C H A P T E R 2 2
Securities Fraud and Insider Trading
TRUE-FALSE QUESTIONS
1. A securities fraud claim can be used as a predicate act in a civil case under the Racketeer Influenced
and Corrupt Organizations Act regardless of whether the defendant has been criminally convicted in
connection with the fraud.
2. Under Rule 10b-5 a company may not have a “no comment” policy, and must act to dispel untrue
rumors.
3. Rule 10b-5 does not result in any private rights of action.
4. Accountants have to sign a written consent before their audited report can be included in a
registration statement.
5. A prediction about the future can be a misstatement under Rule 10b-5, but only if the person making
the prediction does not believe it at the time.
6. Research shows that because of the severe penalties involved, insider trading in China is very rare.
7. Under Rule 10b-5, any use of the mails is sufficient to satisfy the interstate commerce condition
even if the mail does not leave the state.
8. Under the London Stock Exchange rules, if a listed company’s share price moves significantly on
the basis of rumor and the rumor is true, the company must disclose the existence of the rumored
event.
9. The European Union Market Abuse Directive requires member states to enact national legislation
punishing primary, but not secondary insiders.
10. Scienter requires more than mere negligence or lack of due care.
11. The safe harbor provision applies to forward-looking statements in connection with an initial public
offering.
12. The SEC itself has criminal enforcement power.
13. Under the efficient market theory, in an open and developed securities market, the market price of a
company’s stock equals its true value.
14. Under the Sarbanes-Oxley Act of 2002, it is a misdemeanor to knowingly execute a scheme to
defraud any person in connection with any security of a publicly traded company.
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15. Temporary insiders are persons not directly employed by the corporation, but who acquire
confidential information through the performance of professional services.
16. A right of action under section 10(b) may expire before a plaintiff discovers he has been wronged or
even before damages have been suffered at all.
17. If an insider resigns before trading, he or she cannot be held liable for improper insider trading.
18. A controlling shareholder is traditionally considered an insider.
19. An employee who trades or tips using confidential information belonging to his or her employer can
be liable under the Mail and Wire Fraud Acts.
20. There is no provision in the security laws for the payment of bounties to individuals whose tips
result in insider trading prosecutions.
MULTIPLE-CHOICE QUESTIONS
1. Which of the following represents the general rule under rule 10b-5 in regard to the duty of a
company to reveal corporate developments?
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A. A company has no general duty under Rule 10b-5 to reveal corporate developments unless the
company or its insiders (1) trade in securities or (2) recommend trading to someone else.
B. A company has no general duty under Rule 10b-5 to reveal corporate developments unless the
company or its insiders (1) trade in securities, (2) recommend trading to someone else, or (3)
disclose the information as a tip while withholding it from the general public.
C. A company has a general duty under Rule 10b-5 to reveal corporate developments that are
material.
D. A company had a general duty under Rule 10b-5 to reveal corporate developments if it appears
(1) that developments are material and (2) that the material developments will have a negative effect
on the company’s financial reports.
2. Lawsuits under Section 10(b) must be brought within ________ of the date the plaintiff discovered
or should have discovered the facts constituting the violation or within ________ of the date of the
violation, whichever is earlier.
A. two years, five years
B. six months, one year
C. two years, three years
D. one year, two years
3. Section 20(a) imposes ________ liability on every person who, directly or indirectly, controls any
person liable under the 1934 Act, unless the controlling person acted in good faith and did not
directly or indirectly induce the acts constituting the violation.
A. strict
B. individual
C. joint and several
D. criminal
4. The requirement that the defendant in a 10b-5 action have used interstate commerce, the mails, or a
national securities exchange gives Congress the power to regulate the defendant’s conduct under
________.
A. the due process clause of the U.S. Constitution
B. the Commerce Clause of the U.S. Constitution
C. the fifth amendment to the U.S. Constitution
D. executive order 90210
5. A person may be liable under Section 16(b) of the 1934 Act if he or she was an officer or director at
the time of
A. the purchase.
B. the sale.
C. both the purchase and the sale.
D. either the purchase or the sale.
6. In relation to forward-looking statements, under the bespeaks caution doctrine, a court may
determine that the inclusion of sufficient ________ in a document renders immaterial any
misrepresentation or omission contained therein.
A. facts
B. cautionary statements
C. expert opinions
D. information
7. In order to be actionable under Rule 10b-5, misstatements or omissions must be made with
A. negligence.
B. without due care.
C. scienter.
D. facts.
8. Which of the following was the result in SEC v. Texas Gulf Sulphur Co., the case in the text
involving whether a press release giving a misleading impression about the results of a drilling
operation violated Rule 10b–5?
A. That the company acted only in response to rumors and had no obligation to set forth additional
facts regarding the drilling operation, thereby negating any basis for Rule 10b-5 liability.
B. That the company violated Rule 10b-5 by issuing the misleading press release.
C. That a press release standing alone may not violate Rule 10b-5 and that the company could not
be held liable because it made no actionable statements outside the press release.
D. That the company could be held liable under Rule 10b-5 but only because it issued other
statements in addition to the press release.
9. Under what circumstances will reliance be presumed for purposes of establishing liability under
Rule 10b-5?
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A. If the investor shows that the defendant made a public material misrepresentation that would
have caused reasonable investors to misjudge the value of the defendant’s stock.
B. If the investor shows that (1) the defendant made a public material misrepresentation that would
have caused reasonable investors to misjudge the value of the defendant’s stock and (2) the investor
traded shares of the defendant’s stock in an open securities market after the misrepresentations were
made and before the truth was revealed.
C. If the investor shows that (1) the defendant made a public material misrepresentation that would
have caused reasonable investors to misjudge the value of the defendant’s stock, (2) the investor
traded shares of the defendant’s stock in an open securities market after the misrepresentations were
made and before the truth was revealed, and (3) the investor made specific inquiries from
professionals regarding the value of the stock before trading.
D. If the investor shows that (1) the defendant made a public material or nonmaterial
misrepresentation that would have caused reasonable investors to misjudge the value of the
defendant’s stock, (2) the investor traded shares of the defendant’s stock in an open securities market
after the misrepresentations were made and before the truth was revealed, and (3) the investor made
specific inquiries from professionals regarding the value of the stock before trading.
10. The materiality of a misstatement or omission under Rule 10b-5 is judged at the time
A. the statement is made.
B. of the stock purchase.
C. of the injury.
D. of the lawsuit.
11. In the case of a(n) ________, the U.S. Supreme Court has ruled that the reliance will be presumed
under Rule 10b-5 if the fact was material.
A. public statement
B. misstatement
C. omission
D. tip
12. Which of the following was the result on appeal before the U.S. Supreme Court in Matrixx
Initiatives v. Siracusano, the securities case in the text involving the issue of whether an issuer must
disclose known information about possible side effects of a drug that could affect the drug’s stock
price even though no proven statistical link exists between use of the drug and the adverse effect?
A. That a bright-line test would be applied requiring at least one civil judgment in favor of a
plaintiff before a defendant would be required to disclose allegations of a link between a drug and an
adverse effect and that the defendants were entitled to dismissal of the case because no showing of a
civil judgment had been introduced.
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B. That no statistical link between the use of the drug and adverse effects was required but that the
defendants were entitled to dismissal of the case because the plaintiffs did not personally suffer
adverse health effects from the drug.
C. That the defendants were entitled to dismissal of the case because the plaintiffs could not prove a
statistical link between use of the drug and adverse effects.
D. That the “total mix of information” test applied in regard to the issue of materiality, that
statistical proof was unnecessary, and that sufficient evidence existed for the plaintiffs to proceed to
trial.
13. Which of the following was the result before the U.S. Supreme Court in Stoneridge Investment
Partners, LLC v. Scientific-Atlanta, Inc., the case in the text involving the issue of whether customer
/ supplier companies that agreed to arrangements allowing an issuer to mislead its auditor are liable
in a private action under section 10(b) of the 1934 Act?
A. That based on “scheme liability,” the customer / supplier companies could be held liable although
no public statement was made.
B. That based on “transaction causation” the plaintiffs could establish reliance and that the plaintiffs
were, therefore, entitled to proceed.
C. That plaintiff investors had no private right of action because they did not rely upon the
statements or representations at issue.
D. That the plaintiff investors had no private right of action because the defendants were not aiders
and abettors and, instead, acted primarily on their own behalf outside the realm of securities
regulation.
14. Which of the following is true regarding who can sue under Rule 10b–5?
A. Only those who purchased the securities at issue may sue.
B. Only those who sold the securities at issue may sue.
C. Only those who have actually purchased or sold the securities at issue may sue.
D. Anyone who either actually purchased or sold the securities at issue, and also anyone who can
prove that he or she would have purchased or sold the securities at issue had they known the true
facts may sue.
15. When can a securities fraud claim be used as a predicate act in a civil case under the Racketeer
Influenced and Corrupt Organizations Act (RICO)?
A. When the defendant has been arrested in connection with the fraud.
B. When a conspiracy can be proven.
C. When the defendant has been criminally convicted in connection with the fraud.
D. When the defendant has been held liable for other civil damages in connection with the fraud.
16. Under the Securities Fraud Enforcement Act, when may a brokerage house be fined?
A. If it knew or recklessly disregarded information that would indicate insider trading activities on
the part of its employees.
B. Whenever an employee is found guilty of insider trading.
C. If it was negligent in failing to discover insider trading.
D. A brokerage house may not be fined under the Act.
17. Which of the following is true regarding “holder” claims?
A. They are disallowed by federal statute.
B. State law is preempted, and they are allowed under federal law only if the plaintiff purchased
securities issued under fraudulent pretenses.
C. They may be allowed under blue sky laws as either individual or class actions.
D. They may be allowed under blue sky laws, but not as class actions.
18. Which of the following is true regarding Section 16(c)’s restriction on selling stock short?
A. Section 16(c) prohibits officers, but not directors, from selling any of their company’s equity
securities short.
B. Section 16(c) prohibits directors, but not officers, from selling any of their company’s equity
securities short.
C. Section 16(c) prohibits officers or directors from selling any of their company’s equity securities
short.
D. Section 16(c) allows both officers and directors to sell their company’s equity securities short so
long as the equities are obtained and delivered within twenty days after the short sale.
19. A(n) _______ period is any period longer than three business days during which _______ of the
participants in a retirement plan are prevented from trading.
A. loss causation, 80%
B. scheme liability, 25%
C. blackout, 50% or more
D. stock parking, 80%
20. Section 16(b) of the 1934 Act governs ________ by officers, directors, and greater-than-10%
shareholders of equity securities of a public company.
CHAPTER 22 SECURITIES FRAUD AND INSIDER TRADING 355
A. fraud
B. deceptive practices
C. short-swing profits
D. unorthodox transactions
21. Which of the following is not a requirement for a Rule 10b-5 violation?
A. The defendant either used the mails, an instrumentality of interstate commerce, or a facility of a
national securities exchange.
B. The defendant made a statement that either misrepresented or omitted a fact of material
importance.
C. The misrepresentation or omission was made with scienter.
D. The statement was made in connection with a public offering.
22. Which of the following is false regarding the misappropriation theory of insider trading?
A. If a trader discloses to a source of nonpublic information that he or she plans to trade on the basis
of that information, there is no violation under the misappropriation theory.
B. Liability under the misappropriation theory requires deception.
C. The misappropriation theory widens the class of persons who can be found liable for insider
trading.
D. The trader cannot be held liable unless he or she is an insider of the company whose securities
are traded.
23. Which of the following is true regarding the regulation propounded by the SEC titled Regulation
Analyst Certification, Regulation AC?
A. It prohibits analysts from issuing reports that they do not personally believe to be true, and it also
requires the disclosure of any analyst compensation arrangements related to specific
recommendations or views contained in research reports.
B. It prohibits analysts from issuing reports that they do not personally believe to be true, but it does
not require disclosure of any compensation reports.
C. It requires that analysts report compensation arrangements in relation to recommendations or
views contained in research reports but, because of problems involving proof, it does not specifically
prohibit analysts from issuing reports that they do not personally believe to be true.
D. The regulation will be put into action in phases with the first phase, effective in 2012, requiring
disclosure of compensation arrangements in relation to recommendations or views contained in
research reports and the second phase, effective in 2014, prohibiting entirely the issuance of
recommendations or views in relation to stock for which an initial public offering was made within
the previous twelve months.
24. Which of the following is true regarding remedies available under Rule 10b–5?
A. The measure of damages is typically out-of-pocket loss, or an investor may elect to rescind the
transaction; and the court may award prejudgment interest; but punitive damages are unavailable.
B. The measure of damages is typically out-of-pocket loss with no right on the part of an investor to
elect to rescind the transaction, and the court may award prejudgment interest; but punitive damages
are unavailable.
C. The measure of damages is typically out-of-pocket loss, or an investor may elect to rescind the
transaction; the court may award prejudgment interest; and punitive damages are available in
appropriate cases.
D. The measure of damages is typically out-of-pocket loss with no right on the part of an investor to
elect to rescind the transaction, the court may award prejudgment interest, and punitive damages are
available in appropriate cases.
25. Which of the following is not a part of the safe harbor provision for forward–looking statements
under the 1934 Act?
A. A statement containing a projection of revenues, income, or other financial items.
B. A statement of the plans and objectives of management for future operations.
C. A statement of future economic performance.
D. A statement in a financial statement prepared in accordance with generally accepted accounting
principles.
26. Which of the following is true regarding the state of mind needed in order to find a violation of
Section 16(b) involving short-swing trading?
A. Liability is imposed under Section 16(b) regardless of the insider’s state of mind.
B. Intent to violate the securities laws must be found in order for there to be a violation of Section
16(b).
C. A trader must at least act without caution in order to be found liable for violating Section 16(b).
D. A trader must at least act negligently in order to be found liable for violating Section 16(b).
27. Under Section 16(b) pertaining to short-swing profits, a person will be considered a(n) ________ of
any securities held by his or her immediate family or any other relative living in his or her
household.
A. family owner
B. beneficial owner
C. actual owner
D. imputed owner
28. If a purchase or sale by an officer, director, or greater-than-10 percent shareholder that would
otherwise result in recoverable short-swing profits was involuntary and did not involve the payment
of cash and if there was no possibility of speculative abuse of inside information, than a court may
hold that it was a(n) ________ to which no liability will attach.
A. innocent transaction
B. approved negotiation
C. unorthodox transaction
D. designated sale
29. Section 16(a) of the 1934 Act requires that officers, directors, and greater-than-10 percent
shareholders of companies that have registered any class of equity securities under the 1934 Act file
________ reports with the SEC and with an national securities exchange on which their company’s
equity securities are listed.
A. actual ownership
B. beneficial ownership
C. insider ownership
D. listed stock
30. Sampson, an accountant and auditor with ABC Accounting, was auditing XYZ Company. Delilah,
the president of XYZ Company, told Sampson that she really needed to keep her job and that if the
true condition of the company were exposed, she would certainly be fired. She tells Sampson that
she is sure she can turn things around if he will only look help her out in the audit report. Sampson,
who was infatuated with Delilah, agreed to include inaccurate numbers in the company’s audit report
knowing that the opinion would be included in the company’s annual report on Form10-K filed with
the SEC. Unfortunately, Delilah was not able to turn the company’s performance around, and it
went into bankruptcy later that year. Sampson becomes aware that an investigation is being
conducted. Which of the following is true regarding his potential liability?
A. Because he is a secondary actor, he cannot be found liable for the violation of any laws involving
securities although he was aware of how the audit opinion would be used.
B. Because he is a primary actor, he can be found liable for the violation of some laws involving
securities, but not Section 10(b).
C. Because he is a primary actor, he can be found liable for a violation of Rule 10(b) because he
participated in the making of a false statement.
D. As a secondary actor, he can be found liable for the violation of Section 10(b) since he was
aware of how the audit opinion would be used.
31. Drug Company X reports the introduction of a new pill that is guaranteed to cause weight loss with
no side effects. The information was advertised in connection with a public offering of stock of the
company’s stock. Later, it becomes apparent through additional testing that unfortunately the new
pill also results in premature hair loss, a material issue. Monika is the president of Company X and
is very pleased with sales of the drug. She recognizes that she can no longer advertise the drug as
having no side effects, but she does not believe she has made any misrepresentations because she
was not aware of the hair loss side effect when previous statements were made. She decides to do
nothing. Has she made the correct decision as far as Rule 10b-5 is concerned?
A. Yes, because she has no duty to disclose later test results.
B. Yes, because she has no duty to disclose later test results that involve only cosmetic issues.
C. Yes, because she has no duty to disclose later test results that involve issues that are not life
threatening.
D. No, she made the wrong decision because she has an obligation to disclose the results.
Fact Pattern 22-1 (Questions 32-34 apply)
Trudy was hired by Food Corporation to handle a products liability lawsuit brought against it
alleging that it distributed dangerous dog biscuits. Trudy’s investigation brought to light facts
establishing that the biscuits were not defective and that the problem actually involved improper
retention policies on the part of retailers. Trudy is aware that this information will result in the stock
of Food Corporation increasing dramatically. Trudy immediately buys shares of Food Corporation
and tells her fiancé, Frank, about the expected increase as well. Trudy tells Frank because she wants
to borrow money from him for the trade and also because she believes that his investment will
enable them to take a nicer honeymoon. Frank initially resists because of his training in business
law and his concern that trading on the information would violate federal law, but he ends up going
along with Trudy because he too wants a nice honeymoon. Trudy’s suspicions come true. The
lawsuit is dismissed, the stock increases dramatically, and she and Frank go on a great honeymoon.
The day after they return, an investigator from U.S. Attorney’s Office interviews her regarding her
trades and those of Frank.
32. Refer to fact pattern 22-1. Can Trudy be considered an insider of Food Corporation?
A. No
B. Yes, as a derivative insider.
C. Yes, as a temporary insider.
D. It depends on whether she was paid as an employee or independent contractor because she may
be considered an insider only if she was paid as an employee.
33. Refer to fact pattern 22-1. Is there a basis upon which to hold Trudy liable for a securities violation
for disclosing to Frank the information regarding the likely dismissal of the lawsuit?
A. Not unless she had signed a confidentiality agreement with Food Corporation.
B. Yes, she could be held liable as a tipper.
C. Yes, she could be held liable as a tippee.
D. Yes, she could be held liable as a remote tippee.
CHAPTER 22 SECURITIES FRAUD AND INSIDER TRADING 359
34. Refer to fact pattern 22-1. Is there a basis upon which to hold Frank liable for a securities violation
based upon his receipt and use of the information?
A. No because he had no duty toward Food Corporation.
B. Yes, he could be held liable as a tipper.
C. Yes, he could be held liable as a tippee.
D. Yes, he could be held liable as a remote tippee.
OBJECTIVE: AICPA Critical Thinking
ESSAY QUESTIONS
1. List the seven elements of a Rule 10b-5 cause of action.
2. May private plaintiffs, the SEC, or both bring aider and abettor actions under Rule 10(b)? What
must be proven? What type of relief may be sought?
3. Susan, an accountant, prepared an audit report for a company that wanted to include the report in a
registration statement. What must Susan do before the company can do so? What step should she
perform in relation to events occurring subsequent to the date of the certified balance sheet in the
registration statement?
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4. What is the duty of an independent public accountant if, in the course of an audit, the accountant
detects information indicating that an illegal act has or may have occurred?