Associations Class Notes
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
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
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
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
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
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
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
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
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
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
Zapata Corp. v. Maldonado
Here, we run into the same
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.
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.