week 6
bemp1130
chapter17.docxCHAPTER 17 Investor Protection and E-Securities Transactions
New York Stock Exchange
This is the home of the New York Stock Exchange (NYSE) in New York City. The NYSE, nicknamed the Big Board, is the premier stock exchange in the world. It lists the stocks and securities of approximately 3,000 of the world’s largest companies for trading. The origin of the NYSE dates to 1792, when several stockbrokers met under a buttonwood tree on Wall Street. The NYSE is located at 11 Wall Street, which has been designated a National Historic Landmark. The NYSE is now operated by NYSE Euronext, which was formed when the NYSE merged with the fully electronic stock exchange Euronext.
Learning Objectives
After studying this chapter, you should be able to:
1. Describe the procedure for going public and how securities are registered with the Securities and Exchange Commission (SEC).
2. Describe e-securities transactions and public offerings.
3. Describe the requirements for qualifying for private placement, intrastate, and small offering exemptions from registration.
4. Describe insider trading that violates Section 10(b) of the Securities Exchange Act of 1934.
5. Describe the changes made to securities law by the Jumpstart Our Business Startups (JOBS) Act and its effect on raising capital by small businesses.
Chapter Outline
1. Introduction to Investor Protection and E-Securities Transactions
1. LANDMARK LAW • Federal Securities Laws
4. Initial Public Offering: Securities Act of 1933
1. BUSINESS ENVIRONMENT • Facebook’s Initial Public Offering
2. CONTEMPORARY ENVIRONMENT • Jumpstart Our Business Startups (JOBS) Act: Emerging Growth Company
1. DIGITAL LAW • Crowdfunding and Funding Portals
8. Trading in Securities: Securities Exchange Act of 1934
1. Case 17.1 • United States v. Bhagat
2. Case 17.2 • United States v. Kluger
3. ETHICS • Stop Trading on Congressional Knowledge Act
“The insiders here were not trading on an equal footing with the outside investors.”
—Judge Waterman Securities and Exchange Commission v. Texas Gulf Sulphur Company 401 F.2d 833, 1968 U.S. App. Lexis 5796 (1968)
Introduction to Investor Protection and E-Securities Transactions
Prior to the 1920s and 1930s, the securities markets in this country were not regulated by the federal government. Securities were issued and sold to investors with little, if any, disclosure. Fraud in these transactions was common. To respond to this lack of regulation, in the early 1930s Congress enacted federal securities statutes to regulate the securities markets, including the Securities Act of 1933 and the Securities Exchange Act of 1934. The federal securities statutes were designed to require disclosure of information to investors, provide for the regulation of securities issues and trading, and prevent fraud. Today, many securities are issued over the Internet. These e-securities transactions are subject to federal regulation.
WEB EXERCISE
Visit the website of the New York Stock Exchange at www.nyse.com . Click on “About Us” and click on “Overview.” Read the description of NYS Euronext.
In 2012, Congress enacted the Jumpstart Our Business Startups (JOBS) Act, to make it easier for smaller businesses to raise capital, and the Stop Trading on Congressional Knowledge (STOCK) Act, to prohibit insider trading by government employees.
This chapter discusses federal securities laws, e-securities transactions, investor protection, ethics, and securities reform.
Securities Law
The federal and state governments have enacted statutes that regulate the issuance and trading of securities. These are referred to collectively as securities law . The primary purpose of these acts is to promote full disclosure to investors and to prevent fraud in the issuance and trading of securities. These federal and state statutes are enforced by federal and state regulatory authorities, respectively. The following feature discusses major federal securities statutes.
Landmark Law Federal Securities Laws
Following the stock market crash of 1929, Congress enacted a series of statutes designed to regulate securities markets. These federal securities statutes are designed to require disclosure to investors and prevent securities fraud. The two primary securities statutes enacted by the federal government, both of which were enacted during the Great Depression years, are:
· Securities act of 1933. The Securities Act of 1933 is a federal statute that regulates primarily the issuance of securities by companies and other businesses. 1 This act applies to original issue of securities, both initial public offerings (IPOs) by new public companies and sales of new securities by existing companies. The primary purpose of this act is to require full and honest disclosure of information to investors at the time of the issuance of the securities. The act also prohibits fraud during the sale of issued securities. Securities are now issued online, and the 1933 act regulates the issue of securities online.
· Securities exchange act of 1934. The Securities Exchange Act of 1934 is a federal statute designed primarily to prevent fraud in the subsequent trading of securities. 2 This act has been applied to prohibit insider trading and other frauds in the purchase and sale of securities in the after markets, such as trading on securities exchanges and other purchases and sales of securities. The act also requires continuous reporting—annual reports, quarterly reports, and other reports—to investors and the Securities and Exchange Commission (SEC). Securities are now sold online and on electronic stock exchanges. The 1934 act regulates the purchase and sale of securities online.
These acts have been amended over the years. Additional federal statutes that promote investor protection and regulate securities issuance and trading are the Jumpstart Our Business Startups (JOBS) Act and the Stop Trading on Congressional Knowledge (STOCK) Act.
Securities and Exchange Commission
The Securities Exchange Act of 1934 created the Securities and Exchange Commission (SEC) , a federal administrative agency that is empowered to administer federal securities law. The SEC is an agency composed of five members who are appointed by the president. The major responsibilities of the SEC are:
Securities and Exchange Commission (SEC)
The federal administrative agency that is empowered to administer federal securities laws. The SEC can adopt rules and regulations to interpret and implement federal securities laws.
WEB EXERCISE
Go to the website of the Securities and Exchange Commission, at www.sec.gov . Click on “What We Do” and read the introduction.
· Adopting rules (also called regulations) that further the purpose of the federal securities statutes. These rules have the force of law.
· Investigating alleged securities violations and bringing enforcement actions against suspected violators. These enforcement actions may include recommendations of criminal prosecution. Criminal prosecutions of violations of federal securities laws are brought by the U.S. Department of Justice.
· Bringing a civil action to recover monetary damages from violators of securities laws. A whistleblower bounty program allows a person who provides information that leads to a successful SEC action in which more than $1 million is recovered to receive 10 percent to 30 percent of the money collected.
· Regulating the activities of securities brokers and advisors. This includes registering brokers and advisors and taking enforcement action against those who violate
Definition of Security
Congress has enacted the Securities Act of 1933, the Securities Exchange Act of 1934, and several other securities statutes to regulate the issuance and sale of securities. For these federal statutes to apply, however, a security must first be found. Federal securities laws define securities as:
security
(1) An interest or instrument that is common stock, preferred stock, a bond, a debenture, or a warrant; (2) an interest or instrument that is expressly mentioned in securities acts; or (3) an investment contract.
· Common securities. Interests or instruments that are commonly known as securities are common securities .
Examples
Common stock, preferred stock, bonds, debentures, and warrants are common securities.
· Statutorily defined securities. Interests or instruments that are expressly mentioned in securities acts are statutorily defined securities .
Examples
The securities acts specifically define preorganization subscription agreements; interests in oil, gas, and mineral rights; and deposit receipts for foreign securities as securities.
· Investment contracts. A statutory term that permits courts to define investment contracts as securities. The courts apply the Howey test 3 to determine whether an arrangement is an investment contract and therefore a security. Under this test, an arrangement is considered an investment contract if there is an investment of money by an investor in a common enterprise and the investor expects to make profits based on the sole or substantial efforts of the promoter or others.
Examples
A limited partnership interest is an investment contract because the limited partner expects to make money based on the effort of the general partners. Pyramid schemes where persons give money to a promoter who promises them a high rate of return on their investment is an investment contract because the investors expect to make money from the efforts of the promoter.
investment contract
A flexible standard for defining a security.
Howey test
A test stating that an arrangement is an investment contract if there is an investment of money by an investor in a common enterprise and the investor expects to make profits based on the sole or substantial efforts of the promoter or others.
Mutual funds sell shares to the public, make investments in stocks and bonds for the long term, and are restricted from investing in risky investments. Because mutual funds are sold to the public, they must be registered with the SEC.
CONCEPT SUMMARY Definition of Security
|
Type of Security |
Definition |
|
Common securities |
Interests or instruments that are commonly known as securities, such as common stock, preferred stock, debentures, and warrants. |
|
Statutorily defined securities |
Interests and instruments that are expressly mentioned in securities acts as being securities, such as interests in oil, gas, and mineral rights. |
|
Investment contracts |
A flexible standard for defining a security. Under the Howey test, a security exists if an investor invests money in a common enterprise and expects to make a profit from the significant efforts of others. |
Initial Public Offering: Securities Act of 1933
The Securities Act of 1933 regulates primarily the issuance of securities by corporations, limited partnerships, and companies. Section 5 of the Securities Act of 1933 requires securities offered to the public through the use of the mails or any facility of interstate commerce to be registered with the SEC by means of a registration statement and an accompanying prospectus.
Securities Act of 1933
A federal statute that regulates primarily the issuance of securities by corporations, limited partnerships, and associations.
Section 5 of the Securities Act of 1933
A section that requires an issuer to register its securities with the SEC prior to selling them to the public.
A business or party selling securities to the public is called an issuer . An issuer may be a new company (e.g., Facebook) that is selling securities to the public for the first time. This is referred to as going public . Or the issuer may be an established company (e.g., General Motors Corporation) that sells a new security to the public. The issuance of securities by an issuer is called an initial public offering (IPO) .
initial public offering (IPO)
The sale of securities by an issuer to the public.
Many issuers of securities employ investment bankers , which are independent securities companies, to sell their securities to the public. Issuers pay a fee to investment bankers for this service.
Registration Statement
A company that is issuing securities to the public must file a written registration statement with the SEC. The general form for registering with the SEC is called Form S-1 . The issuer’s lawyer normally prepares the S-1 filing registration statement with the help of the issuer’s managers, accountants, underwriters, and other professionals. The registration statement is filed electronically with the SEC.
registration statement
A document that an issuer of securities files with the SEC and that contains required information about the issuer, the securities to be issued, and other relevant information.
A registration statement must contain descriptions of (1) the securities being offered for sale; (2) the registrant’s business; (3) the management of the registrant, including compensation, stock options and benefits, and material transactions with the registrant; (4) pending litigation; (5) how the proceeds from the offering will be used; (6) government regulation; (7) the degree of competition in the industry; and (8) any special risk factors. In addition, a registration statement must be accompanied by financial statements certified by certified public accountants.
Registration statements usually become effective 20 business days after they are filed unless the SEC requires additional information to be disclosed. A new 20-day period begins each time a registration statement is amended. At the registrant’s request, the SEC may accelerate the effective date (i.e., not require the registrant to wait 20 days after the last amendment is filed). The date that the registration becomes effective is called the effective date .
The SEC does not pass judgment on the merits of the securities offered. It decides only whether the issuer has met the disclosure requirements.
Prospectus
A preliminary prospectus is a written disclosure document that must be submitted to the SEC along with the registration statement. A prospectus contains much of the information included in the registration statement. This preliminary prospectus is used as a selling tool by the issuer. It is provided to prospective investors to enable them to evaluate the financial risk of an investment. The issuer must make a final prospectus (which includes the final price of the securities and any amendments required by the SEC) available to purchasers before or at the time of purchase. The issuer can make the final prospectus available on a website.
preliminary prospectus
A written disclosure document that must be submitted to the SEC along with the registration statement and given to prospective purchasers of the securities.
WEB EXERCISE
Go to the New York Stock Exchange website, at www.nyse.com/about/listed/IPO_Index.html , to view the “IPO Showcase” list of the most recent IPOs. What is the most recent listing? Click on the company's name and read the brief history of the company.
A prospectus must contain the following language in capital letters and bold (usually red) type:
THESE SECURITIES HAVE NOT BEEN APPROVED OR DISAPPROVED BY THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION NOR HAS THE SECURITIES AND EXCHANGE COMMISSION OR ANY STATE SECURITIES COMMISSION PASSED UPON THE ACCURACY OR ADEQUACY OF THIS PROSPECTUS. ANY REPRESENTATION TO THE CONTRARY IS A CRIMINAL OFFENSE.
The following feature discusses the initial public offering of Facebook, Inc.
Business Environment Facebook’s Initial Public Offering
Facebook is a social networking service that was launched in 2004. Facebook has more than 1 billion users worldwide who post billions of comments and hundreds of millions of photographs daily using the Facebook network.
Facebook originally sold stock to several personal and institutional investors, but the company remained a privately held company for eight years. In 2012, Facebook, Inc., went public by issuing shares in an initial public offering (IPO). In the IPO, 421,233,615 shares of Facebook, Inc., were sold to the public. Of this amount, the company sold 180,000,000 shares, and insiders, including its owner Mark Zuckerberg, sold 241,233,615 shares. The company received the proceeds for the shares it sold, and the individuals and institutional shareholders received the proceeds for the shares they sold. The Facebook IPO was one of the largest in U.S. history. The offering share price was $38.00.
Prior to the IPO, the company created a dual-class stock structure . Zukerberg and the other insiders converted shares to Class B stock. Class A stock was sold to the public in the IPO. Class B stock is entitled to 10 votes per share, while class A stock is entitled to 1 vote per share. After the IPO, the holders of Class B stock controlled 96 percent of the voting power of the company, with Zuckerberg controlling 55.9 percent of the voting power of the company.
As a public company, Facebook, Inc., will have to file annual, quarterly, and other reports with the Securities and Exchange Commission (SEC) and make public disclosures to the SEC and its shareholders. The shares of Facebook, Inc., are traded on NASDAQ under the symbol FB.
The cover page of Facebook's prospectus appears in Exhibit 17.1 .
Filed Pursuant to Rule 424(b)(4)
Registration No. 333-179287
PROSPECTUS
Facebook, Inc. is offering 180,000,000 shares of its Class A common stock and the selling stockholders are offering 241,233,615 shares of Class A common stock. We will not receive any proceeds from the sale of shares by the selling stockholders. This is our initial public offering and no public market currently exists for our shares of Class A common stock.
We have two classes of common stock, Class A common stock and Class B common stock. The rights of the holders of Class A common stock and Class B common stock are identical, except voting and conversion rights. Each share of Class A common stock is entitled to one vote. Each share of Class B common stock is entitled to ten votes and is convertible at any time into one share of Class A common stock. The holders of our outstanding shares of Class B common stock will hold approximately 96.0% of the voting power of our outstanding capital stock following this offering, and our founder, Chairman, and CEO, Mark Zuckerberg, will hold or have the ability to control approximately 55.9% of the voting power of our outstanding capital stock following this offering.
Our Class A common stock has been approved for listing on the NASDAQ Global Select Market under the symbol “FB.”
We are a “controlled company” under the corporate governance rules for NASDAQ-listed companies, and our board of directors has determined not to have an independent nominating function and instead to have the full board of directors be directly responsible for nominating members of our board.
Investing in our Class A common stock involves risks. See “Risk Factors” beginning on page 12 .
|
PRICE $38.00 A SHARE |
||||
|
|
Price to Public |
Underwriting Discounts and Commissions |
Proceeds to Facebook |
Proceeds to Selling Stockholders |
|
Per share |
$38.00 |
$0.418 |
$37.582 |
$37.582 |
|
Total |
$16,006,877,370 |
$176,075,651 |
$6,764,760,000 |
$9,066,041,719 |
We and the selling stockholders have granted the underwriters the right to purchase up to an additional 63,185,042 shares of Class A common stock to cover over-allotments.
The Securities and Exchange Commission and state regulators have not approved or disapproved of these securities, or determined if this prospectus is truthful or complete. Any representation to the contrary is a criminal offense.
The underwriters expect to deliver the shares of Class A common stock to purchasers on May 22, 2012.
MORGAN STANLEY J.P. MORGAN GOLDMAN, SACHS & CO.
May 17, 2012
Exhibit 17.1 Facebook, Inc., Prospectus
Examples
Twitter, Inc., an online social networking and microblogging service, went public in 2013 at $26 per share. Alibaba Group Holding Limited, a China-based company that operates various e-commerce businesses, went public in 2014 at $68 per share. Both companies are listed on the New York Stock Exchange; Twitter is listed under the stock symbol TWTR, and Alibaba is listed under the stock symbol BABA.
WEB EXERCISE
Go to finance.yahoo.com . Enter the symbol “FB” and click. What is Facebook stock currently selling at? Enter the symbol “TWTR” and click. What is Twitter stock currently selling at? Enter the symbol BABA and click. What is Alibaba stock currently selling at?
Small Company Offering Registration (SCOR)
A method for small companies to sell up to $1 million of securities during a 12-month period to the public by using a question-and-answer disclosure form called Form U-7.
Sale of Unregistered Securities
Sale of securities that should have been registered with the SEC but were not violates the Securities Act of 1933. Investors who purchased such unregistered securities can rescind their purchase and recover damages. The U.S. government can impose criminal penalties on any person who willfully violates the Securities Act of 1933.
Example
Space Corporation sells shares of its stock to the public at $8.00 per share. Within months, the price of the stock drops to $2.00. Space Corporation did not register its stock offering with the SEC. Because there has been a sale of unregistered securities in this example, the purchasers can rescind their purchase of the stock and get their money back (which is often highly unlikely). If the management of Space Corporation did not register the securities willfully, the U.S. government can file a criminal lawsuit to seek criminal penalties.
Regulation A Offering
The JOBS Act amends Regulation A to permit nonreporting companies to sell up to $50 million of securities (the SEC can increase the amount every two years) to the public during a 12-month period, pursuant to a simplified registration with the SEC. Issuers must file an offering statement with the SEC. An offering statement requires less disclosure than a registration statement and is less costly to prepare. Investors must be provided with an offering circular prior to the purchase of securities.
Regulation A
A regulation that permits an issuer to sell $50 million of securities pursuant to a simplified registration process.
A Regulation A offering is a public offering. The offering may have an unlimited number of purchasers who do not have to be accredited investors. The issuer can advertise the sale of the security. There are no resale restrictions on the securities, so the investor can immediately sell the securities. Thus, Regulation A permits a company to conduct a mini–public offeringand have a public trading market in its securities. Issuers of securities under Regulation A must submit audited financial statements with the SEC annually.
Small Company Offering Registration (SCOR)
Small businesses often need to raise capital and must find public investors to buy company stock. The SEC has adopted the Small Company Offering Registration (SCOR) for companies proposing to raise $1 million or less in any 12-month period from a public offering of securities. The SEC requires that a SCOR form (Form U-7) be completed by the company and be made available to potential investors. Form U-7 is a question-and-answer disclosure form that small businesses can complete and file without the services of an expensive securities lawyer. Form U-7 doubles as a prospectus.
WEB EXERCISE
Go to http://com.ohio.gov/secu/docs\U-7.pdf . Review this Form U-7 to determine what information an issuer must provide when completing the form.
SCOR form questions require the issuer to develop a business plan that states specific company goals and how it intends to reach them. The SCOR form is available only to domestic businesses. The offering price of the common stock of a SCOR offering may not be less than $5 per share. Although qualifying as an exemption from federal registration, SCOR requires the offering to be registered with the state. Most states have adopted this form of registration.
The following feature discusses the Jumpstart Our Business Startups (JOBS) Act of 2012.
Contemporary Environment Jumpstart Our Business Startups (JOBS) Act: Emerging Growth Company
In 2012, Congress enacted the Jumpstart Our Business Startups Act (JOBS) Act . 4 The purpose of this federal statute is designed to make it easier for startup companies to raise capital through initial public offerings (IPOs).
Jumpstart Our Business Startups (JOBS) Act
A federal statute that is designed to make it easier for startup companies to raise capital through securities offerings.
The JOBS Act creates a new class of public company and a new category of issuer under federal securities laws called the emerging growth company (EGC) . EGC status is often referred to as the IPO on-ramp . Most entrepreneurial and high-tech companies who are planning to do an initial public offering of securities qualify for this new status, whereas previously they would have been subject to the securities law provisions applicable to much larger companies.
For an existing company to qualify as an EGC, the company must have (1) not gone public more than five years ago, (2) less than $1 billion in annual revenue (to be indexed for inflation every five years), (3) issued no more than $1 billion in debt, and (4) less than $700 million in stock outstanding after an IPO. These companies are not the extremely large corporations that are listed on the New York Stock Exchange (NYSE) or even the size of most companies listed on the NASDAQ stock exchange (although a few companies the size of an EGC are listed on NASDAQ).
By qualifying as an EGC, the company is exempt from a broad range of requirements typically imposed on companies pursuing an IPO. The main benefits for qualifying as an EGC are the following:
· An EGC may submit a confidential draft registration statement with the SEC for review by SEC staff. This confidential filing allows companies, if they choose to do so, to withdraw a proposed IPO without having to disclose confidential business information.
· An EGC is subject to dramatically reduced IPO communication restrictions: An EGC may communicate with institutional accredited investors to test the waters to see if there is enough interest in its IPO before going forward with it.
· An EGC needs to provide only two years of audited financial statements when filing an IPO registration to issue securities, not the three years of audited financial statements that would have previously been required.
· Qualifying as an EGC frees the company from the restriction of the Sarbanes-Oxley Act that prohibits investment banks and research analysts of the same firm from communication with each other.
· Qualification allows EGCs to file for registration of securities using a streamlined process and reduced disclosure of financial information than is true for non-EGC IPOs.
The JOBS Act provisions help EGCs to decide whether to go public and significantly reduces the costs if they choose to go public. A company can retain EGC status for only five years after its IPO. The majority of companies that choose to go public qualify to do so as an EGC.
Well-Known Seasoned Issuer
The public has access to substantial historical and current information and financial data about the largest public companies. In 2005, the SEC created a new category of issuer called a well-known seasoned investor (WKSI) . To qualify as a WKSI, an issuer must have either (1) issued $1 billion of securities in the previous three years or (2) at least $700 million of outstanding equity securities owned by nonaffiliate investors. Because of their size and presence in the market, WKSIs are granted substantial flexibility of communication not provided to other issuers. In addition to a statutory prospectus, a WKSI can release factual information, forward-looking information, electronic communications, and free-writing prospectuses without significant restrictions during the entire offering period. A WKSI can file a simplified registration statement with the SEC and immediately begin selling the registered securities.
emerging growth company (EGC)
A class of public company created by the JOBS Act that may issue securities pursuant to specific rules under federal securities laws.
Civil Liability: Section 11 of the Securities Act of 1933
Private parties who have been injured by certain registration statement violations by an issuer or others may bring a civil action against the violator under Section 11 of the Securities Act of 1933 . Plaintiffs may recover monetary damages when a registration statement, on its effective date, misstates or omits a material fact. Civil liability under Section 11 is imposed on those who (1) defraud investors intentionally or (2) are negligent in not discovering the fraud. Thus, the issuer, certain corporate officers (e.g., chief executive officer, chief financial officer, chief accounting officer), directors, signers of the registration statement, underwriters, and experts (e.g., accountants who certify financial statements and lawyers who issue legal opinions that are included in a registration statement) may be liable.
Section 11 of the Securities Act of 1933
A provision of the Securities Act of 1933 that imposes civil liability on persons who intentionally defraud investors by making misrepresentations or omissions of material facts in the registration statement or who are negligent for not discovering the fraud.
All defendants except the issuer may assert a due diligence defense against the imposition of Section 11 liability. If this defense is proven, the defendant is not liable. To establish a due diligence defense, the defendant must prove that, after reasonable investigation, he or she had reasonable grounds to believe and did believe that, at the time the registration statement became effective, the statements contained therein were true and there was no omission of material facts.
due diligence defense
A defense to a Section 11 action that, if proven, makes the defendant not liable.
Example
In the classic case Escott v. BarChris Construction Corporation , 5 the company was going to issue a new bond to the public. The company prepared financial statements wherein the company overstated current assets, understated current liabilities, overstated sales, overstated gross profits, overstated the backlog of orders, did not disclose loans to officers, did not disclose customer delinquencies in paying for goods, and lied about the use of the proceeds from the offering. The company gave these financial statements to its auditors, Peat, Marwick, Mitchell & Co. (Peat Marwick), who did not discover the lies. Peat Marwick certified the financial statements that became part of the registration statement filed with the SEC.
The bonds were sold to the public. One year later, the company filed for bankruptcy. The bondholders sued Russo, the chief executive officer (CEO) of BarChris; Vitolo and Puglies, the founders of the business and the president and vice president, respectively; Trilling, the controller; and Peat Marwick, the auditors. Each defendant pleaded the due diligence defense. The court rejected each of the party’s defenses, finding that the CEO, president, vice president, and controller were all in positions to have either created or discovered the misrepresentations. The court also found that the auditor, Peat Marwick, did not do a proper investigation and had not proven its due diligence defense. The court found that the defendants had violated Section 11 of the Securities Act of 1933 by submitting misrepresentations and omissions of material facts in the registration statement filed with the SEC.
Section 12 of the Securities Act of 1933
A provision of the Securities Act of 1933 that imposes civil liability on any person who violates the provisions of Section 5 of the act.
Civil Liability: Section 12 of the Securities Act of 1933
Private parties who have been injured by certain securities violations may bring a civil action against the violator under Section 12 of the Securities Act of 1933 . Section 12 imposes civil liability on any person who violates the provisions of Section 5 of the act. Violations include selling securities pursuant to an unwarranted exemption and making misrepresentations concerning the offer or sale of securities. The purchaser’s remedy for a violation of Section 12 is either to rescind the purchase or to sue for damages.
Example
Technology Inc., a corporation, issues securities to investors without qualifying for any of the exempt transactions permitted under the Securities Exchange Act. The securities decrease in value. In this example, the issuer has issued unregistered securities to the public. The investors can sue the issuer to rescind the purchase agreement and get their money back, or they can sue and recover monetary damages.
SEC Actions: Securities Act of 1933
The SEC may take certain legal actions against parties who violate the Securities Act of 1933. The SEC may (1) issue a consent decree whereby a defendant agrees not to violate securities laws in the future but does not admit to having violated securities laws in the past; (2) bring an action in U.S. district court to obtain an injunction to stop challenged conduct; or (3) request the court to grant ancillary relief, such as disgorgement of profits by the defendant.
Criminal Liability: Section 24 of the Securities Act of 1933
Section 24 of the Securities Act of 1933 imposes criminal liability on any person who willfully violates either the act or the rules and regulations adopted thereunder. 6 A violator may be fined, imprisoned, or both. Criminal actions are brought by the Department of Justice.
Section 24 of the Securities Act of 1933
A provision of the Securities Act of 1933 that imposes criminal liability on any person who willfully violates the 1933 act or the rules or regulations adopted thereunder.
E-Securities Transactions
The Internet has become an important vehicle of the disclosure of information about companies, online trading, and the public issuance of securities. Securities—stocks and bonds—are purchased and sold online worldwide by millions of persons and businesses each day. Individuals and businesses can open accounts at online stock brokers, such as Charles Schwab, Ameritrade, and others, and freely trade securities and manage their accounts online. Electronic securities transactions , or e-securities transactions, are becoming commonplace in disseminating information to investors, trading in securities, and issuing stocks and other securities to the public. Trading in e-securities transactions will become an even more important method for offering, selling, and purchasing securities.
E-Securities Exchanges
The New York Stock Exchange (NYSE) is operated by NYSE Euronext , which was formed when the NYSE merged with the fully electronic stock exchange Euronext. The NYSE lists the stocks and securities of approximately 3,000 of the world’s largest companies for trading. These companies include Ford Motor Company, IBM Corporation, The Coca-Cola Company, China Mobile Communications Corporation, and others.
The National Association of Securities Dealers Automated Quotation System (NASDAQ) is an electronic stock market. NASDAQ has the largest trading volume of any securities exchange in the world. More than 3,000 companies are traded on NASDAQ, including companies such as Microsoft Corporation; Yahoo! Inc.; Starbucks Corporation; Amazon.com , Inc.; Facebook, Inc.; and eBay Inc., as well as companies from China, India, and other countries around the world. NASDAQ, which is located in New York City, owns interests in electronic stock exchanges around the world.
EDGAR
Most public company documents—such as annual and quarterly reports—are now available online. The SEC requires both foreign and domestic companies to file registration statements, periodic reports, and other forms on its electronic filing and forms system, EDGAR , the SEC electronic data and records system. Anyone can access and download this information for free.
NASDAQ
NASDAQ is the world’s largest electronic securities exchange. It lists more than 3,000 U.S. and global companies and corporations.
EDGAR
The electronic data and record system of the Securities and Exchange Commission (SEC).
WEB EXERCISE
Visit the website of EDGAR, at www.sec.gov/edgar.shtml. Click on “About EDGAR.” Read the first two paragraphs of “Important Information About EDGAR.”
E-Public Offerings
Companies are now issuing shares of stock over the Internet. This includes companies that are making electronic initial public offerings , or e-initial public offerings (e-IPOs), by selling stock to the public for the first time. E-securities offerings provide an efficient way to distribute securities to the public. Google Inc. conducted its IPO online.
The following feature discusses a new electronic method for issuing securities to the public.
Digital Law Crowdfunding and Funding Portals
The JOBS Act created a new funding mechanism called crowdfunding for entrepreneurs and small businesses to raise small amounts of capital from public investors using online portals. Crowdfunding can be used by small companies that do not want to meet the requirements and expense of issuing securities pursuant to a registered offering and do not qualify for or do not wish to comply with the restrictions of any of the exemptions from registration.
The JOBS Act permits securities of an issuer to be sold to the public using an intermediary's funding portal , which is an Internet website. A funding portal, the website operator, must register with the SEC. Many crowdfunding portals have launched to fill this role.
Crowdfunding allows small companies to raise up to $1 million during a 12-month period from many small-dollar investors through Web-based platforms. The JOBS Act sets limits on how much money an individual can spend purchasing securities sold pursuant to the crowdfunding provision. The yearly aggregate money each person may invest in offerings of this type is 2 percent of a person's net worth or annual earnings if neither exceeds $40,000 (at most $1,600) and not more than $10,000 if a person's annual earnings or net worth exceeds $100,000.
If a company intends to raise less than $100,000, it is not required to have an accountant review its financial statements. If the company intends to raise between $100,000 and $500,000, an independent review of its financial statements must be conducted by a CPA firm. If the company is going to raise more than $500,000 of capital, an independent statement audit must be conducted by a CPA firm. Crowdfunding offerings are subject to the antifraud provisions of the Securities Act of 1933 and the Securities Exchange Act of 1934.
funding portal
An Internet website that companies may use to issue securities to the public under the crowdfunding provisions of the JOBS Act.
crowdfunding
A method that allows small companies to raise capital from many small-dollar investors through Web-based platforms.
Numerous crowdfunding Websites are available for entrepreneurs to raise money from a crowd of investors to fund their small businesses and projects. These Web platforms include Kickstarter, IndieGoGo, and others. The Web platform usually charges about 5 percent of the money raised.
Exempt Securities
Certain securities are exempt from registration with the SEC. These securities are usually offered by certain institutions, or the securities have certain characteristics that federal laws and the SEC believe do not require SEC oversight when issued. Once a security is exempt, it is exempt forever. It does not matter how many times the security is transferred. Exempt securities include the following:
exempt securities
Securities that are exempt from registration with the SEC.
· Securities issued by any government in the United States (e.g., municipal bonds issued by city governments).
· Short-term notes and drafts that have a maturity date that does not exceed nine months (e.g., commercial paper issued by corporations).
· Securities issued by nonprofit issuers, such as religious institutions, charitable institutions, and colleges and universities.
· Securities of financial institutions (e.g., banks, savings associations) that are regulated by the appropriate banking authorities.
· Insurance and annuity contracts issued by insurance companies.
· Stock dividends and stock splits.
· Securities issued in a corporate reorganization in which one security is exchanged for another security.
Critical Legal Thinking
1. What is an exempt transaction? Why does the government permit securities to be issued without having to register them with the Securities and Exchange Commission (SEC)
Exempt Transactions
The Securities Act of 1933 primarily regulates the issuance of securities by corporations, limited partnerships, other businesses, and individuals. 7 Pursuant to the Securities Act of 1933 and rules adopted by the SEC, some securities that would otherwise have to be registered with the SEC before being issued (e.g., common stock) are exempt from registration with the SEC because the offering meets requirements established by the act and SEC rules. These are called exempt transactions . Thus, the securities sold pursuant to an exempt transaction do not have to be registered with the SEC.
exempt transaction
An offering of securities that do not have to be registered with the SEC because the offering meets specified requirements established by securities laws and the SEC.
Example
An issuer sells common stock to investors. Normally, such an offering would have to be registered with the SEC. If this sale of common stock is sold in an issuance that qualifies as an exempt transaction, however, the sale of the common stock does not have to be registered with the SEC before being issued.
However, exempt transactions that do not have to be registered with the SEC are subject to the antifraud provisions of the federal securities laws. Therefore, the issuer must provide investors with adequate information, such as annual reports, quarterly reports, proxy statements, and financial statements, even though a registration statement is not required.
The most widely used transaction exemptions include the nonissuer exemption, intrastate offering exemption, private placement exemption, and small offering exemption. These exempt transactions are discussed in the paragraphs that follow.
Nonissuer Exemption
Nonissuers, such as average investors, do not have to file a registration statement prior to reselling securities they have purchased. This nonissuer exemption exists because the Securities Act of 1933 exempts from registration those securities transactions not made by an issuer, an underwriter, or a dealer.
nonissuer exemption
An exemption from registration stating that securities transactions not made by an issuer, an underwriter, or a dealer do not have to be registered with the SEC (e.g., normal purchases of securities by investors).
Example
An investor who owns shares of IBM can resell those shares to another investor at any time without having to register with the SEC.
Intrastate Offering Exemption
The Securities Act of 1933 provides an intrastate offering exemption that permits local businesses to obtain from local investors capital to be used in the local economy without the need to register with the SEC. 8 There is no limit on the dollar amount of capital that can be raised pursuant to an intrastate offering exemption. SEC Rule 147 stipulates that an intrastate offering can be made only in the one state in which all of the following requirements are met: 9
intrastate offering exemption
An exemption from registration that permits local businesses to raise capital from local investors to be used in the local economy without the need to register with the SEC.
1. The issuer must be a resident of the state for which the exemption is claimed. A corporation is a resident of the state in which it is incorporated.
2. The issuer must be doing business in that state. This requires that 80 percent of the issuer’s assets be located in the state, 80 percent of its gross revenues be derived from the state, its principal office be located in the state, and 80 percent of the proceeds of the offering be used in the state.
3. The purchasers of the securities must all be residents of that state.
The intrastate offering exemption assumes that local investors are sufficiently aware of local conditions to understand the risks associated with their investment.
Private Placement Exemption
The Securities Act of 1933 provides that an issue of securities that does not involve a public offering is exempt from the registration requirements. 10 SEC Rule 506 —known as the private placement exemption—allows issuers to raise capital from an unlimited number of accredited investors without having to register the offering with the SEC. 11 There is no dollar limit on the securities that can be sold pursuant to this exemption.
SEC Rule 506 (private placement exemption)
An exemption from registration that permits issuers to raise capital from an unlimited number of accredited investors and no more than 35 nonaccredited investors without having to register the offering with the SEC.
An accredited investor is defined as: 12
accredited investor
A person, a corporation, a company, an institution, or an organization that meets the net worth, income, asset, position, and other requirements established by the SEC to qualify as an accredited investor.
· Any natural person who has individual net worth or joint net worth with a spouse that exceeds $1 million, to be calculated by excluding the value of the person’s primary residence.
· A natural person 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.
· A charitable organization, a corporation, a partnership, a trust, or an employee benefit plan with assets exceeding $5 million.
· A bank, an insurance company, a registered investment company, a business development company, or a small business investment company.
· Insiders of the issuers, such as directors, executive officers, or general partners of the company selling the securities.
· A business in which all the equity owners are accredited investors.
The rationale underlying the private placement exemption is that accredited investors have the sophistication to understand the risk involved with the investment and can also afford to lose their money if the investment fails. The SEC is empowered to review the definition of accredited investor periodically and to make changes to the definition.
The law permits no more than 35 nonaccredited investors to purchase securities pursuant to a private placement exemption. These nonaccredited investors are usually friends and family members of the insiders. Nonaccredited investors must be sophisticated investors, however, either through their own experience and education or through representatives (e.g., accountants, lawyers, business managers). General selling efforts, such as general solicitation of or advertising to the public, are not permitted if there are to be any nonaccredited investors.
nonaccredited investor
An investor who does not meet the qualifications to be an accredited investor.
The JOBS Act of 2012 allows an issuer to use public solicitation and advertising to locate accredited investors as long as no nonaccredited investors are sold securities. Receipt of the solicitation or advertisement by a nonaccredited investor does not destroy this exemption as long as the recipient is not allowed to purchase securities in the offering. SEC rules require issuers to verify accredited investor status of investors claiming to be accredited investors.
Many emerging businesses use the private placement exemption to raise capital. In addition, many large established companies use this exemption to sell securities, such as bonds, to a single investor or a very small group of investors such as pension funds and investment companies.
Small Offering Exemption
Securities offerings that do not exceed a certain dollar amount are exempt from registration. 13 SEC Rule 504 exempts from registration the sale of securities not exceeding $1 million during a 12-month period. The securities may be sold to an unlimited number of accredited and unaccredited investors, but general selling efforts to the public are not permitted. This is called the small offering exemption.
SEC Rule 504 (small offering exemption)
An exemption from registration that permits the sale of securities not exceeding $1 million during a 12-month period.
Restricted Securities
Securities sold pursuant to the intrastate, private placement, and small offering exemptions are subject to restrictions on resale for a period of time after the securities are issued. Securities sold pursuant to these exemptions are called restricted securities . SEC Rule 147 states that securities issued pursuant to an intrastate offering exemption cannot be sold to nonresidents for a period of nine months. SEC Rule 144 states that securities issued pursuant to the private placement exemption or the small offering exemption cannot be resold for six months if the issuer is an SEC reporting company (e.g., larger firms) or one year if the issuer is not an SEC reporting company (e.g., smaller firms).
London, England, the United Kingdom
London is the site of the London Stock Exchange. Established in 1801, it is the largest stock exchange in Europe. The United Kingdom is a member of the European Union (EU), a regional organization of countries in Europe. The EU has adopted measures to provide uniform contract law in specific economic sectors. The EU is working on developing a general uniform contract law for member countries.
Trading in Securities: Securities Exchange Act of 1934
Unlike the Securities Act of 1933, which regulates the original issuance of securities, the Securities Exchange Act of 1934 regulates primarily subsequent trading. 14 It provides for the registration of certain companies with the SEC, the continuous filing of periodic reports by these companies to the SEC, and the regulation of securities exchanges, brokers, and dealers. It also contains provisions that assess civil and criminal liability on violators of the 1934 act and rules and regulations adopted thereunder.
Securities Exchange Act of 1934
A federal statute that regulates primarily trading in securities.
Section 10(b) and Rule 10b-5
Section 10(b) of the Securities Exchange Act of 1934 is one of the most important sections in the entire 1934 act. 15 Section 10(b) prohibits the use of manipulative and deceptive devices in contravention of the rules and regulations prescribed by the SEC. Pursuant to its rule-making authority, the SEC has adopted SEC Rule 10b-5 , 16 which provides the following:
Section 10(b) of the Securities Exchange Act of 1934
A provision of the Securities Exchange Act of 1934 that prohibits the use of manipulative and deceptive devices in the purchase or sale of securities in contravention of the rules and regulations prescribed by the SEC.
SEC Rule 10b-5
A rule adopted by the SEC to clarify the reach of Section 10(b) against deceptive and fraudulent activities in the purchase and sale of securities.
It shall be unlawful for any person, directly or indirectly, by use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange,
a. to employ any device, scheme, or artifice to defraud,
b. to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
c. to engage in any act, practice, or course of business that operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
Rule 10b-5 is not restricted to purchases and sales of securities of reporting companies. 17 All transfers of securities, whether made on a stock exchange, in the over-the-counter market, in a private sale, or in connection with a merger, are subject to this rule. 18 The U.S. Supreme Court has held that only conduct involving scienter (intentional conduct) violates Section 10(b) and Rule 10b-5. Negligent conduct is not a violation. 19
scienter
Intentional conduct. Scienter is required for a violation of Section 10(b) and Rule 10b-5 to occur.
Section 10(b) and Rule 10b-5 require reliance by the injured party on the misstatement. However, many sales and purchases of securities occur in open-market transactions (e.g., on stock exchanges), where there is no direct communication between the buyer and the seller.
Civil Liability: Section 10(b) of the Securities Exchange Act of 1934
Although Section 10(b) and Rule 10b-5 do not expressly provide for a private right of action, courts have implied such a right. Generally, a private plaintiff may bring a civil action and seek rescission of the securities contract or to recover damages (e.g., disgorgements of the illegal profits by the defendants) where there has been intentional conduct that violates Section 10(b) and rules adopted thereunder by the SEC. Private securities fraud claims must be brought within two years after discovery or five years after the violation occurs, whichever is shorter.
SEC Actions: Securities Exchange Act of 1934
The SEC may investigate suspected violations of the Securities Exchange Act of 1934 and of the rules and regulations adopted thereunder. The SEC may enter into consent decreeswith defendants, seek injunctions in U.S. district court, or seek court orders requiring defendants to disgorge illegally gained profits.
In 1984, Congress enacted the Insider Trading Sanctions Act , 20 which permits the SEC to obtain a civil penalty of up to three times the illegal profits gained or losses avoided on insider trading. The fine is payable to the U.S. Treasury. Under the Sarbanes-Oxley Act, the SEC may issue an order prohibiting any person who has committed securities fraud from acting as an officer or a director of a public company.
Insider Trading Sanctions Act
A federal statute that permits the SEC to obtain a civil penalty of up to three times the illegal benefits received from insider trading.
Criminal Liability: Section 32 of the Securities Exchange Act of 1934
Section 32 of the Securities Exchange Act of 1934 makes it a criminal offense to violate willfully the provisions of the act or the rules and regulations adopted thereunder. 21 Under the Sarbanes-Oxley Act of 2002, a person who willfully violates the Securities Exchange Act of 1934 can be fined or imprisoned for up to 25 years, or both. A corporation or another entity may be fined up to $2.5 million.
Section 32 of the Securities Exchange Act of 1934
A provision of the Securities Exchange Act of 1934 that imposes criminal liability on any person who willfully violates the 1934 act or the rules or regulations adopted thereunder.
There is a six-year statute of limitations for criminal prosecution of violations of the Securities Act of 1933 and the Securities Exchange Act of 1934.
Critical Legal Thinking
1. Why was insider trading made illegal? What percentage of insider trading do you think the government catches?
Insider Trading
One of the most important purposes of Section 10(b) and Rule 10b-5 is to prevent insider trading . Insider trading occurs when a company employee or company advisor uses material nonpublic information to make a profit by trading in the securities of the company. This practice is considered illegal because it allows insiders to take advantage of the investing public.
insider trading
When an insider makes a profit by personally purchasing shares of a corporation prior to public release of favorable information or by selling shares of a corporation prior to the public disclosure of unfavorable information.
In the Matter of Cady, Roberts & Company , 22 the SEC announced that the duty of an insider who possesses material nonpublic information is either to (1) abstain from trading in the securities of the company or (2) disclose the information to the person on the other side of the transaction before the insider purchases the securities from or sells the securities to him or her.
For purposes of Section 10(b) and Rule 10b-5, Section 10(b) insiders are defined as (1) officers, directors, and employees at all levels of a company; (2) lawyers, accountants, consultants, and agents and representatives who are hired by the company on a temporary and nonemployee basis to provide services or work to the company; and (3) others who owe a fiduciary duty to the company.
Section 10(b) insiders
(1) Officers, directors, and employees at all levels of a company; (2) lawyers, accountants, consultants, and agents and representatives who are hired by the company on a temporary and nonemployee basis to provide services or work to the company; and (3) others who owe a fiduciary duty to the company.
Example
The Widger Corporation has its annual audit done by its outside certified public accountants (CPAs), Young & Old, CPAs. Priscilla is one of the CPAs who conduct the audit. The audit discloses that the Widger Corporation’s profits have doubled since last year, and Priscilla rightfully discloses this fact to Martha, the chief financial officer (CFO) of Widger Corporation. Both Martha and Priscilla are insiders. The earnings information is definitely material, and it is nonpublic until the corporation publicly announces its earnings in two days. Prior to the earnings information being made public, Priscilla and Martha buy stock in Widger Corporation at $100 per share. After the earnings information is made public, the stock of Widger Corporation increases to $150 per share. Both Priscilla and Martha are liable for insider trading, in violation of Section 10(b) and Rule 10b-5, because they traded in the securities of Widger Corporation while they were insiders in possession of material, nonpublic inside information. Martha and Priscilla could be held civilly liable and criminally guilty of insider trading, in violation of Section 10(b) and Rule 10b-5.
In the following case, the court had to decide whether an insider was criminally liable for insider trading.
CASE 17.1 FEDERAL COURT CASE Insider Trading United States v. Bhagat
436 F.3d 1140, 2006 U.S. App. Lexis 3008 (2006) United States Court of Appeals for the Ninth Circuit
“The fact that this evidence was all circumstantial does not lessen its sufficiency to support a guilty verdict.”
—Rawlinson, Circuit Judge
Facts
Atul Bhagat worked for NVIDIA Corporation (Nvidia). Nvidia competed for and won a multimillion-dollar contract to develop a video-game console for Microsoft Corporation. On receiving the news, Nvidia’s chief executive officer (CEO) sent company-wide e-mails announcing the contract award, advised Nvidia employees that the information should be kept confidential, and imposed a trading blackout on the purchase of Nvidia stock by employees for several days. Within roughly 20 minutes after the final e-mail was sent, Bhagat purchased a large quantity of Nvidia stock. Bhagat testified that he read the e-mails roughly 40 minutes after he purchased the stock.
The United States brought criminal charges against Bhagat in U.S. district court, charging him with insider trading. Bhagat stuck with his story regarding his purchase of Nvidia stock. Based on circumstantial evidence, the jury convicted Bhagat of insider trading. Bhagat appealed.
Issue
Is Bhagat criminally guilty of insider trading?
Language of the Court
To convict Bhagat of insider trading, the government was required to prove that he traded stock on the basis of material, nonpublic information. The government offered significant evidence to support the jury’s conclusion that Bhagat was aware of the confidential information before he executed his trades. The e-mails were sent prior to his purchase. The e-mails were found on his computer. Finally, Bhagat took virtually no action to divest himself of the stock, or to inform his company that he had violated the company’s trading blackout.
Decision
The U.S. court of appeals upheld the U.S. district court’s judgment, finding Bhagat criminally guilty of insider trading. The U.S. court of appeals remanded the case to the U.S. district court for sentencing of Bhagat.
Ethics Questions
1. Do you think Bhagat committed the crimes he was convicted of? Was his description of his innocence believable?
Tipper–Tippee Liability
A person who discloses material nonpublic information to another person is called a tipper . A person who receives such information is known as a tippee . A tippee is liable for acting on material information that he or she knew or should have known was not public. The tipper is liable for the profits made by the tippee. This is called tipper–tippee liability . If the tippee tips other persons, both the tippee (who is now a tipper) and the original tipper are liable for the profits made by these remote tippees. The remote tippees are liable for their own trades if they knew or should have known that they possessed material inside information.
tipper
A person who discloses material nonpublic information to another person.
tippee
A person who receives material nonpublic information from a tipper.
Example
Nicole is the CFO of Max Steel Corporation. In her position, she receives copies of the audits of the financial statements from the company’s auditors—certified public accountants—before they are made public. Nicole receives an audit report showing that the company’s earnings have tripled this year. This is material nonpublic information. Nicole calls her brother Peter and tells him the news. Peter knows Nicole’s position at Max Steel. Peter purchases stock in Max Steel before the audit reports are made public and makes a significant profit after the audit reports are made public and the price of Max Steel stock increases. Here there is illegal tipping. Nicole the tipper and Peter the tippee could be held civilly liable and criminally guilty for tipping in violation of Section 10(b) and Rule 10b-5.
In the following case, the court addressed the issue of tipper–tippee liability.
CASE 17.2 FEDERAL COURT CASE Tipper–Tippee Liability United States v. Kluger
722 F.3d 549, 2013 U.S. App. Lexis 13880 (2013) United States Court of Appeals for the Third Circuit
“The conspiracy, so far as is known, constituted the longest such scheme in United States history.”
—Greenberg, Circuit Judge
Facts
Matthew Kluger, a lawyer, worked at several of the largest law firms in the United States and engaged primarily in mergers and acquisitions legal work for client companies of the law firms. He became the linchpin of a three-man insider trading scheme whereby he would pass nonpublic, material inside information about what client companies were planning to merge onto his friend Kenneth Robinson, the middleman, who in turn relayed the inside information to Garrett Bauer, a professional stock trader. Bauer would then execute trades based on the inside information. Over the course of 17 years the co-conspirators reaped more than $47 million in profits, which was split among them. Their activities were uncovered eventually by the Federal Bureau of Investigation (FBI), who executed a search warrant at Robinson’s home. After uncovering evidence of the insider trading scheme, Robinson agreed to cooperate with the government and, unbeknown to Kluger and Bauer, began recording their conversations. This led to the arrests of Kluger, Bauer, and Robinson. The United States brought criminal charges against the three co-conspirators in U.S. district court. Robinson pled guilty and became a witness against Kluger and Bauer. Kluger and Bauer eventually pled guilty to securities fraud. Kluger was sentenced to 12 years in jail; Bauer was sentenced to 9 years in jail; and Robinson, because he cooperated with the government, was sentenced to only 27 months in jail. Kluger’s 12-year sentence was thought to be the longest insider-trading sentence ever imposed. Kluger appealed, asserting that the court imposed too harsh a sentence on him.
Issue
Was the 12-year jail sentence imposed on defendant Kruger warranted?
Language of the Court
The conspiracy spanned 17 years and, so far as is known, constituted the longest such scheme in United States history. By punishing the conspirator who is the source of the information, we are reinforcing the deterrence message sent to would-be tippers. Unfortunately for Kluger, the district court found that his actions constituted a more thuggish, more direct example of taking other people’s stuff.
Decision
The U.S. court of appeals upheld Kluger’s jail sentence.
Ethics Questions
1. Was Kluger more at fault than Bauer or Robinson? Was it ethical for Robinson to receive a lighter jail sentence because he became a government witness?
Misappropriation Theory
As previously discussed, the courts have developed laws that address trading in securities by insiders who possess inside information. But sometimes a person who possesses inside information about a company is not an employee or a temporary insider of that company. Instead, the party may be an outsider to the company. The SEC adopted SEC Rule 10b5-1 , which prohibits outsiders from trading in the security of any issuer on the basis of material nonpublic information that is obtained by a breach of duty of trust or confidence owed to the person who is the source of the information. Thus, an outsider’s misappropriation of information in violation of his or her fiduciary duty, and trading on that information, violates Section 10(b) and Rule 10b5-1. This rule is called the misappropriation theory .
SEC Rule 10b5-1
An SEC rule that prohibits the trading in the security of any issuer on the basis of material nonpublic information obtained in a breach of duty of trust or confidence owed to the person who is the source of the information.
misappropriation theory
A rule that imposes liability under Section 10(b) and Rule 10b5-1 on an outsider who misappropriates information about a company, in violation of his or her fiduciary duty, and then trades in the securities of that company.
Example
iCorporation and eCorporation are in secret merger discussions. iCorporation hires an investment bank to counsel it during merger negotiations. An employee of the investment bank purchases stock in eCorporation. Once the merger is publicly announced, the stock of eCorporation substantially increases in value, and the employee of the investment bank sells the stock and makes a significant profit. In this example, the employee is not an insider in eCorporation, so he cannot be held liable under Section 10(b) for traditional insider trading. Under the misappropriation theory, however, the employee of the investment bank can be held liable for violating Section 10(b) because he misappropriated the secret merger information when he was a temporary insider of iCorporation in order to purchase illegally the stock of eCorporation before the merger was publicly announced.
Aiders and Abettors
Many principal actors in a securities fraud obtain the knowing assistance of other parties to complete the fraud successfully. These other parties are known as aiders and abettors . The U.S. Supreme Court has held that aiders and abettors are not civilly liable under Section 10(b)-5 and Rule 10b-5. 23 Aiders and abettors can, however, be held criminally liable.
aiders and abettors
Parties who knowingly assist principal actors in the commission of securities fraud.
The following ethics feature discusses a law that prohibits government employees from engaging in insider trading.
Ethics Stop Trading on Congressional Knowledge (STOCK) Act
Members of the U.S. Congress, officials of the executive branch of government, and judges often possess inside material information about statutes they will pass, prosecutions they will make, and decisions they will make that will affect the economy; the financial system; and the prices of stocks, bonds, commodities, and other securities. To prevent these government insiders from profiting on such information, in 2012 Congress enacted the Stop Trading on Congressional Knowledge (STOCK) Act . 24 This federal statute prohibits members and employees of Congress, the president and all employees of the executive branch, and judges and employees of the judicial branch from using any nonpublic information derived from the individual's position or gained from performance of the individual's duties for personal benefit. The act also prohibits them from receiving special access to initial public offerings.
Example
If a member of Congress learns of a bill that would benefit companies in a certain industry and their stock prices, the member is prohibited from trading in the securities of these companies based on this information.
The act requires members of Congress to disclose publicly any financial transaction of stocks, bonds, commodities futures, and other securities transactions on their website within 45 days of the transaction. The executive branch and judicial branch are also subject to disclosure rules. The act imposes civil and criminal penalties. In addition, the act denies federal pensions to members of Congress who are convicted of felonies involving public corruption.
Ethics Questions
1. Why was the STOCK Act enacted? Why was such an act not enacted before 2012?
Short-Swing Profits
Section 16(a) of the Securities Exchange Act of 1934 defines any person who is an executive officer, a director, or a 10 percent shareholder of an equity security of a reporting company as a Section 16 statutory insider who is subject to rules of Section 16. Statutory insiders must file reports with the SEC to disclose their ownership and trading in the company’s securities. 25 Reports must be filed with the SEC and made available on the company’s website within two days after the trade occurs.
Stop Trading on Congressional Knowledge (STOCK) Act
A federal statute that prohibits members and employees of Congress, employees of the executive branch, and employees of the judicial branch from using any nonpublic information derived from the individual's position or gained from performance of the individual's duties for personal benefit.
Section 16 statutory insider
A person who is an executive officer, a director, or a 10 percent shareholder of an equity security of a reporting company.
Section 16(b)
Section 16(b) of the Securities Exchange Act of 1934 requires that any profits made by a statutory insider on transactions involving short-swing profits —that is, trades involving equity securities occurring within six months of each other—belong to the corporation. 26 The corporation may bring a legal action to recover these profits. Involuntary transactions, such as forced redemption of securities by the corporation or an exchange of securities in a bankruptcy proceeding, are exempt. Section 16(b) is a strict liability provision. Generally, no defenses are recognized. Neither intent nor the possession of inside information need be shown.
Section 16(b) of the Securities Exchange Act of 1934
A section of the Securities Exchange Act of 1934 requiring that any profits made by a statutory insider on transactions involving short-swing profits belong to the corporation.
short-swing profits
Profits that are made by statutory insiders on trades involving equity securities of their corporation that occur within six months of each other.
Example
Rosanne is the president of a corporation and a statutory insider who does not possess any inside information. On February 1, she purchases 1,000 shares of her employer’s stock at $10 per share. On June 1, she sells the stock for $14 per share. The corporation can recover the $4,000 profit because the trades occurred within six months of each other.
SEC Section 16 Rules
The SEC has adopted the following rules under Section 16:
He will lie sir, with such volubility that you would think truth were a tool.
William Shakespeare
All's Well That Ends Well (1604)
· It defines officer to include only executive officers who perform policy-making functions. Officers who run day-to-day operations but are not responsible for policy decisions are not included.
Examples
Policy-making executives include the CEO, the president, vice presidents in charge of business units or divisions, the CFO, the principal accounting officer, and so on.
· It relieves insiders of liability for transactions that occur within six months before becoming an insider.
Example
If a noninsider buys shares of a company on January 15, is hired by the company and becomes an insider on March 15, and sells the shares on May 15, there is no liability.
· It states that insiders are liable for transactions that occur within six months of the last transaction engaged in while an insider.
Example
If an insider buys shares in his company on April 30 and leaves the company on May 15, he cannot sell the shares before October 30. If he does, he violates Section 16(b).
CONCEPT SUMMARY Section 10(b) and Section 16(b) Compared
|
Element |
Section 10(b) and Rule 10b-5 |
Section 16(b) |
|
Covered securities |
All securities. |
Securities required to be registered with the SEC under the 1934 act. |
|
Inside information |
Defendant made a misrepresentation or traded on inside (or perhaps misappropriated) information. |
Short-swing profits recoverable whether or not they are attributable to misappropriation or inside information. |
|
Recovery |
Belongs to the injured purchaser or seller. |
Belongs to the corporation. |
State “Blue-Sky” Laws
Most states have enacted securities laws. State securities laws generally require the registration of certain securities, provide exemptions from registration, and contain broad antifraud provisions. State securities laws are usually applied when smaller companies are issuing securities within that state. The Uniform Securities Act has been adopted by many states. This act coordinates state securities laws with federal securities laws.
state securities laws (“blue-sky” laws)
State laws that regulate the issuance and trading of securities.
State securities laws are often referred to as “blue-sky” laws because they help prevent investors from purchasing a piece of the blue sky. The state that has most actively enforced its securities laws is New York. The office of the New York state attorney has brought many high-profile criminal fraud cases in recent years.
WEB EXERCISE
Visit the website of the Office of the New York State Attorney, at www.ag.ny.gov . Click on “Investor Protection” and read the description of what the New York Investor Protection Bureau does.
Law Case with Answer
Securities and Exchange Commission v. Texas Gulf Sulphur Company
1. Facts Texas Gulf Sulphur Co. (TGS), a mining company, drilled an exploratory hole—Kidd 55—near Timmins, Ontario. Assay reports showed that the core from this drilling proved to be remarkably high in copper, zinc, and silver. TGS kept the discovery secret, camouflaged the drill site, and diverted drilling efforts to another site to allow TGS to acquire land around Kidd 55. TGS stock traded at $18 per share.
Eventually, rumors of a rich mineral strike began circulating. On Saturday, the New York Times published an unauthorized report of TGS drilling efforts in Canada and its rich mineral strike. On Sunday, officers of TGS drafted a press release that was issued that afternoon. The press release appeared in morning newspapers of general circulation on Monday. It read, in pertinent part, “The work done to date has not been sufficient to reach definite conclusions and any statement as to size and grade of ore would be premature and possibly misleading.”
The rumors persisted. Three days later, at 10:00 a.m., TGS held a press conference for the financial media. At the time of the press conference, TGS stock was trading at $37 per share. At this press conference, which lasted about 10 minutes, TGS disclosed the richness of the Timmins mineral strike and that the strike should run to at least 25 million tons in ore.
The following two company executives who had knowledge of the mineral strike at Timmins traded in the stock of TGS:
· Crawford. Crawford telephoned orders to his Chicago broker about midnight on the day before the announcement and again at 8:30 in the morning of the day of the announcement, with instructions to buy at the opening of the stock exchange that morning. Crawford purchased the stock he ordered.
· Coates. Coates telephoned orders to his stock broker son-in-law to purchase the company’s stock shortly before 10:20 a.m. on the day of the announcement, which was just after the announcement had been made. Coates purchased the stock he had ordered.
After the public announcement, TGS stock was selling at $58. The SEC brought an action against Crawford and Coates for insider trading, in violation of Section 10(b) of the Securities Exchange Act of 1934. Are the defendant executives liable for engaging in insider trading?
Answer
Yes, the defendant executives are liable for engaging in insider trading, in violation of Section 10(b) of the Securities Exchange Act of 1934. The insiders in this case were not trading on an equal footing with the outside investors. They alone were in a position to evaluate the probability and magnitude of what seemed from the outset to be a major ore strike.
Crawford telephoned his orders to his Chicago broker about midnight on the day before the announcement and again at 8:30 in the morning of the day of the announcement, with instructions to buy at the opening of the stock exchange that morning. Crawford sought to, and did, “beat the news.” Before insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to ensure its availability to the investing public. In this case, where a formal announcement to the entire financial news media had been promised in a prior official release known to the media, all insider activity must await dissemination of the promised official announcement. Crawford, an insider, traded while in the possession of material nonpublic information and is therefore liable for violating Section 10(b).
Coates’s telephone order was placed shortly before 10:20 a.m. on the day of the announcement, which occurred a few minutes after the public announcement. When Coates purchased the stock, the news could not be considered already a matter of public information. Insiders should keep out of the market until the established procedures for public release of the information are carried out instead of hastening to execute transactions in advance of, and in frustration of, the objectives of the release. Assuming that the contents of the official release could be acted upon, instantaneously, at a minimum, Coates should have waited until the news could reasonably have been expected to appear over the media of widest circulation rather than hastening to ensure an advantage to himself and his broker son-in-law.
Both Crawford and Coates, insider executives of TGS, engaged in illegal insider trading, in violation of Section 10(b) of the Securities Exchange Act of 1934. Securities and Exchange Commission v. Texas Gulf Sulphur Company, 401 F.2d 833, 1968 U.S. App. Lexis 5797 (United States Court of Appeals for the Second Circuit)
Critical Legal Thinking Cases
1. 17.1 Definition of Security The Farmer’s Cooperative of Arkansas and Oklahoma (Co-Op) was an agricultural cooperative that had approximately 23,000 members. To raise money to support its general business operations, Co-Op sold promissory notes to investors that were payable upon demand. Co-Op offered the notes to both members and nonmembers, advertised the notes as an “investment program,” and offered an interest rate higher than that available on savings accounts at financial institutions. More than 1,600 people purchased the notes, worth a total of $10 million. Subsequently, Co-Op filed for bankruptcy. A class of holders of the notes filed suit against Ernst & Young, a national firm of certified public accountants that had audited Co-Op’s financial statements, alleging that Ernst & Young had violated Section 10(b) of the Securities Exchange Act of 1934.
Are the notes issued by Co-Op securities? Reeves v. Ernst & Young, 494 U.S. 56, 110 S.Ct. 945, 1990 U.S. Lexis 1051 (Supreme Court of the United States)
2. 17.2 Definition of Security Dare To Be Great, Inc. (Dare), was a Florida corporation that was wholly owned by Glenn W. Turner Enterprises, Inc. Dare offered self-improvement courses aimed at improving self-motivation and sales ability. In return for an investment of money, the purchaser received certain recordings, records, and written materials. In addition, depending on the level of involvement, the purchaser had the opportunity to help sell the Dare courses to others and to receive part of the purchase price as a commission. There were four different levels of involvement.
The task of salespersons was to bring prospective purchasers to “Adventure Meetings.” The meetings, which were conducted by Dare people and not the salespersons, were conducted in a preordained format that included great enthusiasm; cheering and charming, exuberant handshaking; standing on chairs; and shouting. The Dare people and the salespersons dressed in modern, expensive clothes, displayed large sums of cash, drove new expensive automobiles, and engaged in hard-sell tactics to induce prospects to sign their name and part with their money. In actuality, few Dare purchasers ever attained the wealth promised. The recordings and materials distributed by Dare were worthless.
Is this sales scheme a “security” that should have been registered with the SEC? Securities and Exchange Commission v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, 1973 U.S. App. Lexis 11903 (United States Court of Appeals for the Ninth Circuit)
3. 17.3 Intrastate Offering Exemption The McDonald Investment Company was a corporation organized and incorporated in the state of Minnesota. The principal and only place of business from which the company conducted operations was Rush City, Minnesota. More than 80 percent of the company’s assets were located in Minnesota, and more than 80 percent of its income was derived from Minnesota. McDonald sold securities to Minnesota residents only. The proceeds from the sale were used entirely to make loans and other investments in real estate and other assets located outside the state of Minnesota. The company did not file a registration statement with the SEC.
Does this offering qualify for an intrastate offering exemption from registration? Securities and Exchange Commission v. McDonald Investment Company, 343 F.Supp. 343, 1972 U.S. Dist. Lexis 13547 (United States District Court for the District of Minnesota)
4. 17.4 Transaction Exemption Continental Enterprises, Inc. (Continental), had 2,510,000 shares of stock issued and outstanding. Louis E. Wolfson and members of his immediate family and associates owned in excess of 40 percent of those shares. The balance was in the hands of approximately 5,000 outside shareholders. Wolfson was Continental’s largest shareholder and the guiding spirit of the corporation, who gave direction to and controlled the company’s officers. During the course of five months, without public disclosure, Wolfson and his family and associates sold 55 percent of their stock through six brokerage houses. Wolfson and his family and associates did not file a registration statement with the SEC with respect to these sales.
Do the securities sales by Wolfson and his family and associates qualify for an exemption for registration as a sale “not by an issuer, an underwriter, or a dealer”? United States v. Wolfson, 405 F.2d 779, 1968 U.S. App. Lexis 4342 (United States Court of Appeals for the Second Circuit)
5. 17.5 Section 10(b) Leslie Neadeau was the president of T.O.N.M. Oil & Gas Exploration Corporation (TONM). Charles Lazzaro was a registered securities broker employed by Bateman Eichler, Hill Richards, Inc. (Bateman Eichler). The stock of TONM was traded in the over-the-counter market. Lazzaro made statements to potential investors that he had “inside information” about TONM, including that (1) vast amounts of gold had been discovered in Surinam and that TONM had options on thousands of acres in the gold-producing regions of Surinam; (2) the discovery was “not publicly known, but would be subsequently announced;” and (3) when this information was made public, TONM stock, which was then selling for $1.50 to $3.00 per share, would increase to $10.00 to $15.00 within a short period of time and might increase to $100.00 per share within a year.
Potential investors contacted Neadeau at TONM, and he confirmed that the information was not public knowledge. Relying on Lazzaro’s and Neadeau’s statements, the investors purchased TONM stock. The “inside information” turned out to be false, and the shares declined substantially below the purchase price. The investors sued Lazzaro, Bateman Eichler, Neadeau, and TONM, alleging violations of Section 10(b) of the Securities Exchange Act of 1934. The defendants asserted that the plaintiffs’ complaint should be dismissed because they participated in the fraud. Who wins? Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S.Ct. 2622, 1985 U.S. Lexis 95 (Supreme Court of the United States)
Ethics Case
1. 17.6 Ethics Case James O’Hagan was a partner in the law firm Dorsey & Whitney in Minneapolis, Minnesota. Grand Metropolitan PLC (Grand Met), a company based in London, England, hired Dorsey & Whitney to represent it in a secret tender offer for the stock of the Pillsbury Company, headquartered in Minneapolis. While this transaction was still secret, O’Hagan began purchasing call options for Pillsbury stock. Each call option gave O’Hagan the right to purchase 100 shares of Pillsbury stock at a specified price.
O’Hagan continued to purchase call options for two months, and he became the largest holder of call options for Pillsbury stock. O’Hagan also purchased 5,000 shares of Pillsbury common stock at $39 per share. These purchases were all made while Grand Met’s proposed tender offer for Pillsbury remained secret to the public. When Grand Met publicly announced its tender offer one month later, Pillsbury stock increased to nearly $60 per share. O’Hagan sold his Pillsbury call options and common stock, making a profit of more than $4.3 million.
The U.S. Department of Justice charged O’Hagan with criminally violating Section 10(b) and Rule 10b-5. This was not a case of classic insider trading because O’Hagan did not trade in the stock of his law firm’s client, Grand Met, but the government alleged that O’Hagan was liable under the misappropriation theory for trading in Pillsbury stock by engaging in deceptive conduct by misappropriating the secret information about Grand Met’s tender offer from his employer, Dorsey & Whitney, and from its client, Grand Met. United States v. O’Hagen, 521 U.S. 642, 117 S.Ct. 2199, 1997 U.S. Lexis 4033 (Supreme Court of the United States)
1. Describe the misappropriation theory.
2. Did O’Hagen act ethically in this case?
3. Did O’Hagen act illegally in this case?
