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Business Associations > Securities & Insider Trading > Flashcards

Securities & Insider Trading Flashcards

1
Q

rule

RULE 10b-5 /securities regulation

A

= it is unlawful

  • for any person,
  • directly or indirectly,
  • by the use
  • of any means or instrumentality of interstate commerce or the mails OR
  • of any facility of any national securities exchange
  • in connection with the purchase or sale of any security, to
    1. Employ any device, scheme, or artifice to defraud
    2. Make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading; or
    3. Engage in any act, practice, or course of business that operates or would operate as a fraud or a deceit upon any person,
  • in connection with the purchase or sale of any security
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2
Q

3 possible effects of violation

RULE 10b-5 /securities regulation

A

A violation of the rule can result in

  1. a private suit for damages,
  2. an SEC suit for injunctive relief, or
  3. criminal prosecution.
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3
Q

general elements of cause of action

RULE 10b-5 /securities regulation

A

private P must show following elements to recover damages under rule 10b-5:

  1. fraudulent conduct
  2. in connection w/ purchase or sale of security by P
  3. in interstate commerce
  4. reliance
  5. damages
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4
Q

fraudulent conduct - element

ELEMENTS /rule 10b-5

A
  • The plaintiff must show that the defendant engaged in some fraudulent conduct.
  • This can take a number of forms, e.g., making a material misstatement or making a material omission.
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5
Q

fraudulent conduct - materiality

ELEMENTS /rule 10b-5

A
  • A statement or omission will be considered material if there is a substantial likelihood that a reasonable investor would consider it important in making her investment decision.
  • No bright line test of materiality exists, but a plaintiff need not prove that the information is statistically significant or valid.
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6
Q

A company released information that its leading cold remedy product was poised for growth and therefore the company’s revenues were expected to increase greatly. At the time the company made the statements, it knew that a few doctors had evidence of a possible link between the company’s product and
a loss of the sense of smell in patients and that those findings were going to be given at a professional association meeting. The company did not release information about the possible link. IS THERE MATERIALITY?

fraudulent conduct - materiality example
ELEMENTS /rule 10b-5

A

Under the circumstances, a reasonable investor might consider information about the possible link material.

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7
Q

fraudulent conduct - scienter

ELEMENTS /rule 10b-5

A
  • To be fraudulent and actionable under rule 10b-5, the conduct complained of must have been undertaken with an intent to deceive, manipulate, or defraud.
  • SC says standard includes knowingly, circuit courts have uniformly held recklessness to be sufficient
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8
Q

connection w/ P’s purchase/sale of security - element

ELEMENTS /rule 10b-5

A
  • If P is a private person, the fraudulent conduct must be in connection w/ purchase or sale of a security by P himself.
  • term “in connection with” = interpreted broadly
  • – includes transactions such as
    1. exchanges of stock for assets
    2. mergers
    3. contracts to sell
  • – excludes potential purchasers who did not buy (b/c of the fraud) and people who already own shares and refrain from selling (b/c of the fraud)

[SEC v. Zandford (2002) = broker’s sale of client’s securities with intent to misappropriate the proceeds constituted fraud in connection with a sale of a security by plaintiff]

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9
Q

connection w/ P’s purchase/sale of security - nontrading Ds

ELEMENTS /rule 10b-5

A

= Nontrading Defendants Can Be Held Liable

  • focus here is on a sale or purchase by plaintiff
  • D need not have purchased or sold any securities

EXAMPLE = nontrading D (like a co. that intentionally publishes misleading press release) can be held liable to a person who purchased or sold securities on the market on the basis of the press release

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10
Q

connection w/ P’s purchase/sale of security - aiding & abetting
ELEMENTS /rule 10b-5

A

= Private Plaintiff May Not Maintain Suit Based on Aiding and Abetting

  • An action brought by a private P pursuant to section 10(b) of the 1934 Act may not be based on a D’s status as an “aider and abettor” of other Ds’ fraud
  • BUT the government may base an action on aiding and abetting
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11
Q

in interstate commerce - element

ELEMENTS /rule 10b-5

A

AKA fraudulent conduct must involve use of some means of interstate commerce
(something as simple as use of telephone or mail will suffice)

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12
Q

reliance - element

ELEMENTS /rule 10b-5

A
  • Generally, reliance is an element of a rule 10b-5 cause of action.
  • BUT in a NONDISCLOSURE case, reliance is presumed; AKA the P need not prove reliance on undisclosed info
  • ALSO, in a MISREPRESENTATION action on securities sold in a well-defined market (like national stock exchange), reliance on any public misrepresentations may be presumed based on the FRAUD ON THE MARKET theory
    = Investor who buys/sells stock at the price set by the market does so in reliance on the integrity of that stock, which in turn is based on publicly available info [AKA Basic presumption]
  • SO seems like only in the case of face-to-face misrepresentation (i.e., stock not sold on an exchange) will P have to prove reliance
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13
Q

reliance - rebuttal of presumption

ELEMENTS /rule 10b-5

A

The presumption of reliance may be rebutted

EXAMPLES = by showing

  1. that the plaintiff would have acted the same way even with full disclosure,
  2. that the price was not affected by the misrepresentation, or
  3. that the plaintiff did not trade in reliance on the integrity of the market.
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14
Q

damages - element

ELEMENTS /rule 10b-5

A

A private plaintiff must show that the defendant’s fraud caused the plaintiff damages.

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15
Q

Insider trading

RULE 10b-5 /securities regulation

A
  • Rule 10b-5’s greatest impact is to prohibit most instances of trading securities on the basis of inside information
  • inside info = info not disclosed to public that an investor would think is important when deciding whether or not to invest in a security
  • a person violates rule 10b-5 if he breaches a duty of trust and confidence owed to:
    (i) the issuer,
    (ii) shareholders of the issuer, or
    (iii) in the case of misappropriators, another person who is the source of the material nonpublic information.
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16
Q

who may be liable?

INSIDER TRADING /rule 10b-5

A
  1. insiders
  2. tippers and tippees
  3. misappropriators
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17
Q

insiders

WHO MAY BE LIABLE /insider trading

A
  • Anyone who breaches a duty not to use inside information for personal benefit can be held liable under rule 10b-5.
  • Typical securities insiders, such as directors, officers, controlling shareholders, and employees of the issuer are deemed to owe a duty of trust and confidence to their corporation which is breached by trading on inside information.
  • Constructive insiders, such as a securities issuer’s CPAs, attorneys, and bankers performing services for the issuer, also owe such a duty.
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18
Q

On Monday, Dee, the president of a publicly held mining company, is told by company geologists that they just discovered a huge cache of gold on company property. Dee contacts the company’s outside attorney, Alex, to discuss how she should go about disclosing the information. Dee and Alex decide that it would be best to announce the information to the public on Friday. The announcement will probably cause the price of the company’s stock to skyrocket. WHO WOULD BE LIABLE?

insiders - example
WHO MAY BE LIABLE /insider trading

A

Neither the geologists, Dee, nor Alex may purchase company stock before the information is made public, unless they disclose the information to the seller.

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19
Q

tippers and tippees

WHO MAY BE LIABLE /insider trading

A

Where an insider gives a tip of inside information to someone else who trades on the basis of the inside information, the tipper can be liable under rule 10b-5 if the tip was made for any improper purpose

  • IMPROPER PURPOSE: in exchange for money or a kickback, as a gift, for a family member’s benefit, for reputational benefit, etc.
  • The tippee can be held liable derivatively if the tipper breached a duty and the tippee knew that the tipper was breaching the duty.
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20
Q

On Monday, Dee, the president of a publicly held mining company, is told by company geologists that they just discovered a huge cache of gold on company property. Dee contacts the company’s outside attorney, Alex, to discuss how she should go about disclosing the information. Dee and Alex decide that it would be best to announce the information to the public on Friday. The announcement will probably cause the price of the company’s stock to skyrocket. Dee meets her brother Bob in a restaurant and tells him about the gold find, and Bob purchases company stock before the announcement. A stranger, Steve, overhears Dee explain that the company has just discovered gold and purchases stock before the public announcement is made. WHO MAY BE LIABLE?

tippers and tippees - example
WHO MAY BE LIABLE /insider trading

A

Dee can be held liable as a tipper and Bob can be held liable as a tippee. But Steve would not be liable under rule 10b-5.

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21
Q

misappropriators

WHO MAY BE LIABLE /insider trading

A
  • Under the misappropriation doctrine, gov can prosecute a person under rule 10b-5 for trading on market information in breach of a duty of trust and confidence owed to the source of the information
  • BUT the duty need not be owed to the issuer or shareholders of the issuer.
  • comes from US v. O’Hagan (1997)
  • market information = info about the supply of or demand for stock of a particular company
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22
Q

misappropriators - nonexclusive list of circumstances under which a person will be deemed to owe a duty of trust and confidence in a misappropriation case
WHO MAY BE LIABLE /insider trading

A
  1. When the person agrees to maintain information in confidence
  2. When the person communicating the information and the person with whom it is communicated have a history of sharing confidences so that the recipient of the information should know that the person communicating the information expects the recipient to maintain confidentiality
  3. When the person receives the information from a spouse, child, parent, or sibling (unless the recipient can prove that he had no reason to know that the information was confidential)
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23
Q

Alex works as an attorney at a law firm. BigCorp retains Alex’s firm in connection with a tender offer it is planning to make. Alex does not work on the tender offer in any way, but he comes across information about it while in the firm’s photocopy room. If Alex trades in securities related to the tender offer, CAN HE BE HELD LIABLE?

misappropriators - example
WHO MAY BE LIABLE /insider trading

A

Yes, he can be held liable under rule 10b-5 in an action by the government, because by trading on the information, he breaches a duty of trust and confidence that he owes to the firm.

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24
Q

overview

REMEDIES /securities regulation

A
  • The federal courts have exclusive jurisdiction over claims arising under rule 10b-5.
  • To remedy a rule 10b-5 violation, individual Ps can sue for damages or rescission.
  • Damages = based on the difference between
    1. price paid (or received) by P AND
    2. the average share price in the 90-day period after corrective information is disseminated
  • Rescission = available in lieu of damages
  • NOTE = punitive damages are not available under rule 10b-5, but might be under appropriate state-law claims for fraud.
25
Q

insider trading sanctions act

REMEDIES /securities regulation

A

AKA 1934 Act §21A

  • provides an important weapon against insider trading.
  • authorizes the SEC to sue persons who illegally trade on the securities exchanges while in possession of material, nonpublic information (and their tippees), as well as persons who violate the Act by communicating such information
  • SEC can sue for a civil penalty equal to three times the profit gained or loss avoided by D’s unlawful purchase, sale, or communication = treble-damages penalty
  • treble damages penalty is key b/c means D may lose more than his ill-gotten profits, thereby creating a powerful disincentive to insider trading
26
Q

private right of action

INSIDER TRADING SANCTIONS ACT /remedies

A
  • Act creates a 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.
  • Damages are limited, however, to the profit gained or loss avoided by D in the subject transactions.
27
Q

criminal penalties

INSIDER TRADING SANCTIONS ACT /remedies

A

The civil penalties are in addition to all other existing sanctions, including

  • jail terms of up to 10 years and
  • criminal fines of up to $1 million for individuals and
  • criminal fines of up to $2.5 million for corporations.
28
Q 
rule
SECTION 16(b) /securities regulation
A
  1. Section 16(b) of the Securities Exchange Act of 1934 provides that
    - any profit realized by
    - a director, officer, or shareholder owning more than 10% of the outstanding shares of the corporation
    - from any purchase and sale, or sale and purchase,
    - of any equity security of his corporation
    - within a period of less than six months
    must be returned to the corporation.
  2. The section applies to publicly held corporations
    - whose shares are traded on a national exchange OR
    - that have at least 2,000 shareholders (or 500 shareholders who are not accredited investors) in any outstanding class and more than $10 million in assets.
29
Q 
Strict Liability Imposed
SECTION 16(b) /securities regulation
A
  • The purpose of section 16(b) is to prevent unfair use of inside information and internal manipulation of price.
  • This is accomplished by imposing strict liability for covered transactions whether or not there is any material fact that should or could have been disclosed—no proof of use of inside information is required.
30
Q 
three elements of cause of action 
SECTION 16(b) /securities regulation
A
  1. purchase and sale or sale and purchase within six months
  2. equity security
  3. officer, director, or more than ten percent shareholder
31
Q

purchase and sale or sale and purchase within six months

ELEMENTS OF CAUSE OF ACTION /section 16(b)

A
  • Section 16(b) applies only to profits from purchases/sales made within a six-month period.
  • Usually easy to define purchase/sale. However, some transactions—such as reclassification, conversion, and exercise of stock options—where time and event of purchase/sale is uncertain.
  • The test normally applied to determine whether there is a purchase/sale is whether “this is the kind of transaction in which abuse of inside information is likely to occur.”
32
Q

equity security

ELEMENTS OF CAUSE OF ACTION /section 16(b)

A
  • Section 16(b) applies only to purchases and sales of equity securities.
  • An equity security is any security other than a pure debt instrument, including options, warrants, preferred stock, common stock, etc.
33
Q

officer/director/<10% shareholder - requirement

ELEMENTS OF CAUSE OF ACTION /section 16(b)

A

Section 16(b) applies only to purchases and sales made by officers, directors, or more than 10% shareholders.

34
Q

officer/director/<10% shareholder - deputization of director

ELEMENTS OF CAUSE OF ACTION /section 16(b)

A
  • Ordinarily, it is easy to identify the officers, directors, and 10% shareholders of a corporation.
  • In some instances, however, a person may “deputize” another person to act as his representative on the board.
  • In these cases, securities transactions of the principal will come within section 16(b).
35
Q

officer/director/<10% shareholder - timing issues

ELEMENTS OF CAUSE OF ACTION /section 16(b)

A

Officers or Directors =

  • Purchases/sales made by persons before becoming officer/director generally are excluded from scope of 16(b), because a person generally does not have access to inside information sought to be protected from abuse under 16(b) before becoming officer/director.
  • On the other hand, purchases/sales made within six months after ceasing to be an officer/director can come within section 16(b).

More than Ten Percent Shareholder =

  • A person is a more than 10% shareholder if he directly or indirectly owns more than 10% of any class of equity security of the corporation at the time immediately before both the purchase and the sale.
  • Thus, the purchase that brings a shareholder over the 10% threshold is not within the scope of section 16(b).
36
Q 
profit realized
SECTION 16(b) /securities regulation
A
  • The profit recoverable under section 16(b), known as “short swing profit,” includes not only traditional profits, but also losses avoided.
  • “Profit” is determined by matching the highest sales price against the lowest purchase price during any six-month period.
  • Remember, use of inside information is not material to this recovery.
37
Q

Don Director purchases 100 shares of his company’s stock at $9 on February 1. He sells 100 shares on August 1 at $7 per share. He then buys 100 shares at $1 per share on November 15. What is the profit recoverable under section 16(b) (short swing profit)

profit realized - example
SECTION 16(b) /securities regulation
A

Despite the fact that the stock he purchased in February was sold at a loss of $2 per share in August, and he now holds shares with a basis of $1, he will be liable for a profit under section 16(b). The August sale will be matched with the November purchase, resulting in a “profit” of $6 per share, and causing him to be liable in the amount of $600.

38
Q

introduction

SARBANES-OXLEY ACT OF 2002 /securities regulation

A
  • SOX was enacted in 2002 in response to corporate financial scandals.
  • The SOX primarily affects companies registered under the 1934 Act (AKA those whose shares are traded on a national securities exchange or that have at least 2,000 record shareholders and more than $10 million in assets)
39
Q

public company accounting oversight board

SARBANES-OXLEY ACT OF 2002 /securities regulation

A
  • The SOX provides for the creation of a Public Company Accounting Oversight Board to register public accounting firms that prepare audit reports for companies reporting under the 1934 Act.
  • Only a public accounting firm registered with the Oversight Board may prepare or issue audit reports with respect to a registered company.
  • The Board establishes rules for
    1. auditing,
    2. quality control,
    3. ethics, and
    4. independence relating to preparation of audit reports.
40
Q

public company audit committees

CORPORATE RESPONSIBILITY /sarbanes-oxley act of 2002

A
  • The SOX requires the board of directors of each 1934 Act company to establish an audit committee comprised of board members.
  • The audit committee is responsible for overseeing the appointment, compensation, and work performed by the registered public accounting firm.
41
Q

corporate responsibility for financial reports

CORPORATE RESPONSIBILITY /sarbanes-oxley act of 2002

A
  • The SOX provides for criminal fines of up to $5 million and imprisonment for up to 20 years for willfully certifying an untrue report.
  • Under the SOX, companies filing reports under the 1934 Act must have their CEO, CFO, or similar person certify in each report, among other things, that:
    1. The officer has reviewed the report
    2. Based on the officer’s knowledge, the report is true and does not contain any material omissions
    3. The report fairly presents the financial position of the company
    4. The signing officer is
    • a. responsible for establishing internal controls,
    • b. has designed such controls to ensure that material information is made known to the officer, and
    • c. has evaluated the controls within 90 days prior to the report.
42
Q

forfeiture of bonuses and profits

CORPORATE RESPONSIBILITY /sarbanes-oxley act of 2002

A
  • If a company is required to restate financial reports because of misconduct with respect to the reports, the company’s CEO and CFO must reimburse the company for any bonus or other incentive-based compensation received by them during the 12-month period after the inaccurate reports were
    1. filed with the SEC OR
    2. made public
    (whichever is earlier)
  • The officers must also turn over to the company any profit that they made from the sale of the company’s securities during the same 12-month period
43
Q

prohibition against insider trades during pension blackout periods
CORPORATE RESPONSIBILITY /sarbanes-oxley act of 2002

A
  • Directors and executive officers of 1934 Act companies may not purchase or sell the company’s stock during a blackout period if the stock was acquired in connection with the officer’s or director’s services for the company.
  • A blackout period = period of at least three consecutive days when at least 50% of the company’s employees who participate in the company’s retirement plan are prohibited from transferring their interests in the company’s securities in the plan.
  • However, blackout periods that are regularly scheduled and described in the plan and disclosed to the employees before they join the plan are excluded.
44
Q

prohibition against insider trades during pension blackout periods - remedies
CORPORATE RESPONSIBILITY /sarbanes-oxley act of 2002

A
  • If a director or officer violates this rule, the company can force the turnover of any profits, regardless of fault or intent.
  • Any shareholder can file a derivative suit to recover the profit if the company fails to take action against the officer or director within 60 days after the shareholder requests the company to take action to recover the profits.
45
Q

prohibition against personal loans to executives

CORPORATE RESPONSIBILITY /sarbanes-oxley act of 2002

A

A company generally may not make any new personal loans to any director or executive officer of the company
EXCEPT to the extent that the loans are made
1. in the ordinary course of the company’s consumer credit business and
2. on terms no more favorable than the company offers to the general public.

46
Q

statute of limitations for fraud

CORPORATE + CRIMINAL FRAUD /sarbanes-oxley act of 2002

A

The SOX provides that the statute of limitations for private cases for securities fraud is the later of

  1. two years after discovery of the facts giving rise to the cause of action or
  2. five years after the action accrued.
47
Q

criminal penalties for defrauding shareholders and the public
CORPORATE + CRIMINAL FRAUD /sarbanes-oxley act of 2002

A

The SOX makes securities fraud crimes punishable by a fine and imprisonment of up to 25 years.

48
Q 
Texas Gulf rule for insider trading
KEY PRINCIPLES /class notes
A

Where an insider has material nonpublic information the insider must either disclose such information before trading or abstain from trading until the information has been disclosed

49
Q

Rationale for the Texas Gulf rule for insider trading
(2 takeaways)
KEY PRINCIPLES /class notes

A

The Rule is based in police on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information

The essence of the Rule is that anyone who has “access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone” may not take “advantage of such information knowing it is unavailable to those with whom he is dealing, i.e., the investing public.”

50
Q 
Who is an insider, according to Exchange Act § 16(b)? 
(3 different categories)
KEY PRINCIPLES /class notes
A

(1) Officers
(2) Directors
(3) 10% Shareholders

51
Q 
Under Chiarella and Dirks, when the duty to disclose arises
KEY PRINCIPLES /class notes
A

Under these cases, Rule 10b-5 liability for insider trading is now premised on a duty to disclose arising from a relationship of trust and confidence between parties to the transaction:

“there can be no duty to disclose where the person who has traded on inside information ‘was not [the corporation’s] agent, . . . was not a fiduciary, [or] was not a person in whom sellers [of the securities] had placed their trust and confidence.”

52
Q 
Who is an insider post-Chiarella and Dirks?
KEY PRINCIPLES /class notes
A

The same three under Exchange Act § 16(b) (Officers, directors, and 10% shareholders)

BUT

“there can be no duty to disclose where the person who has traded on inside information ‘was not [the corporation’s] agent, . . . was not a fiduciary, [or] was not a person in whom sellers [of the securities] had placed their trust and confidence.”

53
Q 
2-part test for when a tippee can be held liable for his/her actions under Rule 10b-5 (via Dirks) 
KEY PRINCIPLES /class notes
A

(1) Tipper breaches fiduciary duty by disclosing information to the tippee, and
(2) Tippee knows or has reason to know of the breach of duty

NOTE: Tippee’s liability is derived from the tipper, “arising from his role as a participant after the fact in the insider’s breach of a fiduciary duty”

54
Q 
Under Dirks, when will disclosure constitute a breach of fiduciary duty? 
KEY PRINCIPLES /class notes
A

“Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.”

55
Q 
What is sufficient for “personal gain” for breach of a fiduciary duty (under Dirks and subject to 10b and Rule 10b-5
KEY PRINCIPLES /class notes
A

A tipper does not have to receive something of monetary or other pecuniary value to personally benefit for tipper liability under 10b and Rule 10b-5
A gift to a relative will suffice (a gift of confidential information to a trading relative or friend)

56
Q 
Misappropriation Theory from US v. O’Hagan 
KEY PRINCIPLES /class notes
A

“A person commits fraud ‘in connection with’ a securities transaction, and thereby violates §10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information”

57
Q 
Which cases give us the rule for the “classic” insider trading theories finding libability for insiders who breach a fiduciary relationship
KEY PRINCIPLES /class notes
A

Chiarella and Dirks

58
Q 
Which case gives us the rule for the misappropriation theory of insider trading, which finds that outsiders can also be liable  
KEY PRINCIPLES /class notes
A

O’Hagan

59
Q 
Avoiding liability under O'Hagan - if someone intends to trade on nonpublic information, how would they avoid liability under O'Hagan
KEY PRINCIPLES /class notes
A
  • Disclosure to the source of the information
  • NOTE: a footnote in O’Hagan suggests that the person attempting to trade on nonpublic information should disclose their intent to trade to both parties in a merger
  • The effect of disclosure: there is no deception, a required element of a 10b-5 violation under Santa Fe Industries

Business Associations (7 decks)

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