Chapter 24: Investor Protection
and Corporate Governance
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The Securities Act of 1933
 Securities Act of 1933 regulates
solicitation, buying and selling of
securities: stocks and bonds.
 Designed to prohibit fraud and
stabilize securities industry.
 Main purpose: full disclosure.
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The Securities Act of 1933
 What is a Security?
• Instruments and interests commonly
known as securities, such as preferred
and common stocks, treasury stocks,
bonds, debentures, and stock
warrants. 
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The Securities Act of 1933
 What is a Security?
• Any interests commonly known as
securities, such as stock options, puts,
calls, or other types of privilege on a
security or on the right to purchase a
security or a group of securities in a
national security exchange. 
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The Securities Act of 1933
 What is a Security?
• Notes, instruments, or other evidence
of indebtedness, including certificates
of interest in a profit-sharing
agreement and certificates of deposit.

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The Securities Act of 1933
 What is a Security?
• Any fractional undivided interest in oil,
gas, or other mineral rights.
• Investment contracts, which include
interests in limited partnerships and
other investment schemes.
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The Securities Act of 1933
 What is a Security: the “Howey” Test.
• 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.
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The Securities Act of 1933
 Registration Statement.
• Unless exempt, an offering must be
registered before offered to the public.
• Issuing corporation must file a
registration statement and prospectus
with the SEC.
• Prospectus is later distributed to
investors.
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The Securities Act of 1933
 Registration Statement.
• Contents:
• 1. The securities being offered for sale,
including their relationship to the registrant’s
other capital securities.
• 2. The corporation’s properties and business
(including a financial statement certified by
an independent public accounting firm). 
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The Securities Act of 1933
 Registration Statement.
• Contents:
• 3. Management of the corporation,
including all benefits, and any interests of
directors or officers in any material
transactions.
• 4. How the corporation intends to use the
proceeds of the sale.
• 5. Any pending lawsuits or special risk
factors.
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The Securities Act of 1933
 Registration Statement.
• Registration Process.
• Waiting Period: securities can be offered but
not sold. All issuers can distribute a red
herring prospectus, advertise with a
tombstone ad, and a free-writing prospectus.
• Posteffective Period: securities can now be
sold.
• Registration Process Review.
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The Securities Act of 1933
 Registration Statement.
• Registration Process.
• Restrictions Relaxed for Well-Known
Seasoned Issuers. In 2005, SEC revised the
registration process and created new
categories of issuers based on size and
market presence. A WKSI has issued $1
billion in securities during last 3 years, or
$700 million outstanding stock in public
hands.
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The Securities Act of 1933
 Exempt Securities and Transactions.
• Regulation A Offerings.
• Up to $5 million in any twelve month period.
• Issuer must file a notice and offering circular
with SEC.
• Companies can “test the waters” without
actually selling.
• Can be sold online. 
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The Securities Act of 1933
 Exempt Securities and Transactions.
• Regulation D Offerings.
• Rule 504: up to $1M during 12 months to
accredited investors only.
• Rule 505: up to $5M during 12 months to
both accredited and unaccredited investors.

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The Securities Act of 1933
 Exempt Securities and Transactions.
• Private Placement Exemption.
• Rule 506: unlimited if no general solicitation
and notice to SEC. Max of 35 unaccredited
investors.
• Resales.
• Rule 144: Rule 505 or 506 securities trigger
registration requirements unless the sale
complies with all of Rule 144’s conditions. 
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The Securities Act of 1933
 Exempt Securities and Transactions.
• Resales.
• Rule 144A: allows sale only to a qualified
institutional buyer.
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Exemptions
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The Securities Act of 1933
 Violations of the 1933 Act.
• Intentional or negligent defrauding of
investors by misrepresenting or omitting
material information in the registration
statement or prospectus. Provides for
criminal penalties, and civil sanctions. 
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The Securities Act of 1933
 Violations of the 1933 Act.
• Defenses: Statement left out was not
material; Plaintiff knew about fraud and
purchased stock; Registrant believed
statements were true.
• CASE 24.1 LITWIN V. BLACKSTONE GROUP, LP
(2011). What material information did
Blackstone omit?
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The Securities Exchange Act of 1934
 Provides for registration of securities
exchanges, brokers, dealers, and
national securities exchanges and
associations.
• Applies to companies with $10 million
in assets and 500 or more
shareholders.
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Introduction:
• Section 10(b) prohibits use of any
manipulative or deceptive device or
contrivance in violation of SEC rules and
regulations.
• SEC Rule 10b(5) prohibits fraud in
connection with the purchase or sale of any
security. 
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Applicability of SEC Rule 10b-5.
• Virtually all cases concerning the trading of
securities, whether on exchanges, OTC, or
private.
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Insider Trading.
• Goal is to prevent purchase or sale of
securities on basis of information that is not
available to the public.
• Applies to corporate directors, officers, and
others with “inside” information, or anyone
who has access to or receives nonpublic
information.
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Disclosure Under SEC 10b-5:
• Any material omission or misrepresentation
in connection with the sale or purchase of
security may violate Section 10(b) or SEC Rule
10b-5. Examples of materials facts in
disclosure: Fraudulent trading by broker. 
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Disclosures Under SEC 10b-5 (cont’d)
• CASE 24.2 SEC V. TEXAS GULF SULPHUR CO.
(1968). Who were the insiders in this case
and what should they have done
differently?
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Private Securities Litigation Reform Act:
provides a “safe harbor” for publiclyheld companies making forward-looking
statements.
• Securities Litigation Uniform Standards
Act.
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Outsiders and SEC Rule 10b-5.
• 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.
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The Securities Exchange Act of 1934
 Section 10(b), SEC Rule 10b-5
and Insider Trading.
• Insider Reporting and Trading-Section
16(B).
• Requires recapture of all short-swing profits
by insiders (those owning 10% of equities)
to corporation.
• Applies to stocks, warrants, options, and
securities.
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The Securities Exchange Act of 1934
 Regulation of Proxy Statements.
• Section 14(1) of the 1934 Act regulates
the sale of proxies from shareholders of
Section 12 companies.
• Remedies for violations include
injunctions to damages.
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Comparison of SEC Rules
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The Securities Exchange Act of 1934
 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). 
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The Securities Exchange Act of 1934
 Violations of the 1934 Act.
• CASE 24.3 GEBHART V. SEC (2010). What
factors did the court analyze to
determine if scienter was present?
• 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 if willful. 
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The Securities Exchange Act of 1934
 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 parties may bring action for
violations of 10(b) and Rule 10b-5. 
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State Securities Laws
 State securities laws are called “blue sky”
laws.
 Requirements.
• Issuers must comply with federal and state
securities laws and states do not allow the
same exemptions as federal government.
 Concurrent Regulation.
• Uniform Securities Act has been adopted in
part by many states.
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Corporate Governance
 Relationship between a corporation
and its shareholders.
 Attempts at Alignment between
Officers and Shareholders.
• Stock Options?
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Corporate Governance
 Goal is to Promote Accountability. 
• (1) The audited reporting of financial
conditions to evaluate managers.
• (2) Legal protections for shareholders so
that violators can be punished and victims
can recover losses. 
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Corporate Governance
 Governance and Corporate Law.
• Board of Directors: responsible to ensure
all corporate officers are operating in best
interests of shareholders.
• Audit Committee: oversees entire process.
• Compensation Committee: assess
performance and design fair
compensation systems.
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Corporate Governance
 Sarbanes-Oxley Act of 2002.
• Sarb-Ox attempts to increase corporate
accountability by imposing strict
disclosure requirements and harsh
penalties for securities violations.
• Applies to all public companies. 
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Corporate Governance
 Sarbanes-Oxley Act of 2002.
• Requires CEO’s to take responsibility for
accuracy of financial statements filed
with SEC.
• Requires independent auditor report
except for smaller companies of less
than $75 million market capitalization
(2010 exemption). 
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Corporate Governance
 Sarbanes-Oxley Act of 2002.
• Other Provisions:
• Public Company Accounting Oversight Board
regulates public accounting firms.
• Internal Controls and Accountability:
Direct federal corporate governance requirements.
High-level managers must maintain internal
controls and disclosures.
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Online Securities Fraud
and Ponzi Schemes
 The SEC is aggressively prosecuting
internet fraud using traditional laws.
 Online Investment Scams.
• Fraudulent Emails.
• Online Investment Newsletters and
Forums.
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Online Securities Fraud
and Ponzi Schemes
 Hacking into Online Stock Accounts.
 Ponzi Schemes. (e.g., Bernie Madoff).
• Offshore Fraud, “Risk Free” Fraud.
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