 Welcome to the unit on federal securities law, federal securities law, and this will distinguish it from state securities law in the United States because we have a system of dual regulation which we'll explore further. All right let's give a little background to federal securities law in the United States. During the 1920s speculation in stocks in the United States grew as more and more common investors put money and risky investments with hidden risks. Now as we look at this background you probably want to ask yourself why did it become necessary to regulate securities? Why did the federal government decide that it was necessary? And part of the problem here I think you'll see is this increasing amount of money going into the stock market in risky investments. And a large part of that was that not only were there risky investments but those risks were hidden. A lot of times investors didn't know what they were getting into. So during the 1920s stock prices climbed steeply but the House of Cards began to tumble in October of 1929. October 1929 is when things started to fall apart. When the Dow Jones Industrial Average, or the DJIA, the Dow Jones Industrial Average lost a quarter of its value in just two days. So one quarter of the value disappeared in two days in October. And those losses continued on into the 1930s, into the early 30s. So we had a serious problem in terms of loss of value, loss of investor confidence in the market. And as a result of this in 1933, Congress passed the Securities Act of 1933. This was the first Federal Securities Act. The 33 Act as it's known requires registration of securities in initial offerings. So when public companies, when companies do a public offering of securities, they have to register with the Securities and Exchange Commission. So those securities have to be registered unless they qualify for some type of exemption. The Key to the 33 Act is a requirement that registration statements and offering documents disclose material information, disclose material information. That's information that would be important to the average investor in determining whether they want to make an investment in a particular type of security. So the investor needs the information. They need to know how to make a knowledgeable decision about investing, and that's the key to the 33 Act. Next year, the next year, Congress passed the Securities Exchange Act, the Securities Exchange Act of 1934. So the first one's referred to as the 33 Act. The second, the 34 Act. And that provided for the regulation of securities exchanges. Our most famous one's today being the New York Stock Exchange and the NASDAQ. So that provided for regulation of those exchanges as well as other exchanges across the country. And regular reporting by companies that offered their securities on these exchanges. Regular reporting. So you see two parts here that are kind of a trust. The Securities Act 1933, when a company issues its securities, its stock for instance, it's going to make a registration, it's going to disclose information. The 34 Act makes sure that's an ongoing situation where stocks are offered on public exchanges. That regular reporting is very important in terms of disclosures for investors. The 34 Act, one more important thing which was to establish the Securities and Exchange Commission. Securities and Exchange Commission. And that is the federal regulator for securities in the United States. So let's take a closer look here. And as you go through this, you know, we're talking a lot here about securities. Ask yourself, well, what is a security? How would you define a security? And it's probably more complex than you think. There are certain things that we think of as normally being securities and others that might be a little in the gray area. So the key question again is what is a security? Well fortunately for us, the 33 Act gives us a definition. 33 Act has a definition of securities. So let's take a look at that as it appears here. And you'll see that a security includes many things that we probably normally would think of as securities. Things like stocks. We've talked about earlier, stocks are the ownership interest and corporations. Bonds. Loans made by companies. Notes. Like promissory notes indicating a promise by a company to pay back a loan. Oil gas interest. That's probably a few here you don't recognize. But what you'll see is that the securities 1933 Securities Act defines it in a way in which it provides a listing, which can be helpful. But of course the limitations of a listing are that sometimes you can't list everything that might come up. And so how do you think that would be handled? How would you handle the idea that some types of new investments may come along? Not specifically named in the definition set up by the 33 Act. How would you handle that? Well Congress handled it by using a catch essentially a catchall provision. If you look you'll see the term here investment contract. An investment contract. What's an investment contract? And that question kind of hung out there for a few years after passage of the 33 Act until in 1946 the US Supreme Court addressed the issue in the Howie case. And the full citation is Securities and Exchange Commission versus WJ Howie and Company. This is known as the Howie case. And the Howie case recognized the term investment contract as a kind of catchall provision to pick up any other investment scheme not named in the definition Congress had provided that had the characteristics of a security. So basically the case established a test that known as the Howie test for what is an investment contract. Meaning what is something that looks like a security and that appears to be a security doesn't fit into any of the traditional terms that we see listed in the definition. So the court said there's an investment contract where there is one an investment of money. So that makes sense. I mean we invest money that's got to be one aspect of it right. Two in a common enterprise again this makes sense. Generally when we think of a security we're thinking of something that we're investing with other people. So you're investing in a company either through stocks bonds or something similar. Three there has to be an expectation of profits you're not just giving the money for charity or a gift. You're expecting money back and you're expecting that if things work out properly you'll make money off of this. So there has to be an expectation of profits. All this seems to make sense so far. And then the fourth element was that the profits have to be derived solely from the efforts of others solely from the efforts of others. So somebody else has control here. So think about that if you look at a stock or bond and you're giving money over to a company somebody else has the control whether you're going to make money or not. So that's essentially in essence the how we test not only defines investment contract defines whatever can be a security. So for example if you take a look to the left I have an orange tree here and this orange tree is not there just simply to decorate. It demonstrates the case of the how we company. In this case how we was selling off parcels of a citrus grove with the intent of having purchasers lease back the land. How we then had the exclusive right to tend the mid at tend and manage the citrus grove and sell the produce for profit. So you can see all four elements of the of the how we test here. People invested money by buying the land. It was a common enterprise. Other people were also investing in these parcels of orange orange grove. There was an expectation of profits. You were leasing your part of the grove back to how we so they could manage it sell the produce and make profits and how we had the control over how things were managed and basically on how profits were made. So there the Supreme Court found that yes we do have a an investment contract and thus a security. Okay beyond that two more times that we see in 1940 we see the passage of two important pieces of legislation. We see first the Investment Advisor Act. The Investment Advisor Act of 1940 covering an important area because up till now we've been talking about the offer purchase and sale of securities. The Investment Advisor Act deals with the regulation of companies to provide advice and we know that there are people out there who provide advice about investing. So it requires that these Investment Advisors register either with the SEC or with the state securities regulators in order to do business or they must qualify for an exemption from the registration requirements. In keeping with securities laws in general Investment Advisors are required to disclose all material information. So disclosure again is an important part of this. Disclose all material information. Particularly what you want to know about Investment Advisors whether they have any conflicts of interest. For instance if they own a large portion of a company and they are advising their clients to buy stock in that company it could be a conflict there because it could be driving up the price of stock they could sell and get out and their clients might be stuck with stock that's not worth what they paid for it. So again conflicts of interest are an important aspect. The other law of 1940 that was very important was the Investment Company. The Investment Company Act of 1940 and the investment company act again requires registration of companies such as probably the most familiar to you will be mutual funds. Mutual funds and these are pooled investments where a company will pool money and invest in various securities and individuals then can buy or other companies can buy shares in the investment company and they don't have to invest in all of the individual investments the investment companies in investing in. So the Investment Company Act again the most familiar to you would probably be mutual funds if you're familiar with that many people have them especially if you have a retirement plan. So the Investment Company Act again requires disclosure of key information disclosure of material information about particularly again about conflicts of interest. We've talked about the various laws we'll just briefly talk about the regulator since 1934 primary regulator of federal securities activity in the United States has been the Securities and Exchange Commission known as the SEC and thinking about this what authority do you think the SEC should have in order to enforce the securities laws what authority do you think Congress would have given the Securities and Exchange Commission over the years to enforce securities laws. Well as you think about that there's a couple we already know written right into the law is the requirement for various companies to register. So registering registration statements and filings are handled by the SEC in addition to that not only registration but the annual reporting and filing required to have adequate disclosure on securities offered on public markets. So those must be made and they're crucial providing critical disclosures to investors. In addition large investment advisors must register with the SEC and investment companies we talked about earlier and probably most crucially and this is probably something you've thought of yourself is that the SEC needs to have enforcement power and they do. They have the power to enforce the securities laws. They have strong enforcement authority so they can bring administrative cases for administrative judges they can bring civil cases in court and they can work with prosecutors on criminal cases against persons and organizations that violate the laws. So the federal securities laws are a critical component of securities regulation in the United States and the focus tends to be on transparency. It's why there's so much disclosure. Transparency is so critical to the way markets should operate in the United States. So this focus on transparency helps promote some of the most successful securities markets in the world.