US Corporate Law/Securities

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Securities represent a financial interest in a corporation.

Equity vs. debt financing[edit]

Generally, a corporation receives capital in exchange for equity securities or debt securities or a combination of the two. Equity securities are also known as stock. Debt securities are commonly known as bonds: although they are formally divided into bonds and debentures, the word "bond" is often used to refer to both.

A bond evidences a loan to the company, rather than a share of the company's equity. The money or other consideration received in exchange for a bond becomes both an asset and a liability to the company. In contrast, the consideration received for stock becomes an asset of the company without becoming a liability; it adds to the company's equity (the difference between assets and liabilities).

Bonds and debentures[edit]

Life is full of surprises, and even more so when it comes to finances. A person having a good income today may face financial crisis in future. To avoid these unforeseen financial crises everyone invests in different instruments that can fetch extra income. There are many options available in the market that can be classified as risky and non risky. It is very well understood that risky options yield higher gains but non risky ones can give very low returns. Debentures and bonds are two such options that can be taken for good returns on ones investment. Debenture is an instrument issued by a company that can be convertible or non convertible into equities. Bonds are issued by companies or by government and can be seen as a loan taken by them to meet their financial needs. These two instruments are basically loan taken from the investor but have very different repayment conditions.

Debentures

Debentures are issued by a company to raise short to medium term loan needed for expenses or for expansions. Just like equities these can be transferred to anyone, but does not give right of voting in the company’s general meetings. Debentures are simply loans taken by the companies and do not provide the ownership in the company. These are unsecured loans as company is not bound to return the principal amount on the maturity. Debentures are of two types convertible and nonconvertible. The convertible debentures are the ones that can be converted into equity shares at a later time. This convertibility provides attraction to the investor but yield lower interest rates. Non convertible debentures does not convert into equity shares thus can yield a higher interest rate.

Bonds

Bonds are actual contract notes issued by the borrower to pay interest at regular intervals and return the principal on the maturity of the bond. These bonds are issued by the companies for their expenses and future expansions. The bonds are also issued by the government for its expenses. A bond is seen as loan taken by a borrower from the investor so unlike equity share it does not give stake in the company but he is seen as a lender. These bonds are redeemed at a definite time. These are secured loans and can yield low to medium interest rate.

Difference between bonds and debentures

Both bonds and debentures are instruments available to a company to raise money from the public. This is the similarity between the two, but on closer inspection, we find that there are many glaring differences between the two.

Bonds are more secure than debentures. As a debenture holder, you provide unsecured loan to the company. It carries a higher rate of interest as the company does not give any collateral to you for your money. For this reason bond holders receive a lower rate of interest but are more secure.

If there is any bankruptcy, bondholders are paid first and the liability towards debenture holders is less.

Debenture holders get periodical interest on their money and upon completion of the term they get their principal amount back.

Bond holders do not receive periodical payments. Rather, they get principal plus interest accrued upon the completion of the term. They are much more secure than debentures and are issued mostly by government firms.

In Brief:

• Bonds are more secure than debentures, but the rate of interest is lower

• Debentures are unsecured loans but carries a higher rate of interest

• In bankruptcy, bondholders are paid first, but liability towards debenture holders is less

• Debenture holders get periodical interest

• Bond holders receive accrued payment upon completion of the term

• Bonds are more secure as they are mostly issued by government firms

Stock[edit]

Holders of stock have two key rights: voting rights and residual rights. Voting rights enable stockholders to elect the board of directors and approve or reject certain fundamental transactions. Residual rights allow the stockholders to share the company's profits, as well as recover some of the company's assets in the event that it folds, although they generally have the lowest priority in recovering their investment.

Types of stock[edit]

Common and preferred stock[edit]

By default, stock in a corporation is common stock. Common stock is generally accompanied by a voting right and residual right proportional to the number of shares held in the corporation. If a corporation only offers common stock, an owner of 25 percent of the common stock would control 25 percent of shareholder votes, receive 25 percent of any dividend payout and be entitled to 25 percent of any post-liquidation assets after creditors are paid in full.

Stock can also be designated as preferred stock, which gives it a higher level of residual rights. Generally, common stockholders cannot be paid until preferred stockholders are paid. Preferred stock often, but not always, comes with restricted voting rights, or sometimes with no voting rights at all. It is commonly used by investors such as venture capitalists who wish to invest in new companies but also seek to minimize risk.

Preferred stock can be designated as convertible, meaning that it can be converted into common stock at a certain time or times (e.g. at the holder's option). This gives the preferred stockholder the ability to exercise more control over the business later in exchange for giving up their dividend and liquidation preference. Common stock can also be convertible into preferred stock, although such cases are rare.

Classes of stock[edit]

The articles of incorporation may also designate various classes (or series) of stock. Generally, this is done to apportion voting rights and liquidation preferences between various types of investor.

For instance, in a small company, the founders may have Class A common stock, one group of investors may have Class B preferred stock, and another group may have Class C preferred stock. Class A stock may be allotted a certain number of seats on the board so that the founders always have the power to remain on the board. Class B and Class C stock can be given separate allotments of board seats as the shareholders agree, and can be given different levels of liquidation and dividend preference as the shareholders agree.

Par value and legal capital[edit]

A simple way to define par value is as the "face value" of each share. This is a misleading definition, though: if you buy a share of stock for $75, its par value could theoretically be just about anything. If it has a par value at all, the value is probably low, maybe $1. In most cases, the par value will be completely irrelevant to the shareholder.

Par value comes from an era when small corporations were the norm. Three people might have gotten together and agreed to contribute $10 apiece to form a corporation. When the articles of incorporation were drawn up, the number of shares and par value of each share would be included. For three people investing $10 each, the corporation might issue three shares with a par value of $10, six shares with a par value of $5, or thirty shares with a par value of $1. Whichever numbers its owners chose would be recorded in the articles.

In the beginning, the promoter of a corporation (i.e. the person soliciting investments) would almost always set a fixed ratio between amount invested and number of shares received in exchange for that investment. Par value turned this into an absolute legal requirement. There were several reasons to do this: for one, it ensured that shareholders received equal treatment, as they would get equity and dividend rights proportional to their investment.

The legal capital (also called stated capital and paid-in capital) of the corporation would be determined by multiplying par value by the number of shares issued. Lenders were theoretically supposed to use this figure to know how much the corporation was worth at its outset. In practice, this didn't work. Some people learned to contribute property to a new corporation in return for stock at an inflated par value. On the balance sheet, the property would be the corporation's only capital, and because legal capital was fixed, the value of the property would magically go up. While the promoter had $10,000 in stock, the corporation might only have $5,000 worth of assets, but would still be worth $10,000 on paper.

Stocks sold at inflated par values were called watered stock, because the assets of the corporation were "watered down" to increase the apparent value of the stock. Holders of watered stock could be in trouble if a creditor foreclosed on the corporation's assets. If they had received $10,000 in stock for a $5,000 capital contribution, they would not only lose their $5,000 investment but would also be personally liable for the additional $5,000, whether they were the aforementioned promoter lying about the value of their contribution, or an innocent investor relying on par value to gauge the true value of the corporation.

Because par value was such an unreliable indicator of the actual value of stock, and because high par values could create liability for investors if the corporation went belly up, corporate lawyers began advising their clients to issue stocks with low par values. The legal capital of the corporation would still be determined based on par value, but the balance sheet would include the investment over par value as a capital surplus, and everything would still balance. In 1915, New York got wise and authorized corporations to issue "no par stock" with no par value at all, in which case the board of directors would allocate the incoming capital between stated capital and capital surplus.

Thanks in large part to a proliferation of low par and no par stock, watered stock is less of an issue these days. The last major American court case dealing with watered stock was in 1956. (Most corporate statutes also provide that the board of directors exercises conclusive judgment of the value of any property it exchanges for stock, as long as the directors do so in good faith; watered stock still comes up in the context of fraud, though.)

In most places, par value is optional. Under DGCL § 102(a)(4), a corporation can choose between par or no par stock, but must make the election in the articles of incorporation. MBCA § 2.02 does not mandate par value, but allows corporations to voluntarily place par value on their stock. For lawyers, one of the most important considerations surrounding par value is: "How much will it cost?" States often charge a franchise fee for corporations based upon the par value of the outstanding stock, with no par stock given an arbitrary par value for purposes of the calculation.

Distributions[edit]

A distribution is a transfer of the corporation's wealth to its shareholders. There are two types of distribution: dividends and stock repurchases. From the corporation's standpoint, the two transactions are very similar: they both involve a payment from corporate funds to the shareholders.

In par value states[edit]

Under par value regimes, distributions can only be made from the "surplus" of the corporation. The exact definition of "surplus" varies from place to place, but Delaware defines it as the assets that exceed the legal capital of the corporation—the aggregate par value of its shares. This means that in such states, creditors can only rely upon recovering a fraction of the corporation's assets: the rest are free to be distributed to shareholders at any time.

A few other states impose a further restriction: that distributions have to come from earned surplus, the money that comes from corporate profits. This means that companies cannot pay dividends that would bring their assets below the amount of paid-in capital, the total amount that has been directly paid in by shareholders since the company's incorporation.

Under the MBCA[edit]

The Official Comments to the MBCA suggest that a corporation must meet two tests before it makes a distribution. These are:

  • Equity insolvency test - After the distribution, the corporation must be able to pay its debts as they become due in the usual course of its business.
  • Balance sheet test - After the distribution, the corporation's total assets must be greater than or equal to its liabilities plus the amount needed to buy out all of the holders of preferred stock.

Some states have adopted these tests verbatim. Others have gone further: in California, for instance, the balance sheet test under CCC § 500 requires the corporation to have assets greater than 125% of its liabilities after the distribution.

Compliance with these rules falls upon the directors themselves. If they break the rules, they can be individually liable to the company's creditors. The Official Comments indicate that the decision to make a distribution should be treated as any other business decision, and therefore should be subject to the business judgment rule. This means that as long as the directors make the decision in good faith, on an informed basis, and absent a conflict of interest, they will usually be safe.

Securities in public corporations[edit]

Publicly-traded corporations are subject to a number of additional regulatory regimes, most of them federal:

  • Securities Act of 1933 - Regulates the public issuance of securities.
  • Securities Exchange Act of 1934 - Regulates the public trading of securities.
  • Glass-Steagall Act of 1933 and Gramm-Leach-Bliley Act of 2000 - Bar banks from dealing in corporate securities;
  • Investment Advisers Act of 1940 - Regulates professional investment advisors with more than $25 million in managed assets.
  • Investment Company Act of 1940 - Regulates securities investment companies respectively. Many investment-related companies fall under these acts, even those engaging in the trade of "securities" not defined as such under the Securities and Securities Exchange Acts. The main target of these laws is mutual funds and similar companies. Foreign investment companies may not publicly offer in the US without making ICA registrations first.
  • Commodity Exchange Act - Covers trading in all types of futures contracts, expansively defined. Forward contracts and derivatives are not included, but many securities-based futures contracts are.
  • Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley" or "SOXA") - Adds additional rules to prevent fraud and unfair advantage.
  • Rules of the Securities and Exchange Commission (SEC) passed under the above laws.

In addition, most public corporations must follow the rules of the New York Stock Exchange (NYSE), the National Association of Securities Dealers (NASD) or whichever entity is responsible for listing their securities. These exchanges are known as self-regulatory organizations (SROs), as they can regulate listed companies independently of the federal government.

Securities Act of 1933[edit]

The Securities Act of 1933 (also known as the '33 Act) is essentially a consumer protection law for "retail" investors (i.e. not money managers, foundations, pensions, etc.) Its objectives are to provide investors with material financial and other corporate information about issuers of public securities (i.e. stocks and bonds), and to prevent fraud in the offering of such securities.

Many transactions are exempt from regulation under the Securities Act. Section 4 of the Act limits its application to public offerings (according to SEC guidelines, more than 25 offerees) by issuers and their underwriters (i.e. investment banks). This means that the Act primarily applies to companies offering securities to the public, and not to transactions between investors or to sales of stock to small groups of investors (i.e. private placements.)

For public offerings, the main requirement of the Securities Act is registration. An issuer must prepare an extensive statement describing the securities to be offered and detailing the nature of the issuer's business. Once this statement is registered with and approved by the SEC, its data and forecasts are placed in a prospectus for potential investors. Any offering of the securities by the issuer or underwriter must thereafter be accompanied by the prospectus.

Securities Exchange Act of 1934[edit]

While the Securities Act is very limited in scope, the Securities Exchange Act (also known as the Exchange Act or 1934 Act) is much broader. It regulates stock exchanges, brokers, dealers, and even private traders.

SEC Rule 10b-5[edit]

One of the most important provisions in securities law is Rule 10b-5, a general provision against fraud:

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,
a. To employ any device, scheme, or artifice to defraud,
b. 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
c. 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.

The rule, along with Section 10(b) of the Exchange Act, is used to punish a variety of activities, most notably insider trading.


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