Security Markets and Regulations

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I. BACKGROUND – SECURITIES MARKETS AND REGULATION

A. The Basics
1. Two types of securities transactions:
a. Primary market transactions – issuer sells securities to marketplace b. Secondary market transaction – between two outside investors

2. How we protect consumers:
a. Disclosure
b. Process rule
c. Bans
d. Education
e. Intermediaries ( profit-driven incentive to ensure quality

3. What is different about common stock?

a. Centrality of capital markets – prices determine allocation of capital, so want accurate price signals ( economic growth

b. Importance of investments relative to other decisions – large fraction of net worth

c. Irrational greed ( risk entire savings

d. Intangible – depends on expertise (info known by insiders) ( informational asymmetry

e. Underlying value based on capital appreciation, dividends, liquidation

f. Collective Action Problem – investors too numerous to band together

4. Efficient Capital Market Hypothesis (ECMH): How the market learns a. Weak-form: all information concerning historical prices is fully reflected in current price b. Semi-strong: stock prices incorporate all publicly available info (i.e. historical info + current public info) ( protected if purchase at current stock price. c. Strong-form: prices incorporate all information, whether publicly available or not.

1 Securities Disclosure

5. Ways to value securities:
a. Technical analysis – historical stock price patterns b. Fundamental valuation – PDV = expected payment / discount i. Discount for time value of money
I. Reasons for: inflation, uncertainty of return, impatience/hedonism ii. PDV = cash flow / (1 + r)t
I. Risks ( CAPM: R = Rf + beta(Rm – Rf)

6. Firm-specific information worth knowing
a. Projections – expected costs and cash flows
b. Business plan, Use of proceeds of IPO
c. Capital structure
d. Sources of financing
e. Qualifications of management
f. Risks – business, litigation, regulatory
g. Competitors (general info)
h. *Current stock price for, e.g., GE (ECMH)

7. Non-legal Incentives to Disclose
a. Issuer: attract investors, distinguish co. from competitors who don’t disclose b. Underwriter, accountants, etc.: maintain reputation with clients

8. Arguments for mandatory disclosure:
a. Solves coordination problem (like U.S. GAAP)
b. Agency costs – accurate disclosure helps directors discipline managers c. Positive externalities
i. Increase accuracy of securities prices
ii. Firm-specific info useful to competitors and third parties d. Duplicative research – otherwise individuals would fund wasteful research

2 Securities Law Apparatus

9. Securities Exchange Act of 1934 (Exchange Act)
a. Primarily regulates secondary market transactions b. Protects primarily through disclosure obligations i. Antifraud Liability - § 10(b), Rule 10b-5
10. Securities Act of 1933 (Securities Act)
a. Regulates primary market transactions
b. Three Approaches
i. Mandatory Disclosure (registration document and prospectus) ii. Gun-jumping rules
iii. Heightened Antifraud liability

II. MATERIALITY

A. What Matters to Investors?
1. Wanted – Information salient to making investment decisions 2. Not Wanted
a. (Buried facts doctrine) iF disclose too much, undermines value of important info. b. Disclose private info (e.g., CEO heart attack) ( deter good people from becoming CEO c. Disclose secret plans ( companies less inclined to be competitive

B. The...
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