Securities

The Securities Exchange Act of 1934 addresses many areas of securities law. Issuers, subject to certain exemptions, must register with the SEC if they have a security traded on a national exchange. This requirement should not be confused with the registration of an offering under the 1933 act; the two laws are distinct. Securities registered under the 1933 act for a public offering may also have to be registered under the 1934 act.

To provide the public with adequate information about companies with publicly traded stocks, issuers of securities registered under the 1934 act must file various reports with the SEC. Since 1964 this disclosure requirement has applied not only to companies with securities listed on national securities exchanges but also to companies with more than 500 shareholders and more than $5 million in assets. False or misleading statements in any documents required under the 1934 act may result in liability to persons who buy or sell securities in reliance on these statements.

Under the 1934 act, the SEC may revoke or suspend the registration of a security if after notice and opportunity for hearing it determines that the issuer has violated the 1934 act or any rules or regulations promulgated thereunder. Moreover, the 1934 act authorizes the SEC to suspend trading in any security for not more than ten days, or, with the approval of the president, to suspend trading in all securities for not more than 90 days, or to take other measures to address a major market disturbance.

Proxy Solicitation The 1934 act also regulates proxy solicitation, which is information that must be given to a corporation's shareholders as a prerequisite to soliciting votes. Prior to every shareholder meeting, a registered company must provide each stockholder with a proxy statement containing certain specified material, along with a form of proxy on which the security holder may indicate approval or dis-approval of each proposal expected to be presented at the meeting. For securities registered in the names of brokers, banks, or other nominees, a company must inquire into the beneficial ownership of the securities and furnish sufficient copies of the proxy statement for distribution to all the beneficial owners.

Copies of the proxy statement and form of proxy must be filed with the SEC when they are first mailed to security holders. Under certain circumstances preliminary copies must be filed ten days before mailing. Although a proxy statement does not become "effective" in the same way as a statement registered under the 1933 act, the SEC may comment on and require changes in the proxy statement before mailing. Proxies for an annual meeting calling for election of directors must include a report containing financial statements covering the previous two fiscal years. Special rules apply when a contest for election or removal of directors is scheduled.

A security holder owning at least $1,000, or one percent, of a corporation's securities may present a proposal for action via the proxy statement. Upon a shareholder's timely notice to the corporation, a statement of explanation is included with the proxy statement. Security holders will have an opportunity to vote on the proposal on the proxy form. The device is unpopular with management, but shareholders have used this provision to change or challenge management compensation, the conduct of annual meetings, shareholder VOTING RIGHTS, and issues involving discrimination and pollution in company operations.

A company that distributes a misleading proxy statement to its shareholders may incur liability to any person who purchases or sells its securities based on the misleading statement. The U.S. Supreme Court has held that an omitted fact is material if a "substantial likelihood" exists that a reasonable shareholder would consider the information important in deciding how to vote. Mere NEGLIGENCE is sufficient to permit recovery; no evil motive or reckless disregard need be shown. Oftentimes, an appropriate remedy might be a preliminary injunction requiring circulation of corrected materials; it may not be feasible to rescind a tainted transaction after voting. Courts have, however, sometimes ordered a new election of directors, but such action must be in the best interests of all shareholders.

Takeover Bids and Tender Offers Since the 1960s, increasing numbers of takeover bids and tender offers have resulted in bitter contests between the aggressor and the target of the bid. A corporate or individual aggressor might attempt to acquire controlling stock in a publicly held corporation in a number of ways: by buying it outright for cash, by issuing its own securities in exchange, or by a combination of both methods. Stock may be acquired in private transactions, by purchases through brokers in the open market, or by making a public offer to shareholders to tender their shares either for a fixed cash price or for a package of securities from the corporation making the offer.

Takeover bids that involve a public offer for securities of the aggressor company in exchange for shares of the targeted company require that the securities be registered under the 1933 act and that a prospectus be delivered to solicited shareholders. For many years, however, cash tender offers had no SEC filing requirements. The WILLIAMS ACT of 1968, 15 U.S.C.A. §§ 78l, 78m, 78n, amended many sections of the 1934 act to address problems with tender offers. Although most litigation under the Williams Act is between contending parties, courts generally focus on whether the relief sought serves to protect public stockholders.

Pursuant to the Williams Act, any person or group who takes ownership of more than 5 percent of any class of specific registered securities must file a statement within ten days with the issuer of the securities, as well as with the SEC. Required information includes the background of the person or group; the source of funds used and the purpose of the acquisition; the number of shares owned; and any relevant contracts, arrangements, or understandings. The issue of whether an acquisition has taken place, thereby triggering the filing requirement, has been the subject of litigation. Courts have disagreed on this issue when confronted with a group of shareholders who in the aggregate own more than 5 percent and who agree to act together for the purpose of affecting control of the company but who do not act to acquire any more shares.

Restrictions also apply to persons making a tender offer that would result in ownership of more than 5 percent of a class of registered securities. Such a person must first file with the SEC and furnish to each offeree a statement similar to that required of a person who has obtained more than 5 percent of registered stock. A tender offer must be held open for 20 days; a change in the terms holds an offer open at least ten more days. In addition, the offer must be made to all holders of the class of securities sought, and a uniform price must be paid to all tendering shareholders. A shareholder may withdraw tendered shares at any time while the tender offer remains open. Moreover, if the person making the offer seeks fewer than all outstanding shares and the response is oversubscribed, shares will be taken up on a pro rata basis.

The 1934 act also requires every person who directly or indirectly owns more than 10 percent of a class of registered equity securities, and every officer and director of every company with a class of equity securities registered under that section, to file a report with the SEC at the time he acquires the status, and at the end of any month in which he acquires or disposes of these securities. This provision is designed to prevent "short-swing" profits, earned when an individual with inside information engages in short-term trading.

Antifraud Provisions One impetus for enactment of the 1934 act was the damage caused by "pools," which were a device used to run up the prices of securities on an exchange. The pool would engage in a series of well-timed transactions, designed solely to manipulate the market price of a security. Once prices were high, the members of the pool unloaded their holdings just before the price dropped. The 1934 act contains specific provisions prohibiting a variety of manipulative activities with respect to exchange-listed securities. It also contains a catchall section giving the SEC the power to promulgate rules to prohibit any "manipulative or deceptive device or contrivance" with respect to any security. Although isolated instances of manipulation still exist, the provisions manage to prevent widespread problems.

Section 10(b) of the 1934 act contains a broadly worded provision permitting the SEC to promulgate rules and regulations to protect the public and investors by prohibiting manipulative or deceptive devices or contrivances via the mails or other means of interstate commerce. The SEC has promulgated a rule, known as rule 10b-5, that has been invoked in countless SEC proceedings. The rule states:

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

In the 1960s and early 1970s, the courts broadly interpreted rule 10b-5. For example, the rule was applied to impose liability for negligent misrepresentations and for breach of fiduciary duty by corporate management and to hold directors, lawyers, accountants, and underwriters liable for their failure to prevent wrongdoing by others. Beginning in 1975, the U.S. Supreme Court sharply curtailed this broad reading. Doubt exists as to the continued viability of the decisions in some of the prior cases. Nevertheless, although rule 10b-5 does not address civil liability for a violation, since 1946 courts have recognized an implied private right of action in rule 10b-5 cases, and the Supreme Court has acknowledged this implied right (Superintendent v. Bankers Life, 404 U.S. 6, 30 L. Ed. 2d 128, 92 S. Ct. 165 [1971]).

Rule 10b-5 applies to any purchase or sale, by any person, of any security. There are no exemptions: it applies to registered or unregistered securities, publicly held or closely held companies, and any kind of entity that issues securities, including federal, state, and local government securities.

Clauses 1 and 3 of rule 10b-5 use the terms fraud and deceit. Fraud or deceit must occur "in connection with" a purchase or sale but need not relate to the terms of the transaction. For example, in Superintendent v. Bankers Life, the U.S. Supreme Court found a violation of rule 10b-5 when a group obtained control of an insurance company, then sold certain securities and misappropriated the proceeds for their own benefit. In another case a publicly held corporation made misstatements in a press release. Even though the company was not engaged at that time in buying or selling its own shares, a U.S. court of appeals ruled that the statements were made "in connection with" purchases and sales being made by shareholders on the open market.

Insider Trading Rule 10b-5 protects against insider trading, which is a purchase or sale by a person or persons with access to information not available to those with whom they deal or to traders generally. Originally, the prohibition against insider trading dealt with purchases by corporations or their officers without disclosure of material, favorable corporate information. Beginning in the early 1960s, the SEC broadened the scope of the rule. The rule now operates as a general prohibition against any trading on inside information in anonymous stock exchange transactions, in addition to traditional face-to-face proceedings. For example, in In re Cady, Roberts & Co., 40 S.E.C. 907 (1961), a partner in a brokerage firm learned from the director of a corporation that it intended to cut its dividend. Before the news was generally disseminated, the BROKER placed orders to sell the stock of some of his customers. In another case officers and employees of an oil company made large purchases of company stock after learning that exploratory drilling on some company property looked extremely promising (SEC v. Texas Gulf Sulphur, 401 F. 2d 833 [2d Cir. 1968]). In these cases the persons who made the transactions, or persons who passed information to those individuals, were found to have violated rule 10b-5.

However, not every instance of financial unfairness rises to the level of fraudulent activity under rule 10b-5. In Chiarella v. United States, 445 U.S. 222, 100 S. Ct. 1108, 63 L. Ed. 2d 348 (1980), Vincent F. Chiarella, an employee of a financial printing firm, worked on some documents relating to contemplated tender offers. He ascertained the identity of the targeted companies, purchased stock in those companies, and then sold the stock at a profit once the tender offers were announced. The Supreme Court overturned Chiarella's criminal conviction for violating rule 10b-5, ruling that an allegation of fraud cannot be supported absent a duty to speak and that duty must arise from a relationship of "trust and confidence between the parties to a transaction." However, following Chiarella, criminal convictions of lawyers, printers, stockbrokers, and others have been upheld by courts that have ruled that these employees traded on confidential information that was "misappropriated" from their employers, an issue that was not raised in Chiarella. Moreover, courts have also ruled that the person who passes inside information to another person who then uses it for a transaction is as culpable as the person who uses it for his or her own account.

The test for materiality in a rule 10b-5 insider information case is whether the information is the kind that might affect the judgment of reasonable investors, both of a conservative and speculative bent. Furthermore, an insider may not act the moment a company makes a public announcement but must wait until the news could reasonably have been disseminated.

The Insider Trading Sanctions Act of 1984 (Pub. L. No. 98-376, 98 Stat. 1264) and the Insider Trading and Security Fraud Enforcement Act of 1988 (15 U.S.C.A. §§ 78u-1, 806-4a, and 78t-1) amended the 1934 act to permit the SEC to seek a civil penalty of three times the amount of profit gained from the illegal transaction or the loss avoided by it. The penalty may be imposed on the actual violator, as well as on the person who "controlled" the violator—generally the employing firm. A whistle-blower may receive up to 10 percent of any civil liability penalty recovered by the SEC. The maximum criminal penalties were increased from $100,000 to $1 million for individuals and from $500,000 to $2.5 million for business or legal entities.