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Chapter 42
Investor Protection, Insider Trading,
and Corporate Governance
INTRODUCTION
After the stock market crash of 1929, Congress enacted the Securities Act of 1933, the Securities Exchange Act
of 1934, and other legislation to require that investors be provided with more information to help them make buying
and selling decisions and to prohibit deceptive, unfair, and manipulative practices. Since the 1930s, the sale and
transfer of securities have come to be heavily regulated by federal and state statutes and by government agencies.
This chapter looks at these securities regulations, including their application online.
CHAPTER OUTLINE
I. The Securities and Exchange Commission
The Securities and Exchange Commission (SEC) administers the federal securities laws and regulates the
sale and purchase of securities. The SEC’s basic functions include—
A. MAJOR RESPONSIBILITIES
The SEC’s basic functions include—
* Interpret federal securities laws and investigating securities law violations.
* Issue new rules and amending existing rules.
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* Oversee the inspection of securities firms, brokers, investment advisers, and ratings agencies.
* Oversee private regulatory organizations in the securities, accounting, and auditing fields.
* Coordinate U.S. securities regulations with federal, state, and foreign authorities.
ADDITIONAL BACKGROUND—
Organization of the Securities and Exchange Commission
The Securities and Exchange Commission is composed of the following divisions with the stated
responsibilities.
• Corporate Finance: Reviews documents filed by publicly held corporations.
• Market Regulation: Oversees the major securities markets participants.
• Investment Management: Interprets laws affecting investment companies and supervises mutual fund
companies.
• Enforcement: Investigates securities violations, and recommends sanctions, if any, to be pursued and
whether they should be sought in a court or before an administrative law judge.
B. CURRENT REQUIREMENTS
The SEC now requires companies to—
• File certain information electronically so that it may be available online in the SEC’s EDGAR
(Electronic Data Gathering, Analysis, and Retrieval) database.
• Make disclosures about the potential impacts of climate change on future profitability.
C. SOURCES OF INCREASED AUTHORITY
The SEC’s authority has increased since the 1930s, most recently through—
* The Securities Enforcement Remedies and Penny Stock Reform Act of 1990—Expanded the SEC’s
enforcement options and allowed SEC administrative law judges to hear cases involving more
types of alleged securities law violations.
* The Securities Act Amendments of 1990—Authorized the SEC to seek sanctions against those who
violate foreign securities laws.
* The National Securities Markets Improvement Act of 1996—Expanded the power of the SEC to
exempt persons, securities, and transactions from the requirements of the securities laws.
* The Sarbanes-Oxley Act of 2002—Required the SEC to adopt new rules relating to corporate
disclosure requirements and created an oversight board to regulate public accounting firms.
II. The Securities Act of 1933
The Securities Act of 1933 was designed to prohibit various forms of fraud by requiring disclosure of essential
information on the issuance of securities.
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A. WHAT IS A SECURITY?
The definition includes—
* Instruments and interests commonly known as securities (common stock, etc.).
* Interests commonly associated with instruments and interests known as securities (stock options,
1. The Howey Test
An investment contract is any transaction in which a person—
2. Many Types of Securities
Securities have taken many forms—any stake in the ownership or debt of a company. Their most
common forms are stocks and bonds.
B. REGISTRATION STATEMENT
A security must be registered before it can be offered to the public. The issuer files a registration
statement with the SEC and provides investors with a prospectus. A prospectus describes—
• The security being sold.
• The financial operations of the issuing corporation.
• The investment or risk in the security.
ADDITIONAL BACKGROUND—
Can a Contract Be a Prospectus, in a Private Sale of Securities?
Section 12 of the Securities Act of 1933 imposes liability on those who offer securities fiby means of a
prospectus” that contains material misrepresentations or omissions of fact. This section clearly applies to
public offerings. Does it also apply to contracts for private sales of securities? Can the terms of a
private contract be considered a fiprospectus”?
These were the questions in Gustafson v. Alloyd Co., __ U.S. __, 115 S.Ct. 1061, 131 L.Ed.2d 1 (1995).
Arthur Gustafson and the other shareholders of the Alloyd Co. contracted to sell their stock to Wind Point
Partners II, Limited Partnership, and others. The price was based in part on an estimated increase in the
value of Alloyd since the end of the previous year. The contract provided that the price would be adjusted if,
at the end of the current year, an audit showed the actual value to be more or less than the estimate. At the
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If the Supreme Court had ruled that the contract was a prospectus, what else, if anything, would
have to be shown before it could be rescinded?
1. Contents of the Registration Statement
The statement must be in plain English, be filed electronically (for posting on the SEC’s EDGAR
database), and describe—
* The security being offered and its relationship to the registrant’s other securities.
* The registrant’s properties and business, including a financial statement certified by an
2. Registration Process
Securities cannot be sold or advertised until after the SEC reviews the registration statement for
completeness (unless it was issued by a well-known seasoned investor).
a. Prefiling Period
Securities cannot be sold until after the SEC reviews the statement for completeness.
b. Waiting Period
During a waiting period of at least twenty days (and usually more), only certain types of offers
c. Posteffective Period
Investors who were issued a preliminary or free-writing prospectus must be provided with a
final prospectus before or at the time they buy the securities.
C. WELL-KNOWN SEASONED ISSUERS
A well-known seasoned issuer is a firm that has issued at least $1 billion in securities in the previous
three years or has at least $700 million of value of outstanding stock in the public’s hands. This issuer
can offer securities for sale without waiting for SEC review and approval of the registration statement.
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ENHANCING YOUR LECTURE—
WILL INACCURATE INFORMATION IN AN ELECTRONIC PROSPECTUS
INVALIDATE THE REGISTRATION?
Many companies now submit registration statements, prospectuses, and other information to the
Securities and Exchange Commission (SEC) via the Internet. The SEC’s Electronic Data Gathering, Analysis
and Retrieval (EDGAR) system then posts much of this information online to inform investors about the
corporation, the security being sold, and the risk of investing in that security. Some corporations also send
investors a printed prospectus. Theoretically, a corporation should provide the same information in electronic
form as it does in a printed prospectus, but practical difficulties can arise in transmitting digital information.
THE PROBLEM WITH GRAPHICS
material in a prospectus cannot be reproduced in an electronic form on EDGAR, the electronic prospectus
investors is deemed to be part of the electronic document filed with the SEC.
and an electronic version that describes the information shown in the graphics. What if the summary
As anyone who is familiar with the Internet knows, the graphics, images, and audio files created by one
computer are not always readable by another computer when they are exchanged online. The SEC has
created Rule 304 to deal with this situation.a The first part of the rule states that if graphic, image, or audio
version? That was the issue before a federal appellate court in DeMaria v. Andersen.b
THE ELECTRONIC PROSPECTUS CONTAINED INACCURACIES
In anticipation of an initial public offering (IPO), ILife.com, Inc., filed a registration statement and a
prospectus with the SEC via the EDGAR database. ILife.com also distributed a printed version of the
prospectus to the public. The printed prospectus contained a bar graph that provided historical financial
information about the company, while the EDGAR prospectus contained a table that summarized the bar
graph inaccurately (without mentioning losses). Brian DeMaria and other investors filed a suit against officers
of ILife.com. The investors claimed that because of the inaccurate summary, the securities in the IPO were
fiunregistered” and thus were sold in violation of the Securities Act of 1933. The lower court dismissed the
case, and DeMaria appealed.
THE REGISTRATION HELD VALID
Despite the inaccurate summary of the bar graph in the electronic prospectus, the appellate court had no
trouble deciding that the securities sold were still registered as required by the securities act. Federal courts
are bound to follow the SEC’s interpretation of its own regulations unless the interpretations are plainly
erroneous. Here, the SEC had filed a brief explaining that because the graphics in the printed prospectus are
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deemed to be part of the electronic registration statement, it did not matter that the narrative description was
inaccurate.
FOR CRITICAL ANALYSIS
Does the part of Rule 304 that deems a printed prospectus to be part of a registration statement
completely eliminate liability for any inaccuracies in the electronic materials filed? Why or why not?
D. EXEMPT SECURITIES AND TRANSACTIONS
Securities that are exempt from the registration requirements include—
2. Bank and financial institution securities.
4. Securities of nonprofit, educational, and charitable organizations.
6. An insurance, endowment, or annuity contract issued by a state-regulated insurance company.
8. Securities issued in stock dividends and stock splits.
Securities that can be sold without registration include those sold in tin the following transactions.
1. Regulation A Offerings
An issuer’s offer of up to $5 million in securities in any twelve-month period is exempt. The issuer
must file with the SEC a notice of the issue and an offering circular (also provided to investors
before the sale) but this is a simpler and less expensive process than full registration.
a. Testing the Waters
A company can fitest the waters” for potential interest before preparing a circular.
b. Using the Internet
Some companies have sold securities on the Web under Regulation A.
2. Small Offerings—Regulation D
Offers that involve a small amount of money or are not made publicly include the following.
a. Rule 504
Noninvestment company offerings up to $1 million in a twelve-month period are exempt. This
is the exemption used by most small businesses.
b. Rule 505
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c. Rule 506—Private Placement Exemption
Private—nonpublic and not generally advertised—offerings in unlimited amounts are subject to
essentially the same requirements as Rule 505, except—
• There is no limit on the amount of the offering and
• The issuer must believe that each unaccredited investor has sufficient knowledge or
experience to evaluate the investment.
ADDITIONAL BACKGROUND—
Regulation D and Online Public Offerings
Federal (and state) law sets out the requirements for initial public offerings (IPOs). Under SEC interpre-
tations, there is no difference in the disclosure requirements (listed in the text) for online IPOs, only in the
medium of disclosure. There may be new avenues of liability, however. If an online prospectus links to
another Web site, for example, information on that site is considered part of the prospectus. Also, an online
prospectus may not qualify for a Regulation D exemption. Foreign issuers must state that they have not
gone through the U.S. registration procedure.
Following are excerpts from Securities Release No. 33-7856 (April 28, 2000). These excerpts are from
Section C of the report titled fiOnline Offerings” with the relevant footnotes, as numbered.
1. Online Public Offerings
Increasingly, issuers and broker-dealers are conducting public securities offerings online, using the
Internet, electronic mail and other electronic media to solicit prospective investors. Examples of these
electronic communications include investor questionnaires on investment qualifications, broker-dealer
account-opening procedures and directives on how to submit indications of interest or offers to buy in the
also are concerned that investors are being solicited to make hasty, and perhaps uninformed, investment
decisions. [FN72]
Two fundamental legal principles should guide issuers, underwriters and other offering participants in
online public offerings. First, offering participants can neither sell, nor make contracts to sell, a security
before effectiveness of the related Securities Act registration statement. [FN73] A corollary to this principle
dictates that fi[n]o offer to buy … can be accepted and no part of the purchase price can be received until
the registration statement has become effective.” [FN74]
[Footnotes:]
FN69. See Division of Corporation Finance no-action letter Wit Capital Corporation (July 14, 1999).
FN70. We are aware that municipal securities issuers and municipal securities underwriters have begun to
evaluate the online offering process and that a limited number of offerings have been conducted over the
Internet. At this time, we are not addressing the implications of online municipal securities offerings, but we
FN71. See Joseph Weber & Peter Elstrom, Transforming the Art of the Deal, Bus. Wk., July 26, 1999, at
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96; Shawn Tully, Will the Web Eat Wall Street?, Fortune, Aug. 2, 1999, at 112.
FN72. There also have been numerous reports where investors complained that they did not receive
shares in an online IPO. See Randall Smith, So Far, fiE– Underwriting” Gets a Slow Start, Wall St. J., Aug.
FN73. Section 5(a) of the Securities Act, 15 U.S.C. §77e(a).
FN74. Securities Act Rule 134(d), 17 CFR 230.134(d).
FN75. See Sections 2(a)(10) and 5(b) of the Securities Act. Section 5(c) of the Securities Act also
proscribes both oral and written offers before the filing of a registration statement or while the registration
statement is subject to a refusal order, stop order or, before effectiveness, any other public proceeding or
FN76. See Securities Act Rules 134 and 135, n. 68 above.
FN77. See Sections 2(a)(10) and 5(b) of the Securities Act. A confirmation of sale is not deemed a non–
conforming prospectus when sent or given after the effective date of a registration statement if a
prospectus satisfying the requirements of Section 10(a) of the Securities Act is sent or given before or with
the confirmation.
FN78. See Wit Capital Corporation, n. 69 above.
3. Resales and Safe Harbor Rules
Most securities can be resold without registration. Resales of small offerings [Rule 505] and private
offerings [Rule 506] are exempt from registration if, under the following safe harbor rules—
a. Rule 144
• There must be adequate public information about the issuer.
• The securities must have been owned for at least six months (one year if the issuer is not
b. Rule 144A
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E. VIOLATIONS OF THE 1933 ACT
Violations include intentionally defrauding investors by misrepresenting or omitting facts in a registration
statement or prospectus, being negligent in not discovering the fraud, and selling securities before the
effective date of the registration statement or under an exemption for which the securities do not qualify.
CASE SYNOPSIS—
Case 42.1: Omnicare, Inc. v. Laborers District Council Construction
Industry Pension Fund
Omnicare, Inc., a pharmacy services company, filed a registration statement in connection with a public
offering. The statement expressed the company’s opinion that it was in compliance with federal and state
laws. Later, the federal government accused Omnicare of receiving kickbacks from pharmaceutical
manufacturers. The Laborers District Council Construction Industry Pension Fund and others who bought the
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Notes and Questions
How might the defendant have acted differently to avoid this suit? Omnicare might have avoided this
suit by (1) not receiving kickbacks from pharmaceutical manufacturers (if Omnicare is guilty of the allegation),
(2) not stating in its registration statement that it was in compliance with federal and state laws (although this
is likely a statement common to most, if not all, registration statements, in which case its omission might have
1. Remedies
• Violators may be subject to fines up to $10,000, imprisonment up to five years, or both.
2. Defenses
Defenses include—
• A statement was true.
• A statement was not material.
• The plaintiff knew about the misrepresentation and bought the stock anyway.
III. The Securities Exchange Act of 1934
The Securities Exchange Act of 1934 concerns primarily the resale of securities, requiring continuous,
periodic disclosure, under Section 12, by all corporations with securities on the exchanges and those
companies that have assets in excess of $10 million and five hundred or more shareholders.
ENHANCING YOUR LECTURE—
CORPORATE BLOGS AND TWEETS MUST COMPLY
WITH THE SECURITIES AND EXCHANGE ACT
In the fast-paced world of securities trading, there is a great demand for the latest information about
companies, earnings, and market conditions. Corporations have adapted to technology by establishing Web
sites and blogs, and using other interactive online media, such as Twitter and online shareholder forums.
Nearly 20 percent of Fortune 500 companies sponsor blogs. Corporations that use the Internet to distribute
information about the company to investors, however, need to make sure that they comply with SEC
regulations. The SEC treats statements by employees on online media, such as blogs and Twitter, the same
as any other company statements for purposes of federal securities laws.
BEWARE OF TWEETS CONTAINING FINANCIAL INFORMATION
Some corporate blogs include links to corporate employees’ Twitter accounts, so that readers can
communicate directly with, and get updates from, the individual who posted the information. For example,
eBay, Inc., launched its corporate blog in 2008. A few months later, Richard Brewer-Hay, a seasoned blogger
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A 2008 SEC RELEASE PROVIDES GUIDANCE
The reaction of eBay’s lawyers to Brewer–Hay’s tweets was prompted in part by an interpretive release
issued by the SEC in August 2008. The SEC generally embraces new technology and encourages
companies to use electronic communication methods. The SEC noted that fithe use of the Internet has grown
such that, for some companies in certain circumstances, posting of the information on the company’s Web
site, in and of itself, may be a sufficient method of public disclosure.”.
The release also addressed company-sponsored blogs, electronic shareholders’ forums, and other
fiinteractive Web site features.” The SEC acknowledged that blogs and other interactive Web features are a
useful means of ongoing communications among companies, their clients, investors, shareholders, and
FOR CRITICAL ANALYSIS
Would Brewer-Hay’s tweets about what had happened at technology conferences require SEC
disclosures? Why or why not?
A. SECTION 10(B), SEC RULE 10B–5, AND INSIDER TRADING
Section 10(b) and Rule 10b-5 prohibit fraud in connection with the purchase or sale of a security. Rule
10b-5 applies to virtually all securities transactions. The elements of a securities fraud action are—
• A material misrepresentation or omission in connection with the purchase or sale of a security.
• Scienter.
• Reliance by the plaintiff on the material misrepresentation.
• An economic loss.
• Causation (a causal connection between the misrepresentation and the loss)
1. Insider Trading
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.
CASE SYNOPSIS—
Case 42.2: SEC v. Texas Gulf Sulphur Co.
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The Texas Gulf Sulphur Co. (TGS) drilled a hole in 1963 that appeared to yield a core with an ex–
ceedingly high mineral content. Keeping this secret, TGS officers, directors, and employees made substantial
purchases of company stock or accepted stock options. On April 11, 1964, an unauthorized report of the
discovery appeared in the newspapers. On April 12, TGS issued a press release that played down the find.
Later, after the completion of test drilling, TGS announced a strike of at least 25 million tons of ore,
substantially driving up the price of its stock. The SEC filed a suit TGS officers and employees for violating
Rule 10b-5. The court decided that the drilling results were not fimaterial” until April 9 and that the insider–
trading activity before that date was thus not illegal. The SEC appealed.
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Notes and Questions
The problem of determining whether someone has profited from inside information is often obscured by
the fact that persons who work within a given industry do have knowledge about that industry not shared by
the general public. How can one separate those who actively trade on insider information from those
who, by virtue of their position in the industry, make fortuitous trades based not on knowledge of a
particular event but of the industry itself? It would seem unfair that persons who are in a particular
How might the defendants have acted differently to avoid liability in this case? They might well
have avoided liability by disclosing the results of the test drilling to the public on November 12, 1963, or
shortly thereafter.
If the press release by the defendants on April 12, 1964, had included all of the information known
to TGS, instead of playing down the drilling results, would the defendants have avoided liability?
Should liability under SEC Rule 10b-5 be imposed for simply possessing inside information when
trading in securities? It could be argued that for liability under SEC Rule 10b–5 to arise, an investor has to