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Chapter 45
SECURITIES REGULATION
RESTATEMENT
Securities are regulated at the state and federal levels. State regulations are called blue sky laws and focus on
antifraud controls, broker-dealer licensing and registration of the sale of securities. The Uniform Securities Act
provides sample registration forms as well as various levels of regulation that states can adopt.
Following the 1929 stock market crash, Congress engaged in a seven-year project of securities reform and
passed six statutes regulating initial offerings as well as the secondary market.
The Securities Act of 1933 regulates initial sales of securities. Securities are investments in a common enterprise
with profits to come from the efforts of others. Securities can include investments in cattle, orange groves or oil
and gas wells. The 1933 act applies to the sales of stocks, securities, bonds, limited partnerships, etc. Unless
specifically exempted, securities must be registered.
The registration process beings with the filing of a registration statement which is a document containing detailed
information about the offering, the company and its managers. Upon filing, the potential offeror can run
tombstone ads and distribute fired herring” or a preliminary prospectus, but cannot sell shares.
Exemptions from registration include intrastate offerings as well as small offerings and securities sold under the
Regulation D exemptions including Rules 504, 505, and 506 exemptions. The omission or misstatement of
material information in a registration statement results in liability for officers, directors and experts.
The Securities Exchange Act of 1934 regulates the secondary market and requires companies not exempted to
file quarterly and annual reports. Section 10b and Regulation 10b-5 are part of the 1934 act and prohibit insider
trading and material misstatement or omissions of fact in securities sales transactions or prohibits insider trading.
The Private Securities Litigation Reform Act of 1995 placed restrictions on law suits, standards for recovery and
the management of class action law suits.
The 1934 act also controls short-swing profits and regulates the process for tender offers.
The Sarbanes-Oxley Act was passed in 2002 in response to widespread accounting fraud.
The Dodd-Frank Wall Street Reform and Consumer Protection Act was passed in response to the 2008 financial
crisis.
Congress passed the Jumpstart Our Business Startups (JOBS) Act in 2012 to encourage investment in
companies, especially smaller companies.
STUDENT LEARNING OUTCOMES
LO.1: Explain the meaning of state "blue sky laws".
LO.2: Define "security".
LO.3: Compare and distinguish between the Securities Act of 1933 and the Securities Exchange Act of 1934.
LO.4: Explain the changes that the JOBS Act has had on registration exemptions.
LO.5: Explain how the 1934 Act's policy of fostering reliance on market integrity is served by Rule 10b-5 private
investor lawsuits when investors are injured by material misstatements by the issuer.
LO.6: Explain the factors that subject an individual to liability for insider trading.
LO.7: Explain how the primary and secondary markets are regulated by the SEC as well as private
enforcement organizations.
INSTRUCTOR’S INSIGHTS
Break the chapter down into three components – related Learning Outcomes are indicated in ( ):
1. What state regulation of securities exists?
Discuss blue sky laws (LO.1)
2. What is the history of federal regulation market trends?
Define security (LO.2)
Cover the purpose and provisions of the Securities Act of 1933 (LO.3)
Discuss recent changes to registration requirements for Regulation A and emerging growth companies
(LO.4)
3. What forms of securities industry self-regulation exist? (LO.7)
CHAPTER OUTLINE
I. What State Regulation of Securities Exists?
A. State blue sky laws
1. State laws regulating securities labeled fiblue sky” laws from a court opinion labeling securities
frauds as having no more substance than the blue skies above
B. National Securities Markets Improvement Act
II. What is the History of Federal Regulation Market Trends?
A. Federal laws regulating the securities industry
1. Securities Act of 1933
2. Securities Exchange Act of 1934
3. Public Utility Holding Company Act of 1935
4. Trust Indenture Act of 1939
5. Investment Company Act of 1940
6. Investment Advisors Act of 1940
NOTE: Six in a 7-year time frame following the 1929 crash
14. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010
15. Jumpstart Our Business Startups Act
B. The 1933 Act
CASE BRIEF: SEC. v. Edwards
540 U.S. 389 (2004)
FACTS: Ten thousand people invested a total of $300 million in the payphone sale-and-leaseback
arrangements touted by ETS Payphones. Charles Edwards, the Chairman, chief executive
officer, and sole shareholder of ETS, acting partly through a subsidiary, sold payphones to the
public via independent distributors. Under the leaseback and management agreement,
purchasers received a 14% annual return and were not involved in the day-to-day operation of
the payphones they owned. Under the buyback agreement, ETS promised to refund the full
purchase price of the package at the end of the lease or within 180 days of the purchaser’s
request. The payphones did not generate enough revenue for ETS to make the payments
required by the leaseback agreements, so the company depended on funds from new investors
to meet its obligations. In September 2000, ETS filed for bankruptcy protection. The SEC
brought this civil enforcement action alleging that Edwards and ETS had violated the
registration requirements and antifraud provisions of the 1933 Act. The district court concluded
the arrangement was an fiinvestment contract” subject to the securities laws. The Eleventh
Circuit Court of Appeals reversed the lower court because the scheme offered a contractual
entitlement to a fixed rather than a variable return.
ISSUE: Was the fiinvestment” contract” a security and thus regulated by the 1933 Act?
HOLDING: The Supreme Court held that the investment contract can be a security and remanded the case
REASONING: Congress’ purpose in enacting the securities laws was to regulate investments, in whatever form
they are made and by whatever name they are called. To that end, it enacted a broad definition
of fisecurity” sufficient to encompass virtually any investment that might be sold as an
investment. The Court applied the Hovey test for an investment contract, finding (1) an
investment of money, (2) a common enterprise, and (3) an expectation of future fiprofits” from
the efforts of others, including fixed returns based on contracts. The Court determined that the
ETS investment scheme can be an fiinvestment contract” and thus a fisecurity” under the
securities laws.
DISCUSSION POINTS: Have the students discuss the SEC. v. Edwards case as an example of the broad
definition of security sufficient to encompass virtually any instrument that might be sold
as an investment.
C. The filing requirements: registration statements
1. Deals with original distribution of securities
2. Registration statements; prospectus
3. Applicability – stocks; corporate bonds; investment instruments
4. The registration process (See Figure 45-1 in text)
5. Regulation A offerings
a. JOBS Act of 2012 expanded Regulation A
b. Simpler registration process to raise public capital
6. Regulation D exemptions – private placement and limited offerings
a. Rule 506 exemption – private placement exemption; no limitation on offering amount; no more
than 35 nonaccredited investors
7. Intrastate offerings exemption
8. Crowdfunding exemption
9. Enforcement of the 1933 Act – civil and criminal liability
a. Issuers’ civil liability for false or misleading statements: Section 11 – false statements in
registration statement
D. Securities Exchange Act of 1934
1. Registration requirements
a. $10 million assets/500 or more shareholders or NSE listing
d. Certification and disclosure – CEO and CFO must certify under Sarbanes-Oxley Act (see list of
requirements)
i. Criminal penalties of 10 years and/or $1 million for false representations; willful is $5 million
and 20 years
2. Antifraud provision
a. Discuss section 10(b) and Rule 10b-5
b. Scope of application – the antifraud provision applies to mail, national stock exchange, or
CASE BRIEF: Basic, Inc. v. Levinson
485 U.S. 224 (1988)
FACTS: Basic and another company agreed to merge. During the two years prior to the merger, Basic
made three public statements denying that any merger negotiations were taking place or that it
knew of any corporate developments that would account for the heavy trading activity in its
stock. Former shareholders of Basic sold stock between Basic ’s first public denial and the
announcement of the merger. These shareholders brought a Section 10(b) and Rule 10b-5
action against Basic, contending that material misrepresentation had been made in its public
statements denying merger activity. Basic defended that the alleged misrepresentations were
not material. The court of appeals reversed the district court ’s summary judgment for Basic that
preliminary merger discussions are not material information. Basic appealed.
ISSUES: 1. What is the standard of materiality to be used to determine whether preliminary merger
negotiations must be disclosed under Rule 10b-5?
2. Is it appropriate to apply a presumption of reliance on all members of a class of investors?
HOLDING: 1. The standard for materiality is that enunciated in TSC Industries v. Northway. To fulfill the
materiality requirement, there must be a substantial likelihood that the disclosure of the
omitted fact would have been viewed by the reasonable investor as having significantly
2. Yes. Reliance is an element of a Rule 10b-5 cause of action. It provides the requisite
causal connection between a defendant’s misrepresentation and the plaintiff’s injury. The
REASONING: The adoption of the fraud-on-the-market theory was strongly objected to in the dissent to
Levinson. In his dissent, Justice White thought that applying the theory was inappropriate
because the fraud-on-the-market theory is an economic doctrine and is not based on the
traditional legal principles of fraud. He also felt that the link is tenuous between the assumed
reliance by the investors on the fiintegrity” of the market and the stock market price actually
representing the stock’s value. Furthermore, White notes that the Court has disregarded
Congressional preference for wider disclosure of securities information to investors. The
fraud-on-the-market theory does not advance the policy of disclosure as investors lessen their
reliance on publicly disclosed information in favor of following speculative stock trends.
DISCUSSION POINTS: The Supreme Court reconsidered (but did not change) the fraud-on-the-market theory in
Halliburton v. Erica P. John Fund, 134 S. Ct. 2398 (2014). For an advanced discussion,
have students consider the arguments for and against the fraud-on-the-market theory.
CASE BRIEF: Matrixx Initiatives, Inc. v. Siracusano
131 S. Ct. 1309 (2011)
FACTS: Matrixx Initiatives manufactured a cold remedy that accounted for seventy percent of
the company’s sales. The company issued a press release stating that it expected to see a fifty
percent increase in revenue during the cold season, and a few months later in a press release
increased the prediction to an eighty percent increase. Prior to either of these statements the
company was aware of material medical evidence that the product could cause users to lose
their sense of smell. This adverse information later came out in the news and the company’s
stock price plummeted. Investors sued claiming that without the withheld information the press
release statements by Matrixx were misleading.
ISSUE: Was the withheld information material under Section 10(b)?
REASONING: The court held that this information was material as there was a substantial likelihood that a
reasonable investor would conclude that the omitted information would have significantly
altered the mix of information that was made available by the company. Section 10(b) and Rule
10b-5 do not create an affirmative duty to disclose any and all material information (silence,
absent a duty to disclose, is not misleading under Rule 10b-5). However, disclosure was
required in order to make the statements made by Matrixx to the market not misleading.
3. Reliance and the Fraud-on-the-Market Theory
a. Reliance is an important element of proving securities fraud
1. Private Securities Litigation Reform Act of 1995
a. Passed due to concerns about the number of frivolous lawsuits
b. Financial burdens of the suits to accountants
c. Safe harbor rules – can protect themselves with meaningful cautionary statements in financial
5. Trading on insider information
a. Insider Trading Act, 1988 – controlling employees
b. Insider Trading Sanctions Act, 1984
CASE BRIEF: Dirks v. SEC
463 U.S. 646 (1983)
FACTS: Dirks, an investment analyst, received information from a former officer of Equity Funding of
America alleging that the assets of Equity Funding were vastly overstated as a result of
fraudulent corporate practices. Neither Dirks nor his firm owned or traded in Equity Funding
stock. Dirks conducted an investigation and ultimately discussed what he had discovered with
clients and investors, causing some of them to sell Equity Funding stock. When Equity
Funding’s fraud was later exposed, the SEC found that Dirks had aided and abetted violations
of the 1933 and 1934 acts and Rule 10b-5 by giving the information discovered in his
investigation to investors, who later sold their stock. Dirks appealed to the Supreme Court.
ISSUE: Will a tippee be liable under Rule 10b-5 for disclosing inside information, when that disclosure
was not motivated by personal gain?
HOLDING: No. An insider will be liable for trading under Rule 10b-5 only when the insider failed to disclose
material, nonpublic information before trading in it and thus made a secret profit. In the
Chiarella case, it was held that there can be no duty to disclose when the person who traded on
inside information was not the corporation ’s agent and was not a fiduciary or a person in whom
The dissenting opinions stated that Dirks was under an obligation either to make the
REASONING: The duty to disclose under Rule 10b-5 is not automatic when one merely possesses inside
information. The duty to disclose arises when there exists a fiduciary relationship, something
that was not present in Dirks. When an accountant, lawyer, or consultant working for a
company receives corporate information, these professionals may become fiduciaries of the
shareholders since they have a confidential relationship with the company. Thus unlike Dirks,
who was not an employee of Equity Funding, such professionals can be held liable for what
Dirks was accused of.
DISCUSSION POINTS: Have the students discuss the Dirks v. SEC case that illustrates the rule that when the
insider does not breach a fiduciary duty, a tippee does not violate securities laws.
e. Misappropriation theory of insider trading
CASE BRIEF: United States v. O’Hagan
521 U.S. 657 (1997)
FACTS: James O’Hagan was a partner in the law firm of Dorsey & Whitney in Minneapolis, Minnesota.
In July 1988, Grand Metropolitan PLC, a company based in London, England, retained Dorsey
& Whitney as local counsel to represent Grand Met regarding a potential tender offer for the
common stock of the Pillsbury Company, headquartered in Minneapolis. O ’Hagan did no work
on the Grand Met representation. Dorsey & Whitney withdrew from representing Grand Met on
September 9, 1988. Less than a month later, on October 4, 1998, Grand Met publicly
announced its tender offer for Pillsbury stock. On August 18, 1988, while Dorsey & Whitney was
still representing Grand Met, O’Hagan began purchasing call options for Pillsbury stock. Each
option gave him the right to purchase 100 shares of Pillsbury stock by a specified date in
September 1988. Later in August and September O’Hagan purchased additional Pillsbury call
options. By the end of September he owned 2,500 unexpired Pillsbury options, apparently more
than any other individual investor. O’Hagan also purchased, in September 1988, some 5,000
shares of Pillsbury common stock, at a price just under $39 per share. When Grand Met
announced its tender offer in October, the price of Pillsbury stock rose to nearly $60 per share.
O’Hagan then sold his Pillsbury call options and common stock, making a profit of more than
$4.3 million. O’Hagan was charged and convicted of securities fraud in violation of section
10(b) and Rule 10b-5. On appeal he claimed that he was not a fimisappropriator, ” for he had no
fiduciary duty to the Pillsbury shareholders from whom he purchased calls and stock; in fact, he
had not even worked on the transaction at the law firm.
ISSUE: Did O’Hagan violate 10b?
REASONING: fiMisappropriation” requires that there be fideceptive” conduct fiin connection with” a securities
transaction. A fiduciary who pretends loyalty to the principal while secretly converting the
principal’s information for personal gain dupes or defrauds the principal. O ’Hagan’s failure to
disclose his personal trading to his law firm and its client, Grand Met, was a breach of his
fiduciary duty and was fideceptive ” conduct fiin connection with” a securities transaction. The
misappropriation theory is designed to protect the integrity of the securities market against
fioutsiders” like O’Hagan, who have access to confidential information that will affect a
company’s stock price when revealed but have no fiduciary or other duty to the company ’s
shareholders.
DISCUSSION POINTS: Have the students discuss the United States v. O’Hagan case regarding outsiders who
have access to confidential information that will affect a company's stock price.
f. Regulation FD – corporations must release information to all simultaneously
g. Remedy for investors who trade simultaneously with insider – civil suit to recover damages from
insider
E. Disclosure of ownership and short-swing profit
1. Discuss Section 16 of the 1934 Securities Exchange Act
F. Tender offers
G. SEC enforcement under the 1934 Act
1. Dodd-Frank enforcement powers
2. Enforcement and whistleblowers
3. Enforcement and third-party market participants
Consider the fiduciary duty of broker-dealers and investment advisors
4. Regulation of attorneys and accountants by the SEC
a. Liability as experts
b. Rule 2(e) suspension
5. Regulation of corporate officers and auditors
III. What Forms of Securities Industry Self-Regulation Exist?
DISCUSSION POINTS: Thinking Things Through
Problem: Conflicts of Interest – Remedy: Commonsense Rules
Have students explain the conflict of interests faced by research analysts at Merrill Lynch, and have them explain
how new SEC rules address and remedy these conflicts of interest.
ANSWERS TO QUESTIONS AND CASE PROBLEMS
1. Regulation FD. The SEC maintained that Polizzotto violated Regulation FD by disclosing material nonpublic
information to private parties. According to the SEC, all investors, regardless of their size or relationship with
2. fiMaterial” misstatements; reliance. In Basic Inc. v. Levinson, the Supreme Court rejected the defendant’s
bright line rule that merger negotiations are not material until an agreement in principle is reached. The
Because most publicly available information is reflected in the market price, there is a presumption of
3. The misappropriation theory of insider trading. To support a conviction of Falcone, the government had to
prove (1) a breach of duty owed to the owner of the misappropriated information; and (2) Falcone's
knowledge that the tipper had breached the duty. The tipper in this case is Gregory Savage who owed a
4. Fraud in the sale of securities; public release of information. Whether Tuttle can recover depends on the
accuracy of the information MPRL released about its drug. MPRL carefully qualified the research results and
5. Short- swing profits. Jones, an officer, and Sylvan, a director, are prohibited from making short -swing profits
under § 16(b) of the 1934 act and must turn over the profits to the corporation. Winfried, who owned more
6. Insider trading. When corporate insiders trade on the basis of material nonpublic information, or when a
corporate insider gives a tip to a friend or family member for the purpose of having the outsider trade, and
Dorozhko was neither a corporate insider nor a tippee, and the traditional insider theory of insider trading
controlling person under the 1988 Insider Trading Act. He had an obligation under the 1988 act to control
client confidences and make sure that controlled persons did not misuse confidential information. Instead of
cautioning Dale about the confidential information he was to type, he made a joke about making a few bucks
8. Registration exemptions. Banks and insurance companies, as well as directors and executive officers of the
issuing corporation, are considered accredited investors. IA could issue a private placement to be sold to
9. Definition of a security. Dubois is not correct. The sale of the condominium with the rental pool arrangement
was an investment contract and constituted the sale of a security under the Howey criteria. Hocking did
10. Liability of sellers of securities. No. It is not essential under the terms of the act that full title pass to a
transferee for the transaction to be an offer or a sale under the securities laws. Bankers Trust parted with
11. Insider trading. Judgment against Gintel and Cady, Roberts & Co. Cowdin, as a director of Curtis -Wright,
breached his fiduciary duty to the corporation by improperly disclosing the information to Gintel. The tippee is
subject to the same fiduciary duty as the insider where the tippee knows or should know there has been a
12. Litigation Reform Act, Safe Harbor Rules. Lutz cannot successfully bring a Rule 10b-5 securities fraud action
against AODC when AODC’s forward-looking statement about oil production volume turned out to be
13. Definition of security. On the facts set forth, it is clear that the doctors made an investment of money, in the
common enterprise of building and operating a health care facility with the expectation of future profits. The
fourth test of making profits from the efforts of others is the big element in this dispute. It could be argued
14. Antifraud provisions. Judgment for Huddleston. Section 10(b) of the 1934 act and § 11 of the 1933 act involve
distinct causes of action and were intended to address different types of wrongdoing. Section 11 imposes a
stringent standard of liability on parties who play a direct role in a registered offering. Section 10(b) is a
15. Definition of security. Applying the Supreme Court’s test for an investment contract to the Maximum
Consideration Program, a participant must (1) invest $3,000 (2) in the common enterprise of the ILN program
(3) with the expectation of future profits, and (4) from the efforts of others. The third prong of the four -prong
Supreme Court test for investment contracts requires only the expectation of future profits, not the guarantee
of future profits. Ford’s statements created such an expectation. And from Ford’s description, the big awards
would come from the fivelocity of money” that is the future selling of additional programs by others in the
chain-letter-type scheme. Such is clearly an investment contract that must be registered with the SEC in
order to be sold. In Piambino v Bailey, (CA #5) 610 F. 2d 1306, n.9 (1980), the fifth circuit demonstrated the
reality that the disclosure that would be required in a registration statement and prospectus could not be
accomplished under such a scheme. The court stated:
The essential vice of chain or pyramid distribution schemes has been well documented. For
example, if the founder recruited five distributors in the first month and if those five each recruited
five more distributors in month two, and if each of these subsequent recruits enticed five people to
LAWFLIX
Wall Street (1987) (R)
This movie will walk the students through not just the evolution of greed but the evolution of a young broker
To access additional videos that illustrate business law concepts, visit www.cegage.com/blaw/dvl.
management system for classroom use.
