1015
Chapter 42
Securities Law
and Corporate Governance
See Separate Lecture Outline System
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.
ADDITIONAL RESOURCES—
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VIDEO SUPPLEMENTS
The following video supplements relate to topics discussed in this chapter—
PowerPoint Slides
To highlight some of this chapter’s key points, you might use the Lecture Review PowerPoint slides compiled for
Chapter 42.
Business Law Digital Video Library
The Business Law Digital Video Library at www.cengage.com/blaw/dvl offers a variety of videos for group or
individual review. Clips on topics covered in this chapter include the following.
• Legal Conflicts in Business
• Real World Legal
Jack’s Restaurant, Scene 1—A corporate vice president shares information about an upcoming merger with a
trusted bartender, suggesting a deal that will benefit them both. The bartender subsequently shares the information
with a co-worker. The scene explores the boundaries of fiduciary duty and liability in insider trading.
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—
* Interpret federal securities laws and investigating securities law violations.
* Issue new rules and amending existing rules.
* 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
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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.
A. UPDATING THE REGULATORY PROCESS
The SEC 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.
B. THE SEC’S EXPANDING REGULATORY POWERS
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.
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.
A. WHAT IS A SECURITY?
A security exists in any transaction in which a person (1) invests (2) in a common enterprise (3) reasonably
expecting profits (4) derived primarily or substantially from others’ managerial or entrepreneurial efforts.
Securities have taken many forms—any stake in the ownership or debt of a company—but their most common
forms are stocks and bonds. The definition includes—
1. Contents of the Registration Statement
The statement must be in plain English, must be filed electronically, and must contain descriptions of—
* The security being offered and its relationship to the registrant’s other securities.
2. Registration Process
3. Waiting Period
After a statement is filed, there is a waiting period of at least twenty days. During this time, only certain
4. Posteffective Period
5. Restrictions Relaxed for 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.
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 “by means of a prospectus”
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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
“prospectus”?
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 end of the year, according to the audit, the
buyers were entitled to an adjustment. Instead, they filed a suit in a federal district court against the former
shareholders, under Section 12(2) of the Securities Act of 1933, to rescind the deal. The court issued a judgment in
favor of the former shareholders, but the U.S. Court of Appeals for the Seventh Circuit vacated the judgment. The
former shareholders appealed.
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,
THE PROBLEM WITH GRAPHICS
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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 material in a prospectus cannot be
reproduced in an electronic form on EDGAR, the electronic prospectus must include a fair and accurate narrative
description of the omitted data. The second part of Rule 304 provides that the graphic, image, and audio material
contained in the version of a document delivered to investors is deemed to be part of the electronic document filed
with the SEC.
As a result, a corporation can have two versions of a prospectus—a print version that contains graphics and an
electronic version that describes the information shown in the graphics. What if the summary describing the graphics
in an electronic prospectus is inaccurate but the investors received an accurate print version? That was the issue
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 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?
2. Bank and financial institution securities.
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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.
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
2. Regulation D Offerings
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. This is the exemption
used by most small businesses.
b. Rule 505
Private, noninvestment company offerings up to $5 million in a twelve-month period if (1) no general
solicitation or advertising is used; (2) the SEC is notified of the sales; (3) precaution is taken against
nonexempt, unregistered resales; and (4) there are no more than thirty-five unaccredited investors. If
the sale involves any unaccredited investors, all investors must be given material information about
the company, its business, and the securities. The securities cannot be sold by the buyers for at least a
year.
c. Rule 506
ADDITIONAL BACKGROUND—
Online Public Offerings
Federal (and state) law sets out the requirements for initial public offerings (IPOs). Under SEC interpretations,
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 context of a specific public
offering. [FN69] These developments present both potential benefits and dangers to investors. [FN70] On the
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 “[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]
Second, until delivery of the final prospectus has been completed, written offers and offers transmitted by radio and
television cannot be made outside of a Section 10 prospectus except in connection with business combinations.
regulatory accommodations to facilitate online offerings. We appreciate the benefits that technology brings to the
offering process and fully support the need to craft a regulatory system that maximizes these benefits. We also are
mindful of our investor protection mandate and the fundamental principles established by the Securities Act for the
Following are excerpts from Securities Release No. 33-7856 (April 28, 2000). These excerpts are from Section C
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regulatory action in the future. Additionally, the Commission staff will continue to review procedures submitted in
connection with online offerings.
[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 encourage comment on
FN71. See Joseph Weber & Peter Elstrom, Transforming the Art of the Deal, Bus. Wk., July 26, 1999, at 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
Gomes, How Get Rich Hopes of Linux Techies Went Up in Flames, Wall St. J., Aug. 18, 1999, at A1.
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 examination under Section 8 of the
FN76. See Securities Act Rules 134 and 135, n. 68 above.
FN78. See Wit Capital Corporation, n. 69 above.
3. Resales
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 subject
to the 1934 act’s reporting requirements).
• The securities must be sold in limited amounts in unsolicited brokers’ transactions.
• The SEC must be notified of the resale.
b. Rule 144A
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.
2. Civil Sanctions
3. Defenses
Defenses include that a statement was true, or it was not material, or that the plaintiff knew the truth and
bought the stock anyway. Most important is the due diligence defense, under which any defendant, except
the issuer, can assert that he or she reasonably believed at the time of the registration statement the
information was true and there were no material omissions.
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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
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 that eBay hired to report online,
began “tweeting” (posting updates on Twitter) about eBay’s quarterly earnings and what took place at Silicon Valley
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 “the 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.”.
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of federal securities laws. “While blogs or forums can be informal and conversational in nature, statements made
there . . . will not be treated differently from other company statements.” In addition, the release stated that
companies cannot require investors to waive protections under federal securities laws as condition of participating in a
blog or forum. (The release also cautioned companies that they can, in some situations, be liable for providing
hyperlinks to third party information or inaccurate summaries of financial information on their Web sites.)b.
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 any security.
1. Applicability of SEC Rule 10b-5
2. Insider Trading
3. Disclosure under SEC Rule 10b-5
Fraud includes failure to disclose inside information. The text provides examples of what has been
considered material facts calling for disclosure.
ANSWER TO VIDEO QUESTION LTR. 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
CHAPTER 42: SECURITIES LAW AND CORPORATE GOVERNANCE 1027
ANSWER TO VIDEO QUESTION LTR. 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
CASE SYNOPSIS—
Case 42.1: SEC v. Texas Gulf Sulphur Co.
The Texas Gulf Sulphur Co. (TGS) drilled a hole in 1963 that appeared to yield a core with an exceedingly 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
“material” until April 9 and that the insider-trading activity before that date was thus not illegal. The SEC appealed.
information would affect the judgment of reasonable investors. An important factor in determining whether the
discovery of ore is a material fact is the importance attached to it by those who know of it. Stock purchases by those
…………………………………………………………..……………………………………………………………………
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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 industry should be barred from purchasing stocks simply be–
cause they have developed an expertise about that industry that enables them to make profitable investments. Should
higher-level company officers as well as directors be prohibited from holding company stock altogether to eliminate
much of the incentive to engage in insider trading? Because most officers and directors do not engage in insider
trading, such a proposal would probably not be helpful.
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 “use” the inside
information in his or her possession. It might also be argued that the simple “possession” of inside information about
certain stocks, while trading in those stocks, is enough to establish liability. SEC Rule 10b5-1 generally allows corporate
insiders to engage in prearranged or certain other securities transactions without being subject to liability under SEC
Rule 10b-5. In other words, a corporate insider may buy or sell stock without concern for liability if he or she—after
the decision was made to buy or sell the stock—comes into the possession of inside information relating to that stock.
ANSWER TO “WHAT IF THE FACTS WERE DIFFERENT?” IN CASE 42.1
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? Why or why not? Assuming all of the other
circumstances are as they are stated in the case, the answer to this question is most probably yes, because the
defendants’ trading was based on their possession of inside information of a material fact without its public disclosure,
ADDITIONAL BACKGROUND—
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Insiders and Fiduciary Duties
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 ninety years. Instead,
the courts have developed a number of “exceptions.” Some state courts have developed an agency law theory.
According to agency law, an agent may not profit from using the property of his or her principal. It is reasoned by
analogy that a director or officer may not profit from using inside information belonging to the corporation. In other
words, under this reasoning, officers or directors owe a fiduciary duty to their corporation not to engage in the trading
of shares in the corporation on the basis of inside information.
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
4. The Private Securities Litigation Reform Act of 1995
5. Outsiders and SEC Rule 10b-5
Section 10(b) and Rule 10b-5 covers certain “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 under Rule 10b-5.
a. Tipper/ Tippee Theory
This liability extends to tippees (and even remote tippees).
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ANSWER TO VIDEO QUESTION LTR. 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 buying and selling the company’s securities—without
disclosing the merger to those on the other side of the transactions— and splitting the profit with her. The bartender
understood that Susan was not supposed to buy and sell the stock, because she told him. This should be enough to
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.
while those with whom they will deal do not.
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—United States v. Carpenter
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
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impact of the column on the market and share the resulting profits. David Carpenter, a news clerk at the Journal, also
participated in the scheme, acting primarily as a messenger between the conspirators. Over a four-month period, the
net profits resulting from this trading activity were about $690,000. Correlations between the “Heard on the Street”
articles and trading in the Clark account were noted at Kidder Peabody, and inquiries began. Later, the SEC began an
investigation. Eventually, Winans and Carpenter revealed the entire scheme to the SEC. Winans and Felis were
convicted for participating in an insider trading-scheme based on information misappropriated from the Journal, as
well as for mail and wire fraud. Carpenter was convicted of aiding and abetting in the commission of securities fraud
and mail and wire fraud. On appeal, Winans and the others (the appellants) contended that they could not be held
liable under Rule 10b-5 because they were not corporate insiders and did not misappropriate material nonpublic
information from corporate insiders.
6. Insider Reporting and Trading—Section 16(b)
Section 16(b) provides for the recapture by a corporation of all profits realized by officers, directors, and