Chapter 21

1. BUSINESS LAW TODAYEssentials 8th Ed.Roger LeRoy Miller - Institute for University Studies, Arlington, TexasGaylord A. Jentz - University of Texas at Austin, Emeritus Investor Protection, Insider Trading, and Corporate Governance Chapter 21

2. Learning Objectives • What is meant by the term securities? • What are the two major statutes regulating the securities industry? When was the SEC created, and what are its major purposes and functions? • What is insider trading? Why is it prohibited? • What are some of the features of state securities laws? • What certification requirements does the Sarbanes-Oxley Act impose on corporate executives?

3. Introduction • The stock market crash of 1929 showed the need for: • More disclosure from issuers. • Prohibition of deceptive, unfair and manipulative practices in the purchase and sale of securities.

4. Securities Act of 1933 • The Securities Act of 1933 and Securities Exchange Act of 1934 are designed to protect investors from deceptive, unfair and manipulative practices when buying or selling securities. • Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt.

5. What is Security? • Securities Act of 1933 regulates solicitation, buying and selling of securities. • In SEC v. W.J. Howey Co. (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.

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

7. Registration Statement • The Registration Statement must describe: • The securities being offered for sale, including their relationship to the registrant’s other capital securities. • The registrant’s properties and business. • The management of the registrant, remuneration, pension, stock offerings, executive interests and compensation. • How the corporation intends to use the proceeds of the sale. • Description of pending lawsuits or special risk factors.

8. Registration Statement • Registration statement does not become effective until after review and approval by SEC. • Waiting Period: At least 20 days after approval. Oral offers are OK. Actual sales are prohibited. • Red herring prospectus. • Tombstone ads. • Posteffective Period.

9. Exempt Securities • Any Government-issued securities. • Bank and financial institution securities. • Short-term notes. • Non-profit organization securities. • Securities issued to existing securities holders resulting from reorganization, bankruptcy. • Securities issued to common carriers.

10. Exempt Securities • 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).

11. Exempt Transactions

12. Exempt Transactions • Regulation A, small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular. • Small “Reg D” Offerings. • Rule 504: up to $1M during 12 months to accredited investors only. • Rule 504a. • Rule 505: up to $5M during 12 months to both accredited and unaccredited investors. • Section 4(6): up to $5M solely to accredited investors.

13. Violations of the 1933 Act • Intentional or negligent fraud of investors by misrepresenting or omitting material facts in the registration statement and/prospectus. • Defenses: Statement left out was not material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true. • Penalties: • Criminal: up to 5 years in prison and $10,000 fine. • Civil: damages, refund of investment, injunction.

14. Securities Exchange Act of 1934 • Registration of securities exchanges, brokers, dealers, and national securities exchanges and associations. • Requires continuous disclosure system for corporations with securities sold on national exchanges or assets in excess of $5 million and 500 or more shareholders (Sec. 12 companies or 1934 companies).

15. Section 10(b) and Rule 10b(5) & Insider Trading • Section 10(b) prohibits the use of any manipulative or deceptive device or contrivance in contravention of rules and regulations of SEC. • Rule 10b(5) prohibits the commission of fraud in the connection with the purchase or sale of any security. • CASE 21.1 SEC v. Texas Gulf Sulphur Co. (1968).

16. Section 10(b) and Rule 10b(5) & Insider Trading • Insider Trading • Advance information available to corporate officers and directors that can affect future value of stock. • Insider trading prohibited: • 10b(5) “Insiders” (Officers, Executives and Directors). • 10b(5) “Outsiders”. • 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. • CASE 21.2 SEC v. Rocklage (2006).

17. 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.

18. Summary

19. Violations of the 1934 Act • 10b violation—scienter or intent is required to prove criminal penalties. • Imprisonment up to 10 years, fines up to $1 million, $2.5 for partnership or corporation. • 16(b) -- strict liability -- no fault or scienter required -- civil penalties. • CASE 21.3 United States v. Stewart (2004).

20. 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. • States could require registration or qualification. • Uniform Securities Act has been adopted in part by many states.

21. Corporate Governance-Sarbanes Oxley • ‘Sarb-Ox’ passed in 2002, 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. • Oversight by Public Company Accounting Oversight Board. • Protections for Whistleblowers. • Enhanced Penalties.

22. Online Securities Offerings • Landmark Online IPO (1996): Spring Street Brewing Company. • Regulations for online offerings. • SEC October 1995 “use of electronic media should be at least an equal alternative to paper-based media.” Downloadable prospectus is permissible.

23. Online Securities Offerings • Online IPO’s may deliver a prospectus by: • Giving timely and adequate notice (e-mails). • Making the online communication system readily accessible. • Requiring evidence of delivery (email return receipt).

24. Online Securities Offerings • Online offers should not link to other sites in prospectus. • Problems with status of investors on a general website. For example, Reg D offerings can only be made to “accredited investors”. • Perhaps use password protected website.

25. Online Securities Fraud • SEC tries to enforce anti-fraud provisions of Securities Laws. • Use and abuse of internet chat rooms. • Where is the line between free speech and fraud? • Pumping and Dumping: buyer pumps the stock and after it rises, he dumps it, selling at a higher price. • Selling unregistered securities by unregistered stock brokers is a problem.