Discussion Forum on Chapter readings

CHAPTER 18

GOVERNANCE AND REGULATION:

SECURITIES LAW

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LECTURE OUTLINE

Use opening CONSIDER 18.1 to pique students' interest.

18-1 History of Securities Law (See PowerPoint Slide 18-1)

· Initially Regulated at the State Level

· 1929 Stock Market Crash Precipitated Federal Regulation

18-2 Primary Offering Regulation: The 1933 Securities Act (See PowerPoint Slide 18-2)

Regulates Primary Offerings (First‑Time Offerings) of Securities

18-2a What is a Security?

· Investment in a common enterprise with profits to come from the efforts of another (SEC v. Howey)

· Includes stocks, bonds, warrants, debentures, voting‑trust certificates, oil wells, and so forth

· Pension plans are not covered

ANSWER TO CONSIDER 18.2: Walk students through first example tutorial and then move on to the next examples.

1. Limited partnership interests – security.

2. Whether sales of memberships in LLCs are securities would depend upon whether members participated in operation and management or delegated such duties.

3. Same with LLP.

4. Oil and gas leases are security.

5. LLP in an oil field – see #2 above.

6. Real estate investment trust interests – security.

7. World Series tickets – not security.

18-2b Regulating Primary Offerings: Registration (See PowerPoint Slide 18-3)

· Securities and Exchange Commission (SEC)

· SEC – issue injunctions, institute criminal proceedings, enter into consent decrees, handle enforcement and promulgate rules

· First time public offering is called an IPO

18-2c Regulating Primary Offerings: Exemptions

· Exempt securities (from registration) (See PowerPoint Slide 18-4)

· Securities issued by federal, state, county, or municipal governments

· Commercial paper (less than nine months)

· Banks, savings and loans, religious and charitable organization securities

· Insurance policies

· Annuities

· Common carriers (ICC regulates)

· Stock dividends and splits

· Charitable bonds

· Exempt transactions (See Exhibit 18.1 and PowerPoint Slide 18-5 for summary)

· Intrastate offerings (See PowerPoint Slide 18-6)

· Issuer must be domestic business in state where offering is made

· Offerees must all be residents of the state

· Triple 80 requirements

· 80 percent of its assets in the state

· 80 percent of its income earned in the state

· 80 percent of sale proceeds will be used on operations in the state

· Transfer restrictions apply (Rule 147 – 9 months)

· Regulation A – small offering exemption (See PowerPoint Slides 18-7 and 18-8)

· Shortcut method of registration

· S‑1 filed

· Issues of $5,000,000 or less during any twelve month period

· Up to $50,000,00 in JOBS audit requirements met

· SEC can use integration – can group offerings in a year and then exemption is not met

· Regulation D (See PowerPoint Slides 18-9, 18-10, 18-11, and 18-12)

· Rule 504 – $1,000,000 or less only transfer restrictions (up to $2,000,000 if blue-sky registration)

· Rule 505 – $5,000,000 to limited number and types of investors (up to $7,500,000 under JOBS provisions)

· Rule 506 – no amount limit but limits on types of investors

· Limits on types of investors – accredited investors

· Private business development firm

· Directors, officers, partners (general) of issuer

· Banks

· Purchasers of $150,000 or more

· Natural persons with net worth greater than $1,000,000 (Dodd-Frank: residence is excluded from determining net worth)

· Persons with income of greater than or equal to $200,000/year or joint spouse income of $300,000 per year and, with Dodd-Frank changes, expectation that those funding levels will continue

· Limits on advertising

· All must carry restrictions on transfer

· "Bad actors" cannot be involved in Reg D offerings UNLESS SEC-approved

· Crowdfunding under JOBS – up to $1,000,000

· Stock issued pursuant to corporate reorganization is also exempt

· Escrow required

· Background checks

· Portal is registered

ANSWER TO ETHICAL ISSUES (Goldman Sachs): Goldman’s point was that it did not owe a duty of disclosure to sophisticated investors, but the SEC based its charges (and the charges were eventually settled for $515 million) on the fact that Goldman at least owed a duty to disclose that it sometimes took positions contra to their clients’ positions and investments in the market. The regulatory cycle is important here because Goldman was operating in a gray area or in a loophole area – that loophole has now been closed so that Goldman will be unable to make money from secretive positions that their clients knew nothing about. The ethical issue is whether you would want to know, being on the other side, and most folks do want to know when their investment adviser is positioned against them.

Use Exhibit18.3 and PowerPoint Slide 18-13 to give overview of exemptions and registration.

18-2d What Must Be Filed: Documents and Information for Registration (See PowerPoint Slides 18-14 and 18-15)

· Issuer/offeror files a registration statement

· SEC has 20 business days from date of filing to act

· If no action, effective after 20 business days

· Can issue a comment or deficiency letter during that time

· Must remedy deficiencies

· First-time offerings generally take six months for approval

· SEC follows full disclosure standard

· Materials include:

· Description of securities

· Audited financial statement

· List of assets

· Nature of business

· List of management and their shares

· Before registration statement is effective

· Can run tombstone ad – see Exhibit 18.2

· Can issue red herring (sample prospectus)

· Cannot make offers to sell

· Can do shelf registration

· File and get approval

· Can go to market any time within a 2-year period

· Must update information in filing

18-2e Violations of the 1933 Act (See PowerPoint Slide 18-16)

· Section 11 Violations – civil liability for inaccurate information in registration statement

· What is required for a violation?

· Failure to make full disclosure

· Registration statement contains a material misstatement or omission

· Who is liable for a violation? (See PowerPoint Slide 18-17)

· Officers

· Directors

· Anyone who signed registration statement

· Experts (lawyers, accountants, appraisers, geologists)

· Defenses for Section 11 violations (See PowerPoint Slide 18-18)

· Immaterial misstatement

· Investor knew of misstatement and bought anyway

· Due diligence – acted with prudence and had no reason to believe there was a problem

See PowerPoint Slide 18-19.

CASE BRIEF 18.1

Escott v. BarChris Construction Corp.

283 F. Supp. 643 (S.D.N.Y. 1968)

FACTS: BarChris was an expanding bowling alley firm. Its rapid expansion necessitated the sale of debentures it registered with the SEC. The financial disclosures in the registration statement were full of errors (see summary in text). Various purchasers filed suit for 1933 Act violations (false materials in the registration statement). The court dealt with each defendant separately.

Russo: CEO – knew all facts; liable

Vitolo: President – limited education; liable directors

Pugliese: VP – limited education; liable

Kircher: Treasurer – liable

Trilling: Controller, but not director – liable

Birnbaum: Lawyer – young but did not investigate; liable

Auslander: New outside director; liable for failure to ask questions

Peat, Marwick: Liable; failure to ask questions

Answers to Case Questions

1. How much time transpired between the sale of the debentures and Bar Chris's bankruptcy? BarChris sold the debentures in 1961; bankruptcy was filed in early 1962.

2. Give a summary of the types of items that were materially misstated. BarChris omitted the debt disclosure as well as a multitude of other pieces of material information. The summary in the book shows that loans to officers were not disclosed and assets were not valued correctly.

3. Who was sued under Section 11? Who was held liable? Those held liable were those who signed: BarChris’ auditor – Peat, Marwick, Mitchell & Co.; nine directors; the controller; one attorney; two investment bankers serving as directors; and all others who assisted in the preparation of the registration statement. Signers of the statement, underwriters, and auditors were held liable.

· Penalties for violations of Section 11 (See PowerPoint Slide 18-20)

· $10,000 and/or five years

· Injunctions to stop sales

· Civil suits

· Securities Litigation Reform Act of 1995

· Limits attorneys’ fees

· Addresses “professional plaintiff”

· Allows “safe harbor” protection for financial predictions

· Section 12 Violations (See PowerPoint Slide 18-21)

· Selling without registration (unless exempt)

· Selling before the effective date

· False information in the prospectus

· Same penalties as Section 11

· Due diligence and Sarbanes-Oxley (See PowerPoint Slides 18-22, 18-23, 18-24, 18-25, and 18-26 and FOR THE MANAGER’S DESK − A PRIMER ON SARBANES-OXLEY AND DODD-FRANK )

· Auditors’ independence

· Public Company Accounting Oversight Board (PCAOB) (Peek-a-Boo)

· Consists of five presidential appointees

· Nonprofit organization

· No more than two members who are CPAs

· Will develop registration system for public accounting firms

· Establish rules to ensure quality, ethics and auditor independence

· Will inspect firms to determine compliance with Sarbanes-Oxley

· Will investigation violations and impose discipline

· Will encourage high standard in the accounting profession

· All firms must register if doing audits for publicly traded companies

· Auditor independence – cannot do audits of company and do its

· Bookkeeping

· Information systems

· Appraisals

· Actuarial services

· Management or human resources services

· Broker, dealer services

· Legal services

· Expert services

· Other as PCAOB dictates

· Must rotate audit partner every five years

· Audit firms must have internal systems to monitor conflicts (Section 404)

18-3 The Securities Exchange Act of 1934

Regulates Secondary Market (See PowerPoint Slide 18-27)

18-3a Securities Registration

· All traded securities on exchanges must be registered

· All securities of firms with over $10 million in assets and 500 or more shareholders must be registered

18-3b Emerging Growth Companies (EGCs) and 1934 Act Exemption

· JOBS Act has given EGCs a grace period before the 1934 act reporting requirements apply

· EGC is defined under JOBS as

· Less than $1 billion in annual gross revenues

· Publicly traded for less than five years

· A public offering of $700 million or less

· Have not issued $1 billion in debt in the immediate past three years

18-3c Periodic Filing Under the 1934 Act: Those Alphabet Reports (See PowerPoint Slide 18-28)

Same firms – national stock exchange and/or 500 or more shareholders and $10 million or more in assets

· 10‑Q – quarterly financial report

· 10‑K – annual report

· 8‑K – unusual events, spin‑offs

· Periodic filings must be certified under Sarbanes-Oxley

· Both CEO and CFO must sign

· Certify that they have reviewed the report

· Certify that the report contains no untrue statements

· Certify that the financials represent fairly all material aspects of the company’s financial performance

· Certify that they are responsible for sufficient controls on company financial systems

· Penalties of $10 million and/or ten years

18-3d The 1934 Act Antifraud Provision: 10(b) (See PowerPoint Slides 18-29 and 18-30)

· Fraud or misrepresentation in the sale of securities

· Application of 10(b): applies to all firms (only requires interstate commerce)

· Proof of Section 10(b): corporations running afoul

· Failure to give information or giving overly pessimistic information results in violation

· Examples: Failure to disclose pending merger – Texas Gulf Sulphur, failure to disclose a rich mineral strike

· What should be disclosed? (See PowerPoint Slide 18-31)

· Pending takeovers

· Drops in quarterly earnings

· Pending large dividend

· Possible lawsuits

· When to disclose?

See PowerPoint Slide 18-32.

CASE BRIEF 18.2

Siracusano v. Matrixx Initiatives, Inc.

563 U.S. 27 (2011)

FACTS: Matrixx Initiatives, Inc. (“Matrixx”) is a pharmaceutical company that sells Zicam through its wholly-owned subsidiary, Zicam, LLC. One of its products, responsible for 70% of its sales, is Zicam Cold Remedy, a homeopathic product marketed as stopping or minimizing cold symptoms.

In December, 1999, Matrixx began to get questions from physicians whose patients were developing anosmia (loss of the sense of smell). Researchers at medical facilities contacted Matrixx in 2002 to offer access to studies showing that zinc sulfate (present in Zicam) was linked to anosmia.

During this time, Matrixx’s public disclosures did not discuss these inquiries and studies. In fact, on October 22, 2003, Matrixx issued an optimistic press release announcing that its net sales for the third quarter of 2003 had increased by 163% over the third quarter of 2002.

On an October 23, 2003, earnings conference call, executives for Matrixx expressed their “enthusiasm for the most recently completed quarter” and “optimis[m] about the future.” At one point during the call, Zicam executives were asked to “make any comment on the litigation MTXX or its officers are involved in, or whether or not there is any SEC (Securities and Exchange Commission) investigation.” They replied that “[t]he officers of this company are not involved in any litigation,” and that they were not aware of any SEC investigation. In fact, a lawsuit alleging that Zicam caused anosmia had already been filed at this time.

By January 30, 2004, the FDA was “looking into complaints that an over-the-counter common-cold medicine manufactured by a unit of Matrixx Initiatives, Inc., may be causing some users to lose their sense of smell.” Matrixx's stock declined after this report, “falling from $13.55 per share on January 30, 2004 to $11.97 per share on February 2, 2004.”

DECISION BELOW: NECA-IBEW Pension Fund and James Siracusano (plaintiffs/appellants) brought a class action suit against Matrixx and three Matrixx executives (Appellees) alleging a violation of the Securities Exchange Act of 1934 by their failure to disclose material information regarding problems with Zicam. The district court granted Matrixx’s motion to dismiss the complaint. The court of appeals reversed. The shareholders appealed.

ISSUES ON APPEAL: Was the information about Zicam and anosmia material? Was there intent on the part of Matrixx executives to withhold the information?

DECISION: Yes, the information on the evolving questions and studies was material. Even if not statistically significant, this kind of information was likely to influence consumer decisions to buy Zicam. If they are influenced, then it affects the company and investors would also likely be influenced by the decision. The fact that the executives did not release the litigation information and questions makes the case – it was not disclosed because they feared the impact.

Answer to Case Questions

1. Based on this decision, if you had been the executives at Matrixx, what would you have disclosed and when would you have disclosed it? The information that affects a company’s products – affects how investors perceive the company. Also, holding back on the information only loses trust in the company. If Zicam had dealt with the issue publicly, it might not have been its demise.

2. Why is it relevant that consumers would be affected by the studies, whether significant or not? Because the whole picture moves the market, not the exactness of the science on the data. If customers are influenced, the company, and hence, investors, are affected.

3. By 2009, the FDA required that Zicam be removed from stores and warned consumers about the risk of losing their sense of smell. What happens to the company as a result? What will be the impact on Matrixx investors? What will their damages be? The company has lost 70% of the revenues because the product cannot be sold. The company cannot continue without its major product. The investors have lost their investment and could not recover the loss in value of their shares.

· Running afoul of 10(b): how soon can you trade after corporate disclosures? (See PowerPoint Slide 18-33)

· Must allow information to go public

· Texas Gulf Sulphur case and adequate disclosure

· Proof of a violation: how individuals run afoul of 10(b)

· Trading too soon before information is disseminated

· Passing along inside information to friends, relatives, etc. – tippees are also trading on inside information until the information is fully disseminated

ANSWER TO ETHICAL ISSUES (Insider Trading): Discuss Mr. Rajaratnam's comments and the prosecutor's response.

· Who runs afoul: the extent of section 10(b) liability

See PowerPoint Slide 18-34.

CASE BRIEF 18.3

U.S. v. Salman

792 F.3d 1087 (9th Cir. 2015); cert. granted, 136 S.Ct. 899 (2016)

FACTS: In 2002, Maher Kara joined Citigroup's healthcare investment banking group. Over the next

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few years, Maher began to discuss aspects of his job with his older brother, Mounir (“Michael”) Kara. Maher began to suspect that Michael was trading on the information they discussed, although Michael initially denied it. As time wore on, Michael became more brazen and more persistent in his requests for inside information, and Maher knowingly obliged. From late 2004 through early 2007, Maher regularly disclosed to Michael information about upcoming mergers and acquisitions of and by Citigroup clients.

In 2003, Maher Kara became engaged to Salman's sister, Saswan (“Suzie”) Salman. Salman and Michael Kara became fast friends. In the fall of 2004, Michael began to share with Salman the inside information that he had learned from Maher, encouraging Salman to “mirror-imag[e]” his trading activity. Rather than trade through his own brokerage account, however, Salman arranged to deposit money, via a series of transfers through other accounts, into a brokerage account held jointly in the name of his wife's sister and her husband, Karim Bayyouk. Salman then shared the inside information with Bayyouk and the two split the profits from Bayyouk's trading. From 2004 to 2007, Bayyouk and Michael Kara executed nearly identical trades in securities issued by Citigroup clients shortly before the announcement of major transactions.

As a result of these trades, Salman and Bayyouk's account grew from $396,000 to approximately $2.1 million.

The Government presented evidence that Salman knew full well that Maher Kara was the source of the information. Michael Kara (who pled guilty and testified for the Government) testified that, early in the scheme, Salman asked where the information was coming from, and Michael told him, directly, that it came from Maher. Michael further testified about an incident that occurred around the time of Maher and Suzie's wedding in 2005. According to Michael Kara, on that visit, Michael noticed that there were many papers relating to their stock trading strewn about Salman's office. Michael became angry and admonished Salman that he had to be careful with the information because it was coming from Maher. Michael testified that Salman agreed that they had to “protect” Maher and promised to shred all of the papers.

Maher and Michael Kara enjoyed a close and mutually beneficial relationship. Michael helped pay for Maher's college. Maher, for his part, testified that he “love[d] [his] brother very much” and that he gave Michael the inside information in order to “benefit him” and to “fulfill [ ] whatever needs he had.” For example, Maher testified that on one occasion, he received a call from Michael asking for a “favor,” requesting “information,” and explaining that he “owe[d] somebody.” After Michael turned down Maher's offer of money, Maher gave him a tip about an upcoming acquisition instead.

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Michael gave a toast at Maher's wedding, which Salman attended, in which Michael described how he spoke to his younger brother nearly every day and described Maher as his “mentor,” his “private counsel,” and “one of the most generous human beings he knows.” Maher, overcome with emotion, began to weep.

DECISION BELOW: The jury found Salman guilty on all five counts of insider trading.

ISSUE ON APPEAL: Was the furnishing of the information to a family member insider trading under Section 10(b) of the 1934 Act?

DECISION: Yes. Despite differing views around the circuits, the court held that the information was proprietary and was passed to someone with the intent of benefiting them. The tipper need not gain financially to be guilty of insider trading and the information was used to make money.

Answers to Case Questions

1. Explain the differences between and among the Dirks, Newman, and Salman cases. Dirks involved a whistleblower telling an analyst that he suspected a fraud at his company. The analyst used the information to warn clients, and it was still insider trading. In Newman, it was a case in which analysts were getting tips from friends about a company and then offering advice based on that information, although it was not clear that they knew the information was inside information. In Salman, there was a mergers expert who was not with the companies involved, but was assisting the companies with mergers and acquisitions and was passing information along to relatives and they were making money. They all involved inside information, but the sources and purposes were different in terms of usage.

2. List the elements the court requires for proof of insider trading. There has to be someone in the inside who discloses information that should not be made public. Then the person tipping has to have some benefit and the person tipped must have a benefit from that information.

3. What should those who have inside information learn from this decision? Those inside the company need to be very cautious about discussing their work. Those who are in the securities field need to understand where information is coming from. And, if you gain inside information, don’t trade on it.

BUSINESS STRATEGY: HUDDLES WITH ANALYSTS OR STRATEGISTS − DOES IT MATTER?: Goldman came up with a way to have candid discussions internally without having to disclose to its clients its real views by having strategists, not analysts, meet to discuss. The SEC rules covered analysts and so Goldman developed a specific group that would find a way around the SEC requirement. Revisit Goldman’s sophisticated investor position and loophole strategies and the risks of its approach.

· Running afoul with e-commerce

· Pump and dump facilitated by internet

· Posting of false information can be very damaging

· Aiders and abettors (See PowerPoint Slide 18-35)

· Stonebridge Investment Partners LLC v. Scientific American case was troublesome to regulators and investors

· Vendors helped a company paint a rosier picture of its financial condition and performance than was really true and they were complicit in concealing the deal

· Court held that they were not liable unless there was some underlying illegal conduct, despite the fact that the company and its vendors duped the auditor

· Dodd-Frank has expanded liability to cover such situations

FOR THE MANAGER’S DESK: WHAT'S ETHICAL IN INSIDER TRADING?

1. Because the information about their company is already public, the employees would not be doing anything wrong by buying more shares. The only information they have that is not available to the public is their belief that the company can come back from the regulatory sanctions. Investor belief in a company is different from inside information.

2. This was held to not be insider trading, but the case is being revisited and Mr. Cuban is still under investigation. The issue is dilution and advance notice of dilution. There is always a risk of dilution because a company can always sell more shares.

· Sarbanes-Oxley and disclosure

· Must use caution on classification of revenues and expenses

· “Earnings Management” issues present concerns under new standards

· Must work for honest and ethical conduct

· Give full, fair, accurate, timely and understandable information

· Must comply with all laws, rules and regulations

· Standing to sue – must have been an actual seller or purchaser to sue (See PowerPoint Slide 18-36)

· Mental state – need scienter – intent to defraud

· Penalties include $100,000 and up to 25 years per violation (Insider Trading and Securities Fraud Enforcement Act of 1988) (See PowerPoint Slide 18-37)

ANSWER TO CONSIDER 18.3: Yes, he entered a guilty plea because he was passing along proprietary information that should not have been disclosed.

18-3e Insider Trading and Short Swing Profits (See PowerPoint Slides 18-38 and 18-39)

· Applies to officers, directors, and 10 percent shareholders

· Liable to corporations for profits made on sales and purchases or purchases and sales during any six month period

· SEC matches highest sale with the lowest purchase

· Sarbanes-Oxley era: two-day notification of activity in stock

18-3f Regulating Voter Information – Section 14 (See PowerPoint Slides 18-40, 18-41, 18-42)

· Idea is to have full disclosure

· Proxy materials must be registered with the SEC

· Who is soliciting

· How the materials will be sent

· Dodd-Frank requires that company send out shareholder materials; this change will make it easier for shareholders to submit proposals for a vote and also to nominate their own directors

· How much has and will be spent

· Purpose of proxy – an annual meeting

· Shareholder proposal (See Exhibit 18.4)

· Management must include proposals if subject matter is appropriate

· Shareholders can also get list for solicitation but with company now handling proposals, this expense is covered

· Dodd-Frank provides for expanded inclusion in proxy materials

ANSWER TO ETHICAL ISSUE (Wal-Mart): A shareholder can submit proposals for inclusion in the corporation’s proxy materials and on the shareholder ballot if the shareholder has held at least $2,000 (market value) in the corporation’s shares or 1% of the corporation’s voting securities for at least one year. Trinity Wall Street Church owns 3,500 Wal-Mart shares.

Under 17 CFR §240.14a-8, a company can refuse to include a shareholder proposal for a number of reasons that it can provide to the SEC including personal grievances, management functions (ordinary business operations), or that the proposal is not related to the corporation’s business.

The SEC held that Wal-Mart was correct and could exclude the proposal. Trinity filed suit in federal court seeking a preliminary injunction against Wal-Mart from printing, issuing, or mailing the proxy unless it contains the Trinity proposal on guns. The federal district court denied Trinity’s preliminary injunction request concluding that the proposal “deals with guns on the shelves and not guns in society.”

However, after the case went to a full hearing, the federal court granted an injunction holding that the proposal dealt with a proper societal issue of the sale of guns. Trinity had originally filed the proposal following the massacre of the children at Newtown, Connecticut in December 2013.

Wal-Mart has appealed the decision and the Court of Appeals has an expedited hearing scheduled because the latest date for the printing of the Wal-Mart proxy, if it is to meet the federal and its own bylaw standards for proxy notification to shareholders, is April 17, 2015. Trinity Street v. Wal-Mart Stores, Inc., 2015 WL 1905766 (3rd Cir. 2015).

See Exhibit 18.5 for summary of 1933 Act, 1934 Act, and state regulations.

· Shareholders and executive compensation (see also Chapter 17)

· Major concern

· Compensation committees are now comprised of independent directors (Sarbanes-Oxley)

· Remedies for Section 14 violations

· Invalidate proxies

· Invalidate actions at meeting

18-3g Shareholder Rights in Takeovers, Mergers, and Consolidations

· Definitions (See PowerPoint Slide 18-43)

· Merger

Combination of two or more corporations

Example: A Inc. + B Inc. = B Inc.

· Horizontal mergers – merger of two competitors

· Vertical mergers – merger of two firms in the chain of distribution

Examples: Manufacturer and wholesaler, wholesaler and retailer

· Conglomerate mergers – merger between two unrelated companies

Example: Burger franchise and jewelry retailer, generally done to diversify

· Consolidations

Two or more companies form a new firm

Example: A Inc. + B Inc. = C Inc. (See PowerPoint Slide 18-44)

· Tender offer (See PowerPoint Slide 18-45)

· Not a business combination

· Method used to get a combination

· Publicly advertised offer to buy stock

· Generally offer is higher than market to make it attractive

· Takeovers

· Can be friendly – management favors

· Can be hostile – management opposes

· Asset acquisitions

· No change in corporate structure

· Shareholder approval not required

· Filing requirements under the Williams Act (See PowerPoint Slide 18-46)

· Passed in 1968

· Enforced by SEC

· Applies to all offers to buy more than 5 percent of another’s securities

· Filing requirements

· Tender offer statement filed with SEC

· Disclosure information to shareholders

· Target company opposing the takeover (hostile) must file its materials with the SEC

· Required to be disclosed

· Name of offeror

· Source of funding

· Plans for company if takeover is successful

· Number of shares now owned

· Time requirements so shareholders aren’t forced into action

· Definition of tender offers done by courts

· Penalties for violations

· Failure to disclose

· Fraudulent information in the materials

· Proposed changes – Congress is debating more regulation (see supplemental readings for selection of articles)

· Hostile takeovers

· Management must do the following (within ten days of offer)

· Recommend acceptance or rejection

· No opinion (remains neutral)

· Unable to take a position

· Can take action to stop

Examples: White knight, Pac‑man, etc.

ANSWER TO ETHICAL ISSUES (Dillards): The problems may have been caused by Horne’s inexperience in takeovers. Dillard’s took advantage of that lack of experience. The lawsuit between the parties was settled. They needed further details in their contract regarding due diligence.

· State laws affecting tender offers (See PowerPoint Slide 18-47)

· States are enacting statutes to protect their companies

· Types

· Voting‑right restrictions – can accumulate shares but don’t get voting rights: Hawaii, Indiana, Minnesota, Missouri, New York, Ohio, Wisconsin

· Redemption‑rights laws – raiders subject to same redemption price: Maine, Utah, Pennsylvania

NOTE: Pennsylvania passed a new antitakeover statute that has been called the most restrictive of any of the statutes to date; many institutional investors are demanding that companies opt out of its protections so that management is not entrenched

· Fair price laws – all shareholders get a fair price: Connecticut, Georgia, Illinois, Kentucky, Louisiana, Maryland, Michigan, Mississippi, Virginia, Washington

· Third generation statutes (Wisconsin and Pennsylvania) require three‑year waiting periods before a merger can take place (see above note on PA)

· Future of State Antitakeover Statutes

· Seventh circuit has stated economic arguments do not invalidate the statutes

· U.S. Supreme Court refused to grant certiorari – impliedly approved the decision

· Many shareholder proposals deal with opting out of these antitakeover provisions

· Proxy regulations (See PowerPoint Slide 18-48)

· Must follow SEC regulations

· If not, action at meeting can be set aside

· Proxy costs can be reimbursed by directors

18-4 State Securities Laws (See Figure 18.5 and PowerPoint Slides 18-49, 18-50, 18-51, and 18-52 for summary of law)

· Blue Sky Laws (state registration requirements) (See PowerPoint Slide 18-53)

· Can Follow a Merit Review Standard – Securities Reviewed for Their Merit Must Be “Fair, Just, and Equitable”

18-5 International Issues in Securities Laws (See PowerPoint Slide 18-54)

· United States Has Most Stock Exchanges

· European Union Has Regulations on Disclosure

· Insider Trading Becoming More Vigorously Regulated in Other Countries

· Only United States Has Proxy Disclosures

BIOGRAPHY − BERNIE MADOFF: THE LARGEST AND LONGEST PONZI SCHEME IN HISTORY ($50 BILLION AND 18 YEARS)

Discuss these key points:

1. Respected member of the financial community; chairman of NASDAQ.

2. Operations were isolated from scrutiny.

3. The ongoing, absolutely consistent returns were a clue.

4. Those who knew Bernie refused to believe that he could do such a thing.

5. He started small and then had to grow to keep the whole thing going.

ANSWERS TO CHAPTER QUESTIONS AND PROBLEMS

1. The notes were held to be securities. They were investments in a common enterprise with profits from others’ efforts. Reves v. Ernst & Young, 494 U.S. 56 (1990).

2. Yes, they were tippees who violated section 10(b). The broker did not invest on the basis of the information and is not liable. They used proprietary information obtained in a doctor/patient situation. SEC v. Mervyn Cooper and Kenneth E. Rottenberg, No. 95-8535 (C.D. Cal. 1995).

3. The Commission has determined not to pursue an enforcement action in this matter. The SEC held as follows:

The use of social media has proliferated and the Commission is aware that public companies are increasingly using social media to communicate with shareholders and the market generally. The ways in which companies may use these social media channels, however, are not fundamentally different from the ways in which the web sites, blogs, and RSS feeds addressed by the 2008 Guidance.

The SEC held that the company could use Facebook for announcements, but not the personal accounts of executives and directors. However, the SEC also noted that the formal disclosure must then be made promptly after the Facebook posting.

4. The court held that Mr. O’Hagan misappropriated information from his firm and then used it in a way for which it was not intended and was controlled by the firm’s obligation to the client. Misappropriation is a breach of fiduciary duty and involves the use or disclosure of information that was not intended to be made public. United States v. O'Hagan, 521 U.S. 657 (1997).

5. The SEC did not require the proposal, but Pepsi pulled the ads. The ads can affect income, but were more of a social issue.

6. The proposal was included because the animal treatment affected reputation and sales. Lovenheim v Iroquois Brands, Ltd., 618 F. Supp. 554 (D.C. 1985).

7. The advance knowledge of the attacks would not be inside information because it is not proprietary to any particular company. These are individuals who are, in effect, betting on world events and the impact those events will have on the prices of the stock of different companies, depending upon their position with respect to the political (or even weather in some cases) event.

8. No, Chiarella did not violate 10(b). He had non-public information but was not engaged in fraudulent activity. Chiarella v. United States, 445 U.S. 222 (1980).

9. He can serve on the board, but he does not qualify as an independent director. He, therefore, cannot serve on the audit committee.

10. Yes, the proxy vote can be rescinded if the proxy materials contained misrepresentations. Pavlidis v. New England Patriots Football Club, 737 F.2d 1227 (1st Cir. 1984).

11. The test for whether a particular scheme is an investment contract was established in our decision in SEC v. W.J. Howey Co., 328 U.S. 293, (1946). We look to “whether the scheme involves an investment of money in a common enterprise with profits to come solely from the efforts of others.” Id., at 301. This definition “embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.” Id., at 299.…

…[W]hen we held that “profits” must “come solely from the efforts of others,” we were speaking of the profits that investors seek on their investment, not the profits of the scheme in which they invest. We used “profits” in the sense of income or return, to include, for example, dividends, other periodic payments, or the increased value of the investment. There is no reason to distinguish between promises of fixed returns and promises of variable returns for purposes of the test, so understood. In both cases, the investing public is attracted by representations of investment income, as purchasers were in this case by ETS’ invitation to “‘watch the profits add up.’” Moreover, investments pitched as low-risk (such as those offering a “guaranteed” fixed return) are particularly attractive to individuals more vulnerable to investment fraud, including older and less sophisticated investors. Under the reading respondent advances, unscrupulous marketers of investments could evade the securities laws by picking a rate of return to promise. We will not read into the securities laws a limitation not compelled by the language that would so undermine the laws’ purposes.… We hold that an investment scheme promising a fixed rate of return can be an “investment contract” and thus a “security” subject to the federal securities laws. SEC v. Edwards, 540 U.S. 389 (2004).

ETHICS, PUBLIC POLICY, & THE LAW: GOLDMAN SACHS – THE GOLD (?) STANDARD OF WALL STREET

Discuss the following key points:

1. Partnership structure meant partners’ personal assets were on the line so the firm engaged in less risky behavior.

2. The laddering process was a form of trading against clients by ensuring that an IPO was hyped through inside sales.

3. Changing the underwriting standard is fine as long as investors are aware that the standard has been changed and that there is more risk associated with these IPOs.

4 The Abacus deal was set up to decline in value but Goldman distanced itself so that it did not have to make disclosures about the portfolio.

5. Discuss what happens to market trust when there are these types of behaviors from your investment advisor.

INTERACTIVE/COOPERATIVE LEARNING EXERCISES

1. Have students write a publicly held company and obtain a proxy statement and then answer the following:

a. How many directors were up for election?

b. Were there any shareholder proposals?

c. What disclosures are made in the proxy materials?

Reiss v. Pan American World Airways

711 F.2d 11 (2nd Cir.1983)

WINTER, Circuit Judge: Irving Reiss appeals from a judgment granting defendant Pan American World Airways, Inc.’s (“Pan Am”) motion for summary judgment dismissing his class action complaint. The complaint alleged violations of section 10(b) and Rule 10(b)‑5 of the Securities Exchange Act of 1934. Plaintiffs, holders of Pan Am convertible debentures which were being called, sold the debentures rather than convert them into capital stock. They allege that if they had known at the time that Pan Am was attempting to negotiate a merger with National Airlines, Inc. (“National”), they would have converted the debentures into stock rather than selling them. In granting summary judgment upon a detailed stipulation of facts, Judge Broderick held alternatively that Pan Am was not obligated to disclose the existence of the negotiations in question and also that the failure to disclose was not knowingly misleading.

Background. Pan Am had been interested in acquiring National since May 1977. By January, 1978, it had secured a $50,000,000 loan commitment from Citibank, N.A. and Pan Am’s Chairman, William T. Seawell, and Executive Vice President for Finance and Development, James H. Maloon, had met with National’s Chairman, L. B. Maytag. However, Maytag advised Seawell that National was not interested and Pan Am allowed the Citibank loan commitment to expire. Throughout these negotiations confidentiality was preserved. During the next few months, Seawell and Maloon made other fruitless overtures to National. Meanwhile, Texas International Airlines, Inc. began purchasing National stock and petitioned the Civil Aeronautics Board for permission to acquire control. In response, Pan Am began purchasing National shares on its own, acquiring .4% of National’s stock by August 15.

On August 8, 1978, Pan Am’s investment banker, Lehman Brothers Kuhn Loeb Inc., submitted a report to Pan Am recommending a call of debentures prior to September, 1978. One objective of the proposed call was to induce holders to convert debentures into capital stock, since at that time the stock was trading in excess of the so‑called “effective conversion price” – that stock price equal to the amount due debentureholders upon redemption. Other objectives of the call included savings on interest payments, tax savings due to loss‑taking, simplification of the company’s capital structure, and a strengthening of its equity base.

On August 15, 1978, Pan Am’s Executive Committee adopted two resolutions. The first authorized acquisition of up to 10% of National’s stock and further negotiations for the acquisition of National. The second authorized the call of $25,000,000 of 10 1/2% convertible debentures for redemption on September 29, 1978, at 110% of face value plus accrued interest from August 14 to September 29. The particular debentures called were to be deter​mined randomly and were redeemable either in cash or through conversion to capital stock. On August 15, a press release announced the redemption but did not mention Pan Am’s intentions toward National. On the same day, Pan Am secured a second loan commitment from Citibank. Between August 15 and August 23, Pan Am negotiated with National, while increasing its share of stock holdings in National to 4.8%. No public announcement of the negotiations was made.

On August 23, both National and Pan Am issued press releases reporting that a firm merger offer was under consideration. Subsequent press releases on the merger negotiations were also issued and, on September 7, the merger was announced at $41/share. On August 29, Pan Am announced that it was expanding the call to all debentures. At all relevant times, Pan Am common shares were traded at prices exceeding the conversion price of the debentures. However, the price of Pan Am stock rose even higher after the August 23 announcements.

Plaintiff Reiss and the other members of the class sold their debentures between August 15 and August 22. They claim that Pan Am’s failure to disclose the merger negotiations with National between those dates amounted to an intentional withholding of material information in violation of section 10(b) and Rule 10(b)‑5 of the Act. We affirm Judge Broderick’s decision.

Discussion. Reiss argues that Pan Am’s August 15 decision to renew negotiations with National, its second loan commitment from Citibank, and the statutes of these negotiations between August 15 and 23 were material facts which were not timely dis​closed to the debentureholders. His claim is based on the following facts: (1) the August 23 announcement affected the value of the debentures by causing Pan Am’s stock to rise in price; (2) Pan Am’s Form 8‑k for August, 1978, reported the relevant events; and (3) the circumstances on August 15 did not differ significantly from the circumstances on August 23, when the first press release disclosing the merger negotiations was issued. Essentially he argues that since the merger information affected the value of the debentures when announced, it should have been disclosed at the earlier rather than later date. Finally, he contends that scienter is present because Pan Am’s decisions as to the timing of the various announcements was conscious.

We consider first Pan Am’s obligation to disclose various events. Assuming that the partial call of the debentures constituted a “purchase or sale” for purposes of section 10(b) and Rule 10(b)‑5, Pan Am’s August 15 announcement of the partial call of debentures was not misleading. Liability thus must rest on a showing that additional information should have been released so as to avoid “assertions . . . so incomplete as to mislead” the debentureholders. Since such a claim must be viewed “in the light of the facts existing at the time of the release . . .,” hindsight is of limited value and the fact that ultimate disclosure of the negotiations affected stock price is not compelling. This is particularly so since that price was at all times greater than the effective conversion price.

The Form 8‑k is entirely irrelevant since the events it in fact describes occurred after August 23. Thus, even if the contents of an 8‑k constitute an admission of Rule 10(b)‑5 materiality, a conclusion which is anything but self‑evident, this 8‑k was no such admission.

Reiss attempts to supply the missing link by asserting that the facts on August 15 differed in no relevant respect from the facts on August 23, when Pan Am announced its merger offer. Arguing that the fact of an offer on August 23 is no more or less relevant than a loan commitment on August 15 or than Pan Am’s overtures to National between August 15 and 23, Reiss argues that since the status of the negotiations on August 23 was disclosed, the earlier events of supposed equal stature should also have been given to the investing public.

Even assuming these various events were of comparable relevance, however, the preferred conclusion confuses materiality under section 10(b) with consistency in corporate public relations decisions. Disclosure is a matter of corporate discretion where legally material facts are not involved, and, absent a finding of materiality, disclosure at one time does not imply a legal obligation to disclose at a different time. It does not serve the underlying purposes of the securities acts to compel disclosure of merger negotiations in the not unusual circumstances before us. Such negotiations are inherently fluid and the eventual outcome is shrouded in uncertainty. Disclosure may in fact be more misleading than secrecy so far as investment decisions are concerned. We are not confronted here with a failure to disclose hard facts which definitely affect a company’s financial prospects. Rather, we deal with complex bargaining between two (and often more) parties which may fail as well as succeed, or may succeed on terms which vary greatly from those under consideration at the suggested time of disclosure. We have no doubt that Pan Am disclosed the existence of negotiations on August 15 and had those negotiations failed, we would have been asked to decide a section 10(b)‑5 action challenging that disclosure.

The district court also held that Pan Am lacked scienter, an independently dispositive grounds for summary judgment. To prove scienter, more than a conscious failure to disclose must be shown. Rather, there must be proof that the non‑disclosure was intended to mislead. Reiss’s argument itself rebuts any inference to that effect. His contention is that Pan Am called the debentures in order to encourage debentureholders to convert to common stock. He also argues, however, that he and the class he represents sold rather than convert as a result of the nondisclosure. Since conversion would improve Pan Am’s debt structure even more than redemption by retaining investment capital while at the same time securing the interest and tax savings from the call, Pan Am had every reason to disclose information which would have increased the trading price of its common stock, for the higher the stock price, the greater the incentive for debentureholders to convert. The non‑disclosure was thus counterproductive so far as the underlying purpose of the partial call was concerned and can hardly be labeled knowingly misleading.

Plaintiffs will at best be able to prove that Pan Am failed to disclose the negotiations with National because it feared that disclosure would be misleading under the circumstances or would adversely affect the negotiations themselves. In neither case are investors well served by a rule compelling disclosure. Affirmed.

2. Have students search business periodicals to find a merger, consolidation, or acquisition in the past two years. Have them describe the transaction.

SUPPLEMENTAL READINGS

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