Securities OutlineRegulating the Market through DisclosureI. Regulating Securitiesa. Special Characteristics of Securities that require regulation systemi. Information Disparity – individuals involved in the corporation are the people who need to sell the product which is hard to quantifyii. Intangible Product – possibly greater risk of fraud because you can’t identify, taste or quantify what you are getting1. Bundle of contractual rights that can be defined by the partiesiii. Importance of investment and the capital markets – capital markets can’t exist and economy can’t grow without investmentiv. Irrationalityv. Collective Action Problems – small amounts invested from a large group of people mean that the incentives of any individual share holder might not be sufficient to take the kind of action necessary b. Types of Regulation Systems – ex ante rules and ex post sanctions are possiblei. Merit Based regulation system 1. Determining if a product is good and then determining if people should be able to purchase2. Against market based American systemii. Disclosure based regulation system1. Disclosure of info about the underlying economics of enterprise2. Designed to overcome information disadvantagesiii. Education based regulation system1. Courses to educate the investor before allowing them to participate2. Blurred with forced disclosure which should educatec. Purposes of Securities Regulationi. Asymmetric informationii. Collective Action problemsiii. Protection of the Unsophisticated Investoriv. Importance of the Capital Marketsv. Lack of an Alternative Regulatory Schemevi. Securities regulation is partly historical because systems are developed to deal with the rules and revamping the structure would be very costly1. We end up w/ rules upon rules, definitions, safe harbors, etc.d. The Lawsi. Securities Act of 1933: gate keeping process for entry into marketii. Securities Exchange Act of 1934: Regulates secondary market transactions1. Created SEC – Administrative agency in charge of enforcing and creating rules, within the scope of the delegated authorityiii. Sarbanes-Oxley Act of 2002 – Mix of statutes that includes 6 to 8 concepts affecting securities regarding accounting, criminal liabilitye. The Role of the SECi. SEC is always playing catch up (See Ken Lay loan arrangements below)1. There was no rule against Lay’s activity because it was a novel scheme atthe time, hard to predict how people get around rulesII. Information disparity and Disclosure – the underlying premise of securities is regulation to force disclosure and rectify information disparitya. The problem with an information disparityi. Possibility of fraud, but motivation to commit fraud is rare enough that it should not chill market use if checkedii. With info disadvantage many people are hesitant to participateiii. Without people that trust money in the market we have no moneyb. Economics of disclosurei. With no disclosure, theoretically every company would start at average price and those who disclose would have price go up while those who don’t have price go down1. Anti-Regulatory: Market will force disclosure based on the actions of strong companies, result would be uniform disclosure2. Pro-Regulatory: Lemon-Effect – for the market to function there must be a means for detecting lemons. a. A few bad companies without disclosure would erode market confidence and force race to the bottomii. Limitations on economic incentives for disclosure1. If corporation is not issuing securities then it does not have incentive to disclose2. Agency costs: Directors may not have personal incentive3. Still need provisions for anti-fraud4. Efficiency of single standard: market might lead to over disclosure race to find advantageous information (Duplicate work)5. Positive externalities of mandated disclosure: learn something about other investments by comparisoniii. The need for a government regulatory program must be weighed against the deficiencies of a regulator1. Cost of maintaining a central regulating body2. Regulator won’t choose proper disclosure amount3. Conflict of interest with regulator: best interests of investor?c. The state of the marketi. Efficient Market Hypothesis – info accurately reflected in price on market1. Weak form: price incorporates all past info about securities pricea. Knowledge of past price cannot predict future price2. Semi-strong form: price reflects all publicly available informationa. Likely true theoretically, forms assumptions of SECREGb. Demonstrated by quick reaction of market to information3. Strong: price perfectly incorporates all informationa. Likely false, or no SECREG neededii. Fundamental v. Informational Efficiency1. Fundamental efficiency concerns whether the price moved to the correct price given new information2. Informational efficiency concerns whether price moves quickly to a new price that people believe is correct3. Most believe market is info efficient, but not fund efficienta. Thus, ECMH is solely a starting pointiii. Valuing investments1. Present Discount Value: what you would pay today for $ latera. Depends on both the discount rate and riskb. Consider decreasing marginal utility of the dollar2. Risk can be systematic (common to the whole market) and unsystematic (particular to an industry)a. Diversification eliminates unsystematic but not systematicIII. Materiality: if there is a 1) substantial likelihood that a 2) reasonable investor would view the fact as 3) significantly altering the 4) total mix of informationa. If info is goal and disclosure is means, then policing disclosures requires knowing what matters to investorsi. There is no general duty to disclose all material informationii. Analyze whether requires disclosure, prohibits material misstatements, etc.1. Consider requirements against whether or not fact was disclosed2. Partial affirmative statements –consider whether disclosure was necessary to make affirmative statements not misleadingiii. The fact that SEC requires disclosure does not automatically mean that disclosureis material for purposes of 10b-51. Oran v. Stafford – undisclosed facts about Fen-phen not material under the total mix analysis iv. Change in stock price after final disclosure adds some information to whether thedisclosure was materialb. Altering the total mix of informationi. Forward Looking Statements: Consider probability of harm times magnitude of harm (Basic v. Levinson)1. Basic: Denial of merger