Business
Associations Class Notes
Heavy
cutting ahead!
Remember
that the goal is to hook up with the bar review course and to set a foundation
for advanced courses. Tomorrow and
Thursday will go very fast.
Agent for an undisclosed
principal or a partially undisclosed principal –Securities and Exchange Comm’n v. Texas Gulf Sulfur
Co.
You’re
a big
Let
us analyze this in the agency context: they were agents for an undisclosed
principal. Is this per se against public
policy or fraudulent? No, it’s
definitely not. There are many big
investors, buying under 5% of outstanding shares, who
want to keep their transactions confidential for various legitimate
reasons. If you happen to get hints from
the press that all is not well, you can sell without any restriction under
10b-5 and you don’t have to deal with Rule 144 paperwork. On the other hand, they may use the press
carefully to find out that there is positive news and they want to load up on
more stock. In a big Second Circuit
case, a person was an agent for the world’s biggest user of a certain
commodity. But if there is a fiduciary
duty between the agent and the third party or the principal and the third
party, then you must come clean up front.
Also, if the third party puts the direct question to the agent: “Are you
buying only for your own account and not for resale?” and the agent lies, there
is an action in fraud.
There
are two “curlicues” on the doctrine. The
plaintiff’s lawyer will always look for this early if the apparent defendant is
judgment-proof. On the other hand, if
the defendant is GM or Exxon, you’ll always get paid if you win. What happens if the principal gives the agent
the money up front to buy the commodity with, and the agent squanders it away? That may be the commission of a fraud upon
the principal because the money was given in trust. If the principal pays up front and the agent
doesn’t pay, there are two rules. The majority
rule is that you can’t reach the principal under the doctrine of agent for an
undisclosed principal. The more modern
rule in Restatement Second of Agency is to the contrary: whether or not the
principal has already paid the agent, the third party can get relief from the
principal even though the principal has to pay twice. You hire people who you can trust completely
and who are financially solvent to do this kind of thing.
In Texas Gulf Sulfur, the farmers were all
paid. They hired responsible people who
issued their own checks that were valid.
The farmers sued for rescission. Texas
Gulf Sulfur settled the fraud suits. The
Canadian provinces later amended their statutes to require disclosure up front
of the drilling information, that is, it would be considered material to the
transaction.
What
is a partially disclosed principal? This
is where the agent says: “I’m buying for someone else and I can’t tell you who
it is, but I’ll give you my own check and my check is good.” The rules are fairly close to those for the
completely undisclosed principal.
In
fraud and related theories, we are assuming no fiduciary relationship at
all. You have big problems! Starting in 1910, American fraud law began to
expand. Prior to 1910, the law of fraud
was very narrow when it relied upon total non-disclosure. It was helpful if there was an overt material representation or half-truth. But if there was total non-disclosure and no fiduciary or other special relationship
between the parties, most American courts would not have allowed a fraud
claim. Samford Brass, consistent with Restatement Second of Torts, deals with the
special fact doctrine, where the
total non-disclosure is about not only a material
fact, but a highly material fact
which we will call a special
fact. Note that a highly material fact
puts the case in the arena of Sherwood v.
Walker, the barren cow case.
This
case involves securities. We have an
AMEX company that needs to raise equity capital. They undertake a Rule 506 offering with,
among others, Mr. P who is generally sophisticated and moderately knowledgeable
about securities. The company sells him
options to buy stock. In those days,
that meant the option would have to be held for two years before you could get
an unlegended security, and then the security would
have to be held for two years. The security
was unlegended.
The private placement memo did not mention the Rule 144 restrictions on
disposition. The stock does very well
for a time, during which Mr. P goes to the company and asks to exercise the
option. He would have made a lot of
money. But the president of the company
says that exercising the option would violate Rule 144. By the time the holding period was satisfied,
the stock had plummeted. A diversity
suit was brought in federal court under
On
the contract count, the court held that the plaintiff didn’t have a cause of
action. On the fraud side, they reversed
summary judgment for the defendant and remanded for trial. They said that
A
case with a similar result under contract doctrine comes from the 1970’s in
Let’s
wrap up Texas Gulf Sulfur. We have two subdivisions of the case: we’ll
pay more attention to the insider trading portion but we’ll also deal with the
issue of the press release. The top
brass of the company told everyone to keep quiet. Was the management of the company in
violation of § 13 by imposing a blackout period? The court says no: it was within their business
judgment. The SEC agreed. But some people didn’t keep the
blackout! They told other people to go
out and buy lots of stock! This is a
civil proceeding for injunctive relief and disgorgement. The courts have held that the SEC has
inherent power to go into the federal courts and get disgorgement. Note, however, that Sarbanes-Oxley goes
beyond disgorgement. The court holds
that the rule is that mere possession of material inside information is enough
to put everyone under the “Just Say No” rule.
The company insiders said that they weren’t allowed to disclose because
the president of the company would fire them.
The court says that they should abstain.
The thrust of the ruling is equal
protection. It’s a typical
What
about the press release? The majority
opinion screws up worse. They say the
company will be civilly liable to people selling on the basis of the press
release without any discussion of scienter.
Judge Friendly’s concurring opinion corrects
the majority opinion. We now have the
1995 Act which adds on more. Note the
potential liability associated with false press releases and the like. The DJIA has gone up from 880 to 10,300 since
1981. Some days the volume on the NYSE
is 2-3 billion shares. The
over-the-counter market has also grown.
The 1995 Act tries to deal with this.
It enacts a “statutory caution defense”: if your press release has
enough cautionary language, you won’t be held liable. The case law has also developed this
independently of the statute.
Apple
Computer had a successful IPO in the 1970’s.
They were going to come out with Lisa.
Steve Jobs put out a bunch of glowing press releases and a lot of people
believed him. The Wall Street Journal
and New York Times covered the new computer and they wrote many stories saying
it was all crap. The stock shot up and
then took a nosedive. The first issue
was whether press releases could trigger 10b-5.
Could people reading the press releases rely on 10b-5 to get relief if
the stock took a nosedive? The court
said that if you promote your products vigorously enough, you can get sued
under 10b-5. The president wanted
indemnity from the company and vice versa. The jury came in saying that the company had
zero liability, but the president had liability of $100 million. The judge set aside the verdict and ordered a
new trial. The Ninth Circuit opinion
added an important defense: the total mix
of information. They told the judge
that on retrial he must let in as evidence all of the WSJ and NYT articles
because it could be the case that the articles were circulated so broadly that
there could have been no reliance on the Apple press releases. Rumor has it that the company settled to the
tune of $21 million.
In
2003, the California Supreme Court, reviewing a Rule 12(b)(6)
motion (which, in
Texas Gulf Sulfur deals with organized trading market transactions. The people are not dealing one-on-one with
each other. Someone buys GM stock and it
later goes down. GM had suspected that things were going bad but
kept quiet for two weeks while investigating it and a negative press release
comes out after you buy. Under Sherwood v. Walker, can you go to the
SEC and have them find out who was on the other side of your transaction and
force the other person to rescind? No,
because this is impractical. Sherwood must be restricted to
one-on-one situations. The Texas Gulf Sulfur is extremely
egalitarian and equal protection-based.
The next two cases add several limits.
All of Rule 10b-5 is fraud-based and requires scienter. It is generally agreed that Rule 14e-3,
adopted under § 14(e), requires no fraud. Textual analysis of § 14(e) suggests that the
first sentence, which is self-executing, deals with fraud. The second sentence, which came a few years
later and which is not self-executing (that is, requires rulemaking) is clearly
not fraud-based.
Chiarella v.
Here
we had a printer for a big
Justice
Powell said that neither Mr. Chiarella nor the employer
owed a fiduciary duty to the shareholders of the target company. Both Mr. Chiarella
and his employer did, however, owe a fiduciary
duty to the offeror. For the first time
before the U.S. Supreme Court, the government says there is another theory that they want to pull
out. They want to claim that this was misappropriation of the principal’s
confidential information, which, in itself, should be considered fraud. But the theory wasn’t raised in the
indictment, which means that it couldn’t be raised later! But the misappropriation theory is alive and
well, at least in the Second Circuit.
Take,
for example, the case of United States v.
Carpenter out of the Supreme Court.
Carpenter landed a job at the Wall Street Journal. He wrote a column called “Heard on the Street”
that had a great effect on the market.
Some traders would get up extra early to get the WSJ and read that
particular column and trade based on what it said. Carpenter told his lovers of this, and they
made out like bandits. If he was going
to say something good about a company, he would tell his lovers in
advance. At the various brokerage houses
where his lovers traded, the compliance officers and computers picked up on the
pattern. They went to the SEC and the United
States Attorney. There was a joint
investigation, and eventually Carpenter confessed. There was a criminal prosecution under Rule
10b-5 and the Federal Mail/Television/Radio Fraud Act. The jury convicted him on both counts. The Second Circuit affirmed. The case went to the U.S. Supreme Court,
where the mail fraud count was affirmed 8-0.
He clearly had violated the mail fraud statute by robbing his employer
of confidential information. The Rule
10b-5 count was affirmed 4-4. There hasn’t
been a subsequent opinion on the theory of misappropriation, so the Second
Circuit continues to apply it. The
theory is rather uneven in other circuits.
That’s
not the end of the story. SEC v. Dirks was an appeal of an SEC
disciplinary action against a broker-dealer.
In this opinion, the Chiarella test was
made more explicit. The opinion said
that mere possession of inside information is not enough for Rule 10b-5. To that extent, both of these Supreme Court
cases limit the ruling in Texas Gulf
Sulfur. The tipper must have
violated his duty of loyalty to the
company, and there must be a benefit to the tipper. Rule 10b-5 is a fraud section. Many things
can be a benefit: (1) business benefits, (2) reciprocity benefits, or (3) social/romantic/sexual
benefits.
The
president of an NYSE company goes to a bar and bring
his assistant along, gets drunk, talks too loud, and Mr. X overhears in the
next booth. Mr. X has no fiduciary relationship
with the company or anyone else. Can Mr.
X, insofar as 10b-5 is concerned, trade on this information? Yes!
On the other hand, if the president of the company talks about a tender
offer that the company is going to make in two weeks at a big premium, we go to
Rule 14e-3 which says that in the limited context of a tender offer reinstates
the broad mere possession test of Texas Gulf Sulfur. Note that the second sentence of Rule 14e-3
is not a fraud section. It is also quite
broad in that it applies to any tender offer of any security of any company,
public or private. These provisions are
most certainly enforced! Computers can
catch them or ex-lovers can tip off investigators.