Week Thirteen: Accountants & Securities


Organized markets for business capital date from the mid-1600's. Markets historically depend on government, the laws and the courts to provide stable, enforceable transaction rules and to combat fraud. From the start, capital markets have been subject to episodes of mania, panics and crashes. Major market declines tend to expose unstable schemes that had flourished in times of prosperity, and so generate political pressure for government to regulate against such abuses.

The SEC Regulates Public Capital Markets in the U.S.

The sale of new securities to the public, and the public trading of existing securities is extensively regulated by the U. S. Securities and Exchange Commission, a Federal "independent administrative agency". There are 5 commissioners appointed by the President with Senate confirmation, and about 3,500 staff members.

The SEC was originally created in response to the stock market crash of 1929-1932. The Dow Jones Industrial Average fell from a high of 374 in September 1929 to a low of 47 in January 1932 -- an 87% decline that set off a worldwide economic depression. Here's the chart.

The principal laws are the 1933 Securities Act, which deals with new issues and the 1934 Securities Exchange Act, which regulates brokers, exchanges and reporting by publicly traded companies. The Investment Company Act of 1940 governs the mutual fund industry, and there is also an Investment Advisors Act. These laws have been amended often, most recently by the Sarbanes Oxley Act of 2002, and they are supplemented by extensive administrative regulations and rulings issued by the SEC.

The broad definition of "security"

In this context, "securities" include both stocks (equity) and bonds (debt) -- the two basic forms of ownership and control of business entity capital -- and many other arrangments. According to the US Supreme Court, the term "securities" encompasses the various ways in which someone can invest money or property in a common enterprise expecting to make a profit from the significant efforts of others. SEC v. Howey, 328 US 293 (1946)

However, the markets for commodity futures and many transactions in derivatives are regulated by a different Federal agency, the Commodity Futures Trading Commission , leading to inevitable tangles over jurisdiction.

In addition, the Commodity Futures Modernization Act of 2000 prohibited both the SEC and the CFTC from regulating Credit Default Swaps. These unregulated derivative financial instruments appear to have been at the heart of the multi-billion dollar collapse of the American Insurance Group in September 2008, and they continue to pose problems for the stability of the world financial system. The SEC has recently urged Congress to change the law, so as to deal with the systemic risk to the financial markets posed by unregulated Credit Default Swaps, and the opportunities they present for fraud and manipulation.

The '33 Act: New Issues

Registration and Full Disclosure

The '33 Act applies to Initial Public Offerings, secondary offerings by company insiders, and to stocks/bonds issued by established companies. Generally, the issuer must file a registration statement with the SEC before the securities can be sold, and must deliver a "prospectus" to each purchaser. These documents must fully disclose all facts that would be material to a potential investor. They are available to the general public, and now are filed electronically and posted on the SEC's EDGAR website. To see examples, search the Latest Filings for "S-1", the most commonly used registration form.

The theme of US securities law is not "paternalistic" protection of investors from bad investments, but "transparency" -- full public disclosure of known facts. People are allowed to make dumb investments, but they do so while having access to all material facts and knowledge of the risks.

Although the SEC doesn't consider the "merits", the reviewing staff does consider the sufficiency of disclosure and may require amendments. "S-1A" indicates an amended registration.

The Distribution System

Who is involved: Issuing Company, attys, accountants, investment bank advisers, "underwriters" (the brokerage firms that will distribute the securities to the institutions and individuals who are the final buyers)

Limits on advertising and sales activity

  • Cannot sell or offer to sell before statement is filed
  • During waiting period (registration filed, not yet "effective"), can only offer and distribute a preliminary prospectus. "Tombstone" ads by underwriters.
  • Once it's effective: deliver final prospectus and close the sale

Audited Financial Statements are required

Registration Statements must include audited financial statements in the format specified by Regulation SX. This gives SEC a lot of power over the accounting profession. For example, Reg. S-X Rule 2-01(c) sets forth very detailed rules for determining whether an auditor has the required "independence" from the client, "both in fact and in appearance." Regulation SX also specifies the structure to use in presenting financial information (Rules 5-02 for Balance Sheets and 5-03 for Income Statements) and sets forth many specific disclosure requirements.

It's important for accounting students to know about two ongoing SEC projects that are likely to result in significant changes over the next few years.


The SEC is moving to replace EDGAR -- the system for filing required reports electronically -- with interactive data filings using the XBRL specification


The Commission is also moving forward with a proposal that would require US companies to change away from Generally Accepted Accounting Principles and to use International Financial Accounting Standards instead. The target dates for changes would be between 2011 and 2014.

What's Exempt from Registration?

Exemptions due to nature of security or issuer

  • Government organizations
  • short-term commercial paper due in less than 9 mos
  • non-profit organization securities
  • savings and loan securities
  • insurance company policies and contracts (states regulate insurance)
  • reorganization (i.e. bankruptcy) securities

Exemption for small offerings

Rules 504 and 505: no general selling efforts, state registration, and amount is maximum $1 mm over 12 mos., or $5 million over 12 months w/ maximum 35 buyers

Exemption for offerings limited to a single state

Reflects 1933-era view that Congress lacked Constitutional power to regulate activity that didn't cross state borders.

States have their own securities laws covering single-state offerings. See Cal Corps. Code Sec. 25100 and following. Enforcement is by the California Department of Corporations. Many state filings are now online.

Exemption for private placements to experienced investors

Rule 506: Max 35 buyers who are "accredited investors" or have the knowledge & experience to evaluate the merits and risks. Accredited = person with >$1 mm net worth, or > $200K income, or corp w/ => $5 mm in assets, or insiders of the issuer, or institutional investors

Resale restrictions for exempt securities

"Rule 144" stock: "lockup periods" and restrictions on volume for re-sale of shares issued in exempt private placements or small offerings. Must be "legend" printed on the stock certificate saying resale is limited

This means, for example, that company founders and venture capitalists can't immediately dump their shares shortly after a company goes public

Rule 144A: institutions over $100 m can buy and sell to each other w/o 144 time restrictions

The '34 Act: Trading, Exchanges and Reporting

Registration of Exchanges, Brokers & Dealers

SEC gets to review and approve changes in exchange rules for NYSE, NASDAQ, etc.

      Sec. 11 regulates trading by members of exchanges: "market" insiders

      Rule 15: Brokers and dealers must register. SEC can bar violators from securities industry

Required reports by publicly traded companies

If securities are registered under '33 Act or are traded on a national exchange, must file yearly audited financial statements, quarterly (unaudited) reports, and notices of material events. Annual = 10-K, quarterly = 10-Q, material event = 8-K

Reports by Dir's, Officers & >5% Shareholders

Insiders [Forms 3 and 4] must disclose their transactions in company stock. Also transaction reports by owners of 5% or more, on Forms 13D, 13G and 13F (for investment managers)

Summaries of holdings are available online

Regulation of Corporate elections and Proxy Voting: Forms Pre14a and Def 14a

Transparency in Takeover Offers: TO-I and TO-T

Corporate Governance Requirements

All publicly traded companies must have an Audit Committee of the Board of Directors, and only independent (outside) Directors can serve on it. Sec. 10A of the Exchange Act, as added in 1995. This Committee is responsible for hiring the external audit firm, and the auditors report directly to this committee.

For example, here are the minutes [1.6M pdf file] of AIG's Audit Committee meeting on 2/7/08 with PriceWaterhouseCoopers, discussing a potential material weakness in internal control over the valuation of credit derivatives

Sec. 10A(g), as added by Sarbox in 2002, makes it illegal for an audit firm to also provide certain types of accounting and consulting services for a client, and requires audit committee approval for those non-audit services, such as tax work, that are still allowed. Audit fees must be publicly disclosed in proxy vote filings -- which is how we know, for example, that in year 2007 AIG paid PWC $104.8 million for audit work and $10.6 million for tax consulting.

Rule 10b-5: the basic anti-fraud provision

"It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

  • To employ any device, scheme, or artifice to defraud,
  • To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
  • To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,

In connection with the purchase or sale of any security."

Scope of 10b-5: Wharf Holdings

Law Enforcement and Auditors' Liabilities

US System involves dual enforcement: by government and by investors/lawyers

Government enforcement of the '33 and '34 Acts

Potential criminal liability for wilful violation

SEC can seek court injunctions and civil penalties against those selling unregistered securities, or failing to file required reports. SEC litigation releases are here.

Professionals who are directly subject to SEC regulation, such as broker-dealers, investment managers and auditors go thru administrative law proceedings conducted by the Commission itself. [w/ some possibility of appeal to courts.] Administrative proceeding releases are here.

These are often resolved w/ consent orders to "cease and desist": a negotiated settlement, where party in effect says: "I didn't do it and I won't do it again". For example, here's an August 2008 order involving Ernst & Young, where the firm paid $2.3 million, and an engagement partner was suspended from practice, for having entered into an independence-impairing business relationship with an author-investor who also served on the Board of Directors of three EY clients.

Investor suits under state law

Breach of Contract: Investors and creditors who use financial statements generally have no contract with the auditors and are not identified third party beneficiaries.

Negligence: Most courts have also limited auditor liability for negligence, as in Bily v. Arthur Young, 3 Cal. 4th 370 (1992).

Common-law Fraud: Plaintiffs often have difficulty in proving (a) that auditors intended to deceive them by attesting to false financials and (b) that they specifically relied on the auditors' statements in making their investment decisions

Investor lawsuits under the '33 Act

If reg statement is false as to a material fact or omits facts necessary to make it not false that's "securities fraud". No need to show specific reliance by purchaser, and frequently brought as class action on behalf of all purchasers

Who is liable: those who acted intentionally or negligently

  • Company
  • Officers who sign reg st: Pres, Chief financial / acctg officer
  • Directors (at least 1/2 must sign)
  • Underwriters
  • Experts (atty and acct) as to portion they expertise

"Due Diligence" defense

"We acted reasonably and had no reason to know of falsity/omission". Non-experts may rely on experts unless they know info to contrary

Auditor liability

Auditors "attest" as to the material fairness of the financial statements: that they "fairly present in accordance with GAAP".

In order to make sure last annual report still "fairly presents", need to do an update or interim or "S-1" review as part of registration

Escott v. Bar-Chris old leading case of an S-1 review failure causing auditor's liability (Peat Marwick)

Investor lawsuits under the '34 Act and Rule 10b-5

Implied private right of action

Courts held that implicit in Rule 10b-5 was the right of those injured by a violation to bring suit seeking compensation for the loss. If audited financial statements turn out to have been materially inaccurate, such that they did not "present fairly in accordance with GAAP", isn't that an "untrue statement of a material fact or omission to state a material fact necessary in order to make the statements made... not misleading"?

The "fraud on the market" theory

In Basic, Inc. v. Levinson, 485 US 224 (1988) the Supreme Court borrowed from "efficient market" Capital Asset Pricing theory the notion that publicly available corporate financial information -- including false information -- is presumed to be incorporated into the market price at which investors buy or sell. That dispells the need to prove specific reliance.

The class action

Federal Rules of Procedure allow a plaintiff, with court approval, to bring a lawsuit on behalf of all those similarly situated. This means that all losses of all investors that are attributable to a 10b-5 violation can be aggregated into one lawsuit. Stanford University has an online securities class action database

Many publicly traded companies have stock capitalizations in the tens of billions of dollars. The potential liability means that defending a 10b-5 class action lawsuit can be a "bet the company" situation, which creates pressure for compromise settlements to avoid the hazards of litigation. Here's how the Milberg, Weiss firm described its $225 million class action settlement with PriceWaterhouseCoopers in connection with Tyco, Inc.


Liability depends on "scienter", that is having acted "knowingly or recklessly". Simple carelessness, or being a secondary helper ("aiding and abetting") is not enough. The 1995 Exchange Act amendments tried to limit liability by making it proportionate to responsibility, and also required that securities lawsuit plaintiffs plead detailed facts when they file complaints. These rules are procedural hurdles, but there is still a significant chance in the next few years that a securities lawsuit could result in destroying a Big-4 audit firm, just as the Enron case wrecked Arthur Andersen. [See Eric Talley, Cataclysmic Liability Risk among Big Four Auditors, 106 Colum. L. Rev. 1641 (Nov., 2006) 0.5M pdf file]

Insider Trading

"Insider trading" has 2 meanings: trades by those "on the inside" (key employees of publicly traded companies), or trades based on "inside" (material, nonpublic) information

    Legitimate Trades by Insiders

    Required reporting on Forms #3, 4 or schedules 13D, 13G

    Trades by insiders: Sec. 16: disclosure, and Short term profits turnover

      Pay to co. any profit from purchase and sale w/in 6 mos. Intent irrelevant. Enforcement by company or by sh derivative suit if no action w/in 60 days of demand

    Improper Trading: using material nonpublic information

      Why outlaw it?

      Law & economics argument is that insider trades make market prices more efficient, and that it's the exchange market makers, not public investors, who are the losers. Comparative national studies, tho, suggest that insider trading drives non-insiders away from securities markets generally, so capital doesn't get allocated efficiently

      How detect and enforce?

      The "victims" are anonymous market participants. Traders don't know who is taking the other side of the trade.

      Absence until recently of specific US definition of "insider trading"

      Now covered by Rule 10b-5-1

      Before, SEC and courts tried to adapt the general antifraud Rule 10b-5. The theory was that those who traded based on company information not known to the anonymous investing public on the other side of the trade had: "omitted to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading." This created some difficult issues. For example:

        Chiarella case: C worked for a company that printed corporate merger documents. He used what he saw on the job to buy stock in target companies just before public announcement drove the prices up. On appeal of a criminal prosecution, the Supreme Court held that he had not violated Rule 10b-5, because he was not an insider or a fiduciary of the companies involved. It might be unfair, but it wasn't a criminal 10b-5 violation

        Dirks case: D worked as a stock analyst at a brokerage, where he researched Equity Funding Life Co. as a possible investment. A "whistle-blower" inside the company told him that the assets were fraudulently inflated. [Equity Funding was one of the first "computerized" accounting frauds. Company officers generated massive printouts of phony insurance policy info, which fooled Seidman & Co, the auditors.] D told his investor clients, who dumped the stock. After the fraud collapsed, SEC brought administrative proceedings against D for insider trading. The Supreme Court reversed, reasoning that those who receive insider tips that violate a duty of confidentiality must refrain from trading, but here the info was leaked to expose the fraud, not for personal gain, so there was no breach of duty

        Carpenter case: C wrote a popular stock-picking column for the Wall Street Journal. He told his broker friends about his picks in advance of publication, so they could buy just before the public drove the price up, and give C a share of their profits. On appeal from a criminal conviction, the Supreme Court deadlocked 4-4. Some thought there was no "insider trading", because C was not an insider at the companies he wrote about. Others argued that C owed a duty to his employer to keep the information about his stock picks confidential until it was published. They believed that C should not be allowed to use this material nonpublic info in order to get an improper advantage over other investors by -- even though the info did not belong to the companies whose stock was being traded.

      O'Hagan (1997) (assigned)

      Implications for auditors: Deloitte v. Flanagan

      SEC Rule amendments in 2001: Regulation FD and Rule 10b5-1(c)

      Purpose is to distinguish legitimate from improper trades, and to create a safe zone for legitimate insider trades. Insiders should favor prompt disclosure of material events thru filing 8-K forms. Afterwards, they can trade company stock more freely, because the info is no longer "inside", but has become public knowledge.

(c) 2001-08 Robert H. Daniels