1. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Chapter 24: Investor Protection and Corporate Governance © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

2. 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. 2

3. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  3

4. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  4

5. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  5

6. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 6

7. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 7

8. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 8

9. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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).  9

10. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 10

11. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. Posteffective Period: securities can now be sold. Registration Process Review. 11

12. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Securities Act of 1933  Registration Statement. Registration Process. Restrictions Relaxed for Well-Known Seasoned Issuers. In 2005, SEC revised the registration process and created new categories of issuers based on size and market presence. A WKSI has issued $1 billion in securities during last 3 years, or $700 million outstanding stock in public hands. 12

13. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  13

14. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  14

15. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  15

16. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. The Securities Act of 1933  Exempt Securities and Transactions. Resales. Rule 144A: allows sale only to a qualified institutional buyer. 16

17. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Exemptions Exemptions 17

18. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  18

19. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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 24.1 L ITWIN V. B LACKSTONE G ROUP, LP (2011). CASE 24.1 L ITWIN V. B LACKSTONE G ROUP, LP (2011). What material information did Blackstone omit? 19

20. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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 20

21. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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.  The Securities Exchange Act of 1934 21

22. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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.  The Securities Exchange Act of 1934 22

23. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. The Securities Exchange Act of 1934 23

24. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. Examples of materials facts in disclosure: Fraudulent trading by broker.  The Securities Exchange Act of 1934 24

25. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Section 10(b), SEC Rule 10b-5 and Insider Trading. Disclosures Under SEC 10b-5 (cont’d) CASE 24.2 SEC V. T EXAS G ULF S ULPHUR C O. (1968). CASE 24.2 SEC V. T EXAS G ULF S ULPHUR C O. (1968). Who were the insiders in this case and what should they have done differently? The Securities Exchange Act of 1934 25

26. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. The Securities Exchange Act of 1934 26

27. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. The Securities Exchange Act of 1934 27

28. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Section 10(b), SEC Rule 10b-5 and Insider Trading. 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. The Securities Exchange Act of 1934 28

29. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. The Securities Exchange Act of 1934 29

30. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Comparison of SEC Rules 30

31. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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).  The Securities Exchange Act of 1934 31

32. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  Violations of the 1934 Act. CASE 24.3 G EBHART V. SEC (2010). CASE 24.3 G EBHART 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.  The Securities Exchange Act of 1934 32

33. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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.  The Securities Exchange Act of 1934 33

34. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.  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. State Securities Laws 34

35. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Corporate Governance  Relationship between a corporation and its shareholders.  Attempts at Alignment between Officers and Shareholders. Stock Options? 35

36. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  36

37. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 37

38. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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.  38

39. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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).  39

40. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 40

41. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. 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. 41

42. © 2013 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. Online Securities Fraud and Ponzi Schemes  Hacking into Online Stock Accounts.  Ponzi Schemes. (e.g., Bernie Madoff). Offshore Fraud, “Risk Free” Fraud. 42