Chapter 22
Securities
In This Chapter
• Six key securities laws
• Federal regulation
• State regulation
• Rights and liabilities of shareholders
The official definition of securities contained in the Securities Exchange Act of 1934 begins with “any note, stock, treasury stock, bond …” and continues on for a long list of options. The easier definition is that securities are an investment instrument, other than an insurance policy or fixed annuity, issued by a corporation, government, or other organization, which offers evidence of debt or equity. Stock in a Fortune 500 Company is an example of an equity security. A mortgage would be an example of a security that evidences debt. This chapter will review the major laws that apply to this area of law.
Federal Securities Regulation
Securities laws were passed in the aftermath of the stock market crash of 1929. The sustained losses that created the Great Depression prompted Congress to enter the securities area in an attempt to provide some protection to citizens who purchased securities in the securities markets.
def•i•ni•tion
Securities are shares of stock, bonds, and debentures issued by corporations and governments as evidence of ownership and terms of payment of dividends or final pay-off. They are called securities because the assets and/or the profits of the corporation or the creditor of the government stand as security for payment.
Major Federal Laws
There are six securities laws you need to be aware of. The Securities Act of 1933 deals with the distribution of securities when they are first offered to the public. The Securities Act of 1934 addresses the secondary market, or resale, for these securities. The other four include the Securities Enforcement Remedies and Penny Stock Reform Act of 1990, Market Reform Act of 1990, Securities Acts Amendments of 1990, and Private Securities Litigation Reform Act of 1995, plus the Sarbanes-Oxley Act, which was discussed in Chapter 3.
The Securities and Exchange Commission (SEC) implements the laws and rules that govern the securities industry in the United States. It sees its goal as enforcing the laws so that all investors, regardless of their size, have access to certain facts about an investment prior to buying it and for the period of time they own the security.
1990 was an active year for Congress to pass laws and amendments that address securities regulation. The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 gives the SEC broader authority to reduce fraudulent financial reporting and financial fraud. For example, the SEC can disgorge a company of ill-gotten profits and gains through tiered civil money penalties. It can also ask a court to prevent people from serving as directors or officers of companies who have engaged in fraudulent activities. The SEC also issues cease and desist orders, temporary restraining orders, and orders for accounting and disgorgement.
The Securities Acts Amendments of 1990 were designed to increase cooperation between the United States and other countries regarding securities law enforcements. As part of that law, sanctions are allowed against companies that violate federal laws. It also allows the SEC to restrict the activities of brokers, dealers, and investment advisers who have violated foreign securities laws.
The Market Reform Act of 1990 gave the SEC power to deal with the volatility of the markets after the October 1987 market decline. For example, the SEC may suspend trading if the markets become volatile and may require large traders to reveal themselves. In emergency situations, the SEC may use these powers for only ten days at a time.
The Private Securities Litigation Reform Act of 1995 applies to private litigation in an attempt to limit abuses and the number of lawsuits. The Act provides procedures that plaintiffs must take when filing to represent a class. It also set new rules for settlements in securities cases.
The Sarbanes-Oxley Act of 2002, discussed in Chapter 3, also contained numerous securities reforms. It was authored to improve the accuracy and reliability of corporate disclosures under the securities laws. To that end, it enhanced disclosure requirements, auditor and accounting provisions, and enforcement and liability sections.
Securities Act of 1933
The Securities Act of 1933 has two objectives. The first requires that investors receive financial and other significant information concerning securities being offered to the public. The second is to prohibit deceit, misrepresentations, and other fraud in the sale of securities. To do this, the law requires the registration of securities. The registration requires the company to provide essential facts, including …
• A description of the company’s properties and business.
• A description of the security to be offered for sale.
• Information about the management of the company.
• Financial statements certified by independent accountants.
These registration statements must be filed with the SEC and become available to the public shortly after filing.
In addition to the registration, the company must provide a prospectus to each potential purchaser. The prospectus contains the key information from the registration, but removes the burden from the investor of seeking the registration from the SEC.
Citations
The registration statements of United States domestic companies are available on the EDGAR database accessible through the SEC’s website: www.sec.gov.
There are exceptions to the registration requirement. Private offerings to a limited number of persons or institutions do not require a filing. Nor do offerings of limited size, intrastate offerings, and securities of municipal, state, and federal governments. These are exempt to lower the costs of entry for small firms.
While small companies are technically exempt from the registration requirements, a Regulation A offering involves what can be thought of as a mini-registration. A fill in the box form can register offerings of securities of up to $5 million per 12-month period.
Small businesses may make broad inquiries regarding interest in the offering from proposed investors. The solicitation documents must be factual, but provide a beginning step before the company is forced to incur the expense of complying with Regulation A reporting.
If the requirements of the 1933 Act are not followed, there may be civil or criminal liability. The issuer faces civil liability for providing materially false or misleading statements. The sellers of securities may also face civil liability for employing any device or scheme to defraud or obtain money by making untrue statements of material facts. And criminal liability can be imposed on those who willfully make untrue statements of material fact or fail to omit required facts. There can also be criminal liability for employing any device or scheme to defraud through the offer or sale of securities.
Securities Act of 1934
The SEC was created by the Securities Act of 1934, but the act did much more. Remember that while the 1933 Act deals with the creation of securities, the 1934 Act deals with the secondary market in securities.
Citations
The 1934 Act gave the SEC authority over the securities industry. That authority includes the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the securities self-regulatory organizations like the New York Stock Exchange. The SEC also oversees periodic reporting of information for companies with publicly traded securities.
Under the 1934 Act, companies with more than $10 million in assets that are held by more than 500 owners must file annual and other periodic reports. It also creates requirements for disclosure which must be made by the company or shareholders groups when they seek a proxy vote on issues. There are also disclosure requirements when someone seeks to purchase more than 5 percent of a company’s securities by direct purchase. Because these offers are often made to obtain control of a company, the disclosure allows shareholders to make informed decisions.
The 1934 Act requires the registering of exchanges, brokers, and dealers with the SEC when those entities deal in securities traded in interstate commerce.
Insider Trading and the 1934 Act
The 1934 Act also addresses insider trading. Insider trading occurs when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading. While insider trading can involve corporate officers, directors, and employees who trade the company’s securities after learning significant corporate developments, the rules also apply to friends, business associates, family members, and others who hear the tips. It can also extend to employees of law, banking, brokerage, and printing firms who are given the insider information to provide services to the firm. And the same principle applies to government employees who learn the information in the course of regulating the business.
Stay Out of Jail
In 2003 the SEC brought insider trading charges against Martha Stewart, not because her friend Sam Waksal, the founder of ImClone, told her about a problem with his company’s cancer drug. The charges were brought because she then ordered her broker to sell her shares in ImClone before the release of that information. That act on the insider information is insider trading. She went to jail for lying about a stock sale, conspiracy, and obstruction of justice.
Sarbanes-Oxley and the 1934 Act
Sarbanes-Oxley amended the 1934 Act to include a requirement that each company’s CEO and CFO sign a written certification when filing 10-K and 10-Q reports. The signature certifies that the officer has reviewed the report, based on the officer’s knowledge, the report does not contain untrue statement of a material fact or omit a material fact, the financial statements fairly present in all material respects the financial condition of the company, and the signing officers are responsible for internal controls. Information is material if there is a substantial likelihood that reasonable investors would view it as significantly altering the mix of information and considers the fact important when making investment decisions.
If an officer knowingly misrepresents in the certification process, stiff penalties can be assessed. That officer can be fined up to $1 million and imprisoned for up to ten years.
Sarbanes-Oxley also required a change in the way companies present pro forma financial results. In the past, the press release was released in advance of the financials, often with spin because different accounting standards were used. Now, the pro formas cannot contain material misstatements of the financial picture. If the pro forma numbers differ from the official earnings, the company will have to explain why.
State Securities Regulation
Each state has its own blue sky laws designed to protect consumers from fraudulent transactions when they engage in purchasing securities. The SEC is joined by 50 state regulators in overseeing and regulating the securities’ industry. The laws vary from state to state, but have similar threads. Often they require registration of security offerings and registration of brokers and brokerage firms. State law may also provide the state regulators with the authority to pursue securities violators. The state law will regulate the offer and sale of securities as well as the registration and reporting requirements for brokers and dealers.
Citations
The National Securities Markets Improvement Act of 1996 strives to bring some uniformity to the states’ regulation of securities by creating classes of securities that are not subject to state securities registration requirements at offer and sale.
Shareholder Rights and Liabilities
Shareholders are those who own stock in corporations. By owning that stock, shareholders obtain rights and liabilities in the company. Those rights stem from the shareholder’s status as an owner of the company.
Rights
As a result of the stock, shareholders obtain several rights. Those include …
• Ownership right. As owners, shareholders have indirect control over the company. Accordingly, shareholders have the right to properly executed certificates that document their ownership interest. They also have the ability to transfer their shares unless limited by a valid restriction. Often the restriction will be something like a buy-sell agreement that requires the shares to be offered to the company or other shareholders first.
• Right to vote. Shareholders also have the right to vote according to their percentage of ownership at the shareholder’s meeting. This allows shareholders to participate in the election of directors or other special business. State law will govern how many votes each share receives. Shareholders have the right to give their proxy to another for voting purposes. They also may enter agreements regarding how they will vote. To accomplish block voting, shareholders can establish a voting trust.
• Preemptive offer of shares. If the capital stock is increased, shareholders often have the preemptive right to subscribe to the same percentage of the new shares that their old shares represented. This allows the shareholders to prevent the dilution of their interest in the corporation.
• Inspect the books. Shareholders have the right to inspect the books of the corporation. Some, but not all states, require that the inspection be made in good faith, for proper motives, at a reasonable time and place. This right to inspect can be used to gain information for a lawsuit, but not for merely idle curiosity.
• Dividends. Shareholders have a right to dividends, a portion of the declared profits that mirror the shareholder’s interest in the stock of the corporation. To issue dividends the corporation should have earned surplus or retained earnings. The flip side is that the company can’t issue dividends if it is insolvent or doing so would make it insolvent.
Consultation
The exception to the general dividends rule comes from wasting assets corporations. These corporations are designed to exhaust or use up the assets of the corporation—these corporations do things like extract coal, oil, and iron from the earth.
If the money exists, the distribution of dividends is at the discretion of the directors. The directors may choose to accumulate earnings rather than distribute them, especially if the directors know there is a capital project in the future. It is also important for the corporation to maintain an adequate cash reserve and working capital. Directors have broad discretion to choose when to make dividend payments. Those dividends often take the form of cash. The dividend will often be made on a certain date for ease of determining who the shareholders are at that time.
• Capital distribution. If a corporation is dissolved, the shareholders are entitled to capital distributions if any capital remains after the winding up of the corporation in proportion to their ownership interest in the company.
• Shareholder actions. Shareholders also have the right to bring derivative actions. This means the shareholders can sue the directors, officers, or third parties on behalf of the corporation when the corporation refuses to do so. By doing so, the shareholder is enforcing the rights of the corporation and any proceeds or recovery go into the corporation, not to the shareholders.
Before bringing such an action, the shareholder must show that he or she has exhausted their remedies with the corporation first. They must show the directors refused to enforce the right or that the board is so unable to make an impartial decision that the need to go to the board first is excused. Shareholders can also intervene or join in actions brought against the corporation if the corporation does not defend itself or act in good faith. Finally, minority shareholders can bring suit against majority shareholders if the majority acts in an oppressive way against the minority.
Liabilities
A shareholder will usually have limited liability in a corporation. That liability is limited to the extent of his or her capital contribution to the corporation. However, there are exceptions:
• Piercing the corporate veil. A corporation is treated as a separate legal entity—providing that limited liability—only as long as the shareholders and officers treat it as a separate entity. Two corporations can have identical shareholders without being treated as one company. But in certain cases, the court can ignore the general rule and pierce the corporate veil. To do so, the court can consider the following factors: 1) adequate corporate records have not been maintained and the corporate assets have been commingled with other funds; 2) grossly inadequate capitalization; 3) diversion by shareholders of corporate funds or assets; 4) formation of the corporation to evade an exiting obligation; 5) formation of the corporation to perpetrate a fraud or conceal illegality; 6) determination that injustice and inequitable consequences would result.
• Alter ego. Courts will also evaluate whether the corporation is merely the alter ego for the wrongdoer. If that is the case, the court may ignore the corporate form. When the separate personalities of the shareholders, officers, or directors cease from the corporation, then the corporation is merely the alter ego.
There are additional circumstances that will force the liability from the corporation to the individual. Some states’ wage claim statutes provide that shareholders have unlimited liability with employee’s wage claims, the reason being that its an important public policy to make sure that employees are properly paid. In rare instances, if a subscription of stock has been offered but not fully paid for, anyone who did not pay full value is liable for the unpaid balance if the corporation is insolvent and the money is needed to pay creditors. Unauthorized dividends can also be claimed by creditors if the dividends came out of capital.
The Least You Need to Know
• Securities are an investment instrument, other than an insurance policy or fixed annuity, issued by a corporation, government, or other organization, which offers evidence of debt or equity.
• The Securities Act of 1933 deals with the distribution of securities when they are first offered to the public. The Securities Act of 1934 addresses the secondary market for these securities.
• Insider trading occurs when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading.
• Each state has its own blue sky laws designed to protect consumers from fraudulent transactions when they engage in purchasing securities.
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