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Law and Ethics Final Eam > Securities Chapter 28 > Flashcards

Securities Chapter 28 Flashcards

1
Q

After the stock market crash of October 19, 1929, and the ensuing ecnomic depression, Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934 to regulate securities markets

A

Both acts were designed to:

  • Provide Investors with more informaion to help them make buying and selling decisions about securities
  • Prohibit deceptive, unfair, and manipulative practices
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2
Q

The Securities and Exchange Commisions (SEC) is the main independent regulatory agency that administers the 1933 and 1934 securities acts

A

The SEC also plays a key role in:

  • Interpreting the provisions of these acts (and their amendments)
  • Creating regulations governing the purchase and sale of securities
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3
Q

The Securities Act of 1933

A

The Securities Act of 1933 governs initial sales of stock by busiesses
- The act was designed to:
- Prohibit various forms of fraud
- Stabilize the securities industry by requiring that investors receive financial and other significant information conerning the securities being offered for public sale

The act provides that all securities transactions must be registered with the SEC unless they are specifically exempt from the registration requirements

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4
Q

Securities

A

Generally, stocks, bonds, or other items that represent an ownership internest in a corporation or a promise of repayment of debt by a corporation

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5
Q

Securities Include the Following:

A
  1. Instruments and interests commonly known as securities, such as preferred and common stocks, bonds, debentures, and stock warrants
  2. Interests commonly known as securities, such as stock options, puts, and calls, that involve the right to purchase a security or a group of securites on a national security exchange
  3. Notes, intruments, or othe ecidence of indebtness, including certificates of interest in a profit-sharing agreement and certificates of deposit
  4. Any fractional undicded interests in oil, gas, or other mineal rights
  5. Investment contracts, which include interests in limited partnerships and other investments schemes
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6
Q

The Howey Test

Investment contract

A

Investment contract- a transaction in which a person invests in a common enterprise reasonably expecting profits that are derived primarily from the efforts of others

This definition of “investment contract” is known as the Howey Test

It continues to guide the determinatino of what types of contracts can be considered securities

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7
Q

Many types of securities

A

In addition to stick and bonds issued by corporations, securities can take many forms
Examples: Interests in whiskey, cosmetics, worms, boats, vaccum cleaners, and cemetery lots
Almost any stake in the ownership or debt of a company can be considered a security
Examplees: Investment contracts in condominiums, franchises, and limted partnerships in real estate

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8
Q

Registration Statement

Secition 5 of the Securities Act broadly provides that if a security does not qualify for an exemption, that security must be registered before it is offered to the public

Issuing corporations must:

A
  • File a registration statement with the SEC
    • Provide all investors with a prospectus
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9
Q

Prospectus

A

A written document required by securities laws when a security is being sold

The Prospectus describes:
- The security
- The financial operations of the issuing corporation
- The risk attaching to the security

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10
Q

Contents of the Registration Statement

A

The registration statement must be written in plain English and fully descibe the following

  1. The securities being offered for sale, including their realtionship to the registrants other securites
  2. The corporations properties and business (including a financial statement certified by an independtend public accounting firm)
  3. The management of the corporation, including managerial compendation, stock options, pensions, and other benefits
    - Any interests of directors or officers in any materials transactions with the corporation must also be disclosed
  4. How the corporation intends to use the proceeds of the sale
  5. Any pending lawsuits or special risk factors
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11
Q

Registraion Statement (3 of 6)

All companies, both domestic and foreign, must file their registraion statements electronically so that they can be posted on the SEC’s online EDGAR (Electronic Data Gathering, Analysis, and Retrieval) database

A

The EDGAR database includes:
- Material on intial public offerings (IPOs)
- Proxy statements (concerning coting authority)
- Annual reports
- Registrations statements
- Other documents that have been filed with the SEC

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12
Q

Registration Process

The registration statement does not become effective until it has been reviewed and approved by the SEC (unless it is filed by a well-known seasoned issuer)

A

The 1933 act restricts the types of activities that issuer can engage in at each stage of the registration process
- The prefilling period occurs before the registration is filed
- During the prefilling period, the issuer normally cannot sell or offer to sell the securities

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13
Q

Registration Statement

Once the registration statement has been filed, a waiting period begins while the SEC reviews that registration statement for completness

A

During the waiting period:
- The securities can be offered for sale but cannot be sold by the issueing corporation
- Only certain types of offers are allowed at this time
- All issuers can distribute a preliminary prospectus
- A preliminary prospectus contains most of the information that will be include in the final prospectus but often does not include a price
- Most Issuers can distribute a free-written prospectus

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14
Q

Free-writing Prospectus

A

A written, electronic, or graphic communication assocoated with the offer to sell a security and used during the waiting period to supplement other information about the security

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15
Q

Registration Statement

Once the SEC has reviewed and approved the registration statement and the waiting period is over, the registration is effective, and the posteffective period begins

A

During the posteffective period, the issuer can offer and sell the securities without restrictions

If the company issued a preliminary or free-writing prospectus to investors, it must provide those investors with a final prospectus either before or at the time they purchase the securities

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16
Q

Well known seasoned issuers

A well known seasoned issuer (WKSI) is a firm that has one of the following:

A
  1. At least $1 billion in securities in the last three years
  2. Outstanding stock valued at $700 million or more in the hans of the public
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17
Q

WKSIs have a greater flexibility than other issuers

A
  • They can file registration statements the day they announce a new offering
  • They are not required to wait for SEC review and approval
  • They can use a free-writing prospectus at any times, even during the prefiling period
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18
Q

Exempt Securities

A
  • Maintain their exempt status forever
  • Can be resold without being registered

Certain types of securities are exempt from the registration requirements of the Securities Act because they are either
- low risk investments
- regulated by other statutes

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19
Q

Exempt Securities include the following:

A
  • Government-issued securities
  • Bank and financial institution securities
  • Short-term notes and drafts (negotiable intrustments that have a maturity date that does not extend beyond nine months)
  • Securities of nonprofit, educational, and charitable organizations
  • Securities issued by common carriers (railroads and trucking companies)
  • Insurance policies, endowments, and annuity contracts
  • Securities issued in a corporate reorganzation in which one security is exchanged for another or in a bankruptcy proceeding
  • Securities issued in stock dividends and stock splits
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20
Q

There are two types of public offerings under Regulation A:

A
  1. Tier 1- For securities offerings of up to $20 million in a 12 month period
  2. Tier 2- For securities offerings of up to $50 million in a 12 month period

An issuer of $20 million or less of securities can elect to proceed under Tier 1 or Tier 2

Both tiers are subject to certain basic requirements, and Tier 2 offerings are subject to additional requirements
- Purchasers under Tier 2 who are not accredited investors cannot purchase shares that cost more than 10% of their annual income or networth

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21
Q

Accredited Investor

A

Sophisticated investors, such as banks, insurance companies, investment companies, the issuers executive officers and directors, and persons whose income or net worth exceeds certain limits

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22
Q

Small Offerings- Regulation D

A

The SEC’s Regulation D contains several exemptions from registration requirements (Rules 504 and 506) for offers that either:
- Involve a small dollar amount
- Are made in a limited manner

Rule 504 provides that noninvestment company offerings up to $5 million in any twelve-month period are exempt
- Noninvetment companies are firms that are not engaged primarily in the business of investing or trading in securities

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23
Q

Investment Company

A

A company that acts on the behalf of many smaller shareholders/owners by buying a large portfolio of securities and professionally managing that portfolio
- A mutal fund is a well-known type of investment company

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24
Q

Mutal Fund

A

A specific type of investment company that continually buy or sells to investors shares of ownership in a portfolio

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25
Q

Exempt transactions

A

Rule 504 exempts pricate noninvestment company offerings that are not generally solicated or advertised

  • This exemption is often referred to as the private placement exemption because it exempts “transactions not involving any public offering”
  • There are no limits on the amounts offered
  • There can be an unlimited number of accredited investors and up to thirty-five unaccredited investors
  • To qualify for the exemptions, the issuer must believe that each unaccredited investor has sufficient knowledge or experience in finanical matters to be capable of evaluating the investment’s merits and risks
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26
Q

Instrastate Offerings- Rule 147

A

Also exempt are intrastate offerings involving purely local offerings

  • This exemption applies to most offerings that are resticted to residents of the state in which the issuing company is organizaed and doing business
  • For nine months after the last sale, virtually no resales may be made to non residents
    • Precautions must be taken against this possibility
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27
Q

Resales and Safe Harbor Rules

A

Most securities can be resold without registration
- The Securities Act provides exemptions for resales by most persons other than issuers or underwriters
- The average investor who sells shares of stock need not file a registration statement with the SEC

Resales of restricted securities acquired under Rule 504, however, trigger the registration requirements unless the party selling them complies with Rule 144 or Rule 144A
- Rules 144 and 144A are sometimes referred to as safe harbors

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28
Q

Rule 144 exempts restricted securities from registration on resale if all the following conditions are met:

A
  1. There is adequate current public information about the issuer
  2. The person selling the securities has owned them for (1) at least six months if the issuers is subject to the reporting requirements of the 1934 act or (2) at least one year if the issuer is not subject to the 1934 act’s reporting requirements
  3. The securities are sold in certain limited amounts in unsolicited brokers transactions
  4. The SEC is notified of the resale
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29
Q

Securitites that at the time of issue were not of the same class as securities listed on a national securities exchange or quoted in a U.S automated interdealer quitation system may be resold under Rule 144A

A

They may be sold only to a qualified institutional buyer (an institution, such as insurance company or a bank, that owns and invests at least $100 million in securities)

30
Q

It is a violation of the Securities Act to intentionally defraud investors by misrepresenting or omitting facts in a registration statement or prespectus

A

Liability may be imposed on those who are negligent with respect to the preparation of these publications

Selling Sexurities before the effective date of the registration statement or under an exemption for which the securities do not qualify results in liability

31
Q

Remedies

Criminal violations of the 1933 act are prosecuted by the U.S Department of Justice

A

-Violators may be fined up to $10,000, imprisoned for up to 5 years, or both

32
Q

Remedies
The SEC is authorized to impose civil santions against those who willfully violate the act

A

It can request an injunction to prevent further sales of the securities involved or ask a court to grant other reliefs, such as ordering a violator to refund profits

33
Q

Private Parties who purchse securities and suffer harm as a result of false or omitted statements or other violations may bring a suit in a federal court to recover their losses and additional damanges

A
34
Q

Defenses
There are three basic defenses to charges of violations under the 1933 act:

A
  1. The statement or omission was not material
  2. The plaintiff knew about the misrepresentation at the time the stick was purchased
  3. The defendant exercised due diligence is preparing or reviewing the registration and reasonably believed at the time that the statements were true
    - This defense is available to an underwritier or subsequent seller but not to the issuer
35
Q

The Securities Echange Act of 1934
The Securities Exchange Act applies to companies that have:

A
  • Assets in excess in $10 million
  • Five hundred or more shareholders
36
Q

These corporations are referred to as Section 12 companies because they are required to register ttheir securities under Section 12 of the 1934 act

A
  • Section 12 companies must file reports with the SEC annually and quarterly, and sometimes even monthly if specified events occur (such as a merger)
37
Q

The Securities Exchange Act:

  • Authorizes the SEC to engage in market surveillenve to deter undesirable market practices such as:
A
  • Fraud
  • Market manipulation
  • Misrepresentation

Provides for the SEC’s regulation of proxy solicitations for voting

38
Q

The Sarbanes-Oxley Act of 2002

A
  • Attempts to increase corporate accountability by imposing strict disclosure requirements and harsh penalties for violations of securities laws
  • Requires cheif corporate executives to take personal responsibility for the accuracy of financial statements and reports that are filed with the SEC
  • Requires that certain financial and stock-transaction reports be filed with the SEC earlier than was required under the previous rules
  • Created a new entity, called the Public Accounting Oversigh Board, to regulate and oversee public accounting firms
  • Established private civil actions
  • Expanded the SEC’s remedies in administrative and civil actions
39
Q

Section 10(b)

A

Section 10(b) of teh Securities Exchange Act Prohobits the use of any manipulative or deceptive machanism in fiolation of SEC rules and regulations

 - Among the rules that the SEC has promulgated pursuant to the 1934 act is SEC Rule 10b-5
40
Q

SEC Rule 10b-5

A

A rule of the Scurities and Exchange Commission that prohibits the commission of fraud in connection with the purchase or sale of any security

       - SEC Rule 10b-5 applies to almost all cases concerning the trading of securities, whether on organized exchanges, in over-the-counter markets, or in private transactions
          
          - The securities need not be registered under teh 1933 act for the 1934 act to apply
41
Q

Private parties can sue for securities fraud under Rule 10b-5
- The basic elements of a securities fraud action are as follows:

A
  1. A mertial misrepresentation (or omission) in connection with the purchase and sale of securities
  2. Scienter (a wrongful state of mind)
  3. Reliance by the plaintiff on the material misrepresentation
  4. An economic loss
  5. Causation, meaning that there is a causal connection between the misrepresentation and the loss
42
Q

Insider trading

A

The purchase or sale of securities on the basis of information that has not been made available to the public.

One of the major goals of Section 10(b) and SEC Rule 10b-5 is to prevent insider trading

43
Q

Insider information can affect the future market value of the corporate stock and is often possessed by:

A
  • Corporate Directors
  • Officers
  • Majority shareholders

If these individuals act on this information, their positions give them a trading advantage over the general public and other shareholders

44
Q

Disclosure under SEC Rule 10b-5

Any material omission or misrepresentation of material facts in connection with the purchase or sale of a security may violate Section 10(b) of the 1934 act and SEC Rule 10b-5

A

A material fact is significant enough that is would likely affect an investor’s decision as to whether to purchase or sell the company’s securities

45
Q

Some examples of material facts calling for disclosure under SEC Rule 10b-5 include:

A
  1. Fraudulant trading in the company stock by the broker-dealer
  2. A dividend change
  3. A contract for the sale of corporate assets
  4. A new discoverym a new process, or a new product
  5. A significant change in the firm’s financial condition
  6. Potential litigation against the company
46
Q

Outsiders and SEC Rule 10b-5

A

Increasingly, liability under Section 10(b) of the 1934 act and the SEC Rule 10b-5 has been extended to include certain “outsiders” - those who trade on inside information acquired indirectly

47
Q

Two theories have been developed under which outsiders may be held liable for insider trading:

A
  1. Tipper/tippee theory
  2. Misappropriation Theory
48
Q

Anyone who aquires inside information as a result of a corporate insider’s breach of his or her fiduiary duty can be liable under SEC Rule 10b-5.

This liability extends to:

A
  1. Tippees
  2. Remote tippees (tippees of tippees)
49
Q

Tippee

A

A person who receives inside information

50
Q

The tippee is liability only if the following requirements are met:

A
  1. There is a breach of a duty not to disclose inside information
  2. The disclosure is made in ecvhange for personal benefit
  3. The tippee knowns (or should know) of this breach and benefits from it

The misappropriation theory holds liable an individual who wrongfully obtains (misappropriates) inside information and trades on it for their personal gain

51
Q

Insider preorting and trading - Section 16(b)

A

Section 16(b) of the 1934 act provides for the recapture by the corporation of all short-swing profits realized by an insider

52
Q

Short swing profits

A

Profits earned by a purchase and sale, or sale and purchase, of the same security within a six-month period

The courts have fashioned complex rules for determining profits

53
Q

In the context of Section 16(b), insiders mean officers, directors, and large stockholders of Section 12 corporations

A

Large stockholders are those owning 10 percent of the class of equity securities registered under Section 12 of the 1934 act

54
Q

To discourage insiders from using nonpublic information to their personal benefit in the stick market, the SEC requires them to file reports concerning their ownership and trading of their corporation’s securities

A

The SEC exempts a number of transactions under Rule 16b-3

55
Q

Section16(b) applies not only to stock but also to:

A
  • Warrants
  • Options
  • Securities convertible into stock
56
Q

The Private Securities Litigation Reform Act

The disclosure requirements of SEC Rule 10b-5 had the unintended effect of deterring the disclosure of foward-looking information, such as financial forecasts

A

In attempt to solve the problem and promote full disclosure, Congress passed the Private Securities Litigation Reform ACT (PSLRA)

The PSLRA provides a “safe harbor” for publicly held companies that make foward-looking statements
- Those who make such statements are protected against liability for securities fraud if they “meaningful cautionary statements indentifying imporant factors that could cause actual results to differ materially from those in the foward-looking statement”

The PSLEA also affects the level of detail required in securities fraud complaints
- Plaintiffs must specify each misleading statement and how it led them to a mistaken belief

57
Q

Violiations of the Securities Exchange act and SEC Rule 10b-5, including insider trading, may lead to both crminial and civil liability

A
58
Q

Scienter Requirement

A

For either crminal or civil sanctions to be imposed, scienter must exists- this is, the violator must have has an intent to defraud or knowldge of their misconduct

59
Q

Scienter can be proven by showing that the defendant

A
  • Made false statements
  • Wringly failed to disclose material facts
  • Was conspicuously reckless as to the truth or falsity of his or her statements (in some situations)

In a complaint alleging a violation, the plaintiff must state facts giving rse to an inference of scienter

60
Q

Criminal Penalties

A

For violatoins of section 10(b) and Rule 10b-5
- An individual may be fined up to $5 million, imprisioned for twenty years, or both
- A partnership or a corporation may be fined up to $25 million

Under Section 807 of the Barbane-Oxley Act, for a willful violation of teh 1934 act the violator can be imprisioned up to twenty-five years (in addition to being subject to a fine)

For a defendant to be convicted in a criminal presecution under the securities lsaw, there can be no reasonable doubt that the defendant knew they were acting wrongfully
- In other words, a jury is not allowed merely to speculate that the defendant may have acted willfully

61
Q

Civil Sanctions

The SEC can bring a civil action against anyone who purchase or sells a secuirty while in possession of material nonpublic information in violation of the 1934 aact or SEC rules

A
  • The violation mus toccur through the use of a national securities exhchange or a broker or dealer
    • A court can asess a penalty amounting to as much as triple the profits gained or the loss avoided by the guilty party
62
Q

The Insider Trading and Securities Fraud Enforcement Act

A
  • Enlarged teh class of persons who may be subject to civil liability for insider trading
  • Gave the SEC authority to offer monetary rewards to informants
63
Q

Private Parties may also sue violators of Section 10(b) and Rule 10b-5

A
  • A private party can obtain rescission (cancellation) of a contract to buy securitires or damages to the extent of the violators illegal profits

For violations of Section 16(b), a corporation can bring an action to recover the short swing profits

64
Q

A problem that the SEC faces is how to enforce the antifraid provisions of the securities law in the online envionment

A

Internet-related forms of securitires fraud include many types of investment scams
- Spam, online newsletters and bulletin boards, chat rooms, blogs, social media, and tweets can all be used to spread false information and prepetulate fraud
- For a relatively small cost, fraudsters can even build sophisticated Web pages to facilitate their investment scams

65
Q

Investment News Letters
Legitimate online newsletters can help investors gather valuable informatioin, but some e-newsletters are used for fraud

A

An investor reading an e-newsletter may believe that the infomration is unbiased, when in fact the fraudsters will directly profit by convinving investors to buy or sell particular stocks

66
Q

State Securities laws:

A
  • Apply Mainly to instrastate transactions (transactions within one state)
  • Typically have disclosure requirements and antifraud provisions, many of wwhich are pattered after Section 10(b) of the Security Exchange Act of 1934 and SEC Rule 10b-5
  • Provide for the registration of securities offered or issued for sale within the state
67
Q

Methods of registrations, required disclosures, and exemption from registration vary among states

A

Unless an exemption from registration is applicable, ussuers must register or qualify their stock with the appropriate state offical, often called a corporaitions commissioner

Most state securities laws regualte securities brokers and dealers

68
Q

Corporate Governance

A

A set of policies specifying the rights and responsibilities of the various participants in a corporation and spelling out the rules and procedures for making corporate decisions

69
Q

Effective corporate governance is essential in large corporations becuase corporate ownership (by shareholders) is speratated from coporate control (by officers and managers)

A

Officers and managers may attempt to advance their own interests at the expense of the shareholders

70
Q

Some corporations have sought to align the financial interests of their officers with those of the company’s shreaholders by providing the officers with stock options

A

When the market price rises above that level, the officers can sell their shares for a profit

Because a stock markets price generally increases as the corporation prospers, the options give the officers a financial stake in the corporation’s well being and supposedly encourage them to work hard for the benefit of the shareholders

Law and Ethics Final Eam (2 decks)

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