Securities Act of 1933
Securities: General description
Securities are available in the form of bank notes, stock, treasury bonds, different types of bonds, collateral trust certificates, profit sharing agreement, transferable shares, investment contracts, undivided interest in different mineral rights, including oil and gas (Stock Market Crash of 1929). These are different kinds of a tradable financial instrument, issued by a government or private entities. These instruments are issued to raise funds for a business. Securities are sold through issuer transactions and trading transactions. The first method describes direct sales by the issuer to the investors. The second method describes trading through stock exchanges or over-the-counter. The entity that issues securities is called issuer. An individual or an entity that buys securities becomes the owner of the securities. Every country has government regulations that regulate financial instrument trading. These regulations are the securities laws (Stock Market Crash of 1929). Securities laws and regulations ensure that investors receive accurate and required return on investment. Securities do not inherit monetary value. Their profit comes from the claims of their owners regulated by an agreement between the issuer and a holder. Issuer's assets, earnings, and financial situation back value of the securities. Issuers’ financial conditions are valued using various metrics.
1920`s American society and Black Tuesday
A security trading involves transactions of a tremendous amount of money. It is necessary to have specific regulations for conducting the trading or it may break the financial backbone of the country, bringing chaos and catastrophe in both financial and social lives of a country. The general plan of this work includes the study of the Black Tuesday of October 29, 1929, what caused it and what lessons were learnt.
Black Tuesday gave birth to an era, which is called Great Depression. To understand this historical event it is imperative to review financial and social life of the American society of the 1920`s. The end of World War I initiated in the USA a new era of confidence, optimism, and enthusiasm. The US society encountered new technological innovations like radio and cars. Optimism, enthusiasm, innovation coupled with real estate speculation created an attitude of irrational exuberance in the society. In the years between 1925 and 1929, American society increased manufacturing establishments from 183,900 to 206,700; output of these establishments rose from $60.8 billions to $68.0 billions. Automobile production rose from 4,301,000 to 5,358,000 in the years from 1926 to 1929 (Lancaster, 2002). In 1921, Federal Reserve index of industrial production averaged 67, which had risen to 100 in 1925 and to 128 by July 1928 (Galbraith). The robust economy contributed “Get rich quick” physiological attitude to the Americans, contributing to irrational stock market boom. This boom changed investor psychological concept of stock market. Stock market no longer was considered a long-term investment place. Rather, it turned to be a place where people from all lifestyles truly believed they could become rich quickly. The new stock purchasing system “buying on margin” contributed additional resonance into the stock market. Banks were lending money to the brokers, and an individual could have purchased stock by putting down 10 % - 20 % of money and borrowing the rest from the brokers (Stock Market Crash of 1929). Figure 1 shows dynamics of stock price of those years. In the beginning of 1928, Federal Reserve Bank was alarmed by the sharp rise of stock market and started taking measures to avoid market crush. Between April and June of the same year, Fed increased interest rate from 3.5 % to 4 %, with further increase to 4.5 %. By December 1928, open market lending rate increased to 8.6 %. Fed put pressure on member banks to stop lending money to the brokers and an increase of interest rate did little to stop the stock market speculation as brokers were getting money through non-banking loans. Stock market crash started on October 24, 1929, and on October 29 the market collapsed entirely. By November 1929, shares had declined by 40 % causing $26 billion loss (Stock Market Crash of 1929).
The set forth above analysis shows that a robust economy crashed as a house made of mud due to irresponsible acts of baking community, and stockbrokers. The objective of this project is to examine Securities Act of 1933, which US Congress enacted to prevent irresponsible financial activities in the stock market that cause disruption and destruction of country’s economy. We would also focus on the impact of 1933 Act, and we will review analysis of the opponents.
Prelude to 1933 Securities Act
Roaring economy and cultural boom, massive industrialization, and popularization of new technologies characterizes the decade of the1920`s. This success contributed euphoria and confidence to most of the Americas’ economists that stock boom backed by strong economy is extremely safe. Dow stock average soared throughout the 1920s; from 1921 to 1929, it went up from 60 to 400 creating many new millionaires (Colombo). Stock trading became American society’s main pastime activity. Scores of fraudulent companies were formed to take advantage of uninformed investors. Most investors in their minds could have never thought about the stock market crash. By the end of 1929, Dow sank from 400 to 145, and $16 billion worth of market capitalization vanished from NYSE stocks (Colombo). Domino effect continued when it became known that many banks had invested their deposits in the stock market, causing depositors’ lose their savings; major banks and brokerage firms lost solvency; $140 billion depositors’ money disappeared. Nineteen twenty-nine stock market crash led the country to a severe financial crisis that would remain in history as Great depression of America.
Congress began its campaign on securities fraud by targeting the issuers. Congress realized that the issuers’ main goal was to raise fund; thus, they had enough motivation to keep rosy and fraudulent information about their companies from the investors. To induce investors to purchase securities, issuers promoted the value of their company. Brokers also played a significant part by misinterpreting issuers companies’ values and giving false and fraudulent hopes of large profit to the investors. It was later found that issuers’ information about their companies had little or no substantive basis, or was entirely fraudulent. Series of hearings shed light to the severity of the abuses leading to the crash. In hopes of making large profits, millions of investors were buying stocks, thus turning stock market in the state speculative frenzy, which ended on October 29, 1929 (Securities Law History). This tragedy required setting rules and regulations that would prevent speculative frenzies and abuse of stock market. Congress’s fight against security fraud resulted in proclamation of the securities law, the Federal Securities Act of 1933.
Why was the law necessary?
Before the crash, most states had their own securities law, which was called blue sky laws. The stock market crash of 1929 and subsequent Great depression made it clear that alleged “|blue sky” laws failed to protect the country’s financial interest. Except “blue sky” laws, other federal securities laws also existed. However, federal laws and state laws not always correspond perfectly. Courts often were using state laws to interpret federal laws. State laws often varied from state to state and from one federal law to another. The main aspects of differences were reflected in products and transactions covered with the laws, in registration requirements for brokers, dealers, and issuers, and in anti-fraud provisions. Congress determined that the absence of information and distortion of facts played key roles in the 1929 calamity. Congress also uncovered that one half of the $ 50 billion securities sold during the1920s turned out to be worthless. In reaction to this calamity and the lack of a unified law, President Roosevelt gathered a group of advisors whose primary duties were to craft new innovative regulations, which he named the New Deal (Securities Law History). Presidential members and advisors, Benjamin V. Cohen (1894-1983), Thomas Corcoran (1900 – 1981), and James Landis (1899-1964) designed the Securities Act of 1933. James Landis later in 1934 became the chairperson of a newly formed Security Exchange Commission. The Securities Act of 1933 was promulgated on May 27, 1933 and registered under USC, Title 15, Chapter 2 A (7). It has three subchapters: Subchapter I – Domestic securities; Subchapter II – Foreign securities; Subchapter III – Trust indentures. The short title of the act is 15 USC §77a (Securities and Trust Indentures).
Main aspects of the act
Article 1, Section 8, Clause 3 of the U.S. Constitution (Commerce Clause) gives Congress the power “to regulate commerce with foreign nations, and among the several states, and with the Indian tribes.” This clause of US constitution empowered Congress with authority to enforce Securities Act of 1933. The main concept of the securities law is expressed in disclosing material information by the issuers. The statute makes company disclosure mandatory through the registration process. The statute has two objectives (Registrations under the Securities Act of 1933):
- To require that investors receive financial and other significant information concerning securities being offered for public sale;
- To prohibit deceit, misrepresentations, and other fraud in the sale of securities.
The issuer undertakes responsibility not to provide inaccurate material evidence and drop required material fact; thus, ensuring the absence of misleading information in the material fact description. It helps investors to make a judgment whether to purchase the securities (Registrations under the Securities Act of 1933). The Security Exchange Commission (SEC) controls the registration process. Section 5 of the Act states that all securities must be registered with the SEC unless exemption is applied. Exemption identifies either the securities themselves are exempt or transaction is exempt. It should be noted that 1933 Act exempts only the registration part, and not the antifraud provisions (Securities Act of 1933). Section 3 of the Act lists different categories that are exempt for registration. Section 4 describes verity of transactions that are exempt for registration.
Exemptions exist for the following cases:
- Private offerings to a limited number of persons or institutions;
- Offerings of limited size;
- Intrastate offerings; and
- Securities of municipal, state, and federal governments.
Section 6 of the Act describes the actual registration process. Section 7 describes categories of information the issuer must submit to the SEC. All information becomes public through the SEC’s online system. The section 8a of the Act allows cease-and-desist lawsuit against issuers, their directors and executive for violating Security Act’s anti-fraud provisions. The section 20 (d) of the Act allows SEC to strive for an injunction or criminal prosecution for violating Security Act. SEC may not initiate actions against the issuers on behalf of individual investors, but the act allows investors to take actions against issuers under provisions Section 11, Section 5, Section 12 (a) (1). Section 11 allows the purchaser to initiate a lawsuit, even if the investor bought the security in the secondary market. Section 12(a) (2) makes brokers or any individual accountable for offering and selling securities material misstatement or omission, however, this applies to the initial offers, not secondary purchases. Key anti-fraud provisions in particular are described in the section 17 (a) of the Securities Act 1933 (Securities Act of 1933). Anti-fraud provisions make illegal to earn money or property through the employment of any device, scheme or artifice to defraud by applying misstatements or omissions of material.
Effect of 1933 Act: Arguments and Counter Arguments
Federal government introduced three legal documents to prevent occurrence of similar crash of 1929. These legal documents are Securities Act of 1933, Securities Exchange Act of 1934, and Securities and Exchange Commission (SEC) Act. Securities Act of 1933 controls primary market, Securities Exchange Act of 1934 controls secondary trading and the SEC in general regulates the securities business. SEC has the authority to promulgate rules pursuant to the federal securities acts and its own rules. The principal task of the SEC is to register, regulate and discipline broker-dealers, and evaluate actions of the securities exchanges' self-regulatory organizations. This entire package describes Franklin D. Roosevelt’s promised New Deal to improve the country’s economy. FDR sought to bring back public confidence in the securities market, which was devastated by the carnage. Nevertheless, the bill created mixed emotions; financial community reacted negatively to the act proposing to keep laissez-faire approach; some even worried about capital strike; financiers simply would not undertake any entrepreneurial activity (Excerpts from Securities Act of 1933).
Before the 1933 Act, new securities dropped to $350 million in 1933 as compared to $9.4 billion in 1929 (Excerpts from Securities Act of 1933). However, total registered securities from the date when Securities law became effective to September 30, 1936 had totaled more than $7,250,000,000 (Lancaster). Initial public offering of securities grew from $43.6 billion in 1991 to $66.5 billion in 1992, and to $112 billion in 1993. Based on the flow of capital, in 1995, experts valued American securities markets to be the strongest in the world (Excerpts from Securities Act of 1933). The above information and figure 2 reflect how the laws helped to grow investors` confidence. More and more economists believe that mandatory disclosure requirement like Securities Act of 1933 serves as a strong regulatory infrastructure necessary to enable the optimal performance of market-based economies (Excerpts from Securities Act of 1933). In this regard, George Stiglitz, the Nobel laureate in economics, has indicated that the developing world has failed to achieve the promises of globalization due to the lack of adequate securities regulation.
The opponents of the act voiced that before 1933 law all states, except Nevada, accepted the Blue Sky law; the statute applied uniformly to corporation securities and initial public offering (IPO). The opponents agreed that on IPO investor had to rely exclusively upon information provided by the underwriter and broker. The opponent also noted that before 1933 act NYSE provided financial information on listed securities and signaled investment quality through its decisions. On the other side, the framers of the law blamed sellers for providing questionable and useless information.
The Securities Act of 1933 takes the responsibility to resolve these issues. Underlying presumption of the act is that the absence of information of good quality and quantity fueled speculative purchase of stocks and contributed to rapid market decline. The salient features of the acts are mandatory registration, waiting period, and civil liability. The opposing argument stated that the investor had information available on corporate performance and securities trading history. At the same time, George Stigler in 1964 and Gregg Jarrell in 1981, based on their study, concluded that the disclosure of financial information did not have an impact on an average return earned by the investor (Simon, 1988).
Many voiced that the substantial uncertainty about the true value of securities would always make price either overvalued or undervalued. Many expressed the thought that though the availability of good-quality information affects risk character of the purchase, nevertheless, entire valuation depends on unbiased investor. Some argued that effect of legislation should be reflected in the dispersion of market-adjusted returns and not in registration. According to others, the Securities Act must establish a model that shows how to hedge the investor’s risk at the same time increasing the return on investment. The entire concept of Securities Act of 1933 characterizes how to achieve investment quality information, and how good-quality information could help investors in making decision. Securities Act does not prescribe or evaluate returns. The framers of the act intervened on the availability of quality and quantity information of a product, and on regulating returns.
Carol, J. Simon conducted an empirical study on the effect of Securities Act of 1933 (Simon, 1988). His goal was to examine the impact of changes in financial disclosure on the distributions of return earned by the investor. Simon claims that investment quality data was available before the implementation of 1933 Act and after it. According to the author, the consumer could have obtained quality information directly from the seller, through quality of the goods, and third party appraisal. The author also claims that prior to SEC regulation investor was getting the same information from a broker and underwriters, as well as by observing security historic performance, and from an independent appraiser – most notably NYSE listing committee.
The author analyzed the effects of SEC regulation in terms of changes in the means and dispersion of returns earned by investors on new securities. In this regard, the author used capital market data of pre – Act and post – Act publicly traded common stocks; moreover, he used multi-beta asset pricing model to compute abnormal returns. Simon modeled returns on new securities as a function of the overall market, industry effects, and changes in the relative risks. Market beta parameters were let float over the business cycle. For pre-regulation securities, the author used data between 1926 and 1933, and post-regulation between 1934 and 1939. The author used market / rational expectation hypothesis and determined that the security, which incorporates all available information at a given point in time, yields an unbiased estimate of future return to the investor. Return on stock may be determined using model like Capital Asset Pricing Model (CAPM), however it considers only one market index. The author, instead, recommends an Arbitrage Pricing Theory (APT), which uses more global factors plus an idiosyncratic distribution. Author concluded that investor’s return on corporate securities was identical before and after the act; however, initial public offerings on regional exchanges were significantly overpriced; the dispersion of abnormal returns were significantly lower for both corporate and public securities following the Securities Act.
Strength and Weakness
Implementation of Security Act of 1933 produced a positive result, which is represented in figure 2. The objective of the act was to allow a prospective investor to make a fair decision based on trustworthy information; this aim is not always reached as an issuer may not reveal material weakness while complying in theory with the law. The act allows some exemptions, which may be used as loopholes by dishonest issuers. One exemption includes transactions by someone other than an issuer. In essence, this provision exempts virtually all-secondary trading (Securities – Securities Act of 1933).
Whether the implementation of Security Act of 1933 has helped, conducting of Securities trading would always remain an issue for debate; however, it became clear that the act contributed greatly to a stable macro economy, and lowered the capital cost. The act is not a recipe for preventing difficulties of the stock market, which we observed in 1987 and 2008, however, perhaps this bill would not let a catastrophe of 1929 happen again. The Security Act has both proponents and opponents. Those opposing the bill consider it a federal intervention and state that Securities Act does not increase return on investment. The Securities Act did not attempt to influence revenue. The Securities Act is a legal means to prevent the collapse of the national economy, implementation of illegal activities of unethical companies who wish to steal people’s money, and to control greed. Investment is always associated with risk and return. The Securities Act cannot model the risk and return on investment. This task is accomplished with the use of different mathematical financial models that provide means for hedging to reduce the risk while maintaining high profit.