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8/13/2019 Overview of the Securities Laws Bus. Orgs. (1)
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Overview of the Securities Laws
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What are the Securities Laws?
A combination of federal (primarily) and statelaws and regulations governing and regulatingthe purchase and sale of securities, the people
who buy and sell them, the places they arebought and sold, and (more and more) thepeople who manage, direct and adviseenterprises that buy, sell or issue securities
In short, just about everyone with some connectionwith securities
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The Principal Securities Laws
Securities Act of 1933
Securities Exchange Act of 1934
The Investment Company Act of 1940
The Investment Advisers Act of 1940
Focus on: Securities Act of 1933 (Securities Act or 33 Act)
Securities Exchange Act of 1934 (Exchange Act or34 Act)
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Overview of 33 & 34 Acts
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Two Approaches to Regulation of Salesof Securities
Merit regulation
Disclosure
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SecuritiesAct of 1933
Regulation by disclosure: Sunshine is
said to be the best of disinfectants - LouisBrandeis
Full and fair disclosure will separategood from bad investments
Requires registrationof sales ofsecurities with SEC before sale
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Common Transactions (Situations)Faced by All Commercial Lawyers
Do the securities laws apply? i.e., is this thing a security?
Business formation Business separation (bust ups) Controlling and using material undisclosed
information Private tender offers The contested transaction Insider trading
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What is a Security?
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Statutory Definitions
Securities Act, 2(a)(1)
Exchange Act, 3(a)(10)
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Covers All the Accepted Formsof Investment
Stock
Bond
Debenture Option
Note
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None Presents InterpretiveIssues - Really?
Stock is always Stock (except when its
something else)
Not all Notes are equal (at least in terms
of securities regulation)
More on these later...
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Thats a Security?
Unconventional, new and often novel investments can
come within the definition of security
Examples:
chinchilla ranches earthworm farms
whiskey warehouse receipts
condominium rental pools
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SEC v. Howey
Leading Case on Investment ContractAnalysis
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Elements of an Investment
Contract (Howey)
Investment of moneyin a
common enterprisewith an expectation of profits
solely from the efforts of others
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Formation/Termination ofBusiness Relationships
Owning and operating an apartment building
A (an individual) owns and operates the building as a sole proprietorship through a corporation wholly-owned by him through a single person LLC
A and B (individuals) own and operate the building jointly as co-owners of the building through a corporation in which each owns 50% of the shares through a general partnership formed by A and B through a limited partnership in which A is the general partner and B is the
limited partner
through a member-managed LLC, jointly-owned by A and B through a LLC in which A is the sole manager and A and B are members
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General Partnership Interests, LimitedPartnership Interests and LLC Interests
General Partnership Interests: Generallynot a security
Limited Partnership Interests: Generally asecurity
LLC Interests: Depends
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Definition of Security: Summary
If the instrument is on the 2(a)(1) or 3(a)(10) list,generally the securities laws apply
If the instrument is not on the list, Howey applies
The presence or absence of a regulatory schemeoutside the securities laws can be critical
If it walks like a duck and quacks like a duck, itprobably is a duck (author unknown) or I know
pornography when I see it (Potter Stewart) When in doubt, assume the securities laws apply
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The ProducersA Securities Law Lesson
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Characters
Max Bialystock: A Producer
Leo Blum: An Accountant & Producer
Hold Me, Touch Me et al : The Investors
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The Investment :Springtime for Hitler
The worst possible play
Perfectly awful actors
A terrible director
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Investment Purpose
For the Producers: Open and close thesame day
For the Investors: Companionship
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Investment Result
Play is Smash Hit
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Result for the Producers
Busted!
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Were any Securities LawsBroken?
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Possibilities:
33Act: Sections 5 & 12
34 Act: Section 10(b) & Rule 10b-5
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Registration of Securities
Every Sale of a Security Must BeRegistered Under the 33 Act Unless the
Security is an Exempt Security or it is Sold
in an Exempt Transaction
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What Does It Mean toRegisterSecurities?
Registration is a process by which an issuer(registrant) files with the SEC a disclosure
document which is used in connection with the
sale of securities in the transaction described inthe disclosure document
Disclosure document: RegistrationStatement,of which a Prospectusis a substantial part
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Section 5(a), (c)
Unless a registration statement is ineffect..it shall be unlawfulto sell[a]security. Sec. 5(a)(1)
It shall be unlawfulto offer to selloroffer to buyany security, unless a
registration statement has been filedas
to such security. Sec. 5(c)
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Two Concepts
What is an offer?
What is a sale?
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Offer: Section 2(a)(3)
Key points:
definition is broad, but not inclusive
covers attempts to dispose
presumably, broader than offer
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Sale: Section 2(a)(3)
The term sale or sell shall include every
contract of sale or disposition of a securityor interest in a security, for value.
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Securities Exchange Act of1934
Registration & Reporting
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Part of Integrated DisclosureSystem
Begins with 33 Act registration
34 Act registration and reporting focus:trading of securities
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Goals of 33 Act and 34 Act Are Similar
Transparency: Mandatory disclosure ofmaterial information
Consistency: Apply same disclosure
standards and rules for 33 Act registrationand 34 Act reporting Regulation S-K (non-financial information)
Regulation S-X (form & content of financialstatements)
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What is 34 Act Registration?
Under both 33 Act & 34 Act securities
are registered.But
Under 33 Act, transactionsareregistered
Under 34 Act, issuersare registered
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Effect of 34 Act Registration
Company subject to periodic reporting
10-K Annual Report
10-Q Quarterly Report
8-K Report of Unscheduled Events
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Effect (contd)
Most reporting companies required to solicitproxies/consentsunder Section 14
Most reporting companies executive officersanddirectorsreport sales and purchases under Section 16
CEO & CFOcertification of financialstatements,disclosure controlsand internal controls
Company & biddersfor company are subject to tender
offer rules under Sections 13(d) & 14(d)
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Integrated Disclosure System:Summary
Form 8-K
Form 10-K
Form 10-Q
Regulation S-K
Regulation S-X
Form S-1
Form S-3
Schedule 14A
(Proxy Statement)
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Regulation of the Securities
BusinessRegulation of Markets, Broker-
Dealers and Issuers
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Two Types of Stock Markets
Exchange markets
Over-the Counter markets
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Exchange
Customers
Member
Customers
Member
"Specialists"
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OTC Trading
Customers
B/D
Customers
B/D
Trades
NYSE
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NYSE(Listed Companies)
Initial and continuing listing requirements
Governance regulation
R l ti f S iti
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Regulation of SecuritiesMarkets
Multi-layered regulation
Hierarchy:
SEC
Exchange rules, bylaws, etc.
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SEC Regulation
Registration required
Oversight
Approval of rules
Power to suspend, expel or discipline
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An Exchange as an SRO
Adopt and enforce rules and requirementsfor -
membership
trading activities
listing requirements for securities
discipline and suspension
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Regulation of Broker-Dealers
Who regulates?
Exchanges
NASD (Now FINRA)
SEC
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Regulation by SEC
Registration
Membership in NASD
Direct regulation
Sec. 15 and applicable rules: Regulation oftrading activities
Regulation of financial strength (net capital
rule) and provision of credit (margin rules)
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Regulation of Listed Companies
Listing requirements: Qualitative andquantitative
Initial and continuing requirements
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Listing Requirements and Governance
SRO rules must be pre-approved by SEC
Some rule address internal operations(governance) of listed companies
Shareholder vote required for certaintransactions
Restrictions on creation of disparate voting
rights
S b O l
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Sarbanes-Oxleyand Listed Companies
SOX calls for -
Adoption of rules by SEC
Directives to SROs to adopt conforming rules
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Rules Impact on CorporateGovernance
Audit Committee Most Affected
All committee members must beindependent
Direct retention and supervision of auditor Financial literacy requirements
Designation of audit committee financial
expert
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S h d l 14A R i d t t f
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Schedule 14A: Required contents of proxystatements Voting instructions
Information about directors and officers Who they are and whats their background
Executive compensation
Detailed compensation disclosure, particularly forCEO, CFO & top three most highly compensated(NEOS)
CD&A (compensation disclosure & analysis)
Compensation committee report
Corporate governance Principal committees & who is on them
Current spotlight on Audit & Compensation Committees
Leadership structure
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Leadership structure Separation of CEO and Chairman
Lead director & his/her role
Code of ethics
Related party transactions Parties and policies
Securities ownership
Directors, officers and 5% owners All directors and officers as a group
Description & reasons for proposals (otherthan election of directors)
Say on pay At least once in three years shareholders are
asked for advisory vote on compensation forNEOS
Sh h ld P l &
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Shareholder Proposals &Rule 14a-8
Shareholders have two methods of makingproposals to management (directors):
Present proposal at shareholders meeting in
accordance with the corporations governing
documents May be limited or burdened by advance notice requirements
(see MBCA 404(2)) and cost of soliciting proxies
Ask for proposal to be included in managements
proxy statement Including opportunity to vote on managements card
Wh t i h h ld l d
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What is a shareholder proposal coveredby Rule 14a-8?
Recommendation or requirement that boardtake specified action
Can be binding or nonbinding (precatory)
Who submits shareholder proposals?
Individual activist shareholders
Certain institutional shareholders
Labor unions, public employee retirement
systems, etc.
Special interest shareholders
Religious & social responsible investors
Company must include shareholder
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p yproposal unless
It doesnt meet the procedural requirements of
Rule 14a-8, or The proposal falls within one or more grounds
in Rule 14a-8 to exclude it
Procedural requirements Share ownership
At least $2,000 in market value of securities
Held for at least 1 year
And will continue to be held through the date of theshareholders meeting
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Deadline
Must be submitted at least 120 days prior to date
last years proxy materials were sent out bycompany
Ex: 3/22/12 materials sent for 4/3/12 annual meeting, thenshareholder proposal for 2013 annual meeting was due11/23/12
Only one proposal allowed
Length of proposal (including title, proposaland supporting statement) cannot exceed 500
words
S b t ti d t l d R l 14
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Substantive grounds to exclude: Rule 14a-8(i)(1)-(13)
Most common grounds relied on Relates to ordinary business operations of the
company
Conflicts with managements own proposal
Proposal has been substantially implemented Proposal is not a proper basis for shareholder
action
If implemented, proposal would cause corporation
to violate state, federal or foreign law Corporation lacks authority to implement the
proposal
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What does corporation do if it believes there aregrounds to exclude?
If defect is procedural, proponent gets 14 days to cureand resubmit
If defect is believed to be substantive, it can Seek concurrence from SEC
So called no action letter
Pursue declaratory judgment in court
Shareholder nominations for directors
Rule proposed by SEC declared invalid
Amended Rule 14a-8 to permit proposals that merelyrequest that management adopt procedures to allowdirect nominations by shareholders.
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Exempt Transactions
Private Placements & Reg. D
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Section 4: Exempt Transactions
Section 4(2): Private offering exemption
Section 4(1): Resale of securities
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Section 28: Broad Exemption Authority
SEC can exempt any person, security or
transaction from any provision of the 33
Act
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Private Placements: Section 4(2)
Section 4(2) exempts transactions by an
issuer not involving a public offering
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Statutory Elements
transactions by an issuer: doesnt include
resales or secondary offerings
not involving a public offering: What is a
public offering? Where defined?
S E C v Ralston Purina Co 346
http://lawschool.westlaw.com/shared/westlawredirect.asp?task=km&WestlawPath=www.westlaw.com/Find/default.wl?rs=kmfw2.8&vr=2.0&kmvr=2.6&FindType=Y&DB=0000780&serialnum=1953121015http://lawschool.westlaw.com/shared/westlawredirect.asp?task=km&WestlawPath=www.westlaw.com/Find/default.wl?rs=kmfw2.8&vr=2.0&kmvr=2.6&FindType=Y&DB=0000780&serialnum=19531210158/13/2019 Overview of the Securities Laws Bus. Orgs. (1)
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S.E.C. v. Ralston Purina Co., 346
U.S. 119 (1953)
Seminal case of the 4(2) exemption
Section 4(2) exemption should turn on
whether the particular class of persons
affected needs the protection of the [33]Act.
Criteria for Exemption: Early
http://lawschool.westlaw.com/shared/westlawredirect.asp?task=km&WestlawPath=www.westlaw.com/Find/default.wl?rs=kmfw2.8&vr=2.0&kmvr=2.6&FindType=Y&DB=0000780&serialnum=1953121015http://lawschool.westlaw.com/shared/westlawredirect.asp?task=km&WestlawPath=www.westlaw.com/Find/default.wl?rs=kmfw2.8&vr=2.0&kmvr=2.6&FindType=Y&DB=0000780&serialnum=1953121015http://lawschool.westlaw.com/shared/westlawredirect.asp?task=km&WestlawPath=www.westlaw.com/Find/default.wl?rs=kmfw2.8&vr=2.0&kmvr=2.6&FindType=Y&DB=0000780&serialnum=1953121015http://lawschool.westlaw.com/shared/westlawredirect.asp?task=km&WestlawPath=www.westlaw.com/Find/default.wl?rs=kmfw2.8&vr=2.0&kmvr=2.6&FindType=Y&DB=0000780&serialnum=19531210158/13/2019 Overview of the Securities Laws Bus. Orgs. (1)
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Criteria for Exemption: EarlyAdministrative Position
Number of offerees
Availability of information
Access to information
Nature of offerees
Manner of offering
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Applying the Five Factors
Alternative 1: Issuer sells to 10 random WallStreet investors
Alternative 2: Issuer sells $500,000 of securities
to 1,000 random Wall Street investors Alternative 3: Issuer sells $200 million of
securities to 5 of its Vice Presidents
Alternative 4: Issuer sells $2 million of securitiesto 100 employees
C d SEC I t t ti
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Cases and SEC Interpretationsfollowing Ralston Purina
added following criteria Offeree qualification (sophistication &
ability to assume risk)
Availability of information
Manner of offering
Absence of redistribution (restrictions ontransfer)
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RegulationD: What is it?
Safe harbor (nonexclusive means of 4(2) compliance) Separates offerings by
Size (small, medium and large)
Number of participants Information to be supplied
Nature (sophistication & wealth) of participants
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Regulation D: General Matters
Exemption is from Sec. 5 registrationrequirements only
Not exempt from antifraud, civil liability orother provisions of securities laws
Reg D is a safe harbor
Not exclusive; Sec. 4(2) still available
Attempted compliance is not an election
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Reg D Offerings Differentiated By:
Size Rule 504: Up to $1,000,000 Rule 505: Up to $5,000,000 Rule 506: No dollar limitation
Number of Investors
Rule 504: Unlimited Rule 505 & Rule 506: 35 plus unlimited accrediteds
Investor Qualification Rule 504 & Rule 505: None Rule 506: Nonaccrediteds must be sophisticated, alone or with investor
representative
Information Requirements Rule 504: None specified Rule 505 & Rule 506: None required for accrediteds; specified financial
and nonfinancial information for nonaccrediteds
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Reg. D Offerings: Summary
Rule 504 Up to $1 million of securities
No limit on number of investors
No investor qualifications required No information requirements (but fraud rules
apply)
Rule 505 Up to $5 million of securities
35 nonaccrediteds plus unlimited accrediteds
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Reg. D Offerings: Summary
Non accrediteds or representative must besophisticated
Specified (sometimes extensive) information
to nonaccrediteds; nothing required foraccrediteds
Rule 506
No dollar limit
35 nonaccrediteds plus unlimited accrediteds
Specified info. for nonaccrediteds only
Securities Resales
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Securities Resales(Secondary Trading)
Section 4(1) of 33 Act exempts fromregistration requirement transactions by anyseller who is not an issuer, underwriter or
dealer Basic exemption that allows hundreds of
millions of shares to change hands daily onstock exchanges.
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What are restricted securities?
Rule 144(a)(3)
securities acquired directly from the issuer or
an affiliate other than pursuant to aregistration statement
Securities acquired from the issuer subject to
resale restrictions under Rule 502(d)
Rule 144
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Rule 144Safe Harbor for Resale of Securities
Applies to both restricted and affiliate
(control) shares
R l 144 R i
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Rule 144 Requirements
Current public information
Minimum holding period for restrictedstock
Limitation on amount sold
Manner of sale
Notice of sale
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Civil Liabilities
34 ActRule 14a-9 & Rule 10b-5
R l 14 9 El t
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Rule 14a-9 Elements
Misrepresentation or omission of
material fact
in proxy materials
relating to a shareholders meeting
R l 10b 5 El t
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Rule 10b-5 Elements
device, scheme or artifice to defraud, or
misrepresentation/omission of materialfact, or
act, practice, or course of business which
is fraudulent or deceitful,
in connection with the purchase or sale of
any security
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Who can sue?
What do the Rules say?
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Implied Private Right of Action
In adopting the statute, didCongress intend there to be a
private right of action?
Kardon v. National Gypsum
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Kardon v. National Gypsum(1946)
Violation of statute creates a private rightof action if -
statute was intended to protect individual
interests, and the individuals interest is one which the
statute was designed to protect
Based on Restatement of Torts
J I C B k (1964)
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J. I. Case v. Borak (1964)
Expansive view of legislative intent
One of chief purposes of 14(a) was theprotection of investors
surely Congress didnt intend to leave them
without a remedy
C t A h (1975
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Cort v. Ash (1975
Putting the brakes on Borak
Four step inquiry:
Is plaintiff within the class of persons
protected Is there legislative intent to create a private
remedy
Is a private remedy consistent with statutoryscheme
Is area traditionally one for state regulation
C L El t
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Common Law Elements
Materiality
Causation
Reliance
Scienter (state of mind)
Rule 10b-5:
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Rule 10b 5:Elements of the Cause of Action
Key Elements: Materiality
Standing
Scienter (state of mind) Reliance
Causation
M t i lit
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Materiality
TSC v. Northway formulation An omitted fact is material if there is a
substantial likelihood a reasonable investorwould consider it important in deciding how tovote
Would the omitted information altered thetotal mix of information that was available?
Basic v. Levinson When does a future fact become material?
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Standing:
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gin connection with the purchase or sale:
Rule 10b-5 addresses acts or conduct inconnection with the purchase or sale of asecurity
Purchaser/seller requirement Limits plaintiffs to actual purchasers and sellers What if fraud persuaded plaintiff not to buy or
continue to hold?
Birnbaum v. Newport Steel Co., 193 F.2d 401 (2d Cir. 1952) Blue Chip Stamps, p.493
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In connection with requirement
Some connection (causation) between allegedwrongful act and a securities transaction
Ex: Broker liquidates securities in discretionaryaccount. Later, and independent of prior act,
broker misappropriates (steals) clients funds. Result: 10b-5 doesnt apply
Ex: Broker decides to steal clients funds and
does it by liquidating the account and takingthe proceeds.
Result: 10b-5 applies. SEC v. Zandford, p.497, n. 5
Rule 10b-5 & Scienter
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(state of mind)
Early cases ranged from negligence tospecific intent to defraud
Two important cases:
Santa Fe Industries v. Green: deceit ormanipulation required; mismanagement not
enough
Ernst & Ernst v. Hochfelder: Scienter required
What Scienter is Required?
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What Scienter is Required?
Negligence is not enough
Recklessness is probably enough
But Supreme Court hasnt had the final word.
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Rule 10b 5 & Reliance/Causation
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Rule 10b-5 & Reliance/Causation
Reliance a required element, both atcommon law & under Rule 10b-5
Requires showing that the offending
statement played a significant part in thedecision to purchase/sell
But how does plaintiff show reliance on anabsence of information (omission to speak)?
Cant say plaintiff bought or sold on the
basis of what he/she wasnt told
But can say that a reasonable investor would haveconsidered the omitted information to be important
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considered the omitted information to be important.
Affiliated Ute Citizens v. United States, 406 U.S.128 (1972) p. 483, n.9
Reliance and class actions: Whentransactions arent face-to-face (maybecompany isnt even a purchaser or seller),
how do multiple plaintiffs (maybethousands) show reliance? Basic v. Levinson, p. 524
In class actions, reliance will be presumed ifthe misleading statements (misrepresentationsor omissions) are material
A rebuttable presumption, however
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What does this have to do with
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reliance/causation?
A market purchaser/seller is entitled to relyon the market price as fairly pricing theshares, and
When material information ismisrepresented or omitted, mispricingoccurs with consequent loss to
purchasers/sellers A substitute for reliance
Efficient Market
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Efficient Market
Reliance on market requires an efficient market What is an efficient market?
Large weekly trading market
Great number of analysts following the stock Existence of several market makers for the stock
Company has solid record of earnings
History of immediate price movement in response to
company information
Loss Causation
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Loss Causation
Plaintiff must show both Link between alleged wrongdoing and
plaintiffs purchase or sale (transaction
causation or reliance), and Link between alleged wrongdoing and
plaintiffs loss or damage (loss causation)
Ex: Company publishes profit projectionsfor its oil & gas operations that causeplaintiff to invest. Projections dont pan out
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and stock price deteriorates. Cause forfailure to meet projections and decliningstock price the samefalling prices forcrude oil, world wide.
Reliance (transactional causation)present, but no loss causation
but for analysis: but for defendantsmisconduct, loss wouldnt haveoccurred
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Insider Trading & Rule 10b-5
Evolution & Current Standards
Common Law Standard
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Common Law Standard
Majority Rule: Fiduciary duty of insiderdoes not extend to transactions in shares
Liability for fraud (misrepresentations), but not
for omissions
Common Law
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(Contd)
Minority Rule: Insider holds corporateinformation in trust for the benefit of allshareholders.
Duty to disclose to other party before trading
Common Law
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(Contd)
Intermediate View: No duty to disclosebefore trading absent special
circumstances.
Special circumstances: Information which willhave a dramatic impact on the company.
Common Law Limitations
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(Omission cases)
Limited to face-to-face transactions Applied to insider purchases, only. Why?
No duty to non-shareholder purchasers
Rule 10b-5 & Insider Trading
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Rule 10b 5 & Insider Trading
What is insider trading? One definition: Engaging in a securities
transaction (whether face-to-face or in the
market, and whether a purchase or sale)while in the possession of material,undisclosed information about the issuer
of the securities.
Is Insider Trading Bad?
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Is Insider Trading Bad?
Insider trading is unfair there should be informational parity in
securities transactions
insider trading is like getting a peek at theother guys hole card
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Is Insider Trading Bad?
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(Contd)
Contrary view (some economist/lawyers) insider trading promotes an efficient market
eases the jolts of market disclosures
insider trading is an effective, low costcompensation system for managers
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Prevailing View: Insider Trading isBad
But, is it fraud?
When is it fraud?
SEC v. Texas Gulf Sulphur(1968)
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(1968)
Seminal insider trading case Established disclose or abstain rule
Anyone in possession of material,
undisclosed information about an issuer mustdisclose that information or abstain fromtrading securities of the issuer
Applied to issuers, insiders and tippees
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Three cases addressing duty
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Three cases addressing duty
Chiarella v. United States (1980) Dirks v. SEC (1983)
United States v. OHagan(1997)
Chiarella
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Chiarella
Under Rule 10b-5: a purchaser of stock who has no duty to a
prospective seller because he is neither an
insider nor a fiduciary [has] no obligation toreveal material facts.
liability is premised on a duty to disclose
arising from a relationship of trust and
confidence between parties to a transaction.
Chiarella(C td)
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(Contd)
Use of material undisclosed information by apurchaser is not fraud under 10(b) unlesshe was subject to an affirmative duty todisclose before trading.
No fraud without a duty to speak
Mere possession of information does notcreate a duty to speak
Limitations on Chiarella
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tat o s o C a e a
Isnt helpful in analyzing responsibilities ofissuers and traditional insiders
Doesnt resolve status of tippees
Dirks
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Tippee case What duty is breached when tippee trades
on material, undisclosed information?
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OHagan& the MisappropriationTheory
Focus on the duty of thereceiver, notthe duty of the
giver
What is Misappropriation?
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pp p
The use by a fiduciary of material,undisclosed information belonging to aprincipal, without disclosing such use to
the principal the duty is that owed to the principal, not the
duty owed by the principal, and not the dutyowed to the person with whom the trade is
made
OHaganand Rule 10b-5
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Fraud is committed when a personmisappropriates confidential information
for trading purposes, in breach of a duty
owed to the source of the information. That fraud is in connection with a
securities transaction when the
confidential information is used withoutdisclosure to the principal.
OHagan& Rule 14e-3
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Supreme Court upheld Rule 14e-3 (adopted toprevent fraud and manipulation in tender offers)
Rule 14e-3 is the TGS abstain or discloseformulation of insider trading
Doesnt depend on a finding that a duty has been breached
Violation results if,
A tender offer is commenced (or substantiallycommenced), and
A person in possession of material informationrelating to the tender offer,
OHagan& Rule 14e-3
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knows or has reason to know the information comes,directly or indirectly, from B, T. or any person actingon behalf of B or T, and
that person buys or sells T securities prior to public
disclosure of the information
Enforcement tool for SEC
No private right of action
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From TGS to OHagan(Contd)
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(Cont d)
persons with whom the trader has aconfidential relationship
For the corporation, the duty analysis is
more complex
Corporations Duty RegardingMaterial Undisclosed Information
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Material Undisclosed Information
Corporation is not required to disclosematerial information, absent a duty tospeak
Sources of the duty to speak Obligation under listing agreement with stock
exchanges to promptly report material events
Buying or selling own shares Acquisitions
Repurchase programs
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Periodic reporting requirements (8-K, 10-Q &10-K)
Material definitive contracts
Correcting prior filings
Discussing known trends and forward looking
information
Press releases and other information releases
responding to market rumors
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Civil Liability:SEC & Private Actions
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SEC & Private Actions
21A: SEC can seek civil penalty of Disgorgement of profit made or loss avoided,
plus
Penalty of up to 3 times profit gained or lossavoided
20A: Disgorgement measure for privatelitigants
Recovery limited to profit gained or lossavoided
High Profile Convictionsand Settlements Have Not Halted
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Insider Trading
Why Not? Public not convinced it is bad?
Lure of easy money?
Blurring of line between legitimate analysisand insider trading?
Insider Trading has become moresophisticated (harder to detect) Three current examples
Using a Middleman
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Kluger Robinson Bauer(Lawyer) (Mort. Broker) (Investor)
(Source of Info.) (Middleman) (Broker)
Tip Tip
Profits Profits
Mosaic Theory of Financial
Analysis
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Analysis
Analyst gathers information from many sources Company filings
Industry sources
Customer contacts
Creates a mosaic of information for decision purposes If information from company is similar to what is publicly known,
or confirms known speculation, it is not economically materialfor insider trading purposes
Raj Rajaratnams defense
Expert Network
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Institutional Consulting FirmInvestor(Hedge Fund,Mutual Fund,
Investment Advisor)
Consultation
Consultant
(Independent Contractor)
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Controlling Use & Disclosure of
Material Information
Disclosure of Material Information
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Memo/directive to employees likely to beaware of events, circumstances, etc. thatmight trigger disclosure responsibility
Ex: CEO, CFO, Treasurer, VPs of operatingunits.
Memo addresses specific 8-K disclosureresponsibilities
Entering into/terminating material definitive
agreement
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Use of trading windows and black outdates
Insiders only allowed to trade during
designated time periods EX: X days after release of quarterly earnings and
for Y days thereafter
Trading window can be closed at any time
Pre-clearance of all trades in company shares Includes pre-clearance of 10b5-1 plans
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Acquisition Negotiations
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Most acquisition negotiations take place ina highly structured environment ofconfidentiality & secrecy
Generally, no disclosure until a definitiveagreement has been executed
No deal until a final deal
Restrict deal participants
Use code names, offsite meeting places
Acquisition Negotiations
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Business reasons for confidentiality &secrecy
B doesnt want to attract other bidders
T doesnt want to create uncertainty withcustomers, suppliers or employees
B & T want to avoid speculation aboutuncertain events
Acquisition Negotiations
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Legal reasons for confidentiality & secrecy Prevent improper trading by insiders & tippees (is
Gordon Gecko listening?)
Avoid need to correct company-sourced rumors (SEC
view) NYSE rule is broader. Company must confirm/correct/clarify
rumors causing unusual market activity, regardless of sourceof rumors
Avoid trading halts & interruption of repurchaseactivities
Abstain or disclose
Disclosure of Acquisition Negotiations
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Public companies have a variety of obligations toreport or disclose material information abouttheir business and plans, including acquisitionplans Item 1.01 of Form 8-K (entering into & terminating
material contracts) NYSE Rule 202.05: A listed company is expected to
promptly release information that might materiallyaffect the market for the companys shares
Constant question: Has the transaction reacheda point that disclosure is required? A question of materiality
Basic, Incorporated v. Levinson
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Rejected the bright line test for materiality,which held that until an agreement was reachedon price and structure, information about apossible transaction was not material as a
matter of law Adopted the TSC v. Northway formulation of
materiality for Rule 10b-5 purposes
What an average investor would consider important indeciding whether to purchase, sell or hold a security
A Deal Timeline(Using J&J / Guidant Transaction)
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(Using J&J / Guidant Transaction)
Comments and Observations
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Proposed acquisition grew out of existingbusiness relationship
Cordis (J&J) and Guidant: Joint marketing
Discussions began early 04; Board
involvement not until 7/04
Confidentiality Agreement executed 8/4/04
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Function of CA: Exchange business information on
confidential basis
Controls who gets the information
Controls use of the information Evaluation of potential transaction
No disclosure of potential deal
8/17/04: First report to Guidant Board
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Presentation by Guidant investmentbanker (JP Morgan)
Board authorized continued discussions
9/13/04: J&J Board authorized
management to continue discussions
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No agreement on price Price first discussed 9/13/04
Bulk of discussions centered on personnel
issues Balance of terms of Merger Agreement to
be negotiated
9/15/04 - 10/26/04
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Parties continue due diligence andnegotiating terms (other than price) ofMerger Agreement
10/26/04: Discussions at high level focuson price
10/27/04 Guidant Board Meeting
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Board reviewed entire transaction,received presentations on legal issues andevaluations from investment bankers
Result: Board determined to pursue other
alternatives as a stand-alone entity.
i.e., deal is off!
11/1/0412/15/04
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Deal is renegotiated
As of 12/9, price was still open
On 12/12, J&J approved deal; authorizedFinance Committee to fix final terms
Deal approved by J&J and Guidant on12/15
Selective Disclosure &Regulation FD
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Problem: Public companies providinginformation to certain analysts and certainlarge institutional investors before publicly
disclosing the information Causes problems similar to tipping and insider
trading
Certain market participants have informational
advantage over others and over the investingpublic
Selective Disclosure &Regulation FD
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Solution: Regulation FD If company discloses material, nonpublic
information to a broker, analyst or certainsecurity holders, then
If disclosure was intentional, then company mustpublicly disseminate the same information
If disclosure was unintentional, then company mustpromptly publicly disseminate the same
information