Benson v. Stafford, Nos. 1-09-1361, 1-09-3173 (Cons.) The Nonreliance Clause Bars A Fraud Claim

The Illinois Appellate Court recently considered whether or not a party, which signs a written contract that specifically disclaims any representations and warranties, can sue for fraud?

The answer, once again, is a resounding no. The case, like the other cases it follows, is significant.

The plaintiffs brought a claim for "affirmative fraud" against the Defendant. They argued that the Defendant made affirmative misrepresentations to them to induce them to participate in the transaction.

Defendant argued that the nonreliance clause barred any recovery. The opinion sets out the text of the clause as follows:

In the case at bar, the trial court dismissed the affirmative fraud component of count II of plaintiffs’ fourth amended complaint due to the presence of a nonreliance clause in the SPAs that plaintiffs signed. The clause, located in section 6.7 of the SPAs, provided:

Nos. 1-09-1361, 1-09-3173 (Cons.) “6.7 Entire Agreement. This Agreement (including the
documents referred to herein) constitutes the entire agreement among the Parties with respect to the subject matter hereof. There are no warranties, conditions, or representations (including any that may be implied by statute) and there are no agreements in connection with such subject matter except as specifically set forth or referred to in this Agreement. No reliance is placed on any warranty, representation, opinion, advice or assertion of fact made either prior to, contemporaneous with, or after entering into this Agreement, or any amendment or supplement thereto, by any Party or its directors, officers, employees or agents, to any other Party or its directors, officers, employees or agents, except to the extent that the same has been reduced to writing and included as a term of this Agreement, and none of the Parties has been induced to enter into this Agreement or any amendment or supplement by reason of any such warranty, representation, opinion, advice or assertion of fact. Accordingly, there shall be no liability, either in tort or in contract, assessed in relation to any such warranty, representation, opinion, advice or assertion of fact, except to the extent contemplated above.” (Emphasis added.)

Additionally, although the trial court did not discuss it, defendant claimed that section 28
Nos. 1-09-1361, 1-09-3173 (Cons.) 3.1(d)(viii) of the TD Options agreement also provided a nonreliance clause:

“(d) Representations and Warranties of Members. Each Member hereby represents and warrants to the Company and to each other Member and acknowledges that: *** (viii) the determination of such Member to acquire Units in the Company has been made by such Member independent of any other Member and independent of any statements or opinions as to the advisability of such acquisition or as to the properties, business, prospects or condition (financial or otherwise) of the Company and its Subsidiaries which may have been made or given by any other Member or by any agent, employee or other Affiliate of any other Member.”

Defendant relied on the case captioned, Tirapelli v. Advanced Equities, Inc., 351 Ill. App. 3d 450. In Tirapelli, the plaintiff purchased securities from the defendant. Plaintiff's claims of affirmative fraud were dismissed by the Court and the dismissal was affirmed by the Appellate court on the ground that the plaintiffs were "sophisticated parties" who had signed a nonreliance clause. The plaintiffs, therefore, could not rely on Defendant's oral representations that were not contained in the contract. The Appellate Court in Tirapelli, held that the nonreliance clause barred the plaintiffs from stating a cause of action for fraud, stating that “[h]aving agreed in writing that they did not rely on any representations found outside the subscription documents, plaintiffs cannot be allowed to argue fraud based on such representations.” Tirapelli, 351 Ill. App. 3d at 457. We also noted that as sophisticated business people, plaintiffs could have negotiated for the inclusion of any representations that they thought were important. Tirapelli, 351 Ill. App. 3d at 457."

In the Benson case, Defendant argued, and the trial court agreed, that the presence of a nonreliance clause barred plaintiffs from bringing a claim for affirmative fraud as a matter of law.

The appellate Court held that the nonreliance clause barred the affirmative fraud claim because the plaintiffs could not establish justifiable reliance, an element of fraud.

The Court wrote: In the case at bar where there were sophisticated parties to a securities transaction, and in the presence of a non-reliance clause, we will follow Tirapelli and find that plaintiffs cannot state a claim for affirmative fraud because they cannot show reasonable reliance on defendant’s oral representations as a matter of law due to the non-reliance clause in section 6.7 of the SPAs.

Comment: Tirapelli and Benson hold that sophisticated persons who sign a contract with a nonreliance clause are bound by that clause and cannot later claim fraud or fraudulent inducement based on representations outside of the four corners of the contract.

Edward X. Clinton, Jr.

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A Brief Review of Insider Trading Law - Rule 10b-5

Insider trading law is highly complex. This is a brief summary of the law.

Rule 10b-5

1. Insider Trading

15 U.S.C. §78j(b) provides that it is unlawful “[t]o 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 contrivance in 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.” In 1942, the SEC adopted Rule 10b-5, 17 C.F.R. §240.10b-5, which 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,

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

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, 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.

Although 15 U.S.C. §78j(b) and Rule 10b-5 were originally intended to supplement other antifraud provisions of the federal securities laws, they have become the most important provisions with regard to insider trading.

In the typical insider trading case, an insider who is aware of material information not available to the other party to the transaction or the public purchases or sells a security. In both instances, the cases under Rule 10b-5 focus on the accurate disclosure of material information by one who has such information or the abstention from trading until the information becomes public. For example, in Kardon v. National Gypsum Co., 73 F.Supp. 798 (E.D.Pa. 1947), the court ruled that corporate officers breached their fiduciary duty to selling shareholders and violated Rule 10b-5 when they purchased stock from shareholders without informing the shareholders that the stock was about to be acquired by a third party for a higher amount. Kardon is a classic example of prohibited insider trading.

Rule 10b-5 requires that those who possess inside information either refrain from trading in the security while the information is not public or disclose the information to the public themselves. Speed v. Transamerica Corp., 99 F.Supp. 808, supplemental op., 100 F.Supp. 461, petition denied, 100 F.Supp. 463 (D.Del. 1951). In Speed, 99 F.Supp. at 829, the court commented on the rationale for this duty of disclosure shortly after the enactment of Rule 10b-5:

The duty of disclosure stems from the necessity of preventing a corporate insider from utilizing his position to take unfair advantage of the uninformed minority stockholders. It is an attempt to provide some degree of equalization of bargaining position in order that the minority may exercise an informed judgment in any such transaction.

Nondisclosure or inaccurate disclosure of material information, combined with trading by one with inside information, may result in liability under one of the rule’s three clauses: as a scheme to defraud, as an untrue statement or misleading omission, or as an act or practice that operates as a fraud or deceit on someone in connection with the purchase or sale of a security.

The Seventh Circuit addressed insider trading in the context of the penalty provided in SEC v. Lipson, 278 F.3d 656 (7th Cir. 2002). The court held that the former chairman and chief executive officer of Supercuts, Inc., had properly been found liable for selling his company stock while in possession of material nonpublic information about disappointing revenues and high expenses.

Lipson sold 365,000 shares of Supercuts’ stock shortly before the company announced disappointing earnings. The earnings for the quarter amounted to 7 cents per share, significantly below the analysts’ projection of between 17 and 18 cents per share. Judge Ronald Guzman ordered Lipson to pay $2.8 million, which represented disgorgement of $621,000 in losses avoided by selling Supercuts’ stock, prejudgment interest of $348,000, and $1.8 million as punitive damages, which was three times the amount ordered disgorged.

Lipson contended that the jury improperly was instructed that, if it decided Lipson possessed insider information, it could infer that he used the information in selling his stock, and that accordingly, it improperly shifted the burden of persuasion from the SEC to himself. The Seventh Circuit agreed that such would have been improper but said that the jury was entitled to infer that, if Lipson had inside information, his securities trading was influenced by it. The court stated that common sense indicated that Lipson’s decision to sell when he did and to sell how much he did was influenced by the fact that he had possession of insider information that was unfavorable and likely to affect the market price of the stock.

In United States v. Bhagat, 436 F.3d 1140 (9th Cir. 2006), Atul Bhagat challenged his conviction for insider trading, securities tipping, and obstructing the course of an SEC investigation. Bhagat’s employer, Nvidia Corporation, successfully competed for a large contract to develop a video game console (the X-Box) for Microsoft. Nvidia’s CEO then sent a company-wide e-mail late on a Sunday night announcing the contract award. The next morning, Nvidia sent a number of follow-up e-mails. The first e-mail advised Nvidia employees that the X-Box information should be kept confidential. The other e-mails imposed a trading blackout on the purchase of Nvidia stock for several days and required Nvidia’s employees to cancel any open or outstanding orders for Nvidia stock. Bhagat purchased a large quantity of Nvidia stock — his largest purchase in nearly three years — roughly twenty minutes after the final company-wide e-mail. The government contended that Bhagat read the CEO’s Sunday night e-mail prior to purchasing the Nvidia stock.

There was no direct evidence that Bhagat read any of the e-mails prior to making his purchase. The government asked the jury to infer Bhagat’s knowledge of the contract award by virtue of the fact that he had probably read the original e-mail upon entering the office as a “normal, reasonable person” would. 436 F.3d at 1143. The Ninth Circuit upheld the trial court’s conviction of Bhagat, saying that the evidence presented was significant enough to support the jury’s conclusion that Bhagat was aware of the confidential information before he executed his trades.

In 2000, the SEC adopted Rule 10b5-1 to further define what it means to trade securities “on the basis of” material nonpublic information. Rule 10b5-1 addresses the issue of when insider trading liability arises in connection with a trader’s “use” or “knowing possession” of material nonpublic information. This rule provides that a person trades “on the bases of” material nonpublic information when the person purchases or sells securities while aware of the information. However, the rule also sets forth several affirmative defenses, which have been modified to permit persons to trade in certain circumstances when it is clear that the information was not a factor in the decision to trade. Specifically, there is no violation if the trade was made pursuant to a prearranged plan. For further information, see Allan Horwich, The Origin, Application, Validity, and Potential Misuse of Rule 10b5-1, 62 Bus.Law. 913 (2007).

a. What Information Is Material?

In TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 48 L.Ed.2d 757, 96 S.Ct. 2126, (1976), the Supreme Court concluded in the context of proxy solicitations under Rule 14a-9, 17 C.F.R. §240.14a-9, that a fact is material if there is a “substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder.” In 1988, the Supreme Court held that the materiality test announced in TSC Industries applied to actions brought pursuant 15 U.S.C. §77j(b) and Rule 10b-5, 17 C.F.R. §240.10b-5. See Basic Inc. v. Levinson, 485 U.S. 224, 99 L.Ed.2d 194, 108 S.Ct. 978 (1988).

In Basic, the plaintiffs argued that merger discussions between Basic and another company were “material.” Over a two-year period, Basic’s officers met with representatives of Combustion Engineering, Inc., to discuss a possible merger of the two companies. After heavy trading in Basic’s stock, the company issued press releases to the effect that the company was unaware of any corporate developments that would explain the trading volume. Basic and Combustion agreed to merge in December 1978. Basic shareholders who sold their shares during the period from the first public denial of merger activities up to the trading halt imposed before the merger announcement brought a suit against Basic and certain of its directors, alleging that the public statements were false or misleading in violation of Rule 10b-5 and artificially depressed the stock prices. The district court granted summary judgment for Basic. The Sixth Circuit reversed, holding that, even if the discussions with Combustion Engineering were not “material” when they occurred, they became material when the corporation claimed that it was unaware of any corporate developments that would explain the trading volume. The Supreme Court held that “[m]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information.” 108 S.Ct. at 988.

Smith v. Shell Petroleum, Inc., Fed.Sec.L.Rep. (CCH) ¶95,316 (Del.Ch. 1990), is an example of how courts determine whether an omitted fact is “material.” In Smith, Shell Petroleum initiated a short-form merger with a subsidiary. Shell wanted to obtain exclusive ownership of the subsidiary by purchasing the interests of the minority shareholders. The plaintiffs were minority shareholders of the subsidiary. Shell sent disclosure materials to each plaintiff. Each had the option to accept Shell’s offer for the shares or to seek an appraisal of the shares in court. The plaintiffs sued Shell, alleging that Shell’s disclosure materials understated the value of the oil and gas reserves owned by the company by the sum of $1 billion. Shell admitted that the disclosure materials were inaccurate but argued that the $1 billion understatement was not “material.” The Delaware chancery court disagreed, holding that “there is a likelihood that the misdisclosure would have assumed actual significance in the deliberations of a reasonable shareholder in deciding whether to accept the consideration from the short-form merger or whether to seek an appraisal.” Fed.Sec.L.Rep. (CCH) ¶95,316 at p. 96,506. See also Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995) (“If the court determines that there is a substantial likelihood that disclosure of the information would have been viewed by the reasonable investor to have significantly altered the total mix of information, the statement is material.”); SEC v. Maio, 51 F.3d 623, 637 (7th Cir. 1995) (same standard). See also Allan Horwich, The Neglected Relationship of Materiality and Recklessness in Actions Under Rule 10b-5, 55 Bus.Law. 1023 (2000).

b. To Whom Does the Duty To Disclose Apply?

Rule 10b-5, 17 C.F.R. §240.10b-5, applies to “any person” and to securities of all issuers, whether they be small closely held corporations or publicly owned companies. The duty to disclose under Rule 10b-5 is not limited to officers, directors, or controlling shareholders of the issuer who are ordinarily considered to be “insiders.” There are two theories under which a person who trades a security on the basis of confidential information without disclosing that information will be held to have violated Rule 10b-5: (1) the classical theory and (2) the misappropriation theory.

(1) The classical theory

“Under the classical theory, a person violates [Rule 10b-5, 17 C.F.R. §240.10b-5] when he or she buys or sells securities on the basis of material, non-public information and at the same time is an insider of the corporation whose securities are traded.” SEC v. Maio, 51 F.3d 623, 631 (7th Cir. 1995), quoting SEC v. Cherif, 933 F.2d 403, 408 (7th Cir. 1991). “Classical theory applies to trading by insiders (or their tippees) in the stocks of their own corporations.” [Emphasis in original.] Maio, supra, citing Cherif, supra.

An example of insider trading under the classical theory occurred in In re Cady, Roberts & Co., [1961 – 1964 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶76,803 at p. 81,013 (Nov. 8, 1961) (1934 Act Release No. 6668). In Cady, an SEC enforcement proceeding, the respondent was a director of a corporation and an employee of a securities brokerage firm. In his capacity as a director, he learned that the corporation intended to reduce the dividend on its common stock. The respondent disclosed that information to the brokerage firm. The brokerage firm sold the common stock for its customers prior to public disclosure of the dividend reduction. The SEC ruled that the broker had a duty either to disclose the reduction in the dividend rate or to refrain from trading until such disclosure occurred. The holding was based on two principles: (a) the existence of a relationship giving access to information intended to be available for a corporate purpose and not for personal benefit and (b) the “inherent unfairness” when a person uses information knowing it is unavailable to others with whom he is dealing. Thus, the respondent had a duty to existing stockholders and to members of the public who purchased stock before the announcement of the dividend reduction.

SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 89 S.Ct. 1454 (1969), is the leading case under the classical theory of insider trading. In Texas Gulf Sulphur, the company discovered a rich ore strike. The company issued a press release stating that it was premature to draw conclusions about the magnitude or quality of the ore strike. At the same time, employees and officers of Texas Gulf purchased substantial amounts of the company’s stock. They made large profits when the value of the strike was fully disclosed. The court held that the company and the officers violated Rule 10b-5. In effect, the court found a duty to the market generally (and not merely to the shareholders of the corporation involved).

Texas Gulf Sulphur is properly viewed as a major expansion of insider trading liability. The court referred to the responsibility of “anyone in possession of material inside information” and an overall duty to shareholders in the marketplace. 401 F.2d at 848, 851 – 852. The court also commented that one who passes information on to another (the tipper) who buys or sells stock is as culpable as one who uses the information for his own benefit (the tippee). 401 F.2d at 852.

(2) The misappropriation theory

Under the misappropriation theory, a person violates Rule 10b-5, by “misappropriating and trading upon material information entrusted to him by virtue of a fiduciary relationship.” SEC v. Maio, 51 F.3d 623, 631 (7th Cir. 1995), quoting SEC v. Cherif, 933 F.2d 403, 410 (7th Cir. 1991). “Misappropriation theory ‘extends the reach of Rule 10b-5 to outsiders [or their tippees] who would not ordinarily be deemed fiduciaries of the corporate entities in whose stock they trade.’ ” [Emphasis in original.] Maio, supra, quoting Cherif, supra. Under the misappropriation theory, the person trading in the stock need not be an insider of the corporation (or a tippee of an insider) whose stock was traded for the conduct to violate Rule 10b-5. As the court explained in Maio, supra, “the misappropriation of material non-public information from its lawful possessor is regarded as a sufficient breach of fiduciary duty ‘in connection with’ the purchase or sale of a security to justify liability under Rule 10b-5.”

The misappropriation theory arose out of the Supreme Court’s holding in Chiarella v. United States, 445 U.S. 222, 100 S.Ct. 1108 (1980). In Chiarella, the defendant, an employee of a financial printing house hired to print certain documents related to a tender offer, was able to deduce the identities of the target companies. He then purchased stock in those companies and sold the stock at a profit after the tender offers were announced. He was convicted of securities fraud. The Supreme Court reversed his conviction for violating Rule 10b-5 and held that “liability is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.” 100 S.Ct. at 1115. The Court held that Chiarella had no duty to disclose the information because he did not owe a duty to the target company or its shareholders.

Chief Justice Burger dissented in Chiarella. The Chief Justice quoted with approval a commentator who stated, “Any time information is acquired by an illegal act it would seem that there should be a duty to disclose that information.” [Emphasis in original.] 100 S.Ct. at 1121, quoting W. Page Keeton, Fraud, Concealment and Non-Disclosure, 15 Tex.L.Rev. 1, 25 – 26 (1936). The concept became known as the “misappropriation theory.”

Shortly after Chiarella, the SEC promulgated Rule 14e-3, 17 C.F.R. §240.14e-3, which prohibits insiders and others with material nonpublic information from trading in corporate tender offers. See §1.103 below.

Several courts have followed Chief Justice Burger’s dissent in Chiarella and have applied the misappropriation theory to find violations of Rule 10b-5 when a person who was not in a confidential or fiduciary relationship with the issuer traded based on material nonpublic information.

In United States v. Newman, 664 F.2d 12 (2d Cir. 1981), two employees of investment banking firms misappropriated confidential information about mergers and acquisitions proposed by clients of their firms. The employees gave that information to Newman, who purchased stock in the takeover targets. When the merger plans were announced to the public, Newman sold the shares at a substantial profit. He shared the profits with the employees of the investment banking firms. The court held that Newman could be held criminally liable under Rule 10b-5 because he misappropriated material nonpublic information.

Dirks v. SEC, 463 U.S. 646, 77 L.Ed.2d 911, 103 S.Ct. 3255 (1983), made clear that the tipper must breach a fiduciary duty or the tippee has not breached Rule 10b-5. Dirks was an investment analyst who learned from a former employee of Equity Funding that that company had been fraudulently issuing insurance policies and recording the proceeds as income. Dirks tipped several institutions, which then sold $16 million in common stock before the fraud was exposed. He then contacted the SEC and the Wall Street Journal, and the fraud was eventually exposed. Dirks did not use the information himself and did not receive any direct personal benefit. However, the SEC censured Dirks for tipping his inside information. The Supreme Court reversed the censure. According to the Court, the employee’s purpose in informing Dirks was to expose the fraud, not to profit by using the information, so the tipper breached no duty to Equity Funding.

In SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), cert. denied, 105 S.Ct. 2112 (1985), an employee of a financial printing company learned the identity of certain target companies and purchased their stock before information relating to the tender offers became publicly available. Following Newman, supra, the Second Circuit affirmed. It held that “one who misappropriates nonpublic information in breach of a fiduciary duty and trades on that information to his own advantage violates Section 10(b) and Rule 10b-5.” 745 F.2d at 203.

In United States v. Winans, 612 F.Supp. 827 (S.D.N.Y. 1985), aff’d in part, rev’d in part, 791 F.2d 1024 (2d Cir. 1986), a writer for the Wall Street Journal was convicted of an insider trading scheme. Winans used information about the contents of future columns for his own trading, and he tipped the information to others who also used the information. The Second Circuit affirmed Winans’ conviction. Winans argued that he was not guilty because he was not a corporate insider and did not misappropriate information from insiders. However, the Second Circuit held that the misappropriation of nonpublic information from his employer in connection with a scheme to purchase and sell securities constituted a violation of Rule 10b-5. 791 F.2d at 1031 – 1032. The decision of the Second Circuit was affirmed by an equally divided Supreme Court in Carpenter v. United States, 484 U.S. 19, 98 L.Ed.2d 275, 108 S.Ct. 316 (1987).

In United States v. O’Hagan, 521 U.S. 642, 117 S.Ct. 2199 (1997), the Supreme Court formally recognized the validity of the misappropriation theory. The defendant, O’Hagan, was a partner of a law firm. He learned that one of the firm’s clients was preparing a tender offer of the common stock of Pillsbury Company. O’Hagan purchased Pillsbury stock and options on Pillsbury stock. When the tender offer was announced to the public, O’Hagan sold the securities for a profit of $4.3 million. He was convicted of violating 15 U.S.C. §78j(b). The Supreme Court held that “criminal liability under [15 U.S.C. §78j(b)] may be predicated on the misappropriation theory.” 117 S.Ct. at 2206. Under the misappropriation theory, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.” 117 S.Ct. at 2207.

To establish guilt, the government must show that the tipper breached a fiduciary duty. When there is no breach of a fiduciary duty by the tipper, the tippee cannot be prosecuted under Rule 10b-5. In United States v. Chestman, 947 F.2d 551 (2d Cir. 1991), cert. denied, 112 S.Ct. 1759 (1992), the defendant was a stockbroker. One of his clients informed him that a public company, a majority of which was owned by a member of the client’s family, would soon be acquired. The defendant then purchased 3,000 shares of the company’s stock. After the deal was announced, the stock doubled in value. The defendant was convicted of violating Rule 10b-5. The Second Circuit reversed the conviction because the client (the tippee) did not breach a fiduciary duty to his family members and thus did not commit fraud, so the defendant “could not be derivatively liable as [client’s] tippee or as an aider and abettor.” 947 F.2d at 571.

The most significant case discussing the misappropriation theory in recent years is SEC v. Mark Cuban, 09-10996 (5th Circuit 2010). The SEC sued Mark Cuban, a noted entrepreneur for allegedly violating Section 10(b), Rule 10b-5 and Section 17(a) of the 1933 Act. The SEC alleged that Cuban was a large minority shareholder of Mamma.com, a Canadian company and that he received confidential information from the CEO of Mamma.com and agreed not to disclose that information. According to the SEC, Cuban violated the confidentiality agreement by selling his stock before the company announced an additional stock offering that would dilute his stake in the company. The district court dismissed the complaint but the Fifth Circuit reversed holding that Cuban could be held liable under the misappropriation theory because he assumed a duty of trust and confidence when he agreed to keep the information confidential.

Also significant is SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009). The Dorozhko case extends insider trading liability under the misappropriation theory to outsiders who did not have a fiduciary relationship with the company where the outsiders wrongfully obtained the inside information through an affirmative misrepresentation.

c. When Does the Duty To Disclose Arise?

An implicit duty to disclose material information arises when a company or its insiders are trading in the company’s securities while in possession of material information that has not already been disclosed to the public. See, e.g., SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 853 – 854 (2d Cir. 1968) (en banc), cert. denied, 89 S.Ct. 1454 (1969). The Texas Gulf Sulphur court held that “[b]efore insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to insure its availability to the investing public.” 401 F.2d at 854.

d. Scienter Requirement

In an action for insider trading under the classical theory, the plaintiff must prove scienter. SEC v. Adler, 137 F.3d 1325, 1332 (11th Cir. 1998). In Adler, an insider sold thousands of shares of company stock prior to the company’s public disclosure that a major customer had ordered fewer of the company’s products than it had anticipated and that this shortfall in orders would reduce the company’s revenue and earnings for the next fiscal quarter. The SEC argued that the insider’s possession of material nonpublic information when he made the sale established scienter. The court disagreed. It held that scienter is established when the investor used inside information in making the trade. 137 F.3d at 1337. Under this test, “mere knowing possession — i.e., proof that an insider traded while in possession of material nonpublic information — is not a per se violation.” Id. The court explained that

when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade — i.e., that the information was not used. The factfinder would then weigh all of the evidence and make a finding of fact as to whether the inside information was used. Id.

In Elkind v. Liggett & Myers, Inc., 635 F.2d 156 (2d Cir. 1980), the company tipped a financial analyst that its earnings for the second quarter would be lower than expected. A customer of the brokerage firm that employed the analyst sold his shares before the announcement and avoided the loss. The court found that the company had scienter. It held:

One who deliberately tips information which he knows to be material and non-public to an outsider who may reasonably be expected to use it to his advantage has the requisite scienter. 635 F.2d at 167.

A plaintiff must also prove that a tippee had scienter. In United States v. Libera, 989 F.2d 596 (2d Cir. 1993), the defendants obtained information contained in new issues of Business Week prior to the publication of the issues by paying employees of the printer for copies of the proofs of the magazine, and the defendants made significant profits from trading on that information. The defendants were convicted of insider trading because the evidence demonstrated that the tippers breached duties owed to the publisher and the printer and that the tippees (the defendants) were aware that the tippers had breached their duties to the printer and the publisher. 989 F.2d at 600.

In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 47 L.Ed.2d 668, 96 S.Ct. 1375 (1976), the Supreme Court held that scienter, or the intent to deceive, manipulate, or defraud, is an essential element in a private cause of action under Rule 10b-5. Mere negligence does not violate Rule 10b-5. In Ernst & Ernst, the accounting firm was retained by a small brokerage firm to perform periodic audits. In its audits, Ernst & Ernst failed to detect a fraudulent securities scheme being carried out by the president of the brokerage firm, who had been regularly converting funds obtained from clients to his own use. Clients of the brokerage firm filed suit under Rule 10b-5 against Ernst & Ernst for negligently failing to detect and disclose the fraud. The court held that the accounting firm was merely negligent and thus could not be held liable under Rule 10b-5.

In Ernst & Ernst, the Court reserved the question of whether mere recklessness is sufficient to meet the scienter requirement in 15 U.S.C. §78j(b) and Rule 10b-5. 96 S.Ct. at 1381 n.12. Since that time, several circuits have concluded that recklessness will suffice. Several circuits have adhered to a “highly reckless” standard, defined as conduct showing “an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.” Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir.), cert. denied, 99 S.Ct. 642 (1978), quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977). In Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995), the court formulated the test as follows: “The plaintiff must also demonstrate that the deceit was committed with the intent to mislead or at least with recklessness so severe that it is the functional equivalent of intent.”

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The Private Right of Action Under Section 10(b) and Rule 10(b)5

Sometimes it is worth reviewing the basics. How is it that an investor can bring a Section 10b-5 claim against a company and/or its officers and directors where Section 10(b) does not mention the right to sue?

15 U.S.C. §78j(b) provides that it is unlawful “[t]o 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 contrivance in 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.” In 1942, the SEC adopted Rule 10b-5, 17 C.F.R. §240.10b-5, which 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,

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

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, 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.

Neither the Section nor the Rule provides for a private right of action.

However, the United States Supreme Court provided for such a private right of action in a footnote in a 1971 case!

As the Court recently wrote in the Stoneridge decision,

"Though the text of the Securities Exchange Act does not provide for a private cause of action for §10(b) violations, the Court has found a right of action implied in the words of the statute and its implementing regulation. Superintendent of Ins. of N. Y. v. Bankers Life & Casualty Co., 404 U. S. 6, 13, n. 9 (1971). In a typical §10(b) private action a plaintiff must prove (1) a material misrepresenta- tion or omission by the defendant; (2) scienter; (3) a con- nection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation. See Dura Pharmaceuticals, Inc. v. Broudo, 544 U. S. 336, 341–342 (2005)."

Thus, the private right of action, one of the most important claims litigated in federal courts today rests on a single footnote in a Supreme Court opinion.

Edward X. Clinton, Jr.

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What Is A Security Under The Federal Securities Laws?

We thought it would be a good time to review one of the basic concepts of the securities laws: What Constitutes A Security?

The term “security” means

any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 15 U.S.C. §77b(a)(1).

The importance of the definition of “security” becomes apparent in the area of private actions for securities fraud because the standard for establishing securities fraud is much lower than that for common law fraud.

The Supreme Court has adopted a flexible and liberal approach in determining what constitutes a security. In its famous decision of SEC v. W.J. Howey Co., 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100 (1946), the Court held that land sales contracts for citrus groves in Florida, coupled with warranty deeds for the land and a contract to service the land, were “investment contracts” and thus securities. The Court stated that

[a]n 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 a third party. 66 S.Ct. at 1103.

According to the Court, it is immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise. 66 S.Ct. at 1104.

The Howey investment contract analysis has been the starting point in determining the status of transactions in the securities area. In applying this analysis, courts have traditionally looked to the substance of the transaction to decide whether a security is involved and have made the determination regardless of the label placed on the interest by the parties to the transaction. Courts have found that countless schemes designed to produce profits for the participants, such as the sale of franchises, fur-bearing animals, and shares in fishing boats and cemetery lots, were covered by the 1933 Act. See 2 Louis Loss and Joel Seligman, SECURITIES REGULATION, pp. 948 – 956 (3d ed. 1989); Carl W. Schneider, The Elusive Definition of a Security — An Examination of the “Investment Contract” Concept and the Propriety of a Risk Capital Analysis Under Federal Law, 12 Tex.Tech.L.Rev. 911 (1981).

One significant question is whether an interest in a limited liability company is a security. In Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003), the Fourth Circuit held that an interest in an LLC is not a security. The Fourth Circuit held that the plaintiff investor was not seeking to profit “solely” from the efforts of others. The court claimed that he had significant control over the company, including the right to appoint two board members. However, in SEC v. Merchant Capital, 483 F.3d 747 (11th Cir. 2007), the Court held that interests in limited liability partnerships were “investment contracts” under Howey. Also, see United States v. Leonard, 529 F.3d 83 (2d Cir. 2008) (affirming criminal convictions for violating the securities laws and holding that interests in an LLC sold by Defendants were securities under the Howey investment contract test.). As the Leonard court noted, an LLC requires a case by case analysis to determine whether the purchaser had significant control over the operations of the company. 529 F.3d. at 89.

In SEC v. Edwards, 540 U.S. 389, 157 L.Ed.2d 813, 124 S.Ct. 892 (2004), the Supreme Court reaffirmed the validity of Howey, supra. In Edwards, the defendant controlled ETS Payphones, Inc., which sold payphones to the public. The payphones were sold under a sale and leaseback agreement, under which the investor would “purchase” the payphone and then lease it back to ETS in exchange for a payment of $82 each month. For each investor, the $82 payment represented a 14-percent return on the investment. After ETS filed for bankruptcy protection, the SEC filed a civil enforcement action against Edwards, alleging that he had violated the registration requirements of 15 U.S.C. §§77e(a) and 77e(c). The Eleventh Circuit in SEC v. ETS Payphones, Inc., 300 F.3d 1281 (11th Cir. 2002), held that the sale and leaseback scheme was not a “security” because it offered a “fixed rate of return.” The Eleventh Circuit also held that the Howey test “that the return on the investment be ‘derived solely from the efforts of others’” did not apply because the investor had a contractual right to the $82 payment each month. 124 S.Ct. at 896, quoting ETS Payphones, supra, 300 F.3d at 1285. The Supreme Court reaffirmed Howey and held that “an investment scheme promising a fixed rate of return can be an ‘investment contract’ and thus a ‘security’ subject to the federal securities laws.” 124 S.Ct. at 898 – 899.

Some items that give their holders a right of use do not constitute securities. In United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 44 L.Ed.2d 621, 95 S.Ct. 2051 (1975), the Supreme Court found that “stock” entitling its holder to purchase an apartment from a cooperative was not a security because the purchasers were acquiring a right to purchase an apartment. The purchasers were not seeking the benefits accruing to investors. Rather, they were seeking the use of an apartment.

Ordinary commercial paper, even when described as a “note,” is not a security. In C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354 (7th Cir.), cert. denied, 96 S.Ct. 38 (1975), the court held that certain notes were not securities because the notes were ordinary commercial paper. The bank holding the notes was not acting as an investor or business partner. See also American Fletcher Mortgage Co. v. U.S. Steel Credit Corp., 635 F.2d 1247 (7th Cir. 1980), cert. denied, 101 S.Ct. 1982 (1981).

Bank certificates of deposit are not securities. Marine Bank v. Weaver, 455 U.S. 551, 71 L.Ed.2d 409, 102 S.Ct. 1220 (1982). In the Court’s view, because the banking laws amply protect investors in bank CDs, it is unnecessary to subject the issuer banks to liability under the antifraud provisions of the securities laws.

The sale of 100 percent of the outstanding stock of a company involves the sale of a security. Landreth Timber Co. v. Landreth, 471 U.S. 681, 85 L.Ed.2d 692, 105 S.Ct. 2297 (1985). In so holding, the Supreme Court expressed its view that the instrument involved was stock under the plain language of the statute.

A real estate contract may also be a security. In Adams v. Cavanagh Communities Corp., 847 F.Supp. 1390 (N.D.Ill. 1994), investors who had purchased Florida real estate interests on land sales contracts sued the developers for securities fraud. The court held that the land sales agreements were investment contracts. Moreover, since the installment contracts called for a repeated series of decisions to invest, each term payment was a separate offer and sale for determining the statute of limitations. Other courts have held that mortgage participations (Pollack v. Laidlaw Holdings, Inc., 27 F.3d 808 (2d Cir. 1994)) and joint venture interests purchased in reliance on the expertise of the venture’s manages to generate profits (Stone v. Kirk, 8 F.3d 1079 (6th Cir. 1993)) are securities.

Whether a contract or other economic right is a security essentially depends on whether the holder of the contract is acting as an investor who seeks financial benefits based on the work of a promoter or a third party.

The statute makes it clear that a promissory note or share of stock in a small closely held corporation is a security. 15 U.S.C. §77b(a)(1).

Edward X. Clinton, Jr.

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Excellent Summary of Dodd-Frank Act

We recommend an excellent and pithy summary of the Dodd-Frank Act that appears in the most recent issue of the Loyola Consumer Law Review.

The article is titled "The Wall Street Reform Act of 2010 and What it Means for Joe & Jane Consumer," by Cody Vitello.

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The Dodd-Frank Act Has Changed The Definition of an "Accredited Investor"

The Dodd-Frank Act has made a significant change to the definition of an "accredited investor." Under SEC rules (particularly Regulation D) an accredited investor is not entitled to the same protections as other investors in private offerings.

Before the enactment of the Dodd-Frank Act a person was considered an accredited investor under Section 501(a)(5) of the Securities Act if:

in each of the two most recent years he had income in excess of $200,000, or in excess of $300,000 jointly with a spouse, and had a reasonable expectation of reaching that same income level in the current year; or

he had a net worth, individually or jointly with a spouse, in excess of $1,000,000.

Section 413(a) of the Dodd-Frank Act adjusts this second standard by requiring that any calculation of net worth exclude the value of a person’s primary residence. Section 413(a) also requires that the person's net worth be reduced by any negative equity in the primary residence. For example, if the potential investor has a home worth $600,000, but with a mortgage on the home of $800,000 that potential investor would subtract $200,000 from his net worth.

Comment: this is an excellent change because it (a) reduces the number of accredited investors and (b) prevents an illiquid asset (a home) from counting in the definition of accredited investor. This is designed to protect investors.

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