Evidence of a corporation's debts or property.
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.
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.
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. The sarbanes-oxley act of 2002 (Public Company Accounting Reform and Investor Protection Act, Pub. L. 107-204, July 30, 2002, 116 Stat. 745, July 30, 2002) makes securities fraud a serious federal crime and also increases the penalties for white-collar crimes. In addition, it creates a new oversight board for the accounting profession.
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 careful delineation of 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.
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 accomplished. 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: first, information that eventually forms the prospectus, and second, information, which does not need to be furnished to purchasers but is available for public inspection within SEC 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 20 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 20 days after filing. The SEC will usually accelerate the 20-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 usually must 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 he or she lost money. In many circumstances the purchaser need not show that he or 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 500 shareholders and more than $5 million 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 90 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 dis-approval 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 5 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 5 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 5 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 5 percent of registered stock. A tender offer must be held open for 20 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 ).
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 when 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 brokerdealer 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. Itrelies 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.
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 SEC 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.
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 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 ).
In 1956, the commissioners on uniform laws approved the first Uniform Securities Act. A total of 37 states adopted the uniform law, though states frequently diverted from some of its provisions. The commissioners approved a second version of the act in 1985, but only six states adopted the revised version. A third version was approved in 2002. As of May 2003, the state of Missouri had adopted the 2002 version, and two other state legislatures were considering its adoption. Changes in the 2002 Uniform Securities Act include a simplified process for registering securities; more regulation of investment professionals; expanded enforcement powers of administrative agencies; new penalties for violations of the act; and several other changes.
Despite the existence of the various versions of the Uniform Securities Act, 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.
During the early 2000s, a number of high-profile companies became embroiled in major scandals that adversely affected consumer confidence in the companies and led to a number of investigations by the SEC. The most notorious of these scandals involved Houston-based Enron Corporation, one of the world's largest energy, commodities, and service companies. The company suffered a collapse in 2001 that resulted in the largest bankruptcy in U.S. history and numerous lawsuits alleging violations of federal securities laws.
As recent as December 2000, Enron's stock sold for $84.87 per share. However, stock prices fell throughout 2001. On October 16, 2001, the company reported losses of $638 million in the third quarter of 2001 alone. It also announced that it was reducing shareholder equity by $1.2 billion. The SEC began a formal investigation shortly thereafter regarding potential conflicts of interest within the company regarding outside partnerships. Many of the problems centered on flawed accounting practices by Enron and its accounting firm, Arthur Andersen, L.L.P. In 2002, Arthur Andersen was found guilty of obstructing justice by destroying thousands of Enron documents.
Despite the outrage surrounding the Enron fiasco, by May 2003, only 12 individuals had been charged with wrongdoing in relation to their dealings with the company. However, only seven of these individuals were insiders in the company. In August 2002, Michael Kopper, who served as an aide to Enron's chief financial officer Andrew Fastow, pleaded guilty to charges of money laundering and conspiracy to commit fraud. In November 2002, the justice department indicted Fastow on 78 counts, including fraud, money laundering, and obstruction of justice. None of the other top executives with the company, including the former chief executive officer, had been charged as of May 2003.
Enron's downfall was followed by investigations of alleged improprieties by other major companies. The major companies investigated and charged by the SEC in 2002 and 2003 included Xerox Corporation, WorldCom, Inc., and Bristol-Myers Squibb. The scandals had a major effect on the accounting profession, and the SEC was at the center of attention by those calling for enhanced disclosure requirements and enforcement mechanisms.
Banner, Stuart. 1998. Anglo-American Securities Regulation: Cultural and Political Roots, 1690–1860. New York: Cambridge Univ. Press.
Previts, Gary John, and Alfred R. Roberts, eds. 1986. Federal Securities Law and Accounting, 1933–1970: Selected Addresses. New York: Garland.
"Uniform Securities Act." National Conference of Commissioners on Uniform State Laws. Available online at <www.nccusl.org/nccusl/uniformact_summaries/uniformacts-s-usa2002.htm> (accessed August 26, 2003).
Securities and Exchange Commission (SEC)
The U.S. Securities and Exchange Commission (SEC) is a federal agency responsible for administering federal securities laws that protect investors. The SEC also ensures that securities markets are fair and honest and, if necessary, enforces securities laws through the appropriate sanctions. Basically, the SEC oversees the activities of all participants in the securities markets—including publicly held corporations, public utilities, investment companies and advisers, and securities brokers and dealers—to ensure that investors are adequately informed and their interests are protected. Small businesses are most likely to come into contact with the SEC when they decide to make a public offering of debt or securities. Any business wishing to issue stock must first file a registration statement with the SEC. Another role of the SEC is to serve as adviser to the federal courts in Chapter 11 cases (corporate reorganization proceedings under Chapter 11 of the Bankruptcy Reform Act of 1978).
ORGANIZATION AND RESPONSIBILITIES OF THE SEC
The SEC was created by Congress in 1934 under the Securities Exchange Act as an independent, nonpartisan, quasi-judicial regulatory agency. The commission is made up of five members: one chairman and four commissioners. Each member is appointed by the president to a five-year term, with the terms staggered. The commission's staff is made up of lawyers, accountants, financial analysts, engineers, investigators, economists, and other professionals. The SEC staff is divided into divisions and offices, which includes 12 regional and branch offices, each directed by officials appointed by the SEC chairman.
The chairman and commissioners of the SEC are responsible for ensuring that publicly held corporations, brokers or dealers in securities, investment companies and advisers, and other participants in the securities markets comply with federal securities law. These laws were designed to help public investors make informed investment analysis and decisions—principally by ensuring adequate disclosure of material information. The SEC does not, however, make any evaluations of the quality of the company making the IPO; it is concerned only with assuring that the registration statement and prospectus documents contain the information necessary for potential investors to make informed decisions. The SEC also has the authority to initiate legal penalties—both civil and criminal—against companies if the agency determines that the IPO materials contain serious omissions, misleading information, or outright falsehoods. "If the SEC finds mistakes during the registration process, it can delay your IPO," said Chuck Berg in Cincinnati Business Courier. "If it finds mistakes or omissions after your company goes public, your company may soon have a thorough—and unpleasant—understanding of legal liability."
There are seven major laws that the SEC is responsible for administering:
- Securities Act of 1933
- Securities Exchange Act of 1934
- Public Utility Holding Company Act of 1935
- Trust Indenture Act of 1939
- Investment Company Act of 1940
- Investment Advisers Act of 1940
- Sarbanes-Oxley Act of 2002
The Securities Act of 1933, also known as the "truth in securities" law has two primary objectives: 1) to require that investors be provided with material information concerning securities offered for public sale; and 2) to prevent misrepresentation, deceit, and other fraud in the sale of securities. The SEC ensures that both of these objectives are met.
The Securities Exchange Act of 1934 extended the "disclosure" doctrine (from the Securities Act of 1933) to securities listed and registered for public trading on the U.S. securities exchanges. In 1964, the Securities Act Amendments extended disclosure and reporting provisions to equity securities in the over-the-counter market. The act seeks to ensure (through the SEC) fair and orderly securities markets by prohibiting certain types of activities and by setting forth rules regarding the operation of the markets and participants.
The SEC also administers the Public Utility Holding Company Act of 1935. Subject to regulation under this act are interstate holding companies engaged in the electric utility business or in the retail distribution of natural or manufactured gas. Reports to be filed with the SEC by these holding companies include detailed information concerning the organization, financial structure, and operations of the holding company and its subsidiaries. Holding companies are subject to SEC regulation in areas such as corporate structure, acquisitions, and issue and sales of securities.
The Trust Indenture Act of 1939 applies to bonds, debentures, notes, and similar debt securities offered for public sale and issued under trust indentures with more than $7.5 million of securities outstanding at any one time. Other provisions of the act prohibit the indenture trustee from having conflicts of interest; require the trustee to be a corporation with minimal combined capital and surplus; and impose high standards of conduct and responsibility on the trustee.
The SEC also ensures compliance with the Investment Company Act of 1940. This act seeks to regulate the activities of companies engaged primarily in investing, reinvesting, and trading in securities, and whose own securities are publicly offered. It is important for potential investors to understand that although the SEC serves as a regulatory agency in these cases, the SEC does not supervise a company's investment activities, and the mere presence of the SEC as a regulatory agency does not guarantee a safe investment.
The Investment Advisers Act of 1940—also overseen by the SEC—establishes a style, or a system, of regulating investment advisers. The main thrust of this act requires all persons, or firms, that are compensated for advising anyone about securities investment opportunities to be registered with the SEC and conform to the established standards of investor protection. The SEC has the power and ability to strip an investment adviser of his or her registration if a statutory violation has occurred.
In 2002 Congress passed the Sarbanes-Oxley Act and it was signed into law. Parts of this sweeping legislation are the responsibility of the SEC to administer. The act came about in the wake of serious allegations of accounting fraud and a string of bankruptcies of very high-profile, publicly traded companies. The act established stricter reporting requirements and increased the personal responsibility that both CEOs and CFOs must take on when signing corporate reports. Meeting the requirements of this law has increased the workload for publicly traded firms and the firms that do their auditing work. In particular, Section 404 of the Sarbanes-Oxley Act requires that a company's annual report include an official write-up by management about the effectiveness of the company's internal controls. The section also requires that outside auditors attest to management's report on internal controls. An external audit is required in order to attest to the management report.
Finally, the SEC is given some responsibility connected with corporate bankruptcy reorganizations, commonly referred to as Chapter 11 proceedings. Chapter 11 of the Bankruptcy Code grants the SEC permission to become involved in any proceedings, but the SEC is primarily concerned with proceedings directly involving significant public investor interest.
"Fresh Strategies are Needed for the New SEC Reporting Requirements." Corporate Board. March-April 2003.
MacAdam, Donald H. Startup to IPO. Xlibris Corporation, 2004.
Mirza, Patrick. "Some Companies Struggle to Meet SEC Reporting Requirements." HRMagazine. May 2004.
Skousen, K. Fred. An Introduction to the SEC. South-Western College Publishing, 1991.
U.S. Securities and Exchange Commission. "Summary of SEC Actions and SEC Related Provisions Pursuant to the Sarbanes-Oxley Act of 2002." Available from http://www.sec.gov/news/press/2003-89a.htm. 30 July 2003.
Hillstrom, Northern Lights
updated by Magee, ECDI
Evidence of a corporation's debts or property.
SEC v. American International Group
After earlier failed negotiations, the Securities and Exchange Commission (SEC) filed fraud charges against New York-based American International Group (AIG) in November 2004 for violating antifraud provisions of the federal securities laws. The SEC also charged AIG with other aiding-and-abetting violations related to the reporting and record-keeping provisions of those laws. SEC v. American International Group, Inc., No. 1:04CV02070 GK (D.D.C.). Corollary and related criminal charges were pending with the U.S. Department of Justice. A similar case was pending against AIG in the U.S. District Court for the Southern District of Indiana, where a grand jury investigation of "non-traditional insurance" or "income-smoothing" products, marketed by AIG and channeled through Brightpoint Inc., ended in an indictment. The grand jury alleged that some of these marketed financial products were directed at creating agreements with businesses that ostensibly would appear to be insurance policies, and would be accounted for as insurance policies, but did not involve any actual risk transfer.
The SEC action primarily concerned conduct arising from AIG's wholly owned subsidiary, AIG Financial Products Corp. (AIG-FP) for developing, marketing, offering to sell, and selling an earnings-management financial product that purportedly enabled PNC Financial Services Group (PNG), a publicly traded company, to remove certain assets from its balance sheet . Through the use of these derivative financial vehicles, PNC reportedly was able to transfer some $762 million in doubtful loans and investments off of its books, and on to AIG's. These tactics enabled PNC to overstate its 2001 earnings and were in serious violation of generally accepted accounting practices (GAAP).
Concurrent with the filing of the charges, the SEC announced a pending settlement of all charges, including criminal charges against AIG, subject to court approval. The settlement called for the payment from AIG of an $80 million penalty, another $46 million into an SEC disgorgement fund, and the appointment of an independent monitor to examine certain AIG transactions going back to the year 2000. Finally, the $126 million settlement package included an agreement clause providing that AIG would establish a Transaction Review Committee to review certain future transactions involving heightened legal, reputational, or regulatory risk. The settlement would close the books on ongoing investigations into AIG's structuring of financial products for Pittsburgh-based PNC. These transactions, which were terminated in early 2003, had been the subject of a prior SEC action against AIG in 2002. As to the 2004 action, the SEC had warned AIG that a civil action was being contemplated, stemming from company statements in three separate press releases dated January 30, 2002, September 21, 2004, and September 29, 2004.
Notwithstanding early settlement, the charges filed by SEC merit further review, in light of several corporate financial scandals haunting the publicly traded market. In its complaint against AIG, the SEC alleged that from at least March 2001 through January 2002, AIG, through its financial products subsidiary (AIGFP), developed a certain product called a Contributed Guaranteed Alternative Investment Trust Security ("C-GAITS"). It then marketed that product to several publicly traded companies and ultimately entered into three C-GAITS transactions with PNC. For its part, AIG received just under $40 million in fees for the three transactions.
In return for the fees, AIG offered to create a special-purpose entity ("SPE") to which the other party to the transaction (in this case, PNC) would transfer troubled or potentially volatile assets. AIG represented to these parties that, under GAAP, the SPE would not show up on the party's financial statements. Thus, the party would be able to avoid charges on its income statement resulting from declines in the value of those assets transferred to the SPE.
The SEC further alleged in its complaint that, while AIG was marketing this product, independent auditors, who had been retained by some prospective clients and counter-parties, had raised questions about whether certain features of the C-GAITS product could cause the product not to satisfy the GAAP requirements for nonconsolidation of SPEs. AIG failed to inform these potential parties of these issues, which came to light when a different potential party used the same independent auditor as the counter-party that had communicated the issue to AIG. AIG nonetheless went forward and entered into the three C-GAITS transactions with PNC, enabling it to remove $762 million in loan and venture-capital assets from its balance sheet.
Finally, the SEC alleged in its complaint that AIG had recklessly made misstatements of material facts, and that it had omitted to state material facts, about whether the C-GAITS product satisfied the GAAP requirements for nonconsolidation of an SPE. In consenting to the issuance of a final judgment based on the settlement, Defendant AIG neither admitted nor denied the allegations. The SEC brought a prior settled proceeding against PNC as well. In Re: The PNC Financial Services Group, Inc., Securities Act Release No. 33-8112, Exchange Act Release No. 34-46225, July 18, 2002. Investigation continued in 2004 as to other potential defendants.
Dura Pharmaceuticals v. Broudo
Issuing a brief, but unanimous, 11-page opinion, the U.S. Supreme Court clearly enunciated the standard of proof needed by investors who sue for fraud under the Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, 109 Stat. 737 (1995). In Dura Pharmaceuticals v. Broudo, 543 U.S. __, 125 S.Ct. 1627, 161 L.Ed.2d 577 (2005), the high court reversed the ruling of the U.S. Court of Appeals for the Ninth Circuit, which had attached a less stringent meaning to the act's statutory language. The Court instead aligned itself with a majority of the federal appellate courts that had considered the issue, including the U.S. Court of Appeals for the Second Circuit, which had adopted the same approach in dismissing another suit by investors just a few months before the high court's decision. The significance of this closely watched fraud case is to remind potential parties and their legal counsel of the necessity of adequate pleading in a complaint of all necessary elements to establish a viable cause of action .
In causes of action involving publicly traded securities, the actions' basic elements include:
(1) a material misrepresentation (or omission);
(2) scienter ; i.e., a wrongful state of mind;
(3) a connection with the purchase or sale of a security;
(4) reliance on the alleged misrepresentation;
(5) economic loss; and (6) "loss causation" (the causal connection).
On his own behalf, as well as that of a group of shareholders, Michael Broudo filed suit against Dura Pharmaceuticals under the Securities and Exchange Act, 109 Stat. 747, 15 U.S.C. §78u et seq. The class action suit alleged that the company's misleading statements about its antibiotics sales, as well as the prospects for FDA approval of its new spray device for treating asthma, resulted in the plaintiffs' having paid artificially inflated prices for its stock. Later, when the company announced slow drug sales and (eight months later) a failure to obtain FDA approval on the asthma device, there was a significant drop in stock prices. However, the amended complaint filed with the district court only stated the following about economic losses attributable to the alleged misrepresentation about the spray device: "In reliance on the integrity of the market, [the plaintiffs] …paid artificially inflated prices for Dura securities" and the plaintiffs suffered "damage[s] thereby…."
The federal district court dismissed the suit, finding that the plaintiffs had failed to allege a causal connection between the spray device misrepresentation and their economic loss ("loss causation") under the Act's Section 78u-4(b)(4). The court also found that as to the drug sales claim, the plaintiffs had failed to allege the defendants' "scienter" or state of mind; e.g., that the defendants knowingly misrepresented anticipated sales with the intent to induce investment. (These elements parallel those that are necessary to establish a common law tort action for deceit and misrepresentation.)
The Ninth Circuit reversed. It held that plaintiffs could satisfy the loss-causation requirement by simply alleging that the stock prices at the time of purchase were inflated because of the misrepresentation(s). The appellate court added that "the injury occurs at the time of the transaction." Certiorari was granted based on the fact that other circuits differed in their views about loss causation.
In a straightforward and concise manner, Justice Breyer delivered the opinion of the U.S. Supreme Court. The Court held that an inflated purchase price for stock will not, in itself, constitute or proximately cause the requisite economic loss that is necessary to allege and prove "loss causation." The opinion first summarized relevant passages from Section 10(b) of the Securities Exchange Act of 1934 (prohibiting "deceptive device[s]" in connection with the purchase or sale of any security) and correlative Rule 10(b)(5) of the Securities Exchange Commission.
The Court began to dissect the Ninth Circuit's reasoning. First, as a matter of pure logic, noted the Court, no loss is suffered by plaintiffs at the moment when the transaction takes place. This is because the inflated purchase price is offset by ownership of a share that possesses equivalent value at that instant. Second, as a matter of pure logic, the link between an inflated purchase price and any later economic loss is tenuous, because other factors (e.g., changed economic circumstances or investor expectations; or industry-specific or company-specific facts or events) could also trigger a loss in value. Wrote Justice Breyer, Congress's purpose for permitting private suits for securities fraud was "not to provide investors with broad insurance against market losses, but [rather] to protect them against economic losses that misrepresentations actually cause." Accordingly, logic alone would limit references to inflated purchase prices to mere suggestions that "touch upon" a later economic loss.
The Ninth Circuit had concluded that "loss causation is satisfied where the plaintiff shows that the misrepresentation touches upon the reasons for the investment's decline in value." However, Justice Breyer wrote, "To 'touch upon' a loss is not to cause a loss, and it is the latter that the law requires."
Finally, the Court noted that the Ninth Circuit's approach was inconsistent with an important securities law objective. Congress's intent, in creating securities laws, was to permit private actions only where plaintiffs adequately allege and prove the traditional elements of cause and loss. Conversely, the Ninth Circuit's approach would allow recovery in every instance where a misrepresentation leads to an inflated purchase price but does not proximately cause any economic loss.
In summary, the plaintiffs' complaint in the case at hand was legally insufficient with respect to its allegation of "loss causation." While Federal Rules of Civil Procedure Rule 8(a)(2) requires only a "short and plain statement of the claim showing that the pleader is entitled to relief," that "short and plain statement" must allege the requisite elements and give the defendant fair notice of what the plaintiff's claim is and the grounds upon which it rests. Here, the plaintiffs merely alleged that their loss consisted of artificially inflated purchase prices. The complaint nowhere else provided defendant Dura with notice of what the relevant loss might be or what the causal connection might be between the loss and the misrepresentation.
Under the prevailing view, endorsed by the high court, investors who claim that they paid inflated prices for a stock because of fraudulent misrepresentation cannot recover damages unless they can show that any subsequent drop in the stock price was directly tied to the misrepresentation. This can be shown, for example, through the issuance of a subsequent corrective disclosure by the defendant. Without such a showing, plaintiffs fail to carry their burden of proof to establish a causal connection, because many other factors could potentially cause a subsequent drop in share price.
Approximately 190 class-action securities fraud lawsuits are filed each year. Amicus briefs in this case were filed by such entities as AARP, several public pension funds, and the National Association of Shareholder Consumer Attorneys, all in support of the Ninth Circuit's loosened standard, which they argued was necessary to deter recent corporate scandals including that involving Enron. However, the Securities and Exchange Commission supported Dura Pharmaceuticals, telling the Supreme Court that the Ninth Circuit's liberal approach "cannot be reconciled" with the Private Securities Litigation Reform Act.
Sarbanes-Oxley Act Survives Its First Judicial Challenge
In November 2004 the U.S. District Court for the Northern District of Alabama rejected a challenge of the constitutionality of several provisions in the Sarbanes-Oxley Act of 2002. Richard Scrushy, former chief executive officer with HealthSouth Corp., argued that vague terms in the statute rendered it unconstitutional. Lawmakers paid close attention to the decision because it represented the first challenge to the 2002 law that strengthen regulations related to corporate accounting practices.
Scrushy grew up modestly in Alabama and worked his way through Jefferson State Community College. He later attended the University of Alabama, earning a degree in respiratory therapy. He devised a concept for a network of outpatient centers and persuaded several doctors to finance the idea. From this idea, Scrushy formed HealthSouth in 1985. Scrushy built HealthSouth into a Fortune 500 company in just over a decade. He was honored throughout the state of Alabama, including having a campus named in his honor by Jefferson State Community College.
HealthSouth was one of several companies that became embroiled in controversy regarding accounting practices in the new millennium. Government investigators charged Scrushy and other executives with overstating earnings during a period from 1996 through March 2003. According to the government, Scrushy inflated earnings by $2.7 billion during this period in order to convince investors that the company had met Wall Street expectations.
In response to a series of corporate accounting scandals, Congress in 2002 enacted the Sarbanes-Oxley Act, 18 U.S.C. §1350 (Supp. II 2002), which sought to end this corruption. Congress sought to increase the reliability and accuracy of corporate accounting, reporting, and auditing practices with the enactment of the statute. Moreover, the act renders chief executive officers and chief financial officers legally responsible for the validity of their companies' financial statements. When he signed the legislation, President George W. Bush commented, "This law says to every dishonest corporate leader, 'You will be exposed and punished."'
Federal prosecutors indicted Scrushy on 85 counts on October 29, 2003. The prosecution later issued a superceding indictment with 58 counts on September 29, 2004. The indictment claims that Scrushy and other executives devised an elaborate scheme of bogus accounting entries, allowing the company to report fictitious earnings. Fifteen former HealthSouth executives, including several former chief financial officers, reached plea agreements with prosecutors. These executives cooperated with the prosecutors in Scrushy's case. Scrushy, who is the first executive to be charged under Sarbanes-Oxley, pleaded not guilty to the charges.
The charges against Scrushy include three counts of false certification under Section 906 of the Sarbanes-Oxley Act. Under this section, corporate officers must certify that financial statements comply with the requirements of the Securities Exchange Act, 15 U.S.C. §§78 et seq. and that the "information contained in the periodic report fairly presents, in all material respects, the financial condition and results of operations of the issuer." 15 U.S.C. §1350(b). Any corporate officer who certifies a statement that does not comport with these requirements may face a fine of up to $1 million and imprisonment for up to 10 years. 15 U.S.C. §1350(c)(1). Moreover, an officer who "willfully certifies" any statement that does not comply with the section may be fined up to $5 million and imprisoned for up to 20 years. 15 U.S.C. §1350(c)(2).
Scrushy faced charges that he, along with other executives, willfully certified false statements. He claimed that the phrases "fairly presents, in all material respects…" and "willfully certifies" are unconstitutionally vague. U.S. District Judge Karon Bowdre, however, disagreed with Scrushy's arguments. In the opinion, the judge recited numerous instances in which Congress had used similar phrases. For example, the judge pointed out that Congress requires that businesses "fully and fairly present the financial statements" of government pension plans under the Employee Retirement Income Security Act of 1974, 29 U.S.C. §1023(b)(1)(2000).
The final outcome of the case, according to the opinion, should be decided by the jury. "Fairness, materiality, and willfulness are fact intensive questions generally reserved for the jury," Bowdre wrote. "Whether the information contained in the periodic reports certified by Mr. Scrushy fairly presented, in all material respects, the financial condition and results of operations of HealthSouth are questions of fact for the jury and part of the Government's burden of proof in the case." Accordingly, the judge denied the motion. United States v. Scrushy, No. CR-03-BE-0530-S, 2004 WL 2713262 (N.D. Ala. Nov. 23, 2004).
Members of Congress reportedly watched the case with great interest. Among those who commented on the judge's decision was Michael Oxley (R.-Ohio), who had co-sponsored the legislation. According to Oxley, "We weathered the first test when [Scrushy] challenged the constitutionality of the law." He also noted that "it will be interesting" to see the jury's reaction to the statute's requirements.
The Securities and Exchange Commission also brought civil charges against Scrushy, alleging that Scrushy had committed insider trading and had inflated company earnings. After the SEC filed its suit, HealthSouth removed Scrushy from his position as CEO. As part of the criminal prosecution, government officials have additionally sought to force Scrushy to return more than $278 million in assets that he accumulated, including a 92-foot yacht, two airplanes, classic paintings, antique carpets, and a variety of other properties.
In late June 2005, Scrushy as acquitted of all criminal charges by an Alabama jury. In July, Scrushy then asked that civil charges filed by the SEC be dropped due to a lack of evidence. Scrushy stated a desire to return to HealthSouth in some capacity.
Securities and Exchange Commission
SECURITIES AND EXCHANGE COMMISSION
The Securities and Exchange Commission (SEC) is the federal agency primarily responsible for administering and enforcing federal securities laws. The SEC strives to protect investors by ensuring that the securities markets are honest and fair. When necessary, the SEC enforces securities laws through a variety of means, including fines, referral for criminal prosecution, revocation or suspension of licenses, and injunctions.
Headquartered in Washington, D.C., the commission itself is comprised of five members appointed by the president; one position expires each year. No more than three members may be from one political party. With more than 900 employees, the agency has five regional and six district offices throughout the country and enjoys a generally favorable reputation.
Before the October 29, 1929, stock market crash on Wall Street, a company could issue stock without disclosing its financial status. Many bogus or severely undercapitalized corporations sold stock, eventually leading to the disastrous plunge in the market and an ensuing panic. From the havoc wreaked by the crash came the first major piece of federal securities legislation, the Securities Act of 1933 (15 U.S.C.A. § 77a et seq.). The act regulates the primary, or new issue, market. The following year, Congress provided for the creation of the Securities and Exchange Commission when it enacted far-reaching securities legislation in the Securities Exchange Act of 1934 (15 U.S.C.A. § 78a et seq.). These two laws, along with the Trust Indenture Act of 1939 (15a U.S.C.A. §§ 77aaa–77bbbb), the Investment Company Act of 1940 (15 U.S.C.A. §§ 80-1–80a-64), the Investment Advisers Act of 1940 (15 U.S.C.A. §§ 80b-1–80b-21), and the Public Utility Holding Company Act of 1935 (15 U.S.C.A. §§ 79a–79z-6) make up the bulk of federal securities laws under the jurisdiction of the SEC.
In addition to federal statutory authority, the SEC has broad rule-making authority. It has used this power to fashion procedural and technical rules, define terms used in the laws, and make substantive rules implementing the laws. The SEC also devises forms that must be used to fulfill various requirements in the statutes and rules. Moreover, the SEC engages in a significant amount of informal lawmaking through the distribution of SEC releases containing its opinions on questions of current concern. These releases are disseminated to the press, companies and firms registered with the SEC, and other interested persons. In addition to these general public statements of policy, the SEC also responds to individual private inquiries.
Securities Act of 1933 The Securities Act of 1933 regulates the public offering of new issues. All public offerings of securities in inter-state commerce or through the mails must be registered with the SEC before they can be offered and sold, subject to exemptions for specifically enumerated types of securities, such as government securities, nonpublic offerings, offerings below a certain dollar amount, and intrastate offerings. The registration provisions apply to issuers of securities or others acting on their behalf. Issuers must file a registration statement with the SEC containing financial and other pertinent data about the issuer and the securities that are being offered. The Securities Act of 1933 also prohibits fraudulent or deceptive practices in the offer or sale of securities, whether or not the securities are required to be registered.
A major part of the SEC work is to review the registration documents required by the 1933 act and determine when registration is required. Registration with the SEC is intended to allow potential investors to make an informed evaluation regarding the worth of securities. Registration does not mean that the commission approves of the issue or that the disclosures in the registration are accurate, nor does it insure an investor against loss in the purchase.
Registration requires extensive disclosure on behalf of a corporation. For example, 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. Registration consists of two parts: a prospectus, which must be furnished to every purchaser of the security, and other information and attachments that need not be furnished to purchasers but are available in SEC files for public inspection. A registration statement is generally effective 20 days after filing, but the SEC has the power to delay or suspend the effectiveness of the registration statement. When a disclosure or registration statement becomes effective, it is called a prospectus and is used to solicit orders for the security.
Securities Exchange Act of 1934 The Securities Exchange Act of 1934 transferred responsibility for administration of the 1933 act from the federal trade commission to the newly created SEC. The 1934 act also provided for federal regulation of trading in already issued and outstanding securities. Other provisions include disclosure requirements for publicly held corporations; prohibitions on various manipulative or deceptive devices or contrivances; SEC registration and regulation of brokers and dealers; and registration, oversight, and regulation of national securities exchanges, associations, clearing agencies, transfer agents, and securities information processors.
The SEC has broad oversight responsibilities for the self-regulatory organizations within the securities industry. For approximately 140 years prior to 1934, stock exchanges regulated their own members. Self-regulation continues to be an important component of the industry, but as of 2003 the SEC provides additional regulation, including authority to review disciplinary actions taken by a self-regulatory organization. The 1934 act also established the Municipal Securities Rulemaking Board and conferred oversight power upon the commission. The Municipal Securities Rulemaking Board formulates rules for the municipal securities industry. The commission has the authority to approve or disapprove most proposed rules of the board.
The 1934 act seeks to provide the public with adequate information about companies with publicly traded securities. Subject to certain exemptions, disclosure requirements apply not only to companies with securities listed on national securities exchanges but to all companies with more than 500 shareholders and more than $5,000,000 in assets. Companies must file detailed statements with the SEC when first registering under the 1934 act and must provide periodic reports as prescribed by the commission.
Under the 1934 act, the SEC also regulates the solicitation of proxies. Proxies are voting solicitations allowing stockholders to participate in the annual or special meetings of stockholders without actually attending the meeting; the proxy empowers someone else to vote on behalf of the shareholder. Detailed SEC regulations delineate the form of proxies and the information that must be furnished to stockholders. A registered company must furnish each stockolder, before every stockholder meeting, a proxy statement and a proxy form on which he or she can indicate approval or disapproval of each proposal expected to be introduced at the meeting. Companies must file with the commission copies of the proxy statement and the proxy form. The SEC may comment on the proxy statement and insist on changes before it is mailed to security holders.
The williams act of 1968 (Pub. L. No. 90-439, 82 Stat. 454) amended the 1934 act to address recurring problems arising in tender offers and corporate takeovers. A tender offer is a formal request that stockholders sell their shares in response to a large purchase bid; the buyer reserves the right to accept all, none, or a certain number of shares tendered for sale. A takeover occurs when a corporation assumes control of another corporation through an acquisition or merger. Pursuant to the law as amended, any person or group that takes ownership of more than 5 percent of any class of specific registered securities must file a statement within 10 days with the issuer of the security and with the SEC. This statement provides the background of the purchaser, the source of funds used in the purchase, the purpose of the purchase, the number of shares owned, and any relevant contracts, arrangements, or understandings. In addition, no person may make a tender offer unless he or she has first filed with the SEC and provided certain specific information to each offeree. A tender offer must remain open for a minimum of 20 days and at least 10 days after any change in the terms of the offer.
The Securities Act of 1934 also requires any person who beneficially owns, whether directly or indirectly, more than 10 percent of a class of certain registered securities and every officer or director of every company with specific registered securities to report to the SEC. Reports must be filed at the time the status is acquired and at the end of any month in which such a person acquires or disposes of any equity securities of that company. This provision is designed to discourage short-term trading by preventing corporate insiders from unfairly using nonpublic information.
Investment Company Act of 1940 Pursuant to the Investment Company Act of 1940, investment companies must register with the SEC. 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, that is, securities other than those of majority-owned subsidiaries and government securities. Among other types of companies, this act covers "openend 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.
The act prohibits various transactions by investment companies, unless the commission has first made a determination that the transaction is fair. Moreover, the act permits the SEC to bring a court action to enjoin the execution of mergers and other reorganization plans of investment companies if the plans are unfair to security holders. The SEC also has the power to impose sanctions pursuant to administrative proceedings for violation of this act and may file suit to enjoin the acts of management officials involving breaches of fiduciary duties or personal misconduct and may bar such officials from office.
Investment Advisers Act of 1940 This act provides for SEC regulation and registration of investment advisers. The act is comparable to provisions of the 1934 act with respect to broker-dealers but is not as comprehensive. Generally speaking, an investment adviser is a person who engages in the business of advising others with respect to securities and does so for compensation. Certain fee arrangements are prohibited; adverse personal interests in a transaction must be disclosed. Moreover, the SEC may define and prohibit certain fraudulent and deceptive practices.
Other Securities Laws The Trust Indenture Act of 1939 applies to public issues of debt securities in excess of a certain amount. This law prescribes requirements to ensure the independence of indenture trustees. It also requires the exclusion of certain types of exculpatory clauses and the inclusion of certain protective clauses in indentures. In addition, the Public Utility Holding Company Act of 1935 (15 U.S.C.A. §§ 79a–79z-6) was enacted to correct abuses in the financing and operation of electric and gas public utility holding companies; SEC functions under these provisions were substantially completed by the 1950s.
In the wake of major corporate scandals involving the Enron Corporation and the Arthur Andersen accounting firm, Congress enacted the sarbanes-oxley act of 2002 (also known as the Public Company Accounting Reform and Investor Protection Act). The act imposes new disclosure requirements when companies file financial reports. It mandates that the SEC, by rule, requires the principal executive officer and principal financial officer to certify in each annual or quarterly report the accuracy and completeness of the information contained in the report. A knowing violation of this section is punishable by up to 10 years in jail and a $1 million fine. A willful violation is punishable by up to 20 years in jail and a $5 million fine. The act authorizes the establishment of a Public Company Accounting Oversight Board to oversee the accounting profession. The SEC appoints the five-person board. The board is charged with developing standards and enforcing them with appropriate sanctions. It must file an annual report with the SEC.
SEC Enforcement Authority
The commission enforces the myriad laws and regulations under its jurisdiction in a number of ways. The SEC may seek a court injunction against acts and practices that deceive investors or otherwise violate securities laws; suspend or revoke the registration of brokers, dealers, investment companies, and advisers who have violated securities laws; refer persons to the justice department for criminal prosecution in situations involving criminal fraud or other willful violation of securities laws; and bar attorneys, accountants, and other professionals from practicing before the commission.
The SEC may conduct investigations to determine whether a violation of federal securities laws has occurred. The SEC has the power to subpoena witnesses, administer oaths, and compel the production of records anywhere in the United States. Generally, the SEC initially conducts an informal inquiry, including interviewing witnesses. This stage does not usually involve sworn statements or compulsory testimony. If it appears that a violation has occurred, SEC staff members request an order from the commission delineating the scope of a formal inquiry.
Witnesses may be subpoenaed in a formal investigation. A witness compelled to testify or produce evidence is entitled to see a copy of the order of investigation and be accompanied, represented, and advised by counsel. A witness also has the absolute right to inspect the transcript of his or her testimony. Typically the same privileges one could assert in a judicial proceeding, such as the Constitution's fourth amendment prohibition against unreasonable searches and seizures and the Fifth Amendment's privilege against self-incrimination, apply in an SEC investigation. Proceedings are usually conducted privately to protect all parties involved, but the commission may publish information regarding violations uncovered in the investigation. In a private investigation, a targeted person has no right to appear to rebut charges. In a public investigation, however, a person must be afforded a reasonable opportunity to cross-examine witnesses and to produce rebuttal testimony or evidence, if the record contains implications of wrongdoing.
When an SEC investigation unearths evidence of wrongdoing, the commission may order an administrative hearing to determine responsibility for the violation and impose sanctions. Administrative proceedings are only brought against a person or firm registered with the SEC, or with respect to a security registered with the commission. Offers of settlement are common. In these cases the commission often insists upon publishing its findings regarding violations.
An administrative hearing is held before an administrative law judge, who is actually an independent SEC employee. The hearing is similar to that of a nonjury trial and may be either public or private. After the hearing the judge makes an initial written decision containing findings of fact and conclusions of law. If either party requests, or if the commission itself chooses, the commission may review the decision. The SEC must review cases involving a suspension, denial, or revocation of registration. The commission may request oral argument, will study briefs, and may modify the decision, including increasing the sanctions imposed. Possible sanctions in administrative proceedings include censure, limitations on the registrant's activities, or revocation of registration. In 1990 SEC powers were expanded to include the authority to impose civil penalties of up to $500,000, to order disgorgement of profits, and to issue cease and desist orders against persons violating or about to violate securities laws, whether or not the persons are registered with the SEC.
The U.S. Court of Appeals for the District of Columbia or another applicable circuit court of appeals has jurisdiction to review most final orders from an SEC administrative proceeding. Certain actions by the commission are not reviewable.
The SEC may request an injunction from a federal district court if future securities law violations are likely or if a person poses a continuing menace to the public. An injunction may include a provision that any future violation of law constitutes contempt of court.
The SEC may request further relief, such as turning over profits or making an offer to rescind the profits gained from an insider trading transaction. In cases of pervasive corporate mismanagement, the SEC may obtain appointment of a receiver or of independent directors and special counsel to pursue claims on behalf of the corporation.
Willful violations may be punished by fines and imprisonment. The SEC refers such cases to
the Department of Justice for criminal prosecution. "Willfulness" means only that the defendant intended the act, not that he knew that it was a violation of securities laws.
Securities and Exchange Commission. Available online at <www.sec.gov> (accessed August 11, 2003).
Seligman, Joel. 2003. The Transformation of Wall Street: A History of the Securities and Exchange Commission and Modern Corporate Finance. 3d ed. New York: Aspen.
Winer, Kenneth B., and Samuel J. Winer. 2004. Securities Enforcement: Counseling & Defense. Newark, N.J.: Lexis Nexis.
Securities and Exchange Commission
Securities and Exchange Commission
The U.S. Securities and Exchange Commission (SEC) is an independent, nonpartisan, quasi-judicial regulatory agency that is responsible for administering federal securities laws. The main objective of these laws is to protect investors in securities markets in the United States from fraud and other dishonest activities. The laws are designed to ensure that securities markets operate fairly and that investors have access to disclosures of all material information concerning publicly traded securities.
The SEC regulates firms engaged in the purchase and sale of securities, people who provide investment advice, and investment companies. The SEC may also provide the means to enforce securities laws through the appropriate sanctions. The commission may also serve in an advisory capacity to the federal courts in Chapter 11 cases (e.g., corporate reorganization proceedings under Chapter 11 of the Bankruptcy Reform Act of 1978).
ORIGIN AND STRUCTURE
Prior to the creation of the SEC, there were no federal securities laws. The state securities laws that did exist, known as the Blue Sky laws, were easily ignored by securities companies simply by making securities offerings across state lines through the mail. Congressional investigations of the collapse of the stock market in 1929 and the subsequent Great Depression found that investors suffered heavy losses for two major reasons. First, many companies had failed to disclose relevant information. Second, many misrepresentations of financial information had been made to the investors. The SEC was established by Congress in 1934 under the Securities Exchange Act to provide oversight in an attempt to prevent such a situation from arising again.
The commission is headed by five commissioners appointed by the President of the United States with the advice and consent of the Senate. Each commissioner is appointed to a fixed five-year term; terms are staggered so that one expires on June 5 of every year. One of the commissioners is designated as chair by the president. As a matter of policy, no more than three of the five commissioners may be from the same political party. The commission employs financial analysts and examiners,
accountants, lawyers, economists, investigators, and other professionals to carry on its responsibilities.
The SEC employs around 4,000 people in eighteen offices, with headquarters in Washington, D.C., and eleven regional offices throughout the United States. The commission consists of four main divisions—Corporation Finance, Trading and Markets, Investment Management, and Enforcement—as well as other commission offices.
Division of Corporation Finance. Corporation Finance has the overall responsibility of ensuring that disclosure requirements are met by publicly held companies registered with the SEC. Its responsibilities include reviewing registration statements for publicly traded corporate securities, as well as documents concerning proxies, mergers and acquisitions, tender offers, and solicitations.
Division of Investment Management. This division has the responsibility of administering three statutes: the Investment Company Act of 1940; the Investment Advisers Act of 1940; and the Public Utility Holding Company Act of 1935. The Division of Investment Management ensures compliance with regulations regarding the registration, financial responsibility, sale practices, and advertising of investment companies and investment advisers. New products offered by these entities are also reviewed by the staff in this division. The staff reviews and processes investment company registration statements, proxy statements, and periodic reports as per the laws specified under the Securities Act.
Division of Trading and Markets. This division is responsible for overseeing the securities markets and their self-regulatory organizations (SROs), such as the nation's stock exchanges, Financial Industry Regulatory Authority (FINRA), and the Municipal Securities Rulemaking Board. This division is empowered to interpret proposed changes to regulations. This division also registers and regulates trading firms not regulated by an SRO, and it oversees other market participants, such as transfer agents and clearing organizations.
Division of Enforcement. The Enforcement Division has the responsibility of investigating violations of the securities laws and regulations and bringing actions against alleged violators. This division works with the other three divisions, and other SEC offices, to enforce federal securities laws. The SEC is empowered to bring civil actions to a U.S. District Court or to engage in administrative proceedings heard by an independent administrative law judge. While the SEC does not have the authority to bring criminal charges, it may refer its cases to state and federal prosecutors. The SEC typically brings between 400 and 500 civil enforcement actions per year against companies and individuals that it suspects of breaking securities laws.
Office of Compliance Inspections and Examinations. This office conducts and coordinates all compliance inspection programs of brokers, dealers, self-regulatory organizations, investment companies and advisers, clearing agencies, and transfer agents. It determines whether these entities are in compliance with the federal securities laws, with the goal of protecting investors.
SECURITIES LAWS ADMINISTERED BY THE SEC
The Securities and Exchange Commission is responsible for enforcing a wide range of laws passed since the 1930s. The seven major acts enforced by the SEC are the Securities Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Act of 1935, the Trust Indenture Act of 1939, the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the Sarbanes-Oxley Act of 2002. The SEC also enforces the Securities Disclosure Act of 1968, the Depository Institutions and Deregulation Money Control Act of 1980, the Insider Trading Sanctions Act of 1984, and the Commodity Futures Modernization Act of 2000, among others.
Securities Act of 1933. The Securities Act imposes mandatory disclosure requirements on companies that sell their new securities through the securities markets. The act's base philosophy is to let the issuer disclose and to let the investor beware. This act is often referred to as the “truth in securities” law. The act requires that investors receive financial and other significant information concerning securities being offered for public sale. The act also prohibits deceit, misrepresentations, and other fraud in the sale of securities.
In 1975, Congress amended the Securities Act of 1933. The major focus of the amendment was the requirement that the SEC move towards establishing a single nationwide securities market. The law did not specify the structure of a national securities market, but it is assumed that any national market would make extensive use of computers and electronic communication devices.
Securities Exchange Act of 1934. The Securities Exchange Act of 1934 extends the disclosure concepts to securities already outstanding. The major provisions of the Securities Exchange Act of 1934 are as follows:
- The act created the Securities and Exchange Commission as a watchdog for the securities business.
- It required listed companies to file registration statements and periodic financial reports with both the SEC and the exchange.
- It gave the SEC the power to prohibit market manipulation, misrepresentation, and other unfair practices.
- It required all national securities exchanges to register with the SEC and to be under its effective supervision and regulation.
- It gave the Board of Governors of the Federal Reserve System the authority to control margin requirements.
- It granted the SEC the power to control short selling, trading techniques, and the procedures of the exchanges.
- It required officers, directors, and major stockholders to file monthly reports of any changes in their stockholdings.
Public Utility Holding Act of 1935. Interstate holding companies engaged, through subsidiaries, in the electric utility business or in the retail distribution of natural or manufactured gas are subject to regulation under this act. These companies, unless specifically exempted, are required to submit reports providing detailed information concerning the organization, financial structure, and operations of the holding company and its subsidiaries. Holding companies are subject to SEC regulations on such matters as system structure, acquisitions, combinations, and issue and sale of securities.
The Trust Indenture Act of 1939. Under the scrutiny of the SEC, this act applies to debt securities, including bonds, debentures and notes, and similar debt instruments offered for public sale and issued under trust indentures with more than $7.5 million in securities outstanding at any one time. Even though such securities may be registered under the Securities Act, they may not be offered for sale to the public unless a formal agreement between the issuer of bonds and bondholder, known as the trust indenture, conforms to the statutory standards of this act.
Investment Company Act of 1940. Under this act, activities of companies—including mutual funds—engaged primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public, are subject to certain statutory prohibitions and to Securities and Exchange Commission regulation. Public offerings of investment companies' securities must also be registered under the Securities Act of 1933. In this context, it should be noted that although the SEC serves as a regulatory agency in these cases, the SEC does not supervise the company's investment activities. The mere presence of the SEC as a regulatory agency does not in itself guarantee a safe investment for potential investors.
Investment Advisers Act of 1940. The Investment Advisers Act of 1940 establishes a pattern of regulating investment advisers. The main purpose of this act is to ensure that all persons, or firms, that are compensated for providing advising services to anyone about securities investments are registered with the SEC and conform to the established standards designed to protect investors. The SEC has the authority to strip an investment adviser of his or her registration should he or she be found guilty of committing a statutory violation or securities fraud.
Sarbanes-Oxley Act of 2002. The Sarbanes-Oxley Act (commonly called SOX), signed into law by President George W. Bush on July 30, 2002, marked the first significant reform of American business practices in decades. High-profile cases of insider trading and fraud at such companies as Enron and WorldCom—which took place either under the noses or with the implicit approval of the major public accounting firms hired to audit them—led to a movement to increase the power of the SEC. The act was intended to enhance corporate responsibility, combat accounting fraud, and clarify financial disclosures. It also created the Public Company Accounting Oversight Board (PCAOB) to guarantee that the auditing profession remained unbiased in performing its vital role of ensuring corporate compliance with financial reporting standards.
Proponents of the Sarbanes-Oxley Act hoped that its passage would serve to clean up American capital markets, improve corporate governance, and restore investor confidence. A number of critics claim that the act is an unnecessary government intrusion and that the costs associated with compliance put American firms at a competitive disadvantage. One study estimates that Sarbanes-Oxley cost Fortune 500 companies an average of $5.1 million in compliance expenses in 2004, while another study found that the act increased costs associated with being a publicly held company by 130 percent. Whether the critics are correct or not, this act has increased the power of the SEC and has succeeded at least in part in reducing the number of corporate scandals seen during the early-2000s.
SEE ALSO Due Diligence; Ethics; Financial Issues for Managers; Financial Ratios
Aspatore Books Staff. Understanding the Laws Behind Securities Transactions. Boston, MA: Aspatore Books, 2006.
Barber, Marc. “U.S. Clean-Up Operation: Regulators in the U.S. Are as Determined as Ever to Restore Faith after the Series of Accounting Scandals in Recent Years.” Accountant May 2004.
Garg, Ramesh, et al. Basics of Financial Management. 2nd ed. Acton, Massachusetts: Copley Publishing Group, 2002.
“The Investor's Advocate.” U.S. Securities and Exchange Commission. Available from: http://www.sec.gov/about/whatwedo.shtml.
U.S. Securities and Exchange Commission Handbook. International Business Publications, 2008.
Evidence of a corporation's debts or property.
Supreme Court Dismisses Commodity Futures Case
The U.S. Supreme Court in December 2007 dismissed the case of Klein & Co. Futures v. Board of Trade of NYC (No. 06-1265) under Supreme Court Rule 46.1, which applies when the parties agree to a dismissal. The case, which had been argued before the Court in October 2007, involved the question of whether merchants could bring an action against a futures exchange under the Commodities Exchange Act (CEA), 7 U.S.C. § 25. The Second Circuit Court of Appeals concluded that a merchant could not bring such an action, and by dismissing the action, the Supreme Court allowed the Second Circuit's decision to stand.
The case of Klein & Co. Futures v. Board of Trade of NYC involved, in part, the different roles of various parties in commodities futures trading. A commodities futures market is one where customers buy and sell commodities that will be delivered or purchased at some time in the future. The commodities future itself is a contract to sell a particular commodity, such as corn, at a price established by the contract. Many of the customers who buy futures contracts do so with the anticipation that market prices will change so that the customers can then sell the contract to another purchaser for a profit.
Commodity futures contracts are sold at several commodity exchanges, which are governed by rules established by various boards of trade, such as the Board of Trade of the City of New York. Much of the actual trading at these exchanges is conducted by commodity futures merchants, who act as intermediaries for the customers who purchase the futures contracts.
Among the rules that the boards of trade must enact are those related to sales “on margin.” Buying a futures contract on margin allows a customer to acquire a contract while only giving the merchant who makes the purchase a small percentage of the full cost. If the contract experiences fluctuation in value, the customer may be subject to a margin call , which requires the customer to pay the merchant more money to cover for the potential loss in value to the contract. The daily “settlement price,” which is sometimes difficult to calculate, determines whether a customer must pay a margin call.
The boards are regulated under the CEA, which requires each board of trade to enact and enforce rules that govern the exchanges at those markets. Among other provisions, the CEA sets forth circumstances where a private litigant may bring a private cause of action for violating the CEA. The CEA specifically limits the types plaintiffs who may properly bring an action for violating the statute .
Norman Eisler was the Chairman of the New York Futures Exchange (NYFE). He was also a member of the NYFE's settlement committee for Pacific Stock Exchange Technology Index Futures Contract and Options. This committee's primary responsibility was to calculate the price of certain technology contracts for the purpose of calculating margin requirements for customer accounts, among other purposes. Eisler was moreover a customer of Klein & Co. Futures Inc., a merchant of commodity futures, and he was the principal of First West Trading Inc., which was also one of Klein's customers. Klein facilitated trading, along with other obligations, for customers that traded through the Board of Trade of the City of New York.
Acting as a member of the NYFE settlement committee, Eisler secretly manipulated the settlement prices for the technology contracts. While this manipulation benefited Eisler, it caused Klein to miscalculate the margin requirements. In March 2000, the Board of Trade began to receive complaints about irregularities in the settlement prices, but the board failed to make inquiries or place any of the parties on notice that there were any irregularities. During May 2000, Klein computed the margin for the First West account, but Klein based its computations on the incorrect settlement prices that Eisler had provided. After making this computation, Klein informed the Board of Trade that Eisler was unable to meet the margin call, along with other concerns. Klein reported then that if Eisler could not cover the margin deficit, it would impair Klein's net capital.
Klein and the Board of Trade soon discovered the extent of the problem. Eisler was removed from the NYFE settlement committee, and his membership privileges with the Board of Trade were suspended. The remaining settlement committee members recalculated the deficit and determined that First West's margin deficit had escalated to $4.5 million. First West could not meet this obligation, and after Klein took an immediate charge on its net capital to cover the difference, Klein soon collapsed.
Klein brought suit under the CEA against Board of Trade of the City of New York in the U.S. District Court for the Southern District of New York. Klein argued that the Board failed to enforce its own rules and that it violated anti-fraud provisions in the CEA. The Board of Trade responded by arguing that because Klein was not a purchaser or a seller of the futures, the company was not entitled to bring suit. The district court agreed, holding that because First West and not Klein owned the futures contracts, Klein was not entitled under CEA to bring suit. Klein & Co. Futures v. Bd. of Trade, NO. 00-CV-5563-GBD, 2005 WL 427713 (S.D.N.Y. Feb. 18, 2005). On appeal, the Second Circuit Court of Appeals agreed, noting that the CEA limits claims by private plaintiffs to those plaintiffs who actually traded in the commodities market. Since Klein was only a merchant that acted as an intermediary in the trading, the court agreed with the district court and held that Klein did not have standing to bring suit. Klein & Co. Futures, Inc. v. Bd. of Trade, 464 F.3d 255 (2d Cir. 2006).
The Supreme Court granted certiorari on May 17, 2007 and heard oral arguments in the case on October 29. Two months later, on December 28, the Court granted a dismissal of the case under Rule 46, which typically applies when the parties agree to drop an appeal so that the parties can settle the dispute out of court.
Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc.
Federal securities laws give the Security and Exchange Commission (SEC) the power to investigate and prosecute individuals and companies for misleading investors. In addition, the Supreme Court established a private right of action for individuals to sue companies for the financial losses that resulted from the distribution of misleading and fraudulent information about a company's financial health. In Stoneridge Investment Partners LLC v. Scientific-Atlanta, Inc., __U.S.__, 128 S. Ct. 761, 169 L. Ed. 2d 627 (2008), investors in a cable company attempted to use this private right of action to sue the companies that helped the cable company manipulate its balance sheet to make it look more profitable that it was in fact. The Court, however, drew a line and found that this right to sue cannot be extended to corporate vendors and customers.
A class action lawsuit was filed by investors against Charter Communications, Inc. in Missouri federal district court , alleging that the cable company had illegally manipulated its quarterly financial statements to show Wall Street it would meet the market's expectations for cable subscriber growth and operating cash flow. Stonebridge Investment Partners, the lead plaintiff, also sued Charter's accounting firm and two manufacturers of digital cable converter boxes, Scientific-Atlanta and Motorola. The manufacturers were brought into the suit because of an alleged scheme in late 2000, when Charter executives realized that the company would miss projected operating cash flow numbers by $15 to $20 million. To help meet the shortfall, Charter arranged to overpay the two cable box companies $20 for each box it purchased until the end of the year. It was understood that the companies would return the overpayment by buying advertising from Charter.
The plaintiffs claimed this had no economic merit and was a way to record the advertising as revenue and capitalize its purchase of boxes; both actions violated generally accepted accounting principles. By doing so Charter tricked its auditor into approving a financial statement that showed the company had met its projected revenue and operating cash flow numbers. The cable-box manufacturers participated in the plan and drafted documents to make it appear the transactions were unrelated and made in the ordinary course of business and backdated other documents. The plaintiffs contended that Charter and the manufacturers were liable for damages, as they violated 10(b) of the Securities Act of 1943 and SEC Rule 10-b5. The district court dismissed the two manufacturers from the lawsuit and the Eighth Circuit Court of Appeals affirmed the ruling. The appeals court noted that to violate 10(b) a party must make misstatements that were relied upon by the public. In this case the cable-box companies had indeed aided and abetted Charter's fraudulent actions but there was no private right of action for aiding and abetting a 10(b) violation. Because other circuit courts of appeals had permitted investors to sue aiders and abettors of stock fraud , the Supreme Court agreed to resolve the conflict.
The Court upheld the Eighth Circuit ruling in a 5–3 decision. (Justice Stephen Breyer did not participate in the case.) Justice Anthony Kennedy, writing for the majority, noted a 1994 Supreme Court decision in which the Court ruled that the plaintiffs could not use 10(b) to sue aiders and abettors. Though that case led to calls for amending the law to establish private claims against those aiding and abetting stock fraud, Congress declined to follow this course. Instead, in the Private Securities Litigation Reform Act of 1995 (PSLRA), 15 U.S.C. § 78t(e), it directed prosecution of aiders and abettors by the SEC. Therefore, for a plaintiff to prevail against a secondary actor, it must be shown that this actor met each element of the preconditions for liability under § 10(b).
Justice Kenney concluded that the plaintiffs could not show that the companies' “acts or statements” were relied upon by the investors in Charter stock. Reliance is an “essential element” of § a 10(b) private right of action yet the plaintiffs could not show that the companies had a duty to disclose their transactions with Charter. These deceptive acts were not communicated to the public, so no investor had either presumed or actual knowledge of these acts. Without knowledge there could be no reliance. The Court, though it had created a private right of action against primary actors, was reluctant to extend it to aiders and abettors. The practical consequences of an extension could allow plaintiffs with weak cases to “extort settlements from innocent companies,” so those companies could avoid costly litigation. In addition, an expansion could lead to increased costs of doing business and to overseas firms “with no other exposure to our securities laws” declining to do business in the United States. The fact that Congress, in the PSLRA, gave the SEC the power to prosecute secondary actors, was a significant development. The SEC has used this authority to good effect, collecting over $10 billion for distribution to injured investors.
Evidence of a corporation's debts or property.
Tellabs v. Makor Issues & Rights, Ltd.
Congress enacted the Private Securities Litigation Reform Act of 1995 (PSLRA) as a response to a perceived abuse of litigation in private securities fraud actions. Under the statute, a plaintiff must state with particularity both the facts that constitute the alleged violation as well as the facts that demonstrate the defendant's intent to "deceive, manipulate, or defraud" the plaintiff. In Tellabs, Inc. v. Makor Issues & Rights, Ltd., No. 06-484, 2007 WL 1773208 (June 21, 2007), the Court clarified what a plaintiff must prove under this Act.
Federal antifraud securities laws are generally enforced through criminal prosecutions and civil enforcement actions brought by the Jus-tice Department and the Securities and Exchange Commission. Private actions that are brought to enforce these laws are considered to be an effective supplement to these actions. However, if these types of actions are not appropriately contained, they can be abused in a manner that imposes great costs on companies that are in compliance with securities laws.
Under the PSLRA, a plaintiff must meet exacting pleading requirements in order to bring a private securities action. Under the second prong of the statute, which requires that the defendant has acted with the requisite intent, the statute establishes that that plaintiff must "state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind." Congress did not define the term "strong inference," and the federal courts of appeals were split about how the term should be defined. For instance, the Seventh Circuit has held that this strong inference standard is met when the complaint has "allege[d] facts from which, if true, a reasonable person could infer that the defendant acted with the required intent."
Tellabs, Inc. is a manufacturer of specialized equipment for fiber optic networks. A group of investors bought Tellabs stock during the period between December 11, 2000 and June 19, 2001. These investors claimed that the chief executive officer of the company, Richard Notebaert, had violated federal law by engaging in securities fraud after the company's stock fell from $67 to $15.87 per share during a short period of time in 2001. These investors brought suit under the PSLRA against both Tellabs and Notebaert in the U.S. District Court for the Northern District of Illinois. The defendants moved to dismiss the complaint, arguing that the plaintiffs had not met the standards set forth in the PSLRA.
The district court agreed with the defendants and dismissed the complaint, holding that the plaintiffs had failed to plead the case under the PSLRA's requirements. The shareholders subsequently amended their complaint to add references to 27 confidential sources and making more specific allegations regarding Notebaert's mental state. However, the district court again determined that the plaintiffs had not met the PSLRA standards and dismissed the complaint, this time with prejudice. Johnson v. Tellabs, Inc., 303 F. Supp. 2d 941 (N.D. Ill. 2004).
The shareholders appealed the decision to the Seventh Circuit Court of Appeals. The appellate court disagreed with the district court that the plaintiff had not sufficiently alleged that Notebaert had acted with the necessary state of mind under the statute. With respect to the pleading standard, the court said that "courts [should] examine all of the allegations in the complaint and then … decided whether collectively they establish" a strong inference that the defendant had the state of mind necessary to support the complaint.
In reaching its decision, the Seventh Circuit did not mandate an assessment of competing inferences in this type of case. This approach conflicted with one adopted by the Sixth Circuit, which established that "plaintiffs are entitled only to the most plausible of competing inferences." According to the Seventh Circuit, this type of assessment of competing inferences could infringe upon the plaintiffs' rights under the Seventh Amendment, which preserves a right of trial by jury. Makor Issues & Rights, Ltd. v. Tellabs, Inc., 437 F.3d 588 (7th Cir. 2006). Because the circuit courts had become split on the question of how the courts should treat competing inferences in a private securities fraud case, the Supreme Court granted certiorari to resolve the conflict.
In an opinion by Justice Ruth Bader Ginsburg, the Court clarified how the courts should address cases brought under the PSLRA. First, in a motion to dismiss based on Rule 12(b)(6) of the Federal Rules of Civil Procedure, the courts should treat all factual allegations in the complaint as true. Second, the court must consider the complaint in its entirety, taking into account all of the facts alleged by a plaintiff, to determine whether the facts taken collectively give rise to a strong inference that the defendant had the necessary state of mind. Third, a court must take into account all plausible opposing inferences, comparing these opposing inferences with those that support a finding that the defendant had the required scienter.
In the case before the Court, Tellabs argued that the lack of evidence suggesting that Notebaert had a financial motive in his actions showed that the plaintiff could not prove a strong inference that he had the necessary state of mind. The Court said that though motive could be a factor that is considered in the analysis, but the allegations in the complaint must be taken collectively. Thus, the significance that a court attaches to the lack of motive depends on the contents of the entire complaint itself. The Court also said that the Seventh Circuit's concern about the Seventh Amendment was unwar-ranted, noting that Congress has the power to prescribe what must be stated in a complaint.
Because the lower courts had not had the opportunity to consider whether the allegations in the complaint warranted a strong inference of Notebaert's state of mind, the Court vacated the Seventh Circuit's decision and remanded the case to the lower court for further consideration.
Securities and Exchange Commission
SECURITIES AND EXCHANGE COMMISSION
The U.S. Securities and Exchange Commission (SEC) is a regulatory agency responsible for administering U.S. securities laws. The purpose of these laws is to ensure fair markets and to provide accurate information to investors. The major securities laws were enacted in the 1930s after the 1929 stock market crash and the anemic performance of the market in the early 1930s.
The U.S. Congress passed the Securities Act of 1933 (sometimes referred to as the "truth in issuance act") to regulate the primary market—the market for new securities. The act's dual primary purposes related to the sale of securities required companies to submit independently verified financial information, a registration statement, and a prospectus to the Federal Trade Commission to ensure that investors receive credible financial information about companies being offered for public sale, as well as to prohibit fraud and misrepresentation in the sale of securities. Since May 6, 1996, individuals have been able to readily access these statements using the SEC's Electronic Data Gathering, Analysis, and Retrieval System and learn about companies to help them make informed investment decisions.
The Securities Exchange Act of 1934 provided more SEC control, giving it the power to regulate the stock exchanges and the trading practices of the secondary market (a market for currently traded shares). In 1935 the Public Utility Holding Company Act was enacted to regulate all interstate holding companies (a holding company controls other companies by owning their stock) in the utility business. Further, the Trust Indenture Act of 1939 was enacted to allow the SEC oversight in the issuance of bonds, notes, and debentures offered for public sale.
In 1940 Congress passed two laws covering the people working in the security business. The Investment Company Act of 1940 was developed to minimize conflicts of interest by regulating investment companies, including those involved with mutual funds. It focuses on disclosing investment company operations and structure, as well as fund information to the investing public. The Investment Advisers Act of 1940 established regulation of investment advisers and their activities. In 1974 the Employee Retirement Income Security Act gave the SEC jurisdiction over pension funds; and the Sarbanes-Oxley Act of 2002 mandated reforms relating to public accounting fraud and created oversight of the auditing profession through the Public Company Accounting Oversight Board. Other legislation addressed foreign activities, insider trading, and further clarification of existing legislation.
The SEC consists of five presidentially appointed commissioners, only three of whom can be from the same political party. Terms are staggered; thus, each June 5, a person rotates off the commission. To accomplish their duties, the commissioners have office staffs of accountants and lawyers and regional offices in eleven cities.
The organizational structure of the SEC includes four divisions. The Division of Corporation Finance reviews registration statements, tender offers, and mergers and acquisitions. The Division of Market Regulation oversees markets and market participants. The Division of Investment Management is responsible for the enforcement of three statutes: the Investment Company Act of 1940, the Investment Advisers Act of 1940, and the Public Utility Holding Company Act of 1935. The Division of Enforcement is the SEC's investigative arm. After conducting private investigations of possible violations, the Division of Enforcement recommends appropriate commission action either before an administrative law judge or in federal court, and then negotiates settlements.
The commission also has fifteen offices performing duties defined by their titles. For instance, the Office of Compliance, Inspections, and Examinations determines whether all investment organizations are in compliance with federal securities laws.
In enforcing the securities laws, the SEC acts as a guide and adviser whose actions are largely remedial. One common activity of each division is rule making. New rules and rule modifications are usually accomplished in open meetings. Those industries or parties affected by rule changes are allowed to present their positions and make comments in an open meeting. Any SEC investigations are conducted by the Division of Enforcement and the field offices. If the evidence indicates a violation, the SEC can take administrative action (such as suspension) or instigate a civil action in a U.S. district court. If evidence indicates a criminal action, the SEC turns the case over to the U.S. Department of Justice.
More information is available from the Securities and Exchange Commission, 450 Fifth Street NW, Washington, DC 20549; 202-942-7114; or http://www.sec.gov.
see also Securities Acts: Requirements for Accounting
Hirt, Geoffrey A., and Block, Stanley B. (2006). Fundamentals of investment management (8th ed.). Boston: McGraw-Hill/Irwin.
Levy, Haim (1999). Introduction to investments (2nd ed.). Cincinnati: South-Western College.
Securities and Exchange Commission. (2004). Securities and Exchange Act of 1934. Retrieved December 9, 2005, from http://www.sec.gov/about/laws/sea34.pdf
Securities and Exchange Commission. (2004). Trust Indenture Act of 1939. Retrieved December 9, 2005, from http://www.sec.gov/about/laws/tia39.pdf
Mary Jean Lush
Securities and Exchange Commission
SECURITIES AND EXCHANGE COMMISSION
The Securities and Exchange Commission (SEC) is an independent, non-partisan regulatory agency. Created by Congress in 1934 under the Securities Exchange Act, the agency is tasked with regulating the United States investment industry. It ensures that U.S. securities markets operate fairly and honestly and can enforce punishments when violations are made.
SEC regulations are designed to hold publicly held entities, broker-dealers in securities, investment companies, and other securities market participants accountable to federal law. There are six main laws the SEC oversees: the Securities Act of 1933, the Securities Exchange Act of 1934, the Public Utility Holding Company Act of 1935, the Trust Indenture Act of 1939, the Investment Company Act of 1940, and the Investment Advisers Act of 1940.
The Securities Act of 1933, known also as the "truth in securities law," requires investors be provided with information concerning securities offered for public sale. This information often comes in the form of a "prospectus," a brochure detailing the security's history and performance. The act also set regulations to prevent fraud in securities sales.
The information disclosure statements established in the 1933 Securities Act were extended the next year under the Securities Exchange Act. This act extended the disclosure of information to all securities listed and registered for public trading on U.S. securities exchanges, such as the New York Stock Exchange. Disclosure law was further extended in 1964 with the Securities Act Amendments, which made similar provisions for equity securities in the over-the-counter market (securities markets where previously issued securities are re-traded).
The Public Utility Holding Company Act of 1935 regulates interstate holding companies involved in the electric utility industry or the retail distribution of natural or manufactured gas. These businesses are required to file detailed information concerning their operations and holdings.
Regarding bonds and other debt securities, the SEC has the power to regulate under the Trust Indenture Act of 1939. Debt securities offered for public sale and issued under trust agreements must adhere to guideline concerning trustees and capital, including high standards of conduct and responsibility on the part of the trustee.
In addition, the SEC monitors the principles set forth in the Investment Company Act of 1940, regulating the activity of companies engaged primarily in the securities industry—investing, trading in securities, and offering their own securities for public sale.
While the SEC oversees the application of all these laws and guidelines, it is a regulatory agency only and does not supervise any individual company's investment activities. It does have more supervision regarding investment advisers. The Investment Advisers Act of 1940 established a system requiring all persons or organizations who advise about securities investments (and receive compensation for this advisement) be registered with the SEC and conform to their established procedures of investor protection.
Because of SEC oversight, investors in U.S. securities markets are better protected from fraud, whether it be by investment advisers or companies engaged in criminal securities schemes.
See also: New York Stock Exchange, Over-the-Counter Market