Business Associations Class Notes 6/22/04


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 New York based sulfur company.  You dig a big hole in Canada and set a core to Salt Lake City to be assayed.  A visual inspection is done, and it looks good.  Another look showed that it was spectacular.  It’s not a sure thing that there’s sulfur or other minerals for miles around.  It looks like it is potentially good.  What the company did was to hire non-employees to go up to Canada and talk to the farmers on top of the land and offer them a good price for the lease but not the near-spectacular price that the land was really worth.  The agents were probably not told of the results.  Really confidential info is given out on a “need-to-know” basis.  These people bought in their own names and took title in their own names.  After the second, truthful press release they transferred title to Texas Gulf Sulfur, which in turn reimbursed them.


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 New York law including contract and fraud theories.  It is stipulated that there is no fiduciary or special relationship between the parties, in which case a non-disclosure of even a simple material fact could have been fraudulent.


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 New York law would govern.  The case is not under 10b-5.  In fact, often your remedies are better under state than federal law.  10b-5 is a high scienter section.  The court found a New York case from 1920 dealing with an upscale piano store with a huge showroom of half new and half high-quality refurbished pianos.  A lady came into the store thinking a piano was new.  She was not told otherwise, and so she wrote a check and took the piano home.  Later, the piano tuner told her that it wasn’t new.  She sued in fraud, with the stipulation that there was no fiduciary relationship.  There were no consumer laws at the time.  The Court of Appeals of New York held that where one party to the contract is under a false impression as to a special fact and the other party knows that false impression and doesn’t correct it, then if scienter can be shown, there is fraud even though there is no fiduciary or other special relationship.  The Restatement Second of Torts follows the same doctrine.


A case with a similar result under contract doctrine comes from the 1970’s in California: Stare v. Tate.  A couple were getting divorced.  California is a community property state.  As to the husband’s personal earnings post-marriage, even if that property is titled in his name alone, it is community property and the wife has a vested right in that property.  In a common law state, if she dies before him, her interest is said to be inchoate and her will would pass nothing.  In both common law and community property states, a divorce results in a 50-50 split in marital or community property.  The woman’s lawyer sends to the man’s lawyer the final draft of the papers they were to sign for the property settlement.  It was based on the negotiation of the principal.  The wife’s lawyer made a $250,000 mistake against her.  The lawyer turns to the client, saying “we ought to tell them their figures are screwed up”.  The husband says “no way”.  In theory, the judge ought to look over the papers, but the judge never will.  The judge just glances at them.  If the husband had stayed quiet, probably no one would have every discovered it.  But later, at a cocktail party, the ex-husband went up to the ex-wife and tells her how he cheated her out of marital property.  She brings an action to reopen the settlement.  The judge finds that there is a contract principle that is very similar to the tort principal.  Always look at both the contract and tort remedies!  There are times you do not have to show bad faith or scienter in contracts, and the statute of limitations may be a lot longer.


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 Warren Court equal protection opinion, albeit at the Court of Appeals level.  The court also holds that those who tipped and those who are tipped off can be forced to disgorge their unjust gains.  The case never made complete sense because Rule 10b-5 is a fraud section.  Under Ernst & Ernst v. Hochfelder, decided later, it was made clear that the plaintiff must plead and prove scienter.


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 California is called a general demurrer), there was a company that put out materially misleading press releases.  The suit was brought by someone who bought stock in the company but did not sell.  He alleged that he relied on the press release.  Such a person has no cause of action under Rule 10b-5.  The California Supreme Court held that this probably did allege a cause of action under California common law.  The court hinted that the fault standard is negligence, not scienter.  It’s a highly unnerving opinion!



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. United States


Here we had a printer for a big New York City printing shop.  All around the plant there were signs posted saying that all information is highly confidential.  One day, an offeror appears who will make a hostile tender offer, in a few days, for Z, Inc.  He reveals his identity only to the president of the printing company.  He gives the president material to be printed with spaces left blank in key areas.  This is meant to provide anonymity.  The omitted spaces had the exact number of spaces for each company.  There were nine letters left blank.  When Chiarella looked at the numbers, it didn’t take him long to figure out which company the deal was for.  Chiarella runs out and calls his broker to load up on the stock of the target company.  The offer was going to be at a substantial cash premium.  Chiarella doesn’t know who reported him, but it might have been a broken romance.  This is the first criminal prosecution for Rule 10b-5 ever.  Up to 30 years ago, criminal statutes were rarely used for white-collar crime.  The jury found him guilty and the Second Circuit affirmed.  It was held that the indictment alleged no crime, and thus the conviction was overturned.


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.


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