Posner v. Scalia – The Final Round “I regard the posthumous encomia for Scalia as absurd” https://t.co/SIJlR3yYO3— Josh Blackman (@JoshMBlackman) June 25, 2016
Wasn't even most offensive thing he said. Worse: "I see absolutely no value to a judge studying the Constitution" https://t.co/1tU9uwMQgH— Evan Bernick (@evanbernick) June 25, 2016
"From the malice of [Posner] the grave was no hiding place, and the house of mourning no sanctuary" -- TB Macaulay. https://t.co/xRptjl7Etj— Adrian Vermeule (@avermeule) June 25, 2016
The only thing that gives Posner *any* power over his fellow citizens is the old document he says judges shouldn't spend seconds studying— Evan Bernick (@evanbernick) June 25, 2016
I regard pre-mortem paeans to Richard Posner as absurd. https://t.co/jlwoVnAcqy— Professor Bainbridge (@ProfBainbridge) June 25, 2016
Peter Clapman (former chief investment counsel of TIAA) and Robert Koppes (former chief investment counsel of TIAA) have an interesting op-ed in today's WSJ. It starts as a victory lap for shareholder activism's victories over director primacy, but then acknowledges--contra to the claims of activists and their academic allies on the Acela corridor--that this has resulted in a deleterious short-term focus by corporate managers:
Now we see aggressive pushes for stock buybacks and calls to spin off or break up businesses and cut costs, including spending on research and development. Activists increasingly demand board representation to implement their agenda, often meaning that short-term investors take and quickly relinquish boards’ seats. Boards frequently settle with activists out of fear of losing a proxy battle—or worse, winning a Pyrrhic victory.
Surveying this new landscape, we have to ask: Have these efforts yielded a structure that protects the long-term economic interests of shareholders? If the answer is no, then it’s time to revisit earlier assumptions and return to the basic purpose of corporate governance reforms: furthering investors’ long-term interests.
Their solution? Changing the one-share/one-vote paradigm:
Long-term investors should consider pursuing enhanced voting rights that better allow them to drive a long-term agenda.
Making such a right possible in the U.S. will require work. This country’s arcane proxy-voting infrastructure makes it difficult for investors to use such mechanisms in the few cases where they currently exist. In other countries with developed markets, such as France, it is common for shareholders with long holding periods to have greater rights, albeit still with varying degrees of practical issues.
I wrote about dual class voting structures back in the 1990s:
The Short Life and Resurrection of SEC Rule 19c-4 69 Washington University Law Quarterly 565 (1991), available at SSRN: http://ssrn.com/abstract=315375
Revisiting the One-Share/One-Vote Controversy: The Exchanges’ Uniform Voting Rights Policy, 22 Sec. Reg. L.J. 175 (1994)
In that work, I posited that the strongest argument against dual class stock rests on conflict of interest grounds. There is good reason to be suspicious of management's motives and conduct in certain dual class recapitalizations. Dual class transactions motivated by their anti-takeover effects, like all takeover defenses, pose an obvious potential for conflicts of interest. If a hostile bidder succeeds, it is almost certain to remove many of the target's incumbent directors and officers. On the other hand, if the bidder is defeated by incumbent management, target shareholders are deprived of a substantial premium for their shares. A dual class capital structure, of course, effectively assures the latter outcome.
In addition to this general concern, a distinct source of potential conflict between managers' self-interest and the best interests of the shareholders arises in dual class recapitalizations. An analogy to management-led leveraged buyouts ("MBOs") may be useful. In these transactions, management has a clear-cut conflict of interest. On the one hand, they are fiduciaries of the shareholders charged with getting the best price for the shareholders. On the other, as buyers, they have a strong self-interest in paying the lowest possible price.
In some dual class recapitalizations, management has essentially the same conflict of interest. Although they are fiduciaries charged with protecting the shareholders' interests, the disparate voting rights plan typically will give them voting control. The managers' temptation to act in their own self-interest is obvious. Yet, unlike MBOs, in a dual class recapitalization, management neither pays for voting control nor is its conduct subject to meaningful judicial review. As such, the conflict of interest posed by dual class recapitalizations is even more pronounced than that found in MBOs.
While management's conflict of interest may justify some restrictions on some disparate voting rights plans, it hardly justifies a sweeping prohibition of dual class stock. First, not all such plans involve a conflict of interest. Dual class IPOs are the clearest case. Public investors who don't want lesser voting rights stock simply won't buy it. Those who are willing to purchase it presumably will be compensated by a lower per share price than full voting rights stock would command and/or by a higher dividend rate. In any event, assuming full disclosure, they become shareholders knowing that they will have lower voting rights than the insiders and having accepted as adequate whatever trade-off is offered by the firm in recompense. In effect, management's conflict of interest is thus constrained by a form of market review.
I therefore proposed an exchange listing standard that was carefully tailored to remedy the conflict of interest problems posed by dual class recapitalizations, without being overbroad. That proposal was based on state corporate law rules governing transactions posing conflict of interest concerns similar to dual class recapitalizations: two-tier tender offers, freeze-out mergers, and interested director transactions. As it turned out, my proposal basically tracked the proposal put forth by AMEX and thereafter ignored by the Commission. Because I believe that my proposal or one similar to it, such as the AMEX proposal, is a better solution to the dual class stock problem than the pending proposal, a brief review and update of the proposal's main points follows.
The proposal looked first to the type of transaction in question. Any rule should be limited to true dual class stock transactions, thereby eliminating one class of overbreadth concerns by precluding application to other corporate actions. Second, for the reasons discussed above, no safeguards over and above those already provided by state law are necessary with respect to dual class stock issued in an IPO, a subsequent offering or dividend of lesser-voting stock, or dual class stock issued in a bona fide acquisition. Nor are any additional safeguards necessary with respect to super-voting rights shares issued without transfer restrictions or in a lock-up. An exchange listing standard should therefore permit issuers to freely adopt those plans.
Transactions involving more subtle conflicts require some additional safeguards. Among these are exchange offers and recapitalizations creating super-voting rights stock bearing transfer restrictions. In order to dissipate the conflicts of interest they raise, they should be permitted only if they are approved by the corporation's independent directors and disinterested shareholders.
Requiring approval by a committee of independent board members created to negotiate with management and/or the controlling shareholder is common in conflict of interest transactions. In the freeze-out merger context, the Delaware Supreme Court has made clear that this procedure is "strong evidence that the transaction meets the test of fairness." Statutes governing interested director transactions and two-tier tender offers effectively presume that the transaction is fair if approved by the independent directors. There is always, of course, some risk that purportedly independent directors will be biased in favor of their compatriots, but courts give greatest deference to independent directors in contexts like this one in which a market test of the transaction is impractical. This is so in large part, of course, because the absence of a market test gives courts little option but to rely upon independent directors as the chief accountability mechanism. Yet it is also so because courts know that independent directors are capable of serving as an effective accountability mechanism. Despite the potential for structural or actual bias, independent directors have affirmative incentives to actively monitor management and to discipline managers who prefer their own interests to those of shareholders. If the company suffers or even fails on their watch, for example, the independent directors' reputation and thus their future employability is likely to suffer. Guided by outside counsel and financial advisers and facing the risk of person liability for uninformed or biased decisions, disinterested directors therefore should be an effective check on unfairness in a dual class recapitalization.
As for the possible use of dual class stock to encourage long-term investment, there are many historical precedents. One share-one vote is not the historical norm. To the contrary, limitations on shareholder voting rights in fact are as old as the corporate form itself.
Prior to the adoption of general incorporation statutes in the mid-1800s, the best evidence as to corporate voting rights is found in individual corporate charters granted by legislatures. Three distinct systems were used. A few charters adopted a one share-one vote rule. Many charters went to the opposite extreme, providing for one vote per shareholder without regard to the number of shares owned. Most followed a middle path, limiting the voting rights of large shareholders. Some charters in the latter category simply imposed a maximum number of votes to which any individual shareholder was entitled. Others specified a complicated formula decreasing per share voting rights as the size of the investor's holdings increased. These charters also often imposed a cap on the number of votes any one shareholder could cast. Another approach used time-phased voting, in which investors got more votes as the period in which they had held their shares increased.
U San Diego Law professors Lynne Dallas and Jordan Barry did a study of time-phased voting and found that:
We explore Time-Phased Voting (“TPV”), an arrangement in which long-term shareholders receive more votes per share than short-term shareholders. TPV has gained prominence in recent years as a proposed remedy for perceived corporate myopia.
We begin with theory, situating TPV relative to other corporate voting structures such as one-share-one-vote and dual-class stock. By decreasing the influence of short-term shareholders, TPV may encourage managers to act in the long-term interests of their firms. It may also facilitate controlling shareholder diversification and firm equity issuances by enabling controlling shareholders, who are generally long-term shareholders, to maintain their control with lower levels of ownership. In this respect, it resembles a milder form of dual-class stock, but is more targeted toward myopic behavior.
We then investigate U.S. companies’ experiences with TPV in practice. Due to limited U.S. experience with TPV, our sample size is small from a statistical standpoint. Nevertheless, our findings are consistent with our theoretical analysis. Our ownership and voting data suggest that TPV empowers long-term shareholders, but that it does little to encourage long-term shareholding; this may be due to a lack of investor awareness regarding the few companies that have TPV. In the short term, TPV empowers insiders, increasing their control and creating a wedge between their ownership and control of the firm (though a smaller wedge than is typical of dual-class firms). However, in the long term we find that TPV is associated with reduced insider ownership and control. We see a transition in TPV companies, which are mainly mature, family-owned companies, from a concentrated to a more dispersed ownership structure. Relatedly, we find that TPV is associated with significant insider diversification and the issuance of additional equity.
Overall, TPV firms significantly outperformed the market as a whole; an investor who invested in our TPV firm index in 1980 would have more than six times as much money at the end of 2013 as an investor who invested in the S&P 500. While it is not clear that TPV contributed to this strong performance, we believe that shareholders and corporations should be free to experiment with reasonable TPV plans if they so choose.
Long-Term Shareholders and Time-Phased Voting (July 2, 2015). 40 Delaware Journal of Corporate Law 541 (2015); San Diego Legal Studies Paper No. 15-194. Available at SSRN: http://ssrn.com/abstract=2625926
Those interested in this topic should also take a look at Tenure Voting and the U.S. Public Company.
I see no reason why my proposal should not be adopted to allow time-phased voting plans, so maybe this is time to get that ball rolling.
Bloomberg reports that:
Scott Zdrazil, who directs strategy and corporate engagement at the Office of the New York City Comptroller, said ... “we want to talk about the board,” Zdrazil said. “We want to talk about corporate strategy. We want to talk about how this board is the right board for that corporate strategy.”
As I argued in my essay Preserving Director Primacy by Managing Shareholder Interventions (August 27, 2013), available at SSRN: http://ssrn.com/abstract=2298415, however:
Even if we grant Bebchuk (2013)’s claim that hedge funds have incentives to pursue what he calls “PP Action”—i.e., corporate courses of action that will have positive effects on both short- and long-term value—do we really think a hedge fund manager is systematically going to make better decisions on issues such as the size of widgets a company should make than are the company’s incumbent managers and directors? Of course, a hedge fund is more likely to intervene at a higher level of generality, such as by calling for the company to enter into or leave certain lines of business, demanding specific expense cuts, opposing specific asset acquisitions, and the like, but the argument still has traction. Because the hedge fund manager inevitably has less information than the incumbents and likely less relevant expertise (being a financier rather than an operational executive), his decisions on those sorts of issues are likely to be less sound than those of the incumbents. It was not a hedge fund manager who invented the iPhone, after all, but it was a hedge fund manager who ran TWA into the ground.
Overall support for proxy access shareholder proposals is lower this year compared to 2015, a mid-season report by Broadridge and PricewaterhouseCoopers found. According to the report, more than 30 proxy access shareholder resolutions have come to a vote so far this year, of which more than half failed to receive majority support.
Iman Anabtawi’s article, “Predatory Management Buyouts,” was cited in a recent Delaware appraisal case in which Vice Chancellor Laster determined that the fair value of Dell Inc.’s common stock at the time of its sale, by means of a merger, to Michael Dell and Silver Lake Partners was $17.62 per share – approximately 28% more than the final merger consideration of $13.75. Appraisal of Dell, C.A. No. 9322, slip op. at 51 n. 15, 52 (Del. Ch. May 31, 2016) (quoting Iman Anabtawi, Predatory Management Buyouts, 49 U.C. DAVIS L. REV. 1285, 1301 (2016)). Read the article here: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2649192.
TEN of our faculty have been included among those “Most Cited” in their respective specialties for 2010-2014 by Brian Leiter’s Law School Reports. (While citations are, of course, only one measure of influence, UCLA had more faculty on these lists than quite a few of our peer institutions.)
Stephen Bainbridge, #3 in Corporate Law & Securities Regulation, http://leiterlawschool.typepad.com/leiter/2016/05/twenty-most-cited-corporate-law-securities-regulation-faculty-in-the-united-states-2010-2014-inclusi.html
Stuart Banner, #5 in Legal History, http://leiterlawschool.typepad.com/leiter/2016/05/ten-most-cited-legalhistory-faculty-in-the-united-states-2010-2014-inclusive.html
Russell Korobkin, #6 in Law and Economics, http://leiterlawschool.typepad.com/leiter/2016/05/15-most-cited-faculty-in-law-economics-incl-behavioral-law-economics-2010-2014-inclusive.html
Jennifer Mnookin, #9 in Evidence, http://leiterlawschool.typepad.com/leiter/2016/05/ten-most-cited-evidence-faculty-in-the-united-states-2010-2014-inclusive.html
Neil Netanel, #20 in Intellectual Property and Cyberlaw, http://leiterlawschool.typepad.com/leiter/2016/06/20-most-cited-intellectual-propery-cyberlaw-faculty-2010-2014-inclusive.html
Kal Raustiala, #8 in International Law, http://leiterlawschool.typepad.com/leiter/2016/06/20-most-cited-international-law-faculty-2010-2014-inclusive.html
James Salzman, #14 in Administrative and/or Environmental Law, http://leiterlawschool.typepad.com/leiter/2016/05/20-most-cited-administrative-andor-environmental-law-faculty-2010-2014-inclusive.html
Seana Shiffrin, #8 in Law & Philosophy, http://leiterlawschool.typepad.com/leiter/2016/05/ten-most-cited-law-philosophy-faculty-in-the-united-states-2010-2014-inclusive.html
Eugene Volokh, #13 in Con Law and Public Law, http://leiterlawschool.typepad.com/leiter/2016/05/twenty-most-cited-constitutional-public-law-faculty-in-the-united-states-2010-2014-inclusive.html
Alison Frankel thinks the Delaware Chancery Court is encouraging plaintiff lawyers to rush to the courthouse instead of engaging in the potentially lengthy books and records inspection process/litigation:
A few years ago, when corporate defense complaints about multijurisdictional shareholder litigation were at a crescendo, Delaware’s Chancery Court tried to realign incentives for the shareholder bar. Instead of rewarding fast filers, Delaware judges encouraged plaintiffs’ lawyers to demand to see corporate books and records – the “tools at hand,” in Chancery lingo – before drafting derivative complaints. ...
Well, the new dynamic didn’t last long. In two recent opinions – a decision last month in Grant & Eisenhofer’s Wal-Mart case and a ruling yesterday in a Delaware derivative case against Lululemon board members – Strine’s successor, Chancellor Andre Bouchard, has declined to reward plaintiffs’ firms for conducting pre-suit books and records investigations. In both opinions, Chancellor Bouchard said Delaware derivative suits filed after long, fierce litigation to obtain corporate records were precluded by demand futility decisions in cases brought by fast filers in other jurisdictions.
And in both rulings, the chancellor rejected arguments that shareholders were not adequately represented in the fast-filed cases because their lawyers did not wait to examine corporate books and records.
I wonder if the Delaware court, however, isn't sending a different message: namely, corporations need forum selection bylaw or charter provisions. As far as I can tell, neither of the corporations in question had a forum selection bylaw.
Indeed, in a client letter about the Lululemon case, Weil Gotshal opines that:
Delaware corporations should, of course, also consider adopting forum selection provisions requiring that corporate governance litigation be brought in the Delaware Court of Chancery ....
Maybe that's exactly what the Delaware court is trying to encourage?
Steven Davidoff Solomon thinks the proposed Tesla Solar City deal is a bad one that amounts to Elon Musk bailing out Solar City:
Solar City is a maker of solar energy products, basically home and business solar panels. Tesla is a maker of battery-powered cars, though some view the company’s battery-making component as its bigger future.
To Elon Musk, the chairman of SolarCity and the chief executive of Tesla, putting together these two different businesses is “blindingly obvious” and a “no-brainer.” A blog post on the Tesla website explained the reasons:
We would be the world’s only vertically integrated energy company offering end-to-end clean energy products to our customers. This would start with the car that you drive and the energy that you use to charge it, and would extend to how everything else in your home or business is powered.
In other words, the deal makes sense because people who buy Tesla’s cars also want solar power. In a combined company, they can get it in the same place.
The market is not buying it.
To investors, it is as if the Walt Disney Company bought a birthing center business to offer “end-to-end” service for its parent customers. It’s not clear that Tesla owners will really want to buy solar panels, or that if they did, it would be in sufficient number.
I don't think the deal is as bad as all that. I happen to be one of those people who thinks Tesla's future is at least as much in the power generation storage domain as the car space. I have no immediate plans to trade in my Jeep on a Tesla, but I do toy with the idea of adding solar power to the roof of my house. If I do so, I'm pretty sure I'll also get the Tesla Powerwall battery system to store excess solar power-generated electricity for use at night or whenever conditions are suboptimal. Not being able to store solar power for use at night has always struck me as a major downside to solar. If that's right, then integrating panel and battery production may well make business sense.
Having said that, Musk has a pattern of moving money around his various imperial domains seemingly at will (see, e.g., the SpaceX bond matter) and otherwise engaging in conflict of interest transactions. Given that track record, if I were Musk's lawyer, I'd want him to dot all the legal Is and cross all the legal Ts to a fare thee well.
Davidoff Solomon apparently is viewing this deal as essentially an interested director transaction subject to DGCL 144(a):
Tesla did announce some procedures to deal with this conflict. Mr. Musk recused himself from the deliberations at Tesla and Mr. Rive said the same thing at SolarCity. In addition, Tesla said that any deal would be subject to approval by a majority of its disinterested shareholders.
This is part of the standard procedure in conflict situations. The general idea is that each company forms a committee of independent directors with its own advisers and legal counsel. This would ensure approval of the disinterested directors. Then any deal itself would be subject to approval of the disinterested shareholders. The State of Delaware, where a majority of American companies are incorporated, technically requires only that either the disinterested directors or disinterested shareholders approve the deal, but the standard practice is to do both.
In contrast, I would view this deal as being akin to a freeze-out merger by a controlling shareholder (it's not exactly that but I think the analogy works). As such, if I were advising Musk, I'd advise him to adopt the full panoply of prophylactic measures approved by the Delaware Supreme Court in Kahn v. M & F Worldwide Corp., 88 A.3d 635 (Del. 2014):
To summarize our holding, in controller buyouts, the business judgment standard of review will be applied if and only if: (i) the controller conditions the procession of the transaction on the approval of both a Special Committee and a majority of the minority stockholders; (ii) the Special Committee is independent; (iii) the Special Committee is empowered to freely select its own advisors and to say no definitively; (iv) the Special Committee meets its duty of care in negotiating a fair price; (v) the vote of the minority is informed; and (vi) there is no coercion of the minority.
If those conditions are not met, the burden of proof would be on Musk to show that the transaction was entirely fair to the minority shareholders. Trust me, you do not want to be a defendant with the burden of entire fairness in a conflict of interest case. Granted, the choice between the business judgment rule and entire fairness standards of review "is not outcome-determinative and ... defendants prevail under [the fairness] standard of review with some degree of frequency." In re Ezcorp Inc. Consulting Agreement Derivative Litig., No. CV 9962-VCL, 2016 WL 301245, at *28 (Del. Ch. Jan. 25, 2016), reconsideration granted in part, (Del. Ch. Feb. 23, 2016), and appeal refused sub nom. MS Pawn Corp. v. Treppel, 133 A.3d 560 (Del. 2016), and appeal refused sub nom. Roberts v. Treppel, 133 A.3d 560 (Del. 2016). But even so the entire fairness standard is "the most exacting form of review." In re Cysive, Inc. Shareholders Litig., 836 A.2d 531, 557 n.40 (Del. Ch. 2003). "The burden of establishing entire fairness has been perceived as extremely difficult to meet." 6 No. 10 M & A Law. 9 (2003).
If this SEC explainer propaganda piece were an essay exam, it'd get a C- (and that's taking into account rampant grade inflation). It's replete with errors.
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.
Looks straightforward right? But it carefully obfuscates the distinction between debt and equity securities. Granted, one court has held that insider trading in convertible debentures violates Rule 10b–5, but this case is distinguishable from those involving nonconvertible debt securities. Because they are convertible into common stock at the option of the holder, both the market price and interest rate paid on such instruments are affected by the market price of the underlying common stock. Federal securities law recognizes the close relationship of convertibles to common stock by defining the former as equity securities. As such, the status of insider trading in nonconvertible debt remains unresolved. A strong argument can be made, however, that the prohibition should not extend to trading in nonconvertible debt.
The problem is what even the SEC admits is the necessary breach of fiduciary duty. In most states, neither the corporation nor its officers and directors have fiduciary duties to debtholders. Instead, debtholders’ rights are limited to the express terms of the contract and an implied covenant of good faith. Cases in a few jurisdictions purport to recognize fiduciary duties running to holders of debt securities, but the duties imposed in these cases are more accurately characterized as the same implied covenant of good faith found in most other jurisdictions.
The distinction between this implied covenant and a fiduciary duty is an important one for our purposes. An implied covenant of good faith arises from the express terms of a contract and is used to fulfill the parties’ mutual intent. In contrast, a fiduciary duty has little to do with the parties’ intent. Instead, courts use fiduciary duties to protect the interests of the duty’s beneficiary. Accordingly, a fiduciary duty requires the party subject to the duty to put the interests of the beneficiary of the duty ahead of his own, while an implied duty of good faith merely requires both parties to respect their bargain.
A two-step move thus will be required if courts are to impose liability under the disclose or abstain rule on those who inside trade in debt securities. First, the clear holdings of Chiarella and Dirks must be set aside so that the requisite relationship can be expanded to include purely contractual arrangements and the requisite duty expanded to include mere contractual covenants. Second, the implied covenant of good faith must be interpreted as barring self-dealing in nonpublic information by corporate agents. In that regard, consider the leading Met Life decision, which indicates that a covenant of good faith will be implied only when necessary to ensure that neither side deprives the other side of the fruits of the agreement. The fruits of the agreement are limited to regular payment of interest and ultimate repayment of principal. Because insider trading rarely affects either of these fruits, it does not violate the covenant of good faith.
Insofar as public policy is concerned, the argument for creating fiduciary duties—federal or state—running to bondholders is extremely weak. Bond issuances are repeat transactions. Where parties expect to have repeated transactions, the risk of self-dealing by one party is constrained by the threat that the other party will punish the cheating party in future transactions. The issuer’s management has a strong self-interest in the corporation’s cost of capital (i.e., avoiding takeovers, maximizing personal wealth, avoiding firm failure). Management therefore will be slow to do anything that unnecessarily increases their cost of capital. But if they abuse their current bondholders, that will come back to haunt them the next time they want to use the bond market to raise capital. If investors care about protection from insider trading, management therefore will provide it by contract.
In addition, negotiations between the issuer and the underwriters that market the debt securities will produce efficient levels of protection. Because the bond market is dominated by a small number of institutional investors, the relationship between underwriters and bondholders is another example of the repeat transaction phenomenon. Underwriters will not sully their reputations with bondholders for the sake of one issuer. Moreover, in a firm commitment underwriting, the underwriters buy the securities from the issuer. If the indenture does not provide adequate levels of protection, the underwriters will be unable to sell the bonds. Again, if debtholders care about insider trading, the contract will prohibit it.
The disclose or abstain theory thus should not prohibit insiders from trading in debt securities on the basis of material nonpublic information. Having said that, however, various alternative theories of liability may come into play in this context. In particular, the misappropriation theory might apply. Suppose a corporate officer traded in the firm’s debt securities using material nonpublic information belonging to the corporation. As the argument would go, even though the officer owes no fiduciary duties to the bondholders, he owes fiduciary duties to the corporation. The violation of those duties might suffice for liability under the misappropriation theory. The misappropriation theory clearly would not reach trading by an issuer in its own debt securities.
 See, e.g., Broad v. Rockwell Int’l Corp., 642 F.2d 929 (5th Cir.), cert. denied, 454 U.S. 965 (1981); Gardner & Florence Call Cowles Found. v. Empire, Inc., 589 F. Supp. 669 (S.D.N.Y.1984), vacated, 754 F.2d 478 (2d Cir.1985); Fox v. MGM Grand Hotels, Inc., 187 Cal.Rptr. 141 (Cal.Ct.App.1982).
 See Salovaara v. Jackson Nat’l Life Ins., 66 F. Supp. 2d 593, 601 (D.N.J. 1999) (declining to “to extend O’Hagan to a civil case involving a transaction [by an issuer] for high yield debt securities”), aff’d on other grounds, 246 F. 3d 289 (3d Cir. 2001).
Back to the SEC explainer:
Examples of insider trading cases that have been brought by the SEC are cases against: ... Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information ....
What the SEC fails to explain is that the issue of when friends can be held liable in tipping cases is right now before the US Supreme Court. The Supreme Court has granted cert in Salman v. United States, posing the following question for argument:
Whether the personal benefit to the insider that is necessary to establish insider trading under Dirks v. SEC requires proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the Second Circuit held in United States v. Newman, or whether it is enough that the insider and the tippee shared a close family relationship, as the Ninth Circuit held in this case.
The WSJ reports:
In the New York case, U.S. v. Newman, an appeals panel said prosecutors had to prove the insider disclosed the information for a personal benefit that included something valuable being exchanged. The decision upended multiple convictions and top prosecutors complained that the ruling could make it legal for traders to obtain and use confidential information from friends.
Mr. Salman, citing Newman, argued that evidence of a family relationship between the tipper and the tip recipient wasn’t enough to demonstrate that the insider received a personal benefit.
The San Francisco-based Ninth U.S. Circuit Court of Appeals rejected that argument in a ruling last July. The Supreme Court will review the decision and could hear oral arguments as soon as April. Mr. Salman has been serving his prison sentence since August 2014.
There are excellent doctrinal and policy reasons to think that the SEC's consistent pattern of overreaching in these cases will get slapped down by the court. See my earlier posts:
Back to the SEC explainer:
... insider trading undermines investor confidence in the fairness and integrity of the securities market ....
Piffle. Insider trading is said to harm investors in two principal ways. Some contend that the investor’s trades are made at the “wrong price.” A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination.
An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; i.e., a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss.
The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to the shareholder’s loss is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not.
To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. On an impersonal trading market, neither party knows the identity of the person with whom he is trading. Thus, the seller has made an independent decision to sell without knowing that the insider is buying; if the insider were not buying, the seller would still sell. It is thus the nondisclosure that causes the harm, rather than the mere fact of trading.
The information asymmetry between insiders and public investors arises out of the mandatory disclosure rules allowing firms to keep some information confidential even if it is material to investor decision-making. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material information, not to insider trading.
Arguably, for example, the TGS shareholders who sold from November through April were not made any worse off by the insider trading that occurred during that period. Most, if not all, of these people sold for a series of random reasons unrelated to the trading activities of insiders. The only seller we should worry about is the one that consciously thought, “I’m going to sell because this worthless company never finds any ore.” Even if such an investor existed, however, we have no feasible way of identifying him. Ex post, of course, all the sellers will pretend this was why they sold. If we believe Manne’s argument that insider trading is an efficient means of transmitting information to the market, moreover, selling TGS shareholders actually were better off by virtue of the insider trading. They sold at a price higher than their shares would have commanded but for the insider trading activity that led to higher prices. In short, insider trading has no “victims.” What to do about the “offenders” is a distinct question analytically.
A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. It is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade, however. While derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade.
Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the correct price; i.e., the price that would prevail if the information were disclosed. In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.
An argument closely related to the investor injury issue is the claim that insider trading undermines investor confidence in the securities market. In the absence of a credible investor injury story, it is difficult to see why insider trading should undermine investor confidence in the integrity of the securities markets.
There is no denying that many investors are angered by insider trading. A Business Week poll, for example, found that 52% of respondents wanted insider trading to remain unlawful. In order to determine whether investor anger over insider trading undermines their confidence in the markets, however, one must first identify the source of that anger. A Harris poll found that 55% of the respondents said they would inside trade if given the opportunity. Of those who said they would not trade, 34% said they would not do so only because they would be afraid the tip was incorrect. Only 35% said they would refrain from trading because insider trading is wrong. Here lies one of the paradoxes of insider trading. Most people want insider trading to remain illegal, but most people (apparently including at least some of the former) are willing to participate if given the chance to do so on the basis of accurate information. This paradox is central to evaluating arguments based on confidence in the market. Investors that are willing to inside trade if given the opportunity obviously have no confidence in the integrity of the market in the first instance. Any anger they feel over insider trading therefore has nothing to do with a loss of confidence in the integrity of the market, but instead arises principally from envy of the insider’s greater access to information.
Back to the explainer:
What the SEC should have said was "where the courts have disagreed with" the SEC's position and so we got all snippy and decided to adopt bad rules to try to overturn those cases.
The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b–5’s scienter requirement. (Indeed, it does so yet again in the very first excerpt from the explainer quoted above.) To evaluate that argument, let’s explore a hypothetical based on the facts of Diamond v. Oreamuno. Insiders of MAI sold their holdings of firm stock while in possession of bad news that was both material and nonpublic. As such, they avoided significant losses that would have resulted from the drop in MAI’s stock price that occurred when the bad news was made public. Suppose one of the defendants claimed the bad news had not caused his sale; instead, he argues that he would have sold his MAI stock regardless of whether he thought the stock would be going up or down in the future. Perhaps he needed money to pay catastrophic medical bills, for example. Alternatively, perhaps he had a pattern of disposing of MAI stock at regular intervals. Many senior corporate executives receive a substantial portion of their compensation in the form of stock grants or options, which they periodically liquidate to realize their cash value. In either case, our hypothetical defendant would have traded while in possession of material nonpublic information, but not on the basis of such information. Can he be held liable?
In U.S. v. Teicher, the Second Circuit answered that question affirmatively, albeit in a passage that appears to be dictum. An attorney tipped stock market speculators about transactions involving clients of his firm. On appeal, defendants objected to a jury instruction pursuant to which they could be found guilty of securities fraud based upon the mere possession of fraudulently obtained material nonpublic information without regard to whether that information was the actual cause of their transactions. The Second Circuit held that any error in the instruction was harmless, but went on to opine in favor of a knowing possession test. The court interpreted Chiarella as comporting with “the oft-quoted maxim that one with a fiduciary or similar duty to hold material nonpublic information in confidence must either ‘disclose or abstain’ with regard to trading.” The court also favored the possession standard because it “recognizes that one who trades while knowingly possessing material inside information has an informational advantage over other traders.”
In S.E.C. v. Adler, the Eleventh Circuit rejected Teicher in favor of a use standard. Under Adler, “when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade—i.e., that the information was not used.” Although defendant Pegram apparently possessed material nonpublic information at the time he traded, he introduced strong evidence that he had a plan to sell company stock and that that plan predated his acquisition of the information in question. If proven at trial, evidence of such a pre-existing plan would rebut the inference of use and justify an acquittal on grounds that he lacked the requisite scienter. Similarly, the court opined, evidence that the allegedly illegal trades were consistent with trading also would rebut the inference of use.
The choice between Adler and Teicher is difficult. On the one hand, in adopting the Insider Trading Sanctions Act of 1984, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information. In addition, a use standard significantly complicates the government’s burden in insider trading cases, because motivation is always harder to establish than possession, although the inference of use permitted by Adler substantially alleviates this concern.
On the other hand, a number of decisions have acknowledged that a pre-existing plan and/or prior trading pattern can be introduced as an affirmative defense in insider trading cases, as such evidence tends to disprove that defendant acted with the requisite scienter. In contrast, Teicher’s mere possession test is inconsistent with Rule 10b–5’s scienter requirement, which requires fraudulent intent (or, at least, recklessness). In addition, dictum in each of the Supreme Court’s insider trading opinions also appears to endorse the use standard. Indeed, contrary to the Teicher court’s claim, Chiarella simply did not address the distinction between a knowing possession and a use standard. Finally, the Teicher court’s reliance on the trader’s informational advantage is inconsistent with Chiarella’s rejection of the equal access test.
In 2000, the SEC tried to resolve this issue by adopting Rule 10b5–1, which states that Rule 10b–5’s prohibition of insider trading is violated whenever someone trades “on the basis of” material nonpublic information. Because one is deemed, subject to certain affirmative defenses, to have traded “on the basis of” material nonpublic information if one was aware of such information at the time of the trade, Rule 10b5–1 formally rejects the Adler position. In practice, however, the difference between Adler and Rule 10b5–1 may prove insignificant. On the one hand, Adler created a presumption of use when the insider was aware of material nonpublic information. Conversely, as noted, Rule 10b5–1 provides affirmative defenses for insiders who trade pursuant to a pre-existing plan, contract, or instructions. As a result, the two approaches should lead to comparable outcomes in many cases.
Even though Rule10b5–1 thus can be squared with Adler, the SEC clearly intended the Rule to resurrect the mere possession test to the fullest extent possible. Did the SEC have authority to do so in the face of contrary judicial holdings? There is some evidence that supports the SEC’s position. In adopting the Insider Trading Sanctions Act of 1984, for example, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information.
The bulk of the evidence, however, raises serious doubts as to the validity of Rule 10b5–1. The SEC cannot adopt rules that go beyond the scope of the statutes authorizing them. The Supreme Court has consistently held that Section 10(b) of the Exchange Act, which provides the authority under which Rule 10b–5 was adopted, prohibits only fraud and manipulation. In turn, as we have seen, fraud requires proof that the defendant intended to deceive (i.e., scienter). Indeed, the Supreme Court explained in Dirks that “[i]t is not enough that an insider’s conduct results in harm to investors; rather a violation [of Rule 10b–5] may be found only where there is ‘intentional or willful conduct designed to deceive or defraud investors.’ ” Yet, as the Ninth Circuit pointed out in Smith, “a knowing-possession standard would . . . go a long way toward making insider trading a strict liability crime.” Second, as the Ninth Circuit also noted, “the Supreme Court has consistently suggested, albeit in dictum, that Rule 10b–5 requires that the government prove causation in insider trading prosecutions.” In other words, the government must prove that the defendant used the inside information in making the relevant trading decisions. Rule 10b5–1’s failure to impose such a requirement on the government thus leaves it vulnerable to challenge.
 See SEC v. MacDonald, 699 F.2d 47, 50 (1st Cir. 1983) (holding that the scienter “requirement is satisfied if at the time defendant purchased stock he had actual knowledge of undisclosed material information; knew it was undisclosed, and knew it was material, i.e., that a reasonable investor would consider the information important in making an investment decision”).
 137 F.3d 1325 (11th Cir. 1998). The Ninth Circuit subsequently agreed with Adler that proof of use, not mere possession, is required. The Ninth Circuit further held that in criminal cases no presumption of use should be drawn from the fact of possession—the government must affirmatively proof use of nonpublic information. U.S. v. Smith, 155 F.3d 1051 (9th Cir. 1998).
 17 C.F.R. § 240.10b5–1(a).
 See, e.g., Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 473 (1977) (“The language of § 10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception.”).
Returning to the explainer one last time, the SEC's discussion of Rule10b5-2 is even more egregious as it fails to acknowledge the very considerable arguments that the Rule is hopelessly invalid.
Rule 10b5–2 provides “a nonexclusive list of three situations in which a person has a duty of trust or confidence for purposes of the ‘misappropriation’ theory. . . .” First, such a duty exists whenever someone agrees to maintain information in confidence. Second, such a duty exists between two people who have a pattern or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the speaker expects the recipient to maintain the information’s confidentiality. Third, such a duty exists when someone receives or obtains material nonpublic information from a spouse, parent, child, or sibling. On the facts of the famous Chestman case, accordingly, Rule 10b5–2 would result in the imposition of liability because Keith received the information from his spouse who, in turn, had received it from her parent.
There is, however, considerable doubt as to the validity of the Rule. First, while it is true that the court in Chestman court observed that the requisite relationship could be satisfied either by a fiduciary relationship or a “similar relationship of trust and confidence,” the court recognized that so expanding the class of relationships giving rise to liability could lead to results-oriented applications. If a court wishes to impose liability, it need simply conclude that the relationship in question involves trust and confidence, even though the relationship bears no resemblance to those in which fiduciary-like duties are normally imposed. Accordingly, courts should be loath to use this phraseology as a mechanism for expanding the scope of liability. The Chestman court was sensitive to this possibility, holding that a relationship of trust and confidence must be “the functional equivalent of a fiduciary relationship” before liability can be imposed. Chestman also held that, at least as to criminal cases, it would not expand the class of relationships from which liability might arise to encompass those outside the traditional core of fiduciary obligation. Rule 10b5–2, however, goes far beyond relationships that are the functional equivalent of fiduciary relationships by capturing, for example, purely contractual arrangements. Nevertheless, at least one court has upheld the Rule as a valid exercise of the SEC’s rulemaking authority. In my view, however, it did so erroneously.
 US v. Chestman, 947 F.2d 551 (2d Cir.1991), cert. denied 503 U.S. 1004 (1992). Ira Waldbaum was the president and controlling shareholder of Waldbaum, Inc., a publicly-traded supermarket chain. Ira decided to sell Waldbaum to A & P at $50 per share, a 100% premium over the prevailing market price. Ira informed his sister Shirley of the forthcoming transaction. Shirley told her daughter Susan Loeb, who in turn told her husband Keith Loeb. Each person in the chain told the next to keep the information confidential. Keith passed an edited version of the information to his stockbroker, one Robert Chestman, who then bought Waldbaum stock for his own account and the accounts of other clients. Chestman was accused of violating Rule 10b–5. According to the Government’s theory of the case, Keith Loeb owed fiduciary duties to his wife Susan, which he violated by trading and tipping Chestman.
The Second Circuit held that in the absence of any evidence that Keith regularly participated in confidential business discussions, the familial relationship standing alone did not create a fiduciary relationship between Keith and Susan or any members of her family. See id. at 568 (holding that “marriage does not, without more, create a fiduciary relationship”). Likewise, unilaterally entrusting someone with confidential information does not by itself create a fiduciary relationship, even if the disclosure is accompanied by an admonition such as “don’t tell,” which Susan’s statements to Keith included. See id. at 567 (holding that “a fiduciary duty cannot be imposed unilaterally by entrusting a person with confidential information”). Repeated disclosures of business secrets, however, could substitute for a factual finding of dependence and influence and, accordingly, sustain a finding that a fiduciary relationship existed in the case at bar. Id. at 569. On the facts of the case at bar, however, there was no evidence of such repeated disclosures as between Keith and Susan or her family.
Since Keith had no fiduciary duty, his use of the information for personal gain did not violate Rule 10b–5.
 Id. at 568.
 U.S. v. Corbin, 729 F. Supp.2d (S.D.N.Y.2011).
My books on insider trading:
Obeid v. Hogan, No. CV 11900-VCL, 2016 WL 3356851, at *13 (Del. Ch. June 10, 2016):
With the benefit of hindsight, one can discern in Zapata the foundational concepts that animate enhanced scrutiny, the intermediate standard of review that the Delaware Supreme Court introduced openly some four years later in Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946 (Del.1985). First, there is a specific and recurring decision-making context where the realities of the situation “can subtly undermine the decisions of even independent and disinterested directors.” Second, there is a need for an intermediate position which recognizes that “[i]nherent in these situations are subtle structural and situational conflicts that do not rise to a level sufficient to trigger entire fairness review, but also do not comfortably permit expansive judicial deference.”16 Third, the resulting intermediate standard involves examining the reasonableness of the end that the directors chose to pursue, the path that they took to get there, and the fit between the means and the end. The Zapata test thus can be properly regarded as a nascent form of enhanced scrutiny and integrated within the larger body of case law applying the intermediate standard.
16 In re Rural Metro Corp. S'holder Litig., 88 A.3d 54, 81 (Del. Ch.2014), aff'd sub nom. RBC Capital Markets, LLC v. Jervis, 129 A.3d 816 (Del.2015); see Dollar Thrifty, 14 A.3d at 597 (“Avoiding a crude bifurcation of the world into two starkly divergent categories—business judgment rule review reflecting a policy of maximal deference to disinterested board decision-making and entire fairness review reflecting a policy of extreme skepticism toward self-dealing decisions—the Delaware Supreme Court's Unocal and Revlon decisions adopted a middle ground.”); Golden Cycle, LLC v. Allan, 1998 WL 892631, at *11 (Del. Ch. Dec. 10, 1998) (locating enhanced scrutiny under Unocal and Revlon between the business judgment rule and the entire fairness test); see also Stephen M. Bainbridge, Unocal at 20: Director Primacy in Corporate Takeovers, 31 Del. J. Corp. L. 769, 795–96 (2006) (explaining the Delaware Supreme Court's creation of an intermediate standard of review between the entire fairness and business judgment rule standards); Ronald J. Gilson, Unocal Fifteen Years Later (And What We Can Do About It), 26 Del. J. Corp. L. 491, 496 (2001) (“In Unocal, the Delaware Supreme Court chose the middle ground that had been championed by no one. The court unveiled an intermediate standard of review....”).
Pell v. Kill, No. CV 12251-VCL, 2016 WL 2986496, at *16 (Del. Ch. May 19, 2016):
The question of what causes enhanced scrutiny to serve as the operative standard of review is a different inquiry than what it takes to satisfy or fall short of the parameters of the test. Stated generally, enhanced scrutiny applies “where the realities of the decisionmaking context can subtly undermine the decisions of even independent and disinterested directors.” “Inherent in these situations are subtle structural and situational conflicts that do not rise to a level sufficient to trigger entire fairness review, but also do not comfortably permit expansive judicial deference.”11
11 In re Rural Metro Corp. S'holder Litig., 88 A.3d 54, 81 (Del. Ch.2014), aff'd sub nom. RBC Capital Markets, LLC v. Jervis, 129 A.3d 816 (Del.2015); see Dollar Thrifty, 14 A.3d at 597 (“Avoiding a crude bifurcation of the world into two starkly divergent categories—business judgment rule review reflecting a policy of maximal deference to disinterested board decisionmaking and entire fairness review reflecting a policy of extreme skepticism toward self-dealing decisions—the Delaware Supreme Court's Unocal and Revlon decisions adopted a middle ground.”); Golden Cycle, LLC v. Allan, 1998 WL 892631, at *11 (Del. Ch. Dec. 10, 1998) (locating enhanced scrutiny under Unocal and Revlon between the business judgment rule and the entire fairness test); see also Stephen M. Bainbridge, Unocal at 20: Director Primacy in Corporate Takeovers, 31 Del. J. Corp. L. 769, 795–96 (2006) (explaining Delaware Supreme Court's creation of an intermediate standard of review between the entire fairness and business judgment rule standards); Ronald J. Gilson, Unocal Fifteen Years Later (And What We Can Do About It), 26 Del. J. Corp. L. 491, 496 (2001) (“In Unocal, the Delaware Supreme Court chose the middle ground that had been championed by no one. The court unveiled an intermediate standard of review....”).
It's interesting that Vice Chancellor Laster used the same footnote to make similar points.
There's a great op-ed in today's WSJ by David Rosenfeld about the Phil Mickelson insider trading non-case. You may recall that I wrote about this case in The Absurd Insider Trading Case Against Phil Mickelson. In that post, I explained that:
None of the players in this case are insiders of Clorox, so the classic disclose or abstain rule would not apply. Instead, the SEC would have to proceed under a misappropriation theory. In order for that to work, the SEC at a minimum would have to prove that (1) Icahn tipped the information to Walters in breach of a fiduciary duty owed to the person or entity who owned the information, (2) that Icahn got a personal benefit for doing so, (3) that Walters passed the information to Mickelson, (4) Mickelson knew or should have known that the information came was material, nonpublic, and had been disclosed to him in violation of a fiduciary duty by the source. It should also be the case that the SEC will have to prove that Mickelson knew or should have known that Icahn got a personal benefit from making the tip ....
Because the SEC could not make out at least # 4, it had no case against Mickelson. Yet, as Rosenfeld points out:
Mr. Mickelson was named as a “Relief Defendant” in the SEC’s complaint, meaning that Mr. Mickelson was not accused of any legal violations but was alleged to be in possession of ill-gotten gains to which he had no lawful claim. ... As part of a settlement, Mr. Mickelson agreed to surrender the profits from those trades, plus interest. ...
... The money Mr. Mickelson was forced to give up was the proceeds of his own trades. And based on the current state of the law—along with the fact that the SEC declined to charge Mr. Mickelson—it appears that those trades were not legally actionable. If so, it is hard to see a lawful basis for the disgorgement order.
Indeed, not only was there no lawful basis for the order, the order was affirmatively unlawful:
The SEC appears to be taking the position that whenever there has been unlawful conduct by a tipper, any profits derived from trades by a tippee are ill-gotten gains, even if the tippee didn’t have knowledge of a personal benefit, and even if the trades themselves violated no law.
And that's clearly a gross abuse of the SEC's prosecutorial power.
So why did Mickelson settle? As I have noted before, the SEC has a huge advantage in extorting settlements out of innocent defendants:
In civil cases, the government can ask the court to force the defendant to disgorge his ill-gotten gains and, under the Insider Trading Sanctions Act, impose an additional civil fine of up to 3 times the amount of the illegal profit.
So if Mickelson made a profit of about $1 million (the amount he disgorged), went to trial, lost, and got hit with the maximum civil sanction, he'd face a total liability of $4 million. Assume Mickelson's lawyers told him that he had a two in three chance of winning at trial. That mean he still faced an expected sanction of $1.33 million. Settling for $1 million thus made economic sense. (Setting aside the cost of legal fees, the opportunity costs associated with opting for trial, etc..., which make settlement even more attractive.)
In sum, ITSA gives the government a huge club to coerce settlements out of even innocent defendants.
I'm not sure what can be done about this problem, if anything. But at the very least the SEC needs to be named and shamed when they abuse their power in this way.