Ch. 42: Investor Protection, Insider Trading, Corporate Governance

to qualify for the exemption under Rule 506 -

- issuer must believe that each unaccredited investor has sufficient knowledge or experience in financial matter - issuer must be able to assess risks & merits

3. Posteffective Period (registration process)

- once approved by SEC, registration is effective - **issuer can NOW offer & sell the securities w/o restrictions - if co. issued a preliminary prospectus --> must provide investors a *final prospectus* (available to download from a website)

Changes made by Regulation A+

- the cap for Reg A was only $5 million UNTIL JOBS act passed in 2015 - these changes have reduced the significance of the other exemptions list

Registration Process

1. Prefiling Period 2. Waiting Period 3. Posteffective Period

Altayyar v. Etsy (no est. scienter)

Altayyar and other investors alleged that Etsy misrepresented or omitted material facts in its registration statement - and that they had made false & misleading statements about its values. Etsy argued that their statements were true & contained no ommissions of material facts *Court ruling:* Ruled in Etsy's favor - The court found that the plaintiffs had not established scienter.

Regulation of Proxy Statements

Section 14(a) of the 1934 act regulates the solicitation of proxies from shareholders of Section 12 companies 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

Blue Sky Laws

State laws that regulate the offer and sale of securities

Registrations of Securities governed by Act of 1933

Unless exempt, securities MUST be registered w/ SEC *BEFORE* offering the security to the public - corps must file a *registration statement* - must provide all investors with a *prospectus*

accredited investors

bank, insurance company, person whose income/net worth exceeds a certain amt

A corporation can recapture any profits realized by an insider on any sale or purchase of the firm's stock within any period of time. t/f?

false Section 16(b) provides for the recapture by the corporation of all profits realized by an insider on a purchase or sale within any six-month period.

Insider Reporting and Trading - Section 16(b)

"recapture provision" - Any "insider" who buys & sells/sells & buys for profit within 6 months *(short-swing profits)*, must return profits to the corp - insiders are required to file reports w/ the SEC on their ownership and trading of corporation's securities

Tippee (person who receives inside info) is liable only if:

(all must be met) 1. there is a breach of a duty not to disclose inside info 2. the disclosure is made in exchange for personal benefit 3. the tippee knows (or should know) of this breach & benefits from it

Contents of the Registration Statement

(must be written in English & fully describe the following) 1. The securities being offered for sale, including their relationship to the registrant's other securities 2. The corp's properties & business (incl. a financial statement certified by an ind. public acct firm) 3. The mgmt of the corp, including managerial compensation, stock options, pensions & other benefits. Any interests of directors or officers in any material transactions with the corp must also be disclosed. 4. How the corporation intends to use the proceeds of the sale. 5. Any pending lawsuits or special risk factors.

What are the Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5 violations based on?

*"scienter"* - it must exist - intent to defraud or knowledge of misconduct - proved by showing defendant made false statements or wrongfully failed to disclose material facts

Exempt Transactions (under 1933 securities act)

*Regulation A offerings* - tier 1 - tier 2 *Regulation D: small offerings* - rule 504 - rule 506 *Intrastate offerings* - rule 147

which companies does the 1934 act apply to?

*companies that have assets in excess of $10 million & >500 shareholders* referred to as "Section 12 companies" b/c they are required to register their securities under Section 12 of 1934 act.

noninvestment vs. investment companies

*investment cos* - firm that buys a large portfolio of securities & professionally manages it on behalf of many smaller SHs *non-investment cos* - firms that are NOT engaged primarily in the business of investing or trading in securities

Investment Contract (Howey Test)

*the definition of what types of contracts can be considered securities* An investment contract acc. to the Howey test is any transaction in which a person: 1. invests 2. in a common enterprise 3. reasonably expecting profits 4. derived primarily or substantially from others' managerial or entrepreneurial efforts (no personal)

2. Waiting Period (registration process)

- SEC reviews the registration stmt for completeness - Securities can be offered for sale, but CANNOT be sold by the issuing corporation - issuers can distribute a *preliminary prospectus* (contains most info that will be included in the final prospectus, but often does not include a price) - issuers can distribute a *free-writing prospectus* takes 20 days or longer

Tiers in Regulation A offerings

- an issue of $20 million or less can elect Tier 1 or 2 - both tiers have similar basic requirements - Tier 2 has additional requirements - purchases under Tier 2 *who are not accredited investors*, *cannot purchase shares that cost more than 10% of their annual income or net worth*

Sabarnes-Oxley Act

- attempts to increase corporate accountability by imposing strict disclosure requirements & harsh penalties for violations of securities laws - requires executives to take personal responsibility for the accuracy of financial statements and reports that are filed with the SEC If knowingly make false stmts --> executives fined up to $1M and 10 years in prison or both

1. Pre-filing period (registration process)

- before registration stmt is filed - issuer cannot sell the securities

Effect of Violations

- criminal violation: fined up to $10,000 or prison for up to 5 years or both - civil penalties: issued by SEC; for will full violations and injunctions /warnings

Criminal penalties under violations of Section 10(b) and Rule 10b-5

- fines up to $5million, imprisoned for up to 20 years or both - PS or Corp = fined up to $25M

Liability of Insider Trading

- present when the "insider" takes advantage of such info in their personal transactions when they know that the info is unavailable to those with whom they are dealing - liability & penalties under the statute extend to anyone (not just insiders) who has access to or receives info of an nonpublic nature on which trading is based

5 basic elements of a securities fraud under Rule 10b-5:

1. A *material misrepresentation* (or omission) in connection with the purchase and sale of securities. 2. *Scienter* (a wrongful state of mind/ intent for wrongdoing). 3. *Reliance* by the plaintiff on the material misrepresentation. 4. An *economic loss.* 5. *Causation*, meaning that there is a causal connection between the misrepresentation & the loss.

6 common examples of material facts calling for disclosure under SEC Rule 10b-5:

1. Fraudulent trading in the company stock by a broker-dealer. 2. A dividend change (whether up or down). 3. A contract for the sale of corporate assets. 4. A new discovery, a new process, or a new product. 5. A significant change in the firm's financial condition. 6. Potential litigation against the company. **any one of these facts is not automatically considered material - it will be regarded as a material fact ONLY if it is significant enough to affect an investor's decision

What is a Security? (Section 2.1)

1. Instruments & interests commonly known as securities, such as preferred and common stocks, bonds, debentures & stock warrants. 2. Interests commonly known as securities, such as stock options, puts, and calls, that involve the right to purchase a security or a group of securities on a national security exchange. 3. Notes, instruments, or other evidence of indebtedness, including certificates of interest in a profit-sharing agreement and certificates of deposit. 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.

Violations of the 1933 Act

1. Intentionally defraud investors by *misrepresenting or omitting facts in a registration statement or prospectus* 2. Negligence in preparation of registration statements or prospectus 3. Selling securities BEFORE the effective date 4. Selling securities under an exemption to which the securities do not qualify

Civil sanctions under violations of 1934 act or SEC rules:

A court can assess a penalty amounting to as much as triple the profits gained or the loss avoided by the guilty party

3 defenses to violations under the 1933 act:

A defendant can avoid liability by proving any of the following: 1. The statement or omission was NOT material. 2. The plaintiff knew about the misrepresentation at the time the stock was purchased 3. The defendant exercised *due diligence* in preparing or reviewing the registration & reasonably believed at the time that the statements were true

Disclosure under SEC Rule 10b-5

Any material omission or misrepresentation of material facts in connection with the purchase or sale of a security may be a violation key to liability: whether info omitted or misrepresented is *material*

free-writing prospectus

Any type of written/electronic/or graphic offer that - describes the issuer or its securities - includes a legend indicating that the investor may obtain the prospectus at the SEC's website

Tipper/Tippee Theory

Anyone who acquires inside information as a result of a corporate insider's breach of his or her fiduciary duty can be liable under SEC Rule 10b-5 corporate insider (tipper) breaches fiduciary duty to not disclose to tippee

Litwin v. Blackstone Group (defense: The statement/ omission was NOT material)

Blackstone's registration stmt did not mention the impact of losses on its revenues of the investments. Litwin who had invested in Blackstone's IPO filed a suit in a federal district court against Blackstone and its officers, alleging material omissions from the statement. *Blackstone argued as a defense that the omissions were not material* *Court Ruling*: federal appellate court ruled that the alleged omissions were reasonably likely TO BE MATERIAL.

Violations of the 1934 Act

Criminal and civil liability

Example of the tipper/tippee theory:

Executive shares info with member about the company's expected earnings, contracts, other major developments, trusting that he would keep the info confidential Member goes tell his other 6 buddies *As a result - member and his other buddies are all liable*

Rule 144

Exempts restricted securities from registration on resale if all conditions are met: 1. there is adequate current public info (reports filed under 1934 SEA) about the issuer. 2. the person selling the securities has owned them for at least 6 months if the issuer is subject to the reporting requirements of the 1934 act. If the issuer is NOT subject to the 1934 act's reporting requirements, the seller must have owned the securities for at least 1 year. 3. the securities are sold in certain limited amounts in unsolicited brokers' transactions. 4. the SEC is notified of the resale

true insiders

Officers, directors, and employees at all levels of the company, SHs

Rule 506 (private placement exemption)

Private, noninvestment company offerings in *unlimited amounts* that are NOT generally advertised or solicited. **most important exemption for firms that want to raise funds thru the sale of securities w/o registration - there can be an unlimited number of accredited investors - up to 35 unaccredited investors

The Securities Exchange Act of 1934

Provides for the regulation and registration of securities exchanges, brokers, dealers, and national securities associations such as the NASD requires *continuous periodic disclosures* by publicly held corporations to enable the SEC to regulate subsequent trading authorizes the SEC surveillance of the market looking for fraud, market manipulation & misrepresentations

Prospectus

a disclosure document that describes: - the security being sold - the financial operations of the issuing corporation - the investment or risk attaching to the security also serves as a selling tool for the issuing corp

Well-known seasoned issuer (WKSI)

a firm that has issued at least $1 billion in securities in the last 3 years OR has outstanding stock valued at >$700 million in the hands of the public

Regulation A offerings

a much simplified/less expensive process issuer must file w/ the SEC a notice of the issue & an offering circular, which must also be provided to investors before the sale 2 types of public offerings: - Tier 1 & Tier 2

Examples of Securities

almost any stake in the ownership/debt of a company can be considered a security - most common form: stocks & bonds - interests: whiskey, cosmetics, worms, beavers, boats, cemetery lots, vacuums - investment contracts: in condos, franchises, LP in real estate, oil or gas or other mineral rights

Why did Congress enact legislation to regulate the securities market?

b/c of the stock market crash in 1929 *result: Securities Act of 1933 and 1934 - designed to provide investors w/ more helpful info when buying & selling securities and to prohibit fraudulent and unfair practices that caused the crash of '29

certain Transactions are also exempt from registration requirements.

b/c they are very broad - enables issuer to avoid a high cost & complicated procedures some examples: - private offerings that involve a small # of investors - securities offered & sold ONLY to residents of the state in which the issuing firm is incorporated - crowdfunding

Since the adoption of the 1933 and 1934 federal securities acts, the state and federal governments have regulated securities ______________.

concurrently

purpose of compensation committee

determines the compensation of the company's officers

The Registration Statement and Prospectus help unsophisticated investors to -

evaluate the financial risks.

Regulation D: small offerings

exemptions: Rule 504 Rule 506 Rule 147 for those that involve small dollar amount or a made in a limited manner

Marianne makes a false statement about the future earnings potential of her company, DexaCom Co. Shareholders sue Marianne for securities fraud. These shareholders can file their lawsuit pursuant to:

federal & state securities laws

what does Section 12 require?

for those companies to file annual, quarterly, and sometimes even monthly if specified events occur w/ the SEC

Problem SEC faces?

how to enforce the antifraud provisions of the securities laws in the online environment - investment newsletters (investment scams) - ponzi schemes

SEC notification under Rule 504

it's necessary b/c of precautions on resale of these securities & no general advertisement/solicitation is allowed

Misappropriation Theory

liability for insider trading theory holds liable an individual who wrongfully obtains (misappropriates) inside info & trades on it for her or his personal gain

Resales and Safe Harbor Rules

most securities can be resold w/o registration UNLESS, if securities acquired under Rule 506 -> registration requirements --> unless sale complies w/ Rule 144 and Rule 144A

How are registration statements filed?

must be filed *electronically* so it can be posted on the SEC's online EDGAR database - the EDGAR database includes: material on IPOs, proxy statements, annual reports, registration stmts, and other docs filed w/ the SEC

Corporate Governance

narrow definition: he relationship between a corporation and its shareholders broad definition: specifies the rights and responsibilities among different participants in the corporation, such as the BOD, mgrs, SHs, etc & spells out the rules and procedures for making decisions on corporate affairs

is "scienter" required for Section 16(b) violations?

no - neither negligence Section 16 violates are based on STRICT LIABILITY

Intrastate Offerings - Rule 147

offerings which are purely local restricted to residents of the state in which the issuing company is organized and doing business subject to the state securities laws

Securities Act of 1933 is a __________ disclosure law, while the 1934 act provides for _____________ disclosures by publicly held corps.

one time continuos periodic

Outsiders and SEC Rule 10b-5

people who trade on inside information acquired indirectly 2 theories under which outsiders may be held liable for insider trading: *- tipper/tippee theory* *- misappropriation theory*

Rule 504

private, noninvestment company offerings *up to $5 million* in any 12-month period

SEC Rule 10b-5

prohibits the commission of fraud in connection with the purchase or sale of any security (whether registered or not)

Section 10(b) of 1934 act

prohibits the use of any manipulative or deceptive mechanism in violation of SEC rules and regulations

Private Securities Litigation Reform Act (PSLRA)

provides a "safe harbor" for publicly held companies who make forward-looking statements like financial forecasts example: XT Company announces that its projected earnings for a future time period will be a certain amount, but its forecast turns out to be WRONG. The earnings are, in fact, much lower, and the price of XT's stock is affected negatively. The shareholders bring a class-action suit against XT, alleging that its directors violated SEC Rule 10b-5 by disclosing misleading financial information.

SEC notification under Rule 506

same as Rule 504 disclosure docs must be given to the unaccredited investors

In addition to regulating intrastate offers and sales of securities, most states have laws regulating:

securities brokers and dealers.

Tier 1

securities offerings of up to $20 million in a 12 month period

Tier 2

securities offerings of up to $50 million in a 12 month period

Rule 144A

securities that at the time of issue were not of the same class as securities listed on national securities exchange may be resold under this rule may be sold only to a qualified institutional buyer (insurance co, bank that owns/invests at least $100M in sec) seller must take reasonable steps to ensure that the buyer knows the seller is relying on this rule exemption

Some corporations have sought to align the financial interests of their officers with those of the company's shareholders by providing the officers with ________

stock options - enables holders to purch shs of the corp's stock at a set price

sale of securities occur until -

the SEC has reviewed and approved the registration

The 1933 Act & the registration process

the act restricts the types of activities than an issuer can engage in at each stage of the registration process

Flux Corporation is a public company whose shares are traded in the public securities markets. Under the Sarbanes-Oxley Act of 2002, Flux is subject to the direct corporate governance requirements of:

the federal government.

Certain types of securities are EXEMPT from the registration requirements of Securities Act of 1933 b/c -

they are low-risk investments or are regulated by other statutes

how do WKSIs have greater flexibility than other issuers?

they can file registration statements the day they announce a new offering are not required to wait for SEC review & approval can use a free-writing prospectus at any time - EVEN during the prefiling period

what does testing the waters mean?

to determine potential interest w/o actually selling any securities or requiring any commitment from those who express interest

Major goal of Section 10(b) & SEC Rule 10b-5

to prevent *insider trading* - occurs when persons buy or sell securities on the basis of information that is NOT available to the public. - gives the "insider" a trading advantage over the general public

registration of securities is a VERY expensive & burdensome process. t/f?

true - paying attorneys, brokers, underwriters, etc

when does the registration process become effective?

until it has been reviewed & approved by the SEC

Securities and Exchange Commission (SEC)

was created in 1934 to administer the securities laws & create rules and regulations for securities

Exempt Securities include:

• gov't-issued securities • bank & financial institution securities • ST notes & drafts (<9 months maturity) • securities of nonprofit, educational & charitable orgs • securities issued by common carriers (railroads & trucking cos) • insurance policies, endowments & annuity contracts • securities issued in a corporate reorganization in which one security is exchanged for another or in a bankruptcy proceeding • securities issued in stock dividends & stock splits

Securities Act of 1933

• governs initial sales of stock by businesses • prohibits fraud • requires investors (SHs) to receive financial & other significant info concerning securities • many think of this law as a *one-time* or *initial disclosure law* **provides that all securities must be registered w/ the SEC

Basic Functions of SEC?

• interprets federal securities laws & investigates securities law violations • issues new rules & amends existing rules • oversees the inspection of securities firms, brokers, investment advisers & ratings agencies • oversees private regulatory organizations in the securities, accounting & auditing fields • coordinates U.S. securities regulation with federal, state, and foreign authorities