Lecture Notes - Securities (REV)

Lecture Notes - Securities (REV) - Regulation of Regulation...

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Unformatted text preview: Regulation of Regulation of Securities Questions of the Day Questions of the Day What is a security? What are the basic purposes and tenets of securities law? What is the structure of the industry, and of the securities markets, and how are they regulated? Some Terms and Concepts You Should Know Security SEC Securities Act of 1933 Securities Exchange Act of 1934 Securities Exchange Securities Registration Investment Company Act Investment Advisers Act Mutual Fund v Hedge Fund FINRA (and SRO) Sarbanes­Oxley Act SEC Rule 10(b)5 Margin Trading Debt v. Equity Instruments Derivative Collateralized Debt Obligation (CDO) Broker ­ and Dealer Securities Regulation System Securities Regulation System Hallmarks of System Primarily a federally regulated system, with reliance as well on self­regulation (through SROs) and some state law compliance Heavy reliance on fair and adequate disclosures, as compared with “merit” regulation Prohibitions against deceptive practices and market manipulation Primary federal regulator is SEC ­ registration and disclosure, stock exchanges and oversight of SROs Enforcement: SEC, prosecutors and civil actions SIPC – insurance protection SROs ­ FINRA ­ and exchanges (NYSE, AMEX, NASDAQ) Scope: What is a Security? Scope: What is a Security? Securities Act of 1933 The term “security” means any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit­sharing agreement, collateral­ trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting­trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of 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 or instrument commonly known as a “security”, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. Scope: What is a Security? Scope: What is a Security? “Securities” – definition … note, stock, … bond, debenture, evidence of indebtedness… … certificate of interest or participation in any profit­sharing agreement… …in general, any interest or instrument commonly known as a “security”, or any certificate of interest or participation in [any of the listed instruments]… Scope: What is a Security Scope: What is a Security Exemptions Governmental obligations – regulated by Municipal Securities Rulemaking Board and some SEC anti­fraud enforcement Bank securities – regulated by banking regulators Religious and charitable – tax qualifications Private Placements Intra­state issuances (Blue Sky – state registration and disclosure) State Securities Laws State Securities Laws Referred to as “Blue Sky Laws” State securities laws historically have required registration of securities, brokers and brokerage firms in states as well as at the federal level In 1996, however, the National Securities Markets Improvement Act ("NSMIA") was enacted torestrict this burden; it created a class of “covered securities” (generally “listed securities” that don’t need to be state registered Newly issued securities, for example, historically needed to be filed/registered with every state in which they would be offered for sale – in addition to filing with SEC State Securities Laws State Securities Laws However, since NSMIA only preempted state securities registration requirements, broker­dealer and agent/salesperson registration requirements (applicable to individuals engaged in the offer and sale of covered securities) must still be examined to determine whether action is required to be taken in connection with a particular offering or transaction. 2002 Uniform Securities Act: States passed uniform acts that covered both registration and supervision of broker/dealers. In addition, many states have abandoned use of their own particular forms and submissions, and permit the registration filings for broker­dealers and agents to be made through the FINRA’s Central Registry Depository system (CRD), and utilize the examinations conducted by the FINRA for testing purposes. Overview of Federal Overview of Federal Securities Laws Securities Act of 1933 Securities Exchange Act of 1934 Investment Company Act of 1940 Investment Advisors Act of 1940 Sarbanes­Oxley Act of 2002 Securities Act of 1933 Securities Act of 1933 Registration and Disclosure Regulates the public offering and sale of securities in interstate commerce. Prohibits the offer or sale of a security not registered with the SEC, and Requires the disclosure of certain information to the prospective security's purchaser. (The objective of the 1933 Act's registration requirements is to enable a purchaser to make a reasoned decision based on reliable information.) Registration Statement and Prospectus ­ Prospectus must go to every purchaser and disclose…. Securities Act of 1933 Securities Act of 1933 Registration and Disclosure Who has legal responsibility for material misstatements of fact and for omissions Method of offering Description of the security Business of the Issuer Management and Control Financial Statements Risk Factors – special circumstances that could affect success Issuer/Company itself for damages Board of Directors, Management, accountants and lawyers, and the underwriter – for breach of duty to conduct due diligence or fiduciary responsibilities Securities Exchange Act of 1934 Securities Exchange Act of 1934 Public Companies and Secondary Transactions Company Disclosures SEC Registration is required if trading on national exchange Also applicable to “publicly held” companies ­ assets over $10 million and 500 shareholders Annual Reports, quarterly reports and Reports of material changes Similar enforcement for issuance: civil liability for material misstatements or omissions of material facts Securities Exchange Act of 1934 Securities Exchange Act of 1934 Public Companies and Secondary Transactions “Insider” Disclosures and Restrictions Insiders = Officers, Directors and 10% owners Must report purchases and sales of securities to SEC Liability for “short swing” profits (sale and purchase within 6 months) can be recouped by company Securities Exchange Act of 1934 Securities Exchange Act of 1934 Public Companies and Secondary Transactions Takeover and Tender Offer Disclosures Statement filed with SEC when acquiring 5% or more – must be filed within 10 days Background of person or entity acquiring Purpose Source of funding # of shares owned Relevant contracts or understandings Securities Exchange Act of 1934 Securities Exchange Act of 1934 Public Companies and Secondary Transactions Proxy Disclosure Solicitation of shareholder votes Requires certain information be given to a corporation's shareholders as a prerequisite to soliciting votes Annual proxy details board and management compensation SEC Rules promulgated under ‘34 Act SEC Rule 10b­5 – Principal rule for enforcing deceptive and manipulative practices generally Manipulation of Markets Artificial encouragement to buy or sell for deception or fraud SEC Rule 10b­5 SEC Rule 10b­5 It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, To employ any device, scheme, or artifice to defraud, 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 the light of the circumstances under which they were made, not misleading, 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. Investment Company Act of 1940 Investment Company Act of 1940 Closed­end funds Open­end funds (most mutual funds are open­end) (a) Issues new shares on an ongoing basis (i.e. total shares are not fixed), and (b) shares are redeemed, rather than sold/transferred Available to smaller investors Pooling of investor funds to buy specific assets Money Market funds Stock (equity) funds Fixed income ­ bond and debenture funds Tax­exempt issuances (government, municipal) Real estate or other assets Mutual Funds (Investment Mutual Funds (Investment Company Act of 1940) “Share value” fluctuates, based on underlying value of investments on a “per share” basis Closed end shares act more like stock, since # of shares is fixed Organization and Management Structure Sponsor Custodian and Manager/investment advisor Sales Investment Company Act of 1940 Investment Company Act of 1940 and Investment Advisors Act of 1940 Special Rules (different than normal securities laws) Separate registration with the SEC Disclosure of investment policies and strategy – cannot be changed without approval of majority of members Disclosure of investment advisor, including the compensation arrangement and other contract terms Advisor must disclose affiliations and background Annual reports and other financial reports Investment Company Act of 1940 Investment Company Act of 1940 and Investment Advisors Act of 1940 Other requirements and conditions applicable to mutual funds Assets must be held by responsible custodian; principals bonded Capital structures are regulated: initial net worth requirement of $100,000 and limits on debt issuances 90% of earnings must be distributed annually to avoid double taxation (although capital appreciation can occur over time) Mutual funds are uninsured – no SIPC guarantee Generally can’t invest in other funds (some closed­end fund of funds) Investment Company Act of 1940 Investment Company Act of 1940 and Investment Advisors Act of 1940 Other requirements and conditions applicable to mutual funds Limits on margin purchases and selling “short” (borrow to sell in falling market) Cannot make underwriting commitments of more than 25% 40% of open­end (mutual fund) Board members must be “independent”; 1 independent for closed end funds Restrictions on transactions with affiliates (scalping and “dumping”), though fund can engage broker­dealers for research and certain other services Investment Company Act of 1940 Investment Company Act of 1940 and Investment Advisors Act of 1940 Other requirements and conditions applicable to mutal funds Sales commissions (front­end “load”) limited to 8 ½ % (vs no­load funds) Other fees charged to the fund – investment manager/advisor fees usually 1% or less – must be disclosed in detail Market timing and late trading (NY AG Spitzer investigations into practices not described in prospectus) Investment Company Act of 1940 Investment Company Act of 1940 and Investment Advisors Act of 1940 Other funds REIT (Real Estate Investment Trusts) Hedge funds Private investment pools – accredited investors Historically little regulation – not subject to same rules as mutual funds SEC attempt to regulate – adopted rule requiring advisors to register under the Investment Advisors Act Rule required investment advisers to “count as clients the shareholders, limited partners, members, or beneficiaries” of a “private fund.” Goldstein v. SEC (June 23, 2006) – invalidated SEC proposal Sarbanes­Oxley Act of 2002 Sarbanes­Oxley Act of 2002 Significantly increases civil and criminal penalties for securities law violations: establishes longer maximum jail sentences and larger fines for corporate executives, auditors and lawyers who knowingly and willfully misrepresent financial statements Creates the Public Company Accounting Oversight Board (PCAOB) to supervise audit standards and ethics Sarbanes­Oxley Act of 2002 Sarbanes­Oxley Act of 2002 Imposes periodic review by the SEC of public company financial reporting Requires that public companies evaluate and disclose the effectiveness of their internal controls as they relate to financial reporting, and that independent auditors for such companies "attest" to such disclosures Requires that CEOs and CFOs must certify financial reports Sarbanes­Oxley Act of 2002 Sarbanes­Oxley Act of 2002 Requires that companies listed on stock exchanges have fully independent audit committees that oversee the relationship between the company and its auditor Mandates outside auditor independence, including bans on certain types of work for audit clients Requires prompt disclosure of material changes in financial condition and operations Establishes new obligations on lawyers representing companies: withdraw and disclose breaches of fiduciary duty by executives and auditors Sarbanes­Oxley Act of 2002 Sarbanes­Oxley Act of 2002 Bans most personal loans to any executive officer or director Requires accelerated reporting of insider trading and prohibits insider trades during pension fund blackout periods Protects employee whistleblowers who file complaints of corporate fraud; remedies include reinstatement, back pay and benefits, compensatory damages, abatement orders, and reasonable attorney fees and costs. Margin Trading Restrictions Margin Trading Restrictions What is Margin trading? – buying stocks with money borrowed against stocks already owned – i.e. using existing portfolio as collateral for further purchases Regulated by FRB – because it has to do with lending and money supply Different regulations, depending on who the margin accounts is with: Broker/dealer – Regulation T Banks – Regulation U Others – Reg G or Reg X Margin Trading Restrictions Margin Trading Restrictions Not all stocks eligible for purchase on margin (OTC or IPOs) Initial Margin: Reg T limits investor to using 50% or less of borrowed funds (margin funds) to buy securities Maintenance Margin: Under Reg T, after an investor has bought securities on margin, investor must maintain (minimum of) 25% of the total market value of the securities in the margin account (lender can require more) Margin Call: Investor must deposit more cash or securities with broker to maintain maintenance requirements May result from (a) decrease in stock values or (b) charges (interest) on account Securities Exchanges and Trading Securities Exchanges and Trading Membership rules imposed by stock exchanges (NYSE, AMEX, NASDAQ) Self regulation under the supervisory oversight and authority of the SEC (1934 Act) Role of “specialists” to “make markets” in securities Forced negotiated, competitive pricing practices in response to price fixing concerns Prevented rules against trades outside exchanges Regulation of Securities Firms Regulation of Securities Firms Underwriters and Investment Bankers Broker­Dealers Most are members of FINRA Also some Investment Advisors and selling arms of mutual funds and investment companies Regulation of Securities Firms Regulation of Securities Firms Underwriters Support distribution of new securities Use their own capital Buy securities at a discount Committed vs Best Efforts Negotiated fees based on risk Different distribution channels – retail or large blocks (broker­ dealer networks) Joint underwriting Entry of banking companies after removal of Glass­Steagall limits Regulation of Securities Firms Regulation of Securities Firms Underwriters – Regulation of… Responsibility for ‘33 Act compliance FINRA– few additional rules on underwriters Disclosure, Registration, Anti­fraud, etc Some attempts to rein in potential conflicts No chartering and modest capital requirements Complicated by multiple parties – who should underwriter be responsible to? Entrepreneurial – like joint venture Regulation of Securities Firms Regulation of Securities Firms Broker­Dealers Significantly more regulation Broker – for others Dealer – for own account Registration with the SEC May also register as an Investment Advisor under federal securities law Substantive Rules Conflicts Mark­ups Segregation of funds and assets Financial responsibility and Capital requirements Regulation of Securities Firms Regulation of Securities Firms Broker­Dealers Regulation FINRA rules against recommending unsuitable investments FINRA fair spread (profit) rules – 5% markup Rules against churning (turnover in account for fees) “Scalping” (re­selling securities held by dealer) “Boiler Room” activities (high pressure sales) Misuse (or conversion) of customer assets Maintenance of records Regulation of Securities Firms Regulation of Securities Firms Broker­ Dealers Securities Investor Protection Corporation 1970 federal Act that created the Corporation Member organization – most broker­dealers required to be members Not like the FDIC in that no investment protection Protects against lost or stolen (missing) securities and assets May act as liquidator/receiver May borrow from the Treasury to make customers whole ...
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