Securities Regulation Outline PDF

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Securities Regulation Outline for Prof. Langevoort...

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Securities Regulation Outline Introduction 1. Introduction a. Corporations are legal fictions created to facilitate sustained, large-scale business i. Require capital; raised by selling stock to shareholders; legally required that corporations have shareholders ii. Because equity is invested, corporation not required to do anything; investing in common stock risky, so law needs to step in and make act of investing less risky (voting rights, litigation rights, remedies) b. Corporation  VC/Angels  Employees  Public  List/exchange (mkt price) i. First step for a new corp is to sell stock 1. Start-up gets initial capital from founders; bank won’t lend to corp w/ no capital 2. After that, friends and family provide capital base, banks loans, etc. 3. Venture capital funds may be interested & angel investors fund speculative ventures 4. A company who ramps up through investment and grows will issue more stock, possibly to employees ii. After this, company ready to “go public” in IPO; listed on stock exchange & traded among investors 1. May make IPO to raise capital, or because current investors want to sell their shares and there’s no ready market to sell those shares because law prohibits markets from thriving 2. If you want to stay private, must accept illiquidity c. Public company may decide to raise more money and make subsequent offerings (seasoned equity offering) d. Securities regulation looks at act of raising capital & says transparency is essential, as a rational person won’t blindly invest in corps; extends protection to pre-investing stage e. Securities Act of 1933 (’33 Act) 1. Congress’s effort to regulate offer & sale of businesses a. Public offering must be registered, otherwise fed crime, massive liability consequences 2. Method of regulation: a. Requires registration statement w/ SEC i. Information about company & offering itself ii. Elaborate process of effective dates 1. Can only sell after offer has become effective b. Prospectus must be delivered to investors after purchase i. Prospectus essentially same as registration statement c. Registration must be accurate and truthful i. Company cannot lie or omit material information

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ii. If they do lie: 1. Company strictly liable and all purchasers have right of rescission 2. All participants in offering (underwriter, accountant) are all joint/severally liable unless they show due diligence d. Regulates the selling process i. Through a series of effective periods ii. Says when you can advertise and when you can sell f. Securities Exchange Act of 1934 (’34 Act) i. Congress’ attempt to regulate secondary market, i.e. trading among investors ii. Congress wanted to ensure stock market integrity 1. Keep market free of fraud & manipulation 2. Ensure accurate supply & demand iii. Creates the SEC iv. Act allows Congress to: 1. Regulate markets and securities industry 2. Ban manipulation and fraud (Ryle 10b-5) 3. Create concept of public Issuers; large companies on exchange a. These people can’t lie & must affirmatively tell truth by filing 10-K each year and updating every 3 months with 10-Q b. Mandatory disclosure c. Liability here less than strict liability 4. Regulate proxies, tender offers, insider trading g. How would you protect yourself without securities regulation? i. Contract for protections, such as taking half the Board ii. Alternative investments like treasury bills, VC funds iii. Invest carefully, in companies you know well and have been around for a while; you wouldn’t touch start-ups unless you had bargained h. Efficient Market Hypothesis i. Market fairly prices stocks bc smart money dominates 1. When someone wants to buy & drive up price, professionals will sell because stock is now priced more than it’s worth to them 2. When smart money comes back in, price is driven back down & price stays close to whatever consensus thinks is the fair price

Disclosure (’33 and ’34 Acts) 2. Public Company Registration a. Several ways to go public & subject yourself to ’34 Act disclosure requirements: i. § 15, registering under ’33 Act, incl. IPO ii. § 12(b), listing shares on a national stock exchange iii. § 12(g), meeting size requirements of $10 million in asses & 2,000 record holders of stock w/ max of 500 non-AIs 2

1. Doesn’t exclude foreign corps/corps w/ foreign investors a. BUT the SEC will let you out if you have fewer than 300 US SHs 2. There can be more actual SHs as long as there are only 2,000 record SHs 3. Crowdfunding investors don’t count for determining SH number b. Consequences of being publicly traded: i. (1) Continuing disclosure requirements, incl. 10-K, etc.; how has corp done, management’s assessment of performance in light of what it’s disclosing ii. (2) Must submit to intense SEC-regulated proxy regulations iii. (3) SOX (Sarbanes-Oxley) c. Can “go dark” i.e. become private again; SEC makes it hard, but possible 3. Financial Reporting a. ’34 Act reporting consists mainly of filing 10-Ks, 10-Qs, 8-Ks; information needed in each filing found in Regulation S-K i. Foreign companies that sell securities in US only have to file 20-F forms, which are less detailed & intrusive than 10-K; no 10-Q requirement ii. If foreign corp shows that it has fewer than 300 US investors, no need to register; even if you have over 300 US shareholders but are not traded on an exchange, you are allowed to simply post on website the disclosure home country requires b. Since no strict liability equivalent in ’34 Act, it enlists: i. Executives; have superior knowledge, access to info; main focus ii. Board of directors; power to fire CEO/CFO 1. This is rare situation where sec reg goes from fed disclosure laws to state corp law 2. Sarbanes-Oxley caused NYSE/NASDAQ to review listing standards to ensure that all corps listed are majority-independent 3. Also requires audit committee of independent directors, must report on whether it has at least 1 financial expert iii. Auditors, underwriters, lawyers, etc. c. How to incentivize executive truth-telling i. Internal controls; whistleblowers, audits ii. Executive must sign name on 10-K, 8-Q etc. acknowledging that he has control & has assessed internal control system w/in 90 days, found it to be sound or identified material weaknesses that are in process of being fixed iii. Rules 13a-14 & 15d-14: CEO/CFO must certify that he has reviewed report, to officer’s knowledge the report doesn’t contain any untrue statement of material fact, fairly presents in all material respects the financial situation of issuer 1. Fairly presents = no half-truths, any reader of this report would not be misled by any material omission d. 10-K, mix of narrative & financial statements i. Updated every quarter with a 10-Q ii. Must be signed & certified by independent accounting firm saying that it read financial statements, prepared in accordance w/ accounting principles, fairly represent facts; audit firms can’t be beholden to corp for other revenue 1. Also, PCAOB began to regulate accountants post Enron 3

iii. 10A report: if audit firm sees evidence that an illegal act has taken place, must investigate, consider effects, inform management of issuer & audit committee, if user doesn’t act, obligation must deliver report to SEC & resign 1. Auditor must become a whistleblower 4. Materiality & Duty a. Materiality i. When there is a suspicion of wrongdoing, company must: 1. Assess materiality of wrongdoing 2. Determine whether there is a duty to disclose a. Materiality is different from duty; just bc something is material doesn’t mean you have to disclose it! ii. Material info is sufficiently important that an investor would make a decision based on it iii. Basic v. Levinson – materiality for speculative info under § 11 is a function of probability & magnitude of impact 1. Probability: given what was known at the time, likelihood something would happen 2. Magnitude: size of the impact on the company & its investors that will come as a result of event happening a. Something affecting only $5 million in a $1 billion corp is not material; generally more than 5% is material iv. Schlitz – Schlitz giving kickbacks to stores for shelf space, spent about $3 million; SEC accused corp of not revealing truth of how it was making money, Schlitz said $3 million is not material in $1 billion corp; court addressed qualitative & quantitative materiality 1. Qualitative: concerned w/ integrity of people running company 2. Quantitative: affects financial safety of company a. Searching for the right number/metric to apply b. Court says it was material bc $3 million in bribes is the wrong number, it’s possible that Schlitz could lose licenses in certain states/cities as a result of bribes; real question is lost revenue c. Also unwanted attention, FCPA, fines, etc. 3. Odd that court didn’t raise duty as a separate & distinct requirement; assumed that if there’s materiality then there’s duty; not true anymore v. Gaynes v. Houton, 9th Cir. – SEC less likely to push qualitative materiality today; a little too un-nuanced to say management integrity matters always or never b. Duty to Disclose i. No identity btw materiality & duty, separate & distinct; just bc something is material doesn’t mean you have to disclose it 1. Matrix – mere importance does not force disclosure, unless company must to disclose under Reg S-K, it can keep secrets, just can’t lie 2. Ikonos – question of whether Ikonos had an obligation reveal growing number of customer complaints that product was defective didn’t depend only on materiality, also duty 4

ii. Half-truths require disclosure; when corp says something affirmatively but leaves out info that makes it misleading, it’s a half-truth, duty to disclose is implicated 1. Omnicare – Omnicare filing registration statement (shows merging of ’33 and ’34 Acts), strict liability; corp said something objectionable, but started w/ “we believe”; Omnicare said it was opinion, so even if it was violating the law, it didn’t think that; can only be held liable if they didn’t actually believe that, knowingly violated the law a. Kagan says always consider half-truth possibility; look at whether reasonable investor would be misled b. Statute creates disclosure duty when fact that is undisclosed would make what is said not misleading; i.e. eliminate the half truth c. Removes magic bullet of saying “we believe,” doesn’t resolve everything 2. Ex. if an officer says “we’re really proud of our cyber security program” that’s bad news because once it’s been addressed, it must be addressed completely iii. Must disclose material information in registration statement 1. In re Franchard – Glickman was withdrawing money from corp for personal use, board found out, he promised to stop but didn’t; wasn’t reported in registration statement a. Management quality is a material fact that must be disclosed in registration statement iv. Duty to update if you said something that was true in the past, but then change in circumstances not known to rest of world, past statement is now untrue 1. Recognized by some courts, but clearly rejected by 7th Cir. 2. No duty to continuously disclose under federal sec laws 3. Gallagher v. Abbott Labs – if something would need to be included in MD&A or line item, it does not need to be disclosed until the company files its next 10-K or 10-Q a. P says D should have disclosed FDA problems in MD&A, SEC imposes duty to release info, so we’re reaching to that, but FDA letter came 1 week after 10K due 5. Reg S-K a. Common body of instructions for disclosure requirements b. Divided into 5 “line items” that must be disclosed: i. (1) Company information, business model; gives investors close look at how company makes money & operates 1. Item 103: legal proceedings, any material pending legal proceedings other than ordinary routine litigation of business; incl. series of Wells Notices 2. Item 101: allows company to not reveal new products in filings if it would give company competitive disadvantage a. US securities laws allow for more secrecy than other countries because SEC doesn’t want disclosure to reduce value of enterprise, so disclosures mainly backward-looking ii. (2) Capitalization of corp; i.e. shares outstanding, who owns them iii. (3) Financial information; what is company’s situation, how is it performing 5

1. Item 303: MD&A a. Narrative portion of 10-K/10-Q/S-1, management’s obligation to discuss results & give investors opportunity to look at company through eyes of management i. Requires evaluation of all known trends, risks & uncertainties that have shaped the past, are reasonably likely to have an impact on future longterm liquidity & capital resources ii. Financial Reporting Release 36: management must make two assessments: 1. (1) Is known demand, trend, uncertainty reasonably likely to come to fruition? If not, no disclosure required a. SEC has said threshold for reasonably likely to occur is somewhere below 50%, but not exactly clear 2. (2) If it is likely/unsure, then must be disclosed in MD&A iv. (4) Management of corp; board info, five highest-paid execs 1. Item 401(f): describe all legal actions taken against corp directors/officers in last 10 years resulting in sanction relating to person’s competence/integrity to run corp; also pending criminal cases a. US v. Matthews: is grand jury proceeding a pending criminal case? No, kicks in after indictment 2. Item 402: compensation discussed in great detail 3. Item 403: need to disclose number of shares owned by officers/directors 4. Item 404: reveal any conflict of interest transactions involving officers/board a. Transaction w/ amount over $120,000 involving director/officer of corp must be disclosed such that a reasonable investor could understand 5. Item 406: information about company code of ethics a. Any waiver of board of any provision has to be disclosed explicitly 6. Item 407: corporate structures, how board is chosen v. (5) Transactional information; specific upcoming mergers, etc.

’33 Act Public Offerings 6. Underwriting a. Process by which public offering occurs i. Big investment banks ii. One or two managing underwriters & a larger syndicate to back them up, provide additional sales/marketing help, spreads risk iii. Book-building, make a list of things worth buying iv. Buyer derives comfort from quality of bank v. The world prob doesn’t know much about the corp; Goldman stands there and says hey this is a good corp, so that’s something b. Two types of offerings: i. Fixed price, firm commitment offering, set price for everyone 6

1. On effective date, underwriters buy all the stock for themselves from the issuers; then underwriters immediately sell securities to their customers 2. So for a little bit of time, the underwriters bear the risk instead of the issuer 3. So, if Goldman is willing to do this & assume the risk, then a signal to consumers that it’s worth buying; firm commitment is a mintmark ii. Best efforts 1. Underwriter uses its expertise to find buyers, but doesn’t put its own money at risk; no promise to sell all the shares, makes a commission from what is sold 2. Signal to buyers to do research, risk shifts immediately from issuer to investor 7. Registration Statement a. Use Form S-1 or S-3 i. S-1: default form; applies when issuer can’t use S-3 ii. S-3: simplified, can only be used by reporting companies 1. Incorporates both backward AND forward disclosure documents; so it includes anything filed after RS already became effective iii. Consult Reg S-K for disclosure requirements 1. Information about deal itself – who is underwriting it, what use of proceeds will be, etc. iv. Registration statement filed, SEC reviews it & staff comments on statement; if satisfied disclosure conforms to instructions, it will be declared effective 1. Securities may not be sold until SEC has declared it effective 8. Section 11 a. ROA for any person obtaining security pursuant to reg statement containing a (1) misstatement or omission that is (2) actual and (3) material i. There must be materiality & a duty to disclose 1. Reg S-K lists the duties! 2. Applies to half-truths where you left something out, but what’s left is misleading, deceit via omission ii. Liability only extends to most recently filed 10-K, etc.; must have a reg statement, so doesn’t work w/ private/exempt offerings iii. UNLESS plaintiff knew of untruth/omission at time iv. If a corp realizes there’s been a misstatement/omission, then don’t sell securities to people who heard it/cut out the underwriter that did it, etc. 1. Just bc you find something doesn’t mean you have to disclose it; only if what you do say is rendered misleading by omitting it b. Standing i. Anyone who owns issued shares pursuant to registration statement has standing to sue no matter how long chain is; express private ROA ii. Don’t have to show they read/were aware of statement iii. No reliance requirement iv. BUT you do have to show that your shares were from the new ones issued; not existing shares v. There is a little note on whether it’s § 11 eligible, but nobody notices it c. Damages 7

i. Recessionary remedy, you get your money back; ex. if you paid $24 but as a result of the omission the stock price dropped to $10, then you get $14 per share in damages ii. But corps generally spend the money quickly after a public offering; so this liability is huge, could bankrupt the corp d. Potential Ds i. (1) Issuers 1. Primary category of liability is issuer, but SA ’33 extends it to additional categories ii. (2) Signatories 1. Anyone who signed registration statement, so senior management iii. (3) Board of directors iv. (4) Accountants/experts named in registration 1. Incl. accountants, lawyers if experts on whether issuing valid, geologists for oil/gas v. (5) Underwriters e. Defenses i. Issuers have NO true defenses 1. Strict liability w/ no reliance requirement, but can contest elements, ex. materiality, falsity of statements & standing ii. Negative causation; opportunity for D (incl. issuer) to prove that some/all of stock price drop due to other factors; decreases amount of recovery iii. Registration statement (or 10-K) not filed yet iv. §21(e): accompanied by meaningful cautionary language v. Lacked actual knowledge vi. Underwriters have due diligence defense 1. Expertized a. Two obligations for due diligence if expertized, i.e. something that is in your wheelhouse (law for lawyers, accounting for accountants, etc.): i. (1) Reasonable investigation into facts you were opining about ii. (2) Reasonably believed that what was said in registration statement was true & complete b. Also, failure not attributed to lawyer if doing due diligence on account of one of the other actors; may still be liable under malpractice though (not § 11) 2. Non-expertized a. Some liability for non-expert; NO duty to investigate, but have duty to act reasonably in light of what they know b. Escott v. BarChris—built bowling alleys, but only got paid back after the buildings were finished, bowling went bust, so did BarChris, made public offering of securities, then of debt i. Filing riddled w/ misstatements; failed to disclose how much risk it took on by financing methods, disclosed factors it changed recently w/out noting the changes ii. CEO says he didn’t know, but SEC was like lol lies; CEO engineered this 8

iii. Underwriter is the party w/ muscle, must be devil’s advocate, can stand up to issuer; must do an investigation, assume the worst iv. Rule: no single standard of reasonable investigation, the higher up a person is in corporation, the more thorough an investigation he will have to make 9. Section 5 a. All offerings of securities that use facilities of interstate commerce must be registered with SEC, unless exempt i. Registration statement filed w/ SEC on filing day ii. Also gives rules for selling process b. Summary: i. Prohibits certain communication during registration process, rules only apply to issuers, underwriters, and dealers ii. §5(b)(1): unlawful to carry or transmit any prospectus relating to a security for which registration statement has been filed iii. §5(c): Prior to filing, issuer can’t sell or offer to sell securities 1. Sale – §2(3): any disposition of security for value, includes contract for sale a well as actual transfer (gifts, however, are not sales) 2. Offer – §2(3): promot...