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Chapter Twenty Three Rules Governing the Issuance and Trading of Securities

In  Chapter 17 , we said that the corporation was the dominant form of business organization in the United States—and the most regulated. Two of the most strongly regulated aspects of corporate business are the issuance and trading of securities. Corporate securities—stocks and bonds—are used to raise capital for the corporation. They are also used by individuals and institutional investors to accumulate wealth. In the case of individuals, this wealth is often passed on to heirs, who use it to accumulate more wealth. Thus, securities provide a means for one generation in a family to “do better” than the preceding generation. Securities also provide a means for financing pension funds and insurance plans through institutional investment.

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Securities holders are powerful determinants of trends in business: If an individual company, industry, or segment of the economy is not growing and paying a good rate of return, investors will switch their funds to another company, industry, or segment in expectation of better returns. Securities holders (or their proxies) elect the board of directors of a corporation, who, in turn, select the officers who manage the daily operations of a corporation. Finally, securities holders’ ability to bring lawsuits helps keep officers and directors honest in their use of investors’ funds.

Because of their importance to the operation of our free enterprise society and because of the ease with which they can be manipulated, securities have been regulated by governments for nearly a century. This chapter chiefly examines the role of the federal government in regulating securities. We introduce the subject with a brief history of securities regulation that contains a summary of the most important federal legislation. We then turn to the creation, function, and structure of the Securities and Exchange Commission (SEC). In a survey of major and representative securities legislation, we examine the provisions of the Dodd-Frank Act of 2010 and the Sarbanes-Oxley Act of 2002. Both the Securities Act of 1933, which governs the issuance of securities and outlines the registration requirements for both securities and transactions (and the allowable exemptions from those requirements), and the Securities Exchange Act of 1934, which governs trading in securities, are discussed. We then examine the state securities laws and online securities disclosure and fraud regulations. We end with a discussion of the global dimensions of the 1933 and 1934 securities acts; the Foreign Corrupt Practices Act, as amended in 1988; and the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.

Critical Thinking About The Law

Because issuers can manipulate securities easily, federal and state governments have strongly regulated the issuance and trading of securities. Studying the following case example and answering some critical thinking questions about it will help you better appreciate the need for regulation of securities.

Jessica received a phone call from a man claiming to represent Buy-It-Here, a corporation that was relocating to Jessica’s town. The man stated that the corporation was planning to issue new securities, and he was extending this offer to residents in Jessica’s town. He claimed that Buy-It-Here would easily double its profits within six months. The man said that if Jessica sent $3,000, he would buy stock in Buy-It-Here for Jessica. Jessica sent the money; two weeks later, she discovered that Buy-It-Here was in the process of filing for bankruptcy.

1. This case is an example of the need for government regulation. We want the government to protect citizens from cases such as Jessica’s buying stock in a bankrupt company. If we want governmental protection from potentially shady businesses, what ethical norm are we emphasizing?

Clue:  Put yourself in Jessica’s place. Why would you want governmental protection? Now match your answer to an ethical norm listed in  Chapter 1 . Think about which ethical norm businesses would emphasize.

2. Jessica wants to sue Buy-It-Here for misrepresentation. Before she brings her case, what additional information do you think Jessica should discover?

Clue:  What additional information do you want to know about the case? Even without having extensive knowledge about securities, you can identify areas in which you might need more information about Jessica’s case. For example, pay close attention to the role of the telephone caller.

3. Jessica did some research about securities cases in her state. She discovered a case in which a woman named Andrea Stevenson had purchased $100,000 worth of stock from a stockbroker. The company went bankrupt three months later. The stockbroker had known that the company was suffering financial problems but had said nothing to Andrea. The jury in this case found in favor of Andrea. Jessica wants to use Andrea’s case as an analogy in her lawsuit. Do you think that Andrea’s case is an appropriate analogy? Why or why not?

Clue:  What are the similarities between the cases? How are the cases different? Are these differences so significant that they overwhelm the similarities?

Introduction to the Regulation of Securities

Securities have no value in and of themselves. They are not like most goods produced or consumed (e.g., television sets or toys), which are easily regulated in terms of their hazards or merchantability. Because they are paper, they can be produced in unlimited numbers and can be manipulated easily by their issuers.

The first attempt to regulate securities in the United States was made by the state of Kansas in 1912. When other states followed the Kansas legislature’s example, corporations played off one state against another by limiting their securities sales to states that had less stringent regulations. Despite the corporations’ ability to thwart state efforts at regulation rather easily, there was strong resistance to the idea of federal regulation in Congress. It was not until after the collapse of the stock market in 1929 and the free fall of stock prices on the New York Stock Exchange (NYSE)—when the Dow Jones Industrial Average registered an 89 percent decline between 1929 and 1933—that Congress finally acted.

Summary of Federal Securities Legislation

The following legislation, enacted by Congress since 1933, provides the framework for the federal regulation of securities. It is also important to note that this legislation is the basis (enabling act) for rulemaking by the SEC. Congressional legislation is emphasized here, but it is important to remember that SEC rulemaking may be equally significant in the long term. (You will remember that we discussed rulemaking for federal agencies in  Chapter 18 .)

· The Securities Act of 1933 (also known as the Securities Act or the 1933 Act) regulates the initial offering of securities by public corporations by prohibiting an offer or a sale of securities not registered with the Securities and Exchange Commission. The 1933 Act sets forth certain exemptions from the registration process, as well as penalties for violations of the act. This act is examined in detail in this chapter. Both the 1933 and 1934 Acts have been amended by Congress and the SEC rulemaking process, much of which is summarized in the following pages.

· The Securities Exchange Act of 1934 (also known as the Exchange Act) regulates the trading in securities once they are issued. It requires brokers and dealers who trade in securities to register with the Securities and Exchange Commission, the regulatory body created to enforce both the 1933 and 1934 Acts. The Exchange Act is also examined in detail in this chapter.

· The Public Utility Holding Company Act of 1935 requires public utility and holding companies to register with the SEC and to disclose their financial organization, structure, and operating process.

· The Trust Indenture Act of 1939 regulates the public issuance of bonds and other debt securities in excess of $5 million. This act imposes standards for trustees to follow to ensure that bondholders are protected.

· The Investment Company Act (ICA) of 1940, as amended in 1970 and 1975, gives the SEC authority to regulate the structure and operation of public investment companies that invest in and trade in securities. No private causes of action are created by this law. A company is an investment company under this act if it invests or trades in securities and if more than 40 percent of its assets are “investment securities” (which are all corporate securities and securities invested in subsidiaries). Accompanying legislation, entitled the Investment Advisers Act of 1940, authorizes the SEC to regulate persons and firms that give investment advice to clients. This act requires the registration of all such individuals or firms and contains antifraud provisions that seek to protect broker-dealers’ clients.

· The Securities Investor Protection Act (SIPA) of 1970 established the nonprofit Securities Investor Protection Corporation (SIPC) and gave it authority to supervise the liquidation of brokerage firms that are in financial trouble, as well as to protect investors from losses up to $500,000 due to the financial failure of a brokerage firm. The SIPC does not have the monitoring and “bailout” functions that the Federal Deposit Insurance Corporation (FDIC) has in banking; it only supervises the liquidation of an already financially troubled brokerage firm through an appointed trustee.


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