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Chapter Twenty Three Rules Governing the Issuance and Trading of Securities

In  Chapter 17 , we said that the corporation was the dominant form of business organization in the United States—and the most regulated. Two of the most strongly regulated aspects of corporate business are the issuance and trading of securities. Corporate securities—stocks and bonds—are used to raise capital for the corporation. They are also used by individuals and institutional investors to accumulate wealth. In the case of individuals, this wealth is often passed on to heirs, who use it to accumulate more wealth. Thus, securities provide a means for one generation in a family to “do better” than the preceding generation. Securities also provide a means for financing pension funds and insurance plans through institutional investment.

Securities holders are powerful determinants of trends in business: If an individual company, industry, or segment of the economy is not growing and paying a good rate of return, investors will switch their funds to another company, industry, or segment in expectation of better returns. Securities holders (or their proxies) elect the board of directors of a corporation, who, in turn, select the officers who manage the daily operations of a corporation. Finally, securities holders’ ability to bring lawsuits helps keep officers and directors honest in their use of investors’ funds.

Because of their importance to the operation of our free enterprise society and because of the ease with which they can be manipulated, securities have been regulated by governments for nearly a century. This chapter chiefly examines the role of the federal government in regulating securities. We introduce the subject with a brief history of securities regulation that contains a summary of the most important federal legislation. We then turn to the creation, function, and structure of the Securities and Exchange Commission (SEC). In a survey of major and representative securities legislation, we examine the provisions of the Dodd-Frank Act of 2010 and the Sarbanes-Oxley Act of 2002. Both the Securities Act of 1933, which governs the issuance of securities and outlines the registration requirements for both securities and transactions (and the allowable exemptions from those requirements), and the Securities Exchange Act of 1934, which governs trading in securities, are discussed. We then examine the state securities laws and online securities disclosure and fraud regulations. We end with a discussion of the global dimensions of the 1933 and 1934 securities acts; the Foreign Corrupt Practices Act, as amended in 1988; and the Convention on Combating Bribery of Foreign Public Officials in International Business Transactions.

Critical Thinking About The Law

Because issuers can manipulate securities easily, federal and state governments have strongly regulated the issuance and trading of securities. Studying the following case example and answering some critical thinking questions about it will help you better appreciate the need for regulation of securities.

Jessica received a phone call from a man claiming to represent Buy-It-Here, a corporation that was relocating to Jessica’s town. The man stated that the corporation was planning to issue new securities, and he was extending this offer to residents in Jessica’s town. He claimed that Buy-It-Here would easily double its profits within six months. The man said that if Jessica sent $3,000, he would buy stock in Buy-It-Here for Jessica. Jessica sent the money; two weeks later, she discovered that Buy-It-Here was in the process of filing for bankruptcy.

1. This case is an example of the need for government regulation. We want the government to protect citizens from cases such as Jessica’s buying stock in a bankrupt company. If we want governmental protection from potentially shady businesses, what ethical norm are we emphasizing?

Clue:  Put yourself in Jessica’s place. Why would you want governmental protection? Now match your answer to an ethical norm listed in  Chapter 1 . Think about which ethical norm businesses would emphasize.

2. Jessica wants to sue Buy-It-Here for misrepresentation. Before she brings her case, what additional information do you think Jessica should discover?

Clue:  What additional information do you want to know about the case? Even without having extensive knowledge about securities, you can identify areas in which you might need more information about Jessica’s case. For example, pay close attention to the role of the telephone caller.

3. Jessica did some research about securities cases in her state. She discovered a case in which a woman named Andrea Stevenson had purchased $100,000 worth of stock from a stockbroker. The company went bankrupt three months later. The stockbroker had known that the company was suffering financial problems but had said nothing to Andrea. The jury in this case found in favor of Andrea. Jessica wants to use Andrea’s case as an analogy in her lawsuit. Do you think that Andrea’s case is an appropriate analogy? Why or why not?

Clue:  What are the similarities between the cases? How are the cases different? Are these differences so significant that they overwhelm the similarities?

Introduction to the Regulation of Securities

Securities have no value in and of themselves. They are not like most goods produced or consumed (e.g., television sets or toys), which are easily regulated in terms of their hazards or merchantability. Because they are paper, they can be produced in unlimited numbers and can be manipulated easily by their issuers.

The first attempt to regulate securities in the United States was made by the state of Kansas in 1912. When other states followed the Kansas legislature’s example, corporations played off one state against another by limiting their securities sales to states that had less stringent regulations. Despite the corporations’ ability to thwart state efforts at regulation rather easily, there was strong resistance to the idea of federal regulation in Congress. It was not until after the collapse of the stock market in 1929 and the free fall of stock prices on the New York Stock Exchange (NYSE)—when the Dow Jones Industrial Average registered an 89 percent decline between 1929 and 1933—that Congress finally acted.

Summary of Federal Securities Legislation

The following legislation, enacted by Congress since 1933, provides the framework for the federal regulation of securities. It is also important to note that this legislation is the basis (enabling act) for rulemaking by the SEC. Congressional legislation is emphasized here, but it is important to remember that SEC rulemaking may be equally significant in the long term. (You will remember that we discussed rulemaking for federal agencies in  Chapter 18 .)

· The Securities Act of 1933 (also known as the Securities Act or the 1933 Act) regulates the initial offering of securities by public corporations by prohibiting an offer or a sale of securities not registered with the Securities and Exchange Commission. The 1933 Act sets forth certain exemptions from the registration process, as well as penalties for violations of the act. This act is examined in detail in this chapter. Both the 1933 and 1934 Acts have been amended by Congress and the SEC rulemaking process, much of which is summarized in the following pages.

· The Securities Exchange Act of 1934 (also known as the Exchange Act) regulates the trading in securities once they are issued. It requires brokers and dealers who trade in securities to register with the Securities and Exchange Commission, the regulatory body created to enforce both the 1933 and 1934 Acts. The Exchange Act is also examined in detail in this chapter.

· The Public Utility Holding Company Act of 1935 requires public utility and holding companies to register with the SEC and to disclose their financial organization, structure, and operating process.

· The Trust Indenture Act of 1939 regulates the public issuance of bonds and other debt securities in excess of $5 million. This act imposes standards for trustees to follow to ensure that bondholders are protected.

· The Investment Company Act (ICA) of 1940, as amended in 1970 and 1975, gives the SEC authority to regulate the structure and operation of public investment companies that invest in and trade in securities. No private causes of action are created by this law. A company is an investment company under this act if it invests or trades in securities and if more than 40 percent of its assets are “investment securities” (which are all corporate securities and securities invested in subsidiaries). Accompanying legislation, entitled the Investment Advisers Act of 1940, authorizes the SEC to regulate persons and firms that give investment advice to clients. This act requires the registration of all such individuals or firms and contains antifraud provisions that seek to protect broker-dealers’ clients.

· The Securities Investor Protection Act (SIPA) of 1970 established the nonprofit Securities Investor Protection Corporation (SIPC) and gave it authority to supervise the liquidation of brokerage firms that are in financial trouble, as well as to protect investors from losses up to $500,000 due to the financial failure of a brokerage firm. The SIPC does not have the monitoring and “bailout” functions that the Federal Deposit Insurance Corporation (FDIC) has in banking; it only supervises the liquidation of an already financially troubled brokerage firm through an appointed trustee.

· Chapter 11  of the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 gives the SEC the authority to render advice when certain debtor corporations have filed for reorganization.

· The Foreign Corrupt Practices Act (FCPA) of 1977, as amended in 1988, prohibits the direct or indirect giving of “anything of value” to a foreign official for the purpose of influencing that official’s actions. The FCPA sets out an intent or “knowing” standard of liability for corporate management. It requires all companies (whether doing business abroad or not) to set up a system of internal controls to provide reasonable assurance that the company’s records “accurately and fairly reflect” its transactions. The FCPA is discussed in detail in the last section of this chapter.

· The International Securities Enforcement Cooperation Act (ISECA) of 1990 clarifies the SEC’s authority to provide securities regulators of other governments with documents and information and exempts from Freedom of Information Act disclosure requirements all documents given to the SEC by foreign regulators. The ISECA also authorizes the SEC to impose administrative sanctions on securities buyers and dealers who have engaged in illegal activities in foreign countries. Finally, it authorizes the SEC to investigate violations of the securities law set out in the act that occur in foreign countries. The ISECA is also discussed in the last section of this chapter.

· The Market Reform Act of 1990 authorizes the SEC to regulate trading practices during periods of extreme volatility. For example, the SEC can take such emergency action as suspending trading when computer program–driven trading forces the Dow Jones Industrial Average to rise or fall sharply within a short time period.

· The Securities Enforcement Remedies and Penny Stock Reform Act of 1990 (the 1990 Remedies Act) gives the SEC powerful new means for policing the securities industry: cease-and-desist powers and the power to impose substantial monetary penalties (up to $650,000) in administrative proceedings. The 1990 Remedies Act also gives the SEC and the federal courts the following powers over anyone who violates federal securities law:

1. The imposition of monetary penalties by a federal court for a violation of the securities law on petition by the SEC.

2. The power of the federal courts to bar anyone who has violated the fraud provisions of the federal securities laws from ever serving as an officer or a director of a publicly held firm.

3. The power of the SEC to issue permanent cease-and-desist orders against “any person who is violating, has violated, or is about to violate” any provision of a federal securities law.

This act arms the SEC with some of the most sweeping enforcement powers ever given to a single administrative agency other than criminal enforcement agencies such as the Justice Department.

· The Private Securities Litigation Reform Act of 1995 (Reform Act) provides a safe harbor from liability for companies that make statements to the public and investors about risk factors that may occur in the future.

· The Securities Litigation Uniform Standards Act of 1998 sets national standards for securities class action lawsuits involving nationally traded securities. This act amends the 1933 and 1934 Acts and prohibits any private class action suits in state or federal court alleging (1) any untrue statement or omission in connection with the purchase or sale of a covered security or (2) the defendant’s use of any manipulation or deceptive device in connection with the transaction.

· The Sarbanes-Oxley Act of 2002 amends the 1933 and 1934 Acts. Sarbanes- Oxley includes provisions dealing with corporate governance, financial regulation, criminal penalties, and corporate responsibility, all of which are discussed in detail in this chapter. The Credit Rating Agency Reform Act of 2006 creates a new regulatory system by which the SEC identifies and oversees five nationally recognized agencies that issue credit ratings.

· The Dodd-Frank Act of 2010, a wide-ranging reform of regulatory actions that seeks to prevent the recurrence of a major financial catastrophe such as the one that occurred in 2008.

For your convenience, some of the federal securities legislation is summarized in  Table 23-1 .

Table 23-1 Summary of the Major Federal Securities Legislation

Federal Securities Legislation	Purpose
Securities Act of 1933	Regulates generally the issuance of securities.
Securities Exchange Act of 1934	SEC regulates trading in securities.
Public Utility Holding Company Act of 1935	SEC regulates public utility and holding companies through registration and disclosure processes.
Trust Indenture Act of 1939	SEC regulates the public issuance of bonds and other debt securities.
Investment Company Act of 1940	SEC regulates the structure and operation of public investment companies.
Securities Investor Protection Act of 1970	Securities Investor Protection Corporation supervises the liquidation of financially troubled brokerage firms.
Foreign Corrupt Practices Act of 1977, as amended in 1988	Prohibits the payment of anything of value to influence foreign officials’ actions.
International Securities Enforcement Corporation Act of 1990	SEC has authority to provide securities regulators of other governments with information on alleged violators of securities law in the United States and abroad.
Market Reform Act of 1990	SEC regulates the trading practices during periods of extreme volatility.
Securities Enforcement Remedies and Penny Reform Act of 1990	Requires more stringent regulation of broker-dealers who recommend penny-stock transactions to customers.
Securities Enforcement Remedies and Penny Reform Act of 1991	SEC regulates the securities industry through cease-and-desist powers and threat of substantial monetary penalties.
Private Securities Litigation Reform Act of 1995	SEC provides a safe harbor from liability for companies that make statements to the public or investors about risk factors that may occur in the future.
Securities Litigation Uniform Standards Act of 1998	Sets national standards for securities class action lawsuits involving nationally traded securities. Amends the 1933 and 1934 Acts and prohibits any private class action suit in state or federal court alleging (1) any untrue statement or omission in connection with the purchase or sale of a covered security or (2) that the defendant used manipulation or a deceptive device in connection with the transaction.
Sarbanes-Oxley Act of 2002	Amends the 1933 and 1934 Acts and other federal statutes. Includes provisions dealing with corporate governance, financial regulation, criminal penalties, and corporate responsibility.
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005	SEC has authority to advise debtor corporations that have filed for reorganization.
Credit Rating Agency Reform Act of 2006
Dodd-Frank Act of 2010	Creates a registration process through the SEC for rating agencies wishing to become nationally recognized. Congress sought to meet the need to increase the number of agencies from the five established by Section 15E of the 1934 Act.
	Seeks to amend several statutes and the regulatory process involving the SEC and other federal agencies of the federal government. Statute was passed following a major economic downturn (recession) in 2008.

The Securities and Exchange Commission

Creation and Function

The  Securities and Exchange Commission (SEC)  was created under the Securities Exchange Act of 1934 for the purpose of ensuring that investors receive “full and fair” disclosure of all material facts with regard to any public offering of securities. The SEC is not charged with evaluating the worth of a public offering of securities by a corporation (e.g., determining whether the offering is speculative); it is concerned only with whether potential investors are provided with adequate information to make investment decisions. To this end, the commission was given the power to set up and enforce proper registration regulations for securities, as well as to prevent fraud in the registration and trading of securities.

Securities and Exchange Commission (SEC)

The federal administrative agency charged with overall responsibility for the regulation of securities, including ensuring that investors receive “full and fair” disclosure of all material facts with regard to any public offering of securities. It has wide enforcement powers to protect investors against price manipulation, insider trading, and other dishonest dealings.

Structure

Exhibit 23-1  lays out the structure of the SEC. It has five commissioners (inclusive of the chairman), who are appointed by the president with the advice and consent of the Senate; each serves for a period of five years, and no more than three commissioners can be of the same political party. The SEC, based in Washington, DC, has 11 regional offices across the United States. There are five divisions: Corporation Finance, Market Regulation, Enforcement, Corporate Regulation, and Investment Management. (Note in Exhibit 23-1 that in addition to the 5 major divisions, there are several other important offices.)

Division of Corporation Finance

The Division of Corporation Finance is responsible for establishing and overseeing adherence to standards of financial reporting and disclosure for all companies that fall under SEC jurisdiction, as well as for setting and administering the disclosure requirements prescribed by the 1933 and the 1934 Securities Acts, the Public Utility Holding Company Act, and the Investment Company Act. This division reviews all registration statements, prospectuses, and quarterly and annual reports of corporations, as well as their proxy statements. Its importance in offering informal advisory opinions to issuers (corporations about to make a public offering of stock) cannot be overemphasized. Accountants, lawyers, financial officers, and underwriters all rely heavily on advice from this division.

Division of Trading and Markets

This SEC division regulates the national security exchanges (such as the NYSE), as well as broker-dealers registered under the Investment Advisers Act of 1940. Through ongoing surveillance of both the exchanges and broker-dealers, the Division of Market Regulation seeks to discourage manipulation or fraud in the issuance, sale, or purchase of securities. It can recommend to the full commission the suspension of an exchange for up to one year, as well as the suspension or permanent prohibition of a broker or dealer because of certain types of conduct. In addition, the division provides valuable informal advice to investors, issuers, and others on securities statutes that come within the SEC’s jurisdiction.

Division of Enforcement

The Division of Enforcement is responsible for the review and supervision of all enforcement activities

recommended by the SEC’s other divisions and regional offices. It also supervises investigations and the initiation of injunctive actions.

Division of Economic and Risk Analysis

This division integrates financial economics and rigorous data analytics into the core mission of the SEC. It is involved across the entire range of SEC activities, including policy-making, rule-making, enforcement, and examination.

Division of Investment Management

This SEC division administers the ICA of 1940 and the Investment Advisers Act of 1940. All investigations arising under these acts dealing with issuers and dealers are carried out by this Division of Investment Management.

Exhibit 23-1 The Securities and Exchange Commission

St. Patrick’s Day Bailout of an Investment Banking Firm (Bear Stearns, Inc.) by the U.S. Taxpayers

Bear Stearns, Inc. (Bear), an 85-year-old investment banking firm, was headed for insolvency on the weekend of March 15 and 16, 2008, and planned for a bankruptcy filing to take place on Monday, March 17 (St. Patrick’s Day). Fear of a collapse of the financial system led federal regulators—inclusive of (1) the independent Federal Reserve Board (Federal Reserve), (2) the Secretary of the Treasury and his many offices within the Treasury Department, (3) the Office of the Comptroller, (4) the SEC, and (5) independent advisers from the private sector (e.g., Black Rock, Inc.)—to urge Bear’s board of directors to sell the firm to JPMorgan Chase & Company (J.P. Morgan), at a price of $2 a share, or $236 million, in a stock-swap transaction for 39.9 percent of Bear. (On the previous Friday, March 14, the stock value closed on the New York Stock Exchange at $30 a share, that is, at a market value of $3.54 billion.) In addition, the Federal Reserve agreed to fund up to $30 billion of Bear’s nonliquid assets. Regardless of whether the transaction went through, J.P. Morgan would have the opportunity to purchase the headquarters of Bear.

This transaction took place in the midst of a nationwide credit crunch caused in part by cash outflows from subprime and prime mortgage holders, as well as margin calls on derivative contracts held by Bear and other investment banking firms. The market value of Bear’s stock dropped to $11 per share in the days following the announcement on March 17.

Response to this “bailout” or “savior” of the economy (U.S. or world) was diverse, depending on the responder:

· Investors (individual and some institutional). Investors saw this transaction as a “steal” by J.P. Morgan, and many believed that the market itself would have solved the problem. Many threatened litigation to stop the bailout. They pointed out that unlike other bailouts (e.g., Chrysler), the taxpayers were not assured any return on their investment. Further, there was no transparency as to the terms of the secured interest (collateral) for the $30 billion the Federal Reserve was offering to guarantee Bear’s nonliquid assets.

· Employees of Bear. Approximately 14,000 employees saw their jobs disappear, along with their life savings. Many had 401(k) funds as well as private pension funds invested in Bear stock, which was now worth little. After years of loyalty, they believed that the board and senior management of Bear had “sold them out” from a moral perspective.

· Government officials. The chairman of the Federal Reserve and the chairman of the SEC testified before committees of Congress that they had varying degrees of advance notice (48 to 72 hours) of the seriousness of Bear Stearns’ problems. Their response (as set out earlier) was thus dictated by this short period. The failure to find a buyer for Bear Stearns could have led to a run on investment as well as commercial banks worldwide. The chairman of the Federal Reserve emphasized that this was not a “bailout” but rather an action required to save the banking system, which the Federal Reserve is directed to do by its enabling legislation.

· Political actors. This transaction took place in the midst of a national primary campaign by the Democratic Party, which had two candidates (Hillary Clinton and Barack Obama), and a noncontested campaign by the Republican Party (John McCain). Both parties showed their concern in the House and Senate.

· Private platforms and “dark pools.” Trading with increased regulation has led to the establishment of bourses (such as the New York Stock Exchange) or private platforms where trading is hidden from public view. Regulators are thus worried that this development could obscure the true price of a stock. (See J. Creswell and P. Latman, New York Times, Sept. 30, 2010, F-6.)

Critical Thinking About The Law

1. What values were in conflict for the parties to the St. Patrick’s Day bailout described previously?

Clue:  The parties included, among others, the Federal Reserve, the U.S. Secretary of the Treasury and the Treasury Department, the SEC, and the president of the United States, as well as employees of Bear Stearns.  Chapter 1  discusses the values involved in answering this question.

2. Should federal and state “bailouts” of private-sector firms such as Bear Stearns take place as a matter of general principle? Why or why not?

Clue:  What values are in conflict for federal and state governments? What about taxpayers—or are they represented? Politicians? Lobbyists?

Electronic Media, the Age of the Internet, and SEC Internal Functions

Through internal rulings, the SEC has recognized that the use of “electronic media . . . enhances the efficiency of the securities market by allowing for the rapid dissemination of information to investors and financial markets in a more cost-efficient, widespread and equitable manner than traditional paper methods.” The SEC has provided interpretive guidance for the use of electronic media for the delivery of information required by the federal securities law. The SEC has defined electronic media to include audiotapes, videotapes, CD-ROM, email, bulletin boards, Internet websites, and computer networks. Further, securities regulators have authorized the use of social media sites such as Twitter and Facebook for communications by companies to investors and shareholders (April 2, 2013, New York Times, B-1).

The SEC has established the EDGAR (electronic data gathering, analysis, and retrieval) computer system, which performs automated collection, validation, indexing, acceptance, and dissemination of reports required to be filed with the SEC. The SEC requires all domestic companies to make their filings on EDGAR, except those exempted for hardship. EDGAR filings are posted at the SEC website 24 hours after the date of filing.

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

In July 2010, Congress passed a bill that wrought a massive overhaul of federal government financial regulations and seemed to affect every sector of the economy. This piece of legislation became known as the Dodd-Frank bill (statute) 1  so named after its major sponsors: Senator Dodd (D-Conn.), who was chairman of the Senate Banking Committee, and Congressman Frank (D-Mass.), who was chairman of the House Financial Affairs Committee. This bill passed Congress in the midst of a recession and after a collapse of the financial markets in 2008. It sought to respond to the major causes of the financial crises. Actions taken by Congress, outlined in the following subsection, sought to prevent problems similar to those faced by the nation in the period between 2008 and 2010. Nonetheless, a 2011 survey of 94 fund advisers concluded that three-quarters of those surveyed indicated that Dodd-Frank regulations did not change their way of doing business. (See Walt King, Professor, St. Thomas University, Minneapolis, reprinted in parts, Bloomberg Newsweek, October 22, 2013.) As of June 2014, four years after passage of the Act, 208 of 398 proposed rules missed their deadlines. Industry groups continued to lobby to defeat the Act while seeking to tailor the proposed rules to their interests. Some rules are being challenged in court. 2

1  Pub. L. No. 111–203 (2010).

2  Dodd-Frank Progress Report, June 2014, Davis Polk at 2.

Oversight of Financial Problems By Regulatory Agencies

· A new Financial Stability Oversight Council (Council) was established by the Dodd-Frank Act. The council is made up of heads of major regulatory agencies (e.g., Treasury, SEC, FDIC, the Federal Reserve). The council will identify banks or nonbanks that pose a threat to the financial system. The Fed, with the approval of the council, will have the power to break up large firms. It could also require such firms to increase their reserves against future losses.

· The Fed was to be subject to oversight by the Government Accountability Office for a short period during 2008, particularly as to its loans via the discount window.

· Hedge funds larger than $100 million must register with the SEC and provide some information as to trades and their individual portfolios.

· The Office of Thrift Supervision will be absorbed into the Office of the Comptroller of the Currency.

Risk Taking By Large Banks and Nonbanks

Bank holding companies (e.g., Citigroup and Bear Stearns) participated in speculative trades involving mortgage-backed securities and other financial instruments (e.g., derivatives). When these speculative bets went under, the institutions involved could not sell the assets involved, which thus became known as “toxic” assets. The federal government had to spend billions in taxpayer money to bail out these companies. They are presently repaying these loans (at least in part), plus interest and/or preferred shares, to the federal government.

The Dodd-Frank legislation was also intended to prevent FDIC-insured institutions from making speculative trades and to require these entities to sell their interests in hedge funds and private equity funds; only 3 percent of their capital could remain invested in such funds. Investment banks also had to set aside reserves to cover losses. Originators of mortgage securities must hold 5 percent of the credit risk, thus retaining an interest in the performance of the securities. For reasons other than speculation, banks will be allowed to trade in a “proprietary” manner. Banks can also continue to buy or sell from their own accounts to hedge against other investments.

Executive Compensation

Compensation to executives of the largest financial firms was based on quarterly earnings. Earnings increased as these firms sold mortgage-backed securities and derivatives—until the housing “bubble burst.” When subprime mortgages began to fail, the federal government had to bail out the large financial institutions that had speculated heavily in these instruments and derivatives based on them. Anger over the enormous compensation paid to executives of these institutions became a major public issue, as taxpayers saw their “bailout” tax dollars apparently being used to reward executives for serious mismanagement and poor performance.

The Dodd-Frank Act did some things to deal with executive compensation:

· Shareholders were allowed a nonbinding vote on executive compensation, as directed by the SEC.

· Only independent directors of a company could sit on compensation committees of the board.

· Companies would be required to take back compensation if it was based on accounting statements that were later found to be inaccurate.

Too Big To Fail

Nonbank financial companies such as insurance giant AIG could not be legally shut down during the 2008 crisis. The government bailed them out, believing that their bankruptcy would bring about the collapse of the financial system both in the United States and markets worldwide.

The new statute gave the FDIC authority to shut down banks and nonbank financial firms. Taxpayers initially would foot the bill for liquidation, but the money was eventually to be returned to the federal coffers from shareholders and unsecured creditors. Further, the statute ordered an increase in the reserve ratio of the FDIC, but specified that small depository institutions (those with less than $10 billion in consolidated assets) were exempt from making such increases.

A fund of $11 billion was initially established within the Troubled Asset Relief Program (TARP) to cover the costs of shutting down companies. In theory, the government could then shut down huge companies without the taxpayers having to bail them out.

Credit Rating Agencies

Credit rating agencies (such as Moody’s and Standard & Poor’s) evaluated and rated billions in mortgage securities; both the private sector and governments at all levels relied on these ratings. These agencies were paid by the same companies that were issuing and trading in mortgage securities and other forms of debt (and thus had a vital interest in positive ratings). When the housing market crashed, many of the rating agencies sought to downgrade the ratings they had given mortgage securities and other assets.

· Despite what appeared to be a conflict of interest, Congress could not agree on a format to replace the ratings agencies. The Dodd-Frank legislation was intended to make it easier to sue credit rating agencies. In addition, this statute eliminated any federal requirement that banks and other investors rely on ratings set out by these agencies.

· The legislation orders the SEC to study ways to eliminate ratings shopping by issuers.

· It allows the SEC to deregister ratings agencies that have a bad record of violating financial regulations.

· All ratings agencies now have to disclose how they arrive at ratings and how they comply with conflict-of-interest regulations.

Derivatives

Derivatives are synthetic securities that are dependent upon the movement of underlying variables (e.g., interest rates, commodity prices, and security indexes). They are used largely as hedges against risk; often, they are a form of insurance. Many times derivatives are negotiated privately between companies. For example, company X agrees to make a number of payments to company Y, which, in turn, will pay up if a bond issuer Z defaults. When the terms of derivatives are negotiated privately, they are more difficult for regulators to track and assess for risk. They represent a market of approximately $600 trillion worldwide. Derivatives played a huge role in the fall of AIG and the large government bailout that ensued.

The Dodd-Frank statute sought to standardize derivatives traded on exchanges to increase transparency. Derivatives must now be routed through a clearinghouse to ensure that companies using them post collateral (margins). Banks will have to spin off their riskier derivatives and trade them through a subsidiary. Those derivatives will include any that deal in energy, mortgages, credit-default swaps, commodities, and agriculture. Banks can continue to trade derivatives in-house based on interest rates and foreign exchanges and for purposes of hedging risk. The Commodity Futures Trading Commission (CFTC) and the SEC will be the chief regulators of the derivatives market, both drafting and interpreting the regulations. There continues to be some debate over rules set forth to regulate derivatives and swaps.

Consumer Protection

When Dodd-Frank was written, no regulatory authority had the sole responsibility for protecting consumers from predatory lenders. None of the regulatory agencies considered consumer protection their number-one priority. Mortgage brokers steered huge numbers of home buyers into subprime mortgages, often without much attention to the buyers’ ability to pay based on their income. When the credit markets froze up and the 2008 recession came on, these consumers were the first to suffer.

The Dodd-Frank Act developed a new independent regulatory agency, called the Consumer Financial Protection Bureau (Bureau), which was originally located within the Federal Reserve Board (later it was moved to the Treasury Department). The head of the Bureau is appointed by the president for a five-year term. The Bureau is guaranteed a percentage of the annual Fed’s operating expenses. Initially, the formula agreed upon will bring in $500 million annually, although the Bureau may request another $200 million yearly. Staff for this independent agency was drawn initially from several federal agencies, including the Federal Reserve, Federal Trade Commission, Federal Deposit Insurance Corporation, Department of Housing and Urban Development, and National Credit Union. The purpose of the Bureau is to police the financial markets on behalf of savers and borrowers. It is charged with regulating such firms as:

· Banks that issue consumer loans, checking accounts, and/or credit cards

· Mortgage lenders, services, brokers, appraisers, and settlement firms

· Credit counseling firms

· Debt collectors and consumer reporting agencies

· Private-sector student loan companies

Exemptions

Under Dodd-Frank, Congress has exempted auto dealers from the new agency’s jurisdiction, even though they originate nearly 80 percent of all auto loans. Also, 99 percent of the nation’s 7,939 banks (as of this writing) and thrifts (those with less than $10 billion in assets) will not fall under the Bureau’s rules. These banks will instead be examined by traditional regulators, although the Bureau’s rules will be enforced by such examiners. These exemptions at the federal level are a result of strong lobbying at the national and local levels.

The Dodd-Frank statute exempts payday lenders and check-cashing firms as well as auto dealers, leaving these entities to local and state regulation. It also failed to deal with Fannie Mae and Freddie Mac, the mortgage bodies that were responsible for approximately 90 percent of the subprime mortgages that gave rise to the need for this statute. The Dodd-Frank Act also provided for limited regulation of asset management and mutual fund companies.

Regulation of The Regulators By A Court of Law

As with all statutes passed by Congress, the regulating agencies charged with carrying out the Dodd-Frank law are important to its actual enforcement. (See the discussion on rulemaking in  Chapter 18  of this text.) With this particular statute, some 15 separate agencies have been involved in rulemaking and enforcement. Some of these agencies include the Federal Reserve Board, the SEC, the Treasury Department, the Financial Stability Oversight Council, the FDIC, the Commodities Future Trading Commission, the FTC, the OCC, and the Office of Financial Research.

Following the completion of administrative agency rulemaking, there will ordinarily be appeals by those affected. The federal courts of appeals normally hear these cases (see  Chapter 18  on judicial review of rulemaking).

The Sarbanes-Oxley Act of 2002

Following financial and accounting scandals involving Martha Stewart Living, Inc., Tyco International, Inc., Enron Corporation, and others, Congress passed a bipartisan measure in 2002 sponsored by Senator Paul Sarbanes (D-Md.) and Representative Michael Oxley (R-Ohio) and signed into law by President Bush. 3  The act requires a new approach to corporate governance. Chief executive officers (CEOs) and chief financial officers (CFOs) must now certify that statements and reports are accurate, under pain of imprisonment if intent to mislead can be shown ( Exhibit 23-2 ). The Public Company Accounting Oversight Board (PCAOB) was established to regulate accounting firms. 4  The SEC was given

3  H.R. 3762. The act became effective on August 29, 2002; Pub. L. No. 107–204 (codified as Exchange Act § 4), 15 U.S.C. § 78(d)–3. See Greg Ip, “Maybe U.S. Markets Are Still Supreme: Study Finds No Proof that Sarbanes-Oxley Tarnishes the Allure,” Wall Street Journal, C-1 (Apr. 27, 2007).

4  In Free Enterprise Fund v. Public Company Accounting Oversight Board, 129 S. Ct. 2378 (2009), the board’s membership rules were found to be constitutionally wanting in that members could be removed only for good cause. The Supreme Court said that this arrangement violated the separation of powers doctrine and the need of the president to manage the executive branch. The Court ruled 5–4 that the SEC will be able to remove members of the PCAOB at will. However, the Court unanimously held that the Sarbanes-Oxley Act remained fully operational as law.

Exhibit 23-2 Statement Under Oath of Principal Executive Officer and Principal Financial Officer Regarding Facts and Circumstances Relating to Exchange Act Filings

new, expansive powers regarding private civil actions, as well as administrative actions. Some of the provisions of Sarbanes-Oxley are outlined in the following subsections. The SEC, using its rulemaking power, is responsible for implementing these provisions.

Corporate Accountability

Sarbanes-Oxley requires CEOs and CFOs to certify financial reports. Officers must forfeit profits and bonuses if earnings are restated by a company due to securities fraud. Companies are required to disclose material changes in their financial condition immediately. Section 404 of this Act has been the source of much criticism from the business community, especially with regard to its impact on smaller companies. The paperwork is extensive. Management must assure the SEC of the effectiveness of internal controls for financial reporting purposes. Disclosure is required by Sections 404, 406, and 407 of this Act.

New Accounting Regulations

A five-member board with legislative and disciplinary power was established: the Public Company Accounting Oversight Board. A majority of the board is independent from publicly held accounting companies. The board is funded by publicly held companies overseen by the SEC.

The act prohibits auditors (accounting firms) from offering nine specific types of consulting services to their corporate clients.

Criminal Penalties

· The maximum penalty for securities fraud was raised to 25 years.

· A new crime was created under this act for destruction, alteration, or fabrication of records; the maximum penalty permitted under the act is 20 years imprisonment.

· Penalties are increased for CEOs or CFOs who knowingly certify a report that does not meet the requirements of this act; they are now subject to $1 million in fines and up to 5 years in prison. If officers “willfully” certify a noncomplying report, the penalty may be up to $5 million in fines or 20 years in prison or both.

· Under this act, penalties for mail and wire fraud are raised to 20 years; for defrauding pension funds, up to 10 years.

Other Sarbanes-Oxley provisions include:

· Lengthening of the statute of limitations for securities fraud to five years or two years from discovery.

· Protection for whistleblowers who report wrongdoing to employers or participate in a government investigation involving a potential securities violation.

· Preventing officials who are facing court judgments based on fraud charges from using bankruptcy laws to escape liability.

· Prohibiting certain loans to directors and officers if the loans come from public and private companies that are filing initial public offerings (IPOs). Arranging, receiving, or maintaining personal loans, except consumer or housing loans, is forbidden under this act.

The Securities Act of 1933

In the depths of the Great Depression, Congress enacted this first piece of federal legislation regulating securities. Its major purpose, as we have said, was to ensure full disclosure on new issues of securities.

Definition of A Security

When most people use the word securities, they mean stocks or bonds that are held personally or as part of a group in a pension fund or a mutual fund. Congress, the SEC, and the courts, however, have gone far beyond this simple meaning in defining securities. Section 2(1) of the 1933 Act defines the term  security  as:

security

A stock, a bond, or any other instrument of interest that represents an investment in a common enterprise with reasonable expectations of profits that are derived solely from the efforts of those other than the investor.

any note, stock, treasury stock, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit sharing agreement, collateral trust certificate, reorganization certificate or subscription, transferable share, investment contract, voting trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas or other mineral rights, or, in general, any interest or instrument commonly known as a security.*

The words “or, in general, any interest or instrument commonly known as a security” have led to various interpretations by the SEC and the courts of what constitutes a security. In the landmark case of SEC v. Howey, 5  the Supreme Court sought to discover the economic realities behind the façade or form of a transaction and set out specific criteria for the courts to use in defining a security. In Howey, the Court held that the sale to the public of rows of orange trees, with a service contract under which the Howey Company cultivated, harvested, and marketed the oranges, constituted a security within the meaning of Section 2(1) of the 1933 Act. Its decision was based on three elements or characteristics: (1) There existed a contract or scheme whereby an individual invested money in a common enterprise, (2) the investors had reasonable expectations of profits, and (3) the profits were derived solely from the efforts of persons other than the investors. These criteria are examined in detail here because they have been the basis of considerable litigation.

5  328 U.S. 293 (1946).

Common Enterprise

The first element of the Howey test has been interpreted by most courts as requiring investors to share in a single pool of assets so that the fortunes of a single investor are dependent on those of the other investors. For example, commodities accounts involving commodities brokers’ discretion have been held to be “securities” on the grounds that “the fortunes of all investors are inextricably tied” to the success of the trading enterprise.

Reasonable Expectations of Profit

The second element of the Howey test requires that the investor enter the transaction with a clear expectation of making a profit on the money invested. The U.S. Supreme Court has held that neither an interest in a noncontributory, compulsory pension plan nor stock purchases by residents in a low-rent cooperative constitute securities within the definition of Howey. In the case involving the pension plan, 6  the Court stated that the employee expected funds for his pension to come primarily from contributions made by the employer rather than from returns on the assets of the pension plan fund. Similarly, in the low-rent housing case, 7  the Court decided that shares purchased solely to acquire a low-cost place to live were not bought with a reasonable expectation of profit.

6  International Brotherhood of Teamsters, Chauffeurs, Warehousers, & Helpers of America v. Daniel, 439 U.S. 551 (1979).

7  United Housing Foundation, Inc. v. SEC, 423 U.S. 884 (1975).

Profits Derived Solely from the Efforts of Others

The third element of the Howey test requires that profits come “solely” from the efforts of people other than the investors. The word solely was interpreted to mean that the investors can exert “some efforts” in bringing other investors into a pyramid sales scheme, but that the “undeniably significant ones” must be the efforts of management, not the investors.

The following case sets out a summary of a U.S. Supreme Court decision on what constitutes a security.

 Case 23-1 Securities and Exchange Commission v. Edwards

United States Supreme Court 540 U.S. 389 (2004)

Charles Edwards, the CEO and sole shareholder of ETS Payphones, Inc., offered the public investment opportunities in pay phones. The arrangement involved an investor paying $7,000 to own a pay phone. Each investor was offered $82 per month under a leaseback and management arrangement with ETS. The investors also were to recoup their $7,000 investment at the end of five years. ETS did not generate enough revenue to pay its investors, so it filed for bankruptcy. The SEC sued ETS for civil damages arising from alleged violations of federal securities laws. The SEC won at the trial level. The district judge ruled that pay phone leaseback and management agreements were investment contracts covered by federal securities laws. The 11th Circuit Court of Appeals reversed this judgment and ruled in favor of ETS. The SEC was granted certiorari to have the Supreme Court review the definition and application of the term security.

Justice O’Connor

Congress’s purpose in enacting the securities laws was to regulate investments, in whatever form they are made and by whatever name they are called. To that end, it enacted a broad definition of security, sufficient to encompass virtually any instrument that might be sold as an investment, investment contract is not itself defined.

The test for whether a particular scheme is an investment contract was established in our decision in SEC v. W. J. Howey Co., 66 S. Ct. 1100 (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. 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. . . .

There is no reason to distinguish between promises of fixed returns and promises of variable returns for purposes of the test. . . . In both cases, the investing public is attracted by representations of investment income, as purchasers were in this case by ETS’s 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.

Respondent protests that including investment schemes promising a fixed return among investment contracts conflicts with our precedent. We disagree.

Given that respondent’s position is supported neither by the purposes of the securities laws nor by our precedents, it is no surprise that the SEC has consistently taken the opposite position, and maintained that a promise of a fixed return does not preclude a scheme from being an investment contract. It has done so in formal adjudications and in enforcement actions.

The Eleventh Circuit’s perfunctory alternative holding, that respondent’s scheme falls outside the definition because purchasers had a contractual entitlement to a return, is incorrect and inconsistent with our precedent. We are considering investment contracts. The fact that investors have bargained for a return on their investment does not mean that the return is not also expected to come solely from the efforts of others. Any other conclusion would conflict with our holding that an investment contract was offered in Howey itself.

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.*

Reversed and remanded, for the SEC.

Registration of Securities Under The 1933 Act

Purpose and Goals

The 1933 Act requires the registration of nonexempt securities, as defined by Section 2(1), for the purpose of full disclosure so that potential investors can make informed decisions on whether to buy a proposed public offering of stock. As we noted earlier in this chapter, the 1933 Act does not authorize the SEC or any other agency to decide whether the offering is meritorious and should be sold to the public.

Registration Statement and Process

Section 5 of the 1933 Act requires that to serve the goals of disclosure, a registration statement consist of two parts—the  prospectus  and a “Part II” information statement—to be filed with the SEC before any security can be sold to the public. The registration statement provides (1) material information about the business and property of the issuer; (2) description of the significant provisions of the offering; (3) the use to be made of the funds garnered by the offering and the risks involved for investors; (4) the managerial experience, history, and remuneration of the principals, including pensions or stock options; (5) financial statements certified by public accountants attesting to the firm’s financial health; and (6) pending lawsuits. The prospectus must be given to every prospective buyer of the securities. Part II is a longer, more detailed statement than the prospectus. It is not given to prospective buyers, but is open for public inspection at the SEC.

prospectus

The first part of the registration statement the SEC requires from issuers of new securities. It contains material information about the business and its management, the offering itself, the use to be made of the funds obtained, and certain financial statements.

Disclosure

Issuers may use the detailed form (Form S-1). Effective December 4, 2005, the SEC amended the disclosure requirement noted here to recognize four categories of issuers:

1. A nonreporting issuer that is not required to file reports under the 1934 Act. It must use Form S-1, which it did not have to do previously.

2. An unseasoned issuer is an issuer that has reported continuously under the 1934 Act for at least three years. Such an issuer must use Form S-1, but is permitted to disclose less detailed information and to incorporate some information by reference to reports filed under the 1934 Act.

3. A seasoned issuer is an issuer that has filed continuously under the 1934 Act for at least one year and has a minimum market value of publicly held voting and nonvoting stock of $75 million. Such an issuer is permitted to use Form S-03, thus disclosing even less detail in the 1933 Act registration and incorporating even more information by reference to 1934 Act reports.

4. A well-known seasoned issuer is an issuer that has filed continuously for at least one year under the 1934 Act.

During the registration process, the SEC generally bans public statements by some issuers, other than those contained in the registration statement, until the effective date of registration. There are three important stages in this process: prefiling, waiting, and posteffective periods. They are summarized in  Table 23-2 .

Prefiling Period

Section 5(c) of the 1933 Act prohibits any offer to sell or buy securities before a registration statement is filed. The key question here is what constitutes an “offer.” Section 2(3) of the act exempts from the definition any preliminary agreements or negotiations between the issuer and the underwriters or among the underwriters themselves.  Underwriters  are investment banking firms that purchase a securities issue from the issuing corporation with a view to eventually selling the securities to brokerage houses, which, in turn, sell them to the public. These underwriters—such as Goldman Sachs, Kidder Peabody, and First Boston—may arrange for distribution of the public offering of securities, but they cannot make offerings or sales to dealers or the public at this time. During the

Table 23-2 Stages in the Securities Registration Process

Stage	Prohibitions
1. Prefiling period	No offer to sell or buy securities may be made before a registration statement is filed.
2. Waiting period	SEC rules allow oral offers during this period but no sales. A “red herring” prospectus that disavows any attempt to offer or sell securities may be published.
3. Posteffective period	Registration generally becomes effective 20 days after the registration statement is filed, although effective registration may be accelerated or postponed by the SEC. Offer and sale of securities are permitted thereafter.

prefiling period, the SEC regulations also forbid sales efforts in the form of speeches or advertising by the issuer that seeks to “hype” the offering or the issuer’s business. However, a press release setting forth the details of the proposed offering and the issuer’s name, without mentioning the underwriters, is generally permitted.

underwriter

Investment banking firm that agrees to purchase a securities issue from the issuer, usually on a fixed date at a fixed price, with a view to eventually selling the securities to brokers, who, in turn, sell them to the public.

Waiting Period

In the interim between the filing and the time when registration becomes effective, SEC rules allow oral offers but not sales. The SEC examines the prospectus for completeness during this period. SEC rules permit the publication of a written preliminary, or  red herring , prospectus that summarizes the registration but disavows in red print (hence, its name) any attempt to offer or sell securities. Notices of underwriters containing certain information about the proposed issue are also allowed to appear in newspapers during this period, but such notices must be bordered in black and specify that they are not offers to sell or solicitations to buy securities.

red herring

A preliminary prospectus that contains most of the information that will appear in the final prospectus, except for the price of the securities. The “red herring” prospectus may be distributed to potential buyers during the waiting period, but no sales may be finalized during this period.

Posteffective Period

The third stage in the process is called the posteffective period because the registration statement usually becomes effective 20 days after it is filed, although sometimes the SEC accelerates or postpones registration for some reason. Underwriters and lenders can begin to offer and sell securities after the 20 days or upon commission approval, whichever comes first.

Under Section 8 of the 1933 Act, the SEC may issue a “refusal order” or “stop order,” which prevents a registration statement from becoming effective or suspends its effectiveness, if the staff discovers a misstatement or an omission of a material fact in the statement. Stop orders are reserved for the most serious cases. In general, the issuers are forewarned by the SEC in informal  letters of comment or deficiency  before a stop order is put out, so they have the opportunity to make the necessary revisions. The commission may shorten the usual 20-day period between registration and effectiveness if the issuer is willing to make the modifications requested by the SEC staff. This procedure, in fact, is the present trend.

letter of comment or deficiency

Informal letter issued by the SEC indicating what corrections must be made in a registration statement for it to become effective.

The 1933 Act requires that a prospectus be issued upon every sale of a security in interstate commerce except sales by anyone who is not an “issuer, underwriter or dealer.” If a prospectus is delivered more than 9 months after the effective date of registration, it must be updated so that the information is not more than 16 months old. The burden is on the dealer to update all material information about the issuer that is not in the prospectus. Dealers who fail to do so risk civil liability under Sections 12(1) and 12(2) of the 1933 Act.

Communications

The December 2005 revisions brought flexibility to rules regarding written communication by issuers before and during registration of securities. This flexibility depended on certain characteristics of the issuer, including (1) the type of issuer, (2) the issuer’s history of reporting, and (3) the issuer’s market capitalization. These new rules created a type of written communication called a “free-writing prospectus,” which is any written offer, including electronic communication (as defined previously) other than a prospectus required by statute. The new rules provide that:

· Well-known seasoned issuers may engage at any time in oral and written communications, including a free-writing prospectus, subject to certain conditions.

· All reporting issuers (unseasoned issuers, seasoned issuers, and well-known seasoned issuers) may at any time continue to publish regularly released factual business information and forward-looking information (predictions).

· Nonreporting issuers may at any time continue to publish factual business information that is regularly released and intended for use by persons other than in their capacity as investors or potential investors.

· Communications by issuers more than 30 days before filing a registration statement are permitted so long as they do not refer to a securities offering that is the subject of a registration statement.*

All issuers may use a free-writing prospectus after the filing of the registration statement, subject to certain conditions.

Shelf Registration

Traditionally, the marketing of securities has taken place through underwriters who buy or offer to buy securities and then employ dealers across the United States to sell them to the general public. With Rule 415, the SEC has established a procedure, called  shelf registration , that allows a large corporation to file a registration statement for securities it may wish to sell over a period of time rather than immediately. Once the securities are registered, the corporation can place them on the “shelf” for future sale and need not register them again. It can then sell these securities when it needs capital and when the marketplace indicators are favorable. A company that files a shelf-registration statement must file periodic amendments with the SEC if any fundamental changes occur in its activities that would be material to the average prudent investor’s decision to invest in its stock.

shelf registration

Procedure whereby a large corporation can file a registration statement for securities it wishes to sell over a period of time rather than immediately.

“Fictional Filings” with the SEC

Like an extraordinary whimsical tale, Universal Express (not American Express), a small company of alleged postal stores, was able to lose money faster than it issued news releases. The SEC filed suit for fraud against Universal (Company) in 2007, because the company continued to issue billions of unregistered shares following the issuance of news releases. The unregistered shares were used to finance the company and its officers. In 2004, a federal district court in New York ruled that the company and its officers had violated the securities laws and ordered them to pay $21.9 million. The CEO, Richard Altomare, was barred from being an officer or a director of any public company.

Despite the court’s order, Universal continued to issue news releases forecasting $9 million in annual revenues from 9,000 private postal stores. Judge Lynch of the federal district court ruled that there was no evidence the company had any such network of stores. As of the first quarterly report in 2007, Universal said that the 9,000 stores were “members” of its network regardless of the findings of the federal judge. In its suit, the SEC alleged that the company had issued 500 million unregistered shares over 33 months in violation of the 1933 Securities Act and other federal statutes (the basis for the original SEC suit). The company claimed that its old stock issues (before 2004) were allowed by a bankruptcy court ruling. Judge Lynch found such claims to be baseless and dismissed Universal’s justification.

As of 2007, Universal Express continued to trade billions of shares weekly in an over-the-counter penny-stock bulletin board in California. Shares have never sold at more than $0.40 a share. In 2006, Universal lost $18.9 million on revenue of $1.1 million. Altomare acted as the sole member of Universal’s board of directors and received a salary in 2006 of $650,000 (paid for with the sale of unregistered stock). As of 2007, news releases continue to be issued, claiming a “network of postal stores” in the United States producing annual revenues of $9 million. a

a SEC v. Universal Express, Inc. (SDNY), reported at No. 2267, § 94165 (2007).

In April of 2008, Altomare was found in contempt of court for failing to make payments on the judgment issued against him, and in May of that year he was sent to federal prison for 80 days. In 2010, he wrote a book proclaiming his innocence and arguing that he was prosecuted for being a whistleblower against the SEC.

Meanwhile, in 2011, a federal judge ruled that two Florida penny-stock traders who issued unregistered shares of the defunct Universal Express must pay fines of $14 million and $5.3 million. b

b “Universal Express Penny Stock Traders Must Pay $14 M,” by Brian Bandell. Published by South Florida Business Journal, © 2011. Available at www.bizjournals.com/southflorida /news/2011/09/19/universal-express-penny-stock-traders.html.

Securities and Transactions Exempt From Registration Under The 1933 Act

Section 5 of the 1933 Act requires registrations of any sale by any person of any security unless specifically exempted by the 1933 Act. The cost of the registration process, in terms of hiring lawyers, accountants, underwriters, and other financial experts, makes it appealing for a firm to put a transaction together in such a way as not to fall within the definition of a security. If that is impossible, firms often attempt to meet the requirements of one of the following four classes of exemptions to the registration process (summarized in  Table 23-3 ).

Private Placement Exemptions

Section 4(2) of the 1933 Act exempts from registration transactions by an issuer that do not involve any public offering. Behind this exemption is the theory that institutional investors have the sophisticated knowledge necessary to evaluate the information contained in a private placement and, thus, unlike the average investor, do not need to be protected by the registration process set out in the 1933 Act. The private placement exemption is often used in stock option plans, in which a corporation issues securities to its own employees for the purpose of increasing productivity or retaining top-level managers. Because various courts had different views on what factual situations qualified for the private placement exemption, the SEC published Rule 146, which seeks to clarify the criteria used by the commission in allowing this exemption.

The issuer should follow the statutory guidelines (rules) listed here.

1. The number of purchasers of the company’s (issuer’s) securities should not exceed 35. If a single purchaser buys more than $150,000, that purchaser will not be counted among the 35.

2. Each purchaser must have access to the same kind of information that would be available if the issuer had registered the securities.

3. The issuer can sell only to purchasers who it has reason to believe are capable of evaluating the risks and benefits of investment and are able to bear those risks or to purchasers who have the services of a representative with the knowledge and experience to evaluate the risks for them.

4. The issuer may not advertise the securities or solicit public customers.

5. The issuer must take precautions to prevent the resale of securities issued under a private placement exemption.

Table 23-3 Exemptions from the Registration Process Under the 1933 Securities Act

Exemptions	Definition
Private placement	Transactions by an issuing company not involving any public offering. Usually, the transaction involves sophisticated investors with enough knowledge to evaluate information given them (e.g., stock option plans for top-level management).
Intrastate offering	Any security or part of an offering offered or sold to persons resident within a single state or territory.
Small business	Section 3(b) of the 1933 Act allows the SEC to exempt offerings not exceeding $5 million. Regulations A and D promulgated by the SEC define the type of investors and the amount of securities that are exempt within a certain time period.
Other offering exemptions	By virtue of the 1933 Act, exemptions are allowed for transactions by any person other than an issuer, an underwriter, or a dealer. Also, government securities (federal, state, or municipal bonds) are exempt. Also exempt are securities issued by banks, charitable organizations, and savings and loans institutions.

Intrastate Offering Exemption

Section 3 of the 1933 Act provides an exemption for any “security which is part of an issue offered or sold to persons resident within a single state or territory, where the issuer of such security is a resident and doing business within, or, if a corporation, incorporated by, or doing business within such a state.” To qualify for this exemption, an issuer must meet the strictly interpreted doing-business-within-a-state requirement: The issuer must be a resident of the state and “do business” solely with (i.e., offer securities to) people who live within the state.

Courts have interpreted Section 3 very strictly. One federal court ruled that a company incorporated in the state of California and making an offering of common stock solely to residents of California did not qualify for the intrastate exemption because it advertised in the Los Angeles Times, a newspaper sold by mail to residents of other states. Another factor in the court’s decision in this case was that 20 percent of the proceeds from the securities sale were to be used to refurbish a hotel in Las Vegas, Nevada. 8

8  SEC v. Trustee Showboat, 157 F. Supp. 824 (S.D. Cal. 1957).

After that decision, the SEC issued Rule 147, which sets standards for the intrastate exemption by defining important terms in Section 3 of the 1933 Act. For example, an issuer is “doing business within” a state if (1) it receives at least 80 percent of its gross revenue from within the state, (2) at least 80 percent of its assets are within the state, (3) it intends to use 80 percent of the net proceeds of the offering within the state, and (4) its principal office is located in the state. Rule 147 is also concerned with whether the offering has “come to rest” within a state or whether it is the beginning of an interstate distribution. An offering is considered intrastate only if no resales are made to nonresidents of the state for at least nine months after the initial distribution of securities is completed.

Small Business Exemptions

Section 3(b) of the 1933 Act authorizes the SEC, by use of its rulemaking power, to exempt offerings not exceeding $5 million when it finds registration unnecessary. Under this authority, the commission has promulgated Regulations A and D.

Regulation A exempts small public offerings made by an issuer, defined as offerings not exceeding $5 million over a 12-month period. The issuer must file an “offerings” and a “notification circular” with an SEC regional office 10 days before each proposed offering. The circular contains information similar to that required for a 1933 Act registration prospectus, but in less detail, and the accompanying financial statements may be unaudited. It should be noted that for these small business offerings, the SEC staff follows the same “letter of comment” procedure associated with registration statements; thus, a Regulation A filing may be delayed. Regulation A circulars do not give rise to civil liability under Section 11 of the 1933 Act (discussed later in this chapter), but they do make an issuer liable under Section 12(2) for misstatements or omissions (also discussed later in this chapter). The advantages of this regulation for small businesses are that the preparation of forms is simpler and less costly and the SEC staff can usually act more quickly.

Regulation D, which includes Rules 501–506, attempts to implement Section 3 of the 1933 Act. Rule 501 defines an accredited investor as a bank; an insurance or investment company; an employee benefit plan; a business development company; a charitable or educational institution (with assets of $5 million or more); any director, officer, or general partner of an issuer; any person with a net worth of $1 million or more; or any person with an annual income of more than $200,000. This definition is important because an accredited investor, as defined by Rule 501, is not likely to need the protection of the 1933 Act’s registration process.

Rule 504 allows any  noninvestment company  (one whose primary business is not investing or trading in securities) to sell up to $1 million worth of securities in a 12-month period to any number of purchasers, accredited or nonaccredited, without furnishing any information to the purchaser. This $1 million maximum, however, is reduced by the amount of securities sold under any other exemption.

noninvestment company

A company whose primary business is not in investing or trading in securities.

Rule 505 allows any private noninvestment company to sell up to $5 million of securities in a 12-month period to any number of accredited investors (as previously defined) and to up to 35 nonaccredited purchasers. Sales to nonaccredited purchasers are subject to certain restrictions concerning the manner of offering—for example, no public advertising is allowed—and resale of the securities.

Rule 506 allows an issuer to sell an unlimited number of securities to any number of accredited investors and to up to 35 nonaccredited purchasers. The issuer, however, must have reason to believe that each nonaccredited purchaser or representative has enough knowledge or experience in business to be able to evaluate the merits and risks of the prospective investment. Again, certain resale restrictions are attached to offerings made under this rule, as well as a prohibition against advertising. Rule 506 seeks to clarify Section 4(2) of the 1933 Act, dealing with private placement exemptions, as already discussed.

Other Offering Exemptions

Section 4(2) of the 1933 Act allows exemptions for “transactions by any person other than an issuer, underwriter or dealer.” Because Sections 4(3) and 4(4) allow qualified exemptions for dealers and brokers, the issuer and the underwriters become the only ones not exempted. SEC Rules 144 and 144a define the conditions under which a person is not an underwriter and is not involved in selling securities.

Exempt Securities

Government securities issued or regulated by agencies other than the SEC are exempt from the 1933 Act. For example, debt issued by or guaranteed by federal, state, or local governments, as well as securities issued by banks, religious and charitable organizations, savings and loan associations, and common carriers under the Interstate Commerce Commission, are exempt. These securities usually fall under the jurisdiction of other federal agencies, such as the Federal Reserve System or the Federal Home Loan Board, or of state or local agencies.

The collapse of the Penn Central Railroad in 1970 and the default of the cities of Cleveland and New York on municipal bonds led Congress and the SEC to reexamine certain exemptions with a view to eliminating them. In fact, the Railroad Revitalization Act of 1976 eliminated the 1933 Act exemption for securities issued by railroads (other than trust certificates for certain equipment), and 1975 amendments to the securities acts now require firms that deal solely in state and local government securities to register with the commission and to adhere to rules laid down by the Municipal Securities Rulemaking Board.

Other exempt securities are issued in a corporate reorganization or bankruptcy and securities issued in stock dividends or stock splits.

Resale Restrictions

Restrictions are placed on the resale of securities issued for investment purposes pursuant to intrastate, private placement, or small business exemptions.

· Rule 147 states that securities sold pursuant to an intrastate offering exemption (mentioned previously) cannot be sold to nonresidents for nine months.

· Rule 144 states that securities sold pursuant to the private placement or small business exemptions must be held one year from the date the securities are sold.

· Rule 144(a) permits “qualified institutional investors” (institutions that own and invest $100 million in securities, such as banks, insurance companies, and investment companies) to buy unregistered securities without being subject to the holding period of Rule 144. This rule seeks to permit foreign issuers to raise capital in this country from sophisticated investors without registration process disclosures. This also seeks to create a domestic market for unregistered securities.

· Regulation S and Rule 144(a) have attempted to expand the private placement market. See the section in this chapter on the “Global Dimensions of Rules Governing the Issuance and Trading of Securities.”

Exemption	Price Limitation	Limitations on Purchasers	Resales
Regulation A	$5 million	None	Unrestricted
Intrastate Rule 147	None	Intrastate only	Only to residents before nine months
Rule 506	None	Unlimited accredited; 35 unaccredited	Restricted
Rule 505	$5 million	Unlimited accredited; 35 unaccredited	Restricted
Exempt Transactions for Issuers under the 1933 Securities Act

Liability, Remedies, and Defenses Under The 1933 Securities Act

Private Remedies

The 1933 Act provides remedies for individuals who have been victims of (1) misrepresentations in a registration statement, (2) an issuer’s failure to file a registration statement with the SEC, or (3) misrepresentation or fraud in the sale of securities. Each is examined here, along with some affirmative defenses.

Misrepresentations in a Registration Statement

Section 11 of the 1933 Act imposes liability for certain untruths or omissions in a registration statement. Section 11 allows a right of action to “any person acquiring such a security” who can show (1) a material misstatement or omission in a registration statement and (2) monetary damages. The term material is defined by SEC Rule 405 as pertaining to matters “of which an average prudent investor ought reasonably to be informed before purchasing the security registered.” In addition, the issuer’s omission of such facts as might cause investors to change their minds about investing in a particular security are considered material omissions for the purposes of Section 11. These facts include an impending bankruptcy, new government regulations that may be costly to the company, and the impending conviction and sentencing of the company’s top executives for numerous violations of the FCPA of 1977 (discussed later in this chapter).

Three affirmative defenses are available to defendants:

1. The purchaser (plaintiff) knew of the omission or untruth.

2. The decline in value of the security resulted from causes other than the misstatement or omission in the registration statement.

3. The statement was prepared with the due diligence expected of each defendant.

The following case examines alleged omissions of material information. The defendants contended that the omissions were nonmaterial, and due diligence was exercised.

 Case 23-2 Litwin v. Blackstone Group, LP

United States Court of Appeals, Second Circuit 634 F.3d 706 (2011)

Blackstone Group, LP, manages investments. In corporate preparations for an initial public offering (IPO), Blackstone filed a registration statement with the Securities and Exchange Commission (SEC). At the time, corporate private equity’s investments included FGIC Corporation and Freescale Semiconductor, Inc. FGIC insured investments in subprime mortgages. Before the IPO, FGIC’s customers began to suffer large losses. By the time of the IPO, this situation was generating substantial losses for FGIC and, in turn, for Blackstone.

Meanwhile, Freescale had recently lost an exclusive contract to make wireless 3G chipsets for Motorola, Inc. (its largest customer). Blackstone’s registration statement did not mention the impact on its revenue of the investments in FGIC and Freescale. Martin Litwin and others who invested in the IPO filed a suit in a federal district court against Blackstone and its officers, alleging material omissions from the statement. Blackstone filed a motion of dismiss, which the court granted. The plaintiffs appealed.

Justice Straud

Materiality is inherently fact-specific finding that is satisfied when a plaintiff alleges a statement or omission that a reasonable investor would have considered significant in making investment decisions.

However, it is not necessary to assert that the investor would have acted differently if an accurate disclosure was made. Rather, when a district court is presented with a motion [to dismiss,] a complaint may not properly be dismissed on the ground that the alleged misstatements of omissions are not material unless they are so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of their importance. [Emphasis added.]

In this case, the key information that plaintiffs assert should have been disclosed is whether, and to what extent, the particular known trend, event, or uncertainty might have been reasonably expected to materially affect Blackstone’s investments. Plaintiffs are not seeking the disclosure of the mere fact of Blackstone’s investment in FGIC, of the downward trend in the real estate market, or of Freescale’s loss of its exclusive contract with Motorola. Rather, plaintiff claims that Blackstone was required to disclose the manner in which those then-known trends, events, or uncertainties might reasonably be expected to materially impact Blackstone’s future revenues.

The question, of course, is whether a loss in a particular investment’s values will merely affect revenues, because it will almost certainly have some effect. The relevant question is whether Blackstone reasonably expects the impact to be material. [Emphasis added.]

Because Blackstone’s Corporate Private Equity segment plays such an important role in Blackstone’s business and provides value to all of its other asset management and financials related to that segment that Blackstone reasonably expects will have a material adverse effect on its future revenues. Therefore, the alleged omissions related to FGIC and Freescale were plausibly material.*

The U.S. Court of Appeals for the 2nd Circuit vacated the lower court’s dismissal and remanded the case.

Whereas others associated with the company can raise the  due diligence defense , the issuing company cannot. Section 11(a) is very specific about what other individuals may be held jointly or severally liable in addition to the issuing company:

due diligence defense

An affirmative defense raised in lawsuits charging misrepresentation in a registration statement. It is based on the defendant’s claim to have had reasonable grounds to believe that all statements in the registration statement were true and no omission of material fact had been made. This defense is not available to the issuer of the security.

1. Every person who signed the registration statement (Section 16 of the 1933 Act requires signing by the issuer, the issuing company’s CEO, the company’s financial and accounting officers, and a majority of the company’s board of directors)

2. All directors

3. Accountants, appraisers, engineers, and other experts who consented to being named as having prepared all or part of the registration statement

4. Every underwriter of the securities

It should be noted that there are two exceptions to Section 11 liability:

1. An expert is liable only for the misstatements or omissions in the portion of the registration statement that the expert prepared or certified.

2. An underwriter is liable only for the aggregate public offering portion of the securities it underwrote.

Section 11 liability has made such a strong impact that today virtually all professionals and experts involved in the preparation of a registration statement make precise agreements concerning the assignment of responsibility for that statement. Failure to grasp the import of Section 11 and related sections of the 1933 and 1934 Acts can lead to loss of reputation and employment by businesspersons and professionals. The first case brought under Section 11 9  sent tremors through Wall Street, the accounting profession, and outside directors. In that case, the court evaluated each defendant’s plea of due diligence on the basis of each individual’s relationship to the corporation and expected knowledge of registration requirements.

9  Escott v. Barchris Construction Corp., 283 F. Supp. 643 (S.D.N.Y. 1968).

Failure to File a Registration Statement

Failure to file a registration statement with the SEC when selling a nonexempt security is the second basis for a private action by the purchaser for rescission (cancellation of the sale). Section 12(1) of the 1933 Act provides that any person who sells a security in violation of Section 5 (which you recall from the discussion of the registration statement) is liable to the purchaser to refund the full purchase price. A purchaser whose investment has decreased in value may recover the full purchase price without showing a misstatement or fraud if the seller is unable to meet the conditions of one of the exemptions discussed earlier. In short, a business that fails to file a registration statement because of a mistaken assumption that it has qualified for one of the exemptions could be making a very expensive mistake.

Misrepresentation or Fraud in the Sale of a Security

A third basis for a private action is misrepresentation in the sale of a security, as defined by Section 12(2) of the 1933 Act, which holds liable any person who offers or sells securities by means of any written or oral statement that misstates a material fact or omits a material fact that is necessary to make the statement truthful. Unlike Section 11, Section 12(2) is applicable whether or not the security is subject to the registration provisions of the 1933 Act, provided there is use of the mails or other facilities in interstate commerce. The persons liable are only those from whom the purchaser bought the security. For example, under Section 12(2), a purchaser who bought the security from an underwriter, a dealer, or a broker cannot sue the issuer unless able to show that the issuer was “a substantial factor in causing the transaction to take place.” A further requirement is that the purchaser must prove that the sale was made “by means of” the misleading communications. The defense usually raised by sellers in such suits is that they did not know, and using reasonable care could not have known, of the untruth or omission at the time the statement was made.

Fraud in the sale of a security is covered by Section 17(a) of the 1933 Act, which imposes criminal, and possibly civil, liability on anyone who aids and abets any fraud in connection with the offer or sale of a security. Violators may be penalized by fines of up to $10,000, imprisonment up to 5 years, or both. Section 12(a) (2) and Section 17(a) of the 1933 Act set out antifraud enforcement mechanisms. Rule 10(b)-5 applies to the issuance or sales of securities under the 1934 Act and other securities acts, even those exempted by the 1933 Act.

Governmental Remedies

 When a staff investigation uncovers evidence of a violation of the securities laws, the SEC can (1) take administrative action, (2) take injunctive action, or (3) recommend a criminal prosecution to the Justice Department.

Administrative Action

 Upon receiving information of a possible violation of the 1933 Act, the SEC staff undertakes an informal inquiry. This involves interviewing witnesses but generally does not involve issuing subpoenas. If the staff uncovers evidence of a possible violation of a securities act, it may order an administrative hearing before an administrative law judge (ALJ) or ask the full commission for a formal order of investigation. A formal investigation is usually conducted in private under SEC rules. A witness compelled to testify or to produce evidence may be represented by counsel, but no other witness or counsel may be present during the testimony. A witness may be denied a copy of the transcript of his or her testimony for good cause, although the witness is allowed to inspect the transcript.

Witnesses at a private SEC investigation do not enjoy the ordinary exercise of Fourth, Fifth, and Sixth Amendment rights. For example, Fourth Amendment rights are limited because the securities industry is subject to pervasive government regulation, and those going into it know this in advance. Fifth Amendment rights are limited because the production of records related to a business may be compelled despite a claim of self-incrimination. (See the sections on the Fourth and Fifth Amendments in  Chapter 5 .) As for the Sixth Amendment, in a private investigation, the SEC is not required to notify the targets of the investigation, nor do such targets have a right to appear before the staff or the full commission to defend themselves against charges. The wide scope of SEC powers in these nonpublic investigations was reinforced when the U.S. Supreme Court upheld a lower court’s decision to deny injunctive relief with regard to subpoenas directed at plaintiffs in an SEC private investigation. 10  For some of the constitutional reasons noted here, the SEC is being challenged in a 2015 Georgia case. 11

10  SEC v. Jerry T. O’Brien, Inc. et al., 467 U.S. 735 (1984).

11  Hill v. EC, N. District (Georgia), Case No. 1.2015cvo1802, May 19, 2015.

An administrative proceeding may be ordered by the full commission if the SEC staff uncovers evidence of a violation of the securities laws. This proceeding before an ALJ can be brought only against a person or firm that is registered with the commission (an investment company, a dealer, or a broker). The ALJ has the power to impose sanctions, including censure, revocation of registration, and limitations on the person’s or the firm’s activities or practice.

In addition, after a hearing, the full commission may issue a stop order to suspend a registration statement found to contain a material misstatement or omission. If the statement is later amended, the stop order will be lifted. As mentioned earlier in the chapter, stop orders are usually reserved for the most serious cases. The SEC more frequently uses letters of deficiency to obtain corrections to registration statements. The remedies available under the 1991 Remedies Act, discussed earlier in this chapter under “Summary of Federal Securities Legislation,” apply here as well.

Injunctive Action

 The SEC may commence an injunctive action when there is a “reasonable likelihood of further violation in the future” or when a defendant is considered a “continuing menace” to the public. For example, under the 1933 Act, the SEC may go to court to seek an injunction to prevent a party from using the interstate mails to sell a nonexempt security. Violation of an injunctive order may give rise to a contempt citation. Also, parties under such an order are disqualified from receiving an exemption under Regulation A (the small business exemption). Again, the remedies available under the 1991 Remedies Act apply here.

Criminal Penalties

Willful violations of the securities acts and the rules and regulations promulgated pursuant to those acts are subject to criminal penalties. Anyone convicted of willfully omitting a material fact or making an untrue statement in connection with the offering or sale of a security can be fined up to $1 million for each offense or imprisoned for up to 5 years or both. The SEC does not prosecute criminal cases itself, but instead refers them to the Justice Department.

The Securities Exchange Act of 1934

One year after passing the Securities Act of 1933, Congress crafted this second extremely important piece of securities legislation to come out of the Great Depression. More comprehensive than the 1933 Act, it had two major purposes: to regulate trading in securities and to establish the SEC to oversee all securities regulations and bar the kind of large market manipulations that had characterized the 1920s and previous boom periods.

Registration of Securities Issuers, Brokers, and Dealers

Registration of Securities Issuers

Section 12 of the 1934 Securities Exchange Act requires every issuer of debt and equity securities to register with both the SEC and the national exchange on which its securities are to be traded. Congress extended this requirement to all corporations that (1) have assets of more than $10 million, (2) have a class of equity securities with more than 500 shareholders, and (3) are involved in interstate commerce. Registration becomes effective within 60 days after filing unless the SEC accelerates the process. Such companies are referred to as “Section 12” companies.

The commission has devised forms to ensure that potential investors will have updated information on all registrants whose securities are being traded on the national exchanges. Thus, registrants are required to file annual reports (Form 10-K) and quarterly reports (Form 10-Q) as well as SEC-requested current reports (Form 8-K). This last form must be filed within 15 days of the request, which is usually made in response to a perceived material change in the corporation’s position (e.g., a potential merger or bankruptcy) that the commission’s staff believes a prudent investor should know about. It should be noted that the Sarbanes-Oxley Act, discussed earlier in this chapter, should be reviewed for all requirements regarding CEOs and CFOs of issuing companies. Further, the accounting requirements of the FCPA of 1977 set out at the end of this chapter should be reviewed as to company officers’ duties.

In a proposed Codification of the Federal Securities Law (CFSL), the American Law Institute has sought to streamline the registration process under the 1933 and 1934 Acts by requiring single-issuance registration under the 1933 Act and an annual company “offering statement” for securities traded on a national exchange under the 1934 Act. At present, Section 22 of the Exchange Act makes a registering company liable for civil damages to securities purchasers who can show that they relied on a misleading statement contained in any of the SEC-required reports.

Registration of Brokers and Dealers

Brokers and dealers are required to register with the SEC under the Exchange Act unless exempted. A  dealer , as defined by the 1934 Act, is a “person engaged in the business of buying and selling securities for his own account,” whereas a  broker  is a person engaged in the business of “effectuating transactions in securities for the account of others.” The convenient term broker-dealer is used throughout to refer to all those who trade in securities; the specific term broker or dealer is used when only one type of trader is meant.

dealer

A person engaged in the business of buying and selling securities for his or her own account.

broker

A person engaged in the business of buying and selling securities for others’ accounts.

Broker-dealers must meet a financial responsibility standard that is based on a net capital formula; a minimum capital of $25,000 is required in most cases. Brokers are obliged to segregate customer funds and securities.

Analysts or “Cheerleaders”? Conflicts of Interest

In July 2001, to prevent a potential conflict of interest, Merrill Lynch barred its stock analysts from investing in stock they had researched. This was a reaction to several events:

· Individuals and members of Congress had lost confidence in analysts, particularly in an economy and market that had been in a turndown for 18 months. Never before had so many individual investors actually invested in stocks and bonds and seen their paper wealth grow and then fall. The “party” appeared to be over for a time.

· Federal investigators were alleging the manipulation of Internet stock IPOs and the taking of kickbacks by investment bankers in July 2001.

· The same trading companies that had investment banking divisions floating new issuances of securities hired securities analysts to rank the securities of companies for which they were raising. The individual investor had begun to realize that there existed no “Chinese wall” between stock analysts and investment bankers in the same brokerage firm. In fact, some companies gave stock analysts bonuses when they helped encourage investment banking business by giving stocks high ratings. For example, one study showed that bullish ratings were so meaningless that “sell” ratings were less than 2 percent of all ratings shown. In many cases, stocks fell as much as 90 percent from their high before analysts removed their “buy” ratings. a  This could be called “cheerleading.”

a “Stock Analysts Get Overall Rap for Deceiving Investors,” USA Today, July 5, 2001, 10A.

· Money managers who ran large mutual funds with money from IRAs, Keoghs, 401(k)s, and 403(b)s became skeptical of analysts as investors lost confidence in the mutual funds and their managers. These investors, who tended to be passive in nature and dependent on the fund managers and the analysts, saw their retirement funds dwindling rapidly (and in some instances, disappearing almost entirely).

Although this assessment appeared gloomy, many investors argued that analysts should be encouraged to own stocks in the companies on which they do research, believing that they should “put their money where their mouth is.” Some argued that the very purpose of the securities laws is full disclosure and that all analysts should be forced to disclose what holdings they have and to advise investors when they have a potential conflict of interest.

The Securities Investment Protection Act (SIPA) provides a basis for indemnifying the customers of a brokerage firm that becomes insolvent: All registered brokers must contribute to a SIPA fund managed by the SIPC, a nonprofit corporation whose functions are to liquidate an insolvent brokerage firm and to protect customer investments up to a maximum of $500,000. Upon application to the SEC, the SIPC can borrow up to $1 billion from the U.S. Treasury to supplement the fund when necessary.

Under Section 15(b) of the Exchange Act, which contains the antifraud provisions, the SEC may revoke or suspend a broker-dealer’s registration or may censure a broker-dealer. (Municipal securities dealers and investment advisers are subject to similar penalties.) In general, the commission takes such actions against broker-dealers either for putting enhancement of their personal worth ahead of their professional obligation to their customers—conflict of interest—or for trading in or recommending certain securities without having reliable information about the company. Broker-dealers are liable to both government and private action for failing to disclose conflicts of interest. When even the potential for such a conflict exists, a broker must supply a customer with written confirmation of each transaction, including full disclosure of whom the broker is representing in the transaction.

Applying the law to the facts . . .

Assume that Rogers owned 2.1 million shares in WorldCom, a firm that collapsed after the revelation of accounting fraud. He claimed that he ordered his broker-dealer to sell his stock when it was worth $92 a share, but his broker told him not to sell because research reports showed that the company would continue to do well. In fact, the broker knew that WorldCom was grossly overvalued, but he promoted the stock anyway to retain WorldCom’s investment banking business. What is problematic about the broker’s behavior? What liability is he potentially subject to?

Monday, October 23, 2000, was an important day for securities analysts: That was when Regulation Fair Disclosure (FD) became effective. This rule required companies to publicize all potentially market-moving data at the time the data become available. No longer could such data be made available only to certain analysts in a securities firm before being given to the public at large. Analysts traditionally followed one industry and were in frequent contact by phone or email with its CFOs, investor relations officials, and often CEOs. By gaining bits of information from several companies in an industry, they were able to provide earning forecasts and then determine buy, sell, and hold ratings for the trading company they were employed by.

For example, Hallie Frobose, an analyst for 17 years for Brennan and Kubasek Company, may have concentrated on companies that were involved in lumber and forest products. By making telephone calls in the pre-Regulation FD days, she could obtain financial factors off the record for hundreds of variables that might affect earnings expectations for a major company (e.g., Lumber Pacific). By constructing a model with all the important variables and checking them with officers of the lumber company, recommendations could be made to Brennan and Kubasek’s large investors; this was no longer the case for Frobose or her company after October 2000.

Those opposed to Regulation FD argue that it has a “chilling effect” on analysts and contacts they once had with corporate managers and has led to a decrease in the predictability of earnings reports such as Frobose’s. Market inefficiency is a result in the eyes of many.

Those favoring Regulation FD argue that the major purpose of our securities laws is full disclosure and that both large and small investors should have access to the same data, resulting in a “level playing field.”

Disclosure: Compensation

In discussing registration of securities and securities issuers, it is important to note that in 2006, pursuant to its mandate under the Exchange Act of 1934, the SEC set out rules requiring clearer and more complete disclosure of compensation paid to directors, the principal executives, and the three most highly paid executive officers. The issuer (usually a company) must disclose executives’ compensation over the last three years, including salary, bonuses, a dollar value of stock and option awards, amount of compensation over nonequity plans, annual changes in present value of accumulated pension benefits, and all other compensation including perquisites. This type of disclosure is a start toward meeting some of the political arguments made by unions and other groups that compensation has not been fully disclosed to shareholders.

Securities Markets

Earlier in this chapter, we defined a security as a stock or bond or any other instrument or interest that represents an investment in a common enterprise with reasonable expectations of profits derived solely from the efforts of people other than the investors. A security can also be considered as a form of currency that, once issued, can be traded for other securities on what is called a securities market. The concern here is with the markets for stocks and how they are regulated under the Exchange Act.

There are generally two types of markets in stocks: exchange markets and over-the-counter (OTC) markets. The  exchange market  provides for the buying and selling of securities within a physical facility such as the NYSE or regional exchanges such as the Boston, Detroit, Midwest (Chicago), Pacific Coast (Los Angeles and San Francisco), and Philadelphia exchanges. (This, however, is changing as computer and Internet systems are increasingly the medium through which stock sales or trades are made.) These exchanges traditionally prescribed not only the number and the qualifications of their broker-members but also the commissions they could charge. In 1975, commissions were deregulated by the SEC; since then, brokers have been free to set the commissions they charge their customers. Brokers do not trade directly on an exchange market, but rather transmit a customer’s order to a registered specialist in a stock, who buys and sells that security for his or her own account on the floor of the exchange. The NYSE has now become a publicly traded company. In 2007, the SEC approved rule changes by the NYSE relating to the combination of Euronext and NYSE Group. Euronext owns five European exchanges. The combined company now competes with other national and international exchanges for securities business. The SEC will continue to regulate the NYSE Group in the same manner as noted here.

exchange market

A securities market that provides a physical facility for the buying and selling of stocks and prescribes the number and qualifications of its broker-members. These brokers buy and sell stocks through the exchange’s registered specialists, who are dealers on the floor of the exchange.

The  over-the-counter (OTC) market  has no physical facility—computers, telephones, and other forms of communication link OTC members—and no qualifications for membership. Its commissions have always been determined by the law of supply and demand. OTC firms serve as dealers or market makers in stocks and deal directly with the public.

over-the-counter (OTC) market

A securities market that has no physical facility and no membership qualifications and whose broker-dealers are market makers who buy and sell stocks directly from the public.

BATS (Better Alternative Trading System) has been open since 2006. It operates the third-largest electronic exchange in the United States. It has been “stealing” business from its older rivals. Its founder is Steve Ratterman. It handles about 12 percent of the stock traded on public markets.

Today, the National Association of Securities Dealers (NASD) and the exchanges help the SEC to regulate the securities market. In enacting the Securities Exchange Act in 1934, Congress recognized that the stock exchanges had been regulating their members for 140 years and did not seek to dismantle their self-regulatory mechanisms. Rather, it superimposed the SEC on already existing self-regulatory bodies by requiring every “national securities exchange” to register with the SEC. Under Section 6(b) of the Exchange Act, an exchange cannot be registered unless the SEC determines that its rules are designed “to prevent fraudulent and manipulative acts and practices” and to discipline its members for any violations of its rules or the securities laws. Both the NYSE and the NASD have promulgated rules relating to stock transactions and qualifications for those participating in such transactions. In general, these rules are enforced by the self-regulating bodies.

To clarify the SEC’s role, Congress amended the Exchange Act in 1975 to give the SEC explicit authority over all self-regulating organizations (SROs). Any exchange or OTC rule change now requires advance approval from the SEC. The commission also has reviewing power over all disciplinary actions taken by the SROs. Moreover, as mentioned earlier, the 1975 amendments eliminated the power of exchanges to fix minimum commission rates.

The movement by exchanges to “go public” (sell shares and, thus, ownership rights in the exchanges) has changed their nonregulatory aspects as traded companies. The regulatory function continues through SEC oversight. The Financial Industry Regulatory Authority (FINRA) was created as an SRO in 2007 when the NASD merged with the New York Stock Exchange’s regulatory arm. FINRA may soon be overseeing both brokers and financial advisers.

Proxy Solicitations

Procedural and Substantive Rules

Section 14 of the Exchange Act and the accompanying SEC regulations set forth the ground rules governing proxy solicitations by inside management, dissident shareholders, and potential acquirers of a company. You will remember from the discussion in  Chapter 17  that proxies are documents by which the shareholders of a publicly registered company designate another individual or institution to vote their shares at a shareholders’ meeting. They are often used by inside management to defeat proposals by dissident shareholders or to prevent a takeover by a “hostile” company. The real significance of the proxy solicitation process, however, is that it may result in materially changing the direction of the corporation without its owners’ (the shareholders’) awareness. Because very few individual shareholders (under 1 percent) attend annual shareholders’ meetings, proxy voting is management’s major instrument for electing the directors and setting the policy it wants.

Against this background, Congress enacted Section 14 of the Exchange Act—the section known as the Williams Act—making it unlawful for a company to solicit proxies in “contravention of such rules and regulations as the Commission [SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors.” With this broad statutory authority, the SEC has promulgated rules and regulations that require all companies registered under the securities acts to file proxy statements with the commission 10 days before mailing them to shareholders. During this 10-day period, the SEC staff comments on the statements and sometimes asks for changes, usually because it believes that not all material information has been included. Under its Rule 22, the commission requires proxy statements to carry several items of information, ranging from a notice on the revocability of proxies to a notification of the interest that the soliciting individuals or institutions have in the subject matter to be voted on. The purpose of this procedure is to make sure that shareholders have full disclosure on a matter before they agree to any grant of their proxy. The SEC also requires companies to send shareholders a form on which they can mark their approval or disapproval of the subject matter to be voted on. If a proxy is solicited for electing new directors, the shareholders must receive an annual report of the corporation as well.

Shareholder Proposals

If a shareholder of a registered issuing company wishes to place an item on the agenda, Rule 14(a)(8) requires that management be notified in a timely way before a regular shareholder meeting or a special meeting. Once notified, management must include the proposal (200 words or fewer) in the proxy statement it sends to all the shareholders. Management may also include its own view on the proposal. Shareholder proposals in recent years have included prohibitions against discrimination, pollution, dumping of wastes, “golden parachutes,” “poison pills,” and “greenmail” (the last three topics are discussed later in this section under the heading “Remedies and Defensive Strategies”). In a sense, proxy solicitation became a form of shareholder democracy—one that corporate management believed was getting out of hand. After vigorous debate by all interested groups, the SEC amended Rule 14(a) in 1983 to allow management to exclude a shareholder proposal if:

1. under the particular state law governing the corporation, the proposal would be unlawful if agreed to by the directors;

2. it involves a personal grievance;

3. it is related to ordinary operational business functions;

4. it is a matter not significantly related to the company’s business (the commission has defined this criterion as matters accounting for less than 5 percent of the assets, earnings, and sales of a company);

5. the stockholder making the proposal has not owned more than $1,000 worth of stock or 1 percent of the shares outstanding for a period of 1 year or more (although several shareholders may accumulate shares to meet this criterion); and

6. the shareholder proposal received less than 5 percent of the votes when submitted in a previous year.

Furthermore, shareholders are limited to one proposal per annual company meeting.

If management excludes a proposal, it must explain why, and the shareholder may then appeal to the SEC. The SEC staff decides whether the proposal should be placed on the agenda for the next annual meeting. The Dodd-Frank Act (examined earlier in this chapter) gives shareholders a nonbinding vote on executive compensation as directed by the SEC (see  Chapter 18 ).

Proxy Contests

Proxy contests normally come about when an insurgent group of shareholders seeks to elect its own slate of candidates to the board of directors to replace management’s slate. Both insurgent shareholders and management may seek shareholder proxies in this contest.

The SEC has set out specific rules governing disclosure by insurgents and management and the rights of each. An information statement must be filed by the insurgents, disclosing all participants in their group and the background of each, including past employment and any criminal history. In 2010 the SEC set out the “proxy access” role, which requires companies to include the names of all board nominees (even those not backed by the company), directly on the standard ballots distributed before shareholder annual meetings. To win the right to nominate, the investor or group of investors must own at least 3 percent of the company’s stock and have held shares for a minimum of three years. If dissident shareholders wish to oust board members, current shareholders must foot the bill for preparation and mailing of the official proxy for themselves and the dissidents.

Both criminal and civil liability attach to a company that sends a misleading proxy statement to its shareholders. The civil liability is based on a negligence standard (preponderance of the evidence). The SEC may, through injunctive relief, prevent the solicitation of proxies or may declare an election of directors, based on misleading proxies, to be invalid. Under the Insider Trader Sanctions Act of 1984 (discussed later in this chapter), the commission may also institute criminal and administrative proceedings against a company. Furthermore, persons who rely on a misleading proxy statement to buy or sell securities have the right to institute a private action, as do insurgent shareholders in a proxy fight.

Tender Offers and Takeover Bids

A series of hostile takeovers in the 1990s and creative defensive strategies used by management of some targeted companies, renewed concerned parties’ interest in the regulation of tender offers and takeover bids.

In a takeover bid, the acquiring company or individual, using a public  tender offer , seeks to purchase a controlling interest (51 percent) in another company—the target company—which would lead to a takeover of that company’s board of directors and management. The acquiring company makes this public offer in such national newspapers as the Wall Street Journal or the New York Times to company shareholders, requesting that they tender their shares for cash or for the acquiring company’s securities or for both, usually at a price exceeding that quoted for the shares on a national exchange. Because of abuses in the 1960s, when shareholders frequently were given only a short time to make up their minds and, thus, could not properly evaluate tender offers, Congress enacted legislation to give shareholders more information and a longer period to make a decision. This legislation became Sections 13 and 14 of the Securities Exchange Act.

tender offer

A public offer by an individual or a corporation made directly to the shareholders of another corporation in an effort to acquire the targeted corporation at a specific price.

Rules Governing Tender Offers

Sections 13 and 14 together constitute the regulatory framework for tender offers. Section 13 requires any person (or group) that acquires more than 5 percent of any class of registered securities to file within 10 days a statement with both the issuer (the target company) and the SEC. This statement must set forth (1) the background of the acquiring person or group, (2) the source of the funds used to acquire the 5 percent, (3) the purpose(s) of the acquisition of the stock, (4) the number of shares presently owned, (5) any relevant contracts with the target company, and (6) plans of the person or group for the targeted company.

Section 14 provides that no one may make a tender offer that results in ownership of more than 5 percent of a class of registered securities unless that person or group files with the SEC and with each offeree a statement containing information similar to that required by Section 13. It also restricts the terms of the offer, particularly the right of withdrawal by the offerer and extensions or changes in the offer. The “best price” rule applies during tender offers but only to consideration paid for past or future services.

The SEC has issued detailed rules concerning Section 14. For example, even if the offer is a  hostile bid —meaning that the management of the target company opposes it—the target company must either mail the tender offer to all shareholders or promptly forward a list of the shareholders to the tender offerer. Management must also, within 10 days of receiving a tender offer, state whether it opposes or favors it or lacks enough information to make a judgment. SEC rules also compel management to file a form called Schedule 14-9. Schedule 14-9 requires top managers to (1) disclose whether they intend to hold their shares in the company or tender them to the offerer; (2) describe any agreements they may have made with the tender offerer; and (3) disclose, if the tender offer is hostile, whether they have engaged in any negotiations with a friendly or “white knight” company.

hostile bid

A tender offer that is opposed by the management of the target company.

Section 14 of the 1934 Act and SEC rules require that a tender offer be open for at least 20 days so that shareholders will have a reasonable amount of time to consider it. The SEC has also set out certain withdrawal rights for shareholders who have tendered their shares.

Remedies and Defensive Strategies

Remedies

Section 14(e) (known as the Williams Act) makes it a criminal offense to make an untrue or misleading statement or to engage in fraudulent acts or deceptive practices in connection with a tender offer. The emphasis here is on intent to deceive. Shareholders of a targeted company can bring civil actions under Section 14(e) for violations of Sections 13(d) and 14(b) if they can show that they have been injured because they relied on fraudulent statements in the tender offer. In addition, under the Insider Trader Sanctions Act (discussed later in this section under “Securities Fraud”), the SEC may start administrative proceedings against violators, which is a much quicker remedy than going to court.

In the landmark case that follows, in which the U.S. Supreme Court interpreted the meaning of Section 14(e) of the Securities Act, note the Court’s concern over the correct interpretation of the word manipulative, which is the basis for causes of actions brought under this section.

 Case 23-3 Barbara Schreiber v. Burlington Northern, Inc.

United States Supreme Court 472 U.S. 1 (1985)

Petitioner Schreiber, on behalf of herself and other shareholders of El Paso Gas Company, sued Respondent Burlington Northern, claiming that the company had violated Section 14(e) of the Securities Exchange Act of 1934. In December 1982, Burlington issued a hostile tender offer for El Paso Gas Company. Burlington did not accept the shares tendered by a majority of shareholders of El Paso but instead rescinded the December offer and substituted another offer for El Paso in January. The rescission of the first tender offer resulted in a smaller payment per share to El Paso shareholders who retendered after the January offer. The petitioners claimed that Burlington’s withdrawal of the December tender offer and the substitution of the January offer were a “manipulative” distortion of the market for El Paso stock and a violation of Section 14(e). The respondent argued that “manipulative” acts under 14(e) require misrepresentation or nondisclosure and that no such acts had taken place in this case. Therefore, the respondent moved for dismissal of the case based on failure to state a cause of action. The federal district court granted the motion for dismissal. The court of appeals affirmed. Schreiber appealed to the U.S. Supreme Court.

Chief Justice Burger

We are asked in this case to interpret Section 14(e) of the Securities Exchange Act. The starting point is the language of the statute. Section 14(e) provides:

It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact necessary in order to make the statements made, in the light of the circumstances under which they are made, not misleading, or to engage in any fraudulent, deceptive or manipulative acts or practices, in connection with any tender offer or request or invitation for tenders, or any solicitation of security holders in opposition to or in favor of any such offer, request, or invitation. The Commission shall, for the purposes of this subsection, by rules and regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative.

Our conclusion that “manipulative” acts under Section 14(e) require misrepresentation or nondisclosure is buttressed by the purpose and legislative history of the provision. Section 14(e) was originally added to the Securities Exchange Act as part of the Williams Act.

It is clear that Congress relied primarily on disclosure to implement the purpose of the Williams Act. Senator Williams, the bill’s Senate sponsor, stated in the debate:

Today, the public shareholder in deciding whether to accept or reject a tender offer possesses limited information. No matter what he does, he acts without adequate knowledge to enable him to decide rationally what is the best course of action. This is precisely the dilemma which our securities laws are designed to prevent.

The expressed legislative intent was to preserve a neutral setting in which the contenders could fully present their arguments. To implement this objective, the Williams Act added Sections 13(d), 13(e), 14(e), and 14(f) to the Securities Exchange Act. Some relate to disclosure; Sections 13(d), 14(d), and 14(f) all add specific registration and disclosure provisions. Others— Sections 13(e) and 14(d)—require or prohibit certain acts so that investors will possess additional time within which to take advantage of the disclosed information.

To adopt the reading of the term “manipulative” urged by petitioner would not only be unwarranted in light of the legislative purpose but would be at odds with it. Inviting judges to read the term “manipulative” with their own sense of what constitutes “unfair” or “artificial” conduct would inject uncertainty into the tender offer process. An essential piece of information—whether the court would deem the fully disclosed actions of one side or the other to be “manipulative”—would not be available until after the tender offer had closed.

This uncertainty would directly contradict the expressed Congressional desire to give investors full information.

Congress’s consistent emphasis on disclosure persuades us that it intended takeover contests to be addressed to shareholders. In pursuit of this goal, Congress, consistent with the core mechanism of the Securities Exchange Act, created sweeping disclosure requirements and narrow substantive safeguards. The same Congress that placed such emphasis on shareholder choice would not at the same time have required judges to oversee tender offers for substantive fairness.

We hold that the term “manipulative” as used in Section 14(e) requires misrepresentation or nondisclosure. It connotes “conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.” Ernst & Ernst v. Hochfelder, 425 U.S., at 199. Without misrepresentation or nondisclosure, Section 14(e) has not been violated.

Applying that definition to this case, we hold that the actions of respondents were not manipulative. The amended complaint fails to allege that the cancellation of the first tender offer was accompanied by any misrepresentation, nondisclosure, or deception.*

Affirmed in favor of Defendant, Burlington Northern.

Critical Thinking About The Law

Sometimes ambiguity is present in the court’s own reasoning; for example, a judge might argue that a “reasonable” person would not be offended by sexual advances made by a fellow employee. At other times, the court must interpret ambiguity in congressional legislation to make a legal judgment.

Case 23-3 deals with the second of those judicial confrontations with ambiguity. It is important to be aware not only of the Court’s interpretation of an ambiguity but also of the evidence it selects to support that interpretation. The very fact that an important term is ambiguous means that there might be other legitimate interpretations; thus, in judging whether you agree with the particular interpretation at hand, you must evaluate the evidence presented for it. It is also important to recognize the primary ethical norm that informed the Court’s interpretation. The following questions address those considerations.

1. What legislative ambiguity was the Court dealing with in Case 23-3?

Clue: The meaning of this term is the central issue of the case.

2. Specifically, to what evidence did the Court refer to support its own interpretation of the ambiguity?

Clue: Reread the paragraph immediately following the quotation from Section 14(e).

3. In supporting its strict interpretation of legislative ambiguity, the Court stated that Congress intended to leave issues of fairness up to shareholders and not judges, making full disclosure the most important consideration. In this prioritization of the liberty (of shareholders) over potentially more just outcomes (allowing judges to decide fairness), one might argue that the primary ethical norm of liberty drove the Court’s reasoning. What other primary ethical norm is implicit in this prioritization?

Clue:  Consider the primary ethical norm that would be damaged if judges decided fairness (especially with the inevitable increase in court cases).

Defensive Strategies

The business judgment rule, which was discussed in  Chapter 17 , is based primarily on the 50 states’ case law and the Revised Model Business Corporations Act. It has traditionally allowed wide latitude to the managers of targeted companies, as long as they act in good faith in the best interests of shareholders, do not waste the corporate assets, and do not enter into conflict-of-interest situations.

Here is a list of defensive strategies that managements of targeted companies have used to repel hostile takeovers in recent years.

· Awarding large compensation packages (golden parachutes) to target- company management when a takeover is rumored.

· Issuing new classes of securities before or during a takeover battle that require a tender offerer to pay much more than the market price for the stock (poison pill).

· Buying out a “hostile” shareholder at a price far above the current market price of the target company’s stock in exchange for the hostile shareholder’s agreement not to buy more shares for a period of time (greenmail). Congress has now eliminated this defense by legislation.

· Writing supermajority requirements for merger approval into the bylaws and articles of incorporation (porcupine provisions).

· Issuing Treasury shares (stock that was repurchased by the issuing corporation) to friendly parties.

· Moving to states with strong antitakeover (shark repellent) laws.

· Bankrupting the company (scorched-earth policy).

· Prevailing upon another company or individual (a white knight) to buy out the hostile bidder to prevent the undesirable takeover.

Competition between State Legislatures

Antitakeover Regulations

With more than 40 states having statutes that seek to regulate takeovers, it is wise to note that target companies often have sought protection from takeovers by lobbying with state legislatures for detailed regulatory or antitakeover statutes. There are several types of state statutes:

· Statutes similar to the Williams Act (see Section 14 of the 1934 Act).

· Statutes that allow the state legislature to review the merits of a tender offer and/or the adequacy of disclosure. Many of these exempt tender offers that are supported by the target company’s management. Strong lobbying is often involved here.

· Statutes that require “fair prices.” Acquirers must pay all shareholders the highest price paid to any shareholders.

· Statutes that prohibit transactions with an acquirer for a specified period of time after a change in control unless disinterested shareholders approve.

This has led to some debate as to whether such statutes are in the best interest of shareholders (e.g., pension funds, insurance companies, and large institutional shareholders) or voters. Such statutes may be in the short-term interest of a company located in state X, but may be contrary to the best interests of the population of the state when company Y is looking for a place to locate. There are arguments from both sides as to whether such regulatory statutes are helpful when states are competing to obtain corporate opportunities and the jobs that go with them.

Securities Fraud

The courts have had a difficult time defining securities fraud. An appellate court once stated:

Fraud is infinite, and were a Court of Equity once to lay down rules, how far they would go, and no further, in extending their relief against it, or to define strictly the species or evidence of it, the jurisdiction would be cramped, and perpetually eluded by new schemes which the fertility of man’s invention would contrive.*

This is the philosophical position that has been adopted by the SEC: There cannot be a law against every type of fraud imaginable. Instead, the SEC staff has sought to use Section 10(b) of the Securities Act broadly, going beyond its exact language to develop a “fraud-on-the-market” theory that does not require the investor-plaintiff ever to have relied on false documents or specific acts, but only on the integrity of the market and a fair stock price.

Section 10(b) of the Securities Exchange Act

One of the purposes of the Securities Exchange Act of 1934 was to ensure the full disclosure of all material information to potential investors. Full disclosure enables the market mechanism to operate efficiently and ensures that consumers are provided with a fair price for securities. Section 10(b) prohibits the use of the mails or other facilities (e.g., truck or car and satellite or data transmission) in interstate commerce

in connection with the purchase or sale of any security, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.*

This broad statutory language signals a congressional intent to cover all possible forms of fraud. To that end,

it shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, (1) to employ any device, scheme, or artifice to defraud, (2) to make any untrue statement of a material fact necessary in order to make the statements made, in the light of circumstances under which they were made, not misleading or (3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

A private party’s standing to sue under Section 10(b) and associated SEC Rule 10(b)-5 has been upheld in cases in which manipulative or deceptive acts were committed in connection with the purchase or sale of securities. The question of standing that the Supreme Court answers again in the following case is whether the corporation (Matrixx) has made a disclosure of material fact in a timely manner as required by Rule 10(b)-5.

 Case 23-4 Siracusano v. Matrixx Initiatives, Inc.

131 S. Ct. 1309 (2011)

Matrixx Initiatives, Inc., is pharmaceutical company that sells Zicam through its wholly owned subsidiary Zicam, LLC. One of its products, responsible for 70 percent of its sales, is Zicam Cold Remedy, a homeopathic product marketed as stopping or minimizing cold symptoms. In December 1999, Matrixx began to receive 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 percent 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 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.”

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.

Justice Sotomayor

To prevail on a § 10(b) claim, a plaintiff must show that the defendant made a statement that was “misleading as to a material fact.”

Matrixx urges us to adopt a bright-line rule that reports of adverse events associated with a pharmaceutical company’s products cannot be material absent a sufficient number of such reports to establish a statistically significant risk that the product is in fact causing the events. Absent statistical significance, Matrixx argues, adverse event reports provide only “anecdotal” evidence that “the user of a drug experienced an adverse event at some point during or following the use of that drug.” Accordingly, it contends, reasonable investors would not consider significant because only then do they “reflect a scientifically reliable basis for inferring a potential causal link between product use and the adverse event.”

A lack of statistically significant data does not mean that medical experts have no reliable basis for inferring a causal link between a drug and adverse events. As Matrixx itself concedes, medical experts rely on other evidence to establish an inference of causation.

The FDA similarly does not limit the evidence it considers for purposes of assessing causation and taking regulatory action to statistically significant data. For example, the FDA requires manufacturers of over-the-counter drugs to revise their labeling “to include a warning as soon as there is reasonable evidence of an association of serious hazard with a drug; a causal relationship need not have been proved.”

This case proves the point. In 2009, the FDA issued a warning letter to Matrixx stating that “[a] significant and growing body of evidence substantiates that the Zicam Cold Remedy intranasal products may pose a serious risk to consumers who use them.” The letter cited as evidence 130 reports of anosmia the FDA had received few reports of anosmia associated with other intranasal cold remedies, and “evidence in the published scientific literature that various salts of zinc can damage olfactory function in animals and humans.” It did not cite statistically significant data. Given that medical professionals and regulators act on the basis of evidence of causation that is not statistically significant, it stands to reason that in certain cases reasonable investors would as well.

The information provided to Matrixx by medical experts revealed a plausible causal relationship between Zicam Cold Remedy and anosmia. Consumers likely would have viewed the risk associated with Zicam (possible loss of smell) as substantially out-weighing the benefit of using the product (alleviating cold symptoms), particularly in light of the existence of many alternative products on the market. Viewing the allegations of the complaint as a whole, the complaint alleges facts suggesting a significant risk to the commercial viability of Matrixx’s leading product. It is substantially likely that a reasonable investor would have viewed this information “‘as having significantly altered the “total mix” of information made available’”

Matrixx elected not to disclose the reports of adverse events not because it believed they were meaningless but because it understood their likely effect on the market. “[A] reasonable person” would deem the inference that Matrixx acted with deliberate recklessness (or even intent). We conclude, in agreement with the Court of Appeals, that respondents have adequately pleased [materially and] scienter.*

Affirmed.

Critical Thinking About The Law

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?

2. Why is it relevant that consumers would be affected by the studies, whether significant or not?

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 use of Section 10(b) and Rule 10(b)-5 has been controversial in three major types of securities fraud cases: insider trading, misstatements by corporate management, and mismanagement of a corporation ( Table 23-4 ). After each of these areas is explored in turn, a new concept will be mentioned that shareholder suits based on fraud have been invoking: fraud-on-the-market theory.

Table 23-4 Securities Fraud Under Section 10(b) of the Securities Exchange Act of 1934

Activity	Definition
Insider trading	The use of nonpublic information received from a corporate source by an individual(s) who has a fiduciary obligation to shareholders and potential investors and who benefits from trading on such information.
Misstatement of corporation	Any report, release, or financial statement or any other statement that is released by an officer, a director, or an employee of a corporation in connection with the purchase or sale of a security that shows an intent to mislead shareholders or potential investors.
Corporate mismanagement	Any transaction involving the purchase or sale of a security in which there is fraud based on an action of management. The plaintiff must be either a purchaser or a seller of securities in such a transaction.

Insider Trading and Section 10(b)5-1 and 10(b)5-2 of the Securities Act

Insider trading  is the use of material, nonpublic information received from a corporate source by an individual who has a fiduciary obligation to shareholders and potential investors and who benefits from trading on such information. The SEC adopted new guidelines as provided here because federal appellate courts have disagreed on the definition. For example, a trader must now be “aware” of nonpublic information when making the purchase or sale of a security. In 2015, the 2nd Circuit Court of Appeals refused a rehearing of its December 2014 decision. In the 2014 decision, the court set out its original standard for judging insider trading cases but added to it that prosecutors must prove that traders knew the person who would provide the tip and the latter had gained some tangible reward for doing so. Friendship of career advice alone did not count as a benefit or reward. This case has broad implications for those previously convicted of insider trading who have argued that the addition to the standard should be considered in their cases. This case, if adopted by other circuit courts of appeal, could stimulate Congress to act on legislation that would more clearly define insider trading, so that we would no longer need to rely on the case by case approach presently used by courts.

insider trading

The use of material, nonpublic information received from a corporate source by someone who has a fiduciary obligation to shareholders and potential investors and who benefits from trading on such information.

Insiders have been found by the courts to be (1) officers and directors of a corporation; (2) partners in investment banking and brokerage firms; (3) attorneys in a retained law firm; (4) underwriters and broker-dealers; (5) financial reporters; and (6) in a unique case, an employee of a financial printing firm that printed documents for a tender offer. (See  Exhibit 23-3  for a look at Wall Street’s army of insiders, from the general to the grunts.)

There is no statutory definition of insider trading—only case law.

“Holy Toledo”: Securities Fraud May Be Easy

On April 29, 1999, Martin Frankel, a high school graduate and a native of Toledo, Ohio, absconded with a reputed $335 million. In Mr. Frankel’s capacity as founder of “Thunor Trust,” a string of eight insurance companies in several southern states had provided him with large sums of money to invest. The con was uncovered when the Franklin American Corporation, owner of these insurance companies, introduced Frankel as a prominent bond trader on April 28, 1999. After failing to attend a meeting with regulators, Frankel wired $334.6 million of Franklin American’s money to a foreign bank account. In

Exhibit 23-3 Insider Traders

addition, he burned all the documents at his Greenwich, Connecticut, mansion, creating a suspicious fire that led to a police search. He then fled to Europe, ending up in jail in Germany. After a period of six months, he was extradited to the United States and was convicted of fraud charges after pleading guilty. Five states sought roughly $215 million, which Frankel was charged with stealing. Approximately $9 million was received at an auction of 822 diamonds seized from Frankel. On December 10, 2004, he was sentenced to a federal prison for 16 years, 6 months.

Unlike convicted felons Ivan Boesky and Michael Milken, Frankel was not a high-profile individual. The use of aliases and the pretension of being a multimillionaire were all that was required. The fact that he used state-regulated insurance companies in this case may have helped the scheme. The SEC and the Justice Department did not become involved until he fled the country.

Sources: L. Mergener, “Frankel Gets 16 Years for Fraud,” The Blade, December 11, 2004, 1; A. Cowan, “Onetime Fugitive Gets 17 Years for Looting Insurers,” New York Times, December 11, 2004, PB–3; L. Vellequette, “Frankel to Be Subject of CNBC Show,” The Blade, March 18, 2008, 27.

The expansion of targets in insider-trading cases, from management and corporate directors to a Wall Street Journal reporter and a printer employee, has resulted from the SEC enforcement staff’s determination that to provide full disclosure in the marketplace for potential investors, it had to extend its jurisdiction over tippers (insiders) and tippees (those who receive tips from insiders).

Applying the Law to the Facts . . .

Dallas was a CEO of a pharmaceuticals company, and he purchased significant amounts of stock in the company for his children over the years. When news that a new drug manufactured by the company was likely to get FDA approval was leaked by an unknown source, the value of the stock skyrocketed. Unfortunately, the FDA ultimately rejected the drug’s application. Dallas got early notice of the FDA’s planned rejection and immediately called all his children and told them to sell their stock, without telling them why. “Trust me,” he said. They all sold immediately, and one daughter also told her boyfriend to sell his stock on her dad’s advice, which he did. Is anyone in this scenario in trouble? If so, why? What potential penalties might he or she face?

Misstatements of Corporations and Section 10(b)

The second area of controversy regarding Section 10(b) application involves statements by corporate executives. Any report, release, or financial statement or any other statement that sets forth material information (information that would affect the judgment of the average prudent investor) falls within Section 10(b).

Whereas Sections 13 and 14 of the Exchange Act (discussed earlier) apply only to reports, proxy statements, and other documents filed by a company registered with the SEC and a national exchange, Rule 10(b)-5 applies to any statement made by any issuer, registered or not. To be considered a securities fraud, corporate misstatements must meet two requirements: (1) They must be issued “in connection with the purchase or sale of any security,” and (2) there must be a showing of  scienter  (intent). As you read the following case, try to determine how closely the defendants met those requirements.

scienter

Knowledge that a representation is false.

 Case 23-5 Securities and Exchange Commission v. Texas Gulf Sulphur Co.

United States Court of Appeals 401 F.2d 833 (2nd Cir. 1968)

The SEC (plaintiff) brought an action against the Texas Gulf Sulphur Company (TGS) and 13 of its directors, officers, and employees (defendants) for violation of Section 10(b) of the Exchange Act and SEC Rule 10(b)-5, seeking an injunction against further misleading press releases and requesting rescission of the defendants’ purchases and stock options. On June 6, 1963, TGS had acquired an option to buy 160 acres of land in Timmons, Ontario. On November 11, 1963, preliminary drilling indicated that there would be major copper and zinc finds. TGS acquired the land and resumed drilling on March 31, 1964, and by April 8, it was evident that there were substantial copper and zinc deposits. On April 9, Toronto and New York newspapers reported that TGS had discovered “one of the largest copper deposits in America.” On April 12, TGS’s management said that the rumors of a major find were without factual basis. At 10 a.m. on April 14, the board of directors authorized the issuance of a statement confirming the copper and zinc finds and announcing the discovery of silver deposits as well. On April 20, the NYSE announced that it “was barring stop orders [orders to brokers to buy a stock if its price rises to a certain level to lock in profits in case of a sharp rally in that stock] in Texas Gulf Sulphur” because of the extreme volatility in the trading of the stock.

Approximately one month later, rumors circulated about insider trading. It was later found that when drilling began on November 12, 1963, TGS’s directors, officers, and employees owned only 1,135 shares of stock in the company and had no calls (options to purchase shares at a fixed price). By March 31, 1964, when drilling resumed, insiders (tippers) and their tippees had acquired an additional 7,100 shares and 12,300 calls. On February 20, 1964, TGS had issued stock options to three officers and two other employees as part of a compensation package.

From April 9, 1964 to April 14, 1964, when the confirmatory press release was issued, 10 insiders and their tippees made estimated profits of $273,892 on the purchase of their shares or calls of TGS stock. The federal district court dismissed charges against all but two defendants. Those defendants, Clayton and Crawford, appealed, and the SEC appealed from the part of the district court decision that had dismissed the complaint against TGS and the nine other individual defendants.

Judge Waterman

Rule 10(b)-5 was promulgated pursuant to the grant of authority given the SEC by Congress in Section 10(b) of the Securities Exchange Act of 1934. By that Act Congress proposed to prevent inequitable and unfair practices and to ensure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on exchanges. The Act and the Rule apply to the transactions here, all of which were consummated on exchanges.

The essence of the Rule is that anyone who, trading for his own account in the securities of a corporation, has “access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone” may not take “advantage of such information knowing it is unavailable to those with whom he is dealing,” i.e., the investing public. Insiders, as directors or management officers, are, of course, by this Rule, precluded from so unfairly dealing, but the Rule is also applicable to one possessing the information who may not be strictly termed an “insider” within the means of Sec. 10(b) of the Act. Thus, anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such insider information remains undisclosed. So, it is here no justification for insider activity that disclosure was forbidden by the legitimate corporate objective of acquiring options to purchase the land surrounding the exploration site; if the information was, as the SEC contends, material, its possessors should have kept out of the market until disclosure was accomplished.

As we stated in List v. Fashion Park, Inc., “The basic test of materiality is whether a reasonable man would attach importance in determining his choice of action in the transaction in question.” This, of course, encompasses any fact “which in reasonable and objective contemplation might affect the value of the corporation’s stock or securities.” Such a fact is a material fact and must be effectively disclosed to the investing public prior to the commencement of insider trading in the corporation’s securities. The speculators and chartists of Wall and Bay Streets are also “reasonable” investors entitled to the same legal protection afforded conservative traders. Thus, material facts include not only information disclosing the earnings and distributions of a company but also those facts which affect the probable future of the company and those which may affect the desire of investors to buy, sell, or hold the company’s securities.

The core of Rule 10(b)-5 is the implementation of the Congressional purpose that all investors should have equal access to the rewards of participation in securities transactions. It was the intent of Congress that all members of the investing public should be subject to identical market risks—which market risks include, of course, the risk that one’s evaluative capacity or one’s capital available to put at risk may exceed another’s capacity or capital. The insiders here 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; they alone could invest safely, secure in the expectation that the price of TGS stock would rise substantially in the event such a major strike should materialize, but would decline little, if at all, in the event of failure, for the public, ignorant at the outset of the favorable probabilities, would likewise be unaware of the unproductive exploration, and the additional exploration costs would not significantly affect TGS market prices. Such inequities based upon unequal access to knowledge should not be shrugged off as inevitable in our way of life, or, in view of the congressional concern in the area, remain uncorrected.

We hold, therefore, that all transactions in TGS stock or calls by individuals apprised of the drilling results of K-55-1 were made in violation of Rule 10(b)-5.*

Reversed and remanded in favor of Plaintiff, SEC.

Linking Law and Business Economics: Efficient Markets

In microeconomics, you learned that the law of supply and demand brings about equilibrium price levels, assuming a free flow of information and mobility of resources. These factors will create efficient markets.

Microeconomics presents an important link to securities law. When plaintiffs argue a fraud-on-the- market theory, they are arguing that there is a distortion or omission of information and, thus, the purchase or sale of the security is subject to fraud and a violation of securities law.

Corporate Mismanagement and Section 10(b)

The third controversial area of securities fraud under Section 10(b) is corporate mismanagement. Suits alleging corporate mismanagement and fraud brought by minority shareholders in class action or derivative suits must prove three elements: (1) that the transaction being attacked (e.g., the sale of a controlling stock interest in a corporation at a premium) involves the purchase or sale of securities, (2) that the alleged fraud is in connection with a purchase or sale, and (3) that the plaintiff is either a purchaser or a seller of securities in the transaction involved. The Hochfelder case, referred to in the Schreiber case excerpted earlier in this chapter, is an example of fraud perpetrated on shareholders by management. Other cases alleging fraud dealing with reorganizations and mergers have been brought, but since the mid-1970s, the Supreme Court has been reluctant to allow cases brought under Section 10(b) to preempt state laws and, thus, has made plaintiffs meet all three elements in an exacting manner.

Fraud-on-the-Market Theory and Section 10(b)

The Supreme Court has attached stringent criteria to all private-party actions brought under Section 10(b)-5 and SEC Rule 10(b)-5. Defrauded investors generally need to show that their losses resulted from specific conduct of the company or its employees or agents and that they relied on specific misstatements, omissions, or fraudulent actions in making investment decisions. More recently, shareholders have used an efficient-market concept as the basis for suits claiming fraud. That is, they have alleged that they relied on the integrity of an efficient market to assimilate all information about a company and to reflect this information in a fair price for securities. The plaintiff in such a suit argues that when a company makes fraudulent disclosures or omissions, it distorts the information flow to the market and thus fixes the price of the company’s securities too high, in violation of Section 10(b) and Rule 10(b)-5. This fraud-on-the-market theory assumes that the market price reflects all known material information. In a landmark decision (United States v. James O’Hagan, 117 S. Ct. 2199 [1997]) the U.S. Supreme Court upheld this theory.

Insider Trading Bills: Is Congress Corrupt?

The Senate bill states in part: “No member of Congress and no employee of Congress shall use any non-public information derived from the individual’s position as a member of Congress or employee of Congress or gained from performance of the individual’s duties” for personal benefit.

For many years, a separate industry, known as “political intelligence,” was practiced by political insiders connected with hedge funds, mutual funds, and other investors. When bills were passed by members of the House and Senate, powerful new tools were added by which prosecutors could pursue public corruption cases. Numerous amendments were passed. For the first time, firms that collect “political intelligence” must register and report their activities as lobbyists. All such activities obtained from Congress and federal agencies that are used to influence or guide investment decisions must be reported.

Liability and Remedies Under The 1934 Exchange Act

Criminal Penalties

Violations of Section 10(b) and Rule 10(b) may lead individuals to be fined up to $5 million or imprisoned up to 20 years, or both under the Sarbanes-Oxley Act as discussed earlier in this chapter. A partnership or corporation may be fined $25 million for a proven willful violation. The violator may be imprisoned for 25 years in addition to being fined. The SEC must refer all criminal actions to the Justice Department.

SEC Action

Under the Insider Trading Sanctions Act of 1984 12  and the Insider Trading and Securities Enforcement Act of 1988, the SEC may bring a civil suit against anyone violating or aiding or abetting a violation of the 1934 Act or an SEC rule by purchasing or selling a security while in possession of material, nonpublic information. Violations must occur on or through a national securities exchange or from or through a broker or dealer. If the defendant is found liable, the court may impose a fine in an amount triple (treble) the profits that were gained illegally.

12  15 U.S.C. § 78u(d)(2)(A).

The Insider Trading and Securities Fraud Enforcement Act of 1988 enlarged the class of people who may be subject to civil liability for insider trading. Also, bonus payments can be given to anyone providing information leading to the prosecution of insider-trading violations. 13

13  15 U.S.C. § 78u-1.

Private Actions

Private parties may sue violators under Rule 10-5 and Section 10(b). Potential violators include accountants, attorneys, and others who aid and abet violations of Section 10(b). As noted later in this chapter, a corporation can bring an action to recover short-swing profits under Section 16(b). Under Section 10(b), a private plaintiff may seek rescission of a securities contract or recover damages for breach by disgorgement of illegal profits gained. In the following case, the U.S. Supreme Court emphasizes the role of a private plaintiff in actions for securities fraud violations.

 Case 23-6 The Wharf (Holdings) Limited v. United International Holdings, Inc.

United States Supreme Court 121 S. Ct. 1776 (2001)

United International Holdings, Inc., sued The Wharf (Holdings) Limited in federal district court for securities fraud for violating Section 10(b) and Rule 10(6)-5 of the 1934 Exchange Act.

The Wharf (Holdings) Limited is a Hong Kong firm that was interested in obtaining a license to operate a cable television system in Hong Kong. In 1991, the Hong Kong government announced that it would accept bids for the award of an exclusive license to operate a cable television system in Hong Kong. Wharf decided to find a business partner with cable system experience. Wharf located United International Holdings, Inc., a Colorado- based company with substantial experience in operating cable television systems. Wharf orally agreed to grant United an option to buy 10 percent of the stock of the new Hong Kong cable system if Wharf was awarded the license.

In May 1993, Hong Kong awarded the cable franchise to Wharf. When United raised $66 million and tried to exercise its option to invest 10 percent in the new cable company, Wharf refused to permit United to buy any of the new company’s stock. Documents and other evidence showed that at the time Wharf orally granted United the 10 percent stock option, it had not intended ever to sell United any stock in the new venture. The jury held for United and awarded it $67 million in compensatory damages and $58.5 million in punitive damages against Wharf. The court of appeals affirmed. The U.S. Supreme Court granted review.

Justice Breyer

Wharf points out that its agreement to grant United an option to purchase shares in the cable system was an oral agreement. And it says that Section 10(b) does not cover oral contracts of sale. There is no convincing reason to interpret the Act to exclude oral contracts as a class. The Act itself says that it applies to “any contract” for the purchase or sale of a security. Oral contracts for the sale of securities are sufficiently common that the Uniform Commercial Code and statutes of frauds in every State now consider them enforceable. To sell an option while secretly intending not to permit the option’s exercise is misleading, because a buyer normally presumes good faith. Since Wharf did not intend to honor the option, the option was, unbeknownst to United, valueless.*

Affirmed for Plaintiff, United.

Short-Swing Profits

Purpose and Coverage

Section 16(b) of the Exchange Act seeks to further the goal of complete disclosure of insider trading by requiring directors, officers, and owners of more than 10 percent of a class of stock of a registered company to file regular reports with the SEC and the exchanges on which the stock trades. Directors and officers must file an initial statement of their holdings in the company when they take office, and the others must file when they come to own more than 10 percent. A follow-up statement is due monthly if they change their holdings in any manner. Any profits made by a director or an officer or a 10 percent beneficial owner as a result of buying and selling the securities within a 6-month period—known as  short-swing profits —are presumed to be based on insider information. A plaintiff does not have to show that these insiders had access to, relied on, or took advantage of any insider information. In 1991, the SEC adopted new rules relating to Section 16 that (1) created a new form (Form 5) that must be filed by all insiders within 45 days of the end of the issuer’s calendar year, (2) waive liability for insiders for transactions that occur within six months of becoming an insider, (3) make the acquisition of a derivative security (e.g., warrant) fall under Section 16, and (4) define an officer under Section 16 as a person who has a policy function (e.g., CEO, president, and vice president). Now, those company officers who handle day-to-day operations do not fall under Section 16.

Comparative Law Corner Insider Trading Worldwide

Over the past 20 years, insider trading has been vigorously prosecuted. From 1995 to 2005, the stock markets of Britain, Germany, France, Italy, and Switzerland had only 19 criminal convictions. In the United States, the total for Manhattan alone during the same time period was 46 convictions. Britain had only three in this time frame. France had none. From a comparative viewpoint, why the differences in convictions, and what are the implications for people doing business in the United States as opposed to other nations?

The United States has uniform requirements for disclosure for primary offerings and proxy voting. Practices outside the United States are not uniform. a  Further, the regulatory framework set out by the United States is in sharp contrast to the European and Japanese frameworks. Enforcement is weak with regard to insider trading in many countries.

a L. Thomas M. deMercedi, “Insider Trading Can Now Touch Many Corners of the World,” New York Times, August 4, 2007, C-1.

Some Comparative Results

From a comparative viewpoint, it is very difficult for U.S. companies and U.S. citizens to believe that laws dealing with insider trading are not the same in civil law, socialist, or emerging nations’ legal systems. Often, they know only vaguely about their own laws dealing with insider trading (unless advised by specialized counsel), much less about those of other nations. They are shocked when they are cited for violations of many securities laws outlined in this chapter (e.g., the FCPA of 1977 as amended in 1988 and 1998) or of laws of other nations.

Even more striking is the globalization of insider trading when it is alleged to have taken place in another country that has a weak insider-trading regulatory structure (e.g., Pakistan). When a foreign citizen takes part in insider trading on a U.S. exchange following a tip by another foreign citizen, both are stunned when the U.S. Justice Department charges them with insider trading for which criminal penalties are possible. b  The SEC and Justice Department have entered into separate agreements with several nations for assistance in enforcing U.S. securities laws.

b H. Immons and K. Bennhold, “Call for Foreigners to Have a Say on U.S. Market Rules,” New York Times, August 29, 2007, C-1.

short-swing profits

Profits made by directors, officers, or owners of 10 percent or more of the securities of a corporation as a result of buying and selling the securities within a six-month period.

Liability

Suits based on short-swing profits seek to force the insiders to return the profits to the corporation. Only the issuers—meaning the directors and officers of the corporation—and the shareholders have standing to sue. Officers and directors generally do not sue other officers and directors, so virtually all suits are brought by other shareholders. The expense of such litigation, however, makes use of this enforcement action infrequent.

State Securities Laws

State securities laws, often referred to as “blue sky” laws, regulate securities purchased and sold in intrastate commerce. Securities are regulated (concurrently) by both state and federal laws. State laws require that securities be registered (or qualified) with both federal and state authorities. A state official or office is usually so designated. State disclosure requirements and antifraud provisions are similar to each other and to their federal counterparts, such as the Securities Exchange Act of 1934, SEC Rule 10(b), and Section 10(b).

The Uniform Securities Act has been adopted in part by some states to bring uniformity to state security laws. The 1995 National Securities Markets Improvement Act limited regulation of investment companies to the SEC and did away with some state authority in this area.

E-Commerce, Online Securities Disclosure, and Fraud Regulation

Marketplace of Securities

The Internet is now used daily to register securities. Online IPOs are a frequent occurrence that has brought efficiency (in economic terms) to the marketplace of securities. Small companies in particular use the Internet to avoid paying commissions to brokers or underwriters. Regulation A, discussed in this chapter, allows a simple method of registration.

In addition to using the Internet to provide information (e.g., 10-K) to the SEC as required by the 1933 and 1934 Acts, as well as others, potential investors receive information more rapidly and are willing to take advantage of this to purchase or sell securities. Online filing of many documents with the SEC is now routine for most large corporations, which benefit from the additional time given to them that did not exist when they had to use snail mail.

Furthermore, investors and companies can take advantage of the EDGAR database, which includes proxy statements, annual corporate reports, and a multitude of other documents that are filed with the commission. All of this allows the SEC to accomplish its goal of full disclosure. (See  Exhibit 23-1  for where EDGAR is located in the structure of the SEC.)

E-Commerce and Fraud in The Marketplace

The SEC continues to deal with fraud in the marketplace via the Internet. Chat rooms in particular have become cyberworld locations for violations of the 1933 and 1934 Securities Acts. Often, a stock price is “pumped up” as a result of information obtained in chat rooms. After it is “pumped,” it is quickly “dumped.” The SEC has been tracing such actions that seek to manipulate stock prices in violation of the 1934 Exchange Act. As noted in the discussion of the Sarbanes-Oxley Act, penalties can be costly, not only in dollar terms but also in possible prison time.

The list of millions of credit card names and addresses of customers of Target and other companies raised the stakes for the SEC, the FTC, and other government and nongovernment entities that sought to combat such activities.

Global Dimensions of Rules Governing the Issuance and Trading of Securities

The growing internationalization of money and securities markets has made it important to understand the transnational reach of U.S. securities regulations. Both the 1933 Act and the Exchange Act speak of the use of “facilities or instrumentation in interstate commerce.” Interstate commerce is defined in the 1933 Act to include “commerce between any foreign country and the United States.”

This section discusses (1) legislation prohibiting certain forms of bribery and money laundering overseas by U.S.-based corporations and (2) legislation governing foreign securities sold in the United States. You will notice throughout the discussion that provisions of the 1933 Act and the 1934 Exchange Act overlap.

Legislation Prohibiting Bribery and Money Laundering Overseas

The Foreign Corrupt Practices Act of 1977, as Amended in 1988 and 1998

In the course of investigating illegal corporate payments made to President Nixon’s 1972 reelection campaign, the SEC staff came across information showing that hundreds of corporations had also made questionable payments to foreign political parties, heads of state, and individuals to obtain business they would not otherwise have gained. The companies argued that these payments were not illegal under U.S. law and that they were necessary to compete with foreign state-owned and state-operated enterprises and with state-subsidized multinationals. The SEC, however, considered this information material under both the 1933 and 1934 securities acts because it affected the integrity of management and the records of the corporations involved. In 1974 and 1975, the SEC allowed approximately 435 companies to enter into consent orders whereby the companies did not admit to making illegal payments but agreed to report such payments to the SEC in the future. The SEC also urged Congress to enact legislation prohibiting bribery overseas by U.S. corporations.

The FCPA of 1977, as amended in 1988 and 1998, seeks to meet this goal. It applies to companies registered under the Securities Acts of 1933 and 1934 and to all other domestic concerns, whether they do business abroad or not. Its antibribery provisions prohibit all domestic firms from offering or authorizing a “corrupt” payment to a foreign official, a foreign political party, or a foreign political candidate to induce the recipient to act, or to refrain from acting, so that a U.S. corporation can obtain business it would not ordinarily get without the payment. The standard of criminal conduct to which corporate officials and employees are held is “knowing.” If such a payment is known to violate the FCPA, the corporation can be fined up to $2 million, and its officers, directors, stockholders, employees, and U.S. agents can be fined up to $100,000 and imprisoned for up to 5 years. In addition to prohibiting the payment of bribes, the FCPA also bans the “offer” or “promise” of “anything of value,” even if the offer or promise is never consummated. “Facilitating or expediting payments” to ensure routine governmental action is not prohibited.

The FCPA’s accounting provisions, enacted as amendments to Section 13(b) of the Exchange Act, apply only to registered nonexempt companies. They require that companies make and keep records and accounts in “reasonable detail” that “accurately and fairly” reflect transactions. Also, companies are required to maintain systems that provide “reasonable assurance” that transactions have been recorded in accordance with generally accepted accounting principles.

The FCPA is jointly enforced by the Justice Department and the SEC. The SEC can investigate and bring civil charges under the act’s bribery provisions, but it refers criminal cases to the Justice Department for prosecution. The Justice Department can bring both civil and criminal charges against alleged violators of the FCPA. The SEC is charged with enforcement of the accounting provisions and can bring both civil actions and administrative proceedings.

Convention on Combating Bribery of Foreign Officials in International Business Transactions

The Convention on Combating Bribery of Foreign Officials in International Business Transactions (CCBFOIBT) was signed in December 1997 by 34 countries after debate by the Organization for Economic Cooperation and Development (OECD). Signatories are required to criminalize bribery of foreign officials, eliminate the tax deductibility of bribes, and subject companies to wider disclosure. Russia (an observer) and China are not signatories; the 34 signatories include the United States, Canada, Japan, and Germany. The treaty creates one loophole: “grease payments.” It is acknowledged that these facilitating payments are the cost of doing business and can be paid to low-level officials.

The major change for the United States was the need to amend the FCPA to cover foreign subsidiaries of U.S. companies whose activities have a nexus with interstate or foreign commerce. Under current U.S. law, such subsidiaries are not subject to the FCPA.

The International Securities Enforcement Cooperation Act of 1990

After it was found that many insider traders in the United States were holding secret accounts in Switzerland, the SEC in June 1982 entered into a memorandum of understanding with the Swiss government that established a procedure for processing SEC requests for information about Swiss bank clients suspected of insider trading. As reports of overseas “money laundering” of profits made from insider trading in the United States mounted throughout the late 1980s, the SEC encouraged Congress to clarify the commission’s authority to act, not only against those who were sheltering their profits from illegal insider trading in foreign countries but also against others who were violating U.S. securities laws abroad.

In 1990, Congress passed the International Securities Enforcement Cooperation Act (ISECA). The most important provisions of this act are as follows:

1. It provides for giving foreign regulators U.S. government documents and information needed to trace laundered money and those suspected of doing the laundering.

2. It exempts from the Freedom of Information Act (FOIA) disclosure requirements documents given to the SEC by foreign regulators. Without this exemption, foreign regulators would be reluctant to provide U.S. regulators with information and alleged violators could obtain information too easily.

3. It gives the SEC authority to impose administrative sanctions on buyers and dealers who engage in activities that are illegal under U.S. law while they are in foreign countries.

4. It authorizes the SEC to investigate violations of all U.S. securities laws that occur in foreign countries.

Legislation Governing Foreign Securities Sold in The United States

Schedule B of the Securities Act of 1933 sets forth disclosure requirements for initial offerings by foreign issuers of stock on U.S. exchanges. Foreign issuers are entitled to some of the same exemptions in this area as domestic issuers, except that exemptions under Regulation A are granted only to U.S. and Canadian issuers. Also, the SEC has special registration forms for initial foreign offerings. In Section 12(g)(3) of the Exchange Act, Congress gave the SEC power to exempt foreign issuers whose securities are traded on U.S. exchanges or the OTC markets from certain registration requirements if the commission believes that such action would be in the public interest. Under SEC Rule 12(g)(3)-2, the securities of a foreign issuer are exempt from annual and current reports if the issuer or its government furnishes the SEC with annual information material to investors, which is made public in the issuer’s own country. In 1983, the commission published a list of exemptions for foreign-issued securities and adopted regulations that generally require foreign securities registered under the Exchange Act also to be quoted on the National Association of Securities Dealers Authorized Quotations (NASDAQ).

Regulations and Offshore Transactions

Regulation S governs offers and sales of any securities made in offshore transactions. Such transactions are defined as those in which no offer is made to a person in the United States and (1) the buyer is outside the United States at the time the buy order is originated or (2) the transaction is executed in, on, or through the facilities of a designated offshore securities market. No directed selling efforts may be made in the United States.

Regulation S allows U.S. companies to offer securities abroad with some certainty that such securities will be exempt from federal securities registration. The combination of Rule 144A and Regulation S has expanded the private placement market by increasing the liquidity of private placement securities.

Summary

The SEC is the federal agency responsible for overseeing the securities markets and enforcing federal securities legislation.

Several pieces of legislation provide the framework for the federal regulation of securities issuance and trading, but the most important are the Securities Act of 1933 and the Securities Exchange Act of 1934. The most recent additions are the Dodd-Frank Act and the Sarbanes-Oxley Act, which amend both the 1933 and 1934 Acts.

The Securities Act of 1933 seeks to ensure that investors receive full and fair disclosure of all material information about a new stock issue. It prescribes a three-stage registration process for new securities: prefiling, filing, and postfiling. Several types of securities are exempt from registration: principally private placements, intrastate offerings, and small business offerings.

The Securities Exchange Act of 1934 governs six areas of securities trading: the registration of securities issuers and broker-dealers, securities markets, proxy solicitations, tender offers and takeover bids, securities fraud, and short-swing profits. Provisions of the act dealing with securities fraud address insider trading, misstatements by corporate management, and mismanagement of a corporation.

The e-commerce world has made online investing via the Internet a common occurrence. The SEC, with the help of EDGAR, has sought to modernize the securities regulatory system and assist both investors and issuing companies.

The increasing internationalization of securities markets has led Congress and the SEC to extend the reach of U.S. securities regulations through specific agreements with foreign governments and through provisions of the FCPA and the ISECA.

Review Questions

1. 23-1 Do members of Congress presently have to disclose any illegal insider trading? Explain.

2. 23-2 Under the proxy rules, when may the management of a registered issuing company exclude a shareholder proposal from the agenda of an annual meeting? Explain.

3. 23-3 What criteria do the courts use to determine whether an instrument or transaction will be called a security? Explain.

4. 23-4 Which securities must be registered under the 1933 Act? Which must be registered under the 1934 Act? Explain.

5. 23-5 Explain the following statement: The 1934 securities law imposes liability for making a “material” statement or omission in proxy documents.

Review Problems

1. 23-6  Livingston had worked for Merrill Lynch for 20 years as a securities sales representative (account executive). In January 1972, he and 47 other account executives were given the honorary title of “vice president” because of their outstanding sales records. None of their duties changed, however, and they never attended a meeting of the board of directors. In November and December 1972, Livingston sold and repurchased the same number of shares of Merrill Lynch, making a profit of $14,836.37. Merrill Lynch sued Livingston for recovery of the profits, claiming that he had violated Section 16(b) of the Securities and Exchange Act of 1934. Livingston denied such charges. Who won this case? Why?

2. 23-7  Estrada Hermanos, Inc., a corporation incorporated and doing business in Florida, decides to sell $1 million of its common stock to the public. The stock will be sold only within the state of Florida. Jose Estrada, the chair of the board, says that the offering need not be registered with the SEC. Is he right? Explain.

3. 23-8  The boards of directors of DuMont Corp. and Epsot, Inc., agreed to enter into a friendly merger, with DuMont to be the surviving entity. The stock of both corporations was listed on a national stock exchange. In connection with the merger, both corporations distributed to their shareholders proxy statements seeking approval of the proposed merger. About three weeks after the merger was consummated, the price of DuMont stock fell from $25 to $13 as a result of the discovery that Epsot had entered into several unprofitable long-term contracts two months before the merger had been proposed. The contracts will result in substantial losses from Epsot’s operations for at least the next four years. The existence and effect of these contracts, although known to both corporations at the time of the proposed merger, were not disclosed in the proxy statements of either corporation. Can the shareholders of DuMont recover in a suit against DuMont under the 1934 Act? Explain.

4. 23-9  Schlitz Brewing Company failed to disclose on its registration statement, as well as in its periodic reports to the SEC, certain kickback payments that it was making to retailers to encourage them to sell Schlitz products, as well as the fact that the company had been convicted of violating a Spanish tax law. The SEC claimed that the failure to include such information was a violation of the antifraud provisions of the 1933 and 1934 Acts because it was material. Schlitz claimed that the information was not material because the kickbacks represented only $3 million, a tiny sum compared with the company’s $1 billion in revenues. Was the information material, and was its omission thus a violation of Section 10(b) of the 1934 Act and SEC Rule 10(b)-5? Explain.

5. 23-10  International Mining Exchange and a person named Parker sold a “Gold Tax Shelter Investment Program.” Anyone who wished to invest had to write a check payable to an individual designated by International Mining and sign certain papers. Investors acquired a leasehold interest in a gold mine with proven reserves, and they agreed to allow International Mining to arrange for sale options to purchase the gold that would be mined. In effect, investors received the right to profits from the gold mined, in addition to a tax deduction based on the cost of developing the mine. The SEC claimed that this transaction involved “securities” and thus was not exempt from registration under the 1933 Act. International Mining claimed that this transaction did not fall within the definition of a security. What was the result? Explain.

6. 23-11  Continental, a manufacturer of cigarettes, sold to a group of 38 investors bonds with warrants attached to purchase common stock. The sales took place in a high-pressure atmosphere in a room with phones ringing and new orders apparently coming in. Each investor signed an agreement that he or she had received written information about the corporation, and each testified to having access to additional information if requested. The SEC brought an action claiming that Continental was in violation of the registration provisions of the 1933 Act for selling unregistered nonexempt securities. Continental argued that it qualified for a private placement exemption. What was the result? Explain.

Case Problems

1. 23-12  To comply with accounting principles, a company that engages in software development must either “expense” the cost (record it immediately on the company’s financial statement) or “capitalize” it (record it as a cost incurred in increments over time). If the project is in the pre- or postdevelopment stage, the cost must be expensed. Otherwise, it may be capitalized. Capitalizing a cost makes a company look more profitable in the short term. Digimarc Corp., which provides secure personal identification documents, announced that it had improperly capitalized software development costs over at least the previous 18 months. The errors had resulted in $2.7 million in overstated earnings, requiring a restatement of prior financial statements. Zucco Partners, LLC, which had bought Digimarc stock during the relevant period, filed a suit in a federal district court against the firm. Zucco claimed that it could show that there had been disagreements within Digimarc over its accounting. Is this sufficient to establish a violation of SEC Rule 10(b)-5? Why or why not? Zucco Partners, LLC v. Digimarc Corp., 552 F.3d 981 (9th Cir. 2009).

2. 23-13  Jabil Circuit, Inc., is a publicly traded electronics and technology company headquartered in St. Petersburg, Florida. In 2008, a group of shareholders who had owned Jabil stocks from 2001 to 2007 sued the company and its auditors, directors, and officers for insider trading. Jabil’s compensation for executives included stock options. Some stock options were backdated to a time when the stock price was lower, making the options worth more to certain company executives. Backdating is legal as long as it is reported, but Jabil did not report that backdating had occurred. Thus, expenses were understated and net income was overstated by millions of dollars. The shareholders claimed that by rigging the value of the stock options through backdating, the executives had engaged in insider trading. The shareholders also asserted that there was a pattern of stock sales by executives before unfavorable news about the company was reported to the public. The shareholders, however, had no specific information about these stock trades or when (or even if) an executive was aware of any accounting errors related to backdating. Were the shareholders’ allegations sufficient to assert that insider trading had occurred under SEC Rule 10(b)-5? Why or why not? Edward J. Goodman Life Income Trust v. Jabil Circuit, Inc., 594 F.3d 783 (11th Cir. 2010).

3. 23-14  Northstar Financial invested some of the funds of its investors with Schwab Total Bond Market Fund, a fund registered with the SEC under the Investment Company Act. In compliance with the Act, Schwab stated its investment policies in its registration statement. In violation of the Act, it changed its investment strategy from what was stated in its registration statement. Because of this change in investment strategy, the company lost significant money when the housing market imploded. So Northstar Financial filed a class action suit on behalf of its investors against the Schwab Fund for violating the Investment Company Act. The Fund filed a motion to dismiss the suit on grounds that no private action was available under the Act, and the District Court rejected the motion. The Schwab Fund appealed the dismissal. How do you think the Court of Appeals ruled? Why? Northstar Financial Advisors v. Schwab Investments, 615 F.3d 1106 (2010 WL 3169400, 9th Cir. 2010).

Thinking Critically about Relevant Legal Issues

Our laws are far too easy on those who commit securities fraud. Ten thousand dollars and five years in prison are not stiff enough penalties for those who violate the public’s trust in the stock market and thereby undermine our economy.

Because our economy is based on capitalism, our businesses are dependent upon outside sources of funding. If a company wishes to expand or purchase another company, it needs access to outside funds. In addition, people need to make money, and their prospects in today’s job market are uncertain. Thus, people need to supplement their income. For this reason, they are willing to “loan” businesses money to expand by purchasing securities.

When people commit securities fraud, they cause two undesirable outcomes. First of all, they cause investors to lose their money. Many of these investors are counting on their investments to enable them to survive after retirement. By committing fraud, white-collar criminals wipe out the investors’ savings and force them to work extra years. In this sense, these corporate con artists not only are taking money from the investors but also are taking away years of their lives.

Second, when members of the public hear about acts of securities fraud, they become afraid to invest. When people fail to invest, businesses are unable to raise the capital they need. This lack of capital may cause them to lay off workers, close down divisions, or possibly close altogether. At any rate, lack of capital makes our economy run less efficiently, and when that happens, we all suffer.

Clearly, securities fraud isn’t a small crime committed against a business. Instead, its effects are felt by companies, investors, and even workers all across the country. Because acts of securities fraud have such far-reaching effects, those who commit them must be subject to stiffer punishment.

1. What reasons does the author give for harshly punishing those who use securities to defraud people?

2. What evidence does the author provide to support these reasons?

3. What information would be helpful for you to have in evaluating the worth of the author’s claims? (Refer to your answer to question 2.)

4. Which words or phrases in this essay are especially ambiguous?

5. Set out some arguments for the hypothesis “Our laws are far too hard on those who commit securities fraud.”

Assignment On The Internet

The SEC brings civil lawsuits against individuals who are accused of violating one or more securities laws, regulations, or rules. Using the Internet, visit the Securities and Exchange Commission’s litigation website (www.sec.gov) and read a brief or press release of a recent case. What rule or regulation was violated? What did the individual do that violated the rule or regulation? Finally, how does examining the reasoning in a court’s decision about securities law help you to better understand the chapter you just read? To access the briefs and press releases, highlight “Enforcement” and then click on “Litigation Releases.”

 On The Internet

· securities.stanford.edu The Securities Class Action Clearinghouse provides a wealth of information about federal securities litigation, including cases, statutes, reports, and settlements.

· www.sec.gov This is the home page of the Securities and Exchange Commission.

· www.nasaa.org From this page, find out about the North American Securities Administrators Association, an organization devoted to investor protection.

· www.seclaw.com This site provides securities statutes, rules, and regulations at both state and federal levels. Click on the heading “SEC Rules” to find more information.

· www.law.cornell.edu/topics/securities.html This site contains a basic overview of securities law as well as recent judicial decisions about securities law. Click on “Wex legal encyclopedia,” then “Browse.” Under “S,” scroll until you find “Securities law history.”

· lp.findlaw.com This site contains numerous links to securities laws and securities fraud information. In the “Quick Links” tabs at the top of the page, click on “Corporate Counsel.” Once there, click on “Finance,” then on “Securities.”

For Future Reading

· Casenote: “Securities Law—The Implied Private Right of Action Under Rule 10b-5 Does Not Extend Liability to Aiders and Abettors.” Cumberland Law Review 42 (2011): 425.

· Miller, Sandra K., Penelope Sue Greenberg, and Ralph H. Greenberg. “An Empirical Glimpse into Limited Liability Companies: Assessing the Need to Protect Minority Investors.” American Business Law Journal 43 (2006): 609.

· Palmiter, Alan. Securities Regulation: Examples & Explanations. New York: Wolters Kluwer, 2011.

· Soderquist, Larry D., and Theresa A. Gabaldon. Securities Law (Concepts and Insights). Mineola, NY: Foundation Press, 2006.