© 2011 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. 1 Chapter 31: Investor Protection, Insider Trading, and Corporate Governance

2 © 2011 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. Learning Objectives What is meant by the term securities? What are the two major statutes regulating the securities industry? 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?

3 © 2011 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. Securities and Exchange Commission Major Responsibilities of the SEC: –Require disclosure of facts concerning offerings. –Regulate trade in securities. –Investigate securities fraud. –Regulate activities of securities brokers, dealers, and investment advisors. –Supervise mutual fund activities. –Recommend sanctions for violations.

4 © 2011 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. Securities Act of 1933 The Securities Act of 1933 governs the initial sale of stocks by businesses. 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 © 2011 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. What is a Security? In SEC v. Howey (1946), the U.S. Supreme Court held that a security (investment contract) 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.

6 © 2011 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. 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.

7 © 2011 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. 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 © 2011 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. 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 © 2011 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. Registration Process Registration statement does not become effective until approval by SEC. Pre-Filing Period: issuer cannot offer or sell securities. Waiting Period: securities can be offered by not sold. 2005: Free-writing prospectus. Post-Effective Period: registration effective 20 days after approval.

10 © 2011 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. Exempt Securities and Transactions Bank securities sold before 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.

11 © 2011 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. 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).

12 © 2011 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. Exempt Transactions Regulation A Offerings: small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular.

13 © 2011 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. Exempt Transactions Small Offerings: Regulation D. –Rule 504: up to $1M during 12 months to accredited investors only. –Rule 504a. –Rule 505: private, up to $5M during 12 months to both accredited and unaccredited investors. –Rule 506: “private placement” exemption: unlimited amounts, not advertised, to accredited investors only.

14 © 2011 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. Exempt Transactions Section 4(6): up to $5M solely to accredited investors. Intrastate Offerings—Rule 147. Rule 144. Rule 144a.

15 © 2011 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 © 2011 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 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.

17 © 2011 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. 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 $10 million and 500 or more shareholders (Sec. 12 companies or 1934 companies). Securities Exchange Act of 1934

18 © 2011 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) 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.

19 © 2011 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. 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). Section 10(b) and Rule 10b(5) & Insider Trading

20 © 2011 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) and Rule 10b(5) & Insider Trading Disclosure under SEC Rule 10b-5: –Material omission or misrepresentation may violate 1933 Act and antifraud provisions of 1934 Act and SEC Rule 10b-5. –Key is whether insider’s information is “material”, such as: Fraudulent trading by broker-dealer, dividend change, contract for sale of corporate assets, new discovery, process, or product, significant change in financial condition, potential litigation. Case 31.1 SEC v. Texas Gulf Sulphur, Inc. Officers and employees engaged in insider trading. The test of materiality is what would affect the judgment of reasonable investors.

21 © 2011 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. Private Securities Litigation Reform Act of 1995 Provides “safe harbor” for publicly held companies that make forward-looking statements, such as financial forecasts. Protection against liability from securities fraud with “meaningful cautionary statements.”

22 © 2011 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. Outsiders and SEC Rule 10b-5 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, to employer, for instance. –What about “scheme” liability? Case 31.2 Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. Court dismissed claims against Scientific Atlanta and Motorola – Section 10(b) private right of action cannot be applied to “outsiders” (customers or suppliers).

23 © 2011 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. 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. Regulation of Proxy Statements, Sect. 14(a). –Whoever solicits a proxy must fully disclose all of the facts and which shareholders must vote.

24 © 2011 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 10b-5 and 16(b)

25 © 2011 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 10(b) and 10B-5: scienter is required, proved by showing defendant made false statements or wrongfully failed to disclose material facts. 16(b): strict liability -- no fault or scienter required. –Criminal Penalties: Individuals-imprisonment up to 10 years, fines up to $5 million, $2.5 for partnership or corporation. Civil Sanctions. Case 31.3 Stark Trading v. Falconbridge, Ltd. Stark’s 10(b) claim was dismissed because he was aware of the misrepresentations before he bought the stock. Therefore the reliance element was missing.

26 © 2011 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 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.

27 © 2011 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 Need for Effective Corporate Governance. Attempts at Aligning the Interests of Officers with Shareholders. Corporate Governance and Corporate Law. –Importance of Audit and Compensation Committees.

28 © 2011 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. 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.

29 © 2011 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. Key Provisions: Sarbanes-Oxley

30 © 2011 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 SEC is enforcing anti-fraud provisions of Securities Laws. Investment Scams. Online Investment Newsletters and Forums. “Ponzi” Schemes. –Offshore Fraud. –“Risk Free” Fraud: Michael Regan, Bernie Madoff. Hacking into Online Stock Accounts.