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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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.

'via Blog this'

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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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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.

www.clintonlaw.net

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What Is a Security Under the Federal Securities Laws?

One of the most challenging questions in the securities laws is whether a particular interest or contract is a security. If the contract is not a security, the federal Securities Laws do not apply and the promoter does not have to register the investment. If it is a security, the investment must be registered. Thus, whether something is a security is litigated often. There is no definitive answer to the question. The main issue is whether the investor is relying on the efforts of others to earn a return or profit. An investor in a blue chip company purchases a share of stock and hopes to earn a return based on the work of the company and its employees. The question in analyzing an investment contract is whether the holder of the contract is trying to profit from the work of other people or not.

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. Thus, in the Edwards case, 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. and 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 managers to generate profits (Stone v. Kirk, 8 F.3d 1079 (6th Cir. 1993)) are securities.

Comment:

This is a short summary of some of the cases discussing the investment contract test. It is meant to give the reader a basic idea of how the test operates.

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 practicing lawyer should remember that 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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Corporate Law - Piercing the Corporate Veil - Fontana v. TLD Builders, Inc., 362 Ill. App. 3d 491 (Ill. App. 2nd Dist. 2005)

Fontana v. TLD Builders 362 Ill. App. 3d 491 (Ill. App. 2d Dist 2005).

This is probably the most famous piercing the veil case in Illinois because it pierced the corporate veil and held liable a non-shareholder of the corporation. The result is counter-intuitive, but, is understandable when one considers the underlying facts of the case.

The Fontanas alleged that they entered into a contract with TLD under which TLD agreed to construct a single family home in Clarendon Hills for the sum of $1,475,800.

The Fontanas alleged that TLD breached the contract by failing to construct the home as specified in the contract and "by abandoning all work on the home in February 2001, leaving the home incomplete and uninhabitable."

After a bench trial, the court held that TLD breached the contract and failed to cure the breach. As to damages the court held that it would be too costly to complete the home, so the unfinished home should be demolished. The court held that the Fontanas had been damaged in the amount of $1,271,816.10. The trial court entered judgement against TLD and DiCosloa jointly and severally.

The only relevant appeal from the judgment was that of DiCosola. Plaintiffs alleged that DiCosola was the alter ego of TLD and that, after the lawsuit was filed, he caused TLD to cease its business operations so that it had no funds with which to compensate plaintiffs. DiCosola was not a shareholder of TLD.

Theresa DiCosoloa was called as a witness by the Plaintiffs. Mrs. DiCosola admitted that she was the incorporater of TLD. She could provide no evidence that the corporation had any start-up capital. There was no evidence that she or DiCosola ever paid for the stock issued by the corporation. The purported owner of the corporation, Theresa DiCosola, knew nothing about the corporation, did not sign checks, kept no records and did not know whether the corporation had ever earned a profit or a loss.

Theresa "said that she has never received a dividend from TLD and did not know if TLD had profits or losses in the years, 1998,1999, 2000, 2001 and 2002. However, Theresa did sign TLD's income tax returns for those years." She also admitted that she had no idea where the company's assets of $1.8 million went after the lawsuit was filed.

The company had almost no financial records, and almost no records of payments that it made to vendors and subcontractors.

As a result, the trial court found that "Mr. DiCosola is the dominant force behind this corporation" and that the corporation "was little more than a shell which was established to shield him from liability."

In Illinois a party seeking to pierce the corporate veil has the burden of making a substantial showing that the corporation is really a dummy or sham for another person or corporation. In re Estate of Wallen, 262 Ill. App. 3d 61, 68 (1994). The doctrine "imposes liability on the individual or entity that uses a corporation merely as an instrumentality to conduct that person's or entity's business."

The court first rejected the argument that DiCosola could not be held liable because he was not a shareholder. There is authority in Illinois and other states that a non-shareholder can be held liable if the other elements of the test are met.

Illinois uses a two-step test to determine whether the veil should be pierced:

"(1) there must be such unity of interest and ownership that the separate personalities of the corporation and the individual no longer exist; and (2) circumstances must exist such that adherence to the fiction of a separate corporate existence would sanction a fraud, promote injustice, or promote inequitable consequences."

To determine whether the "unity of interest" test has been met courts examine many factors, including (1) inadequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; (4) nonpayment of dividends; (5) insolvency of the debtor corporation; (6) nonfunctioning of the other officers or directors; (7) absence of corporate records; (7) commingling of funds; (9) diversion of assets from the corporation by or to a stockholder or other person or entity to the detriment of creditors; (10) failure to maintain arm's length relationships amont related entities; and (11) whether, in fact the corporation is a mere facade fro the operation of the dominant stockholders." Jacobson v. Buffalo Rock Shooters Supply, Inc., 278 Ill. App. 3d 1084, 1088 (1996).

Obviously, the factors when analyzed strongly favored plaintiffs:

(1) no evidence of adequate capitalization; (2) failure to issue stock; (3) failure to observe corporate formalities; ... (5) insolvency; (6) no evidence that Theresa functioned as a real officer or director; (7) almost total absence of corporate records.

The Appellate Court affirmed the finding of piercing the veil.

Comment: this case involves a corporation and a shareholder who did almost everything wrong - no capital; no records; no consistent use of the corporate name; no effort to follow corporate formalities and evidence of commingling. The result - personal liability in excess of $1.2 million logically follows when one considers the underlying facts and the underlying transaction and the apparent effort to stiff the plaintiffs and deny them their legitimate recovery.

This case is a lesson to all entrepreneurs that it is not enough to form a corporation - you must use the corporation and treat it as a separate and independent person. You must use the corporate checking account or credit card and keep records of corporate expenses. You must keep your own affairs and accounts separate from those of the corporation. Finally, it is wrong to transfer funds to yourself or others to avoid paying your creditors.

A corporation should not be forgotten once established, but carefully maintained over time.

Edward X. Clinton, Jr.
Copyright 2010

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Business Law (Illinois): Miscellaneous Operating Issues 2011 Edition - IICLE - Illinois Institute for Continuing Legal Education | Shop IICLE Product Description

Business Law (Illinois): Miscellaneous Operating Issues 2011 Edition - IICLE - Illinois Institute for Continuing Legal Education | Shop IICLE Product Description

We recommend this excellent book published by the Illinois Institute of Continuing Legal Education. Ed Clinton, Sr. has been the principal author of this chapter since the 1970's. The chapter is a testament to his hard work and persistence.

Edward X. Clinton, Jr.

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Securities Law - SEC Approves Shareholder Advisory Votes on Executive Compensation

The Securities and Exchange Commission by a 3-2 vote approved rules providing for shareholder advisory votes on executive compensation. The final rules as adopted largely follow the rules as proposed by the Commission.

Final Rule 14a-21(b) provides that companies are required at least once every six years to give shareholders an advisory vote as to whether the company’s “Say On Pay” vote will occur every one, two or three years. The votes are advisory only and as such are not binding on the company or the Board of Directors. The compensation of directors is not subject to Say On Pay vote. Results of the vote must be set forth in a Form 8-K within four business days after the shareholders meeting. Brokers are not permitted to vote uninstructed shares in a Say On Pay or Say On Frequency proposals.

The two negative votes were cast by the Republican members of the Commission.

Author’s Commentary
It appears to the author that the issue is over-analyzed, and, to a significant extent, a waste of time. For example, assume that shareholders of a given company over a period of years vote that the executive compensation is excessive and a shareholders’ lawsuit is filed claiming that the compensation is excessive and makes reference to the adverse votes by shareholders. It is unlikely that such a lawsuit would be successful. Existing precedent is to the effect that courts are not the best forum to determine the compensation and benefits of officers. Shareholders routinely lose such lawsuits.

The real concern is that the directors will acknowledge pressure to reduce or hold compensation down after votes suggesting the compensation is excessive.

In this proxy season companies have approached the new issue with a variety of approaches.

The author notes that Northern Trust gave the shareholder the right to select when the subject should be revisited. It states directors recommend you vote each year on the frequency of advisory votes on executive compensation.

The AT&T proxy card states that the Board of Directors recommends you vote every three years on executive compensation.

Northern’s direction is straight forward – “A vote every year is O.K. We can handle criticism.”
AT&T’s director approach is that executive compensation is for directors to set. AT&T wants as few votes on executive compensation as possible.

In sum, this issue is not nearly as important as the media reports have suggested.

Edward X. Clinton, Sr.

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Should Dodd-Frank Be Applied Retroactively?

The SEC is seeking civil penalties from Rajat K. Gupta, a former director of Goldman Sachs for alleged insider trading. The SEC has not sued in federal court, but, rather has filed an administrative proceeding against Mr. Gupta as authorized by the new Dodd-Frank Act.

Rajat K. Gupta, a former director of Goldman Sachs, sued the SEC in the U.S. District Court for the Southern District Of New York, 11-CV-1900 on March 18, 2011, claiming that the administrative action by the SEC against him is unconstitutional because it seeks to retroactively apply provisions of Dodd-Frank § 929P, which amended § 8A of the Securities Act of 1933. In other words, Mr. Gupta is arguing that the alleged violations took place before Dodd-Frank was enacted so the SEC cannot use an administrative proceeding.

According Mr. Gupta's Complaint, there is no expression of Congressional Intent that civil penalties provision of Dodd-Frank can be applied retroactively. Section 4 of Dodd-Frank provides that “except as otherwise provided this Act shall take effect one day after the enactment of the Act.” Dodd-Frank became law on July 21, 2010. All of the conduct alleged occurred prior to that date. Without retroactive application of Dodd-Frank, the Commission could have sought civil penalties against Gupta in a Federal District Court.

The SEC alleged that Mr. Gupta engaged in a trading scheme by providing material non-public information that he obtained in the course of his duties as a member of the Board of Directors of The Goldman Sachs Group, Inc. and Procter & Gamble to Raj Rjaratnam, the manager of a hedge fund called Galleon Management, LP. Currently, Mr. Rjaratnam is on trial for criminal charges brought against him by the U.S. Attorney of the Southern District of New York.

Mr. Gupta claims that the actions brought against him should be determined by a jury. He points out that an appeal from an adverse administrative finding would first be to the Commission itself before any further judicial review. Mr. Gupta claims that he would be deprived of the application of the Federal Rules of Evidence which preclude unreliable evidence such as multiple layers of hearsay that Commission would seek to offer in an administrative proceeding. Also it would impede Mr. Gupta’s ability to seek indemnification for contribution thereby unfairly enhancing the magnitude of the amounts for which he would be exposed. These charges resulting from retroactive application of Dodd-Frank impose new legal consequences on Mr. Gupta even though arising from pre-Dodd-Frank conduct. Mr. Gupta points out that at least one Commissioner, Kathleen L. Casey, has publicly questioned the retroactive application of Dodd-Frank.

Mr. Gupta alleges that his attorney filed a 35-page response to a Wells Notice on Monday February 28, 2011. By that afternoon the staff received authorization to proceed against Mr. Gupta even though there is no record that the Commission met to consider the submission of the Wells response. Further, Mr. Gupta alleges that a copy of the submission was turned over by the Staff to the United States Attorney’s Office for use in the prosecution of Mr. Rajaratnam. Mr. Gupta seeks as a remedy (a) that Dodd-Frank provisions prospectively empowering the Commission to seek civil penalties against non-registered persons in administrative proceedings in lieu of a plenary action in Federal Court cannot be applied against him, and (b) the Commission is acting in bad faith and a discriminatory manner against him.

Mr. Gupta has raised significant legal issues which will apparently be decided in the very near future.

Edward X. Clinton, Sr.

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Matrixx Initiatives, Inc. et al v. Siracusano, et al, 09-1156

SUPREME COURT UNANIMOUSLY REJECTS NARROW INTERPRETATION OF §10B(5)

On March 22, 2011 the United States Supreme Court decided Matrixx Initiatives, Inc. et al v. Siracusano, et al, 09-1156, which reaffirmed its holding in Basic Inc. v. Levinson, 485 U.S. 224 (1988).

In Basic the defendant made misleading statements denying that it was engaged in merger negotiations when, in fact, it was conducting preliminary negotiations. Basic urged a bright-line rule that preliminary negotiations are material only when the parties to merger negotiations reach an agreement in principal. The Supreme Court in Basic rejected that bright-line rule. Accordingly, a claim was stated under Section 10b(5).

The Plaintiffs alleged in Matrixx that Matrixx and three executives failed to disclose a possible link between its leading product, Zicam, a cold medicine, and the loss of smell. Matrixx became aware of several complaints by users of Zicam but contended that the complaints were not statistically significant and accordingly that disclosure was not necessary. Matrixx also sought to defend its turf in other ways. It learned that a research doctor was going to deliver a lecture in which he would reference the fact that various complaints were made by other users of Zicam. Matrixx learned of the proposed presentation and informed the doctor that it did not have permission to use its name. The doctor proceeded with the presentation without mentioning Matrixx.

Plaintiffs complained that Matrixx violated Section 10b(5) by making untrue statements of fact and failing to disclose material facts necessary to make the statements not misleading in an effort to maintain artificially high prices for its leading product Zicam. The Supreme Court rejected that narrow approach and held that other facts could be considered, including other studies providing a link between Zicam and loss of smell.

The unanimous Supreme Court opinion written by Justice Sotomayor represents an affirmation and expansion of Basic. A very important case.

Edward X. Clinton, Sr.

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Two Important Securities Cases Accepted by Supreme Court

The U.S. Supreme Court has agreed to hear two significant cases. The first, Matrix Initiatives Siracusano, No. 09-1158 presents a question regarding materiality. The complaint alleges that Matrixx made false statements about its product Zicam, a nasal spray. Product liability suits had been filed against the company.

Matrixx denied press reports discussing complaints about a loss of smell. A report of an FDA investigation was followed by a drop in the share price despite statements by the company that it was not aware of any such inquiry.

A shareholder complaint suit was filed alleging securities fraud based on claims that the denials of the company were false and misleading. The district court dismissed the complaint and held that adverse product reports regarding a loss of smell did not have to be disclosed because they were not material. The court based its decision on In re Carter-Wallace, Inc., 220 F.3d 36 (2nd Cir. 2000). That rule has also been adopted by the First and Third Circuits.
The Ninth Circuit reversed. Siracusano v. Matrixx Initiatives, Inc., 585 F/3d 1167 (9th Cir. 2009) Citing Basic v. Levinson, 485 U.S. 224 (1988) the Court rejected the statistically significant test used by the district court. Materiality, the court stated, is a question generally reserved for the fact finder. The question is whether the allegations are properly pleaded under the Private Securities Litigation Reform Act (“PSLRA”) and state a cause of action under Bell Atlantic Corp. v. Twombly, 550 U.S. 5543 (2007). The question before the Supreme Court is the test for materiality.

The second securities case focuses on the question of primary liability. Janus Capital Group v. First Derivative Traders, No. 09-525. Defendant Janus Capital Group, Inc. (“JCG”) is a publicly traded asset management firm. It sponsors the Janus Funds. Janus Capital Management LLC (“JCM”) is a wholly owned subsidiary of Janus Capital.

Plaintiffs claim that JCG and JCM violated Section 10(b) of the Securities Exchange Act on the ground that the prospectuses for the funds created the misleading impression that steps would be taken to curb market timing. In fact, the complaint claims there were secret agreements which permitted market timing. As a result, plaintiffs claim they purchased their shares at an inflated price. Following the revelation of the truth, the share price dropped.

The district court dismissed the complaint on the ground that the complaint did not contain any allegations that JCG actually made or prepared the prospectuses or that any of the statements were attributable to it. As to JCM, the court held that the investment adviser did not owe any duty to the shareholders of its parent company when they have not purchased shares of the mutual fund.

The 4th Circuit reversed. In re Mutual Funds Investment Litig., 556 F.3d 111 (4th Cir. 2009). The Court held that the defendants adequately alleged that defendants “made” the misleading statements and that they were properly attributed to JCM the court held.

The allegations as to JCG, however, are insufficient to state a claim for primary liability the court concluded. Its limited role here was not sufficient to cause interested investors to believe that JCG had prepared or approved the Janus fund prospectuses. The court did find that plaintiffs had adequately pleaded a claim for control person liability.

The question of primary liability in Janus traces back to the Supreme Court’s decision in Central Bank Of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). There, the Court held that there is no liability for aiding and abetting under Section 10(b) Since that time the courts have struggled with the question of what constitutes primary liability. Congress restored aiding and abetting for the SEC in the Private Securities Litigation Reform Act but not for private actions. A decision in both cases will come by the end of June 2011.

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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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