What are securities laws?

Securities laws are the federal and state statutes and regulations that control the sale or transfer of rights or ownership interests in a business entity (securities). Specifically, securities laws purport to protect the general public from deceptive practices in the sale or trade of securities. The major securities laws include the Securities Act of 1933 and the Securities Exchange Act of 1934. The primary method of protecting investors prescribed under these acts is thorough disclosure of relevant or material information. As we discuss in this chapter, the requirements for the disclosure of information vary based upon the nature of the sale or transfer of securities.

What is a security?

Most people think of a security as simply stock or other ownership units of a business entity; however, the statutory definition of a security is far more extensive. The term security means any,

note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit-sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral trust certificate, pre-organizational certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate or deposit, or group or index securities (including any interest therein or based on the value thereof) or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any interest commonly known as a security.

The definition of a security is broad, but it leaves open the inclusion of any interest not identified within the definition, but that the court deems to constitute a security. There is a great deal of common law surrounding the judicial interpretation of what constitutes a security. Most notably, the term investment contract from the definition of a security is construed very broadly and is somewhat of catch-all for business interests that may constitute a security.

Discussion: Why do you think Congress applied such a broad definition of what constitutes a security? Does the fact that common law goes much further to define a security affect your opinion about the suitability of the statutory definition?

What qualifies as an investment contract?

The broadest category of a business interest constituting a security is an investment contract. Courts have developed a number of tests to determine what constitutes an investment contract. The most influential is the Howey test. The elements for determining whether a business interest constitutes an investment contract (and thereby a security) are as follows:

an investment of money,

Note: To invest money means to provide any sort of value to the company in exchange for a beneficial interest in or ownership of the company. The investment does not have to be cash or currency.

Example: I receive an ownership interest (10% ownership) in your business activity in exchange for my contribution of a pickup truck for use in the business.

in a common enterprise,

Note: A common enterprise is any form of concerted business activity. The enterprise does not have to be a registered business entity.

Example: A common enterprise may include a default entity form, such as a general partnership.

with the expectation of profits, and

Note: The expectation of profits is a very broad notion. An individual can invest in the enterprise with the purpose of directly or indirectly deriving profits. This may include the objective of taking advantage of any tax benefits associated with the investment.

Example: I invest in ABC, LLC. The LLC will have losses this year and for the next couple of years. I am not actively involved in the business. As such, I will be able to offset the passive losses against the active profits I have in a separate investment. This will reduce my tax liability. Eventually, I expect ABC, LLC to produce a profit.

derived solely from the efforts of others.

Note: Derived solely from the efforts of others means that the investor does not actively take part in the business activity. She may be able to offer limited guidance to the business managers, but she does not take part in the active affairs of the business. This provision seems to eliminate investments in games of chance that do not involve a business activity or a concerted activity with someone else.

Example: I am interested in providing money to Alices design services business. I may offer some guidance to Alice in how to run the business, but I do not take part in any of Alices business operations. It is Alices efforts and not my personal activity that constitute the business (such as in a sole proprietorship or general partnership). Each element of this test requires considerable analysis. Courts have interpreted each element to add a great deal of specificity and complexity to the individual factors.

Discussion: Why do you think the definition of an investment contract has been interpreted so broadly? What would be the potential effect of a narrow interpretation?

Practice Question: Ralph is an avid gambler. He loves to wager money on any type of sporting event or game of chance. He puts his money in a pool to purchase lottery tickets under the understanding that everyone will split any winnings. Is this an investment contract? Why or why not? Does it change your analysis if Ralph and the other investors depend upon Carter to manage the funds, purchase and hold the tickets, collect any winnings, and distribute those funds to any investors? Why?

What are the primary security laws?

Securities are subject to federal and state regulation. State securities laws are known as Blue Sky laws and are discussed at the end of this chapter. The two primary federal laws governing the trade or sale of securities are the Securities Act of 1933 (33 Act) and the Securities Exchange Act of 1934 (34 Act).

33 Act - The 33 Act provides the rules for the initial sale of securities to the public. This includes detailed rules for the personal disclosure to prospective purchasers and disclosure of information to the general public through registration with the Federal Government.

34 Act - The 34 Act concerns the on-going disclosure requirements once company securities are traded publicly, such as on national exchanges. These laws provide for the substantive content of the disclosure, the procedural disclosure requirements, and the repercussions (such as civil and criminal penalties) for failing to adhere to these laws.

Both the 33 and 34 Acts are administered by the Securities Exchange Commission. Along with the regulations promulgated by the SEC, they govern the sale or exchange of securities in any context.

Discussion: Why do you think the securities laws treats the initial sale of securities to the public separately from the subsequent sale of issued securities on public markets? How are these types of securities different?

Practice Question: What type of activity is regulated by the Securities Act of 1933? The Securities Exchange Act of 1934?

What are the regulatory goals of security laws?

The regulatory goals or purpose of the securities laws include:

preventing manipulation of the securities market;

full disclosure of material information to stakeholders;

preventing fraud; and

leveling the playing field between insiders of a company and investors.

Each of these regulatory goals are not independent. Fairness and the prevention of deceit underline each objective.

Discussion: How do you feel about these securities law objectives? Are there any additional objectives that should be achieved under the securities laws?

What is the Securities and Exchange Commission (SEC)?

The Securities and Exchange Commission (SEC) is a semi-independent, administrative agency created in 1934 (as part of the 34 Act) to regulate the sale or exchange of securities. The commissioners are appointed by the President under the advisement of Congress. The SEC is divided into five main divisions regulating: Corporation Finance, Trading and Markets, Investment Management, Enforcement, and Economic and Risk Analysis. The SEC has quasi-legislative and quasi-executive powers. The SEC develops the regulations to carry out the statutory laws passed by Congress. It has the ability to issue cease and desist orders, issue fines, and bring civil actions against issuers of securities who violate the law.

Note: Criminal actions for violation of securities laws are referred to the US Attorneys Office for prosecution.

Discussion: Why do you think securities law requires a dedicated administrative agency? How do you feel about an independent agency making securities regulations with the force and effect of law?

Practice Question: What is the role of the Securities and Exchange Commission in the regulation of securities?

What is an initial public offering?

An initial public offering (IPO) refers to the registration and sale of stocks of a private firm or company to the general public. The primary purpose of the IPO is to generate operating capital for the company or to create liquidity by opening its stock for public trading on stock exchanges or in private (over-the-counter) transactions. Equity shares in a company constitute securities, so the IPO process is subject to securities law and is closely scrutinized by the SEC. The IPO process is complicated and generally involves a number of professional service providers.

The process for an IPO is substantially as follows:

What is the Underwriting Process?

Typically the company seeking capital through an IPO partners with an underwriting firm or investment bank. Underwriting involves hiring an investment bank (or group of investment banks) to market and sell company securities. The underwriter provides support, including determining the type of security to issue, the price to offer, the number of shares to open to the public, and the time frame for which stocks are open to public. The underwriter also facilitates the sale of shares to investors through process known as a road show. The underwriting may also guarantee the placement of a certain quantity of stocks at a given price. In some instances, smaller companies will make an offering directly to individual customers through a licensed broker. This process is known as a direct public offering and is often associated with low-value securities, commonly referred to as penny stocks. For larger companies, investment banks stand in a unique position to be able to create awareness of the issuance and sell the securities to large, institutional investors. This process is commonly known as a road show. The underwriting bank will generally make 1 of 3 different levels of commitment to the issuing company:

• Firm Commitment - A firm commitment is when the underwriting bank act as a dealer and takes ownership or responsibility of any shares that are offered but not sold as part of the IPO. In a firm commitment, the bank receives a profit by negotiating a purchase price from the issuing company that is lower than the share price for purchasers.
• Best Efforts Commitment - If the underwriter makes a best-efforts commitment, she does not guarantee that all of the shares will sale in the issuance at said price. Further, the bank will not take ownership of any unsold shares.
• Standby Commitment - In a standby commitment, the underwriter agrees to purchase any shares not sold in the IPO at the stated subscription price. The fee to the issuer for this type of commitment is generally higher than in a best efforts commitment.

Note: The underwriter has the ability to garner interest in the securities, but no sale of securities can take place at this point. The issuer can only sell to the underwriter or to prospective purchasers identified by the underwriter once the registration process is complete.

Example: ABC Corp intends to undergo an IPO and needs assistance with arranging for the sale of its shares to the public. JP Morgan Bank contracts with ABC Corp to handle the IPO. JP Morgan will advise ABC Corp on the number and value of shares to issue. It will then seek to sell (seek commitments for the purchase of) these shares to institutional investors. JP Morgan makes a firm commitment, so it is obligated to purchase a predetermined number of shares, which it will sell to the institutional investors for a price above what it pays ABC Corp.

Steps in the IPO Process

• Formation of an external team comprising of experts like underwriters, lawyers, certified accountants and exchange commission experts.
• Compilation of information about financial performance and future plan of operations of the company undergoing IPO
• Filling of prospectus and registration statement with Securities and Exchange Commission.
• Underwriter publicly advertises the issuance and seeks to secure investors to purchase the shares.
• Setting up a date on which IPO will be rolled out.
• Issuing the shares to the institutional investors subscribing to the issuance.

What is the Registration Process?

Registration is the process of filing extensive disclosures with the SEC about the companies finances and operations and characteristics of the issuance of securities. The filings with the SEC are made public and provide information to potential investors in the market. The SEC will review the disclosures for completeness, but it does not evaluate the quality of the securities being issued. The approval of the SEC is based upon whether sufficient information is disclosed to allow a potential investor to make an informed decision. Often this is a back-and-forth process until the SEC is satisfied that all necessary information has been disclosed.

Note: Disclosure to the SEC is a very complicated process. Though expensive, businesses generally hire experienced legal firms to help with the disclosure process. Private sale of securities (discussed below) may be exempt from the registration process.

How Does the Solicitation of Purchasers Work?

After the registration process is complete, the issuer will solicit prospective purchasers and consummate the sale of securities. At this point, the investment bank will proceed with the road show and begin contacting potential purchasers. As part of this process, the issuer or underwriter must provide all offerees or prospective purchasers with a disclosure document, known as a prospectus. The prospectus contains much of the same information contained in the registration statement but provides a more concise presentation of material information.

The extensive registration requirements associated with an IPO can be very burdensome and expensive to the company. As such, many companies seeking to raise capital avoid the IPO process and seek equity financing from private investors. This process is known as a private offering and is discussed further below.

Discussion: How do you feel about the extensive registration requirements and sale restrictions on securities? Are these regulations a benefit or detriment to businesses? Society? Why or why not?

Practice Question: Ernest is interested in offering shares of his company, ABC Corp, for sale to the public. He believes that this will bring in the capital necessary to continue growth. Outline the securities law process that ABC Corp will need to undergo prior to selling to the public.

What are the Advantages and Disadvantages of an IPO

• Capital Raise - It is the easiest way to raise large amounts of capital.
• Cost of Capital - Being a publicly scrutinized company usually results in lower borrowing rates.
• Brand Recognition - Going public increases the companys brand recognition among lenders, suppliers, customers, etc.
• Liquidity - Shareholders prefer for their ownership interest to be liquid (easily sold for cash). A public companys shares can be easily sold on the public market. This makes it easier to attract top executive talent with employee stock option plans.
• Mergers and Acquisitions - In a merger of two companies, having one or both companies as a public company can facilitate the process in terms of securing financing and trading stock in the deal.

• Reporting - The company must make routine disclosures (finances, accounting, operations, legal, etc.) to the public.
• Regulation - Public companies are highly regulated by various agencies primarily implement the Securities Act of 1934.
• Expenses - The accounting, tax, and legal expenses of managing a public company are far higher.
• IPO Failure - It is possible that the IPO price does not reach a minimum threshold and the IPO fails.
• Loss of Control - Having a broad group of shareholders means that the existing owners interests are diluted. This results in a general loss of voting power and potential loss of control in the company.

What is a direct public offering?

A direct public offering is the process by which a company offers its shares for sale directly to the public without employing the services of an underwriter. The underwriter has the ability to reach out to large institutional investors and guarantee the sale of a certain quantity of securities. In a direct public offering, the company will generally enlist the services of a broker to make certain the offering is carried out in accordance with the securities laws. The requirement to register securities still applies; however, the company may be able to employ an exemption from registration (discussed below). Once registration (or an exemption therefrom) is complete, the company will advertise the offering and begin selling to individuals, investment firms, etc. The direct public offering has become popular for companies seeking to crowdfund its growth. Numerous websites and services now exist to meet this demand.

Note: The direct public offering is generally employed by smaller firms who cannot attract an investment bank to underwrite the public offering. It is far cheaper than an IPO, particularly if the company is able to employ an exemption from the securities registration process.

Discussion: Why do you think larger companies generally go through the IPO process, rather than undertaking a direct public offering? Can you see any advantages to the IPO over the DPO or vice versa?

Practice Question: How does the process of a direct public offering differ from that of an initial public offering? What are the advantages of the DPO process?

What is crowdfunding and how is it affected by securities registration laws?

The edition of Section 4(a)(6) to the 33 Act introduced equity crowdfunding as a viable option for seeking investors in a new business. Crowdfunding is a sort of mini-public offering that allows the general public to purchase securities directly from an issuer through authorized, private exchanges. Section 4(a)(6) provides for a Section 5 registration exemption for issuances conducted in accordance with specific crowdfunding methods. To qualify for the exemption under Section 4(a)(6), crowdfunding transactions by an issuer (including all entities controlled by or under common control with the issuer) must meet specified requirements, including the following:

the amount raised must not exceed $1 million in a 12-month period (this amount is to be adjusted for inflation at least every five years);

individual investments in a 12-month period are limited to:

the greater of $2,000 or 5 percent of annual income or net worth of an individual, if the annual income or net worth of the investor is less than $100,000;

10 percent of annual income or net worth (not to exceed an amount sold of $100,000), if annual income or net worth of the investor is $100,000 or more (these amounts are to be adjusted for inflation at least every five years); and

transactions must be conducted through an intermediary that either is registered as a broker or is registered as a new type of entity called a funding portal.

Many entrepreneurs see the availability of crowdfunding as an important financing option for smaller companies that otherwise lack the resources to seek a public offering or to comply with statutory or rule-based exemptions. Section 4(a)(6) places the burden of compliance on the crowdfunding broker or portal. To become registered as a crowdfunding broker or funding portal, the entity must comply with the following:

implement procedures to protect purchasers of securities against fraud;

refrain from providing investment advice or soliciting purchasers;

provide disclosures substantially similar to those required in a registration or disclosure document;

allow for questions and feedback on securities being issued;

file an offering statement with the SEC disclosing the terms and details of all issuances (which is also available to investors); and

make annual filings with the SEC and make those fillings available to the public on the crowdfunding site or portal.

The qualified broker or portal must also make certain that all investors meet the accreditation standards laid out by Section 4(a)(6). It cannot employ intermediaries to sell securities on behalf of the broker or portal. It must make certain the securities are understood to be restricted and, with limited exception, cannot be sold within a 12-month period of purchase.

Discussion: Why do you think Congress decided to provide a statutory method for allowing crowdfunding that is exempt from Section 5 registration requirements? Do you think the limitations on investor and the requirements of brokers or portals are sufficient to protect investors? Why or why not?

Practice Question: ABC, LLC is a new company that is growing quickly. It believes that crowdfunding may be the best method for generating much-needed capital. Eric is an investor interested in investing in a startup fund. What are the securities law requirements for ABC to undertake crowdfunding? What are the limitations on Eric as an investor?