This entry contains information applicable to United States law only. Evidence of a corporation's debts or property.
Types of securities include notes, stocks, treasury stocks, bonds, debentures, certificates of interest or participation in profit-sharing agreements, collateral-trust certificates, preorganization certificates or subscriptions, transferable shares, investment contracts, voting-trust certificates, certificates of deposit for a security, and a fractional undivided interest in gas, oil, or other mineral rights. Under certain circumstances, interests in oil- and gas-drilling programs, interests in partnerships, real estate condominiums and cooperatives, and farm animals and land also have been found to be securities. Certain types of notes, such as a note secured by a home mortgage or a note secured by accounts receivable or other business assets, are not securities.
Securities are documents that merely represent an interest or a right in something else; they are not consumed or used in the same way as traditional consumer goods. Government regulation of consumer goods attempts to protect consumers from dangerous articles, misleading advertising, or illegal pricing practices. Securities laws, on the other hand, attempt to ensure that investors have an informed, accurate idea of the type of interest they are purchasing and its value.
Both federal and state laws regulate securities. Before 1929 companies could issue stock at will. Bogus corporations sold worthless stock; other companies issued and sold large amounts of stock without considering the effect of unlimited issues on shareholders' interests, the value of the stock, and ultimately the U.S. economy. Federal securities law consists of a handful of laws passed between 1933 and 1940, as well as legislation enacted in 1970. The federal laws stem from Congress's power to regulate interstate commerce. Therefore the laws are generally limited to transactions involving transportation or communication using interstate commerce or the mail. Federal laws are generally administered by the Securities and Exchange Commission (SEC), established by the Securities Exchange Act of 1934 (15 U.S.C.A. § 78a et seq.). Securities regulation focuses mainly on the market for common stocks.
Securities are traded on markets. Some, but not all, markets have a physical location. The essence of a securities market is its formal or informal communications systems whereby buyers and sellers make their interests known and execute transactions. These trading markets are susceptible to manipulative and deceptive practices, such as manipulation of prices or "insider trading," that is, gaining an advantage on the basis of nonpublic information. To prevent such fraudulent practices, all securities laws contain general antifraud provisions.
Exchange markets, of which the New York Stock Exchange is the largest, have traditionally operated in a rigid manner by carefully delineating the numbers and qualifications of members and the specific functions members may perform. Conversely, over-the-counter markets (OTC) are less structured and typically do not have a physical location.
Based upon dollar volume, the bond market is the largest. Bonds are the debt instruments issued by federal, state, and local government, as well as corporations. The bond market attracts mainly professional and institutional investors, rather than the general public. In addition, many of these obligations are exempt from direct regulatory provisions of the federal securities laws and consequently usually receive little attention from SEC regulators. However, in the mid-1980s, a debacle occurred in the junk bond market, which included insider trading charges. (Junk bonds are highly risky bonds with a high yield.) The scandal, which involved the investment firm of Drexel Burnham Lambert Inc. and trader Michael R. Milken, attracted much attention and a flurry of SEC enforcement activity.
Securities Act of 1933
The first significant federal securities law was the Securities Act of 1933 (15 U.S.C.A. § 77a et seq.), passed in the wake of the great stock market crash of 1929. This law is essentially a disclosure statute. Although the 1933 Act applies by its terms to any sale by any person of any security, it contains a number of exemptions. The most important exemption involves securities sold in certain kinds of transactions, including transactions by someone other than an issuer, underwriter, or dealer. In essence, this provision effectively exempts almost all secondary trading, which involves securities bought and sold after their original issue. Certain small offerings are also exempt.
Although the objective of the 1933 Act's registration requirements is to enable a prospective purchaser to make a reasoned decision based on reliable information, this goal is not always easy to accomplish. For example, an issuer may be reluctant to divulge real weaknesses in an operation and so may try to obfuscate some of the problems while complying in theory with the law. In addition, complex financial information can be extremely difficult to explain in terms understandable to the average investor.
Disclosure is accomplished by the registration of security offerings. In general, the law provides that no security may be offered or sold to the public unless it is registered with the SEC. Registration does not imply that the SEC approves of the issue but is intended to aid the public in making informed and educated decisions about purchasing a security. The law delineates the procedures for registration and specifies the type of information that must be disclosed.
The registration statement has two parts: information that eventually forms the prospectus, and "Part II" information, which does not need to be furnished to purchasers but is available for public inspection within the SEC's files. Full disclosure includes management's aims and goals; the number of shares the company is selling; what the issuer intends to do with the money; the company's tax status; contingent plans if problems arise; legal standing, such as pending lawsuits; income and expenses; and inherent risks of the enterprise.
A registration statement is automatically effective twenty days after filing, and the issuer may then sell the registered securities to the public. Nevertheless, if a statement on its face appears incomplete or inaccurate, the SEC may refuse to allow the statement to become effective. A misstatement or omission of a material fact may result in the registration's suspension. Although the SEC rarely exercises these powers, it does not simply give cursory approval to registration statements. The agency frequently issues "letters of comment," also known as "deficiency letters," after reviewing registration documents. The SEC uses this method to require or suggest changes or request additional information. Most issuers are willing to cooperate because the SEC has the authority to permit a registration statement to become effective less than twenty days after filing. The SEC will usually accelerate the twenty-day waiting period for a cooperative issuer.
For many years an issuer was entitled only to register securities that would be offered for sale immediately. Since 1982, under certain circumstances an issuer has been permitted to register securities for a quick sale at a date up to two years in the future. This process, known as shelf registration, enables companies that frequently offer debt securities to act quickly when interest rates are favorable.
The 1933 Act prohibits offers to sell or to buy before a registration is filed. The SEC takes a broad view of what constitutes an offer. For example, the SEC takes the position that excessive or unusual publicity by the issuer about a business or the prospects of a particular industry may arouse such public interest that the publicity appears to be part of the selling effort.
Offers but not sales are permitted, subject to certain restrictions, after a registration statement has been filed but before it is effective. Oral offers are not restricted. Written information may be disseminated to potential investors during the waiting period via a specially designed preliminary prospectus. Offers and sales may be made to anyone after the registration statement becomes effective. A copy of the final prospectus must usually be issued to the purchaser.
The 1933 Act provides for civil liability for damages arising from misstatements or omissions in the registration statement, or for offers made in violation of the law. In addition, the law provides for civil liability for misstatements or omissions in any offer or sale of securities, whether or not the security is registered. Finally, the general antifraud provision in the law makes it unlawful to engage in fraudulent or deceitful practices in connection with any offer or sale of securities, whether or not they are registered.
In general, any person who acquires an equity whose registration statement, at the time it became effective, contained an "untrue statement of a material fact or omitted to state a material fact" may sue to recover the difference between the price paid for the security (but not more than the public offering price) and the price for which it was disposed or (if it is still owned) its value at the time of the lawsuit. A purchaser must show only that the registration statement contained a material misstatement or omission and that she lost money. In many circumstances the purchaser need not show that she relied on the misstatement or omission or that a prospectus was even received. The SEC defines "material" as information an average prudent investor would reasonably need to know before purchasing the security.
Securities Exchange Act of 1934
The Securities Exchange Act of 1934 addresses many areas of securities law. Issuers, subject to certain exemptions, must register with the SEC if they have a security traded on a national exchange. This requirement should not be confused with the registration of an offering under the 1933 Act; the two laws are distinct. Securities registered under the 1933 Act for a public offering may also have to be registered under the 1934 Act.
To provide the public with adequate information about companies with publicly traded stocks, issuers of securities registered under the 1934 Act must file various reports with the SEC. Since 1964 this disclosure requirement has applied not only to companies with securities listed on national securities exchanges but also to companies with more than five hundred shareholders and more than $5,000,000 in assets. False or misleading statements in any documents required under the 1934 Act may result in liability to persons who buy or sell securities in reliance on these statements.
Under the 1934 Act, the SEC may revoke or suspend the registration of a security if after notice and opportunity for hearing it determines that the issuer has violated the 1934 Act or any rules or regulations promulgated thereunder. Moreover, the 1934 Act authorizes the SEC to suspend trading in any security for not more than ten days, or, with the approval of the president, to suspend trading in all securities for not more than ninety days, or to take other measures to address a major market disturbance.
Proxy Solicitation
The 1934 Act also regulates proxy solicitation, which is information that must be given to a corporation's shareholders as a prerequisite to soliciting votes. Prior to every shareholder meeting, a registered company must provide each stockholder with a proxy statement containing certain specified material, along with a form of proxy on which the security holder may indicate approval or disapproval of each proposal expected to be presented at the meeting. For securities registered in the names of brokers, banks, or other nominees, a company must inquire into the beneficial ownership of the securities and furnish sufficient copies of the proxy statement for distribution to all the beneficial owners.
Copies of the proxy statement and form of proxy must be filed with the SEC when they are first mailed to security holders. Under certain circumstances preliminary copies must be filed ten days before mailing. Although a proxy statement does not become "effective" in the same way as a statement registered under the 1933 Act, the SEC may comment on and require changes in the proxy statement before mailing. Proxies for an annual meeting calling for election of directors must include a report containing financial statements covering the previous two fiscal years. Special rules apply when a contest for election or removal of directors is scheduled.
A security holder owning at least $1,000, or one percent, of a corporation's securities may present a proposal for action via the proxy statement. Upon a shareholder's timely notice to the corporation, a statement of explanation is included with the proxy statement. Security holders will have an opportunity to vote on the proposal on the proxy form. The device is unpopular with management, but shareholders have used this provision to change or challenge management compensation, the conduct of annual meetings, shareholder voting rights, and issues involving discrimination and pollution in company operations.
A company that distributes a misleading proxy statement to its shareholders may incur liability to any person who purchases or sells its securities based on the misleading statement. The U.S. Supreme Court has held that an omitted fact is material if a "substantial likelihood" exists that a reasonable shareholder would consider the information important in deciding how to vote. Mere negligence is sufficient to permit recovery; no evil motive or reckless disregard need be shown. Oftentimes, an appropriate remedy might be a preliminary injunction requiring circulation of corrected materials; it may not be feasible to rescind a tainted transaction after voting. Courts have, however, sometimes ordered a new election of directors, but such action must be in the best interests of all shareholders.
Takeover Bids and Tender Offers
Since the 1960s, increasing numbers of takeover bids and tender offers have resulted in bitter contests between the aggressor and the target of the bid. A corporate or individual aggressor might attempt to acquire controlling stock in a publicly held corporation in a number of ways: by buying it outright for cash, by issuing its own securities in exchange, or by a combination of both methods. Stock may be acquired in private transactions, by purchases through brokers in the open market, or by making a public offer to shareholders to tender their shares either for a fixed cash price or for a package of securities from the corporation making the offer.
Takeover bids that involve a public offer for securities of the aggressor company in exchange for shares of the targeted company require that the securities be registered under the 1933 Act and that a prospectus be delivered to solicited shareholders. For many years, however, cash tender offers had no SEC filing requirements. The Williams Act of 1968, 15 U.S.C.A. §§ 78l, 78m, 78n, amended many sections of the 1934 Act to address problems with tender offers. Although most litigation under the Williams Act is between contending parties, courts generally focus on whether the relief sought serves to protect public stockholders.
Pursuant to the Williams Act, any person or group who takes ownership of more than five percent of any class of specific registered securities must file a statement within ten days with the issuer of the securities, as well as with the SEC. Required information includes the background of the person or group; the source of funds used and the purpose of the acquisition; the number of shares owned; and any relevant contracts, arrangements, or understandings. The issue of whether an acquisition has taken place, thereby triggering the filing requirement, has been the subject of litigation. Courts have disagreed on this issue when confronted with a group of shareholders who in the aggregate own more than five percent and who agree to act together for the purpose of affecting control of the company but who do not act to acquire any more shares.
Restrictions also apply to persons making a tender offer that would result in ownership of more than five percent of a class of registered securities. Such a person must first file with the SEC and furnish to each offeree a statement similar to that required of a person who has obtained more than five percent of registered stock. A tender offer must be held open for twenty days; a change in the terms holds an offer open at least ten more days. In addition, the offer must be made to all holders of the class of securities sought, and a uniform price must be paid to all tendering shareholders. A shareholder may withdraw tendered shares at any time while the tender offer remains open. Moreover, if the person making the offer seeks fewer than all outstanding shares and the response is oversubscribed, shares will be taken up on a pro rata basis.
The 1934 Act also requires every person who directly or indirectly owns more than 10 percent of a class of registered equity securities, and every officer and director of every company with a class of equity securities registered under that section, to file a report with the SEC at the time he acquires the status, and at the end of any month in which he acquires or disposes of these securities. This provision is designed to prevent "short-swing" profits, earned when an individual with inside information engages in short-term trading.
Antifraud Provisions
One impetus for enactment of the 1934 Act was the damage caused by "pools," which were a device used to run up the prices of securities on an exchange. The pool would engage in a series of well-timed transactions, designed solely to manipulate the market price of a security. Once prices were high, the members of the pool unloaded their holdings just before the price dropped. The 1934 Act contains specific provisions prohibiting a variety of manipulative activities with respect to exchange-listed securities. It also contains a catchall section giving the SEC the power to promulgate rules to prohibit any "manipulative or deceptive device or contrivance" with respect to any security. Although isolated instances of manipulation still exist, the provisions manage to prevent widespread problems.
Section 10(b) of the 1934 Act contains a broadly worded provision permitting the SEC to promulgate rules and regulations to protect the public and investors by prohibiting manipulative or deceptive devices or contrivances via the mails or other means of interstate commerce. The SEC has promulgated a rule, known as rule 10b-5, that has been invoked in countless SEC proceedings. The rule states:
It shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, (1) to employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of circumstances under which they were made, not misleading, or (3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
In the 1960s and early 1970s, the courts broadly interpreted rule 10b-5. For example, the rule was applied to impose liability for negligent misrepresentations and for breach of fiduciary duty by corporate management and to hold directors, lawyers, accountants, and underwriters liable for their failure to prevent wrongdoing by others. Beginning in 1975, the U.S. Supreme Court sharply curtailed this broad reading. Doubt exists as to the continued viability of the decisions in some of the prior cases. Nevertheless, although rule 10b-5 does not address civil liability for a violation, since 1946 courts have recognized an implied private right of action in rule 10b-5 cases, and the Supreme Court has acknowledged this implied right (Superintendent v. Bankers Life, 404 U.S. 6, 30 L. Ed. 2d 128, 92 S. Ct. 165 [1971]).
Rule 10b-5 applies to any purchase or sale, by any person, of any security. There are no exemptions: it applies to registered or unregistered securities, publicly held or closely held companies, and any kind of entity that issues securities, including federal, state, and local government securities.
Clauses 1 and 3 of rule 10b-5 use the terms fraud and deceit. Fraud or deceit must occur "in connection with" a purchase or sale but need not relate to the terms of the transaction. For example, in Superintendent v. Bankers Life, the U.S. Supreme Court found a violation of rule 10b-5 where a group obtained control of an insurance company, then sold certain securities and misappropriated the proceeds for their own benefit. In another case a publicly held corporation made misstatements in a press release. Even though the company was not engaged at that time in buying or selling its own shares, a U.S. court of appeals ruled that the statements were made "in connection with" purchases and sales being made by shareholders on the open market.
Insider Trading
Rule 10b-5 protects against insider trading, which is a purchase or sale by a person or persons with access to information not available to those with whom they deal or to traders generally. Originally, the prohibition against insider trading dealt with purchases by corporations or their officers without disclosure of material, favorable corporate information. Beginning in the early 1960s, the SEC broadened the scope of the rule. The rule now operates as a general prohibition against any trading on inside information in anonymous stock exchange transactions, in addition to traditional face-to-face proceedings. For example, in In re Cady, Roberts & Co., 40 S.E.C. 907 (1961), a partner in a brokerage firm learned from the director of a corporation that it intended to cut its dividend. Before the news was generally disseminated, the broker placed orders to sell the stock of some of his customers. In another case officers and employees of an oil company made large purchases of company stock after learning that exploratory drilling on some company property looked extremely promising (SEC v. Texas Gulf Sulphur, 401 F. 2d 833 [2d Cir. 1968]). In these cases the persons who made the transactions, or persons who passed information to those individuals, were found to have violated rule 10b-5.
However, not every instance of financial unfairness rises to the level of fraudulent activity under rule 10b-5. In Chiarella v. United States, 445 U.S. 222, 100 S. Ct. 1108, 63 L. Ed. 2d 348 (1980), Vincent F. Chiarella, an employee of a financial printing firm, worked on some documents relating to contemplated tender offers. He ascertained the identity of the targeted companies, purchased stock in those companies, and then sold the stock at a profit once the tender offers were announced. The Supreme Court overturned Chiarella's criminal conviction for violating rule 10b-5, ruling that an allegation of fraud cannot be supported absent a duty to speak and that duty must arise from a relationship of "trust and confidence between the parties to a transaction." However, following Chiarella, criminal convictions of lawyers, printers, stockbrokers, and others have been upheld by courts that have ruled that these employees traded on confidential information that was "misappropriated" from their employers, an issue that was not raised in Chiarella. Moreover, courts have also ruled that the person who passes inside information to another person who then uses it for a transaction is as culpable as the person who uses it for his or her own account.
The test for materiality in a rule 10b-5 insider information case is whether the information is the kind that might affect the judgment of reasonable investors, both of a conservative and speculative bent. Furthermore, an insider may not act the moment a company makes a public announcement but must wait until the news could reasonably have been disseminated.
The Insider Trading Sanctions Act of 1984 (Pub. L. No. 98-376, 98 Stat. 1264) and the Insider Trading and Security Fraud Enforcement Act of 1988 (15 U.S.C.A. §§ 78u-1, 806-4a, and 78t-1) amended the 1934 Act to permit the SEC to seek a civil penalty of three times the amount of profit gained from the illegal transaction or the loss avoided by it. The penalty may be imposed on the actual violator, as well as on the person who "controlled" the violator — generally the employing firm. A whistle-blower may receive up to 10 percent of any civil liability penalty recovered by the SEC. The maximum criminal penalties were increased from $100,000 to $1 million for individuals and from $500,000 to $2.5 million for business or legal entities.
Regulation of the Securities Business
Only dealers or brokers who are registered with the SEC pursuant to the 1934 Act may engage in business (other than individuals who deal only in exempted securities or handle only intrastate business). Firms act in three principal capacities: broker, dealer, and investment adviser. A broker is an agent who handles the public's orders to buy and sell securities for a commission. A dealer is a person in the securities business who buys and sells securities for her or his own account, and an investment adviser is paid to advise others on investing in, purchasing, or selling securities. Investment advisers are regulated under the Investment Advisers Act of 1940 (15 U.S.C.A. § 80b et seq.). This law provides for registration similar to that in the 1934 Act for brokers and dealers, but its coverage is generally not as comprehensive. Certain fee arrangements are prohibited, and adverse personal interests in a transaction must be disclosed. Moreover, the SEC may define and prohibit certain fraudulent and deceptive practices.
The SEC has the power to revoke or suspend registration or impose a censure if the broker-dealer has violated federal securities laws or committed other specified misdeeds. Similar provisions apply to municipal securities dealers and investment advisers.
Problems may arise in a number of ways. For example, a broker-dealer may recommend or trade in securities without adequate information about the issuer. "Churning" is another problem. Churning occurs when a broker-dealer creates a market in a security by making repeated purchase from and resale to individual retail customers at steadily increasing prices. This conduct violates securities antifraud provisions if the broker-dealer does not fully disclose to customers the nature of the market. Churning also occurs when a broker causes a customer's account to experience an excessive number of transactions solely to generate repeated commissions. Fraudulent "scalping" occurs when an investment adviser publicly recommends the purchase of securities without disclosing that the adviser purchases such securities before making the recommendation and then sells them at a profit when the price rises after word of the recommendation spreads.
In 1990 Congress enacted the Penny Stock Reform Act (15 U.S.C.A. § 78q-2), which gives the SEC authority to regulate the widespread incidence of high-pressure sales tactics in the peddling of low-priced speculative stocks to unsophisticated investors. Dealers in penny stocks must provide customers with disclosure documents discussing the risk of such investments, the customer's rights in the event of fraud or abuse, and compensation received by the broker-dealer and the salesperson handling the transaction.
Securities Investor Protection Corporation
The Securities Investor Protection Act of 1970 (15 U.S.C.A. § 78aaa et seq.) created the Securities Investor Protection Corporation (SIPC) to supervise the liquidation of securities firms suffering from financial difficulties and to arrange for the payment of customers' claims through its trust fund in the event of a broker-dealer's bankruptcy. SIPC is a government-sponsored, private, nonprofit corporation. It relies on the SEC and self-regulatory organizations to refer brokers or dealers having financial difficulties. In addition, SIPC has authority to borrow money (through the SEC) if its trust fund from which it pays claims is insufficient. SIPC guarantees repayment of money and securities up to $100,000 in cash equity and up to $500,000 overall per customer.
Self-Regulatory Organizations
Although the SEC plays a major role in regulating the securities industry, regulation responsibilities also exist for self-regulatory organizations. These organizations are private associations to which Congress has delegated the authority to devise and enforce rules for the conduct of an association's members. Before 1934 stock exchanges had regulated themselves for well over a century. The 1934 Act required every national security exchange to register with the SEC. An exchange cannot be registered unless the SEC determines that its rules are designed to prevent fraud and manipulative acts and practices and that the exchange provides appropriate discipline for its members.
Congress extended federal registration to non-exchange, or OTC, markets in 1938 and authorized the establishment of national securities associations and their registration with the SEC. Only one association, the National Association of Securities Dealers, had been established as of the mid 1990s.
In 1975 Congress expanded and consolidated the SEC's authority over all self-regulatory organizations. The SEC must give prior approval for any exchange rule changes, and it has review power over exchange disciplinary actions.
Investment Companies
Under the Investment Company Act of 1940 (15 U.S.C.A. § 80a et seq.), investment companies must register with the SEC unless they qualify for a specific exception. Investment companies are companies engaged primarily in the business of investing, reinvesting, or trading in securities. They may also be companies with more than 40 percent of their assets consisting of "investment securities" (securities other than securities of majority owned subsidiaries and government securities). Investment companies include "open-end companies," commonly known as mutual funds. The SEC regulatory responsibilities under this act encompass sales load, management contracts, the composition of boards of directors, capital structure of investment companies, approval of adviser contracts, and changes in investment policy. In addition, a 1970 amendment imposed restrictions on management compensation and sales charges.
Every investment company must register with the SEC. Registration includes a statement of the company's investment policy. Moreover, an investment company must file annual reports with the SEC and maintain certain accounts and records. Strict procedures safeguard against looting of investment company assets. Officers and employees with access to the company's cash and securities must be bonded, and larceny or embezzlement from an investment company is a federal crime. In addition, the Investment Company Act of 1940 imposes substantive restrictions on the activities of registered investment companies and persons connected with them and provides for a variety of SEC and private sanctions.
State Regulation
State securities laws are commonly known as blue sky laws because of an early judicial opinion that described the purpose of the laws as preventing "speculative schemes which have no more basis than so many feet of blue sky" (Hall v. Geiger-Jones, 242 U.S. 539, 372 S. Ct. 217, 61 L. Ed. 480 [1917]). A Uniform Securities Act has been partially or substantially adopted by a majority of states, but much diversity among state securities laws still exists. Typical provisions include prohibitions against fraud in the sale of securities, registration requirements for brokers and dealers, registration requirements for securities to be sold within the state, and sanctions and civil liability under certain circumstances. In addition to complying with the registration requirements of the 1933 Act, a nationwide distribution of a new issue requires compliance with state blue sky provisions as well.
A majority of states have laws regulating takeovers of companies incorporated or doing business within the state. Although the courts have invalidated some of these statutes, these laws tend to aid in preserving the status quo of management.
See: Mergers and Acquisitions; Risk Arbitrage; Stock Market; Stockholder's Derivative Suit.
