LexisNexis Corporate & Securities Law Community 2011 Top 50 Blogs

Your donation keeps us advertisement free

Friday
Mar092012

Presidential Candidates and Sarbanes Oxley

During this presidential cycle, there have been plenty of calls for repeal of Dodd Frank (or significant portions thereof).  Some have also indicated a desire to repeal Sarbanes Oxley.  Newt Gingrich has called for repeal of SOX.  So has, apparently Rick Santorum and Ron Paul

Mitt Romney has supported the repeal of portions of Dodd Frank.  He apparently thinks that SOX should also be repealed.  According to one recent report:

After Mr. Romney vowed to repeal President Barack Obama’s health care overhaul and the Dodd-Frank financial regulation law, a voter in the crowd asked whether his list of repeals would include Sarbanes-Oxley, as well.  “Yes,” Mr. Romney said. “People who have spent their life in Washington in many cases … don’t understand that when they write a piece of legislation what kind of impact that’s going to have in the private sector, how many people’s lives will be affected by it.”

An off the cuff answer to a single question doesn't necessarily provide complete information about the candidate's views.  While some sections of the Act are controversial (section 404(b) for example), others, for the most part are not (the mandatory separation of auditing and non-auditing functions).  Moreover, Romney's web site is a bit more nuanced on the issue (calling for amendments "to relieve mid-size companies from onerous requirements"). 

Its possible, therefore, that the candidate has a more complex view on SOX than could have been articulated in a rapid question and answer format.  Nonetheless, with Congress increasingly involved in this area, one can hope that this will encourage public debate over the corporate governance provisions in SOX and Dodd Frank and their role in promoting investor protection.   

Thursday
Mar082012

Lawrence v. Bank of America: Allegations of Actual Knowledge of Ponzi Scheme Fall Short

In Lawrence v. Bank of America, D.C. Docket No. 8:09-cv-02162-VMC-TGW, 2012 LEXIS 777 (11th Cir. Jan. 11, 2012), putative class action plaintiffs alleged “(1) common law fraud; (2) conversion; and (3) breach of fiduciary duty” against Bank of America (“BOA”). These causes of action stemmed from allegations that BOA was aware of, and “substantially assisted in,” a Ponzi scheme by one of its account holders.  The Eleventh Circuit Court of Appeals affirmed the district court’s holding to dismiss the initial complaint and denied the plaintiffs leave to amend their complaint.

Through his company, Diamond Ventures LLC, Beau Diamond (“Diamond”) allegedly engaged in a Ponzi scheme and deposited millions of dollars from investors into an account at BOA. By upgrading the account to the Premier Banking Division which could “provide daily updates on major deposits and wire transfers,” the plaintiffs alleged BOA should have been on alert that only $15,400,000 of the $37,600,000 deposited was invested in foreign exchange companies. Additionally, Diamond described his business to BOA as an “investment club,” even though BOA prohibited such “clubs.”

Under the federal securities laws, there is no cause of action for aiding and abetting violations of the antifraud provisions. See Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). In order to survive a motion to dismiss for aiding and abetting under state law, a plaintiff must show “(1) an underlying violation on the part of the primary wrongdoer; (2) knowledge of the underlying violation by the alleged aider and abetter; and (3) the rendering of substantial assistance in committing the wrongdoing by the alleged aider and abettor.”

The court held that the plaintiffs’ allegations were too weak to infer that it was plausible the bank had “actual knowledge” of the scheme, in spite of the alleged “atypical” transactions. Even though BOA authorized numerous large transactions by Diamond, it was not required to “investigate” them under Florida law.

The plaintiffs attempted to strengthen the inference of actual knowledge by showing that a BOA representative advised another bank customer that Diamond’s clients were “happy with their investment,” and consequently, that customer transferred money to Diamond Ventures. The court found that this “amendment would have been futile” because the positive comments do not “necessarily establish [BOA’s] participation in a Ponzi scheme.”

The primary materials for this case may be found on the DU Corporate Governance website.

Wednesday
Mar072012

Citizens United and the SEC (Part 3)

So what might happen if the SEC doesn't propose rules requiring disclosure of political contributions? 

Efforts are afoot in Congress to provide a legislative solution.  Congressman Van Hollen recently reintroduced the DISCLOSE 2012 Act. This is legislation that would impose a variety of disclosure requirements on corporations in connection with campaign contributions.   

Most of the proposed legislation deals with mandatory reports to the Federal Election Commission.  Tucked away inside, however, is a proposed amendment to the Federal Election Campaign Act that would add a mandatory disclosure requirement aimed at shareholders.  While the provision also applies to non-profits and their donors, the title of the proposed section identifies its primary intent:  "Shareholders' Right to Know."  

The provision applies to a "covered organization which submits regular, periodic reports to its shareholders, members, or donors on its finances or activities".  Because a covered organization includes a corporation, this language would presumably apply to any public company that distributes proxy materials to shareholders. 

The language, however, could be much broader and apply to non-public companies that routinely distribute financial materials to shareholders.  Companies may do so because of state law requirements (perhaps to conform with the duty of complete honesty), contractual obligations, and on a voluntary basis in order to keep shareholders informed.

The proposed legislation provides that the information distributed to shareholders must include "in a clear and conspicuous manner, the information included in the statements filed by the organization under section 324 with respect to the campaign-related disbursements made by the organization during the period covered by the report."  The proposed requirement also mandates that companies maintaining a web site include a link to the disclosure at the FEC web site.  The link must go up within 24 hours of posting at the FEC site and remain in place at least one year from the date of the relevant election.  

The provision requires disclosure to shareholders.  Yet the agency with more than 70 years of experience crafting shareholder disclosure -- the SEC -- is nowhere mentioned in the legislation. To the extent there is a need for implementing regulations, therefore, the task presumably falls to the FEC.  An agency with no experience in shareholder disclosure owuld become primarily responsible for shareholder disclosure. 

The approach also opens the door for conflicting regulation.  Nothing in the legislation changes the SEC's general authority to regulate the content of a proxy statement.  Thus, whatever disclosure the FEC imposes, the SEC could add to it.  Moreover, even if the SEC did not impose additional requirements, the antifraud provisions would still be available for actions against companies in the event of incomplete disclosure.  Thus, the SEC (and private parties) could bring actions against companies conforming to the FEC disclosure requirements where the disclosure was viewed as materially incomplete.     

In short, companies confront the risk of disclosure regulation by a second agency not necessarily equipped for the task.  They confront the risk of conflicting regulatory regimes.  And the SEC confronts the possibility that the proxy disclosure requirements will need to be shared with another agency.  

None of this sounds particularly appealing.  Can this be headed off?  Presumably if the SEC acts, there will either be less reason (or no reason) for legislation designed to regulate disclosure to shareholders.  Moreover, the requirements will be ensconced in regulations rather than statutes, providing greater flexibility in crafting the standards.   Finally, it will leave corporate disclosure where it belongs, with the SEC.  

Of course, the concern over congressional intervention is only as serious as the likelihood the legislation will be adopted.  It has 117 co-sponsors.  Nevertheless, Congress is very divided these days and likely to remain without a consensus on this issue, at least through the November elections.  But after that, all bets are off.  Pressure for reform will likely continue to build.  Moreover, serious abuse or scandal may cause Congress to act with unscheduled alacrity.  Recall that Sarbanes Oxley was moribund until the collapse of Worldcom.  Campaign finance disclosure could easily undergo a similar reincarnation. 

The Commission needs to take control of this issue and not cede away such an important disclosure issue to another agency.  For that to occur, the Commission will need to move forward with rulemaking in this area. 

Wednesday
Mar072012

Citizens United and the Political Process

While all eyes focused yesterday on the Republican primaries/caucuses taking place on Super Tuesday, some Democrats also caucused. 

Caucuses were held, for example, in Colorado.  For those in Denver, copies of the platform for the Democratic Party of Denver was distributed (a copy is here).  One of the planks in the Platform provided: "We believe that corporations are not persons and should not be treated as persons under the law and support legislation to reverse the effects of the Citizens United case."

It has to be a relatively rare circumstance where a local party platform specifically references a Supreme Court opinion and takes issue with something as esoteric as the status of corporations.  Nonetheless, it is evidence of the deep feelings stirred by the opinion and perhaps another indication that the issue will eventually generate a legislative change.  

Tuesday
Mar062012

Citizens United and the SEC (Part 2)

We are discussing the SEC's role in requiring disclosure of political expenditures.  The issue was recently addressed by  Commissioner Aguilar at SEC Speaks in February.  SEC Speaks is a special forum.  It's an annual conference about the SEC.  Because the conference takes place in Washington, most or all of the commissioners typically speak.  Moreover, the broad based nature of the conference and the emphasis on the SEC effectively provide commissioners with a broad range of choice in selecting an appropriate topic. 

And in fact, the talks spanned the gamut.  The Chair gave a "state of the SEC" address, reviewing a number of changes and initiatives that have taken place at the Agency.  Commissioner Walter essentially did a retrospective on her long tenure at the Commission (as a staff member and as a commissioner). Commissioner Gallegher spoke about liability for the failure to supervise by compliance and legal personnel at broker dealers and investment advisors.  Commissioner Paredes discussed the Volker Rule. 

Commissioner Aguilar's talk wasn't about the merits of political contributions by corporations but about the need to protect shareholders and investors by ensuring adequate disclosure.  The existing disclosure regime, he reasoned, often left shareholders "in the dark as to whether the companies they own, or contemplate owning, are making political expenditures." Without adequate disclosure, shareholders and investors could not "can make informed decisions about whether to purchase, hold, or sell shares – and how to exercise their voting rights."

He noted the calls on the Agency to initiate rulemaking on the issues.  A group of law professors submitted a rulemaking petition.  So has 21 civic organizations.  In addition: 

The Commission has also received letters from Members of Congress, from elected government officials with fiduciary responsibility for nearly one trillion dollars in pension fund assets, and from a coalition of United States Senators. Each of these letters asked the Commission to take action to require public disclosure of corporate political spending.

The staff has taken some steps in the direction of disclosure by refusing to allow for the exclusion of shareholder proposals addressing campaign contributions.  They have become popular.  According to Commissioner Aguilar:  

in 2011, out of the 465 shareholder proposals appearing on public company proxy statements, 50 proposals were related to political spending.  In fact, more proposals of this type were included in proxy statements than any other type of proposal.  During the 2011 proxy season, 25 of the companies in the S&P 100 included proposals on their proxy statements requesting disclosure of corporate spending on politics. 

For the most part, however, these proposals are precatory and, as a result, need not be followed even if adopted.   

The Commission could be actively pursuing rulemaking efforts in this area, with the efforts still nonpublic.  The speech from Commissioner Aguilar, however, suggested that the development of disclosure standards was not an area of priority.  He called on the Commission the "act swiftly to rectify the situation by requiring transparency."

Any lack of priority may have a number of understandable explanations.  For one thing, the Agency is busy with the burdens of Dodd-Frank.  Political disclosure is not mandated and, as a result, operates under no required time frame.

Another possibility is that the SEC is hesitant to enter a thicket that will almost certainly result in serious attack, no matter what position it takes (the pactice of unprecedented criticism mentioned by Commissioner Walter described in her talk at SEC Speaks).  Indeed, if even settlement in the Goldman case can generate criticism (over whether it involved coordination with the Administration), there is little doubt that something as volatile as political contributions will produce the same result. 

But having said that, there is a potentially serious draw back to any inactivity by the Commission.  It may well lose control over the issue and see corporate disclosure regulated by yet another agency.  We will address that in the next post. 

 

Monday
Mar052012

Citizens United and the SEC (Part 1)

Whatever one thinks of Citizens United and the opinion by Justice Kennedy, the impact seems ubiquitous.  Super pacs are everywhere and corporate money seems to be sloshing through the system.

Even some on the Supreme Court are concerned.  In a statement appended to the decision to stay the Montana Supreme Court, Justices Ginsburg and Bryer all but asked for an appropriate cert petition to permit reconsideration of the decision.  As they noted:

Montana’s experience, and experience elsewhere since this Court’s decision in Citizens United v. Federal Election Comm’n, 558 U. S. ___ (2010), make it exceedingly difficult to maintain that independent expenditures by corporations "do not give rise to corruption or the appearance of corruption." Id., at ___ (slip op., at 42). A petition for certiorari will give the Court an opportunity to consider whether, in light of the huge sums currently deployed to buy candidates’ allegiance, Citizens United should continue to hold sway. 

It wasn't supposed to be this way.  Justice Kennedy saw a solution:  Corporate governance.  As he reasoned in Citizens United:   

Shareholder objections raised through the procedures of corporate democracy, . . . can be more effective today because modern technology makes disclosures rapid and informative. A campaign finance system that pairs corporate independent expenditures with effective disclosure has not existed before today. . . . With the advent of the Internet, prompt disclosure of expenditures can provide shareholders and citizens withthe information needed to hold corporations and elected officials accountable for their positions and supporters. Shareholders can determine whether their corporation’spolitical speech advances the corporation’s interest inmaking profits, and citizens can see whether elected officials are "‘in the pocket’ of so-called moneyed interests." . . . The First Amendment protects political speech;and disclosure permits citizens and shareholders to react to the speech of corporate entities in a proper way. This transparency enables the electorate to make informed decisions and give proper weight to different speakers and messages.  

In effect, for Justice Kennedy, disclosure was enough.  With disclosure, shareholders could determine whether contributions are profit maximizing behavior and, if not, could hold management "accountable".  

We have already discussed the fallacy of this approach.  It reflects a lack of understanding of the governance process, particularly the limits imposed under state law on shareholder authority.  But whatever the weaknesses, the approach presupposes that political contributions will be subject to clear disclosure requirements. 

Disclosure is for the most past the responsibility of the SEC.  Moreover, disclosure is the principle mechanism behind private ordering.  The market is informed and companies can respond in the most efficient way. That is not to say that all disclosure is a good thing.  Disclosure burdens can become excessive.  This has been a particular concern with respect to proxy disclosure.  

SEC intervention in this area, however, does not seem to fit the "excessive disclosure" concern.  Rather than merely add complexity, the information is something shareholders seem to want.  More importantly, inaction may result in significant administrative consequences. 

Congress has proposed legislation that could preempt the area.  The legislation would require companies to report political contributions to the the Federal Election Commission (FEC).  In addition, however, the legislation would require disclosure to shareholders.  Only the DISCLOSURE 2012 ACT leaves execution of these requirements to the FEC, not the SEC.  In other words, congressional intervention would oust the SEC for the disclosure process.   

SEC rulemaking efforts in this area might head off the legislation.  So is the SEC moving forward in this area?  We will discuss this in the next post. 

 

Friday
Mar022012

"Spending Time with Family" and the Antifraud Provisions

It is a time honored practice to explain a CEO's resignation as motivated by family concerns.  It might be to spend more time with family or something a bit more generic (family reasons, which presumably could, for example, include such things as repairing relations with a spouse). 

When the CEO of Pfizer resigned in 2010, the press release indicated he wanted to “recharge my batteries, spend some rare time with my family and prepare for the next challenge in my career.”  The departing CEO of Restuarant.com likewise wanted to spend time with family.  So did Dick Notebart when he stepped down as CEO of Qwest.  The same was true at Red Roof Inn and Kellogg

With respect to the recent resignation of the CEO at Stryker, the press release indicated that he resigned "for family reasons".  According to the WSJ

The 48-year-old executive resigned Feb. 8 after apparently losing the confidence of some key board members at the medical-device maker, according to a person familiar with the matter.  Those board members became bothered after learning of [the CEO's] purported affair while he was involved in divorce proceedings, this person said. The divorce isn't final, according to Michigan court documents. The alleged affair couldn't be independently confirmed.

We have no idea whether any of this is true.  Nor do we know whether the resignation was prompted by anything other than family reasons.  Indeed, romantic involvement with a former employee by a CEO going through a divorce, to the extent it even occurred, doesn't seem to raise the types of concerns that typically result in a CEO being pressured to leave. 

Nonetheless, it got us thinking about whether a company could be successfully sued under the antifraud provisions (the infamous Rule 10b-5) when using the "family" explanation for a CEO's departure.  The practice may be widespread.  As the WSJ noted:

Boards force out a CEO over what they consider unethical behavior more often than commonly believed but rarely divulge that's the reason, according to experts. Many directors want their leader to live by high standards, and will replace the CEO if they believe he or she "has shown bad judgment in personal life,'' a succession-planning specialist said.

We start with the assumption that the motivation is true.  Officers commonly depart for family reasons.  So the issue under the antifraud provisions is not whether the family explanation is false but whether, having disclosed one motivation, the company is required to reveal any other significant motivation for the departure. 

This arises from the obligation under the antifraud provisions to ensure that all statements to the market are accurate and complete, an obligation that, by the way, also arises under state law.  See Sherwood v. Ngon, 2011 Del. Ch. LEXIS 202 (Del. Ch. Dec, 11, 2011) (statement may have been misleading by implying that motivation given for removing director " was the only reason that motivated the board to remove him from the Company's slate.").  

Resolution of the disclosure issue for the most part depends upon the materiality of any omitted motivations.    Materiality, in turn, depends upon the context. 

In many cases, there is an argument that omitted motivations won't be material either because they are unimportant to reasonable investors or because the market already knows the truth.  Thus, shareholders in a company where earnings or stock prices have performed poorly will know that these were factors likely played a role in the resignation, even if they were unstated. See Zahid Iqbal & Dan French, Executive share ownership, trading behavior, and corporate control, 59 J. of Economics and Business 298, 299 (2007) (noting that while companies often attribute executive departure to "early retirement" or "personal reasons," at least one study  concluded that "whatever the reason stated [for an executive's departure], the majority of executive turnover during financial distress is associated with the financial condition of the company."). 

Moreover, in those circumstances, share prices sometimes actually go up.  Shareholders do not care about the reason for the departure, only that the departure occurred.  In other cases, the departure of the CEO may matter but the reasons do not. 

Motivations that have the strongest chance of crossing the materiality threshold are those that reflect not so much on the CEO but on the company.  Thus, for example, a "resignation" of a CEO as part of an interenal investigation into financial fraud or a departure arising out of criminal investigation of the company may well be material.  These motivations suggest problems inside the company that shareholders and investors would want to know about. 

What about allegations of unethical behavior?  For one thing, that concept is extremely broad with no automatic content.  Moreover, context clearly matters.  Ethical issues in the context of a CEO who remains at the helm may be very material (and therefore subject to disclosure).  Investors would want to know about the unethical behavior in assessing their trust in management when buying shares.  Shareholders would presumably weight the factor when voting for directors. 

In the context of a CEO's resignation, however, departures as a result of "ethical" concerns would generally seem to add little to the total mix.  The trust issue is not particularly important since the CEO is departing.  Materiality might be a concern if the CEO's behavior somehow results in substantial exposure to the company (say the loss of all government contracts).  But this would likely not be the case in most instances.  

Returning to the Stryker situation, the company disclosed that the CEO departed for "family reasons."  The share prices hardly changed.  When the WSJ published an article hinting at other possible motivations, the share prices again hardly changed.  Perhaps the market did not believe the hints.  Or, perhaps the market didn't care.  In other words, perhaps the motivations for the resignation were not material. 

The materiality of omitted motivations in the context of a resigning CEO will depend on each specific set of circumstances.  Nonetheless, as a general rule, it will often be a difficulty case to maintain. 

Thursday
Mar012012

SEC v. Huff: Disgorgement Amount in Civil Enforcement Suit does not have to be Exact

On January 3, 2012, the 11th Circuit Court of Appeals in SEC v. Huff, No. 11-10758 (11th Cir. Jan. 3, 2012) affirmed the trial court’s decision to order the defendant to disgorged all of the profits associated with the fraudulent scheme.   

The Securities and Exchange Commission (“SEC”) filed a civil enforcement action against Anthony Huff (“Huff”) for allegedly diverting millions of dollars from Certified Services, Inc. (“Certified”) to another company, Midwest Merger Management, LLC.  The district court held Huff liable for five counts of securities law violations and ordered Huff to disgorge over $10 million plus interest.  SEC v. Huff, No. 08-60315-CIV-ROSENBAUM (S.D. Fla.).  Huff appealed the decision, claiming that the trial court’s liability determination and disgorgement amount were based on insufficient evidence and constituted an abuse of discretion.

In a per curiam opinion, the 11th Circuit held that the trial court did not abuse its discretion in ordering the multimillion dollar disgorgement.  More specifically, the court explained that the defendant had failed to meet “his heavy burden” of showing that the trial court had erred in finding that he fit the requirements of a “controlling person” under section 20(a) of the Securities Exchange Act.  15 U.S.C. § 78t(a).   The finding that Huff reviewed and approved the misleading SEC filings was considered “wholly plausible” and the court held that the lower court did not err in finding that Huff in fact “had the requisite power to directly or indirectly control or influence the specific corporate policy” which led to the fraudulent conduct.
 
Huff also appealed the trial court’s calculation of $10.017 million plus interest as an appropriate amount of money for disgorgement.  He claimed that the trial court’s amount was not exact.  A court, however, is not required to be precise in its approximation.  SEC v. ETS Payphones, Inc., 408 F.3d 727, 735 (11th Cir. 2005) (stating that the SEC’s burden for showing the amount subject to disgorgement is “light”).  In addition, the 11th Circuit held that the trial court did not abuse its “broad discretion” in ordering disgorgement of “the profits associated with the fraudulent scheme” based upon the “pervasive” nature of the fraud.  As a result, the 11th Circuit upheld the trial court’s holding that Huff should pay over $10 million plus interest for his securities law violations.

The primary materials for this case may be found on the DU Corporate Governance website.

Saturday
Feb252012

“NIMBY” Austerity

In poker, when a good player catches an opponent trying to bluff, the explanation often includes: “The story he was trying to tell me just didn’t make any sense.”  In other words, the hand the bluffer was attempting to represent didn’t fit the actions he took leading up to the bluff.  I thought of this when I read in the Wall Street Journal (here) that:

European Central Bank President Mario Draghi warned beleaguered euro-zone countries that there is no escape from tough austerity measures and that the Continent's traditional social contract is obsolete. 

The reason I thought of the bluffer telling an unconvincing story when I read this was because for many people in the world, the story leading up to this statement goes as follows:

(1) We get pushed to the brink of the worst global financial crisis since the Great Depression of 1929 by a combination of fat cats taking excessive risks and complicit regulators refusing to oversee critical areas of the market while implicitly guaranteeing the fat cats’ losses. 

(2)  Somewhere on the way to holding the wrongdoers accountable, the script gets flipped and we are told the crisis is actually one of unsustainable safety nets.  In perhaps the greatest twist in the story, those telling us that the crisis is now about over-spending also tell us that de-regulation is now a key component of the cure. 

(3)  Finally, the fat cats and their cronies in government tell the blue collar workers of the world that in order for crisis to be averted the blue collar workers must all tighten their belts.  The fat cats and their cronies then get into their chauffeured limos and drive off to their gated communities to count the profits that their recently bailed out firms are generating.

Obviously, it would be hard for me to tell this story in a more lopsided way, but my point is not that the failure to regulate swaps, or the repeal of Glass-Steagal, is more to blame for our current difficulties than overspending.   Nor am I trying to argue that imposing austerity measures on the middle class is an ineffective response.  What I am trying to say is that perceptions matter, and that I fear that the perception of a large portion of the global population is that they are being told a story designed to bluff them into giving up a lot, while those doing the asking don’t appear to be giving up much at all.  (For example, go here to read why Michael Moore thinks "America Is Not Broke.")  

This is what I mean by NIMBY (not-in-my-back-yard) austerity, and this is a problem because it goes to legitimacy.  When the people don’t believe their government has any legitimate basis for asking them to sacrifice, the response often comes in the form of riots like we are seeing in Greece.  What the leaders of the world that are calling for austerity need to do is create a sense of shared sacrifice.  I’m not sure how they best go about doing that, but I’m pretty sure it doesn’t include seeking sympathy for how tough it is to juggle a household staff, second home, and $50,000 vacation on a short bonus.

Thursday
Feb232012

SEC v. Weintraub: Businessman Liable for Multi-Billion Dollar Tender Offers

In SEC v. Weintraub, No. 11-21549-CIV-HUCK/BANDSTRA (S.D. Fla. Dec. 30, 2011), the court granted the U.S. Securities and Exchange Commission’s (“SEC”) motion for summary judgment against defendants Allen E. Weintraub and AWMS Acquisition, Inc., for violating Securities and Exchange Act sections 10(b) and 14(e) and SEC rules 10b-5 and 14e-8.

According to the SEC, Weintraub is the sole owner and director of AWMS Acquisition, Inc., d/b/a Sterling Global Holdings (“Sterling Global”).  On March 19, 2011, Weintraub sent a letter to Eastman Kodak Company (“Kodak”) that offered to purchase all of the company’s outstanding stock at a 46 percent premium for $1.3 billion.  Ten days later, Weintraub sent a similar letter to American Airlines’ parent company AMR Corporation (“AMR”), offering to purchase all of the company’s outstanding stock at a 48 percent premium for $3.25 billion.  Neither Kodak nor AMR responded to Weintraub’s letters.  Weintraub also contacted several reporters and media outlets, falsely informing them that Sterling Global was in “discussions” with Kodak and that “several large institutions” were backing him in the deal with AMR.

The SEC alleged that, despite Weintraub’s representation that he had received financing from banks to engage in these transactions, he in fact had received no financial backing from any of the three banks he approached.  Weintraub failed to disclose to Kodak, AMR, these companies’ shareholders, and the press that he pled guilty to money laundering and organized fraud in 2008, he was currently on probation, the United States District Court for the Southern District of Florida “permanently enjoined him from acting as an officer or director of any public company as a result of a previous violation of federal securities law” in 2002, he currently owed a judgment of $1,050,000 to the court, he filed for bankruptcy in 2007, and that Sterling Global was dissolved in 2010.

Section 10(b) and rule 10b-5 require that plaintiffs prove a material misrepresentation or omission, a connection between the misrepresentation or omission and purchase or sale of a security, and scienter.  Whereas ordinary plaintiffs must also prove reliance, causation, and economic loss, the SEC has a lower standard and is only required to show the first three elements.

The court held that the first element of the section 10(b) and rule 10b-5 claim was met, because Weintraub repeatedly made misrepresentations and omissions concerning “(1) his and Sterling Global’s ability and intention to consummate the deals with Kodak and AMR, (2) his personal background, (3) his ownership of stock in AMR, and (4) his representations to media outlets.”  Not only did Weintraub and Sterling Global lack the financial ability to purchase these companies’ outstanding stock, Weintraub consciously withheld material information regarding the prior dissolution of his company and his inability to act as an officer or director for the company, among several other items.

A false statement or omission is material when “there is a substantial likelihood that a reasonable investor would have believed the false or misleading statement or omission was important in deciding whether to purchase, sell, or hold securities.”  Weintraub’s statements to the two companies, their shareholders, and the press about his purported tender offers “gave the impression that [they] were serious and could be relied upon by investors”; thus, the court determined they were material.

The court held that the second and third elements of section 10(b) and rule 10b-5 were met because an offer to purchase a company’s outstanding stock is “in connection with” the purchase or sale of a security, and because Weintraub clearly intended to deceive the public when he sent offer letters after failing to acquire financing. 

The SEC also successfully proved Weintraub’s violations of section 14(e) and rule 14e-8.  Section 14(e) states that “[i]t shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact…in connection with any tender offer….”  The court held that Weintraub unmistakably made material misrepresentations and omissions regarding his purported tender offers and personal background. 

The primary materials for this case may be found at the DU Corporate Governance website.

Wednesday
Feb222012

The SEC and Small Capital Formation: The Bad Girl Provisions (Part 4)

Bad actor provisions are often described as "bad boy" provisions.  See Securities Act Release No. 9211 (May 25, 2011) (noting that bad actor provisions are "sometimes called 'bad boy' provisions").  This is another hallowed and ancient term in the lexicon of securities lawyers.  The term has been around at least since 1982. 

Nonetheless, times change and so do terms.  We note this exchange in a recent roundtable on small business capital formation:

MR. BERKELEY:The only other point that I would make is that the bad boy -- excuse me, bad person -- provisions --

MS. CROSS: Bad actor.

MR. BERKELEY: Bad actor provisions -- that's --politically correct is bad. Bad persons is not politically correct.

MS. CROSS: Bad actor.

MR. BERKELEY: Okay, sorry. My apologies to all concerned. It's only been bad boys since 1982 or thereabouts, but you know -

Politically correct or not, one suspects that the term "bad boy" is simply wrong.  There are no doubt plenty of women who are bad actors and are, therefore, disqualified from using the relevant exemptions.  Time to give women their due and jettison the term "bad boy" from the securities lexicon.

Tuesday
Feb212012

The SEC and Small Capital Formation: Strengthening the Bad Actor Provisions (Part 3)

The recently formed Advisory Committee on Small and Emerging Companies has recently recommended that the SEC relax the general solicitation requirement for offerings under Rule 506.  We have been discussing the connection between any relaxation and the SEC's proposal to extend bad actor disqualifications to offerings under Rule 506.

While expansion of the use of general solicitations can benefit legitimate companies raising capital, extension of the bad actor provisions to Rule 506 seeks to ensure that this expanded authority will not be used by recidivists. 

To the extent that these reforms can be read in conjunction, it suggests that considerable thought needs to be given to the appropriate type of bad actor provisions.  These provisions generally disqualify issuers, brokers, promoters, and certain large shareholders from relying on the relevant exemption (only Regulation A and Rule 505 contain bad actor provisions) to the extent having engaged in the specified disqualifying conduct. 

Several observations about this approach deserve comment.  First, the Commission has proposed an extension of the bad actor provisions to Rule 506.  The SEC has asked for comments on whether the bad actor provisions should be extended to Rule 504, the seed capital rule.  The answer is that they should for the reasons specified here:   Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.  Under certain circumstances, Rule 504 allows for the use of general solicitations.  Extending the bad actor provisions to the rule would effecitvely prohibit recidivists from using general solicitations while preserving the right for legitimate companies.

Second, the category of bad actors should be expanded.  Violations of the registration requirements sometimes involve active participation by transfer agents and lawyers.  This occurs because exempt securities typically contain a legend on the certificate restricting resale.  Often, fraudulent offerings involve the improper removal of the restriction.  The legend is lifted by the transfer agent typically after receiving an opinion of counsel.

Transfer agents and lawyers should, therefore, be included in the type of persons who can render an exemption inapplicable.  For both, however, this should only occur where they are found, in effect, to be active and knowing participants in a registration violation.  This is discussed in greater detail here:  Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.

Strong bad actor provisions will help insure that any relaxation in the ban on general solicitations is accompanied by requirements designed to prevent improper use of this authority.  In short, bad actor provisions target bad actors without interfering with the ability of legitimate companies to raise capital. 

Monday
Feb202012

The SEC and Small Capital Formation: General Solicitations and Private Placements (Part 2)

Small capital formation is an important area that requires constant reexamination.  After all, the central system for regulating capital raising was put in place in the Securities Act of 1933, long before the invention of cell phones, email blasts and the Internet.  Technology alone, therefore, necessitates constant reexamination.  

The committee has been relatively active, having met three times so far:  Oct. 2011, Jan. 2012 and Feb. 2012.  The Committee has looked at a number of tough issues, including crowdfunding.  The Committee has, so far, issued one recommendation.  The recommendation relates to the relaxation of the general solicitation requirement for private placements.  The recommendation provides that:

the Commission take immediate action to relax or modify the restrictions on general solicitation and general advertising to permit general solicitation and general advertising in private offerings of securities under Rule 506 where securities are sold only to accredited investors.

General solicitations are, in general, prohibited under Regulation D.  The big exception is in Rule 504, the seed capital exemption.  General solicitations can be made under the rule if the offering meets certain requirements under state law.  17 CFR 230.504. 

General solicitations facilitate capital raising by allowing companies to mass market an exempt offering, thereby locating the largest number of potential investors in a cost effective way.  The tension in the area, however, is that the same mass marketing techniques can also facilitate fraudulent offerings.  Who hasn't received an email suggesting great things about a penny stock.  Similarly, pump and dumps generally require some type of general solicitation to succeed.  For more on this, see Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.   

One way to take this tension into account is to allow for general solicitations in some cases but take other steps designed to minimize the possibility that the exemption will be used for improper purposes.  The SEC has a rule proposal outstanding that would do that by extending bad actor disqualifications to offerings under Rule 506.  See Securities Act Release No. 9211 (May 25, 2011).  To the extent these proposals are adopted (something more or less mandated by Dodd-Frank), any relaxation in the general solicitation requirements under Rule 506 will be done in conjunction with restrictions on the use of the authority by recidivists and other bad actors.

Thus under this model general solicitations will facilitate capital raising by legitimate companies while bad actor provisions will ensure that recidivists who violate the rule will be prohibited from using it.  We will discuss a few of the implications of this approach in the next post.

For more on this topic, see Seed Capital, Rule 504 and the Applicability of Bad Actor Provisions.     

Saturday
Feb182012

Has Anything Changed Since Citizens United to Revive the Anti-Corruption Rationale?

Yahoo reports that the Supreme Court has blocked a Montana Supreme Court ruling that upheld a state ban on corporate political independent expenditures.  The ruling appears to be in direct conflict with Citizens United, though the Montana Supreme Court did seek to distinguish its ruling on the basis of Montana’s unique experience with corruption.  See Western Tradition Partnership, Inc. v. Attorney General, 363 Mont. 220, [ ] (2011) (“unlike Citizens United, this case concerns Montana law, Montana elections and it arises from Montana history”); id. at  [ ] (“The question then, is when in the last 99 years did Montana lose the power or interest sufficient to support the statute, if it ever did.”).  You can find the full text of the Montana opinion here.

Interestingly, a quote from Justice Ginsburg in the Yahoo article, on behalf of herself and Justice Breyer, raises the question of whether the reality of post-Citizens United corporate spending on elections might change the Court’s conclusion as to the absence of any corruption concern vis-à-vis corporate independent expenditures:

Justice Ruth Bader Ginsburg, a dissenter in Citizens United, issued a brief statement for herself and Justice Stephen Breyer saying that campaign spending since the decision makes "it exceedingly difficult to maintain that independent expenditures by corporations 'do not give rise to corruption or the appearance of corruption.'"

To see for yourself whether there is any room for revisiting the rejection of the anti-corruption rationale in Citizens United, you might want to go back to that opinion (which you can find here) and (re-)read pages 40-45, which contain the bulk of the majority’s discussion of that point.  In particular, I’d ask you to consider what you think of the “evidence” the majority presents to support its conclusion that “independent expenditures, including those made by corporations, do not give rise to corruption or the appearance of corruption.”  Specifically, ask yourself whether that evidence is sufficient to take that determination out of the hands of Congress.  Finally, ask yourself what you think of the majority’s further conclusion that: “The appearance of influence or access, furthermore, will not cause the electorate to lose faith in our democracy.”  Before answering that question, you might want to read some of the comments that follow the Yahoo article.

Friday
Feb172012

The SEC and Small Capital Formation: The Advisory Committee on Small and Emerging Companies (Part 1)

The Commission recently set up the Advisory Committee on Small and Emerging Companies.  Implemented under the Federal Advisory Committee Act, the SEC announced the formation of the Committee in September 2011.  The committee is intended to focus on the capital raising needs of companies with less than $250 million in market capitalization.  The plan is to have the committee provide advice on: 

  • Capital raising through private placements and public securities offerings.
  • Trading in the securities of small and emerging and small publicly traded companies.
  • Public reporting requirements of such companies.

The committee has two chairs, Stephen M. Graham, Partner at Fenwick & West LLP in Seattle, and M. Christine Jacobs, CEO and Chairman at Theragenics Corp. in Buford, Ga.  In addition, the other members include: 

  • David A. Bochnowski, Chairman and CEO, Northwest Indiana Bancorp, Munster, Ind.
  • John J. Borer III, Senior Managing Director and Head of Investment Banking, Rodman & Renshaw LLC, New York, N.Y.
  • Dan Chace, Manager, Wasatch Micro Cap Fund, Salt Lake City, Utah
  • Milton Chang, Managing Director, Incubic Venture Fund, Menlo Park, Calif.
  • Joseph (Leroy) Dennis, Partner, McGladrey & Pullen, Bloomington, Minn.
  • Shannon L. Greene, CFO, Tandy Leather Factory, Fort Worth, Texas
  • Kara B. Jenny, CFO, BlueFly Inc., New York, N.Y.
  • Steven R. LeBlanc, Senior Managing Director of External Private Market, Teacher Retirement System of Texas, Austin, Texas
  • Richard L. Leza, Chairman of the Board, Exar Corp., Fremont, Calif.
  • Paul Maeder, General Partner, Highland Capital Partners, Lexington, Mass.
  • Kathleen A. McGowan, Vice President - Finance, Tobira Therapeutics Inc., Manalapan, N.J.
  • Catherine V. Mott, CEO and Founder, Blue Tree Capital Group, Pittsburgh, Pa.
  • Karyn Smith, Deputy General Counsel, Zynga Inc., San Francisco, Calif.
  • Dan Squiller, CEO, PowerGenix, San Diego, Calif.
  • Charlie Sundling, Chairman and CEO, Pipeline Software, Orange County, Calif.
  • Timothy Walsh, Director, State of New Jersey Division of Investment, Trenton, N.J.
  • Gregory C. Yadley, Partner, Shumaker, Loop & Kendrick LLP, Tampa, Fla.

In addition, there are two observers: 

  • Sean Greene, Associate Administrator for Investment and Special Advisor for Innovation, U.S. Small Business Administration
  • A. Heath Abshure, Arkansas Securities Commissioner and Chairman of the Corporation Finance Section of the North American Securities Administrators Association.

In the release announcing the formation of the Committee, the Commission proved for a two year period of operation "unless, before the expiration of that time period, its charter is re-established or renewed in accordance with the Federal Advisory Committee Act." 

The Commission has a web site that chronicles the activities of the Committee.  The Committee has a charter and bylaws in place. 

Thursday
Feb162012

Weaknesses in the Monitoring Function of the Board of Directors

Boards are primarily tasked with monitoring management.  As a matter of fiduciary law, Delaware requires that boards put in place a system designed to ensure that the board is informed.  In fact, this is a poorly developed area of law that lacks any guarantee that the reporting systems are meaningful. 

The WSJ reported that prosecutors had presented evidence to a grand jury in connection with alleged payments by Avon that may have violated the Foreign Corrupt Practices Act.  According to the article, Avon conducted an internal investigation of the matter.  As the article stated:

Authorities are focused on a 2005 internal audit report by the company that concluded Avon employees in China may have been bribing officials in violation of the Foreign Corrupt Practices Act, according to three people familiar with the matter. Avon had earlier said it first learned of bribery allegations in 2008.

The report, however, was, apparently, not given to the board of directors.  Again, as the article reports:

Executives at Avon headquarters in New York who saw the audit report at the time didn't disclose its findings to the board's audit committee, finance committee or the full board, according to people familiar with the investigation. Board members didn't learn of the audit report until after Avon launched its own internal investigation of overseas bribery allegations in 2008, say the people familiar with the situation.

One possible reason that the board did not receive the report was that it was required to be submitted and management simply did not follow through.  Another possibility, however, was that there was no system in place that required officers to provide the board with this type of information.  In other words, disclosure was discretionary and the relevant officers chose not to disclose it. 

To the extent the explanation is the latter, this is because Delaware law, while more or less requiring that there be some kind of reporting system in place (Caremark), has declined to give any real content to this requirement.  The courts have noted that liability can arise where "the directors utterly failed to implement any reporting or information system or controls".  Stone v. Ritter, 911 A.2d 362 (Del. 2006).  In other words, it is not enough to show that the system failed to provide important information to the board about ongoing internal problems.  Instead, plaintiffs must show that the entire system amounted to an utter failure of the reporting system. 

While officers for the most part will presumably bring significant issues to the board, there is an incentive not to if it makes them look bad.  Boards, after all, have the authority to fire officers deemed responsible for any misdeeds or mismanagement.   For a discussion of management's control over information given to the board and the rational goal of neutralizing the board's ability to intervene in corporate affairs, see Essay: Neutralizing the Board of Directors and the Impact on Diversity

The solution is not to leave the discretion in the hands of management but to mandate that certain types of information always be given to the board.  This may be the right thing to do but under the current state of law in Delaware it may not be what is legally required.

Wednesday
Feb152012

In re eBay, Inc. Derivative Litigation: A Failed Attempt to Bypass the Initial Demand Requirement

In In re eBay, Inc. Derivative Litigation, 2011 WL 3880924 (D. Del. Sep. 2, 2011), the plaintiff, an eBay shareholder, filed a derivative lawsuit against eBay and its board of directors. The complaint included violations of §8 of the Clayton Act for the re-nomination of an eBay board member who contemporaneously served on the board of an allegedly competing company. The defendants filed a motion to dismiss for failure to state a claim upon which relief may be granted. The United States District Court for the District of Delaware granted the defendants’ motion and dismissed the complaint.

Dawn Lepore, the allegedly interlocking member, became a director of eBay in 1999 and a director for the New York Times Company (“NY Times”) in 2008. In March 2009, eBay’s proxy statement re-nominated Lepore for another term on the board, and she was re-elected at the annual meeting in April of the same year. Both eBay and the NY Times attribute a large portion of their revenues to selling advertisements. Directors are enjoined from serving on the boards of competing companies at the same time under §8 of the Clayton Act.

Prior to bringing a derivative action, the plaintiff must show that it made an initial demand to the board of directors under the Federal Rules of Civil Procedure Rule 23.1. This initial demand may be excused if the plaintiff can show a “‘reasonable doubt’ that: (1) the directors were disinterested and independent; or (2) the challenged transaction was the product of a valid exercise of business judgment.” In this case, the plaintiff conceded that the directors were disinterested and independent.

Demonstrating that the challenged transaction was the product of a valid exercise of business judgment requires plaintiffs to plead “particularized facts sufficient to raise (1) a reason to doubt that the action was taken honestly and in good faith or (2) a reason to doubt that the board was adequately informed in making the decision.”

The plaintiff made three arguments attempting to show that the re-nomination was not taken in good faith nor adequately informed. First, the plaintiff alleged the re-nomination of Lepore was per se illegal as a violation of the Clayton Act, so the board should not be afforded protection under the business judgment rule which presumes the Board of Directors acted in the best interest of the corporation. The court rejected this claim because the plaintiff failed to show the directors “knowingly and intentionally” approved of illegal conduct.

Second, the plaintiff alleged the board’s action was ultra vires, or beyond the authorized power of the corporation, because its decision to place Lepore on the proxy was outside the scope of its authority. However, the court rejected this because there is nothing in eBay’s charter prohibiting the board’s action.

Third, the plaintiff alleged the board’s action was taken in bad faith. The court also rejected this claim stating that bad faith exists only when "a transaction [is] authorized for some purpose other than a genuine attempt to advance corporate welfare or is known to constitute a violation of applicable positive law” and that was not the case here.

The primary materials for this case may be found on the DU Corporate Governance website.

Tuesday
Feb142012

Shareholder Access: An Update

As Ted Allen has noted over at ISS, at least two companies so far have agreed to either adopt or submit to shareholders (with a supporting recommendation from management) an access proposal. Both however involve proposals with ownership thresholds higher than those adopted in the SEC's shareholder access rule. 

Western Union has agreed to propose a bylaw that would allow 5% owners who held the shares at least three years to include a "limited" number of nominees in the company's proxy statement.  Western Union is arguing that because it is submitting this proposal to shareholders, it may omit a proposal submitted by Norges Bank.   The Norges Bank proposal sought to give access right to shareholders with 1% of the shares who had held the shares for one year.  Under Rule 14a-8(i)(9), companies can omit any proposal that "directly conflicts with one of the company's own proposals to be submitted to shareholders at the same meeting."  Western Union is asserting that the differences in the respective access proposals constitutes a direct conflict. 

The other company that has apparently adopted an access bylaw is KSW. According to Ted Allen's post: 

In early January, KSW Inc., a small-cap firm, adopted a proxy access bylaw (5 percent for one year) in response to a binding shareholder proposal from the Furlong Fund that requests a 2 percent stake for one year. The company is seeking SEC approval to omit the fund's proposal and asserts that it has "substantially implemented" the resolution.

The bylaw adopted by KSW sets out the standard. While establishing a 5% ownership requirements, the bylaw arguably also limits access to individual shareholders who meet that threshold, excluding groups of shareholders who collectively own that amount. 

The KSW bylaw describes a "Nominator" as "a stockholder . . . who meets the criteria, and complies with the procedures" in the bylaw.  It further provides that the Nominator must "have beneficially owned 5% or more of the Company’s outstanding common stock (the “Required Shares”) continuously for at least one year". 

The bylaw does not expressly provide that the ownership percentage may be met by a group of shareholders.  Contrast this with the proposal approved submitted to shareholders of Cryo Cell back in 2007 that sought to give access right to "a shareholder or a group of shareholders." 

The provision also gives the person presiding at the meeting the right to disqualify candidates.  See KSW Bylaw ("The presiding officer of the meeting for election of Directors will, if the facts warrant, determine that a nomination was not made in accordance with the procedures prescribed by this By-Law 13, and if he or she should so determine, he or she will so declare to the meeting and the defective nomination will be disregarded.").

The other development has been, as the WSJ has noted, by HP to put a shareholder access proposal to a vote, although not this year. 

The Palo Alto, Calif., technology giant will give its stockholders the chance to approve so-called proxy access through a bylaw vote at its 2013 annual meeting. If the measure passes, investors who own at least 3% of H-P shares for at least three years would be allowed to nominate up to 20% of the company's directors, the company said. The vote would be binding, meaning H-P would be bound by the results.

HP apparently agreed to submit the proposal as part of a deal to get Amalgamated Bank  to withdraw an access proposal.

This is a very slow beginning to shareholder access.  The only real advantage to this case by case approach is that over time some proposals will be put in place (there are already a few) and some shareholder nominees will find their way into the company's proxy statement.  As companies get actual experience with shareholder access, the empirical data will likely make it much harder for opponents to assert that the practice is damaging to the governance of public corporations.    

Monday
Feb132012

Insider Trading and Congress: The Difficulties in Application

The Washington Post reported that Representative Spencer Bachus was under investigation by Office of Congressional Ethics.  According to the article: 

OCE investigators are examining whether Bachus violated Securities and Exchange Commission laws that prohibit individuals from trading stocks and options based on “material, non-public” inside information, said the individuals, who spoke on the condition of anonymity because of the sensitivity of the matter. The office also is investigating whether Bachus violated congressional rules that prohibit members of Congress from using their public positions for private gain.

The article provided one scenario that may have given rise to concerns about insider trading.  Congressman Bachus allegedly attended a "closed-door briefing" by high ranking government officials then traded options the next day.  As the article describes:

On Sept. 18, 2008, at the height of the economic meltdown, Bachus participated in a closed-door briefing with then-Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben S. Bernanke. At the time, he was the highest-ranking Republican member of the Financial Services Committee. According to a book Paulson would later write, the topic of the meeting was the high likelihood of decline across the entire economy if drastic steps were not taken.  The next day, Sept. 19, Bachus traded “short” options, betting on a broad decline in the nation’s financial markets, and collected a profit of $5,715.

Congressman Bachus, as the article makes clear, vigorously denies that any wrong doing occurred.  For one thing, he asserts that "no inside information provided in the briefing by Paulson and Bernanke." 

Nonetheless, the scenario provides a basis for a tutorial on the difficulties that can arise in applying the prohibitions on insider trading in these types of circumstances.  The difficulties, by the way, can be traced to poorly reasoned decisions by the Supreme Court (with Dirks and Chiarella the best examples). 

First, insider trading requires the use of material nonpublic information.  To the extent no such information was revealed at the briefing, there can be no insider trading.  

Assume, however, for sake of this tutorial, that Paulson and Bernanke presented nonpublic data that demonstrated a continued decline in the economy (perhaps statistical data or data on some of the companies at risk for collapse).  There is by the way nothing in the Washington Post article that in fact suggests this occurred and, as we have noted, the Congressman denies that there was any material nonpublic information disclosed at the briefing. 

To the extent any such data demonstrated that the economy was better or worse than anticipated, such non-public data could be material.  Materiality, however, is examined in the context of the "total mix" of available information.  To the extent the data merely confirmed what the market already knew (that things were getting worse), it might not change the "total mix" of available information.  In those circumstances, data about the economy might not be material. 

Alternatively, assume for sake of this tutorial that the briefing did not involve nonpublic data but did provide Paulson and Bernanke with an opportunity to express their pessimistic opinions on the direction of the economy.  Opinions and statements of belief can qualify as material information. See Va. Bankshares v. Sandberg, 501 U.S. 1083 (1991) ("We think there is no room to deny that a statement of belief by corporate directors about a recommended course of action, or an explanation of their reasons for recommending it, can take on just that importance.").

Moreover, the persons expressing the opinion matter.  Id.  ("Shareholders know that directors usually have knowledge and expertness far exceeding the normal investor's resources, and the directors' perceived superiority is magnified even further by the common knowledge that state law customarily obliges them to exercise their judgment in the shareholders' interest.").  With the information coming from two critically important financial regulators, reasonable investors may have viewed the opinions about the economy as material. 

But again, one must examine the "total mix" of available information.  It is also highly likely that the market knew that Paulson and Bernanke were concerned about a continued decline in the economy.  To the extent merely repeating these views at the briefing, the opinions are probably not material.  

Even assuming that the briefing involved the disclosure of material non-public information (which Congressman Bachus denies), this alone does not establish a violation of the prohibitions on insider trading.  Under the law of insider trading, it depends upon how the information was conveyed.  Dirks required that the information be told in breach of a fiduciary obligation.  For this to impoose a duty, it would have to be shown that those in Congress somehow had a fiduciary obligation with respect to the information received as a result of their positions.  As Robert Khuzami, the director of the Division of Enforcement at the Commission, noted in testimony:

There does not appear to be any case law that addresses the duty of a Member with respect to trading on the basis of information the Member learns in an official capacity. However, in a variety of other contexts, courts have held that “[a] public official stands in a fiduciary relationship with the United States, through those by whom he is appointed or elected."  Commenters have differed on whether securities trading by a Member based on information learned in his or her capacity as a Member of Congress violates the fiduciary duty he or she owes to the United States and its citizens, or to the Federal Government as his or her employer.

Alternatively, it would need to be shown that the information was used in violation of a duty of trust and confidence.  One way for that to occur is to show that the information told at the briefing was intended to be confidential and that those attending understood and accepted this expectation.  In fact, there may have been no such expectation.  Indeed, Bernanke and Paulson may have expected (even wanted) the information to be disclosed to the public.  

On the other hand, the duty of trust and confidence could come from sources other than Paulson and Bernanke.  To the extent, for example, that Congress imposed on its members a duty of trust and confidence with respect to this type of information, its use would potentially violate the proscriptions on insider trading.  In any event, for insider trading to have occurred, a duty of trust and confidence (and a violation of that duty of trust and confidence) needs to be found somewhere.  As Robert Khuzami, the director of the Division of Enforcement at the Commission, noted in testimony:

Existing Congressional ethics rules also may be relevant to the analysis of duty for both Members and their staff. For example, Paragraph 8 of the Code of Ethics for Government Service provides that “Any person in Government service should . . . [n]ever use any information coming to him confidentially in the performance of governmental duties as a means for making private profit.”

Nonetheless, the area remains untested.  The legal uncertainty is, therefore, very high.  Indeed, the need for a duty explains the approach taken in the STOCK Act, the legislation designed to clarify the application of insider trading prohibitions to Congress.  As the legislation provides:

For purposes of the insider trading prohibitions arising under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 issued thereunder (or any successor to such Rule), section 602 affirms a duty arising from a relationship of trust and confidence owed by each Member of Congress and each employee of Congress to Congress, the United States Government, and the citizens of the United States.

Finally, even if there was a duty and even if the briefing involved material non public information, that may not be enough to establish insider trading.  To the extent the contents of the briefing were leaked or otherwise disclosed to the public, the information would be reflected in share prices.  Any trading that occurred thereafter would not constitute insider trading.  

All of this suggests that insider trading claims against those in Congress attending a government briefing on a subject widely known to the public will be very difficult to bring.  It is made infinitely more complicated by the duty analysis, something that the Supreme Court grafted onto the law several decades ago. 

Saturday
Feb112012

David Cay Johnston on “How to avoid a securities class action”

Pulitzer Prize-winning journalist and author David Cay Johnston has posted an opinion piece on Reuters providing some advice on “How to avoid a securities class action.”  He notes that research by Jonathan Rogers, Sarah Zechman, and Andrew Van Buskirk (available here) has shown that the risk of getting sued for stock price declines increases  when  the price drop is preceded by unusually optimistic statements about future earnings that is paired with insider selling. 

While this may seem somewhat obvious, Johnston notes that Gregory Roussel, who coaches executives on “how to talk up their companies without inviting litigation,” finds that certain executives are simply reluctant to tone down their enthusiasm.  Johnston goes on to note that overly enthusiastic executives may nonetheless find a reprieve by way of the “puffery” defense, which allows those accused of securities fraud to argue their misstatements were immaterial because they were essentially akin to a used car salesman telling a prospective buyer that the car at issue is “great.”  (For more on the puffery defense, you might want to check out David Hoffman’s “The Best Puffery Article Ever.”  David is also quoted by Johnston in his opinion piece.) 

However, Johnston cites my paper “Is Puffery Material to Investors? Maybe We Should Ask Them” for the proposition that judges are perverting the definition of materiality, which turns on what a reasonable investor would consider important, when they extend this doctrine to securities transactions too frequently.  In the paper, I argue that courts should survey investors before concluding as a matter of law that no reasonable investor would consider the alleged puffery material.  My own survey findings, which I discuss in the paper, suggested that judges are prone to doing a very bad job of predicting what actual investors would consider material.  Courts are already familiar with using surveys this way, as it is relatively common in Lanham Act cases.  

Regardless, Johnston ultimately concludes that:

[C]ompanies should make their insiders put proceeds from stock sales into escrow for some period of time — 90 days ought to do it — after upbeat executive statements. If the price drops during that time, make them take the lower price or wait until the price recovers.