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CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 21
whole or in part.
4. Civil Sanctions
• In a suit by the SEC, a court may assess as a penalty as much as triple the profits gained or
the loss avoided by the guilty party.
All states have their own laws that regulate intrastate offers and sales of securities.
A. REQUIREMENTS
Certain features (registration requirements, antifraud provisions, broker regulations) are common to all
state blue-sky laws.
V. Corporate Governance
Corporate governance is the system by which business corporations are governed and controlled, according
to the Organization of Economic Cooperation and Development. Effective governance requires more than
compliance with the law. Because corporate ownership is separated from corporate control, conflicts of
Corporate governance has become an issue of concern not only for U.S. corporations, but also for
corporate entities around the world. With the globalization of business, a corporation’s bad acts (or lack of
control systems) can have far-reaching consequences. Different models of corporate governance exist, often
whole or in part.
the community—to be a priority. The coordinated model still encourages innovation and cost and quality
A. ATTEMPTS AT ALIGNING THE INTERESTS OF OFFICERS WITH THOSE OF SHAREHOLDERS
Providing stock options to align the financial interests of shareholders and officers has proved to be an
imperfect control device. Officers have manipulated circumstances to artificially inflate stock prices to
• The audited reporting of corporate financial progress so that managers can be evaluated.
• Legal protection for shareholders.
1. The Company Benefits
3. The Board of Directors
Directors, who must operate for the shareholders’ benefit, are responsible for monitoring officers
and can be sued for failing to do their jobs effectively.
penalties for violations of securities laws. Certain reports must be filed with the SEC earlier than under
previous law. Other provisions create new private civil actions and expand the SEC’s remedies.
1. More Internal Controls and Accountability
The act introduces federal corporate governance requirements for public companies’ boards and
whole or in part.
24 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS
whole or in part.
Public companies with a market capitalization, or market float, of less than $75 million are not
required to provide an auditor’s report on management’s assessment of internal controls.
3. Certification and Monitoring Requirements
Chief executive officers and chief financial officers must certify that these documents are accurate
A. ONLINE INVESTMENT SCAMS
Scams may be propagated via spam, fraudulent Web pages, online newsletters and bulletin boards, chat
rooms, blogs, and tweets.
To inflate the price of a stock and thereby profit from its sale, its holders may pay others to tout the
stock online. Potential investors may be duped if the identities of those who pay for this service are
not disclosed when the law requires it. The same tactic may be employed in other online venues
such as forums, using any number of aliases to falsify interest in the stock.
The schemes may claim to consist of risk-free or low-risk investments.
ADDITIONAL BACKGROUND—
through an offshore or dummy corporation.
CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 25
TEACHING SUGGESTIONS
1. Ask students to identify any stocks they own at present as well as the reasons they purchased those
stocks in the first place. Have these stocks met their investment objectives? Were there particular
reasons that the stocks performed better or worse than expected over time? Do the students plan to
3. Use examples other than the familiar stocks and bonds to explore investments that fit the legal definition
of a security. Why did this legal definition of a security come about? Are there any elements that
should be added or subtracted?
Cyberlaw Link
DISCUSSION QUESTIONS
1. What are securities? Securities are evidence of obligation to pay money or the right to participate in earnings
and the distribution of corporate trusts and other property. The principal method of long-term and initial corporate
financing is the issuance of stocks (equity) and bonds (debt), both of which are sold to investors. Stocks represent the
markets; (3) investigating securities fraud; (4) regulating the activities of securities brokers, dealers and investment
advisers and requiring their registration; (5) supervising the activities of mutual funds; and (6) recommending
administrative sanctions, injunctive remedies, and criminal prosecution against those who violate securities laws.
3. What information must be included in a registration statement prior to a security being offered to the
26 INSTRUCTOR’S MANUAL FOR BUSINESS LAW: COMMERCIAL LAW FOR ACCOUNTANTS
whole or in part.
5. What are some examples of material facts that must be disclosed in connection with the purchase or
sale of a security? A material fact is any fact that would significantly influence an investor’s decision to purchase or
not purchase a security. Some examples of material facts that should be disclosed under the rule might include (1) a
new ore discovery, (2) fraudulent trading in the company stock by a broker-dealer, (3) a dividend change (whether up
or down), (4) a contract for the sale of corporate assets, (5) a new discovery of a process or product, or (6) a
7. What is the misappropriation theory? This theory of liability holds that if an individual wrongfully obtains—
misappropriates—inside information and trades on it to his or her personal gain, then the individual should be held
liable, because in essence, he or she stole information rightfully belonging to another. The courts will normally require
that some fiduciary duty have been violated and some harm have come to the defrauded party before they hold the
corporations they direct and audit than those who work within the firms. How will the new requirements for certified
financial disclosures likely affect who is selected to be an officer of the corporation? These requirements may
change the attributes of corporate officers from “good” personal contacts (among the directors) to “good” personal
ethics and business ability.
10. What is the difference between the traditional theory of insider trading liability and the misappropriation
theory? Liability is imposed under the traditional theory generally only when a trader or tipper is an insider of the
company whose stock is traded. In this scenario, the trader breaches a fiduciary duty owed to the company’s
shareholders. Under the misappropriation theory, liability is imposed when a trader or tipper bases a trade on—or
“misappropriates”—confidential information obtained from his or her source of the information. In this situation, the
CHAPTER 7: SECURITIES LAW AND CORPORATE GOVERNANCE 27
whole or in part.
2. Ask each student to acquire a mutual fund prospectus and to examine the types of securities maintained in his or
her respective fund to determine whether the basket of securities is, in the student’s opinion, the optimal portfolio for
promoting the stated objectives of the fund.
key drugs had failed its clinical trial and reminded her not to discuss this information with anyone. Patricia was aware
that her brother, William Beaver, owned Cubist stock, and she told Scott that she wanted to tell her brother about the
failed trial. Scott tried to discourage her. Patricia had an “understanding” with William, however, and told him that she
had heard significant negative news about Cubist. He sold his 5,583 shares of its stock and tipped his friend David
Jones, who sold his 7,500 shares. On January 16, 2002, Cubist publicly announced the trial results, and the price of
In Securities Exchange Commission v. Rocklage, 470 F.3d 1 (1st Cir. 2006), the U.S. Court of Appeals for
the First Circuit affirmed the lower court’s decision and remanded the case for further proceedings. The appellate
court recognized that the misappropriation theory bases liability on the deception of the source of the information. In
this case, “Mrs. Rocklage engaged in deceptive devices, in connection with a securities transaction, when she tricked
in her tip to William, but it did not “negate the original deception. * * * Because of the way in which Mrs. Rocklage first
acquired this information, her overall scheme was still deceptive: it had as part of it at least one deceptive device.”
Are there any circumstances in which the disclosure to the source that his or her information will be
revealed to others might serve to avoid liability? Explain. The SEC opined in the Rocklage case that disclosure to
whole or in part.
the trader breaches a fiduciary duty owed to the source.
What effect could the holding in this case have on stock transactions in this jurisdiction? Are persons
with inside information likely to become involved in fewer stock transactions? Or is there likely to be very
little change in the number of deals and the way in which they are conducted? Is there some other legal basis
application for the approval of ImClone’s lead product. The government investigated Stewart’s trades, the media
reported on the investigation, and the value of MSLO stock dropped. Six months later, at a conference attended by
investors and others. Stewart briefly defended her trading and gave a forty-minute presentation on MSLO. Stewart
was charged in a federal district court with fraud in connection with the purchase and sale of MSLO securities. She
filed a motion for a judgment of acquittal on this charge. In United States v. Stewart, the court granted the motion,
conference.”
There were three public statements considered by the court in the Stewart case. With respect to the first
statement, the government contended that “an inference of intent can be drawn from the fact that The Wall Street
Journal,” in which the statement appeared, “is the most widely read financial publication in the nation.” But the court
Are questions about the sufficiency of evidence common in securities fraud cases? No. Few civil
securities fraud opinions reach the question of sufficiency of the evidence—the question more frequently is whether a
complaint states a claim on which relief can be granted, or whether the existence of a material fact justifies the denial
of a motion for summary judgment. Also, as the court in the Stewart case acknowledged, in criminal securities fraud
whole or in part.
deny the jury any opportunity to operate beyond its province. The jury may not be permitted to conjecture merely, or to
conclude upon pure speculation . . . The critical point . . . is the existence or non-existence of reasonable doubt as to
guilt. If the evidence is such that reasonable [jurors] must necessarily have such doubt, the judge must require
acquittal, because no other result is permissible within the fixed bounds of jury consideration.”
Dale Emerson served as the chief financial officer for Reliant Electric Co., a distributor of electricity
serving portions of Montana and North Dakota. Reliant was in the final stages of planning a takeover of
Dakota Gasworks, Inc., a natural gas distributor that operated solely within North Dakota. Emerson went on a
weekend fishing trip with his uncle, Ernest Wallace. Emerson mentioned to Wallace that he had been putting
in a lot of extra hours at the office planning a takeover of Dakota Gasworks. On returning from the fishing trip,
1. Would registration with the SEC be required for Dakota Gasworks securities? Why or why not? In
this scenario, Dakota Gasworks was the target company in a successful takeover; it did not issue new
securities to raise capital or offer any securities to the public. Therefore, it would not have been required to
register with the SEC.
3. What theory or theories might a court use to hold Wallace liable for insider trading? Because
Wallace acquired inside information as a result of Emerson’s breach of his fiduciary duty, Wallace could be
held liable for insider trading under the tipper/tippee theory. Wallace would have to have known that the
information came from a breach of the fiduciary duty.
whole or in part.
up with lower salaries because of competition in the labor market, even for managers.
Laws against insider trading were put in place to prevent insiders—usually highly paid upper-level
managers—from undeservedly benefiting from their positions in the publicly head companies. If insider
trading were no longer illegal, insiders would stand to make fortunes from buying the companies’ stock
EXAMPREP—
ISSUE SPOTTERS
customer delinquencies, and pending lawsuits.
2. Lee is an officer of Magma Oil, Inc. Lee knows that a Magma geologist has just discovered a new
deposit of oil. Can Lee take advantage of this information to buy and sell Magma stock? Why or why
not? No. The Securities Exchange Act of 1934 extends liability to officers and directors in their personal
