Friday, October 12, 2012

Corporations Law: Implied Civili Liability - Rule 10(b)(5) outline

 Implied Civil Liability – Rule 10b-5 Study Guide
Rule 10b-5- 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,
  1. to employ any device, scheme, artifice to defraud,
  2. 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 light of the circumstances under which they were made, not misleading, or
  3. 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.

A. Elements of a Cause of Action under Rule 10b-5:
  1. Standing
    1. Rule 10b-5 is limited to “actual purchasers and sellers of securities”. (Blue Chip Stamps)
    2. The text of Rule 10b-5 proscribes only fraud “in connection with the purchase or sale” of securities.
  2. Materiality
    1. The basic test for materiality is whether the fact would have been important to a reasonable investor’s decision to buy, sell, or hold the stock. (Texas Gulf Sulphur)
    2. For speculative events, materiality “will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity”. (Texas Gulf Sulphur, Basic)
    3. Opinions and beliefs of directors can be material. (Virginia Bankshares)
      1. What the board thinks of a given transaction is certainly important to how a reasonable investor would act.
      2. But there needs to be objective evidence in the form of provable facts that either support or contradict the statements made.
  3. Causation and Reliance
    1. Proof of materiality has basically replaced causation. If it’s material, the investor probably relied on it.
    2. Fraud on the Market theory
      1. In Basic, a plurality of the Court adopted the view that an investor is entitled to rely on the integrity of the market, even when he or she does not learn of the actual misrepresentation.
      2. The defendant can present evidence to rebut this presumption.
  4. Scienter
    1. Scienter- “intent to deceive, manipulate, defraud”
    2. The court in Ernst & Ernst held that scienter was a necessary element of a Rule 10b-5 cause of action and that the plaintiff has to show intentional or willful conduct, not mere negligence.
  5. Damages
    1. The court adopts an “out of pocket” damages test, meaning the plaintiffs get the difference between price they paid and the actual value received in the transaction. (Texas Gulf Sulphur)
    2. Thus, if a defendant sells securities actually worth $10 per share for $20 after representing to the plaintiff that they have a value of $40, the recovery is $10 per share, and the fact that the promised value was $40 is irrelevant.

B. Insider Trading

A corporate “insider” receives material nonpublic information for a legitimate corporate purpose and then trades on the basis of that information. Rule 10b-5 is applicable.

Types of Insider Trading:
  1. Traditional Insider
  2. “Tippee”
  3. “Temporary” Insider
  4. Misappropriation
  5. Remote “tippee”
  6. Rule 14e-3, which prohibits any person in possession of material nonpublic information about a tender offer from trading in securities affected by the offer without disclosing such information, and from communicating such information to others who do not need to know it in order to effectuate the offers.

In the Matter of Cady, Roberts & Co. (1961)
  • In a board meeting, the directors of Curtiss-Wright decided to cut the corporation’s dividends.
  • Cowdin attended this board meeting and was a director of both Curtiss-Wright and a partner at Cady, Roberts & Co.
  • Cowdin left the board room and called Gintel, a Cady, Roberts partner, to inform him of the dividend cut before the information was publicly released.
  • Gintel then sold the firm’s Curtiss-Wright stock.
  • It is clear that Cowdin was a corporate “insider” of Curtiss-Wright as a result of his position on the board. He could therefore not trade on this information.
    • The court held that it is a logical sequence that Gintel could also not trade on that information.
    • Gintel knew Cowdin possessed non-public material information and he is therefore treated as an insider as well
  • The rule is that the insider has the affirmative duty to either disclose the nonpublic material information before trading or walk away from the transaction.

Chiarella v. United States (1980)- mere possession of nonpublic information does not give rise to a duty to disclose or abstain; only a specific relationship does that.

Dirks v. SEC (1983)
  • The tippee does not automatically inherit the insider’s fiduciary duty to disclose or abstain.
  • A tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should have known that there has been a breach.
  • The test for whether disclosure to the tippee represents a breach of fiduciary duty is if the insider personally will benefit, directly or indirectly, from his disclosure.
  • This requires courts to focus on objective criteria, i.e., whether the insider receives a direct or indirect personal benefit from the disclosure.
    • Did the insider receive any monetary gain for making the tip?
    • Did the insider receive any reputational gain that will translate into future earnings?
    • Did the insider make a gift of confidential information to a trading relative or friend?

SEC v. Lund (C.D. Cal. 1983)
  • Lund received material nonpublic information, but it was not in violation of a fiduciary duty. It was disclosed to find investors for their joint venture.
  • Not liable as a tippee under Dirks, because no breach of the fiduciary’s duty.
  • But found liable as a temporary insider by virtue of his friendship with the CEO.

United States v. O’Hagan (1997)
  • O’Hagan is a partner at Dorsey & Whitney.
  • Dorsey & Whitney represent Grand Met, which is considering a take over bid for Pillsbury.
  • O’Hagan does not work on the deal, but knows about it and buys Pillsbury stock and makes over $4 million once the takeover happens.
  • The stock in which he traded was not the stock of his firm’s client, which was Grand Met. He traded in the shares of Pillsbury to which he owed no duty.
  • Misappropriation theory holds that a person violates Rule 10b-5 when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.
  • If a fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no violation, although the fiduciary may remain liable under state law for breach of a duty of loyalty.

United States v. Chestman (2nd Cir. 1991)
  • This case deals with liability of the tippee of a misappropriator (remote tippee)
  • Ira was President and CEO of Waldbaums, which was about to be acquired by A&P.
  • Ira told his sister, Shirley, who told her daughter, Susan who told her husband, Keith.
  • Keith then told his broker Chestman, who went out and bought Waldbaums stock.
  • Keith is the alleged misappropriator. Chestman is liable if Keith owed and breached a fiduciary duty to his wife that Chestman knew or should have known about.
  • What constitutes a fiduciary relationship?
    • The common law has recognized that some associations are inherently fiduciary, including attorney and client, executor and heir, guardian and ward, principal and agent, trustee and trust beneficiary, and senior corporate official and shareholder.
    • But what if we don’t have one of these traditional fiduciary relationships? Look for the essential characteristics of a relationship of trust and confidence, which are dependence and influence.
  • What about the family context?
    • Mere family relationships or marriage is not enough.
    • Need to show evidence of repeated disclosure of business secrets.
  • The jury in this case was not given any evidence of past disclosures. Keith owed neither the Waldbaum family or Susan a fiduciary duty or its functional equivalent and did not defraud them by disclosing news of the pending tender offer to Chestman. No Rule 10b-5 violation.
  • The court says Chestman still violated Rule 14e-3 (just have to prove they traded on nonpublic material information about a pending tender offer).

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