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Securities Regulation + Insider Trading

Securities: a way for companies to raise money

Includes:
- Stocks (I.e. equity in a company)
- Corporate bonds (essentially loans to companies)
- Investment contracts

Investment contracts:

An investment of money
In a common enterprise
With the expectation of future profits from the effort of others

SEC v. Edwards, 540 U.S. 389 (2004)

Facts	Holding
ETS Payphones, led by Edwards, sold payphone packages to investors for $300 mil Investors promised fixed return per month ETS relied on funds from investors to fulfill obligations; then filed bankruptcy SEC brought suit alleging ETS violated registration requirements + antifraud provisions of 1933 act	Investment contract can be investment of money, common enterprise, or expectation of future "profits" (including fixed returns) Court determined ETS investment scheme can be investment contract and thus security under securities laws

Policy goals behind regulating these investments are to ensure investors have complete, transparent info so they can make reasonably informed investment decisions
- Do not guarantee any specific investment result

Securities Exchange Act of 1933 ('33 Act):

Regulates issuance of securities
- Governs initial public offerings (IPOs) of primary offerings
Goal = fraud prevention
- Strictly limits marketing and disclosures around issuance of securities in order to make sure investors know both the good and bad before they make their investment decision
SEC can enforce
- SEC can bring actions to enforce standards of conduct set forth in this act

Steps of an IPO:

Banks underwrite the IPO; helps company value their stock, set a price, and market the IPO
- Can offer firm commitment
  - I.e. bank purchases all stock and then resells it (better for company)
- OR can offer best efforts
  - i.e. bank does not buy stock but helps market it and earns commission on sales (less risky for bank)
Registration with SEC
- 2 components: Registration Statement and Prospectus
- Includes very detailed company info including audited financial statements, assets...
Sales effort – private promotion of stock
Going Effective Date – when shares get sold to public

Important Exemptions from '33 Act

(Registration Requirements and Marketing Limitations)

Direct Offerings (DPO)
- Skip bank backing, and sell directly to public
Regulation A Offerings
- These are relatively small offerings
- Allow companies to raise money up to a cap w simplified registration
Private Placement
- Shares are offered privately to sophisticated or accredited investors

'33 Act Liability:

Fraud in Connection with Sale	Fraud in Registration Statement of Prospectus
Seller of a security makes a misstatement or omission in connection with the sale of a security Civil and criminal liability can result	Any misstatement or omission in registration Statement or Prospectus Purchaser of security can recover against anyone who signed the document (attorneys, auditors, etc.) Civil and criminal liability is possible Professional due diligence defense to civil claims

Securities Exchange Act of 1934 ('34 Act):

Regulates issuers of securities on an ongoing basis
SEC can enforce the '34 act

Requires Certain regular filings:

Form 10-K annually
Form 10-Q quarterly
Form 8-K when significant development occurs, whether good or bad

Fair Disclosure Rule: requires companies make material info – good and bad – available to everyone at the same time

Was every investor on a level playing field?
What constitutes "material" info that is to be disclosed?

Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011)

Facts	Holding
Matrixx, pharmaceutical, faced securities fraud class action for allegedly misleading investors Matrixx made optimistic statements on growth of its cold remedy product despite being aware of complaints linking it to loss of smell	Court held that Matrixx's failure to disclose info constituted material omission, satisfying "materiality" requirement of section 10b claim Evidence of causation need not be statistically significant for disclosure purposes & investors shouldn't be limited to such data

Basic, Inc. v. Levinson, 485 U.S. 224 (1988)-- Defined materiality standard

Materiality depends on whether reasonable investor would find info important in decision making process
Supported fraud-on-the-market theory – presuming reliance on public material misrepresentation

'34 Act Liability:

Section 18

Section 10(b) and Rule 10b-5

Everything in '34 Act filings must be true

Civil/criminal liability can result if
1. Company makes false/misleading statements in filings
2. Somone relies on those statements
3. The price was affected by the fraudulent filing

Antifraud provisions
May not make public fraudulent statement in connection w purchase/sale of any security

Private Plaintiff must show:
1. Misstatement or omission of material fact
2. Intent
3. Purchase or sale
4. Reliance on fraudulent statement
5. Economic loss
6. Causation

Basic Inc. V. Levinson – presumption of reliance in fraud-on-the-market theory
- For a court to presume the investor relied on the public info in buying/selling a security, there must be:
  - (1) an efficient market for the security
  - (2) public misrepresentation
  - (3) purchase/sale between misrepresentation is corrected

'34 Act: Insider Trading

Insider Trading: purchase or sale of securities for a profit based on material nonpublic information (MNPI) obtained in breach of fiduciary duty (or its functional equivalent)

Relationship of trust exists btw. shareholder and insiders
- If insiders trade on MNPI, then shareholders are unfairly disadvantage
Constitutes violation of civil law (enforced by SEC) and criminal law (enforced by DOJ)

Government must prove:

Defendant traded on MNPI
Fiduciary duty was breached

Section 10(b) of '34 Act's antifraud provisions = genesis of prohibition on insider trading
- Case law has answered important questions
- BUT we don't have specific "insider trading" statute
Strangers can trade on MNPI
- Illegal insider trading occurs when MNPI is obtained and used in breach of a fiduciary duty (or its functional equivalent)

Theories of Insider Trading:

Classic Insider Trading

Tipper/Tippee Insider Trading

Misappropriation Insider Trading

When a corporate insider trades on MNPI
Insiders can be "constructive insiders"
- I.e. professionals retained temporarily (attorneys, accountants, etc.)

When an insider (tipper) gives information to a 3^rd party (tippee)

Tipper liable when:
1. Knowingly or recklessly disclosed material, non-public info
2. To someone who would trade/further disclose info
3. In breach of confidentiality obligations and for personal benefit

Tippee liable if:
1. Knowingly/recklessly received material, non-public info
2. Traded AND tippee knew/should've known
3. Disclosure constituted breach of source's fiduciary
4. Tipper disclosed for personal benefit

Occurs when someone trades on MNPI misappropriated from someone to whom trader owes fiduciary duty

Example: attorney trades on client's info
- Outsider does not owe duty to corporation's shareholders, but to the party that entrusted outsider w confidential info

Case Law on Insider Trading Theory:

Dirks v. SEC, 463 U.S. 646 (1983) – (tipper/tippee) where insider did not benefit personally from disclosure, there was no liability
U.S. v. Salman, 137 S.Ct. 420 (2016) – (tipper/tippee) insider stands to benefit when tippee is a family member trading on nonpublic info
United States v. O’Hagan, 521 U.S. 642 (1997) – (misappropriation) lawyer whose firm worked on tender offer held liable on misappropriation theory after he traded in stock of company who was target of tender offer