Chapter 19: Investor Protection, Insider Trading, and Corporate Governance

BLAW 220 Final Exam Review

Why Does Investor Protection, Insider Trading, and Corporate Governance Matter to Me?

In this chapter, we explore securities regulations and laws on insider trading, in order to explain how to avoid breaking the rules. We also discuss corporate governance and accountability. Consider what happened to Jun Ying, who was an executive with Equifax when the consumer credit reporting agency experienced a massive data breach affecting 145 million Americans. Acting on this sensitive information before it became public, Ying sold about $1 million in shares of Equifax stock. When news of the hack reached global financial markets, the stock’s value dropped 15 percent. Yin was convicted of insider trading, and scolded by a federal prosecutor for thinking of “his own financial gain, before the millions of people exposed in this data breach even knew they were victims.”

Securities Act of 1933

Securities Act of 1933

Types of a Security

• Preferred and common stocks, treasury stocks, bonds, debentures, and stock warrants

• Stock options, puts, calls, or other types of privilege on a security (or on the right to purchase a security) on a national security exchange

The Howey Test

•  An investment contract is any transaction in which a person invests in a common enterprise, reasonably expecting profits derived primarily (or substantially) from others’ managerial or entrepreneurial efforts.

• This test guides the determination of what types of contracts can be considered securities.

Registration Statement

Prospectus

The prospectus also serves as a selling tool for the issuing corporation.

Contents of the Registration Statement

• Securities being offered for sale, including their relationship to issuer’s other securities

• Corporation’s properties and business

• Management of the corporation

• How the corporation intends to use proceeds of sale

• Any pending lawsuits or special risk factors

The Registration Process

• Prefiling period: Issuer normally cannot sell, or offer to sell the securities.

• Waiting period: The securities can be offered for sale, but cannot legally be sold.

• Post effective period: The issuer can offer, and sell the securities without restrictions.

Exempt Securities

• Maintain their exempt status forever

• Are low-risk investments, or are regulated by other statutes

• Can be resold without being registered

• Include the following: 

  • Government-issued securities

  • Bank and financial institution securities

  • Short-term notes and drafts

  • Securities of nonprofit, educational, and charitable organizations.

Exempt Transactions

Regulation A Offerings

• Securities issued by an issuer that has offered less than $50 million in securities during any twelve-month period if the issuer meets specific requirements:

  • Two types of public offerings: Tier 1 and Tier 2

    • Tier 1 for offerings of up to $20 million in a twelve-month period. (Unlimited number of investors, both accredited and unaccredited.)

    • Tier 2 for offerings of up to $50 million with additional review requirements in a twelve-month period. (Unlimited number of investors, but unaccredited investors may not invest more than 10 percent of their annual income or net worth.)

• Testing the waters:

  • Companies can “test the waters,” and find out potential interest from investors without selling securities or requiring investor commitment.

Regulation D

• Rule 504: Noninvestment company offerings up to $5 million in any twelve-month period.

• Rule 506: Private noninvestment company offerings in unlimited amounts that are not generally advertised or solicited. Unlimited number of accredited investors and thirty-five unaccredited investors. 

Unregistered Restricted Securities

• Restricted securities must be registered before resale unless they qualify for a safe harbor under Rule 144 or 144A.

Violations of the 1933 Act

Remedies 

• Violators may be fined and/or imprisoned. 

• The SEC is authorized to seek civil sanctions against those who willfully violate the 1933 Act.

• The SEC can request an injunction to prevent further sales of the securities involved, or ask the court to grant other relief (such as an order to a violator to refund profits).

Defenses

• The statement or omission was not material.

• The plaintiff knew about the misrepresentation at the time of purchasing the stock.

• The defendant exercised due diligence in preparing the registration, and reasonably  believed at the time that the statements were true and there were no omissions of material facts.

Section 10(b), SEC Rule 10b-5, and Insider Trading

SEC Rule 10b-5, and Insider Trading

• Basic elements of a securities fraud action:

  • Material misrepresentation

  • Scienter 

  • Reliance by plaintiff on material misrepresentation

  • Economic loss

  • Causation

Types of Disclosure under SEC Rule 10b-5

• Fraudulent trading

• Dividend change

• Contract for sale of corporate assets

• New discovery, process, or product

• Significant change in firm’s financial condition

• Potential litigation against company

Outsiders and SEC Rule 10b-5

• Tipper/Tippee theory: “Tippees” who receive inside information as a result of a fiduciary breach are liable.

• Misappropriation theory: A person who wrongfully obtains inside information, and trades 

Securities and Exchange Commission v. Texas Gulf Sulphur Co.

• On November 12, 1963, the Texas Gulf Sulphur Company (TGS) drilled a hole that appeared to yield a core with an exceedingly high mineral content, although further drilling would be necessary to establish whether there was enough ore to be mined commercially. TGS kept secret the results of the core sample.

• After learning of the ore discovery, officers and employees of the company made substantial purchases of TGS’s stock or accepted stock options (rights to purchase stock).

Regulation of Proxy Statements

• Section 14(a) of Securities Exchange Act of 1934 regulates solicitation of proxies from Shareholders of Section 12 companies.

• Whoever solicits a proxy must fully and accurately disclose in the proxy statement all of the facts that are pertinent to the matter on which the shareholders are to vote.

• Scienter Requirement

− Scienter not required for Section 16(b) violations

Oklahoma Firefighters Pension and Retirement System v. Six Flags

• In partnership with Riverside Investment Group, a Chinese real estate developer, Six Flags said that Riverside’s “financing [for the parks] is in place” and that construction was underway. Eventually, the development deal collapsed, and Six Flags’ stock price plunged from $73.88 to $31.89 per share.

• A labor-union retirement system that had purchased Six Flags common stock brought suit against the company for violating the Securities Exchange Act of 1934. The plaintiffs’ case was based largely on testimony that Riverside was an untrustworthy business partner while publicly stating otherwise.

• The district court granted defendant’s motion to dismiss, holding that the plaintiffs had not sufficiently alleged scienter. The plaintiffs appealed.

State Securities Laws

Required for State Securities Laws

• State securities laws apply mainly to intrastate transactions.

Concurrent Regulation

• Issuers must comply with both federal and state laws. Most duplicate regulations have been eliminated.

Corporate Governance

Governance and Corporate Law

• Effective corporate governance is essential in large corporations because corporate ownership (by shareholders) is separated from corporate control (by officers and managers). Under these circumstances, officers and managers may attempt to advance their own interests at the expense of the shareholders.

The Board of Directors

• Aligns the interests of officers and shareholders

− Problems with stock options

− Outside directors

The Sarbanes-Oxley Act

• More internal controls and accountability

− The act introduced direct federal corporate governance requirements for public companies.

• Exemptions for smaller companies

• Certification and monitoring requirements

− Section 906: Chief executive officers (CEOs) and chief financial officers (CFOs) must certify that the corporate financial statements “fairly represents in all material respects, the financial conditions and results of operations of the issuer.”

• Sections 302 and 404 of Sarbanes-Oxley require high-level managers (the most senior officers) to establish and maintain an effective system of internal controls.

− The system must include “disclosure controls and procedures” to ensure that company financial reports are accurate and timely and to document financial results prior to reporting.

− Senior management must reassess the system’s effectiveness annually.