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Chapter 21

SECURITIES REGULATION

Suggested Additional Assignments

Research: Direct Public Offerings

The Web site http://www.dfdpo.com is a useful source of information about direct public offerings. Ask

students to think of a business idea that would pass the “Screen Test” at this site.

Research: IPOs

Ask students to obtain a preliminary or final prospectus from a company that has recently been through an

Chapter Overview

Chapter Theme

Congress passed the Securities Act of 1933 and the Securities Exchange Act of 1934 to ensure that the

country never suffers through another economic crisis as catastrophic as the Great Depression. It is in no

small part owing to these laws that the United States has enjoyed so many years of economic stability.

Quote of the Day

“Definition of insider trading: Stealing too fast.” –Calvin Trillin (b. 1935), essayist.

Introduction

The Securities and Exchange Commission

The SEC creates law through rules, releases and no-action letters. In addition to creating laws, the SEC

What Is a Security?

A security is any transaction in which the buyer (1) invests money in a common enterprise, and (2)

expects to earn a profit predominantly from the efforts of others.

Securities Act of 1933

The 1933 Act requires that, before offering or selling securities, the issuer must register the securities with

the SEC, unless the securities qualify for an exemption.

EDGAR is an acronym for Electronic Data Gathering Analysis and Retrieval.

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Exempt Transactions

Section 4(2) of the 1933 Act exempts from registration “transactions by an issuer not involving any

public offering.”

Intrastate Offering Exemption

Under SEC Rule 147, an issuer is not required to register securities that are offered and sold only to

residents of the state in which the issuer is incorporated and does business.

Regulation D

Any offering that meets the requirements of Regulation D qualifies as a private offering under the 1933

Act.

Additional Case: SEC v. InterLink

Michael Gartner founded InterLink “to develop private, fully integrated telecommunication networks and

video phone systems.” InterLink prepared an offering memorandum for a sale of its securities. The

document contained no financial statements or other financial information about the company other than

Question: What are the requirements for Rule 506 under Reg D?

Answer:

• No public solicitation

• No limit on the maximum value of securities sold in a 12-month period

Question: InterLink sold stock to hundreds of investors. Is that a violation of Rule 506?

it makes no public solicitation.

Question: Did InterLink comply with Rule 506?

Answer: No, because it:

• Sold to more than 35 unaccredited investors,

Question: InterLink did not comply with Rule 506. Does that mean it definitely made a public

offering?

1993 U.S. Dist. LEXIS 20163 (1993).

Chapter 21 Securities Regulation 3

Question: Did InterLink have a private offering?

Question: What penalty will InterLink and Gartner face? Under what section of the 1933 Act?

Answer: They have violated the following sections of the 1933 Act:

Regulation A

Although an offering under Regulation A (Reg A) is called a private offering, it really is a small public

offering. Reg A permits an issuer to sell up to $50 million of securities publicly in any 12-month period.

Crowdfunding

Congress recently passed the JOBS Act which permits privately held companies to sell up to $1 million in

securities in any 12 month period provided that they:

• Make a filing with the SEC and provide appropriate disclosure to the purchaser at the time of

purchase and then annually

• Limit investments as follows:

Direct Public Offerings

In a DPO, companies sell stock themselves under Regulation A or Rule 504. Both of these rules permit

public offerings of stock without registration.

Research: Direct Public Offerings

If students completed this suggested assignment, ask them to answer these questions:

Question: What is a direct public offering?

Note that these provisions are inconsistent. An investor whose income is $50,000 but net worth is $150,000, falls

into both categories.

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Regulation A, which permits a company to sell up to $5 million of securities in 12 months. The company

must provide each investor with an offering circular.

Question: Are there any disadvantages for the company?

effort and ingenuity on the part of the company.

involved may be small to a company or to the SEC, but can be a lot to an individual investor. There

Answer: These are the components of the Screen Test:

1. The business would excite prospective investors, making them want to share its future.

2. There is a history of profitable operations under the company’s present management.

Public Offerings

A company’s first public sale of securities is called an initial public offering.

Any public sale of securities after the IPO is called a secondary offering.

Research: IP0s

If students completed the suggested research assignment on IPOs, ask them to present their findings.

You Be The Judge: EBC I, Inc. v. Goldman Sachs & Co.

Facts: Goldman Sachs was the lead underwriter for eToys’s initial public offering. eToys agreed to sell

shares of stock to Goldman at a price of $18.65 per share, for resale to the public at $20. Goldman’s

potential profit was $1.35 per share.

On the first day of the offering, the price of eToys’ stock rose as high as $85 and closed at $76.56.

You Be The Judge: Did Goldman have a fiduciary duty to eToys? Did it violate this duty?

Argument for eToys: A fiduciary relationship exists between two parties if one of them is under a duty

to act for or to give advice for the benefit of the other. eToys hired Goldman for its expertise and paid

Chapter 21 Securities Regulation 5

handsomely for its advice about many aspects of going public. The company would never have relied on

this advice had it known about the side deals with other clients—deals that could harm eToys.

eToys trusted Goldman, the bank betrayed that trust, and eToys suffered an enormous financial penalty as

a result.

Argument for Goldman Sachs: This is a simple case: eToys sold stock, Goldman bought it. Goldman

negotiated the best price it could. If eToys was unhappy with this deal, it had no one to blame but itself.

If eToys expected Goldman to act as a fiduciary, the agreement should have stated so explicitly. The

company always knew that its interests were different from Goldman’s. eToys sought the highest price;

Goldman had to ensure that it could resell the shares at a profit. The lower the price to eToys, the lower

Holding: Goldman’s motion to dismiss was denied. The court held that Goldman did have a fiduciary

relationship and that, if the allegations in the complaint were true, Goldman had violated its duty to

eToys.

Question: At what price did Goldman Sachs buy stock from eToys?

Answer: $18.65.

Question: At what price did Goldman sell the eToys stock to the public? For what profit per share?

Question: In most public underwritings, the underwriter makes a profit on the stock sale of about 7 or

8%, as was the case here. If Goldman is going to make about the same percentage profit no matter

what it pays for the stock, why does it have an incentive to buy at a low price from eToys?

Answer: The lower the price that Goldman pays, the lower the price it can charge the public and the

kickbacks from other clients to whom it had sold the stock.

Question: How high did the stock trade on the first day?

Question: Who made the largest profit that day?

Answer: People who purchased the shares from Goldman at $20 and resold them immediately at a

Question: Who is most upset by the $85 price.

Answer: eToys is upset that it sold stock for $18.65 that was, at least on day 1, worth $85. That’s

referred to as “leaving a lot of money on the table.”

Question: Whose fault was it that eToys left a lot of money on the table?

Question: Why does eToys disagree with this view?

some of their profits.

Question: Even if that were true, why would it be a problem? Wasn’t eToys still at fault for

negotiating a bad deal?

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Answer: If the company had known about the conflict of interest, it would have negotiated harder.

to disclose any conflicts of interest.

Question: What is a fiduciary relationship?

Question: Why would Goldman have a fiduciary duty to eToys?

Answer: eToys claimed that it relied upon Goldman’s expertise in pricing the IPO. Also, Goldman

7% profit would be. At least that was the theory.

Question: If eToys is correct, how did Goldman violate its fiduciary duty?

Answer: Goldman failed to disclose its private side deals with clients.

Question: Do we know for sure that Goldman violated its fiduciary duty?

Sales of Restricted Securities

Rule 144 limits the resale of two types of securities issued by public companies: control securities and

restricted securities.

Liability Under the 1933 Act

Liability for Selling Unregistered Securities

Section 12(a)(1) of the 1933 Act imposes liability on anyone who sells a security that is neither registered

nor exempt.

Fraud

Under Section 12(a)(2) of the 1933 Act, the seller of a security is liable for making any material

misstatement or omission, either oral or written, in connection with the offer or sale of a security.

Criminal Liability

Liability for Registration Statement

Additional Case: Rombach v. Chang

Facts: Family Golf Centers, Inc., a public company that owned and operated 119 golf courses

nationwide, sold shares in a second public offering to raise funds to acquire more courses. Within two

years of the second offering Family Golf Center’s earnings declined, its stock price fell by 43%, and the

company filed for bankruptcy protection.

355 F.3d 164; 2004 U.S. App. LEXIS 778 United States Court of Appeals for the Second Circuit, 2004

Chapter 21 Securities Regulation 7

Issue: Did the defendants violate §11 by issuing a false or misleading registration statement?

Holding: Judgment for defendants affirmed. Plaintiffs complained that the registration statement should

have disclosed that the (1) the company’s creditors had pressured it to complete a public offering, (2) it

Question: What is the goal of a registration statement?

Answer: To give potential investors enough information to make an informed decision.

Question: Is a registration statement by definition defective if the investment turns out to be

worthless?

Answer: Some investors feel that way, but the answer is “no.” All investments involve risk. The

Question: Why did the plaintiffs’ file suit in this case?

precarious financial position.

Question: Did the court agree?

Answer: No. Because the registration statement did include many warnings, including that the

Question: What is the moral of this story?

Answer: It is important to read the registration statement carefully and heed its warnings.

Securities Exchange Act of 1934

Under the 1934 Act, an issuer must register with the SEC if (1) it completes a public offering under the

1933 Act, or (2) its securities are traded on a national exchange (such as the New York Stock Exchange),

or (3) it has at least 2,000 shareholders (with a maximum of 500 non-accredited investors) and total assets

that exceed $10 million. Note, however, that shareholders who acquire stock through an employee

compensation plan or through the crowdfunding exemption do not count toward these limits. A company

can deregister if its number of shareholders falls below 300 or if it has fewer than 500 shareholders and

assets of less than $10 million.

Disclosure Requirements—Section 13

Like the 1933 Act, the 1934 Act focuses on disclosure. The difference is that the 1933 Act requires

Proxy Requirements—Section 14

Under SEC rules, a company is not required to solicit proxies from shareholders, but it is still required to

Short-Swing Trading—Section 16

Section 16 was designed to prevent corporate insiders—officers, directors, and shareholders who own

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Liability Under the 1934 Act

Section 18

Under Section 18, anyone who makes a false or misleading statement in a filing under the 1934 Act is

liable to buyers or sellers who (1) acted in reliance on the statement and (2) can prove that the price at

which they bought or sold was affected by the false filing.

Section 10(b)

Section 10(b) of the 1934 Act prohibits fraud in connection with the sale of any security, whether or not

registered under the 1934 Act. The SEC adopted Rule 10b-5 to implement Section 10(b). Liability under

Rule 10b-5 requires:

• A misstatement or omission of a material fact in connection with a securities transaction,

• The loss must have been caused by the misstatement or omission of fact.

Case: Matrixx Initiatives, Inc. v. Siracusano

Facts: Zicam Cold Remedy was a nasal spray (or gel) that accounted for 70% of Matrixx’s sales revenue.

Its active ingredient was zinc gluconate. Matrixx began receiving reports that some Zicam users had

developed anosmia (that is, they had lost their sense of smell). The company learned for the first time that

some studies had linked the use of zinc sulfate to the loss of smell.

Matrixx then found out that two doctors were planning to make a presentation at a conference about

patients who had developed anosmia after Zicam use. Matrixx sent them a letter warning them that they

did not have permission to use the name of Matrixx or its products. The doctors deleted references to

Zicam.

Nine people filed suit against Matrixx alleging that Zicam had damaged their sense of smell. Matrixx then

After the Food and Drug Administration (FDA) announced that it was investigating Zicam, Matrixx’s

stock price fell. Matrixx issued a press release stating:

“Matrixx believes statements alleging that Zicam products caused anosmia (loss of smell) are completely

unfounded and misleading. In no clinical trial of zinc gluconate gel products has there been a single report

of lost or diminished olfactory function (sense of smell). A multitude of environmental and biologic

2011 U.S. LEXIS 2416, SUPREME COURT OF THE UNITED STATES, 2011.

Chapter 21 Securities Regulation 9

Issues: Was Matrixx required to report allegations of harm for which there was not statistical correlation?

Did Matrixx violate §10(b) and Rule 10b-5?

Excerpts from Justice Sotomayor’s Decision, writing for a unanimous court: To prevail on a §10(b)

claim, a plaintiff must show that the defendant made a statement that was misleading as to

Given that medical professionals and regulators act on the basis of evidence of causation that is not

statistically significant, it stands to reason that in certain cases reasonable investors would as well. As a

result, assessing the materiality of adverse event reports is a fact-specific inquiry that requires

Moreover, it bears emphasis that §10(b) and Rule 10b-5(b) do not create an affirmative duty to disclose

any and all material information. Disclosure is required under these provisions only when necessary to

make statements made, in the light of the circumstances under which they were made, not misleading.

Even with respect to information that a reasonable investor might consider material, companies can

control what they have to disclose under these provisions by controlling what they say to the market.

ETHICS Matrixx learned that its products were potentially causing a loss of smell, which is no minor

matter. People with anosmia cannot properly taste food so often lose interest in eating, which can lead to

malnutrition and depression.

Question: Did the company have an ethical obligation to alert the public to this issue?

Answer: Students’ answers will vary on this point. Some will say that Matrixx should have

Zicam and anosmia had been established, the company did not have an obligation.

Question: What about its obligation to its shareholders? Answer: Based on the court’s decision, it is

clear that Matrixx had both a legal and ethical obligation to acknowledge the potential link between

Zicam’s ingredients and anosmia while reporting that a number of Zicam users had filed lawsuits.

Question: Why

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Case: Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc.

Facts: Charter Communications, a cable operator, engaged in a variety of fraudulent practices to pump

up its financial statements. When these efforts fell short, Charter approached two of its suppliers,

Scientific-Atlanta and Motorola, for help. These two companies supplied Charter with the digital cable

converter (set top) boxes that Charter furnished its customers. Charter arranged to overpay the suppliers

$20 for each box it purchased, with the understanding that they would return the overpayment by

purchasing advertising from Charter. These transactions had no economic purpose other than inflating

Charter’s revenue and operating cash flow numbers by $17 million.

The inflated numbers were included in financial statements filed with the SEC and reported to the

public. Purchasers of Charter stock sued the two suppliers alleging that they had violated §10(b) and Rule

10b-5. The District Court granted Scientific–Atlanta’s motion to dismiss. The United States Court of

Appeals for the Eighth Circuit affirmed. The Supreme Court granted certiorari.

Issue: Is someone who aids and abets a violation of § 10(b) also liable under the statute?

Holding: No, judgment for Scientific-Atlanta affirmed. According to the court, reliance by Stoneridge

on Scientific-Atlanta’s deceptive acts is an essential element of the §10(b) cause of action. In this case,

no member of the investing public had knowledge, either actual or presumed, of Scientific-Atlanta’s

deceptive acts during the relevant times. Thus, Stoneridge cannot show reliance upon any of Scientific–

Here, Scientific-Atlanta was acting in concert with Charter in the ordinary course as a supplier. The

transactions took place in the marketplace for goods and services, not in the investment sphere. Charter

was free to do as it chose in preparing its books and conferring with its auditor. In these circumstances,

the investors cannot be said to have relied upon any of Scientific-Atlanta’s deceptive acts in the decision

to purchase or sell securities. Because they cannot show reliance, Scientific-Atlanta has no liability to

Stoneridge.

Question: Did Charter make false statements about the company’s financial strength?

Question: What role is this fraud did Scientific-Atlanta play?

Answer: Scientific-Atlanta, and Motorola, helped Charter inflate their financials by agreeing to

Question: In agreeing to this plan, didn’t all of the companies engage in fraud?

Question: if Scientific-Atlanta and Motorola helped Charter inflate its financials that it filed with the

SEC, why are they not liable for their involvement?

Answer: In order to be liable for fraud under §10(b), the investor (Stoneridge) must prove that they

128 S. Ct. 761, 2008 U.S. LEXIS 1091, Supreme Court of the United States, 2008.

Chapter 21 Securities Regulation 11

Question: Does that mean that Scientific-Atlanta, and Motorola get away with their involvement in

Charter’s scheme?

Answer: Not necessarily. The court pointed out that imposing liability using securities laws was not

The Private Securities Litigation Reform Act of 1995

The Private Securities Litigation Reform Act modifies many existing laws, including the 1934 Act. Its

Insider Trading

A fiduciary violates Rule 10b-5 (insider trading) if she trades stock of her company while in possession of

nonpublic material information, unless she has committed in advance to a plan to sell those securities.

Insider trading is a crime punishable by fines and imprisonment, but someone who trades on inside

information is liable only if he breaches a fiduciary duty.

Ask students to consider the following examples from a newspaper article on insider trading.

Do they

agree with the newspaper’s answers?

1. You are a taxi driver who overhears a well-dressed passenger, clearly a corporate bigwig, ebulliently

describe how his employer is about to receive approval for a new blockbuster cure for cancer. You

tell your broker to buy 1,000 shares of the stock.

2. You are the chauffeur for that same executive—he hired you with the understanding that everything

you overhear stays in the car—and he talks of the impending approval.

3. Your broker tells you to sell stock in a company because he just received a call from that company’s

chief executive, who instructed him to dump all his holdings. You sell the stock.

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4. The same broker advises you to sell but does not say why. He says only that he has a strong belief

that you should do it.

5. A friend tells you that he is depressed because his wife has learned that she will probably be laid off

next week from her job as a top executive. Her company has discovered deep financial problems, he

says, and will disclose them soon. You reassure him, but when he leaves, you call your broker and

execute an order to sell short 5,000 shares of the company’s stock.

6. At your country club, you play golf with a new member who talks about a great new product his

company is about to introduce. He implies that the stock will rise sharply. The next day, you buy

some of the stock.

7. You play golf with that same new member, who talks about the new product but gives no hint that he

is associated with the company or where he received the information. You buy.

8. At a party, you overhear an executive—whom you recognize but do not know—tell another guest that

his company’s outlook has taken a turn for the worse that has not been reported. You call your broker

and sell your interest in that company.

Case: Securities and Exchange Commission v. Steffes.

Facts: Florida East Coast Industries, Inc. (FECI), was a publicly traded company that operated a freight

railroad between Jacksonville and Miami. Gary Griffiths was a vice president at FECI, whose job it was

to oversee maintenance of the railcars. He was married to the sister of his high school friend, Rex Steffes.

He had helped Rex’s son Cliff obtain a job driving trains for FECI.

The CFO of FECI asked Griffiths to prepare an inventory of all the rolling stock the company owned and

to arrange trips among its rail yards in a special railroad car reserved for visitors. Griffiths also heard that

a large number of men in suits had been touring the company’s rail yards. Yard employees began asking

Griffiths whether FECI would be sold and whether they would lose their jobs. Indeed, it turned out that

Issue: Did the defendants engage in illegal insider trading by misappropriating information from their

employer?

Excerpts from Judge Dow’s Opinion: Unlike the typical insider trading case, Griffiths is not alleged to

have been part of the confidential merger negotiations, or even directly informed of their existence.

2011 U.S. Dist. LEXIS 85496 UNITED STATES DISTRICT COURT FOR THE NORTHERN DISTRICT OF

ILLINOIS.

Chapter 21 Securities Regulation 13

Defendants argue that the information allegedly possessed by Griffiths and Cliff—such as the fact that

visitors were touring rail yards and taking trips in railway cars—cannot reasonably be considered material

in the context of securities trading. But the SEC does not contend that each of these underlying facts on its

Griffiths argues that the complaint “fails to allege the way in which Griffiths may have benefitted directly

or indirectly from the disclosure.” Griffiths himself did not trade in FECI stock. And Griffiths points out

that the complaint does not specifically allege that Griffiths knew that his family members would trade on

the information that he provided. Nevertheless, the complaint adequately alleges a breach of fiduciary

Defendants’ motions to dismiss are respectfully denied.Question: Why was Gary Griffiths

considered guilty of insider trading if he did not have access to any confidential information?

Question: Can Gary be considered a “tipper” if he did not share any explicitly confidential

information?

Sarbanes-Oxley Act

• Imposes fines and imprisonment on anyone who interferes with a federal investigation into fraud.

Dodd-Frank Act

• Provides a reward system for whistleblowers, and

Blue Sky Laws

State statutes that regulate the sale of securities are called blue sky laws. All states and the District of

Columbia have blue sky laws.

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Exemption from State Regulation

To make life easier for issuers of stock, Congress passed the National Securities Markets Improvement

Act (NSMIA) of 1996. Essentially, states may no longer regulate offerings of securities that are:

• Traded on a national exchange,

State Regulation

Any securities offerings not covered by the NSMIA must comply with state securities laws.

Typically, states take one of the following approaches to securities offerings:

• Registration by notification. Some states permit issuers with an established track record simply to

file a notice before offering their securities.

Facilitating State Regulation

There are three options that ease the process of complying with state securities requirements.

• Under the Coordinated Equity Review (CER) program, the issuer files in every state in which it

wants to sell securities, but it only has to deal with one, which takes responsibility for

Multiple Choice Questions

1. CPA QUESTION When a common stock offering requires registration under the Securities Act of

1933:

(a) The registration statement is automatically effective when filed with the SEC.

(b) The issuer would act unlawfully if it were to sell the common stock without providing the

investor with a prospectus.

(d) The issuer may make sales 10 days after filing the registration statement.

2. CPA QUESTION Pace Corp. previously issued 300,000 shares of its common stock. The shares are

now actively traded on a national securities exchange. The original offering was exempt from

registration under the Securities Act of 1933. Pace has $2.5 million in assets and 425 shareholders.

With regard to the Securities Exchange Act of 1934, Pace is:

(a) Required to file a registration statement because its assets exceed $2 million in value

Chapter 21 Securities Regulation 15

(b) Required to file a registration statement even though it has fewer than 500 shareholders

from registration

(d) Not required to file a registration statement unless insiders own at least 5 percent of its

outstanding shares of stock

3. Lily would like to raise money for her video game start-up by advertising the shares on her website,

but without substantial financial disclosure. What should she do?

(a) Nothing. If she is going to solicit purchasers publicly, she must undertake an IPO.

(b) Use Rule 504 to sell up to $1 million in stock to accredited investors, and make sure the offering

is exempt under state law.

law.

(d) Use Rule 505 sell up to $5 million in stock to an unlimited number of accredited investors and no

more than 35 unaccredited investors.

4. If a public traded company wishes to issue more stock, it will undertake a(n)_________. If the

underwriter buys the stock and resells it to the public, that is a ______________ underwriting.

Before buying the stock, investors must receive a copy of the ____________.

(a) IPO, best efforts, registration statement.

(b) IPO, firm commitment, registration statement

(d) Secondary offering, firm commitment, prospectus

5. Three months ago, Noah bought stock under Rule 506 in TreesNFlowers, Inc. He has lost interest in

the company and would like to sell the stock. Which of the following statement is true:

(a) He can sell the stock now, so long as he sells it to an accredited investor.

(b) He can sell the stock now so long as the company grants permission.

(d) He could sell the stock in three months, but only if the company goes public in the meantime.

Essay Questions

1. A railroad’s employees noticed that a lot of people in suits were touring the rail yard. The CFO asked

for a list of all trains owned by the company. Workers began speculating that the company might be

sold and they would all lose their jobs. The company’s code of conduct made it illegal to disseminate

material nonpublic information. Two employees – an engineer and a trainman – bought stock in the

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railroad. When the railroad did indeed change hands, they were able to sell their stock for a million

dollar profit. Are the employees liable under insider trading rules?

2. Fluor, an engineering and construction company, was awarded a $1 billion project to build a coal

gasification plant in South Africa. Fluor signed an agreement with a South African client that

prohibited them both from announcing the agreement until March 10. Accordingly, Fluor denied all

rumors that a major transaction was pending. Between March 3 and March 6, the State Teachers

Retirement Board pension fund sold 288,257 shares of Fluor stock. After the contract was announced,

the stock price went up. Did Fluor violate Rule 10b-5?

Answer: Fluor was not in violation because the company lacked scienter. Fluor had no intent to

3. Do you love ice cream? Here is an opportunity for you! For only $800, you can buy a cow from

Berkshire Ice Cream. The company gets milk from the cow and you get to share in the profits from

the sale of ice cream. Just last month, Berkshire mailed $32,000 worth of checks to investors—who

are expecting a 20 percent annual rate of return. Are there any problems with this plan?

Answer: This ice cream company is selling a security and must comply with both state and federal

4. ETHICS ETS Payphones, Inc. sold pay phones to the public. The company then leased back the pay

phones from the purchaser, promising a guaranteed 14 percent annual return on their investment.

Although ETS’s marketing materials trumpeted the “incomparable pay phone” as “an exciting

business opportunity,” the pay phones did not generate enough revenue for ETS to make the required

payments. The SEC sued, alleging that ETS had been selling unregistered securities. Were the pay

phone contracts securities under the 1933 Act? These allegedly “guaranteed” investments are

particularly attractive to older and less sophisticated investors. Was it ethical to pitch a high risk

investment to vulnerable investors who were unable to assess the risks accurately?

5. Suppose that, while waiting in line at the grocery store, you overhear a stranger saying that the FDA

is going to approve a new drug tomorrow—one that will be a huge success for Alpha

Pharmaceuticals. Is it legal for you to buy stock in Alpha?

Discussion Questions

1. Federal security laws are based on the assumption that investors are knowledgeable enough to assess

the quality of a stock so long as the issuer provides adequate disclosure. Many states take a different

Chapter 21 Securities Regulation 17

approach – they refuse to permit the sale of securities that they deem to be of poor quality. Should

securities laws protect investors in this way?

2. ETHICS David Sokol worked at Berkshire Hathaway for legendary investor Warren Buffett, who is

renowned not only for his investment skills but also his ethics. Bankers suggested to both Sokol and

the CEO of Lubrizol that the company might be a good buy for Berkshire. Sokol then found out that

the CEO of Lubrizol planned to ask his board for permission to approach Berkshire about a possible

acquisition. Sokol purchased $10 million worth of Lubrizol stock before recommending Lubrizol to

Buffett. Sokol mentioned to Buffett “in passing” that he owned shares of Lubrizol. Buffett did not ask

any questions about the timing or amount of Sokol’s purchases. Sokol made a $3 million profit when

Berkshire acquired Lubrizol. Did Sokol violate insider trading laws? Did he behave ethically? What

about Buffett?

Answer: Was the information Sokol had material? Buffett defended the purchase by saying that

3. Refco Inc. failed to disclose in SEC filings that millions of dollars of its accounts receivables were

uncollectible. Two months after its IPO, the company went bankrupt. Shareholders filed suit against

the company’s law firm, alleging that it was liable under Section 10(b) for drafting Refco’s SEC

filings that contained these material omissions. Is the law firm liable? Should it be? Is this a stronger

or weaker case than Stoneridge?

Answer: The 2d Circuit found that Stoneridge foreclosed these liability claims. The court said that

4. Twitter is valued at close to $10 billion. Yet, because it is still privately held, it is not required to

make any disclosure about its finances. Once the number of its shareholders reaches 500, it will be

deemed a public company and will be required to make significant (and expensive) financial

disclosure Should the SEC change its rules so that these reporting requirements are not triggered

until companies have more than 500 shareholders? Which is more important – to minimize the

disclosure burden on companies or to protect investors who are willing to buy stock even without

financial disclosure?

5. Do you agree with the court’s decision in the Stoneridge case?

6. Mark Cuban, the owner of the Dallas Mavericks basketball team, also owned stock in Mamma.com.

At the request of the company’s Board of Directors, the CEO called Cuban to tell him that the

company was about to sell stock, which Cuban could buy if he wished. But before revealing this

information, the CEO told Cuban that he had to keep the information confidential. After learning

about the sale, Cuban responded, “Well, now I’m screwed. I can’t sell.” Afterward, he spoke with the

investment banker handling the deal to learn more about the company’s financials. He then sold his

18 Unit 4 Business Organizations

entire holding of Momma.com shares before the stock sale was announced. Has Cuban violated Rule

10b-5?

Answer: This is not an issue of tipper/tippee liability because the CEO did not violate his fiduciary

responsibility. The issue is whether or not Cuban misappropriated the information about the offering.

7. The SEC believes that anyone in possession of nonpublic material information about a company

should be required to disclose it before trading on the stock of that enterprise. Instead, the courts have

developed a more complex set of rules. Do you agree with the SEC or the courts on this issue?

Bonus Exam Strategy:

Question: Darrel McDaniels worked as a maintenance person for a printing company that was

working on five announcements of corporate takeover bids. Mr. McDaniels bought $1,500 worth

of stock in one of the companies mentioned in the announcements. When the announcement was

made public, Mr. McDaniels sold his stock and made $12,000. Can the SEC charge Mr. McDaniels

with anything?

Strategy: This is a securities question. Mr. McDaniels used non-public information to buy stock and

Result: Mr. McDaniels has a fiduciary duty to his employer, the printing company. According to