978-1133019145 Chapter 11 Solution Manual

Unlock access to all the studying documents.

View Full Document

service or otherwise on a password-protected website for classroom use.

CHAPTER 11

Public Corporations and Securities Regulations

THEME

Chapter 11 is an introduction to public corpora-

tions and securities regulations. It begins with a

very basic discussion of public corporations and

the act of going public, which is followed by a

discussion of securities markets and the Securi-

ties and Exchange Commission (SEC). This

chapter then examines the Securities Act of

1933, the Securities Exchange Act of 1934, and

the Sarbanes-Oxley Act of 2002.

CHAPTER GOAL

The goal of this chapter is for students to

become familiar with the following terms

and topics concerning public corporations

and securities regulations:

• Public corporation, publicly held corpora-

tion, public offering, initial public offering,

and securities

• Securities markets in the United States and

the SEC

• Important provisions of the major laws

regulating securities in the United States:

the Securities Act of 1933, the Securities

Exchange Act of 1934, and the Sarbanes-

Oxley Act of 2002

• State securities regulations, or blue sky

laws

• The role of corporate paralegals who spe-

cialize in securities law

• Resources available to corporate parale-

gals who may be assisting in the securities

area

SUGGESTED APPROACH

Students may find it interesting to examine

securities cases that are in the news in con-

junction with their discussion of the material

in this chapter. Students should also become

somewhat familiar with the blue sky laws of

their home state and with other research and

reference aids dealing with securities. Stu-

dents may find it interesting to learn more

about corporations they are familiar with by

looking at the disclosure documents filed on

the SEC’s website.

LECTURE NOTES

The Public Corporations

1. A public corporation is a corporation that

has shares listed on a national securities

exchange or regularly traded in a market

maintained by one or more members of a

national securities association. The term

public corporation may be used synony-

mously with publicly held corporation

and publicly traded corporation. Public

corporations have a public market for

their shares, regardless of their size.

2. Securities that are offered and traded

publicly are subject to federal securities

regulations.

3. Any securities offered, sold, or delivered

through any means of interstate com-

merce are considered to be part of a pub-

lic offering and must first be registered in

accordance with the Securities Act of

1933 and any applicable state securities

law.

4. When the shareholders and directors of a

corporation decide to offer the corpora-

tion’s stock to the public, it is referred to

as going public.

5. The corporation’s first public offering of

its stock is referred to as an initial public

offering (IPO).

6. Corporate shareholders and directors typi-

cally decide to offer their stock for public

sale to take advantage of the capital gener-

ated from the sale of the stock.

CHAPTER 11 Public Corporations and Securities Regulations 77

service or otherwise on a password-protected website for classroom use.

7. Disadvantages to going public include

the loss of corporate control by the cur-

rent shareholders and the cost.

8. Initial public offerings tend to be more

popular when stock market values and

investor optimism are high. In times

when market values and market confi-

dence are lower, the number of initial

public offerings tends to decline.

9. After the decision is made to take a cor-

poration public, the issuers of the stock

typically enter into an underwriting

agreement. The underwriters agree to sell

the shares of the corporation to dealers

for resale.

Securities and Securities Markets

10. Shares of stock, bonds, notes, and any

documents showing a share in a company

or a debt owed by a company or a gov-

ernment are usually included in the defi-

nition of the term securities.

11. The U.S. Supreme Court has defined a

security as any investment in a common

enterprise from which the investor is “led

to expect profits solely from the efforts of

a promoter or a third party.”

12. Securities of a public corporation may be

traded at a stock exchange or over the

counter.

13. Traditionally, stock exchanges were ac-

tual physical locations where securities

were traded by exchange members on the

exchange floor. In recent years, with the

advent of online trading, not all exchang-

es use exchange floors for the trading of

stocks and commodities.

14. The New York Stock Exchange (NYSE)

trades the largest volume of stock, and is

generally considered to be the most pres-

tigious exchange. It sets listing standards

that include a minimum shareholder dis-

tribution, minimum number of shares

traded, and minimum assets and revenue.

Trading on the New York Stock Ex-

change has always taken place on a trad-

ing floor where qualified floor brokers

and specialists buy and sell stock in an

auction style. In recent years, the NYSE

has moved to a hybrid market that auto-

mates much of what the brokers and

dealers do, although there is still trading

on the floor of the New York Stock Ex-

change.

15. When the National Association of Securi-

ties Dealers Automated Quotation

(NASDAQ) system opened in 1971, it

was not considered a stock exchange, but

rather an automated quotation system for

over-the-counter stocks. With no trading

floor, the NASDAQ served as a new

model for the stock exchanges, and in

2006, the NASDAQ moved from a na-

tional securities association to a national

securities exchange, falling under the

rules of the Securities and Exchange

Commission.

16. Stock exchanges and the NASDAQ are

both self-regulated. They are also both

subject to the Securities Exchange Act of

1934.

Securities and Exchange Commission

17. The Securities Exchange Act of 1934

created the Securities and Exchange

Commission (SEC), which is headed by

five presidential appointees.

18. The primary mission of the SEC is to

protect investors and maintain the integri-

ty of the securities markets.

Federal Regulation of Securities Offerings

under the Securities Act of 1933

19. The Securities Act of 1933 was the first

significant federal legislation to protect

the investor through the imposition of

disclosure and antifraud measures for

corporations issuing securities through

means of interstate commerce.

78 PART I Guide for Instructors and Answers to Chapter Review Questions

service or otherwise on a password-protected website for classroom use.

20. The SEC imposes disclosure require-

ments upon corporations that offer secu-

rities to the public through enforcement

of the Securities Act of 1933, which re-

lates to the initial registration and issu-

ance of securities through means of inter-

state commerce.

21. Section 5 of the Securities Act of 1933

requires that, prior to the issuance of any

securities through interstate commerce,

the issuer must file a registration state-

ment with the SEC. The purpose of the

registration statement is to disclose the

information necessary to allow investors

to make informed decisions.

22. The prospectus, which constitutes Part I

of the registration statement, contains

important disclosures concerning the

corporation. The prospectus must be fur-

nished to the purchaser of securities after

the securities have been registered with

the SEC.

23. Section 5(b) of the Securities Act prohib-

its the sale of registered securities with-

out a prospectus that meets the require-

ments of the Securities Act.

24. Regulation C allows the use of a sum-

mary prospectus to sell securities of a

registered corporation, as long as the

summary prospectus includes a required

statement indicating that the more com-

plete prospectus is available.

25. A red herring prospectus may be used

prior to the effective date of a registration

statement. The red herring prospectus

must specifically state that sales may not

be made until the effective date of the

registration statement.

26. Tombstone ads are also used during the

waiting period to announce a securities

offering and to disseminate certain in-

formation regarding the offering. These

tombstone ads, which are frequently

found in the business section of major

newspapers, must follow certain guide-

lines and contain certain legends pre-

scribed by the rules.

27. The Registration Statement (Form S-1) is

filed electronically with the SEC via its

Electronic Data Gathering, Analysis, and

Retrieval (EDGAR) system, along with

the required supporting documents and

filing fee.

28. Registration statements, annual reports,

and other disclosure documents of all

public corporations may be accessed

through the EDGAR database at

http://www. sec.gov.

Exemptions from the Registration Re-

quirements of the Securities Act of 1933

29. An issue of securities may be exempt

from the registration requirements of the

Securities Act of 1933 because of the

type or class of securities or the specific

transaction involving the securities.

30. Securities that are scrutinized by other

governmental agencies, such as the bank-

ing or insurance commissions, or securi-

ties that are sold to a specific group of in-

formed investors, often fall under the

category of exempted securities.

31. Exemption from the registration require-

ments of the Securities Act does not pro-

vide exemption from the other provisions

of the Securities Act or related securities

regulations, especially the antifraud pro-

visions.

Antifraud Provisions of the Securities Act

of 1933

32. The Securities Act includes several anti-

fraud provisions to protect investors who

rely on the disclosures mandated by the

Securities Act.

33. Section 11 of the Securities Act of 1933

provides that everyone who signs or con-

tributes material information to the regis-

tration statement has a duty to provide

complete and accurate information. All

the individuals who sign or contribute to

CHAPTER 11 Public Corporations and Securities Regulations 79

service or otherwise on a password-protected website for classroom use.

the registration statement, including the

underwriter and the directors, are respon-

sible for any misstatements and omis-

sions throughout the registration state-

ment, except experts. Experts are respon-

sible for misstatements and omissions on-

ly in those parts of the registration state-

ment that they are responsible for having

prepared or certified.

34. Section 12 of the Securities Act of 1933

concerns the prospectus, and is designed

to protect investors from purchasing se-

curities based on false or misleading pro-

spectuses or sales pitches.

35. Section 17 prohibits fraudulent conduct

with regard to the sale of, or offer to sell,

securities.

Federal Regulations Imposed on Public

Corporations under the Securities Ex-

change Act of 1934

36. The Securities Exchange Act of 1934

protects securities investors and the gen-

eral public by regulating securities ex-

changes and markets, by requiring peri-

odic reporting of information regarding

the issuance of securities, and by prohib-

iting fraud and manipulation in the trad-

ing of securities.

37. In addition to the registration require-

ments under the Securities Act, the Ex-

change Act requires the issuer of all non-

exempt securities traded on a national se-

curities exchange to register those securi-

ties with that exchange. All exchanges

are required to be registered with the

SEC.

38. Pursuant to the Securities Exchange Act

of 1934, all nonexempt public corpora-

tions must file annual (Form 10-K) and

quarterly (Form 10-Q) reports with the

SEC.

39. Form 8-K must be completed and filed

by the issuer of registered securities

when certain pertinent information in the

registration statement changes.

40. The periodic reports required by the Se-

curities Exchange Act of 1934 are filed

electronically via EDGAR and are avail-

able to the public.

41. The Securities Exchange Act of 1934

provides certain requirements for the use

of proxies and proxy statements.

42. Regulations 14A and 14C require that if

the proxy solicitation is made on behalf

of the board of directors and relates to the

election of directors, the proxy statement

must be accompanied or preceded by an

annual report to shareholders that meets

the requirements of Rule 14a-3.

43. The annual report to shareholders, which

is an important shareholders’ relations

tool, includes the corporation’s financial

statements, a description of the corpora-

tion’s business during the most recent

year, information concerning each direc-

tor and officer, and other information re-

quired by Rule 14a-3. The annual report

is designed to promote a positive image

of the corporation.

Antifraud Provisions of the Securities Ex-

change Act of 1934

44. Section 10(b) of the Securities Exchange

Act of 1934 prohibits any misleading or

fraudulent means in connection with the

purchase or sale of any security.

45. Insider trading is prosecuted under §

10(b) of the Securities Exchange Act.

Section 10(b) makes it unlawful for an

insider to purchase or sell stock based on

information that has not been released to

the public, thereby taking unfair ad-

vantage of the uninformed investor.

46. When corporate insiders become aware

of nonpublic corporate information, they

must disclose that information to the pub-

lic, or they must abstain from acting on

that information. Since disclosure of pri-

vate corporate information is usually not

an option to the corporate insider, absten-

80 PART I Guide for Instructors and Answers to Chapter Review Questions

service or otherwise on a password-protected website for classroom use.

tion from trading is usually what is re-

quired.

47. Profits made by an insider on the purchase

and sale of securities within a six-month pe-

riod are referred to as short-swing profits

and are prohibited under § 16 of the Securi-

ties Exchange Act of 1934.

Sarbanes-Oxley Act of 2002

48. In 2002, Congress passed the Sarbanes-

Oxley Act, also known as the Public Ac-

counting Reform and Investor Protection

Act of 2002, in response to major corpo-

rate and accounting scandals in the Unit-

ed States in 2000 and 2001.

49. The Sarbanes-Oxley Act of 2002 subjects

corporations to tighter controls with re-

gard to their accounting and auditing

procedures, corporate governance, and

reporting requirements.

50. The Sarbanes-Oxley Act established the

Public Company Accounting Oversight

Board (PCAOB), a new entity to oversee

auditors and the audit of public compa-

nies.

51. Section 302 of the Sarbanes-Oxley Act of

2002 requires the chief executive officer

(CEO) and chief financial officer (CFO)

of public corporations to certify the 10-K

and 10-Q and similar reports, indicating

the following:

• They have reviewed the report.

• The report is truthful.

• The financial statements included in

the report fairly represent the finan-

cial condition and results of operation

of the corporation.

• They have established and main-

tained controls as prescribed by stat-

ute.

• They have disclosed to their auditors

and the audit committee any signifi-

cant problems with internal controls

and any fraud involving management

or key employees.

52. The Sarbanes-Oxley Act of 2002 also

requires public corporations to appoint a

certain number of independent directors

to the board and to the audit committee in

particular.

53. The Sarbanes-Oxley Act significantly

increases the maximum criminal penal-

ties that may be imposed on corporate of-

ficers for securities law violations.

State Securities Regulation—Blue Sky

Laws

54. Blue sky laws are state laws concerning

the sale of securities. Blue sky laws co-

ordinate with the federal securities acts

and are considered to be valid so long as

they do not conflict with pertinent federal

acts.

55. Most states have adopted, at least to a

significant extent, the original Uniform

Securities Act (1956), the Uniform Secu-

rities Act (1985), or the Uniform Securi-

ties Act (2002). However, blue sky laws

vary from state to state, and the laws of

any state where a contract for the sale of

securities is entered into or executed

must be consulted.

State Regulation of Stock Offerings

56. In addition to filing at the federal level,

blue sky laws may require the issuers of

securities to file at the state level.

57. State securities registration is typically

coordinated with the filing of the regis-

tration statements with the SEC, and less

information may be required at the state

level because the information needed will

be of public record with the SEC.

State Securities Regulation—Antifraud

Provisions

58. State statutes also prohibit fraudulent ac-

tivities connected with the offer, sale, and

purchase of securities, similar to the anti-

fraud provisions found in the Securities

Act of 1933 and the Securities Exchange

Act of 1934.

CHAPTER 11 Public Corporations and Securities Regulations 81

service or otherwise on a password-protected website for classroom use.

The Paralegal’s Role

59. Corporate paralegals who specialize in

securities law are often very involved in

assisting with initial public offerings,

with blue sky research and filing, and

with preparing and filing the 10-K and

other periodic reports required by the

SEC.

CASE BRIEFS

Carpenter v. United States, 108 S.Ct. 316

(U.S. 1987)

Purpose: This is an example of an insider

trading case prosecuted under § 10(b) of the

Securities Exchange Act of 1934. Although

this case includes several related issues, the

case has been edited to give focus to the §

10(b) charges as discussed in the text.

Cause of Action: Violation of § 10(b) of the

Securities Exchange Act of 1934, violation of

federal mail and wire fraud statutes, and con-

spiracy

Facts: In the summer of 1982, Defendant R.

Foster Winans (“Winans”) became one of the

two writers of a Wall Street Journal daily col-

umn, “Heard on the Street.” That column dis-

cussed selected stocks or groups of stocks,

giving positive and negative information about

those stocks and taking “a point of view with

respect to investment in the stocks that it re-

views.” Because of the perceived quality and

integrity of the column, the column had an

impact on the market for the featured stock.

Contrary to the official policy and

practice at the Journal, Winans entered into a

scheme in October 1983 with Peter Brant

(“Brant”) and Kenneth P. Felis (“Felis”) to

give them advance information as to the tim-

ing and contents of the column. Both Brant

and Felis were connected with the Kidder

Peabody brokerage firm in New York City.

Brant and Felis were then able to buy or sell

based on the probable impact of the column

on the market. Profits were to be shared. Over

a four-month period, Brant and Felis made

several prepublication trades on the basis of

information given them by Winans for a net

profit of about $690,000.

In November 1983, correlation be-

tween the “Heard” articles and trading in the

Clark and Felis accounts were noted at Kidder

Peabody and inquiries began. Some time later,

the SEC began an investigation. On March 29,

1984, Winans and his roommate, David Car-

penter (who was also charged in the scheme),

went to the SEC and revealed the entire

scheme. An indictment and bench trial fol-

lowed. Winans, Carpenter, and Felis were

charged with participating in a scheme to trade

in securities based on information misappro-

priated from the Wall Street Journal in viola-

tion of § 10(b) and 32 of the Securities Ex-

change Act of 1934 and Rule 10b-5 promul-

gated thereunder. They were also charged with

violation of various mail and wire fraud stat-

utes. All three defendants were also charged

with conspiracy to violate those statutes and to

obstruct justice by their agreement to cover up

and obstruct any investigation of the scheme.

With respect to the § 10(b) charges,

the courts below held that the deliberate

breach of Winans’s duty of confidentiality and

concealment of the scheme was a fraud and

deceit on the Journal. The district court found

Winans and Felis guilty of securities fraud by

misappropriating material, nonpublic infor-

mation from the Wall Street Journal in con-

nection with the purchase and sale of securi-

ties, and of mail and wire fraud. Winans and

Felis were also convicted of conspiracy to

commit such securities and mail and wire

frauds and to obstruct justice. Carpenter was

convicted of aiding and abetting in the com-

mission of securities fraud and mail and wire

fraud. With a minor exception, the court of

appeals upheld the convictions.

Carpenter, Felis, and Winans appealed

to the U.S. Supreme Court. The appellants ar-

gued that they could not be held criminally

liable for violating, or conspiring to violate, or

aiding and abetting in violating, § 10(b) of the

82 PART I Guide for Instructors and Answers to Chapter Review Questions

service or otherwise on a password-protected website for classroom use.

Securities Exchange Act of 1934, and Rule

10b-5, because they were not corporate insid-

ers or “quasi-insiders” and did not misappro-

priate material nonpublic information from

such insiders or “quasi-insiders.”

Issue: Can the petitioners be held criminally

liable for violating, or conspiring to violate, or

aiding and abetting in violating, § 10(b) of the

Securities Exchange Act of 1934, even though

they were not corporate insiders and did not

misappropriate material nonpublic information

from such insiders?

Holding: Yes, judgment of the lower court is

upheld.

Reasoning: Although the victim of the fraud,

the Journal, was not a buyer or seller of the

stocks traded in or otherwise a market partici-

pant, the fraud was nevertheless considered to

be “in connection with” a purchase or sale of

securities within the meaning of the statute

and the rule. The courts reasoned that the

scheme’s sole purpose was to buy and sell se-

curities at a profit based on advance infor-

mation of the column’s contents. The court

found it irrelevant that petitioners might not

have interfered with the Journal’s use of its

confidential information, publicized the in-

formation, deprived the Journal of the first

public use of the information, or caused the

Journal monetary loss, because the Journal

was deprived of its important right to exclu-

sive use of the information prior to disclosing

it to the public. The confidential information

was generated from the business, and the

business had a right to decide how to use it

prior to disclosing it to the public.

Merrill Lynch v. Livingston, 566 F.2d 1119

(9th Cir. 1978)

Purpose: This case includes a good discussion

of the applicability to employees of the short-

swing provisions of § 16(b) of the Securities

Exchange Act.

Cause of Action: Violation of § 16(b) of the

Securities Exchange Act of 1934

Facts: In 1972, Merrill Lynch awarded 48 of

its account executives with the title of “Vice

President,” including defendant-appellant Wil-

liam G. Livingston (“Livingston”). Livingston

had worked for Merrill Lynch as a securities

salesman with the title of “Account Execu-

tive” for several years. Livingston had exactly

the same duties after he was awarded the title

as he did before the recognition. He was not

included in meetings of the board of directors

or the executive committee, and he acquired

no executive or policy-making duties.

Livingston and other salespersons for

Merrill Lynch received some information that

was not generally available to the investing

public, such as the growth production rankings

on the various Merrill Lynch retail offices.

Livingston’s supervisor, a branch office man-

ager, testified that the information Livingston

received about the company was not useful for

purposes of trading stock in the company.

In November and December 1972,

Livingston sold a total of 1,000 shares of Mer-

rill Lynch stock. He repurchased 1,000 shares

of Merrill Lynch stock in March 1973, realiz-

ing a profit of $14,836.37.

Merrill Lynch brought suit against Liv-

ingston demanding repayment of the profit he

made on a short-swing transaction in the secu-

rities of his employer in alleged violation of §

16(b) of the Securities Exchange Act of 1934

(15 U.S.C. § 78p [1971]). The district court

held that Livingston was an officer with ac-

cess to inside information within the meaning

of § 16(b) of the Securities Exchange Act of

1934 and ordered Livingston to repay the

$14,836. The predicate for the district court’s

decision was that § 16(b) imposes strict liabil-

ity on any person who holds the title of “of-

ficer” and who has access to information

about his company that is not generally avail-

able to the members of the investing public.

Livingston appealed the decision to the U.S.

Court of Appeals.

CHAPTER 11 Public Corporations and Securities Regulations 83

service or otherwise on a password-protected website for classroom use.

Issue: Is an employee considered an officer

under the meaning of § 16(b) of the Securities

Act regarding short-swing transactions merely

because he holds the title of an officer?

probable than not that the individual has ac-

cess to insider information. The Court of Ap-

peals found that insider information under §

16(b) does not mean all information about the

company that is not public knowledge. Instead

it encompasses that kind of confidential in-

formation about the company’s affairs that

would help the particular employee to make

Livingston did not receive insider in-

formation within the meaning of § 16(b). The

generally available to all Merrill Lynch sales-

people. It was not information reserved for

company management, nor did it give him any

kind of advantage in his security transactions

over any other salesperson for Merrill Lynch.

1. What are some of the advantages and

disadvantages of taking a privately held

corporation public?

Advantages of taking a privately held

creased immediate and future availa-

bility of capital through the sale of

stock to the public. Publicly held cor-

porations may also have added incen-

other incentives. In addition, the pub-

licly held corporation has the ad-

vantage of gaining national exposure

for itself and its products and/or

services.

2. What are the two general requirements of

§ 5 of the Securities Act of 1933 with re-

gard to securities that are offered or sold

through any means of interstate com-

merce?

1. Prior to the issuance of any securi-

ties sold to the public, the issuer

2. A prospectus meeting the require-

ments of Section 5 of the Securities

3. What is the due diligence defense?

It is a defense available to individuals

who use due diligence to ascertain the

To whom is the due diligence defense

available?

It is available to individuals, other than

4. What is the purpose of Form 8-K?

It is to notify the SEC and the public

when certain information contained in

84 PART I Guide for Instructors and Answers to Chapter Review Questions

service or otherwise on a password-protected website for classroom use.

6. What is the definition and the origin of

the term “blue sky laws”?

The term refers to state statutes regu-

lating securities. It was derived from

an early U.S. Supreme Court case in

more basis than so many feet of blue

sky.”

7. As a 20 percent shareholder in a publicly

owned corporation, Jane has decided to

sell her shares. What special require-

cent of the stock in the publicly owned

corporation, she is subject to § 16 of

the Exchange Act, which provides that

any profits realized from the purchase

and sale (or sale and purchase) of the

equity securities of a corporation by

insiders and/or principal shareholders

8. What is the purpose of the Sarbanes-

Oxley Act, and what prompted its pas-

sage?

The Sarbanes-Oxley Act was passed to

subject public corporations to tighter

controls concerning their accounting

and auditing procedures, corporate

9. What are the purposes of the proxy and

the proxy statement?

The proxy is used by shareholders to

meetings without actually attending.

10. When is the Form 10-K filed?

The 10-K must be filed electronically

with the SEC via EDGAR within 90

days after the end of the corporation’s