Securities & Stock Exchanges: Concepts, Laws, and Regulations


(Editor’s note: Multiple posts I’m currently working on build on material from this post, which is a law school research paper I wrote as an introduction to securities laws in the United States.  For non-attorneys, this is probably most readable by ignoring the specific references to cases, regulations, and forms.  I took Securities Law under the instruction of Peter Marchetti, a law professor that previously worked as a staff attorney at investment banks in New York and Boston.  In the course of my research for this paper, I requested the syllabus for the “Securities Law” course from more than a dozen top-tier law schools and concluded that Securities Regulation: Cases and Analysis is the most popular textbook used to teach securities laws.  Much of this research paper is derived from that textbook.  It is a useful reference, even for non-attorneys, on the legal mechanics of securities and markets.  The textbook’s authors are law professors at New York University School of Law and University of Michigan Law School.  As always, I must disclose upfront: anything I write about the law should never be construed as legal advice.)


Securities laws exist to protect investors.  That protection comes in the form of encouraging full disclosure from companies and deterring fraud.  The securities laws in the United States were originally enacted in the early 1930s during the Great Depression.[i]  The laws were an acknowledgement by Congress of the importance of securities markets to the national economy.  The lack of such laws just a few years earlier were a cause of the Wall Street Crash of 1929, the infamous “Black Tuesday” of October 29, 1929.  The panic from the massive volume of stock sell-off on that day was so great that it is often remembered for people jumping out of office windows.

In enacting the original securities laws, in 1933 and 1934, Congress had two main goals.  The primary goal was to prevent company insiders and market professionals from taking advantage of investors.  The secondary goal was to discourage irrational behavior by investors based on frenzies and speculative markets.  Despite many changes over the last eighty years in technology and the speed that information travels, securities laws still exist to preserve their original purpose.

Transactions involving securities can be divided into “primary transactions” and “secondary transactions”.  In a primary transaction, the seller of a security is the company itself, called an “issuer”, that offers and sells its own securities directly to an investor.  The proceeds from such a transaction go to the company for its own purposes.  Such purposes typically include uses like working capital, purchase of new equipment, debt consolidation, and acquisition of other companies.  In a secondary transaction, the issuer does not participate in the transaction.  Instead, an existing investor resells securities to another investor.  There is a selling investor, buying investor, often a securities exchange, and usually one or more securities brokers involved.

The two main sources of federal securities law are the Securities Act of 1933[ii] and the Securities Exchange Act of 1934.[iii]  The Securities Act of 1933, often called just the “Securities Act”, focuses on primary transactions by an issuing company selling securities to investors.[iv]  The Securities Exchange Act of 1934, often called just the “Exchange Act”, deals with the considerably more complex issues of secondary transactions buying and selling securities between investors.[v]

The Exchange Act does not simply govern secondary transactions between buyers and sellers of securities.[vi]  It also regulates securities market intermediaries, which includes broker-dealers and securities exchanges.[vii]  Because regulation of intermediaries and securities exchanges necessarily requires oversight, Congress established an administrative agency when they enacted the Exchange Act to monitor the securities markets and enforce its laws: the Securities and Exchange Commission (SEC).

The SEC consists of five commissioners, one of whom is designated Chairman, and all of whom are appointed by the President of the United States.  The Exchange Act requires that not more than three commissioners be from the same political party.  The SEC is headquartered in Washington, D.C., and has several regional office, the largest of which is in New York.  Several different divisions exist in the SEC, including Corporate Finance, Trading and Markets, Investment Management, Enforcement, and “Risk, Strategy, and Financial Innovation”.  The Division of Corporate Finance manages the periodic filings required from issuers to investors, along with statements required for public offerings, and other disclosures.  The Division of Trading and Markets regulates broker-dealers and other self-regulatory organizations.  The Division of Investment Management oversees investment companies, investment advisors, and mutual funds.  The Division of Enforcement investigates violations of securities laws, and may initiate enforcement actions in federal court or conduct administrative proceedings.  Criminal proceedings must be referred to the federal Justice Department.[viii]

The Division of Risk, Strategy, and Financial Innovation is the newest division of the SEC.  It was created in 2009 to prevent another Financial Crisis like the Great Recession of 2008.  The division, commonly called “Risk Fin”, exists to keep up with Wall Street innovation.  Those innovations includes sophisticated financial instruments and collateralized debt obligation securities, like what resulted in the collapse of the subprime mortgage market.  Risk Fin works with experts in areas including economic research and financial strategy to understand emerging trends and develop policies to keep securities markets stable.

The Justice Department handles criminal enforcement of securities law violations.  That enforcement typically comes from a referral from the SEC to the U.S. Attorney General, which is authorized by Section 21(d) of the Exchange Act.[ix]

Definition of “Security”

But what exactly is a “security”?  That term is defined in § 2(a)(1) of the Securities Act[x] and § 3(a)(10) of the Exchange Act.[xi]  Both definitions include a broad list of financial instruments, including stocks, bonds, warrants, certificates of deposits, debentures, and the somewhat recursive statements “any instrument commonly known as a ‘security’”.[xii]  The list in both definitions also include the term “investment contract”.[xiii]  And it is that term “investment contract” that provides the SEC with a “catch-all” mechanism to regulate any clever new “sophisticated” or “innovative” financial instruments.[xiv]  The “catch-all” provision of “investment contract” also covers forged or nonexistent securities that are represented to be any form of security.[xv]

One of the most common forms of securities is stock.  Stocks is equity rather than debt, and represent shares of ownership in a corporation, including a claim to the corporation’s cash and assets.  Ownership of stock allows the stockholder, also called a “shareholder”, to participate in voting to elect the corporation’s board of directors.  Shareholders receive a return on their investment in stock in the form of an increase in the value of each share, distribution of the corporation’s profits in the form of a dividend, or through the corporation’s repurchase of the stock.  Stock in a company can be either “common stock” or one or more classes of “preferred stock”.  All corporations have, at minimum, common stock with a general claim of ownership of the corporation’s assets and voting rights.  Preferred stock has whatever predetermined rights the company had decided upon when the corporation issues that class of shares.  “Warrants” are a form of security related to stock, in the form of a contract, whereby a corporation provides a person with the option to purchase a set amount of the corporation’s stock at a pre-determined price.  “Convertible debt” is a form of security where a bank or other entity loans money to a corporation and the corporation agrees that the bank has the option to convert the debt into corporate shares.

Corporations are the only legal entity that can issue stock.  Corporations are created by state law, customarily through filing a corporate charter with the Secretary of State.  Many corporations choose to incorporate in the State of Delaware, which has well-defined corporate law codified in its Delaware General Corporation Law.[xvi]  Corporations have a board of directors, that represent the shareholders, and officers, responsible for day-to-day management of the company.

“Investment contracts”, as previously stated, provide the catch-all provision for defining a security.  The test for determining whether a financial instrument is an “investment contract” is referred to as “the Howey test”, named after the 1946 U.S. Supreme Court case that first addressed the definition of “investment contract”.  SEC v. W. J. Howey, 328 U.S. 293 (1946)[xvii].  In that case, the U.S. Supreme Court defined the term broadly, declaring:

“an investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise . . . . It embodies a flexible rather than a static principle, one that is capable of adaptation to meet the countless and variable schemes devised by those who seek the use of the money of others on the promise of profits.”

In practice, to satisfy the Howey test requires “a contract, transaction or scheme” and four additional elements: (1) a person invests his money, (2) in a common enterprise, (3) is led to expect profits, and (4) solely from the efforts of the promoter or a third party.  Securities law cases continue to use the Howey test and apply its elements to new types of financial instruments and unique fact patterns.

Disclosures, Materiality, & “Total Mix”

“The most valuable commodity I know of is information.”[xviii]  Gordon Gekko famously said that in the 1987 movie “Wall Street”.[xix]  As stated in the beginning of this report, securities laws exist to protect investors.  That protection comes in the form of encouraging full disclosure from companies and deterring fraud.  Disclosure of information by companies is the heart of federal securities regulation.  Investors are entitled to make decisions based on current and complete information about a company.  Not all information is equally relevant to investors.    For example, forward-looking information about a company’s future prospects tends to be more relevant to investors than information about the company’s past.  The relevance to investors of specific information is often the focus of securities litigation.

Materiality” is the proper term for information that is relevant to investors.  Deciding whether information is material is a threshold issue in determining if securities regulations apply to statements about a company.  Both making “any untrue statement of a material fact” and omitting “to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading” are subject to regulation under the antifraud protection provided by Exchange Act Rule 10b-5.[xx]  Statements made by the company itself, as well as its director and officers, are subject to that antifraud protection.

Some information is automatically deemed material by statute and the SEC, through its rule-making authority.  For example, anything required to be disclosed in an SEC filing, like the annual Form 10-K and quarterly Form 10-Q, is deemed to be material and must be disclosed.  The SEC filing requirements are contained in Regulation S-K, the focal point of the SEC disclosure system.  Rule 408 of the Securities Act and Rule 12b-20 of the Exchange Act both require disclosure of any information as may be necessary to make any other statement not misleading.[xxi]

The legal standard for determining the materiality of information, not established by statute or SEC rule, is TSC Industries, Inc. v. Northway, 426 U.S. 438 (1976).[xxii]  In that case, the U.S. Supreme Court declared that information is material if there is a “substantial likelihood that the disclosure. . . .  would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”[xxiii]  “[T]he ‘total mix’ of information” mentioned in TSC Industries then is important in determining materiality.[xxiv]  As applied by the courts, “total mix” refers to the particular information’s significance in relation to other disclosed information.[xxv]

Misstatements and omissions are also subject to scrutiny as to their materiality to investors.  Companies are often unable to be exact in their accounting and financial projections.  The SEC, in its “Staff Accounting Bulletin No. 99”, addressed that issue by establishing, as a rule of thumb, that misstatements and omissions that account for less than 5% of a company’s earnings are presumptively immaterial.[xxvi]  The SEC also stated in that same document that, notwithstanding any rule of thumb, “financial management and the auditor must consider both ‘quantitative’ and ‘qualitative’ factors in assessing an item’s materiality.”[xxvii]

Prior misstatements by a company can be measured by for their materiality based on a “market measure”.  That market measure is the reaction of the stock price after the company makes a public announcement acknowledging the misstatement.  The Third Circuit Court of Appeals applied market measure in the case of In re Merck & Co., Inc. Securities Litigation, 432 F.3d 261 (3d. Cir. 2005), holding that “the materiality of disclosed information may be measured post hoc by looking to the movement, in the period immediately following disclosure, of the firm’s stock.”[xxviii]  That case also states succinctly that “[a]n efficient market for good news is an efficient market for bad news.”[xxix]  Courts have also applied market measure using the standard of statistical significance of abnormal stock returns of sufficient practical magnitude as evidence of materiality for companies with publicly traded stock that trade on secondary markets that are presumed to be efficient.  One such case is Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011).[xxx]   In Matrixx, the U.S. Supreme Court, in a unanimous opinion, held that a plaintiff can maintain a claim for securities fraud based on the effect to the stock price of a publicly traded company after that company admits a previous failure to disclose negative information.[xxxi]

The “total mix” formulation has also given rise to two defenses: the “truth on the market” defense and the “bespeaks caution” doctrine.  As established in Longman v. Food Lion, Inc., 197 F.3d 675 (4th Cir. 1999), the “truth on the market” defense effectively means that, when a company promptly issues a correction as to a misstatement or omission, the previous misstatement or omission is immaterial.[xxxii]  The “bespeaks caution” doctrine applies a similar concept to forward-looking statements, rendering those statements immaterial as a matter of law if the statements are accompanied by disclosure of risks.  See, e.g., Kaufman v. Trump’s Castle Funding, 7 F.3d 357 (3d Cir. 1993).[xxxiii]

Public Companies

The distinction between a “public company” and a “private company” is important as it applies to securities laws.  Public companies must provide many mandatory disclosures and comply with regulatory obligations.  Perhaps the easiest way to define a public company might be to simply say that a public company is not a private company.  The vast majority of companies are private, meaning that they have a small numbers of investors and most of their businesses relationships are built on personal relationships.  The investors in a private company often consist of just family and friends of the founders.  Shares of private corporations are typically held long-term and rarely, if ever, traded.

A public company is one with broadly dispersed ownership.  That ownership can exist in a variety of forms by many parties, often with entirely different motivations and interests in the company’s economics and control.  Officially, Congress has defined and redefined the meaning of a “public company” multiple times.  The original definition was in Section 12(a) of the Exchange Act in 1934, to prohibit broker-dealers of securities from effecting transactions over a national exchange “unless a registration is effective” for that security.[xxxiv]  That required establishing a process for registration of securities, which exists in Section 12(b) of the Exchange Act, and accomplished using Form 10 provided by the SEC.[xxxv]

Congress broadened the definition of “public company” in 1936 by adding Section 15(d) to the Exchange Act, which requires companies registering securities for a sale in a public offering under the Securities Act to comply after the effective registration date of the offering with the period disclosure requirements of the Exchange Act.[xxxvi]  That amendment did not require registrants to comply with Section 14 requirements for proxy solicitations and tender offers.[xxxvii]  Nor did it require compliance with reporting of insider stock trades and “short-swing profit rules” imposed by Section 16.[xxxviii]

The next major revision to the definition of a “public company” occurred almost thirty years later in 1964, when Congress added Section 12(g) to the Exchange Act.[xxxix]  That section removed the limitation of applying only to transactions involving “broker-dealers”.[xl]  Instead, all securities issuers having a nexus to interstate commerce were now required to register with the SEC if they had more than a threshold level of assets and threshold number of holders of equity securities.[xli]  Removing the “broker-dealers” limitation means that a company can be considered a public company even if it is not listed on a national securities exchange.[xlii]  Section 12(g) remains to this day as the legal standard for defining a “public company”.[xliii]

The Jumpstart Our Business Startups Act of 2012 (JOBS Act) sets the current threshold levels of assets and number of holders of equity securities.[xliv]  The current thresholds are $10 million in total assets, and either 2,000 shareholders of record for a class of equity security, or 500 total shareholders of record for a class of equity who are not “accredited investors”.[xlv]  Accredited investors include certain institutions, along with natural persons that have either an annual individual income of $200,000, annual income between spouses of $300,000, or $1 million net worth when excluding the person’s primary residence.[xlvi]  “Total shareholders”, for the purposes of Section 12(g), means issuers are required to count “beneficial owners” rather than “legal owners”.[xlvii]  Attempts to combine owners into a trust or other legal entity to circumvent the registration requirements are ineffective.[xlviii]

A public company may revert to a private company, known informally as “going dark”.  That requires negating three triggers that result in becoming a public company.  First, the company must delist on any national securities exchange.  Second, the company must ensure they no longer qualify as a public company under Section 12(g).  And third, if the company has filed a prior effective registration statement with the SEC, the company must meet requirements established by Section 15(d) to suspend public company status.  The second trigger, ensuring the company doesn’t qualify under Section 12(g), requires certification under SEC Rule 12g-4 that the company has fewer than 300 shareholders or, alternatively, fewer than 500 shareholders and less than $10 million in total assets on the last day of its prior three fiscal years.

Additionally, Section 15(d) of the Exchange Act provides a mechanism for issuers to suspend their public company status.[xlix]  That can be accomplished, temporarily, by the company showing that they have fewer than 300 holders of record at the beginning of a fiscal year.[l]  The company’s suspension as a public reporting company is automatically lifted at the beginning of any fiscal year in which the issuer has 300 or more holders of record.[li]

Public Company Disclosures

Three principle documents are required from public companies pursuant to authority conferred by Section 13(a) of the Exchange Act.[lii]  Those documents are Form 8-K, Form 10-K, and Form 10-Q.[liii]  Investors and other interested persons can view these documents the same day they are filed by the company through the EDGAR system on the SEC’s website.

Form 10-K is the most extensive document the SEC requires from public companies.  The form is an annual filing that requires detailed audited financial statements and various financial disclosures.  Informational items enumerated in Regulation S-K must also be disclosed about the registrant’s business, properties, legal proceedings, market for common stock, directors, officers, executive compensation, certain relationships and related transactions, and principal accounting fees and services.  The outcome of any matters submitted to a shareholder vote must also be disclosed.  Form 10-K requires a supplement to the financial disclosures referred to as the “Management Discussion and Analysis”, or “MD & A” section.  The MD & A section must be in the form of a narrative and contain a discussion of the issuer’s “financial condition, changes in financial condition and results of operations.”  The emphasis is on forward-looking information, not on historical financial data, and must address “known trends or uncertainties” that the issuer “reasonably expects” to affect the company’s future cashflow, balance sheet, and income statement.  Issuers customarily combine their Form 10-K with the SEC Rule 14a-3 annual report that must be sent to shareholders.

Form 10-Q is a quarterly filing that is effectively a streamlined version of Form 10-K.  There are similarities and differences between Form 10-Q and Form 10-K.  The quarterly form, unlike the annual Form 10-K, does not require audited financial data, but must at least comply with generally accepted accounting principles.  Both Form 10-Q and Form 10-K, pursuant to Section 302 of the Sarbanes-Oxley Act, must be personally certified by the company’s chief executive officer and chief financial officer.  Those personal certifications must state affirmatively that they reviewed the report and, to the best of their personal knowledge, there are no material misstatements or omissions.  The personal certifications of the CEO and CFO must also include various representations regarding the company’s “internal controls” to maintain the accuracy and completeness of its financial statements.

Form 8-K is filed upon the occurrence of specified events deemed to be of particular importance to investors.  The current incarnation of Form 8-K is a result of the Sarbanes-Oxley Act, which was enacted in 2002 to address the massive wave of accounting scandals from major public companies like Enron and WorldCom.[liv]  Section 409 of the Sarbanes-Oxley Act granted the SEC authority to require Exchange Act reporting companies to disclose “on a rapid and current basis” material information changes.[lv]  Items required to be reported on Form 8-K must be disclosed within four business days of the specified event.[lvi]  The list of items to be reported is quite thorough, which the SEC sorts into nine major categories.  Those categories are “Registrant’s Business & Operations”, Financial Information, “Securities & Trading Markets”, “Matters Related to Accountants & Financial Statements”, “Corporate Governance & Management”, Asset-Backed Securities, Regulation FD, Other Events, and “Financial Statements & Exhibits”.  Regulation FD addresses “selective disclosure” of non-public material information by companies and company insiders.  When that information is disclosed to select sources, Regulation FD requires the information also be disclosed publicly in an SEC filing through Form 8-K.[lvii]

Rule 10b-5: The “Catch-All” Antifraud Provision

Fraud must always be a conscious concern to investors in securities markets because the value of any given security is based on available information.  The prospect of short-term gain provides direct incentive to be dishonest, rewarding dishonesty at the expense of honesty.  Antifraud provisions in both the Exchange Act and Securities Act seek to deter fraud through a variety of countermeasures.  In the Securities Act, both Section 11 and Section 12 explicitly create private liability.[lviii]  In the Exchange Act, Sections 9(e) and 18 provide causes of action for specific forms of securities fraud.[lix]  Rule 10b-5 of the Exchange Act, though, is the most widely used antifraud provision for private plaintiffs.[lx]

Rule 10b-5 is the catch-all antifraud provision for federal securities laws.[lxi]  Its broad language enables a private action by a purchaser or seller of “any security” against “any person” who has used “any manipulative or deceptive device or contrivance” in connection with the purchase or sale of a security.[lxii]  Courts have always held that the private cause of action in Rule 10b-5 is judicially implied, even though it is not explicitly stated.  The U.S. Supreme Court formally acknowledged as much in Herman & MacLean v. Huddleston et al., 459 U.S. 375 (1983).[lxiii]  The plaintiff has a heightened burden on a Rule 10b-5 claim, compared with other antifraud provisions.  Under Rule 10b-5, the plaintiff must prove the defendant acted with “scienter” and intended to deceive, manipulate, or defraud.[lxiv]

Standing for a claim brought under Rule 10b-5 requires the plaintiff to have bought or sold the underlying securities, which is known as the “Birnbaum Rule”, and was adopted by the U.S. Supreme Court in Blue Chip Stamps, et al. v. Manor Drug Stores, 421 U.S. 723 (1975).[lxv]  Courts also broadly interpret the requirement that the fraudulent conduct be “in connection with the purchase or sale of any security”.  See, e.g., SEC v. Zandford, 535 U.S. 813 (2002), holding standing existed where stockbroker sold his customer’s securities and used the proceeds for his own benefit.[lxvi]  It must also be noted, though, that the SEC in its role as a regulatory agency may always bring a lawsuit against individuals and entities.[lxvii]

Class action lawsuits deserve a special mention regarding antifraud standing.  Securities fraud often affects thousands of investors, particularly when it involves publicly-traded companies.  Class actions are significantly more economical for defrauded investors than many individual lawsuits, especially for smaller investors.  The aggregate amounts of potential damages also make class action lawsuits more expensive to litigate and more compelling for defendants to settle.  Current estimates are that half of all securities fraud class actions are dismissed.  Roughly half of the remaining suits are settled for less than the estimates costs to defend.  Fewer than one securities fraud class action per year goes to trial.  While the frequency of settlements may seem entirely beneficial, it creates incentive for class action attorneys to file lawsuits with little or no merit (so-called “strike suits”).  To address the increasing number of unmeritous securities law class action suits, in 1995 Congress enacted the Private Securities Litigation Reform Act, or PSLRA.[lxviii]  The PSLRA imposes additional pleading requirements on plaintiffs, restrictions on discovery, and limitations on defendant liability.[lxix]  Interestingly, the PSLRA has not reduced the number of securities fraud class action lawsuits.

The Exchange Act includes a “savings clause”, in the form of Section 28(a), that preserves securities causes of action brought under state law.[lxx]  In 1998, Congress modified that preservation of state rights when it passed the Securities Litigation Uniform Standards Act,[lxxi] codified as Exchange Action Section 28(f).[lxxii]  That section preempts most securities class actions brought under state law, but does not include derivative actions, fraud involving issuer buy-back transactions, and certain mergers and tender offers.[lxxiii]

Insider Trading

Insider trading” is an inaccurate term.  Based on its modern interpretation, the proper phrase should probably be “based-on-impermissible-non-public-information trading”.  That term isn’t as convenient to write, though, so most people think trading on “inside” information only applies to directors, officers, and employees of the company whose stock is being traded.  The concept of insider trading originated as a form of common law fraud, based on “active concealment,” that involved failure to disclose “special facts” (material information).  See, e.g., Strong v. Repide, 213 U.S. 419 (1909).[lxxiv]  After Congress passed the Exchange Act of 1934, the insider trading doctrine, as developed by the SEC and courts, became two theories of actionable conduct: the “classical theory” and the “misappropriation theory”.

The classical theory of insider trading applies SEC Rule 10b-5 and consists of an “insider” that trades shares of his own company, without disclosing confidential information.[lxxv]  A frequently-cited case that applies the classical theory is Chiarella v. United States, 445 U.S. 222 (1980).[lxxvi]  In Chiarella, the Court applied Rule 10b-5 to a criminal fraud involving a printing company employee, Chiarella, that learned about a takeover bid while printing documents for the acquiring company.[lxxvii]  Chiarella bought the target company’s stock before the takeover bid was publicly known, and then sold the stock after that information became public, ultimately profiting $30,000.[lxxviii]  The issue was whether Chiarella had a “duty to disclose” his “inside information” to the sellers of the target company’s stock that he purchased.[lxxix]  The Court concluded that “not every instance of financial unfairness constitutes fraudulent activity under § 10(b),” holding that “a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information.”[lxxx]

Based on the Court’s holding in Chiarella, the question then is: When does the duty arise to disclose the inside information?  The answer came a few years later in Dirks v. SEC, 463 U.S. 646 (1983).[lxxxi]  In Dirks, the Court held that the duty to disclose must arise “from the existence of a fiduciary relationship.”[lxxxii]  The issue is not merely if the recipient (“tippee”) received information from the person with inside information (“tipper”), but rather if the information was received “improperly”.[lxxxiii]  A tippee assumes a fiduciary duty “only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.”[lxxxiv]  Determining that breach of duty “requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit.”[lxxxv]  Both tipper and tippee are jointly-and-severally liable for any profits obtained by the tippee, according to Dirks.[lxxxvi]  Courts have also applied Dirks to criminal proceedings by holding that a conviction of the tippee is not contingent on conviction of the tipper.  See, e.g., United States v. Evans, 486 F.3d 315 (7th Cir. 2007).[lxxxvii]

The misappropriation theory of insider trading picks up where the classical theory leaves off.  In fact, the misappropriation theory was almost part of the Chiarella decision that resulted in the classical theory.  In Chiarella, the government offered a “misappropriation theory” that Chiarella breached a duty owed to the source of the information, rather than a duty owed to a company involved in the trading.[lxxxviii]  However, the U.S. Supreme Court concluded that theory was not presented to the jury in the trial court and could not be presented for the first time on appeal.[lxxxix]  In United States v. O’Hagan, 521 U.S. 642 (1997), the Court held that “a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of the information [is] guilty of violating § 10(b) and Rule 10b-5.”[xc]  The Court concluded “[a] company’s confidential information. . . .  qualifies as property to which the company has a right of exclusive use.  The undisclosed misappropriation of such information, in violation of a fiduciary duty. . . . constitutes fraud akin to embezzlement.”[xci]

The misappropriation theory, like all legal innovations, leads to unique applications.  For example, does the fiduciary duty of the misappropriation doctrine apply to a spouse and other family members?  The SEC created Rule 10b5-2 specifically to provide guidance on this matter.  The courts have held there is both a duty as well as a defense, in cases like SEC v. Rocklage, 470 F.3d 1 (1st Cir. 2006).[xcii]  The duty exists “[w]henever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling.”[xciii]  The defense applies when “the person receiving or obtaining the information may demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties’ history, pattern, or practice of sharing and maintaining confidence, and because there was no agreement or understanding to maintain the confidentiality of the information.”[xciv]

A primary mechanism promulgated by the SEC to prevent potential violations of insider trading is Regulation FD.  As previously discussed, Regulation FD addresses “selective disclosure” of non-public material information by companies and company insiders.  When that information is disclosed to select sources, Regulation FD requires the information also be disclosed publicly in an SEC filing through Form 8-K.

Rule 14e-3 is a “disclosure rule” that facilitates exchange of inside information between companies regarding potential tender offers.  The rule creates a duty to “abstain or disclose, without regard to whether the trader owes a pre-existing fiduciary duty to respect the confidentiality of the information.”[xcv]  Unlike the Rule 10b-5 antifraud provision, Rule 14e-3 does not require deception or breach of a fiduciary duty.[xcvi]

Rule 10b-18 similarly creates a safe harbor provision for corporations, and their agents and affiliates, to engage in share buyback programs without potential liability for stock manipulation that may normally apply under Section 9(a)(2) and Section 10(b).[xcvii]  The rule only applies to the company’s common stock and has specific requirements that must be met.[xcviii]

Big boy letters” are another mechanism used between sophisticated institutional investors to avoid Rule 10b-5 violations.  A “big boy letter” is an agreement between sophisticated investors wherein one party admits having confidential information they don’t want to disclose and the other party waives any claim of reliance on the non-disclosed fact.  While waivers of claims are unenforceable under Exchange Act § 29(a), many courts have held that the “waiver of reliance” is an effective bar to a claim by a private plaintiff.

Damages & Remedies

Damages in cases involving securities fraud are typically calculated as compensatory out-of-pocket damages.  The measure of damages is the difference between price paid for the stock and the value of the security at the time of the purchase.  Additionally, Section 11 and Section 12 of the Securities Act encourages fraud suits in public offerings by providing generous standards for recovery.  Section 11 is similar to Rule 10b-5, but removes the elements of scienter and reliance for a plaintiff to recover.  The damages in a Section 11 claim are based on “value”, but not necessarily “market value.”  Section 12 of the Securities Act serves a similar purpose for creating liability in public offerings, but provides no defenses to defendants and also allows the remedy of rescission of the purchase.

Most securities fraud causes, though, are not primary transactions between the company itself and entities securities buying directly from that company. Class action lawsuits make up the vast majority of securities fraud cases, relying on Rule 10b-5 to recover against the company and its officers for misrepresentations.  This type of fraud is referred to as “fraud on the market”. While this type of fraud also allows recovery using compensatory out-of-pocket damages as the measure of damages, these claims are unusual in the sense that the investors did not buy stock directly from the company.  Instead, the investors typically bought the securities from each other, but the company is being held liable based on its misrepresentations.

Transactions directly between two parties, often referred to as “face-to-face transactions”, give the courts discretion to apply the equitable remedies of restitution and rescission.  Rescission undoes the transaction, allowing the plaintiff to effectively return the securities for a refund.  See, e.g., Garnatz v. Stifel, Nicolaus & Co., Inc., 559 F.2d 1357 (8th Cir. 1977).[xcix]  Restitution, referred to by some court cases as “disgorgement”, requires the defendant to give the plaintiff whatever profits the defendant made at the expense of plaintiff.  See, e.g., Pidcock v. Sunnyland America Inc., 854 F.2d 443 (11th Cir. 1988).[c]

Punitive damage may be available under state laws for a claim of common law fraud, since securities claims brought under Rule 10b-5 are fraud claims.  However, under federal law, punitive damages are not recoverable because Exchange Act Section 28(a) limits recovery for a 10b-5 claim to “actual damages”.  Many Rule 10b-5 claims are also class actions, which means that state claims are also preempted entirely by the Securities Litigation Uniform Standards Act.

Section 16 of the Exchange Act addresses insider trading.  Section 16 requires “statutory insiders” like company officers, and requires disgorgement of “short-swing” profits obtained by those statutory insiders.  “Short-swing” profits are profits made from a profit or sale of their own company’s stock by buying and then selling the stock within a six month period.  Section 16(b) authorizes shareholders to bring derivative actions on behalf of the company to enforce disgorgement from short-swing transactions by statutory insiders.  That same section also creates strict liability for officers, directors, and “large block” beneficial owners (those owning more than 10% of the company).  Section 16(c) of the Exchange Act bans all short sales of the company’s equity securities by the statutory insiders.

Insider trading remedies are also governed by the Insider Trading and Securities Fraud Enforcement Act of 1988[ci], or simply “Insider Trading Act”.  A person liable under that act for insider trading or providing insider tips (“tipping”) may be held liable for a civil penalty of the greater of $1 million or three times the profits made or losses avoided by the controlled person.  The Insider Trading Act also authorizes the SEC to pay bounties to persons who provide information that eventually leads to imposition of a civil penalty on the alleged violator of insider trading laws.  An informant can receive up to 10% of the penalty collected.


Securities law as it exists in the United States is a vast body of law that encompasses more details than could possibly be addressed in a single research paper.  The whole concept of securities has grown from simple common law fraud involving “special facts” at the beginning of the twentieth century into two well-defined federal legislative acts that have been refined by Congress, the Securities & Exchange Commission, and the court system over eighty years: the Securities Act of 1933 and Exchange Act of 1934.

I have paid particular attention in this paper to the core structure of securities law that affects most people, the definition of securities, the role of disclosures, public companies, fraud, insider trading, damages, and remedies.  Those concepts I believe are the backbone of securities laws as they affect our society.  That said, there are additional concepts I read about while preparing this paper, but would’ve liked more time to write about.  Those concepts include various forms of securities act liability, securities offerings that are exempt from various rules (“exempt offerings”), secondary distributions, shareholder voting, and public enforcement by the SEC.

Public offerings deserve their own mention.  Public offerings receive much attention in the business news, particularly initial public offerings (IPO’s).  They are vitally important in raising capital for innovation.  Public offerings also provide an opportunity to reward the investors and humans that contribute to that innovation.  There are different types of offerings, special disclosures, and a detailed process and timeline that must be strictly adhered.  However, once again, public offerings I felt were beyond the scope of this research paper.

Overall, though, I am proud of what I have actually written.  The core concepts I addressed in this paper were thoroughly researched by myself.  I believe they will provide any reader with an adequate and useful introduction to concepts and regulations involving securities law.


[i] Securities Act of 1933; Exchange Act of 1934.

[ii] Securities Act of 1933.

[iii] Exchange Act of 1934.

[iv] Securities Act of 1933.

[v] Exchange Act of 1934.

[vi] Id.

[vii] Id.

[viii] Exchange Act § 21(d).

[ix] Id.

[x] Securities Act § 2(a)(1).

[xi] Exchange Act § 3(a)(10).

[xii] Id.

[xiii] Id.

[xiv] Id.

[xv] Id.

[xvi] General Corporation Law, Title 8, Delaware Code.

[xvii] SEC v. W. J. Howey, 328 U.S. 293 (1946).

[xviii] Gordon Gecko, “Wall Stret”, (1987).

[xix] “Wall Street” (1987).

[xx] SEC Rule 10b-5, 17 C.F.R. 240.10b-5.

[xxi] Rule 408, Securities Act; Rule 12b-20, Exchange Act.

[xxii] TSC Industries, Inc. v. Northway, 426 U.S. 438 (1976).

[xxiii] Id.

[xxiv] Id.

[xxv] Id.

[xxvi] Staff Accounting Bulletin No. 99.

[xxvii] Id.

[xxviii] In re Merck & Co., Inc. Securities Litigation, 432 F.3d 261 (3d. Cir. 2005).

[xxix] Id.

[xxx] Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011).

[xxxi] Id.

[xxxii] Longman v. Food Lion, Inc., 197 F.3d 675 (4th Cir. 1999).

[xxxiii] Kaufman v. Trump’s Castle Funding, 7 F.3d 357 (3d Cir. 1993).

[xxxiv] Exchange Act § 12(a).

[xxxv] Exchange Act § 12(b).

[xxxvi] Exchange Act § 15(d).

[xxxvii] Id.

[xxxviii] Id.

[xxxix] Exchange Act § 12(g).

[xl] Id.

[xli] Id.

[xlii] Id.

[xliii] Id.

[xliv] Jumpstart Our Business Startups Act of 2012 (JOBS Act).

[xlv] Id.

[xlvi] Id.

[xlvii] Id.

[xlviii] Id.

[xlix] Exchange Act § 15(d).

[l] Id.

[li] Id.

[lii] Exchange Act § 13(a).

[liii] Id.

[liv] Sarbanes-Oxley Act of 2002.

[lv] Id.

[lvi] Id.

[lvii] Regulation FD.

[lviii] Securities Act § 11; Securities Act § 12.

[lix] Exchange Act § 9(e); Exchange Act § 18.

[lx] SEC Rule 10b-5, 17 C.F.R. 240.10b-5.

[lxi] Id.

[lxii] Id.

[lxiii] Herman & MacLean v. Huddleston et al., 459 U.S. 375 (1983).

[lxiv] SEC Rule 10b-5, 17 C.F.R. 240.10b-5.

[lxv] Blue Chip Stamps, et al. v. Manor Drug Stores, 421 U.S. 723 (1975).

[lxvi] SEC v. Zandford, 535 U.S. 813 (2002).

[lxvii] SEC Rule 10b-5, 17 C.F.R. 240.10b-5.

[lxviii] Private Securities Litigation Reform Act.

[lxix] Id.

[lxx] Exchange Act § 28(a).

[lxxi] Securities Litigation Uniform Standards Act.

[lxxii] Exchange Act § 28(f).

[lxxiii] Id.

[lxxiv] Strong v. Repide, 213 U.S. 419 (1909).

[lxxv] SEC Rule 10b-5, 17 C.F.R. 240.10b-5.

[lxxvi] Chiarella v. United States, 445 U.S. 222 (1980).

[lxxvii] Id.

[lxxviii] Id.

[lxxix] Id.

[lxxx] Id.

[lxxxi] Dirks v. SEC, 463 U.S. 646 (1983).

[lxxxii] Id.

[lxxxiii] Id.

[lxxxiv] Id.

[lxxxv] Id.

[lxxxvi] Id.

[lxxxvii] United States v. Evans, 486 F.3d 315 (7th Cir. 2007).

[lxxxviii] Chiarella v. United States, 445 U.S. 222 (1980).

[lxxxix] Id.

[xc] United States v. O’Hagan, 521 U.S. 642 (1997).

[xci] Id.

[xcii] SEC v. Rocklage, 470 F.3d 1 (1st Cir. 2006).

[xciii] Id.

[xciv] Id.

[xcv] SEC Rule 14e-3, 17 C.F.R. 240.14e-3.

[xcvi] Id.

[xcvii] SEC Rule 10b-18, 17 C.F.R. 240.10b-18.

[xcviii] Id.

[xcix] Garnatz v. Stifel, Nicolaus & Co., Inc., 559 F.2d 1357 (8th Cir. 1977).

[c] Pidcock v. Sunnyland America Inc., 854 F.2d 443 (11th Cir. 1988).

[ci] Insider Trading and Securities Fraud Enforcement Act of 1988.

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