Bader v. Blankfein: The Demand Requirement Under the Proxy Rules
Benjamin Hager
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PrintIn Bader v. Blankfein, No. 09-0309-cv (2d Cir. Dec. 14, 2009), Bader brought a derivative action on behalf of nominal-defendant Goldman Sachs Group, Inc. (“Goldman”) against Blankfein and other named director-defendants (collectively “Blankfein”). Bader alleged Blankfein violated section 14(a) of the Securities and Exchange Act of 1934 (“1934 Act”) and SEC regulations by negligently issuing a proxy statement that lacked requisite disclosures and contained materially false statements and omissions. The U.S. District Court for the Eastern District of New York granted Blankfein’s motion to dismiss. In affirming the lower court’s decision, the U.S. Second Circuit Court of Appeals held, among other things, (1) a pre-suit demand on Goldman’s Board of Directors was required before Bader commenced this action, and (2) a pre-suit demand on Goldman’s Board would not have been futile.
Goldman’s 2007 proxy statement (“Proxy”) was prepared according to Schedule 14(a) and Item 402 of Regulation S-K. Item 402 required Goldman to disclose the value of stock option grants to its CEO and its four highest compensated officers. Goldman elected to value stock option grants using grant date present values. SEC regulations in effect at the time required that Goldman make additional disclosures if it used a variation of common option pricing models to calculate grant date present value. Required additional disclosures included, among other things, a description of the pricing model and any model adjustments for non-transferability or risk of forfeiture.
Although Goldman allegedly used an alternative pricing model, its Proxy did not contain a description of the pricing model employed. In addition, its Proxy did not contain any model adjustments. Furthermore, Bader alleged option values contained in the Proxy understated the true value of the option grants by approximately 50%. Consequently, he commenced this action and alleged the grant date present values set forth in the Proxy were materially false, in violation of Section 14(a) of the 1934 Act and SEC Rule 14a-9. Moreover, Bader alleged that the miscalculations were due to Blankfein’s negligent actions. Importantly, however, Bader failed to make a pre-suit demand on Goldman’s Board of Directors before commencing this action.
Blankfein moved to dismiss the case because Bader failed to make a pre-suit demand. The trial court granted Blankfein’s motion. On appeal, Bader argued, among other things, (1) “there is no pre-suit demand requirement for shareholder derivative suits under section 14 of the 1934 Act because proxy misstatements are not a product of business judgment”; and (2) “in the alternative, demand was excused . . . as futile because [Goldman’s] directors were either interested or not independent.”
First, Bader argued that there was no pre-suit demand requirement because SEC regulations at issue required “full disclosure,” which is not a product of directors’ business judgment. The court, however, held that disclosure of stock option values is a product of business judgment, and thus, pre-suit demand is required in an action brought under Section 14 of the 1934 Act. Specifically, SEC regulations at issue implicated a business judgment because Blankfein decided what option pricing model to use and what disclosures were required. Put another way, “[t]he information [regarding option valuation that was] required to be disclosed could not have been done automatically or without thought.” Therefore, Bader should have made a demand upon Goldman’s Board of Directors prior to commencing the Section 14 derivative action at bar.
Second, Bader argued pre-suit demand would have been futile because Goldman’s Board of Directors were interested or not independent. In rejecting this argument, the court deferred to the lower court’s judgment: Bader’s “‘complaint[,] [even if amended, would] not create a reasonable doubt that the majority of the directors are disinterested and independent, and therefore fails to establish that it would have been futile to make demand upon Goldman’s Board of Directors prior to commencing this action.’” Because Goldman’s Board of Directors were clearly disinterested and independent, a pre-suit demand was required before Bader commenced the action at bar.
In sum, the U.S. Second Circuit Court of Appeals affirmed the lower court’s order dismissing Bader’s suit because Bader failed to make a pre-suit demand on Goldman’s Board of Directors before bringing a Section 14 derivative action, and because Bader failed to show that a pre-suit demand would have been futile.
The primary materials for this post are available on the DU Corporate Governance website.
Bank of America and a Lesson on the Total Mix
The saga of SEC's case against the Bank of America in connection with the failure to disclose the bonuses paid by Merrill Lynch just before the merger continues.
On Monday, Judge Rakoff issued an order excluding expert testimony provided by BofA. This is no small matter. BofA has made widespread use of experts in the case. As the court described:
- For its part, the Bank, on December 10, served the reports of no fewer than six purported experts, namely, Irving S. Becker, who opined on the issue of executive compensation; Stephen B. Blum, who opined on accounting issues; Prof. Joseph A. Grundfest of Stanford Law School, who opined on the issue of materiality; Prof. William W. Holder of the University of Southern California Business School, who opined on accounting issues; Prof. R. Glenn Hubbard of Columbia Business School, who opined on the issue of materiality; and Morton A. Pierce, Esq., who opined on disclosure practices.
So what happened?
It seems that the Bank, as part of its defense, has alleged that "shareholders already knew, as a result of widespread media reports, that Merrill was expected to pay billions of dollars in year-end bonuses." In other words, knowledge of the impending payment of the bonuses was part of the "total mix" of available information.
There are, however, two problems with the argument.
First, while the concept of total mix is imbedded into all of the antifraud provisions, its significance varies depending upon the particular provision at issue. Thus, total mix in the context of Rule 10b-5 means any information known to the market. But the SEC did not bring an 10b-5 case against BofA. The Amended Complaint prudently limits the claims to Section 14(a) (specifically, Rules 14a-3 and 14a-9). In this context, "total mix" means not the total mix of available information to the market place, but the total mix of information available to shareholders.
In general (as one need only look to TSC Industries, 426 U.S. 438 (1976) for support), this means the total mix of information actually distributed to or received by shareholders. In other words, shareholders are not obligated to consider what the market knows before voting. Instead, they need only consult the proxy materials (including the annual report in most cases) that was provided by the company. Thus, while some shareholders likely knew about the bonuses from the media reports, others did not because it was not mentioned in the proxy materials.
Judge Rakoff did not exactly exclude the information on this basis. But he did rely on representations in the proxy statement where BofA informed shareholders that "You should rely only on the information contained or incorporated by reference into this document." In fact, even without the statement the total mix analysis would have compelled the same result.
In any event, BofA's attempt to argue otherwise caused the Judge to suggest hypocrisy.
- In effect the Bank is arguing that, even tough it expressly warned its shareholders to disregard the media, it can now defend itself by asserting that a reasonable shareholder would have disregarded these warnings and, by consulting the media, perceived the Bank's alleged lies were immaterial. Even a zealous advocate might perceive that such an argument hints at hypocrisy.
Second, the SEC again, in an artful piece of strategy, didn't exactly allege that the misstatement was the failure to disclose the bonuses. Instead, BofA violated Rule 14a-9 by failing to disclose that it had already approved the bonues. As the complaint notes: "The omission of Bank of America's agreement authorizing Merrill to pay discretionary year-end bonuses made the statements to the contrary in the joint proxy statement and its several subsequent amendments materially false and misleading."
As a result, predictions by the media that bonuses would be paid were irrelevant to whether BofA misstated the already approved nature of the payments. As Judge Rakoff noted:
- The fact that the media were predicting, as the Bank claims, that Merrill would in fact pay bonuses is entirely irrelevant to any aspect of this issue, for the alleged falsehood consisted of representing as a contingency what was in fact an agreement already reached, and it does not appear that virtually any of the media reports disclosed that agreement.
This can only be seen as a blow for the defense proposed by BofA. Nonetheless, it is largely black letter law (except for the reference to "hypocrisy") and a correct statement of the securities laws. The SEC gets credit on this one for good lawyering, starting with a carefully drafted complaint.
For the opinion and other primary material, check out the DU Corporate Governance web site.
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Wednesday, January 06, 2010Delaware's Top Five Worst Shareholder Decisions for 2009 (Conclusion) (UNPUBLISHED)
J. Robert Brown 
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The system of corporate governance in the United States has many positive aspects. The degree of disclosure in this country likely exceeds all others. But there is one place where the development of the law has bordered on the irrational. In a country of 300 million people, the substance of most aspects of corporate governance are determined by the State of Delaware, a tiny place geographically (save Rhode Island, it is the smallest state in the country) and demographically (the 45th smallest state based upon the 2000 census).
It is also a state with a financial incentive to skew the law in a manner that maximizes revenue. Foreign corporations allow Delaware to avoid charging a sales tax. As we quoted in an earlier post:
- The revenue that the legal industry generates for the State of Delaware is also of vital importance to the First State and its residents as well. Over $709 million or 21.6 percent of all of the state's general fund revenue in fiscal year 2007 came from the corporate franchise tax and related fees. Corporations generated another $15 million in special fund revenue and about $10 million for local governments.
This represents only a portion of the economic benefits gained by the state. Yet this is the state that determines the standards for board behavior in the largest companies in the country (and the world).
The results are predictable. Incorporation in Delaware usually means reincorporation. Reincorporation is ordinarily done through a merger. Under the laws of all 50 states, a merger can only be initiated by the board of directors. States that want to attract corporations (and their tax dollars) must appeal to management. Delaware does that with a law that is extraordinarily pro-management in its orientation.
This can be seen from the cases decided in 2009. The cases selected as the worst have a decidedly pro-management flavor. They reaffirmed the ostrich approach, permitting management to remain unaware of critical matters within the corporation, including those that affect the voting rights of shareholdes or the solvency of the company. They continued to deny shareholders the right to information on matters of clear importance to owners. Finally, they continued to diminish the role of the duty of loyalty, despite clear circumstances suggesting a conflict of interest.
The cases explain why the process of creeping preemption of corporate governance continues. Bills in the House and the Senate would once again preempt Delaware law in connection with compensation committees, compensation consultants, and, if the Senate Bill gets adopted, with respect to the test for excessive compensation. A review of the worst five decisions for 2009 illustrates why this is occurring.
Executive Compensation, Sandy Weill, and Subservient Boards (UNPUBLISHED)
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Citigroup has always been an interesting story. In Opening Japan's Financial Markets, a book I published back in 1994, I wrote a chapter on Citigroup's (ne Citibank) unique efforts to crack the otherwise very closed world of Japanese banking. It has a rich history and while there have been many mistakes, it has also had a history of innovation.
Citigroup has fallen on hard times. Over the weekend, The New York Times published a story about Sandy Weill, the architect of Citigroup. The story has a number of themes, including Weill's "responsibility" for current crisis at the Bank (“'One of the major mistakes that I made was my recommending Chuck Prince,' he says of his handpicked successor, who ran the company from 2003 to 2007."), and his irrelevancy to any solution (when approaching the Citigroup board in 2007 to become involved, "No one responded to his offers.").
We don't have an opinion on Weill's leadership although he did grow Citibank into the world's largest financial institution. Likewise, whatever his mistakes, the article points out that he has taken a considerable portion of his wealth and donated it to assorted charitable causes, not something that everyone with a comparable net worth can say.
Mostly, though, we found insightful some of Weill's approach to compensation. The piece noted that, after retiring, Weill was "horrified" at having been "cast as a greedy, out-of-touch Wall Streeter taking advantage of taxpayers" The basis?
- One news item, in particular, was crushing: Last winter, The New York Post ran a picture of Mr. Weill on its front page with the headline, “Pigs Fly: Citi Jets Ex-C.E.O. to Cabo.” He had taken the corporate plane to vacation in Mexico, weeks after Citi had accepted a $45 billion taxpayer bailout. The flight provoked a public outcry and media frenzy.
Weill responded honorably by issuing a press release and promising "to never again use the Citi jet." He likewise terminated his consulting contract in which he got the "jet, as well as office space, cars and security."
But the fact that he had the benefits at all was the more interesting note and reminiscent of a time when imperial CEOs could receive from subservient boards compensation packages that continued the corporate largess even into retirement and even though the retiring CEOs had the net worth and income to pay any such expenses directly.
It was the era of Jack Welch at GE, who received post-retirement benefits that included, among other things, court side tickets and unlimited use of the corporate jet. Both Welch and Weiss became rich heading their respective companies. Yet despite the wealth, they accepted post-retirement packages that provided them with services and assets that their great wealth could easily afford. Somehow using corporate assets provided greater satisfaction than using their own.
With public attention, both CEOs ultimately decided to give back or reduce significantly these post-retirement benefits. But for every CEO that acted this way, there were no doubt plenty of others that merrily continued to use the corporate jet and take advantage of other similar benefits. In other words, morality and principled behavior is not an adequate check on this type of largess. It instead takes an active, strong board of directors. Unfortunately this was not typically the case then and is not typically the case today.
The types of benefits given to Weiss-Welch are probably not as common today. More rigorous disclosure requirements have made it harder to keep these types of post-retirement packages out of the public eye. Yet the problem of subservient boards that pay excessive compensation remains unchanged. It remains the great unfixed problem of the current financial crisis and, from all indications, will remain unfixed once the crisis ends.
Delaware's Top Five Worst Shareholder Decisions for 2009 (#1): The Delaware Courts and the Utter Lack of Diversity (UNPUBLISHED)
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There is a problem of diversity in the board room. There are few women CEOs. Only slightly more than 10% of the directors are women or people of color. This compares with countries like Norway that have legislatively commanded companies to increase gender representation on their boards to at least 40% (a change that appears to be working).
The lack of diversity is harmful. It ensures that boards will be filled with persons coming from similar backgrounds with similar views. It deprives CEOs of a wider range of views that could improve the effectiveness of decisionmaking.
A similar lack of diversity exists within the Delaware courts. The judges on the Supreme Court and Chancery Court have almost identical backgrounds. There is only one woman. There are no people of color. Most come from defense oriented law firms. In other words, when they address corporate governance legal issues, there is little that would suggest a diversity of views or considerations.
Nor does there seem to be much impetus to change. This year a Chancery Court judge resigned. The pool of applicants seeking the position consisted mostly of lawyers with similar backgrounds. There were no people of color and only one woman. The prize, as it always does, went to a Caucasian male with a mostly defense oriented background.
Diversity on the court might well result in judges with a broader viewpoint. Like diversity in the boardroom, diversity on the court might improve the decision making process. This in turn would enhance the credibility of the court on matters of corporate governance and perhaps slow the rapid pace of federal preemption.
When asked about changes in the legal profession and the lawyers practicing before the Delaware courts, Chief Justice of the Delaware Supreme Court explained that: "The Bar is much more diverse than it was in 1970 or even in 1990 and it is becoming increasingly so, which is a positive factor." Perhaps that diverse bar will one day have a diverse court to consider its views.
Bank of America and a Lesson on the Total Mix (UNPUBLISHED)
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Bank of America and a Lesson on the Total Mix
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The saga of SEC's case against the Bank of America in connection with the failure to disclose the bonuses paid by Merrill Lynch just before the merger continues.
On Monday, Judge Rakoff issued an order excluding expert testimony provided by BofA. This is no small matter. BofA has made widespread use of experts in the case. As the court described:
- For its part, the Bank, on December 10, served the reports of no fewer than six purported experts, namely, Irving S. Becker, who opined on the issue of executive compensation; Stephen B. Blum, who opined on accounting issues; Prof. Joseph A. Grundfest of Stanford Law School, who opined on the issue of materiality; Prof. William W. Holder of the University of Southern California Business School, who opined on accounting issues; Prof. R. Glenn Hubbard of Columbia Business School, who opined on the issue of materiality; and Morton A. Pierce, Esq., who opined on disclosure practices.
So what happened?
It seems that the Bank, as part of its defense, has alleged that "shareholders already knew, as a result of widespread media reports, that Merrill was expected to pay billions of dollars in year-end bonuses." In other words, knowledge of the impending payment of the bonuses was part of the "total mix" of available information.
There are, however, two problems with the argument.
First, while the concept of total mix is imbedded into all of the antifraud provisions, its significance varies depending upon the particular provision at issue. Thus, total mix in the context of Rule 10b-5 means any information known to the market. But the SEC did not bring an 10b-5 case against BofA. The Amended Complaint prudently limits the claims to Section 14(a) (specifically, Rules 14a-3 and 14a-9). In this context, "total mix" means not the total mix of available information to the market place, but the total mix of information available to shareholders.
In general (as one need only look to TSC Industries, 426 U.S. 438 (1976) for support), this means the total mix of information actually distributed to or received by shareholders. In other words, shareholders are not obligated to consider what the market knows before voting. Instead, they need only consult the proxy materials (including the annual report in most cases) that was provided by the company. Thus, while some shareholders likely knew about the bonuses from the media reports, others did not because it was not mentioned in the proxy materials.
Judge Rakoff did not exactly exclude the information on this basis. But he did rely on representations in the proxy statement where BofA informed shareholders that "You should rely only on the information contained or incorporated by reference into this document." In fact, even without the statement the total mix analysis would have compelled the same result.
In any event, BofA's attempt to argue otherwise caused the Judge to suggest hypocrisy.
- In effect the Bank is arguing that, even tough it expressly warned its shareholders to disregard the media, it can now defend itself by asserting that a reasonable shareholder would have disregarded these warnings and, by consulting the media, perceived the Bank's alleged lies were immaterial. Even a zealous advocate might perceive that such an argument hints at hypocrisy.
Second, the SEC again, in an artful piece of strategy, didn't exactly allege that the misstatement was the failure to disclose the bonuses. Instead, BofA violated Rule 14a-9 by failing to disclose that it had already approved the bonues. As the complaint notes: "The omission of Bank of America's agreement authorizing Merrill to pay discretionary year-end bonuses made the statements to the contrary in the joint proxy statement and its several subsequent amendments materially false and misleading."
As a result, predictions by the media that bonuses would be paid were irrelevant to whether BofA misstated the already approved nature of the payments. As Judge Rakoff noted:
- The fact that the media were predicting, as the Bank claims, that Merrill would in fact pay bonuses is entirely irrelevant to any aspect of this issue, for the alleged falsehood consisted of representing as a contingency what was in fact an agreement already reached, and it does not appear that virtually any of the media reports disclosed that agreement.
This can only be seen as a blow for the defense proposed by BofA. Nonetheless, it is largely black letter law (except for the reference to "hypocrisy") and a correct statement of the securities laws. The SEC gets credit on this one for good lawyering, starting with a carefully drafted complaint.
For the opinion and other primary material, check out the DU Corporate Governance web site.
Corporate Governance and IPOS
In the debate on corporate governance, its nice to know the facts. Thus, when someone claims that the preferred system of regulation is one that involves private ordering, its nice to dispel the approach by noting that in practice it doesn't seem to work.
Davis Polk has produced some intriguing empirical work with respect to the governance practice of companies that undertake IPOs. The data is for companies with controlling shareholders and without. The study of all companies (including the controlling ones) looked at 50 IPOs in 2007 and 2008, with the amounts ranging from $136.5 million to $17.86 billion.
These companies, like most large public companies, have staggered boards and combine the positions of CEO/Chairman. Here are some of the stats.
- 28 (56%) companies on NYSE; 21 (42%) on NASDAQ; and one (2%) on AMEX
- 32 companies (64%) had classified boards
- 20 companies (40%) had a separate chairman and CEO (Of those 20 companies with a separate chairman, 4 (20%) had an independent chairman)
- 44 (88%) required a plurality standard for board elections, with only 6 (12%) requiring a majority standard for board elections
- 3 (6%) companies had shareholders’ rights plans. Of the remaining 47 (94%) of the companies, 43 (91%) had the authority to issue “blank check” preferred stock
Add in that a high percentage (80% in one study) of most IPOs are companies incorporated (or, more acurately, reincorporated) in Delaware.
SEC v. Pirate Investor: Publishing Insider Information
In SEC v. Pirate Investor, LLC, 2009 WL 2949091 (4th Cir., Sept. 15, 2009), the SEC filed suit against Pirate Investor, LLC (“Pirate”), alleging the publisher made fraudulent misrepresentations violating §10(b) of the 1934 Securities Exchange Act. The court held that the Appellants’ conduct did constitute securities fraud and that the First Amendment to the Constitution did not shield their conduct.
According to the opinion, Pirate published investment newsletters and emails to subscribers. Co-defendant Frank Stansberry was Pirate’s editor-in-chief; he wrote and published Pirate’s investment newsletters and emails. In April 2002, Stansberry discovered that USEC, Inc. (“USEC”), which provided uranium enrichment services to the United States government, was renegotiating a contract with a Russian corporation. Under a 1993 international pact between the U.S. and Russia entitled “Megatons for Megawatts,” Russia sold warhead uranium to USEC for use in power plants. USEC would negotiate the contract with a Russian corporation, subject to U.S. and Russian government approval. Stansberry heard about negotiations of a new agreement in February 2002, but that the agreement was still awaiting approval from both governments. He contacted Steven Wingfield, USEC’s Director of Investor Relations to discuss the contract.
Subsequently, Stansberry, on behalf of Pirate, published a special report (the “Report”) on USEC’s upcoming contract. The Report analyzed USEC’s financials and role in the pact, and included a statement that a senior USEC executive told Stansberry about a May 22nd approval date for the contract. Stansberry also created and distributed an email solicitation (the “Solicitation”) containing the same claim of information about the contract approval date, but not disclosing which company it was. In order to discover the company’s identity, people had to pay Pirate $1,000 for a copy of the Report.
The Solicitation went out in various waves, with later emails also including representations about USEC’s rising share prices. Ultimately, Pirate sold 1,217 copies of the Report, earning $1,005,000 in net proceeds and $626,500 in profits for Pirate alone. The court, however, found that Wingfield never told Stansberry the agreement would be approved on May 22nd; in fact, it was approved June 19.
The SEC filed a complaint charging Pirate and Stansberry with securities fraud under § 10(b) of the ’34 Exchange Act. At trial, the U.S. District Court for the District of Maryland ruled that Pirate and Stansberry violated § 10(b) by falsely claiming a company insider provided the information in the Solicitation and Report. Pirate and Stansberry appealed to the U.S. Court of Appeals for the Fourth Circuit, arguing they had not violated § 10(b) and that the First Amendment protected their conduct.
The court first considered whether Pirate’s conduct was a § 10(b) violation. Section 10(b) violations require a false statement or omission of a material fact with scienter in connection with the purchase or sale of securities. Since Wingfield never gave Stansberry a date, the court said that Pirate’s statements were misstatements of fact. In determining whether the statements were material, the court applied the Food Lion standard: that information is material if there is a substantial likelihood that a reasonable investor would consider the fact important in deciding to buy or sell, or would have viewed the total mix of information about the company to be significantly altered by the fact’s disclosure. Under a clear error standard, the court said that since the information came from an insider there was no serious question of materiality because directors tend to have better access to information. The court also noted trial testimony by investors that the Solicitation’s purported insider information induced them to buy both the Report and shares of USEC, which also indicated the information was material.
Scienter, the court said, refers to “a mental state embracing intent to deceive, manipulate or defraud” and the SEC could meet its burden by showing Pirate and Stansberry acted intentionally or recklessly. After rejecting Pirate’s contention that the “actual malice” standard from New York Times Co. v. Sullivan required the SEC to prove the violations with clear and convincing evidence, the court emphasized that the proper standard was a preponderance of the evidence. Under that standard, the court said the district court’s ruling was not clearly erroneous since Wingfield did not give Stansberry a closing date; thus, it inferred that Stansberry knew his claim of inside information pointing to May 22nd was false. This, the court said, was classic evidence of scienter.
The court next analyzed the “in connection with” the purchase or sale of securities § 10(b) element, and began by considering factors other courts had used. The first factor was whether a securities sale was necessary to the completion of the fraudulent scheme. The court said the fraud was not complete when investors paid for the Report because those investors still needed to purchase USEC stock. However, once investors purchased USEC the stock price rose, thereby lending credibility to the Solicitation so Pirate could obtain more payments. Further, emails from Stanberry explicitly mentioned how he expected the rise in USEC stock prices would improve Pirate’s reputation among investors generally, bolstering future profits. Thus, the court said this factor indicated the statements were “in connection” with a securities transaction.
The court rejected the next factor, whether the parties’ relationship was such that it would necessarily involve trading in securities, because the decision whether to purchase securities rested solely with those who received the Solicitation and purchased the Report, not with Pirate.
The third factor looked to whether the defendants intended to induce a securities transaction. This was satisfied, said the court, because Pirate sent the Report to investors after they had paid the $1,000, because the Report also contained the misrepresentations, and because the Report instructed investors to “call [their] broker now and tell him to buy shares of USEC.”
In considering the fourth factor, whether material misrepresentations were “disseminated to the public in a medium upon which a reasonable investor would rely,” the court applied the Texas Gulf standard, which has two elements: 1) the misrepresentations in question were disseminated to the public in a medium upon which a reasonable investor would rely, and 2) they were material when disseminated. Since materiality was already established, the court focused on the test’s first prong. The Texas Gulf standard was focused on notice and concerned with attaching liability under the securities laws for statements made in any medium, no matter how tangentially related to the securities markets, and that individuals would run the risk of unknowingly incurring § 10(b) liability. After admitting that most investors would not rely on stock tips distributed as SPAM, the court refused to exempt Pirate and Stansberry because they knew that they were directing their misstatements to particular investors who did rely on internet investment advice.
Pirate and Stansberry contended that to apply § 10(b) to everyone who makes statements about securities would have a chilling effect on reporting of financial matters. They asked the court to carve out an exception for publishers of non-personalized financial news who do not have a financial interest in the securities they discuss. The Defendants argued that the cannon of constitutional avoidance demanded such an exception because “in connection with” is too vague. Rejecting this argument, the court explained that the cannon applies only when a statute is found to have more than one plausible construction. Section 10(b), the court explained, was not vague because Congress intended it to provide a flexible regime for addressing new, unforeseen types of fraud. In this case the cannon did not apply because there was only one interpretation. Since Pirate and Stansberry’s statements had met three of the four factors for being “in connection with” a securities transaction, the court upheld the lower court’s ruling that they had indeed violated § 10(b) of the Exchange Act.
Finally, the court addressed Pirate and Stansberry’s contention regarding First Amendment protections. The statements were not protected speech, ruled the court, because the First Amendment does not shield fraud. Laws directly punishing fraudulent speech survive constitutional scrutiny even where applied to pure, fully protected speech; thus, the First Amendment did not protect Pirate and Stansberry’s misleading assertions in the Report and Solicitation. Similarly, the court ruled that the permanent injunction was not an unlawful prior restraint because it only enjoined engaging in unprotected (fraudulent) speech.
Primary materials for this case may be found on the DU Corporate Governance web site.
Merck v. Reynolds: Merck v. Reynolds: The Supreme Court, Rule 10b-5, and the Statute of Limitations (A Prediction)
It is difficult to predict the outcome of a case from the questions at oral argument. Nonetheless, the tenor of the questioning makes this case possible to predict. Most of the Justices were active in their questioning, particularly Justice Sotomayor. Justice Thomas apparently was silent through the entire proceeding.
The case will come out in favor of Respondents and the vote may be unanimous, although 7-2 is a safer bet. Of the seven justices, five of them will be Bryer, Stevens, Sotomayor, Ginsburg, and Scalia. Justice Kennedy only asked a few questions but his is likely to be the sixth.
The majority will, however, divide over the standard ultimately adopted. A majority will, however, favor a standard that either begins the statute of limitations upon actual knowledge or upon actual and constructive knowledge, with constructive knowledge not requiring any investigation or inquiry but including any information that is known to the market. Justice Alito seems the most likely to take the position that investors have a duty to inquire but will rely on the standard enunciated in the Seventh Circuit. That circuit triggered inquiry notice only at the time that the facts constituting the fraud could be discovered within the two year period of limitations.
The transcript of the oral argument is here. The primary materials in the case can be found at the DU Corporate Governance web site. The Faculty amicus brief is posted on SSRN.
Merck v. Reynolds: The Supreme Court, Rule 10b-5, and the Statute of Limitations (Faculty Amici and the Meaning of Lampf)
One of the most puzzling things about this area of law has been the judicial interpretation of the Supreme Court's analysis in Lampf. Lampf held that under Rule 10b-5, the courts should look to the one year, three year limitations period in Section 9(e) of the Exchange Act. Congress superseded Lampf in 2002 (in SOX) by adopting Section 1658(b) and a two year, five year period. Congress, however, made clear that it was only extending the time period but otherwise leaving the analysis in Lampf untouched. Thus, in construing Section 1658, it was important to understand the meaning of Lampf.
In determining the limitations period, Lampf looked to Section 9(e) and explicitly rejected the limitations period in Section 13 of the Securities Act of 1933. Section 13 contained an inquiry notice standard (the limitations period began upon discovery or when, upon reasonable diligence, discovery would have occurred). Section 9(e) was triggered only by discovery. It was clear, therefore, that in using Section 9(e) as a model, the Court in Lampf had rejected an inquiry notice standard and had intended to adopt an actual discovery standard for commencing the period of limitations. This point was made at length in the brief submitted by law faculty.
It was this very point that Justice Scalia brought home during the oral argument.
- JUSTICE SCALIA: Mr. Shanmugam, in Lampf we -- we had to choose between what statute of limitations provision, Federal one, we thought applied. And we had two choices. One was section 77m, which reads after such discovery -- "after the discovery of the untrue statement or the omission or after such discovery should have been made by the exercise of reasonable diligence." That was one choice. The other choice was 78i(e), which simply said: "unless brought with one year after the discovery of the facts constituting the violation. No statement of "or after it should have been made by the exercise," okay? We chose the latter in Lampf. Now, you are telling me that there was no choice between the two, that -- that "after discovery" always means after discovery was made or after it should have been made? What were we doing in Lampf, spinning our wheels?
- MR. SHANMUGAM: No --
- JUSTICE SCALIA: I mean, I read this statute -- and 1658 tracks, not 77m, which says "after discovery should have been made"; it tracks 78i(e), which says "after discovery." Now, to me that means after discovery, period.
- MR. SHANMUGAM: Well, Justice Scalia, the Court did choose to essentially incorporate the language from -- section 9e of the 1934 Act. There were various provisions in the '33 Act and the '34 Act that incorporated discovery rules.
- JUSTICE SCALIA: Just tell me what the difference was between 77m and 77i(e)?
- MR. SHANMUGAM: Well --
- JUSTICE SCALIA: What was the difference, unless it was that 77m -- I'm sorry, 78i(e) --absolutely required knowledge?
- MR. SHANMUGAM: Well, I think one potential difference is that section 13, section 77m, refers to discovery of the untrue statement or the omission. But I think more broadly with regard to both section 9e and the other provisions of the 1934 Act to which the Court looked, courts had actually construed those provisions as reaching both actual and constructive discovery at the time the Court decided Lampf. So I --
- JUSTICE SCALIA: So there was no difference between the two and we were just wasting our time?
- MR. SHANMUGAM: No, there was really --there was no difference between the two, and I think really for the reasons that the government states in its brief as well as the reasons that we state in our opening brief, the default understanding has always been that a reference to discovery includes at least constructive discovery. And a rule that triggers the limitations period from actual discovery would have significant vices because it would give plaintiffs --
Since Justice Scalia is unlikely to concede that the Court in Lampf was just "wasting our time," he is likely to agree that the Court selected Section 9(e) for a reason and the only meaningful reason is that the Section relied upon an actual knowledge rather than inquiry notice standard.
The transcript of the oral argument is here. The primary materials in the case can be found at the DU Corporate Governance web site. The Faculty amicus brief is posted on SSRN.
Merck v. Reynolds: The Supreme Court, Rule 10b-5, and the Statute of Limitations (Faculty Amici and Plain Meaning)
The argument in the faculty amicus brief could be summed up in two words: Plain meaning. The language of the statute provided that the two year limitations period began to run after discovery. It did not provide that the limitations period should begin to run after inquiry or investigation. The plain language was not lost on some of the Justices.
Justice Stevens, in a colloquy with Kannon K. Shanmugam, counsel for Petitioners, made the point that Shanmugan was moving beyond the plain language of the statute.
- JUSTICE STEVENS: In the text of the statute it says "two years after discovery," and you argue it should mean two years after he should have discovered, and that period being measured by a date from inquiry notice, which is not mentioned in the statute at all.
- MR. SHANMUGAM: Well, I think that understanding the term "discovery," Justice Stevens, that term really can't be meaningfully understood without reference to the common law against which the statute was enacted. And this Court in interpreting discovery rules --
- JUSTICE STEVENS: But you do agree that you are reading as though it meant two years after he should have discovered?
- MR. SHANMUGAM: Well, that's right, and again I think that getting to the point of "should have discovered" is a fairly modest step. But this Court has repeatedly made clear in interpreting the discovery rule that a plaintiff must exercise reasonable diligence in order to invoke the rule's benefits, and that is simply because the discovery rule is an equitable rule and it effectively incorporates the principle of laches, that is the principle that a plaintiff who sleeps on his rights is not entitled to the benefits of equity. Indeed --
But, perhaps predictably, it was Justice Scalia who honed in on the argument with the greatest force and precision. Here is a colloquy between Justices Scalia and Kannon K. Shanmugam, counsel for Petitioners.
The transcript of the oral argument is here. The primary materials in the case can be found at the DU Corporate Governance web site. The Faculty amicus brief is posted on SSRN.
Merck v. Reynolds: The Supreme Court, Rule 10b-5, and the Statute of Limitations (The Role of Faculty Amici)
Its sometimes hard to determine the role of amici, particularly at oral argument. Nonetheless, a number of the Justices on the Court specifically referred to arguments made by "amici" and used language almost precisely from the amicus brief written by law faculty. For example, here is a colloquy between Justice Sotomayor and Kannon K. Shanmugam, counsel for Petitioners.
- JUSTICE SOTOMAYOR: Could you -- could you tell me what the difference is between actual knowledge and constructive knowledge? Because as I read the amici who have submitted briefs arguing that actual discovery should be our standard, they appear to say that actual discovery or actual knowledge includes anything that is in the public domain; that parties are presumed -- and we have plenty of cases that say that -- to know what's out there. So outside of that, how would constructive knowledge or constructive discovery be any different?
- MR. SHANMUGAM: Well I think --
- JUSTICE SOTOMAYOR: Would it require the shareholder to find the guy in Burma? Or to go and attempt in every case to engage employees in dishonorable conduct by talking about their business in private, company business essentially, that we are asking employees to engage in potentially fiduciary breaches?
- MR. SHANMUGAM: I think it's an open question, Justice Sotomayor, as to what actual discovery would -- would actually mean, and I think that there would be a pretty good argument that you don't actually discover the underlying facts until the plaintiff himself subjectively actually has them in his possession.
- JUSTICE SOTOMAYOR: Well, that's going further than the amici are suggesting. The amici are suggesting, and assuming we accept their suggestion, that it should be everything that is in the public domain, which seems reasonable to me.
- MR. SHANMUGAM: Well --
- JUSTICE SOTOMAYOR: What in addition do you think constructive knowledge would include that the actual knowledge standard doesn't?
- MR. SHANMUGAM: Well, I think it does --constructive knowledge obviously also includes information in the public domain, and we believe that the plaintiffs in this case were on inquiry notice precisely because of that information.
- JUSTICE SOTOMAYOR: Putting all of that --what in addition to that would it include, in your mind?
- MR. SHANMUGAM: Well, for purposes of the inquiry notice analysis, I think that that's all you look to. You look to either information in the plaintiff's possession or information in the public domain. And once there is sufficient information --
- JUSTICE SOTOMAYOR: So -- so you are conceding amici's point that actual -- an actual knowledge standard is the same as a constructive knowledge standard?
- MR. SHANMUGAM: Well, I would hope at a minimum that if the Court were to embrace an actual discovery standard, it would look to information in the public domain, precisely because otherwise you really would be rewarding an ostrich plaintiff because the plaintiff who claimed not to read what was in the newspapers could have the benefit of additional time.
The reference to amici and the suggestion that actual knowledge extends to information in the public domain was the argument made by Faculty in its amicus brief. It was a position that Justice Sotomayor considered "reasonable" and one that, by the end of the colloquy, Shanmugam was essentially supporting.
The transcript of the oral argument is here. The primary materials in the case can be found at the DU Corporate Governance web site. The Faculty amicus brief is posted on SSRN.
Merck v. Reynolds: The Supreme Court, Rule 10b-5, and the Statute of Limitations
We will resume our examination of the Financial Stability Act tomorrow. Today we will provide some thoughts on Merck v. Reynolds. The Supreme Court heard oral argument in the case yesterday. Merck v. Reynolds involves the dull sounding but extremely important issue of the commencement of the statute of limitations under Rule 10b-5. (The transcript of the oral argument is here). The case turned on when the statute began to run once plaintiffs were on inquiry notice of the possibility of fraud.
Most of the legal analysis submitted by the parties and by amici turned on the significance and meaning of inquiry notice.
I authored an amicus brief along with James Cox at Duke, Lisa Casey at Notre Dame, and Lyman Johnson at Washington & Lee (and supported by 24 other faculty who agreed with the position taken in the brief and lent their name to it) where we took the position that inquiry notice wasn't relevant, that the statute of limitations only began to run when plaintiffs had "actual" knowledge of the fraud.
It was an aggressive position to take since ten circuits had held that commencement of the statute of limitations depended upon inquiry notice. Nonetheless, in our view, the actual knowledge standard was supported by the language of the limitations period (Section 1658), the legislative history to the Section, and the Supreme Court's interpretation in Lampf, the decision that adopted a federal limitations period before Congress intervened. Moreover, academics, including Lyman Johnson, had written articles back in the 1990s indicating that the limitations period began upon actual rather than inquiry notice. We also took the position that actual knowledge included any information known to the market, at least in cases governed by fraud on the market.
Petitioners in their Reply Brief largely ignored our arguments. Our brief was cited for one position designed to show that we supported Petitioners. As their brief described:
- While some of respondents' amici suggest that such a requirement will still impose excessive burdens on "retired school teacher(s) in Boca Raton," CtW Br. 24, others correctly recognize "the reality of class action securities litigation": viz., that the lead plaintiffs are usually large institutional investors that possess ample resources to conduct investigations themselves. Faculty Br. 32.
The strategy to otherwise ignore the arguments may have been a bad one. The oral argument suggests considerable interest on the part of the Justices with the actual knowledge standard. We'll pick that up in the next post.
The primary materials in the case can be found at the DU Corporate Governance web site.
Merck v. Reynolds: The Supreme Court, Rule 10b-5, and the Statute of Limitations
The Supreme Court heard oral argument in Merck v. Reynolds, a case that involved the standard for determining the onset of the statute of limitations under Rule 10b-5. The transcript of the oral argument is here. The primary materials in the case can be found at the DU Corporate Governance web site.
We will post on it at length tomorrow. Suffice it to way that the positions taken by the amicus brief filed by law faculty appears to have had some influence. We will end the series with a predication on the outcome of the case.
In re MIVA, Inc. Securities Litigation and the Problem of Loss Causation
In the securities fraud class action In re MIVA, Inc. Securities Litigation, No. 2:05-cv-00201-JES-DNF (M.D. Fla. Aug. 25, 2009), Magistrate Judge Douglas N. Frazier recommended the United States District Court of the Middle District of Florida grant the defendants’ motion for summary judgment. The Magistrate Judge held that the plaintiffs could not present a triable issue of fact on the issues of loss causation and damages.
The plaintiffs were a class of persons who purchased or acquired securities of FindWhat.com (“FindWhat”) between September 3, 2003 and May 4, 2005. They alleged that the defendants, including the company (FindWhat.com, which changed its name to MIVA, Inc. in 2005) and officers and directors, issued public statements reporting continuous growth from the company’s pay-per-click internet advertising services. The plaintiffs alleged that these encouraging statements caused FindWhat’s stock price to soar to over $26 per share, which in turn caused plaintiffs to purchase the stock at artificially inflated prices. In actuality, according to the plaintiffs, FindWhat was experiencing a severe decline in revenues and two of the company’s primary revenue generating distribution partners were using illegal means to inflate revenues. Plaintiffs claimed loss of their investments as a result.
Plaintiffs alleged that the defendants’ conduct amounted to a violation of Section 10(b) of the Securities Exchange Act of 1934 (“1934 Act”) and Rule 10b-5, which prohibits the use of any "device, scheme, or artifice to defraud," and creates liability for any misstatement or omission of a material fact to investors. Additionally, the plaintiffs alleged that by virtue of their high positions with FindWhat and their awareness of FindWhat’s operations, the individual defendants were “control persons” and therefore subject to liability pursuant to Section 20(a) of the 1934 Act. Section 20(a) provides for joint and several liability for “control persons.”
The plaintiffs originally relied on eleven public statements from FindWhat that they alleged led to their purchases of shares at artificially inflated prices. The court, however, dismissed nine of the eleven statements, concluding that they were non-actionable and could not form a basis of liability for any of the defendants. The court also narrowed the class period to conform to the dates of the two remaining misstatements, resulting in a class of investors who purchased securities from February 23, 2005 to May 4, 2005. The plaintiffs were required to show that the two remaining misstatements were the cause of FindWhat’s inflated stock price.
Under Rule 10b-5 and Dura Pharmaceuticals v. Broudo, 544 U.S. 336, 342 (2005), the plaintiffs had a burden to prove a causal connection between the defendants’ allegedly fraudulent misrepresentation and the plaintiffs’ economic loss. To prove this, the plaintiffs relied on an expert who performed an extensive analysis of the effect of the allegedly misleading statements on FindWhat’s stock price. The expert completed the study before the ruling dismissing nine of the eleven statements. He testified that the inflated stock price was due to false statements that predated the narrowed class period and were not actionable by the court. The expert stated that the two actionable fraudulent statements contributed to maintaining the inflated stock price, but the court found that he presented no data to support his conclusion.
The study did not directly connect the two surviving misstatements to the stock inflation, and therefore there was no evidence of loss causation and economic loss attributable to the two allegedly fraudulent misstatements. The court held that the plaintiffs failed to prove a causal connection between the defendants’ material misrepresentation and the plaintiffs’ loss as required under Rule 10b-5 and Dura Pharmaceuticals. The Private Securities Litigation Reform Act of 1995 (“PSLRA”) also required the plaintiffs to have facts that strongly suggest a deliberate fraud, but the court found that based on their expert’s testimony they did not have strong facts.
Magistrate Judge Douglas N. Frazier found that the plaintiffs could not present a triable issue of fact showing that the alleged misstatements were the cause of the economic loss to the plaintiffs as required under § 10(b) and the PSLRA. Therefore, he recommended that United States District Court grant defendants’ motion for summary judgment.
The primary materials for this post are available on the DU Corporate Governance website.
Another Voice for Resurrecting Glass Steagall
Congressman Conyers has announced that he will introduce legislation to provide for a "modernized and updated version of the Glass-Steagall Act." It is part of the growing recognition that complete repeal was a mistake, something pointed out in The "Great Fall": The Consequences of Repealing the Glass-Steagall Act, a piece published before repeal occurred. Much of the focus so far has been on the need to restrain deposit taking banks from engaging in higher risk practices associated with investment banking activities.
But there is another, more subtle issue that supports separation. The international and historical evidence demonstrates that once commercial banks are allowed to engage in investment banking activities, they eventually dominate the business, with independent investment banking firms (essentially brokers rather than banks) ultimately eliminated or consigned to an insignificant niche.
Because commercial banks are typically more conservatively managed and because they favor debt over equity, the elimination of independent investment banking firms threatens the depth and liquidity of equity markets. Investment banking firms, in contrast, make money from the market and benefit from more active trading markets.
Thus, in Of Brokers, Banks and the Case for Regulatory Intervention in the Russian Securities Markets, I marshalled the evidence that this was the case and argued that Russia should adopt a version of Glass Steagall in order to permit its capital markets to more completely develop. This crisis has resulted in the elimination of independent investment banking firms, with Merrill and Bear now owned by commercial banks, Lehman gone, and Goldman and Morgan having converted to banks.
Resurrecting Glass Steagall would presumably allow for the return of independent investment banking firms, with entities like Goldman and Morgan likely to revert back to their prior status. This in turn would allow for the survival of a class of intermediaries uniquely committed to active securities markets.
Dreiling v. America Online: Ninth Circuit Rejects an Attempt to Expand Liability Under Section 16(b)
In Dreiling v. America Online Inc., 578 F.3d 995 (9th Cir. 2009), the Ninth Circuit Court of Appeals rejected an attempt to expand the scope of liability under §16(b) of the Securities Exchange Act of 1934. The court held that strict liability under § 16(b) required plaintiffs to clearly prove insider status.
In August, 1998 America Online, Inc. (“AOL”) and InfoSpace, Inc. (“InfoSpace”) entered into an agreement (the “Agreement”) to jointly provide an interactive website called the “AOL White Pages.” InfoSpace CEO, Naveen Jain (“Jain”), represented InfoSpace during negotiations with AOL. Under the agreement, InfoSpace would produce and manage the AOL White Pages and AOL would distribute the product to its subscribers.
InfoSpace agreed to compensate AOL by: (1) granting AOL conditional warrants to purchase up to 5% of InfoSpace stock, (2) making quarterly cash payments to AOL, and (3) sharing advertising revenue generated by the AOL White Pages. InfoSpace proposed to expense the warrants at InfoSpace’s pre-IPO price in order to mitigate its own expenses. In late 1999, Jain and AOL agreed in principle to suspend InfoSpace’s revenue-sharing obligations under the Agreement. Jain sought to formalize this amendment (“Amendment 1”) before the second quarter of 2000 in order to bulk up InfoSpace’s second-quarter balance sheet after learning about InfoSpace’s inability to meet analyst expectations. In 1999 and 2000, Jain sold a significant amount of his InfoSpace stock. As a result, AOL executed its first InfoSpace stock transaction in early 2000 followed by further sales during the year. Subsequently, InfoSpace’s stock price crashed.
Dreiling, a former InfoSpace shareholder, filed a derivative shareholder action against AOL, seeking disgorgement of AOL’s profits derived from the sale of its InfoSpace stock. Dreiling’s complaint alleged that AOL and Jain sought to (1) secretly influence the corporate affairs of InfoSpace by creating artificial revenues and earnings, (2) hold their shares during the creation of artificial revenues and earnings, and (3) then sell their shares to unsuspecting investors at artificially inflated prices as a result of their concerted efforts.
The district court granted AOL’s motion for summary judgment on the ground that Dreiling had not provided any evidence suggesting that AOL was subject to short-swing profit rules under § 16(b).
Section 16(b) of the Act identifies three classes of “insiders” whose profits from short-swing trades are subject to disgorgement: directors, officers, and beneficial owners of more than 10% of any class of security registered under U.S. securities laws. Short-swing profits are those realized by any class of insiders from a securities transaction within any period of less than six months from the date of initial purchase. This rule imposes strict liability on insiders, regardless of motive, and disgorges profits from all short-swing trades, even those not actually based on inside information.
In the current case, AOL was neither an InfoSpace director nor officer. Therefore, the court noted, that AOL may only be required to disgorge short-swing trading profits by being a beneficial owner of more than 10% of InfoSpace shares. Although the Act does not define “beneficial owner,” case law suggests reference to § 13(d) of the Act to define beneficial owner for purpose of establishing insider status. The Rule extends to groups of shareholders. Rule 13d-5 defines a group as arising “when two or more persons agree to act together for the purpose of acquiring, holding, voting or disposing of equity securities of an issuer.” Ultimately, the relevant inquiry in determining whether a group existed to create a beneficial ownership is whether the parties “agreed to act together for the purpose of acquiring, holding voting or disposing of a firm’s securities.”
The court held that § 16(b) of the Act does not provide Dreiling any remedy for his first assertion that AOL and Jain acted as a group. The 9th Circuit held that at most AOL and Jain worked together to fraudulently inflate InfoSpace’s revenues and earnings. Concerted efforts to engage in accounting fraud do not form a group for §13(d) purposes. Furthermore, while § 10(b) of the Act permits actions brought by private litigants against issuers, it bars private litigants from bringing actions against “secondary actors”, such as AOL, for aiding and abetting securities fraud. Ultimately, the court stated that Dreiling may not assert a securities fraud claim that he could not bring under § 10(b) simply by accommodating the claim into § 16(b).
Next, Dreiling’s allegation that AOL and Jain entered into a beneficial agreement to acquire InfoSpace stock at pre-IPO price was also unsuccessful. The court held that Dreiling failed to present evidence that AOL and InfoSpace entered into an agreement for anything other than to create a website and market it to AOL members. The warrants given to AOL were merely compensation for marketing InfoSpace’s product. Moreover, even if Dreiling established an agreement mainly to purchase InfoSpace stock at pre-IPO price, the agreement was with InfoSpace, not Jain. Dreiling did not point to authority for his assertion that Jain became a member under § 13(d) merely by participating in negotiations that resulted in a business agreement.
Finally, Dreiling argued that AOL’s agreement to enter into Amendment 1 in 2000 suggested “hold” and “sell” claims. The court found that these arguments failed on several grounds. Primarily, the agreement was between AOL and InfoSpace, not AOL and Jain. Moreover, numerous InfoSpace employees participated in drafting Amendment 1. Finally, Amendment 1 did not involve an effort to “hold” and “sell” stock, but was an attempt to affect InfoSpace’s balance sheets. This is not the type of agreement that §13(d) sought to regulate. Ultimately, the court concluded that Dreiling failed to show any evidence of coordination between AOL and Jain in his personal capacity, regarding the stock transactions they separately executed.
Overall, the Ninth Circuit Court of Appeals affirmed the district court’s decision to grant AOL summary judgment.
The primary materials for the post are available on the DU Corporate Governance website.
Reconsidering the Demise of Glass Steagall
In the midst of this financial crisis, many seem to be reconsidering the wisdom of completely repealing Glass Steagall (in this 10th year anniversary). Apparently those are the views of two former Chairmen of Citigroup and Paul Volcker.
While these are certainly important figures, they are arriving late to the view. At least some of the adverse consequences of repealing Glass Steagall (including the demise of independent investment banking firms) was predicted well before repeal. See The "Great Fall": The Consequences of Repealing the Glass-Steagall Act.
SEC v. Dorozhko: Second Circuit Closes Insider Trading Loophole for Computer Hacking?
In SEC v. Dorozhko, 574 F.3d 42 (2d. Cir. 2009), Oleksandr Dorozhko allegedly hacked into IMS Health, Inc.’s (“IMS”) earnings report and used the information to make net profits of $286,456.59 in one day of trading in IMS put options. In this case, the Second Circuit held that computer hacking may be considered “deceptive” under Section 10(b) of the Securities Exchange Act of 1934 depending on how the hacker infiltrated a company’s computer system.
According to the SEC’s allegations, Dorozhko hacked into IMS’s earnings report on October 17th, before the information was available to the public, Dorozhko purchased $41,670.90 of put options. That afternoon, IMS revealed that their earnings per share were 28% below Wall Street Expectations. Once IMS’s stock price plummeted from $29.56 to $21.20, Dorozhko sold his put options, thereby gaining a profit of $286,456.59.
Initially, the SEC filed suit against Dorozhko seeking a preliminary injunction. The United States District Court for the Southern District of New York denied the SEC’s “motion for a preliminary injunction on the grounds that the conduct alleged in the complaint--- essentially, computer hacking – cannot be “deceptive” under Section 10(b) of the Securities Exchange Act of 1934 as defined by the Supreme Court unless conduct involved a breach of a fiduciary duty. The SEC appealed this decision to the Second Circuit U.S. Court of Appeals. The blog has discussed this case and other relevant insider trading information relating to the case on two previous posts.
Section 10(b) “prohibits the use or employ, in connection with the purchase or sale of any security…, [of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe.” Thus, the issue before the Second Circuit was whether or not “computer hacking” was “deceptive” under §10(b). The Second Circuit decided that the district court misinterpreted Chiarella v. United States, United States v. O’Hagan, and SEC v. Zandford to establish a “fiduciary-duty requirement as an element of every violation of Section 10(b).”
The Second Circuit went on to conclude, “[i]n our view, misrepresenting one’s identity in order to gain access to information that is otherwise off limits, and then stealing that information is plainly ‘deceptive’ within the ordinary meaning of the word.” Therefore, the court held that computer hacking may be “deceptive” under Section 10(b). However, according to the court, hacking that exploits a weakness in a computer system causing a malfunction to gain greater access, may not be “deceptive” for the purposes of § 10(b).
The Second Circuit appears to have opened the door to the legal theory that computer hacking may at least sometimes be considered “deceptive” under Section 10(b) in connection with insider trading, while closing the door on the idea that “deceptive” under Section 10(b) can only occur through a violation of a duty (whether fiduciary or a duty of trust and confidence). The Second Circuit remanded the case back to the District Court to determine whether the computer hacking in this case was deceptive.
The primary materials for this post are available on the DU Corporate Governance website.
DiLorenzo v. Norton: The Hurdles in Derivative Suits for Backdated Stock Options
On August 3, 2009, a District of Columbia federal judge dismissed a shareholder derivative suit alleging that ePlus Inc. (“ePlus”) officers and directors backdated stock options in violation of ePlus’s stock option plan. The judge ruled that the plaintiff failed to adequately plead standing to pursue his claims and failed to adequately plead demand futility. Consequently, the court granted ePlus’s motion to dismiss.
Christopher DiLorenzo (the “plaintiff”) alleged that the officers of ePlus (the “defendants”) transferred corporate assets to themselves by backdating stock option grant dates. Backdating occurs when the grant date for the options is selected retroactively, or in hindsight, to be a day when the market price of the stock was lower than the price on the date the option is actually granted. While backdating is not illegal, companies are required to record compensation costs for “in the money” options. Moreover, some companies prohibit the granting of backdated stock options in their stock option plans.
Having failed to record the requisite compensation expenses in connection with option grants, ePlus announced in its 8-K report that it would need to restate certain previously issued financial statements. The plaintiff alleges that on at least nine occasions between fiscal years ending March 31, 1997 and March 31, 2006, the defendants caused ePlus to issue backdated stock grants, in violation of the ePlus stock option plan (options were required to be granted at an exercise price not less than fair market value on the date of the grant). The plaintiff’s complaint includes claims of breach of fiduciary duty, abuse of control, constructive fraud, corporate waste, unjust enrichment, and gross mismanagement in violation of the Securities Exchange Act of 1934 and state law.
The court granted the defendant’s motion to dismiss and stated that the plaintiff lacked standing to pursue his claims. In order to assert claims as to each of the nine stock option grants, the plaintiff must have been a shareholder during each grant since each one is a separate and discrete transaction. The plaintiff alleged that he was a stockholder at “all relevant times” but the court found that this was insufficiently particular to establish standing.
Plaintiff conceded that he did not have contemporaneous stock ownership until six years after the issuance of the first backdated stock option and prior to only one of the nine grants he was challenging. The plaintiff asked the court to grant him leave to further amend his complaint to include that fact. The court reasoned that granting the plaintiff leave to amend would be appropriate if properly pleading plaintiff’s standing would withstand the defendant’s motion to dismiss, a condition the plaintiff could not meet because of the court’s ruling regarding the demand futility issue.
The court held that granting defendant’s motion to dismiss was appropriate because the plaintiff had failed to sufficiently plead demand futility. In order to establish that demand would be futile, the plaintiff must allege facts that if true establish that the directors are incapable of making an impartial decision regarding the issue in litigation. Where it is alleged that the directors made a conscious business decision, in breach of their fiduciary duties, the 2-prong test established in Aronson applies. Under Aronson, the plaintiff must allege particularized facts giving rise to a reasonable doubt that (1) the directors are disinterested and independent, and (2) that the challenged transaction was otherwise the product of a valid exercise of business judgment.
First Prong of Aronson-Disinterested and Independent
Citing Aronson, the court stated that a reasonable doubt as to a director’s disinterestedness exists if a director (1) receives a personal benefit from a transaction that is not equally shared by the stockholders, or (2) if a substantial likelihood of liability exists. In order to establish a substantial threat of liability, a plaintiff must plead with particularity facts sufficient to establish that the directors knowingly participated in the granting and/or concealment of backdated options. The court stated that board approval of a transaction, even if later proved to be improper, is insufficient to infer culpable knowledge or bad faith on the part of the individual directors.
In support of its contention that the defendants acted with the requisite level of scienter, the plaintiff pointed to ePlus’s 10-K which included the Audit Committee’s findings from its investigation into ePlus’s stock option practices. Their investigation identified instances in which ePlus issued stock options in violation of the company’s stock option plan.
As to the 2004 option grants, the report stated that the Compensation Committee awarded the 2004 options in April, but believing that the options had not been awarded, the Committee made a new award of the same options at a price lower than the market value in April. This modification was not in accordance with the stock option plan, but the report admitted that the April options had been cancelled and that the Compensation Committee approved the new grant based on the mistaken belief that the options had not been effectively awarded earlier. As a result, the court stated that the directors did not act with scienter because they did not knowingly backdate the stock option grants.
Additionally, the court reasoned that the plaintiff’s allegation that a majority of ePlus’s directors at the time of the complaint were involved in granting the option was insufficiently particular to excuse demand based on disinterestedness. The court reasoned that mere membership on a committee or board without specific allegations as to defendants’ role or conduct is insufficient to support a finding that the directors were not disinterested. Additionally, plaintiff alleged that only two directors at most actually received the 2004 option grants. As a result, the court held that the plaintiff failed to plead with particularity that a majority of the board was not disinterested or that they received a personal benefit not shared equally by the stockholders.
Second Prong of Aronson--Business Judgment
The second prong under the Aronson test requires that the plaintiff allege particularized facts giving rise to a reasonable doubt that the challenged transaction was otherwise the product of a valid exercise of business judgment. The plaintiff argued that backdating per se raises a doubt that the defendants’ conduct was a valid exercise of business judgment. The court reasoned that because the plaintiff had not satisfied the first prong under Aronson, plaintiff’s allegation as to the 2004 options also fail to excuse demand under the second prong of the Aronson test.
The primary materials for this post are available on the DU Corporate Governance website.
Loss Causation Under Rule 10b-5: Separating Fraud From Bad News
In Fener v. Belo Corp., 2009 WL 2450674 (5th Cir. Aug. 12, 2009), the Fifth Circuit Court of Appeals affirmed the district court’s decision to deny class certification to shareholders of Belo Corporation. The court held that the shareholders’ motion for class certification failed to show the loss causation element required to establish securities fraud-on-the-market theory.
Belo Corporation (“Belo”) is a media company that owns various media outlets, including the Dallas Morning News (“DMN”). Approximately 60% of Belo’s publishing revenue and 30% of its total revenue comes from DMN, and advertising sales make up about 90% of DMN’s revenue. Plaintiffs alleged that Belo paid bonuses for achieving circulation targets, rigged audits of DMN’s circulation, and implemented a no-return policy that eliminated any incentive for distributors to return unsold newspapers. The plaintiffs claimed that, as a result of these practices, the defendants artificially increased circulation numbers, which led to improperly inflated revenues for DMN and overstated profits for Belo.
On March 9, 2004, Belo announced that DMN’s circulation would decrease 2.5% on daily papers and 3.5% on Sunday papers. On August 5, 2004, Belo issued a press release that stated that an internal investigation revealed questionable circulation practices. Correcting these fraudulent practices resulted in an additional 1.5% daily paper circulation decline and a 5% Sunday decline. The following day, Belo’s stock price dropped substantially and several analysts downgraded the stock.
Plaintiffs brought a class action and requested that the district court certify the litigation as a class action. Defendants objected, arguing that plaintiffs could not demonstrate that fraudulent disclosure in the press release was the primary cause of the stock decline. The district court agreed with the defendants and denied class certification.
In its decision, the court stated that in a securities fraud case, a plaintiff must prove, inter alia, the causal connection between the material misrepresentation and the loss. To make that connection, the plaintiff must show “(1) that the negative truthful information causing the decrease in price is related to an allegedly false, non-confirmatory positive statement made earlier and (2) that it was more probable than not that it was this negative statement, and not other unrelated negative statements, that cause a significant amount of the decline.” In this case, the primary issue was whether plaintiffs submitted enough information to demonstrate loss causation.
In their motion, the plaintiffs submitted about one hundred pages of support, including excerpts from Belo’s SEC Form 10-k for two years, historical stock prices, SEC S-3 forms from 1996 to 2006, financial data from Yahoo! Finance, and a daily share price chart. Plaintiffs did not, however, submit expert testimony. Defendant’s answer included expert testimony, claiming that the press release contained three separate pieces of information: “DMN’s circulation decrease resulted from (1) fraudulent overstatements; (2) changes in DMN’s methodology; and (3) industry-wide decline in newspaper circulation.” The expert concluded that the stock price decline was related to the non-fraudulent disclosures and not the fraudulent one. Plaintiffs responded with expert testimony that the press release should be examined as one disclosure and that the market already absorbed the non-fraudulent information.
In reaching its decision, the court looked to the holding in Oscar Private Equity Investments v. Allegiance Telecom Inc., 487 F.3d 261 (5th Cir. 2007), and concluded that where multiple items are released the plaintiffs must prove that the fraudulent disclosure caused a significant amount of the decline. Furthermore, the court examined the plain language of the press release and concluded that it did consist of three separate pieces of information. As a result, the court held that the plaintiffs failed to demonstrate loss causation. The court stated that, “conceivably, DMN’s fraudulent practices could have resulted in 90% of the circulation decline, but if the stock price fell because the market was concerned only with the reason for the other 10%, loss causation could not be proven.”
The court further explained that long term investors could have been more concerned with the overall trend of declining newspaper sales. The court stated that “[i]f the fraud did not cause the price of the stock to increase, and its disclosure does not cause the price to go down, no injury has occurred.” As a result, the court affirmed the district court’s decision.
The primary materials for this post are available on the DU Corporate Governance website.
SEC v. Tambone: Specificity, Scienter, and 10b-5 violations
In a previous post this blog covered SEC v. Tambone, the case against James R. Tambone and Robert Hussey, executives of Columbia Funds Distributor, Inc.. Neither defendant made false statements, but the SEC alleged that they distributed prospectuses that they knew were misleading. The court held that the SEC's allegations met the required elements § 10(b), Rule 10(b)-5, § 206 of the Investment Advisors Act, and § 15(c) of the Exchange Act, and reversed and remanded the case for further proceedings.
Defendants James Tambone and Robert Hussey filed petitions for, and the First Circuit granted, en banc review. Tambone has filed a supplemental brief focusing on the SEC's "implied representation" theory and requests the dismissal of the SEC's Section 10(b) claim against him.
Tambone argues that the "brightline/making test" is dispositive of the SEC's 10b-5(b) claims. In order to support a primary liability claim the SEC must allege that the defendant personally made statements. The SEC has long held that "to make" means "to create.” Tambone claims that the court should dismiss the SEC's "implied representation" theory because it fails to rise to the level of creating or making a statement.
Tambone goes on to argue that the SEC failed to plead any purported wrong doing sufficient to establish primary liability. Specifically, Tambone asserted that the SEC had not identified the substance of any misleading comments made, proposed or reviewed by him that were then incorporated into any particular prospectuses. Furthermore, Tambone contended that the SEC had not identified a relationship that would give rise to a duty to investigate or disclose under the SEC's "Shingle Theory." Tambone also claimed that the SEC's "Entanglement Theory" must fail, asserting in essence that there was not a significant enough relationship between himself and those who distributed the misleading prospectus.
Finally, Tambone argued that extending 10b-5 liability to an "implied representation" would be an impermissible dilution of the statutory scienter requirement. To survive dismissal the SEC must allege facts showing that the defendant acted with "the intent to deceive, manipulate or defraud." Tambone asserts that the SEC's allegations might amount to omissions or even inexcusable negligence, but fail to meet the required scienter of affirmative intent, or "extreme departure from the standards of ordinary care."
The primary materials for the post are available on the DU Corporate Governance website.
Limited Partnership Units As Securities: Liberty Property Trust v. Republic Properties Corp.
In Liberty Property Trust v. Republic Properties Corporation, 2009 U.S. App. LEXIS 18880 (D.C. Cir. Aug. 21, 2009), plaintiffs sued Republic Properties Corporation and its only two shareholders, Grigg and Kramer, alleging securities fraud under Rule 10b-5, control person liability, and various infractions under state law. The court held that the limited partnership units at issue were “securities” for purposes of the Securities Exchange Act of 1934.
Grigg and Kramer were real estate developers and jointly owned Republic Properties Corporation (“Corporation”). In October 2004, the Corporation entered into a $100 million mixed-use development agreement (“Agreement”) with the City of West Palm Beach, Florida, that included representations that the Corporation did not use bribery to secure the contract. The next month, the Corporation hired Liberti, a West Palm Beach commissioner, as a paid consultant. Liberti later voted to approve and amend the Agreement to the benefit of the Corporation.
In July 2005, Grigg and Kramer, formed, and appointed themselves as trustees in, Republic Property Trust (the “Trust”), a real estate investment trust (REIT). The Trust established Republic Property Limited Partnership (“Limited Partnership”). The Trust owned 88% of the Limited Partnership and was its sole general partner. As part of the Trust’s IPO, the Corporation sold rights in the Agreement to the Limited Partnership in exchange for 100,234 limited partnership units, valued at $1.2 million.
On May 5, 2005, Liberti was indicted on unrelated bribery charges and subsequently pled guilty. Subsequently, the City of West Palm Beach notified the Corporation of its intent to terminate the Agreement and end the project.
The Limited Partnership’s successors in interest brought suit in the District Court for the District of Columbia, alleging that defendants failed to disclose the relationship between Liberti and the Corporation before transferring the Agreement in exchange for limited partnership units. As part of the claim, plaintiffs asserted that the Limited Partnership interests were securities under § 10(b) of the Exchange Act. The district court disagreed, finding that the Limited Partnership units were not securities because Grigg and Kramer were on both sides of the transaction.
The Court of Appeals for the District of Columbia, in a split decision, reversed. In analyzing the issue, the court looked to the definiton of “investment contract” in the Securities Exchange Act. The Supreme Court in SEC v. W.J. Howey, 328 U.S. 293 (1946) defined the phrase as an investment of money in a common enterprise with the expectation of profits from the efforts of the promoter or third party. The defendants argued that they controlled both the Corporation that assigned the Agreement and the Trust that, as the General Partner for the Limited Partnership, signed the Contribution Agreement. As such, any profits from the Limited Partnership interests would come from the the Trust that they controlled and not from the efforts of others.
The majority declined to find the absence of a security solely because defendants controlled both entities. As the opinion noted: "Such an approach required the court to disregard both entities. And the appellees point to no cases where defendants have avoided liability--under the securities laws or elsewhere--on the basis of their own control, pervasive or otherwise. We see no reason to pioneer a new application of that limited doctrine on the facts before us." The court instead emphasized that the Limited Partnership and the Corporation were separate and distinct entities and served independent purposes; thus, a transaction could occur that benefited the Corporation at the expense of the Limited Partnership, requiring the protection of securities laws.
Nor did the majority find the argument that Griggs and Kramer controlled the Trust persuasive. They collectively owned only 9% of the Trust. Moreover, although they served as trustees, they held only two of the six positions on the Board of Trustees. The court acknowledged that the Board had only three Trustees at the time the Contribution Agreement was executed. Nonetheless, to the extent both expected other Trustees to join the Board, they were expecting profits to be generated from the efforts of others.
Judge Randolph, in his dissent, argued that the majority should have limited its analysis to Howey’s focus on economic reality, rather than relying on the use of the corporate form. Arguing that Grigg and Kramer did control the Limited Partnership, the Judge opined that because they controlled the purchase of the partnership units, they could not have been relying on anyone else to make a profit, and thus the limited partnership units were not securities.
The primary materials for this post are available on the DU Corporate Governance website.
SEC v. BofA: Let the Litigation Begin
We called it (although, in fairness, we had a 50-50 chance). The SEC plans to litigate the case against Bank of America in connection with the non-disclosure of the bonuses paid by Merrill Lynch. And, from the statement issued about the matter, will consider adding defendants (read individuals) if the facts uncovered in discovery warrant it.
- "[W]e will vigorously pursue our charges against Bank of America and take steps to prove our case in court," the SEC said in a statement. "We will use the additional discovery available in the litigation to further pursue the facts and determine whether to seek the court's permission to bring additional charges in this case."
Its not such a big surprise. To drop the case would be to concede that it was misguided to begin with, a reflection of government pressure rather than a case brought on the merits. The only mystery is why the Commission didn't just take this position as soon as Bank of American professed innocence in pleadings filed before Judge Rakoff. Once that happened, there could be no settlement. At least now the facts of the matter will come to light as the discovery process moves along.