Going Public Federal Securities Laws
ComplianceApril 10, 2014

Going Public: Federal Securities Laws

A corporation often outgrows the scope and size envisioned or provided for by its original investors. In order to expand its marketing, production, or services, new sources of capital are often needed. One method of raising this capital is to sell shares to the general public. This concept is known as going public.

Advantages and disadvantages of going public

There are several advantages to going public. First, selling shares is less costly than borrowing money, as dividends do not have to be paid to shareholders, while creditors must be repaid. Secondly, a public offering of securities results in an increase in the net worth of the corporation, thus making it easier to obtain future financing. In addition, public trading of a corporation’s shares, especially if traded on a national securities exchange may enhance the corporation’s prestige, thus giving it an edge over its competitors.

There are also disadvantages to going public. The management loses some control over the corporation since power must be shared with outside shareholders who will have the right to vote and inspect the corporate records. The corporation may also become subject to a takeover through the purchase of its shares on the open market. Also, public trading subjects the corporation to the reporting and disclosure requirements of both the federal securities laws and of the exchange where the shares are traded.

The process of going public

The process of going public begins with an initial meeting between the corporation and an underwriter. An underwriter is a company that purchases shares of a corporation and arranges for their sale to the general public.

If the underwriter decides to undertake the public offering, it issues a non-binding letter of intent to the corporation. This letter of intent outlines the nature of the offering, the internal steps the corporation must take for the deal to go forward, and the underwriter’s compensation.

A legally-binding underwriting agreement follows. In this agreement the corporation warrants that it is in good standing, that its financial representations are true and accurate, and that it will file a registration statement with the Securities and Exchange Commission (SEC) as required by the Securities Act of 1933.

The corporation also warrants that it will comply with the securities statutes of the states in which its securities will be sold. State securities laws are known as Blue Sky laws. Blue Sky laws vary from state to state. Generally, they contain antifraud provisions, requirements that the securities be registered with the state, and provisions for the licensing of the broker-dealers who actually sell the securities to the public.

In the underwriting agreement, the underwriter agrees to purchase the shares of the corporation at a particular price. The difference between this purchase price and the offering price to the public represents the underwriter’s commission.

After this underwriting agreement is signed, and the corporation’s registration statement is accepted by the SEC, the underwriter may begin to offer the shares to the public. The corporation will then be established as one that is publicly traded.

Federal securities laws

Securities have no intrinsic value. Unlike real property or tangible personal property, securities represent an interest in a business enterprise. Thus, the value of securities depends upon the value of the underlying business.

There are many factors that go into determining the value of a business. These factors include the company’s profits, gross sales, market share and competition. They also include general business conditions, trends in that industry, perceptions by investors and the general public, and psychological factors.

Many of these factors are learned through disclosure by the business itself. Some of these factors may be subject to manipulation by those seeking to profit by buying or selling securities. In order to provide for full disclosure and to prevent manipulation and fraud, Congress enacted the federal securities laws.

The federal securities laws consist of several statutes that regulate a broad range of economic activity. General business corporations are most concerned with the Securities Act of 1933, the Securities Exchange Act of 1934 and the Sarbanes-Oxley Act of 2002.

The Securities Act of 1933

The Securities Act of 1933 applies primarily to the initial issue of securities. The ‘33 Act provides that no security may be offered or sold to the public unless it is registered with the Securities and Exchange Commission.

The securities are registered on Form S-1 (Registration Statement). This document contains all of the information that a reasonable investor needs to make an informed judgment whether or not to purchase a corporation’s securities. This information includes a description of the securities being offered, the use of the money received, the capital structure of the corporation, its financial statements, a description of its business, and information about its major shareholders, officers, directors, and pending legal proceedings.

The ‘33 Act provides for civil liability for false or misleading statements in the Registration Statement for every person who signed it, every director, every underwriter, and any professional (account-ant, attorney, etc.) for that part of the registration statement the professional prepared or certified.

Certain securities, such as United States or state bonds, are exempt from registration under the ‘33 Act. In addition, certain transactions are exempt from registration.

Exempt transactions are governed by complex rules. One such exemption is a private placement. In a private placement, the securities are offered to a limited number of people, no general solicitation or advertising is made, and the offer is made to sophisticated investors. The reasoning behind the exemption is that the securities are offered to persons with deep knowledge of investments. Therefore, they have the resources and ability to undertake their own investigation. They do not require the type of disclosure necessary to protect the ordinary investor.

The Securities Exchange Act of 1934

The Securities Exchange Act of 1934 established the Securities and Exchange Commission as the federal agency charged with enforcement of the securities laws.

In addition to its enforcement power, the SEC can regulate the trading of securities through its rulemaking powers. The ability to make rules in connection with securities confers broad power upon the SEC because these rules have the force of law.

The major difference between the ‘33 and ‘34 Acts is that the ‘33 Act deals primarily with the original issue of the corporation’s securities. The ‘34 Act, on the other hand, deals primarily with subsequent trading. Thus, provisions of the ‘34 Act apply to the corporation that issues the securities, the exchanges where they are traded, and the people who buy and sell them.

The ‘34 Act requires every corporation that issues securities registered with the SEC to file periodic reports. These reports include Form 10-K, an annual report containing broad disclosures about the corporation’s business and finances, Form 10-Q, a quarterly report containing information about the corporation’s finances, and Form 8-K, a report which the corporation must file shortly after certain events including a change in control, an asset sale or purchase, a bankruptcy, a change in accountants, a change in financial information, or a resignation of directors.

The ‘34 Act also contains extensive antifraud provisions. Section 10(b) and Rule 10b-5 make it unlawful to make any untrue statement of fact or to omit to state a material fact in connection with the purchase or sale of a security. Actions against “insider trading” are based upon the failure to disclose a material fact required by Rule 10b-5.

Section 14 and the rules promulgated thereunder govern the nature of the disclosure required when proxies are solicited. For example, Section 14(a) requires anyone soliciting a proxy to disclose to the shareholder all of the material information about the issues being voted on. Rule 14(a)-9 prohibits the solicitation of proxies containing any false or misleading statements of material fact

Another antifraud provision, Section 16(b), is known as the “short-swing rule.” This rule prohibits any officer, director, or 10% shareholder of a corporation from profiting from the purchase and sale of that corporation’s securities within a six-month period. The corporation is entitled to recover the profits.

The Sarbanes-Oxley Act of 2002

The Sarbanes-Oxley Act of 2002 was enacted after it was discovered that some corporations were providing incorrect financial information in their SEC filings. Sarbanes-Oxley imposed new requirements on corporations, their directors and executive officers and imposed new and severe penalties for failures to comply. Among other things, Sarbanes-Oxley created a new agency to oversee the accounting firms auditing public corporations, required audit committees to have independent directors, required lawyers to report violations of securities laws, required the chief executive officer and chief financial officer to certify the accuracy of the annual and quarterly reports, required additional information to be disclosed in the periodic filings, required insiders to report their trading activities within 2 days after the trade, protected whistleblowers and increased the prison terms and fines for violations of certain securities laws.

The Dodd-Frank Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act, which was enacted in 2010, was a comprehensive overhaul of the nation’s financial industry. Although its main function was to change the way financial institutions were regulated, the Act also contained a number of requirements that affected publicly traded companies in general.

Many of the provisions of the Act that affected public companies dealt with executive compensation. For example, the Act required public companies to obtain a non-binding shareholder vote on the compensation to be paid to executive officers, required disclosures and a non-binding vote for any golden para-chute payments and required compensation committees to be comprised of independent directors.

The Act also authorized the SEC to adopt rules allowing shareholders to nominate candidates for directors using the company’s proxy statement, prohibited brokers from voting any shares they do not own on significant matters unless the broker received specific voting instructions from the beneficial owner of the shares and allowed whistleblowers to receive monetary awards for reporting violations to the SEC.