THE SECURITIES EXCHANGE ACT OF 1934
Securities Exchange Act of 1934 (’34 Act) regulates transfers of securities after the initial sale. Basically, it picks up where the ’33 Act leaves off. More specifically, it deals with regulation of securities exchanges, brokers, and dealers in securities. It also created the Securities and Exchange Commission. The ’34 Act makes it illegal to sell a security on a national exchange unless a registration is effective for the security. Registration under the ’34 Act requires filing prescribed forms in a timely manner with the applicable stock exchange and the SEC. The registered issuer must then file periodic reports as well as report significant developments that would affect the value of the security. The ’34 Act contains several provisions allowing for civil liability of individuals trading securities. The most notable of these provisions are discussed below.
• Note: Most securities law violations under the ’34 Act may be enforced civilly (bring a lawsuit) either by private plaintiffs or the SEC. The Private Securities Litigation Reform Act of 1995 (PLSRA) states that only the SEC can pursue claims against third parties not directly responsible for the securities law violation. The Department of Justice is primarily charged with bringing criminal actions for violation of securities laws.
When must a company register with the Securities Exchange Commission pursuant to the ’34 Act?
A company issuing securities must either register or perfect and exemption from registration. There are, however, other situations that subject a company to SEC public reporting requirements. The company becomes known as a “reporting company”. A company is generally required to register with the SEC if it meets any of the following characteristics:
• it completes a public offering pursuant to the ’33 Act;
• securities of the company are traded on a national exchange (such as the NYSE or CME); or
• it has 2,000 or more total shareholders (or 500 or more unaccredited shareholders) of unrestricted securities and a total asset value of more than $10 million.
The 2,000 (or 500 unaccredited) shareholder rule does not apply to shareholders who acquired shares through sanctioned crowdfunding or pursuant to employee compensation plans. Notably, if an issuer later drops below the shareholder limitation numbers, it may apply to the SEC to be exempted from the ’34 Act reporting requirements.
• Discussion: Why do you think the SEC requires a company to register in the above-referenced scenarios? Do you think the size of the company (number of shareholders or value of assets) should determine whether reporting is required? Why or why not?
• Practice Question: ABC Corp is a private company that has been steadily growing over the past several years. They have gone through several private offerings and have a large number of accredited and unaccredited investors. They also have substantial land holdings as well as equipment. Under what conditions might ABC Corp be forced to registered with the SEC and become a reporting company?
What disclosures are required of registered companies under the ’34 Act?
A reporting company must make routine disclosures to the public by filing reports with the SEC. The information required to be disclosed is substantially as follows:
• Reporting Company Initial Statement – Similar to the registration statement required under the ’33 Act, a company initially registering as a reporting company under the ’34 Act must make an initial disclosure of information. This information primarily concerns the operations, equity structure, and securities issued by the company.
• Annual Reporting – Reporting companies are required to make detailed annual reports to the SEC, which are also provided to security holders. The disclosure takes place on Form 10-K and it contains all relevant operational data, an explanation of company performance, audited financial statement, and detailed information about corporate officers and directors.
• Quarterly Reports – The reporting company must file and disclose to shareholders a quarterly report on Form 10-Q. The quarterly report contains similar information to that contained in the annual report, but it only covers the most recent quarter of the fiscal year. Also, the financial statement included in the quarterly report is not audited.
• Special Reports – The reporting company must disclose to the SEC and shareholders via Form 8-K any major operational, structural, financial, or ownership changes in the company within a reasonable time of the occurrence. Major occurrences include: new security issuances, changes in corporate control (officer and directors), mergers, acquisitions, changes in auditor, etc.
The information disclosed in each of the above reports must be certified as accurate by corporate executives (including the company’s CEO and CFO). These individuals must also attest to the operable status of controls over internal affairs and finances. This includes attesting that the company has in place an audit committee to examine the efficiency of internal controls.
• Discussion: Why do you think the SEC requires such extensive, recurring disclosures for reporting companies? Do you think these reporting requirements serve the intended purpose?
• Practice Question: What are the reporting requirements of companies that registered pursuant to The Securities Exchange Act of 1934?
What is liability under “Section 10(b)” and “Rule 10(b)(5)” of the 1934 Act?
Section 10(b) prohibits fraud in connection with the purchase and sale of any security. This provision applies whether or not the security is registered under the ’34 Act. The SEC adopted Rule 10(b)(5) to implement section 10(b). Together, these anti-fraud provisions are the basis for most litigation under the ’34 Act. These provisions make it unlawful to use most communication methods (such as the mail, internet, or wire) or any national securities exchange to defraud any person in connection with the purchase or sale of any security. Any party directly connected to the sale of securities is potentially liable; though there may be limits on the liability of certain professionals, such as auditors, bankers, accountants, etc. Rule 10(b)(5) allows for a cause of action by the SEC as well as private actions. Generally, Rule 10(b)(5) prohibits the following conduct in connection with the sale of a security:
• using any device, scheme, or other artifice to defraud purchasers;
⁃ Example: A device or scheme includes any sales or investment program, whether done in person or via distant communication, to defraud participants.
• making any untrue statement or failing to disclose any material fact that make the statement misleading; or
⁃ Example: This includes making false statements or failing to disclose relevant information in the process of selling or transferring a security.
• employing any practice that would deceive or defraud.
⁃ Note: This is a very broad, catch-all provision.
These prohibitions give rise to a potential cause of action for plaintiffs under Rule 10(b)(5), the elements of which are as follows:
• Deceit – A plaintiff must demonstrate deceit through the misrepresentation or omission of information. This must be done either intentionally or recklessly. Simple negligence is not enough to establish liability.
• Material Information – The information must be material to the purchaser of the security. That is, the information must be important to a potential investor in making the decision of whether or not to purchase the security. What is material information is interpreted very broadly and based on the individual situation of the company.
• Purchase of Sale of a Security – The information must directly related to the purchase or sale of a security. An individual who does not purchase or sell a security based upon the deceitful information cannot bring an action under this provision.
• Reliance on the Information – The actual purchaser must rely on the misrepresented information. Reliance is assumed if material information is omitted or broadly stated to the whole market.
• Cause Damages – The plaintiff must suffer some actual damages resulting from or caused by the omission or misrepresentation. This normally comes in the form of a diminution in the value of the shares purchased.
In summary, to recover under Rule 10(b)(5), a plaintiff, whether the SEC or a private plaintiff, must show that an individual trading in securities had an intent to deceive the purchaser. Intent to deceive may be inferred from a partial or untimely disclosure of important information.
• Discussion: How do you feel about the extensive liability or breadth of potential actions available under Section 10(b) or Rule 10(b)(5)? Do you think these provisions are overly broad? Why or why not?
• Practice Question: Bernie is the head of a new investment firm. His firm solicits money from investors and invests that money in short-term, high-risk securities. Bernie has been suffering substantial losses, but has been able to continue to pay investor returns from the funds invested by new investors. In order to attract new investors, he is falsifying much of the information on his investment returns. The DOJ gets word of his practices and begins an investigation. In the meantime, shareholders bring a civil action under Rule 10(b)(5) to recover their losses from Bernie. What elements will they have to demonstrate in Bernie’s conduct to find him liable?
What is “insider trading” under Rule 10(b)(5)?
Insider trading is the sale or purchase of securities by individuals privy to non-public, material information of a firm based upon her special relationship with the firm. Generally, anyone who has material, non-public information must either disclose that information prior to trading the securities or abstain from trading in the effected or related security. Normally, insiders include officers, directors, and professionals in fiduciary relationships with the firm. The negative aspect of insider trading is that it provides individuals an advantage over others in the sale or purchase of securities and undermines the integrity of the market and the confidence of those investing in securities. Section 10 of the ’34 Act has been broadly interpreted to prohibit the practice of trading securities based on material, non-public information received as an insider or from an insider of a company.
• Note: Trading securities on non-public information is most commonly addressed in 10(b)(5) actions. The SEC is charged with bringing civil actions under Rule 10(b)(5), while the Department of Justice is charged with bringing criminal actions against violators.
Elements of a 10(b)(5) Action
The insider or an individual receiving information from an insider is liable for trading securities based on the information. A “tippee” is a person who learns of nonpublic information from an insider. Upon receipt, this person is considered to be a legal, temporary insider. As a temporary insider, the tipee is subject to the prohibitions of Section 10(b) prohibiting the insider from trading securities based upon the inside information. The elements of a 10(b)(5) action are the same for criminal and civil actions and are as follows:
• Information – The insider must have material, non-public information.
⁃ Note: This type of information is generally the result of detailed knowledge of business performance or long-term plans that will affect the corporation’s value in the market if it were publicly known.
⁃ Example: I am a director on the board of ABC Corp. I receive a report that demonstrates that the corporation’s cost of production is going to drop dramatically in the near future due to a drop in materials cost. This information is not public and it will certain increase corporate profits.
• Fiduciary Duty – A core element of a 10(b)(5) action is the breach of a fiduciary duty. Insiders and third parties may have a fiduciary with regard to the material, non-public information.
⁃ Insiders – Corporate insiders have a fiduciary duty to the company.
⁃ Example: Corporate insiders who have a fiduciary duty include: board members, major shareholders, employees, and so-called temporary insiders, such as lawyers and investment bankers who are doing deals for the company.
⁃ Third Parties – A fiduciary duty exists for third parties in a personal relationship with an insider if:
⁃ the third party receives information and promises to keep the information secret;
⁃ the insider has a reasonable expectation that the recipient will not tell; or
⁃ the recipient has obtained the information from her spouse, parent, child or sibling.
• Trading and/or Misappropriation – Either the insider or third party may breach a fiduciary duty by trading on (i.e., using the information to make stock trades) or misappropriating the information.
⁃ Insiders (Tippers) – The insider breaches a fiduciary duty by trading on the information. Further, an insider misappropriates and breaches his fiduciary duty by transmitting information if:
⁃ he knows the information was confidential, and
⁃ he expected some personal gain.
⁃ Third Parties (Tippees) – Third parties misappropriate information obtained through a professional or personal relationship from an insider. Therefore, a third party violates a fiduciary duty to the rightful owner of the information by trading on the information if she knows:
⁃ the information is confidential,
⁃ that it was transmitted in breach of a fiduciary duty, and
⁃ the insider expected a personal gain from transmitting the information.
The idea of holding a third-party, recipient of material, non-public information liable for trading on that information is based on theory that the information is misappropriated from the rightful owners (shareholders). The third party has no duty to reveal the nonpublic information to the public, since she was not in a fiduciary position with respect to company. Trading on that information, however, is effectively breaching a duty owed to those shareholders to either disclose that information or refrain from trading. In summary, anyone who has material, non-public information must either disclose the information prior to trading the securities or abstain from trading in the effected or related security.
Examples of Insider Trading
ImClone case of 2001 – Martha Stewart sold around 4000 shares of a biopharmaceutical company, ImClone systems, after she received information from a broker at Merrill Lynch, whose name was Peter Bacanovic. The information was shared by the broker to Martha when the company was awaiting FDA’s decision on Erbitux, an anti-cancer. The information was that ImClone system’s CEO, Samuel Waksal, was selling all his shares of the company.
Shortly after selling of the shares by Martha, FDA rejected the drug application and the company’s shares fell by 16% in a day. Since Martha sold her shares earlier, she was saved from a loss of more than $45,000. Since the sale was made on a tip of the CEO selling his shared which was not public at that time, it was considered as insider trading and Martha was changed by SAE with obstruction of justice and securities fraud and insider trading in 2003.
Directors of companies are not the only people who have the potential to be convicted of insider trading. In 2003, Martha Stewart was charged by the SEC with obstruction of justice and securities fraud – including insider trading – for her part in the 2001 ImClone case. After a case in 2004, Martha’s charges were reduced to crime of obstruction of a proceeding, conspiracy and making false statements to federal investigators. She served five months as punishment in a federal corrections facilty.
Amazon Insider Trading Case – In September 2017, former Amazon.com Inc’s one of the financial analyst Brett Kennedy was charged with insider trading. Kennedy was believed to have provided information regarding the quarterly sales to Maziar Rezakhani before they were released to the public. Rezakhani made a profit of $115,977 as per SEC, by trading Amazon shared based on this information and paid $10,000 to Kennedy in return for the information.
• Discussion: How do you feel about holding a tippee of insider information liable under Section 10(b)? Is it fair to consider a tippee to be a temporary insider? Why or why not? Do you think the knowledge requirement for third parties is fair? Why or why not?
• Practice Question: Arnold is a director of ABC Corp. He is specifically involved in a committee that evaluates potential mergers and acquisitions. He becomes aware that a group of managers are considering a manager buyout that would allow the managers to purchase all corporate shares and make the company private (i.e., no longer publicly traded). This would ease the regulatory burdens of reporting to the SEC. Also, the buy-out will drive up the price of shares temporarily. What Arnold face liability if he purchased a large block of ABC shares based upon this knowledge? What if he provided this information to his brother-in-law who subsequently purchased a large block of shares?
What damages are available to a plaintiff under Section 10(b) and Rule 10(b)(5)?
While both the SEC and a private plaintiff may enforce the antifraud provisions of Section 10 and Rule 10(b)(5), only purchasers or sellers of securities may bring a private action for damages under Rule 10(b)(5). A private plaintiff in a suit under 10(b)(5) may recover for the actual damages suffered as a result of purchasing the security. As part of the action, a buyer must allege specific damages due to the seller’s fraud. The measure of damages is generally the difference between what is paid over the value of the security received. The measure of a defrauded seller’s damages is the difference between the fair value of all that the seller received and the fair value of what he or she would have received had there been no fraud. In an SEC action under 10(b)(5), the civil penalty for gaining illegal profits with nonpublic information is three times the profits gained. The statute of limitation is 5 years from the wrongful transaction.
• Note: A purchaser may also be entitled to receive consequential damages from the purchase of securities. Consequential damages include lost dividends, brokerage fees, and taxes. The court may also order payment of interest on funds. Punitive damages for the conduct are not available.
• Discussion: Why do you think the law allows for different calculations of damages for injured shareholders versus damages in actions by the SEC?
• Practice Question: ABC Corp issues securities last year. The shares sold for $10 each. The S-1 that they filed contained some materially incorrect information supplied by the CEO. Since that time, the shares have dropped to $5 each on the public market, which reflects the real value of the shares at the time of issuance. Amy is a shareholder who purchased 100,000 shares. She and the SEC are bringing an action against ABC under Rule 10(b)(5). What are the potential damages against ABC?
What is “insider trading” under Section 14 of the 1934 Act?
Rule 10(b)(5) is not the only securities law to target trading of securities by individuals with inside information. Rule 14(e)(3) is an insider tradition provision that applies specifically to corporate buyouts or takeovers. This provision prohibits anyone from trading on insider information if the trader knows that the information was obtained from either party to the proposed buyout. The information is effectively misappropriated from the companies. No fiduciary duty is required as in 10(b)(5) actions.
• Discussion: Why do you think the securities laws provide for a special cause of action for insider trading based upon information obtained about a corporate takeover or buyout?
• Practice Question: ABC Corp is in the midst of dealing with a proposed corporate buyout of ABC Corp by 123 Corp. Earl is a news reporter who learns from a low-level employee at ABC Corp that there are likely merger-acquisition talks happening. Earl seizes the opportunity to purchase a large block of ABC Corp and 123 Corp stock. The merger is likely to push up the share price of both entities. Is early potentially liable under the securities laws?
What is liability under “Section 16” of the 1934 Act?
Section 16 of the ’34 Act governs the sale or transfer of securities by “insiders” of the corporation. An insider is an officer, director, or large shareholder (holding 10% or more of outstanding securities). Insiders must generally register with the SEC an indicate their ownership interest at the time of filing the registration statement or within 2 days of becoming an insider (i.e., acquiring a large ownership of shares). Section 16 prohibits insiders from making “short-swing” profits by trading their shares within 6 months of the registration or acquiring the shares. There is an assumption that insiders have material, non-public information during this period. As such, any trades during this period are per se illegal. Any profits derived from the sale are forfeited to the corporation.
- Note: The SEC does not enforce the short-swing profit rule; rather, this rule is enforced through civil action by the company or shareholders.
- Discussion: Why do you think the securities laws absolutely prohibit insiders from earning short-swing profits from trading the business securities? Do you think that allowing for private civil actions for such profits is an effective manner of policing this practice? Why or why not?
- Practice Question: McKenzie is the Chief Operating Officer of ABC Corp. She recently acquired a large block of stock as part of her executive compensation. There is a rumor in the market that 123 Corp is interested in partnering with ABC Corp for an international joint venture. The speculation has pushed up the stock price. McKenzie is considering selling most of the stock she recently acquired, which will yield a handsome profit for her. Does she face potential civil liability for this action?
What is liability under “Section 18” of the 1934 Act?
Section 18 of the ’34 imposes liability on any person “who shall make or cause to be made any false and misleading statement of material fact in any application, report, or document filed under the act”. Section 18 is based upon a theory of fraud. Unlike under rule 10(b)(5), however, Section 18 applies only to the documents required to be filed under the ’34 Act. This includes annual, quarterly, and special reports. A plaintiff must prove that:
• the defendant knowingly made a false statement,
• the plaintiff relied on the false or misleading statement, and
• the plaintiff suffered damages as a result of that reliance.
Unlike the sections 11 and 12 of the 1933 Act, the defendant’s good faith in making the written statement is a defense. Further, unlike sections 11 and 12, the Section 18 plaintiff must prove reliance by the plaintiff shareholder on that information.
• Note: The statute of limitations for bringing a Section 18 action was extended under Sarbanes-Oxley Act to 5 years from the wrongful act, and within 2 years of discovery.
• Discussion: Why do you think that Section 18 provides a specific cause of action for material misstatements in a public disclosure document? How do you feel about the availability of a good faith defense? What about the requirement that the plaintiff prove reliance on the statement?
• Practice Question: ABC Corp issues a Form 10-K annual report containing numerous material errors in the financial information. The errors drastically misstate the asset holdings of the company. If a group of shareholders learn of the misstatement and decide to bring a lawsuit, what must the shareholders show to hold ABC Corp liable under Section 18?
What is criminal liability under the 1934 Act?
The ’34 Act provides for criminal sanctions for willful violations of its statutes or corresponding regulations. More specifically, it imposes liability for false, material misstatement in applications, reports, documents, and registration statements. Individuals face up to a 25-year sentence and business entities face fines of up to $25 million. Many professionals (accountants) have been found guilty for failure to disclose information. The common defense for this criminal charge is a lack of intent to deceive or defraud.
• Note: Most criminal prosecutions occur under Section 10(b) or Rule 10(b)(5).
• Discussion: How do you feel about the possibility of criminal liability for violation of the securities laws? Should these penalties be reserved for intentional deceit? Why or why not?