The Use of Insider Information

            Use Of Insider Information

The case of SEC v. Bauer (No. 12-1860) decided by the 7^th Circuit Court of Appeals on July 22, 2013 represents an expansive discussion and application of insider trading principals.  Bauer was the general counsel of the investment adviser of an open-end bond fund.   Open-end funds are required to sell and redeem fund shares at any time.  Because they cannot tell when they might be called upon to redeem shares in substantial quantities, they must have substantial cash available.   The Fund sold bonds at the time it had a liquidity problem because its cash reserves were low and it had to liquidate shares from its portfolio.

At the time of sale, Bauer was seeking employment in another part of the country and had redeemed bonds of the Fund from her personal portfolio.  The bonds had a value of about $44,000.

The SEC learned of Bauer’s sale and sought an injunction against Bauer for violating SEC Rule 10b-5.  The District Court for the Eastern District of Wisconsin granted summary judgment to the SEC and Bauer appealed.  The case is unusual as one of the few cases the SEC brought insider trading claims in connection with a mutual fund redemption.

The 7th Circuit reversed the granting of summary judgment and remanded to determine if Bauer’s conduct violated the misappropriation theory of insider trading.

After Bauer’s redemption, the SEC filed suit against Bauer and several other key management personnel of the Fund, the investment advisor and the broker dealer.  The claims were brought under § 17(a) of the Securities Act, Section 10(b) of the Exchange Act, and SEC Rule 10b-5.

            Section 10(b) prohibits fraud in connection with the purchase or sale of a security.  The statute in part, provides:

 “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange –

. . .

(b)       To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.”

Section 10(b) thus prohibits (1) using any manipulative or deceptive device in contravention of rules prescribed by the SEC (2) in connection with the purchase or sale of securities. 

Pursuant to its § 10(b) ruling making authority, the SEC adopted Rule 10b-5, which provides in part:

”It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

“(a)     To employ any device, scheme, or artifice to defraud, [or]

. . .

(c)        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.” 

There are two theories of insider trading: (1) the classical theory, is violated when a corporate insider trades in securities of his corporation on the basis of material, non-public information.  The relationship gives rise to an affirmative duty to disclose or abstain from trading so that the insider does not have an unfair advantage over uninformed purchasers or sellers of the companies’ stocks.  (2)  Under the “misappropriation theory” of insider trading § 10(b) is violated when a corporate outsider “misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.”  This qualifies as a “deceptive device” because the outsider trades on confidential information entrusted to him for non-trading purposes, and thereby “defrauds the principal of the exclusive use of that information.”   Under the misappropriation theory, the disclosure obligation “runs to the source of the information” rather than the trading counterparty – an outsider entrusted with confidential information must either refrain from trading or disclose to the principal that he plans to trade on the information.  The misappropriation theory is “designed to protect the integrity of the securities markets against abuses by ‘outsiders’ to a corporation who have access to confidential information that will affect the corporation’s security price when revealed, but owe no fiduciary or other duty to the corporation’s shareholders.” 

The SEC argued that Bauer violated both the classical theory and the misappropriation theory of insider trading.  However, according to the 7th Circuit the SEC never presented the misappropriation theory to the district court.  The SEC argued that Bauer was a traditional insider which was an invocation of the classical theory.

The Seventh Circuit stated that the relevant question is whether Bauer acted with scienter in abandoning ship – whether she knew or recklessly disregarded the fact that she was unfairly avoiding losses based on her access to non-public information.  According to the 7th  Circuit, “that is a permissible inference but not a mandatory one.”

The Court then discussed the distinction between when “possession” versus “use” of material non-public information is misapplied.  The 7th Circuit then went on to state that the SEC has the burden to prove that insider information played a causal role in the trade and said that step will be up to the jury whether to infer the decision by Bauer to sell was influenced by the information.

In sum, this is a comprehensive opinion by Judge Zagel, a District Court Judge for the Northern District of Illinois, sitting by designation.

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Illinois Court Rejects Breach of Fiduciary Duty Claim Against Insurance Broker

Insurance brokers have a fiduciary duty to their clients. However, according to the Illinois Appellate Court, that fiduciary duty only applies to a specific policy and a specific period.

The case captioned Garrick v. Mesirow Financial Holdings, Inc., 2013 IL App (1st) 122228, explains this principle.

The plaintiffs brought a professional negligence action against their previous insurance brokers, Mesirow Finanical. They alleged that Mesirow had negligently failed to include a pair of diamond earrings as an insured item in an insurance policy.

Years later, the earrings were lost and the plaintiffs sued Mesirow. By that time the plaintiffs had a different insurance broker.

The court set forth its reasoning as follows:

"[D]efendants owed a duty only with respect to a specific policy, for a specific policy period. 735 ILCS 5/2-2201(a) (West 2004). They owed a duty only for a policy that they procured. It is the insured's responsibility to advise his insurance broker of his insurance needs. ... Plaintiffs' argument attempts to broaden the statutorily defined duty of an insurance broker so that it would include responsibility for a policy that the broker did not obtain. There is no allegation in plaintiffs' amended complaint that plaintiffs informed defendants or even their subsequent insurance producer of their purchase of the replacement earring...."

This holding is consistent with common sense and economics. The person who buys insurance knows best what he or she owns and should be able to report that to his insurance carrier.

Edward X. Clinton, Jr.

www.clintonlaw.net

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Seventh Circuit Rejects Force-Placed Insurance Claim

The case is captioned Randy Cohen v. American Security Insurance Company and Wachovia Mortgage, 11-3422. It is an important case because it offers a thoughtful and thorough discussion of this problematic issue.

Mortgage lenders often require the home owner (borrower) to maintain hazard insurance on the mortgaged property. As the Court notes, the purpose of the insurance is "to protect the lender's interest in the collateral."

Problems arise when the borrower fails to keep the property insured. The mortgage lender then purchases insurance for the borrower, usually at a cost far higher than the typical homeowner's insurance policy.

One plaintiff in the case, Martha Schilke, alleged that the lender fraudulently placed insurance on her home when her own homeowner's policy lapsed.

The Seventh Circuit rejected her claim, holding that she (and the other plaintiff) had not stated a plausible claim in their complaints. The Court holds as follows:

"The loan agreement and related disclosures and notices conclusively demonstrate that there was no deception at work. It was Schilke's responsibility to maintain hazard insurance on the property at all times; if she failed to do so, Wachovia had the right to secure the insurance itself and pass the cost on to her. Wachovia fully disclosed that lender-placed insurance may be significantly more expensive than her own policy and may include a fee or other compensation to the bank and its insurance-agency affiliate. In short, maintaining property insurance was Schilke's contractual obligation and she failed to fulfill it; because the consequences of that failure were clearly disclosed to her, none of her claims for relief can succeed."

The opinion describes the multiple warnings the borrower received before Wachovia purchased insurance for her benefit.

Edward X. Clinton, Jr.

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Urologists take investment battle to court - Health Care News - Crain's Chicago Business

Urologists take investment battle to court - Health Care News - Crain's Chicago Business:

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District Court Dismisses 10b-5 Lawsuit Against Green Mountain Coffee

GOLESORKHI v. GREEN MOUNTAIN COFFEE ROASTERS, INC., Dist. Court, D. Vermont 2013 - Google Scholar:

The decision set forth above granted the defendants' motion to dismiss, but gave the plaintiffs leave to amend their complaint. The case is a 10b-5 securities lawsuit where the plaintiffs have alleged that they lost money because the defendants (the company and three officers) made false statements about the company's future prospects in a press release and an analyst meeting in February 2012.

Plaintiffs were stockholders of Green Mountain Coffee. The fact-pattern is a typical one: Green Mountain made certain projections of sales and then "missed estimates" in that its actual results were not as good as it had projected. 

Plaintiffs challenged two sets of statements, a press release from February 1, 2012 and statements at an analyst meeting on February 21, 2012. 

In the February 1, 2012 press release, the company reaffirmed prior guidance as to earnings and sales growth. According to the district court's opinion, "The "prior revenue and earnings estimates" to which [the company officer] referred included a total consolidated net sales growth of 60 to 65 percent in 2012, non-GAAP earnings per diluted share in the range of $2.55 to $2.65, and capital expenditures between $630 million and $700 million for fiscal year 2012." 

Later, on May 2, 2012, the company announced that it had missed estimates as to sales growth and that it was lowering its earnings estimates for the year. Sales grew 37%, which was substantially less than the 40-50% growth that had been estimated in February 2012. In the May 2012 announcement, the company lowered its earnings estimate for the year from $2.65 to $2.50. Plaintiffs then filed their class action.

The court explains that the statements were accompanied by disclaimers:

"The Press Release also contained a litany of disclaimers and warnings. First, it explained that the Company was providing non-GAAP results in the interest of transparency even though the numbers provided did not take into account certain expenses and liabilities, including currency risks, legal and accounting expenses, and non-cash related items. Id. Second, the release contained a lengthy paragraph warning readers that certain representations in the document were "Forward-Looking Statements" that reflected management's best analyses at that point in time and therefore might not prove to be accurate predictions of the Company's actual results. GMCR further stated that among other factors, "the difficulty in forecasting sales and production levels," "the impact of the loss of major customers for the Company or reduction in the volume of purchases by major customers," "the Company's level of success in continuing to attract new customers," "sales mix variances," and "delays in the timing of adding new locations with existing customers," could all affect whether the Company would meet its performance expectations. Id. at 5.

In its Press Release, GMCR also directed investors to the set of risks it had described more thoroughly in the Company's Annual Report on Form 10-K for fiscal year 2011 and other filings with the SEC. See Compilation of Cautionary Statements, ECF No. 32-13 at *2-8. That document describes many of the aforementioned factors in greater detail, including several passages that specifically address the difficulties of predicting demand and the effect that changes in demand would have on the Company's financial performance. For example, GMCR stated that its results were extremely dependent on the sales of Keurig® single-cup brewing systems and K-Cup® portion packs; "any substantial or sustained decline in the acceptance of [those products]," GMCR explained, "would materially adversely affect us." Id. at *2. In addition, GMCR stated that demand for its products could be dampened by competition from other brands; changes in consumer tastes and preferences; changes in consumer lifestyles; national, regional, and local economic conditions; perceptions or concerns about the environmental impact of its products; demographic trends; and perceived or actual health benefits. Id. at 2, 4. GMCR also noted that the nature of its products—mainly hot beverages—exposed the Company to seasonal variations in demand. Id. at 6."

The disclaimers were sufficient to defeat the 10b-5 claim. The district court concluded that the statements at issue were forward-looking statements and that those statements were accompanied by meaningful cautionary language. Thus, the statements were not actionable and the complaint was dismissed.

In the alternative, the court held that the plaintiffs had not pleaded scienter, or intent to defraud, because there were insufficient allegations that the defendants knew their statements were false or misleading.

Edward X. Clinton, Jr.

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LLC Operating Agreement Defeats Unjust Enrichment and Breach of Fiduciary Duty Claims

WOSS, LLC v. 218 ECKFORD, LLC, 102 AD 3d 860 - NY: Appellate Div., 2nd Dept. 2013 - Google Scholar:

The plaintiff LLC was a member of the defendant LLC 218 Eckford. It then brought numerous claims against the defendant LLC on the ground that it had not received the appropriate share of profits. Plaintiff's claims were entirely defeated because plaintiff was a member of 281 Eckford and signed the operating agreement. Plaintiff could not bring a claim for unjust enrichment because the operating agreement (a written contract) controlled the outcome. Plaintiff could not bring a claim for breach of fiduciary duty because plaintiff did not allege a fiduciary relationship.

Comment: the lesson here is that the operating agreement was thoughtfully drafted. The provisions of the operating agreement are a contract that governed the parties' business relationship. There were no holes in the agreement (at least according to the court) for the plaintiff to run through to bring a cause of action.

In sum, where there is more than one person involved in a business venture or undertaking, the operating agreement is crucial. It governs the parties' business relationship. This is where legal work is most valuable to the entrepreneur. The lawyer can draft the agreement to reflect the client's wishes and can avoid many pitfalls.

Edward X. Clinton, Jr.

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Corporate Law - Dissolved Corporation Lacks Standing To Sue For Claims Arising After Dissolution

Sometimes a client asks whether a dissolved corporation can bring a lawsuit. The answer is not clear. If the claim accrued before the corporation was dissolved, the corporation can sue. However, under this case (see below) a dissolved corporation cannot sue if the claim "arose" after it was dissolved.

Corporations are dissolved usually when the corporation fails to pay its annual fee to the Illinois Secretary of State.

The case is A Plus Janitorial Co., v. Group Fox, Inc., 2013 Il App (1st) 120245. In the A Plus case, the plaintiff attempted to bring a breach of contract claim against another party. Section 12.80 of the Illinois Business Corporation Act states that the dissolution of a corporation does not "take away or impair any civil remedy available to or against such corporation...." The court reasoned that the statute preserves any claims that were in existence (or which had accrued) before the corporation was dissolved. However, the A Plus court held that the dissolved corporation does not have the ability to sue for a claim that arose after it was dissolved.

Since the alleged breach of contract occurred after dissolution, the corporation could not sue.

Comment: This is a case of careless behavior by the plaintiff. A corporation can be reinstated by paying a fine and the past due fees to the Illinois Secretary of State. At most, the fees would run a few hundred dollars. Failing to pay these fees wasted years of work on the litigation that followed. The lesson here is simple - if there is any doubt about corporate status, clean it up before filing.

Edward X. Clinton, Jr.

www.clintonlaw.net

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