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CHAPTER 8: SECURITIES LAWCHAPTER 8: SECURITIES LAW
UNIVERSITY OF TOLEDO LEGAL AND ETHICAL ENVIRONMENT OF BUSINESS Cohen
Securities Regulation
De�nition of Security
Federal Securities Laws
State Blue Sky Laws
PowerPoint
Securities Regulation De�nition of Security Federal Securities Laws State Blue Sky Laws When starting or running a business, access to capital is key to the growth of the business as well as its success. More often than not, companies will not be able to e�ectively grow simply by bootstrapping and using only internally generated pro�ts to grow the business. Most companies will in fact have to raise money over time to grow the business or even just to keep the business alive. Sometimes, owners want to raise money simply to sell personal ownership, take some money o� the table and reduce risk by putting their funds in other ventures. Access to capital markets is important. And when gaining access to these capital markets, most business owners will be in some shape or form selling securities. And the sale of securities is a highly regulated endeavor.
SECURITIES REGULATION The regulation of securities was initially controlled by the states. The �rst law regarding securities regulation was enacted in 1911 in Kansas to protect investors from unscrupulous stock promoters who promised investors to “make it rain (generate pro�ts and thus dividends or capital appreciation)” but instead gave them a “blue sky” or investments that were worthless. So Kansas became the �rst state to pass a law regulating the sale of investments, which was mainly due to the e�orts of Joseph Norman Dolley who was the bank commissioner of Kansas at the time.
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Other states followed over the ensuing years and have similar laws today, which are now referred to as “blue sky laws”. The federal government, on the other hand, did not get involved in securities regulation until after the stock market crash of 1929. At the time of the crash, investors were speculating on stocks and using leverage to buy stocks on margin (borrowing) to generate greater return on investment. A lot of stock hucksters were in the stock market and manipulating stock values among other things that led investors to believe that some stocks were much safer bets than the hidden reality. So when the stock market took a tiny dip on that fateful Friday in 1929, many investors had to pay margin calls to lenders. And unfortunately, many of those investors could not cover the margin calls, which then caused thousands of loan defaults. Thereafter, a wave of companies began going bankrupt and those investments cratered. This wave of defaults and bankruptcies had a cascading e�ect on stock prices downward where millions of people lost billions of dollars and led to a worldwide depression that lasted right up until the United States entered World War II in 1941. Congress did however act long before the outbreak of World War II and the end of the Great Depression as it believed that the stock market had a signi�cant fraud problem. Congress got into stock regulation with the passing of two key pieces of legislation: 1. The Securities Act of 1933, and 2. The Securities Exchange Act of 1934. The Securities Act of 1933 was created to regulate the initial sales of stock by companies while the Securities Exchange Act of 1934 dealt with the regulation of stocks in the secondary market, as traded between parties either through formal exchanges or private transactions. Both acts including subsequent amendments combined with the regulations promulgated by the Securities and Exchange Commission (SEC) serve as the governance structure of the sale of (nonexempt) securities.
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DEFINITION OF SECURITY Laws serve to regulate, and understanding the terms in the law is key to understanding how to act legally. The �rst question to ask when it comes to securities laws is this: What is a security? If the transaction contemplates the sale of something other than a security, then the securities laws will not apply. For example, Farmer Jack wants to sell 100 hogs. He can take those hogs to the market, and then sell his hogs directly to buyers. This is the sale of hogs and thus not a sale of a security. Securities laws thus do not apply. Let’s say on the other hand that Farmer Jack has 100 hogs that he wants to sell in six (6) months at a certain price. Farmer Jack can o�er to sell those 100 hogs, six (6) months in the future at a speci�ed price. Buyer Bob wants to buy the hogs but rather than buy the hogs today, he can enter into a “futures contract” to pay Farmer Joe for the 100 hogs six (6) months in the future at a certain price. What is the “futures contract”? Is it a security? Two sources exist for the de�nition of a security – common law and statutory law. And with the Securities Act of 1933, federal statutory law put a framework and de�nition around the term security, including but not limited to notes (promise to repay a debt); stock (ownership certi�cate in a company); bonds (debt in a company); debentures (debt in a company); warrants (right to buy stock in a company); subscriptions (agreement to buy stock in a company); voting trust certi�cates; rights to oil, gas, and minerals (commodities futures and mineral rights); and limited partnership interests. Further a contract that gives an individual ownership in indebtedness or business participation is a security. Naturally after a statute is passed and regulations are promulgated by the regulatory agency, laws, regulations, and statutes will be tested in the courts. In the SEC v. W.J. Howey Co., 328 U.S. 293 (1946), the U.S. Supreme Court created dicta which essentially de�ned a “security” for the purposes of the 1933 Act. The Court’s interpretation was
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very broad and loose and was written as “(a security is) a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect pro�ts solely from the e�orts of a promoter or a third party.” And the Court further opined “The test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the o�er, the plan of distribution, and the economic inducements held out to the prospect.” So using the test created by the Supreme Court in Howey, is the agreement for Buyer Bob to acquire the 100 hogs in the future from Farmer Jack a security? Seemingly, this contract for Buyer Bob to acquire 100 hogs in the future from Farmer Jack because in fact Buyer Bob anticipates making money o� of Farmer Jack’s labor over the next 6 months while he raises the pigs for slaughter at open market. Further, as Buyer Bob can sell his pig contract to others who might want to buy the pigs, this transaction even seems more like a security because Buyer Bob can sell the contract to a third party and never has to buy or sell the actual pigs. This type of transaction may or may not be regulated but if it were done through a regulated market, like the CME Group or the Chicago Mercantile Exchange then it would actually be regulated through the Commodity Futures Trading Commission (CFTC), which is an independent regulatory agency of the United States.
De�nition of “Securities” under State Law Although federal laws preempt state laws, state laws also apply to securities transactions and must be followed. So for a business desiring to raise capital, compliance with both state and federal securities law is required. So, for example, a business is located in Ohio. First, the business needs to determine what type of method desired to raise the funds (e.g. bond, stock) and then determine if that is a security that falls under federal law and under Ohio law. It is possible that something that is not a security under federal law will be a security under state law.
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a. Majority of States A majority of the states however do only de�ne a security using the Howey test as established by the U.S. Supreme Court. As previously mentioned, Howey dictates that (a security is) a contract, transaction, or scheme whereby a person invests his money in a common enterprise and is led to expect pro�ts solely from the e�orts of a promoter or a third party. The Howey opinion further stated that the test [for determining whether an instrument is a security] . . . is what character the instrument is given in commerce by the terms of the o�er, the plan of distribution, and the economic inducements held out to the prospect. Thirty four out of �fty states follow this precedent.
b. Minority of States: Risk Capital Test California was the �rst state to utilize the risk capital test to determine whether an instrument used to raise capital is a security. In 1959, some entrepreneurs bought land and decided to build a country club in Marin County, CA. These entrepreneurs did what many do and sought out other people’s money (OPM) to pay for some of the club’s development costs and reduce their personal �nancial risk in the transaction. These entrepreneurs sold what was described as “charter” memberships in the club, meaning these members were the �rst members and founders of the club. These members, however, would not share in the pro�ts or ownership of the club. The bene�t to these charter members would be that they have the right to use club facilities. Under the federal de�nition of a security as established by Howey in 1946, these charter memberships would not be securities because the members’ contributions were to gain membership, but not to gain pro�t. But the California Supreme Court opined in Silver Hills Country Club v. Sobieski, that these memberships were in fact securities. Examining the
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following factors, which combined were called the “risk capital test, the Court explained that if these criteria were met, then it’s a security: 1) are the funds raised for a business venture or enterprise; 2) is the o�ering to the public at large; 3) do investors have the power to a�ect the success of the enterprise; and 4) is the investor’s money is substantially at risk because it is not secured. The Sobieski court held that the sale of membership to a country club, in this instance prior to it being built, was a security because the corporate securities act in California was designed to protect the public from schemes to attract “risk capital” and because the Charter members could actually lose their money and get no bene�t if the new club failed – so the capital was at risk of being lost. And the individual charter members had no control whether the club was built and the promised bene�ts received as that was in the control of the issuers of the memberships. Ultimately, the California Supreme Court found that a security may exist in transactions even where capital is provided without an expectation of material bene�t (pro�t or the like). So under the risk capital test, a transaction that involves raising “funds for a business venture or enterprise; an indiscriminate o�ering to the public at large where the persons solicited are selected at random; a passive position on the part of the investor; and the conduct of the enterprise by the issuer with other people’s money” will more or less be considered a securities o�ering subject to some state securities laws. The challenge to entrepreneurs or promoters raising money then is arm-chair review by lawyers and courts using the risk capital test to focus retrospectively on what an investor stands to lose as opposed to the expected gain.
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Aside from California, the following states/jurisdictions have used the courts to adopt the risk capital test or some variation of it when determining whether or not there is a “security”: Hawai’i (SC, 1971); Arkansas (SC, 1987), Guam (Appellate Division, 1981), Court of Appeals of Ohio (10th District (Columbus and surrounding areas), 1975), Oregon (SC, 1976). Several states, including Alaska, Georgia, Michigan, North Dakota, Oklahoma, and Washington, have adopted the test through legislation and thus have statutes on the books. A couple of other statues have regulations that imply the use of the rule in Illinois, New Mexico, North Carolina, Wisconsin, and Wyoming. In summation, courts in states where the risk capital test has been adopted will use the Howey test and risk capital test to determine whether a transaction is a security. If under either test the court �nds that the transaction meets the established criteria, then it will conclude that it is a security.
FEDERAL SECURITIES LAWS Now that the de�nition of a security is more readily understandable, what federal securities laws apply to transactions involving securities and how so? As previously mentioned, the two main federal securities laws are the Securities Act of 1933 which regulates the primary o�erings of securities, and the Securities Exchange Act of 1934 which regulates the sales of securities in the secondary market, which include private transactions or transactions through known “exchanges” (e.g. Nasdaq). Prior to discussing the speci�cs of the federal securities laws, please note that the SEC is the administrative agency tasked by congress to regulate the securities industry. The SEC was created in the Securities and Exchanged Act of
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1934, which makes it the enabling statute for the SEC. The SEC at that time was also tasked with creating the regulations and policing primary o�erings that were regulated a year earlier under the Securities Act of 1933. The SEC promulgates rules relating to securities registration, �nancial exchanges, and company �nancial reporting. It has the power to promulgate regulations that govern securities, issue injunctions to force companies to stop engaging in potentially illegal activities, �le both civil and criminal actions in administrative court against companies or individuals, enter into consent decrees which are essentially no contest pleas (no lo contender) by litigants, and enforce administrative rulings. The SEC has signi�cant infrastructure and sta� to perform all of these functions.
The Securities Act of 1933 The 1933 Act regulates primary o�erings. A primary o�ering is a �rst time securities o�ering by the issuer (e.g. company). This is referred to as an initial public o�ering, an IPO, which is mostly commonly used when companies o�er stock for the �rst time on a regulated and public market. The general rule is that any entity o�ering a security for the �rst time to the public will have to make proper �lings with the SEC, such as providing audited �nancial statements among other things. Naturally, these �lings are extremely costly and “going public” has a litany of other negatives such as:
Continued and ongoing expenses; Loss of control; Loss of privacy; Performance pressure; Litigation challenges; Dealing with investors; and, Dynamic issues such as lack of management �exibility, hostile take over threats and the like.
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Accordingly, when possible, companies that want to sell securities to raise money should look for 1933 Act exemptions, which fall into two categories: 1. Exempt securities, and 2. Exempt transactions.
a. Exempt Securities Certain investments, called exempt securities, have been excluded speci�cally from coverage of the 1933 act. The following is a list of some of the exemptions:
Government securities (e.g. usually bonds, etc.) that are issued by federal, state, county, or municipal governments for public purposes, such as bridges, roads, stadiums, arenas, general infrastructure; Commercial paper which is de�ned as short- term unsecured promissory notes issued by companies (maturity date under nine months); Securities issued by banks, savings and loans, and religious and charitable organizations; Annuities which are guaranteed payments over the life of an individual; Insurance Policies which cover the life of an individual; Securities of common carriers, which transport individuals on a regular schedule but only those regulated by the Interstate Commerce Commission; Stock dividends and stock splits, which occur when the company pays a dividend in stock, or provides and investor with say 2 shares for the 1 share owned by the investor; and, Bonds issued by charities, 501 (c) 3 or 501 (c) 6, also known as Charitable Bonds.
b. Exempt Transactions i. The Intrastate O�ering Exemption
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This is an example of one limitation on the federal government based on the interstate commerce clause – states have the sole right to regulate this type of transaction. There is no limit to the amount of money raised. But to satisfy the requirement for this exemption, the investor(s)/buyer(s)/ o�eree(s) and the issuer must all be residents of the same state (no exception). Further, the entity issuing the securities must also meet the following requirements:
1. At least 80% of the entities assets must be located in the state;
2. At least 80% of the entities income must be earned from operations within the state;
3. At least 80% of the proceeds from the sale must be used on operations within the state;
4. A nine-month transfer restriction where securities can only be transferred between state residents also applies.
ii. Small-O�ering Exemption: Regulation A
A Regulation A exemption is really a way to reduce �ling requirements as only a short- form, �ll in the blank, registration statement is �led. This applies to security issues up to $5,000,000 dollars during any 12-month period. The investment cap goes up to $50,000,000 if the o�ering company has audited �nancial statements, which came into e�ect in 2012 with the Jump Start Our Business Startups Act (JOBS).
iii. Small-O�ering Exemption: Regulation D
Regulation D was created to simplify fundraising for smaller, entrepreneurial start- ups and early stage companies. It’s a three-tier rule, with named Rules 504, 505, and 506,
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which permit the sale of securities without registration. Sellers must �le a Form D informational statement about the transaction, often in the form of a private placement memorandum shared with the investors.
Rule 501 of the regulation provides key de�nitions including that of an accredited investor. Regulation D investors must be accredited investors for the exemption to hold. The following is a list of the accredited investor categories:
A natural person (not a corporation, LLC or LP) with income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year, or individuals with net worth (excluding primary residence), or joint net worth with spouse, that exceeds $1,000,000 at the time of the purchase; Banks, insurance companies, registered investment companies, business development companies, or small business investment companies; Businesses where all owners are accredited investors; Charitable organizations with greater than $1,000,000 in assets; Directors and o�cers, or general partners of the company selling the securities; ERISA employee bene�t plan if the plan has a bank, insurance company, or registered investment adviser making investment decisions or if the plan has total assets greater than $5,000,000;
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Under JOBS, certain types of o�erings under Regulation D provide accredited status for investors with net worth or income of $100,000 to invest up to �ve percent ($2,000 max) and those worth or earning more than $100,000 up to 10 % ($100,000 max); and, Certain trusts with assets in excess of million, not formed to acquire the securities o�ered, and under the direction of a sophisticated investor.
Rule 502 regulates the advertising of the o�ering and how it is presented to investors. JOBS allows however provides for more general advertising and registered crowd- funding sites on the Internet. JOBS crowd- funding expansion is a signi�cant change in securities laws, revolutionary in fact and the most signi�cant enhancement since the legislation �rst passed. Crowd-funding rules which were promulgated in 2016 allows solicitations to raise $1,000,000 over a 12- month period in amounts by individuals investors similar to limits set by the JOBS regulations above. Rule 503 is the requirement that Form D, an SEC Filing form be used to �le a notice of an exempt securities o�ering under Regulation D, which requires that notice to be �led by companies and funds that have sold securities without registration under the Securities Act of 1933 in an o�ering based on a claim of exemption under Rule 504, 505, or 506 of Regulation D or Section 4(6) of that statute within 15 days after the �rst sale of securities in the o�ering. This rule DOES NOT apply to securities o�erings by companies where all investors are accredited investors.
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The three tiers of Regulation D exemptions are as follows.
A Rule 504 exemption applies to o�erings up to an including $1,000,000 (during any 12- month period). Sales of securities to insiders such as directors, o�cers, and employees are not included in the $1,000,000 million limit. Rule 504 exemptions apply in o�erings of up to $2,000,000 when registered under the applicable state blue sky law. Under JOBS, �rms must have audits for o�erings over $500,000 and �nancial reviews from CPA �rms for o�erings between $100,000 and $500,000.
A Rule 505 exemption covers sales of securities up to $5,000,000, with a cap of 35 (expanded de�nition) nonaccredited investors. Like Rule 504, the Rule 505 sale can go as high at $7,500,000 with a state registration. This type of raise will generally require a prospectus.
A Rule 506 exemption has no dollar limit, but investor type and numbers are limited. Nonaccredited investors are capped at 35.
The Private Placement governed by Rule 144 Under regulations promulgated after Dodd–Frank, the private placement market under Regulation D eliminated “bad-actors” with a history of failed o�erings and investor litigation from soliciting funding from third parties unless supervised.
But in general, this rule is a “safe-harbor” exemption to sellers. Provided that the seller meets these criteria, the transaction is exempt from 1933 Act registration:
1. Holding Period. Stock cannot be sold except after a holding period, which is at least six months for a company subject to the Securities Exchange Act of 1934, and one year, if the issuer of the securities is not subject to the
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reporting requirements under the 1934 Act. The holding period starts at the time the restricted security are bought and paid in full.
2. Current Public Information. There must be adequate current information about the issuing company publicly available before the sale can be made. For reporting companies, this generally means that the companies have complied with the periodic reporting requirements of the Securities Exchange Act of 1934. For nonreporting companies, this means that certain company information, including information regarding the nature of its business, the identity of its o�cers and directors, and its �nancial statements, is publicly available.
3. Trading Volume Formula. If you are an a�liate, the number of equity securities you may sell during any three-month period cannot exceed the greater of 1% of the outstanding shares of the same class being sold, or if the class is listed on a stock exchange, the greater of 1% or the average reported weekly trading volume during the four weeks preceding the �ling of a notice of sale on Form 144.
4. Ordinary Brokerage Transactions. If you are an a�liate, the sales must be handled in all respects as routine trading transactions, and brokers may not receive more than a normal commission.Neither the seller nor the broker can solicit orders to buy the securities.
5. Filing a Notice of Proposed Sale With the SEC. If you are an a�liate, you must �le a notice with the SEC on Form 144 if the sale involves more than 5,000 shares or the aggregate dollar amount is greater than $50,000 in any three-month period.
Example: Standard Exemption Statement in a Private Placement Memorandum
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The Shares have not been registered under the Securities Act of 1933, and the Company is not subject to the reporting and information requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). Therefore, information about the Company is not publicly available. Prior to making any decision on the O�ering, prospective investors are invited to ask questions of and obtain additional information from the Company concerning the Company and the terms and conditions of the O�ering. For any such inquiries, prospective investors should contact CEO of the Company, at the o�ces of the Company at 123 ABC Street, Smithtown, New York 10001, Telephone: (123) 456-7890. You should evaluate such information in connection with the information contained in this Memorandum. The Company has not authorized any person to provide you with information inconsistent with the information set forth herein or any representation as to future performance of the Company or future value of the Shares. Certain documents not included with this Memorandum are available for review by prospective investors, including the organizational documents of the Company and its predecessor, NewCo, LLC, employment agreements and other material contracts of the Company.
c. Company Filing Requirements
If the securities o�ered do not meet any exemption, then the company must register the securities. This is a time consuming and expensive process. The primary documents that must be �led with the SEC are the registration statement called an S-1 and a prospectus. Samples can be readily found utilizing any search engine on the internet. The prospectus has a narrow de�nition and a broad de�nition. The narrow de�nition of a prospectus is a formal document provided to all securities investors who purchase the stock. A broader de�nition of prospectus, which has signi�cant legal implications, is any document released by the issuer including any ad or written materials, formal or otherwise. So companies must be very diligent about ads or any
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other information they release regarding an o�ering.
Filing fees are contingent on the size of the o�ering and the SEC has 20 days to act on the �ling. If the SEC does not act on the �ling within 20 days then the registration statement becomes automatically e�ective. The SEC will generally �le a comment letter or de�ciency letter during the 20-day period, which spells out issue with the registration statement that must be corrected by the issuer.
Registration statements require full disclosure and include the following types of disclosures:
1. A description of the o�ering such as types of securities being o�ered, why the securities are being o�ered, how the securities will �t into the business’s existing capital structure, and how the proceeds will be used in a sources and uses of funds statement;
2. Audited �nancial statements by an independent third-party auditor utilizing both GAAP and FASB standards, usually more than one year;
3. A list of all corporate assets as well as corresponding liabilities
4. A description of the issuers business and relevant activities
5. A capitalization table that includes all the ownership vested in management as well as board members
6. Other relevant and material information, such as pending lawsuits, potential exposure to economic weakness or technology threats or the like
After the registration statement is �led the issuer may release a tombstone ad or send out a red herring prospectus. Tombstone ads look like an actual tombstone and are commonly found in The Wall Street Journal. A red herring prospectus gets its
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name from the red lettering at the top of the document which noti�es the reader that the registration is not yet e�ective and therefore the prospectus is subject to change.
d. 1933 Act Violations
When an issuer has not submitted a registration statement to the SEC as required under the 1933 Act, then a Section 11 rules violation has occurred. Further, the registration statement must also contain full disclosures that are also truthful. Section 11 is essentially an anti-fraud provision designed to protect investors who purchase securities and that they receive a registration statement when necessary and that the registration statement is in fact truthful. Violation of Section 11 can lead to both civil and criminal penalties. Four separate elements are required for a Section 11 violation and they are: 1) The investor purchased a security that was required to have a registration statement, 2. The registration statement contained a material misstatement or omission, 3. The investor does not need to show reliance on the material misstatement or omission unless the purchase made over a year after the e�ective date of the registration statement, and 4. The investor experiences an actual loss. Directors and o�cers of the issuer and any person that provided material input into the registration statement’s preparation including accounts, lawyers, experts, engineers, underwriters, appraisers and the like can be liable. Directors and o�cers are jointly and severally liable for the liability under Section 11 whereas the others subject to liability are only liable for the materials they submit for the registration statement. Defendants in a Section 11 action either on a civil or criminal o�ense have defenses to the actions. The
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defendant carries the burden of proving that the defense exists. Defenses include:
Immateriality – the misstatement or omission was not material, such as listing an executive’s salary as $110,000 in the registration statement when it is in fact $120,000. The additional $10,000 in salary paid to the executive when the issuer raised $5,000,000 is not relevant to the success or failure of the company because $10,000 is very small relative to the amount of money raised. Investor Knowledge – a professional investor with knowledge of a material misstatement or an omission in the registration statement cannot buy the security and then sue because they were taking the risk. A amateur investor might have another argument. Due Diligence – provides that if the defendants can show that they were acting reasonably in the preparation of the registration statement then they would not have liability. For example, a director that signs the registration statement who relies on a national public accounting �rm to audit the company books and that audit turns out to be fraudulent due to bad behavior from one individual accountant, then how would the director foresee that type of illegal behavior by a reputable CPA �rm.
To review an excellent examination of Section 11 liability and its analysis and imposition on individuals that signed a registration statement, please see Escott v. BarChris Construction Corporation, 283 F. Supp. 643 (S.D.N.Y 1968). This is considered a seminal case on the requirements and application of due diligence related to a sale of securities under the 1933 Act. BarChris, a builder of bowling alleys, o�ered debentures for sale. The company was under dire �nancial straights and did not disclose this in its prospectus. Even though the lead
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underwriter performed due diligence on the company and hired outside legal counsel to review the company as, the underwriter was held liable for its failure to adequately conduct due diligence. The intent of the law was to protect investors from misrepresentations and omissions by the issuer. The underwriter signed the registration statement and missed the fraud so it was held liable. Penalties imposed for a Section 11 violation are $10,000 per violation as well as potentially up to 5 years in jail. The SEC can also enjoin the company through an injunction and force them to cease and desist the alleged behavior. Section 12 violations care the same criminal penalties as Section 11 violations for the following o�enses: 1) Selling securities without a registration as required (without an exemption); 2) Selling securities before the e�ective date of the registration statement, or 3) Selling securities using false information in the prospectus.
The Securities and Exchange Act of 1934 The enabling statue of the SEC regulates securities and their issuers in the secondary market. The law impacts securities sales, brokers, agents, dealers, public exchanges, and companies of a certain size or that are traded on public exchanges. The law also requires publicly traded companies among others to make �lings on a quarterly and annual basis. These �lings can be found through the Edgar database at www.sec.gov. Registration. The main requirement of this law is that all securities traded on public platforms need to be registered, which includes required quarterly �lings. And as amended, any company with over $10,000,000 in assets and 500 unaccredited investors or 2,000 shareholders total must register.
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Reporting. The periodic reporting requirements include the 10-Q, 10-K, and 8-K forms, all of which can be found on Edgar online at www.sec.gov.com. These are quarterly, annual, and unusual event �lings. The CEO and CFO must sign and certify under Sarbanes–Oxley requirements which requires them reading the report, that the report is true to their knowledge with no misleading statements, that the �nancial statements fairly represent the �nancial condition of the company and that �nancial controls are in place to guarantee that future reporting will be accurate. If the certifying o�cer fails in his/her duty, then penalties are up to 20 years in jail and $10,000,000 in �nes and or penalties. Violations. 10(b) Anti-fraud provisions, application, and proof really focus on fraud or misrepresentation in the sale of securities. The application of the law applies to all �rms provided they are in interstate commerce. Proof of Section 10(b) could come in several forms but mainly hinge on a failure to disclose either bad or good information or giving overly optimistic or pessimistic information. So the company must disclose when it’s in merger discussions or when a buyout o�er has been provided. Unpredicted swings in quarterly earnings, potential litigation, or other areas impact the company’s current ability to perform should be disclosed. Evidence. The general proof required for a 10(b) violation might be insiders or tippees trading securities too soon before information is disseminated, or passing along inside information to those who then trade on this information. These are essentially insider trading cases. Since 2000, the SEC, under Rule 10b5-1, de�nes insider trading as any securities transaction made where a person involved in the trade is aware of nonpublic material information and that person has a duty to maintain con�dentiality of this knowledge. This activity is a violation of the law and can lead to civil and criminal prosecution. This does not apply to all individuals with such knowledge who engage in the sale of securities btw.
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Information “known” has to be material, which means that releasing the information would likely a�ect the company’s stock price. Examples of material information: company buyout o�er, a merger opportunity, a positive or negative earnings announcement, new intellectual property discoveries such as FDA approval of a new drug, positive recommendations by a reputable analyst, or generally favorable new releases. To limit insider trading, companies can no longer be selective as to how information is released and analysts or big investors cannot get information prior to the market. A typical insider would be Directors and O�cers or corporate executives that would have direct access to material information before the public. Misappropriation theory or classical theory expands the lists of people subject to insider trading where certain relationships give rise to con�dentiality, such as with legal counsel. In United States v. O’Hagen, 521 U.S. 657 (1997), the Court provided a list of person that would be subjected to insider trading by stating, “The classical theory applies not only to o�cers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become �duciaries of a corporation. See Dirks v SEC, 463 U.S. 646, 655, n. 14 (1983).” Interestingly enough, a corporate janitor is not on that list. So if a janitor �nds a piece of paper in a fax machine that has information about a corporate buyout, and then calls his rich uncle with the news for buy a bunch of stock – would that be insider trading? The court in O’Hagan continued that … “misappropriation theory” holds that a person commits fraud “in connection with” a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates con�dential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a �duciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and con�dentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a �duciary relationship
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between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a �duciary-turned-trader’s deception of those who entrusted him with access to con�dential information.” Are misappropriation theory and classical theory di�erent or complimentary? The regulations promulgated by the SEC in are pretty speci�c and described three instances that would call for a duty of trust or con�dentiality:
1. When a person expresses agreement to maintain con�dentiality (lawyer);
2. Past interactions show mutual con�dentiality; and,
3. When a person hears information from a spouse, parent, child or sibling whom they know to have a duty.
Often times, information leaves the building through a “tipper” and ends up in the hands of a “tippee”. The tipper breaks the �duciary duty by revealing the inside information. The tippee then knowingly uses the information to make a trade or money, which is breaking con�dentiality. The courts often times require mutual �nancial gain by both parties. A tipper could be the brother of a company director or o�cer of a CEO who tells his college buddy inside information. If the neighbor in turn knowingly uses this inside information to purchase securities, then the tippee is guilty of insider trading. Which “tipper” is guilty of a violation would be more di�cult to determine. SEC regulations also prevent insiders such as o�cer, directors, and larger shareholders from generating short swing pro�ts, which are loosely de�ned by 16(b) as pro�ts earned on the sale and or purchase and vice versa of stock during any six-month period. If any of these people have short swing pro�ts, then the SEC will make them return the gains.
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Shareholder Voting. Shareholders have the right to vote for certain things in a corporation, including the board of directors, executive compensation, evaluate political spending, review buyout o�ers, to name a few. Shareholder voting is a complex area where the 1934 Act allows corporations or other shareholders to solicit proxies for their voting rights. In other words, the shareholder gives the proxy the right to vote on behalf of the shareholder. This proxy issue is governed under Section 14 of the 1934 Act. This same act also governs how shareholders can submit proposals to the corporation for the shareholders to approve or disapprove. The William’s Act. In the case of merger, consolidation or acquisition which needs to be approved by shareholders, a tender o�er statement must be �led with both the SEC and the prospective company by the o�ering company with additional information and details sent to the target company’s shareholders regarding the o�er. A registration statement for a tender o�er must include o�eror’s name, funding sources for the o�er, integration plans if the takeover occurs, and its current ownership position in the target company. After the tender, shareholders have seven days to withdraw shares, and if shares are not withdrawn, then the shares can be purchased 15 days after the tender o�er period commenced. Terms can change and shareholders must be noti�ed and given 10 days to tender their shares at that new price. Criminal and civil penalties may be imposed by the SEC against the o�eror in the event of “fraudulent, deceptive or manipulative” practices used in making a tender o�er. Financial penalties may also be assessed for omissions or misstatements of material facts in the tender o�er materials. Terminology: Mergers. A merger is generally the combination of two corporations, and thereafter, one corporation exists
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where economies of scale demand eliminating over lapping personnel for e�ciency gains. The way to determine which company was in power during the process is to see which CEO remains as CEO after the merger. Consolidations. Two companies combine to form one new company. Acquisitions. The acquisition of another �rm’s assets avoids shareholder approval but is subject to Clayton Act restrictions. Generally, the acquirer’s corporate structure does not change and the company that had its assets acquired will liquidate and close. Tender O�ers. A tender o�er is the process undertaking for a company to combine with another through merger or consolidation. This usually leads to some form of takeover, which can be friendly or hostile. The target company’s management favors a friendly takeover while a hostile takeover is opposed.
STATE BLUE SKY LAWS There are 50 states, and each one has its own state securities laws. So not only do issuers of securities have to adhere to federal law, issuers must also comply with state blue sky laws in any state in which their securities are sold. State securities laws fall into two general categories: 1. Comply with SEC standards for full disclosure, and 2. Comply with merit review standard. SEC standards require a �ling is required, and with proper information the o�ering is approved for public sale. Under a merit review standard, the state regulatory agency examines the o�ering and approves the o�ering based on its merits related to capitalization, cap table, and or other issues related to penny-stock. If the o�ering is deemed “fair, just and equitable”, then it will be approved. Beware of companies that simply register in states to avoid merit review. And all states have registration exemptions just like the SEC. States also regulate brokers and agents of securities within the state and it is always
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good to do background checks on those person selling unregistered securities.
