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Chapter 21 Investor Protection, Insider Trading, and Corporate Governance

Chapter 21 Investor Protection, Insider Trading, and Corporate Governance . 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?

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Chapter 21 Investor Protection, Insider Trading, and Corporate Governance

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  1. Chapter 21 Investor Protection, Insider Trading, and Corporate Governance

  2. 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? 

  3. Learning Objectives • What certification requirements does the Sarbanes-Oxley Act impose on corporate executives?

  4. 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. 

  5. Securities Act of 1933 • Securities are instruments such as corporate stock or limited partnership interests that evidence ownership or debt. 

  6. Securities Act of 1933 • What is a Security? • The Howey test: 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. SEC v. Howey, (1946).

  7. Securities Act of 1933 • 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 (http://www.sec.gov) and state securities agencies before offered to the public. 

  8. Securities Act of 1933 • Registration Statement. • Corporation must file a registration statement and prospectus with the SEC. • The Prospectus is later distributed to investors.

  9. Securities Act of 1933 • Registration Statement: Contents. • (1) The securities being offered for sale, including their relationship to the issuer’s other capital securities. • (2) The corporation’s properties and business (including a financial statement certified by an independent public accounting firm). 

  10. Securities Act of 1933 • Registration Statement: Contents. • (3) The management of the corporation, including managerial compensation, stock options, pensions, and other benefits. Any interests of directors or officers in any material transactions with the corporation must be disclosed. 

  11. Securities Act of 1933 • Registration Statement: Contents. • (4) How the corporation intends to use the proceeds of the sale. • (5) Any pending lawsuits or special risk factors.

  12. Securities Act of 1933 • Registration Process. • Registration statement does not become effective until approval by SEC. • Prefiling Period: issuer cannot offer or sell securities. • Waiting Period: securities can be offered by not sold. 2005: Free-writing prospectus. 

  13. Securities Act of 1933 • Registration Process. • Registration statement does not become effective until approval by SEC. • Prefiling Period: issuer cannot offer or sell securities. • Waiting Period: securities can be offered by not sold. 2005: Free-writing prospectus. 

  14. Securities Act of 1933 • Registration Process. • Post-Effective Period: registration effective 20 days after approval. • Well-Known Seasoned Investors. • Firm that has issued $1 billion in securities during previous three years, with $700 million value outstanding.

  15. Securities Act of 1933 • Exempt Securities and Transactions. • Bank securities sold before 1933. • Commercial paper if maturity date does not exceed 9 months. • Charitable organizations. • Existing holders in reorganization, bankruptcy. • Financing railroad equipment. 

  16. Securities Act of 1933 • Exempt Securities and Transactions. • 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).

  17. Securities Act of 1933 • Exempt Securities and Transactions. • Regulation A Offerings. • Small offering up to $5 million in a 12 month period to “test the waters”; but requires a circular. • Companies have used the internet to raise money directly, bypassing traditional investment firms.

  18. Securities Act of 1933 • Exempt Securities and Transactions. • Small Offerings: Regulation D. • Rule 504: up to $1M during 12 months to accredited investors only. • Rule 505: private, up to $5M during 12 months to both accredited and unaccredited investors. 

  19. Securities Act of 1933 • Exempt Securities and Transactions. • Small Offerings: Regulation D. • Rule 506--Private Placement Exemption. unlimited amounts, no advertising, to accredited investors only. • Resales and Safe Harbor Rules. • Rule 144. • Rule 144a. 

  20. Securities Act of 1933 • Violations. • Intentional or negligent fraud of investors by misrepresenting or omitting material facts in the registration statement and/prospectus. • Remedies: • Criminal: up to 5 years in prison, $10,000 fine. • Civil: damages, refund of investment, injunction.

  21. Securities Act of 1933 • Violations. • Defenses: Statement left out was not material; Plaintiff knew about fraud and purchased stock; Registrant believed statements were true. • CASE 21.1 Litwin v. Blackstone Group, LP (2011). Were Blackstone’s omissions “material”?

  22. Securities Exchange Act of 1934 • Registration of securities exchanges, brokers, dealers, and national securities exchanges and associations.

  23. Securities Exchange Act of 1934 • 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).

  24. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Section 10(b) prohibits the use of any manipulative or deceptive device or contrivance in contravention of rules and regulations of SEC. 

  25. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Rule 10b(5) prohibits the commission of fraud in the connection with the purchase or sale of any security.

  26. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Insider Trading: advance information available to corporate officers and directors that can affect future value of stock. 10b(5) “Insiders” include officers, executives and directors).

  27. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and 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. 

  28. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Disclosure under SEC Rule 10b-5: key is whether information is “material.” • CASE 21.2 SEC v. Texas Gulf Sulphur Co. (1968). Who were the insiders in this case and what should they have done differently? 

  29. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • 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.

  30. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Insider Reporting and Trading—16(b). • Recapture by corporation of profits during previous six months gained by insider trading. • Applies to stocks, warrants, options and convertible securities.

  31. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Private Securities Litigation Reform Act of 1995. • “Safe harbor” for publicly held companies that make forward-looking statements, such as financial forecasts.“ 

  32. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Private Securities Litigation Reform Act of 1995. • Meaningful cautionary statements” protect against securities fraud. • CASE 21.3 Dura Pharmaceuticals, Inc. v. Broudo (2005).

  33. Securities Exchange Act of 1934 • Section 10(b), SEC Rule 10b-5, and Insider Trading. • Regulation of Proxy Statements, Sect. 14(a). • Whoever solicits a proxy must fully disclose all of the facts and which shareholders must vote.

  34. Securities Exchange Act of 1934 • Violations of the 1934 Act. • Scienter Requirement. Proved by showing defendant made false statements or wrongfully failed to disclose material facts. • 16(b): strict liability -- no fault or scienter required.

  35. Securities Exchange Act of 1934 • Violations of the 1934 Act. • Criminal Penalties: Individuals-imprisonment up to 10 years, fines up to $5 million, $2.5 for partnership or corporation. • Civil Sanctions: up to triple profits.

  36. 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. 

  37. State Securities Laws • States could require registration or qualification. • Uniform Securities Act has been adopted in part by many states.

  38. Corporate Governance • Corporate governance is essentially the relationship between a corporation and its shareholders. 

  39. Corporate Governance • Attempts at Aligning the Interests of Officers with Shareholders. • Stock Options. • “Outside” Directors?

  40. Corporate Governance • Goal is to Promote Accountability. • Involves, at minimum: • Audited reporting of financial progress, so managers can be evaluated. • Legal protections for shareholders, so violators of the law can be punished for misbehavior. 

  41. Corporate Governance • Goal is to Promote Accountability. • Benefits to the Company. • Governance and Corporation Law. • Board of Directors. • Audit Committee. • Compensation Committee.

  42. The Sarbanes-Oxley Act • 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. 

  43. The Sarbanes-Oxley Act • More Internal Controls and Accountability. • Direct federal corporate governance requirements. • Sections 302 and 404. • Exemptions for Smaller Companies.

  44. The Sarbanes-Oxley Act • Certification and Monitoring Requirements. • By CEOs and CFOs. • Avoids the “ignorance defense.”

  45. Online Securities Fraud • SEC is enforcing anti-fraud provisions of Securities Laws. • Online Investment Scams. • Fraudulent E-Mails. • Online Investment Newsletters and Forums. 

  46. Online Securities Fraud • “Ponzi” Schemes. • Offshore Fraud. • “Risk Free” Fraud: Michael Regan, Bernie Madoff.

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