2.  The Securities and Exchange Act of 1934 created the SEC, an independent federal regulatory agency that administers federal securities laws.  © 2012 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

3.  SEC basic functions:  1. Interprets federal securities laws and investigates securities law violations.  2. Issues new rules and amends existing rules.  3. Oversees the inspection of securities firms, bro kers, investment advisers, and ratings agencies.  © 2012 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. 3

4.  SEC basic functions:  4. Oversees private regulatory organizations in the securities, accounting, and auditing fields.  5. Coordinates U.S. securities regulation with federal, state, and foreign authorities © 2012 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. 4

5.  Updating the Regulatory Process.  SEC’s Expanding Powers.  Securities Enforcement Remedies and Penny Stock Reform Act of 1990.  Securities Acts Amendments of 1990.  Market Reform Act of 1990.  © 2012 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. 5

6.  The SEC’s Expanding Powers (cont’d).  National Securities Markets Improvement Act of 1996.  The Sarbanes-Oxley Act of 2002 (discussed later in the chapter). © 2012 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. 6

7.  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. © 2012 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. 7

8. 1.Instruments and interests commonly known as securities, such as preferred and common stocks, treasury stocks, bonds, debentures, and stock warrants. © 2012 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. 8

9. 2. 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.  © 2012 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. 9

10. 3. Notes, instruments, or other evidence of indebtedness, including certificates of interest in a profit-sharing agreement and certificates of deposit.  © 2012 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. 10

11. 4. Any fractional undivided interest in oil, gas, or other mineral rights. 5. Investment contracts, which include interests in limited partnerships and other investment schemes. © 2012 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. 11

12.  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. © 2012 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. 12

13.  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. © 2012 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. 13

14.  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). © 2012 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. 14

15.  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. © 2012 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. 15

16.  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. © 2012 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. 16

17.  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. © 2012 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. 17

18.  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. © 2012 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. 18

19.  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.  © 2012 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. 19

20.  Regulation D Offerings.  Rule 506: unlimited if no general solicitation and notice to SEC. Max of 35 unaccredited investors.  Resales and Safe Harbor Rules.  Generally, most securities can be resold without registration.  © 2012 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. 20

21.  Resales and Safe Harbor Rules.  Rule 144: Rule 505 or 506 securities trigger registration requirements unless the sale complies with all of Rule 144’s conditions (pages 818-819).  Rule 144A: allows sale only to a qualified institutional buyer. © 2012 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. 21

22. © 2012 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. 22

23.  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.  © 2012 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. 23

24.  Defenses: Statement left out was not material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true. © 2012 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. 24

25.  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. © 2012 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. 25

26.  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.  © 2012 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. 26

27.  Applicability of SEC Rule 10b(5).  Virtually all cases concerning the trading of securities, whether on exchanges, OTC, or private.  © 2012 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. 27

28.  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. © 2012 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. 28

29.  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.  © 2012 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. 29

30.  Disclosure Under SEC 10b-5  Examples (cont’d):  Dividend Change.  Contract for sale of corporate assets.  New discovery, process, or product.  Significant change in firms financial condition.  Potential litigation against the company.  © 2012 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. 30

31.  Disclosure Under SEC 10b-5 (cont’d)  CASE 29.1 SEC v. Texas Gulf Sulphur Co. (1968). Who were the insiders in this case and what should they have done differently? © 2012 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. 31

32.  Disclosure Under SEC 10b-5 (cont’d):  Private Securities Litigation Reform Act: provides a “safe harbor” for publicly-held companies making forward- looking statements.  Securities Litigation Uniform Standards Act. © 2012 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. 32

33.  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. © 2012 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. 33

34.  Requires recapture of all short-swing profits by insiders (those owning 10% of equities) to corporation.  Applies to stocks, warrants, options, and securities. © 2012 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. 34

35.  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. © 2012 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. 35

36. © 2012 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. 36

37.  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).  © 2012 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. 37

38.  CASE 29.2 Gebhart 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. © 2012 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. 38

39.  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.  © 2012 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. 39

40.  CASE 29.3 Stark Trading v. Falconbridge, Ltd. (2009). If an investor is aware of misrepresentations, can he still recover? © 2012 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. 40

41.  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. © 2012 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. 41

42.  Relationship between a corporation and its shareholders.  Attempts at Alignment between Officers and Shareholders.  Stock Options?  Goal is to Promote Accountability.  © 2012 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. 42

43.  Corporate governance involves:  ( 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.  © 2012 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. 43

44.  Board of Directors: responsible to ensure all corporate officers are operating in best interests of shareholders.  Compensation Committee: assess performance and design fair compensation systems. © 2012 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. 44

45.  Sarb-Ox attempts to increase corporate accountability by imposing strict disclosure requirements and harsh penalties for securities violations.  Applies to all public companies.  © 2012 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. 45

46.  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).  © 2012 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. 46

47.  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. © 2012 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. 47

48.  The SEC is aggressively prosecuting internet fraud using traditional laws.  Investment Scams.  Online Investment Newsletters and Forums.  Ponzi Schemes. (e.g., Bernie Madoff) © 2012 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. 48