Corporate and Security Law

Many corporate transactions have securities law implications. Therefore, it is almost impossible to ignore securities law in the corporate life.  There are two major pieces of federal laws that deal with securities: Securities Act of 1933 and Securities Exchange Act of 1934.  Sarbanes-Oxley Act of 2002 is another major law passed by Congress to deal with massive corporate scandals. 

Anytime a corporate offers or sells securities, it should consider federal and state securities laws.  Under federal law, a registration statement must be filed and be effective before a security may be sold.  Prospectuses must be prepared and used in each case, unless there is an exemption.  The followings are the things to consider:

1. Does the transaction involve a security?
2. Is the security being offered or sold?
3. Is a registration exemption available?

These questions are trickier than it may at first seem.  For example, the 2nd question may look quite straightforward, but in corporate mergers and asset acquisitions, where the acquiring corporation pays for the acquisition with its own securities, although shareholders of the acquired corporation has no dealings with the acquiring corporation, if they vote to approve the merger or asset sale, then the security is being offered and sold.

Exemption on registration is extremely important.  Most publicly held companies can register and sell securities for a lower percentage of the dollar amount involved, so registration is more practical for them.  But for privately owned company, it’s too expensive and time consuming. Therefore, an exemption must be available for every offer and sale of its securities.  Usually an exemption can be found.  The company just needs to be represented by counsel who is expert enough in securities law to know exactly how the offering has to be done.

The Security Exchange Act (referred to as Exchange Act later) requires the registration under two circumstances.  First, an issuer must register securities when the securities are to be traded on a stock exchange.  Second, an issuer must register securities if the number of shareholders and amount of assets reach the statutory threshold.  Under §12(g)(1), the threshold is 500 shareholders and $10 million assets.  Form 10 is the general registration form used by most issuers.

Both Securities Act and Exchange Act require registration, but the purposes are different.  Registration under the Securities Act allows the securities to be sold in a particular transaction, while registration under the Exchange Act subjects issuer to Act’s periodic reporting requirements and other requirements. 

Sarbanes-Oxley Act mostly impacts publicly held companies.  Section 301 regulates the audit committees of publicly held companies.  Section 302 regulates the certification of annual and quarterly reports by the CEO and CFO of Exchange Act reporting companies.  Section 303 makes it fraudulent to influence the conduct of audits for the purpose of making financial statements materially misleading.  Section 401 regulates the disclosures in periodic reports.  A critically important provision about periodic reporting is Section 409 – Real Time issuer Disclosures, which requires each reporting company to disclose, on a rapid and current basis, any additional information concerning material changes in the financial condition of the issuer. 

Insider Trading and other Securities Fraud

Rule 10b-5 under the Exchange Act is the basis of the federal regulation dealing with insider trading and various fraudulent conducts in the sale of securities.  The rule prohibits any person by any means
(a) to employ any device or scheme to defraud, or
(b) to make any untrue statement of a material fact or to omit a material fact, or
(c) to engage in any act which operates as a fraud or deceit upon any person,
in connection with the purchase or sale of any security. 
The goal is to protect the investing public and to secure fair dealing in the securities markets by promoting full disclosure of inside information.

Rule 10b-5 involves criminal liabilities.  A willful violation of the rule is a felony and action may be brought by the Justice Department.  The Securities and Exchange Commission (SEC) may bring actions seeking injunctions against violations and requesting the court to impose civil penalties. 
 
One key to the question is what constitutes materiality.  The courts utilize a probability/magnitude analysis to determine whether information or an omitted fact is material.  Basically, materiality depends on the significance a reasonable inventor would place on the withheld or misrepresented information.   

Another question is who is subject to these trading constraints.  The courts have found violations of 10b-5 where corporate insiders used undisclosed information for their own benefit.  This is because they have the duty to disclose based on a fiduciary or other similar relationship, such as trust and confidence, placed upon them.

Short-Swing Trading

Rule 16 under the Exchange Act deals with short-swing trading, which is a form of the insider trading.  Rule 16 is a spring gun that can hit the innocent as easily as the guilty.  It provides that

1. each owner of more than 10% of any equity security registered under the Exchange Act, and each director and officer of an issuer of such security, file reports with the SEC and relevant stock exchanges reporting their holdings and changes in such holdings,
2. any profit realized by any of the above persons on any purchase and sale, or sale and purchase, of non-exempt equity security within period of less than 6 months, shall be recoverable by the issuer,
3. it is unlawful for any of the above persons to sell any non-exempt equity security if (1) the person does not own the security (short sale) or (2) if owning the security, does not deliver it against the sale within prescribed period.

On calculation of profit realized, it is entirely possible to have profits under Rule16 when, in fact, one has suffered a loss when all transactions during a period are taken into account.  This is because transactions will be matched and if several transactions are involved, any losses during the period are ignored.

Securities laws have broad impact on corporate conducts and cover many issues.  Corporations need to hire competent securities law attorney for consultation.

Lei Jiang LLC provides legal service in securities, merger and acquisition transactions.  For more detailed information, tailored analyses, and legal opinions, please contact us.