Securities regulation in the United States, as in the entire developed world, stands at a crossroads. An era when the principles and concepts of securities law were shaped purely by domestic policy goals has been displaced by one of international convergence. We are now seeing cooperation among securities regulators, as in the International Organisation of Securities Commissions (IOSCO), bilateral cooperation in enforcement through memoranda of understanding and increasing efforts by companies, exchanges and securities regulators to influence the regimes of other countries. The US, which has the largest and most liquid capital markets in the world, has been a net exporter of securities regulation, but US regulators are beginning to import concepts from abroad and domestic securities reform is increasingly informed by international pressures.
In addition, American idea leaders in this area have recently grown increasingly concerned that US securities regulation and the risk of class action litigation are leading to a loss of competitive position for the US capital markets, an adverse impact on certain financial sector jobs and on domestic capital formation. As a result, the discussion of these issues, which usually involves only technical experts, now has the attention of bankers, academics, trial and defence lawyers, SEC commissioners and their staff and interested politicians as well as foreign securities regulators, off-shore financial intermediaries and foreign companies.
Where this debate will lead is uncertain. Accordingly, the following chapter attempts to both summarise the US securities regime and to place it within its domestic, historic and political context and to note which features of US securities regulation are unique or unusual. Without such an approach, it will be impossible to assess which elements of US securities regulation should or could be updated and which might be an example or counter-example for the rest of the world.
2. GENERAL DESCRIPTION OF THE CAPITAL MARKETS
As noted, the US stock markets are the largest and most liquid in the world. Of fundamental importance, however, is not the absolute size of the markets but the fact that stock ownership in the United States is a middle-class affair. Approximately 50 per cent of American households own stock. The participation of the middle classes in the stock market, especially as a means to save for retirement in a world of increasing pension uncertainty, means that it is not politically or socially acceptable for the stock market game to be rigged. While in American society, more than in almost any other, it is seen as acceptable that there are economic winners and losers, it is little appreciated outside the US that the winners are supposed to win through fair play. In a world where the rules are not always followed, therefore, some are punished, and in amounts and with prison sentences that are astounding to those not steeped in the domestic culture. As we shall see, a distinctive feature of US securities regulation is its emphasis on enforcement and the ability of multiple players, some political appointees and some private, to enforce the laws.
3. REGULATORY STRUCTURE
There was no federal regulation of securities until the Great Depression. Until then, all securities regulation, like most economic regulation, had been left to state judges under common law and various state regulators, of which New York State, as the regulator of Wall Street, was the most powerful. It was only after the crash of 1929, when millions of ordinary people lost their savings and investments, and in the wake of widely followed congressional hearings which exposed the excesses and cheating of the barons of Wall Street, that President Roosevelt decided to regulate the securities markets. In 1933 the Securities Act was passed and in 1934 the Securities Exchange Act (the ‘Exchange Act’) was passed. At the same time the Securities and Exchange Commission (SEC) was created to maintain the integrity and stability of the capital markets and protect investors from fraud.
Until 2002, the two Depression era statutes survived largely unchanged, with only minor modifications to address particular problems. The regulatory emphasis of those two statutes, when it comes to securities offering and distribution, was heavily tilted towards disclosure rather than directives to companies on internal governance. Much of that changed with the Sarbanes-Oxley Act of 2002 (SOXA), the first major philosophical change in regulatory theory since the Depression era statutes. In many ways, SOXA was a panicked response by Congress to a middle class revolt prompted by losses in the stock market and corporate scandals resulting in mounting evidence that some among the managerial classes, aided by bankers, accountants and lawyers, had not been playing fair. At the same time, the SEC, partly for accidental reasons of staffing and partly because it was seen as asleep at the switch, lost prestige on Capitol Hill. The result was SOXA, a statute of many good ideas but badly implemented, as it was rushed through without the usual careful SEC review. SOXA shifted the tectonic plates of US federal securities regulation. For the first time, direct regulatory requirements were placed on companies. Moreover, Congress, for the first time in many years, did not leave to the SEC the explicit or implicit direction to exempt foreign companies where appropriate. As a result, SOXA, and most especially the costly internal controls provision of Section 404, has come under severe criticism from many quarters, not least from US stock exchanges and some US policymakers that have become increasingly concerned over the statute’s adverse impact on the global competitiveness of the US capital markets.
The SEC, like many commissions and agencies created during the New Deal, is an ‘independent’ agency not under the direct control of the President or the executive branch. Its five commissioners, three of the President’s party, two not, are nominated by the President for a set term, approved by the Senate and may not be removed except for ‘cause’ – which essentially means virtually impossible to remove. This radical concept of a federal agency not answerable directly to politicians, either of the executive or legislative branch, was subjected to constitutional challenge in the 1930s both on the basis that it impinged upon state power and that it violated the separation of powers.
Of course, no one believes the SEC or other independent agencies to be totally removed from political pressure; after all, Congress controls the budget and the executive branch has its ways and means. But it is more distant from such pressure than many other regulators worldwide, a fact crucial to understanding the US system. From the moment when President Roosevelt put that crafty old market rigger Joe Kennedy in charge of the SEC on the correct theory that it takes a reformed thief to catch a thief, the SEC has been viewed as tough and technocratic. It was also the beginning of a long tradition of SEC personnel coming from the private sector or moving to the private sector. Its prestige in the United States has been virtually unsullied in the more than 60 years of its existence.
The two Depression era statutes, among the first statutory codes drafted against a common law backdrop, are written in a broad language of majestic uncertainty. The real power therefore lies with the interpreter and primary enforcer – the SEC – which issues rules and regulations implementing these statutes and also issues interpretations of and guidance on compliance with various provisions of the federal securities laws. As international players began to understand in the roll-out of SOXA regulations, the SEC’s regulatory rule making takes place in a very open manner, with proposed rules subject to notice and comment by anyone who cares to participate and SEC open meetings broadcast via webcast. Additionally, the SEC manages the registration and disclosure system mandated by the Securities Act and the Exchange Act, and it regulates the activities of entities engaged in buying and selling securities and in investment management. The SEC also has the authority to grant exemptive relief under each of the statutes it administers, and over the years Congress has substantially increased the SEC’s exemptive powers.
The SEC has four divisions, organised along functional lines. The Division of Corporate Finance oversees public disclosure of corporate information by issuers of securities. It reviews disclosure documents that public companies are required to file with the SEC, including registration statements for new securities offerings under the Securities Act, periodic reports under the Exchange Act, proxy materials, and materials required to be delivered to shareholders pursuant to tender offers and mergers and acquisitions. The Division of Market Regulation regulates broker-dealers, securities exchanges, transfer agents, securities information processors and other major participants in the US securities markets. The Division of Investment Management regulates the mutual fund industry and examines statutory filings by such entities pursuant to the Investment Company Act and the Investment Advisers Act. Finally, the Enforcement Division is responsible for seeking consent decrees and fines, collecting investor claims funds and, where necessary, going to trial.
A key difference between the US system of securities regulation and that of many other nations is the existence of multiple enforcers of the law. As state law was replaced or preempted only where it was in direct conflict with the federal securities laws, the states retained a role in securities laws which created a situation of regulatory competition, a concept that is widely accepted in the United States. The SEC is an active civil enforcer of the securities laws using broad powers to collect information from potential offenders and to enter into settlements, to collect fines and impose other sanctions. The ability to create claims funds for investors is virtually unique. The ability of private actors to enforce the law, such as wronged investors relying on the entrepreneurial plaintiff’s bar to bring class actions, is also uniquely American. Finally, the presence of state enforcers to act as regulatory competitors to the SEC in the area of enforcement, such as most recently New York’s attorney general, is also a unique feature of the American system. The enforcement culture is much more intense and public than in most other jurisdictions, a fact that has come as an unwelcome ‘surprise’ to many foreign companies in the last few years. This enforcement gap between the US and other countries is likely to continue over the medium term. Longer term, other jurisdictions are likely to catch up.
4. ISSUANCE OF NEW SECURITIES
In regulatory terms, there are two broad categories of securities offers and sales: those to the retail public, which are registered with the SEC, require the payment of a filing fee and are subject to review by SEC staff; and private placements to limited numbers of sophisticated investors, which are not registered or subject to review by SEC staff. We describe each in turn.
The general rule is that any public offer or sale of securities must be registered with the SEC unless a specific exemption applies. Once a registration statement is filed, it is subject to review by the SEC. A ‘security’ is defined broadly in the legislation and case law. As well as common stock, stock options and debentures, the courts have found it to embrace limited partnerships, real estate syndications, notes issued by commercial and industrial companies, investments in citrus groves and oil drilling leases.
Until the recent enactment of securities offering reforms, securities could not be offered to the public until a registration statement was filed with the SEC. Oral offers could be made only once a registration statement containing a ‘preliminary prospectus’ was filed and securities could not be sold until the SEC declared the registration statement containing a prospectus to be ‘effective’. Moreover, only a ‘prospectus’ meeting the requirements of the statute could be used, ie, no summaries, term sheets or advertisements. Technical rules on what could be delivered, when, and in which form made a great deal of sense in 1933. In today’s fast moving world, they seemed absurd, and the SEC’s securities offering reforms adopted as of 1 December 2005 were designed to update these rules for a world of internet communication and against a backdrop of existing disclosure and transparency. Under the offering reforms, all public companies and underwriters of their securities are allowed to use any written materials once a preliminary prospectus is on file with the SEC, while large companies with a good reporting track record and at least $700 million in common equity float, known as ‘well-known seasoned issuers’ (WKSIs) can make written offers even before a preliminary prospectus is filed, so long as all such written materials are filed (for debt offerings, an issuer will be able to qualify as a WKSI by having issued at least $l billion in SEC-registered debt within the last three years and having filed its SEC reports on time in the past year). This ability to use what is known as a ‘free writing prospectus’ (a summary written document that meets the sales needs of the offering) put US regulation more in line with the securities offering practices of a number of other developed countries.
Under the offering reforms, most large issuers can extend written offers without delivering a preliminary prospectus, and sales could be confirmed without the delivery of a final prospectus so long as an effective registration statement is on file with the SEC on the theory that ‘access equals delivery’. Any correction or supplementary material information required to ensure that the preliminary prospectus is not misleading must now be provided to investors before the time at which a contract for the sale of securities is entered into by some other means, typically in the form of a ‘free writing prospectus’ that need only be filed after delivery. Under the offering reforms, only unseasoned issuers continue to be subject to a physical preliminary prospectus delivery requirement, and then only at the time that a written offer is made (a term sheet containing pricing and other material information that was not available at the time of delivery of the preliminary prospectus is now typically delivered before the time that orders to purchase securities are confirmed). The prospectus, together with any issuer free writing prospectus and/or supplementary information, must contain ‘full and fair’ disclosure of all material information, ie, information that would allow a reasonable investor to make an informed investment decision about the issuer of a security, the offering and the security itself. The prospectus must not be misleading by omission. Once a company has registered securities with the SEC, it is considered a ‘registrant’ and becomes subject to the secondary trading rules, corporate governance and periodic reporting requirements under the Exchange Act.
As recently as ten years ago, the disclosure gap between the United States requirements and the rest of the world was huge. That gap has narrowed considerably, either because local requirements have become substantially similar to US requirements (as in the EU), because of the IOSCO disclosure principles or because US mutual and pension funds investing internationally have pressured companies to increase disclosure. While there exist laggard jurisdictions, major corporations find themselves operating more and more under a global standard. All registration statements must disclose all material information and must contain or ‘incorporate by reference’, among other things, the description of the securities offered and the price at which they are offered, a business description of the company, a discussion of recent operating and financial performance and future prospects, risk factors that may affect the issuer’s business, results of operations or financial condition or the value of the securities, exposure to market risk, disclosure of any material legal proceedings, disclosure of executive compensation and related party transactions, the plan of distribution in the offering, and audited financial statements for, in most cases, the most recently ended three fiscal years, together with the relevant auditors’ reports. With some minor exceptions, the US disclosure requirements are very similar to the IOSCO standards.
In essence, regulation has been catching up with the practices of the securities industry, shifting from one of the review of offerings to the review of companies. The shift in emphasis from the regulation and review of primary offerings to the review and support of large companies with active secondary trading markets led to the creation in 1982 of what are known as ‘shelf’ registrations: certain companies that are already known to the market can pre-register and put up on the ‘shelf’ potential offerings of stock, debt and derivatives. This previously reviewed and cleared possibility of any number of offerings can be sold in a ‘takedown’ at a moment’s notice. These shelf registration statements have become increasingly important, and approximately 99 per cent of the US Fortune 500 companies have an active shelf registration. By filing a registration statement including a base prospectus with the SEC and incorporating by reference its Exchange Act filings and other material information as it is released, a company can offer securities on short notice as financing needs and market opportunities present themselves merely by filing a supplemental prospectus updating for all material information not included in or incorporated by reference into the base prospectus to the date of the takedown. The supplemental prospectus is not subject to review by the SEC. In addition, under the recent offering reforms, restrictions on ‘at the market’ offerings have been eliminated altogether, while WKSIs are entitled to automatic shelf effectiveness upon filing not subject to review by the SEC.
In order to qualify for shelf registration of securities to be offered on a continuous or delayed basis or in ‘at the market’ offerings, a public company must be a ‘seasoned issuer’, meaning that it must be current in its Exchange Act filings for at least 12 months before filing the shelf registration statement, must not have defaulted on any debt or preferred stock since the end of its last fiscal year, and must have securities held worldwide by non-affiliates with an aggregate market value of $75 million or more. The offering reforms have extended the shelf registration period to three years (from two years under previously-applicable rules) for all eligible companies while allowing WKSIs to pay registration fees on a ‘pay-as-you-go’ basis.
The offering reforms have resulted in the reduction of transaction costs and probably eliminate incentives for most domestic WKSIs to use the private placement market.
The other major type of securities placements in the United States are those which are ‘exempt’ from registration, of which the largest category is the various flavours of private placement to sophisticated investors. It is worth noting that the US system of regulation differs from a number of other countries in that an exemption must exist both for the initial distribution and for any subsequent transfer of the securities. Most securities transactions are exempt from registration because they do not involve an issuer, underwriter or dealer as those terms are defined under the Securities Act, since the buyers and sellers are generally ordinary investors involved in secondary trading.
The statutory exemption for private placements is cryptic in that it contains only a few short words not involving a ‘public offering’. Given the existence of the ‘put’ (a statutory remedy that allows an investor to sell back a security to a company at the original purchase price for one year following purchase in the event that the company violates the registration requirements), and the very broad definition of underwriter, it is not surprising that market actors sought more specific interpretations from the SEC as modern capital markets developed in the aftermath of World War II. The legal technique that the SEC uses, called a ‘safe harbour’, is another unusual feature. Essentially, if a securities distribution or subsequent sale meets all of the formal and technical requirements of the safe harbour, the company, seller and buyer can be certain that their boat has reached a port in a storm. However, it does not necessarily follow that attempted compliance or other ways of making a private placement outside the safe harbour will necessarily be a public offering. The safe harbour mechanic has left, therefore, enormous room for market practice and legal judgment which, from time to time over the last 60 years has been either officially adopted or repudiated by the SEC.
The most frequently used safe harbours are those established pursuant to Regulation D, Rule 144A and Regulation S.
Regulation D exempts offerings made to an unlimited number of ‘accredited investors’, a term that embraces most institutions likely to invest in privately placed securities, and up to 35 other persons. No specific disclosure is required if an offering is only made to accredited investors, but the market practice for large offerings by companies which are not well known in the market is to provide information substantially equivalent to that included in a registered deal. No general solicitation or advertising of the offering is permitted and certain offering restrictions and specific policy on resales of the securities must be imposed. The key requirements to be an accredited investor have not changed for over two decades and what seemed like the kind of money only available to the super-sophisticated at that time (net worth of $ l million, or annual income of $200,000 or more during the last two years and a reasonable expectation of the same in the current year) has, by dint of inflation and increasing prosperity, been acquired by a much wider group.
The most internationally well-known private placement exemption is that provided by Rule 144A for resales to Qualified Institutional Buyers (generally, institutions that have $100 million or more invested in securities of unaffiliated issuers) or QIBs. Indeed, the terms ‘144A’ and ‘QIB’ have passed into the lexicon of bankers and companies from around the world. As a technical matter, Rule 144A provides a resale exemption that effectively allows private placements to be underwritten and permits secondary trading in unregistered securities between QIBs. Rule 144A provides that an investment bank that immediately or otherwise resells securities acquired from an issuer in a private placement under Rule 144A will not be deemed a dealer or an underwriter under the Securities Act. Further, so long as the reselling institution reasonably believes that the purchasers of a security in a Rule 144A private placement are QIBs, the exemption will be preserved. Thus, in one regulation, both the initial distribution and subsequent transfers are permitted in the closed world of QIBs. Rule 144A contains publicity restrictions substantially identical to those prescribed under Regulation D and requires that the company must agree to provide certain current information to potential investors who request it (without limitation as to time). Although the Rule does not require a prospectus or information document to be delivered in connection with a sale, the market practice is to provide an offering circular to QIBs at the time of offer and the time of sale, in which the disclosure closely parallels the disclosure that would be made if the offering were registered. The offering reforms have eliminated much of the need for Rule 144A transactions by registered issuers within the United States, and Rule 144A has become more and more identified as an international technique.
Regulation S provides a safe harbour for offshore offerings targeted at non-US persons. Regulation S is actually the successor to a series of market practices that developed in the late 1960s and early 1970s with respect to the Eurodollar bond market, then the key means to recycle petrodollars and the only cross-border securities market in the pre-euro days. The safe harbour was widely demanded by market participants, essentially to create clear rules on how long offshore dollar-denominated bonds needed to stay offshore before they could safely be bought by US investors without calling into question the offshore nature of the transaction. In today’s world of global equity offerings, euro-based equity markets and other elements, it has gone far beyond its original purposes. To fall within the safe harbour, the offering must be made in an ‘offshore transaction’, no directed selling efforts may be made in the US by the issuer, a distributor of the securities, their respective affiliates or any person acting for them, and various restrictions on the manner of offering must be implemented depending on the type of securities offered and the type of issuer involved. Despite the suspicions expressed by some who do not understand the safe harbour technique, Regulation S was never an attempt by the SEC to regulate the world securities markets. Rather, it described clear rules about where the SEC would not regulate.
On the same day in 1991 that Rule 144A came into existence, Regulation S clarified and updated a number of SEC interpretations and market practices. The US private placement market has since grown exponentially. Internationally, the rules provided by Rule 144A and Regulation S, as well as the ability for one offering to be made under both rules at the same time (known as a ‘side-by-side’ transaction) has created a legal framework that permits foreign companies and US sophisticated investors to take advantage of the increasing depth of the global capital markets, most especially within the Eurozone, secure in the knowledge that they need not bother with US registration rules. One unintended consequence of the Rule 144A/Regulation S regulatory framework has been to create the conditions for international regulatory competition. In a business environment of global investing and the new liquidity and depth of the Euro-markets, when US securities regulation creates unattractive conditions (as in Sarbanes-Oxley), the Rule 144A/Regulation S framework provides a way for foreign companies to reach US investors while avoiding the more burdensome elements of US securities regulation.
The basic philosophy of the US securities laws and the SEC is one of national equivalence, which is to say that foreign companies are treated the same as US companies unless a specific exemption has been made to take account of the situation of the foreign company. This treatment contrasts and often conflicts with the EU principle of mutual recognition where the host country recognises and accepts the regulation by the home country, whatever that might be. The difference between these two principles can be expected to create increasing discord over the next few years unless there is substantial regulatory convergence. The SEC has adopted the IOSCO principles with respect to disclosure by foreign companies issuing securities outside of their home jurisdiction. Rearguard battles are being fought in areas such as the disclosure of executive compensation but these are second order issues. The remaining area of contention is financial disclosure where, for registered offerings, the SEC still insists upon a reconciliation to US Generally Accepted Accounting Principles (GAAP). There is a goal, much discussed by the SEC staff and their EU counterparts, for the SEC to recognise International Financial Reporting Standards (IFRS) and no longer to require those companies that report in IFRS, ie EU companies, to reconcile to US GAAP. While it is largely understood that such a step will happen, most observers do not expect it until the SEC is happy with both the content of issuers’ IFRS financial statement disclosures and the extent to which the accounting standard setting bodies and the enforcement of IFRS are independent of direct political interference. One step in this direction was the SEC’s recent signing of a protocol with the United Kingdom’s Financial Services Authority and Financial Reporting Council for the confidential sharing of information on the application of IFRS in the financial statements of issuers listed in the United Kingdom and registered with the SEC.
As a legacy from the 1930s, the US securities laws contained until recently a number of outdated restrictions on publicity intended to limit the conditioning of the market for securities offerings. To the relief of those of us who make a living trying to describe these rules to international bankers and foreign companies, the offering reforms, whose implementation was delayed by the intense regulatory work required by SOXA, mark one of the first times when US securities regulators have been overt ‘importers’ of more modern international practices.
Under the offering reforms, all companies enjoy safe harbours for the publication of a broad range of ‘non-prospectus’ information, including the level of information that may be disclosed about a company and its business and the offering, the terms of the securities being offered, information about the underwriters, offering schedules, account opening procedures, procedures for submitting initial indications of interest and anticipated credit ratings. The offering reforms have also codified the practice of allowing Exchange Act reporting companies to regularly publish factual business information and forward-looking information such as earnings forecasts before and during an offering.
The current law broadens the safe harbours for the type of research that can be published by underwriters before and during an offering, so long as the research reports are distributed in the regular course of business and research is not initiated on a company immediately prior to or during an offering. Research reports published in reliance on these safe harbours would be subject to Exchange Act liability under Rule 10b-5 (discussed further in section 7), but would not be subject to the heightened ‘prospectus’ liability under the Securities Act or Exchange Act. The securities laws currently provide a safe harbour for any research that is published by a broker-dealer not acting as an underwriter on an Exchange Act reporting company. The proposed reforms will expand this safe harbour to non-reporting companies as well.
5. LISTING
In the United States a company is required to ‘register’ with the SEC if it is listed on NASDAQ or the NYSE or if it has more than 500 investors. Registration will subject the company to the public disclosure and periodic reporting of the Exchange Act. It will also, in a post-SOXA world, subject it to most of the corporate governance and all auditor independence standards.
In practical terms, any company seeking to broadly access the liquidity of the US public markets must be listed. The initial public listing and registration processes can be and usually are done simultaneously. A company contemplating a listing must contact the stock exchange to arrange for the submission of a listing application and the signing of a listing agreement. Copies of these and other documents filed with the stock exchange must also be filed with the SEC. A listing application must contain, among other things, information about the issuer’s business, organisation and financial history – a requirement that in most cases is satisfied by attaching a copy of a draft registration statement recently or simultaneously filed with the SEC. A listing agreement will require the company, among other things, to comply with various membership, conduct and corporate governance requirements of the stock exchange as well as with US securities laws and regulations.
A company need not engage in an offering of securities to register and list shares on a national stock exchange. For example, a number of higher profile foreign private issuers having their primary listing outside of the US have listed on the NYSE or NASDAQ after registering treasury stock and/or stock option plans with the SEC. The requirement that a company become a ‘registrant’ once it has passed 500 investors was put into the law in 1964 in light of abuses where private companies were selling shares to large numbers of retail investors, and the public policy behind it is the mandate of investor protection, especially that of retail investors. Under previously applicable rules that have very recently been modified, in order to ‘deregister’, a company must have had fewer than 300 investors, or in the case of most foreign companies, fewer than 300 US investors. This numerical threshold has, in the wake of SOXA, come as an unpleasant surprise to certain large foreign companies who have decided that the benefits of a US listing no longer justify the increased regulatory expenses of SOXA. Following two years of extensive lobbying by foreign private issuers, industry groups and its European sister regulator, CESR, the SEC recently adopted reforms that allow select foreign private issuers to deregister before some of SOXA’s most arduous regulatory requirements come into effect.
Under the SEC’s recent deregistration reform, the 300 investor test has been retained as a default, but the conditions under which foreign private issuers could deregister have been significantly broadened. The reformed deregistration rule allows any foreign private issuer listed on a foreign market that has been registered with the SEC for at least one year to exit the US public markets and the associated burdens of the Exchange Act if the average daily trading volume of its equity securities in the US is five per cent or less of the average daily trading volume of such securities in its primary trading market (defined as up to two foreign primary markets) during a recent 12-month period. Any potential ‘deregistrant’ must not have conducted a US public offering in the past year and has to undertake to publish English-language copies of its home country reports on the Internet.
6. SECONDARY TRADING, PERIODIC REPORTING AND CORPORATE GOVERNANCE REQUIREMENTS APPLICABLE TO REGISTRANTS
Once a company has become a ‘registrant’ pursuant to the Securities Act (ie, by registering securities pursuant to an offering) or the Exchange Act (ie, by registering securities pursuant to a listing of securities on a national stock exchange), it becomes subject to the secondary trading, corporate governance and periodic reporting requirements under the Exchange Act.
Like most countries, the US prohibits insider trading, selective disclosure and stock manipulation. These rules, widely accepted internationally, are intended to ensure market efficiency through ‘information parity’ and protect the investing public from the harm caused by its absence.
Insider trading rules prohibit individuals, whether or not they are affiliated with the company, from selling or buying stock if they are aware of material non-public information at the time of the transaction. The US insider trading laws are broader than those of many countries in that tippees unrelated to the company are captured by the prohibition. Since insider trading in a stock can damage the company’s reputation, especially where company insiders are the culprits, companies usually implement restrictive rules or ‘trading plans’ which govern when officers or directors may sell company stock. Regulation Fair Disclosure prohibits public companies from disclosing information selectively to analysts or any other market participants. Consequently, compliance departments of all listed companies work closely with management to ensure that material information, such as earnings releases or projections, are released simultaneously to market professionals and investors. Regulation M under the Exchange Act prohibits persons from directly or indirectly fraudulently manipulating the price of shares listed on a national securities exchange through market transactions and thereby misleading public investors as to the actual conditions of the public market for the security being distributed. Regulation M contains exceptions for certain stabilisation transactions effected in conjunction with an offering so long as all material information with respect to the plan of distribution for such securities is disclosed. Limited after-distribution stabilisation sales (pursuant to ‘greenshoe’ options) are also an accepted practice in US securities offerings. They are used primarily in initial public offerings and exercised only if the price of the securities in public trading following the offering exceeds the offering price. There remain, however, key differences in other stabilisation practices between the US and the rest of the world, with various US disclosure rules essentially eliminating the practice in the US while it remains common and accepted for 30 days in the EU. Convergence of stabilisation practices and rules will be an ongoing challenge.
No US securities regulation has created as much international controversy as SOXA, which, for the first time in the history of US securities regulation, switched the focus from disclosure in securities offerings to actual conduct of companies. Congress did not give itself much time to deal with the international consequences and the SEC, weakened by poor leadership at a crisis moment, was unable to move the draft legislation or obtain an informal understanding that it could exempt foreign companies. The strength of the international reaction would lead an optimist to hope that the lessons have been learned, although a pessimist will note that Congressional memories are short. SOXA amended and added significantly to the corporate governance provisions of the Exchange Act, which were minimal before the corporate fraud scandals leading to SOXA’s adoption.
Among other things, SOXA requires CEOs and CFOs of companies with securities registered in the US to certify the accuracy and completeness of information contained in the company’s quarterly and annual reports and the maintenance of effective disclosure controls and procedures. The extent to which this certification requirement, largely and quickly accepted by US CEOs and CFOs, has stirred deep anxieties and resentments among executives from more collectivist countries is an interesting cultural study beyond the scope of this paper. In addition, the SEC adopted rules requiring companies to maintain, evaluate and report on a system of disclosure controls and procedures. SOXA also imposed new restrictions on reporting companies, including requirements on the composition and operation of audit committees and outright prohibitions on the performance of certain non-audit services by external accountants. For listed companies, the NYSE and NASDAQ as directed by the SEC, have adopted new corporate governance standards addressing a broad range of issues, including a requirement of majority-independent boards of directors and board committees, implementation of objective independence standards, the operation of audit committees and executive compensation. The SEC, which found itself hamstrung by Congress and the political environment, provided exemptions and changes for foreign companies at the margins. However, many of the changes were deeply resented by foreign companies listed in the United States. Surprisingly, those that seemed most controversial at the outset, such as full independence of the audit committee and auditor independence standards, seemed quickly to lose steam in an international environment which was heading towards convergence in any event. The requirement that auditors attest the internal financial controls (section 404), initially underestimated, has become the most controversial and costly. The burdens imposed by some of these requirements, particularly section 404, have caused some foreign private issuers to question the benefits of listing in the United States and, along with the risk of litigation in the US, are widely considered to be the impetus behind the SEC’s deregistration reforms as well as the main cause of the decline in the US stock exchanges’ global competitiveness for new issuers.
It now seems strange that the Depression era makers of the US securities laws started first with the concept of the review of the sale of securities and only looked later at what has become the main event, continuing disclosure and transparency by public companies. The current emphasis on periodic reporting is not unusual internationally, as the EU Transparency Directive illustrates. More unusual is the scope of SEC review and comments on these disclosures. The SEC is extremely active in reviewing and commenting on public company periodic filings including comments on the financial statements. Even so, there were criticisms that not enough reviews were being done and SOXA now requires that each public company be reviewed at least once every three years. It is apparent that Fortune 500 companies or companies in industries where there have been enforcement issues can expect targeted reviews. This shift in emphasis creates part of the policy justification for the offering reforms on the theory that reviews of WKSIs at the time of offering should not be necessary in light of the ongoing review cycle.
Under the Exchange Act, all registrants and most issuers must file periodic reports with the SEC. Recent legislation and rules have shifted the reporting requirements towards more real-time disclosure of specified material events. Listed registrants must also provide copies of their SEC-filed reports to the stock exchange. Registered US companies must file annual reports (on Form 10-K) and quarterly reports for the first three fiscal quarters (on Form l0Q). Each report must contain information expressly required, plus all further material information so as to make the required information ‘not misleading’ in light of the circumstances under which it is disclosed.
Annual reports filed with the SEC require the disclosure of information that is essentially identical to that required by an initial Securities Act registration statement, including Management’s Discussion and Analysis and US GAAP audited financial statements. Most registrants will have to file their annual reports within 60 days of their fiscal year end. Because many registrants prepare annual reports separate from their Forms 10-K and the Exchange Act proxy rules require that the proxy statement be delivered to shareholders informing them of the annual meeting for the election of directors must be accompanied or preceded by an annual report including most of the information required by Form 10-K, many registrants incorporate material from the annual report into Form 10-K by reference, and the annual report is filed as an exhibit to Form 10-K.
Quarterly reports on Form 10-Q need only be filed by US registrants and are essentially updates of information contained in the annual report. Quarterly reports must contain financial statements, although these do not have to be audited. They are an opportunity for registrants to disclose any other material information necessary to ensure that the quarterly disclosure, when read as an update on the annual report, is not misleading. Currently, issuers must file quarterly reports on Form 10-Q within 40 days after the end of each of the issuer’s first three fiscal quarters.
Additionally, registered US issuers must disclose a broad array of material information on an ongoing basis. A Form 8-K must be filed upon the occurrence of a specified event, and may be filed voluntarily to disclose any other information the issuer judges to be material to the market or necessary to ensure compliance with secondary trading rules. In most cases, reports on Form 8-K must be filed within four business days of the occurrence of the specified event.
The system for foreign private issuers was set up over 25 years ago in an attempt to be deliberately inviting to foreign companies. Thus, on an annual basis, they are required to file their Form 20-F six months after their fiscal year end. While this may have made sense in the distant past, it is a surprising and silly deadline these days, and any foreign company with an active shelf registration must now file the financial statements and much of the other information required by Form 20-F by the end of the first quarter to retain the possibility of issuing securities. The extent to which Form 20-F will wither as disclosures converge and as IFRS comes into use is a question that the SEC will have to address over the next few years. Form 20-F reflects the IOSCO principles and requires essentially the same disclosure as a Form 10-K, although there are various exceptions that take account of the registrant’s home country disclosure regime. As noted above, financial statements must be prepared in accordance with home country GAAP and reconciled to US GAAP and certain matters, such as individual executive compensation, need only be disclosed if such disclosure is provided in home country reports.
The other key accommodation made to foreign companies was to exempt them from any US periodic reporting requirements and put in place a system of home country recognition of interim reports. Event-driven disclosure requirements are also more flexible with respect to foreign private issuers. Form 6-K is much more limited than Form 8-K in its event-driven disclosure requirements and requires additionally that a foreign company furnish to the SEC what it makes public at home.
7. SECURITIES LAW LIABILITY
The US securities laws impose liability for misstatements or omissions contained in the company’s Securities Act registration statements or Exchange Act registration statements and reports, as well as for any manipulative or deceptive practices relating to the purchase or sale of securities. As is well known, class action securities litigation has become a major industry in the US. Consequently, companies and underwriters devote significant resources to factual, legal and accounting due diligence both in the context of an offering and also with respect to their annual and periodic reports.
A unique feature of the US securities laws is that any purchaser of securities, whether in a public offering or in a private placement, has a ‘put’, that is the right to sell the security back to the seller at the price it was purchased if there has been a violation of the public offering provisions or if there has been a material misstatement or omission in the offering document. In the case of a violation of the public offering provisions there is no defence, but in the case of a material misstatement or omission, any seller other than the company can escape liability by sustaining the burden of proof that it had conducted a reasonable investigation and could not know about the error. This self-enforcing provision has all the in terrorem effect on companies and underwriters that one might expect and has led directly to the custom of ‘due diligence’ by underwriters (an expression that appears nowhere in the US securities laws), and the delivery of disclosure opinions and comfort letters in initial offerings. It also has, luckily, a very short life as it can typically only be used for one year. It is critical for an understanding of this process, which has been largely and uncritically exported into legal systems with a very different structure of liability, to realise that the point of this investigation in US law is to create a record for a defence so that most players, other than the company, may escape liability.
With respect to public or registered offerings, the Securities Act also allows a buyer to recover damages for a decline in the value of a security for untrue statements of material facts and for omissions to state material facts in the prospectus and registration statement at the time that it becomes effective. The scope of those persons covered by potential liability is much wider in the US than in many other countries. It includes the company, certain officers such as the CEO and the CFO, the company’s directors, the underwriters and the company’s accountants. Controlling shareholders, and control is a wide concept, can also be held liable. As a practical matter, an issuer has virtually no defence against such ‘prospectus liability’. Other offering participants, such as directors, underwriters and controlling shareholders, have a ‘due diligence’ defence and can avoid liability by establishing that they conducted a reasonable investigation of the information contained in the registration statement and that, based on such investigation, they had reasonable grounds to believe and did believe that the statements were accurate and complete at the time the registration statement became effective. The standard of what is reasonable is that required of ‘a prudent man in the management of his own property’. The offering reforms have not substantively changed these liability provisions, although they have rectified the perceived timing mismatch between the time at which a contract for the sale of securities is entered into and the time at which a final prospectus is available.
Under the offering reforms, the SEC has clarified that one appropriate time at which to apply liability for material misstatements or omissions is the moment that a contract of sale is entered into or the ‘time of sale’, which based on current investment banking and brokerage practices typically occurs a substantial amount of time prior to the delivery of a final prospectus. In effect, the SEC made clear that any modifications, corrections or additions that are made available to investors after the time of sale (including updates in a final prospectus or registration statement) should not be taken into account for purposes of determining whether all material information has been made available to the investor. In facilitating the timely delivery of information to prospective investors, the SEC has liberalised the manner in which information could be delivered, providing for ‘free writing prospectuses’ that are subject to Securities Act liability whether or not they are filed and irrespective of the time of filing.
As a practical matter, companies have a much greater level of protection under the Exchange Act in their annual and periodic reports which support secondary trading of their securities. A provision of the Exchange Act and the rule adopted under it – Rule 10b-5 – make unlawful the failure to disclose material facts or the use of false or misleading statements or any other manipulative or deceptive practices in connection with the purchase or sale of any security. Liability under this provision requires a finding of scienter, a Latin word not used in any other context in American English, which generally means an intent to deceive, manipulate or defraud, or reckless disregard for the truth. Unfortunately for companies with active shelf registrations, this distinction is not meaningful, as they must keep their shelves current by incorporating their Exchange Act filings by reference, thereby subjecting them to prospectus liability. Trading on inside information would constitute a manipulative or deceptive practice. Notably, because Rule 10b-5 regulates all securities transactions in interstate commerce, it applies to private placements, other exempt offerings and, in some cases, even transactions in foreign securities among non-US residents so long as the appropriate jurisdictional nexus exists.
8. OTHER CONSEQUENCES OF TRANSACTING IN US-REGISTERED OR LISTED SECURITIES
Any solicitation of proxies, consents or authorisations with respect to a security registered pursuant to Exchange Act must be accompanied by a proxy statement containing certain specified information (the SEC has recently adopted an amendment to the proxy rules that allows companies and other soliciting persons, as of July 2007, to furnish proxy materials to shareholders by posting the materials on the internet and providing shareholders with notice of such materials’ availability). Practically all transactions in a registrant’s equity securities by its officers, directors, and ten per cent holders must be reported to the SEC and the market. The acquisition by a registrant of its own equity securities is generally permitted under the Exchange Act so long as no manipulation is involved and all such transactions are disclosed in the registrant’s annual report. Further, a person who acquires, directly or indirectly, the beneficial ownership of five per cent or more of a class of equity securities registered under the Exchange Act must report the acquisition to the company, the exchange where the security is listed, and the SEC. Such report, in the form of a prescribed schedule, must be filed within ten days after acquisition of such beneficial ownership.
A special system of rules under the Exchange Act governs tender offer practices in the United States. Under these provisions, any person who makes a tender offer to purchase, directly or indirectly, more than five per cent of an Exchange Act reporting company’s securities must provide information to the SEC, the company, and, if applicable, the stock exchange. The information that must be included in a tender offer statement depends on whether an issuer or another person is conducting the tender offer, whether the tender offer is full or partial and whether cash or securities are being offered in consideration of tender, but generally must include at least a summary term sheet, information about the subject company, the terms of the offer and the purposes of the transaction. As in any other securities offering, it is unlawful for any person to make any untrue statement of a material fact or omit to state a material fact or to engage in any fraudulent, deceptive, or manipulative acts in connection with a tender offer. Because the SEC takes the position that any tender offer involving contact with the US is subject to its regulation, foreign companies seeking to acquire targets with even a minor US investor base face a myriad of decisions and regulatory requirements, even if the target company’s securities are not registered with the SEC (foreign companies may be exempted from some, but not all, of the applicable rules).
A tender offer for a foreign issuer target may be exempt from most (but not all) tender offer rules if less than ten per cent of the target’s ‘free float’ is held by US investors, but free float analyses (which typically exclude shares held by ten per cent shareholders, holders of restricted shares and insiders) are fraught with numerous exclusions and complications that often make a positive determination difficult. If the exemption is not met, rules governing the conduct of tender offers often present challenges in coordinating with the applicable rules of other jurisdictions, such as the target’s home country or the country of its primary listing. These rules include that a tender offer remain open for at least 20 business days, that consideration be paid within three business days of the close of the tender offer and that the target company publicly declare its position on the tender offer within 10 business days of its commencement. Certain tender offer conduct rules will apply even if the above exemption is met (ie, the requirement that US shareholders be treated equally to shareholders in all other jurisdictions and that no securities that are the subject of a tender offer be purchased outside the tender offer). There are many other complex rules governing the manner in which tender offers may be carried out which are beyond the scope of this brief introduction, although we note that the SEC has made efforts to specifically accommodate companies when it can. In addition, if a sufficient US investor base exists and securities of the acquiring company are to be used in consideration of tender, a specific registration statement for use in business combination transactions (which requires extensive disclosure on the acquirer and the target, including pro forma financial statements) must be filed, whether or not the acquirer and/or the target are SEC US-registered.
9. REGULATION OF MARKET PARTICIPANTS
Long a sleepy backwater in the international context, the regulation of market participants has over the last few years developed an increasingly international tone even as, at least in the United States, the regulatory framework is yet to undergo a fundamental rethink in light of the increasing globalisation of the world’s financial markets.
Brokers and dealers of securities in the United States are subject to extensive regulation by the SEC, the NASD, other self-regulatory organisations and by the states.
The Exchange Act generally requires each securities broker-dealer to register with the SEC, to become a member of the NASD and the securities exchanges on which it intends to operate, and to register with state securities regulators in the states where it has offices or contacts with public customers. Registered broker-dealers are subject to numerous regulations aimed primarily at protecting investors from securities fraud and abusive sales practices, including those relating to their net capital, record-keeping and reporting obligations, dealing with customers, control of securities in custody and marketing and trading practices.
In the world of internet brokerage and cross-border exchange consolidation, the SEC rules on the interaction of foreign broker-dealers with US investors are in need of a substantial rethink and overhaul. Under current rules, a foreign broker-dealer can approach sophisticated US investors under very limited circumstances and most trades require the assistance of a US-registered ‘babysitter’ broker-dealer. It is virtually impossible for most retail investors to have direct access to a foreign broker-dealer (and thus enjoy decreased transaction costs), no matter how well regulated or solid. By sharp contrast, any US investor who physically travels abroad to open an account can do so. This regulatory situation is not stable and is most harmful to US retail investors that may not have the contacts or wherewithal to travel frequently abroad. It is to be expected that dealing with the appropriate conditions under which US retail investors may diversify internationally while enjoying the decreased transaction costs enjoyed by large investors should be an increasingly important item on the SEC’s agenda.
The US stock exchanges are subject to extensive registration requirements and regulation and include within their functions a mandate to be a self-regulatory organisation. These regulations have been designed purely with the US domestic market in mind and there has been a long controversy about the ability of foreign exchanges or broker-dealers to have trading screens or other electronic access into the United States without being subject to the full panoply of US regulation. That controversy is still on-going. In addition, the merger of the NYSE and Euronext generated much controversy, some rational but some irrational, about the extraterritorial impact of the US exchange regulations on a foreign exchange and foreign companies listed on that exchange. Ultimately, the relevant European regulators and the SEC were able to work out a framework for cooperation which required no legal changes but which calmed the controversy. It is certain that we have not seen the last of such incidents nor the need for more regulatory frameworks of cooperation.
Mutual funds and their advisers are regulated by the SEC. Under the Investment Company Act, an entity that holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities and owns, or proposes to acquire, investment securities having a value exceeding 40 per cent of its total assets, such as most mutual funds, is an ‘investment company’ subject to regulation by the SEC. Unless an exemption applies, an investment company must register with the SEC by filing a detailed form describing its investment objectives, policies and restrictions.
The Investment Company Act imposes corporate governance, capital structure and market conduct requirements on registered mutual funds. Most registered mutual funds are required to have boards of directors, at least two-fifths of whom are independent. The Investment Company Act also generally requires that sales and redemptions of redeemable shares of mutual funds be at a price based on the fund’s net asset value, places restrictions on the types of investments that can be made by registered mutual funds and imposes strict limits on mutual fund transactions with affiliates.
The Investment Advisers Act requires that all persons providing investment advice to clients register with the SEC as ‘investment advisers’, unless they are specifically exempt. Whether or not registered, all investment advisers act as fiduciaries and owe their clients a series of fiduciary duties, including the duty to recommend suitable investments based on the clients’ financial situation, investment experience and investment objectives, and all are subject to inspection by the SEC. Investment advisers are also generally prohibited from engaging in principal transactions (ie transactions between client accounts and the adviser’s proprietary accounts) and client cross-transactions (ie, trades executed between client accounts for a fee) without full written disclosure and the client’s consent. The Investment Advisers Act subjects registered investment advisers to reporting, record-keeping and disclosure requirements, as well as marketing and contractual fee restrictions.
Hedge funds, relying on a ‘private adviser’ exemption, have traditionally remained unregulated. The SEC, in December 2004, attempted to promulgate regulations that would have required many hedge fund advisers, both in the US and abroad, to register under the Investment Advisers Act. The SEC narrowly, and controversially, reached this outcome by changing the way in which hedge fund advisers must count clients (number of individual investors in funds serviced under the new regulation, rather than the actual number of funds), but was thwarted by the federal courts which held that the regulations were arbitrary and therefore beyond the SEC’s statutory authority. In response, the SEC has recently proposed a measure that would extend the antifraud provisions of the Investment Advisers Act to hedge funds and would raise the net worth qualification in Regulation D from $1 million to $1.5 million in order to further restrict retail access to hedge funds. Given the rapid growth of the hedge fund market and the increasing number of enforcement cases involving hedge fund advisers, it remains to be seen whether the SEC’s concerns that increasing retail interest in hedge funds will expose smaller, unsophisticated investors, as well as pension funds and charitable organisations, to these alternative investments will materialise and whether some form of registration and the attendant regulation will be required to limit abuses while preserving hedge funds’ unique characteristics.
10. CONCLUSION
US securities regulation has long had an extraterritorial component that was at times the subject of controversy abroad. Recently, in part as a result of SOXA, the burdens of the random lottery of US class action litigation and the increasing competitive weight of non-US capital markets, the effects of this extraterritoriality have come under closer scrutiny domestically. It is a helpful sign that a public debate, involving US and foreign interested actors, has been engaged and although the contours cannot be predicted at the moment, it is certain that the next few years will involve an increasing dialogue in this area with the possibility of significant changes.
This chapter is a highly telescoped summary of complex and lengthy laws and regulations. Readers are warned to read it in that spirit.
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