chapter 37 corporations investor protection and online securities offerings
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Chapter 37 Corporations Investor Protection and Online Securities Offerings

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Introduction. Historical Background: 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.. Introduction. The Securities Act of 1933 and Securities Exchange Act of 1934 are de

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Presentation Transcript
  • Historical Background: 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.
  • 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.
1 the sec
§ 1: The SEC
  • The Securities and Exchange Commission is an independent federal regulatory agency that enforces federal securities laws. The SEC :
    • Regulates disclosure of facts in offerings made through national securities exchanges (e.g., NASDAQ, NYSE).
    • Investigates and prosecutes securities fraud.
    • Registration and regulation of securities brokers, dealers and investment advisors.
    • Securities Regulations.
expanded powers of the sec
Expanded Powers of the SEC
  • Securities Enforcement Remedies and Penny Stock Reform Act of 1990.
  • Securities Acts Amendments of 1990.
  • Market Reform Act of 1990.
    • National Securities Markets Improvement Act of 1996.
2 the securities act of 1933
§ 2: The Securities Act of 1933
  • Securities Act of 1933 regulates solicitation, buying and selling of securities: stocks and bonds.
  • 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.
registration statement
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 SEC and state (seeTexas) securities agencies before offered to the public.
  • Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.
contents of registration statement
Contents of Registration Statement
  • Description of the significant provisions of the registrant’s “offering” and how the registrant intends to use the proceeds from the sale.
  • Description of the registrant’s properties and business.
contents of registration statement 2
Contents of Registration Statement [2]
  • Description of the management of the registrant, remuneration, pension, stock offerings, executive interests and compensation.
  • Financial statement certified by and independent accounting firm.
  • Description of pending lawsuits.
exemptions to registration
Exemptions to Registration
  • Bank securities sold before 1933.
  • Commercial paper if maturity date does not exceed 9 months.
  • Charitable organization securities.
  • Securities issued to existing securities holders resulting from reorganization, bankruptcy.
  • Securities issued to finance railroad equipment.
exemptions to registration 2
Exemptions to Registration [2]
  • Any insurance, endowment, annuity contract or government-issued securities.
  • Securities issued by banks, savings and loan association, farmers' cooperatives.
  • Regulation A, small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular.
  • Securities issued to existing securities holders, stock split, dividend (really a transaction exemption).
securities act exempt transactions
Securities Act Exempt Transactions
  • 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.
    • (Also Regulation A)
securities act exempt transactions 2
Securities Act Exempt Transactions [2]
  • Rule 147 Intrastate Sales.
  • Broker/Dealer Transactions.
  • Casual Sales .
  • Resales of Restricted Securities by “Control Persons.”
    • Rule 144 and 144(a).
securities act violations
Securities Act Violations
  • Violation of the Securities Act to intentionally or negligently defraud investors by misrepresenting or omitting material facts in the registration statement and/prospectus.
securities act defenses penalties
Securities Act Defenses & Penalties
  • 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.
3 the securities exchange act of 1934
§3: The 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).
purposes of 1934 act 2
Purposes of 1934 Act[2]
  • Rule 14(a) proxy regulations.
  • Market surveillance by SEC.
  • Rule 10(b) prohibits fraud with insider trading and disclosure regulations.
  • Rule 16(b) insider reporting and trading.
  • Rule 13 tender offer regulations.
section 10 b and rule 10b 5
Section 10(b) and Rule 10b(5)
  • 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.
section 10 b and rule 10b 5 2
Section 10(b) and Rule 10b-5 [2]
  • Insider trading prohibited:
    • 10b(5) “Insiders”.
    • 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.
violations of the 1934 act
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.
section 16 a b
Section 16 (a) & (b):
  • 16(a): Stockholders who become owners of 10 or more of the classes of equity stock must report their ownership to the SEC.
  • 16(b): Profits realized by the insider on any purchase and sale, or sale and purchase, of the corporation's stock within any six-month period must be forfeited to the corporation.
  • Also applicable to warrants and options and securities convertible into stock.
insider trading sanctions act of 1984
Insider Trading Sanctions Act of 1984
  • SEC can bring suit in federal court against anyone violating or aiding in a violation of the 1934 act or SEC rules by purchasing or selling a security while in the possession of material non-public information.
  • Must be a public sale (triple profits awardable).
insider trading and securities fraud enforcement act of 1988
Insider Trading and Securities Fraud Enforcement Act of 1988
  • Enlarged class of person who may be liable under insider-trading rules.
  • SEC can award a bounty to informers.
  • SEC got more power to prevent insider trading.
  • Criminal penalties were increased to 10 years and $2.5 million.
4 regulation of investment companies
§4: Regulation of Investment Companies
  • Act on behalf of many smaller shareholders by buying stock and professionally managing the “portfolio.” (MUTUAL FUNDS.)
  • To safeguard company assets, all securities must be held by a bank or stock exchange member.
  • No dividends paid except from undistributed net income.
5 state securities laws
§5 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.
emerging trends
Emerging Trends
  • First Public Offering over the Internet 1996.
  • SEC has begun to regulate sale of securities on the internet.
  • There are dozens of “IPO’s” offered via internet brokers such as .
  • Virtually all major corporations have on-line financial statements, “forward-looking” information.


6 online securities offerings and disclosures
§6: Online Securities & Offerings and Disclosures
  • 1996—Springtree first online IPO.
  • Regulations Governing Online Securities Offerings.
    • 1995-SEC “Use of Electronic Media for Delivery Purposes” for delivery of prospectus: timely and adequate notice, communication system easily accessible and evidence of delivery.
    • Potential Liabilty (hyperlinking)
7 online securities fraud
§7: Online Securities Fraud
  • Use of Chat Rooms to manipulate prices (“pump and dump”)
    • Jonathan Leed case.
    • By 2001, over 100 cases prosecuted by SEC.
  • Illegal Securities Offerings
    • Unregistered offerings.
case 37 1 sec v texas gulf sulphur 10b 5 disclosure requirements
Case 37.1: SEC v. Texas Gulf Sulphur(10b-5 Disclosure Requirements)
  • FACTS:
    • TGS drilled a hole that appeared to yield a core with an exceedingly high mineral content. Keeping this secret, TGS officers, directors, and employees made substantial purchases of company stock or accepted stock options.
    • Later, an unauthorized report of the discovery appeared in the newspapers and TGS issued a press release that played down the find.
    • After test drilling, TGS announced a strike of 25 million tons of ore, substantially driving up the price of its stock. The SEC sued TGS officers and employees for violating Rule 10b-5.
case 37 1 sec v texas gulf sulphur 10b 5 disclosure requirements30
Case 37.1: SEC v. Texas Gulf Sulphur(10b-5 Disclosure Requirements)
    • The court decided that the drilling results were “material” and that the insider-trading activity before the press release was illegal.
    • The test of “materiality” is whether the information would affect the judgment of reasonable investors. An important factor in determining whether the discovery of ore is a material fact is the importance attached to it by those who know of it.
    • Stock purchases by those who knew of the drilling virtually compelled the inference that the insiders were influenced by the information.
case 37 2 sec v warde outsiders and 10b 5
Case 37.2: SEC v. Warde(Outsiders and 10b-5)
  • FACTS:
    • Downe was a director of Kidde and Warde was a friend of Downe. In June 1987, Kidde became the target of a takeover attempt by Hanson Trust PLC, a British firm.
    • In August, Kidde announced it would merge with Hanson. The price of Kidde stock increased, and warrants for the shares, which had been priced at $1 in June, went to $26.50.
    • Between June and August, Downe and Warde bought and sold warrants several times, earning very large profits.
    • The SEC sued Warde for insider trading.
case 37 2 sec v warde outsiders and 10b 532
Case 37.2: SEC v. Warde(Outsiders and 10b-5)
    • The court ordered Warde to pay more than $3 million in penalties and interest.
    • Liability as a tippee (Warde) requires proof that the tipper (Downe) intended to benefit the recipient or made “a gift of confidential information” to the person
    • The court rejected Warde’s claims that his purchases were based on market savvy, rumor, and public information.
case 37 3 u s v o hagan outsiders and rule 10b 5
Case 37.3: U.S. v. O’Hagan(Outsiders and Rule 10b-5)
  • FACTS:
    • O’Hagan was a partner in the law firm of Dorsey & Whitney. Grand Met PLC hired Dorsey & Whitney to assist in a takeover of Pillsbury Company.
    • Before the tender offer, O’Hagan bought Pillsbury stock. When the offer was announced, O’Hagan made a profit of more than $4 million.
    • The SEC prosecuted O’Hagan for, among other things, securities fraud in violation of Rule 10b-5 under the misappropriation theory, on the basis of O’Hagan’s fiduciary duties to his law firm and Grand Met.
case 37 3 u s v o hagan outsiders and rule 10b 534
Case 37.3: U.S. v. O’Hagan(Outsiders and Rule 10b-5)
    • U.S. Supreme Court held that liability under Rule 10b-5 can be based on the misappropriation theory.
    • The Court concluded that misappropriation under Section 10(b) requires conduct that involves a “deceptive device or contrivance” used “in connection with” the purchase or sale of securities. “
    • The fraud is complete “when, without disclosure to his principal, he uses the information to purchase or sell securities.”
case 37 4 medtox v morgan capital insider reporting and trading
Case 37.4: Medtox v. Morgan Capital(Insider Reporting and Trading)


  • Medtox--Editek, Inc. issued shares of convertible preferred stock.
  • Morgan Capital bought some of the preferred stock when the number of common shares that it could have received on conversion would have been less than 10 percent. Morgan Capital waited and sold the stock for more than 18% for a profit of $551,456.84.
  • Editek sued Morgan Capital alleging that the firm had violated Section 16(b).
case 37 4 medtox v morgan capital insider reporting and trading36
Case 37.4: Medtox v. Morgan Capital(Insider Reporting and Trading)
    • The court awarded the $551,456.84 to Editek.
    • Morgan Capital was a 10 percent shareholder of Editek for purposes of Section 16(b) liability, because for at least one day before it converted its preferred shares, those shares could have been converted to obtain more than 10 percent of the common stock.
    • The presumption arises under Section 16(b) that Morgan Capital’s holdings afforded it the potential for access to corporate information not available to a smaller shareholder on that day.
case 37 5 in re mci worldcom section 10 b and rule 10b 5
Case 37.5: In Re MCI Worldcom(Section 10(b) and Rule 10b-5)
  • FACTS:
    • Investors learned that MCI was negotiating to buy SkyTel and Skytel stock rose 12 percent. Later, it was reported that MCI had registered as a domain name. SkyTel’s stock price rose 16 percent before noon.
    • MCI said the registration was done by an employee acting alone and “is not an indication of official company intention.” SkyTel’s stock price fell to less than the previous day’s price.
    • On May 28, MCI announced that it would buy all of SkyTel’s stock. Investors who sold the stock sued MCI. MCI filed a motion to dismiss.
case 37 5 in re mci worldcom section 10 b and rule 10b 538
Case 37.5: In Re MCI Worldcom(Section 10(b) and Rule 10b-5)
    • The investors successfully proved scienter through motive and opportunity, as well as facts from which an inference of conscious misbehavior or recklessness could be drawn.
    • “[B]eing able to acquire a company for a significantly reduced price is a sufficient economic benefit to satisfy the motive requirement for scienter.”
    • Also, “it was MCI itself that registered the domain name, and not, as Ms. Gibson suggested, an MCI employee acting alone.”