chapter 21 investor protection, insider trading, and corporate governance

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CHAPTER 21 INVESTOR PROTECTION, INSIDER

TRADING, AND CORPORATE GOVERNANCE


LEARNING OBJECTIVES

What is meant by the term securities?What are the two major statutes

regulating the securities industry?What is insider trading? Why is it

prohibited?What are some of the features of state

securities laws? 2


LEARNING OBJECTIVES

What certification requirements does the Sarbanes-Oxley Act impose on corporate executives?

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SECURITIES ACT OF 1933

The Securities Act of 1933 governs the initial sale of stocks by businesses.

Designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities.

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Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt.

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What is a Security?• The Howey test: Any transaction in

which a person: (1) invests (2) in a common enterprise (3) reasonably expecting profits (4) derived primarily from others’ managerial or entrepreneurial efforts. SEC v. Howey, (1946).

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Registration Statement.• If a security does not qualify for an

exemption under §5 of the Securities Act of 1933, the security must be registered with the Securities Exchange Commission (http://www.sec.gov) and state securities agencies before offered to the public.

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http://www.sec.gov/



Registration Statement.• Corporation must file a registration

statement and prospectus with the SEC.• The Prospectus is later distributed to

investors.

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Registration Statement: Contents.• (1) The securities being offered for sale,

including their relationship to the issuer’s other capital securities.

• (2) The corporation’s properties and business (including a financial statement certified by an independent public accounting firm).

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Registration Statement: Contents.• (3) The management of the corporation,

including managerial compensation, stock options, pensions, and other benefits. Any interests of directors or officers in any material transactions with the corporation must be disclosed.

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Registration Statement: Contents.• (4) How the corporation intends to use

the proceeds of the sale.• (5) Any pending lawsuits or special risk

factors.

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Registration Process.• Registration statement does not become

effective until approval by SEC.• Prefiling Period: issuer cannot offer or sell

securities.• Waiting Period: securities can be offered

by not sold. 2005: Free-writing prospectus.

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Registration Process.• Registration statement does not become

effective until approval by SEC.• Prefiling Period: issuer cannot offer or sell

securities.• Waiting Period: securities can be offered

by not sold. 2005: Free-writing prospectus.

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Registration Process.• Post-Effective Period: registration

effective 20 days after approval.Well-Known Seasoned Investors.

• Firm that has issued $1 billion in securities during previous three years, with $700 million value outstanding.

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Exempt Securities and Transactions.• Bank securities sold before 1933.• Commercial paper if maturity date does

not exceed 9 months.• Charitable organizations.• Existing holders in reorganization,

bankruptcy. • Financing railroad equipment.

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Exempt Securities and Transactions.• Any insurance, endowment, annuity

contract or government-issued securities.• Securities issued by banks, savings and

loan association, farmers' cooperatives.• Securities issued to existing securities

holders, stock split, dividend (really a transaction exemption).

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Exempt Securities and Transactions.• Regulation A Offerings.

• Small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular.

• Companies have used the internet to raise money directly, bypassing traditional investment firms.

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Exempt Securities and Transactions.• Small Offerings: Regulation D.

•Rule 504: up to $1M during 12 months to accredited investors only.

•Rule 505: private, up to $5M during 12 months to both accredited and unaccredited investors.

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Exempt Securities and Transactions.• Small Offerings: Regulation D.

•Rule 506--Private Placement Exemption. unlimited amounts, no advertising, to accredited investors only.

• Resales and Safe Harbor Rules.•Rule 144.•Rule 144a.

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Violations.• Intentional or negligent fraud of

investors by misrepresenting or omitting material facts in the registration statement and/prospectus.

• Remedies: • Criminal: up to 5 years in prison, $10,000 fine.• Civil: damages, refund of investment, injunction.

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Violations.• Defenses: Statement left out was not

material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true.•CASE 21.1 Litwin v. Blackstone Group,

LP (2011). Were Blackstone’s omissions “material”?

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SECURITIES EXCHANGE ACT OF 1934

Registration of securities exchanges, brokers, dealers, and national securities exchanges and associations.

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Requires continuous disclosure system for corporations with securities sold on national exchanges or assets in excess of $10 million and 500 or more shareholders (Sec. 12 companies or 1934 companies).

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Section 10(b) prohibits the use of any

manipulative or deceptive device or contrivance in contravention of rules and regulations of SEC.

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Rule 10b(5) prohibits the commission of

fraud in the connection with the purchase or sale of any security.

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Insider Trading: advance information

available to corporate officers and directors that can affect future value of stock. 10b(5) “Insiders” include officers, executives and directors).

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Disclosure under SEC Rule 10b-5:

• Material omission or misrepresentation may violate 1933 Act and antifraud provisions of 1934 Act and SEC Rule 10b-5.

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Disclosure under SEC Rule 10b-5: key is

whether information is “material.”• CASE 21.2 SEC v. Texas Gulf Sulphur Co.

(1968). Who were the insiders in this case and what should they have done differently?

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Outsiders and SEC Rule 10b-5.

• Tipper/tippee theory--insider’s fiduciary duty must be breached.

• Misappropriation theory -- one wrongfully obtains inside info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance.

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Insider Reporting and Trading—16(b).

• Recapture by corporation of profits during previous six months gained by insider trading.

• Applies to stocks, warrants, options and convertible securities.

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Private Securities Litigation Reform Act of

1995.• “Safe harbor” for publicly held companies

that make forward-looking statements, such as financial forecasts.“

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Section 10(b), SEC Rule 10b-5, and Insider Trading.• Private Securities Litigation Reform Act of

1995.• Meaningful cautionary statements” protect

against securities fraud.• CASE 21.3 Dura Pharmaceuticals, Inc. v.

Broudo (2005). 33



Section 10(b), SEC Rule 10b-5, and Insider Trading.• Regulation of Proxy Statements, Sect.

14(a). • Whoever solicits a proxy must fully disclose

all of the facts and which shareholders must vote.

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Violations of the 1934 Act.• Scienter Requirement. Proved by

showing defendant made false statements or wrongfully failed to disclose material facts.

• 16(b): strict liability -- no fault or scienter required.

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Violations of the 1934 Act.• Criminal Penalties: Individuals-

imprisonment up to 10 years, fines up to $5 million, $2.5 for partnership or corporation.

• Civil Sanctions: up to triple profits.

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STATE SECURITIES LAWS

State securities laws are called “blue sky” laws.

Issuers must comply with federal and state securities laws and states do not allow the same exemptions as federal government.

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STATE SECURITIES LAWS

States could require registration or qualification.

Uniform Securities Act has been adopted in part by many states.

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CORPORATE GOVERNANCE

Corporate governance is essentially the relationship between a corporation and its shareholders.

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Attempts at Aligning the Interests of Officers with Shareholders.• Stock Options.• “Outside” Directors?

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Goal is to Promote Accountability.• Involves, at minimum:

• Audited reporting of financial progress, so managers can be evaluated.

• Legal protections for shareholders, so violators of the law can be punished for misbehavior.

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Goal is to Promote Accountability.• Benefits to the Company.• Governance and Corporation Law.• Board of Directors.• Audit Committee.• Compensation Committee.

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THE SARBANES-OXLEY ACT

Attempts to increase corporate responsibility by:• Stricter disclosure requirements.• Harsher penalties for legal violations.• Corporate officers take responsibility for

financial statements and SEC reports.• CEO’s and CFO’s must personally certify

reports. 43



More Internal Controls and Accountability.• Direct federal corporate governance

requirements.• Sections 302 and 404.

Exemptions for Smaller Companies.

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Certification and Monitoring Requirements.• By CEOs and CFOs.• Avoids the “ignorance defense.”

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ONLINE SECURITIES FRAUD

SEC is enforcing anti-fraud provisions of Securities Laws.

Online Investment Scams.Fraudulent E-Mails.Online Investment Newsletters and

Forums. 46


ONLINE SECURITIES FRAUD

“Ponzi” Schemes.• Offshore Fraud.• “Risk Free” Fraud: Michael Regan, Bernie

Madoff.

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chapter 21 investor protection, insider trading, and corporate governance

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