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Overview of the Securities Laws

What are the Securities Laws?

A combination of federal (primarily) and state laws and regulations governing and regulating the purchase and sale of securities, the people who buy and sell them, the places they are bought and sold, and (more and more) the people who manage, direct and advise enterprises that buy, sell or issue securities
In short, just about everyone with some connection with securities

The Principal Securities Laws

Securities Act of 1933 Securities Exchange Act of 1934 The Investment Company Act of 1940 The Investment Advisers Act of 1940

Focus on:
Securities Act of 1933 (Securities Act or 33 Act) Securities Exchange Act of 1934 (Exchange Act or 34 Act)

Overview of 33 & 34 Acts

Two Approaches to Regulation of Sales of Securities

Merit regulation Disclosure

Securities Act of 1933

Regulation by disclosure: Sunshine is said to be the best of disinfectants - Louis Brandeis Full and fair disclosure will separate good from bad investments Requires registration of sales of securities with SEC before sale

Common Transactions (Situations) Faced by All Commercial Lawyers

Do the securities laws apply?
i.e., is this thing a security?

Business formation Business separation (bust ups) Controlling and using material undisclosed information Private tender offers The contested transaction Insider trading

What is a Security?

Statutory Definitions
Securities Act, 2(a)(1) Exchange Act, 3(a)(10)

Covers All the Accepted Forms of Investment

Stock Bond Debenture Option Note

None Presents Interpretive Issues - Really?

Stock is always Stock (except when its something else) Not all Notes are equal (at least in terms of securities regulation) More on these later...

Thats a Security?
Unconventional, new and often novel investments can come within the definition of security Examples: chinchilla ranches earthworm farms whiskey warehouse receipts condominium rental pools

SEC v. Howey
Leading Case on Investment Contract Analysis

Elements of an Investment Contract (Howey)

Investment of money in a common enterprise with an expectation of profits solely from the efforts of others

Formation/Termination of Business Relationships

Owning and operating an apartment building
A (an individual) owns and operates the building
as a sole proprietorship through a corporation wholly-owned by him through a single person LLC

A and B (individuals) own and operate the building

jointly as co-owners of the building through a corporation in which each owns 50% of the shares through a general partnership formed by A and B through a limited partnership in which A is the general partner and B is the limited partner through a member-managed LLC, jointly-owned by A and B through a LLC in which A is the sole manager and A and B are members

General Partnership Interests, Limited Partnership Interests and LLC Interests

General Partnership Interests: Generally not a security Limited Partnership Interests: Generally a security LLC Interests: Depends

Definition of Security: Summary

If the instrument is on the 2(a)(1) or 3(a)(10) list, generally the securities laws apply If the instrument is not on the list, Howey applies The presence or absence of a regulatory scheme outside the securities laws can be critical If it walks like a duck and quacks like a duck, it probably is a duck (author unknown) or I know pornography when I see it (Potter Stewart) When in doubt, assume the securities laws apply

The Producers
A Securities Law Lesson

Max Bialystock: A Producer Leo Blum: An Accountant & Producer Hold Me, Touch Me et al : The Investors

The Investment : Springtime for Hitler

The worst possible play Perfectly awful actors A terrible director

Investment Purpose
For the Producers: Open and close the same day For the Investors: Companionship

Investment Result
Play is Smash Hit

Result for the Producers


Were any Securities Laws Broken?

33Act: Sections 5 & 12 34 Act: Section 10(b) & Rule 10b-5

Registration of Securities
Every Sale of a Security Must Be Registered Under the 33 Act Unless the Security is an Exempt Security or it is Sold in an Exempt Transaction

What Does It Mean to Register Securities?

Registration is a process by which an issuer (registrant) files with the SEC a disclosure document which is used in connection with the sale of securities in the transaction described in the disclosure document Disclosure document: Registration Statement, of which a Prospectus is a substantial part

Section 5(a), (c)

Unless a registration statement is in shall be unlawfulto sell [a] security. Sec. 5(a)(1) It shall be unlawfulto offer to sell or offer to buyany security, unless a registration statement has been filed as to such security. Sec. 5(c)

Two Concepts
What is an offer? What is a sale?

Offer: Section 2(a)(3)

Key points:
definition is broad, but not inclusive covers attempts to dispose
presumably, broader than offer

Sale: Section 2(a)(3)

The term sale or sell shall include every contract of sale or disposition of a security or interest in a security, for value.

Securities Exchange Act of 1934

Registration & Reporting

Part of Integrated Disclosure System

Begins with 33 Act registration 34 Act registration and reporting focus: trading of securities

Goals of 33 Act and 34 Act Are Similar

Transparency: Mandatory disclosure of material information Consistency: Apply same disclosure standards and rules for 33 Act registration and 34 Act reporting
Regulation S-K (non-financial information) Regulation S-X (form & content of financial statements)

What is 34 Act Registration?

Under both 33 Act & 34 Act securities are registered.But Under 33 Act, transactions are registered Under 34 Act, issuers are registered

Effect of 34 Act Registration

Company subject to periodic reporting
10-K Annual Report 10-Q Quarterly Report 8-K Report of Unscheduled Events

Effect (contd)
Most reporting companies required to solicit proxies/consents under Section 14 Most reporting companies executive officers and directors report sales and purchases under Section 16

CEO & CFO certification of financial statements, disclosure controls and internal controls
Company & bidders for company are subject to tender offer rules under Sections 13(d) & 14(d)

Integrated Disclosure System: Summary

Form 8-K Form 10-K Form 10-Q

Regulation S-K Regulation S-X

Form S-1 Form S-3

Schedule 14A (Proxy Statement)

Regulation of the Securities Business

Regulation of Markets, BrokerDealers and Issuers

Two Types of Stock Markets

Exchange markets Over-the Counter markets


"Specialists" Member Member

Customers Customers

OTC Trading





NYSE (Listed Companies)

Initial and continuing listing requirements Governance regulation

Regulation of Securities Markets

Multi-layered regulation Hierarchy:
SEC Exchange rules, bylaws, etc.

SEC Regulation
Registration required Oversight
Approval of rules

Power to suspend, expel or discipline

An Exchange as an SRO
Adopt and enforce rules and requirements for membership trading activities listing requirements for securities discipline and suspension

Regulation of Broker-Dealers
Who regulates?
Exchanges NASD (Now FINRA) SEC

Regulation by SEC
Registration Membership in NASD Direct regulation
Sec. 15 and applicable rules: Regulation of trading activities Regulation of financial strength (net capital rule) and provision of credit (margin rules)

Regulation of Listed Companies

Listing requirements: Qualitative and quantitative
Initial and continuing requirements

Listing Requirements and Governance

SRO rules must be pre-approved by SEC Some rule address internal operations (governance) of listed companies
Shareholder vote required for certain transactions Restrictions on creation of disparate voting rights

Sarbanes-Oxley and Listed Companies

SOX calls for Adoption of rules by SEC Directives to SROs to adopt conforming rules

Rules Impact on Corporate Governance

Audit Committee Most Affected
All committee members must be independent Direct retention and supervision of auditor Financial literacy requirements Designation of audit committee financial expert

Proxy Regulation
14(a) of 34 Act empowers SEC to adopt and enforce rules governing the solicitation of proxies for use at any shareholder meeting of public companies
SEC has adopted rules governing the entire proxy solicitation process
From setting the record date to the final count

Rules are in addition to state law requirements

Do not replace state law requirements

Schedule 14A: Required contents of proxy statements

Voting instructions Information about directors and officers
Who they are and whats their background

Executive compensation
Detailed compensation disclosure, particularly for CEO, CFO & top three most highly compensated (NEOS)
CD&A (compensation disclosure & analysis) Compensation committee report

Corporate governance
Principal committees & who is on them
Current spotlight on Audit & Compensation Committees

Leadership structure
Separation of CEO and Chairman Lead director & his/her role

Code of ethics

Related party transactions

Parties and policies

Securities ownership
Directors, officers and 5% owners All directors and officers as a group

Description & reasons for proposals (other than election of directors) Say on pay
At least once in three years shareholders are asked for advisory vote on compensation for NEOS

Shareholder Proposals & Rule 14a-8

Shareholders have two methods of making proposals to management (directors):
Present proposal at shareholders meeting in accordance with the corporations governing documents
May be limited or burdened by advance notice requirements (see MBCA 404(2)) and cost of soliciting proxies

Ask for proposal to be included in managements proxy statement

Including opportunity to vote on managements card


What is a shareholder proposal covered by Rule 14a-8?

Recommendation or requirement that board take specified action
Can be binding or nonbinding (precatory)

Who submits shareholder proposals?

Individual activist shareholders Certain institutional shareholders
Labor unions, public employee retirement systems, etc.

Special interest shareholders

Religious & social responsible investors

Company must include shareholder proposal unless

It doesnt meet the procedural requirements of Rule 14a-8, or The proposal falls within one or more grounds in Rule 14a-8 to exclude it

Procedural requirements
Share ownership
At least $2,000 in market value of securities Held for at least 1 year And will continue to be held through the date of the shareholders meeting

Must be submitted at least 120 days prior to date last years proxy materials were sent out by company
Ex: 3/22/12 materials sent for 4/3/12 annual meeting, then shareholder proposal for 2013 annual meeting was due 11/23/12

Only one proposal allowed Length of proposal (including title, proposal and supporting statement) cannot exceed 500 words


Substantive grounds to exclude: Rule 14a8(i)(1)-(13)

Most common grounds relied on
Relates to ordinary business operations of the company Conflicts with managements own proposal Proposal has been substantially implemented Proposal is not a proper basis for shareholder action If implemented, proposal would cause corporation to violate state, federal or foreign law Corporation lacks authority to implement the proposal

What does corporation do if it believes there are grounds to exclude?

If defect is procedural, proponent gets 14 days to cure and resubmit If defect is believed to be substantive, it can
Seek concurrence from SEC
So called no action letter

Pursue declaratory judgment in court

Shareholder nominations for directors

Rule proposed by SEC declared invalid Amended Rule 14a-8 to permit proposals that merely request that management adopt procedures to allow direct nominations by shareholders.

Exempt Transactions
Private Placements & Reg. D

Section 4: Exempt Transactions

Section 4(2): Private offering exemption Section 4(1): Resale of securities


Section 28: Broad Exemption Authority

SEC can exempt any person, security or transaction from any provision of the 33 Act


Private Placements: Section 4(2)

Section 4(2) exempts transactions by an issuer not involving a public offering


Statutory Elements
transactions by an issuer: doesnt include resales or secondary offerings
not involving a public offering: What is a public offering? Where defined?


S.E.C. v. Ralston Purina Co., 346 U.S. 119 (1953)

Seminal case of the 4(2) exemption Section 4(2) exemption should turn on whether the particular class of persons affected needs the protection of the [33] Act.


Criteria for Exemption: Early Administrative Position

Number of offerees Availability of information Access to information Nature of offerees Manner of offering


Applying the Five Factors

Alternative 1: Issuer sells to 10 random Wall Street investors Alternative 2: Issuer sells $500,000 of securities to 1,000 random Wall Street investors Alternative 3: Issuer sells $200 million of securities to 5 of its Vice Presidents Alternative 4: Issuer sells $2 million of securities to 100 employees


Cases and SEC Interpretations following Ralston Purina added following criteria
Offeree qualification (sophistication & ability to assume risk) Availability of information Manner of offering Absence of redistribution (restrictions on transfer)

Regulation D: What is it?

Safe harbor (nonexclusive means of 4(2) compliance)

Separates offerings by Size (small, medium and large) Number of participants Information to be supplied Nature (sophistication & wealth) of participants

Regulation D: General Matters

Exemption is from Sec. 5 registration requirements only Not exempt from antifraud, civil liability or other provisions of securities laws Reg D is a safe harbor Not exclusive; Sec. 4(2) still available Attempted compliance is not an election

Reg D Offerings Differentiated By:

Rule 504: Up to $1,000,000 Rule 505: Up to $5,000,000 Rule 506: No dollar limitation

Number of Investors
Rule 504: Unlimited Rule 505 & Rule 506: 35 plus unlimited accrediteds

Investor Qualification
Rule 504 & Rule 505: None Rule 506: Nonaccrediteds must be sophisticated, alone or with investor representative

Information Requirements
Rule 504: None specified Rule 505 & Rule 506: None required for accrediteds; specified financial and nonfinancial information for nonaccrediteds

Reg. D Offerings: Summary

Rule 504
Up to $1 million of securities No limit on number of investors No investor qualifications required No information requirements (but fraud rules apply)

Rule 505
Up to $5 million of securities 35 nonaccrediteds plus unlimited accrediteds

Reg. D Offerings: Summary

Non accrediteds or representative must be sophisticated Specified (sometimes extensive) information to nonaccrediteds; nothing required for accrediteds

Rule 506
No dollar limit 35 nonaccrediteds plus unlimited accrediteds Specified info. for nonaccrediteds only

Securities Resales (Secondary Trading)

Section 4(1) of 33 Act exempts from registration requirement transactions by any seller who is not an issuer, underwriter or dealer
Basic exemption that allows hundreds of millions of shares to change hands daily on stock exchanges.

What are restricted securities?

Rule 144(a)(3)
securities acquired directly from the issuer or an affiliate other than pursuant to a registration statement Securities acquired from the issuer subject to resale restrictions under Rule 502(d)

Rule 144 Safe Harbor for Resale of Securities

Applies to both restricted and affiliate (control) shares

Rule 144 Requirements

Current public information Minimum holding period for restricted stock Limitation on amount sold Manner of sale Notice of sale

Civil Liabilities 34 Act

Rule 14a-9 & Rule 10b-5


Rule 14a-9 Elements

Misrepresentation or omission of material fact in proxy materials relating to a shareholders meeting


Rule 10b-5 Elements

device, scheme or artifice to defraud, or misrepresentation/omission of material fact, or act, practice, or course of business which is fraudulent or deceitful, in connection with the purchase or sale of any security

Who can sue?

What do the Rules say?


Implied Private Right of Action

In adopting the statute, did Congress intend there to be a private right of action?

Kardon v. National Gypsum (1946)

Violation of statute creates a private right of action if statute was intended to protect individual interests, and the individuals interest is one which the statute was designed to protect

Based on Restatement of Torts


J. I. Case v. Borak (1964)

Expansive view of legislative intent One of chief purposes of 14(a) was the protection of investors
surely Congress didnt intend to leave them without a remedy


Cort v. Ash (1975

Putting the brakes on Borak Four step inquiry:
Is plaintiff within the class of persons protected Is there legislative intent to create a private remedy Is a private remedy consistent with statutory scheme Is area traditionally one for state regulation

Common Law Elements

Materiality Causation Reliance Scienter (state of mind)


Rule 10b-5: Elements of the Cause of Action

Key Elements:
Materiality Standing Scienter (state of mind) Reliance Causation


TSC v. Northway formulation
An omitted fact is material if there is a substantial likelihood a reasonable investor would consider it important in deciding how to vote Would the omitted information altered the total mix of information that was available?

Basic v. Levinson
When does a future fact become material?

Basic Formulation
Balance the probability a future event will occur against the impact of it occurring Sliding scale test
the bigger the impact, even a low probability of occurrence can lead to a materiality conclusion same event and probability can lead to different materiality conclusions for different parties

Standing: in connection with the purchase or sale:

Rule 10b-5 addresses acts or conduct in connection with the purchase or sale of a security Purchaser/seller requirement
Limits plaintiffs to actual purchasers and sellers What if fraud persuaded plaintiff not to buy or continue to hold?
Birnbaum v. Newport Steel Co., 193 F.2d 401 (2d Cir. 1952) Blue Chip Stamps, p.493


In connection with requirement

Some connection (causation) between alleged wrongful act and a securities transaction Ex: Broker liquidates securities in discretionary account. Later, and independent of prior act, broker misappropriates (steals) clients funds.
Result: 10b-5 doesnt apply

Ex: Broker decides to steal clients funds and does it by liquidating the account and taking the proceeds.
Result: 10b-5 applies. SEC v. Zandford, p.497, n. 5

Rule 10b-5 & Scienter (state of mind)

Early cases ranged from negligence to specific intent to defraud Two important cases:
Santa Fe Industries v. Green: deceit or manipulation required; mismanagement not enough Ernst & Ernst v. Hochfelder: Scienter required


What Scienter is Required?

Negligence is not enough Recklessness is probably enough
But Supreme Court hasnt had the final word.


What is Reckless?
Highly unreasonable conduct Extreme departure from ordinary conduct Tantamount to intent to defraud


Scienter Applied: Historical Facts vs. Forward Looking Statements

Historical facts: Standard is recklessness Forward looking statements: Plaintiff must show actual knowledge of false projection


Rule 10b-5 & Reliance/Causation

Reliance a required element, both at common law & under Rule 10b-5
Requires showing that the offending statement played a significant part in the decision to purchase/sell But how does plaintiff show reliance on an absence of information (omission to speak)?

Cant say plaintiff bought or sold on the basis of what he/she wasnt told

But can say that a reasonable investor would have considered the omitted information to be important. Affiliated Ute Citizens v. United States, 406 U.S. 128 (1972) p. 483, n.9

Reliance and class actions: When transactions arent face-to-face (maybe company isnt even a purchaser or seller), how do multiple plaintiffs (maybe thousands) show reliance?
Basic v. Levinson, p. 524 In class actions, reliance will be presumed if the misleading statements (misrepresentations or omissions) are material
A rebuttable presumption, however

Fraud on the Market

Premise: An efficient market reflects (values) all known information about a company - the good, the bad and the ugly Material misrepresentations and omissions distort information and therefor distort the value of the traded shares.


What does this have to do with reliance/causation?

A market purchaser/seller is entitled to rely on the market price as fairly pricing the shares, and When material information is misrepresented or omitted, mispricing occurs with consequent loss to purchasers/sellers A substitute for reliance

Efficient Market
Reliance on market requires an efficient market What is an efficient market?
Large weekly trading market Great number of analysts following the stock Existence of several market makers for the stock Company has solid record of earnings History of immediate price movement in response to company information


Loss Causation
Plaintiff must show both
Link between alleged wrongdoing and plaintiffs purchase or sale (transaction causation or reliance), and Link between alleged wrongdoing and plaintiffs loss or damage (loss causation)

Ex: Company publishes profit projections for its oil & gas operations that cause plaintiff to invest. Projections dont pan out

and stock price deteriorates. Cause for failure to meet projections and declining stock price the same falling prices for crude oil, world wide. Reliance (transactional causation) present, but no loss causation but for analysis: but for defendants misconduct, loss wouldnt have occurred

Insider Trading & Rule 10b-5

Evolution & Current Standards


Common Law Standard

Majority Rule: Fiduciary duty of insider does not extend to transactions in shares
Liability for fraud (misrepresentations), but not for omissions


Common Law (Contd)

Minority Rule: Insider holds corporate information in trust for the benefit of all shareholders.
Duty to disclose to other party before trading


Common Law (Contd)

Intermediate View: No duty to disclose before trading absent special circumstances.
Special circumstances: Information which will have a dramatic impact on the company.


Common Law Limitations (Omission cases)

Limited to face-to-face transactions Applied to insider purchases, only. Why?
No duty to non-shareholder purchasers


Rule 10b-5 & Insider Trading

What is insider trading? One definition: Engaging in a securities transaction (whether face-to-face or in the market, and whether a purchase or sale) while in the possession of material, undisclosed information about the issuer of the securities.


Is Insider Trading Bad?

Insider trading is unfair
there should be informational parity in securities transactions insider trading is like getting a peek at the other guys hole card


Is Insider Trading Bad? (Contd)

Insider trading hurts market efficiency Insider trading will destroy market confidence
investors wont play in a rigged game


Is Insider Trading Bad? (Contd)

Contrary view (some economist/lawyers)
insider trading promotes an efficient market
eases the jolts of market disclosures

insider trading is an effective, low cost compensation system for managers


Prevailing View: Insider Trading is Bad

But, is it fraud? When is it fraud?


SEC v. Texas Gulf Sulphur (1968)

Seminal insider trading case Established disclose or abstain rule
Anyone in possession of material, undisclosed information about an issuer must disclose that information or abstain from trading securities of the issuer

Applied to issuers, insiders and tippees


Again, is it fraud?
Can there be fraud without a duty to speak?


Three cases addressing duty

Chiarella v. United States (1980) Dirks v. SEC (1983) United States v. OHagan (1997)


Under Rule 10b-5:
a purchaser of stock who has no duty to a prospective seller because he is neither an insider nor a fiduciary [has] no obligation to reveal material facts. liability is premised on a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.


Use of material undisclosed information by a purchaser is not fraud under 10(b) unless he was subject to an affirmative duty to disclose before trading.

No fraud without a duty to speak Mere possession of information does not create a duty to speak


Limitations on Chiarella
Isnt helpful in analyzing responsibilities of issuers and traditional insiders Doesnt resolve status of tippees


Tippee case What duty is breached when tippee trades on material, undisclosed information?


Answer in Dirks
Focus is on duty of tipper


Dirks Formulation
If disclosure to tippee is a breach of tippers duty, and tippee knows it, then tippee is liable How do you know tipper is under a duty?
Look to some personal benefit to the tipper for the tip


OHagan & the Misappropriation Theory Focus on the duty of the receiver, not the duty of the giver

What is Misappropriation?
The use by a fiduciary of material, undisclosed information belonging to a principal, without disclosing such use to the principal
the duty is that owed to the principal, not the duty owed by the principal, and not the duty owed to the person with whom the trade is made


OHagan and Rule 10b-5

Fraud is committed when a person misappropriates confidential information for trading purposes, in breach of a duty owed to the source of the information. That fraud is in connection with a securities transaction when the confidential information is used without disclosure to the principal.

OHagan & Rule 14e-3

Supreme Court upheld Rule 14e-3 (adopted to prevent fraud and manipulation in tender offers)
Rule 14e-3 is the TGS abstain or disclose formulation of insider trading
Doesnt depend on a finding that a duty has been breached

Violation results if,

A tender offer is commenced (or substantially commenced), and A person in possession of material information relating to the tender offer,

OHagan & Rule 14e-3

knows or has reason to know the information comes, directly or indirectly, from B, T. or any person acting on behalf of B or T, and that person buys or sells T securities prior to public disclosure of the information

Enforcement tool for SEC

No private right of action


From TGS to OHagan: Where are we now?

A person commits securities fraud by trading on the basis of material undisclosed information if in doing so, the person, breaches a duty owed to
shareholders (typically, trading by issuers and insiders), or the company (typically, trading by insiders, tippers and tippees), or

From TGS to OHagan (Contd)

persons with whom the trader has a confidential relationship

For the corporation, the duty analysis is more complex


Corporations Duty Regarding Material Undisclosed Information

Corporation is not required to disclose material information, absent a duty to speak Sources of the duty to speak
Obligation under listing agreement with stock exchanges to promptly report material events Buying or selling own shares
Acquisitions Repurchase programs

Periodic reporting requirements (8-K, 10-Q & 10-K)

Material definitive contracts Correcting prior filings Discussing known trends and forward looking information

Press releases and other information releases responding to market rumors


Material Inside Information: Use vs. Possession

SEC v. Adler, p. 637
SEC argument: Knowing possession of material undisclosed information by an insider coupled with trading, is a violation of Rule 10b-5
Alternative reason for transaction is no excuse

Holding in case: Possession is not enough; information must be used in connection with a securities transaction
strong inference of use if trading occurs

Civil Liability: SEC & Private Actions

21A: SEC can seek civil penalty of
Disgorgement of profit made or loss avoided, plus Penalty of up to 3 times profit gained or loss avoided

20A: Disgorgement measure for private litigants

Recovery limited to profit gained or loss avoided

High Profile Convictions and Settlements Have Not Halted Insider Trading
Why Not?
Public not convinced it is bad? Lure of easy money? Blurring of line between legitimate analysis and insider trading?

Insider Trading has become more sophisticated (harder to detect)

Three current examples

Using a Middleman
Kluger (Lawyer) (Source of Info.) Robinson (Mort. Broker) (Middleman) Bauer (Investor) (Broker)




Mosaic Theory of Financial Analysis

Analyst gathers information from many sources
Company filings Industry sources Customer contacts

Creates a mosaic of information for decision purposes

If information from company is similar to what is publicly known, or confirms known speculation, it is not economically material for insider trading purposes

Raj Rajaratnams defense


Expert Network
Institutional Investor (Hedge Fund, Mutual Fund, Investment Advisor) Consulting Firm


Consultant (Independent Contractor)


Controlling Use & Disclosure of Material Information


Disclosure of Material Information

Memo/directive to employees likely to be aware of events, circumstances, etc. that might trigger disclosure responsibility
Ex: CEO, CFO, Treasurer, VPs of operating units. Memo addresses specific 8-K disclosure responsibilities
Entering into/terminating material definitive agreement

Acquisition/disposition of material assets Changes in control of the company Other material events

Information reported to Disclosure Committee or person(s) responsible for making disclosure determinations
Is the information/event material? If so, can it be disclosed now? Must it be disclosed?

Use of trading windows and black out dates

Insiders only allowed to trade during designated time periods
EX: X days after release of quarterly earnings and for Y days thereafter Trading window can be closed at any time

Pre-clearance of all trades in company shares

Includes pre-clearance of 10b5-1 plans

Rule 10b5-1
Addresses the use vs. possession problem Insider can trade pursuant to a preexisting plan, when the trading decision and the timing of trades are out of insiders hands, even though insider has material, undisclosed information about the issuer
Cannot have such information at the time the plan is set up

Acquisition Negotiations
Most acquisition negotiations take place in a highly structured environment of confidentiality & secrecy
Generally, no disclosure until a definitive agreement has been executed No deal until a final deal Restrict deal participants Use code names, offsite meeting places

Acquisition Negotiations
Business reasons for confidentiality & secrecy
B doesnt want to attract other bidders T doesnt want to create uncertainty with customers, suppliers or employees B & T want to avoid speculation about uncertain events


Acquisition Negotiations
Legal reasons for confidentiality & secrecy
Prevent improper trading by insiders & tippees (is Gordon Gecko listening?) Avoid need to correct company-sourced rumors (SEC view)
NYSE rule is broader. Company must confirm/correct/clarify rumors causing unusual market activity, regardless of source of rumors

Avoid trading halts & interruption of repurchase activities

Abstain or disclose

Disclosure of Acquisition Negotiations

Public companies have a variety of obligations to report or disclose material information about their business and plans, including acquisition plans
Item 1.01 of Form 8-K (entering into & terminating material contracts) NYSE Rule 202.05: A listed company is expected to promptly release information that might materially affect the market for the companys shares

Constant question: Has the transaction reached a point that disclosure is required?
A question of materiality

Basic, Incorporated v. Levinson

Rejected the bright line test for materiality, which held that until an agreement was reached on price and structure, information about a possible transaction was not material as a matter of law Adopted the TSC v. Northway formulation of materiality for Rule 10b-5 purposes
What an average investor would consider important in deciding whether to purchase, sell or hold a security


A Deal Timeline (Using J&J / Guidant Transaction)


Comments and Observations

Proposed acquisition grew out of existing business relationship
Cordis (J&J) and Guidant: Joint marketing

Discussions began early 04; Board involvement not until 7/04


Confidentiality Agreement executed 8/4/04

Function of CA:
Exchange business information on confidential basis
Controls who gets the information Controls use of the information
Evaluation of potential transaction

No disclosure of potential deal


8/17/04: First report to Guidant Board

Presentation by Guidant investment banker (JP Morgan) Board authorized continued discussions


9/13/04: J&J Board authorized management to continue discussions

No agreement on price
Price first discussed 9/13/04

Bulk of discussions centered on personnel issues Balance of terms of Merger Agreement to be negotiated


9/15/04 - 10/26/04
Parties continue due diligence and negotiating terms (other than price) of Merger Agreement 10/26/04: Discussions at high level focus on price


10/27/04 Guidant Board Meeting

Board reviewed entire transaction, received presentations on legal issues and evaluations from investment bankers Result: Board determined to pursue other alternatives as a stand-alone entity.
i.e., deal is off!


11/1/04 12/15/04
Deal is renegotiated As of 12/9, price was still open On 12/12, J&J approved deal; authorized Finance Committee to fix final terms Deal approved by J&J and Guidant on 12/15

Selective Disclosure & Regulation FD

Problem: Public companies providing information to certain analysts and certain large institutional investors before publicly disclosing the information
Causes problems similar to tipping and insider trading
Certain market participants have informational advantage over others and over the investing public

Selective Disclosure & Regulation FD

Solution: Regulation FD
If company discloses material, nonpublic information to a broker, analyst or certain security holders, then
If disclosure was intentional, then company must publicly disseminate the same information If disclosure was unintentional, then company must promptly publicly disseminate the same information
Within later of 24 hours or start of next days trading