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Darden Shareholders Elect All Twelve Starboard-Nominated Directors to Board

On October 10, 2014, Darden Restaurants, Inc. (NYSE: DRI) released a statement announcing that shareholders had elected all twelve of the directors nominated by activist shareholder, Starboard Value, L.P., to replace its current board of directors. The announcement, based on the preliminary results of Darden’s Annual Meeting, signaled the end of an enduring proxy fight between the current board and Starboard. The voting results can be found here.  

Starboard, Darden’s second largest shareholder holding 8.8% of the restaurant conglomerate, openly criticized the corporate strategies implemented by the current board. In December 2013, Starboard began petitioning the current board to implement various strategies it thought would help improve Darden’s overall governance, operational efficiency, and shareholder value. In May 2014, Darden announced its plan to sell the Red Lobster chain and ignored investors’ request that the company split-off its real estate assets prior to sale. Starboard had previously argued for the creation of another publicly traded company consisting of Darden’s real estate. 

Starboard responded by officially launching its campaign to overthrow Darden’s current board. After plans to sell Red Lobster were announced, Starboard nominated twelve new directors to be elected in Darden’s upcoming proxy. On September 11, 2014, Starboard released nearly 300-pages of recommendations for improving Darden’s business. The document listed Starboard’s top priorities for Darden, with the first being: “Infusing a major upgrade in the leadership at Darden.”  

Darden’s current board then attempted to prevent a complete overturn by nominating eight new candidates, four of which were also nominated by Starboard. Investor dissatisfaction with the current board, however, was so significant that all twelve of Starboard’s nominees were elected as new directors. Speaking on behalf of the newly elected board, Starboard’s Chief Executive Officer, Jeffrey Smith, emphasized the new board is enthusiastic about putting Darden on track for long-term success and maximum shareholder value.

The new directors elected include: Betsy S. Atkins, Margaret Atkins, Jean Birch, Bradley Blum, Peter Feld, James Fogarty, Cynthia Jamison, William Lenehan, Lionel Nowell III, Jeffrey Smith, Charles Sonsteby, and Alan Stillman.

Darden is the world’s largest company-owned and operated full service restaurant company. The company manages and oversees several casual dining subsidiaries which include, among others: Olive Garden, Longhorn Steakhouse, The Capital Grill, and Yard House.  


The Misguided View of Shareholder Engagement

Michael Goldhaber has an interesting piece on American Lawyer, Marty Lipton's War on Hedge Fund Activists. The article mostly uses as a template for the discussion the views of Marty Lipton and Lucian Bebchuk (with a bit of CJ Strine thrown in). Mr. Lipton was described as asserting that "activism is awful for companies and the economy over the long run."  

At the same time, however, he was represented as having recognized that, to stop activism, boards need to encourage institutional investors to vote against activists.  "Lipton will never win his war until institutional shareholders vote against activists more. He is the first to say so, and others agree."

Yet if this were the case, the appropriate strategy would be to peal off long term and other institutional investors.  This would mean a concerted effort by management to work with, and support, long term shareholders.  There is, however, little evidence that this is the common strategy at Mr. Lipton's firm.  

Take shareholder access.  This is a proposal designed to allow mostly large (those with 3% or more alone or in a group) shareholders who have held the shares for a long term(three years) to simply have the right to submit nominees (no more than 25% of the board) for inclusion the the company's proxy firm.  One would suspect that if long term investors had this authority, they might be more hesitant to support hedge funds and other investors who engage in proxy contests.  

In fact, however, the latest missive from the Firm on shareholder access (The Unintended Consequences of Proxy Access Elections) is highly critical.  As the memo describes:  

  • Proponents of proxy access frequently speak in terms of "shareholder representation" and "democracy." These buzzwords are intended to appeal to the American understanding of political fairness. However, this metaphor fundamentally misunderstands the nature of a corporate board. In the United States, a public company board is not designed to be a representative democracy in which different directors speak for particular interest groups. Widespread utilization of proxy access could produce a system in which various factions nominate their candidates and the result could be an unpredictable array of representatives all owing allegiance to their individual sponsors. Such a situation could easily produce a dysfunctional board riven by divisive deadlocks and incapable of making decisions or providing effective oversight.

In other words, institutional shareholders should support management but management should not support institutional investors.  Perhaps that explains why institutional investors are less supportive of management than Mr. Lipton would like.   





Criminal Authorities File Charges Against Defendant in SEC Insider Trading Case 

According to the U.S. Attorney’s Office in Massachusetts, Robert H. Bray (“Bray”) was arrested by the FBI in November 2014 and charged with participating in an insider trading conspiracy for his transactions in Wainwright Bank & Trust Company (“Wainwright”) stock based on information he received from J. Patrick O’Neill (“O’Neill”). 

Allegedly, O’Neill learned through his position as a senior vice president at Eastern Bank Corporation (“Eastern Bank”) of the intended acquisition of Wainwright. Bray and O’Neill golfed and socialized at the same country club. After learning from O’Neill about the pending acquisition, Bray purchased 31,000 Wainwright shares. Bray had never previously purchased Wainright securities. When Eastern Bank publicly announced the acquisition, Wainwright’s stock price increased by about ninety-four percent. In the following months, Bray sold all of his Wainright securities generating nearly $300,000 in profits.

A few months after the transactions, the Security and Exchange Commission (“SEC”) began seeking information from Eastern Bank about trades in Wainwright stock.   O’Neill quit his job at Eastern Bank and did not respond to the SEC inquiry. The SEC then subpoenaed both O’Neil and Bray to testify in the SEC’s investigation. Both men asserted their Fifth Amendment privilege against self-incrimination for all questions addressed to them.

The SEC filed civil charges against Bray and O’Neill on August 18, 2013 for violating Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.  This pending SEC action seeks injunctions against each of the defendants from further violations of the securities law, discouragement of profits with interest, and additional civil penalties of up to three times the defendants’ gains.  The SEC press release for this case can be found here.  The civil complaint for this case may be found on the DU Corporate Governance website. 

In addition, on October 31, 2014, the United States Attorney’s Office of the District of Massachusetts charged O’Neill with the one count of conspiracy to commit securities fraud.  The FBI press release for this case can be found here.  


United States v. Bailey: Ninth Circuit Determines Rule 404(b) Does Not Bar Evidence of Additional Transactions 

In United States v. Bailey, No. 13-50467 (9th Cir. Dec. 10, 2014) (Bailey II), the Ninth Circuit Court of Appeals affirmed the United States District Court for the Central District of California’s ruling admitting evidence of securities distributions other than those related to the specific unlawful sale alleged in the case. The district court ruling was the result of a retrial of an earlier conviction that was reversed and remanded by the Ninth Circuit in 2012 (Bailey I). 

In 2003, the SEC filed a civil complaint against Bailey alleging a violation of Rule S-8.  Bailey settled the lawsuit with no admission of liability. Then in 2004, Bailey was criminally charged for issuing stock to a third party (“Owens”) in violation of Rule S-8. In that case, Bailey I, the prosecution offered the civil complaint as evidence of “knowledge” and “intent.” The Ninth Circuit determined that the SEC’s complaint was not admissible under the Federal Rules of Evidence 404(b) because it was not sufficient to support a finding that Bailey had committed the other act. The case was remanded for a new trial. 

On remand, Bailey was convicted of selling unregistered securities.  Over Bailey’s objections, the district court admitted an itemized list of additional stock transactions between Bailey and Owens. On appeal, Bailey argued the district court abused its discretion by admitting evidence of additional securities distributions besides the two that resulted in the specific unlawful sales at issue. Bailey also contended the jury instructions did not accurately define the word “willfully” because the district court used a definition of “willfully” that allowed Bailey to be convicted without knowledge his conduct was unlawful.

In Bailey II, the Ninth Circuit determined Rule 404(b) did not apply because the evidence of additional transactions between Bailey and Owens was “inextricably intertwined” with the transactions at issue and provided context regarding Bailey and Owen’s relationship. Thus the district court did not abuse its discretion when it admitted the evidence at issue. The Ninth Circuit also explained that “willful” conduct does not require knowledge of illegality, and therefore Bailey’s challenge to the jury instructions failed. 

Accordingly, the Ninth Circuit Court of Appeals affirmed the district court’s ruling admitting evidence of securities distributions other than those related to the specific unlawful transactions.

The primary materials for the post are available on the DU Corporate Governance Website.


Omitted Shareholder Proposals and the Anti-Fraud Provisions

Michican apparently has a unique provision with respect to shareholder proposals.  The Corporate Code in the state required companies to provide notice of meetings to shareholders (not the unusual part) and to include notice of any shareholder proposal that is a proper subject for shareholder action (the unusual part).  As the provision provides: 

  • Unless the corporation has securities registered under section 12 of title I of the securities exchange act of 1934, chapter 404, 48 Stat. 892, 15 U.S.C. 78l, notice of the purposes of a meeting shall include notice of shareholder proposals that are proper subjects for shareholder action and are intended to be presented by shareholders who have notified the corporation in writing of their intention to present the proposals at the meeting. The bylaws may establish reasonable procedures for the submission of proposals to the corporation in advance of the meeting. 

In GWYN R. HARTMAN REVOCABLE LIVING TRUST v. SOUTHERN MICHIGAN BANCORP, INC., the Sixth Circuit allowed a suit to go forward that notified shareholders only that a "shareholder planned to propose a resolution urging the board to amend the company’s bylaws."  There was no actual description of the proposal.  

The shareholder challenged the sufficiency of the notice and the Sixth Circuit agreed that a claim had been stated.   

  • We are hard-pressed to understand how mere acknowledgement of the existence of a proposal—without describing even its subject matter—amounts to “notice” under the statute. By Bancorp’s lights, “notice of a shareholder proposal” requires only a statement that there will be a shareholder proposal. By our lights, that is not “notice.”

The case turned entirely on Michigan law.  But this brings up an interesting aside with respect to Rule 14a-8 and shareholder proposals under the federal system.

The holding may turn on state law but implicates concepts under the federal proxy rules.  Rule 14a-8 no doubt at first blush looks like an example of administrative support for shareholders, allowing them to include in some cases their proposal in the company's proxy statement.  The actual exegesis of the provision, however, was quite different.  The rule was largely designed to eliminate a problem confronted by issuers with respect to disclosure under the antifraud provisions.   

  • One of the earliest disclosure problems [under the proxy rules] concerned the failure by management to disclose shareholder proposals that it knew would be made at an upcoming meeting. The problem of nondisclosure was particularly acute when management sought discretionary voting authority in order to oppose the proposal. The Commission responded by amending the proxy rules. Management was required to disclose any proposal that it knew would be made at the meeting and to provide shareholders with an opportunity to vote on the matter. . . . While mostly solving the concern under the antifraud provisions, the requirement left management in the uncomfortable position of having to craft a description of a proposal that it was not making.  Amendments proposed two years later sought to lift the obligation from management. Shareholders would be allowed to include their proposal in the company’s proxy statement and, whenever opposed by management, could insert a one hundred word statement of support.

The SEC, Corporate Governance, and Shareholder Access to the Board Room  The effect of the changes? "[T]hey solved a serious problem, providing ground rules for the disclosure of shareholder proposals but shifting the burden from management back to the proposing shareholders."

Rule 14a-8 fixed things for proposals included in the proxy statement.  What about those omitted?  A proxy proposal omitted under Rule 14a-8 may still, in some cases, be presented at the shareholder meeting.  Rule 14a-4 allows a company to seek discretionary voting authority for "[a]ny proposal omitted from the proxy statement and form of proxy pursuant to § 240.14a-8".  Nonetheless, it would presumably be material to shareholders to know in deciding whether to grant the discretionary authority that the authority was going to be used to vote down specific proposals at the meeting.  A failure to disclose the possibility would at least in some cases vioate the antifraud provisions.  

The federal proxy rules have no express requirement like the one in Michigan but the antifraud provisions arguably have the same effect.  


SEC v. Hayter: Granting Civil Penalty and the Calculation of Civil Penalties

In 2010, the SEC filed a civil enforcement action against, among others, Edward Hayter, Wayne Burmaster, North Bay South Corporation (“North Bay”), the Caddo Corporation, and Beaver Creek Financial Corporation (collectively, the “Defendants”) for an alleged “pump and dump” scheme involving BIH Corporation’s (“BIH”) stock. (See Press Release here).

With respect to North Bay, the United States District Court for the Middle District of Florida granted the Commission’s motion for final judgment against North Bay after it defaulted by failing to respond.  The district court enjoined North Bay from “committing further securities law violations; ordering it to pay disgorgement; and imposing a civil penalty in an amount to be determined by the Court upon a motion by the Commission.” (See SEC v. Hayter, at 3).  

The only issue remaining before the court, therefore, was the amount of the civil penalty. The purpose of civil penalties is to punish security violations and deter future violations. In order to determine the amount of the civil penalty, the court classified the violation in accordance with the statutory procedure.

The Securities Exchange Act (“ Exchange Act”) provides three tiers of civil monetary penalties for violations.  The first tier applies to all violations of the Exchange Act, the second tier to those violations involving fraud, deceit, manipulation, or deliberate or reckless disregard of a regulatory requirement, and the third to all violations meeting the second-tier criteria that also resulting in a substantial loss or creating significant risk of substantial losses to other persons. For third tier violations, the maximum penalty a court may impose is the greater of $130,000 or the violator’s pecuniary gain. (See SEC v. Hayter, at 5).

In determining the appropriate penalty,  the court first found that the “pump and dump” scheme involved fraud. Accordingly,  North Bay was subject to either a  second or third tier penalty.  In addition, however, the court found that $1.1 million loss resulting from the pump and dump scheme constituted a substantial loss.  As a result, North Bay’s behavior qualified for the third-tier.   

The Commission sought a penalty equal to the pecuniary gain obtained by North Bay.  A Commission accountant valued North Bay’s pecuniary gain at $86,557. Agreeing with the valuation, the court ordered North Bay pay a civil penalty in the amount of $86,557.

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


Sarnacki v. Golden: Smith & Wesson Rely On Special Litigation Committee Report To Dismiss Derivative Suit 

In Sarnacki v. Golden, et al, Docket No. 14-01414 (1st Cir. Apr 14, 2014), Aaron Sarnacki, a citizen of Maine, filed a derivative suit against Smith & Wesson, a gun manufacturer, as well as its current and former directors and CEO (collectively “Defendants”). The suit asserted state law claims of breach of fiduciary duties, waste of corporate assets, and unjust enrichment. 

Sarnacki alleged that in 2007, Smith & Wesson made false public statements about the demand for their products in an attempt to sell excessive inventory by raising both sales and earnings projections.  The Plaintiff further asserted that some of the Defendants did so while selling millions of Smith & Wesson shares. Following a reduction in projected net income, Smith & Wesson’s share price dropped 40 percent. In December of 2007, the company again reduced its projections before finally withdrawing them altogether in January of 2008.

Sarnacki filed a derivative suit in Massachusetts state court. The suit was dismissed in January 2009 for failure to make a pre-suit demand on the board. Shortly after the dismissal, Smith & Wesson received two demand letters from other shareholders. The board formed a special committee to evaluate the claims.  The special committee consisted of three outside directors, including two who also served on the Audit Committee.  The committee hired independent outside counsel.   

Some months later, Sarnacki sent Smith & Wesson a letter demanding an independent investigation of the board’s 2007 actions. Counsel for Smith & Wesson informed Sarnacki of the special committee and requested proof that Sarnacki held shares during the relevant periods.  In October 2010, Sarnacki again filed suit, this time, in Federal District Court in Arizona, and alleged Nevada state law claims of breach of fiduciary duties, waste of corporate assets, and unjust enrichment. Two months later, the special committee concluded a lack of evidence existed to prove that the directors committed any breach of fiduciary duty and issued a report recommending that the claims not be pursued.

In January 2011, both parties consented to a transfer of the case to the Federal District Court in Massachusetts, and in July 2011, Smith & Wesson filed a motion to dismiss based on the special committee’s findings. The motion was denied, and the court ordered limited discovery on the sufficiency of the special committee’s report. Following discovery, Smith & Wesson moved for summary dismissal based on the special committee’s report. The court granted the dismissal in March 2014.

Sarnacki then appealed to the US Court of Appeals for the First Circuit. Both parties agreed that Delaware law, as adopted by Nevada, applied. The law requires a court to conduct a two-prong test after a corporation has moved for summary dismissal based on a special committee report in a shareholder suit. The first prong requires the corporation to prove the special committee’s independence and that the decision was supported by good faith and a reasonable basis. Even where, however, the standard has been met, the court retains the discretion to apply its own “independent business judgment rule” where the company’s actions met the test but do not “appear to satisfy its spirit.”

On appeal, Sarnacki challenged the independence of the special committee for two reasons. First, Sarnacki argued that two of the three directors were not independent because they were members of Smith & Wesson’s audit committee in 2007 when the alleged misstatements occurred.  Moreover, the Audit Committee directly dealt with the financial misrepresentations made by Smith & Wesson. Next, he argued a lack of independence because members of the audit committee were defendants in the present action.

The First Circuit, however, disagreed with Sarnacki and held that status as a defendant to an action or approval of the relevant transactions did not establish a lack of independence. The court also noted the Audit Committee was never accused of wrongdoing in any demand letter or suit and Sarnacki provided no evidence of bias by the special committee.

The court also rejected a Sarnacki’s argument that the district court erred by failing to consider his arguments alleging a lack of independence as a whole.  Finally, Sarnacki argued it was not his burden to prove independence. The First Circuit agreed with Sarnacki, but determined that Smith & Wesson satisfied the burden.

In determining the good faith and reasonableness standard, the First Circuit focused on the process rather than the conclusion of the special committee. It concluded Sarnacki did not provide evidence that the process used by the special committee was inadequate. Accordingly, the First Circuit Court of Appeals found Smith & Wesson satisfied both prongs and affirmed the lower court’s judgment.

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


Delaware Tries Again on Rapid Arbitration

On March 12, 2015, House Bill 49 was introduced in the Delaware State House to enact the Delaware Rapid Arbitration Act (DRAA).  The purpose of the DRAA is stated to be to

  • give Delaware business entities a method by which they may resolve business disputes in a prompt, cost-effective, and efficient manner, through voluntary arbitration conducted by expert arbitrators, and to ensure rapid resolution of those business disputes. The Act is intended to provide an additional option by which sophisticated entities may resolve their business disputes.  

The proposed legislation comes in response to the finding in Delaware Coalition for Open Government v. Strine upholding a lower court decision striking down the confidential arbitration program that had been in place since 2009 in Delaware's Court of Chancery on the ground that it violated First Amendment standards of openness in court proceedings.  Under the confidential program, certain business disputes could be resolved by secret arbitration conducted by Court of Chancery judges rather than at trial.

In striking down the program, U.S. District Judge Mary A. McLaughlin found that its operations involved

  • a sitting judge of the Chancery Court, acting pursuant to state authority, hears evidence, finds facts, and issues an enforceable order dictating the obligations of the parties… The court concludes that the Delaware proceeding functions essentially as a nonjury trial before a Chancery Court judge. Because it is a civil trial, there is a qualified right of access and this proceeding must be open to the public.

The DRAA is careful to avoid the constitutional issues encountered by the earlier program.  It stipulates that the role of the courts will be limited and public.  Judges of the Court of Chancery will not serve as arbitrators under DRAA.  Instead, any person appointed by the parties may serve as an arbitrator.  If the parties do not specify a person or a category of persons to serve, or if the person specified by the parties fails to serve, the Court of Chancery has discretion to appoint an arbitrator.

Further, under the DRAA, the Court of Chancery is vested with jurisdiction to enter relief in aid of arbitration until the arbitrator is appointed. In addition, the Court of Chancery is vested with authority to appoint an arbitrator in the event that the parties fail to do so, or the arbitrator they chose is unable or unwilling to serve. The Court of Chancery is also vested with jurisdiction to hear petitions for relief from arbitrators who, due to “exceptional circumstances” believe that the financial penalties of the Act should not apply to them. Finally, the DRAA provides for limited review of arbitral awards in the Supreme Court of Delaware, unless the parties contract for no review or, alternatively, for review before an appellate arbitral panel.

.Other features of the DRAA include strict limits on how long an arbitration should take and penalizes arbitrators who fail to act within those limits. Drafters also expect that use of DRAA will help avoid the extensive e-discovery that sometimes occurs in arbitrations not under the Act.

Why seek to implement DRAA in light of the failure of the earlier arbitral program?  The race to remain competitive as a state amenable to business interests is never-ending.  The race has shifted its focus from being the preferred state of incorporation to being the state that offers the most favorable regime of corporate governance.  With a rapid arbitration process, Delaware seeks to provide a system it believes is desired by the business community as an alternative to otherwise expensive litigation. 

Whatever one thinks about the merits of arbitration, it is interesting to consider the motives of (or the pressure put on?) the Delaware legislature in passing the DRAA while at the same time considering legislation to prohibit fee-shifting by-laws (discussed here and here).  On the one hand the legislature seems to be accommodating business interests while on the other it disadvantages them.  The race to lead—for better or worse—in corporate governance matters continues apace.


US v. Newman and the Rewriting of the Law of Insider Trading (Part 16)

How will this case come out? 

First, the court has to decide whether to take the case en banc.  Second, assuming it does, the court has to decide whether to revise the analysis of the Newman panel. 

With respect to the decision on rehearing en banc, the case warrants rehearing.  Predicting the outcome of these things is inherently uncertain.  Nonetheless, the case involves important legal issues that arguably (clearly?) conflict with a Supreme Court decision that will have a significant effect on the ability to trade on material inside information.  On that basis, the court should rehear the case en banc.

If the issue is considered in political terms, the court should also grant rehearing.  The panel in Newman consisted of three judges appointed by Republican presidents.  The panel included judges Winter (appointed by President Reagan), Parker (appointed by the second President Bush), and Hall (appointed by the second President Bush).  The list of judges in the Second Circuit and their date of appointment is here.   

The full Second Circuit that will consider the petition for rehearing en banc currently has a majority of judges appointed by Democratic presidents.  There are 13 active judges.  Eight were appointed by Democratic presidents (5 by President Obama; 3 by President Clinton) and five by Republican presidents (1 by President Bush Sr. and four by the second President Bush).  This change is relatively recent; in 2008, for example, the court was divided equally between appointees of Republican and Democratic presidents (with one vacancy).  

The rules of the Second Circuit provide that only active judges can vote on whether to hear a matter en banc where democratic appointees have a decisive advantage.  See IOP Rule 35.1(b) ("Only an active judge may vote to determine whether a case should be heard or reheard en banc.").  On that issue, therefore, the appointees of Democratic presidents have an 8-5 advantage.  Moreover, two of the judges on the Newman panel, Judges Winter and Parker, cannot participate in the poll since both have taken senior status.  A vote that breaks along party lines will, therefore, result in the court agreeing to rehear the case en banc. 

In political terms, the decision on the merits is much closer.  The rules of the Second Circuit provide that decisions en banc are to be made by active judges.  In addition, however, the rules allow the senior judges on the relevant panel to participate.  See IOP 35.1(d) ("Only an active judge or a senior judge who either sat on the three-judge panel or took senior status after a case was heard or reheard en banc may participate in the en banc decision.").  

Judges Winter and Parker, having taken senior status, cannot, therefore, participate in the decision to rehear en banc but can participate in the actual decision by the full court.  If they do, the political balance in the decision making phase shifts from 8-5 in favor of appointees of Democratic presidents to 8-7, still an advantage but a much closer one.  This does not, of course, take into account other factors that may change the make-up of the full court such as recusals. 

Of course, what would be best would be a decision that does not break along party lines but instead results in a clear and unequivocal reversal of the analysis in Newman.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here. 


US v. Newman and the Rewriting of the Law of Insider Trading (Part 15)

Perhaps the most interesting foray into the case was an amicus brief filed by three law professors arguing that the case was correctly decided. The brief correctly noted the policy goal of Dirks.

  • As the analyst-insider communication, a liability standard that is overly broad or unclear will deter market participants from seeking quality information on which to trade and thereby damage the healthy functioning of capital markets. The Supreme Court fashioned the personal benefit test accordingly, to draw a clear line between permissible and impermissible information gathering, so that analysts and investors would know when trading was permissible and not be needlessly deterred from seeking the best information available to them. 

Likewise, the brief rightfully noted that a test based upon friendship did not depend upon the purpose of the tip.  Professor's Amicus Brief ("Unlike the personal benefit test, the fact that an analyst can be characterized as a social “friend” of the insider who discloses information, does nothing to illuminate the purpose for which the disclosure was actually made.").  But of course, neither did the pecuniary benefit test.  An insider benefiting from the disclosure of material non-public information could still be acting in the best interest of the corporation and shareholders.

The brief concluded from this that the government's position would undermine the purposes set out in Dirks.  

  • the rule advocated by the government and the SEC would undermine in a fundamental way the policy purpose for which the Supreme Court adopted the personal benefit test. If mere evidence of “friendship” is presumptive evidence of personal benefit, then virtually all disclosures are potentially subject to prosecution, because insiders are far more likely to be involved in discussion of their companies with people they know than with strangers. As such, analysts and insiders who are engaged in industry activity that the Supreme Court correctly understands to be normal, socially beneficial, and important to the integrity of capital markets, and that it explicitly seeks to protect, would operate at peril of prosecution for securities fraud simply because they talk regularly, have common friends with whom they socialize, or have some other point of social interaction that could lead to their characterization as “friends.” Based only on such arbitrary and amorphous facts, the disclosure of material information in good faith, or for a permissible purpose under Rule 10b, presumptively criminal. That rule would have the same predictable chilling effect on analyst-insider communications that the Supreme Court set out to avoid in Dirks. It cannot possibly be what the Supreme Court intended.

The analysis is flawed.  It conflicts with an approach in Dirks that treated tips to friends and relatives differently than tips to market professionals.  It is Dirks that indicated that the nature of the relationship rather than the purpose of the disclosure was what mattered. 

To the extent that there is some concern that the friendship standard can interfere with corporate communications (the two alleged tippees in this case were in fact market participants), the solution is to narrow the definition of friendship.  The approach taken in Newman is to instead require some kind of pecuniary/objective gain in all cases.  Such a test would apply not just where the friend was an analyst or other market participant but also to tips by parents to children, wives to husbands, etc.  In those circumstances, there is no need to immunize the communications in order to protect the market disclosure process (which is what Dirks intended) yet the test in Newman would do exactly that.   

We will include one more post that will provide a possible basis for predicting the outcome of any en banc hearing. With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.    


US v. Newman and the Rewriting of the Law of Insider Trading (Part 14)

The Justice Department has rightfully sought rehearing en banch.  The government challenged the panel's interpretation of personal benefit, particularly with respect to gifts. 

  • First, seizing on an issue raised briefly by only one defendant, the Opinion redefines a critical element of insider trading liability—the requirement that the insider-tipper have acted for a “personal benefit”—in a manner that: (i) runs contrary to Dirks v. SEC, 463 U.S. 646 (1983), the decision that first established the personal benefit requirement; (ii) conflicts with decisions of other circuits, and, indeed, prior decisions of this Court; and (iii) conflicts with the definition accepted by all parties and relied upon by the District Court below. Even on its own terms, the new definition is deeply confounding and, contrary to the Panel’s express intention of supplying clarity, is certain to engender confusion among market participants, parties, judges, and juries.

The government also challenged the need for tippees to "know" that the tipper received a benefit and the decision in this case that there was inadequate evidence to make this showing. 

  • Second, applying this new and incorrect definition of personal benefit, and holding for the first time that a culpable tippee must know that the insider-tipper who supplied the inside information acted for such a benefit (a requirement the Government argued against, but does not challenge herein), the Panel erroneously ordered dismissal of the charges against the tippee-defendants in this case. Specifically, the Panel held that the Government’s evidence was insufficient to prove that the defendants knew the insidertippers had acted for a personal benefit, and, indeed, insufficient even to prove that the insider-tippers had acted for a personal benefit at all. These unfounded conclusions led the Panel to deny the Government the opportunity to retry its case in light of the newly announced knowledge requirement.

The SEC likewise filed an amicus brief supporting the request for rehearing en banc.  The SEC did not take issue with the need of the tippee to know of the benefit but did take issue with the panel's interpretation of benefit in the context of the gift analysis.

  • In particular, the panel decision states that evidence of friendship between an insider who tips and his tippee is insufficient to support an inference that the insider derived a personal benefit from the tipping—a requirement for liability. That ruling is directly at odds with Supreme Court and prior Second Circuit decisions holding that an insider derives a personal benefit—and thus engages in prohibited insider trading—by disclosing inside information to a friend who then trades, because that is equivalent to the insider himself profitably trading on the information and then giving the trading profits to the friend, which is obviously illegal.

The SEC asserted that rehearing was necessary given the uncertainty resulting from the opinion.  See SEC Amicus Brief ("The panel decision also creates uncertainty about the precise type of benefit that the panel believes an insider who tips confidential information must receive to be liable. Some passages in the decision suggest that certain non-pecuniary benefit to the insider is a sufficient predicate for liability, but others could be read to require some form of a pecuniary gain in exchange for disclosing the information."). 

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 13)

Newman did one other thing.  Until that decision, lower courts had allowed for the imposition of liability on tippees (and remote tippees) when the circumstances surrounding the receipt of the information suggested that it was improperly disclosed.  The courts did not specifically require that the tippees and sub-tippees actually know the benefit received by the insider.

The panel in Newmansought to change that approach.  Knowledge of the actual benefit was required.  The impact of the approach is to allow any tippee or sub-tippee to trade with abandon as long as they are not informed of the actual benefit, despite awareness that the information was improperly disclosed.  This of course is the norm.  To the extent, for example, that the tippee benefits from tipping the information to sub-tippees (for example by sharing trading profits), there will be no insider trading so long as both are kept in the dark about the actual benefit obtained by the insider. 

As a practical matter, therefore, insider trading for tippees will be limited to those circumstances where the tippee actually provides the benefit (by for example sharing trading profits).  Unless the tippee is particularly loquacious, sub-tippees will never be liable, even when aware that inside information was wrongfully disclosed.     

The approach is not quite wrong; there is a certain logic in concluding that the awareness of the breach of fiduciary duty requires awareness of the benefit. It is, however, excessively narrow and unrealistic.  Moreover, there are many readings of Dirks that, while "logical" are inconsistent with any reasonable interpretation of the prohibition on insider trading.  

Take for example the fact that defendants in Newman were almost certainly not fiduciaries (one was in the finance department; another in investor relations).  The panel could also have read Dirks as exonerating these individuals because of the absence of this duty.  Yet no court has ever adopted this approach, something that would allow most employees to trade on (and tip) material non-public information.       

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 12)

The panel's view of benefit was not, however, consistent with Dirks.

Dirks contained two approaches to benefit.  One dealt with disclosure to market participants.  This required some kind of objective benefit.  The second dealt with disclosure to friends and relatives.  This required only the showing of the requisite relationship.  The panel of the Second Circuit found that evidence of a close relationship was not, standing alone, sufficient.  Instead, the tip had to hold the promise of some type of pecuniary or similar gain.  

In doing so, the panel essentially replaced the two standards with a single test based upon pecuniary/objective gain. Indeed, given the need for a pecuniary or similar gain, it is difficult to see the relevance of friendship or family to the analysis.  Moreover, the analysis ignored the difference between disclosure to market participants and to friends/relatives.  The Supreme Court in Dirks sought to protect one but not the other.  Indeed, by using the term "gift", the Court intended to capture disclosures given, as one dictionary put it, "voluntarily without payment in return".

There may have been room to argue for a narrow interepretation of the friendship standard, particularly when applicable to market participants.  But assuming the requisite friendship, Dirks did not leave room for the requirement that the information provide a pecuniary/objective benefit to the tipper.  Such an approach would essentially allow unlimited disclosure of material non-public information among family and friends without triggering the prohibition on insider trading, at least where the tipper received no pecuniary gain/benefit.  This is exactly what Dirks wanted to prevent by articulating the gift standard.   

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 11)

The main issue in the case was the court’s view of benefit.  The case did not, apparently, turn on allegations that the tippers received a pecuniary gain from disclosing the inforomation.  Instead, the government argued that there was sufficient evidence of friendship.  The court found the evidence of friendship to be inadequate.

  • The circumstantial evidence in this case was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips.  As to the Dell tips, the Government established that Goyal and Ray were not “close” friends, but had known each other for years, having both attended business school and worked at Dell together. Further, Ray, who wanted to become a Wall Street analyst like Goyal, sought career advice and assistance from Goyal. The evidence further showed that Goyal advised Ray on a range of topics, from discussing the qualifying examination in order to become a financial analyst to editing Ray’s résumé and sending it to a Wall Street recruiter, and that some of this assistance began before Ray began to provide tips about Dell’s earnings.   The evidence also established that Lim and Choi were “family friends” that had met through church and occasionally socialized together.  The Government argues that these facts were sufficient to prove that the tippers derived some benefit from the tip.   

To the extent that this evidence was sufficient, the court reasoned, “practically anything would qualify.” 

In addition, however, the court reasoned that evidence of friendship, standing alone, was not enough. In addition to friendship, there had to be an inference that the tip of non-public information provided "at least a potential gain of a pecuniary or similarly valuable nature.” 

  • This standard, although permissive, does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature. If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity. To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee's trades “resemble trading by the insider himself followed by a gift of the profits to the recipient,” see , we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. 

Moreover, the “benefits” that were alleged to have occurred were deemed not to be significant.  “Career advice” was characterized as “little more than the encouragement one would generally expect of a fellow alumnus or casual acquaintance.”  Id.  (“Crucially, Goyal testified that he would have given Ray advice without receiving information because he routinely did so for industry colleagues.”).  As for inferring that the inside information was provided in return for the career advice, the Second Circuit panel found that the insider “disavowed that any such quid pro quo existed” and that the evidence showed that the career advice had begun before insider information had been provided.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 10)

With all of that background, lets jump ahead to US v. Newman, 773 F.3d 438 (2nd Cir. 2014). 

In that case, the government  brought criminal actions against Todd Newman and Anthony Chiasson for insider trading.  Both were convicted in a six week trial.   Under the alleged facts, the government asserted that a number of analysts at hedge funds obtained material non-public information (advanced knowledge of earnings) from employees at public companies (Dell and NVIDIA). In one case, the employee was the head of investor relations.  In another, the employee was someone in the "finance unit."  Neither appear to have been officers.

The non-public information was then alleged to have passed on to portfolio managers.  The government asserted that Newman and Chiasson received and used this information, earning profits of $4 million and $68 million for their funds. Both were ultimately convicted by a jury of trading on material nonpublic information. 

The panel of the Second Circuit reversed.  In setting out the test for insider trading, the held that:

  • the Government must prove each of the following elements beyond a reasonable doubt: that (1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit. 

The court found that there was insufficient evidence to demonstrate that the tippers had benefited from the tip.  As a result, all tippees were exonerated.  In addition, to the extent that there was a benefit, the court found that there was insufficient evidence to demonstrate that Newman and Chiasson were aware that it existed. 

As the court put it, both Newman and Chiasson were “several steps removed from the corporate insiders” and as a result were unaware of “the source of the inside information.”   Indeed, with respect to Dell, both Newman and Chiasson were  “three and four levels removed from the inside tipper”.  See Id. (“a tippee's knowledge of the insider's breach necessarily requires knowledge that the insider disclosed confidential information in exchange for personal benefit.”). 

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 9)

So, in summary, Dirks successfully protected the relationship between insiders and market participants.  The analysis, however, had numerous gaps that subsequent courts for the most part just ignored them.  Fiduciary duties for purposes of insider trading extended to all employees, not just officers and directors.  Fiduciary duties applied to sales, even where the buyers were not shareholders and a fiduciary duty did not actually exist. 

At the same time, Dirks did not protect the relationship between insiders and their family members or friends.  The decision treated disclosure to these persons as a breach of an insider’s fiduciary duty.  The case, therefore, encouraged communications between insiders and market participants and discouraged communications between friends and family.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 8)

With respect to tippee analysis, Dirks made clear that insider trading was predicated upon a breach of a duty by the insider.  In other words, the tippee’s duty was derivative.  The trading activities of the tippee were, therefore, largely irrelevant.  Instead, the tippee was guilty of insider trading if the insider was guilty (which meant having a benefit) and the tippee knew about the breach.  As the Court reasoned: 

  • Thus, some tippees must assume an insider's duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly.  And for Rule 10b-5 purposes, the insider's disclosure is improper only where it would violate his Cady, Roberts duty. Thus, 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 know that there has been a breach.  . . . Tipping thus properly is viewed only as a means of indirectly violating the Cady, Roberts disclose-or-abstain rule.  

The emphasis, therefore, was on the awareness of the tippee that the information had been disclosed improperly.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 7)

The need for a breach of fiduciary duty, for all of its problems, did not accomplish the goal of the Supreme Court.  Secrist was still open to a claim that he violated those duties by tipping information to Dirks that harmed the company (albeit while helping the market).  The Court addressed the continuing uncertainty by defining breach in a narrow manner, unconnected to state law. 

Breach occurred when the fiduciary obtained a benefit.  Moreover, benefit had to be something pecuniary or objective.  See Dirks, at 663 (“This requires courts to focus on objective criteria, i. e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”).  Reputational benefit, for example, left open the possibility that the Secrists of the world could still be subject to uncertainty to the extent the government could claim that the tip was in return for something ephemeral such as improved reputation. 

The analysis had little connection to state law fiduciary duty principles.  For the most part, fiduciary duties looked to the interests of shareholders.  The Court, however, ignored the impact on shareholders and instead focused entirely on the benefits (or lack thereof) to the insider.  The approach was both under and over inclusive.  Insiders routinely benefit from the corporation without violating their fiduciary obligations (getting paid compensation for example).  Likewise the absence of benefit does not mean they were acting in the best interests of shareholders. 

The made up nature of the standard had some intended advantages.  Much of the uncertainty was gone.  The “slip of the tongue” cases where material nonpublic information was accidentally disclosed in a manner that did not benefit the corporation (and even caused harm) were no longer actionable.  Moreover, the practical reality was that insiders rarely gave away information in circumstances detrimental to the company unless they somehow benefited. 

The test, therefore, largely protected the flow of information from insiders to market participants.  The Court, however, understood that relationships between fiduciaries and family/friends raised different concerns.  In those circumstances, there was no presumptive benefit to the company and no need to protect the flow of information between insiders and friends/family. 

As a result, the Court recognized that in these circumstances, there was no need for an overinclusive rule that would protect the two way flow of communications.  As a result, a pecuniary benefit was not required. See Dirks, at 664 (“The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”).  The analysis turned not on the nature of the benefit but on the nature of the relationship.    

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 6)

Of course, the most noticeable gap in the Court’s requirement of a fiduciary relationship concerned the application to officers aware of material nonpublic information about other companies.  During the takeover waive of the 1980s, the Court’s analysis threatened to give a pass to any insider of a bidder who became aware of an impending offer for the shares of a target company. The officer of the bidder had no fiduciary obligation to the shareholders of the target company and could, at least to the extent that Dirks required a fiduciary relationship, trade without triggering the prohibitions on insider trading. 

Ultimately, this gap in the analysis was filled with the invention of the doctrine of misappropriation.  Misappropriation allowed authorities to treat as insider trading instances where persons (not just fiduciaries) traded on material nonpublic information in violation not of a fiduciary duty but of a duty of trust and confidence.  Freed of the need for a fiduciary duty, an insider of a bidder who traded in the shares of a target could be guilty of insider trading. 

Of course, even this fix contained analytical holes and silly evidentiary requirements.  Insider trading suddenly depended upon whether husbands and wives, parents and children, psychiatrists and patients, had obligations of trust and confidence. Decisions turned on the closeness of buddies on the golf course.  

Insider trading cases, therefore, required an exploration of the marital relationship, the closeness of family members, and the strength of friendships.  Moreover, the tipper always had an incentive to argue that a relationship of trust and confidence existed (so that tipper was not really a tipper since the “tip” was conveyed within a relationship of trust and confidence) and the tippee always had an incentive to argue that the relationship did not exist (so that the tippee was not really a tipper since he/she did not violate a duty of trust and confidence). These cases where, therefore, invariably a she said, he said, raising considerable uncertainty and litigation risk. 

The Supreme Court eventually affirmed the misappropriation theory.  See US v. O’Hagan, 521 U.S. 642 (1997).  Today, O’Hagan and approval of the misappropriation theory has an air of inevitability.  That, however, was not true. 

First, O’Haganstill drew a dissent from three Justices (Scalia, Thomas and Rehnquist).  More importantly, the doctrine had, apparently, come close to rejection by the Supreme Court only a decade earlier.  In 1987, the Supreme Court had divided 4-4 on a case raising the misappropriation theory.  See Carpenter v. United States, 484 U.S. 19 (1987) (“The Court is evenly divided with respect to the convictions under the securities laws and for that reason affirms the judgment below on those counts. For the reasons that follow, we also affirm the judgment with respect to the mail and wire fraud convictions.”). 

What happened between Dirks and O’Hagan?  Most noticeably, the Court experienced a significant turnover. The majority in Dirksconsisted of Justices Powell (the author of the opinion), Berger, Stevens, White, O’Connor, and Rehnquist.  Justice Blackmun wrote a dissent, joined by Justices Brennan and Marshall.  In Carpenter, the lineup was the same except that Justice Kennedy had replaced Powell.  By 1997, however, Chief Justice Burger was gone.  So were Justices Brennan, Blackmun and Marshall.  Instead, the Court included Breyer, Thomas, Souter, Ginsburg and Scalia.  From the original decision in Dirks, only Rehnquist, Stevens and O’Connor remained. 

In other words, approval of the misappropriation theory by the Supreme Court took 14 years from the Dirks decision and only occurred where the Court experienced significant turnover and consisted mostly of justices with no direct attachment to the decision in Dirks.  Only in these circumstances was the misappropriation theory affirmed.   

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 5)

First was the problem of coverage.  To the extent limiting the analysis to fiduciaries, the Court promised to leave the prohibitions on insider trading inapplicable to most insiders or their advisors. 

To address the problem of accountants and lawyers, the Court invented what has become known as the “temporary insider” doctrine.  Persons hired by the company could assume a fiduciary duty.  See Id.  (“Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes. “). 

While fiduciary duty concepts were probably fluid enough under state law to allow its extension to untraditional classes of persons (beyond officers, directors and key employees), the Court adopted an interpretation that more or less always imposed temporary fiduciary obligations on these advisers.  The Court cited no state law cases for this interpretation.  The idea that investment banks or lawyers could be sued for breach of fiduciary duty to shareholders as a general course (as opposed to aiding and abetting a breach) was inconsistent with state law.  Nonetheless, the Court needed to plug a gap created by its own analysis, otherwise Dirks would not be able to legally tip information but lawyers and accountants could.

With respect to ordinary employees or officers selling rather than buying shares, the opinion remained silent.  Lower courts (and the SEC) for the most part ignored the discontinuity between the need for a fiduciary duty and its application to these groups of individuals.  Insider trading applied to ordinary employees and to officers who sold even though under state law, it almost certainly did not. 

With respect to the latter group, the SEC could rely on In re Cady Roberts, an administrative decision that did extend the prohibition on insider trading to non-shareholders.  See In re Cady Roberts, 40 SEC 907 (admin proc. Nov. 8, 1961).  Indeed, in Dirks, the Court often referred to the “Cady Roberts duty.”  Cady Roberts, however, found that insiders had a duty to purchasers not because of a fiduciary relationship but  because of the obvious unfairness to the investing public.  See Id. (“We cannot accept respondents’ contention that an insider’s responsibility is limited to existing stockholders and that he has no special duties when sales of securities are made to non-stockholders. This approach is too narrow. It ignores the plight of the buying public-- wholly unprotected from the misuse of special information.”). 

Officers and directors of corporations, however, do not have fiduciary obligations to the investing public.  The case does not, therefore, provide any meaningful support for applying fiduciary principles to purchasers of shares from insiders (at least purchasers who are not already shareholders).  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  

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