Chapter 40
Corporations – Investor Protection
and Online Securities Offerings
© 2004 West Legal Studies in Business
A Division of Thomson Learning
1
Introduction
Historical Background: stock market crash
of 1929 showed the need for:
 More disclosure from issuers.
 Prohibition of deceptive, unfair and
manipulative practices in the purchase and sale
of securities.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
2
Introduction
The Securities Act of 1933 and Securities
Exchange Act of 1934 are designed to protect
investors from deceptive, unfair and
manipulative practices when buying or selling
securities.
Securities are instruments such as corporate
stock or limited partnership interests that
evidence ownership or debt.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
3
§ 1: The SEC
The Securities and Exchange Commission is
an independent federal regulatory agency that
enforces federal securities laws. The SEC :
 Regulates disclosure of facts in offerings
made through national securities
exchanges (e.g., NASDAQ, NYSE).
 Investigates and prosecutes securities fraud.
 Registration and regulation of securities
brokers, dealers and investment advisors.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
4
Expanding Regulatory
Powers of the SEC
Securities Enforcement Remedies and Penny
Stock Reform Act of 1990.
Securities Acts Amendments of 1990.
Market Reform Act of 1990.
National Securities Markets Improvement Act of
1996.
The Sarbanes-Oxley Act of 2002.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
5
§ 2: The Sarbanes-Oxley
Act of 2002
Attempts to increase corporate accountability:
 Imposes stricter disclosures.
 Harsher penalties for violations.
 Requires CEO’s to take responsibility for accuracy of
financial statements filed with SEC.
 Creates new private civil actions.
Creates Public Company Accounting Oversight
Board regulates public accounting firms.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
6
The Sarbanes-Oxley
Act of 2002
Key Provisions:





Certification Requirements.
Loans to Officers and Directors.
Protections for Whistleblowers.
Enhanced Penalties.
Statute of Limitations for Securities Fraud.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
7
§ 3: The Securities Act of 1933
Securities Act of 1933 regulates solicitation,
buying and selling of securities: stocks and
bonds.
In SEC v. Howey (1946), the U.S. Supreme
Court held that a security exists in any
transaction in which a person: (1) invests (2)
in a common enterprise (3) reasonably
expecting profits (4) derived primarily from
others’ managerial or entrepreneurial efforts.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
8
Registration Statement
Case 40.1: SEC v. Alpha Telecom, Inc. (2002).
If a security does not qualify for an exemption
under §5 of the Securities Act of 1933, the
security must be registered with the SEC and
state securities agencies before offered to the
public.
Corporation must file a registration statement
and prospectus with the SEC. Prospectus is later
distributed to investors.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
9
Contents of
Registration Statement
Description of the significant provisions of the
registrant’s “offering” and how the registrant
intends to use the proceeds from the sale.
Description of the registrant’s properties and
business.
Description of the management of the registrant,
remuneration, pension, stock offerings, executive
interests and compensation.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
10
Contents of
Registration Statement [2]
Financial statement certified by an independent
accounting firm.
Description of pending lawsuits.
“Red Herring” prospectus.
Tombstone ads.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
11
Exempt Securities
Bank securities sold before 1933.
Commercial paper if maturity date does not
exceed 9 months.
Charitable organization securities.
Securities issued to existing securities holders
resulting from reorganization, bankruptcy.
Securities issued to finance railroad
equipment.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
12
Exempt Securities [2]
 Any insurance, endowment, annuity contract or
government-issued securities.
 Securities issued by banks, savings and loan
association, farmers' cooperatives.
 Regulation A, small offering up to $5 million in a 12
month period to “test the waters”; but requires a
circular.
 Securities issued to existing securities holders, stock
split, dividend (really a transaction exemption).
© 2004 West Legal Studies in Business
A Division of Thomson Learning
13
Exempt Transactions
Small “Reg D” Offerings
 Rule 504: up to $1M during 12 months to
accredited investors only.
 Rule 504a.
 Rule 505: up to $5M during 12 months to both
accredited and unaccredited investors.
 Rule 506: unlimited if no general solicitation
and notice to SEC. Max of 35 unaccredited
investors.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
14
Securities Act
Exempt Transactions
[2]
Section 4(6): up to $5 million to accredited
investors.
Rule 147 Intrastate Sales.
Broker/Dealer Transactions.
Casual Sales .
Resales of Restricted Securities by “Control
Persons.”
 Rule 144 and 144(a).
© 2004 West Legal Studies in Business
A Division of Thomson Learning
15
Violations of the 1933 Act
Violation of the Securities Act to
intentionally or negligently defraud
investors by misrepresenting or
omitting material facts in the
registration statement and/prospectus.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
16
Violations of the 1933 Act
Defenses: Statement left out was not material;
Plaintiff knew about fraud and purchased stock;
Registrant believed statements were true.
Penalties:
 Criminal: up to 5 years in prison and $10,000 fine.
 Civil: damages, refund of investment, injunction.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
17
§4: The Securities
Exchange Act of 1934
Registration of securities exchanges, brokers,
dealers, and national securities exchanges and
associations.
Requires continuous disclosure system for
corporations with securities sold on national
exchanges or assets in excess of $5 million and
500 or more shareholders (Sec. 12 companies or
1934 companies).
© 2004 West Legal Studies in Business
A Division of Thomson Learning
18
Purposes of 1934 Act [2]
Rule 14(a) proxy regulations.
Market surveillance by SEC.
Rule 10(b) prohibits fraud with insider trading
and disclosure regulations.
Rule 16(b) insider reporting and trading.
Rule 13 tender offer regulations.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
19
Insider Trading: Section 10(b)
and Rule 10b-5
Section 10(b) prohibits the use of any
manipulative or deceptive device or contrivance
in contravention of rules and regulations of
SEC.
Rule 10b(5) prohibits the commission of fraud
in the connection with the purchase or sale of
any security.
Case 40.2: SEC v. Texas Gulf Sulphur (1968).
© 2004 West Legal Studies in Business
A Division of Thomson Learning
20
Insider Trading: Section 10(b)
and Rule 10b-5
Section 10b(5) “Insiders”.
Rule 10b-5 “Outsiders”.
 Tipper/Tippee theory--insider’s fiduciary duty must
be breached
 Misappropriation theory -- one wrongfully obtains
inside info and trades on it. Courts still require
fiduciary duty be breached, e.g., to employer.
 Case 40.3: U.S. v. O’Hagan (1997).
© 2004 West Legal Studies in Business
A Division of Thomson Learning
21
Violations of the 1934 Act
Scienter or intent is required to prove civil or
criminal penalties under 10(b) and Rule 10b-5.
 Violator must have had intent to defraud (false
statements or wrongfully failed to disclose material
facts).
 Case 40.4: In re MCI WorldCom, Inc.
Securities Litigations (2000).
© 2004 West Legal Studies in Business
A Division of Thomson Learning
22
Violations of the 1934 Act
Criminal Penalties:
 10(b) and Rule 10b-5, a person faces $5
million and 20 years in prison, $25 million for
partnership or corporation.
 Sarbanes-Oxley provides for 25 years in
prison.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
23
Violations of the 1934 Act
Civil Sanctions:
 Both SEC and Private Parties Can Bring
Actions Against Violators under the Insider
Trading and Securities Fraud Enforcement Act.
 Private Actions for violations of 10(b) and
Rule 10b-5.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
24
§5: Regulation of
Investment Companies
Act on behalf of many smaller shareholders
by buying stock and professionally managing
the “portfolio.” (MUTUAL FUNDS.)
To safeguard company assets, all securities
must be held by a bank or stock exchange
member.
No dividends paid except from undistributed
net income.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
25
§ 6: State Securities Laws
State securities laws are called “blue sky”
laws.
Issuers must comply with federal and state
securities laws and states do not allow the
same exemptions as federal government.
States could require registration or
qualification.
Uniform Securities Act has been adopted in
part by many states.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
26
§ 7: Online Securities
Offerings and Disclosures
Springstreet Brewing Co. was the first online
IPO (1996).
Regulations Governing Online Securities
Offerings:
 Timely and Adequate Notice of Delivery of
Information.
 The online communication system must be easily
accessible.
 Some evidence of delivery is required.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
27
Potential Liability Created by
Online Offering Materials
Online offerings should exercise caution in
hyperlinking to external documents.
There is also a concern if the offering is placed
on a website that can be viewed by anyone.
 Many offerings are restricted to a limited number of
“unaccredited” investors.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
28
§ 8: Online Securities Fraud
The SEC is aggressively prosecuting internet
fraud using traditional laws.
Investment Scams.
Using Chat Rooms to Manipulate Stock Prices.
 Pumping and Dumping.
 Jonathan Lebed charged with securities fraud.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
29
Law on the Web
SEC’s Edgar database.
Free Edgar.
Center for Corporate Law at University of
Cincinnati School of Law.
Securities Act of 1933.
Securities Act of 1934.
Information on Investor Protection.
© 2004 West Legal Studies in Business
A Division of Thomson Learning
30