1. © 2004 West Legal Studies in Business A Division of Thomson Learning 1 Chapter 40 Corporations – Investor Protection and Online Securities Offerings Chapter 40 Corporations – Investor Protection and Online Securities Offerings

2. © 2004 West Legal Studies in Business A Division of Thomson Learning 2 Introduction Historical Background: 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. Historical Background: 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.

3. © 2004 West Legal Studies in Business A Division of Thomson Learning 3 Introduction 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. 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.

4. © 2004 West Legal Studies in Business A Division of Thomson Learning 4 § 1: The SEC The Securities and Exchange Commission is an independent federal regulatory agency that enforces federal securities laws. The SEC :  Regulates disclosure of facts in offerings made through national securities exchanges (e.g., NASDAQ, NYSE).  Investigates and prosecutes securities fraud.  Registration and regulation of securities brokers, dealers and investment advisors. The Securities and Exchange Commission is an independent federal regulatory agency that enforces federal securities laws. The SEC :  Regulates disclosure of facts in offerings made through national securities exchanges (e.g., NASDAQ, NYSE).  Investigates and prosecutes securities fraud.  Registration and regulation of securities brokers, dealers and investment advisors.

5. © 2004 West Legal Studies in Business A Division of Thomson Learning 5 Expanding Regulatory Powers of the SEC Securities Enforcement Remedies and Penny Stock Reform Act of 1990. Securities Acts Amendments of 1990. Market Reform Act of 1990. National Securities Markets Improvement Act of 1996. The Sarbanes-Oxley Act of 2002. Securities Enforcement Remedies and Penny Stock Reform Act of 1990. Securities Acts Amendments of 1990. Market Reform Act of 1990. National Securities Markets Improvement Act of 1996. The Sarbanes-Oxley Act of 2002.

6. © 2004 West Legal Studies in Business A Division of Thomson Learning 6 § 2: The Sarbanes-Oxley Act of 2002 Attempts to increase corporate accountability:  Imposes stricter disclosures.  Harsher penalties for violations.  Requires CEO’s to take responsibility for accuracy of financial statements filed with SEC.  Creates new private civil actions. Creates Public Company Accounting Oversight Board regulates public accounting firms. Attempts to increase corporate accountability:  Imposes stricter disclosures.  Harsher penalties for violations.  Requires CEO’s to take responsibility for accuracy of financial statements filed with SEC.  Creates new private civil actions. Creates Public Company Accounting Oversight Board regulates public accounting firms.

7. © 2004 West Legal Studies in Business A Division of Thomson Learning 7 The Sarbanes-Oxley Act of 2002 Key Provisions:  Certification Requirements.  Loans to Officers and Directors.  Protections for Whistleblowers.  Enhanced Penalties.  Statute of Limitations for Securities Fraud. Key Provisions:  Certification Requirements.  Loans to Officers and Directors.  Protections for Whistleblowers.  Enhanced Penalties.  Statute of Limitations for Securities Fraud.

8. © 2004 West Legal Studies in Business A Division of Thomson Learning 8 § 3: The Securities Act of 1933 Securities Act of 1933 regulates solicitation, buying and selling of securities: stocks and bonds. 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. Securities Act of 1933 regulates solicitation, buying and selling of securities: stocks and bonds. 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.

9. © 2004 West Legal Studies in Business A Division of Thomson Learning 9 Registration Statement Case 40.1: SEC v. Alpha Telecom, Inc. (2002). If a security does not qualify for an exemption under §5 of the Securities Act of 1933, the security must be registered with the SEC 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. Case 40.1: SEC v. Alpha Telecom, Inc. (2002). If a security does not qualify for an exemption under §5 of the Securities Act of 1933, the security must be registered with the SEC 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.

10. © 2004 West Legal Studies in Business A Division of Thomson Learning 10 Contents of 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. Description of the management of the registrant, remuneration, pension, stock offerings, executive interests and compensation. 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. Description of the management of the registrant, remuneration, pension, stock offerings, executive interests and compensation.

11. © 2004 West Legal Studies in Business A Division of Thomson Learning 11 Contents of Registration Statement [2] Financial statement certified by an independent accounting firm. Description of pending lawsuits. “Red Herring” prospectus. Tombstone ads. Financial statement certified by an independent accounting firm. Description of pending lawsuits. “Red Herring” prospectus. Tombstone ads.

12. © 2004 West Legal Studies in Business A Division of Thomson Learning 12 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. 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.

13. © 2004 West Legal Studies in Business A Division of Thomson Learning 13 Exempt Securities [2] 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). 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).

14. © 2004 West Legal Studies in Business A Division of Thomson Learning 14 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.  Rule 506: unlimited if no general solicitation and notice to SEC. Max of 35 unaccredited investors. 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.  Rule 506: unlimited if no general solicitation and notice to SEC. Max of 35 unaccredited investors.

15. © 2004 West Legal Studies in Business A Division of Thomson Learning 15 Securities Act Exempt Transactions [2] Section 4(6): up to $5 million to accredited investors. Rule 147 Intrastate Sales. Broker/Dealer Transactions. Casual Sales. Resales of Restricted Securities by “Control Persons.”  Rule 144 and 144(a). Section 4(6): up to $5 million to accredited investors. Rule 147 Intrastate Sales. Broker/Dealer Transactions. Casual Sales. Resales of Restricted Securities by “Control Persons.”  Rule 144 and 144(a).

16. © 2004 West Legal Studies in Business A Division of Thomson Learning 16 Violations of the 1933 Act Violation of the Securities Act to intentionally or negligently defraud investors by misrepresenting or omitting material facts in the registration statement and/prospectus.

17. © 2004 West Legal Studies in Business A Division of Thomson Learning 17 Violations of the 1933 Act 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. 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.

18. © 2004 West Legal Studies in Business A Division of Thomson Learning 18 §4: The Securities Exchange Act of 1934 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). 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).

19. © 2004 West Legal Studies in Business A Division of Thomson Learning 19 Purposes of 1934 Act [2] Rule 14(a) proxy regulations. Market surveillance by SEC. Rule 10(b) prohibits fraud with insider trading and disclosure regulations. Rule 16(b) insider reporting and trading. Rule 13 tender offer regulations. Rule 14(a) proxy regulations. Market surveillance by SEC. Rule 10(b) prohibits fraud with insider trading and disclosure regulations. Rule 16(b) insider reporting and trading. Rule 13 tender offer regulations.

20. © 2004 West Legal Studies in Business A Division of Thomson Learning 20 Insider Trading: Section 10(b) and Rule 10b-5 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 40.2: SEC v. Texas Gulf Sulphur (1968). 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 40.2: SEC v. Texas Gulf Sulphur (1968).

21. © 2004 West Legal Studies in Business A Division of Thomson Learning 21 Insider Trading: Section 10(b) and Rule 10b-5 Section 10b(5) “Insiders”. Rule 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, e.g., to employer.  Case 40.3: U.S. v. O’Hagan (1997). Section 10b(5) “Insiders”. Rule 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, e.g., to employer.  Case 40.3: U.S. v. O’Hagan (1997).

22. © 2004 West Legal Studies in Business A Division of Thomson Learning 22 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).  Case 40.4: In re MCI WorldCom, Inc. Securities Litigations (2000). 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).  Case 40.4: In re MCI WorldCom, Inc. Securities Litigations (2000). Violations of the 1934 Act

23. © 2004 West Legal Studies in Business A Division of Thomson Learning 23 Violations of the 1934 Act 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. 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.

24. © 2004 West Legal Studies in Business A Division of Thomson Learning 24 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 Actions for violations of 10(b) and Rule 10b-5. Civil Sanctions:  Both SEC and Private Parties Can Bring Actions Against Violators under the Insider Trading and Securities Fraud Enforcement Act.  Private Actions for violations of 10(b) and Rule 10b-5.

25. © 2004 West Legal Studies in Business A Division of Thomson Learning 25 §5: 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. 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.

26. © 2004 West Legal Studies in Business A Division of Thomson Learning 26 § 6: 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. 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. © 2004 West Legal Studies in Business A Division of Thomson Learning 27 § 7: Online Securities Offerings and Disclosures Springstreet Brewing Co. was the first online IPO (1996). Regulations Governing Online Securities Offerings:  Timely and Adequate Notice of Delivery of Information.  The online communication system must be easily accessible.  Some evidence of delivery is required. Springstreet Brewing Co. was the first online IPO (1996). Regulations Governing Online Securities Offerings:  Timely and Adequate Notice of Delivery of Information.  The online communication system must be easily accessible.  Some evidence of delivery is required.

28. © 2004 West Legal Studies in Business A Division of Thomson Learning 28 Potential Liability Created by Online Offering Materials Online offerings should exercise caution in hyperlinking to external documents. There is also a concern if the offering is placed on a website that can be viewed by anyone.  Many offerings are restricted to a limited number of “unaccredited” investors. Online offerings should exercise caution in hyperlinking to external documents. There is also a concern if the offering is placed on a website that can be viewed by anyone.  Many offerings are restricted to a limited number of “unaccredited” investors.

29. © 2004 West Legal Studies in Business A Division of Thomson Learning 29 § 8: Online Securities Fraud The SEC is aggressively prosecuting internet fraud using traditional laws. Investment Scams. Using Chat Rooms to Manipulate Stock Prices.  Pumping and Dumping.  Jonathan Lebed charged with securities fraud. The SEC is aggressively prosecuting internet fraud using traditional laws. Investment Scams. Using Chat Rooms to Manipulate Stock Prices.  Pumping and Dumping.  Jonathan Lebed charged with securities fraud.

30. © 2004 West Legal Studies in Business A Division of Thomson Learning 30 Law on the Web SEC’s Edgar database. SEC’s Edgar database Free Edgar. Center for Corporate Law at University of Cincinnati School of Law. Center for Corporate Law at University of Cincinnati School of Law Securities Act of 1933. Securities Act of 1933 Securities Act of 1934. Securities Act of 1934 Information on Investor Protection. Information on Investor Protection SEC’s Edgar database. SEC’s Edgar database Free Edgar. Center for Corporate Law at University of Cincinnati School of Law. Center for Corporate Law at University of Cincinnati School of Law Securities Act of 1933. Securities Act of 1933 Securities Act of 1934. Securities Act of 1934 Information on Investor Protection. Information on Investor Protection