Securities and Antitrust

Securities Fraud

What Is Securities Fraud?

Securities fraud happens when someone provides false information to influence investments or the purchase or sale of securities.

The New York Stock Exchange suddenly collapsed in 1929 when the value of stocks traded on the exchange plummeted. The crash made lawmakers and the public aware of dishonest practices that surrounded investment in securities.

A study of the issues involving investment in securities quickly identified these issues:

  • To invest wisely, investors need adequate information about securities and the firms offering them.
  • Sellers of securities were making inaccurate claims about the quality of the securities, the risks involved, and the returns investors could expect from them. This is securities fraud, which happens when a person or organization provides false information to influence investments or the purchase or sale of securities.

Congress enacted two laws to address these issues—the Securities Act of 1933 and the Securities Exchange Act of 1934. These two acts established fundamental concepts of securities regulations.

  • Intelligent investment decisions require disclosure of accurate and meaningful information about securities and their issuers. Laws must specify what information must be disclosed.
  • The government must punish those who provide inadequate or inaccurate information about investments.
  • People who have inside information about firms issuing securities must be regulated. These include persons who have insider information but are not employees of the firm, such as accountants, attorneys, and employees of professional sellers of securities and stock exchanges.
  • The country needed a federal agency to regulate the issuance, sale, and purchase of securities.

Several definitions are important to laws surrounding the sale of securities. A security is an interest in an enterprise in which the investor expects a financial return—money—that will primarily be from the efforts of others. Corporations can issue equity securities, which are stocks, or debt securities, which are investments called debentures and bonds. Corporations can also issue preferred stock, which is considered a hybrid that has characteristics of an equity and a debt security.

Common stock is an interest in a corporation that includes specified rights but no guarantee of a financial return. Preferred stock is an interest in a corporation that includes rights that are superior to the rights of common stockholders. For instance, a preferred stock might have a fixed dividend rate, similar to the coupon rate of a bond. The coupon rate is the fixed rate of return paid by a bond that is stated on its face and is paid in quarterly, semiannual, or annual installments. This rate would give holders of preferred stock superior rights over common stockholders in terms of financial returns. As with common stock, however, no financial return is guaranteed. Another difference between these two stocks concerns voting rights. Common stock shareholders can generally vote on issues such as stock splits and corporate policy. Preferred stock does not carry voting rights.

A debenture is a long-term financial instrument that requires a corporation to return the amount of the initial investment but that is not secured. Not secured means that the company does not provide money, equipment, or buildings as collateral to use if the debenture holders fail to make money from the investment. A bond is also a long-term instrument requiring a corporation to return the original investment with interest, but a bond is secured by some collateral.

Which Laws Address Securities Fraud?

The Securities and Exchange Commission inspects securities firms, brokers, investment advisors, and rating agencies. Regulating securities is important because truthful and adequate information helps buyers and sellers make wise decisions.

The Securities and Exchange Commission (SEC), created by the Securities Exchange Act of 1934, administers federal securities law and issues. The SEC also amends the rules that govern securities fraud. It regulates securities firms, brokers, investment advisors, and rating agencies.

The crash of 1929 shook the confidence of investors in the stock market and securities in general. To resolve the issues that contributed to the crash and restore confidence in the markets, Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934.

The Securities Act of 1933 addresses the initial sale of securities and seeks to ensure that investors have the information they need to make valid investment decisions. Section 5 of the act requires that almost all securities be registered with the Securities and Exchange Commission before they are offered for sale. The registration statement that is required includes information about the security itself and the firm offering the security. Until the registration statement is approved, the security cannot be offered to the public.

The act's registration process is intended to prevent fraud in the initial sale of securities, and that process is effective but also expensive. Therefore, another part of the act provides that certain kinds of securities and certain transactions involving securities are exempt from registration requirements. Pursuant to these provisions, securities fall into one of three categories.

Most securities simply have to be registered with the Securities and Exchange Commission before they can be sold. These securities are classified as "registered, unrestricted securities."

Certain other securities are exempt from the registration requirement. These include securities that are regulated under other laws (government securities, securities issued to finance the purchase of railroad equipment, and annuities issued by insurance companies), securities issued in connection with internal corporate transactions (stock splits, stock dividends, and corporate reorganizations), securities issued by charities, and small issues of securities (less than $5 million). Securities in this category are classified as "unrestricted, unregistered securities."

A final category related to the registration of securities focuses on the circumstances under which securities are issued and sold rather than on the securities themselves. Regulation D under the Securities Act of 1933 contains several rules that allow securities to avoid registration if their issuers meet certain qualifications and if the actual sale of the securities is restricted in specific ways. Regulation D Rule 504 was amended in 2016 and allows securities that are issued by non-SEC reporting companies (which are defined as companies whose primary activity is not investing and that have fewer than 2,000 stockholders) to avoid registration with the Securities and Exchange Commission if the company offers less than $5 million in securities in a 12-month period and the securities are not offered to the general public through a general solicitation. Regulation D Rule 506 allows an exemption from registration for securities issued by non-SEC reporting companies without restriction in amount if the securities are offered only to accredited investors (defined as wealthy individuals who are sophisticated investors) and a limited number of unaccredited investors. Securities in this category are classified as "restricted, unregistered securities."

Exempt Securities and Exempt Transactions

Securities offered by a firm must be registered with the Securities and Exchange Commission unless the securities are exempt or the transactions are exempt.
While the Securities Act deals with the initial issuance of a security, the Securities Exchange Act of 1934 addresses other issues that involve the sale of securities. One of the most important subjects of that act is insider trading, which is the buying and selling of securities by those who have knowledge that is not available to the public or employed by or connected with the firm that is issuing securities. Those who are "inside" the firm may have information that is not yet available to the public or not ever available to the public. For this reason, they may not buy or sell securities of the firm before the relevant information about the security becomes public. Rule 10b-5 of the Securities Exchange Act of 1934 prohibits fraud in any sale or purchase of a security and is intended to protect investors and the integrity of securities markets. The market price of any particular security is a function of a variety of influences. General economic conditions, both domestic and international, can affect the market price of a security on any day. Political actions can influence the market price of a security. Consumer confidence can also impact the market price of a security. It is assumed that buyers and sellers of securities make their decisions with equal access to information about the security and that buyers and sellers can have confidence that they do have equal access to that information. Therefore, any action or device that gives a buyer or a seller of a security more information about the security than others can have a tendency to undermine that confidence in equal access to information not only in the security in question, but in the market in general. Provisions such as Rule 10b-5 are intended not only to protect individual buyers and sellers of securities, but to protect the perceived fairness and integrity of the market.