© 2008 West Legal Studies in Business A Division of Thomson Learning 1 BUSINESS LAW TODAY Essentials 8 th Ed. Roger LeRoy Miller - Institute for University Studies, Arlington, Texas Gaylord A. Jentz - University of Texas at Austin, Emeritus Chapter 21 Investor Protection, Insider Trading, and Corporate Governance

© 2008 West Legal Studies in Business A Division of Thomson Learning 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?

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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 ( 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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).

© 2008 West Legal Studies in Business A Division of Thomson Learning 11 Exempt Transactions

© 2008 West Legal Studies in Business A Division of Thomson Learning 12  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. Exempt Transactions

© 2008 West Legal Studies in Business A Division of Thomson Learning 13  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. Violations of the 1933 Act

© 2008 West Legal Studies in Business A Division of Thomson Learning 14  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). Securities Exchange Act of 1934

© 2008 West Legal Studies in Business A Division of Thomson Learning 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).

© 2008 West Legal Studies in Business A Division of Thomson Learning 16  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). Section 10(b) and Rule 10b(5) & Insider Trading

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 18 Summary

© 2008 West Legal Studies in Business A Division of Thomson Learning 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).

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 23 Online Securities Offerings  Online IPO’s may deliver a prospectus by: Giving timely and adequate notice ( s). Making the online communication system readily accessible. Requiring evidence of delivery ( return receipt).

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.

© 2008 West Legal Studies in Business A Division of Thomson Learning 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.