Chapter 24 Investor Protection

2 Chapter Objectives 1. Define what is meant by the term securities. 2. Describe the purpose and provisions of the Securities Act of Explain the purpose and provisions of the Securities Exchange Act of Identify federal laws that specifically regulate investment companies. 5. Point out some of the features of state securities laws.

3 Securities Act of 1933 Prohibits fraud and stabilizes the securities industry by requiring disclosure of all essential information relating to the issuance of stocks to the investing public.

4 The Securities and Exchange Commission The SEC was a direct result of the stock market crash of The 1934 Securities Exchange Act established the SEC as an independent regulatory agency whose function was to administer the 1933 and 1934 acts. What is the source of the national government’s authority to regulate the securities industry?

5 Registration Statement Registration requirements  Securities, unless exempt, must be registered with the SEC before being offered to the public through the mails or any facility of interstate commerce.  The registration statement must include detailed financial information about the issuing corporation; the intended use of the proceeds of the securities being issued; and certain disclosures, such as interest of directors or officers and pending lawsuits. Prospectus  A prospectus must be provided to investors, describing the security being sold, the issuing corporation, and the risk attaching to the security.

6 Exempt Transactions The SEC has exempted certain offerings from the require- ments of the Securities Act of Exemptions may be determined on the basis of the size of the issue, whether the offering is private or public, and whether advertising is involved.

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9 Securities Exchange Act of 1933 Provides for the regulation and registration of securities exchanges, brokers, dealers and national securities associations. Maintains a continuous disclosure system for all corporations with securities on the securities exchanges and for those companies that have assets in excess of $10 million and five hundred or more shareholders.

10 Section 10(b), SEC Rule 10b-5, and Insider Trading Applies to insider trading by corporate officers, directors, majority shareholders, and any persons receiving information not available to the public who base their trading on this information. Liability for violation can be civil or criminal. May be violated by failing to disclose “material facts” that must be disclosed under this rule. Applies in virtually all cases concerning the trading of securities. A firm does not have to have its securities registered under the 1933 Act for the 1934 Act to apply. Applies only when the requisites of federal jurisdiction are present.

11 Case 24.1 Diamond v. Oreamuno Chairman of the board, Oreamuno, and president, Gonzalez, of Management Assistance, Inc.(MAI), sold their MAI stock after learning it was going to drop dramatically. After the stock fell, Diamond brought a shareholder’s derivative lawsuit on behalf of MAI to recover the profits the defendants (Oreamuno & Gonzalez) had made. What did the courts rule? What is the difference between a suit brought by an individual investor-shareholder and a shareholder’s derivative suit?

12 Case 24.2 SEC v. Texas Gulf Sulphur Co. TGS drilled a hole that appeared to yield a core with exceedingly high mineral content and kept these results secret. Officers and employees made significant stock purchases even though further drilling was necessary to establish the commercial viability of the discovery. When TGS, after testing, announced the strike and drove up the stock price significantly, the SEC brought suit for insider trading prohibited by Rule 10b-5. The court held that most defendants had not violated 10b-5 and the SEC appealed. Who is hurt by insider trading?

13 Should Insider Trading Be Legal? The SEC rule covers not only corporate insiders but even “outsiders” who receive trade tips from insiders. Some people doubt that such extensive regulation is necessary. How would you argue against the legalization of insider trading?

14 Case 24.3 SEC v. Warde Edward Downe became director of Kidde, Inc. through his friend and also chairman of Kidde, Fred Sullivan. Thomas Warde was a good friend of Downe. Sullivan learned that Hanson Trust PLC was trying to take over Kidde, Inc., which eventually led to a merger. Before the merger actually occurred, Downe and Warde bought and sold warrants several times to earn large profits. The SEC filed a suit alleging insider trading violations. Warde was found liable and ordered to pay over $3 million in penalties and interest. How does the decision in this case make it easier for the SEC to win in other insider- trading cases?

15 Case 24.4 United States v. O’Hagen James O’Hagen worked in a law firm that assisted Grand Met to takeover the Pillsbury Co. O’Hagan bought shares of Pillsbury knowing the price would go up, and then sold them for a high profit. The SEC prosecuted O’Hagan for securities fraud. What did the courts rule? If a nonlawyer employee of Dorsey & Whitney, such as a paralegal, learned about the tender offer and traded profitably on the inside information, could the employee be held liable under the misappropriation theory? Why or why not?

16 Insider Reporting and Trading-Section 16(b) To prevent corporate officers and directors from taking advantage of inside information, the 1934 Act requires officers, directors, and shareholders owning 10% or more of the issued stock of a corporation to turn over to the corporation all short-term profits realized from the purchase and sale or sale and purchase of corporate stock within any six-month period.

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18 Proxy Statements The SEC regulates the content of proxy statements sent to shareholders by corporate managers of Section 12 companies who are requesting authority to vote on behalf of the shareholders in a particular election on specified issues. Section 14(a) is essentially a disclosure law, with provisions similar to the antifraud provisions of SEC Rule 10b-5.

19 Insider Trading: The Use-Possession Debate There is a scienter requirement for insider trading liability. Does the mere possession of inside information while trading in securities establish an intent to defraud, or must the trader actually use the inside information for intent to be established? Does anyone who unwittingly acquires inside information face a legal risk?

20 The Expanding Powers of the SEC The 1990 Securities Acts Amendments authorized the SEC to seek sanctions against those who violate foreign securities laws. These amendments increase the ability of the SEC to cooperate in international securities law enforcement. Under the Market Reform Act of 1990, the SEC can suspend trading in securities in the event that the prices rise and fall excessively in a short period of time.

21 Regulation of Investment Companies The Investment Company Act of 1940 provides for SEC regulation of investment company activities. It was altered and expanded by the amendments of 1970 and 1975.

22 State Securities Laws All states have corporate securities laws (blue sky laws) that regulate the offer and sale of securities within state borders; designed to prevent “speculative schemes which have no more basis than so many feet of ‘blue sky.’” States regulate securities concurrently with the federal government.

23 For Review 1. What is the essential purpose of the Securities Act of 1933? What is the essential purpose of the Securities Exchange Act of 1934? 2. What is a registration statement? What must it include? What is a prospectus? 3. Basically, what constitutes a security under the Securities Act of 1933? 4. What is SEC Rule 10b-5? What is the key to liability under this rule? To what kinds of transactions does SEC Rule 10b-5 apply? 5. Name two theories under which “outsiders” can be held liable for violating SEC Rule 10b-5.