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Dynamic business law 4e kubasek 4e CH41

Chapter 41
Corporations: Securities and Investor Protection

Copyright © 2017 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.


• LO41-1: What is a security?
• LO41-2: What requirements are imposed by the Securities Act of 1933?
• LO41-3: How does the Securities Exchange Act of 1934 regulate the

trading of securities?
LO41-4: How are investment companies regulated?
LO41-5: How do states regulate securities?


Chapter 41 Hypothetical Case 1

As this chapter indicates, although the Securities and Exchange Commission (SEC) requires the registration of securities, the SEC does not
approve these securities. In other words, the SEC does not make any judgment about the worth of securities. Instead, it simply enforces the
requirement that issuers provide certain information to potential buyers, including: (1) a description of the securities offered for sale; (2) an
explanation of how proceeds from the sale of the securities will be used; (3) a description of the registrant's business and properties; (4)
information about the management of the company; (5) a description of any pending lawsuits in which the registrant is involved; and (6)
financial statements certified by an independent public accountant.

As the federal administrative agency with primary responsibility for regulating the United States securities market, should the Securities
and Exchange Commission formulate a judgment regarding the worth of soon-to-be-issued securities and inform potential investors of that
judgment? Does the SEC have an ethical obligation to potential investors to make and publicize such valuation judgments?


Chapter 41 Hypothetical Case 2

Thomas Abramson is a quality control manager for Capitol-IZE Pharmaceutical Company, Inc. The company is headquartered and
has its principal production facility in Indianapolis, Indiana. For several years, Capitol-IZE Pharmaceutical has been engaged in the
research and development of a new cancer drug, Izerion. As part of the federal regulatory procedure for mass-marketing a new
drug, Capitol-IZE Pharmaceutical applied to the Food and Drug Administration (FDA) for final approval of Izerion.

Yesterday, Abramson's supervisor informed him in somber fashion that the FDA had rejected the company's application for final
approval of Izerion. Apparently, the FDA was concerned about serious side effects that manifested during the drug's clinical trials.
Abramson's supervisor further advised him that next Monday Capitol-IZE Pharmaceutical is scheduled to go public with a press
release concerning the FDA's rejection of Izerion.


Chapter 41 Hypothetical Case 2 (cont'd)

Abramson is frantic. He owns approximately 6,000 shares of Capitol-IZE Pharmaceutical stock, and he knows that news of the FDA's rejection of
Izerion will be disastrous to the company, its employees, and its shareholders. Capitol-IZE Pharmaceutical stock is currently valued at $47.50 per
share, and news of the FDA's disapproval of Izerion will likely drive the stock down to one-half of its current value.

Abramson quickly runs the numbers on his calculator. A reduction of 50% of the stock's value would represent a personal loss of $142,500.
Abramson's Capitol-IZE Pharmaceutical stock is his only retirement plan, aside from a modest pension he will receive from the company (assuming
the company survives the announcement).

Abramson has a plan. Today, he will instruct his financial planner to immediately sell all 6,000 shares of his Capitol-IZE Pharmaceutical Company, Inc.
stock. Abramson rationalizes his decision by assuring himself that anyone else in his position would do the same thing.

Is Thomas Abramson's plan legal? Is it ethical?


Securities and the SEC

• Security: Investment in a common enterprise with the reasonable

expectation of profit gained predominantly from others' efforts
Securities and Exchange Commission: Created in 1934 to:

• Enforce securities laws
• Interpret provisions of securities acts
• Regulate the trade of securities
• Regulate the activities of securities brokers, dealers, and advisers


Expansion of SEC Powers in the 1990s

• Securities Enforcement Remedies and Penny Stock Reform Act of 1990
• Market Reform Act of 1990
• Securities Acts Amendments of 1990
• National Securities Markets Improvement Act of 1996
• Sarbanes-Oxley Act of 2002


Securities Act of 1933 Requirements:
Registration Statement

Securities Act of 1933: Passed to legitimize security transactions by requiring
registration of securities
Registration statement is document containing:

Description of securities offered
Explanation of how proceeds from sale will be used
Description of registrant's business and properties
Information about management of company
Description of pending lawsuits
Certified financial statements


Securities Act of 1933: Terminology, Rules, and Procedures

Prospectus: Written document similar to registration statement, used as a selling tool to attract potential investors
Periods of the registration statement and prospectus filing process:

Prefiling period
Waiting period
Posteffective period

Exempt transactions: Securities exempt from standard SEC registration requirements
Limited offers: Involve small amounts of money, or are offered only to sophisticated investors

Private placement exemption: Exempts private offerings of securities
Rule 505: States that private offerings may not exceed $5 million in a 12-month period, and firms do not have to believe that investors have a reasonable ability to
evaluate risk

Rule 504: Exempts noninvestment firms that offer no more that $1 million in securities in a 12-month period
Section 4(6): Exempts securities offered only to accredited investors for amount less than $5 million


Securities Act of 1933: Terminology, Rules, and Procedures

Intrastate issues: Exempt local investors in local businesses
Resales of securities: Exempt transactions by any person other than an issuer, underwriter,
or dealer

Restricted securities: Securities acquired under Rule 505, 506, or Section 4(6) that must be
registered for resale, unless investor follows Rule 144 or 144(a)

Violations may result in:

Administrative action
Injunctive action
Criminal prosecution

Securities Exchange Act of 1934

• Section 10(b): Prohibits use of manipulative and deceptive devices to bypass SEC

• Insider trading: Trading in which company employee or executive uses material
inside information to make profit

• Misappropriation theory: Individual who wrongly acquires and uses inside
information for profit is liable for insider trading


Securities Exchange Act of 1934: Terms, Rules, and Procedures

Tipper/tippee theory: Individual who receives material inside information as a result of
insider's breach of duty is guilty of insider trading

Statutory insiders: Certain stockholders, executive officers, and directors who must file
reports detailing their ownership and trading of the corporation's securities

Short-swing profits: Profits made from sale of company stock within any six-month period
by statutory insider; per Section 16(b), these profits must be returned to company


Securities Exchange Act of 1934: Terms, Rules, and Procedures

Proxy: Document that authorizes an individual to vote shareholder's share of stocks at a
shareholders' meeting

Proxy solicitation: Process of obtaining authority to vote on behalf of shareholder
Violations of Securities Exchange Act of 1934 may result in:

Criminal penalties
Civil penalties
Suits against those involved in insider trading under Insider Trading Sanctions Act of 1984


State Securities Regulation

• Blue-sky laws: Regulate the offering and sale of securities within the state

• Some laws exempt from federal securities regulation may be subject to
state laws

• Often similar to federal securities laws
• Uniform Securities Act: Most states have adopted


Chapter 41 Hypothetical Case 3

Although the Securities and Exchange Commission has existed as a federal administrative agency for over 70 years (the
Commission was created in 1934), some critics question the need for its continued existence, or alternatively argue for
significant deregulation of stock trades. According to critics, there is arguably no need for significant federal regulation of
publicly-traded securities, since market conditions dictate legitimacy and honesty in securities transactions; after all, for how
long could a corporation exist if it does not strive to ensure the integrity of its stock?

How do you respond to this line of reasoning, that the free market will dictate fair and honest stock trades? In your answer,
consider the history and mission of the Securities and Exchange Commission.

Reference: About the SEC: What We Do


Chapter 41 Hypothetical Case 4

A new tech start-up, Tolumetrix, is planning to go public in an initial public offering (IPO). One of the company's executives, Richard Columbus, is
charged with preparing the company's registration statement and prospectus, which are required.

Columbus is unfamiliar with the process of creating and filing these documents and with securities in general; a programmer by trade, he is new to
the entire process of running a successful company. He decides to use the documents provided by a similar company as a template.

Columbus files the forms to the SEC and immediately begins making oral offers to sell the company's stock. He sends a copy of the prospectus
identical to the one that has been submitted to the SEC. He does not send a follow-up version of the prospectus after many changes are requested
and made and the final approval has come from the SEC.

Has Columbus—and Tolumetrix—violated the 1933 Securities Act? Explain your answer.


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