We are in the middle of the "director compensation project," a series of posts exclusively by students who show the amount of compensation paid to directors and the amount of compensation to the CEO (including perks).  Is there a relationship?  You decide.

In the meantime, we take a moment to provide an update on the conviction of Joe Nacchio.  Of particular interest, one of the judges on the Tenth Circuit, Mike McConnell, announced he was resigning and taking a position at Stanford.  Judge McConnell wrote the majority opinion in the Nacchio appeal, reversing the conviction, a decision that was ultimately overturned by the court en banc (with McConnell writing a vigorous dissent).  The motive for the change is unclear, although there are many possibilities (pay, regime change and the reduced possibility of a Supreme Court appointment). 

It is the case, however, that for most judges (the Delaware courts excepted), positions on the federal bench largely limit their ability to weigh in on the important legal issues of the moment out of concern over the appearance of bias or prejudgment.  Judge McConnell will have a much less constrained position as Professor.

At the Supreme Court, a series of amicus briefs have been filed on behalf of Nacchio.  Some of them are posted on the DU Corporate Governance web site.  They were filed by the Chamber of Commerce, the National Association of Criminal Defense Lawyers, and the Washington Legal Foundation, all of whom filed briefs in the lower courts.  We note that in one of the briefs, The Race to the Bottom, made a guest appearance.  In the brief filed by the National Association of Defense Lawyers and the New York Council of Defense Lawyers.  According to the brief:

• Even detractors of such testimony observe that the Tenth Circuit in this case has perhaps written “the final chapter in the era of excessive deference to economic analysis.” J. Robert Brown, U.S. v. Nacchio: The Death Knell for Special Treatment of Economic Analysis in Securities Cases?, TheRacetotheBottom.org, Feb. 26, 2009, http://www.theracetothebottom.org/nacchiotrial/us-v-nacchio-the-death-knell-for-specialtreatment-of-econom.html.

The government has until May 22 to file its response. 

In the district court, Nacchio has requested a new trial based upon evidence obtained in the civil action brought by the SEC.  He has requested a hearing.  The government has opposed the request for a new trial.

Joe Nacchio went to prison last Tuesday in Pennsylvania after the 10th Circuit and Justice Breyer denied his petition for certiorari. The only remaining issue, therefore, is whether the Supreme Court will hear the case.  A tantalizing suggestion in the Tenth Circuit opinion suggests that it will not.

The 10th Circuit order was issued by the same panel that reversed the lower court and ordered a new trial (before being overturned by the circuit en banc).  In other words, it couldn't be described as a court hostile to Nacchio.  In the order, the panel had this to say about Nacchio's petition before the US Supreme Court:

• Mr. Nacchio, on the other hand, maintains that he must show only that there is a reasonable chance that the Supreme Court will accept certiorari. Renewed Emergency Application for Release at 9-11; Reply Br. at 2. We need not decide this question, however, because the showing as to even the more lenient standard is insufficient: Mr. Nacchio has not shown that there is a reasonable chance that the Supreme Court will grant his petition.  (emphasis added)

This is no idle statement.  This comes from a panel that includes a Judge (McConnell) who takes pride in the fact that the US Supreme Court has taken five cases (Wikipedia says four but Judge McConnell noted at the University of Denver a few weeks ago that there was a fifth) where he has written an opinion (whether majority, dissenting or concurring) and the Supreme Court had decided in a manner consistent with those opinions and another judge who sided with Nacchio in the merit appeal and the earlier request for bail.  Having said that, as the commentator to this post notes, Judge McConnell did dissent from the decision to deny bail. 

And, right now, the panel is saying that the Court won't take the Nacchio appeal.

We have not been following closely the back and forth on whether Joe Nacchio should be released on bail pending the outcome of his petition for ceriorari in the US Supreme Court.  Nonetheless, we were aware of the 34 page opinion issued by Judge Krieger (federal district court in Denver and successor to Judge Nottingham) denying Nacchio bail and ordering him to appear at prison on Tuesday of this week.

In our review of the cert petition, we were highly critical of some of the legal arguments contained in the document, viewing them as either incorrect or overstated (that had Nacchio disclosed the internal projections at issue, other circuits would have "regard[ed] [the statements] as misleading and punish[ed] him for disclosing;" and that if the opinion was upheld, insiders "cannot buy or sell company shares ever.").  The arguments were presumably stated in such a fashion to attract the attention of the Supreme Court to the case.

As a result, we read with interest the opinion by Judge Krieger and viewed her characterization of the cert petition with interest.  She had this to say:

• At this point, some of the newly-formed arguments raised in the Petition appear to be strategically crafted to create the appearance of circuit split on issues of law with a hope of attracting the interest of the Supreme Court.  But in doing so, the Defendant has been forced to mischaracterize the holdings and reasoning of the Tenth Circuit panel and en banc decisions and to elevate dicta in cases from other circuit courts.

The case is on appeal to the Tenth Circuit where bail is unlikely to be granted then on to the Supreme Court.  From the looks of things, Nacchio will be reporting to prison on Tuesday as commanded by Judge Krieger.

The primary materials in this case can be found at the DU Corporate Governance web site.

Predicting what will happen to a cert petition is not always easy.  This case has a couple of things going for it.  Maureen Mahoney is well known to the justices and anything she authors will likely get a serious examination.  Likewise, the advocacy of Judge McConnell on the Tenth Circuit, a smart and conservative judge, will likewise cause some on the Court to pause over the case.  The closeness of the en banc (it was, after all, a 5-4 decision) also helps.  Finally, the case involves Rule 10b-5 and the Supreme Court expressed a willingness in Stoneridge to put an end to any more expansion of the antifraud provision.  The Court could decide that this case presents another opportunity to implement that agenda.

Weighing in against the granting of certiorari is that the case really doesn't raise particularly important legal issues.  It mostly turns on the facts.  The real question is not about the standard of materialty for internal projections but whether Nacchio had in his possession facts that indicated his projections to the market no longer had a reasonable basis.   A jury found that he did.  While it is possible to argue the facts either way (that the information was too uncertain, that the percentage of the shortfall was not enough to cross the materiality threshold), the jury found otherwise.  For the Supreme Court to come out in Nacchio's favor, it will have to find that the information known to Nacchio was immaterial as a matter of law.  This is unlikely.

Our prediction:  Cert denied.

Judge Nottingham continues to be the additional judge in the decision making process.  After laying out a series of legal arguments about the reasons for reversal, Nacchio's cert petition takes direct aim at the trial judge.  As the brief notes:

• As the en banc dissenters explained in detail, the majority mischaracterized the district court’s decision, ignored settled law, and ducked meritorious issues to gloss over obviously prejudicial errors by a district judge whose “sense of fairness toward this defendant” was very much in doubt, App.92a (McConnell, J., dissenting), and who openly displayed ethnic bias against the defendant and his counsel and recently resigned in disgrace in a lurid prostitution and obstruction of justice scandal.

While it seems fair game to argue that in a close case on the evidentiary issue, there was some evidence of unfairness towards the Defendant, the brief goes well beyond that.  It suggests that the Court ought to take a close look at the matter because of the moral turpitude of the trial judge. 

It is an interesting approach and one that ordinarily would be high risk.  Judges do not take kindly to aspersions cast on other judges.  Nonetheless, with someone as experienced in Supreme Court behavior as Maureen Mahoney, she must be thinking that in this case, the reference to the trial judge's out of the courtroom peccadilloes will attract the eye of some justices, perhaps those with an accentuated sense of morality and self righteousness.  One can only guess who that would be.

The cert petition takes the position that, based upon the 10th Circuit's holding, insiders "cannot buy or sell company shares ever."

This is another example of hyperbole masquerading as analysis. The sentence is only potentially correct if in fact an insider always knows inside information and cannot disclose the inside information to the public.

Nacchio was convicted of having inside information. The information was internal data suggesting that the forecasts he had issued to the public were no longer valid. Had Nacchio wanted to trade, he merely needed to tell this to the market. Had he disclosed that there was doubt about the validity of the external forecasts, he likely would have been able to trade (assuming there was nothing else going on that qualified as material).

Moreover, once disclosure occurred, Nacchio would have been able to sell shares with impunity. While insiders often come into contact with inside information that interferes with the ability to trade, the Commission has addressed this by allowing insiders to put in place non-discretionary trading plans under Rule 10b5-1. Had Nacchio disclosed that there was internal information suggesting the forecasts were no longer valid and then put in place a 10b5-1 plan, he would have been able to sell as many shares as the plan permitted.

The brief for certiorari also trots out the position that the 10th Circuit decision will result in less disclosure, discouraging the use of projections.

• It will also seriously discourage companies from issuing projections at all. Nacchio’s inside information was supposedly “material” here only because Qwest had first made public projections. Supra 13, 20-21. If making a projection can render internal forecasts and interim results “material,” and subject executives to criminal liability, without reasonable safeguards like those applied in Shaw and Wielgos, companies will not do it.

There are several responses to this. 

First, as most securities lawyers already know, the issuance of projections is already fraught with risk.  Projections must have a reasonable basis and, when proven wrong, are open to allegations of fraud.  Once issued, most securities lawyers likewise know that projections may require updating if ultimately they cease to be accurate.  That there may be liability for issuing projections and then trading on information that suggests the projections are no longer valid is already widely known and unlikely to be altered by anything in the Nacchio decision.

Second, the argument that companies may restrict disclosure is an old one, soundly rejected by the Supreme Court in Basic.  As the Court noted in that case:

• The final justification offered in support of the agreement-in-principle test seems to be directed solely at the comfort of corporate managers. A bright-line rule indeed is easier to follow than a standard that requires the exercise of judgment in the light of all the circumstances. But ease of application alone is not an excuse for ignoring the purposes of the securities acts and Congress' policy decisions.

Basic, 485 US at 236.

Finally, it is a strange argument to suggest that it was the internal forecasts that subjected Nacchio to criminal liability.  It was his trading that did that.  Had he not traded or traded after the information was disclosed, there would have been no criminal liability.

The main substantive argument is presented in a confusing fashion.  According to the brief:

• The Tenth Circuit’s materiality analysis conflicts with several other circuits, which have held that internal predictions and interim operating results are immaterial as a matter of law unless they establish a very strong likelihood that the company’s eventual reported performance will be substantially below what the market is expecting.

The first observation about the question is that it conflates several issues.  Internal predictions and interim operating results are entirely different types of information.  One is soft (predictions) and the other is hard (actual operating results).  The tests for each are different and cannot be conflated.  Moreover, the issue with interim operating results ordinarily centers not on materiality but on the duty do disclose.  When must companies, in between quarterly reports, disclose changes in interim financial results.  Finally, while the issue is pitched as the materiality of internal forecasts, the government will likely argue that what Nacchio knew was hard information that alerted existing, public forecasts.  In other words, the government will argue that this is not about internal forecasts at all.

Nonetheless, the brief argues that the standards for assessing the materiality of "predictive information" is murky and unclear and requires clarification.  The brief seeks clarity.  At the same time, the standard adopted by the Court ought to be high, with the brief contending that the "extreme departure" standard in the First Circuit is the appropriate one.

The case relies mostly on language from Shaw v. Digitial, 82 F.3d 1194, 1201-02 (1st Cir. 1996), a somewhat dated First Circuit case.  According to the brief, "[t]he First Circuit held that “soft” information like internal predictions is always immaterial."  Soft information is generally a category of information that encompasses projections and appraisals. 

It is a relatively extraordinary statement since most would recongize that in fact projections are extraordinarily material to those trading in the market.  Indeed, the very importance of the information is what makes the category of information such a difficult and sensitive disclose issue.  Given that, we povide the language from footnote 21, which does not say that soft information is always immaterial.

• 21 It bears reemphasizing that the plaintiffs' claim is sustainable only to the extent it relates to the nondisclosure of "hard" material information, as opposed to "soft" information in the nature of projections. See In re Verifone Sec. Litig., 784 F. Supp. 1471, 1482 (N.D. Cal. 1992), aff'd, 11 F.3d 865 (9th Cir. 1993); see generally 2 Loss & Seligman, supra, at 622 n.66. Although DEC had no obligation to disclose a forecast of results for the quarter in progress at the time of the offering, it was permitted to do so. If it had chosen to disclose such a forward-looking projection, and if the projection was made with reasonable basis and in good faith, it would have been protected by the SEC's safe harbor provision. See SEC Rule 175, 17 C.F.R. § 230.175; see also Arazie v. Mullane, 2 F.3d 1456, 1468 (7th Cir. 1993); Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995);  cf. Private Securities Litigation Reform Act of 1995, Pub. L. No. 104-67, § 102, 109 Stat. 737, 749-55 (creating expanded statutory protection for forward-looking statements). Furthermore, had DEC chosen to disclose projected results, such a disclosure (if reasonable) could very well have rendered the "hard" interim information underlying the projection immaterial as a matter of fact or of law, unless the market would have had some reason to discredit the projection, thereby creating a substantial likelihood that a reasonable investor might still have found the underlying information important to the total mix of information available.

The footnote arose in the context of whether a company was required to disclose projections in a shelf registration statement and amounts to nothing more than the general view that, in general, there is no obligation to disclose internal projections in the first instance.  It does not deal with a situation where the company discloses a projection then obtains internal information suggesting that the projection is incorrect. 

Moreover, the remainder of the discussion of Shaw in the brief, oddly, does not involve projections at all but, as the brief notes, the standard for the disclosure of “'hard' intra-quarterly operating results the company."  In other words, it addresses when changes in earnings must be disclosed in between quarterly reports, not the standard for soft information. 

There is a split in the circuit.  Some courts have applied a "substantial certainty" standard in determining the materiality of projections, a standard reminiscent of the "agreement in principle standard" for merger negotiations that was done away with in Basic. But this case is not about when projections are material enough that non-disclosure would make another statement inaccurate or incomplete under the anti-fraud rules.  This case involves the standard for information known to an insider that suggests an existing, already disclosed projection is now inaccurate.  As a result, these cases do not help Defendant.