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Using state corporate law to fill the gaps in federal insider trading law

The WSJ Law Blog reports that:

Doug Whitman, a former hedge-fund manager, doesn’t deny that he probed public companies for nonpublic information.

But when he goes on trial next week on charges of securities fraud and conspiracy, his lawyers plan to argue that his motives  were pure, and that his conduct squared with the 1983 Supreme Court decision Dirks v. SEC, which protects certain trading on inside information, so long as there is no payoff, the WSJ’s Reed Albergotti reports in today’s paper. ...

During Wednesday’s hearing, U.S. District Judge Jed Rakoff, who is presiding over the case, was ... receptive to arguments challenging the law used to prosecute Mr. Whitman.

The government must prove that Mr. Whitman knew that the original sources of the inside stock tips were violating duties they owed to company shareholders to keep the information secret.

But Mr. Whitman’s attorneys argued in a motion to the court that the federal law that deals with the issue is vague, and that because all of the alleged conduct occurred in California, the court should consider the state laws there, where only high-level employees owe fiduciary duties.

Judge Rakoff said he was “impressed” Mr. Whitman’s lawyers raised the issue, adding that the question of which laws should apply has “been ducked” by courts for 25 years.

Might I repectfully encourage Judge Rakoff and the counsel to check out my article Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Washington and Lee Law Review 1189 (1995)? You can download the full text of the paper here: Download INCORPORATING STATE LAW FIDUCIARY DUTIES INTO THE FEDERAL INSIDER TRADING PROHIBITION.pdf (568.4K).

The introduction follows:

Someone violates the federal insider trading prohibition only if his trading activity breached a fiduciary duty owed either to the investor with whom he trades or to the source of the information. [FN1] From a securities law perspective, the federal prohibition thus is an empty shell. It has no force or substance until it has been filled with fiduciary duty concepts.

Despite the centrality of the fiduciary duty element to the federal prohibition, the fiduciary element has received relatively little attention from courts or commentators. On close examination, however, requiring a breach of fiduciary duty as a prerequisite for insider trading liability raises two interesting questions: What is the precise fiduciary duty at issue? Is the source of that duty federal or state law? Despite over a decade of experience *1191 with the fiduciary duty requirement, neither of these questions has a clear and convincing answer.

The failure to resolve these issues has robbed the federal insider trading prohibition of coherence and predictability. [FN2] Perhaps this lack of coherence was acceptable when insider trading was a low priority item for federal prosecutors, and the major penalty was disgorgement of profits. Today, however, insider trading is a major Securities and Exchange Commission (SEC or Commission) enforcement target and carries penalties that can only be described as draconian. [FN3] Due process and simple fairness thus require that the fiduciary duty element be taken more seriously than it has been to date.

Perhaps the fiduciary duty requirement's substantive content is ignored because courts and commentators assume that there is a single fiduciary duty, applicable to all relevant market players, that proscribes the use of confidential information for personal gain. If so, this assumption's inherent invalidity was exposed by the SEC's enforcement effort directed at insider trading in corporate debt securities. [FN4] Under state law, corporate officers and directors generally owe no fiduciary duties to debt securityholders. As a result, assuming state law provides the requisite fiduciary duty, one can plausibly argue that insider trading in debt securities is not unlawful. As this Article will demonstrate, similar state law arguments can be made in a variety of contexts, including the very core of the federal prohibition -- its application to corporate officers and directors. This possibility has generated some critical commentary in the debt security context, [FN5] but its full implications remain largely unexplored. This Article seeks to fill that gap.

Part II of this Article briefly traces the evolution of the current insider trading regime, with particular emphasis on the fiduciary duty element. Part III then explores the content of the fiduciary duty element. Part III argues *1192 that liability is premised not on the mere existence of a fiduciary relationship, but rather on the breach of a specific fiduciary duty -- namely, the duty to refrain from self-dealing in confidential information owned by another party.

The inquiry then shifts to identifying the source of the requisite duty. As a preliminary matter, Part IV argues that the insider trading prohibition is a species of federal common law. Specifically, it is an example of interstitial lawmaking in which the courts are using common-law adjudicatory methods to flesh out Rule 10b-5's bare bones. Once this view of the prohibition is accepted, a choice of law question arises. In crafting a rule of decision for federal common-law cases, courts can either create a unique federal standard or incorporate state law into the federal rule. In the latter case, the cause of action remains federal, but the content of federal law is supplied by the incorporated state law principles. The decision to incorporate state law depends upon whether there are important federal interests that would be adversely affected by doing so. If so, the court will create a uniform federal standard, but if not, the court may incorporate state law.

In order to decide whether state fiduciary duties should be incorporated into the federal insider trading prohibition, we thus must ask two questions: Would incorporation adversely affect prosecution of insider trading under the federal securities laws and, if so, would any identifiable policy goal of those laws be frustrated thereby? Part V addresses the former concern, examining the implications of adopting state law fiduciary duty concepts as the rule of decision. It demonstrates that use of state law principles will at least complicate insider trading prosecutions and probably will substantially limit the prohibition's scope.

In light of that finding, Part VI then turns to the latter concern. Because a unique federal set of fiduciary duties applicable to insider trading is most easily justified if application of state law would frustrate an identifiable federal policy goal, Part VI examines the purported federal interests underlying the insider trading prohibition. As Part VI demonstrates, none of the commonly asserted federal policies requires creation of a unique set of federal fiduciary duties. Rather, the insider trading prohibition is justified solely by the need to protect property rights in valuable information.

Based on this analysis, Part VI argues that it is creation of a unique federal rule -- not incorporation of state law principles -- that would frustrate the policies of the securities laws. The Supreme Court has repeatedly made clear that the federal securities laws do not displace the much broader body of state corporate law. To the contrary, the Court has *1193 specifically indicated that questions of fiduciary duty are governed by state law. If the fiduciary duty necessary for insider trading liability is supplied by federal law, a substantial tension thus would develop between the insider trading prohibition and the federalism policies of the securities laws. Incorporating state law fiduciary duties into the prohibition would resolve that tension. Moreover, state law fiduciary duties are generally consistent with the property rights rationale for regulating insider trading. Accordingly, incorporating state law fiduciary duties would advance the federalism policies of the federal securities laws, without frustrating any of the other policies thereof.

Corporate law in the EU

The Defining Tension has an update on the EU's plans for future development of what Europeans call company law (and we call corporate law). To my mind, the two interesting questions are (1) whether the EU will eventually abandon the real seat doctrine and thus allow the development of competitive federalism such as we have here in the US (which raises the question of which country would become the EU's Delaware) and (2) the role of codetermination in harmonization of EU law. As regular readers know, I'm a big fan of competitive federalism and a big skeptic of codetermination.

SOX at 10

Yesterday was the 10th anniversary of the passage of the Sarbanes-Oxley Act. JW Verret had some timely thoughts, which I share:

There are many days that I wish Larry Ribstein were still here, and today is definitely one of those days.  He would have had a lot to say about the tenth anniversary of SOX today.  He and Henry Butler noted in their book “The Sarbanes-Oxley Debacle: What We’ve Learned; How to Fix It” that:

“while the direct costs are substantial, they are only the tip of the iceberg….An important aspect of SOX’s indirect costs is the Act’s impact on litigation. SOX gives litigators the benefit of 20/20 hindsight to identify minor or technical reporting mistakes as the basis for lawsuits against corporations, officers, and directors. While the first major market correction will be painful for investors, SOX will surely turn it into a festival for trial lawyers. Litigation on this scale should not be confused with shareholder protection. SOX has created a ticking litigation time bomb.”

Kevin Lacroix discusses a 2011 study from Cornerstone Research that demonstrated just how prescient Larry and Henry were on this aspect of SOX.  This study shows how cases involving accounting allegations are increasingly common in nearly all of the years after SOX, that cases involving internal control weakness allegations are much more likely to settle, and that cases involving accounting allegations dominate settlements as they make up 70-90% of total settlement dollars.  So it turns out, as Larry and Henry predicted, SOX has become quite the precocious child at tens-years old (which corresponds, I am told, with fourth grade). ...

I miss Larry too, precisely because he was very nearly unrivaled in his ability to get to the heart of the problems with laws like SOX.

In any case, if you are one of those who still struggle daily with SOX's complexities, may I suggest my book Complete Guide to Sarbanes-Oxley?

Roe on the Delaware-Washington Interaction in Corporate Lawmaking

Mark Roe's work on the relationship between Delaware and Washington (i.e., state and federal law) in regulating corporate governance strongly influenced my approach to corporate federalism in my book Corporate Governance after the Financial Crisis, so I was very interested to see his new paper A Spatial Representation of Delaware-Washington Interaction in Corporate Lawmaking. Here's the abstract:

Delaware and Washington interact in making corporate law. In prior work I showed how Delaware corporate law can be, and often is, confined by federal action. Sometimes Washington acts and preempts the field, constitutionally or functionally. Sometimes Delaware tilts toward or follows Washington opinion, even if that opinion does not square perfectly with its own consensus view of the best way to proceed. And sometimes Delaware affects Washington activity, effectively coopting a busy Washington from acting in ways that do not accord with Delaware’s major constituents’ view of best practice. Delaware influences Washington decision-making when Delaware is positioned between its own ultimate preferences (determined in part by its primary constituencies’ consensus position) and Washington’s prevailing preferences. Since Congress has a long and complex agenda, if key players in Washington become satisfied that the Delaware legal outputs are close enough to their own preferences, Delaware can induce Washington to desist from going further.

At the Columbia Symposium on Delaware corporate lawmaking, I presented a straight-forward spatial model paralleling spatial models that political scientists have used to illustrate other contexts of government jurisdictional interaction. In this article, I describe and set forth that model to illustrate Delaware-Washington interaction in the last decade’s making of proxy access rules.

The extension of his thesis to the proxy access debate is both timely and highly useful. I'm not convinced the diagrams he uses to illustrate the analysis help all that much, but as always YMMV. In any case, it's an important and highly recommended paper.

Geography of Revlon-Land is #1

My new article The Geography of Revlon-Land is the #1 most downloaded new article on SSRN's mergers and acquisitions topic list:

Curiously, however, no top 20 law review has called to accept it. How very odd. I suppose I may have to actually start submitting it to them.

Why I have two hit counters

It's not because I'm preoccupied with my stats or obsessed with climbing the rankings in Paul Caron's quarterly survey of law professor blogs. (Both of those things are true, of course, they're just not the reason for this specific decision.) As James Joyner observed recently, Sitemeter has been acting up for a while now:

I’ve been using SiteMeter since the earliest days* of OTB, going back to February 4, 2003. There have been some glitches from time to time over the years but, for the most part, it’s done a good job of tracking visits in real time.  It’s been down for three days now and, given that their website hasn’t been updated in years—they’re still “sponsored” by the old Truth Laid Bear site, which hasn’t been in operation in forever—I’m wondering if there’s anyone there doing maintenance anymore.

... SiteMeter has always had three advantages that kept it on my site. First, because I’ve used it since the beginning, it give me a steady state measure. Second, because it was so ubiquitous in those early days, it gives me a means of comparing performance to other blogs. Third, it lets me know who’s on my site and sending people to my site in real time.  Google Analytics, by contrast, tells me who was on the site yesterday.

In addition to the problems James notes, Sitemeter has been very glitchy lately. Sometimes the counter widget shows two counters. Sometimes the widget code wipes out the entire sidebar.

Like James, I'm pretty dissatisfied with Sitemeter right now. But also like James, at least for right now, I've used Sitemeter since the biog started and the three advantages he cites apply to my site as well. (it's sort of a path dependency story, kind of.)  But I'm going to experiment with Statcounter and maybe Google Analytics to see if I can get more stable and accurate stats, because if Sitemeter keeps resting on its laurels, there may come a time when those advantages no longer justify using it. (After all, sometimes following a path gets so costly not even strong path dependency can justify continuing to follow it.)

Solar Power Breakthrough Reported at UCLA

The LA Times carries an article today on a new solar film being developed at UCLA: (excerpt)

One of the holy grails of solar cell technology may have been found, with researchers at UCLA announcing they have created a new organic polymer that produces electricity, is nearly transparent and is more durable and malleable than silicon. The applications are mind-boggling. Windows that produce electricity. Buildings wrapped in transparent solar cells. Laptops and phones – or even cars or planes – whose outer coverings act as chargers. It might even be sprayed on as a liquid. The promise of cheap and easy-to-apply site-generated solar electricity might now be a lot closer to reality. Of course, the idea of solar films and solar plastics is not new. The breakthrough to making a transparent film, however, came with isolating only one band of light in the spectrum.

“[A solar film] harvests light and turns it into electricity. In our case, we harvest only the infrared part,” says Professor Yang Yang at UCLA’s California Nanosystems Institute, who has headed up the research on the new photovoltaic polymer. Absorbing only the infrared light, he explains, means the material doesn’t have to be dark or black or blue, like most silicon photovoltaic panels. It can be clear. “We have developed a material that absorbs infrared and is all transparent to the visible light.”...

 

via uclafacultyassociation.blogspot.com

Very cool. Makes one proud to be a Bruin.

Dodd-Frank at Two: Bad for Business and the Constitution

Dodd–Frank, President Obama’s financial-regulation reform, had its two-year anniversary over the weekend. The act, spanning 2,319-pages, is an embodiment of former White House chief of staff Rahm Emanuel’s maxim to never let a serious crisis “go to waste.” Capitalizing on the fervor after the 2008 financial crisis, Dodd-Frank purported to promote financial stability, accountability, and transparency. Unfortunately, we would have all been better off if the crisis had been “wasted” than used to pass this legislation. Not surprisingly, much of why Dodd-Frank is damaging for our economy — including its massive regulatory structure and its contribution to economic uncertainty — could be remedied by addressing Dodd-Frank’s constitutional problems. 

Dodd-Frank hurts our economy because one of its central premises is that bureaucratic experts with near-unlimited discretion make the best stewards of our economy. These experts believe that if they promulgate enough rules, they can somehow fix our complicated financial system. In Dodd-Frank, this has already led to more than 8,000 pages of regulations, and regulators are only about 30 percent finished. 

This contributes to an increasingly regulated but tepid economic climate. As the Economist explained, Dodd-Frank “will smother financial institutions in so much red tape that innovation is stifled and America’s economy suffers.” The House Committee on Financial Services estimated that complying with the law will take about 24 million labor hours a year, or, as the Financial Services Roundtable explained, require that businesses hire about 26,477 personnel just to comply with those already-finalized regulations. 

via www.nationalreview.com

Well said.

Partnoy's Wait

The publisher of my friend Frank Partnoy's book Wait: The Art and Science of Delay, but I've been procrastinating on a review. But this week, I'm going to dive in. Reports to follow.

In the meanwhile, it's worth noting at the outset that the book is getting praise from lots of sources. For example, The Economist's Schumpeter columnist (who has been delaying reviewing my book, BTW!) wrote that:

Mr Partnoy argues that too many people fail to recognise what good public speakers and comedians all understand: that success depends on knowing when to delay, and for how long. The important thing is not to do things first but to do them right. And doing them right often involves taking a bit more time. ...

Delay even works in fields where time might seem to be of the essence. Doctors and pilots can profit from following a checklist, even when doing things they have done many times before. A list slows them down and makes them more methodical, as Atul Gawande describes in “The Checklist Manifesto”. The best sportsmen wait until the last split second before hitting the ball.

Mr Partnoy argues that people need to learn how to manage delay just as they learn how to manage everything else. Sometimes putting things off makes sense: the silliest impositions on our time occasionally have the decency to self-combust. Still, the rules of sensible time-management apply to procrastinators as much as everyone else. Don't delay tackling problems that will grow worse if ignored, such as your credit-card bill. And create a to-do list to fool yourself into doing your second-most-important job while procrastinating over the most important one.

 In the WSJ, Christopher F. Chabris wrote that:

Frank Partnoy's "Wait: The Art and Science of Delay" is about the value of waiting. His examples range widely, and so does the time scale of the delay involved: the elite baseball hitter's ability to wait the extra milliseconds to "find" a pitch; the comedian's ability to wait a few seconds to deliver a punchline; the skilled matchmaker's advice that blind daters suppress their snap judgments and wait a full hour before deciding whether they might want to go on a second date; the innovative company's ability to hang on to creative ideas, for months or even years, until they pay off. "We are hard-wired to react quickly," Mr. Partnoy says. "Modern society taps into that hardwiring, tempting us to respond instantly to all kinds of information and demands. Yet we are often better off resisting both biology and technology." ...

Mr. Partnoy's intention in "Wait" is to take on those who evangelize the power of thinking quickly, "getting things done" and leading an organized life. We can praise efficiency ("Bob answers every email," "he always gives you a quick decision," "he never misses a deadline") but fail to take note of what is sacrificed in its name. (We rarely hear "Bob's emails never say anything interesting," "he doesn't seem to think very deeply about the matters" or "his work is on time but never more than competent.") "Wait" offers a valuable counterweight to this attitude, reminding us that quality should matter as much as speed. ...

"Wait" does not peddle secrets of success, though it does contain some inspirational quotes for the slow-at-heart. ("Don't just do something, stand there" is one of my favorites.) The book succeeds most when it directs our attention to the range of situations where delay has value and when it counters the widespread intuition that faster is always better.

Mr. Partnoy quotes the psychologist Robert Sternberg: "The essence of intelligence would seem to be in knowing when to think and act quickly, and knowing when to think and act slowly." Taking some extra time to think about when to take extra time could pay off handsomely. In the long run, of course.

 

 

Putting New Sheets on a Procrustean Bed: How Benefit Corporations Address Fiduciary Duties, the Dangers Created and Suggestions for Change by J. William Callison :: SSRN

This Article considers the present structure of benefit corporations, as enacted by several states, and finds it wanting on several levels -- the concept of "general public benefit" is too limited and prevents shareholders from choosing the ends to be promoted by their corporation; there is a negative inference concerning the appropriate ends of corporations that are not benefit corporations; there are insufficient constraints on directors' fiduciary duties; and there are significant enforcement issues. The paper concludes by suggesting alternative structures to mitigate these problems.

Callison, J. William, Putting New Sheets on a Procrustean Bed: How Benefit Corporations Address Fiduciary Duties, the Dangers Created and Suggestions for Change (July 9, 2012). American Univ. Journal of Law & Business, Forthcoming. Available at SSRN: papers.ssrn.com

Callison's become a leading important expert on B Corps, so this important paper is sure to be highly influential.

An algorithm for predicting whether your tweet will go viral

From UCLA News:

Reporters, bloggers and other media trying to boost their Twitter presence can learn a few tips from an unexpected discipline: electrical engineering.

Roja Bandari, a Ph.D. candidate in electrical engineering at UCLA, developed an algorithm that predicts with 84 percent accuracy whether a news article will be popular on Twitter or bomb on the social media site.

Scamblogger bashes UC-Irvine Law

Law Prof/Scamblogger Paul Campos links an old post by yours truly in bashing UC-Irvine law school:

A few years ago, somebody decided it would be a good thing for the University of California to open another law school. Now even a few years ago this was obviously a terrible idea.  Today . . . well.

So it has come to pass that UC-Irvine's dean, Erwin Chemerinsky, has taken to the pages of the National Law Journal to explain why it's actually a good thing that the dumpster fire that is the California market for new (and old) attorneys has now been supplemented by another law school. And not just another law school, but one that will charge nearly $47,000 this year in resident tuition and fees, and $53,000 to non-residents, while conveniently located smack in the middle of one of the most expensive places to live in the USA.  (Estimated cost of attendance at UCI this fall is $71,000/$77,000.  Debt-financing a law degree  from the school will result in a total debt of $250,000 to $280,000 for the class of 2015 six months after graduation, assuming COL increases). ...

I still think it was a lousy idea. It's a very expensive place to get a left-liberal legal education that'll mostly prepare you for a career in low paying public interest law jobs. So trust fund babies only need apply, and that's why we have [name of law school where I have a lot of friends, so I won't mention the name].

My "Geography of Revlon-land" gets an endorsement

From American University law professor Kenneth Anderson.

You can download it here. If you're the EIC of a top 20-ish law review, you can accept it here.

This is (a) why we have to have tenure and (b) the liberal dominance of higher ed is a bad thing

Whoever said inquisitions and witch hunts were things of the past? A big one is going on now. The sociologist Mark Regnerus, at the University of Texas at Austin, is being smeared in the media and subjected to an inquiry by his university over allegations of scientific misconduct.

Regnerus's offense? His article in the July 2012 issue of Social Science Research reported that adult children of parents who had same-sex romantic relationships, including same-sex couples as parents, have more emotional and social problems than do adult children of heterosexual parents with intact marriages. That's it. Regnerus published ideologically unpopular research results on the contentious matter of same-sex relationships. And now he is being made to pay.

via chronicle.com

For those who say you don't need tenure to protect academic freedom, I say this case stands as a sad example of why it is needed. To those who's say that the left's dominance of higher ed doesn't matter, I say this case stands as a sad example of how it ensures a politically correct environment in the classroom and the laboratory.

If Congress were a puppy, I'd swat its nose with a newspaper

Of course, as a dog lover, I would never swat a real dog with a rolled up newspaper. When it comes to Congress, however, I would have no such compunctions. Remember all the effort we put into getting the STOCK Act passed to ban Congressional insider trading? Remember how we suspected the House GOP leadership, especially Eric Cantor, were trying to kill it or at least water it down?

Well, I thought that was one battle won.

But now Broc Romanek reports that:

I guess Congress is not satisfied that it's approval rating is down to single digits. As noted in this CNN article, the House Ethics Committee came up with a 14-page memo to interpret the STOCK Act differently than its Senate counterpart and found that spouses and children are exempt from the new law that had banned insider trading in Congress. The Office of Government Ethics, which oversees all federal executive branch employees, sided with the House.

So there you have it. A different standard for Congress compared to other federal employees. A group of ethics officials who have no understanding of beneficial ownership (guess they should have read our new "Beneficial Ownership Table Handbook"). And back to Square #1 in providing some integrity on the Hill. House Majority Leader Eric Cantor now claims that his office inadvertently created the loophole. 

Right. I don't believe Cantor for a minute. He's a bad pup who simply won't learn his lessons. I hope I never run into him with a rolled up newspaper in hand, or I'll be in big trouble.