Chapter Twenty Three Rules Governing the Issuance and Trading of Securities In Chapter 17, we said that the corporation was the dominant form of business organization in the United States—and the most regulated. Two of the most strongly regulated aspects of corporate business are the issuance and trading of securities. Corporate securities—stocks and bonds—are used to raise capital for the corporation. They are also used by individuals and institutional investors to accumulate wealth. In the case of individuals, this wealth is often passed on to heirs, who use it to accumulate more wealth. Thus, securities provide a means for one generation in a family to “do better” than the preceding generation. Securities also provide a means for financing pension funds and insurance plans through institutional investment. Securities holders are powerful determinants of trends in business: If an individual company, industry, or segment of the economy is not growing and paying a good rate of return, investors will switch their funds to another company, industry, or segment in expectation of better returns. Securities holders (or their proxies) elect the board of directors of a corporation, who, in turn, select the officers who manage the daily operations of a corporation. Finally, securities holders’ ability to bring lawsuits helps keep officers and directors honest in their use of investors’ funds. Because of their importance to the operation of our free enterprise society and because of the ease with which they can be manipulated, securities have been regulated by governments for nearly a century. This chapter chiefly examines the role of the federal government in regulating securities. We introduce the subject with a brief history of securities regulation that contains a summary of the most important federal legislation. We then turn to the creation, function, and structure of the Securities and Exchange Commission (SEC). In a survey of major and representative securities legislation, we examine the provisions of the Dodd-Frank Act of 2010 and the Sarbanes-Oxley Act of 2002. Both the Securities Act of 1933, which governs the issuance of securities and outlines the registration requirements for both securities and transactions (and the allowable exemptions from those requirements), and the Securities Exchange Act of 1934, which governs trading in securities, are discussed. We then examine the state securities laws and online securities disclosure and fraud regulations. We end with a discussion of the global dimensions of the 1933 and 1934 securities acts; the Foreign Corrupt Practices Act, as amended in 1988; and the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.Critical Thinking About The Law Because issuers can manipulate securities easily, federal and state governments have strongly regulated the issuance and trading of securities. Studying the following case example and answering some critical think ...

1. Chapter Twenty Three Rules Governing the Issuance and
Trading of Securities
In Chapter 17, we said that the corporation was the dominant
form of business organization in the United States—and the
most regulated. Two of the most strongly regulated aspects of
corporate business are the issuance and trading of securities.
Corporate securities—stocks and bonds—are used to raise
capital for the corporation. They are also used by individuals
and institutional investors to accumulate wealth. In the case of
individuals, this wealth is often passed on to heirs, who use it to
accumulate more wealth. Thus, securities provide a means for
one generation in a family to “do better” than the preceding
generation. Securities also provide a means for financing
pension funds and insurance plans through institutional
investment.
Securities holders are powerful determinants of trends in
business: If an individual company, industry, or segment of the
economy is not growing and paying a good rate of return,
investors will switch their funds to another company, industry,
or segment in expectation of better returns. Securities holders
(or their proxies) elect the board of directors of a corporation,
who, in turn, select the officers who manage the daily
operations of a corporation. Finally, securities holders’ ability
to bring lawsuits helps keep officers and directors honest in
their use of investors’ funds.
Because of their importance to the operation of our free
enterprise society and because of the ease with which they can
be manipulated, securities have been regulated by governments
for nearly a century. This chapter chiefly examines the role of
the federal government in regulating securities. We introduce
the subject with a brief history of securities regulation that
contains a summary of the most important federal legislation.
We then turn to the creation, function, and structure of the
Securities and Exchange Commission (SEC). In a survey of

2. major and representative securities legislation, we examine the
provisions of the Dodd-Frank Act of 2010 and the Sarbanes-
Oxley Act of 2002. Both the Securities Act of 1933, which
governs the issuance of securities and outlines the registration
requirements for both securities and transactions (and the
allowable exemptions from those requirements), and the
Securities Exchange Act of 1934, which governs trading in
securities, are discussed. We then examine the state securities
laws and online securities disclosure and fraud regulations. We
end with a discussion of the global dimensions of the 1933 and
1934 securities acts; the Foreign Corrupt Practices Act, as
amended in 1988; and the Convention on Combating Bribery of
Foreign Public Officials in International Business
Transactions.Critical Thinking About The Law
Because issuers can manipulate securities easily, federal and
state governments have strongly regulated the issuance and
trading of securities. Studying the following case example and
answering some critical thinking questions about it will help
you better appreciate the need for regulation of securities.
Jessica received a phone call from a man claiming to represent
Buy-It-Here, a corporation that was relocating to Jessica’s
town. The man stated that the corporation was planning to issue
new securities, and he was extending this offer to residents in
Jessica’s town. He claimed that Buy-It-Here would easily
double its profits within six months. The man said that if
Jessica sent $3,000, he would buy stock in Buy-It-Here for
Jessica. Jessica sent the money; two weeks later, she discovered
that Buy-It-Here was in the process of filing for bankruptcy.
1. This case is an example of the need for government
regulation. We want the government to protect citizens from
cases such as Jessica’s buying stock in a bankrupt company. If
we want governmental protection from potentially shady
businesses, what ethical norm are we emphasizing?
Clue: Put yourself in Jessica’s place. Why would you want
governmental protection? Now match your answer to an ethical
norm listed in Chapter 1. Think about which ethical norm

3. businesses would emphasize.
2. Jessica wants to sue Buy-It-Here for misrepresentation.
Before she brings her case, what additional information do you
think Jessica should discover?
Clue: What additional information do you want to know about
the case? Even without having extensive knowledge about
securities, you can identify areas in which you might need more
information about Jessica’s case. For example, pay close
attention to the role of the telephone caller.
3. Jessica did some research about securities cases in her state.
She discovered a case in which a woman named Andrea
Stevenson had purchased $100,000 worth of stock from a
stockbroker. The company went bankrupt three months later.
The stockbroker had known that the company was suffering
financial problems but had said nothing to Andrea. The jury in
this case found in favor of Andrea. Jessica wants to use
Andrea’s case as an analogy in her lawsuit. Do you think that
Andrea’s case is an appropriate analogy? Why or why not?
Clue: What are the similarities between the cases? How are the
cases different? Are these differences so significant that they
overwhelm the similarities?
Introduction to the Regulation of Securities
Securities have no value in and of themselves. They are not like
most goods produced or consumed (e.g., television sets or toys),
which are easily regulated in terms of their hazards or
merchantability. Because they are paper, they can be produced
in unlimited numbers and can be manipulated easily by their
issuers.
The first attempt to regulate securities in the United States was
made by the state of Kansas in 1912. When other states
followed the Kansas legislature’s example, corporations played
off one state against another by limiting their securities sales to
states that had less stringent regulations. Despite the
corporations’ ability to thwart state efforts at regulation rather
easily, there was strong resistance to the idea of federal
regulation in Congress. It was not until after the collapse of the

4. stock market in 1929 and the free fall of stock prices on the
New York Stock Exchange (NYSE)—when the Dow Jones
Industrial Average registered an 89 percent decline between
1929 and 1933—that Congress finally acted.
Summary of Federal Securities Legislation
The following legislation, enacted by Congress since 1933,
provides the framework for the federal regulation of securities.
It is also important to note that this legislation is the basis
(enabling act) for rulemaking by the SEC. Congressional
legislation is emphasized here, but it is important to remember
that SEC rulemaking may be equally significant in the long
term. (You will remember that we discussed rulemaking for
federal agencies in Chapter 18.)
· The Securities Act of 1933 (also known as the Securities Act
or the 1933 Act) regulates the initial offering of securities by
public corporations by prohibiting an offer or a sale of
securities not registered with the Securities and Exchange
Commission. The 1933 Act sets forth certain exemptions from
the registration process, as well as penalties for violations of
the act. This act is examined in detail in this chapter. Both the
1933 and 1934 Acts have been amended by Congress and the
SEC rulemaking process, much of which is summarized in the
following pages.
· The Securities Exchange Act of 1934 (also known as the
Exchange Act) regulates the trading in securities once they are
issued. It requires brokers and dealers who trade in securities to
register with the Securities and Exchange Commission, the
regulatory body created to enforce both the 1933 and 1934 Acts.
The Exchange Act is also examined in detail in this chapter.
· The Public Utility Holding Company Act of 1935 requires
public utility and holding companies to register with the SEC
and to disclose their financial organization, structure, and
operating process.
· The Trust Indenture Act of 1939 regulates the public issuance
of bonds and other debt securities in excess of $5 million. This
act imposes standards for trustees to follow to ensure that

5. bondholders are protected.
· The Investment Company Act (ICA) of 1940, as amended in
1970 and 1975, gives the SEC authority to regulate the structure
and operation of public investment companies that invest in and
trade in securities. No private causes of action are created by
this law. A company is an investment company under this act if
it invests or trades in securities and if more than 40 percent of
its assets are “investment securities” (which are all corporate
securities and securities invested in subsidiaries).
Accompanying legislation, entitled the Investment Advisers Act
of 1940, authorizes the SEC to regulate persons and firms that
give investment advice to clients. This act requires the
registration of all such individuals or firms and contains
antifraud provisions that seek to protect broker-dealers’ clients.
· The Securities Investor Protection Act (SIPA) of 1970
established the nonprofit Securities Investor Protection
Corporation (SIPC) and gave it authority to supervise the
liquidation of brokerage firms that are in financial trouble, as
well as to protect investors from losses up to $500,000 due to
the financial failure of a brokerage firm. The SIPC does not
have the monitoring and “bailout” functions that the Federal
Deposit Insurance Corporation (FDIC) has in banking; it only
supervises the liquidation of an already financially troubled
brokerage firm through an appointed trustee.
· Chapter 11 of the Bankruptcy Abuse Prevention and Consumer
Protection Act of 2005 gives the SEC the authority to render
advice when certain debtor corporations have filed for
reorganization.
· The Foreign Corrupt Practices Act (FCPA) of 1977, as
amended in 1988, prohibits the direct or indirect giving of
“anything of value” to a foreign official for the purpose of
influencing that official’s actions. The FCPA sets out an intent
or “knowing” standard of liability for corporate management. It
requires all companies (whether doing business abroad or not)
to set up a system of internal controls to provide reasonable
assurance that the company’s records “accurately and fairly

6. reflect” its transactions. The FCPA is discussed in detail in the
last section of this chapter.
· The International Securities Enforcement Cooperation Act
(ISECA) of 1990 clarifies the SEC’s authority to provide
securities regulators of other governments with documents and
information and exempts from Freedom of Information Act
disclosure requirements all documents given to the SEC by
foreign regulators. The ISECA also authorizes the SEC to
impose administrative sanctions on securities buyers and dealers
who have engaged in illegal activities in foreign countries.
Finally, it authorizes the SEC to investigate violations of the
securities law set out in the act that occur in foreign countries.
The ISECA is also discussed in the last section of this chapter.
· The Market Reform Act of 1990 authorizes the SEC to
regulate trading practices during periods of extreme volatility.
For example, the SEC can take such emergency action as
suspending trading when computer program–driven trading
forces the Dow Jones Industrial Average to rise or fall sharply
within a short time period.
· The Securities Enforcement Remedies and Penny Stock
Reform Act of 1990 (the 1990 Remedies Act) gives the SEC
powerful new means for policing the securities industry: cease-
and-desist powers and the power to impose substantial monetary
penalties (up to $650,000) in administrative proceedings. The
1990 Remedies Act also gives the SEC and the federal courts
the following powers over anyone who violates federal
securities law:
1. The imposition of monetary penalties by a federal court for a
violation of the securities law on petition by the SEC.
2. The power of the federal courts to bar anyone who has
violated the fraud provisions of the federal securities laws from
ever serving as an officer or a director of a publicly held firm.
3. The power of the SEC to issue permanent cease-and-desist
orders against “any person who is violating, has violated, or is
about to violate” any provision of a federal securities law.
This act arms the SEC with some of the most sweeping

7. enforcement powers ever given to a single administrative
agency other than criminal enforcement agencies such as the
Justice Department.
· The Private Securities Litigation Reform Act of 1995 (Reform
Act) provides a safe harbor from liability for companies that
make statements to the public and investors about risk factors
that may occur in the future.
· The Securities Litigation Uniform Standards Act of 1998 sets
national standards for securities class action lawsuits involving
nationally traded securities. This act amends the 1933 and 1934
Acts and prohibits any private class action suits in state or
federal court alleging (1) any untrue statement or omission in
connection with the purchase or sale of a covered security or (2)
the defendant’s use of any manipulation or deceptive device in
connection with the transaction.
· The Sarbanes-Oxley Act of 2002 amends the 1933 and 1934
Acts. Sarbanes- Oxley includes provisions dealing with
corporate governance, financial regulation, criminal penalties,
and corporate responsibility, all of which are discussed in detail
in this chapter. The Credit Rating Agency Reform Act of 2006
creates a new regulatory system by which the SEC identifies
and oversees five nationally recognized agencies that issue
credit ratings.
· The Dodd-Frank Act of 2010, a wide-ranging reform of
regulatory actions that seeks to prevent the recurrence of a
major financial catastrophe such as the one that occurred in
2008.
For your convenience, some of the federal securities legislation
is summarized in Table23-1.
Table 23-1 Summary of the Major Federal Securities Legislation
Federal Securities Legislation
Purpose
Securities Act of 1933
Regulates generally the issuance of securities.
Securities Exchange Act of 1934
SEC regulates trading in securities.

8. Public Utility Holding Company Act of 1935
SEC regulates public utility and holding companies through
registration and disclosure processes.
Trust Indenture Act of 1939
SEC regulates the public issuance of bonds and other debt
securities.
Investment Company Act of 1940
SEC regulates the structure and operation of public investment
companies.
Securities Investor Protection Act of 1970
Securities Investor Protection Corporation supervises the
liquidation of financially troubled brokerage firms.
Foreign Corrupt Practices Act of 1977, as amended in 1988
Prohibits the payment of anything of value to influence foreign
officials’ actions.
International Securities Enforcement Corporation Act of 1990
SEC has authority to provide securities regulators of other
governments with information on alleged violators of securities
law in the United States and abroad.
Market Reform Act of 1990
SEC regulates the trading practices during periods of extreme
volatility.
Securities Enforcement Remedies and Penny Reform Act of
1990
Requires more stringent regulation of broker-dealers who
recommend penny-stock transactions to customers.
Securities Enforcement Remedies and Penny Reform Act of
1991
SEC regulates the securities industry through cease-and-desist
powers and threat of substantial monetary penalties.
Private Securities Litigation Reform Act of 1995
SEC provides a safe harbor from liability for companies that
make statements to the public or investors about risk factors
that may occur in the future.
Securities Litigation Uniform Standards Act of 1998
Sets national standards for securities class action lawsuits

9. involving nationally traded securities. Amends the 1933 and
1934 Acts and prohibits any private class action suit in state or
federal court alleging (1) any untrue statement or omission in
connection with the purchase or sale of a covered security or (2)
that the defendant used manipulation or a deceptive device in
connection with the transaction.
Sarbanes-Oxley Act of 2002
Amends the 1933 and 1934 Acts and other federal statutes.
Includes provisions dealing with corporate governance,
financial regulation, criminal penalties, and corporate
responsibility.
Bankruptcy Abuse Prevention and Consumer Protection Act of
2005
SEC has authority to advise debtor corporations that have filed
for reorganization.
Credit Rating Agency Reform Act of 2006
Dodd-Frank Act of 2010
Creates a registration process through the SEC for rating
agencies wishing to become nationally recognized. Congress
sought to meet the need to increase the number of agencies from
the five established by Section 15E of the 1934 Act.
Seeks to amend several statutes and the regulatory process
involving the SEC and other federal agencies of the federal
government. Statute was passed following a major economic
downturn (recession) in 2008.
The Securities and Exchange Commission
Creation and Function
The Securities and Exchange Commission (SEC) was created
under the Securities Exchange Act of 1934 for the purpose of
ensuring that investors receive “full and fair” disclosure of all
material facts with regard to any public offering of securities.
The SEC is not charged with evaluating the worth of a public
offering of securities by a corporation (e.g., determining
whether the offering is speculative); it is concerned only with

10. whether potential investors are provided with adequate
information to make investment decisions. To this end, the
commission was given the power to set up and enforce proper
registration regulations for securities, as well as to prevent
fraud in the registration and trading of securities.
Securities and Exchange Commission (SEC)
The federal administrative agency charged with overall
responsibility for the regulation of securities, including
ensuring that investors receive “full and fair” disclosure of all
material facts with regard to any public offering of securities. It
has wide enforcement powers to protect investors against price
manipulation, insider trading, and other dishonest dealings.
Structure
Exhibit23-1 lays out the structure of the SEC. It has five
commissioners (inclusive of the chairman), who are appointed
by the president with the advice and consent of the Senate; each
serves for a period of five years, and no more than three
commissioners can be of the same political party. The SEC,
based in Washington, DC, has 11 regional offices across the
United States. There are five divisions: Corporation Finance,
Market Regulation, Enforcement, Corporate Regulation, and
Investment Management. (Note in Exhibit 23-1 that in addition
to the 5 major divisions, there are several other important
offices.)
Division of Corporation Finance
The Division of Corporation Finance is responsible for
establishing and overseeing adherence to standards of financial
reporting and disclosure for all companies that fall under SEC
jurisdiction, as well as for setting and administering the
disclosure requirements prescribed by the 1933 and the 1934
Securities Acts, the Public Utility Holding Company Act, and
the Investment Company Act. This division reviews all
registration statements, prospectuses, and quarterly and annual
reports of corporations, as well as their proxy statements. Its
importance in offering informal advisory opinions to issuers

11. (corporations about to make a public offering of stock) cannot
be overemphasized. Accountants, lawyers, financial officers,
and underwriters all rely heavily on advice from this division.
Division of Trading and Markets
This SEC division regulates the national security exchanges
(such as the NYSE), as well as broker-dealers registered under
the Investment Advisers Act of 1940. Through ongoing
surveillance of both the exchanges and broker-dealers, the
Division of Market Regulation seeks to discourage manipulation
or fraud in the issuance, sale, or purchase of securities. It can
recommend to the full commission the suspension of an
exchange for up to one year, as well as the suspension or
permanent prohibition of a broker or dealer because of certain
types of conduct. In addition, the division provides valuable
informal advice to investors, issuers, and others on securities
statutes that come within the SEC’s jurisdiction.
Division of Enforcement
The Division of Enforcement is responsible for the review and
supervision of all enforcement activities
recommended by the SEC’s other divisions and regional offices.
It also supervises investigations and the initiation of injunctive
actions.
Division of Economic and Risk Analysis
This division integrates financial economics and rigorous data
analytics into the core mission of the SEC. It is involved across
the entire range of SEC activities, including policy-making,
rule-making, enforcement, and examination.
Division of Investment Management
This SEC division administers the ICA of 1940 and the
Investment Advisers Act of 1940. All investigations arising
under these acts dealing with issuers and dealers are carried out
by this Division of Investment Management.
Exhibit 23-1 The Securities and Exchange Commission
St. Patrick’s Day Bailout of an Investment Banking Firm (Bear
Stearns, Inc.) by the U.S. Taxpayers

12. Bear Stearns, Inc. (Bear), an 85-year-old investment banking
firm, was headed for insolvency on the weekend of March 15
and 16, 2008, and planned for a bankruptcy filing to take place
on Monday, March 17 (St. Patrick’s Day). Fear of a collapse of
the financial system led federal regulators—inclusive of (1) the
independent Federal Reserve Board (Federal Reserve), (2) the
Secretary of the Treasury and his many offices within the
Treasury Department, (3) the Office of the Comptroller, (4) the
SEC, and (5) independent advisers from the private sector (e.g.,
Black Rock, Inc.)—to urge Bear’s board of directors to sell the
firm to JPMorgan Chase & Company (J.P. Morgan), at a price of
$2 a share, or $236 million, in a stock-swap transaction for 39.9
percent of Bear. (On the previous Friday, March 14, the stock
value closed on the New York Stock Exchange at $30 a share,
that is, at a market value of $3.54 billion.) In addition, the
Federal Reserve agreed to fund up to $30 billion of Bear’s
nonliquid assets. Regardless of whether the transaction went
through, J.P. Morgan would have the opportunity to purchase
the headquarters of Bear.
This transaction took place in the midst of a nationwide credit
crunch caused in part by cash outflows from subprime and
prime mortgage holders, as well as margin calls on derivative
contracts held by Bear and other investment banking firms. The
market value of Bear’s stock dropped to $11 per share in the
days following the announcement on March 17.
Response to this “bailout” or “savior” of the economy (U.S. or
world) was diverse, depending on the responder:
· Investors (individual and some institutional). Investors saw
this transaction as a “steal” by J.P. Morgan, and many believed
that the market itself would have solved the problem. Many
threatened litigation to stop the bailout. They pointed out that
unlike other bailouts (e.g., Chrysler), the taxpayers were not
assured any return on their investment. Further, there was no
transparency as to the terms of the secured interest (collateral)
for the $30 billion the Federal Reserve was offering to
guarantee Bear’s nonliquid assets.

13. · Employees of Bear. Approximately 14,000 employees saw
their jobs disappear, along with their life savings. Many had
401(k) funds as well as private pension funds invested in Bear
stock, which was now worth little. After years of loyalty, they
believed that the board and senior management of Bear had
“sold them out” from a moral perspective.
· Government officials. The chairman of the Federal Reserve
and the chairman of the SEC testified before committees of
Congress that they had varying degrees of advance notice (48 to
72 hours) of the seriousness of Bear Stearns’ problems. Their
response (as set out earlier) was thus dictated by this short
period. The failure to find a buyer for Bear Stearns could have
led to a run on investment as well as commercial banks
worldwide. The chairman of the Federal Reserve emphasized
that this was not a “bailout” but rather an action required to
save the banking system, which the Federal Reserve is directed
to do by its enabling legislation.
· Political actors. This transaction took place in the midst of a
national primary campaign by the Democratic Party, which had
two candidates (Hillary Clinton and Barack Obama), and a
noncontested campaign by the Republican Party (John McCain).
Both parties showed their concern in the House and Senate.
· Private platforms and “dark pools.” Trading with increased
regulation has led to the establishment of bourses (such as the
New York Stock Exchange) or private platforms where trading
is hidden from public view. Regulators are thus worried that
this development could obscure the true price of a stock. (See J.
Creswell and P. Latman, New York Times, Sept. 30, 2010, F-6.)
Critical Thinking About The Law
1. What values were in conflict for the parties to the St.
Patrick’s Day bailout described previously?
Clue: The parties included, among others, the Federal Reserve,
the U.S. Secretary of the Treasury and the Treasury Department,
the SEC, and the president of the United States, as well as
employees of Bear Stearns. Chapter 1 discusses the values
involved in answering this question.

14. 2. Should federal and state “bailouts” of private-sector firms
such as Bear Stearns take place as a matter of general principle?
Why or why not?
Clue: What values are in conflict for federal and state
governments? What about taxpayers—or are they represented?
Politicians? Lobbyists?
Electronic Media, the Age of the Internet, and SEC Internal
Functions
Through internal rulings, the SEC has recognized that the use of
“electronic media . . . enhances the efficiency of the securities
market by allowing for the rapid dissemination of information
to investors and financial markets in a more cost-efficient,
widespread and equitable manner than traditional paper
methods.” The SEC has provided interpretive guidance for the
use of electronic media for the delivery of information required
by the federal securities law. The SEC has defined electronic
media to include audiotapes, videotapes, CD-ROM, email,
bulletin boards, Internet websites, and computer networks.
Further, securities regulators have authorized the use of social
media sites such as Twitter and Facebook for communicati ons
by companies to investors and shareholders (April 2, 2013, New
York Times, B-1).
The SEC has established the EDGAR (electronic data gathering,
analysis, and retrieval) computer system, which performs
automated collection, validation, indexing, acceptance, and
dissemination of reports required to be filed with the SEC. The
SEC requires all domestic companies to make their filings on
EDGAR, except those exempted for hardship. EDGAR filings
are posted at the SEC website 24 hours after the date of
filing.Dodd-Frank Wall Street Reform and Consumer Protection
Act of 2010
In July 2010, Congress passed a bill that wrought a massive
overhaul of federal government financial regulations and
seemed to affect every sector of the economy. This piece of
legislation became known as the Dodd-Frank bill (statute)1 so
named after its major sponsors: Senator Dodd (D-Conn.), who

15. was chairman of the Senate Banking Committee, and
Congressman Frank (D-Mass.), who was chairman of the House
Financial Affairs Committee. This bill passed Congress in the
midst of a recession and after a collapse of the financial markets
in 2008. It sought to respond to the major causes of the
financial crises. Actions taken by Congress, outlined in the
following subsection, sought to prevent problems similar to
those faced by the nation in the period between 2008 and 2010.
Nonetheless, a 2011 survey of 94 fund advisers concluded that
three-quarters of those surveyed indicated that Dodd-Frank
regulations did not change their way of doing business. (See
Walt King, Professor, St. Thomas University, Minneapolis,
reprinted in parts, Bloomberg Newsweek, October 22, 2013.) As
of June 2014, four years after passage of the Act, 208 of 398
proposed rules missed their deadlines. Industry groups
continued to lobby to defeat the Act while seeking to tailor the
proposed rules to their interests. Some rules are being
challenged in court.2
1 Pub. L. No. 111–203 (2010).
2 Dodd-Frank Progress Report, June 2014, Davis Polk at
2.Oversight of Financial Problems By Regulatory Agencies
· A new Financial Stability Oversight Council (Council) was
established by the Dodd-Frank Act. The council is made up of
heads of major regulatory agencies (e.g., Treasury, SEC, FDIC,
the Federal Reserve). The council will identify banks or
nonbanks that pose a threat to the financial system. The Fed,
with the approval of the council, will have the power to break
up large firms. It could also require such firms to increase their
reserves against future losses.
· The Fed was to be subject to oversight by the Government
Accountability Office for a short period during 2008,
particularly as to its loans via the discount window.
· Hedge funds larger than $100 million must register with the
SEC and provide some information as to trades and their
individual portfolios.
· The Office of Thrift Supervision will be absorbed into the

16. Office of the Comptroller of the Currency.Risk Taking By Large
Banks and Nonbanks
Bank holding companies (e.g., Citigroup and Bear Stearns)
participated in speculative trades involving mortgage-backed
securities and other financial instruments (e.g., derivatives).
When these speculative bets went under, the institutions
involved could not sell the assets involved, which thus became
known as “toxic” assets. The federal government had to spend
billions in taxpayer money to bail out these companies. They
are presently repaying these loans (at least in part), plus interest
and/or preferred shares, to the federal government.
The Dodd-Frank legislation was also intended to prevent FDIC-
insured institutions from making speculative trades and to
require these entities to sell their interests in hedge funds and
private equity funds; only 3 percent of their capital could
remain invested in such funds. Investment banks also had to set
aside reserves to cover losses. Originators of mortgage
securities must hold 5 percent of the credit risk, thus retaining
an interest in the performance of the securities. For reasons
other than speculation, banks will be allowed to trade in a
“proprietary” manner. Banks can also continue to buy or sell
from their own accounts to hedge against other
investments.Executive Compensation
Compensation to executives of the largest financial firms was
based on quarterly earnings. Earnings increased as these firms
sold mortgage-backed securities and derivatives—until the
housing “bubble burst.” When subprime mortgages began to
fail, the federal government had to bail out the large financial
institutions that had speculated heavily in these instruments and
derivatives based on them. Anger over the enormous
compensation paid to executives of these institutions became a
major public issue, as taxpayers saw their “bailout” tax dollars
apparently being used to reward executives for serious
mismanagement and poor performance.
The Dodd-Frank Act did some things to deal with executive
compensation:

17. · Shareholders were allowed a nonbinding vote on executive
compensation, as directed by the SEC.
· Only independent directors of a company could sit on
compensation committees of the board.
· Companies would be required to take back compensation if it
was based on accounting statements that were later found to be
inaccurate.Too Big To Fail
Nonbank financial companies such as insurance giant AIG could
not be legally shut down during the 2008 crisis. The government
bailed them out, believing that their bankruptcy would bring
about the collapse of the financial system both in the United
States and markets worldwide.
The new statute gave the FDIC authority to shut down banks
and nonbank financial firms. Taxpayers initially would foot the
bill for liquidation, but the money was eventually to be returned
to the federal coffers from shareholders and unsecured
creditors. Further, the statute ordered an increase in the reserve
ratio of the FDIC, but specified that small depository
institutions (those with less than $10 billion in consolidated
assets) were exempt from making such increases.
A fund of $11 billion was initially established within the
Troubled Asset Relief Program (TARP) to cover the costs of
shutting down companies. In theory, the government could then
shut down huge companies without the taxpayers having to bail
them out.Credit Rating Agencies
Credit rating agencies (such as Moody’s and Standard & Poor’s)
evaluated and rated billions in mortgage securities; both the
private sector and governments at all levels relied on these
ratings. These agencies were paid by the same companies that
were issuing and trading in mortgage securities and other forms
of debt (and thus had a vital interest in positive ratings). When
the housing market crashed, many of the rating agencies sought
to downgrade the ratings they had given mortgage securities and
other assets.
· Despite what appeared to be a conflict of interest, Congress
could not agree on a format to replace the ratings agencies. The

18. Dodd-Frank legislation was intended to make it easier to sue
credit rating agencies. In addition, this statute eliminated any
federal requirement that banks and other investors rely on
ratings set out by these agencies.
· The legislation orders the SEC to study ways to eliminate
ratings shopping by issuers.
· It allows the SEC to deregister ratings agencies that have a
bad record of violating financial regulations.
· All ratings agencies now have to disclose how they arri ve at
ratings and how they comply with conflict-of-interest
regulations.Derivatives
Derivatives are synthetic securities that are dependent upon the
movement of underlying variables (e.g., interest rates,
commodity prices, and security indexes). They are used largely
as hedges against risk; often, they are a form of insurance.
Many times derivatives are negotiated privately between
companies. For example, company X agrees to make a number
of payments to company Y, which, in turn, will pay up if a bond
issuer Z defaults. When the terms of derivatives are negotiated
privately, they are more difficult for regulators to track and
assess for risk. They represent a market of approximately $600
trillion worldwide. Derivatives played a huge role in the fall of
AIG and the large government bailout that ensued.
The Dodd-Frank statute sought to standardize derivatives traded
on exchanges to increase transparency. Derivatives must now be
routed through a clearinghouse to ensure that companies using
them post collateral (margins). Banks will have to spin off their
riskier derivatives and trade them through a subsidiary. Those
derivatives will include any that deal in energy, mortgages,
credit-default swaps, commodities, and agriculture. Banks can
continue to trade derivatives in-house based on interest rates
and foreign exchanges and for purposes of hedging risk. The
Commodity Futures Trading Commission (CFTC) and the SEC
will be the chief regulators of the derivatives market, both
drafting and interpreting the regulations. There continues to be
some debate over rules set forth to regulate derivatives and

19. swaps.Consumer Protection
When Dodd-Frank was written, no regulatory authority had the
sole responsibility for protecting consumers from predatory
lenders. None of the regulatory agencies considered consumer
protection their number-one priority. Mortgage brokers steered
huge numbers of home buyers into subprime mortgages, often
without much attention to the buyers’ ability to pay based on
their income. When the credit markets froze up and the 2008
recession came on, these consumers were the first to suffer.
The Dodd-Frank Act developed a new independent regulatory
agency, called the Consumer Financial Protection Bureau
(Bureau), which was originally located within the Federal
Reserve Board (later it was moved to the Treasury Department).
The head of the Bureau is appointed by the president for a five -
year term. The Bureau is guaranteed a percentage of the annual
Fed’s operating expenses. Initially, the formula agreed upon
will bring in $500 million annually, although the Bureau may
request another $200 million yearly. Staff for this independent
agency was drawn initially from several federal agencies,
including the Federal Reserve, Federal Trade Commission,
Federal Deposit Insurance Corporation, Department of Housing
and Urban Development, and National Credit Union. The
purpose of the Bureau is to police the financial markets on
behalf of savers and borrowers. It is charged with regulating
such firms as:
· Banks that issue consumer loans, checking accounts, and/or
credit cards
· Mortgage lenders, services, brokers, appraisers, and settlement
firms
· Credit counseling firms
· Debt collectors and consumer reporting agencies
· Private-sector student loan companiesExemptions
Under Dodd-Frank, Congress has exempted auto dealers from
the new agency’s jurisdiction, even though they originate nearly
80 percent of all auto loans. Also, 99 percent of the nation’s
7,939 banks (as of this writing) and thrifts (those with less than

20. $10 billion in assets) will not fall under the Bureau’s rules.
These banks will instead be examined by traditional regulators,
although the Bureau’s rules will be enforced by such examiners.
These exemptions at the federal level are a result of strong
lobbying at the national and local levels.
The Dodd-Frank statute exempts payday lenders and check-
cashing firms as well as auto dealers, leaving these entities to
local and state regulation. It also failed to deal with Fannie Mae
and Freddie Mac, the mortgage bodies that were responsible for
approximately 90 percent of the subprime mortgages that gave
rise to the need for this statute. The Dodd-Frank Act also
provided for limited regulation of asset management and mutual
fund companies.Regulation of The Regulators By A Court of
Law
As with all statutes passed by Congress, the regulating agencies
charged with carrying out the Dodd-Frank law are important to
its actual enforcement. (See the discussion on rulemaking
in Chapter 18 of this text.) With this particular statute, some 15
separate agencies have been involved in rulemaking and
enforcement. Some of these agencies include the Federal
Reserve Board, the SEC, the Treasury Department, the Financial
Stability Oversight Council, the FDIC, the Commodities Future
Trading Commission, the FTC, the OCC, and the Office of
Financial Research.
Following the completion of administrative agency rulemaking,
there will ordinarily be appeals by those affected. The federal
courts of appeals normally hear these cases (see Chapter 18 on
judicial review of rulemaking).The Sarbanes-Oxley Act of 2002
Following financial and accounting scandals involving Martha
Stewart Living, Inc., Tyco International, Inc., Enron
Corporation, and others, Congress passed a bipartisan measure
in 2002 sponsored by Senator Paul Sarbanes (D-Md.) and
Representative Michael Oxley (R-Ohio) and signed into law by
President Bush.3 The act requires a new approach to corporate
governance. Chief executive officers (CEOs) and chief financial
officers (CFOs) must now certify that statements and reports are

21. accurate, under pain of imprisonment if intent to mislead can be
shown (Exhibit 23-2). The Public Company Accounting
Oversight Board (PCAOB) was established to regulate
accounting firms.4 The SEC was given
3 H.R. 3762. The act became effective on August 29, 2002; Pub.
L. No. 107–204 (codified as Exchange Act § 4), 15 U.S.C. §
78(d)–3. See Greg Ip, “Maybe U.S. Markets Are Still Supreme:
Study Finds No Proof that Sarbanes-Oxley Tarnishes the
Allure,” Wall Street Journal, C-1 (Apr. 27, 2007).
4 In Free Enterprise Fund v. Public Company Accounting
Oversight Board, 129 S. Ct. 2378 (2009), the board’s
membership rules were found to be constitutionally wanting in
that members could be removed only for good cause. The
Supreme Court said that this arrangement violated the
separation of powers doctrine and the need of the president to
manage the executive branch. The Court ruled 5–4 that the SEC
will be able to remove members of the PCAOB at will.
However, the Court unanimously held that the Sarbanes-Oxley
Act remained fully operational as law.
Exhibit 23-2 Statement Under Oath of Principal Executive
Officer and Principal Financial Officer Regarding Facts and
Circumstances Relating to Exchange Act Filings
new, expansive powers regarding private civil actions, as well
as administrative actions. Some of the provisions of Sarbanes -
Oxley are outlined in the following subsections. The SEC, using
its rulemaking power, is responsible for implementing these
provisions.Corporate Accountability
Sarbanes-Oxley requires CEOs and CFOs to certify financial
reports. Officers must forfeit profits and bonuses if earnings are
restated by a company due to securities fraud. Companies are
required to disclose material changes in their financial
condition immediately. Section 404 of this Act has been the
source of much criticism from the business community,
especially with regard to its impact on smaller companies. The
paperwork is extensive. Management must assure the SEC of the
effectiveness of internal controls for financial reporting

22. purposes. Disclosure is required by Sections 404, 406, and 407
of this Act.New Accounting Regulations
A five-member board with legislative and disciplinary power
was established: the Public Company Accounting Oversight
Board. A majority of the board is independent from publicly
held accounting companies. The board is funded by publicly
held companies overseen by the SEC.
The act prohibits auditors (accounting firms) from offering nine
specific types of consulting services to their corporate
clients.Criminal Penalties
· The maximum penalty for securities fraud was raised to 25
years.
· A new crime was created under this act for destruction,
alteration, or fabrication of records; the maximum penalty
permitted under the act is 20 years imprisonment.
· Penalties are increased for CEOs or CFOs who knowingly
certify a report that does not meet the requirements of this act;
they are now subject to $1 million in fines and up to 5 years in
prison. If officers “willfully” certify a noncomplying report, the
penalty may be up to $5 million in fines or 20 years in prison or
both.
· Under this act, penalties for mail and wire fraud are raised to
20 years; for defrauding pension funds, up to 10 years.
Other Sarbanes-Oxley provisions include:
· Lengthening of the statute of limitations for securities fraud to
five years or two years from discovery.
· Protection for whistleblowers who report wrongdoing to
employers or participate in a government investigation
involving a potential securities violation.
· Preventing officials who are facing court judgments based on
fraud charges from using bankruptcy laws to escape liability.
· Prohibiting certain loans to directors and officers if the loans
come from public and private companies that are filing initial
public offerings (IPOs). Arranging, receiving, or maintaining
personal loans, except consumer or housing loans, is forbidden
under this act.

23. The Securities Act of 1933
In the depths of the Great Depression, Congress enacted this
first piece of federal legislation regulating securities. Its major
purpose, as we have said, was to ensure full disclosure on new
issues of securities.Definition of A Security
When most people use the word securities, they mean stocks or
bonds that are held personally or as part of a group in a pension
fund or a mutual fund. Congress, the SEC, and the courts,
however, have gone far beyond this simple meaning in defining
securities. Section 2(1) of the 1933 Act defines the
term security as:
security
A stock, a bond, or any other instrument of interest that
represents an investment in a common enterprise with
reasonable expectations of profits that are derived solely from
the efforts of those other than the investor.
any note, stock, treasury stock, bond, debenture, evidence of
indebtedness, certificate of interest or participation in any profit
sharing agreement, collateral trust certificate, reorganization
certificate or subscription, transferable share, investment
contract, voting trust certificate, certificate of deposit for a
security, fractional undivided interest in oil, gas or other
mineral rights, or, in general, any interest or instrument
commonly known as a security.*
The words “or, in general, any interest or instrument commonly
known as a security” have led to various interpretations by the
SEC and the courts of what constitutes a security. In the
landmark case of SEC v. Howey,5 the Supreme Court sought to
discover the economic realities behind the façade or form of a
transaction and set out specific criteria for the courts to use in
defining a security. In Howey, the Court held that the sale to the
public of rows of orange trees, with a service contract under
which the Howey Company cultivated, harvested, and marketed
the oranges, constituted a security within the meaning of
Section 2(1) of the 1933 Act. Its decision was based on three
elements or characteristics: (1) There existed a contract or

24. scheme whereby an individual invested money in a common
enterprise, (2) the investors had reasonable expectations of
profits, and (3) the profits were derived solely from the efforts
of persons other than the investors. These criteria are examined
in detail here because they have been the basis of considerable
litigation.
5 328 U.S. 293 (1946).Common Enterprise
The first element of the Howey test has been interpreted by
most courts as requiring investors to share in a single pool of
assets so that the fortunes of a single investor are dependent on
those of the other investors. For example, commodities accounts
involving commodities brokers’ discretion have been held to be
“securities” on the grounds that “the fortunes of all investors
are inextricably tied” to the success of the trading
enterprise.Reasonable Expectations of Profit
The second element of the Howey test requires that the investor
enter the transaction with a clear expectation of making a profit
on the money invested. The U.S. Supreme Court has held that
neither an interest in a noncontributory, compulsory pension
plan nor stock purchases by residents in a low-rent cooperative
constitute securities within the definition of Howey. In the case
involving the pension plan,6 the Court stated that the employee
expected funds for his pension to come primarily from
contributions made by the employer rather than from returns on
the assets of the pension plan fund. Similarly, in the low-rent
housing case,7 the Court decided that shares purchased solely to
acquire a low-cost place to live were not bought with a
reasonable expectation of profit.
6 International Brotherhood of Teamsters, Chauffeurs,
Warehousers, & Helpers of America v. Daniel, 439 U.S. 551
(1979).
7 United Housing Foundation, Inc. v. SEC, 423 U.S. 884
(1975).Profits Derived Solely from the Efforts of Others
The third element of the Howey test requires that profits come
“solely” from the efforts of people other than the investors. The
word solely was interpreted to mean that the investors can exert

25. “some efforts” in bringing other investors into a pyramid sales
scheme, but that the “undeniably significant ones” must be the
efforts of management, not the investors.
The following case sets out a summary of a U.S. Supreme Court
decision on what constitutes a security. Case 23-1 Securities
and Exchange Commission v. Edwards
United States Supreme Court 540 U.S. 389 (2004)
Charles Edwards, the CEO and sole shareholder of ETS
Payphones, Inc., offered the public investment opportunities in
pay phones. The arrangement involved an investor paying
$7,000 to own a pay phone. Each investor was offered $82 per
month under a leaseback and manage ment arrangement with
ETS. The investors also were to recoup their $7,000 investment
at the end of five years. ETS did not generate enough revenue to
pay its investors, so it filed for bankruptcy. The SEC sued ETS
for civil damages arising from alleged violations of federal
securities laws. The SEC won at the trial level. The district
judge ruled that pay phone leaseback and management
agreements were investment contracts covered by federal
securities laws. The 11th Circuit Court of Appeals reversed this
judgment and ruled in favor of ETS. The SEC was granted
certiorari to have the Supreme Court review the definition and
application of the term security.Justice O’Connor
Congress’s purpose in enacting the securities laws was to
regulate investments, in whatever form they are made and by
whatever name they are called. To that end, it enacted a broad
definition of security, sufficient to encompass virtually any
instrument that might be sold as an investment, investment
contract is not itself defined.
The test for whether a particular scheme is an investment
contract was established in our decision in SEC v. W. J. Howey
Co., 66 S. Ct. 1100 (1946). We look to whether the scheme
involves an investment of money in a common enterprise with
profits to come solely from the efforts of others. This definition
embodies a flexible rather than a static principle, one that is
capable of adaptation to meet the countless and variable

26. schemes devised by those who seek the use of the money of
others on the promise of profits. . . .
There is no reason to distinguish between promises of fixed
returns and promises of variable returns for purposes of the test.
. . . In both cases, the investing public is attracted by
representations of investment income, as purchasers were in this
case by ETS’s invitation to watch the profits add up. Moreover,
investments pitched as low-risk (such as those offering a
“guaranteed” fixed return) are particularly attractive to
individuals more vulnerable to investment fraud, including
older and less sophisticated investors. Under the reading
respondent advances, unscrupulous marketers of investments
could evade the securities laws by picking a rate of return to
promise. We will not read into the securities laws a limitation
not compelled by the language that would so undermine the
laws’ purposes.
Respondent protests that including investment schemes
promising a fixed return among investment contracts conflicts
with our precedent. We disagree.
Given that respondent’s position is supported neither by the
purposes of the securities laws nor by our precedents, it is no
surprise that the SEC has consistently taken the opposite
position, and maintained that a promise of a fixed return does
not preclude a scheme from being an investment contract. It has
done so in formal adjudications and in enforcement actions.
The Eleventh Circuit’s perfunctory alternative holding, that
respondent’s scheme falls outside the definition because
purchasers had a contractual entitlement to a return, is incorrect
and inconsistent with our precedent. We are considering
investment contracts. The fact that investors have bargained for
a return on their investment does not mean that the return is not
also expected to come solely from the efforts of others. Any
other conclusion would conflict with our holding that an
investment contract was offered in Howey itself.
We hold that an investment scheme promising a fixed rate of
return can be an investment contract and thus a security subject

27. to the federal securities laws.*
Reversed and remanded, for the SEC.Registration of Securities
Under The 1933 ActPurpose and Goals
The 1933 Act requires the registration of nonexempt securities,
as defined by Section 2(1), for the purpose of full disclosure so
that potential investors can make informed decisions on whether
to buy a proposed public offering of stock. As we noted earlier
in this chapter, the 1933 Act does not authorize the SEC or any
other agency to decide whether the offering is meritorious and
should be sold to the public.Registration Statement and Process
Section 5 of the 1933 Act requires that to serve the goals of
disclosure, a registration statement consist of two parts—
the prospectus and a “Part II” information statement—to be
filed with the SEC before any security can be sold to the public.
The registration statement provides (1) material information
about the business and property of the issuer; (2) description of
the significant provisions of the offering; (3) the use to be made
of the funds garnered by the offering and the risks involved for
investors; (4) the managerial experience, history, and
remuneration of the principals, including pensions or stock
options; (5) financial statements certified by public accountants
attesting to the firm’s financial health; and (6) pending
lawsuits. The prospectus must be given to every prospective
buyer of the securities. Part II is a longer, more detailed
statement than the prospectus. It is not given to prospective
buyers, but is open for public inspection at the SEC.
prospectus
The first part of the registration statement the SEC requires
from issuers of new securities. It contains material information
about the business and its management, the offering itself, the
use to be made of the funds obtained, and certain financial
statements.Disclosure
Issuers may use the detailed form (Form S-1). Effective
December 4, 2005, the SEC amended the disclosure requirement
noted here to recognize four categories of issuers:
1. A nonreporting issuer that is not required to file reports

28. under the 1934 Act. It must use Form S-1, which it did not have
to do previously.
2. An unseasoned issuer is an issuer that has reported
continuously under the 1934 Act for at least three years. Such
an issuer must use Form S-1, but is permitted to disclose less
detailed information and to incorporate some information by
reference to reports filed under the 1934 Act.
3. A seasoned issuer is an issuer that has filed continuously
under the 1934 Act for at least one year and has a minimum
market value of publicly held voting and nonvoting stock of $75
million. Such an issuer is permitted to use Form S-03, thus
disclosing even less detail in the 1933 Act registration and
incorporating even more information by reference to 1934 Act
reports.
4. A well-known seasoned issuer is an issuer that has filed
continuously for at least one year under the 1934 Act.
During the registration process, the SEC generally bans public
statements by some issuers, other than those contained in the
registration statement, until the effective date of registration.
There are three important stages in this process: prefiling,
waiting, and posteffective periods. They are summarized
in Table 23-2.Prefiling Period
Section 5(c) of the 1933 Act prohibits any offer to sell or buy
securities before a registration statement is filed. The key
question here is what constitutes an “offer.” Section 2(3) of the
act exempts from the definition any preliminary agreements or
negotiations between the issuer and the underwriters or among
the underwriters themselves. Underwriters are investment
banking firms that purchase a securities issue from the issuing
corporation with a view to eventually selling the securities to
brokerage houses, which, in turn, sell them to the public. These
underwriters—such as Goldman Sachs, Kidder Peabody, and
First Boston—may arrange for distribution of the public
offering of securities, but they cannot make offerings or sales to
dealers or the public at this time. During theTable 23-2 Stages
in the Securities Registration Process

29. Stage
Prohibitions
1. Prefiling period
No offer to sell or buy securities may be made before a
registration statement is filed.
2. Waiting period
SEC rules allow oral offers during this period but no sales. A
“red herring” prospectus that disavows any attempt to offer or
sell securities may be published.
3. Posteffective period
Registration generally becomes effective 20 days after the
registration statement is filed, although effective registration
may be accelerated or postponed by the SEC. Offer and sale of
securities are permitted thereafter.
prefiling period, the SEC regulations also forbid sales efforts in
the form of speeches or advertising by the issuer that seeks to
“hype” the offering or the issuer’s business. However, a press
release setting forth the details of the proposed offering and the
issuer’s name, without mentioning the underwriters, is generally
permitted.
underwriter
Investment banking firm that agrees to purchase a securities
issue from the issuer, usually on a fixed date at a fixed price,
with a view to eventually selling the securities to brokers, who,
in turn, sell them to the public.Waiting Period
In the interim between the filing and the time when registration
becomes effective, SEC rules allow oral offers but not sales.
The SEC examines the prospectus for completeness during this
period. SEC rules permit the publication of a written
preliminary, or red herring, prospectus that summarizes the
registration but disavows in red print (hence, its name) any
attempt to offer or sell securities. Notices of underwriters
containing certain information about the proposed issue are also
allowed to appear in newspapers during this period, but such
notices must be bordered in black and specify that they are not
offers to sell or solicitations to buy securities.

30. red herring
A preliminary prospectus that contains most of the information
that will appear in the final prospectus, except for the price of
the securities. The “red herring” prospectus may be distributed
to potential buyers during the waiting period, but no sales may
be finalized during this period.Posteffective Period
The third stage in the process is called the posteffective
period because the registration statement usually becomes
effective 20 days after it is filed, although sometimes the SEC
accelerates or postpones registration for some reason.
Underwriters and lenders can begin to offer and sell securities
after the 20 days or upon commission approval, whichever
comes first.
Under Section 8 of the 1933 Act, the SEC may issue a “refusal
order” or “stop order,” which prevents a registration statement
from becoming effective or suspends its effectiveness, if the
staff discovers a misstatement or an omission of a material fact
in the statement. Stop orders are reserved for the most serious
cases. In general, the issuers are forewarned by the SEC in
informal letters of comment or deficiency before a stop order is
put out, so they have the opportunity to make the necessary
revisions. The commission may shorten the usual 20-day period
between registration and effectiveness if the issuer is willing to
make the modifications requested by the SEC staff. This
procedure, in fact, is the present trend.
letter of comment or deficiency
Informal letter issued by the SEC indicating what corrections
must be made in a registration statement for it to become
effective.
The 1933 Act requires that a prospectus be issued upon every
sale of a security in interstate commerce except sales by anyone
who is not an “issuer, underwriter or dealer.” If a prospectus is
delivered more than 9 months after the effective date of
registration, it must be updated so that the information is not
more than 16 months old. The burden is on the dealer to update
all material information about the issuer that is not in the

31. prospectus. Dealers who fail to do so risk civil liability under
Sections 12(1) and 12(2) of the 1933 Act.Communications
The December 2005 revisions brought flexibility to rules
regarding written communication by issuers before and during
registration of securities. This flexibility depended on cer tain
characteristics of the issuer, including (1) the type of issuer, (2)
the issuer’s history of reporting, and (3) the issuer’s market
capitalization. These new rules created a type of written
communication called a “free-writing prospectus,” which is any
written offer, including electronic communication (as defined
previously) other than a prospectus required by statute. The new
rules provide that:
· Well-known seasoned issuers may engage at any time in oral
and written communications, including a free-writing
prospectus, subject to certain conditions.
· All reporting issuers (unseasoned issuers, seasoned issuers,
and well-known seasoned issuers) may at any time continue to
publish regularly released factual business information and
forward-looking information (predictions).
· Nonreporting issuers may at any time continue to publish
factual business information that is regularly released and
intended for use by persons other than in their capacity as
investors or potential investors.
· Communications by issuers more than 30 days before filing a
registration statement are permitted so long as they do not refer
to a securities offering that is the subject of a registration
statement.*
All issuers may use a free-writing prospectus after the filing of
the registration statement, subject to certain conditions.Shelf
Registration
Traditionally, the marketing of securities has taken place
through underwriters who buy or offer to buy securities and
then employ dealers across the United States to sell them to the
general public. With Rule 415, the SEC has established a
procedure, called shelf registration, that allows a large
corporation to file a registration statement for securities it may

32. wish to sell over a period of time rather than immediately. Once
the securities are registered, the corporation can place them on
the “shelf” for future sale and need not register them again. It
can then sell these securities when it needs capital and when the
marketplace indicators are favorable. A company that files a
shelf-registration statement must file periodic amendments with
the SEC if any fundamental changes occur in its activities that
would be material to the average prudent investor’s decision to
invest in its stock.
shelf registration
Procedure whereby a large corporation can file a registration
statement for securities it wishes to sell over a period of time
rather than immediately.“Fictional Filings” with the SEC
Like an extraordinary whimsical tale, Universal Express (not
American Express), a small company of alleged postal stores,
was able to lose money faster than it issued news releases. The
SEC filed suit for fraud against Universal (Company) in 2007,
because the company continued to issue billions of unregistered
shares following the issuance of news releases. The unregistered
shares were used to finance the company and its officers. In
2004, a federal district court in New York ruled that the
company and its officers had violated the securities laws and
ordered them to pay $21.9 million. The CEO, Richard Altomare,
was barred from being an officer or a director of any public
company.
Despite the court’s order, Universal continued to issue news
releases forecasting $9 million in annual revenues from 9,000
private postal stores. Judge Lynch of the federal district cour t
ruled that there was no evidence the company had any such
network of stores. As of the first quarterly report in 2007,
Universal said that the 9,000 stores were “members” of its
network regardless of the findings of the federal judge. In its
suit, the SEC alleged that the company had issued 500 million
unregistered shares over 33 months in violation of the 1933
Securities Act and other federal statutes (the basis for the
original SEC suit). The company claimed that its old stock

33. issues (before 2004) were allowed by a bankruptcy court ruling.
Judge Lynch found such claims to be baseless and dismissed
Universal’s justification.
As of 2007, Universal Express continued to trade billions of
shares weekly in an over-the-counter penny-stock bulletin board
in California. Shares have never sold at more than $0.40 a
share. In 2006, Universal lost $18.9 million on revenue of $1.1
million. Altomare acted as the sole member of Universal’s
board of directors and received a salary in 2006 of $650,000
(paid for with the sale of unregistered stock). As of 2007, news
releases continue to be issued, claiming a “network of postal
stores” in the United States producing annual revenues of $9
million.a
aSEC v. Universal Express, Inc. (SDNY), reported at No. 2267,
§ 94165 (2007).
In April of 2008, Altomare was found in contempt of court for
failing to make payments on the judgment issued against him,
and in May of that year he was sent to federal prison for 80
days. In 2010, he wrote a book proclaiming his innocence and
arguing that he was prosecuted for being a whistleblower
against the SEC.
Meanwhile, in 2011, a federal judge ruled that two Florida
penny-stock traders who issued unregistered shares of the
defunct Universal Express must pay fines of $14 million and
$5.3 million.b
b“Universal Express Penny Stock Traders Must Pay $14 M,” by
Brian Bandell. Published by South Florida Business Journal, ©
2011. Available at www.bizjournals.com/southflorida
/news/2011/09/19/universal-express-penny-stock-
traders.html.Securities and Transactions Exempt
From Registration Under The 1933 Act
Section 5 of the 1933 Act requires registrations of any sale by
any person of any security unless specifically exempted by the
1933 Act. The cost of the registration process, in terms of
hiring lawyers, accountants, underwriters, and other financial
experts, makes it appealing for a firm to put a transaction

34. together in such a way as not to fall within the definition of a
security. If that is impossible, firms often attempt to meet the
requirements of one of the following four classes of exemptions
to the registration process (summarized in Table 23-3).Private
Placement Exemptions
Section 4(2) of the 1933 Act exempts from registration
transactions by an issuer that do not involve any public
offering. Behind this exemption is the theory that institutional
investors have the sophisticated knowledge necessary to
evaluate the information contained in a private placement and,
thus, unlike the average investor, do not need to be protected by
the registration process set out in the 1933 Act. The private
placement exemption is often used in stock option plans, in
which a corporation issues securities to its own employees for
the purpose of increasing productivity or retaining top-level
managers. Because various courts had different views on what
factual situations qualified for the private placement exemption,
the SEC published Rule 146, which seeks to clarify the criteria
used by the commission in allowing this exemption.
The issuer should follow the statutory guidelines (rules) listed
here.
1. The number of purchasers of the company’s (issuer’s)
securities should not exceed 35. If a single purchaser buys more
than $150,000, that purchaser will not be counted among the 35.
2. Each purchaser must have access to the same kind of
information that would be available if the issuer had registered
the securities.
3. The issuer can sell only to purchasers who it has reason to
believe are capable of evaluating the risks and benefits of
investment and are able to bear those risks or to purchasers who
have the services of a representative with the knowledge and
experience to evaluate the risks for them.
4. The issuer may not advertise the securities or solicit public
customers.
5. The issuer must take precautions to prevent the resale of
securities issued under a private placement exemption.Table 23-

35. 3 Exemptions from the Registration Process Under the 1933
Securities Act
Exemptions
Definition
Private placement
Transactions by an issuing company not involving any public
offering. Usually, the transaction involves sophisticated
investors with enough knowledge to evaluate information given
them (e.g., stock option plans for top-level management).
Intrastate offering
Any security or part of an offering offered or sold to persons
resident within a single state or territory.
Small business
Section 3(b) of the 1933 Act allows the SEC to exempt
offerings not exceeding $5 million. Regulations A and D
promulgated by the SEC define the type of investors and the
amount of securities that are exempt within a certain time
period.
Other offering exemptions
By virtue of the 1933 Act, exemptions are allowed for
transactions by any person other than an issuer, an underwriter,
or a dealer. Also, government securities (federal, state, or
municipal bonds) are exempt. Also exempt are securities issued
by banks, charitable organizations, and savings and loans
institutions.Intrastate Offering Exemption
Section 3 of the 1933 Act provides an exemption for any
“security which is part of an issue offered or sold to persons
resident within a single state or territory, where the issuer of
such security is a resident and doing business within, or, if a
corporation, incorporated by, or doing business within such a
state.” To qualify for this exemption, an issuer must meet the
strictly interpreted doing-business-within-a-state requirement:
The issuer must be a resident of the state and “do business”
solely with (i.e., offer securities to) people who live within the
state.
Courts have interpreted Section 3 very strictly. One federal

36. court ruled that a company incorporated in the state of
California and making an offering of common stock solely to
residents of California did not qualify for the intrastate
exemption because it advertised in the Los Angeles Times, a
newspaper sold by mail to residents of other states. Another
factor in the court’s decision in this case was that 20 percent of
the proceeds from the securities sale were to be used to
refurbish a hotel in Las Vegas, Nevada.8
8 SEC v. Trustee Showboat, 157 F. Supp. 824 (S.D. Cal. 1957).
After that decision, the SEC issued Rule 147, which sets
standards for the intrastate exemption by defining important
terms in Section 3 of the 1933 Act. For example, an issuer is
“doing business within” a state if (1) it receives at least 80
percent of its gross revenue from within the state, (2) at least 80
percent of its assets are within the state, (3) it intends to use 80
percent of the net proceeds of the offering within the state, and
(4) its principal office is located in the state. Rule 147 is also
concerned with whether the offering has “come to rest” within a
state or whether it is the beginning of an interstate distribution.
An offering is considered intrastate only if no resales are made
to nonresidents of the state for at least nine months after the
initial distribution of securities is completed.Small Business
Exemptions
Section 3(b) of the 1933 Act authorizes the SEC, by use of its
rulemaking power, to exempt offerings not exceeding $5 million
when it finds registration unnecessary. Under this authority, the
commission has promulgated Regulations A and D.
Regulation A exempts small public offerings made by an issuer,
defined as offerings not exceeding $5 million over a 12-month
period. The issuer must file an “offerings” and a “notification
circular” with an SEC regional office 10 days before each
proposed offering. The circular contains information similar to
that required for a 1933 Act registration prospectus, but in less
detail, and the accompanying financial statements may be
unaudited. It should be noted that for these small business
offerings, the SEC staff follows the same “letter of comment”

37. procedure associated with registration statements; thus, a
Regulation A filing may be delayed. Regulation A circulars do
not give rise to civil liability under Section 11 of the 1933 Act
(discussed later in this chapter), but they do make an issuer
liable under Section 12(2) for misstatements or omissions (also
discussed later in this chapter). The advantages of this
regulation for small businesses are that the preparation of forms
is simpler and less costly and the SEC staff can usually act
more quickly.
Regulation D, which includes Rules 501–506, attempts to
implement Section 3 of the 1933 Act. Rule 501 defines
an accredited investor as a bank; an insurance or investment
company; an employee benefit plan; a business development
company; a charitable or educational institution (with assets of
$5 million or more); any director, officer, or general partner of
an issuer; any person with a net worth of $1 million or more; or
any person with an annual income of more than $200,000. This
definition is important because an accredited investor, as
defined by Rule 501, is not likely to need the protection of the
1933 Act’s registration process.
Rule 504 allows any noninvestment company (one whose
primary business is not investing or trading in securities) to sell
up to $1 million worth of securities in a 12-month period to any
number of purchasers, accredited or nonaccredited, without
furnishing any information to the purchaser. This $1 million
maximum, however, is reduced by the amount of securities sold
under any other exemption.
noninvestment company
A company whose primary business is not in investing or
trading in securities.
Rule 505 allows any private noninvestment company to sell up
to $5 million of securities in a 12-month period to any number
of accredited investors (as previously defined) and to up to 35
nonaccredited purchasers. Sales to nonaccredited purchasers are
subject to certain restrictions concerning the manner of
offering—for example, no public advertising is allowed—and

38. resale of the securities.
Rule 506 allows an issuer to sell an unlimited number of
securities to any number of accredited investors and to up to 35
nonaccredited purchasers. The issuer, however, must have
reason to believe that each nonaccredited purchaser or
representative has enough knowledge or experience in business
to be able to evaluate the merits and risks of the prospective
investment. Again, certain resale restrictions are attached to
offerings made under this rule, as well as a prohibition against
advertising. Rule 506 seeks to clarify Section 4(2) of the 1933
Act, dealing with private placement exemptions, as already
discussed.Other Offering Exemptions
Section 4(2) of the 1933 Act allows exemptions for
“transactions by any person other than an issuer, underwriter or
dealer.” Because Sections 4(3) and 4(4) allow qualified
exemptions for dealers and brokers, the issuer and the
underwriters become the only ones not exempted. SEC Rules
144 and 144a define the conditions under which a person is not
an underwriter and is not involved in selling securities.Exempt
Securities
Government securities issued or regulated by agencies other
than the SEC are exempt from the 1933 Act. For example, debt
issued by or guaranteed by federal, state, or local governments,
as well as securities issued by banks, religious and charitable
organizations, savings and loan associations, and common
carriers under the Interstate Commer ce Commission, are
exempt. These securities usually fall under the jurisdiction of
other federal agencies, such as the Federal Reserve System or
the Federal Home Loan Board, or of state or local agencies.
The collapse of the Penn Central Railroad in 1970 and the
default of the cities of Cleveland and New York on municipal
bonds led Congress and the SEC to reexamine certain
exemptions with a view to eliminating them. In fact, the
Railroad Revitalization Act of 1976 eliminated the 1933 Act
exemption for securities issued by railroads (other than trust
certificates for certain equipment), and 1975 amendments to the

39. securities acts now require firms that deal solely in state and
local government securities to register with the commission and
to adhere to rules laid down by the Municipal Securities
Rulemaking Board.
Other exempt securities are issued in a corporate reorganization
or bankruptcy and securities issued in stock dividends or stock
splits.Resale Restrictions
Restrictions are placed on the resale of securities issued for
investment purposes pursuant to intrastate, private placement,
or small business exemptions.
· Rule 147 states that securities sold pursuant to an intrastate
offering exemption (mentioned previously) cannot be sold to
nonresidents for nine months.
· Rule 144 states that securities sold pursuant to the private
placement or small business exemptions must be held one year
from the date the securities are sold.
· Rule 144(a) permits “qualified institutional investors”
(institutions that own and invest $100 million in securities, such
as banks, insurance companies, and investment companies) to
buy unregistered securities without being subject to the holding
period of Rule 144. This rule seeks to permit foreign issuers to
raise capital in this country from sophisticated investors without
registration process disclosures. This also seeks to create a
domestic market for unregistered securities.
· Regulation S and Rule 144(a) have attempted to expand the
private placement market. See the section in this chapter on the
“Global Dimensions of Rules Governing the Issuance and
Trading of Securities.”
Exemption
Price Limitation
Limitations on Purchasers
Resales
Regulation A
$5 million
None
Unrestricted

40. Intrastate Rule 147
None
Intrastate only
Only to residents before nine months
Rule 506
None
Unlimited accredited; 35 unaccredited
Restricted
Rule 505
$5 million
Unlimited accredited; 35 unaccredited
RestrictedExempt Transactions for Issuers under the 1933
Securities ActLiability, Remedies, and Defenses Under The
1933 Securities ActPrivate Remedies
The 1933 Act provides remedies for individuals who have been
victims of (1) misrepresentations in a registration statement, (2)
an issuer’s failure to file a registration statement with the SEC,
or (3) misrepresentation or fraud in the sale of securities. Each
is examined here, along with some affirmative
defenses.Misrepresentations in a Registration Statement
Section 11 of the 1933 Act imposes liability for certain untruths
or omissions in a registration statement. Section 11 allows a
right of action to “any person acquiring such a security” who
can show (1) a material misstatement or omission in a
registration statement and (2) monetary damages. The
term material is defined by SEC Rule 405 as pertaining to
matters “of which an average prudent investor ought reasonably
to be informed before purchasing the security registered.” In
addition, the issuer’s omission of such facts as might cause
investors to change their minds about investing in a particular
security are considered material omissions for the purposes of
Section 11. These facts include an impending bankruptcy, new
government regulations that may be costly to the company, and
the impending conviction and sentencing of the company’s top
executives for numerous violations of the FCPA of 1977
(discussed later in this chapter).

41. Three affirmative defenses are available to defendants:
1. The purchaser (plaintiff) knew of the omission or untruth.
2. The decline in value of the security resulted from causes
other than the misstatement or omission in the registration
statement.
3. The statement was prepared with the due diligence expected
of each defendant.
The following case examines alleged omissions of material
information. The defendants contended that the omissions were
nonmaterial, and due diligence was exercised. Case 23-2 Litwin
v. Blackstone Group, LP
United States Court of Appeals, Second Circuit 634 F.3d 706
(2011)
Blackstone Group, LP, manages investments. In corporate
preparations for an initial public offering (IPO), Blackstone
filed a registration statement with the Securities and Exchange
Commission (SEC). At the time, corporate private equity’s
investments included FGIC Corporation and Freescale
Semiconductor, Inc. FGIC insured investments in subprime
mortgages. Before the IPO, FGIC’s customers began to suffer
large losses. By the time of the IPO, this situation was
generating substantial losses for FGIC and, in turn, for
Blackstone.
Meanwhile, Freescale had recently lost an exclusive contract to
make wireless 3G chipsets for Motorola, Inc. (its largest
customer). Blackstone’s registration statement did not mention
the impact on its revenue of the investments in FGIC and
Freescale. Martin Litwin and others who invested in the IPO
filed a suit in a federal district court against Blackstone and its
officers, alleging material omissions from the statement.
Blackstone filed a motion of dismiss, which the court granted.
The plaintiffs appealed.Justice Straud
Materiality is inherently fact-specific finding that is satisfied
when a plaintiff alleges a statement or omission that a
reasonable investor would have considered significant in
making investment decisions.

42. However, it is not necessary to assert that the investor would
have acted differently if an accurate disclosure was made.
Rather, when a district court is presented with a motion [to
dismiss,] a complaint may not properly be dismissed on the
ground that the alleged misstatements of omissions are not
material unless they are so obviously unimportant to a
reasonable investor that reasonable minds could not differ on
the question of their importance. [Emphasis added.]
In this case, the key information that plaintiffs assert should
have been disclosed is whether, and to what extent, the
particular known trend, event, or uncertainty might have been
reasonably expected to materially affect Blackstone’s
investments. Plaintiffs are not seeking the disclosure of the
mere fact of Blackstone’s investment in FGIC, of the downward
trend in the real estate market, or of Freescale’s loss of its
exclusive contract with Motorola. Rather, plaintiff claims that
Blackstone was required to disclose the manner in which those
then-known trends, events, or uncertainties might reasonably be
expected to materially impact Blackstone’s future revenues.
The question, of course, is whether a loss in a particular
investment’s values will merely affect revenues, because it will
almost certainly have some effect. The relevant question is
whether Blackstone reasonably expects the impact to be
material. [Emphasis added.]
Because Blackstone’s Corporate Private Equity segment plays
such an important role in Blackstone’s business and provides
value to all of its other asset management and financials related
to that segment that Blackstone reasonably expects will have a
material adverse effect on its future revenues. Therefore, the
alleged omissions related to FGIC and Freescale were plausibly
material.*
The U.S. Court of Appeals for the 2nd Circuit vacated the lower
court’s dismissal and remanded the case.
Whereas others associated with the company can raise the due
diligence defense, the issuing company cannot. Section 11(a) is
very specific about what other individuals may be held jointly

43. or severally liable in addition to the issuing company:
due diligence defense
An affirmative defense raised in lawsuits charging
misrepresentation in a registration statement. It is based on the
defendant’s claim to have had reasonable grounds to believe
that all statements in the registration statement were true and no
omission of material fact had been made. This defense is not
available to the issuer of the security.
1. Every person who signed the registration statement (Section
16 of the 1933 Act requires signing by the issuer, the issuing
company’s CEO, the company’s financial and accounting
officers, and a majority of the company’s board of directors)
2. All directors
3. Accountants, appraisers, engineers, and other experts who
consented to being named as having prepared all or part of the
registration statement
4. Every underwriter of the securities
It should be noted that there are two exceptions to Section 11
liability:
1. An expert is liable only for the misstatements or omissions in
the portion of the registration statement that the expert prepared
or certified.
2. An underwriter is liable only for the aggregate public
offering portion of the securities it underwrote.
Section 11 liability has made such a strong impact that today
virtually all professionals and experts involved in the
preparation of a registration statement make precise agreements
concerning the assignment of responsibility for that statement.
Failure to grasp the import of Section 11 and related sections of
the 1933 and 1934 Acts can lead to loss of reputation and
employment by businesspersons and professionals. The first
case brought under Section 119 sent tremors through Wall
Street, the accounting profession, and outside directors. In that
case, the court evaluated each defendant’s plea of due diligence
on the basis of each individual’s relationship to the corporation
and expected knowledge of registration requirements.

44. 9 Escott v. Barchris Construction Corp., 283 F. Supp. 643
(S.D.N.Y. 1968).Failure to File a Registration Statement
Failure to file a registration statement with the SEC when
selling a nonexempt security is the second basis for a private
action by the purchaser for rescission (cancellation of the sale).
Section 12(1) of the 1933 Act provides that any person who
sells a security in violation of Section 5 (which you recall from
the discussion of the registration statement) is liable to the
purchaser to refund the full purchase price. A purchaser whose
investment has decreased in value may recover the full purchase
price without showing a misstatement or fraud if the seller is
unable to meet the conditions of one of the exemptions
discussed earlier. In short, a business that fails to file a
registration statement because of a mistaken assumption that it
has qualified for one of the exemptions could be making a very
expensive mistake.Misrepresentation or Fraud in the Sale of a
Security
A third basis for a private action is misrepresentation in the sale
of a security, as defined by Section 12(2) of the 1933 Act,
which holds liable any person who offers or sells securities by
means of any written or oral statement that misstates a material
fact or omits a material fact that is necessary to make the
statement truthful. Unlike Section 11, Section 12(2) is
applicable whether or not the security is subject to the
registration provisions of the 1933 Act, provided there is use of
the mails or other facilities in interstate commerce. The persons
liable are only those from whom the purchaser bought the
security. For example, under Section 12(2), a purchaser who
bought the security from an underwriter, a dealer, or a broker
cannot sue the issuer unless able to show that the issuer was “a
substantial factor in causing the transaction to take place.” A
further requirement is that the purchaser must prove that the
sale was made “by means of” the misleading communications.
The defense usually raised by sellers in such suits is that they
did not know, and using reasonable care could not have known,
of the untruth or omission at the time the statement was made.

45. Fraud in the sale of a security is covered by Section 17(a) of the
1933 Act, which imposes criminal, and possibly civil, liability
on anyone who aids and abets any fraud in connection with the
offer or sale of a security. Violators may be penalized by fines
of up to $10,000, imprisonment up to 5 years, or both. Section
12(a) (2) and Section 17(a) of the 1933 Act set out antifraud
enforcement mechanisms. Rule 10(b)-5 applies to the issuance
or sales of securities under the 1934 Act and other securities
acts, even those exempted by the 1933 Act.Governmental
Remedies
When a staff investigation uncovers evidence of a violation of
the securities laws, the SEC can (1) take administrative action,
(2) take injunctive action, or (3) recommend a criminal
prosecution to the Justice Department.Administrative Action
Upon receiving information of a possible violation of the 1933
Act, the SEC staff undertakes an informal inquiry. This involves
interviewing witnesses but generally does not involve issuing
subpoenas. If the staff uncovers evidence of a possible violation
of a securities act, it may order an administrative hearing before
an administrative law judge (ALJ) or ask the full commission
for a formal order of investigation. A formal investigation is
usually conducted in private under SEC rules. A witness
compelled to testify or to produce evidence may be represented
by counsel, but no other witness or counsel may be present
during the testimony. A witness may be denied a copy of the
transcript of his or her testimony for good cause, although the
witness is allowed to inspect the transcript.
Witnesses at a private SEC investigation do not enjoy the
ordinary exercise of Fourth, Fifth, and Sixth Amendment rights.
For example, Fourth Amendment rights are limited because the
securities industry is subject to pervasive government
regulation, and those going into it know this in advance. Fifth
Amendment rights are limited because the production of records
related to a business may be compelled despite a claim of self-
incrimination. (See the sections on the Fourth and Fifth
Amendments in Chapter 5.) As for the Sixth Amendment, in a

46. private investigation, the SEC is not required to notify the
targets of the investigation, nor do such targets have a right to
appear before the staff or the full commission to defend
themselves against charges. The wide scope of SEC powers in
these nonpublic investigations was reinforced when the U.S.
Supreme Court upheld a lower court’s decision to deny
injunctive relief with regard to subpoenas directed at plaintiffs
in an SEC private investigation.10 For some of the
constitutional reasons noted here, the SEC is being challenged
in a 2015 Georgia case.11
10 SEC v. Jerry T. O’Brien, Inc. et al., 467 U.S. 735 (1984).
11 Hill v. EC, N. District (Georgia), Case No. 1.2015cvo1802,
May 19, 2015.
An administrative proceeding may be ordered by the full
commission if the SEC staff uncovers evidence of a violation of
the securities laws. This proceeding before an ALJ can be
brought only against a person or firm that is registered with the
commission (an investment company, a dealer, or a broker). The
ALJ has the power to impose sanctions, including censure,
revocation of registration, and limitations on the person’s or the
firm’s activities or practice.
In addition, after a hearing, the full commission may issue a
stop order to suspend a registration statement found to contain a
material misstatement or omission. If the statement is later
amended, the stop order will be lifted. As mentioned earlier in
the chapter, stop orders are usually reserved for the most
serious cases. The SEC more frequently uses letters of
deficiency to obtain corrections to registration statements. The
remedies available under the 1991 Remedies Act, discussed
earlier in this chapter under “Summary of Federal Securities
Legislation,” apply here as well.Injunctive Action
The SEC may commence an injunctive action when there is a
“reasonable likelihood of further violation in the future” or
when a defendant is considered a “continuing menace” to the
public. For example, under the 1933 Act, the SEC may go to
court to seek an injunction to prevent a party from using the

47. interstate mails to sell a nonexempt security. Violation of an
injunctive order may give rise to a contempt citation. Also,
parties under such an order are disqualified from receiving an
exemption under Regulation A (the small business exemption).
Again, the remedies available under the 1991 Remedies Act
apply here.Criminal Penalties
Willful violations of the securities acts and the rules and
regulations promulgated pursuant to those acts are subject to
criminal penalties. Anyone convicted of willfully omitting a
material fact or making an untrue statement in connection with
the offering or sale of a security can be fined up to $1 million
for each offense or imprisoned for up to 5 years or both. The
SEC does not prosecute criminal cases itself, but instead refers
them to the Justice Department.The Securities Exchange Act of
1934
One year after passing the Securities Act of 1933, Congress
crafted this second extremely important piece of securities
legislation to come out of the Great Depression. More
comprehensive than the 1933 Act, it had two major purposes: to
regulate trading in securities and to establish the SEC to
oversee all securities regulations and bar the kind of large
market manipulations that had characterized the 1920s and
previous boom periods.Registration of Securities Issuers,
Brokers, and DealersRegistration of Securities Issuers
Section 12 of the 1934 Securities Exchange Act requires every
issuer of debt and equity securities to register with both the
SEC and the national exchange on which its securities are to be
traded. Congress extended this requirement to all corporations
that (1) have assets of more than $10 million, (2) have a class of
equity securities with more than 500 shareholders, and (3) are
involved in interstate commerce. Registration becomes effective
within 60 days after filing unless the SEC accelerates the
process. Such companies are referred to as “Section 12”
companies.
The commission has devised forms to ensure that potential
investors will have updated information on all registrants whose

48. securities are being traded on the national exchanges. Thus,
registrants are required to file annual reports (Form 10-K) and
quarterly reports (Form 10-Q) as well as SEC-requested current
reports (Form 8-K). This last form must be filed within 15 days
of the request, which is usually made in response to a perceived
material change in the corporation’s position (e.g., a potential
merger or bankruptcy) that the commission’s staff believes a
prudent investor should know about. It should be noted that the
Sarbanes-Oxley Act, discussed earlier in this chapter, should be
reviewed for all requirements regarding CEOs and CFOs of
issuing companies. Further, the accounting requirements of the
FCPA of 1977 set out at the end of this chapter should be
reviewed as to company officers’ duties.
In a proposed Codification of the Federal Securities Law
(CFSL), the American Law Institute has sought to streamline
the registration process under the 1933 and 1934 Acts by
requiring single-issuance registration under the 1933 Act and an
annual company “offering statement” for securities traded on a
national exchange under the 1934 Act. At present, Section 22 of
the Exchange Act makes a registering company liable for civil
damages to securities purchasers who can show that they relied
on a misleading statement contained in any of the SEC-required
reports.Registration of Brokers and Dealers
Brokers and dealers are required to register with the SEC under
the Exchange Act unless exempted. A dealer, as defined by the
1934 Act, is a “person engaged in the business of buying and
selling securities for his own account,” whereas a broker is a
person engaged in the business of “effectuating transactions in
securities for the account of others.” The convenient
term broker-dealer is used throughout to refer to all those who
trade in securities; the specific term broker or dealer is used
when only one type of trader is meant.
dealer
A person engaged in the business of buying and selling
securities for his or her own account.
broker

49. A person engaged in the business of buying and selling
securities for others’ accounts.
Broker-dealers must meet a financial responsibility standard
that is based on a net capital formula; a minimum capital of
$25,000 is required in most cases. Brokers are obliged to
segregate customer funds and securities.Analysts or
“Cheerleaders”? Conflicts of Interest
In July 2001, to prevent a potential conflict of interest, Merrill
Lynch barred its stock analysts from investing in stock they had
researched. This was a reaction to several events:
· Individuals and members of Congress had lost confidence in
analysts, particularly in an economy and market that had been in
a turndown for 18 months. Never before had so many individual
investors actually invested in stocks and bonds and seen their
paper wealth grow and then fall. The “party” appeared to be
over for a time.
· Federal investigators were alleging the manipulation of
Internet stock IPOs and the taking of kickbacks by investment
bankers in July 2001.
· The same trading companies that had investment banking
divisions floating new issuances of securities hired securities
analysts to rank the securities of companies for which they were
raising. The individual investor had begun to realize that there
existed no “Chinese wall” between stock analysts and
investment bankers in the same brokerage firm. In fact, some
companies gave stock analysts bonuses when they helped
encourage investment banking business by giving stocks high
ratings. For example, one study showed that bullish ratings were
so meaningless that “sell” ratings were less than 2 percent of all
ratings shown. In many cases, stocks fell as much as 90 percent
from their high before analysts removed their “buy”
ratings.a This could be called “cheerleading.”
a“Stock Analysts Get Overall Rap for Deceiving
Investors,” USA Today, July 5, 2001, 10A.
· Money managers who ran large mutual funds with money from
IRAs, Keoghs, 401(k)s, and 403(b)s became skeptical of

50. analysts as investors lost confidence in the mutual funds and
their managers. These investors, who tended to be passive in
nature and dependent on the fund managers and the analysts,
saw their retirement funds dwindling rapidly (and in some
instances, disappearing almost entirely).
Although this assessment appeared gloomy, many investors
argued that analysts should be encouraged to own stocks in the
companies on which they do research, believing that they should
“put their money where their mouth is.” Some argued that the
very purpose of the securities laws is full disclosure and that all
analysts should be forced to disclose what holdings they have
and to advise investors when they have a potential conflict of
interest.
The Securities Investment Protection Act (SIPA) provides a
basis for indemnifying the customers of a brokerage firm that
becomes insolvent: All registered brokers must contribute to a
SIPA fund managed by the SIPC, a nonprofit corporation whose
functions are to liquidate an insolvent brokerage firm and to
protect customer investments up to a maximum of $500,000.
Upon application to the SEC, the SIPC can borrow up to $1
billion from the U.S. Treasury to supplement the fund when
necessary.
Under Section 15(b) of the Exchange Act, which contains the
antifraud provisions, the SEC may revoke or suspend a broker -
dealer’s registration or may censure a broker-dealer. (Municipal
securities dealers and investment advisers are subject to similar
penalties.) In general, the commissio n takes such
actions against broker-dealers either for putting enhancement of
their personal worth ahead of their professional obligation to
their customers—conflict of interest—or for trading in or
recommending certain securities without having reliable
information about the company. Broker-dealers are liable to
both government and private action for failing to disclose
conflicts of interest. When even the potential for such a conflict
exists, a broker must supply a customer with written
confirmation of each transaction, including full disclosure of