Securities Regulation

Introduction

Info Price

(last updated 18 Jan 12)

Information Price

• Auction 1: no information– Information is critical to pricing– Discount for lack of info

• Auction 2: inside information – Information through signaling– Efficient Capital Market Hypothesis

• Auction 3: widespread information– Can you feel the fraud?– Consider effect on subsequent auctions

Securities industry demographics(Feb 2009)

Public companies:• 12,000 (securities

registered with SEC)• 7,500 operating

companies

Investment advisers: • 11,300 (includes hedge

fund managers)• up from 7,546 in 2002

Broker-dealers: • 5,500 firms• 173,000 branch offices

(up from 75,000 in 2001)• 665,000 registered reps

Mutual funds: • 950 complexes (such as

Vanguard)• 4,600 registered funds

(Vanguard 2050 Target Fund)

Nationally recognized statistical rating organizations

• Ten (S&P, etc)

Stock exchanges• Eleven exchanges (NYSE)

Clearing agencies• Five

What are incentives to disclose?

Nature of US securities regulation

Securities regulationMandatory disclosure• Sales of securities to public• Public companies – periodic disclosureAntifraud liability• Private actions• SEC enforcementRegulate intermediaries (gatekeepers)• Self-regulation• SEC disciplinary oversight

* * *Legislation• Securities Act of 1933• Securities Exchange Act of 1934 • 5 Commissioners

• 4 Divisions • various offices (inc OGC)

Securities fraud

Elements• Material • Misrepresentation or omission• Scienter• Reliance• Causation• Damages

Rule 10b-5 adds:• Jurisdictional nexus (federal court)• Transactional nexus (“in connection

with purchase or sale of securities”)

How value an investment?

What is a security?

Types of Securities

Type Cash Flow Rights

Liquidation Rights

Voting Rights

Common stock

Residual + discretionary

Last in line (junior)

Elect board + fundamental transactions

Preferred stock

Residual + fixed

Next in line Contingent (sometimes)

Debt P&I: fixed + contractual

First in line (senior)

None

Valuation

Which investment would you choose? (assuming 5% interest rate)

1.Put $10 million under mattress for two years

2.Annuity that pays $2.5 million every year for next four years

3.Preferred stock that pays $400,000 per year (in perpetuity)

FV = PV * (1 + i) ^ n

* * *

PV = FV / (1 + i) ^ n

Investment #1

PV = $10,000,000 / (1 +.05) 2

PV = $10,000,000 / (1.05) 2

PV = $10,000,000 / (1.1025)

PV = $ 9,070,295

Investment #2

PV1 = $2,500,000/(1.05)1 = $ 2,380,952

PV2 = $2,500,000/(1.05)2 = $ 2,267,574

PV3 = $2,500,000/(1.05)3 = $ 2,159,594

PV4 = $2,500,000/(1.05)4 = $ 2,056,756

PV = $ 8,864,876

Investment #3

PV = FVpymt / i

PV = $400,000 / .05

PV = $8,000,000

Investment #3

(assume 4% interest rate)

PV = FVpymt / i

PV = $400,000 / .04

PV = $10,000,000

End

#2 - $10 million in 2-year 10% bond

FV = PV * (1 + i) ^ n

PV = FV / (1 + i) ^ n

Year FV Present Value

1 $1,000,000 $1,000,000 / (1.05) 1 = $ 952,381

2 $1,000,000 $1,000,000 / (1.05) 2 = $ 907,029

2 $10,000,000 $10,000,000 / (1.05) 2 = $ 9,070,295

Total $10,929,705

#5 - zero-coupon bond ($15 million – 3 years)

Year FV Present Value (discount 15%)

1 $ 0 $ 0

2 $ 0 $ 0

3 $15,000,000 $15,000,000 / (1.15) 3 = $ 9,860,000

Total $9,860,000

FV = PV * (1 + i) ^ n

PV = FV / (1 + i) ^ n

#5 - zero-coupon bond ($15 million – 3 years)

Year FV Present Value (assuming 5%)

1 $ 0 $ 0

2 $ 0 $ 0

3 $15,000,000 $15,000,000 / (1.05) 3 = $ 12,957,562

Total $12,957,562

FV = PV * (1 + i) ^ n

PV = FV / (1 + i) ^ n