Chapter 24 Investor Protection

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Chapter 24Investor Protection
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Chapter Objectives

• 1. Define what is meant by the term securities.
• 2. Describe the purpose and provisions of the
  Securities Act of 1933.
• 3. Explain the purpose and provisions of the
  Securities Exchange Act of 1934.
• 4. Identify federal laws that specifically
  regulate investment companies.
• 5. Point out some of the features of state
  securities laws.

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Securities Act of 1933

• Prohibits fraud and stabilizes the securities
  industry by requiring disclosure of all essential
  information relating to the issuance of stocks to
  the investing public.

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The Securities and Exchange Commission

• The SEC was a direct result of the stock market
  crash of 1929.
• The 1934 Securities Exchange Act established the
  SEC as an independent regulatory agency whose
  function was to administer the 1933 and 1934
  acts.
• What is the source of the national governments
  authority to regulate the securities industry?

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Registration Statement

• Registration requirements
• Securities, unless exempt, must be registered
  with the SEC before being offered to the public
  through the mails or any facility of interstate
  commerce.
• The registration statement must include detailed
  financial information about the issuing
  corporation the intended use of the proceeds of
  the securities being issued and certain
  disclosures, such as interest of directors or
  officers and pending lawsuits.
• Prospectus
• A prospectus must be provided to investors,
  describing the security being sold, the issuing
  corporation, and the risk attaching to the
  security.

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Exempt Transactions

• The SEC has exempted certain offerings from the
  require- ments of the Securities Act of 1933.
• Exemptions may be determined on the basis of the
  size of the issue, whether the offering is
  private or public, and whether advertising is
  involved.

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Securities Exchange Act of 1933

• Provides for the regulation and registration of
  securities exchanges, brokers, dealers and
  national securities associations.
• Maintains a continuous disclosure system for all
  corporations with securities on the securities
  exchanges and for those companies that have
  assets in excess of 10 million and five hundred
  or more shareholders.

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

• Applies to insider trading by corporate officers,
  directors, majority shareholders, and any persons
  receiving information not available to the public
  who base their trading on this information.
• Liability for violation can be civil or criminal.
• May be violated by failing to disclose material
  facts that must be disclosed under this rule.
• Applies in virtually all cases concerning the
  trading of securities. A firm does not have to
  have its securities registered under the 1933 Act
  for the 1934 Act to apply.
• Applies only when the requisites of federal
  jurisdiction are present.

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Case 24.1 Diamond v. Oreamuno

• Chairman of the board, Oreamuno, and president,
  Gonzalez, of Management Assistance, Inc.(MAI),
  sold their MAI stock after learning it was going
  to drop dramatically. After the stock fell,
  Diamond brought a shareholders derivative
  lawsuit on behalf of MAI to recover the profits
  the defendants (Oreamuno Gonzalez) had made.
• What did the courts rule?
• What is the difference between a suit brought by
  an individual investor-shareholder and a
  shareholders derivative suit?

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Case 24.2 SEC v. Texas Gulf Sulphur Co.

• TGS drilled a hole that appeared to yield a core
  with exceedingly high mineral content and kept
  these results secret. Officers and employees
  made significant stock purchases even though
  further drilling was necessary to establish the
  commercial viability of the discovery. When TGS,
  after testing, announced the strike and drove up
  the stock price significantly, the SEC brought
  suit for insider trading prohibited by Rule
  10b-5.
• The court held that most defendants had not
  violated 10b-5 and the SEC appealed.
• Who is hurt by insider trading?

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Should Insider Trading Be Legal?

• The SEC rule covers not only corporate insiders
  but even outsiders who receive trade tips from
  insiders.
• Some people doubt that such extensive regulation
  is necessary.
• How would you argue against the legalization of
  insider trading?

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Case 24.3 SEC v. Warde

• Edward Downe became director of Kidde, Inc.
  through his friend and also chairman of Kidde,
  Fred Sullivan. Thomas Warde was a good friend of
  Downe. Sullivan learned that Hanson Trust PLC
  was trying to take over Kidde, Inc., which
  eventually led to a merger. Before the merger
  actually occurred, Downe and Warde bought and
  sold warrants several times to earn large
  profits. The SEC filed a suit alleging insider
  trading violations. Warde was found liable and
  ordered to pay over 3 million in penalties and
  interest.
• How does the decision in this case make it easier
  for the SEC to win in other insider-trading
  cases?

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Case 24.4 United States v. OHagen

• James OHagen worked in a law firm that assisted
  Grand Met to takeover the Pillsbury Co. OHagan
  bought shares of Pillsbury knowing the price
  would go up, and then sold them for a high
  profit. The SEC prosecuted OHagan for
  securities fraud.
• What did the courts rule?
• If a nonlawyer employee of Dorsey Whitney, such
  as a paralegal, learned about the tender offer
  and traded profitably on the inside information,
  could the employee be held liable under the
  misappropriation theory? Why or why not?

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Insider Reporting and Trading-Section 16(b)

• To prevent corporate officers and directors from
  taking advantage of inside information, the 1934
  Act requires officers, directors, and
  shareholders owning 10 or more of the issued
  stock of a corporation to turn over to the
  corporation all short-term profits realized from
  the purchase and sale or sale and purchase of
  corporate stock within any six-month period.

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Proxy Statements

• The SEC regulates the content of proxy statements
  sent to shareholders by corporate managers of
  Section 12 companies who are requesting authority
  to vote on behalf of the shareholders in a
  particular election on specified issues.
• Section 14(a) is essentially a disclosure law,
  with provisions similar to the antifraud
  provisions of SEC Rule 10b-5.

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Insider Trading The Use-Possession Debate

• There is a scienter requirement for insider
  trading liability.
• Does the mere possession of inside information
  while trading in securities establish an intent
  to defraud, or must the trader actually use the
  inside information for intent to be established?
• Does anyone who unwittingly acquires inside
  information face a legal risk?

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The Expanding Powers of the SEC

• The 1990 Securities Acts Amendments authorized
  the SEC to seek sanctions against those who
  violate foreign securities laws.
• These amendments increase the ability of the SEC
  to cooperate in international securities law
  enforcement.
• Under the Market Reform Act of 1990, the SEC can
  suspend trading in securities in the event that
  the prices rise and fall excessively in a short
  period of time.

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Regulation of Investment Companies

• The Investment Company Act of 1940 provides for
  SEC regulation of investment company activities.
• It was altered and expanded by the amendments of
  1970 and 1975.

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State Securities Laws

• All states have corporate securities laws (blue
  sky laws) that regulate the offer and sale of
  securities within state borders designed to
  prevent speculative schemes which have no more
  basis than so many feet of blue sky.
• States regulate securities concurrently with the
  federal government.

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For Review

• 1. What is the essential purpose of the
  Securities Act of 1933? What is the essential
  purpose of the Securities Exchange Act of 1934?
• 2. What is a registration statement? What must
  it include? What is a prospectus?
• 3. Basically, what constitutes a security under
  the Securities Act of 1933?
• 4. What is SEC Rule 10b-5? What is the key to
  liability under this rule? To what kinds of
  transactions does SEC Rule 10b-5 apply?
• 5. Name two theories under which outsiders can
  be held liable for violating SEC Rule 10b-5.