BUSINESS LAW TODAY
Essentials 9th Ed.
Roger LeRoy Miller - Institute for University Studies, Arlington, Texas
Gaylord A. Jentz - University of Texas at Austin, Emeritus
Chapter
21
Investor Protection,
Insider Trading, and
Corporate Governance
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Learning Objectives
 What is meant by the term securities?
 What are the two major statutes regulating



the securities industry?
What is insider trading? Why is it prohibited?
What are some of the features of state
securities laws?
What certification requirements does the
Sarbanes-Oxley Act impose on corporate
executives?
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Securities and Exchange Commission
 Major Responsibilities of the SEC:
Require disclosure of facts concerning
offerings.
Regulate trade in securities.
Investigate securities fraud.
Regulate activities of securities brokers,
dealers, and investment advisors.
Supervise mutual fund activities.
Recommend sanctions for violations.
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Securities Act of 1933
 The Securities Act of 1933 governs the


initial sale of stocks by businesses.
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.
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What is a Security?
 In SEC v. Howey (1946), the U.S. Supreme
Court held that a security (investment
contract) 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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Registration Statement
 If a security does not qualify for an

exemption under §5 of the Securities Act
of 1933, the security must be registered
with the Securities Exchange Commission
(http://www.sec.gov) 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.
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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.
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Registration Statement
 Description of the management of the
registrant, remuneration, pension,
stock offerings, executive interests and
compensation.
 Financial statement certified by and
independent accounting firm.
 Description of pending lawsuits.
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Registration Process
 Registration statement does not become


effective until approval by SEC.
Pre-Filing Period: issuer cannot offer or sell
securities.
Waiting Period: securities can be offered by
not sold. 2005: Free-writing prospectus.
 Post-Effective Period: registration effective
20 days after approval.
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Exempt Securities and Transactions
 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.
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Exempt Securities
 Any insurance, endowment, annuity
contract or government-issued
securities.
 Securities issued by banks, savings
and loan association, farmers'
cooperatives.
 Securities issued to existing securities
holders, stock split, dividend (really a
transaction exemption).
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Exempt Transactions
 Regulation A Offerings: small offering
up to $5 million in a 12 month period to
“test the waters”; but requires a
circular.
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Exempt Transactions
 Small Offerings: Regulation D.
Rule 504: up to $1M during 12 months to
accredited investors only.
Rule 504a.
Rule 505: private, up to $5M during 12
months to both accredited and
unaccredited investors.
Rule 506: “private placement” exemption:
unlimited amounts, not advertised, to
accredited investors only.
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Exempt Transactions
 Section 4(6): up to $5M solely to
accredited investors.
 Intrastate Offerings—Rule 147.
 Rule 144.
 Rule 144a.
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Violations of the 1933 Act
 Intentional or negligent fraud of investors by


misrepresenting or omitting material facts in
the registration statement and/prospectus.
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.
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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 $10 million and 500 or more
shareholders (Sec. 12 companies or
1934 companies).
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Section 10(b) and Rule 10b(5)
& Insider Trading
 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.
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Section 10(b) and Rule 10b(5)
& Insider Trading
 Insider Trading
Advance information available to corporate
officers and directors that can affect future
value of stock.
 Insider trading prohibited:
10b(5) “Insiders” (Officers, Executives and
Directors).
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Disclosure under SEC Rule 10b-5
 Material omission or misrepresentation may

violate 1933 Act and antifraud provisions of
1934 Act and SEC Rule 10b-5.
Key is whether insider’s information is
“material”, such as:
 Fraudulent trading by broker-dealer, dividend change,
contract for sale of corporate assets, new discovery,
process, or product, significant change in financial
condition, potential litigation.
 CASE 21.1
SEC v. Texas Gulf Sulphur, Inc.
(1968). Officers and employees engaged in insider
trading. The test of materiality is what would affect
the judgment of reasonable investors.
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Private Securities Litigation
Reform Act of 1995
 Provides “safe harbor” for publicly held
companies that make forward-looking
statements, such as financial forecasts.
 Protection against liability from
securities fraud with “meaningful
cautionary statements.”
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Outsiders and SEC Rule 10b-5

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, to employer, for instance.
 What about “scheme” liability?
 CASE 21.2 Stoneridge Investment Partners, LLC v.
Scientific-Atlanta, Inc. (2008). Court dismissed claims
against Scientific Atlanta and Motorola – Section 10(b)
private right of action cannot be applied to “outsiders”
(customers or suppliers).
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Insider Reporting and Trading
—Section 16(b)
 Section 16(b).
Recapture by corporation of profits during
previous six months gained by insider trading.
Applies to stocks, warrants, options and
convertible securities.
 Regulation of Proxy Statements, Sect.
14(a).
Whoever solicits a proxy must fully disclose all
of the facts and which shareholders must vote.
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Comparison of 10b-5 and 16(b)
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Violations of the 1934 Act



10(b) and 10B-5: scienter is required, proved by
showing defendant made false statements or
wrongfully failed to disclose material facts. 16(b):
strict liability -- no fault or scienter required.
Criminal Penalties: Individuals-imprisonment up to
10 years, fines up to $5 million, $2.5 for partnership
or corporation.
Civil Sanctions.
CASE 21.3 Stark Trading v. Falconbridge, Ltd. (2009).
Stark’s 10(b) claim was dismissed because he was aware
of the misrepresentations before he bought the stock.
Therefore the reliance element was missing.
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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.
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Corporate Governance
 Need for Effective Corporate
Governance.
 Attempts at Aligning the Interests of
Officers with Shareholders.
 Corporate Governance and Corporate
Law.
Importance of Audit and Compensation
Committees.
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Sarbanes-Oxley Act of 2002
 Attempts to increase corporate responsibility
by:
 Stricter disclosure requirements.
 Harsher penalties for legal violations.
 Corporate officers take responsibility for financial
statements and SEC reports.
 CEO’s and CFO’s must personally certify reports.
 Oversight by Public Company Accounting


Oversight Board.
Protections for Whistleblowers.
Enhanced Penalties.
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Key Provisions: Sarbanes-Oxley
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Online Securities Fraud
 SEC is enforcing anti-fraud provisions
of Securities Laws.
 Investment Scams.
 Online Investment Newsletters and
Forums.
 “Ponzi” Schemes.
Offshore Fraud.
“Risk Free” Fraud: Michael Regan, Bernie
Madoff.
 Hacking into Online Stock Accounts.
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