Chapter 28: Investor Protection and Corporate Governance

Registration

1933 Securities Act: all securities (excluding exemptions) must be registered before being offered to public Prospectus: disclosure document that describes the security being sold, financial operations of the issuing corporation, and investment/risk attached to security. Prefiiling (no offers), Waiting (offers), Posteffective (sales) periods Free-Writing Prospectus: written/electronic/graphic offer that describes issuer or securities and includes legend indicating that the investor may obtain the prospectus at the SEC's web site during Waiting Period.

Board of Directors and Accountability

Audit Committee: oversees accounting and financial reporting processes (both internal and outside auditors) and "internal controls" Compensation Committee: determines compensation of officers

Exempt Securities and Transactions

Certain types of securities are exempt from the SEC registration requirements: Regulation A Offerings: not exceeding $50mm within a 12 month period, must file notice of issue and offering circular, allowed to "test waters" for potential interest (online sales) Small Offerings- Regulation D 1. Rule 504: small non-investment companies offering up to $1mm in a 12 month period 2. Rule 505: private, non-investment company offering up to $5mm in a 12 month period 3. Rule 506: private, non-investment company offering unlimited amounts that are not generally solicited or advertised (private placement)

Promoting Accountability

Corporate Governance involves: 1. audited reporting of financial conditions at the corporation so managers can be evaluated 2. Legal protections for shareholders so that violators of the law who attempt to take advantage of shareholders can be punished for misbehavior and victims can recover damages

What is a security?

Preferred and common stocks, bonds, debentures, stock warrants, options, debt notes, interest in oil, gas, or other mineral rights, or investment contracts (limited partnerships and other investment schemes) Howey Test: an investment contract is any transaction which a person invests in a common enterprise reasonably expecting profits derived primarily or substantially from others' managerial or entrepreneurial efforts.

Securities Exchange Act of 1934

Provides for the regulation and registration of securities exchanges, brokers, dealers, and national securities associations. Unlike 1933, provides for continuous periodic disclosures by publicly held corporation to enable the SEC to regulate subsequent trading.

Violations of the 1933 Act

Remedies: fines up to $10k, imprisonment up to 5 years or both Defenses: 1. statement/omission was immaterial 2. plaintiff knew about misrepresentation at the time the stock was purchased 3. The defendant exercised due diligence in preparing/reviewing registration and reasonably believed that statements were true (available to underwriter/subsequent seller, not issuer)

Violations of the 1934 Act

Scienter or intent is required to prove civil or criminal penalties under 10(b) and Rule 10b-5. Violator must have had intent to defraud (false statements or wrongfully failed to disclose material facts). Scienter is NOT required for 16(b) violations Criminal Penalites: $5mm (individual)/$25mm (corporation/parntership), 20 years prison

Regulation of Proxy Statements

Section 14(a) of S&E Act: regulates solicitation of proxies from shareholders; whoever solicits a proxy must fully and accurately disclose in the proxy statement all of the facts that are pertinent to the matter on which shareholders are to vote.

Blue Sky Laws

State laws that regulate the offering and sale of corporate securities within its borders.

Ponzi Scheme

a fraudulent investment operation in which money collected from new investors is used to pay off earlier investors

Requirements Under State Securities Laws

apply mainly to intrastate transactions disclosure requirements and anti-fraud provisions patterned after 1934 10(b)

Sarbanes-Oxley Act

attempts to increase corporate accountability by imposing strict disclosure requirements and harsh penalties for violations of securities laws (direct federal corporate governance for publicly-traded companies) More Internal Controls and Accountability Exemptions for Smaller Companies (less than $75mm market cap) Certification and Monitoring Requirements -CEO/CFO verification of statements - all members of audit committee must be outside directors

Well Known Seasoned Issuer (WKSI)

firm that has issued at least $1B in securities in the last 3 years or has outstanding stock valued at least $700mm can file registration statements the day they announce a new offering and are not required to wait for SEC review/approval, can use free writing prospectus at any time

Securities Act of 1933

governs initial sales of stock by businesses by requiring that investors receive financial and other significant information concerning the securities being offered for public sale.

Resales and Safe Harbor Rules

most securities can be resold without registration. Resales of restricted securities under Rule 505/506 trigger registration requirements unless the selling party complies with Rule 144 or 144A. Rule 144: exempts registration on resale if: 1. there is adequate current public information about issuer. 2. the seller has owned security for at least six months if subject to 1934, one year if not 3. Securities are sold in certain limited transactions in unsolicited brokers' transactions 4. the SEC is notified of the resale OR Rule 144A: securities that at the time of issue were not of the same class as securities listed on national securities exchange or quoted in US automated interdealer quotation system may be resold.

1934 Section 10(b) and Rule 10b-5

prohibits use of any manipulative or deceptive mechanism in violation of SEC rules. Rule 10b-5: prohibits the commission of fraud in connection with the purchase/sale of securities. Buyers/Sellers must disclose material facts (fraudulent trading, dividend change, contract for sale of corporate assets, new discovery, significant change in finances, potential litigation) Aimed at preventing Insider Trading: when persons buy/sell securities based on information not available to the public.

Private Securities Litigation Reform Act

provides a "safe harbor" for publicly-held companies making forward-looking statements to protect against liability for securities fraud

1934 Section 16(b)

provides for the recapture by the corporation of all short-swing profits realized by an insider on a purchase/sale of corporation's stock within any six month period. (Irrelevant whether insider actually used inside information)

Concurrent Regulaton

since adoption of 1933/34, state and federal govts have regulated securities concurrently: Uniform Securities Act

Proxy Statement

statement required of a firm when soliciting shareholder votes filed in advance of the annual meeting.

Aliging the Interests of Officers and Shareholders

stock options created vested interest, led to problems with "cooking" books to keep share prices high to sell for profits Movement towards more outside directors to more closely monitor actions of corporate officers

Corporate Governance

the relationship between a corporation and its shareholders (rights and responsibilities among different stakeholders in corporation) Essential because corporate ownership (shareholders) is separate from corporate control