978-1285770178 Lecture Note BL ComLaw 1e IM-Ch07 Part 3

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