Unlock document.
This document is partially blurred.
Unlock all pages and 1 million more documents.
Get Access
14 UNIT EIGHT: BUSINESS ORGANIZATIONS
into the possession of inside information relating to that stock.
ADDITIONAL BACKGROUND—
Insider Trading
Officers and directors owe fiduciary duties to their corporation and its shareholders with respect to
corporate business and property. Shares in the corporation are private property, however, and trading in
those shares is not usually a corporate transaction. Thus, at common law a century ago, directors and
officers were considered to owe no fiduciary duties when they traded in the shares of their corporations.
Directors or officers with inside information could trade with impunity without disclosing the information (as
long as they avoided outright fraud).
Although this rule is sometimes stated to be the majority rule, it has been applied in few cases over the
last hundred years. Instead, the courts have developed a number of “exceptions.” Some state courts have
It has been contended that, although it is wrong for an officer or director to use his or her position to
obtain trading profits in the stock of the corporation, if trading does not injure or damage the corporation in any
way, there should be no conclusion of wrongdoing. Do your students agree with this contention? Does
insider trading in the stock of a corporation do no harm to the corporation?’”
In Diamond v. Oreamuno, 24 N.Y.2d 494, 248 N.E.2d 910, 301 N.Y.S.2d 78 (1969), the court pointed out
that “despite the lack of any specific allegation of damage, it may well be inferred that the defendants’ actions
might have caused some harm to the enterprise. Although the corporation may have little concern with the
2. Disclosure under SEC Rule 10b-5
A key to liability is whether inside information is material. Facts to be disclosed include—
• Fraudulent trading in the company’s stock.
CHAPTER 42: INVESTOR PROTECTION, INSIDER TRADING, AND CORPORATE GOVERNANCE 15
• Potential litigation against the company.
3. Outsiders and SEC Rule 10b-5
Section 10(b) and Rule 10b-5 covers certain “outsiders” (those who trade on inside information ac-
quired indirectly).
a. Tipper/ Tippee Theory
Anyone who acquires inside information as a result of a corporate insider’s breach of his or
her fiduciary duty can be liable under Rule 10b-5. This liability extends to tippees (and even
remote tippees) if—
• There is a breach of a duty not to disclose inside information.
b. Misappropriation Theory
Under the misappropriation theory, if an individual misappropriates inside information and
trades on it to personal gain, the individual is liable, as long as a fiduciary duty has been
violated and harm to the defrauded party has occurred.
ADDITIONAL BACKGROUND—
Misappropriation Theory
R. Foster Winans, a reporter for the Wall Street Journal, co-authored an influential daily financial column
called “Heard on the Street.” The column discussed selected stocks, and after its publication, there was often
a noticeable change in the market price of the company stock that was the subject of the column. Winans
entered into a scheme with Kenneth Felis and another stockbroker at Kidder Peabody to give the brokers
advance information as to the timing and contents of the “Heard on the Street” column. The brokers would
then buy or sell stock based on the probable impact of the column on the market and share the resulting
In United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), the U.S. Court of Appeals for the Second
Circuit upheld the convictions of the defendants, ruling that the defendants had violated insider-trading laws
by trading to their profit on the basis of information obtained by Winans in violation of his duty to his employer
to keep the information confidential. The court brushed aside the defendant’s argument that the
4. Insider Reporting and Trading—Section 16(b)
Section 16(b) provides for the recapture by a corporation of all profits realized by officers, directors,
5. The Private Securities Litigation Reform Act
This act provides a “safe harbor” for companies that issue forward-looking statements, such as
earnings forecasts, from federal class-action suits if the statements prove to be inaccurate. Plaintiffs
must—
• Specify each misleading statement and explain how it led to a mistaken belief.
B. REGULATION OF PROXY STATEMENTS
Section 14(a) of the 1934 act regulates management’s solicitation of proxies from shareholders of
Section 12 companies. There must be full and accurate disclosure. SEC Rule 14a-9 is similar to the
antifraud provisions of Rule 10b-5. Remedies for violations range from enjoining a shareholder vote to
damages.
C. VIOLATIONS OF THE 1934 ACT
Violations of Section 10(b) and Rule 10b-5 include insider trading (a crime). Violations of Section 16(b)
include sales by insiders of stock acquired less than six months before.
1. Scienter Requirement
Section 10(b) and Rule 10b-5 require proof of an intent to defraud or knowledge of the
CASE SYNOPSIS—
Case 42.3: Rand-Heart of New York, Inc. v. Dolan
Dolan Company specializes in professional services and business information. DiscoverReady, a Dolan
subsidiary, performed litigation support, working mostly for Bank of America. When Bank of America
expressed concern about Dolan’s finances and indicated it would send no new work to DiscoverReady until
the concerns were resolved, Dolan’s board authorized the sale of DiscoverReady. Dolan did not immediately
CHAPTER 42: INVESTOR PROTECTION, INSIDER TRADING, AND CORPORATE GOVERNANCE 17
disclose these facts to the public. Soon after revealing that a decline in revenue “exceeded our expectations,”
largely due to “a reduction in new work from DiscoverReady’s largest customer,” Dolan filed for bankruptcy.
..................................................................................................................................................
Notes and Questions
What is scienter? Scienter is intent to defraud or knowledge of misconduct. In the context of an alleged
violation of the Securities Act of 1934, proof of scienter is required to establish securities fraud. How is
ADDITIONAL CASES ADDRESSING THIS ISSUE —
Violations of the 1934 Act
Cases involving claims of Section 10(b) and SEC Rule 10b-5 violations include the following:
• Halperin v. EBanker USA.com, Inc., 295 F.3d 352 (2d Cir. 2002) (in investors’ action against three
corporations and several officers and directors, alleging that the defendants fraudulently misrepresented the
future registration of certain securities, the securities’ offerings did not contain material omissions—”[a]n
offeror is not liable for securities fraud simply because the investment did not turn out as the investor hoped”).
• In re ATI Technologies, Inc. Securities Litigation, 216 F.Supp.2d 418 (E.D.Pa. 2002) (among other things,
the plaintiffs’ complaint pled with sufficient particularity that public announcements made about certain
2. Scienter Not Required for Section 16(b) Violations
18 UNIT EIGHT: BUSINESS ORGANIZATIONS
Liability under Section 16(b) is strict liability.
3. Criminal Penalties
For violations of Section 10(b) and Rule 10b-5, an individual may be fined up to $5 million, impris-
oned up to twenty years (twenty-five years for a willful violation), or both, and a partnership or
corporation may be fined up to $2.5 million. The standard of proof is beyond a reasonable doubt.
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.
D. SECURITIES FRAUD ONLINE AND PONZI SCHEMES
The antifraud provisions of the securities laws apply in the online environment to cover securities fraud
via spam, online newsletters and bulletin boards, chat rooms, blogs, social media, and tweets, and false
but sophisticated Web sites.
1. Investment Newsletters
2. Ponzi Schemes
ADDITIONAL BACKGROUND—
Securities Fraud Online
A criminal hacker may use keystroke-monitoring software on a public-use computer terminal (such as in a
library) to uncover another’s private online brokerage account number and password. With this data, the
hacker can use the account’s funds to commit securities fraud online. The hacker can trade in, and thereby
inflate the price of, stock that the hacker owns and can then sell at a profit. This profit may be further masked
through an offshore or dummy corporation.
IV. State Securities Laws
All states have their own laws that regulate intrastate offers and sales of securities.
A. REQUIREMENTS UNDER STATE SECURITIES LAWS
Certain features (registration requirements, antifraud provisions, broker regulations) are common to all
state blue-sky laws.
CHAPTER 42: INVESTOR PROTECTION, INSIDER TRADING, AND CORPORATE GOVERNANCE 19
B. CONCURRENT REGULATION
Under the National Market Securities Improvement Act of 1996, the SEC regulates most national
securities activities. The National Conference of Commissioners on Uniform State Laws recommended
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
interest can arise.
ENHANCING YOUR LECTURE—
CORPORATE GOVERNANCE IN OTHER NATIONS
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
depending on the degree of capitalism in the particular nation. In the United States, corporate governance
tends to give priority to shareholders’ interests. This approach encourages significant innovation and cost
and quality competition. In contrast, the coordinated model of governance that prevails in continental Europe
and Japan considers the interests of so-called stakeholders—employees, managers, suppliers, customers,
and the community—to be a priority. The coordinated model still encourages innovation and cost and quality
competition, but not to the same extent as the U.S. model.
FOR CRITICAL ANALYSIS
Why does the presence of a capitalist system affect a nation’s perspective on corporate
governance?
A. ALIGNING THE INTERESTS OF OFFICERS WITH THOSE OF SHAREHOLDERS
1. Problems with Stock Options
Providing stock options to align the financial interests of shareholders and officers has proved to be
2. Outside Directors
More boards include outside directors, who ostensibly monitor closely the actions of corporate
officers.
20 UNIT EIGHT: BUSINESS ORGANIZATIONS
B. PROMOTING ACCOUNTABILITY
Firms with greater shareholder rights have higher profits, higher sales growth, higher firm value, and
other economic advantages. Corporate governance involves—
• The audited reporting of corporate financial progress so that managers can be evaluated.
• Legal protection for shareholders.
1. Governance and Corporation Law
2. 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.
a. The Audit Committee
An audit committee oversees the corporate accounting and financial reporting processes,
including the internal controls designed to ensure that the reports are accurate.
b. The Compensation Committee
This committee determines the amount of compensation to be paid to the officers and is
responsible for assessing those officers’ performance.
C. THE SARBANES-OXLEY ACT OF 2002
This act attempts to increase accountability by imposing stricter disclosure requirements and harsher
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
2. Exemptions for Smaller Companies
3. Certification and Monitoring Requirements
Chief executive officers and chief financial officers must certify that these documents are accurate
and complete. These officers are directly accountable for the accuracy of the reports, and may be
subject to civil and criminal penalties for violations.
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
invest in other stocks? What criteria do they use to make those investments/ What effect, if any, do
the securities laws have on their decision to invest?
2. Ask students whether stocks or bonds or some other form of corporate financing is the most preferable
way for corporations to obtain financing. What are the advantages and disadvantages of each method?
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?
22 UNIT EIGHT: BUSINESS ORGANIZATIONS
Cyberlaw Link
Should federal or state securities laws place additional limit on the offering or sale of securities
over the Internet? If so, what should those limits be?
DISCUSSION QUESTIONS
1. What are securities? Securities are evidence of obligation to pay money or the right to participate in earnings
2. What are the major responsibilities of the Securities and Exchange Commission? The SEC is an indepen-
dent regulatory agency whose function is to administer the 1933 and 1934 acts by (1) requiring disclosure of facts
3. What information must be included in a registration statement prior to a security being offered to the
public? The registration statement must include (1) a description of the significant provisions of the security offered
4. What is a red herring prospectus? A red herring prospectus may be distributed during the twenty-day period
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
6. What is the tipper/tippee theory? Anyone who acquires inside information as a result of a corporate insider’s
7. What is the misappropriation theory? This theory of liability holds that if an individual wrongfully obtains—
8. Will audit and compensation committees be effective in enhancing the directors’ ability to monitor
officers’ actions? Yes, because the officers (and other persons working for a corporation) will know that their actions
are being subject to multiple, different levels of scrutiny, with consequences for misconduct. No, because those who
9. How are securities laws being applied in the online environment? The Internet is essentially being
viewed as a new medium for delivery of information and the transaction of business rather than a new environment
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
ACTIVITY AND RESEARCH ASSIGNMENTS
1. Ask each student to obtain a prospectus advertised in a tombstone ad in a financial newspaper, such as the Wall
Street Journal, and describe the procedures that need to be followed so as to be able to acquire shares of that
particular security.
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.
EXPLANATIONS OF SELECTED FOOTNOTES IN THE TEXT
Footnote 21: Blackstone Group, L.P., manages investments. One of its divisions, or “businesses,” is
“Corporate Private Equity,” which consists of about 40 percent of the assets under management. Before making an
24 UNIT EIGHT: BUSINESS ORGANIZATIONS
initial public offering (IPO), Blackstone filed a registration statement with the SEC. At the time, Corporate Private
Equity’s investments included FGIC Corp. and Freescale Semiconductor, Inc. In the registration statement,
In Litwin v. Blackstone Group, LP, the U.S. Court of Appeals for the Second Circuit vacated and remanded.
The plaintiffs adequately pleaded that Blackstone omitted material information. The information concerned the extent
to which known events and trends could reasonably be expected to affect Blackstone’s investments and revenue. The
plaintiffs alleged that Blackstone should have disclosed this information. In particular, a reasonable investor would
want to know the expected effect on Corporate Private Equity’s future revenue.
Would the view of materiality asserted by the plaintiffs in this case require companies like Blackstone
to issue enormous collections of information for the scores of companies and other assets in which they
invest? Including all such information would obviously bury material information in a flood of unnecessary detail. In
fact, the securities laws prohibit this result and protect against by requiring that information must be material and
Blackstone raised more than $4.5 billion through the IPO. Blackstone officers received nearly all of
the net proceeds. If the company had disclosed the omitted information in its registration statement, how
might these results have been different? Informed investors would probably not have been willing to pay the same
price for shares of Blackstone’s stock as they paid without the omitted information. Thus, most likely, the amount of
capital raised through the IPO would have been less, and the proceeds that the Blackstone officers received would
have likewise been less.
Footnote 30: Between May 4 and June 22, 2009, Boeing Co. made announcements that implied its
Dreamliner, which had not yet flown, was on track for its “First Flight” (a significant milestone in the development of
new aircraft) scheduled for June 30. Meanwhile, however, the plane failed important stress tests—before and after
In United States v. Newton, the U.S Court of Appeals for the Seventh Circuit affirmed. Investors' allegations
that when the Dreamliner was announced to be on track, company executives knew about the likely postponement of
the flight, based on internal e-mails, were insufficient to establish scienter.
Corporate governance involves the rights and responsibilities among different corporate participants and
affects the relationship between a corporation and its shareholders. Effective corporate governance requires more
than simple compliance with the law. How did Newton’s conduct in the circumstances of this case impact the
corporate governance of RLAB? The bad acts of corporate officers and managers who attempt to advance their
CHAPTER 42: INVESTOR PROTECTION, INSIDER TRADING, AND CORPORATE GOVERNANCE 25
been violated. In fact, an officer’s violation of the securities laws will more than likely decrease the company’s value
and status.
