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1
Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
20
Quote of the Day
“Definition of insider trading:
Stealing too fast.”
Calvin Trillin
essayist
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2
Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
Securities and Exchange
Commission (SEC)
 Created in 1934 to regulate the
securities industry:
• Rules – to fill in gaps left by state securities
statutes.
• Releases – informal pronouncements on
current issues, particularly proposed
changes in the rules.
• No-Action Letters – the answer to a
question; states that the SEC will take no
action (meaning that they approve of the
transaction in question.)
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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What is a Security?
 A security is any transaction in which
the buyer:
• (1) invests money in a common enterprise
and,
• (2) expects to earn a profit predominately
from the efforts of others.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
Securities Act of 1933
 The 1933 Act requires that, before
offering or selling securities, the issuer
must register the securities with the
SEC, unless the securities qualify for an
exemption.
 When an issuer registers securities, the
SEC does not investigate the quality of
the offering.
 The 1933 Act prohibits fraud in any
securities transaction.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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1933 Act -- Exemptions
 General Exemption – those made by
the SEC “for the public interest.”
 Exempt Securities
• Government securities, Blank securities,
Short-term notes, Non-profit issues,
Insurance policies and annuity contracts
 Regulation D covers private offerings;
Regulation A covers “small” public
offerings.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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1933 Act -- Exemptions
 Exempt Transactions
• Section 4(2) of the 1933 Act exempts from
registration “transactions by an issuer not
involving any public offerings.”
• Under SEC Rule 147, an issuer is not
required to register securities that are
offered and sold only to residents of the
state in which the issuer is incorporated
and does business.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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1933 Act -- Exemptions

Regulation D
• Rule 504 – allows up to $1 million in securities
sold in 12-month period; may advertise if
transaction is registered and limited to accredited
investors. (Sales that don’t meet this limit are
restricted stock and cannot be resold in less than
one year.)
• Rule 505 – may sell up to $5 million in 12-month
period; may not advertise; may have unlimited
accredited investors and 35 unaccredited
investors.
• Rule 506 – like Rule 505 except amount is
unlimited and unaccredited investors who cannot
evaluate the risk for themselves must have a
purchaser representative.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Public Offerings
 Reg A permits an issuer to sell $5 million
of securities publicly in any 12-month
period.
 Direct Public Offerings – stock sold directly
by the company, without going through a
broker.
• This option is cheaper and may increase loyalty
among customers, but..
• It can be expensive to mail disclosure statements
and to set up trading systems.
 A company’s first public sale of securities
is called its initial public offering (IPO).
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Public Offerings (cont’d)
 A company selling stock may hire an
investment bank to serve as the
underwriter.
• In a firm commitment underwriting, the
bank buys the stock, then resells it. Risk of
loss is borne by the bank.
• In a best efforts underwriting, the bank acts
as the agent, selling the stock for the
company, which bears the risk of loss.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Public Offerings (cont’d)
 A registration statement is required for
a company preparing to sell stock. Its
purpose is:
• To notify the SEC that a sale of securities is
pending, and
• To disclose information to purchasers.
 A prospectus is a portion of the
registration statement which must be
given to prospective purchasers.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Public Offerings (cont’d)
 The company’s sales effort is restricted
during the pre-filing and waiting periods.
• The quiet period begins when an
underwriter is hired and ends 25 days after
the IPO. Company officers must not “hype”
their stock during this time.
• The waiting period is after the registration
statement is filed, but before the SEC
approves it. A simple ad can be published
during this time, and indications of interest
are gathered, but no sales can be made.
• The SEC may require changes to the
registration statement before allowing the
stock to go effective (begin to be sold).
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Sales of Restricted Securities
 Rule 144 limits the resale of two types
of securities: control securities and
restricted securities.
• A control security is one held by any
shareholder who owns more than 10
percent of a class of stock or by any officer
or director.
• A restricted security is any stock purchased
in a private offering.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Liability
 Liability is imposed on anyone selling
unregistered and non-exempt
securities.
 Fraud imposes liability on the seller if
any interstate commerce is used (such
as U.S. mail, telephone, banks – which
includes practically every transaction!)
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
Liability (cont’d)
 Criminal liability is imposed on anyone
who willfully violates the Act of 1933.
 If a final registration statement contains
a material misstatement or omission,
the purchaser of the security can
recover from everyone who signed the
registration statement.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
Securities Exchange
Act of 1934
 Registration – an issuer must register
with the SEC if:
• It completes a public offering under the
1933 Act,
• Its securities are traded on a national
exchange, or
• It has at least 500 shareholders and its
assets exceed $10 million.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Securities Exchange
Act of 1934 (cont’d)
 Section 13 requires companies to file
the following documents:
• An initial, detailed information statement
when the company first registers.
• Annual reports on Form 10-K, containing a
detailed analysis of the company’s
performance, and information about officers
and directors.
• Quarterly reports on Form 10-Q, which are
less detailed than 10-Ks.
• Form 8-Ks to report any significant
developments or changes.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Securities Exchange
Act of 1934 (cont’d)
 Proxy Requirements - Section 14 –
allows shareholders to vote without
attending the meeting.
 Short-Swing Trading - Section 16 –
prevents insiders from manipulating the
market using inside information; this
section limits insiders from buying and
then selling (or selling then buying)
company stock within a 6 month period.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Liability


Section 18 holds liable those who make a false
or misleading statement in a filing.
Section 10(b) prohibits fraud in the purchase
and sale of any security whether or not the
security is registered under the 1934 Act. This
applies to:
• Misstatement or omission of material fact that was
relied upon
• Scienter (willful misstatement)
• Either purchasers or sellers

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Internet chat rooms are sometimes involved in
fraud when a stock owner hypes the stock, then
sells in the ensuing rush; this is hard to track.
Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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The Private Securities
Litigation Reform Act of 1995
 An amendment to the 1934 Act, intended to
discourage fraud sits by shareholders.
 Companies are liable to shareholders for
“forward-looking statements” (projections
about future earnings or plans) only if the
company does not warn that the
predictions may not come to pass, and the
shareholders can prove that the executives
knew the predictions were false.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Insider Trading
 Someone who trades on inside
information is liable only if he has a
fiduciary duty to the company whose
stock he has traded.
 Fiduciaries
• A fiduciary violates Rule 10b-5 if she trades
stock of her company while in possession
of nonpublic material information.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Insider Trading (cont’d)
 Tippers -- Insiders who pass on non-
public, material information are liable
under Rule 10b-5, even if they do not
trade themselves, as long as:
• (1) they know the information is confidential
and,
• (2) they expect some personal gain.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
Insider Trading (cont’d)
 Tippees --Those who receive tips are
liable for trading on inside information,
even if they do not have a fiduciary
relationship to the company, as long as:
• (1) they know the information is
confidential,
• (2) they know it came from an insider who
was violating his fiduciary duty, and
• (3) the insider expected some personal
gain.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Insider Trading (cont’d)
 Takeovers
• This rule prohibits trading on inside
information during a tender offer if the
trader knows the information was obtained
from either the bidder or the target
company.
 Misappropriation
• A person is liable if he trades in securities
(1) for personal profit, (2) using confidential
information, and (3) in breach of a fiduciary
duty to the source of the information.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Foreign Corrupt Practices Act
 Under the Foreign Corrupt Practices
Act, it is a crime for any American
company (whether reporting under the
1934 Act or not) to make or promise to
make payments or gifts to foreign
officials, political candidates, or parties
in order to influence a governmental
decision, even if the payment is legal
under local law.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
20
Blue Sky Laws
 State statutes regulating securities are
called blue sky laws (because crooks
were willing to sell investors “a piece of
the great blue sky”).
• All the states and the District of Columbia
all have blue sky laws.
 The National Securities Markets
Improvement Act of 1996 limits this
state regulation of securities.
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
20
Blue Sky Laws
 State regulation may take one of these
approaches to securities offerings:
• Registration by notification – for issuers
with an established track record
• Registration by coordination – allows
issuers to submit copies of their SEC
registration to the state also
• Registration by qualification – requires a full
blown registration of some issuers
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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Blue Sky Laws
 Three options for complying with state
regulation requirements:
• Coordinated Equity Review (CER) – the
issuer only deals with one state, which then
coordinates with other states
• Small Company Offering Registration
(SCOR) – for use in offerings up to $1
million over any 12-month period
• Uniform Limited Offering Exemption –
under this exemption, most states are
exempt from registering offerings under
Rule 505
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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“Congress passed the Securities Act
of 1933 and the Securities
Exchange Act of 1934 to ensure that
the country never suffers through
another economic crisis as
catastrophic as the Great
Depression. It is in no small part
owing to these laws that the United
States has enjoyed so many years
of economic stability.”
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Legal Environment 4th Ed.
COPYRIGHT © 2011 South-Western/Cengage Learning.
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