SEC REGULATIONS. SEC Regulations Gadinis Fall 2010

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1 SEC REGULATIONS What is Securities Liability? o Securities Liability = compromise between caveat emptor and risk of markets. o Companies disclose all relevant information to investors o Investors choose which securities to buy and at what price o Companies are liable only for misstatements/omissions in disclosure, not for poor business decisions So the question becomes not whether a particular business decision was wise, but whether it was properly disclosed (e.g.: executive bonuses) Role of securities regulators is to ensure that information is available to investors so that they can make informed decisions Key Statutes o Securities Act of 1933 Transactional focus: offering and sale of securities Purpose: disclosure to investors through registration and prospectus Provides public and private remedies o Securities Exchange Act of 1934 SEC (not covered) Stock exchanges, broker-dealers, SROs (not covered) Requires continuous disclosure for reporting companies o 33 Act is thus focused on individual transactions, and 34 Act is focused on continual reporting. Challenge of securities law since then has been to bring these two things together. o Integrated Disclosure System While the 33 Act is transaction-oriented, the 34 Act is company-oriented: Annual Reports to Shareholders; Form 10-K; etc. Yet, a lot of the information included in the prospectus focuses on the issuer as a company SEC Rules established uniform disclosure requirements: Eligible reporting companies can use 34 Act documentation for 33 Act purposes through form S-3 Reporting companies can address gun-jumping restrictions to the flow of information to investors Filings under both Acts can refer to information in items under Regulation S-K (non-financial disclosure) and S-X (accounting disclosure). Market Efficiency 1

2 o A market is efficient when the prices fully reflect available information Three formulations: Weak: current prices reflect fully only past stock prices and returns (i.e., backwards looking only). Thus, we cannot make predictions about the future, but only claim that current prices efficiently reflect past performance. The result is that stock prices appear random (a random walk) Semi-strong: Market prices reflect all publicly available information. The moment that information becomes public it is reflected in price. Strong: Market prices reflect all information, even private information. While information is not available to all, once someone who has the information acts on it, it effectively becomes public. Semi-strong approach is the most widely studied, and also the weak one. By 1970s market efficiency was a widely accepted view. o Critiques: Rationality Investors, both professional and amateur, are not rational People are influenced by other factors besides available information, including external needs (i.e. need to sell stock to buy a house) or irrational psychological biases (e.g. risk aversion, a tendency to see patterns where none exist) Noise Traders: Random or Not? Efficient market argument: Noise traders (i.e. irrational traders) act randomly, and so cancel each other out, leaving the markets in an efficient equilibrium But, in fact there are systematic patterns among noise traders, both individuals and institutions Arbitrage: Efficient market argument: Even when some people act irrationally to inflate or deflate a stock price, arbitrageurs will buy or sell identical or extremely similar stocks which are differently valued (either more or less) to make a profit. This will produce market efficiency overall. E.g.: short selling: the arbitrageur thinks a stock is going down, so she sells the stock at a high price (without actually having it) for later delivery, and then when the stock price falls she buys the stocks for delivery. The arbitrageur reaps the profit from the difference. But, there are limits to arbitrage. There is a limited availability of substitutes and risk, especially when an entire market is overvalued. 2

3 o If everyone believes that the market is going up all the time, the rational investor will buy, and not sell, because there is no way to know when the bubble will burst. Thus arbitrage may not work under these conditions. Conclusion: Markets are certainly not fully rational, but they are probably rational to some degree. But we don t know to what degree. Debate over Disclosure See class 11 slides. Definition of a Security for 33 Act What is a Security -- To come within the registratin requirement of 5 of the 33 Act, the property interest that is offered or sold must be a security. 2(a)(1) of the 33 Act and 3(a)(10) of the 34 Act define three basic categories of securities subject to registration: o Interests or Instruments Specifically Mentioned: - the 33 Act expressly classifies certain financial instruments/interests as securities. However, it also provides that the definition will not apply if the context otherwise requires. Stock - if so called stock possesses the characteristics normally associated with stock (i.e., it carries dividend and voting rights, it is negotiable, it can be pledged, and it can appreciate in value) then it is a security under the 33 Act. Landreth Timber Co. v. Landreth (1985) - SCOTUS held that the sale of 100% of the stock in a corporation = security transaction because the stock possessed all characteristics typical of stock o prior courts had applied the sale of business doctrine which exempted from federal securities laws sales of all or substantially all of the stock in closely held corporation. o Gould v. Ruefenacht: Court applied Landreth to sale of 50% of a company s stock. But United Housing Foundation, Inc. v. Forman (1979) - SCOTUS holds that the sale of stock in a nonprofit housing cooperative did not involve a security b/c it lacked the usual indicia of a stock (it was not transferable, there was no right to receive dividends...). The purchasers essential bought living quarters for personal use and were not investing in stock. (Promissory) Notes - specifically listed in 2(a)(1) of the 33 Act and 3(a)(10) of the 34 Act, but presents a problem b/c many notes clearly are not securities (e.g., mortgage notes, or the note signed by a consumer buying an automobile on credit) 3

4 Reves Family Resemblance Test - used by courts to determine whether a note is a security (includes a presumption and an exception to the presumption) o Start with presumption that every note is a security o Exceptions (which rebut the presumption) ( adopted by SCOTUS in Reves v. Ernst & Young) - notes listed below, and those bearing a family resemblence to them, are deemed not to be securities under the 33 Act Consumer financing Home mortgages Short-term loans secured by assets of a small business Character loans to bank customers Short-term secured financing of accounts receivable Short-term open-account debts incurred in the ordinary course of business (especially when the debt is collaterized) Commercial bank loans for current operations o Four Factors for determining family resemblance to a note listed above The motivations of the seller and buyer of the note (e.g., was the transaction one for investment, or instead to finance the purchase of a consumer item) The plan of distribution of the instrument, if any (e.g., if the instrument is traded, the likelihood that it is a security increases) The reasonable expectations of the investing public (e.g., does the public reasonably expect to have the protections of the 33 Act in this kind of transaction?) Reves Court noted that this may result in a security even if the economic analysis of the transaction suggest that the note is not a security The existence of a comparable scheme of regulation diminishes the likelihood that a note is a security in a particular case Commercial Paper Short-term prime-quality notes issued typically by large corporations for current operations and purchased by institutional investors Doesn t have to follow 33 Act, unclear whether if has to follow 34 Act. 4

5 3(a)(3) of 33 Act exempts any note, draft, bill of exchange, or banker s acceptance which arises out of a current transaction or the proceeds of which have been or are to be used for current transactions, and which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited. Prior to Reves, it was assumed that the 34 Act likewise excluded commercial paper (though the exemption is only specified in the 33 Act). However, only one justice in Reves said that commercial paper was likewise excluded under the 34 Act;; 4 refused to take a position, and 4 expressed doubt. So open question. o Investment Contracts - 2(a)(1) of the 33 Act includes a catchall reference to investment contracts. Traditional Howey Test - an investment contract is any contract or profitmaking scheme whereby (1) a person invests his money in (2) a common enterprise and (3) expects to make a profit (4) solely from the efforts of the promoter or a third party who is responsible for management SEC v. W.J. Howey Co.: sale of a row of citrus trees, when the cultivation, harvesting and marketing was handled by an affiliate of seller, was an investment contract. Unique one-on-one agreements are not securities (Marine Bank v. Weaver). Courts have gone beyond the criteria of the Howey test to require registration in situations where the investors participated to some extent in management and where the benefits derived by them were something other than cash profits Modern Test - Four criteria for determining whether a particular property interest or participation in a profit-making venture is an investment contract : Does the investor have an expectation of profit? o Profit = capital appreciation or participation in earnings o Profit does not mean a desire to use or consume the item purchased. United Housing Foundation Inc. v. Forman: Court found no expectation of profit where purchasers in housing cooperative sought living quarters. o SEC v. Edwards SCOTUS holds that fixed returns could also be considered expected profits under Howey Test. Purchasers 5

6 bought payphones that were then leased back to ETS for a fixed amount per year and full refund upon expiry. Is there a common enterprise? (i.e., a number of investors who stand in a similar relationship to a business in which they invest in common) o Horizontal Commonality - there must be a sharing or pooling of funds or other assets by several investors and profits derived from these combined funds o Vertical Commonality - a common enterprise will be found if the investor is relying on the efforts of the promoter to make a profit ( a common enterprise is one in which the fortunes of the investor are interwoven with and dependent upon the efforts and success of those seeking the investment. - Glen W. Turner Enterprises) Broad Vertical Commonality: Common Enterprise if there is some connection between efforts of promoter and collective success of investors. Strict Vertical Test - requires that the investment manager s fortunes rise and fall with those of the investors SEC v. Alliance Leasing Schofield v. First Commodity court found no investment contract where broker was paid a fixed commission). Does the success of the enterprise depend mainly on the efforts of persons other than the investors o SEC v. Turner: Turner Restatement of the Howey test, in which this factor depends on whether the efforts made by someone other than the investor are the undeniably significant ones. o Risk Capital Test Some states use this test to ID wehn their state s blue sky laws apply to unorthodox transactions. Even if the investors are active in the management, does the scheme involve the raising of capital to finance the venture, which is then controlled by a third party? o Timing of Third-Party Efforts SEC v. Life Partners, the court held that an enterprise did not involve securities where the third party expended effort seeking out investment opportunities, 6

7 and structured the acquisition of assets by the enterprise, but after the investment was made, the third party undertook no significant additional tasks But SEC v. Mutual Benefits Court held there is no basis for excluding pre-purchase managerial activities from the investment contract analysis. o Franchise Arrangements: Not generally considered investment contract Crowley v. Montgomery Ward: economic reality is that the contributions of the francisees significantly and substantially affect profits, so therefore not an investment contract. But SEC v. Aqua-Sonic: Franchisees were not active salespeople; Aqua-Sonic primarily used them for capital, so this was investment contract. Do the investors need the protection of the 33 Act? o SCOTUS has held that if a detailed scheme of federal regulation applies to a particular investment or contract, the 33 Act may not apply In 1975, with Blue Chip Stamps v. Manor Drug Stores, SCOTUS began to limit the scope of federal securities law to the regulation of the public trading markets and interstate investment promotions o Any Interest or Instrument Commonly Known as a Security - catchall provision in general, any interest or instrument commonly known as a security. Interests in Partnerships and LLCs as Securities o Generally follow Howey Investment Contract Tests. o Interests in Partnerships Courts will explore whether a partner is a passive participant. General Partnerships - sale of a general partnership normally does not constitute the sale of a security, b/c general partners ordinarily take an active part in management Exceptions (from Williamson v. Tucker) o An agreement among the parties leaves so little power in the hands of the partner that the arrangement in fact distributes power as would a limited partnership U.S. v. Leaonard Partnership may still be a security if, despite formal powers, partner participation was minimal. 7

8 o The partner is so inexperienced and unknowledgeable in business affairs that he is incapable of intelligently exercising partnership powers o The partner is so dependent on some unique entrepreneurial or managerial ability of the promoter or manager that he cannot replace the manager of the enterprise or otherwise exercise meaningful partnership power Limited Partnerships - almost always held to be securities, b/c limited partners obtain an interest in the partnership in return for a contribution of cash or other property, but have little or no role in managing the business Exception - limited partner retains significant control o Interests in LLCs member-managed LLCs approximate general partnerships; manager-managed LLCs approximate limited partnerships. Derivative Securities and Synthetic Investments o Derivatives Traditionally, the CFTC regulated futures and the SEC regulated securities; 2010 Dodd-Frank Act specifically included security based swaps in the defintion of security. Futures Non-stock futures are not securities Stock futures are securities and may be regulated both by the SEC and CFTC Options Non-stock options are not securities Stock options are securities ( 2(a)(1) of 33 Act). o Synthetic stock options (cash-settled) are securities as well Caiola v. Citibank. Swaps Negotiated agreement btwn two parties in which each promisses to make a payment to the other, with the payments occurring at diferent times and determined under different formulas. Ex., fixed-for-floating interest rate swap. Likely would not be common enterprise under Howey, but security swaps are specifically characterized as securities by Dodd-Frank. Securitization o Items not regarded as securites can be repackaged into securities through contractual arrangements... Can be found to be securities through either an investment contract/howey or Note/Reves analysis. Gary Plastic Packaging Co. v. Merrill Lynch Court found security where Merrill offered certificats of deposit (including negotiating special rates with 8