chapter 26: investor protection, insider trading, and corporate governance

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Chapter 1: Legal EthicsCHAPTER 26: INVESTOR PROTECTION, INSIDER

TRADING, AND CORPORATE GOVERNANCE

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Learning Objectives1. What is meant by the term securities? 2. What are the two major statutes

regulating the securities industry?3. What is insider trading? Why is it

prohibited?4. What are some of the features of

securities laws?5. What certification requirements does the

Sarbanes-Oxley Act impose on corporate executives?


The Securities Act of 1933• Securities Act of 1933 regulates solicitation,

buying and selling of securities: stocks and bonds.

• Designed to prohibit fraud and stabilize securities industry.

• Main purpose: full disclosure.


The Securities Act of 1933• What is a Security?– Instruments and interests commonly known as

securities, such as preferred and common stocks, treasury stocks, bonds, debentures, and stock warrants.


The Securities Act of 1933• What is a Security?– Any interests commonly known as securities, such

as stock options, puts, calls, or other types of privilege on a security or on the right to purchase a security or a group of securities in a national security exchange.


The Securities Act of 1933• What is a Security?– Notes, instruments, or other evidence of

indebtedness, including certificates of interest in a profit-sharing agreement and certificates of deposit.


The Securities Act of 1933• What is a Security?– Any fractional undivided interest in oil, gas, or

other mineral rights. – Investment contracts, which include interests in

limited partnerships and other investment schemes.


The Securities Act of 1933• What is a Security: the “Howey” Test. – In SEC v. Howey (1946), the U.S. Supreme

Court held that a security exists in 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.


The Securities Act of 1933• Registration Statement.– Unless exempt, an offering must be registered

before offered to the public.– Issuing corporation must file a registration

statement and prospectus with the SEC.– Prospectus is later distributed to investors.


The Securities Act of 1933• Registration Statement.– Contents:

1. The securities being offered for sale, including their relationship to the registrant’s other capital securities.

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


The Securities Act of 1933• Registration Statement.– Contents:

3. Management of the corporation, including all benefits, and any interests of directors or officers in any material transactions.

4. How the corporation intends to use the proceeds of the sale.

5. Any pending lawsuits or special risk factors.


The Securities Act of 1933 Registration Statement.–Registration Process.•Waiting Period: securities can be offered but

not sold. All issuers can distribute a red herring prospectus, advertise with a tombstone ad, and a free-writing prospectus.


The Securities Act of 1933 Registration Statement.–Registration Process.• Posteffective Period: securities can now

be sold. •Well-Known Seasoned Issuers. In 2005,

SEC revised the registration process and created new categories of issuers based on size and market presence.


The Securities Act of 1933 Registration Statement.–Registration Process.•WKSI has issued at least $1 billion in

securities during previous three years, or has at least $700 million outstanding stock in hands of public.


The Securities Act of 1933 Exempt Securities and Transactions.–Regulation A Offerings.• Up to $5 million in any twelve month

period. • Issuer must file a notice and offering

circular with SEC.• Companies can “test the waters” without

actually selling.• Can be sold online.


The Securities Act of 1933 Exempt Securities and Transactions.–Regulation D Offerings.• Rule 504: up to $1M during 12 months to

accredited investors only.• Rule 505: up to $5M during 12 months to

both accredited and unaccredited investors.


The Securities Act of 1933 Exempt Securities and Transactions.–Private Placement Exemption.• Rule 506: unlimited if no general

solicitation and notice to SEC. Max of 35 unaccredited investors.

–Resales.• Rule 144: Rule 505 or 506 securities trigger

registration requirements unless the sale complies with all of Rule 144’s conditions.


The Securities Act of 1933 Exempt Securities and Transactions.–Resales.• Rule 144A: allows sale only to a qualified

institutional buyer.


The Securities Act of 1933 Violations of the 1933 Act.–Intentional or negligent defrauding of

investors by misrepresenting or omitting material information in the registration statement or prospectus. Provides for criminal penalties, and civil sanctions.


The Securities Act of 1933 Violations of the 1933 Act.–Defenses: Statement left out was not

material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true.• CASE 26.1 LITWIN V. BLACKSTONE

GROUP, LP (2011). What material information did Blackstone omit?


• Provides for registration of securities exchanges, brokers, dealers, and national securities exchanges and associations. – Applies to companies with $10 million in assets

and 500 or more shareholders.

The Securities Exchange Act of 1934


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

• Section 10(b) prohibits use of any manipulative or deceptive device or contrivance in violation of SEC rules and regulations.

• SEC Rule 10b(5) prohibits fraud in connection with the purchase or sale of any security.



• Section 10(b), SEC Rule 10b-5 and Insider Trading.– Applicability of SEC Rule 10b-5.• Virtually all cases concerning the trading of securities,

whether on exchanges, OTC, or private.



• Section 10(b), SEC Rule 10b-5 and Insider Trading.– Insider Trading.• Goal is to prevent purchase or sale of securities

on basis of information that is not available to the public.• Applies to corporate directors, officers, and

others with “inside” information, or anyone who has access to or receives nonpublic information.




Section 10(b), SEC Rule 10b-5 and Insider Trading.–Disclosure Under SEC 10b-5:• Any material omission or

misrepresentation in connection with the sale or purchase of security may violate Section 10(b) or SEC Rule 10b-5.



Section 10(b), SEC Rule 10b-5 and Insider Trading.–Disclosures Under SEC 10b-5 (cont’d)• CASE 26.2 SEC V. TEXAS GULF SULPHUR

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



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

provides a “safe harbor” for publicly-held companies making forward-looking statements.–Securities Litigation Uniform Standards

Act.



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, e.g., to employer.



Insider Reporting and Trading-Section 16(B).–Requires recapture of all short-swing

profits by insiders (those owning 10% of equities) to corporation.–Applies to stocks, warrants, options,

and securities.



Regulation of Proxy Statements.–Section 14(1) of the 1934 Act regulates

the sale of proxies from shareholders of Section 12 companies.–Remedies for violations include

injunctions to damages.


Comparison of SEC Rules



Violations of the 1934 Act.–Scienter or intent is required to prove

civil or criminal penalties under 10(b) and Rule 10b-5.–Violator must have had intent to

defraud (false statements or wrongfully failed to disclose material facts).



Violations of the 1934 Act.–CASE 26.3 GEBHART V. SEC (2010).

What factors did the court analyze to determine if scienter was present?–Criminal Penalties. • 10(b) and Rule 10b-5, a person faces $5 million

and 20 years in prison, $25 million for partnership or corporation. Sarbanes-Oxley provides for 25 years in prison if willful.



Violations of the 1934 Act.–Civil Sanctions: Both SEC and Private

Parties Can Bring Actions Against Violators under the Insider Trading and Securities Fraud Enforcement Act. Private parties may bring action for violations of 10(b) and Rule 10b-5.


State Securities Laws State securities laws are called “blue

sky” laws.–Requirements. Issuers must comply with

federal and state securities laws and states do not allow the same exemptions as federal government.–Concurrent Regulation.Uniform Securities Act

has been adopted in part by many states.


Corporate Governance• Relationship between a corporation

and its shareholders.

• Attempts at Alignment between Officers and Shareholders.– Stock Options?


Corporate Governance• Goal is to Promote Accountability. – (1) The audited reporting of financial

conditions to evaluate managers. – (2) Legal protections for shareholders so

that violators can be punished and victims can recover losses.


Corporate Governance• Governance and Corporate Law.–Board of Directors: responsible to ensure

all corporate officers are operating in best interests of shareholders.–Audit Committee: oversees entire process.–Compensation Committee: assess

performance and design fair compensation systems.


Corporate Governance• Sarbanes-Oxley Act of 2002.– Sarb-Ox attempts to increase corporate

accountability by imposing strict disclosure requirements and harsh penalties for securities violations.

– Applies to all public companies.


Corporate Governance• Sarbanes-Oxley Act of 2002.– Requires CEO’s to take responsibility for accuracy of

financial statements filed with SEC.– Requires independent auditor report except for

smaller companies of less than $75 million market capitalization (2010 exemption).


Corporate Governance• Sarbanes-Oxley Act of 2002.– Other Provisions: • Public Company Accounting Oversight Board

regulates public accounting firms.

– Internal Controls and Accountability: Direct federal corporate governance requirements. High-level managers must maintain internal controls and disclosures.


Online Securities Fraud and Ponzi Schemes

• The SEC is aggressively prosecuting internet fraud using traditional laws.

• Online Investment Scams.– Fraudulent Emails.– Online Investment Newsletters and Forums.


Online Securities Fraud and Ponzi Schemes

• Hacking into Online Stock Accounts.• Ponzi Schemes. (e.g., Bernie Madoff).– Offshore Fraud.– “Risk Free” Fraud.

chapter 26: investor protection, insider trading, and corporate governance

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securities industry

group of securities

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