1032 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
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 violation range from enjoining a shareholder vote to damages.
CASE SYNOPSIS—
Case 42.2: Gebhart v. SEC
Alvin Gebhart and his wife Donna sold investments to clients of Mutual of New York (MONY) and later Mutual
Services Corp. (MSC). Among the investments were notes issued by MHP Conversions, LLC. The notes financed the
purchase of mobile home parks by Community Service Group (CSG), which facilitated sales of the parks to the
residents. The Gebharts did not investigate MHP or CSG as investments, but relied on the representations of a fellow
MONY salesperson, Jack Archer. The Gebharts sold $2.4 million in notes to their clients before CSG collapsed due to
excessive debt. The National Association of Securities Dealers’ National Adjudicatory Council found that the Gebharts
committed fraud and imposed sanctions, which the SEC upheld. The Gebharts petitioned for review, claiming that they
acted in good faith.
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Notes and Questions
Assuming that CSG’s collapse and consequent default on the notes was inevitable, did the Gebharts act
unethically? At the least, the Gebharts recklessly misled their clients, with serious financial consequences to the clients
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ANSWERS TO QUESTIONS AT THE END OF CASE 42.2
1. 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 Gepharts had acted with
scienter? According to the court, whether the Gebharts ever intended to defraud anyone was “irrelevant to whether
2. 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 discussing administrative agencies, this is a general policy of
1. Criminal Penalties
2. 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.
CASE SYNOPSIS—
Case 42.3: Stark Trading v. Falconbridge, Ltd.
Stark Trading was a minority shareholder in Falconbridge, Inc. Noranda, Inc., owned 59 percent of Falconbridge.
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Noranda offered its common stockholders preferred stock for their common stock. Noranda also offered to redeem the
preferred stock for $25 a share, which exceeded the market value of the common stock. On the same day, Noranda
offered minority shareholders in Falconbridge 1.77 shares of Noranda common stock for each share of Falconbridge
common stock. Stark knew that Noranda’s value was overstated by the offer to its common stockholders. Stark thought
that the Falconbridge stock was undervalued in the market. This meant that Noranda was buying out Falconbridge’s
violation of Rule 10b-5. The court dismissed the suit. The plaintiffs appealed.
Thus reliance was missing from the plaintiffs’ claim.
…………………………………………………………..……………………………………………………………………
Notes and Questions
Noranda imposed a requirement on the offer to exchange its stock for Falconbridge shares: more than half of the
minority shareholders had to accept. The offer would have failed if a majority of the minority shareholders did not
tender their shares. If Stark considered the offer too low, why didn’t it try to dissuade the other minority shareholders
from tendering? For example, Stark might have mailed them each a copy of its letter to the Ontario Securities
ANSWER TO “THE GLOBAL DIMENSION” QUESTION IN CASE 42.3
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.
ANSWER TO “THE LEGAL ENVIRONMENT DIMENSION”
QUESTION IN CASE 42.3
Stark’s assessment of the value of Falconbridge proved correct. On the day the suit in this case was filed, the
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Noranda shares that Stark had received in exchange for its Falconbridge shares were worth about 50 percent more
than what Stark had paid in accepting the offer. In other words, the plaintiffs could not allege that they had suffered a
loss as a result of the trade. What effect does this fact have on their complaint? To establish a violation of Rule 10b-5,
or to collect damages for fraud, a party must have suffered an economic loss as a result of a misrepresentation. If the
plaintiffs did not sell any of their shares at a loss, they could not plead such a loss to establish their case and collect
damages. This would further undercut the “plausibility” of their allegation.
ADDITIONAL CASES ADDRESSING THIS ISSUE —
Recent 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”).
materially false or misleading and made with conscious or reckless disregard for their falsity, and that controlling
persons materially misstated inventory, but corporate officials were immune from liability under safe harbor provisions
IV. State Securities Laws
All states have their own laws that regulate intrastate offers and sales of securities.
A. REQUIREMENTS
Certain features (registration requirements, antifraud provisions, broker regulations) are common to all state
blue-sky laws.
B. CONCURRENT REGULATION
Under the National Market Securities Improvement Act of 1996, the SEC regulates most national securities
1036 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
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’
FOR CRITICAL ANALYSIS
Why does the presence of a capitalist system affect a nation’s perspective on corporate governance?
A. ATTEMPTS AT ALIGNING THE INTERESTS OF OFFICERS WITH THOSE OF SHAREHOLDERS
Providing stock options to align the financial interests of shareholders and officers has proved to be an imperfect
control device. Officers have manipulated circumstances to artificially inflate stock prices to keep the value of
options high, or the options have been “repriced” to avoid losses when stock prices dropped.
B. THE GOAL IS TO PROMOTE ACCOUNTABILITY
• The audited reporting of corporate financial progress so that managers can be evaluated.
• Legal protection for shareholders.
C. GOVERNANCE AND CORPORATE LAW
Under the law, a corporation must have a board of directors elected by the shareholders. Thus, the key element
of corporate structure is the board, which makes important decisions about the firm.
1. The Board of Directors
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Directors, who must operate for the shareholders’ benefit, are responsible for monitoring officers and can
be sued for failing to do their jobs effectively.
2. The Compensation Committee
1038 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
D. 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.
1. Reporting on Effectiveness of Internal Controls
2. Other Provisions
3. More Internal Controls and Accountability
4. Certification and Monitoring
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.
VI. Online Securities Fraud
Early cases involving online securities fraud included attempts to sell unregistered securities on a Web auction site in
violation of securities law.
A. INVESTMENT SCAMS
There are infinite variations of investment scams, but most promise spectacular returns for small investments.
Many are pyramid (“Ponzi”) schemes, in which the initial “investors” are paid with funds provided by later
participants. Scams may be propagated via spam, fraudulent Web pages, online newsletters and bulletin boards,
chat rooms, blogs, and tweets.
C. PONZI SCHEMES
These schemes sometimes fool U.S. residents into investing in offshore companies, or they may claim to consist
of risk-free or low-risk investments.
ADDITIONAL BACKGROUND—
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Online Securities Fraud
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?
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 and the
2. What are the major responsibilities of the Securities and Exchange Commission? The SEC is an independent regulatory
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 for sale, including the
relationship between that security and the other capital securities of the registrant along with a statement of how the
4. What is a red herring prospectus? A red herring prospectus may be distributed during the twenty-day period after
registration before the sale of securities can take place. The red herring prospectus gets its name from the red legend printed
across it stating that the registration has been filed but has not become effective.
5. What are some examples of material facts that must be disclosed in connection with the purchase or sale of a security? A
6. What is the tipper/tippee theory? Anyone who acquires inside information as a result of a corporate insider’s breach of
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 do the monitoring must be outside
9. How are securities laws being applied in the online environment? The Internet is essentially being viewed as a new
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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
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 29: Patricia Rocklage was the wife of Scott Rocklage, the chairman and chief executive officer of Cubist
Pharmaceuticals, Inc. Scott had sometimes disclosed material, nonpublic information about Cubist to Patricia, and she had
always kept the information confidential. On December 31, 2001, Scott told Patricia that one of Cubist’s key drugs had failed its
clinical trial and reminded her not to discuss this information with anyone. Patricia was aware that her brother, William Beaver,
owned Cubist stock, and she told Scott that she wanted to tell her brother about the failed trial. Scott tried to discourage her.
Patricia had an “understanding” with William, however, and told him that she had heard significant negative news about Cubist.
He sold his 5,583 shares of its stock and tipped his friend David Jones, who sold his 7,500 shares. On January 16, 2002, Cubist
In Securities Exchange Commission v. Rocklage, 470 F.3d 1 (1st Cir. 2006), the U.S. Court of Appeals for the First Circuit
affirmed the lower court’s decision and remanded the case for further proceedings. The appellate court recognized that the
misappropriation theory bases liability on the deception of the source of the information. In this case, “Mrs. Rocklage engaged
in deceptive devices, in connection with a securities transaction, when she tricked her husband into revealing confidential
information to her so that she could, and did, assist her brother with the sale of his Cubist stock. * * * [B]efore her husband’s
initial disclosure about the clinical trial, Mrs. Rocklage did absolutely nothing to correct his mistaken understanding that she
would keep the trial results confidential.” And she did this, “knowing full well that in obtaining that information she would
enable her brother to execute a securities transaction. She then actively facilitated a securities transaction by tipping her
brother, and securities were in fact sold based on her information.” The court conceded that Patricia’s disclosure to Scott might
have eliminated any deception involved in her tip to William, but it did not “negate the original deception. * * * [B]ecause of
the way in which Mrs. Rocklage first acquired this information, her overall scheme was still deceptive: it had as part of it at least
one deceptive device.”
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 shareholders. Under the
misappropriation theory, liability is imposed when a trader or tipper bases a trade on—or “misappropriates”—confidential
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information obtained from his or her source of the information. In this situation, the trader breaches a fiduciary duty owed to
the source.
To be liable under the misappropriation theory, does a tipper have to receive a “personal benefit”? Actually, this is an
open question, as the court in this case noted. There is no express requirement that a tipper receive a personal benefit. Even if
there were, “the mere giving of a gift to a relative or friend is a sufficient personal benefit. The gift of information Mrs. Rocklage
gave her brother meets that standard.”
What effect could the holding in this case have on stock transactions in this jurisdiction? Are persons with inside
information likely to become involved in fewer stock transactions? Or is there likely to be very little change in the number of
deals and the way in which they are conducted? Is there some other legal basis on which the SEC could regulate these sorts of
transactions?
There were three public statements considered by the court in the Stewart case. With respect to the first statement,
the government contended that “an inference of intent can be drawn from the fact that The Wall Street Journal,” in which the
statement appeared, “is the most widely read financial publication in the nation.” But the court found “no evidence that
Stewart chose the forum for the statement. The fact that The Wall Street Journal, as a financial publication, had an interest in an
investigation into a stock trade by the well-known CEO of a public company does not evidence Stewart’s intent.” The
government argued that Stewart’s intent with respect to the second statement could be inferred because she released it
knowing that it would be widely disseminated in financial publications. “This argument,” concluded the court, “can be made
with respect to any public statement [and] adds nothing to the evidence of criminal intent.”
How does the scienter, or intent, requirement in the context of criminal securities fraud differ from its counterpart in
the context of civil securities fraud? Scienter, or intent, in the civil securities fraud context, indicates a mental state embracing
1044 INSTRUCTOR’S MANUAL TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
intent to deceive, manipulate, or defraud. This is a required element of any claim of securities fraud. As stated in the text, in a
criminal prosecution, the government must also prove that the defendant acted willfully, that is, with a realization that she was
acting wrongfully.
ANSWERS TO ESSAY QUESTIONS IN
STUDY GUIDE TO ACCOMPANY BUSINESS LAW, TWELFTH EDITION
BY HOLLOWELL & MILLER
1. What is the process by which a company sells securities to the public? The sale of securities (stocks or bonds) is governed
by the Securities Act of 1933, which was enacted to prevent various forms of fraud and to stabilize the securities industry by
requiring that all essential information concerning the issuance of securities be made available to the investing public. Section 5
of the 1933 act provides that if a security does not qualify for an exemption, it must be registered before it is offered for sale to
the public either through the mails or through any facility of interstate commerce. The issuing corporation must file a
registration statement with the SEC and investors must be provided with a prospectus that describes the security being sold, the
issuing corporation, and the investment risk attached to the security. In principle, the registration statement and the
prospectus supply sufficient information to enable unsophisticated investors to evaluate the financial risk involved. The
registration statement must include (1) a description of the significant provisions of the security offered for sale, including the
2. How is insider trading regulated by Section 10(b), SEC Rule 10b-5, and Section 16(b)? Section 10(b) of the Securities
Exchange Act of 1934 and SEC Rule 10b-5. Section 10(b) of the 1934 Securities Exchange Act and SEC Rule 10b-5 define inside
information and extend liability to officers and directors in their personal transactions for taking advantage of such information
when they know it is unavailable to the persons with whom they are dealing. Rule 10b-5 applies in virtually all cases concerning
the trading of securities and covers notes, bonds, joint ventures, etc. Rule 10b-5 is applicable, however, only when the
transaction involves interstate commerce but this limitation is somewhat illusory because virtually no commercial transaction
can be completed without using the mails or a stock exchange facility. Rule 10b-5 covers not only corporate officers, directors,
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and majority stockholders but also certain “outsiders” having access to (or receiving) information about a nonpublic nature on
which trading is based. Any material omission or misrepresentation of material facts in connection with the purchase or sale of
a security may violate Section 10(b) and Rule 10b-5. Consequently, the courts have tried to articulate a standard for deciding
when information becomes public knowledge and insiders are no longer liable for using that information. The courts have
suggested that insiders should refrain from trading for a “reasonable waiting period” when the news is not readily available to
the investing public. Although the traditional insider trading case involves true insiders—corporate officers, directors, and
REVIEWING—
SECURITIES LAW AND CORPORATE GOVERNANCE
Dale Emerson served as the chief financial officer (CFO) for Reliant Electric Co., a distributor of electricity serving
portions of Montana and North Dakota. Reliant was in the final stages of planning a takeover of Dakota Gasworks, Inc.,
a natural gas distributor that operated solely within North Dakota. Emerson went on a weekend fishing trip with his
uncle, Ernest Wallace. Emerson mentioned to Wallace that he had been putting in a lot of extra hours at the office
Reliant stock rose 72 percent before leveling out. Wallace then sold his Reliant stock for a gross profit of $14,400. Ask
your students to answer the following questions, using the information presented in the chapter.
1. Would registration with the SEC be required for Dakota Gasworks securities? Why or why not? In this scenario,
Dakota Gasworks was the target company in a successful takeover; it did not issue new securities to raise capital or
offer any securities to the public. Therefore, it would not have been required to register with the SEC.
2. Did Emerson violate Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5? Why or why not?
wrong or knew that his uncle would use this information to trade on the information (that he should not have
3. What theory or theories might a court use to hold Wallace liable for insider trading? Because Wallace acquired
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inside information as a result of Emerson’s breach of his fiduciary duty, Wallace could be held liable for insider trading
under the tipper/tippee theory. Wallace would have to have known that the information came from a breach of the
fiduciary duty.
4. Under the Sarbanes-Oxley Act, who would be required to certify the accuracy of financial statements filed with the
SEC? Under the Sarbanes-Oxley Act, the chief executive officers and the chief financial officers are required to certify
the financial statements.
DEBATE THIS:
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.