1. © 2007 West Legal Studies in Business, A Division of Thomson Learning Chapter 27 Investor Protection and Corporate Governance

2. © 2007 West Legal Studies in Business, A Division of Thomson Learning 2 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? How are securities laws being applied in the online environment? Learning Objectives

3. © 2007 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.

4. © 2007 West Legal Studies in Business, A Division of Thomson Learning 4 Securities Exchange Act 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. © 2007 West Legal Studies in Business, A Division of Thomson Learning 5 What is a Security? 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. CASE 27.1 SEC v. Alpha Telcom, Inc. (2002).

6. © 2007 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 (http://www.sec.gov) and state securities agencies before offered to the public.http://www.sec.gov Corporation must file a registration statement and prospectus with the SEC. Prospectus is later distributed to investors.

7. © 2007 West Legal Studies in Business, A Division of Thomson Learning 7 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.

8. © 2007 West Legal Studies in Business, A Division of Thomson Learning 8 Registration Statement 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.

9. © 2007 West Legal Studies in Business, A Division of Thomson Learning 9 Exempt Securities 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.

10. © 2007 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. 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).

11. © 2007 West Legal Studies in Business, A Division of Thomson Learning 11 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.

12. © 2007 West Legal Studies in Business, A Division of Thomson Learning 12 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.

13. © 2007 West Legal Studies in Business, A Division of Thomson Learning 13 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

14. © 2007 West Legal Studies in Business, A Division of Thomson Learning 14 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 27.2 SEC v. Texas Gulf Coast Sulphur Co. (1968).

15. © 2007 West Legal Studies in Business, A Division of Thomson Learning 15 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. Section 10(b) and Rule 10b(5) & Insider Trading

16. © 2007 West Legal Studies in Business, A Division of Thomson Learning 16 Insider Reporting and Trading— Section 16(b) Section 16(b). Recapture by corporation of profits during previous six months gained by insider trading. Applies to stocks, warrants, options and convertible securities.

17. © 2007 West Legal Studies in Business, A Division of Thomson Learning 17 Penalties for 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. –CASE 27.3 In re Stewart (2004). 16(b) -- strict liability -- no fault or scienter required -- civil penalties.

18. © 2007 West Legal Studies in Business, A Division of Thomson Learning 18 Corporate Governance--Sarbanes- Oxley Act of 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.

19. © 2007 West Legal Studies in Business, A Division of Thomson Learning 19 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.

20. © 2007 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.

21. © 2007 West Legal Studies in Business, A Division of Thomson Learning 21 Online Securities Offerings and Disclosures 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.

22. © 2007 West Legal Studies in Business, A Division of Thomson Learning 22 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).

23. © 2007 West Legal Studies in Business, A Division of Thomson Learning 23 Potential Liability of 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.

24. © 2007 West Legal Studies in Business, A Division of Thomson Learning 24 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.