Business Associations Class Notes 6/23/04

More on 10b-5

Chiarella itself established that 10b-5 is a fraud rule. That was amplified by SEC v. Dirks. The latter case held that the tipper must have violated his duty of loyalty to the company and must have received a benefit, broadly defined, from doing so. A breach of the duty of care of the tipper to the company is not enough.

In a prior exam, the CEO of an NYSE company went with an assistant to a local café, ordered too much to drink, and talked way too loud to his assistant. In the booth next to him was Mr. X, who owed no fiduciary duty to the company or the two individuals. He overheard, and he went out and loaded up on the company’s stock. 10b-5 does not apply to this situation because Chiarella and Dirks, insofar as 10b-5 is concerned, overrule the mere possession test of Texas Gulf Sulfur. This is due to the literal language of 10b-5 because it’s a fraud statute. Justice Powell explained that journalists and others perform valuable functions in society and in the securities markets. If a journalist gets a company official to say more than he should, with the company official violating only his duty of care to the company and getting no benefit, and the journalist spreads the word, then society is all the better for it, so the journalist shouldn’t be punished.

Consider 14e-3 in this situation. The president and his executive assistant were discussing a bigger NYSE company that was going to pick up the subject NYSE company in a statutory merger at a big premium. This was confidential. Nobody knew it except the two companies and their agents. Both § 14(e) and 14e-3 are limited to tender offers. So the question is whether a statutory merger or sale of all assets is ever a tender offer. The answer is no, because they are both non-coercive in that the shareholders and board of directors must vote on it. A tender offer is more hostile and doesn’t require shareholder or board approval. So 14e-3 does not apply either. However, what Mr. X did in soliciting shareholders was probably a tender offer and there was no compliance.

If 14e-3 had been adopted when Chiarella was decided, then Mr. Chiarella would have run afoul of 14e-3 because the undisclosed information related to a tender offer and under 14e-3 the mere possession test of Texas Gulf Sulfur, in that limited circumstance, is reinstated. That is to say that the plaintiff need not prove fraud, breach of fiduciary duty of loyalty, or benefit by the tipper. Is 14e-3 a valid Rule? Two big cases say yes, and Shipman says they’re right. The first is United States v. Chestman, a criminal case from the 1980’s from the Second Circuit. In this case, a wife of a top executive in New York was told by her husband that there was going to be a tender offer. She called her daughter and shared this, telling the daughter up front, “Don’t tell anyone else.” (Never do that!) The daughter then shared the information with her husband. The daughter did not tell the husband that it was highly confidential. The husband shared the information with his stock broker and doesn’t tell the broker it’s confidential. So the broker goes out and loads up on the company’s stock for himself and his customers.

There followed a criminal prosecution under 14e-3 and 10b-5 of the stock broker. The husband was granted immunity to testify against the broker. There was a jury conviction on both counts. The case came up before the Second Circuit. As to 10b-5, the court applies the Dirks-Chiarella test. They hold that the government didn’t prove that the daughter and the daughter’s husband were fiduciaries to each other, and since the daughter didn’t get the husband to promise to keep it confidential before she told him, the 10b-5 “chain” was broken, and thus the broker’s conviction on the 10b-5 count had to be overturned. But as to the 14e-3 count, they held that the Rule is valid. They ruled that no fiduciary duty need be found. The conviction was upheld and the sentence was not reduced.

There are courts that would hold that there is always a fiduciary duty between husband and wife under a status concept so long as they are living together and they’re not contemplating divorce. What the Court of Appeals held was that they wouldn’t buy the status argument. They admitted that fiduciary duty and confidential handling of information can flow from one of two sources: (1) status, which is the most common, or (2) contract. For example, if the wife had said up front: “Husband, this must be kept in the strictest confidence, and I’ll only tell you if you promise to keep it secret”, then there is a contract. By contrast, if a cab driver overhears you talking on a cell phone about anything but a tender offer, the cabbie can pig out on that stock. On the other hand, if you tell the cab driver that you’re about to make a highly confidential call, ask him if he will keep it confidential, and he says yes, then there is a contractual fiduciary duty, and if the cab driver pigs out, he violates Rule 10b-5.

A U.S. Supreme Court out of the last five years upheld 14e-3. In the process of doing so, they also discussed 10b-5. A senior partner in a Minneapolis law firm had embezzled $500,000 from clients and was about to be found out. He needed a quick fix. A client of the firm was planning a confidential tender offer at a big premium for the stock of X, Inc. He bought a bunch of options on X, Inc. in his own name. The SEC, as to the public trading markets, now heavily relies on computers, though it wasn’t always so. In Justice Ginsburg’s opinion on 10b-5, she noted that the alleged wrongful sale or purchase must be proven to be on account of the inside information. She held that it was in this particular case. The language of this opinion led to the new rules 10-b5(1) and 10-b5(2) where you can send notice to the SEC that you’re going to sell and if, at the time, there is no undisclosed, unfavorable information, but such information develops after that, you can still go ahead and sell under certain circumstances.

Also in the last five years, Regulation FD (“fair disclosure”) under the Securities Exchange Act of 1934 relates to publicly reporting companies. That’s because it’s a rule under § 13, the reporting provision. If an officer or director spills the beans on undisclosed information, then within two days you must publicly file a report with the SEC as to “what the beans are” so that everybody can play on a level playing field. This was very controversial! The SEC chairman barely got it passed. The deciding vote came in from one of the commissioners, who joined only after the Commission put in a big exemption from the Rule: a bona fide member of the media doing bona fide media work to whom the beans are spilled does not have to comply with Regulation FD. The holdout commissioner was correct, in Shipman’s opinion. He didn’t want the rule challenged on First Amendment grounds.

Since the 1980’s, there have been a number of amendments to the Securities Exchange Act of 1934 on insider trading. None of the statutes define insider trading; Congress has left that to the courts. However, there are a number of very important provisions. One of them is that lawyers, CPA firms, investment bankers, and the company itself must avoid reckless conduct in safeguarding material, undisclosed inside information. In one of Shipman’s exam questions, a guy is a partner in a law firm. His son goes to the office and the father takes a phone call while the father is in the office. The call is from someone planning a big tender offer. The son is a party animal! He’s also quick-witted. He’s a finance major. He leaves and pigs out. How do we advice the senior partner of the law firm when the FBI appears? First, we tell him to be nice to the FBI. Next, we advise him that the partner was reckless in talking in front of his son. Don’t share confidential information with anybody. The partner is going to pay treble damages! In a civil action, the SEC can triple the ante! The partner must come up with the big money to get the SEC and FBI off of the firm’s back. You have to give it to him straight, according to Shipman. It’s his problem, not the firm’s. Also, all law firms have very careful written procedures on buying and selling securities that you must adhere to. If you work for a firm that does a lot of takeover work, the spouse should invest in mutual funds, not stocks. Pigging out is a basic human instinct!

Duties of care of loyalty and of full and fair disclosure

These three duties overlap heavily. Federal Rules of Civil Procedure 23 and 23.1 have to do with kinds of class actions. 23.1 deals with a shareholder bringing a suit on behalf of the corporation. The duty doesn’t run to the shareholder personally, but it does run to the corporation. It’s a lot harder to start a Rule 23.1 action off the ground than it is to get a Rule 23 action started. Under Crosby v. Beam, as to close corporations in Ohio, one of the express holdings is that if it’s something that before Crosby you had to assert derivatively, you can now go directly if it’s a close corporation. Why might you want to avoid a class action? Class certification is a big hurdle on things like preemptive rights. You’d rather just bring it directly.

This is an area of heavy legislative challenge. The 1995 Act, as to fraud actions involving securities, put a whole new layer of restrictions on class actions or quasi-class actions. A quasi-class action is where twenty individual shareholders bring twenty different suits on the same transaction. The 1998 Act expanded this, saying that if the class action involving fraud and securities is in the state courts under state law, then the defendants can remove them to the (more defendant-friendly) federal courts. The newest kid on the block, about to be born, is a bill before the Senate this week. It’s a class action bill recently passed by the House. It’s broader than securities and says that as to many class actions entirely under state law, even if only negligence is alleged, the defendants may remove to the federal courts. This is very popular in the House, but not popular with the federal bench. In the Senate, it’s going to be close. Shipman predicts it will become law eventually. At the state level, there has been a lot of tort reform action, including in Ohio. A massive bill just passed in Mississippi.

Business judgment rule on the merits – Smith v. Van Gorkum

This case stands for the business judgment rule on the merits. This is duty of care only. The directors were the cream of the Chicago business community. The action was brought as a class action after the merger rather than a derivative action. The class action was approved by the Chancery Court and the Supreme Court does not upset it. There was no special litigation committee to pass on the action. The old man had met with Pritzker, of medical school fame. They went to the opera. Pritzker said: “I’ll make cash merger offer to all of your shareholders at a 33% cash premium and I want you to support it. I want the board to agree not to shop it around.” The company counsel tells him that if he doesn’t accept the offer, he could be held liable in a shareholder derivative action. So about an hour later, the deal is green-lighted. Keep in mind the big premium and the sterling reputation of the Pritzkers. Because of the no-shop clauses, they never sought an alternative deal. The deal was submitted to shareholders, who overwhelmingly approved it. The merger closed, and then this action was brought after the fact. The chancellor threw the case out under the business judgment rule, saying that the board met and considered the deal and thus it was fine.

This case hit the corporate world like a bombshell because this is the way boards did business before this case! Before Zahn v. Transamerica, the first big 10b-5 case, insider trading was rife! The Delaware Supreme Court says that the business judgment rule can be shredded by the plaintiff showing (1) fraud, (2) ultra vires, (3) bad faith, (4) arbitrary or capricious action, or (5) waste (recklessness by the directors). But then they added: (6) gross negligence on the merits, and (7) procedural gross negligence. Here, the Delaware Supreme Court said that there was procedural gross negligence by the board, which gets us into the role of shareholder approval in a public company in Delaware and Ohio.

In Delaware, the rule, at least since the 1940’s has been that if holders of a disinterested majority of shares, after full and fair disclosure up-front, vote not to sue or to approve or ratify, then upon such approval the business judgment rule is broadened. In Delaware, if you have such approval and creditors aren’t hurt, then unless the plaintiff shows (1) fraud, (2) ultra vires, (3) illegality, and (4) waste, then the shareholders’ judgment rule applies and the plaintiffs are tossed out of court. In Ohio, it’s even broader. Claman v. Robertson came from the 1940’s in the Ohio Supreme Court. The Ohio Supreme Court held that even if there were fraud upon the company, if the fraud were openly and fully discussed in the proxy statement asking for the shareholders not to sue and shareholders holding a disinterested majority vote not to sue, then it will be okay. This didn’t work to save the defendants here because the proxy statement to the shareholders was riddled with material disclosure violations.

The opinion of the Delaware Supreme Court can be fundamentally criticized. The remand scared the directors witless, because the potential liability could be tens of millions of dollars. It was settled out at around $20 million, of which the insurance company supplied about $14-15 million. Pritzker threw in the other $5 million. What the court failed to make clear on remand was that this was a strict duty of care action. Most of the directors of the company were independent, outside directors in every sense. Even the old man, the CEO, who put pressure on the directors was not engaged in a conflict of interest. The duty of care, like a fraud action, both are standard tort actions. Like standard tort actions for damages, the plaintiff must plead and prove causation-in-fact. Here, there was a 33% premium. What they failed to emphasize was that the company may have been fully priced out, and if the jury finds this to be the case then there is no legal damage should because there is no causation-in-fact. Later cases recognize this, but duty of loyalty is different. It’s trickier and in a lot of ways much more plaintiff-oriented. If Del. § 102(b) or R.C. 1701.59(D) had been in effect at the time of Smith v. Van Gorkum, it is doubtful that the plaintiff would have been able to show a cause of action. It would be next to impossible to show that the action was reckless. But let’s say the action arose in Ohio in 2004 under .59(D). The action would be reckless now because Smith v. Van Gorkum has been around a long time. A trier of fact could easily find recklessness.

Business judgment rule on procedural motions before summary judgment

Summary judgment is the first time that defendants can raise business judgment on the merits. But business judgment on procedural motions can be raised at the same time as 12(b)(6) motions. The problem is that once you reach the summary judgment stage, there has already been a lot of time for discovery, which is very dangerous and uncomfortable. Defenses that you can raise at 12(b)(6) or earlier and before substantial discovery will make your legal fees much lower. You will rely on affidavits, briefs, and oral arguments, and these are much cheaper and faster.

Special litigation committees – Gull v. Exxon Corp.

Exxon, after World War II, secretly financed elections in Italy, which, at the time, violated neither United States nor Italian law. (In the 1970’s, the Securities Exchange Act of 1934 was amended by the Foreign Corrupt Practices Statute, and this statute would catch such behavior today.) Several years later, a minority shareholder instituted an action against the company and the old board members. From the newcomers, a three-person litigation committee was appointed. Counsel for Exxon went into court and got a stay of the proceedings while the three-person special litigation committee investigated. They hired special legal counsel and a special independent CPA firm. They investigated, submitted a report to the committee, and the committee opined that it would be in the best interests of the company if the litigation were terminated. Exxon counsel returned to court and asked for an order of dismissal on the merits. The court granted the order subject to the caveat that the plaintiff’s lawyer would be given authority to take depositions on the good faith of the committee and their disinterested status. After that’s been done, they were to come back to court, and if it is proven that the committee is disinterested and proceeded diligently and in good faith, and had independent lawyers and CPAs, then the court would dismiss the case. There was authority in the New York state courts that is even more pro-defendant.

Zapata Corp. v. Maldonado

Here, we run into the same problem in Delaware. Zapata was a demand-excused derivative action brought against a company and its directors and officers on both duty of loyalty and duty of care grounds. In the real world, plaintiffs will allege breaches of all three branches of the fiduciary principle, including also the duty of full and fair disclosure up-front. A special litigation committee of squeaky clean people is selected. They hire independent legal counsel and independent CPAs. They conclude that the suit is not in the best interests of the company. That’s every defense lawyer’s dream! There’s something to it: even if you have a good cause of action, you often are better off not pursuing it. For example, you have a good tort suit against X, but if you sue, then you’ll expose yourself to criminal liability. If you are the lawyer for the defendant, you cannot explicitly raise this in negotiations with the plaintiff. But everyone is aware of it. A wise defendant will settle for a few thousand dollars.

When the motions are filed, the chancellor says that derivative actions are good for the corporation, and public policy indicates that we will look at the business judgment defense on the merits, but not the business judgment defense of procedure. This goes up to the Delaware Supreme Court, which holds that either on a demand-excused action or demand-required action, the chancellor is to exercise her business judgment in reviewing the business judgment of the special litigation committee. The Ohio authority on this is scanty. Since 1978, there has been a lot of Sixth Circuit and District Court authority that the defense won’t be given much weight.

Aronson v. Lewis

The old man is the CEO, president, and majority shareholder. Most of the directors are his friends who have no business connection with him or the company. They’re not officers or employees, but they’re all social friends of the president, which is no surprise. The plaintiff’s petition under 23.1 must state whether demands have been made on directors, and if not, it must state why not. The plaintiff alleges in his petition that demand was not made because it would be futile to make demand on the directors. In the old days, on these facts, when you made all of the directors defendants in good faith, they would “wave you through”. Note that the defendants’ lawyers, acting under Rule 23.1, before the answer is filed, moved for dismissal on the grounds that the demand should have been made but wasn’t. The court uses the complaint to determine what the plaintiff alleged, which was that most of the directors were not officers or employees and had no business relationship with the CEO, but that all of them were close social friends.

The court first holds that the mere fact that a director is a social friend of the controlling shareholder or inside directors does not ipso facto make that person an inside director. The court also establishes that where you have a compensation question and most of the directors passing on the compensation are independent, outside directors, you must allege waste, that is, recklessness concerning the compensation. That’s important because neither directors nor shareholders can ratify or decide not to sue on waste. The court holds that where you claim that demand is excused, you must be very clear and detailed and complete on your allegations. For example, one allegation in the complaint is that the old man is old, and the plaintiff alleges that’s enough to show he’s not worth what a younger man would be worth. The court says that this is not nearly good enough. You must show waste in detail, that is, that the old man’s mental or physical capacities are at such a point that paying him such a good salary is a waste of corporate assets and you would have to allege, in detail, why that’s true. If, for example, the old man had advanced Alzheimer’s, that would be good enough.

Therefore, on this Rule 23.1 motion (before an answer is filed and well before summary judgment), the Supreme Court ruled that the Court of Chancery ought to dismiss. Sometimes, the plaintiff will be allowed to refile, but other times the dismissal can be with prejudice, saying that it’s all over. If the action is an individual action or a class action under Rule 23, the particular defense that the plaintiff should have made demand on directors but didn’t is not available. In general, avoid Rule 23.1 if you can if you’re a plaintiff.

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