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Wikipedia's flawed entry on misappropriation-based insider trading

In US v. O'Hagan, the SCOTUS explained that there are two theories on which one can be held liable for insider trading:

Under the "traditional" or "classical theory" of insider trading liability, §10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a "deceptive device" under §10(b), we have affirmed, because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation." Chiarella v. United States, 445 U.S. 222, 228 (1980). That relationship, we recognized, "gives rise to a duty to disclose [or to abstain from trading] because of the `necessity of preventing a corporate insider from . . . tak[ing] unfair advantage of . . . uninformed . . . stockholders.' " Id., at 228-229 (citation omitted). The classical theory applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of a corporation. See Dirks v. SEC, 463 U.S. 646, 655, n. 14 (1983).

The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates §10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. See Brief for United States 14. Under this theory, a fiduciary's undisclosed, self serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary turned trader's deception of those who entrusted him with access to confidential information.

The two theories are complementary, each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corporate "outsider" in breach of a duty owed not to a trading party, but to the source of the information. The misappropriation theory is thus designed to "protec[t] the integrity of the securities markets against abuses by `outsiders' to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders." Ibid.

I had occasion today to look at Wikipedia's treatment of insider trading. It correctly recognizes that misappropriation is an alternative basis of liability, but in doing so it misstates the misappropriation theory:

A newer view of insider trading, the "misappropriation theory" is now part of US law. It states that anyone who misappropriates (steals) information from their employer and trades on that information in any stock (not just the employer's stock) is guilty of insider trading.

For example, if a journalist who worked for Company B learned about the takeover of Company A while performing his work duties, and bought stock in Company A, illegal insider trading might still have occurred. Even though the journalist did not violate a fiduciary duty to Company A's shareholders, he might have violated a fiduciary duty to Company B's shareholders (assuming the newspaper had a policy of not allowing reporters to trade on stories they were covering).

Let's start with the claim that liability arises where on "steals" information. As defined by the Court In O'Hagan, however, the misappropriation theory does not deal with theft of inside information--or, at least, not directly--but rather holds that a fiduciary's undisclosed use of information belonging to his principal, without disclosure of such use to the principal, for personal gain constitutes fraud in connection with the purchase or sale of a security and thus violates Rule 10b-5. Instead of basing liability on stealing information, the Court based the theory on “a fiduciary’s undisclosed, self serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality."

I'm being a stickler here because this is a longstanding sore point. I have long argued that the only coherent basis for imposing insider trading liability is protection of property rights in information. From a policy perspective, those who steal information ought to be liable for insider trading. The trouble is that O’Hagan cannot be read to permit imposition of liability on such persons.

On to the next problem with the Wikipedia entry. The entry claims that the journalist in the hypothetical "might have violated a fiduciary duty to Company B's shareholders (assuming the newspaper had a policy of not allowing reporters to trade on stories they were covering)." Wrong. The journalist is an agent of the newspaper and owes the newspaper fiduciary duties regardless of whether or not the company has an explicit policy. Put another way, the journalist's relevant duties arise out of the employment relationship not a policy in the employee handbook.

What would happen if the newspaper had an explicit policy of allowing journalists to trade on the basis of such information? I discuss that here.

One thing the entry does get right is that "the journalist did not violate a fiduciary duty to Company A's shareholders."

The misappropriation theory's origins are commonly traced to Chief Justice Burger's Chiarella dissent. Burger contended that the way in which the inside trader acquires the nonpublic information on which he trades could itself be a material circumstance that must be disclosed to the market before trading. Accordingly, he argued, "a person who has misappropriated nonpublic information has an absolute duty [to the persons with whom he trades] to disclose that information or to refrain from trading."

In O’Hagan, the court’s majority opinion grounded liability under the misappropriation theory on deception of the source of the information. As the majority interpreted the theory, it addresses the use of "confidential information for securities trading purposes, in breach of a duty owed to the source of the information." Under this theory, the majority explained, "a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information." So defined, the majority held, the misappropriation theory satisfies § 10(b)'s requirement that there be a "deceptive device or contrivance" used "in connection with" a securities transaction.

The Supreme Court thus expressly declined to embrace Chief Justice Burger's argument in Chiarella that the misappropriation theory created a disclosure obligation running to those with whom the misappropriator trades. Instead, it is the failure to disclose one's intentions to the source of the information that constitutes the requisite disclosure violation under the O'Hagan version of the misappropriation theory.

Sokol's trades: Did he have material information?

Steve Bradford says no:

Here’s a chronology derived from the Berkshire Hathaway news release  :

1. December 14: Sokol purchased 2,300 shares of Lubrizol.
2. December 21: Sokol sold those 2,300 shares.
3. January 5, 6, and 7: Sokol purchased 96,060 shares of Lubrizol, pursuant to a 100,000-share limit order he had placed.
4. Jan. 14 or 15: Sokol for the first time discussed with Warren Buffett the idea of purchasing Lubrizol. Buffett was skeptical.
5. Jan. 24: Buffett sent Sokol a short note indicating his skepticism about acquiring Lubrizol.
6. Jan. 25: Sokol discussed a possible purchase with James Hambrick, the CEO of Lubrizol.
7. Subsequent to Jan. 25, Sokol reported his discussion with Hambrick to Buffett and the Berkshire Hathaway board approved the purchase.

According to the Wall Street Journal, the profit on Sokol’s 96,060 shares would be $3 million.

... One is liable for trading on nonpublic information only if that information is material, and Sokol doesn’t appear to have had any material information when he purchased the stock—at least if we accept the Berkshire Hathaway account.

According to Berkshire Hathaway, Sokol had not suggested the Lubrizol acquisition to anyone prior to his purchases.  He approached Buffett a week after his last purchase and the matter did not go to the full board until much later. Thus, the only nonpublic information Sokol could have had at the time of the trades was knowledge that he intended to suggest the Lubrizol acquisition to Buffett.

Was that material? Fortunately, Basic v. Levinson, decided by the United States Supreme Court in 1988, addresses this very question: whether information about a possible acquisition is material. Basic says that one must consider both the probability that the acquisition will occur and the magnitude of the transaction if it does occur.

It’s pretty clear that the magnitude of the Lubrizol transaction, if it did occur, was fairly high: it was a $9 billion deal offering a substantial premium above the pre-deal price of the Lubricol stock.

But the probability at the time Sokol purchased was extraordinarily low. Basic says to consider “indicia of interest in the transaction at the highest corporate levels.” Some of the indicia Basic points to are “board resolutions, instructions to investment bankers, and actual negotiations between the principals or their intermediaries.”

If one accepts the Berkshire Hathaway account, nothing even close to that had happened when Sokol bought his stock.  The Berkshire Hathaway board had not even discussed the Lubrizol deal, much less approved a resolution to negotiate with Lubricol. Sokol himself was not even a director  of Berkshire Hathaway. As far as is known, no one had contacted an investment banker. And, at the time of the trades, there had been no negotiations.  Sokol himself didn't talk to Lubrizol until after the stock purchases. Under Basic standards, the probability was virtually nil.

Basic says to weigh the probability and magnitude together to determine materiality, and the magnitude is high, but magnitude alone certainly can’t be enough if there is absolutely nothing to establish probable corporate interest in the deal. A thought in one employee’s head (unless, perhaps, that employee were Warren Buffett himself) does not make a possible acquisition material.

Good analysis.

Sokol, Buffett, Berkshire-Hathaway, Insider Trading?-Updated and Bumped

The WSJ reports that:

David Sokol, widely seen as the leading contender to succeed billionaire Warren Buffett at the helm of Berkshire Hathaway Inc., defended himself Thursday morning after resigning unexpectedly amid surprising revelations about his personal stock trading.

In an unusual and personal announcement Wednesday evening, Mr. Buffett said the resignation followed revelations that Mr. Sokol had purchased roughly $10 million in shares of a chemicals company that Berkshire recently agreed to buy at the suggestion of Mr. Sokol, Lubrizol Corp.

"I don't believe I did anything wrong," Mr. Sokol said in an interview on CNBC. "I don't think you can ask executives not to invest their own families' capital." ...

Mr. Buffett said Mr. Sokol, 54 years old, had bought 96,060 shares in January, before Berkshire reached a $9 billion deal to acquire the company. Berkshire's purchase price of $135 per share meant that Mr. Sokol's stake rose $3 million in value. ...

Securities lawyers debated whether Mr. Sokol's dealings could fall into a gray legal area. In broad terms, insider trading laws prohibit individuals from trading on shares based on material nonpublic information in violation of some duty of trust.

One key question, lawyers say, is whether Mr. Sokol knew that he would pitch a Lubrizol deal to Mr. Buffett, or even that he might do so, at the time he bought Lubrizol shares. If Mr. Sokol did know at that time, that could suggest he had material information at the time he bought the shares, lawyers said.

However, lawyers said it could be hard to show that Mr. Sokol misappropriated information in breach of a duty to Berkshire. A question would be whether in buying shares he wrongly used knowledge about what Berkshire was likely to do.

It's hard to see how what Sokol did qualifies as insider trading under SEC Rule 10b-5. The classic disclose or abstain theory doesn't apply because Sokol didn't trade in the stock of the company of which he is an insider. So you'd have to rely on the misappropriation theory. The trouble here is that the SCOTUS in US v. O'Hagan made clear that liability is premised on the use of “confidential information for securities trading purposes, in breach of a duty owed to the source of the information.” Under this theory, the majority explained, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.” If Sokol traded before Berkshire made any decisions, did he really trade on the base of confidential information belonging to Berkshire-Hathaway? In effect, he traded on the basis of what he knew that HE intended to do. Even though he's an agent of Berkshire, I'm not sure trading on the basis of the knowledge that he was going to pitch a takeover to his boss counts as inside information.

Larry Ribstein opines:

Sokol may have had material information when he bought his second batch of shares: i.e., that he was going to pitch the company to Buffett.  Although he didn’t know whether Buffett would go for it, a company’s just being pitched to Buffett by a trusted insider likely increases its value. [Update:  See Sorkin: "though he had no control over Mr. Buffett’s ultimate decision, he was one of a select few who were in a position to influence such a transaction."]

But did Sokol breach a duty to Berkshire?  The company policy says employees should ask “themselves whether they are willing to have any contemplated act appear the next day on the front page of their local paper—to be read by their spouses, children and friends—with the reporting done by an informed and critical reporter.”

On the other hand, Buffett knew.  On the third hand, did Buffett know the extent of Sokol’s ownership, or the fact that he bought the shares knowing of Berkshire’s possible interest?  On the fourth hand, it seems highly unlikely Sokol thought he was doing anything wrong.

Berkshire might be hurt if Sokol had a conflict of interest in pitching the deal.  But that conflict was disclosed.

OTOH, just the day before Larry had praised Judge Posner's recent decision holding that "disclosure of the conflict was not enough to eliminate the breach of fiduciary duty issue." As Posner wrote:

To have a conflict and to be motivated by it to breach a duty of loyalty are two different things—the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus a disloyal act is actionable even when a conflict of interest is not—one difference being that the conflict is disclosed, the disloyal act is not.

I think the distinction Posner drew is bogus, but if you buy it, disclosure by Sokol might not excuse disloyal acts.

What might be the disloyal act? I'm thinking that In re eBay, Inc. Shareholders Litigation, 2004 WL 253521 (Del. Ch. 2004), may come into play here. During the late 1990s, a phenomenon known as spinning became common. In return for hiring a given investment bank to do their firm’s work, executives of that firm would receive preferential allocations of shares being sold in an IPO by another client of that investment bank. The executives would then sell those shares almost immediately, typically at a much higher price than then IPO sale price. Spinning thus apparently accounted for at least some of the persistent problem of under-pricing of IPO stocks.

The individual defendants here were executives of eBay who spun shares sold to them by Goldman Sachs. Plaintiffs are shareholders of eBay, suing derivatively. Plaintiffs advance the clever argument that the executives usurped a corporate opportunity from eBay.

Did Sokol's buying up shares in Lubrizol likewise usurp an opportunity he should have left on the plate for Berkshire-Hathaway? I think it would be a very aggressive application of the doctrine. But in the course of his opinion Chancellor Chandler further explained that "even if one assumes that IPO allocations like those in question here do not constitute a corporate opportunity, a cognizable claim is nevertheless stated on the common law ground that an agent is under a duty to account for profits obtained personally in connection with transactions related to his or her company." Granted, making a profit on inside information differs from the kickbacks at issue in eBay, but doesn't prompting your firm to buy a company in which you've invested similarly invoke fiduciary obligations?

Here we might turn for guidance to Pfeiffer v. Toll, C.A. No. 4140-VCL, slip op. (Del. Ch. Mar. 3, 2010), and Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949). As I've explained elsewhere:

In Brophy, the defendant insider traded on the basis of information about a stock repurchase program the corporation was about to undertake. Stephen M. Bainbridge, Securities Law: Insider Trading 20-21 (2d ed. 2007). In a very real sense, the insider was competing with the corporation, which both agency law and corporate law clearly proscribe. Indeed, the insider’s conduct in fact directly threatened the corporation’s interests. If his purchases caused a rise in the stock price, the corporation would be injured by having to pay more for its own purchases. A derivative suit seeking redress for that potential injury thus was quite proper.

In Toll, the Court defined a Brophy claim as follows:

“[A] plaintiff seeking to prevail on a Brophy claim ultimately must show that: 1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.” In re Oracle Corp., 867 A.2d 904, 934 (Del. Ch. 2004) (hereinafter “Oracle”), aff’d, 872 A.2d 960 (Del. 2005) (TABLE).

Toll, slip op. at 16.

If Sokol's trades drove up the price of Lubrizol, perhaps a Delaware court would extend Brophy to misappropriation cases? Indeed, a Delaware court might not even require a showing that the trades effected the price of Lubrizol stock. The Toll Court explained that:

In the typical scenario in which an insider trades based on material information that allegedly was not disclosed to stockholders, a corporation can recover for actual harm causally related (in both the actual and proximate sense) to the breach of the duty of loyalty. Without limiting the types of harm that could be related causally to a loyalty breach, the obvious candidates are costs and expenses for regulatory proceedings and internal investigations, fees paid to counsel and other professionals, fines paid to regulators, and judgments in litigation.

What all this shows, I think, is that the case stretches the boundary of insider trading liability. The misappropriation theory requires that you use information that belongs to the principal. Could one construct an argument based on corporate opportunities, agency law, Brophy and Toll that Sokol's information belonged to Berkshire-Hathaway? I've tried to play around with that in the preceding paragraphs, but I remain unpersuaded that there is a violation of federal law here.

Finally, Larry asks:

My question: what should federal law have to do with all this? The “hook” for federal securities liability is the trading in Lubrizol — but the breach of duty that triggers liability has to do with the details of Sokol’s dealings with Buffett and Berkshire. This, as I’ve said before, is appropriately a matter of state law. See my article, Federalism and Insider Trading, 6 Supreme Court Economic Review, 123 (1998).

A fair question, but one that I think has a good answer. I addressed this point at length (pp. 39-45, 83-84) of The Law and Economics of Insider Trading: A Comprehensive Primer, and even more length in Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Washington and Lee Law Review 1189 (1995).

I argue that insider trading is not defined in the federal securities statutes. Instead, its definition has evolved through a process of common-law adjudication. At the core of the resulting rule is a requirement that the alleged inside trade constitute a breach of the trader's fiduciary duty to refrain from self-dealing in confidential information. Once the substantive definition of insider trading is viewed as a species of federal common law, the question arises whether federal courts should incorporate state law as the rule of decision or create a unique federal standard. I demonstrate that the insider trading prohibition can be justified only as a mechanism for protecting property rights in information. As such, the prohibition has relatively little to do with the traditional securities regulation concerns of disclosure and fraud. To the contrary, insider trading became a matter of federal concern because of the SEC's self-interest and that of some of its regulatory constituents. To be sure, the exigencies of detecting and prosecuting insider trading warrant a continuing federal regulatory role. Because there is no significant federal policy interest at stake, however, there is no reason to create a unique federal rule defining insider trading. Instead, courts should adopt state law fiduciary duty principles as the rule of decision.

Granted, reliance on state law will complicate insider trading prosecutions. But no more so than in any other case where state standards are incorporated into federal common law. In any case, there are affirmative reasons to adopt state law as the rule of decision. By acknowledging that insider trading is primarily a matter for state law, like all other questions of fiduciary duty, this approach accords proper deference to the states' position as the primary regulator of corporate governance questions. Finally, because state law fiduciary duty rules are designed to protect property rights, looking to them to define insider trading will more clearly tie the prohibition to the rationale for regulating insider trading.

Posner on related party transactions

Larry Ribstein notes a new Posner opinion:

Francis Pileggi brings news of an interesting Posner opinion in CDX Liquidating Trust v. Venrock Associates, (7th Cir. March 29, 2011), a case decided under Delaware law.  As Mr. Pileggi notes, the case held, among other things, that disclosure of a conflict of a director’s interest may “insulate the agreement from attack, but does not, per se, protect the director from a claim for breach of fiduciary duty.”  This is an established principle, but benefits from Judge Posner’s clear articulation.  The case also raises some interesting procedural issues.

The case involved a VC’s (Venrock) bridge loan which provided for a substantial payment to the lender in the event of liquidation that would leave nothing left for the shareholders. As Posner says, “[t]he disinterested directors of Cadant [the borrower] * * * who voted for the loan were engineers without financial acumen, and because they didn’t think to retain their own financial advisor they were at the mercy of the financial advice they received from Copeland [who was a director both of the VC and the borrower] and the other conflicted directors.”

The borrower’s board approved a sale of assets for enough to pay off the creditors and preferred (including the VC) but not the common.  The sale was approved by a simple majority of both common and preferred voting together and the preferred voting separately.  The question is whether the bridge loans were a breach of the VC’s fiduciary duty.  Here’s Posner:

The accusation is that the directors were disloyal. They persuaded the district judge that disclosure of a conflict of interest excuses a breach of fiduciary duty. It does not. It just excuses the conflict. * * *

To have a conflict and to be motivated by it to breach a duty of loyalty are two different things—the first a factor increasing the likelihood of a wrong, the second the wrong itself. Thus a disloyal act is actionable even when a conflict of interest is not—one difference being that the conflict is disclosed, the disloyal act is not. A director may tell his fellow directors that he has a conflict of interest but that he will not allow it to influence his actions as director; he will not tell them he plans to screw them. If having been informed of the conflict the disinterested directors decide to continue to trust and rely on the interested ones, it is because they think that despite the conflict of interest those directors will continue to serve the corporation loyally.

I agree that disclosure of the conflict was not enough to eliminate the breach of fiduciary duty issue.  But should it be enough for liability to show that the disinterested directors relied on the interested one?

I don't buy Posner's analysis. Posner's trying to be his usual clever self, but the analysis simply makes no sense. In oder for disclosure to cure a conflict of interest, there must be full disclosure of all material facts relating to both the transactions and the director's conflict of interest. If the interested director failed to disclose that "he plans to screw them," neither the conflict nor the disloyal act has been excused.

An update on what I'm reading

Walter Olson's Schools for Misrule: Legal Academia and an Overlawyered America:

The latest book from Olson (The Excuse Factory) is part historical overview and part cutting-edge commentary examining corporate case studies and public and tort law with a sharp analysis of the academic system and the internal and external forces shaping its agenda. Law schools mould the future leaders of America, shaping the nation and influencing consensus. Recent legal scholars have infiltrated politics, journalism, and broadcasting, claiming greater authority and creating potentially serious social repercussions. The author explores perceived political bias at Harvard and Yale, their dependence on "left-tilting philanthropy," and the tendency of professors to permeate the curriculum with their own values. Additionally, Olson argues, the commercialization of American universities creates markets of intellectual property and a culture of one-upmanship. Often with tongue firmly in-cheek, Olson addresses the "American disease" of dubious injury claims and product liability lawsuits, the ever-spurious "recovered memory" litigation, and other legal precedents. This hard-hitting, witty account reveals the effect of law on the individual and the collective and astutely forecasts the future of law reform, in the academy, in politics, and across the globe.

Steven Brust's Tiassa:

The 18th novel (after 2010's Iorich) in Brust's sprawling Dragaera fantasy series is a wonderful return to form, setting assassin hero Vlad Taltos in a contest of wits and wills against imperial guard captain Khaavren, the formidable protagonist of 1992's The Phoenix Guards. On the run from his former employers, the Jhereg, Vlad swings back into town for a surreptitious visit to his family and finds himself wanted all over again by Khaavren, who is chasing a magical silver statue of a tiassa. A cat-and-mouse game ensues, full of plots, counterplots, unlikely disguises, swordfights, and mistaken identities. Fans will love the full cast of favorite characters and the resolution of longstanding plots and mysteries, and like most of Brust's books, this witty, wry tale stands well alone and is very accessible to new readers.

J Brian Benestad's Church, State, and Society: An Introduction to Catholic Social Doctrine:

How can the Catholic faith help not only Catholics, but all people, build a just and flourishing society?

The Catholic Church contributes first and foremost to the common good by forming the consciences of the faithful. Faith helps reason achieve a proper understanding of the common good and thereby guides what individuals need to do to live justly and harmoniously. In this book, J. Brian Benestad provides a detailed and accessible introduction to Catholic social doctrine (CSD), the Church's teachings concerning the human person, the family, society, political life, charity, justice, and social justice.

Church, State, and Society explains the nuanced understanding of human dignity and the common good found in the Catholic intellectual tradition. It makes the case that liberal-arts education is an essential part of the common good because it helps people understand their dignity and all that justice requires. The author shows the influence of ancient and modern political philosophy on CSD philosophy and examines St. Augustine, St. Thomas Aquinas, papal social encyclicals, Vatican Council II, and postconciliar magisterial teaching. Benestad highlights the teachings of popes John Paul II and Benedict XVI that the attainment of the common good depends on the practice of the virtues by citizens and leaders alike.

The book is divided into four parts. The first treats key themes of social life: the dignity of the human person, human rights, natural law, and the common good. Part two focuses on the three principal mediating institutions of civil society: the family, the Church, and the Catholic university. Part three considers the economy, work, poverty, immigration, and the environment, while part four focuses on the international community and just war principles. The conclusion discusses tension between CSD and liberal democracy.

"In Delaware, a preferred stockholder’s rights are contractual in nature.”

So states VC Leo Strine in Fletcher Int'l v. Ion Geophysical Corp. Edward McNally explains that:

Fletcher International LTD v. Ion Geophysical Corp., C.A. 5109-VCS (March 29, 2011)

This is another in the line of decisions that stress that preferred stockholder rights are what is set out in the certificate of incorporation and nothing more.  Thus, if the preferred stockholders bargain for the right to consent to the sale of stock by any subsidiary, then they do not also have the right to vote on the sale of subsidiary stock by the parent.

Specifically Strine opined that:

In Delaware, a preferred stockholder’s rights “are contractual in nature.”27    Where the language governing the preferred stockholder’s rights is “clear and unambiguous, it must be given its plain meaning.”28    Furthermore, such rights “are to be strictly construed and must be expressly contained in the relevant certificates.”29

27 In re Appraisal of Metromedia Int’l Group, Inc., 971 A.2d 893, 899 (Del. Ch. 2009) (citing Matulich v. Aegis Commc’ns Group, Inc., 942 A.2d 596, 600 (Del. 2008)).

28 Benihana of Tokyo, Inc. v. Benihana, Inc., 906 A.2d 114, 120 (Del. 2006) (citing Northwestern Nat’l Ins. Co. v. Esmark, Inc., 672 A.2d 41, 43 (Del. 1996)).

29 Waggoner v. Laster, 581 A.2d 1127, 1134 (Del. 1990). See also Baron v. Allied Artists Pictures Corp., 337 A.2d 653, 657 (Del. Ch. 1975).

What's interesting to me is that no where in the opinion does the dread word "Jedwab" appear. A few years ago, I wrote a very long blog post on the rights of preferred stockholders, in which I discussed former Delaware Chancellor Allen's opinion in Jedwab v. MGM Grand Hotels, Inc., 509 A.2d 584 (Del. Ch. 1986), which held that directors owe fiduciary duties to preferred stockholders as well as common stockholders where the right claimed by the preferred “is not to a preference as against the common stock but rather a right shared equally with the common.” Presumably, since the specific claims at issue did not allege a breach of fiduciary duty, Strine did not feel it necessary to address that issue. Still, it's at least a little curious that the scholarly Strine--who frequently offers up interesting dicta in his many long textual footnotes (of which this opinion has several) did not even mention the Jedwab issue.

Is it too much to hope that Delaware courts may finally be waking up to the myriad of ways in which Jedwab is inconsistent with Delaware Supreme Court precedent and, moreover, just plain bad policy?

What's the origin of "nice talk, GI"?

As long as I can remember, my family's used the phrase "nice talk, G.I." as a reprimand for using bad words. I broke it out on Twitter this pm. Wondering whether this was common usage, I googled it (as a phrase) and came up with only 46 results. Which got me to wondering where we got it from.

SEC charges FDA employee with insider trading: One-off or trend?

Cases against federal employees alleging insider trading have been very rare. Interestingly, however, almost concurrently with the reintroduction of the STOCK Act to ban such trading comes news that the SEC has charged a Food and Drug Administration employee with insider trading:

The Securities and Exchange Commission today charged a U.S. Food and Drug Administration (FDA) chemist with insider trading on confidential information about upcoming announcements of FDA drug approval decisions, generating more than $3.6 million in illicit profits and avoided losses.

The SEC alleges that Cheng Yi Liang illegally traded in advance of at least 27 public announcements about FDA drug approval decisions involving 19 publicly traded companies. Some announcements concerned the FDA’s approval of new drugs while others concerned negative FDA decisions. In each instance, he traded in the same direction as the announcement. Liang went to great lengths to conceal his insider trading. He traded in seven brokerage accounts, none of which were in his name. One belonged to his 84-year-old mother who lives in China. ...

Daniel M. Hawke, Chief of the SEC’s Market Abuse Unit, added, “The insider trading laws apply to employees of the federal government just as they do to Wall Street traders, corporate insiders, or hedge fund executives. Many government agencies like the FDA routinely possess and generate confidential market-moving information. Federal employees who misappropriate such information to engage in insider trading risk exposing themselves to potential civil and criminal charges for violating the federal securities laws.”

Employees, yes. members of Congress, not so much. I explain all in Insider Trading Inside the Beltway:

In United States v. O'Hagan, the US SCOTUS grounded liability under the misappropriation theory on deception of the source of the information; the theory addresses the use of “confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”[1] According to the Court, “a fiduciary’s undisclosed, self serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.”[2] So defined, the Court held, the misappropriation theory satisfies § 10(b)’s requirement that there be a “deceptive device or contrivance” used “in connection with” a securities transaction.[3]

Where a Member of Congress, a Congressional staffer, or other government information obtains material nonpublic information in the course of their duties and then uses it to trade in the stock of the relevant issuer, their conduct could be colloquially described as a theft of the information, but under O’Hagan any potential insider trading liability under the misappropriation theory would require proof of a duty of disclosure between the official and the source of the information.

The Standards of Ethical Conduct for Employees of the Executive Branch provide that: “Public service is a public trust, requiring employees to place loyalty to the Constitution, the laws and ethical principles above private gain.”[1] Accordingly, an employee of the Executive Branch should be deemed an agent of the government or, at least, to stand in a similar relationship of trust and confidence with the government.[2] The Standards further provide that: “An employee shall not engage in a financial transaction using nonpublic information, nor allow the improper use of nonpublic information to further his own private interest or that of another, whether through advice or recommendation, or by knowing unauthorized disclosure.”[3] As such, the relationship between the government and one of its employees is such that the undisclosed use by the latter of information gained in the course of his employment would give rise to liability under the misappropriation theory.

So this should be a very straightforward case.

The interesting question is whether this case portends greater SEC attention to insider trading by government employees. There's a lot of chatter these days about political intelligence, but that's not this case. This is classic insider trading by somebody with access to confidential information.

Moreover, it's insider trading by a guy who made classic boneheaded errors:

The SEC alleges that Liang used the trading profits for his own personal benefit. Checks totaling at least $1.2 million were written from the accounts he used for trading to a bank account in his name, to him or his wife directly, or to credit card companies to pay off balances in accounts in his or his wife’s name. Nearly $65,000 worth of checks were written from the brokerage accounts to car dealerships to purchase vehicles later registered to Liang and his wife.

Hint: If you live on a government salary, don't start depositing hundreds of thousands of dollars into your personal bank accounts. If you went to the trouble of using 7 brokerage accounts under false names to hide your trail, don't then write checks on those accounts to buy yourself a car.

My guess is that the SEC got a tip that something wasn't kosher w/r/t Liang. Once they subpoenaed this financial records the whole thing would have unraveled very quickly.

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[1] 5 C.F.R. § 2635.101. I assuming here that government ethics rules embodied in the terms of employment of government employees banning the use of nonpublic information for personal gain will be deemed to constitute the requisite agreement. In fact, however, the question of whether an employee handbook constitutes a contract arises in many legal settings and, in general, does not admit of easy resolution. See generally 19 Williston on Contracts § 54:10 (4th ed. 2009) (discussing cases).

[2] Joseph Kalo, Deterring Misuse of Confidential Government Information: A Proposed Citizens’ Action, 72 Mich. L. Rev. 1577, 1581 (1974) (“The application of fiduciary duties to activities of government employees is not novel.”).

[3] 5 C.F.R. § 2634.703(a). Nonpublic information is defined for this purpose as “information that the employee gains by reason of Federal employment and that he knows or reasonably should know has not been made available to the general public.” Id., § 2634.703(b).

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[1] Id. at 652.

[2] Id.

[3] Id. at 656-57.

Constituency directors

Lewis Lazarus opines on the question of representative directors, concluding that "Directors Designated By Investors Owe Fiduciary Duties to the Company as a Whole and Not to the Designating Investor."

Investors who make substantial investments often demand a seat on their company's board of directors.  That is a reasonable request as it permits the investor to have a representative on the board of directors with a voice in management of the company.  It is well-settled that directors elected by stockholders of a Delaware corporation owe fiduciary duties to the company and all its stockholders once they serve on the board.  Thus, they may make decisions in the exercise of their fiduciary duty that are different than what is in the best interest of designating investor. ...

As stated in Phillips v. Insituform of N. Am., Inc., 1987 WL 16285, at *10 (Del. Ch. Aug. 27, 1987) the "law demands of directors ... fidelity to the corporation and all of its shareholders and does not recognize a special duty on the part of directors elected by a special class to the class electing them."  ...

[Delaware] cases teach that directors designated by particular stockholders or investors owe duties generally to the company and all of its stockholders.  Where the interests of the investor and the company and its common stockholders potentially diverge, the directors cannot favor the interests of the investor over those of the company and its common stockholders.

As a general rule, I think that's right. It's especially important when the sponsoring investor has a conflict of interest, such as where the sponsoring investor proposes a transaction with the corporation.

In some cases, however, a bright line rule might not make sense. Suppose a financially distressed company with a unionized work force negotiated give backs from the union. As a condition of those give backs, the union required representation on the corporation’s board of directors. My research on these cases suggests that board of director representation is a way of maximizing access to information and bonding its accuracy. The employee representatives will be able to verify that the original information about the firm’s precarious financial situation was accurate. Employee representatives on the board also are well-positioned to determine whether the firm’s prospects have improved sufficiently to justify an attempt to reverse prior concessions through a new round of bargaining.

The anticipated role of the union representative in such cases is almost certain to conflict with the duties of the director as set forth by Mr Lazarus. Suppose that as a condition of granting the concessions, the union insisted that its director be free to pass any information to the union. The board of directors agreed. Would it matter if the proposal was disclosed to the shareholders and the shareholders elected the union representative to the board, as opposed to the union representative being appointed by the board to fill a vacancy?
 
What if the union insisted that the union representative on the board be allowed to vote as s/he understands the interests of the union to demand? Should the board of directors (or the shareholders) be denied the power to agree where that is necessary to obtain concessions that might save the company?

To take another example, suppose a corporation has failed to pay dividends on preferred stock for a sufficient period of time that the holders of the preferred are now entitled to elect a majority of the board. Would Delaware courts really say that the board cannot prefer the interests of the preferred holders? Isn’t looking out for the interests of the preferred shareholders the very purpose of giving otherwise nonvoting preferred shares the right to elect a board in the event of failure to pay dividends?

As a final example, what about the case in which a dissident shareholder successfully wages a short slate proxy contest on a platform calling for, say, the sale of the company. Surely the sponsoring shareholder should surely be entitled to expect their nominees to pursue that goal. Indeed, the sponsor might reasonably expect the directors not just to "advocate" for the shareholder's position, but to vote for it and take other action.

Granted, I don't think the sponsor should be able to punish the directors for failing to do so. In the recent Airgas case, discussed by Lazarus, three directors sponsored by a takeover bidder declined to support the bidder's demand that the target's poison pill be lifted. If the bidder doesn't like that result, it should have picked people with a greater sense of loyalty. On the other hand, I wouldn't necessarily fauly directors who had been elected on the basis of a campaign to sell the company from insisting that the pil be dropped.

So I think we have to take these cases contextually.

STOCK Act Reintroduced to Ban Insider Trading by Members of Congress

BNA reports that:

Rep. Louise Slaughter (D-N.Y.) introduced a bill March 17 that would prohibit members of Congress and federal employees from profiting, or helping others profit, from non-public information—primarily through stock and futures trading—gleaned through their access to privileged, political-based information.

In a March 18 statement, Slaughter's office said the Stop Trading on Congressional Knowledge Act would foster greater oversight of “the growing ‘political intelligence’ industry.” Slaughter said the legislation, H.R. 1148, which is co-sponsored by Rep. Tim Walz (D-Minn.), “is about fairness and transparency.” Similar bills introduced several times since 2006 have failed to gain traction.

The bill would level the playing field between corporate and congressional insiders. While the federal securities laws already prohibit trading on material nonpublic corporate information, there is no analogous restriction for information gained in the course of government service.

The bill would amend the 1934 Securities Exchange Act and the Commodity Exchange Act to make it illegal for congressmen and their staffs to trade based on information picked up through knowledge of pending or prospective legislation. It has been referred to the committees on Financial Services, Agriculture, Judiciary, and Administration.

In the statement explaining the bill, Slaughter's office said “there is reason to believe some members of Congress or their staff may have shared nonpublic information about current or upcoming congressional activities with individuals outside of Congress working for political intelligence firms.” It said that indications were that the information was used for “investment purposes.” The statement added that “the increase in the number of political intelligence firms suggests that the leaking of nonpublic congressional information occurs regularly.” ...

Slaughter and Rep. Brian Baird (D-Wash.) introduced similar bills in 2009, 2006, and 2007 (41 SRLR 153, 2/2/09). While the bills failed to pass, a Financial Services subcommittee held an oversight hearing on the topic in July 2009 (41 SRLR 1358, 7/20/09).

My article Insider Trading Inside the Beltway reviewed the need for and analyzed the potential effectiveness of the 2009 version. The abstract follows:

A 2004 study of the results of stock trading by United States Senators during the 1990s found that that Senators on average beat the market by 12% a year. In sharp contrast, U.S. households on average underperformed the market by 1.4% a year and even corporate insiders on average beat the market by only about 6% a year during that period. A reasonable inference is that some Senators had access to – and were using – material nonpublic information about the companies in whose stock they trade.

Under current law, it is unlikely that Members of Congress can be held liable for insider trading. The proposed Stop Trading on Congressional Knowledge Act addresses that problem by instructing the Securities and Exchange Commission to adopt rules intended to prohibit such trading.

This article analyzes present law to determine whether Members of Congress, Congressional employees, and other federal government employees can be held liable for trading on the basis of material nonpublic information. It argues that there is no public policy rationale for permitting such trading and that doing so creates perverse legislative incentives and opens the door to corruption. The article explains that the Speech or Debate Clause of the U.S. Constitution is no barrier to legislative and regulatory restrictions on Congressional insider trading. Finally, the article critiques the current version of the STOCK Act, proposing several improvements.

Mutual fund shareholder activism

It's been a core tenet of my critique of shareholder activism that insitutional investors who parent organizations have close business ties with corporate America are unlikely to be particularly active in corporate governance. In Shareholder Activism in the Obama Era, for example, I opined that:

... corporate managers are well-positioned to buy off most institutional investors that attempt to act as monitors. Bank trust departments are an important class of institutional investors, but are unlikely to emerge as activists because their parent banks often have or anticipate commercial lending relationships with the firms they will purportedly monitor. Similarly, insurers “as purveyors of insurance products, pension plans, and other financial services to corporations, have reason to mute their corporate governance activities and be bought off.” Mutual fund families whose business includes managing private pension funds for corporations are subject to the same concern.

The claim is confirmed by a recent study that examined the relationship between how mutual funds voted on shareholder proposals relating to executive compensation and pension-management business relationships between the funds’ families and the targeted firms. The authors concluded that such ties influence fund managers to vote with corporate managers rather than shareholder activists at both client and non-client portfolio companies.[1] Voting with management at non-client firms presumably is motivated by a desire to attract new business and send signals of loyalty to existing clients.

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[1] Rasha Ashraf et al., Do Pension-Related Business Ties Influence Mutual Fund Proxy Voting? Evidence from Shareholder Proposals on Executive Compensation (November 23, 2010), http://ssrn.com/abstract=1351966.

A corporation's obligation to obey the law

Stephen Padfield takes issue with my assertion that "Corporations have the same obligation to obey the law as natural persons":

To the extent that corporations don't actually exist and thus can't be physically put in jail, this seems not quite correct.  Furthermore, the actual human decisionmakers and "owners" often appear to be significantly immunized from jail for corporate malfeasance because of the responsibility dilution inherent in doing business in the corporate form.  This is obviously to a significant degree an empirical question, but I'm certainly not going to take at face value the assertion that corporations are precisely as subject to the law as natural persons.  Particularly when that assertion is trotted out in support of fending off attempts to regulate corporations more rigorously because, "They have no soul to save and they have no body to incarcerate."

Point well taken. The overlap may not be precise. But I think both theory and law suggest that the corporation has a duty to obey the law that is at least analogous to that of a natural person.

• American Law Institute Principles of Corporate Governance sec. 2.01(b) provides that a corporation "Is obliged, to the same extent as a natural person, to act within the boundaries set by law."
• Even Milton Friedman in his famed critique of corporate social responsibility opined that the corporation's proper objective is "to make as much money as possible while con­forming to the basic rules of the society, both those embodied in law and those embodied in ethical custom"
• Although they can't be sent to jail, corporations can be fined and sued. In the extreme case, to the point of being forced out of business (e.g., Arthur Anderson), although admittedly that is rare.
• It is true that directors and officers often escape liability due to the corporate form's insulating powers. Yet, as Martin Petrin has pointed out, "it has gone mostly unnoticed that corporate directors and officers can be held personally liable in tort to non-shareholder third parties based on failures in exercising their core corporate duties." Indeed, such liability seems to be on the upswing.

So maybe the parallel isn't all that inapt after all.

Schumpeter on Corporate Personhood

The Economist's Schumpeter has an interesting column on corporate personhood in the most recent issue. He (?) argues:

The legal conceit that companies are natural persons is vital to capitalism. It simplifies litigation greatly: companies can act like individuals when it comes to owning property or making contracts. Timur Kuran of Duke University argues that the idea of corporate personhood goes a long way to explaining why the West pulled ahead of the Muslim world from the 16th century onwards. Muslim business groups were nothing more than temporary agglomerations which dissolved when any partner died or withdrew. Legal personhood gave Western firms longevity. ...Western companies turbocharged the industrial revolution and laid the foundations for mass prosperity.

I agree, as regular readers know. I also agree with Schumpeter's implicit concern that US law confers personhood on the corporation without a coherent theory of why it does so or where the boundaries of that legal fiction are to be located. As I complained after the recent AT&T decision:

Chief Justice Roberts could have summed up his opinion far more succinctly: "Because at least 5 of us say so."

The Citizens United decision last term attracted much criticism--not least from Con Law Professor-in Chief Obama--for holding that a corporation is a person and as such has certain constitutional rights. While I agreed with the holding, I was disturbed that the Chief Justice's majority opinion for the Supreme Court so obviously lacked a coherent theory of the nature of the corporation and, as such, also lacked a coherent theory of what legal rights the corporation possesses.

The utterly specious word games that drive this opinion simply confirm that Chief Justice Roberts  has failed to articulate  a plausible analytical framework for this important problem.

Returning to Schumpeter, however, I disagree rather strongly with his chief concern:

Nor is it unreasonable to wonder why the idea of corporate personhood should only cut one way: if companies enjoy the same rights as flesh-and-blood humans then shouldn’t they be under the same obligations? The conservative majority on the Supreme Court is in danger of digging a trap for itself: strengthening the arguments of people who insist that companies have a moral duty to pursue social rather than merely business ends.

It's not clear why Schumpeter is worried on this score.  On the one hand, corporations already have the "same obligations" as natural persons in the key respects. Corporations have the same obligation to obey the law as natural persons. Corporations are taxpayers, just like natural persons. In time of war, corporations have even been conscripted, being told by the government what to make and what pricesto charge. So why is Schumpeter worried?

In any case, Schumpeter seems also to be concerned that corporate personhood strengthens the arguments of the corporate social responsibility crowd. But how? Just as natural persons are free to refuse to be Good Samaritans, corporations remain free to decline to comply with "moral" duties. Giving the corporation recognition as a legal person, doesn't change that analysis as far as I can tell. Granted, he is subject to strict word limits, but some elaboration would have been helpful.

As it is, I think Schumpeter gets it exactly backwards. The CSR crowd sees corporate personhood as an obstacle to their goals rather than a means to their ends. Corporate personhood gives corporations legal rights and protections that help protect them from the demands of CSR activists.

Finally, Schumpeter offers a propsoed "fix" for the problem:

What would help is if the Supreme Court (and indeed corporate law in general) adopted a clear principle when it comes to the analogy between artificial persons and real ones: that companies should be treated as people only in so far as it is expedient. They clearly need to be able to enter into contracts just like individuals. But they should not be treated as if they experience such essentially human emotions as embarrassment and a desire for self-expression. Thus they should not have the same rights to privacy and political freedom as a citizen, but should have only as much of a right to confidentiality and political participation as is helpful for the efficient functioning of business (including letting firms contribute to the public debate on the regulation of business).

But who decides what is expedient? Ultimately, whether it is expedient for corporations to have some right or another will depend on whether 5 justices of the SCOTUS think it's expedient.

As a decision rule, Schumpeter's proposal sucks. It provides no certainty or predictability, due to the lack of a bright-line test. It relies on a concept-expediency--that is inherently ambiguous and, worse yet, largely subjective.

Consider, for example, his suggestion that firms be granted free speech rights to "contribute to the public debate on the regulation of business." Given how pervasive business is in our culture and how pervasively business is regulated, virtually any corporate speech arguably would fall under that protection. E.g., a corporation could argue against recognition of same-sex marriage because doing so would affect employee benefits.

We need is a better rule, but relying on 5 old men and women in robes--most without any business experience--and their wet behind the ears law clerks to decide what is and what is not expedient is not a better rule. In fact, sub silentio, it's essentially what we do know.

Yours truly quoted re corporate political campaigns

NPR:

The percentage of undisclosed money in the political system went up during last year's midterm elections. That's because of a dramatic increase in advertising by anonymously funded freelance organizations such as the American Action Fund and Citizens for Strength and Security.

Much of the money is thought to come from corporations. Now, proponents of transparency are winning disclosure battles one corporation at a time. ...

Stephen Bainbridge, who teaches corporate law at UCLA law school, says most of corporate America isn't all that eager to get into politics. "I think that there have been situations in which some of the chamber's donors have been reluctant to be [seen] publicly doing battle with the Obama administration," he says. "But at the same time, I think we have not seen the floodgates open."

Bainbridge says top management is worried about bigger things, like "say on pay," which would give shareholders the power to control executive compensation.

"I think most corporations don't perceive this sort of disclosure as being particularly problematic," he says.

So when shareholders start calling for changes, Bainbridge says, keeping political money secret often seems like a battle that's not worth fighting.

Which is not to say I think this sort of disclosure is a good idea. The point I was trying to make is that I suspect it's not an issue on which Corporate America will go to the mattresses.