investor protection, insider trading, and corporate governance

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Investor Protection, Insider Trading, and

Corporate Governance

Investor Protection, Insider Trading, and

Corporate Governance

Chapter

21Chapter

21

BUSINESS LAW TODAYBUSINESS LAW TODAY Essentials 9Essentials 9thth Ed. Ed.Roger LeRoy Miller - Institute for University Studies, Arlington, TexasRoger LeRoy Miller - Institute for University Studies, Arlington, TexasGaylord A. Jentz - University of Texas at Austin, EmeritusGaylord A. Jentz - University of Texas at Austin, Emeritus


Learning ObjectivesLearning Objectives

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

the securities industry? the securities industry? What is insider trading? Why is it prohibited?What is insider trading? Why is it prohibited? What are some of the features of state What are some of the features of state

securities laws?securities laws? What certification requirements does the What certification requirements does the

Sarbanes-Oxley Act impose on corporate Sarbanes-Oxley Act impose on corporate executives?executives?


Securities and Exchange Securities and Exchange CommissionCommission

Major Responsibilities of the SEC:Major Responsibilities of the SEC:Require disclosure of facts concerning Require disclosure of facts concerning

offerings.offerings.Regulate trade in securities.Regulate trade in securities.Investigate securities fraud.Investigate securities fraud.Regulate activities of securities brokers, Regulate activities of securities brokers,

dealers, and investment advisors.dealers, and investment advisors.Supervise mutual fund activities.Supervise mutual fund activities.Recommend sanctions for violations.Recommend sanctions for violations.


Securities Act of 1933Securities Act of 1933

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

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

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


What is a Security?What is a Security?

In In SEC v. Howey SEC v. Howey (1946), the U.S. Supreme (1946), the U.S. Supreme Court held that a security (investment Court held that a security (investment contract) exists in contract) exists in anyany transaction in transaction in which a person: (1) invests (2) in a which a person: (1) invests (2) in a common enterprise (3) reasonably common enterprise (3) reasonably expecting profits (4) derived primarily expecting profits (4) derived primarily from others’ managerial or entrepreneurial from others’ managerial or entrepreneurial efforts.efforts.


Registration StatementRegistration Statement

If a security does not qualify for an If a security does not qualify for an exemption under §5 of the Securities Act exemption under §5 of the Securities Act of 1933, the security must be registered of 1933, the security must be registered with the Securities Exchange Commission with the Securities Exchange Commission ((http://www.sec.govhttp://www.sec.gov) and state securities ) and state securities agencies before offered to the public.agencies before offered to the public.

Corporation must file a registration Corporation must file a registration statement and prospectus with the SEC. statement and prospectus with the SEC. Prospectus is later distributed to Prospectus is later distributed to investors.investors.



Description of the significant Description of the significant provisions of the registrant’s “offering” provisions of the registrant’s “offering” and how the registrant intends to use and how the registrant intends to use the proceeds from the sale. the proceeds from the sale.

Description of the registrant’s Description of the registrant’s properties and business.properties and business.



Description of the management of the Description of the management of the registrant, remuneration, pension, registrant, remuneration, pension, stock offerings, executive interests and stock offerings, executive interests and compensation.compensation.

Financial statement certified by and Financial statement certified by and independent accounting firm.independent accounting firm.

Description of pending lawsuits.Description of pending lawsuits.


Registration ProcessRegistration Process

Registration statement does not become Registration statement does not become effective until approval by SEC.effective until approval by SEC.

Pre-FilingPre-Filing Period: Period: issuer cannot offer or sell issuer cannot offer or sell securities.securities.

WaitingWaiting Period: Period: securities can be offered by securities can be offered by not sold. 2005: Free-writing prospectus.not sold. 2005: Free-writing prospectus.

Post-EffectivePost-Effective Period: Period: registration effective registration effective 20 days after approval.20 days after approval.


Bank securities sold before 1933.Bank securities sold before 1933. Commercial paper if maturity date does Commercial paper if maturity date does

not exceed 9 months.not exceed 9 months. Charitable organization securities.Charitable organization securities. Securities issued to existing securities Securities issued to existing securities

holders resulting from reorganization, holders resulting from reorganization, bankruptcy. bankruptcy.

Securities issued to finance railroad Securities issued to finance railroad equipment.equipment.

Exempt Securities and Exempt Securities and TransactionsTransactions


Exempt SecuritiesExempt Securities

Any insurance, endowment, annuity Any insurance, endowment, annuity contract or government-issued contract or government-issued securities.securities.

Securities issued by banks, savings Securities issued by banks, savings and loan association, farmers' and loan association, farmers' cooperatives.cooperatives.

Securities issued to existing securities Securities issued to existing securities holders, stock split, dividend (really a holders, stock split, dividend (really a transaction exemption).transaction exemption).


Regulation A OfferingsRegulation A Offerings: small offering : small offering up to $5 million in a 12 month period to up to $5 million in a 12 month period to “test the waters”; but requires a “test the waters”; but requires a circular.circular.

Exempt Exempt TransactionsTransactions



Small Offerings: Regulation D.Small Offerings: Regulation D.Rule 504: up to $1M during 12 months to Rule 504: up to $1M during 12 months to

accredited investors accredited investors onlyonly..Rule 504a.Rule 504a.Rule 505: private, up to $5M during 12 Rule 505: private, up to $5M during 12

months to both accredited and months to both accredited and unaccredited investors.unaccredited investors.

Rule 506: “Rule 506: “private placementprivate placement” exemption: ” exemption: unlimited amounts, not advertised, to unlimited amounts, not advertised, to accredited investors only. accredited investors only.



Section 4(6): up to $5M solely to Section 4(6): up to $5M solely to accredited investors.accredited investors.

Intrastate Offerings—Rule 147.Intrastate Offerings—Rule 147. Rule 144.Rule 144. Rule 144a.Rule 144a.


Intentional or negligent fraud of investors by Intentional or negligent fraud of investors by misrepresenting or omitting material facts in misrepresenting or omitting material facts in the registration statement and/prospectus. the registration statement and/prospectus.

DefensesDefenses: Statement left out was not material; : Statement left out was not material; Plaintiff knew about fraud and purchased Plaintiff knew about fraud and purchased stock; Registrant believed statements were stock; Registrant believed statements were true.true.

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

Violations of the 1933 ActViolations of the 1933 Act


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

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

Securities Exchange Act of Securities Exchange Act of 19341934


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

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

Section 10(b) and Rule 10b(5) Section 10(b) and Rule 10b(5) & Insider Trading& Insider Trading


Insider TradingInsider TradingAdvance information available to corporate Advance information available to corporate

officers and directors that can affect future officers and directors that can affect future value of stock. value of stock.

Insider trading prohibited:Insider trading prohibited:10b(5) “Insiders” (Officers, Executives and 10b(5) “Insiders” (Officers, Executives and

Directors).Directors).

Section 10(b) and Rule 10b(5) Section 10(b) and Rule 10b(5) & Insider Trading& Insider Trading


Material omission or misrepresentation may Material omission or misrepresentation may violate 1933 Act and antifraud provisions of violate 1933 Act and antifraud provisions of 1934 Act and SEC Rule 10b-5.1934 Act and SEC Rule 10b-5.

Key is whether insider’s information is Key is whether insider’s information is “material”, such as:“material”, such as:Fraudulent trading by broker-dealer, dividend change, Fraudulent trading by broker-dealer, dividend change,

contract for sale of corporate assets, new discovery, contract for sale of corporate assets, new discovery, process, or product, significant change in financial process, or product, significant change in financial condition, potential litigation.condition, potential litigation.

CASE 21.1CASE 21.1 SEC v. Texas Gulf Sulphur, Inc. SEC v. Texas Gulf Sulphur, Inc. (1968).(1968). Officers and employees engaged in insider Officers and employees engaged in insider trading. The test of materiality is what would affect trading. The test of materiality is what would affect the judgment of reasonable investors.the judgment of reasonable investors.

Disclosure under SEC Rule 10b-Disclosure under SEC Rule 10b-55


Provides “safe harbor” for publicly held Provides “safe harbor” for publicly held companies that make forward-looking companies that make forward-looking statements, such as financial forecasts.statements, such as financial forecasts.

Protection against liability from Protection against liability from securities fraud with “meaningful securities fraud with “meaningful cautionary statements.”cautionary statements.”

Private Securities Litigation Private Securities Litigation Reform Act of 1995Reform Act of 1995


Outsiders and SEC Rule 10b-5Outsiders and SEC Rule 10b-5

Outsiders and SEC Rule 10b(5):Outsiders and SEC Rule 10b(5):Tipper/tippee theory--insider’s fiduciary duty must be Tipper/tippee theory--insider’s fiduciary duty must be

breached.breached.Misappropriation theory -- one wrongfully obtains inside Misappropriation theory -- one wrongfully obtains inside

info and trades on it -- Courts still require fiduciary duty info and trades on it -- Courts still require fiduciary duty be breached, to employer, for instance.be breached, to employer, for instance.

What about “scheme” liability? What about “scheme” liability? CASE 21.2CASE 21.2 Stoneridge Investment Partners, LLC v. Stoneridge Investment Partners, LLC v.

Scientific-Atlanta, Inc. Scientific-Atlanta, Inc. (2008).(2008). Court dismissed claims Court dismissed claims against Scientific Atlanta and Motorola – Section 10(b) against Scientific Atlanta and Motorola – Section 10(b) private right of action cannot be applied to “outsiders” private right of action cannot be applied to “outsiders” (customers or suppliers).(customers or suppliers).


Insider Reporting and TradingInsider Reporting and Trading—Section 16(b)—Section 16(b)

Section 16(b).Section 16(b).Recapture by corporation of profits during Recapture by corporation of profits during

previous six months gained by insider trading.previous six months gained by insider trading.Applies to stocks, warrants, options and Applies to stocks, warrants, options and

convertible securities.convertible securities.

Regulation of Proxy Statements, Sect. Regulation of Proxy Statements, Sect. 14(a).14(a).Whoever solicits a proxy must fully disclose all Whoever solicits a proxy must fully disclose all

of the facts and which shareholders must vote.of the facts and which shareholders must vote.


Comparison of 10b-5 and 16(b)Comparison of 10b-5 and 16(b)


10(b) and 10B-5: 10(b) and 10B-5: scienterscienter is required, proved by is required, proved by showing defendant made false statements or showing defendant made false statements or wrongfully failed to disclose material facts.wrongfully failed to disclose material facts. 16(b): 16(b): strict liabilitystrict liability -- no fault or -- no fault or scienterscienter required. required. Criminal Penalties: Individuals-imprisonment up to Criminal Penalties: Individuals-imprisonment up to

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

Civil Sanctions.Civil Sanctions. CASE 21.3CASE 21.3 Stark Trading v. Falconbridge, Ltd. Stark Trading v. Falconbridge, Ltd. (2009). (2009).

Stark’s 10(b) claim was dismissed because he was aware Stark’s 10(b) claim was dismissed because he was aware of the misrepresentations before he bought the stock. of the misrepresentations before he bought the stock. Therefore the reliance element was missing.Therefore the reliance element was missing.

Violations of the 1934 ActViolations of the 1934 Act


State securities laws are called “blue State securities laws are called “blue sky” laws.sky” laws.

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

States could require registration or States could require registration or qualification.qualification.

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

State Securities LawsState Securities Laws


Corporate GovernanceCorporate Governance

Need for Effective Corporate Need for Effective Corporate Governance.Governance.

Attempts at Aligning the Interests of Attempts at Aligning the Interests of Officers with Shareholders.Officers with Shareholders.

Corporate Governance and Corporate Corporate Governance and Corporate Law.Law.Importance of Audit and Compensation Importance of Audit and Compensation

Committees.Committees.


Sarbanes-Oxley Act of 2002Sarbanes-Oxley Act of 2002

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

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

Oversight by Public Company Accounting Oversight by Public Company Accounting Oversight Board.Oversight Board.

Protections for Whistleblowers.Protections for Whistleblowers. Enhanced Penalties.Enhanced Penalties.


Key Provisions: Sarbanes-OxleyKey Provisions: Sarbanes-Oxley


Online Securities FraudOnline Securities Fraud

SEC is enforcing anti-fraud provisions of SEC is enforcing anti-fraud provisions of Securities Laws.Securities Laws.

Investment Scams.Investment Scams. Online Investment Newsletters and Online Investment Newsletters and

Forums.Forums. ““Ponzi” Schemes.Ponzi” Schemes.

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

Madoff.Madoff.

Hacking into Online Stock Accounts.Hacking into Online Stock Accounts.

investor protection, insider trading, and corporate governance

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