Joined: 31 Jan 2005
|Posted: Mon Apr 28, 2014 8:27 am Post subject: Class notes for Security Regulations
|As explained in class; these are my lecture notes. THEY ARE RESTRICTED BY THIS CAVEAT: They may contain spelling errors, grammatical errors, or even contextual errors. They are being reproduced here just to provide students in BL6 with an opportunity to supplement their class notes on this subject matter.
RULE lOb-5 AND SECTION 16(b)
BASICALLY ANY ATTEMPT TO CHEAT IS UNLAWFUL
SEE YOUR E-MAIL FROM INSTRUCTOR OR
SEE INSTRUCTOR’S WEBSITE
Violation of rule can result in private suit for damages, an SEC suit for injunctive relief, or criminal prosecution.
GENERAL ELEMENTS OF CAUSE OF ACTION UNDER RULE 10b-5
To recover damages Private plaintiff must show following:
ANY TYPE OF Making material misstatement or making material omission.
Statement/omission considered material if substantial likelihood reasonable investor would consider it important in making investment decision. EXAMPLE: Several insiders bought stock in their mining company on basis of inside information regarding substantial mineral find. When information publicly released, price of stock soared. Mineral discovery material fact. [SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968)]
SCIENTER (Guilty Mind)
To be fraudulent and actionable under 10b-5, conduct must have been undertaken w/intent to deceive, manipulate, or defraud. USSCT.: Includes cases where misstatement made knowingly, but has reserved issue whether misstatements made recklessly are proscribed (Circuit courts uniformly held recklessness to be sufficient).
IN CONNECTION WITH PURCHASE OR SALE OF A SECURITY BY PLAINTIFF
PLAINTIFF PRIVATE INDIVIDUAL
Term "in connection with" interpreted broadly. Broker's sale of client's securities w/intent to misappropriate proceeds constituted fraud
WITH A SALE OF A SECURITY BY PLAINTIFF
Term includes transactions such as exchanges of stock for assets, mergers, contracts to sell, etc.
NONTRADING DEFENDANTS CAN BE HELD LIABLE
Focus here: On sale/purchase by PLAINTIFF, DEFENDANT need not have purchased or sold any securities. Thus, nontrading defendant, such as a company that intentionally publishes misleading press release, can be held liable to persons who purchased or sold securities on market on basis of press release.
PRIVATE PLAINTIFF MAY NOT MAINTAIN SUIT BASED ON BASIS OF DEFENDANT'S AIDING AND ABETTING OTHER DEFENDANTS FRAUD
IN INTERSTATE COMMERCE
Fraudulent conduct must involve use of some means of interstate commerce; something as simple as use of the telephone or mail will suffice.
Generally: Reliance element of l0b-5 C/A. However, in nondisclosure case reliance presumed; i.e., plaintiff need not prove reliance on undisclosed information. Similarly, in misrepresentation action on securities sold in well-defined market (e.g., national stock exchange), reliance on any public misrepresentations may be presumed based on fraud on market theory: Investor who buys/sells stock at price set by market does so in reliance on integrity of stock, which in turn based on publicly available information. [Basic, Inc. v. Levinson, 485 U.S. 224 (1988)]
1) REBUTTAL OF PRESUMPTION
Presumption may be rebutted (e.g., by showing plaintiff would have acted same way even w/full disclosure; price not affected by misrepresentation, or plaintiff didn't trade in reliance on integrity of market).
Private plaintiff must show defendant's fraud caused plaintiff damages.
May not be obvious, BUT lOB-5's greatest impact: prohibits most instances of trading securities on basis of inside information (i.e., information not disclosed to public that an investor would think important when deciding whether/not to invest in the security).
Early insider trading cases: Focused on duty of trader to disclose or abstain from trading. Trend: Clear person violates l0b-5 if he breaches duty of trust and confidence owed to: (i) the issuer, (ii) shareholders of the issuer, or (iii) misappropriation (see below), 3rd. party person source of the material nonpublic information.
WHO MAY BE LIABLE?
Anyone who breaches duty not to use inside information for personal benefit can be liable under lOB-5.
Typical securities insiders, such as directors, officers, controlling shareholders, and employees of the issuer are deemed to owe duty of trust and confidence to their corporation which is breached by trading inside information.
CONSTRUCTIVE INSIDERS, such as securities issuer's, CPAs, attorneys, and bankers performing services for the issuer, also owe such a duty. EXAMPLE: Monday, Dee, President of a publicly held mining company, told by company geologists just discovered huge cache of gold on company property. Dee contacts company's outside attorney, Alex, to discuss how she should go about disclosing information. Dee and Alex decide: best to announce information to public Friday. Announcement will probably cause company's stock to skyrocket. Neither geologists. Dee, nor Alex may purchase company stock before information made public, unless they disclose information to anyone selling them stock.
TIPPERS AND TIPPEES
Where insider gives tip of inside information to someone else who trades on basis of inside information, tipper can be liable under l0b-5 if the tip made for any improper purpose (e.g., in exchange for money/kickback, as a gift, for a family member's benefit, for reputational benefit, etc.).
Tippee can be held liable derivatively if tipper breached duty and tippee knew tipper was breaching duty. EXAMPLE: Same facts: Dee meets her brother, Bob, in restaurant and tells him about the gold find, and Bob purchases company stock before announcement, Dee can be held liable as a tipper and Bob derivatively as tippee. But: stranger, Steve, overhears Dee telling Bob and purchases stock before public announcement made, Steve would not be liable under l0b-5.
38.5. Chiarella worked as a "markup man' in NY composing room Pandick Press, a financial printer. Documents Chiarella handled: 5 secret announcements of corporate takeovers. Tender offerors had hired Pandick Press to print offers, would be made public when tender offers made to shareholders of target corporations. Documents delivered to Pandick Press, identities of acquiring and target corporations concealed by blank space or false names. True names would not be sent to Pandick Press until night of final printing. Chiarella able to deduce names of target companies before final printing. W/o disclosing knowledge, he purchased stock in target companies and sold shares immediately after takeover attempts were made public. Chiarella realized gain of $30K in 14 months. Federal government indicted Ghiarella for criminal violations of Section 10(b) of Securities Exchange Act of 1934. Is Chiarella guilty? Chiarella v. United States, 445 U.S. 222, 100 S Ct 1108 63 , L.Ed.2d 348 (1980)]
38.5. U.S. Supreme Court reversed trial court's judgment that had convicted Chiarella on all counts. Court of Appeals: Anyone an insider or not who receives material nonpublic information may not use that information to trade in securities until information made public. USSCT. rejected rule, holding: SECTION 10B-5: Not liable for insider trading unless owes duty to disclose information. Duty only arises if person owes fiduciary duty to company in whose shares he has traded.
Chiarella did not owe fiduciary duty to target companies of whose shares he purchased. Court: Not every instance of financial unfairness constitutes fraudulent activity under Section 10(b). Element required making silence fraudulent: duty to disclose absent in this case. No duty could arise from Chiarella's relationship w/sellers of target company's securities for Chiarella had no prior dealings with them. He was not their agent, he was not a fiduciary, and he was not a person in whom sellers had placed their trust and confidence. He was, in fact, a complete stranger who dealt with the sellers only through impersonal market transactions. Duty to disclose under §10(b) not arise from the mere possession of nonpublic market information.
MISAPPROPRIATORS: MISAPPROPRIATION DOCTRINE
Government can prosecute under l0b-5 for trading on market information (i.e., information about supply or demand for stock of particular company in breach of a duty of trust and confidence owed to source of information;
Here's a nonexclusive list of circumstances under which person deemed to owe duty of trust and confidence in misappropriation case:
SEE CLASS HANDOUT
Federal courts exclusive jurisdiction over claims arising under l0b-5.
REMEDYS FOR 10B-5 VIOLATIONS
Individual plaintiffs can sue for damages or rescission.
Damages based on difference between price paid (or received) by plaintiff, and average share price in 90-day period after corrective information disseminated.
Rescission available in lieu of damages. NOTE punitive damages not available under 10b-5, but might be under appropriate state law claims for fraud.
INSIDER TRADING SANCTIONS ACT AND
INSIDER TRADING AND SECURITIES FRAUD ENFORCEMENT ACT 1934 Act §21A
Important weapon against insider trading. Authorizes SEC (SECURITIES AND EXCHANGE COMMISSION) to sue persons who illegally trade on SECURITIES EXCHANGES while in possession of material, nonpublic information (and their tippees), as well as persons who violate Act by communicating such information, for a civil penalty equal to THREE TIMES profit gained or loss avoided by defendant's unlawful purchase, sale, or communication.
Treble-damages penalty important, because it means defendant may lose more than ill-gotten profits, thereby creating powerful disincentive to insider trading.
PRIVATE RIGHT OF ACTION INSIDER TRADING AND SECURITIES FRAUD
Creates private remedy against one who illegally trades while in possession of material, nonpublic information on behalf of any person who contemporaneously traded same class of securities.
Civil penalties discussed above in addition to all other existing sanctions, including jail terms up to 10 years, and criminal fines of up to $1M for individuals and $2.5M for corporations.
B. SECTION 16(B) OF THE SECURITIES EXCHANGE ACT OF 1934
Any profit realized by director, officer, or shareholder owning more than 10% of outstanding shares of corporation from any purchase and sale, or sale and purchase, of any equity security of his corporation w/in a period of less than six months must be returned to the corporation.
Applies to publicly held corporations whose shares traded on national exchange or that have at least 500 shareholders in any outstanding class and at least $10M in assets.
STRICT LIABILITY IMPOSED
Purpose of section 16(b) to prevent unfair use of inside information and internal manipulation of price. Accomplished by imposing strict liability for covered transactions whether or not any material fact that should or could have been disclosed NO PROOF OF USE OF INSIDE INFORMATION IS REQUIRED.
ELEMENTS OF CAUSE OF ACTION
PURCHASE AND SALE OR SALE AND PURCHASE W/IN SIX MONTHS
Only to profits from purchases and sales made w/in six month period. Most instances, easy to define purchase or sale. However, some areas of corporate stock transactions such as reclassification, conversion, and exercise of stock options where time and event of purchase or sale is uncertain. Test normally applied to determine whether there is a purchase or sale is whether "this is the kind of transaction in which abuse of inside information is likely to occur."
Applies only to purchases and sales of equity securities. An equity security: Any security other than pure debt instrument, including options, warrants, preferred stock, common stock, etc.
OFFICER, DIRECTOR, OR TEN PERCENT SHAREHOLDER
APPLIES ONLY TO PURCHASES AND SALES MADE BY OFFICERS, DIRECTORS, OR MORE THAN 10% SHAREHOLDERS.
DEPUTIZATION OF DIRECTOR
Ordinarily, easy to identify officers, directors, and 10% shareholders. Income instances, however: Person may "deputize" another person to act as his representative on board. In these cases, securities transactions of principal will come w/in section 16(b).
OFFICERS OR DIRECTORS
Purchases/sales made by persons before becoming officer or director generally EXCLUDED from 16(b), because person generally not have access to inside information sought to be protected from abuse under section 16(b) before becoming officer or director.
Other hand, purchases and sales made w/in six months AFTER ceasing to be officer/director can come w/in section 16(b).
TEN PERCENT SHAREHOLDER
Person is more than 10% shareholder if directly or indirectly owns more than 10% of any class of equity security of Corp. at time immediately before both purchase and sale.
Thus, purchase that brings shareholder over the 10% threshold is not w/in scope of section 16(b).
PROFIT REALIZED "SHORT SWING PROFITS"
Not only traditional profits, also losses avoided. "Profit" determined by matching highest sales price against lowest purchase price during any six-month period.
REMEMBER use of inside information not material to recovery.
EXAMPLE: SEE CLASS HANDOUT