Critical Legal Cases for Chapter 41
41.1 Definition of a Security: Yes, the Dare sales scheme is a security that should have been registered
with the Securities and Exchange Commission (SEC). In SEC v. W.J. Howey Co., the U.S. Supreme Court
defined an “investment contract” as a scheme that involves (1) an investment of money (2) in a common
enterprise (3) with the profits to come solely from the efforts of others. The Supreme Court stated that this
definition should be broadly and flexibility construed.
The court applied the Howey test in the instant case and held that the Dare multilevel sales scheme
was an investment contract. There was obviously an investment of money in a common enterprise. The
only difficult issue was whether the Dare plan derived profits for the investors from the efforts of others.
The court held that the word “solely” should not be read literally. The court held although investors must
exert some effort—mainly convincing friends, neighbors, and others to attend the Adventure Meetings—
primarily their profits came from the efforts of others, i.e., from the efforts of the Dare people at the
meetings to convince the attendees to sign up and pay money for one of the Adventure levels.
The court held that the Dare multilevel sales scheme was an “investment contract” and therefore a
security that had to be registered with the SEC before it was sold. The court held that Turner had sold
unregistered securities in violation of securities laws and granted an injunction against Turner from
selling any more Dare plans.
Note: Previous purchasers could sue to rescind the purchase agreement and recover the money they
paid. Securities and Exchange Commission v. Glenn W. Turner Enterprises, Inc., 474 F.2d 476, Web
1973 U.S. App. Lexis 11903 (United States Court of Appeals for the Ninth Circuit).
41.2 Intrastate Offering Exemption: No, the issue of securities by McDonald Investment Company
(McDonald) does not qualify for the intrastate offering exemption from registration. The company met
most of the requirements for an intrastate offering exemption, such as (1) the company was a resident of
Minnesota, i.e., it was incorporated in Minnesota; (2) its principal place of business was in Minnesota; (3)
it was doing business in Minnesota with over 80 percent of its assets located in the state and over 80
percent of its revenues derived from within the state; and (4) the purchasers of the securities were all
residents of the state. However, to qualify for the exemption, at least 80 percent of the proceeds from the
offering must be invested in the state. Here, the entire proceeds from the securities issue were invested in
loans on real estate and other assets located outside the state of Minnesota. Because of this fact, the Court
held that the transaction did not qualify for an intrastate offering exemption from registration and issued
an injunction prohibiting the continued sale of the securities.
Note: Investors who purchased the securities could also rescind their purchase agreement. Securities
and Exchange Commission v. McDonald Investment Company, 343 F.Supp. 343, Web 1972 U.S. Dist.
Lexis 13547 (United States District Court for the District of Minnesota).
41.3 Transaction Exemption: No, the sale of the Continental securities by Wolfson and his family and
associates does not qualify for an exemption from registration as a sale “not by an issuer, underwriter, or
dealer.” The Court held that an issuer includes any person who directly or indirectly controls the issuer. In
this case, Wolfson controlled Continental. He was its largest shareholder, made the policy decisions for
the corporation, and controlled and directed the company’s officers.
The court found that the defendants had tried to conceal the sale of the securities by selling them over
an 18-month period through many different brokers. The court held that these sales constituted a major
“distribution” of Continental securities that should have been registered with the Securities Exchange
Commission if the sales did not qualify for an exemption from registration. The court held that the
securities sales did not qualify as a sale “not by an issuer” because Wolfson had been found to have been
in control of the issuer of the securities—Continental. The court held that Wolfson and his family and
associates should have registered the securities with the SEC, and that they had violated Section 5 of the
Securities Act of 1933 because they had not registered the securities.
Note: On the witness stand, the defendants took the position that they operated at a level of corporate
finance far above such “details” as securities laws and were too busy with “large affairs” as to bother
themselves with such minor matters as securities laws. The court, obviously, rejected this defense. United
States v. Wolfson, 405 F.2d 779, Web 1968 U.S. App. Lexis 4342 (United States Court of Appeals for the
Second Circuit).
41.4 Insider Trading: No, Chiarella is not criminally liable for violating Section 10(b) of the Securities
Exchange Act of 1934. The U.S. Supreme Court reversed the trial court’s judgment that had convicted
Chiarella on all counts. The Court of Appeals affirmed the conviction by holding that anyone—an insider
or not—who receives material nonpublic information may not use that information to trade in securities
until the information is made public. The U.S. Supreme Court rejected this rule, holding that a person is
not liable for insider trading under Section 10(b) unless he owes a duty to disclose the information. The
Supreme Court held that this duty only arises if the person owes a fiduciary duty to the company in whose
shares he has traded.
The Supreme Court held that Chiarella did not owe a fiduciary duty to the target companies of whose
shares he purchased. The court stated:
Not every instance of financial unfairness constitutes fraudulent activity under Section
10(b). The element required making silence fraudulent—a duty to disclose—is absent in
this case. No duty could arise from Chiarella’s relationship with the sellers of the target
company’s securities for Chiarella had no prior dealings with them. He was not their agent,
he was not a fiduciary, and he was not a person in whom the sellers had placed their trust
and confidence. He was, in fact, a complete stranger who dealt with the sellers only through
impersonal market transactions. We hold that a duty to disclose under Section 10(b) does
not arise from the mere possession of nonpublic market information.
The U.S. Supreme Court reversed Chiarella’s conviction. Chiarella v. United States, 445 U.S. 222, 100
S.Ct. 1108, 63 L.Ed.2d 348, Web 1980 U.S. Lexis 88 (Supreme Court of the United States).
41.5 Section 10(b): The plaintiff investors win and may sue the defendants for the alleged violations of
Section 10(b) of the Securities Exchange Act of 1934. The defendants had asserted that the common-law
defense of in pari delicto (“unclean hands”) prohibited the plaintiffs from suing because they had
participated in the fraud with the defendants, i.e., the plaintiffs thought they were trading on “inside
information” when they purchased the TONM securities. Under the in pari delicto theory, if two parties to
illegal conduct are mutually or equally at fault, they cannot use the court system to sue the other party to
the illegal conduct. The issue in the instant case is whether the in pari delicto theory should be applied to
securities laws.
The U.S. Supreme Court held that the in pari delicto theory does not apply to actions brought for
alleged violations of securities laws. Thus, the plaintiffs in this case who had participated in the insidertrading scheme with the defendants could sue the defendants for disclosing false inside information to
them. The Supreme Court stated: “We conclude that the public interest will most frequently be advanced
if defrauded tippees are permitted to bring suit and to expose illegal practices by corporate insiders and
broker dealers to full public view for appropriate sanctions.” The court held that the in pari delicto theory
did not apply to suits alleging violations of Section 10(b) and that the plaintiffs could maintain their
lawsuit against the defendants. Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 105 S.Ct.
2622, 86 L.Ed.2d 215, Web 1985 U.S. Lexis 95 (Supreme Court of the United States).
41.6 Insider Trading: The Sullair Corporation (Sullair) wins and, under Section 16(b) of the Securities
Exchange Act of 1934, may recover the profits made by Hoodes on the sale and purchase of the securities
of Sullair securities. The court held that Section 16(b) is a “flat rule” which imposes strict liability for
profits earned by any officer or director or 10 percent shareholder who purchases and sells or sells and
purchases equity securities of his corporation within a period of less than six months.
The court found that Hoodes, who was an officer of Sullair, was a statutory insider for purposes of
Section 16(b). The court held that the Section 16(b) rule applied whenever the defendant held his position
at the time of the initial transaction that gave rise to his liability. The court found that the two
transactions—the sale of securities by Hoodes on July 20 and the purchase of securities on August 20—
had occurred within six months of each other and were covered by Section 16(b). The court held that the
corporation could recover $11,350 from Hoodes—the difference between the price he sold the original
6,000 shares for on July 20, 1982 ($38,350) and the fair market value of the 6,000 shares he purchased on
August 20, 1982 ($27,000). Sullair Corporation v. Hoodes, 672 F.Supp. 337, Web 1987 U.S. Dist. Lexis
10152 (United States District Court for the Northern District of Illinois).
41.7 Insider Trading: Yes, the defendant executives Crawford and Coates are each liable for engaging in
insider trading, in violation of Section 10(b) of the Securities Exchange Act of 1934. 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.
Crawford telephoned his orders to his Chicago broker about midnight on the day before the
announcement and again at 8:30 in the morning of the day of the announcement with instructions to buy
at the opening of the stock exchange that morning. Crawford sought to, and did, “beat the news.” Before
insiders may act upon material information, such information must have been effectively disclosed in a
manner sufficient to ensure its availability to the investing public. Here, where a formal announcement to
the entire financial news media had been promised in a prior official release known to the media, all
insider activity must await dissemination of the promised official announcement. Crawford, an insider,
traded while in the possession of material nonpublic information and is therefore liable for violating
Section 10(b).
Coates’s telephone order was placed shortly before 10:20 A.M. on the day of the announcement,
which occurred a few minutes after the public announcement. When Coates purchased the stock, the news
could not be considered already a matter of public information. Insiders should keep out of the market
until the established procedures for public release of the information are carried out instead of hastening
to execute transactions in advance of, and in frustration of, the objectives of the release. Assuming that
the contents of the official release could instantaneously be acted upon, at a minimum, Coates should
have waited until the news could reasonably have been expected to appear over the media of widest
circulation, rather than hastening to ensure an advantage to himself and his broker son-in-law.
Both Crawford and Coates, insider executives of Texas Gulf Sulphur Company, engaged in illegal
insider trading, in violation of Section 10(b) of the Securities Exchange Act of 1934. Securities and
Exchange Commission v. Texas Gulf Sulphur Company, 401 F.2d 833, Web 1968 U.S. App. Lexis 5797
(United States Court of Appeals for the Second Circuit)
VI. Business Ethics Cases
41.8 Ethics: No, each of the limited partnership offerings does not alone qualify for a private placement
offering exemption from registration. To qualify for a private placement offering, the following
requirements must be met: (1) there is no dollar limit on the amount of securities sold; (2) there is no limit
on the number of accredited investors, but there is a limit of 35 unaccredited investors; and (3) disclosure
of material financial and other information must be made to the investors.
In applying these requirements to the instant case, the court held that (1) Intertie had not kept track of
the qualifications or the number of unaccredited investors; (2) the investors were not given material
financial and other information about Intertie or its financial difficulties: (3) the investors were not
informed that the limited partnerships could not support themselves or that partnership funds were being
commingled; and (4) the investors were not informed that Intertie and the limited partnerships was a
pyramid or “Ponzi” scheme whereby the funds raised in later partnership offerings were used to support
earlier partnerships. The court held that each limited partnership did not on its own qualify for a private
placement exemption because there were too many unaccredited investors and the investors were not
provided with adequate disclosure of material information.
Integration: In addition, the court integrated all of the thirty limited partnership offerings into one
offering. Separate securities offerings will be integrated if they are made about the same time, involve the
same class of securities, are sold for the same consideration, and the proceeds are used for the same
purpose. Here, the court found the existence of sufficient factors to integrate the offerings. The court held
that this one integrated offering did not qualify for a private placement exemption from registration
because there were too many unaccredited investors and material financial and other information was not
disclosed to the investors. The court issued an injunction against Murphy. Securities and Exchange
Commission v. Murphy, 626 F.2d 633, Web 1980 U.S. App. Lexis 15483 (United States Court of Appeals
for the Ninth Circuit).
41.9 Ethics: R. Foster Winans, a reporter for the Wall Street Journal, was one of the writers of the
“Heard on the Street” column, a widely read and influential column in the Journal. This column
frequently included articles that discussed the prospects of companies listed on national and regional
stock exchanges and the over-the-counter market. David Carpenter worked as a news clerk at the Journal.
The Journal had a conflict of interest policy that prohibited employees from using nonpublic information
learned on the job for their personal benefit. Winans and Carpenter were aware of this policy.
Kenneth P. Felis and Peter Brant were stockholders at the brokerage house of Kidder Peabody.
Winans agreed to provide Felis and Brant with information that was to appear in the “Heard” column in
advance of its publication in the Journal. Generally, Winans would provide this information to the
brokers the day before it was to appear in the Journal. Carpenter served as a messenger between the
parties. Based on this advance information, the brokers bought and sold securities of companies discussed
in the “Heard” column. During 1983 and 1984, prepublication trades of approximately 27 “Heard”
columns netted profits of almost $690,000. The parties used telephones to transfer information. The Wall
Street Journal is distributed by mail to many of its subscribers.
Eventually, Kidder Peabody noticed a correlation between the “Heard” column and trading by the
brokers. After an SEC investigation, criminal charges were brought against defendants Winans,
Carpenter, and Felis in U.S. district court. Brant became the government’s key witness. Winans and Felix
were convicted of conspiracy to commit securities, mail, and wire fraud. Carpenter was convicted of
aiding and abetting the commission of securities, mail, and wire fraud. The defendants appealed their
convictions. Can the defendants be held criminally liable for conspiring to violate, and aiding and abetting
the violation of Section 10(b) and Rule 10b-5 of securities law? Did Winans act ethically in this case? Did
Brant act ethically by turning government’s witness?
R. Foster Winans was a reporter for the Wall Street Journal in the early 1980s, when he wrote a column
called "Heard on the Street,” in which he discussed the future prospects of companies and their securities.
His positive comments would increase the value of the stock; his negative would deflate the value.
Winans leaked his columns to Peter Brant and Kenneth Felis in exchange for a share of the profits. When
this was discovered, Winans was found guilty of the federal crimes of mail and wire fraud, and insider
trading.
Winans acted unethically by artificially creating a desire for the stocks through his column (a violation of
Section 10(b))and collaborating with Felis, Brany, and Carpenter to cash in on this. Because the
defendants used by telephone and mail systems (telephone calls and the mail distribution of the Wall
Street Journal), they were found to be in violation of the Rule 10b-5.
The question of whether Brandt acted ethically by turning government's witness is one that can be
debated by the students. Was he just trying to get off easier, or was he truly repented of his acts? Is there
honor amongst thieves?
In fact, in 1988 he had a book Trading Secrets published by St. Martins of New York, which detailed his
activities in insider trading. New York had enacted a "Son of Sam" statute. These statutes preclude
criminals from making a profit on a crime, and require both the author and publisher to relinquish all
profits from sales of such materials over to the New York victim's compensation agency. Simon &
Schuster, another publisher, had brought suit and the Supreme Court held that the "Son of Sam" law
violates the Freedom of Speech Clause of the U.S. Constitution. United States v. Carpenter , 484 U.S. 19,
108 S.Ct. 316, 98 L.Ed.2d 275, Web 1987 U.S. Lexis 4815 (Supreme Court of the United States).