Overview of the Securities Laws Bus. Orgs. (1)

8/13/2019 Overview of the Securities Laws Bus. Orgs. (1)

1/158

Overview of the Securities Laws


2/158

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


3/158

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)


4/158

Overview of 33 & 34 Acts


5/158

Two Approaches to Regulation of Salesof Securities

Merit regulation

Disclosure


6/158

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


7/158

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


8/158

What is a Security?


9/158

Statutory Definitions

Securities Act, 2(a)(1)

Exchange Act, 3(a)(10)


10/158

Covers All the Accepted Formsof Investment

Stock

Bond

Debenture Option

Note


11/158

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...


12/158

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


13/158

SEC v. Howey

Leading Case on Investment ContractAnalysis


14/158

Elements of an Investment

Contract (Howey)

Investment of moneyin a

common enterprisewith an expectation of profits

solely from the efforts of others


15/158

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


16/158

General Partnership Interests, LimitedPartnership Interests and LLC Interests

General Partnership Interests: Generallynot a security

Limited Partnership Interests: Generally asecurity

LLC Interests: Depends


17/158

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


18/158

The ProducersA Securities Law Lesson


19/158

Characters

Max Bialystock: A Producer

Leo Blum: An Accountant & Producer

Hold Me, Touch Me et al : The Investors


20/158

The Investment :Springtime for Hitler

The worst possible play

Perfectly awful actors

A terrible director


21/158

Investment Purpose

For the Producers: Open and close thesame day

For the Investors: Companionship


22/158

Investment Result

Play is Smash Hit


23/158

Result for the Producers

Busted!


24/158

Were any Securities LawsBroken?


25/158

Possibilities:

33Act: Sections 5 & 12

34 Act: Section 10(b) & Rule 10b-5


26/158

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


27/158

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


28/158

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)


29/158

Two Concepts

What is an offer?

What is a sale?


30/158

Offer: Section 2(a)(3)

Key points:

definition is broad, but not inclusive

covers attempts to dispose

presumably, broader than offer


31/158

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.


32/158

Securities Exchange Act of1934

Registration & Reporting


33/158

Part of Integrated DisclosureSystem

Begins with 33 Act registration

34 Act registration and reporting focus:trading of securities


34/158

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)


35/158

What is 34 Act Registration?

Under both 33 Act & 34 Act securities

are registered.But

Under 33 Act, transactionsareregistered

Under 34 Act, issuersare registered


36/158

Effect of 34 Act Registration

Company subject to periodic reporting

10-K Annual Report

10-Q Quarterly Report

8-K Report of Unscheduled Events


37/158

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)


38/158

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)


39/158

Regulation of the Securities

BusinessRegulation of Markets, Broker-

Dealers and Issuers


40/158

Two Types of Stock Markets

Exchange markets

Over-the Counter markets


41/158

Exchange

Customers

Member

Customers

Member

"Specialists"


42/158

OTC Trading

Customers

B/D

Customers

B/D

Trades

NYSE


43/158

NYSE(Listed Companies)

Initial and continuing listing requirements

Governance regulation

R l ti f S iti


44/158

Regulation of SecuritiesMarkets

Multi-layered regulation

Hierarchy:

SEC

Exchange rules, bylaws, etc.


45/158

SEC Regulation

Registration required

Oversight

Approval of rules

Power to suspend, expel or discipline


46/158

An Exchange as an SRO

Adopt and enforce rules and requirementsfor -

membership

trading activities

listing requirements for securities

discipline and suspension


47/158

Regulation of Broker-Dealers

Who regulates?

Exchanges

NASD (Now FINRA)

SEC


48/158

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)


49/158

Regulation of Listed Companies

Listing requirements: Qualitative andquantitative

Initial and continuing requirements


50/158

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


51/158

Sarbanes-Oxleyand Listed Companies

SOX calls for -

Adoption of rules by SEC

Directives to SROs to adopt conforming rules


52/158

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


53/158

S h d l 14A R i d t t f


54/158

54

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


55/158

55

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 &


56/158

56

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


57/158

57

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


58/158

58

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


59/158

59

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


60/158

60

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


61/158

61

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.


62/158

Exempt Transactions

Private Placements & Reg. D


63/158

63

Section 4: Exempt Transactions

Section 4(2): Private offering exemption

Section 4(1): Resale of securities


64/158

64

Section 28: Broad Exemption Authority

SEC can exempt any person, security or

transaction from any provision of the 33

Act


65/158

65

Private Placements: Section 4(2)

Section 4(2) exempts transactions by an

issuer not involving a public offering


66/158

66

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=1953121015


67/158

67

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=1953121015


68/158

68

Criteria for Exemption: EarlyAdministrative Position

Number of offerees

Availability of information

Access to information

Nature of offerees

Manner of offering


69/158

69

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


70/158

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)


71/158

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


72/158

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


73/158

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


74/158

74

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


75/158

75

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


76/158

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.


77/158

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


78/158

Rule 144Safe Harbor for Resale of Securities

Applies to both restricted and affiliate

(control) shares

R l 144 R i


79/158

Rule 144 Requirements

Current public information

Minimum holding period for restrictedstock

Limitation on amount sold

Manner of sale

Notice of sale


80/158

80

Civil Liabilities

34 ActRule 14a-9 & Rule 10b-5

R l 14 9 El t


81/158

81

Rule 14a-9 Elements

Misrepresentation or omission of

material fact

in proxy materials

relating to a shareholders meeting

R l 10b 5 El t


82/158

82

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


83/158

83

Who can sue?

What do the Rules say?


84/158

84

Implied Private Right of Action

In adopting the statute, didCongress intend there to be a

private right of action?

Kardon v. National Gypsum


85/158

85

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)


86/158

86

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


87/158

87

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


88/158

88

Common Law Elements

Materiality

Causation

Reliance

Scienter (state of mind)

Rule 10b-5:


89/158

89

Rule 10b 5:Elements of the Cause of Action

Key Elements: Materiality

Standing

Scienter (state of mind) Reliance

Causation

M t i lit


90/158

90

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?


91/158

Standing:


92/158

92

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


93/158

93

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


94/158

94

(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?


95/158

95

What Scienter is Required?

Negligence is not enough

Recklessness is probably enough

But Supreme Court hasnt had the final word.


96/158


97/158

Rule 10b 5 & Reliance/Causation


98/158

98

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


99/158

99

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


100/158

What does this have to do with


101/158

101

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


102/158

102

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


103/158

103

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


104/158

104

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


105/158

105

Insider Trading & Rule 10b-5

Evolution & Current Standards

Common Law Standard


106/158

106

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


107/158

107

(Contd)

Minority Rule: Insider holds corporateinformation in trust for the benefit of allshareholders.

Duty to disclose to other party before trading

Common Law


108/158

108

(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


109/158

109

(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


110/158

110

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?


111/158

111


Insider trading is unfair there should be informational parity in

securities transactions

insider trading is like getting a peek at theother guys hole card


112/158



113/158

113

(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


114/158

114

Prevailing View: Insider Trading isBad

But, is it fraud?

When is it fraud?

SEC v. Texas Gulf Sulphur(1968)


115/158

115

(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


116/158

Three cases addressing duty


117/158

117

Three cases addressing duty

Chiarella v. United States (1980) Dirks v. SEC (1983)

United States v. OHagan(1997)

Chiarella


118/158

118

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)


119/158

119

(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


120/158

120

tat o s o C a e a

Isnt helpful in analyzing responsibilities ofissuers and traditional insiders

Doesnt resolve status of tippees

Dirks


121/158

121

Tippee case What duty is breached when tippee trades

on material, undisclosed information?


122/158


123/158


124/158

124

OHagan& the MisappropriationTheory

Focus on the duty of thereceiver, notthe duty of the

giver

What is Misappropriation?


125/158

125

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


126/158

126

g

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


127/158

127

g

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


128/158

128

g

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


129/158

From TGS to OHagan(Contd)


130/158

130

(Cont d)

persons with whom the trader has aconfidential relationship

For the corporation, the duty analysis is

more complex

Corporations Duty RegardingMaterial Undisclosed Information


131/158

131

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


132/158

132

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


133/158

Civil Liability:SEC & Private Actions


134/158

134

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


135/158

135

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


136/158

136

g

Kluger Robinson Bauer(Lawyer) (Mort. Broker) (Investor)

(Source of Info.) (Middleman) (Broker)

Tip Tip

Profits Profits

Mosaic Theory of Financial

Analysis


137/158

137

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


138/158

138

Institutional Consulting FirmInvestor(Hedge Fund,Mutual Fund,

Investment Advisor)

Consultation

Consultant

(Independent Contractor)


139/158

139

Controlling Use & Disclosure of

Material Information

Disclosure of Material Information


140/158

140

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


141/158


142/158

142

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


143/158

Acquisition Negotiations


144/158

144

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



145/158

145

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



146/158

146

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


147/158

147

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


148/158

148

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)


149/158

149

(Using J&J / Guidant Transaction)

Comments and Observations


150/158

150

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


151/158

151

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


152/158

152

Presentation by Guidant investmentbanker (JP Morgan)

Board authorized continued discussions

9/13/04: J&J Board authorized

management to continue discussions


153/158

153

g

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


154/158

154

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


155/158

155

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


156/158

156

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


157/158

157

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


158/158

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

Documents

Overview of the Securities Laws Bus. Orgs. (1)