is Thomas Abramson's plan legal? Is it ethical? 41-5 Securities and the SEC • Security: Investment in a common enterprise with the reasonable • expectation of profit gained predominantly from others' efforts Securities and Exchange Commission: Created in 1934 to: • Enforce securities laws • Interpret provisions of securities acts • Regulate the trade of securities • Regulate the activities of securities brokers, dealers, and advisers 41-6 Expansion of SEC Powers in the 1990s • Securities Enforcement Remedies and Penny Stock Reform Act of 1990 • Market Reform Act of 1990 • Securities Acts Amendments of 1990 • National Securities Markets Improvement Act of 1996 • Sarbanes-Oxley Act of 2002 41-7 Securities Act of 1933 Requirements: Registration Statement • • Securities Act of 1933: Passed to legitimize security transactions by requiring registration of securities Registration statement is document containing: • • • • • • Description of securities offered Explanation of how proceeds from sale will be used Description of registrant's business and properties Information about management of company Description of pending lawsuits Certified financial statements 41-8 Securities Act of 1933: Terminology, Rules, and Procedures • • Prospectus: Written document similar to registration statement, used as a selling tool to attract potential investors Periods of the registration statement and prospectus filing process: • • • • • Prefiling period Waiting period Posteffective period Exempt transactions: Securities exempt from standard SEC registration requirements Limited offers: Involve small amounts of money, or are offered only to sophisticated investors • • Private placement exemption: Exempts private offerings of securities Rule 505: States that private offerings may not exceed $5 million in a 12-month period, and firms not have to believe that investors have a reasonable ability to evaluate risk • • Rule 504: Exempts noninvestment firms that offer no more that $1 million in securities in a 12-month period Section 4(6): Exempts securities offered only to accredited investors for amount less than $5 million 41-9 Securities Act of 1933: Terminology, Rules, and Procedures (cont'd) • • Intrastate issues: Exempt local investors in local businesses Resales of securities: Exempt transactions by any person other than an issuer, underwriter, or dealer • Restricted securities: Securities acquired under Rule 505, 506, or Section 4(6) that must be registered for resale, unless investor follows Rule 144 or 144(a) • Violations may result in: • • • Administrative action Injunctive action Criminal prosecution 41-10 Securities Exchange Act of 1934 • Section 10(b): Prohibits use of manipulative and deceptive devices to bypass SEC rules • Insider trading: Trading in which company employee or executive uses material inside information to make profit • Misappropriation theory: Individual who wrongly acquires and uses inside information for profit is liable for insider trading 41-11 Securities Exchange Act of 1934: Terms, Rules, and Procedures • Tipper/tippee theory: Individual who receives material inside information as a result of insider's breach of duty is guilty of insider trading • Statutory insiders: Certain stockholders, executive officers, and directors who must file reports detailing their ownership and trading of the corporation's securities • Short-swing profits: Profits made from sale of company stock within any six-month period by statutory insider; per Section 16(b), these profits must be returned to company 41-12 Securities Exchange Act of 1934: Terms, Rules, and Procedures (cont'd) • Proxy: Document that authorizes an individual to vote shareholder's share of stocks at a shareholders' meeting • • Proxy solicitation: Process of obtaining authority to vote on behalf of shareholder Violations of Securities Exchange Act of 1934 may result in: • • • Criminal penalties Civil penalties Suits against those involved in insider trading under Insider Trading Sanctions Act of 1984 41-13 State Securities Regulation • Blue-sky laws: Regulate the offering and sale of securities within the state only • Some laws exempt from federal securities regulation may be subject to state laws • Often similar to federal securities laws • Uniform Securities Act: Most states have adopted 41-14 Chapter 41 Hypothetical Case • Although the Securities and Exchange Commission has existed as a federal administrative agency for over 70 years (the Commission was created in 1934), some critics question the need for its continued existence, or alternatively argue for significant deregulation of stock trades According to critics, there is arguably no need for significant federal regulation of publicly-traded securities, since market conditions dictate legitimacy and honesty in securities transactions; after all, for how long could a corporation exist if it does not strive to ensure the integrity of its stock? • How you respond to this line of reasoning, that the free market will dictate fair and honest stock trades? In your answer, consider the history and mission of the Securities and Exchange Commission Reference: About the SEC: What We Do 41-15 Chapter 41 Hypothetical Case • A new tech start-up, Tolumetrix, is planning to go public in an initial public offering (IPO) One of the company's executives, Richard Columbus, is charged with preparing the company's registration statement and prospectus, which are required Columbus is unfamiliar with the process of creating and filing these documents and with securities in general; a programmer by trade, he is new to the entire process of running a successful company He decides to use the documents provided by a similar company as a template Columbus files the forms to the SEC and immediately begins making oral offers to sell the company's stock He sends a copy of the prospectus identical to the one that has been submitted to the SEC He does not send a follow-up version of the prospectus after many changes are requested and made and the final approval has come from the SEC • Has Columbus—and Tolumetrix—violated the 1933 Securities Act? Explain your answer 41-16 ... Regulation • Blue-sky laws: Regulate the offering and sale of securities within the state only • Some laws exempt from federal securities regulation may be subject to state laws • Often similar... proceeds from sale will be used Description of registrant's business and properties Information about management of company Description of pending lawsuits Certified financial statements 41-8 Securities... used; (3) a description of the registrant's business and properties; (4) information about the management of the company; (5) a description of any pending lawsuits in which the registrant is involved;