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Discuss the civil and criminal penalties for violations of the 1934 Act.
There are criminal and civil penalties for violations of the 1934 Act including violations of Section 10(b) and Rule 10b-5. For example, insider trading under the Securities Exchange Act of 1934 can constitute a criminal offense, with criminal penalties. Violators of these laws may also be subject to civil liability. For any sanctions to be imposed, however, there must be scienter - the violator must have had an intent to defraud or knowledge of his or her misconduct (see Chapter 14). Scienter can be proved by showing that a defendant made false statements or wrongfully failed to disclose material facts. Violations of Section 16(b) include the sale by insiders of stock acquired less than six months before the time of sale. These violations are subject to civil sanctions. Liability under Section 16(b) is strict liability. Neither scienter nor negligence is required. For violations of Section 10(b) and Rule 10b-5, an individual may be fined up to $5 million, imprisoned for up to twenty years, or both. A partnership or a corporation may be fined up to $25 million. Under Section 807 of the Sarbanes-Oxley Act of 2002, for a willful violation of the 1934 act the violator may, in addition to being subject to a fine, be imprisoned for up to twenty-five years. In a criminal prosecution under the securities laws, a jury is not allowed to speculate on whether a defendant acted willfully - in other words, there can be no reasonable doubt that the defendant knew he or she was acting wrongfully. The SEC can bring a suit in a federal district court against anyone violating, or aiding in a violation of, the 1934 act or SEC rules by purchasing or selling a security while in the possession of material nonpublic information (15 U.S.C. Section 78u(d)(2)(A)). The violation must occur on or through the facilities of a national securities exchange or from or through a broker or dealer (transactions pursuant to a public offering by an issuer of securities are exempted). The court may assess as a penalty as much as triple the profits gained or the loss avoided by the guilty party. Profit or loss is defined as "the difference between the purchase or sale price of the security and the value of that security as measured by the trading price of the security at a reasonable period of time after public dissemination of the nonpublic information" (15 U.S.C. Section 78u(d)(2)(C)). The Insider Trading and Securities Fraud Enforcement Act of 1988 enlarged the class of persons who may be subject to civil liability for insider-trading violations. This act also gave the SEC authority to award bounty payments (rewards given by government officials for acts beneficial to the state) to persons providing information leading to the prosecution of insider-trading violations (15 U.S.C. Section 78u-1). Private parties may also sue violators of Section 10(b) and Rule 10b-5. A private party may obtain rescission of a contract to buy securities or damages to the extent of the violator's illegal profits. Those found liable have a right to seek contribution from those who share responsibility for the violations, including accountants, attorneys, and corporations. For violations of Section 16(b), a corporation can bring an action to recover the short-swing profits.
Define and explain a merger.
A merger involves the legal combination of two or more corporations. After a merger, only one of the corporations continues to exist, and the remaining corporation continues as the surviving corporation. In a merger, the surviving corporation is vested with the disappearing corporation's preexisting legal rights and obligations.
Define a red herring prospectus and a tombstone ad and explain their interrelationship.
A red herring prospectus is a preliminary prospectus that can be distributed to potential investors after the registration statement (for a securities offering) has been filed with the Securities and Exchange Commission. The name derives from the red legend printed across the prospectus stating that the registration has been filed but has not become effective. A tombstone ad is an advertisement, in a format resembling a tombstone, of a securities offering. The ad informs potential investors of where and how they may obtain a prospectus.
Distinguish a short-form merger from a regular merger.
A short-form merger occurs between a substantially owned subsidiary corporation and its parent company when the parent company owns at least 90 percent of the outstanding shares of each class of stock of the subsidiary corporation. State statutes can provide for a simplified procedure that does not require approval of the shareholders with the merger only needing to be approved by the board of directors of the parent corporation before it is filed with the state. A copy of the merger plan must be sent to each shareholder of record of the subsidiary corporation.
Distinguish between a voluntary and involuntary termination of a corporation.
A voluntary dissolution can occur two ways: (1) by shareholder initiated proceedings as a result of a unanimous shareholder vote; or (2) by the board of directors and submitted to the shareholders for a vote. Most states require that articles of dissolution be filed, which contains certain required information and notice to creditors. An involuntary dissolution can occur in an action brought by the secretary of state or the state attorney general for any of the following reasons: (1) failure to comply with administrative requirements (taxes, filings, registered agent, etc.); (2) procurement of a corporate charter through fraud or misrepresentation; (3) abuse of corporate powers; (4) violation of the state's criminal code after demand to discontinue the violation; (5) failure to commence business operations; and (6) abandonment of operations before starting up. Sometimes an involuntary termination can occur because of deadlock of the board of directors although the courts are reluctant to intervene only when absolutely necessary to prevent irreparable injury. Courts can also involuntarily dissolve a corporation because of mismanagement.
How does a purchase of stock differ from a purchase of assets? Define and explain the significance of a tender offer.
An alternative to the purchase of assets is the purchase by the aggressor corporation of a substantial number of the voting shares of the stock of another corporation (the target corporation). When the aggressor corporation makes a public offer to all shareholders of the target corporation, it is called a tender offer. The price of the stock in the tender offer is generally higher than the market price of the stock prior to the announcement of the tender offer. The tender offer can be conditional upon the receipt of a specified number of outstanding shares by a specified date or the aggressor can make an exchange tender offer in which it offers target shareholders its own securities in exchange for their target stock. Federal securities laws strictly control the terms, duration, and circumstances under which most tender offers are made.
Explain the significance of appraisal rights and their importance to a dissenting shareholder in regards to a merger or a consolidation.
An appraisal right aids a dissenting shareholder who is unhappy about the merger or consolidation and does not want to be a shareholder in a corporation that is new or different from the one in which the shareholder originally invested. An appraisal right arises by statute and entitles the dissenting shareholder to be paid the fair value for the number of shares held on the date of the merger or consolidation.
Summarize the similarities and the differences between a merger and a consolidation and give an example of an equation that illustrates each.
Both concepts involve a combination of preexisting corporations, but both concepts are legally distinct proceedings. In a merger, corporations A and B agree that A will absorb B and A continues as the survivor, summarized in the equation A + B = A. As a result, A's articles of incorporation are deemed amended to include any changes that are stated in the articles of merger. As stated above, the surviving corporation is vested with the disappearing corporation's preexisting legal rights and obligations. In a consolidation, corporations A and B consolidate to form an entirely new entity - corporation C, summarized as A + B = C. The articles of consolidation take the place of A's and B's original incorporation articles and are thereafter regarded as C's corporate articles. As also stated above, the new successor corporation accedes to all the rights, privileges, powers and title to the formers' property as well as assuming all the debts and obligations of the disappearing corporations. However, whether a combination is in fact a merger or a consolidation, the rights and liabilities of shareholders, the corporation and its creditors are the same such as: (1) the board of directors of each corporation involved must approve a merger or consolidation plan; (2) the shareholders of each corporation must vote approval (2/3, 3/4, etc.) of the plan at a shareholders meeting; (3) once approved by all the directors and the shareholders, the merger or consolidation plan is filed, usually with the secretary of state; and (4) when all state requirements are satisfied, the state issues a certificate of merger or a certificate of consolidation.
Discuss the major provisions of the Sarbanes-Oxley Act and explain its significance to those dealing with securities transactions.
Following a series of corporate scandals, Congress passed the Sarbanes-Oxley Act. The act separately addresses certain issues relating to corporate governance. Generally, the act attempts to increase corporate accountability by imposing strict disclosure requirements and harsh penalties for violations of securities laws. Among other things, the act requires chief corporate executives to take responsibility for the accuracy of financial statements and reports that are filed with the SEC. Chief executive officers and chief financial officers personally must certify that the statements and reports are accurate and complete. Additionally, the new rules require that certain financial and stock-transaction reports must be filed with the SEC earlier than was required under the previous rules. The act also mandates SEC oversight over a new entity, called the Public Company Accounting Oversight Board, which regulates and oversees public accounting firms. Other provisions of the act created new private civil actions and expanded the SEC's remedies in administrative and civil actions. The act's key provisions relating to corporate accountability are in Exhibit 42-3, which may be found on page 816 of the text.
Define and explain a consolidation.
In a consolidation, two or more corporations combine so that each corporation ceases to exist and a new one emerges. Both of the former corporations disappear and a new successor corporation emerges that accedes to all the rights, privileges, powers and title to the formers' property as well as assuming all the debts and obligations of the disappearing corporations.
Discuss when outsiders may be liable for insider trading under Rule 10b-5.
Outsiders can be held liable under Rule 10b-5 under the tipper/tippee theory or the misappropriation theory. The tipper/tippee theory applies when anyone receives inside information as a result of someone's breach of a fiduciary duty to the corporation whose shares are traded. Unless there has been a breach of a duty not to disclose inside information and the tippee knows of this breach (or should know of it), liability under this theory cannot result. In contrast, under the misappropriation theory, if an individual wrongfully obtains (misappropriates) inside information and trades on it to his or her personal gain, then the individual is liable because he or she stole information rightfully belonging to another. Courts will normally hold that some fiduciary duty to some lawful possessor of material nonpublic information must have been violated and some harm to the defrauded party must have occurred for liability to exist.
Explain the significance of Section 10(b) and Rule 10b-5.
Section 10(b) is one of the most important sections of the Securities Exchange Act of 1934 because it prohibits the use of any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the SEC may prescribe. One such rule is Rule 10b-5, which prohibits the commission of fraud in connection with the purchase or sale of any security. Rule 10b-5 imposes liability upon anyone for engaging in insider trading, which is trading securities based upon either receiving or having access to information of a non-public nature. SEC Rule 10b-5 applies to almost all cases concerning the trading of securities, whether on organized exchanges, in over-the-counter markets, or in private transactions. Generally, the rule covers just about any form of security. The securities need not be registered under the 1933 act for the 1934 act to apply. Private parties can sue for securities fraud under Rule 10b-5. The basic elements of a securities fraud action are as follows: ■ A material misrepresentation (or omission) in connection with the purchase and sale of securities. ■ Scienter (a wrongful state of mind). ■ Reliance by the plaintiff on the material misrepresentation. ■ An economic loss. ■ Causation, meaning that there is a causal connection between the misrepresentation and the loss. Examples of material facts that require disclosure are: ■ Fraudulent trading in the company stock by a broker-dealer. ■ A dividend change (whether up or down). ■ A contract for the sale of corporate assets. ■ A new discovery, a new process, or a new product. ■ A significant change in the firm's financial condition. ■ Potential litigation against the company. Note that none of these facts, in itself, is automatically a material fact. Rather, it will be regarded as a material fact if it is significant enough that it will likely affect an investor's decision to purchase or sell certain securities.
How does Section 14(a) regulate proxy statements?
Section 14(a) regulates the solicitation of proxies from shareholders and the content of proxy statements, which are statements sent to shareholders by corporate managers who are requesting authority to vote on behalf of the shareholders in a particular election on specified issues. Whoever solicits a proxy must fully and accurately disclose in the proxy statement all of the facts that are pertinent to the matter on which the shareholders are to vote. SEC Rule 14a-9 is similar to the antifraud provisions of SEC Rule 10b-5. Remedies for violations range from injunctions to prevent a vote from being taken to monetary damages.
Explain the purview and significance of Section 16(b) and how it differs in its application from Section 10(b).
Section 16(b) of the 1934 Act limits insiders as to how quickly certain stock may be sold by them by providing for a recapture by the corporation of all profits realized by the insider on any purchase and sale or sale and purchase of the corporation's stock within any six-month period. It is irrelevant whether such an insider (officers, directors and certain large shareholders of Section 12 corporations) actually used the inside information; all such short-swing profits must be returned to the corporation. Section 16(b) covers only short-swing activities, whereas Section 10(b) covers purchases or sales. In the context of Section 16(b), insiders means officers, directors, and large stockholders of Section 12 corporations. (Large stockholders are those owning 10 percent of the class of equity securities registered under Section 12 of the 1934 act.) To discourage such insiders from using nonpublic information about their companies to their personal benefit in the stock market, the SEC requires them to file reports concerning their ownership and trading of the corporation's securities. Section 16(b) applies not only to stock but also to warrants, options, and securities convertible into stock. In addition, the courts have fashioned complex rules for determining profits. As mentioned above in Questions 17 and 18, violations of Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5, including insider trading, may lead to both criminal and civil liability. For either criminal or civil sanctions to be imposed, scienter must exist - that is, the violator must have had an intent to defraud or knowledge of his or her misconduct. Scienter can be proved by showing that the defendant made false statements or wrongfully failed to disclose material facts. In some situations, it can even be proved by showing that the defendant was consciously reckless as to the truth or falsity of his or her statements. Exhibit 42-2, page 809, compares various aspects of SEC Rule 10b-5 and Section 16(b).
Under the 1933 Securities Act, distinguish exempt securities from exempt transactions.
Securities are exempt under the 1933 act if they are bank securities sold before July 27, 1933; commercial paper with a maturity date of less than nine months; securities of charitable organizations; certain securities from corporate reorganizations; securities exchanged with the issuer's existing security holders, provided no commission is paid; securities issued to finance railroad equipment purchases; annuities and other issues of insurance companies; government-issued securities; securities issued by banks and other institutions subject to government supervision; issues of up to $5 million in any twelve month period under Regulation A. In addition, even if the securities are nonexempt, the transaction concerned may be exempt if it falls under any one of the following: Rule 504 - noninvestment company offerings up to $1 million in any twelve month period; Rule 504a - offerings up to $500,000 in any one year by "blank check" companies; Rule 505 - private, noninvestment company offerings up to $5 million in any twelve month period; Rule 506 - private, noninvestment company offerings in unlimited amounts that are not generally advertised or solicited; Rule 147 - intrastate issues; or Section 4(6) - offerings up to $5 million made solely to accredited investors in any twelve-month period (not advertised or solicited) and Rule 506 - the private placement exemption. The above language is an amplification of the chart at Exhibit 42-1 (page 802 and below).
Describe the legislative intent and scope of coverage of the 1934 Securities Exchange Act.
The Securities Exchange Act of 1934 regulates the activities of the security exchanges, stockbrokers, dealers and national securities associations. The SEC regulates the markets in which securities are traded by maintaining 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. The act regulates proxy solicitation for voting and it allows the SEC to engage in market surveillance to regulate undesirable market practices such as fraud, market manipulation, misrepresentation, and stabilization.
Compare and contrast the takeover defenses of crown jewel, greenmail, poison pill, white knight, golden parachute and Pac-man.
The crown jewel defense is when the target corporation sells off its most valuable asset making it less attractive for takeover. The Pac-man defense is where the target corporation attempts its own takeover of the proposed acquiring corporation. In the poison pill defense, the target corporation issues to its stockholders rights to purchase additional shares at low prices when there is a takeover attempt. This makes the takeover undesirably or even prohibitively expensive for the acquiring corporation. The white knight defense strategy is where the target corporation solicits a merger with a third party, which then makes a better (often simply a higher) tender offer to the target's shareholders. The third party that "rescues" the target is the "white knight." Sometimes, a target corporation will seek an injunction against an aggressor on the ground that the attempted takeover violates antitrust laws. This defense may succeed if a court finds that the takeover would result in a substantial increase in the acquiring corporation's market power. Because antitrust laws are designed to protect competition rather than competitors, incumbent managers who are able to avoid a takeover by resorting to the use of private antitrust actions are unintended beneficiaries of the laws. Although listed by the authors of the text as a defense, greenmail is not a defense but a means of "financially blackmailing" the target corporation because to regain control, a target company may pay a higher-than-market price to repurchase the stock bought by the acquiring corporation. When a takeover is attempted through a gradual accumulation of target stock rather than a tender offer, the intent may be to get the target company to buy back the shares at a premium price - a concept similar to blackmail. Likewise, the golden parachute is really not a defense, but a plan to accommodate top management in the event of a takeover where a company establishes special termination or retirement benefits that must be paid to top management if they are "retired" as a result of the takeover. In other words, a departing high-level manager's parachute will be "golden" when he or she is forced to "bail out" of the company.
Identify the primary purpose of the Securities Act of 1933 and define "securities" under that statute.
The primary purpose of the Securities Act of 1933 is to reduce fraud by imposing greater disclosure requirements thus providing some stability to the securities industry. "Securities" under the act include notes, stock, treasury stock, bonds, debentures, evidence of indebtedness, certificates of interest or participation in any profit-sharing agreement, collateral-trust certificates, preorganization certificates or subscriptions, transferable shares, certificates of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, voting trust certificates and investment contracts, or, in general any interest or instrument commonly known as a "security," or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. Basically, the courts have interpreted the above statutory definition to mean that a security exists in any transaction in which a person invests, in a common enterprise, reasonably expecting profits, derived primarily or substantially from others' managerial or entrepreneurial efforts. Section 5 of the 1933 Securities Act broadly provides that if a security does not qualify for an exemption, then that security must be registered before it is offered to the public and issuing corporations must file a registration statement and investors must be provided with a prospectus that describes the security being sold, the issuing corporation and the investment or risk attached to the security involved.
What must a registration statement contain?
The registration statement must include: (1) a description of the significant provision of the security; (2) a description of the registrant's properties and business; (3) a description of the registrant's management including security holdings, its renumeration, pension benefits and interests of officers or directors in any material transactions with the corporation; (4) a financial statement certified by an independent public accounting firm; and (5) a description of pending lawsuits.
Explain how a dissenting shareholder elects to exercise his/her appraisal rights and discuss what problems, if any, may occur by such an election.
The statute granting appraisal rights may contain elaborate statutory procedures which if not strictly complied with can result in forfeiture of such rights. Usually, a written notice of dissent must be filed by the dissenting shareholder prior to the vote of the shareholders on the proposed transaction. In addition, after the merger or consolidation has been approved, the dissenting shareholders must make a written demand for payment and for fair value. Valuation of shares is often a point of contention between the dissenting shareholder and the corporation. Fair value is defined as the value on the day prior to the day on which the vote was taken. The corporation must make a written offer to purchase a shareholder's stock, accompanying the offer with a current balance sheet and income statement for the corporation, and if they don't agree on the fair value, a court will determine it.
Define and state the significance of blue sky laws.
Today, all states have their own corporate securities laws, or blue sky laws, that regulate the offer and sale of securities within individual state borders. (The phrase blue sky laws dates to a 1917 United States Supreme Court decision in which the Court declared that the purpose of such laws was to prevent "speculative schemes which have no more basis than so many feet of 'blue sky.'") Article 8 of the Uniform Commercial Code, which has been adopted by all of the states, also imposes various requirements relating to the purchase and sale of securities. Despite some differences in philosophy, all state blue sky laws have certain features. Typically, state laws have disclosure requirements and antifraud provisions, many of which are patterned after Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. State laws also provide for the registration or qualification of securities offered or issued for sale within the state and impose disclosure requirements. Unless an exemption from registration is applicable, issuers must register or qualify their stock with the appropriate state official, often called a corporations commissioner. Additionally, most state securities laws regulate securities brokers and dealers. The Uniform Securities Act, which has been adopted in part by several states, was drafted to be acceptable to states with differing regulatory philosophies.
Describe the basic functions of the Securities and Exchange Commission.
Today, the sale and transfer of securities are heavily regulated by federal and state statutes and by government agencies. The Securities and Exchange Commission (SEC) is the main independent regulatory agency that administers the 1933 and 1934 securities acts. The SEC also plays a key role in interpreting the provisions of these acts (and their amendments) and in creating regulations governing the purchase and sale of securities. The agency continually updates regulations in response to legislation, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, and particular challenges, such as climate change. The SEC now requires companies to make disclosures about the potential impacts of climate change on their future profitability. A listing of the SEC's general duties is as follows: ■ Requiring disclosure of facts concerning offerings of securities listed on national securities exchanges and offerings of certain securities traded over the counter (OTC). ■ Regulating the trade in securities on the national and regional securities exchanges and in the OTC markets. ■ Investigating securities fraud. ■ Requiring the registration of securities brokers, dealers, and investment advisers and regulating their activities. ■ Supervising activities conducted by mutual funds companies. ■ Recommending administrative sanctions, injunctive remedies, and criminal prosecution in cases involving violations of securities laws. (The Fraud Section of the Criminal Division of the U.S. Department of Justice prosecutes violations of federal securities laws.) See https://www.sec.gov/Article/whatwedo.html. The Sarbanes-Oxley Act of 2002 (H.R. 3762), which will be discussed below, further expanded the authority of the SEC by directing the agency to issue new rules relating to corporate disclosure requirements and by creating an SEC oversight board.
Distinguish a purchase of assets from a merger or consolidation.
When a corporation acquires all or substantially all of the assets of another corporation by direct purchase, the purchasing or acquiring corporation simply extends its ownership or control over more physical assets. Unlike a merger or consolidation, no change in the corporate legal entity occurs; thus, the acquiring corporation is not required to obtain shareholder approval for the purchase. However, the corporation being acquired is selling its assets, thus substantially changing its business position and therefore must obtain both board of directors and shareholder advance approval. In most states, a dissenting shareholder of the selling corporation can exercise appraisal rights. Unlike a merger or consolidation, the purchasing corporation is generally not responsible for liabilities of the selling corporation unless: (1) the purchasing corporation impliedly or expressly assumes the seller's liabilities; (2) the sale amounts to what in fact is a merger or consolidation; (3) the purchaser continues the seller's business and retains the same personnel; or (4) the sale is fraudulent to elude liability.
