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CHAPTER 42
SECURITIES LAW AND CORPORATE GOVERNANCE
ANSWERS TO QUESTIONS
AT THE ENDS OF THE CASES
CASE 42.1—QUESTION (PAGE 822)
WHAT IF THE FACTS WERE DIFFERENT?
Suppose that further drilling had revealed that there was not enough ore at this site to be mined
commercially. Would the defendants still have been liable for violating SEC Rule 10b-5? Assuming all of
CASE 42.2—QUESTIONS (PAGE 826)
1A. At one point in the opinion (not included here), the court noted that “there is no evidence in the
record that the Gebharts ever intended to defraud anyone.” Why, then, did the court conclude that the
Gebharts had acted with scienter? According to the court, whether the Gebharts ever intended to
defraud anyone was “irrelevant to whether the Gebharts made statements recklessly.” As the court
noted in its opinion, “the ultimate question” in determining whether scienter exists “is whether the
defendant knew his or her statements were false, or was consciously reckless as to their truth or falsity.”
The court pointed to the many ways in which the Gebharts had failed to confirm the truth of Archer’s
statements to them and of their own statements to their investors, and concluded that the Gebharts
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“were consciously aware of the risk that their statements [to investors] were false.” Thus the Gebharts
had acted with scienter.
2A. According to the court, if the evidence before an agency is “susceptible to more than one
rational interpretation,” the court “may not substitute its judgment for that of the agency.” Why do the
courts show such deference to agency rulings? As you will read later in the text, in the chapter
CASE 42.3—QUESTIONS (PAGE 828)
THE GLOBAL DIMENSION
Noranda and Falconbridge were Canadian companies. Falconbridge Ltd. was later bought by Xstrata, a
Swiss mining company. On what basis could a U.S. court exercise jurisdiction in this case? The stock of
these companies was traded in U.S. stock exchanges. Thus Rule 10b-5 could be applied. Also, the
plaintiffs in this case included U.S. firms.
THE LEGAL ENVIRONMENT DIMENSION
Stark’s assessment of the value of Falconbridge proved correct. On the day the suit in this case was filed,
the Noranda shares that Stark had received in exchange for its Falconbridge shares were worth about 50
ANSWERS TO QUESTIONS IN THE REVIEWING FEATURE
AT THE END OF THE CHAPTER
1A. Registration
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2A. Securities laws
Emerson did not fail to disclose a material fact in connection with the purchase or sale of securities.
What he did do was use bad judgment and breach a fiduciary duty by mentioning the planned takeover
to his uncle, who then took the information and used it to his advantage. There is no indication in the
facts that Emerson intended to do anything wrong or knew that his uncle would use this information to
trade on the information (that he should not have disclosed).
3A. Insider trading theory
4A. Certification
Under the Sarbanes-Oxley Act, the chief executive officers and the chief financial officers are required to
certify the financial statements.
ANSWER TO DEBATE THIS QUESTION IN THE REVIEWING FEATURE AT
THE END OF THE CHAPTER
Inside trading should be legalized. The more quickly information about publicly held companies
gets into the hands of the public, the more efficient the stock market becomes. Therefore, insider
trading should be made legal because both good and bad company information will be made completely
public more quickly. Those in publicly held companies who profit from having access to such inside
information will end up with lower salaries because of competition in the labor market, even for
managers.
ANSWERS TO QUESTIONS AND CASE PROBLEMS
AT THE END OF THE CHAPTER
42-1A. Registration requirements
CHAPTER 42: SECURITIES LAW AND CORPORATE GOVERNANCE 371
(Chapter 42—Page 817)
42-2A. QUESTION WITH SAMPLE ANSWER: Registration requirements
42–3A. Insider trading
(Chapter 42—Pages 820 & 824–826)
There is likely enough evidence in the facts of this problem to find that David violated the law because
there was a clear pattern—every time David called his brother or father, Mark or Jordan bought more RS
stock. To establish liability under Section 10(b) and SEC Rule 10b-5 requires proof of an intent to defraud
or knowledge of misconduct with respect, in this case, to a failure to disclose material facts used at the
42-4A. Securities laws
(Chapter 42—Pages 823 & 826–828)
This case involved a “pump-and-dump” securities fraud scheme through which its perpetrators
42-5A. Securities trading
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(Chapter 42—Pages 823 & 826–828)
Criminal charges were filed against Svoboda and Robles under Section 10(b) of the Securities Exchange
Act of 1934 and Securities and Exchange Commission (SEC) Rule 10b-5, which generally prohibit fraud in
connection with the purchase or sale of securities. Svoboda pleaded guilty, and was sentenced to a year
and a day of incarceration and ordered to pay a $200,000 criminal fine. A jury found Robles guilty, and
“A person commits fraud under Section 10(b) and Rule 10b-5 when he misappropriates
confidential information for securities trading purposes, in breach of a duty owed to the source of the
information. . . . If a person who misappropriates confidential information then tips another individual,
the tippee also is liable . . . for trading on the information if the tipper’s breach of his duty to the
principal has been established and the tippee is aware of the tipper’s breach.” The defendant must have
acted with scienter, “an intent to deceive, manipulate, or defraud . . . or at least knowing misconduct.”
42–6A. CASE PROBLEM WITH SAMPLE ANSWER: Duty to disclose
Affirmed. There was no negligence by the officers of Orphan. There was no duty to disclose early drug
42–7A. Violations of the 1934 act
CHAPTER 42: SECURITIES LAW AND CORPORATE GOVERNANCE 373
(Chapter 42—Pages 820 & 824–826)
Five elements are required to establish a violation of Rule 10b-5. A plaintiff must show (1) a material
misrepresentation or omission of fact, (2) scienter or intent to defraud, (3) a connection with the
purchase or sale of a security, (4) causation, and (5) economic loss. In this case, Zucco could likely
establish the requirement of material misrepresentation with Digimarc’s announcement about the
improper capitalization of the software development costs. The third, fourth, and fifth elements—
connection with the purchase or sale of a security, causation, and economic loss—might be
42–8A. Insider trading
(Chapter 42—Pages 824–826)
No. These allegations are not sufficient to show a violation of Rule10b-5 for insider trading claims
because the complaint was too general. The allegations were insufficient to state Section 10(b) and Rule
42-9A. A QUESTION OF ETHICS: Violations of the 1934 act
(a) The court issued a summary judgment against the defendants and ordered injunctive
relief. The defendants were given time to respond to the injunction order, after which “the court will
determine . . . the appropriateness and amount of any order of disgorgement with . . . interest as well
as with respect to the assessment and amount of any other civil penalties.”
Under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5, it must be shown that the
“Defendants made misrepresentations or omissions of material fact in connection with the offer or sale
of a security. . . . A fact is considered material if there is a substantial likelihood that a reasonable
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investor would consider the fact important, and the fact, if disclosed, would have significantly altered
the total mix of information made available to the reasonable investor.”
The court found that Montana, Lyttle and Knight “misrepresented the use, safety and control of
the investor funds. Each represented to the investors that their funds would be placed in a program that
would generate extraordinary rates of return with no risk to the principal. The evidence makes clear that
neither promise was ever intended nor did it ever materialize. In fact, no Trading Program even existed.”
The “Defendants’ representations and assurances made in connection with the offers for sale of
securities, in particular with regard to the use, safety, rates of return and control of the funds they were
investing, were important in terms of the investors’ decisions to invest.”
Proof of scienter is also required. “Persons who act with an intent to deceive or with reckless
regard for the truth are deemed to possess the necessary scienter.” In this case, “it is clear that Montana
. . . acted recklessly in relying on Lyttle’s representations concerning the Trading Program without
performing any due diligence to confirm what Lyttle had told him and the investors. Montana failed to
verify the details of the Trading Program, never mind its existence, including whether the promised rates
of return could actually be achieved or whether the investor funds were, in fact, safe.” There is no
“evidence or argument indicating anything other than Montana’s apparent, complete willingness to
the investors as “unsophisticated.”
There is an adage that if something sounds too good to be true, it probably is. That would seem
to apply to the promises of Montana, Lyttle, and Knight in this case. Their clients may have been
fueled—and fooled—by their own greed as much as by the outlandish claims of these con artists. Eager
to increase their wealth quickly and easily, the investors may have declined to conduct their own due
diligence so as not to discourage themselves. For that reason, there may be less sympathy for the losses
suffered by the investors.
Of course, the investors may have been honestly unsophisticated and truly defrauded by
Montana, Lyttle, and Knight’s representations as to the safety of the principal. The investors’ only ethical
CHAPTER 42: SECURITIES LAW AND CORPORATE GOVERNANCE 375
transgression may have been to trust too readily in their advisors’ veracity. In that circumstance, it
would seem less fair, or at least less supportable, that they should suffer a loss.
ANSWER TO VIDEO QUESTION NO. 42–10
Real World Legal: Jack’s Restaurant, Scene 1
(a) Assuming that the companies involved in the merger are Section 12 companies, what
statutory provisions prohibit Susan from trading common stock based on her inside knowledge of
the merger with GTS? Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5,
which was issued under the 1934 act, prohibit fraud in connection with the purchase or sale of
any security. Rule 10b-5 applies to virtually all securities transactions when the requisites of
federal jurisdiction are met. Liability extends to officers or directors who use of inside
information in their personal transactions when they know the information is not available to
those with whom they deal. Liability also extends to anyone who has access to or receives
information of a nonpublic nature on which trading is based. Fraud in this context includes a
failure to disclose the inside information. The key is whether the information, or material fact, is
significant enough to affect an investor’s decision to buy or sell securities..
Thus, the failure to disclose the merger in connection with a purchase of the company’s stock by
(b) Did Susan breach a fiduciary duty to the corporation by telling the bartender about
the proposed merger? Does the fact that she may be laid off by the company after the merger
affect her duties? Explain. Corporate directors and officers are fiduciaries. Among other things,
this status includes a duty of loyalty to the corporation. Under this duty, officers are required to
subordinate their self-interest to the interest of the corporation. This means that they should not
use information that is not public to make a profit trading securities.
In the situation presented in this clip, Susan the corporate officer breached her duty of loyalty
to her company when she told the bartender about her company’s pending merger (which was
not public information) and suggested that they use this knowledge to make a profit buying and
selling the company’s stock. The fact that she expects to be laid off once the merger has closed
does not affect this duty or absolve her of its breach.
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(c) Under what theory might it be illegal for the bartender to buy shares in the company
based on the information that he got from Susan? Analyze the owner’s potential liability. Is there
enough evidence of scienter in this scenario for the Securities and Exchange Commission to file
criminal charges against Susan if the bartender buys the stock? Discuss. Section 10(b) of the 1934
act and SEC Rule 10b-5 covers “outsiders” (those who trade on inside information acquired
indirectly). Anyone who acquires inside information as a result of a corporate insider’s breach of
his or her fiduciary duty can be liable. This liability extends to tippees (and even remote tippees).
The key to liability is that the information was obtained as a result of someone’s breach of a
fiduciary duty to the corporation whose shares are traded. A tippee is liable only if (1) there is a
breach of a duty not to disclose inside information, (2) the disclosure is in exchange for a personal
benefit, and (3) the tippee knows (or should know) of this breach and benefits from it
Here, Susan breached her fiduciary duty of loyalty to her company by disclosing the
information about the merger to the bartender. She disclosed this fact in anticipation of his
indicate that he understood the nature of her disclosure of the merger, and of course he
understood that both of them would profit from their deal.
criminal prosecution, there can be no reasonable doubt that the defendant knew he or she was
they know about the merger while those with whom they will deal do not.