Chapter 17 – Financial and Securities Regulations
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Chapter 17
Financial and Securities Regulations
Learning Objectives
This chapter is designed as an introduction to the complex legal area of securities. The student is
exposed to the expansive meaning given the term security. Details of the Sarbanes-Oxley Act of
2002 are included as a discussion of the federal government’s response to the numerous recent
corporate scandals including the passage of the new Dodd-Frank Wall Street Reform and
Consumer Protection Act. Furthermore, the student should gain a basic knowledge of the federal
laws that regulate the initial issuance and the subsequent sales of securities. Finally, the student is
introduced to securities regulation by state governments. When the study of this chapter is
completed, the student should realize the technicalities of this subject matter and the need for
competent legal advice about any phase of securities regulation.
References
Ali, P. and G. Gregoriou, International Corporate Governance after Sarbanes-Oxley. Wiley
Pub. (2006).
Banks, E., The Failure of Wall Street: How and Why Wall Street Fails and What Can be
Done About It. Palgrave Macmillan (2004).
Biegelman, M.T. and J. Bartow, Executive Roadmap to Fraud Prevention and Internal
Control: Creating a Culture of Compliance. Wiley Pub. (2006).
Bloomenthal, H.S., Going Public Handbook. West Publishing (2003).
Geisst, C., Undue Influence: How the Wall Street Elite Put the Financial System at Risk.
Wiley Pub. (2005).
Green, S., Sarbanes-Oxley and the Board of Directors: Techniques and Best Practices for
Corporate Governance. Wiley Pub. (2005).
Hamill, P.J. and B.M. O’Neill, Securities Law Digest. West Publishing (2003).
Hazen, T., Hazen’s Concise Hornbook on Principles of Securities Regulation. West
Publishing (2005).
Kleeburg, R., Initial Public Offering. Thomson/Texere (2005).
Niskanen, W., After Enron: Lessons for Public Policy. Rowman & Littlefield Publishers
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Bottom-Line Results. J. Ross Pub. (2006).
O’Brien, J., Wall Street on Trial: A Corrupted State? Wiley Pub. (2003).
Partnoy, F., Infectious Greed: How Deceit and Risk Corrupted the Financial Markets. H.
Holt and Co. (2003).
Quarterman, J., Risk Management Solutions for Sarbanes-Oxley Section 404 IT
Compliance. Wiley Pub. (2006).
Taylor, H., The Joy of SOX: Why Sarbanes-Oxley and Service-Oriented Architecture May
Be the Best Thing that Ever Happened to You. Wiley Pub. (2006).
Vise, D. and M. Malseed, The Google Story. Delacorte Press (2005).
Website: http://www.sec.gov
Teaching Outline
I. Introduction
Emphasize:
Table 17.1—“Laws Regulating Securities Transactions”
A. What is a Security? (LO 17-1)
Emphasize:
That since the objective of securities laws is to protect uninformed people from
investing their money without sufficient information, the term security is given a very
broad definition. Point out that the definition covers much more than corporate stocks
and bonds.
1. Bankers Trust Company served as an agent for corporate customers by placing their
commercial paper for sale. This function of a commercial bank acting as a dealer of
commercial paper was challenged by the Securities Industry Association.
Issue: Were these sales subject to federal securities laws?
2979 (1984).
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manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
2. W.J. Howey Company and Howey–in-the-Hills Service, Inc., are Florida corporations
under common control and management. Howey Company offered to sell to the public
its orange grove, tree by tree. Howey–in-the-Hills Service, Inc., offered these buyers a
contract wherein the appropriate care, harvesting, and marketing of the oranges would
be provided. Most of the buyers who signed the service contracts were nonresidents of
Florida who had very little knowledge or skill needed to care for and harvest the
oranges. These buyers were attracted by the expectation of profits. When the profits
were not forthcoming, the buyers sued based on the 1933 Securities Act registration
requirements not being satisfied.
Issue: Did the Howey Company sell securities?
were not satisfied, the controllers of these “Howey” companies have violated the
Federal Securities Act of 1933. SEC v. W.J. Howey Co., 328 U.S. 293 (1946).
Additional Matters for Discussion:
The following points, which are not discussed in the text, may provide for further
discussion—the “Sale of Business” Doctrine and how the Supreme Court has limited its
application, the “Family Resemblance” Test, and the exceptions based on the concept of
duplicate regulation.
Case Examples:
1. Ivan K. Landreth and his sons sold all their stock in a lumber business to Samuel Dennis
and John Bolten. Dennis and Bolten formed the Landreth Timber Company, and they
hired Ivan Landreth to continue as a consultant concerning the daily operations of this
business. After the business proved to be unsuccessful financially, Dennis and Bolten
sued Landreth. These plaintiffs claimed their purchase of the timber business could be
rescinded since Landreth failed to register the sale of the stock with the SEC. Landreth
argued that since all the stock was sold to Dennis and Bolten, the sale of business
doctrine exempted the transaction for the federal law.
Issue: Does the sale of business doctrine apply in this factual setting?
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© 2016 by McGraw-Hill Education. This is proprietary material solely for authorized instructor use. Not authorized for sale or distribution in any
manner. This document may not be copied, scanned, duplicated, forwarded, distributed, or posted on a website, in whole or part.
regulations. It is reasonable that Dennis and Bolten would expect the federal laws to
apply. Furthermore, Landreth agreed to assist in the daily operations of the business.
Landreth Timber Company v. Landreth, 105 S.Ct. 2297 (1985).
2. The plaintiff alleges that he purchased a 50 percent interest in a company in reliance on
financial documents and oral representations. When he began to doubt the accuracy of
these representations, he brought an action alleging violations of the 1933 Securities Act
and the 1934 Securities Exchange Act.
Issue: Does the “sale of business” doctrine exempt this transaction from the securities
laws?
3. The Weavers purchased a $50,000 certificate of deposit (CD) from the Marine Bank on
February 28, 1978. The Weavers pledged their CD to the Marine Bank as a guarantee of
a $65,000 loan the Bank made to Columbus Packing Company. (Although it is not clear
what relationship the Weavers had with Columbus, they likely were friends or relatives
of the owners of the Columbus Packing Company.) At the time the loan was guaranteed,
Columbus already owed the Marine Bank $33,000, and its checking account with the
Bank was overdrawn by a substantial amount. None of these facts were revealed to the
Weavers prior to their guarantee being made.
Issue: Did the Marine Bank violate the antifraud provisions of the federal securities law
by not revealing to the Weavers the full financial condition of the Columbus Packing
Company?
not fall within “the ordinary concept of a security.” Marine Bank v. Weaver, 102 S.Ct.
1220 (1982). (Note: This decision does not preclude the Weavers from seeking damages
from the bank on grounds other than securities violations.)
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4. A pension plan entered into under a collective-bargaining agreement between a local
labor union and employer trucking firms required all employees to participate in the
plan but not to pay anything into it. An employee was required to have twenty years of
continuous service in order to be eligible for a pension. Daniel, who had over twenty
years of service, was denied a pension upon retirement because of a short break in
service. Daniel then brought suit alleging that the union misrepresented and omitted to
state material facts with respect to the value of a covered employee’s interest in the plan.
He claimed that this constituted fraud in connection with the sale of a security in
violation of Section 10(b) of the Securities Exchange Act of 1934.
Issue: Is a noncontributory, compulsory pension plan a “security” within the meaning of
the Securities Act of 1933 and the Securities Exchange Act of 1934?
the Securities Acts should apply to pension plans. International Brotherhood of
Teamsters v. Daniel, 99 S.Ct. 790 (1979).
B. Securities and Exchange Commission
Explain:
The nature of the Securities Act of 1933.
That this law makes it illegal to use the mails or any other means of interstate
communication or transportation to sell securities without disclosing certain financial
information to potential investors.
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A. Parties Regulated
Emphasize:
The role of the Securities Act of 1933 in regulating the initial sales of securities.
Is a disclosure law requiring that investors bear furnished information from which they
should be able to make intelligent decisions whether or not to purchase a security.
The two types of documents the issuer has to show before a securities transaction is
“tombstone ad.”
Obtain a recent prospectus from a local securities broker and pass it among students.
Ask them if they think most investors read and understand prospectuses.
Why this 1933 Act does not prohibit sales of worthless securities so long as full
disclosure is made.
The terms prefiling period, waiting period, and tombstone ads.
Prospectus
Explain:
That a prospectus must be furnished to any interested investor, and it must conform
to the statutory requirements.
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The contents of a prospectus form.
$10,000 fine or any combination of the two.
Civil liability under the 1933 Act usually involves a buyer of securities suing for a
refund of the investment.
That this section of the text involves three sections of the 1933 Act that directly apply to
civil liability of parties involved in issuing securities.
responsible.
That a plaintiff-purchaser need not prove reliance on the registration statement in
order to recover the amount of an investment.
That a defendant can defend the suit by proving actual knowledge of the falsity by the
purchaser. Knowledge of the falsity by a defendant need not be proved.
contractual relationship with the seller, the remedy of rescission and a refund of the
purchase price is also available.
Section 17: Fraudulent Transactions
Emphasize:
That the significance of Section 17 in the sale of securities.
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Additional Matters for Discussion:
The name of Section 12(2) as the name suggests involves false or misleading
documents.
The importance of scienter in Section 17(a) cases.
The reasons for imposing criminal liability on lawyers and accountants. Refer
particularly interested students to Section 24 of the 1933 Securities Act, 15 U.S.C.A.
Section 77x.
Cases for Discussion:
1. The shareholders of Alloyd, Inc. sold their stock in a private sale agreement. The
contract specified a price for the estimated increased value in the company’s worth
between the time of sale and the end-of-the-year audited financial statements. The
contract further provided that any party disappointed with estimated value could seek
an adjustment after the financial records were audited. The buyers were disappointed
with the estimated increased value. Rather than seeking an adjustment in the
purchase price, they sought to rescind their purchase under § 12(2) claiming that the
information provided (as a prospectus) at the time of the sale was false or misleading.
Issue: Does § 12(2) apply to private sale contracts?
Alloyd Co., Inc., 115 S.Ct. 1061 (1995).
2. Billy Pinter is an oil and gas producer and a registered securities agent in Texas.
Maurice Dahl is an investor from California. Desiring to invest in oil and gas leases,
Dahl was introduced to Pinter. After Dahl invested at least $20,000 with Pinter, Dahl
assisted fellow investors in completing a subscription-agreement form prepared by
Pinter. When these investments became worthless, Dahl and others sued Pinter. They
sought to rescind their investments claiming that the purchased securities were not
registered under Section 12(1) of the 1933 Securities Act. Pinter asserted the defense
of in pari delicto on the grounds that Dahl was at least equally at fault for the
securities not being registered. Dahl and the other plaintiffs contend that Section
12(1) imposes a strict liability standard on Pinter; therefore, the in pari delicto
defense is not available.
Issue: In a Section 12(1)—failure to register securities—case, may a defendant
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effectively raise the defense of in pari delicto?
investor, precluding suit would interfere significantly with effective enforcement of
the securities law. However, if the plaintiff is more of a promoter than an investor,
the in pari delicto defeat may be used to deny the plaintiff’s recovery. The Court
concluded that the trial court needed to make factual findings concerning the role of
Dahl and the other investors. Pinter v. Dahl, 113 S.Ct. 927 (1993).
3. Two securities brokers, as employees of a broker-dealer firm, produced false
information about the Lawn-A-Mat Chemical & Equipment Corporation. This false
information was given to potential investors to induce the purchase of Lawn-A-Mat
stock. Evidence of these brokers’ wrongful actions was given to their supervisor,
Peter Aaron. When he did nothing to prevent further distribution of false information,
the SEC sought to enjoin Aaron from aiding and abetting continuous violations of
Section 17(a) of the Federal Securities Act of 1933.
Issue: Is the SEC required to establish scienter as an element of a civil enforcement
action to enjoin violations of Section 17(a) of the 1933 Act?
1945 (1980).
4. The respondent engaged in a fraudulent “short selling” scheme by placing orders with
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to make covering purchases and never delivered the securities. Consequently, the
brokers had to buy replacement shares on the open market in order to deliver shares
to investor-purchasers and the brokers suffered substantial financial losses. Naftalin
was convicted of violating Section 17(a) of the Securities Act of 1933 by using a
scheme and artifice to defraud in the sale of securities.
Issue: Does Section 17(a)(1) of the Securities Act of 1933 prohibit frauds against
brokers as well as investors?
(1979).
D. Defenses
Emphasize:
The major types of defenses used to avoid civil liability, recognized by the Securities
Act of 1933. The three most important defenses are materiality, statue of limitations,
and due diligence.
Materiality
Emphasize:
That the statute of limitations is a defense for both civil and criminal liability.
That the basic period is one year. The one year does not start to run until the
discovery of the untrue statement or omission.
Due Diligence
Emphasize: