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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Seventh Circuit Holds That A Demand on the Board of Directors Was Not Required

In a shareholder derivative lawsuit, the plaintiffs are the shareholders of the company. They bring a lawsuit against someone for wrongdoing. Because the proceeds of the case really belong to the corporation, a doctrine of corporate law has developed under which the plaintiffs must first "demand" that the directors of the corporation bring the lawsuit themselves. What happens when the directors themselves are accused of wrongdoing? Can they really be expected to comply with a demand that they sue themselves for money? Thus, under this exception, courts have held that the "demand" requirement is "excused" in certain cases. The Seventh Circuit has recently decided one such case.

See Westmoreland County Employee Retirement System v. Parkinson, Jr. et. al. No.12- 3342  (August 16, 2013).

According to the opinion, Baxter International had severe problems with a medical device called Colleague Infusion Pump (Pump). The Pumps were used to deliver intravenous fluids to patients. The Pumps had a range of difficulties over a period of years. At first Baxter worked diligently to fix the problems but then its efforts allegedly tapered off.  The FDA sent a series of warning letters to Baxter.

The plaintiff shareholders filed their lawsuit several years after the problems became known. By that time, about 200,000 Pumps were in use throughout the country. Plaintiffs sued 13 directors of Baxter and several corporate officers.  Plaintiffs made no demand before filing the lawsuit that the directors take action. According to the District Court the plaintiffs failed to show that demand was not necessary.  The district court dismissed the lawsuit.

The Seventh Circuit reversed and reinstated the case.



The defendants were directors and a few interested officers. The complaint alleged that the  defendants breached their fiduciary duties by consciously disregarding their duties to bring Baxter in compliance with a consent decree and applicable law.
 According to the court demand is necessary unless there is reasonable doubt that the directors are disinterested or the action was otherwise the product of a valid exercise of business judgment.

According to the Court if a director breaches his duty of loyalty he can not rely on the business judgment rule. The 7th circuit said that the Defendants gave up in trying to fix the pumps and threw in the towel. Baxter began to focus on the development of a new pump  and to a great extent did not continue to fix the problems with the old pump despite warnings of the FDA.

According to the 7th Circuit, the defendant directors actions fell outside the protection of the business judgment rule. The Court said ”the directors knew of the problem, having been warned but took no steps to remedy the situation.” The Court went on to say that there was a reasonable probability of a finding of bad faith by the directors.

The judgment of the district court was reversed.

Cases holding that the demand requirement was excused are rare, but significant.

Edward X. Clinton, Sr.

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Ninth Circuit Rejects Securities Fraud Claim By Purchasers of Hard Rock Hotel Condominiums

The case is captioned Salameh v. Tarsadia Hotel. It is an investment contract case, where the plaintiff alleges that certain contracts he signed were really securities and that the securities should have been registered under the Federal Securities laws.

The facts, from the plaintiffs' complaint, were as follows:

Forty plaintiffs signed contracts to purchase condominium units in a Hard Rock Hotel then under construction. Plaintiffs alleged that they were obligated also to sign Rental Management Agreements with Defendant Tarsadia in which Tarsadia would be the exclusive management agent for the hotel.

Plaintiffs alleged that they were not given keys to the units purchased and could not occupy the units for more than 28 days each year. Therefore, according to plaintiffs, the purchase should be viewed as an investment contract, not a purchase of real estate.

Plaintiffs alleged that Defendants did not comply with the Securities Act of 1933, Sections 12 (a) and Section 10 B of the Securities  Exchange act of 1934, the California Securities Law and were guilty of common law fraud.   

The District Court held that the defendants did not sell securities. It reasoned that the contract to purchase the condominium and the contract under which the hotel was to be managed were two separate contracts signed 15 months apart.

The 9th Circuit affirmed.

The 9th Circuit acknowledged that the both the Securities Act of 1933 and the Securities Exchange Act of 1934 defines the term security to include the  term “investment  contract” . The Court also noted that the term “investment contract” has been interpreted to include novel, uncommon devices.” The investment contract concept embodies a flexible rather than a static principle, one that is capable of adaptation to meet countless and variable schemes  by those who seek the use of the money of others  on the promise of profits. SEC v. Howey 328 U.S.281. The Court went on to say whether a real estate transaction is a security, substance governs, not label, or form. However, the Court held that the Condo Purchase and Management Agreements were not offered  as a package.

The material delivered to plaintiffs do not allege that management agreement forthcoming.  The Court said that there was a significant time gap between the execution of the Condo Purchase Agreement and the Management Agreement The Court said that the two transactions were distinct. The Court went on to say that there was no reason why there could not be a market for ownership of a condo as a short term vacation home.

The Court said that taking all nonconclusionary allegations as true, Plaintiffs did not sufficiently allege claims under federal or state securities laws. The Court also went on to reject the common law fraud claims.

Although the Court made passing reference to  the amicus brief of the SEC,  it was not persuaded. The well-written and thoughtful brief of the SEC stated in part :

“The Commission believes that the district court, in determining that the hotel-room sales did not  sales of investment contracts, failed to give effect to the economic realities of the transaction as required by Supreme Court and Ninth Circuit precedents.

The Commission is concerned that the district court’s holding on the investment contract issue, unless reversed, would seriously erode the investor protection of the securities laws. It would impermissibly allow a promoter to avoid the coverage of these laws by (1) artificially dividing a single investment into ostensibly separate parts and (2) including a written disclaimer that falsely state that there is no investment exception.”

The brief also stated that (1) the sales agreements left the plaintiffs with so little use or control that it was obvious from the beginning that the defendants would exercise exclusive control to rent and operate the rooms; the reality of the defendant’s plan made if obvious from the outset that these  rooms would be necessary to serve as the hotels guest rooms; and  the hotel was under construction during the entire period, making the time gap between the room sales  and rental program inconsequential.

The Ninth Circuit rejected the arguments of the SEC:


"Plaintiffs' strongest argument that the two contracts, signed about a year apart, form a single transaction is their assertion that the "economic reality" shows that the two transactions are part and parcel of one scheme. They contend that the Purchase Contract, combined with external factors, such as the zoning ordinance, gave them no choice but to sign the Rental Management Agreement when it was later presented. This argument has some force. See Hocking, 885 F.2d at 1461; see also Tcherepnin v. Knight, 389 U.S. 332, 336 (1967). But to accept this argument, we not only would have to ignore the large time gap between the two transactions that were executed with different entities, but also the fact that Plaintiffs' complaint is void of any allegation that they were induced to buy the condominiums by the Rental Management Agreement. The economic reality as we see it is that these two transactions were distinct. Moreover, Plaintiffs' economic-reality argument rests on the implicit assumption that the only viable use for the condominiums was as an investment property, but there is no plausible reason why there cannot be a viable market for owner-occupied hotel-condominiums for use as short-term vacation homes. See Brief of Amici Real Estate Roundtable & National Association of Realtors 3-6. This conclusion undercuts Plaintiffs' economic assumptions. See Forman, 421 U.S. at 858 (holding that a security does not exist "where [a consumer] purchases a commodity for personal consumption or living quarters for personal use")."

In my opinion, this is an unfortunate result that is not consistent with precedent Doubtless there were substantial losses suffered by the investors.

Edward X. Clinton, Sr.

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Illinois Court Rejects Law Firm's Claim Against Bank For Fraudulent Check

DIXON, LAUKITIS AND DOWNING, PC v. Bank, Ill: Appellate Court, 3rd Dist. 2013 - Google Scholar:

Over the past several years, lawyers have become victims to check scams. The scam works like this. The lawyer receives a fraudulent check and deposits the check in his trust account. The lawyer is unaware that the check is fraudulent. The lawyer deducts his legal fee from the check and remits the balance to the client. Two or three weeks later the bank discovers that the check is fraudulent and deducts the amount of the check back to the lawyer's account. The problem is that there is a time gap between when a check is deposited (Here May 25, 2011) and when the bank learns that the check is a fraud (here June 10, 2011). By writing checks on their trust account, the lawyers often unwittingly convert other client funds that they hold. They must then reach in their pockets and make good the losses to their clients.

Here the law firm was a victim of such a scam. It tried to sue the bank that dishonored the check, Busey Bank, but was unsuccessful.

The trial court rejected the law firm's negligence claim on the ground that the bank had no duty to the law firm. Instead, the parties' duties were set forth in the account agreement, which provided that the law firm bore the risk of loss until the final settlement of the check.  The account agreement provided: "Deposits - We will give only provisional credit until collection is final for any items, other than cash, we accept for deposit (including items drawn 'on us')."

Further, the Uniform Commercial Code, Section 4-214(a) "provides that a collecting bank may charge back a customer's account when the bank makes provisional settlement but does not receive final payment on an item if the collecting bank gives notice to its customer by midnight of the next banking day."

Here, the bank complied with Section 4-214(a) by giving prompt notice to the law firm that the check was fraudulent.

The appellate court affirmed the dismissal of the law firm's negligence action against the bank.

Comment: The lesson here is that if there is any doubt as to the validity of the check, the lawyer should wait until the bank confirms that collection is final before paying out the proceeds. Thus, the lawyer must wait before paying out the funds even if the client calls repeatedly and threatens to sue the lawyer or file a grievance with the ARDC. The case is clear - if you draw funds on a check before final settlement of the check (several weeks after the check is deposited) it is your fault if the check is a fraud. I agree with this result. Any other result would require the bank to act as an insurer for bad checks. That would inevitably lead to losses by the taxpayers.

Edward X. Clinton, Jr.

www.clintonlaw.net

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Seventh Circuit Rejects Bank's Efforts To Sue Accountants

Bank of America, NA v. Knight, Court of Appeals, 7th Circuit 2013 - Google Scholar:

The Seventh Circuit has affirmed the dismissal of a complaint against an accounting firm employed by Knight Industries. In Illinois, there is a statute that governs accountant liability to third parties. The Bank is considered a third party because it did not hire the accounting firm directly. Instead, Knight Industries hired the accountants. The accountants "invoked the protection of 225 ILCS 450/30.1, which provides that an accountant is liable only to its clients unless the accountant itself committed fraud (which no one alleges here) or "was aware that a primary intent of the client was for the professional services to benefit or influence the particular person bringing the action" (§450/30.1(2))." The statute does not apply to a claim by the accountant's client against the accounting firm. Thus, had the bankruptcy trustee for Knight Industries brought the claim, the claim might have been successful.


The Seventh Circuit held that the complaint did not state a claim for fraud because the allegations in the complaint were vague and imprecise. The complaint did not set out specifically which parties were responsible for the wrongful conduct. The Bank was allowed to amend the complaint twice, but the complaint did not state a claim. The Seventh Circuit noted that "in court, as in baseball, three strikes and you're out."


Edward X. Clinton, Jr.

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New York Court Holds LLC Is Bound By Option Agreement

FUNDAMENTAL LLC v. CAMMEBY'S, 985 NE 2d 893 - NY: Court of Appeals 2013 - Google Scholar:

This is a simple breach of contract case. In 2006, the LLC granted an option to Cam Funding to allow Cam Funding "to acquire one third of Fundamental's membership units for a strike price of $1,000, provided the option was exercised on or before June 9, 2011. This agreement was signed by Forman, as manager of Fundamental, and was accepted and agreed to by Schron, as manager of Cam Funding, and Grunstein and Forman, the sole members of Fundamental."

Later the LLC amended its operating agreement in an effort to alter the terms of the option. Obviously, Cam Funding was not a member of the LLC and did not sign the operating agreement.The court explains:

"Fundamental relied on paragraph 3.3 of its operating agreement, dated December 22, 2005 and amended and restated September 3, 2009, which states that

"[a]dditional Interests shall not be issued except upon the consent of the Board of Managers [i.e., Grunstein and Forman] and the unanimous consent of the Members [i.e., Grunstein and Forman]. Upon the issuance of any additional Interests, the Person to whom such Interests are issued shall make a capital contribution to the Company in respect of such issuance in an amount equal to at least the fair market value per Interest so issued.""

The trial court held that the 2006 option agreement was binding and enforceable and that the subsequent amendment of the operating agreement did not nullify the option agreement. The trial court entered judgment in favor of the party exercising the option, Cammeby's. The appellate court affirmed the judgment.

Edward X. Clinton, Jr.

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Fraud and Proof of Reliance

In fraud cases, the plaintiff must prove, among other things, that she reasonably relied on the factual assertion made by the defendant.

All too often blue chip defendants turn around and argue that no one could ever rely on what they said because the assertions were puffery or because the plaintiff should have understood they were not telling the truth. These arguments are inconsistent and contradict the institution's claim that it is a credible institution whose word is worthy of consideration. Sometimes courts accept these arguments.

Recently, in United States v. McGraw Hill Companies and Standard and Poors Financial Services, LLC, 2013 U.S. Dist. Lexis 99961, the district judge refused to accept these arguments.

The United States sued S&P for fraud, for giving high ratings to mortgage backed securities. The issuers of those mortgage backed securities would pay S&P to rate the issue. S&P would then evaluate the creditworthiness of the issue and announce a final grade.

Why did the United States sue? Because in the recent financial crisis, the government was often left holding the bag when mortgage-backed securities proved worthless.

SP's major defense was that its statements were "puffery." The district court correctly recognizes the inconsistency in this argument. SP was paid to provide credit ratings for bond and other securities. SP is one of three companies that have the qualifications to do this work. SP opinions are relied upon by tens of thousands of market participants every day.

The district court explains: "Defendants lead off with a proposition that is deeply and unavoidably troubling when you take a moment to consider its implications. They claim that, out of all the public statements that S&P made to investors, issuers, regulators and legislators regarding the company's procedures for providing objective, data-based credit ratings that were unaffected by potential conflicts of interest, not one statement should have been relied upon by investors, issuers, regulators, or legislators who needed to be able to count on objective, data-based credit ratings."  The district court correctly rejected this argument and denied the motion to dismiss.

Under the law, subjective claims about a product are puffery. Claims like this are puffery: "Prices will never again be this low!" or "This is the best car for the money!" "When you buy a car from us, we treat you like family!"

When SP informed market participants that a certain bond issue had a AAA rating, it was not engaging in puffery. SP was giving its informed opinion as the creditworthiness of the issuer. If it was not giving an informed opinion, why was it charging so much money for "puffery?"

SP is a blue chip institution that made some bad judgments that cost the taxpayers a great deal of money. Investors and others had the right to rely on the integrity of its opinions.

Edward X. Clinton, Jr.

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Is A General Partnership Interest a Security?

CAN AN INSTRUMENT REFERRED TO AS  A GENERAL PARTNERSHIP INTEREST BE A SECURITY? 

This court answered the question with a "yes" answer?

SEC v. Louis v. Schooler and First Financial Planning Corporation, 12-cv-2164 (S.D. Cal. July 1, 2013).

The SEC filed a complaint against Schooler and the other Defendants alleging that they violated the anti fraud provisions of the Federal Securities Laws. The SEC also sought a temporary restraining order freezing assets and the appointment of a temporary receiver. The complaint alleges that defendants defrauded thousands of investors by selling 50 million dollars worth of general partnership units. The SEC alleged that the defendants sold $50 million of worth of general partnership interests "without disclosing material facts regarding the true value of the underlying land, the mortgages encumbering the properties, and when ownership of the underlying land was transferred from Defendants to the general partnerships." 

The district court granted the ex parte request for a temporary restraining order.

The SEC contended that the Schooler and the other defendants violated Section 5 of the Securities Act and Section 10(b) of the Exchange Act by failing to register the general partnership as a security.

The defendants then filed a motion to dissolve the TRO.

Over the years, there have been many attempts to avoid labeling an investment a security and therefore not subject to the remedies available to an investment under the Securities Laws.

In the Schooler case, the district court rejected Schooler’s arguments that the partnership interest was not a security.  The court ruled: 

The so called general partnership agreement leaves “so little in the hands of the investor that the investment is in fact a limited partnership interest. The court concluded that the partners are so inexperienced and unknowledgeable in the general partnership business affairs that they are incapable of intelligently exercising their partnership powers; or the partners are so dependent on some unique entrepreneurial or managerial experience of the promoter or manager that they cannot replace the manager of the enterprise or otherwise exercise meaningful partnership or venture powers.

According to the Court, the SEC pleaded  sufficient facts to establish the second and third factors, the Court reasoned that,  having already obtained a preliminary injunction, the SEC has presumptively met its burden to state a claim.

The court also noted that the SEC  alleged that the general partnership investors included a retired school teacher, a water filter salesman and a pharmacist.  The court concluded that these investors were not likely to be sophisticated investors. 

The motion to dismiss the TRO was denied. The writer predicts that there is little doubt that the SEC will prevail on the merits.

There have been numerous efforts to dodge the securities laws to avoid the  remedies that the securities laws provide. Such efforts frequently fail. The purpose of the securities law is to protect investors by requiring promoters to register the securities or to comply with one of the exceptions, such as Regulation D. 

Edward X. Clinton, Sr.

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Illinois Court Affirms Decision Striking Down Noncompete Because of Inadequate Consideration

FIFIELD v. PREMIER DEALER SERVICES INC, No. 1–12–0327., June 24, 2013 - IL Court of Appeals | FindLaw:

This case deals with a noncompetition agreement between an employee and a company. The court held, consistent with long-standing Illinois precedent, that a noncompete is not binding unless the employee has been employed for at least two years.

In October 2009, Premier made an employment offer to plaintiff Fifield. The offer was conditioned upon his execution of a noncompetition agreement which provided:

“Employee agrees that for a period of two (2) years from the date Employee's employment terminates for any reason, Employee will not, directly or indirectly, within any of the 50 states of the United States, for the purposes of providing products or services in competition with the Company (i) solicit any customers, dealers, agents, reinsurers, PARCs, and/or producers to cease their relationship with the Company * * * or (ii) interfere with or damage any relationship between the Company and customers, dealers, agents, reinsurers, PARCs, and/or producers * * * or (iii) * * * accept business of any former customers, dealers, agents, reinsurers, PARCs, and/or producers with whom the Company had a business relationship within the previous twelve (12) months prior to Employee's termination.'



Fifield worked for three months and resigned. Premier sought to enforce the noncompetition agreement. The trial court ruled that the agreement was void for lack of consideration because Fifield had not worked for at least two years before he quit.


The appellate court agreed that three months employment was insufficient consideration to allow the noncompetition agreement to be enforceable.


Comment: this is a rare legal decision which announces a clear rule. Whether this is a good idea remains to be seen. Some employee may quit after 23 months to avoid the noncompetition agreement and force the court to reconsider this bright line rule.

Edward X. Clinton, Jr.

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Illinois Appellate Court Affirms Enormous Award For Retaliatory Discharge

Holland v. SCHWAN'S HOME SERVICE INC., Ill: Appellate Court, 5th Dist. 2013 - Google Scholar:

This is a retaliatory discharge case in which the plaintiff claimed that he was fired for exercising his rights under the workers compensation act. After a trial, the jury awarded plaintiff about $600,000 in compensatory damages and $3.6 million in punitive damages.

The majority affirmed the jury verdict, concluding that the defendant worked an injured employee until he sustained further injuries. The court comments:

The evidence presented at the trial introduced the jury to an employer that intentionally worked an injured employee beyond his medical restrictions to the point that he suffered from severe pain from a work-related injury. When the employee's treating physician took him off work for recovery and treatment, it retaliated against the injured employee by terminating his employment. The need to deter employers from engaging in this type of reprehensible conduct is obvious and substantial. In light of the evidence considered and weighed by the jury, we will not overturn its assessment of punitive damages as being excessive or unconstitutional. 

There is also a strong dissent, filed by Justice Spomer, which argued that the employee was never fired at all, merely demoted. Thus, there was no retaliatory discharge.

In recent years, there has been much fuss over the Illinois Workers Compensation Act and some have argued that the Act is unfair to employers. This case is also controversial and, in my view, is a strong candidate to be reviewed by the Illinois Supreme Court.

Edward X. Clinton, Jr.

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National Football League's Efforts To Sue Insurers in California Are Rebuffed

National Football League v. FIREMAN'S FUND INSURANCE COMPANY, Cal: Court of Appeal, 2nd Appellate Dist., 5th Div. 2013 - Google Scholar:

The NFL has been sued by dozens of former players who allege that they were injured playing football in the 1950s, 60s and 70s. The NFL is defending the cases. As usual, the liability litigation against the league spawned an enormous cloud of coverage litigation.

The insurers sued in New York, where the league has its headquarters, for declaratory judgments that their policies do not cover the concussion lawsuits. The NFL tried to sue in California, but the California court held that the NFL is really a resident of New York and that the litigation to be fought out in the courts of New York. The order stays the California cases pending the results of the New York litigation.

Undoubtedly there was an advantage to litigating in California as opposed to New York.

Edward X. Clinton, Jr.

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Court Resolves LLC Dispute By Compelling Arbitration

RITZ-CARLTON MANAGEMENT COMPANY, LLC v. ASSOCIATION OF APARTMENT OWNERS OF KAPALUA BAY CONDOMINIUM, Dist. Court, D. Hawaii 2013 - Google Scholar:

This case does not make any new law. Rather, it holds that an arbitration clause in a limited liability company operating agreement is binding and enforceable under the Federal Arbitration Act.

Dispute resolution is an important provision in any operating agreement. That provision should be carefully considered before any members are accepted into the limited liability company.

Edward X. Clinton, Jr.

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Well-Drafted LLC Operating Agreement Allows Members to Be Terminated

Berndt v. Berndt, Wis: Court of Appeals, 4th Dist. 2013 - Google Scholar:

This is a decision of the Wisconsin Court of Appeals, affirming the grant of summary judgment to an LLC and two members who terminated the interests of two other members. Here, the operating agreement allowed members to be removed for wrongful conduct. The Court concluded that the Defendants appropriately (a) gave notice of the termination; and (b) offered to purchase the interests of the departing members.

The court rejected an argument that the actions taken by the Defendants were not in good faith. The covenant of good faith and fair dealing did not apply because the Defendants had proper grounds to terminate the plaintiffs' interests in the LLC.

This case illustrates the importance of carefully drafting an operating agreement for every limited liability company. The terms of the operating agreement allowed the Defendants to terminate the Plaintiffs for wrongful conduct and to purchase their interests in the company.

Edward X. Clinton, Jr.

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District Court Compels Arbitration of Dispute Between Broker and Insurance Company

Chambers v. AVIVA LIFE & ANNUITY CO., Dist. Court, ND Illinois 2013 - Google Scholar:

This is a routine dispute between a broker and an insurance company. The broker was required to maintain errors and omissions insurance. He allegedly failed to do so and the insurance company brought a collection action against him for the cost of the errors and omissions insurance.

The broker then brought claims against the insurance company. However, all of his claims were dismissed because the parties had entered into an arbitration agreement, which is governed by the Federal Arbitration Act, 9 U.S.C. Section 4.

In recent years, the United States Supreme Court has decided several cases which have strengthened the Federal Arbitration Act.  These decisions serve to remove many typical civil litigation cases from the court.

Here, Judge Kendall granted the motion to dismiss and compelled arbitration pursuant to the parties' agreement.  Usually, the court stays the lawsuit while the arbitration is pending.  Here the court, based on cases decided in other circuits, elected to dismiss the entire case. This is an issue which may be litigated in the future.

The court writes:

"The FAA provides that once the Court determines that arbitration should be compelled, the Court "shall on application of one of the parties stay the trial of the action until such arbitration has been had in accordance with the terms of the agreement, providing the applicant for the stay is not in default in proceeding with such arbitration." 9 U.S.C. § 3. Pursuant to this provision, all of the defendants requested this Court to stay the case pending arbitration of Chambers's claims. However, the Court finds that dismissal of the case, and not a stay, is the proper remedy in this case."
Edward X. Clinton, Jr.

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LLC Operating Agreements And Fiduciary Duty

This post is based upon an excellent article in Business Law Today titled, Eliminating Fiduciary Duty Uncertainty - The Benefits of Effectively Modifying Fiduciary Duties in Delaware LLC Agreements. The authors are Paul Altman, Elisa Maas and Michael Maxwell.

The issue is whether members of an LLC owe each other fiduciary duties. In the absence of any explicit disclaimers, Courts have held that the members of an LLC do owe each other a fiduciary duty.

A fiduciary duty is a high duty requiring the members to be loyal to the enterprise and each other. They are not permitted to (a) divert business to another entity; or (b) take excessive compensation or, obviously convert company assets.

There are situations where these fiduciary duties can hinder the members of the LLC. The authors recommend that any disclaimer of any fiduciary duty be explicit and unambiguous.

If the LLC operating agreement is silent, the courts will assume that all of the traditional fiduciary duties apply.

Edward X. Clinton, Jr.

www.clintonlaw.net

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Where There Is No LLC Operating Agreement, The Statute Controls

Davis v. WINNING STREAK SPORTS, LLC, Kan: Court of Appeals 2013 - Google Scholar:

Sometimes an LLC is formed, but the parties fail to prepare an operating agreement. Here, the parties formed an LLC and then engaged in litigation.

How are disputes resolved when the parties do not prepare an operating agreement? There is a simple answer - the state statute provides the terms of the parties operating agreement.

The Court explained:


"The controlling statute for this appeal is K.S.A. 17-7670, which provides:

"(a) Subject to such standards and restrictions, if any, as are set forth in its operating agreement, a limited liability company may, and shall have the power to, indemnify and hold harmless any member or manager or other person from and against any and all claims and demands whatsoever.
"(b) To the extent that a member, manager, officer, employee or agent has been successful on the merits or otherwise or the defenses of any action, suits or proceeding, or in defense of any issue or matter therein, such director, officer, employee or agent shall be indemnified against expenses actually and reasonably incurred by such person in connection therewith, including attorney fees."

Since there was no operating agreement, the plaintiff who had prevailed in other litigation with the LLC was entitled to indemnification. The Appellate Court remanded the case and instructed the trial court to use standards developed in Delaware courts interpreting Delaware's limited liability company act.

Comment: We see this problem quite often - people establish an LLC, but fail to take the time to engage a lawyer and complete the operating agreement. They are then often stuck with a bargain they did not anticipate in that the state statute provides the terms of the operating agreement. This is a cautionary but common tale.

Edward X. Clinton, Jr.

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LLC Question - Does The LLC Have To Buy The Interest Of A Departing member?

CONCORDIA PARTNERS, LLC v. Ward, Dist. Court, D. Maine 2013 - Google Scholar:

The typical LLC operating agreement contains a provision governing the terms of a member's withdrawal. The operating agreement often provides that the other members or the LLC itself have a right of first refusal. This means if Member X wants to sell his interest in the company, he must first offer it to the other members. They have a period of time in which to buy his interest or refuse to buy it.

The LLC at issue here was governed by the law of the State of Maine. Like most states, Maine allows the members to set the rules by drafting an operating agreement.

The court explains the terms of the agreement as follows:

"Under Section 8.3, before a member can transfer his or her interest in Concordia, the Transferring Member must notify the Managers of the company. In this regard, Section 8.3 provides:
If any Transferring Member, desires to transfer . . . all of any part of theLLC Units owned by the Transferring Member and such proposed transfer is not subject to the provisions set forth in Section 8.2 hereof [pertaining to Selling Members with a Bona Fide Offer], the Transferring Member shall first notify the Managers stating the nature of the Offered Interest to be transferred and the name of the person to whom the same is to be transferred and the manner of and reason for such transfer and the consideration (if any) to be received.

(Operating Agreement ¶ 8.3.) Providing notice triggers a period during which Concordia, as an "Optionee" under Section 8.1(e), has the option to purchase the member's interest for its Fair Value: "For a period of forty-five (45) days after determination of Fair Value in accordance with Section 8.1 above . . . the Optionee shall have the option to purchase the Offered Interest at its Fair Value upon the Deferred Payment Terms." (Id. ¶ 8.3.) The same Section then goes on to state:
If the Optionee (collectively) does not exercise the option to purchase the entire Offered Interest prior to the expiration of the Transfer Option Period, the Transferring Member may transfer the entire Offered Interest, provided the transfer occurs on the terms stated in the original notice received by the Managers to the person named therein and the transfer occurs within thirty (30) days following the expiration of the Transfer Option Period.

(Id.) Therefore, under Section 8.3, when a Transferring Member notifies Concordia of its desire to sell its membership units, Concordia as an "Optionee" has the right to purchase that member's interest in Concordia. However, nothing in Section 8.3 obligates Concordia to purchase a member's interest."


In this case the court dismissed a claim by the withdrawing member. That member sought to compel the LLC to purchase his interest. His claim failed because the Operating Agreement did not require the LLC to purchase the interest. The only requirement was that the member offer the interest to the LLC. There was no requirement to buy the interest.

Comment: this is a routine case. It illustrates the importance of the operating agreement and the importance of carefully drafting that agreement before you invest your money in the LLC.

Edward X. Clinton, Jr.

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