BUSINESS LAW - CORPORATE RIGHTS CASE

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](1): Inside Information in Markets

• Seller offers to sell his shares of a corporation, but for what reason?
• Cash for consumption, paying off debts, or reinvesting in other assets
• Or knows that the corporation’s earnings will decline
• Buyer should adjust his offer to buy downward to take account of the latter
• Buyer offers to purchase shares of a corporation, but for what reason?
• Investing excess cash
• Or knows that the corporation earnings will increase
• Seller should adjust his offer to sell upward to take account of the latter
• Inefficient Market - mutually beneficial transactions will not occur
• Some buyers would be willing to buy at a higher price
• Some sellers would be willing to sell at a lower price
• Thus, some transactions will not occur

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](2): Lessons for Securities Markets

• Markets are less efficient at determining prices
• Wider bid-ask spreads
• Investors without confidential information will exit the markets
• Fewer small investors will participate directly in the markets
• Savings of small investors will be channeled to professional investors
• Market price will be determined the bids and asks of professional investors with non-public information
• Only investors who believe they have better non-public information will trade
• Participating investors will focus on obtaining better non-public information
• Investors will focus less effort on generating new information or assessing public information

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](3): Laws Governing Insider Trading

• Insider Trading means trading on “material non-public information”
• Three main securities laws govern insider trading
• Section 16(b) of SEC Act (1934)
• Regulates short-swing purchases and sales by corporate insiders
• SEC Rule 14e-3(a):
• Civil liability for trading on non-public information about tender offers
• SEC Rule 10b-5, Sections (1) or (3):
• Civil liability for fraudulent practices, which includes insider trading
• Applies to corporate insiders, quasi insiders, and their tippees
• Applies to outsiders with a duty of confidentiality and their tippees

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](4): Section 16(b) of SEC Act (1934)

• Obligations of directors, officers, and owners of more that 10% of shares in any corporation:
• Must report all trades in the stock of their corporation
• Must refund any profits on “short-swing” trades to the corporation
• A short-swing trade is a purchase and subsequent sale within 6 months
• Section 16(b) allows corporate insiders to trade in their stocks, but prevents them from profiting on non-public information
• Stock is an important dimension of compensation and incentives
• But studies show that managers out-perform other investors in trading the stock of their own corporation
• Securities analysts watch reported trades of insiders
• Sarbanes-Oxley (2002) requires reports to be filed within two business days

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](5): Insider Trading Under Rule 14e-3(a)

• Williams Act (1968) amended the SEC Act (1934) and allows the SEC to regulate tender offers
• Section 14(e) governs fraudulent practices, just as Rule 10b-5(1) and (3)
• Rule 14e-3(a) prohibits purchase or sale of securities on the basis of material non-public information about a tender offer
• If trader knows or has reason to know that the information was non-public and was acquired directly or indirectly from the directors, managers, employees, advisors, or representatives of either corporation
• Adopted after US v. Chiarella (1980) in which a printer of tender offer solicitations identified the parties and traded in the target stock
• Rule 14e-3(d)(1) also prohibits the communication of material non-public information by insiders when it is reasonably foreseeable that the communication will result in a violation of Rule 14e-3(a)

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](6): Insider Trading Under Rule 10b-5

• (1) purchase or sale of securities (or related benefit)
• (2) on the basis of material non-public information
• (3) that was obtained by either a
• (a) breach of a fiduciary duty, or
• (b) breach of a duty of confidentiality
• (4) with knowledge of both (2) and (3)
• What does “knowledge” mean?
• Known or should have known that the
• Information was material and non-public
• Information was obtained by a breach of a duty
• No defense for conscious ignorance of the source of the information

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](7): Rule 10b5-1

• Rule 10b5-1 allows directors and officers to diversify by selling their stock holdings without violating Rule 10b-5.
• Rule 10b5-1(b): “On the basis of” means that the trader was aware of the non-public information when trading
• Rule 10b5-1(c)(1): Affirmative Defenses
• (A) Before becoming aware of the non-public information, the person
• (1) Entered into a binding contract to purchase or sell, OR
• (2) Instructed an agent (broker or trustee) to purchase or sell, OR
• (3) Adopted a written plan for purchasing or selling
• (B) The contract, instruction, or plan
• (1) Specified the number of shares, price, and date, OR
• (2) Included a written formula or computer program for same, OR
• (3) Allowed no influence by the person on the agent

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](8): Civil Penalties for Insider Trading

• Traditional penalty = disgorgement of profits from the trading
• Loss avoided = sale price - market price after information becomes public
• Profit gained = market price after information becomes pubic - purchase price
• Payment to Treasury, or compensate investors (Sarbanes-Oxley (2002))
• Disgorgement has NO deterrence effect (aside from criminal penalties)
• Insider Trading and Securities Fraud Enforcement Act (1988)
• New penalty: Treble (3X) the profit gained or loss avoided
• New penalties for “Controlling Persons” such as employers
• Corporation and its advisors such as investment banks, law firms, accounting firms
• If knew or recklessly disregarded that employees were violating Rule 10b-5 and failed to take appropriate steps to prevent the violations
• If knowingly or recklessly failed to enforce a policy to prevent violations
• penalty up to $1 million OR treble the profit gained or loss avoided of employer
• Bounty for informers up to 10% of the penalty imposed

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](9): Civil Liability for Insider Trading

• Traditional Remedy = rescission of transactions
• damages = true stock value at time of sale - transaction price
• Or the profit of the trader with the non-public information, if larger
• traditional problems for plaintiff: identifying whether the other trader had non-public information and then proving reliance on the public information
• Insider Trading and Securities Fraud Enforcement Act (1988)
• Affirmed the private right to sue for damages
• Defined class of “contemporaneous traders”
• No need to prove that each plaintiff traded (purchased or sold) with a person having material non-public information
• No need to prove that each individual relied on public information if stock traded on a public exchange
• Damages of class limited to the profit gained or loss avoided by traders with non-public information

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](10): Questions Addressed in Cases

• What is “Material” Information?
• Basic v. Levinson (1988)
• What is “Non-Public” Information?
• SEC v. Texas Gulf Sulfer (1968)
• What is a “Related Benefit”?
• Dirks v. SEC (1983)
• What is a Breach of Fiduciary Duty?
• Dirks v. SEC (1983)
• What is a Breach of Duty of Confidentiality
• US v. O’Hagan (1997)

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](11): SEC v. Texas Gulf Sulfer - Facts

• Texas Gulf discovers large copper deposit in Ontario, and schedules a press release on April 16, 1964
• 9:40 AM: Canadian press release
• 10:00 AM: U.S. press release begins
• 10:15 AM: U.S. press release is completed
• 10:29 AM: News hits Merrill Lynch internal private wire
• 10:54 AM: News hits Dow Jones ticker tape
• Trading by Directors of Texas Gulf
• 8:30 AM: Crawford places buy order on Midwest Stock Exchange
• 10:20 AM: Coates places buy order with his broker son-in-law
• Stock price rises from $16-18 in November 1963; to $29 on April 15 1964; to $37 on April 16 (day of the press release); and then to $58 on May 15.

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](12): SEC v. Texas Gulf Sulfer - Decision

• Did the information become public at 10:15?
• NO: because not adequately disseminated yet
• Did the information become public at 10:30?
• Probably Not: because not adequately disseminated yet
• Did Crawford and Coates violate Rule 10b-5?
• Yes, insiders cannot place orders to be executed after the press release
• Did the information become public at 11:00?
• Because it was announced on the Dow Jones ticker?
• NO: information must be effectively disclosed to markets
• Press release is just the first step in disclosure to the markets
• Investors require some time to read in business media
• Investors may also require time to evaluate the implications for the corporation

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](13): SEC v. Texas Gulf Sulfer - Questions

• Did the other defendant insiders violate Rule 10b-5?
• YES, they were buying stock and receiving stock options from the initial drilling
• Classic examples of insider trading
• Is the April 12 press release false or misleading?
• “The work done to date has not been sufficient to reach definite conclusions and any statement as to size and grade of ore would be premature and possibly misleading”
• In a shareholder lawsuit claiming that the April 12 statement was false or misleading, what is the legal relevance of the reaction of the business press to the press release?
• Material Fact because the business press discussed it?
• Reliance because the business press disseminated it?
• Would the interview with Northern Minor violate Regulation FD?

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](14): Breach of Duty Under Rule 10b-5

• Which Insiders have a Fiduciary Duty?
• Corporate Insiders: directors, officers, and employees
• Quasi-Insiders have a contractual fiduciary duty
• Investment bankers, attorneys, accountants, consultants
• Which Outsiders have a Duty of Confidentiality?
• Outsiders who have access to the non-public information from their employment
• Outsiders have a duty of confidentiality to their employer
• Employer has a contractual duty to the corporation
• Employees of firms providing services to the corporation
• Duty of Confidentiality derives from the Misappropriation Theory
• Rule 10b5-2(b): Duty arises when there is an confidentiality agreement or a history and practice of maintaining confidences
• See U.S. v. O’Hagan (1997)

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](15): Tippers and Tippees

• Who is a Tipper?
• Person with non-public information who conveys the information to a Tippee
• Tipper may be an insider or outsider, but can also be a Tippee
• Who is a Tippee?
• Person who receives non-public information from a Tipper
• Tippee will typically have no relationship to the corporation or its advisors
• Liability for Tippees of Insiders
• know or should have know that the information was obtained by a breach of a fiduciary duty
• Liability for Tippees of Outsiders
• know or should have know that the information was obtained by a breach of a duty of confidentiality

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](16): Related Benefit

• Do Tippers violate Rule 10b-5 if they do not trade?
• YES, as long as they receive benefits in some other way
• Tipper could receive cash by the Tippee (e.g. Ivan Boesky)
• Tipper could receive commissions on other transactions by Tippees
• Tipper could receive raises or bonuses from his employer with Tippees as clients
• Tipper could benefit personally from helping family or friends
• Assuming the Tipper knows that the family member or friend will trade
• Do Tippees violate Rule 10b-5 if their Tipper did not benefit?
• No clear decisions, but don’t count on it!!!
• Tippers can benefit in many ways other than trading
• If an earlier Tipper in the chain benefited, that may be sufficient for a violation by the current Tippee

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](17): Knowledge of Tippees

• Do Tippees violate Rule 10b-5 if they do not actually know that the information is non-public?
• Suppose the tip came from a friend or relative?
• Assume that the friend or relative could not have access to non-public information
• Suppose the tip came from your broker? Martha Stewart
• Assume that they would not tip non-public information
• What does it mean that Tippees “should have known”?
• One should be suspicious if the tip comes from an insider
• One case suggests that a Tippee has an obligation to ask the Tipper when the circumstances are suspicious
• Do Tippees violate Rule 10b-5 if they do not actually know of the breach of duty?
• No clear decisions, but don’t count on it!!!

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](18): SEC v. Dirks (1983)

• Was Dirks a corporate or quasi insider of Equity Funding?
• NO, Dirks was an investment analyst at a brokerage firm
• Was Dirks a Tippee from a corporate or quasi insider?
• YES, Secrist, the Tipper, was a former officer of Equity Funding
• Did Secrist trade the stock of Equity Funding?
• NO, Secrist was primarily interested in exposing the fraud
• Did Secrist benefit is some other way? Maybe
• Did Dirks trade the stock of Equity Funding?
• NO, Dirks pursued the fraud
• Did Dirks benefit in some other way? Maybe

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](19): SEC v. Dirks (1983)

• Did Dirks tip this information to others?
• YES, to clients of the brokerage firm who dumped Equity Funding
• So what is the SEC position that Dirks violated Rule 10b-5?
• (1) Tippee from an insider Secrist
• (2) Dirks benefited as a Tipper to the clients of the brokerage firm
• His compensation from his brokerage firm was higher - conflicting evidence
• Why does the Supreme Court reject this SEC position?
• Secrist did not breach a fiduciary duty to the shareholders of Equity Funding because he did not benefit from trading or any other way
• Dirks had no independent duty to the shareholders of Equity Funding
• So Dirks had no duty to disclose or abstain from trading

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](20): SEC v. Dirks (1983) - Questions

• Suppose that Secrist had sold shares of Equity Funding
• Would Secrist violate Rule 10b-5?
• Yes, he was a corporate insider and traded on it
• Would Dirks then violate Rule 10b-5?
• Yes, if he received higher bonuses from tipping clients of his firm
• Dirks would be a Tippee who inherited the breach of duty by Secrist
• Would Dirks’ Brokerage Firm then violate Rule 10b-5?
• Yes, the firm benefits from helping clients and their future business
• Firm would be a Tipper and knows that its clients will trade and benefit
• Firm would be presumed to know that Dirks obtained non-public information
• Would the Clients of the Brokerage Firm violate Rule 10b-5?
• No, they would not be expected to know that the information was non-public

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](21): U.S. v. O’Hagan (1997)

• Was O’Hagan a corporate insider? NO
• Was O’Hagan a quasi-insider?
• No, he was a partner for the law firm who had represented Grand Met
• BUT he was not assigned to work on the acquisition of Pillsbury
• Where did O’Hagan obtain the non-public information?
• From another partner assigned to work on the acquisition of Pillsbury
• This other partner was a quasi-insider who had represented Grand Met
• Did the other partner breach his fiduciary duty to the law firm?
• No, he did not trade on the information
• No, he had no reason to know that O’Hagan would trade
• Was O’Hagan a tippee from a quasi-insider?
• No, he was an Outsider with a duty of confidentiality to the law firm

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](22): U.S. v. O’Hagan (1997)

• Did O’Hagan violate Rule 10b-5?
• Yes, because he breached a duty of confidentially to his employer
• Yes, because he misappropriated the non-public information
• Yes, because he traded on the information
• Supreme Court adopts the “misappropriation theory”
• Would a Tippee of O’Hagan violate Rule 10b-5?
• Yes, if Tippee traded and knew or should have known of the breach
• Does Rule 14e-3(a) require a breach of duty when trading on non-public information about a tender offer?
• No, anybody who trades is liable (probably breaching a duty)
• Court upholds this Rule in order to protect the tender offer process

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](23): Regulation FD (2000)

• Policy Concern: “selective disclosure” of information to securities professionals
• non-public information is then passed to their clients for trading
• Rule 100: Whenever an issuer, or person acting on its behalf,
• discloses material non-public information
• to securities market professionals (or to shareholders who may trade)
• the issuer must make a public disclosure of the information
• simultaneously (for intentional disclosures)
• promptly (for non-intentional disclosures)
• Applies only to senior officers and public relations officers
• Violation if officers knew or should have known that the information was both material and non-public
• Not a violation of Rule 10b-5 and thus no private lawsuits

Wharton School: Government & Legal Environment of Business - BPUB 621 - Visiting Professor Martin K. Perry

[5](24): Litton v. Lehman Brothers
(2d Cir. 1992)

• Litton seeking acquisitions in defense technology in 1982
• hires Lehman Bros. as investment banker
• Lehman suggests Itek Corp. (electronic warfare)
• Lehman employees use inside information to buy Itek stock
• drove the market price of Itek stock from $26 to $33
• Litton must offer a higher tender offer price
• planned to offer $42.50, but increased offer to $48 (January 1983)
• Litton discovers the facts in 1986, sues Lehman for fraud
• District Court rejects fraud claim, but 2d Circuit reverses
• Lehman fails to inform Litton why the market price is increasing
• Market price determines the tender offer and takeover price
• affects the Itek Board’s recommendation and Itek shareholder decisions