ProfessorBainbridge.com

Congressional insider trading: "Congress is getting rich off Wall Street and Peter Schweizer won't stop until everyone knows it"

From The Daily Beast:

In the Spring of 2010, a bespectacled, middle-aged policy wonk named Peter Schweizer fired up his laptop and began a months-long odyssey into a forbidding maze of public databases, hunting for the financial secrets of Washington’s most powerful politicians. Schweizer had been struck by the fact that members of Congress are free to buy and sell stocks in companies whose fate can be profoundly influenced, or even determined, by Washington policy, and he wondered, do these ultimate insiders act on what they know? Yes, Schweizer found, they certainly seem to. Schweizer’s research revealed that some of Congress’s most prominent members are in a position to routinely engage in what amounts to a legal form of insider trading, profiting from investment activity that, he says, “would send the rest of us to prison.”

Walter Olson courteously rounds up the list of high profile cases identified by Schweizer:

Washington has been buzzing for the past 48 hours over revelations that some of Capitol Hill’s best-known lawmakers have been making fortunes speculating in the stocks of companies affected by official actions, typically while in possession of market-moving inside information. Rep. John Boehner (R-OH), Senatorial wife Teresa Kerry and others made bundles trading in health companies’ stocks shortly before Congressional or executive-branch action affecting the companies’ fortunes. After closed-door 2008 meetings in which Fed chairman Ben Bernanke briefed Congress on the gravity of the financial collapse, some lawmakers dumped their own stockholdings or even placed bets that the market would fall. Rep. Nancy Pelosi (D-CA) got access to highly desirable IPO (initial public offering) stock placements, some in companies with business before Congress. And so on. Studies have found that lawmakers as a group reap far above-average returns on their investments—suggesting either that these politicians are among the world’s cleverest investors, or else that they are profiting from inside information. All this has been turned into a front-page issue thanks to Throw Them All Out, a book by Hoover fellow Peter Schweizer, whose findings were showcased the other night on 60 Minutes.

Regular readers know that I believe Congressional insider trading is both wrong morally and ethically but also legal under current law. Hence, my support for the STOCK Act, which would ban it. See my article  Insider Trading Inside the Beltway. Very regular readers know I've been going back and forth with law professor Donna Nagy on this issue in the comments section of a prior post. FWIW, Olson agrees with me:

So the question is: is all this legal? While there’s some difference of opinion on the issue among law professors, the proper answer to that question is most likely going to be, “Yes, it’s legal.” As UCLA’s Stephen Bainbridge points out, existing insider trading law, developed by way of a long series of contested cases under the Securities and Exchange Commission’s Rule 10b-5, assigns liability to persons who are not corporate insiders if they are violating a recognized duty of loyalty to those for whom they work. As applied to the investment whizzes of the Hill, this implies that trading on inside information might be a violation if done by Congressional staffers (since they owe a duty of loyalty to higher-ups) but not when done by members of Congress themselves.

So, apparently, does Schweizer:

When Schweizer began his project, he consulted a former securities regulator, who happened to have an office down the hall from his in Florida. The adviser told him that investigators always look for two things in insider-trading cases: whether individuals had access to material information and whether they engaged in unusual trading. There is probably no group of people on earth with greater access to inside information than members of Congress; K Street lobbying firms get rich fees from hedge funds for ferreting out intelligence (such as whether some pending legislation has the votes to pass) that any member of the Senate or House routinely obtains in the cloak room.

But there have been no insider-trading cases brought against members of Congress, nor will there likely be. This is partly because, though insider-trading law is not settled, case law usually requires that an offending insider bear fiduciary responsibility at the company involved. But Congress’s relative immunity also owes to the fact that, in this regard, as in many others, Congress lives by its own rules. Schweizer notes that the Senate’s ethics manual devotes an entire chapter to the proper use of the mail and of Senate stationery, but is silent on the subject of insider trading. Ditto the rules of the House, which state that a member’s recusal from a vote affecting his or her stock portfolio “might be denying a voice” in the process. Neither the executive nor judicial branches allow such laxity.

Only one way to find out for use, of course. So I bought the book. As should you. It reams out the corruption on both sides of the aisle in Washington.

The Complete Cover for Corporate Governance After the Financial Crisis

The countdown to publication of Corporate Governance after the Financial Crisis continues to run rapidly. Today, we signed off on the final cover, reproduced below:

Be sure to check out the glowing blurbs!

And then go preorder your copy now:

Makes a great Christmas gift too.

Congressional insider trading errors

Securities Law Prof Blog:

60 Minutes ran a piece last night on members of Congress who may have used confidential information obtained through their positions to make profitable stock trades.  Curiously, the correspondent asserted that the practice is “perfectly legal” and legislation is necessary to prohibit the conduct.

Yet this common wisdom -- that insider trading by Congressional insiders  may be unethical, but is legal -- is “a specious claim,” according to Professor Donna Nagy, who has  written a law review article, “Insider Trading, Congressional Officials, and Duties of Entrustment” (available on SSRN), as well as a shorter  Roll Call piece, “Enforce Laws to Fight Lawmaker Insider Trading."  Professor Nagy explains that this fundamental misunderstanding stems from two misconceptions:  “a lack of regard for the broad and sweeping duties of entrustment that attach to public office and an unduly restrictive view of the Supreme Court’s precedents….”  As she explains, “the (un)lawfulness of Congressional insider trading therefore turns on whether these officials owe duties of trust and confidence to others who would be deceived and defrauded by the self-serving use of nonpublic Congressional knowledge.”

Is there any debate about the answer to that question?  While legislation to clarify insider trading law generally may be useful, there is no “legal loophole” that permits insider trading by Congressional insiders.

Wrong. First, there is debate. Second, with all due deference to Prof. Nagy, for whom I have great respect, I firmly believe that those of us on the other side of the debate have the better argument.

As I've mentioned several times lately, in my article Insider Trading Inside the Beltway I explained that:

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.

Here's the relevant excerpt (in thanks for which you should go download a copy of the whole article, yes?):

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 initial question is whether that duty must arise out of a fiduciary duty or whether the requisite duty can be created, inter alia, by agreement. This is so because, as we shall see, while Congressional aides and other government employees have duties arising out of both their fiduciary relationship with their employer and their employment contract, Members of Congress are bound only by the implied obligations created by Congressional ethics rules.[1] Whether those latter obligations rise to the level of a contractual duty to refrain from insider trading is debatable, but they clearly do not rise to the level of a fiduciary duty.

SEC Rule 10b5-2 purports to resolve this issue by providing “a nonexclusive list of three situations in which a person has a duty of trust or confidence for purposes of the ‘misappropriation’ theory....”[2] First, such a duty exists whenever someone agrees to maintain information in confidence.[3] 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.[4] Third, such a duty exists when someone receives or obtains material nonpublic information from a spouse, parent, child, or sibling.[5]

Whether the SEC has authority to create a rule imposing misappropriation liability on the basis of an arms-length contractual duty of confidentiality—as opposed to a fiduciary duty-based duty of confidentiality—has not been fully tested. In S.E.C. v. Cuban,[6] a district court held that a non-fiduciary could be help liable for misappropriation-based insider trading liability only where the trader had agreed both to keep information confidential and not to use the information for personal gain.[7] In doing so, the court criticized Rule 10b5-2 and held that the SEC lacked authority to adopt the rule as drafted:

The court concludes that, by its terms, Rule 10b5-2(b)(1) attempts to base misappropriation theory liability on an agreement that lacks an obligation not to trade on or otherwise use confidential information. … Nothing in Rule 10b5-2(b)(1) requires that the agreement encompass an obligation not to trade on or otherwise use the information.

That Rule 10b5-2(b)(1) relates to an agreement to preserve confidentiality is supported by the language and design of Rule 10b5-2 as a whole. …

Because Rule 10b5-2(b)(1) attempts to predicate misappropriation theory liability on a mere confidentiality agreement lacking a non-use component, the SEC cannot rely on it to establish Cuban’s liability under the misappropriation theory. To permit liability based on Rule 10b5-2(b)(1) would exceed the SEC’s § 10(b) authority to proscribe conduct that is deceptive. … This is because, as the court has explained, under the misappropriation theory of liability, it is the undisclosed use of confidential information for personal benefit, in breach of a duty not to do so, that constitutes the deception.[8]

The present state of the law thus leaves unresolved which of three viable alternatives is correct:

• As per Rule 10b5-2, a fiduciary duty is not required; rather, a mere agreement to keep information confidential suffices.
• As per Cuban, a fiduciary duty is not required; rather, an agreement is sufficient provided it explicitly bans the undisclosed use of the information in question sufficient.
• In light of the emphasis in Chiarella and Dirks that liability is premised on a duty arising out of a fiduciary relationship, the SEC lacked authority to adopt Rule 10b5-2 and a fiduciary duty is required.

As it turns out, however, we need not resolve which of these approaches is correct.[9] Executive Branch and Congressional employees can be held liable under the misappropriation theory under all three alternatives, while Members of Congress cannot be held liable under any of them.

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.”[10] 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.[11] 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.”[12] 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.

Likewise, both members of a Congressman’s staff and Committee staffers are employees of their respective houses.[13] In addition, both are subject to an ethical obligation never to “use any information received confidentially in the performance of governmental duties as a means for making private profit.”[14] These employment relationships should suffice for Congressional staffers to be deemed to have an agency or other relationship of trust and confidence with their employing agency. In S.E.C. v. Cherif,[15] for example, the court held that “a person violates Rule 10b-5 and Section 10(b) by misappropriating and trading upon material information entrusted to him by virtue of a fiduciary relationship such as employment.”[16] Put into O’Hagan’s terminology, “a [staffer’s] undisclosed, self serving use of [Congressional] information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the [Congress].”[17]

A different answer seemingly obtains, however, when we turn to the case of Members of Congress. Of whom are Members of Congress agents or fiduciaries? With whom do they have the requisite relationship of trust and confidence out of which the requisite duty to disclose before trading arises? The only logical candidate is the electorate. Although there is some precedent in other contexts for the proposition that “a public official … owe[s] a fiduciary duty to the public to make governmental decisions in the public’s best interest,”[18] such a duty would be irrelevant to the problem at hand. What is needed under insider trading law is either a duty to the person with whom one trades or to the source of the information, not some generalized duty to members of the public in the abstract. Accordingly, the predominant view, as stated by former SEC enforcement official Thomas Newkirk, is that “[i]f a congressman learns that his committee is about to do something that would affect a company, he can go trade on that because he is not obligated to keep that information confidential …. He is not breaching a duty of confidentiality to anybody.”[19]

To be sure, if either Rule 10b5-2 or the Cuban opinion alternative prevails, and the Congressional ethics manuals’ prohibition of insider trading by members are deemed to provide the requisite agreement, liability might be imposed on members who violate that obligation. As we have seen, however, those alternatives remain controversial.[20] In addition, unlike ethics rules embedded in an employee policy manual that is incorporated into an employment contract, it is conceptually more difficult to regard the Congressional ethics rules as an agreement of the sort contemplated by the Cuban decision.[21]  With whom is a Member of Congress in privity? If consideration is required, is there a quid pro quo?

An apt precedent for treating stock trading by Congressional staffers and Members of Congress differently is provided by U.S. v. Carpenter.[22] R. Foster Winans wrote the widely read “Heard on the Street” column for the Wall Street Journal, which provides investing information and advice. Because that column apparently had a short lived effect on the price of the stocks it covered, someone who knew the column’s contents in advance could profit by trading in the affected stocks. Although Wall Street Journal policy stated that prior to their publication the contents of columns were the Journal’s confidential property, Winans, before publication, disclosed the contents of his columns to several friends who then traded in the affected stocks. Winans and his friends were convicted of mail and wire fraud and insider trading under Rule 10b-5 pursuant to the misappropriation theory.[23]

In Carpenter, the Second Circuit held that Winans and his fellow conspirators committed illegal insider trading by “secreting, stealing, purloining or otherwise misappropriating material non-public information in breach of an employer-imposed fiduciary duty of confidentiality,” on the basis of which they then traded in the stock of issuers mentioned in Winans’ columns.[24] In dicta, the court indicated that the Wall Street Journal could have traded on the basis of the information in question:

Appellants argue that it is anomalous to hold an employee liable for acts that his employer could lawfully commit. Admittedly, … the Wall Street Journal or its parent, Dow Jones Company, might perhaps lawfully disregard its own confidentiality policy by trading in the stock of companies to be discussed in forthcoming articles. … Although the employer may perhaps lawfully destroy its own reputation, its employees should be and are barred from destroying their employer’s reputation by misappropriating their employer’s informational property. … Here, appellants, constrained by the employer’s confidentiality policy, could not lawfully trade by fraudulently violating that policy, even if the Journal, the employer imposing the policy, might not be said to defraud itself should it make its own trades.[25]

Nothing in O’Hagan is inconsistent with the distinction drawn in Carpenter. The misappropriation theory bans undisclosed trading by an agent or other fiduciary in breach of a duty of loyalty to the principal; it does not ban trading by the principal in the same information, even if the agent in question developed the information for the principal. As an employer, a Member of Congress is free to trade; as an employee, the staffer is not.

SCOTUS to rule on Obamacare ... and Freedom

The WSJ presents:

Nearly Everything You Need to Know About the Health Care Decision

But they miss the most basic question of all; namely, will we be a free people after this decision or subjects ruled by Congressional whims on everything except perhaps the "right" to kill the unborn?

Law Porn Morphs into Law Spam

Former NYU law school dean John Sexton famously invented what's now known as "law school porn." It started out as an overwrought glossy alumni magazine that Sexton had sent to every law professor in the land. He expended it to include flyers, postcards, and so on, all lauding NYU at lengths that would have made PT Barnum blush.

Sextonism, as Brian Leiter aptly called it, spread wildly. Today, I'd guess that 67% of the mail I get at the office is law porn that goes straight into the recycling bin without ever being read.

Lately, however, I've noticed a new trend. Snail mail law porn is turning into email law spam.

In my in box today, for example, I find an email from the University of Washington celebrating the "Clinical Law Program 2010-2011 Annual Report  Highlights." I have no relationship with the University of Washington, its law school, or especially its clinical program. Heck, I barely have a relationship with my school's clinical program. So why the frak am I getting this spam? The answer is that they got an email list of all law professors (probably bought it from the AALS) and made the same economic calculus that all spammers make. Sending out masses of spam is so cheap, that even if only one or two law professors take note of the email positively, UW has won. If those law faculty members happen to be among the chosen few whom US News surveys as part of its annual law school ranking process, UW really wins big.

While the economic calculation behind law spam differs but little from that behind, say, Nigerian scam spam, one wonders whether law school spammers like UW will take a reputational hit that the Nigerian con artists avoid. Unlike the vast majority of spam I receive, I know who sent this spam note to my inbox. And I now hold them -- and their school -- in disdain. If a modest percentage of law faculty feel the same way I do, the cumulative hit to Washington's reputation may impose real costs on the school.

Unfortunately, the UW spam is but one example of several I received just today. Presumably, UW and its ilk (sadly, probably including my school), figure that the reputational hit will be modest because "everybody does it."

But I invite readers on law faculties to send me examples of law spam. I'll post them periodically in hopes that naming and shaming the spammers will do some good.

Will 60 Minutes Accuse Boehner and Pelosi of Insider Trading

On the heels of ex-lobbyist Jack Abramoff's claim that insider trading on Captiol Hill is rampant comes a report that 60 Minutes is going to do an expose on the subject:

House Minority Leader Nancy Pelosi is the subject of a report on the stock investments of members of Congress that is to air Sunday on CBS' "60 Minutes."

The San Francisco Democrat and House Speaker John Boehner, R-Ohio, were questioned separately at their weekly news conferences Nov. 3 by reporter Steve Kroft. Neither had granted Kroft's previous requests for interviews.

Kroft asked both leaders about stock transactions they made while Congress was considering legislation that could affect the financial and insurance industries. Pelosi and Boehner vigorously denied any connection. ...

roft asked Pelosi why she and her investor husband, Paul Pelosi, bought an initial public offering of stock in Visa, the San Francisco-based credit card company, in March of 2008.

The same month, former House Judiciary Committee Chairman John Conyers, D-Mich., introduced the Credit Card Fair Fee Act, which would have given merchants the power to negotiate lower fees with credit card companies. The bill, hostile to the credit card industry, was passed by the committee but never brought to the floor. Pelosi was speaker at the time, and controlled which legislation came to a vote.

Regular readers know that we've covered Congressional insider trading for a long time here at PB.com. Indeed, I eventually went beyond blogging to academic scholarship on the issue in Insider Trading Inside the Beltway, in which I explained that:

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.

The Fundamental Error: Shareholders & Ownership

Broc Romanek posts:

Bob Monks is one of the long-time warriors in the battle for corporate governance reform. Ever since creating ISS a long time ago, Bob has been on the front lines to get corporate governance even considered when the need for some type of market reform seemed necessary. That's why I find his recent piece where he asks " What does it mean to be a shareholder or owner in 2011?" so interesting. Under that umbrella question, he also asks these four questions:

1. What do owner and shareholder mean in regards to corporations and governance?

2. Can we lump all stock owners together or do we need multiple classes of stock to accommodate owners with different levels of interest and participation?

3. To whom does management owe fiduciary duty when considering the interest of owners? Does having one class of ownership work in management's favor because it keeps shareholders from ever truly working together to enact change?

4. How can you have "shareholder responsibility" when there is no possibility of shareholders having a common interest and working together. Because there are today so many different classes and categories of shareholders - arbs, derivatives, borrowed stock, etc - that common purpose is impossible.

The middle two questions are very thought provoking and deserve extended analysis at some point in the future. As for numbers 1 and 4, however, they are old bugbears here at PB.com.

How Many Times Must I Say It? Shareholder Do Not Own the Corporation!

Ownership implies a thing capable of being owned. To be sure, we often talk about the corporation as though it were such a thing, but when we do so we engage in reification. While it may be necessary to reify the corporation for semantic convenience, it can mislead. Conceptually, the corporation is not a thing, but rather simply a set of contracts between various stakeholders pursuant to which services are provided and rights with respect to a set of assets are allocated.

Because shareholders are simply one of the inputs bound together by this web of voluntary agreements, ownership is not a meaningful concept in nexus of contracts theory. Someone owns each input, but no one owns the totality. Instead, the corporation is an aggregation of people bound together by a complex web of contractual relationships.

As I explain in detail in my article The Board of Directors as Nexus of Contracts, the shareholders' contract with the firm has some ownership-like features, including the right to vote and the fiduciary obligations of directors and officers.

Even so, however, shareholders lack most of the incidents of ownership, which we might define as the rights to possess, use, and manage corporate assets, and the rights to corporate income and assets. For example, shareholders have no right to use or possess corporate property. Cf. W. Clay Jackson Enterprises, Inc. v. Greyhound Leasing and Financial Corp., 463 F. Supp. 666, 670 (D. P.R. 1979) (stating that “even a sole shareholder has no independent right which is violated by trespass upon or conversion of the corporation’s property”). Management rights, of course, are assigned by statute solely to the board of directors and those officers to whom the board properly delegates such authority. Indeed, to the extent that possessory and control rights are the indicia of a property right, the board is a better candidate for identification as the corporation’s owner than are the shareholders. As an early New York opinion put it, “the directors in the performance of their duty possess [the corporation’s property], and act in every way as if they owned it.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918).

This remains true even if a single shareholder (or cohesive group) owns a majority of the corporation's voting stock. To be sure, ownership of such a control block gives shareholders substantial de facto control by virtue of their ability to elect and remove directors, yet this still does not confer either possessory or management rights on such shareholders. Indeed, an effort by such a shareholder to exercise such rights might well constitute a breach of fiduciary duty by the controlling shareholder. In appropriate instances of such misconduct by a controlling shareholder, the board may well have a fiduciary duty to the minority to take steps to dilute the majority shareholder's control (as by issuing more stock). See, e.g., Delaware Chancellor Allen's opinion in Mendell v. Carroll, 651 A.2d 297, 306 (Del. Ch. 1994), in which he suggested that the board of directors could "deploy corporate power against the majority stockholders" to prevent "a threatened serious breach of fiduciary duty by the controlling stock." Granted, as I haveobserved elsewhere on this blog, "corporate law is far more tolerant of hegemony than constitutional law," but Allen's dicta would make no sense if majority voting control equalled ownership.

Let me offer another illustration. As I discuss in my article Unocal at 20, if shareholders own the corporation, the board of directors of a target corporation would have no proper role in reponding to a tender offer. The shareholders' decision to tender their shares to the bidder would no more concern the institutional responsibilities or prerogatives of the board than would the shareholders' decision to sell their shares on the open market or, for that matter, to sell their homes. Both stock and a home would be treated as species of private property freely alienable by their owners. Yet, as we all know, corporate law confers an effective gatekeeping function on the target's board of directors by allowing them to deploy potent takeover defenses.

In discussing corporations, it is easy to lose sight of the overriding fact—that firms are nothing more than groups of people. We often find ourselves using jargon like owners, monitors, team members, agent, principal, partner, manager, employee, and shareholder. We also often find ourselves engaged in a form of reification—treating firms as though they were things having an existence separate from the people who comprise them—when we say things like “General Motors did so and so.” General Motors is a firm; it is pure fiction to say General Motors did anything. Reification is often useful, or even necessary, because it permits us to utilize a form of shorthand—it is easier to say General Motors did so and so than to attempt in conversation to describe the complex process which actually may have taken place. Indeed, it is very difficult to think about large firms without reifying them. Reification, however, can be dangerous. It becomes easy to lose sight of the fact that firms aren't things, they are simply a group of people for whom the law has provided an off-the-rack relationship we call the corporation. There simply is nothing there that can be owned.

Shareholder Activism and Heterogeneity

It's good to see long time shareholder activist Bob Monks has realized that shareholders are heterogenous. But does he realize the extent to which that observation undercuts the case for shareholder activism?

As my colleague Iman Anabtawi observed: “On close analysis, shareholder interests look highly fragmented.” Iman Anabtawi, Some Skepticism About Increasing Shareholder Power 4 (unpublished manuscript on file with author). She documents divergences among investors along multiple fault lines: short-term versus long-term, diversified versus undiversified, inside versus outside, social versus economic, and hedged versus unhedged. Shareholder investment time horizons are likely to vary from short-term speculation to long-term buy-and-hold strategies, for example, which in turn is likely to result in disagreements about corporate strategy. Even more prosaically, shareholders in different tax brackets are likely to disagree about such matters as dividend policy, as are shareholders who disagree about the merits of allowing management to invest the firm’s free cash flow in new projects.

Consequently, as I explain in The Case for Limited Shareholder Voting Rights, it is hardly surprising that the modern public corporation’s decision-making structure precisely fits Kenneth Arrow’s model of an authority-based decision-making system. Overcoming the collective action problems that prevent meaningful shareholder involvement would be difficult and costly, of course. Even if one could do so, moreover, shareholders lack both the information and the incentives necessary to make sound decisions on either operational or policy questions.  Under these conditions, it is “cheaper and more efficient to transmit all the pieces of information to a central place” and to have the central office “make the collective choice and transmit it rather than retransmit all the information on which the decision is based.”  Accordingly, shareholders will prefer to irrevocably delegate decision-making authority to some smaller group.

What is that group? The Delaware code, like the corporate law of virtually every other state, gives us a clear answer: the corporation’s “business and affairs ... shall be managed by or under the direction of the board of directors.”  Hence, as an early New York decision put it, the board’s powers are “original and undelegated.” Manson v. Curtis, 119 N.E. 559, 562 (N.Y. 1918). 

The central argument against shareholder activism thus becomes apparent. Active investor involvement in corporate decision making seems likely to disrupt the very mechanism that makes the public corporation practicable; namely, the centralization of essentially non-reviewable decision-making authority in the board of directors. The chief economic virtue of the public corporation is not that it permits the aggregation of large capital pools, as some have suggested, but rather that it provides a hierarchical decision-making structure well-suited to the problem of operating a large business enterprise with numerous employees, managers, shareholders, creditors, and other inputs. In such a firm, someone must be in charge: “Under conditions of widely dispersed information and the need for speed in decisions, authoritative control at the tactical level is essential for success.”  While some argue that shareholder activism “differs, at least in form, from completely shifting authority from managers to” investors, it is in fact a difference in form only. Shareholder activism necessarily contemplates that institutions will review management decisions, step in when management performance falters, and exercise voting control to effect a change in policy or personnel. For the reasons identified above, giving investors this power of review differs little from giving them the power to make management decisions in the first place. Even though investors probably would not micromanage portfolio corporations, vesting them with the power to review board decisions inevitably shifts some portion of the board’s authority to them. This remains true even if only major decisions of A are reviewed by B. The board directors of General Motors, after all, no more micromanages GM than would a coalition of activist institutional investors, but it is still in charge.

Disgraced ex-lobbyist Jack Abramoff "confirms" Congressional insider trading

CNBC reports that:

As many as a dozen members of Congress and their aides took part in insider trading based on foreknowledge of market moving information on Capitol Hill, disgraced Washington lobbyist Jack Abramoff told CNBC in an interview.

Abramoff, who was once one of the wealthiest and most powerful lobbyists in Washington before a corruption scandal sent him to federal prison for more than three years, said that many of those members of Congress bragged to him about their stock trading prowess while dining at the exclusive restaurant he owned on Pennsylvania Avenue. ...

Generally, however, legal analysts say that Wall Street insider trading laws do not apply to Congress. As an open and public institution, the legal assumption has long been that any member of the public can have access to information about how Congress works. In practice, though, that's simply not true, as powerful members of Congress come into contact daily with market-moving tidbits. That gap between the law and the reality has made Capitol Hill a virtual free-fire zone for insider trading. Over the years, academic studies have found that members of the House of Representatives beat the market by as much as six percent per year and members of the Senate do even better than that.

Regular readers know that we've covered Congressional insider trading for a long time here at PB.com. Indeed, I eventually went beyond blogging to academic scholarship on the issue in Insider Trading Inside the Beltway, in which I explained that:

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.

Crowdfunding and Securities Fraud

Steve Bradford criticizes a new paper arguing that exempting crowdunding from the securities laws' registration requirements would promote fraud. Bradford concludes:

As I explain in my article, small businesses face a significant capital gap. The existing exemptions are simply too expensive for very small offerings, leaving very small startups with no effective outlet for capital. Hazen claims that the existing securities exemptions are sufficient. That may be true for larger businesses, but it clearly isn’t true for offerings by very small startups. Securities law is an impassable obstacle for many small businesses. The expense to comply with the existing exemptions is simply too great relative to the size of the offering.

A properly constructed crowdfunding exemption will make new sources of capital available to small startups, and I think that gain will outweigh the potential losses. Moreover, the risk to any particular investor is minimized by limiting the amount each investor may invest. On the whole, I think the benefit of the exemption will exceed its cost.

Bradford's right.

ABA Keeps Plurality Voting as the Default for Electing Directors

First, some background. In most cases, state corporate law contemplates that shareholder action requires the affirmative votes of a majority of the shareholders present at a meeting at which there is a quorum.  When it comes to electing directors, however, state law until recently merely required a plurality shareholder vote. Delaware General Corporation Law § 216(3) formerly provided, for example, that “Directors shall be elected by a plurality of the votes of the shares present in person or represented by proxy at the meeting and entitled to vote on the election of directors.” The comments to MBCA § 7.28(a), which also used a plurality standard, defined that term to mean “that the individuals with the largest number of votes are elected as directors up to the maximum number of directors to be chosen at the election.”

The federal proxy rules accommodated state law by providing, in former SEC Rule 14a-4(b), that the issuer must give shareholders three options on the proxy card with respect to electing directors. A shareholder could vote for all of the nominees for director, withhold support for all of them, or withhold support from specified directors by striking out their names.

The net effect of these rules was that the corporate electoral system did not provide for a straight up or down vote for directors. Instead, one either granted authority to the proxy agent to vote for the specified candidates or one withheld authority for the agent to do so. Absent a contested election, because only a plurality vote was required, so long as the holder of at least a single share granted authority for his share to be cast in favor of the nominees, the slate of directors nominated by the incumbent board therefore would be elected even if every other shareholder withheld authority for their shares to be voted.

The origins of the plurality rule are somewhat obscure. It presumably arose to deal with situations in which there are more nominees than vacant director positions, which is most commonly the case in contested elections. In a close race, abstentions and spoiled ballots might mean that fewer nominees than the number of vacancies would receive a majority of the votes cast. In the worst case, which is made more likely by the use of slate voting, the election might fail completely as no directors would receive a majority. Plurality voting avoided that risk and the adverse consequences that might follow.

Over time, withholding authority to vote for some or all of the nominees put forward by the incumbent board became a common protest tactic by shareholder activists. In the 2004 shareholder revolt at The Walt Disney Company, for example, shareholder activists opposed the election of CEO Michael Eisner and certain other candidates. Under the then-existing plurality standard, Eisner would have been reelected even if holders of a majority of the shares had withheld authority for their shares to be voted for him. In the event, holders of 43% of Disney shares withheld such authority. Although Eisner was reelected, the high vote was seen as a powerful protest. Shortly thereafter, he initiated a succession process.

The Disney episode triggered considerable interest in changing the traditional plurality standard so as to transform the process from a mere opportunity to send a protest signal into a real election. In 2006, Delaware responded to considerable pressure from activists and others by amending the statutory provisions on director election to accommodate various forms of majority voting.

A number of Delaware corporations had responded to post-Disney pressure from shareholder activists by voluntarily adopting so-called Pfizer policies—named after the first prominent corporation to adopt one—pursuant to which directors who receive a majority of withhold “votes” are required to submit their resignation to the board. Section 141(b) of the Delaware General Corporation Law was amended to accommodate such bylaws. It does so by providing that: “A resignation [of a director] is effective when the resignation is delivered unless the resignation specifies a later effective date or an effective date determined upon the happening of an event or events. A resignation which is conditioned upon the director failing to receive a specified vote for reelection as a director may provide that it is irrevocable.”

The trouble with these so-called Pfizer or plurality-plus policies, at least from the perspective of shareholder activists, is that the board retains authority to turn down the resignation of a director who fails to get the requisite majority vote. In City of Westland Police & Fire Retirement System v. Axcelis Technologies, Inc., 1 A.3d 281 (Del. 2010), the Delaware Supreme Court confirmed that the board has substantial discretion to do just that. Axcelis Technologies had a seven-member board staggered into three classes. In 2008, all three of the incumbent directors up for reelection failed to receive a majority of the votes cast. Pursuant to the company’s plurality-plus policy, all three submitted their resignations. The board rejected all three resignations. A shareholder initiated a § 220 request to inspect the relevant books and records of the company preparatory to filing a derivative suit challenging the board’s decision. In order to prevent shareholders from conducting fishing expeditions, Delaware courts will grant such inspection requests only where there is a credible basis from which to infer that some wrongdoing may have occurred. In acknowledging that § 220 requests sometimes can be meritorious in this context, the Court observed that “the question arises whether the directors, as fiduciaries, made a disinterested, informed business judgment that the best interests of the corporation require the continued service of these directors, or whether the Board had some different, ulterior motivation.”  It thus seems fair to infer that the business judgment rule will be the standard by which courts evaluate board decisions under such policies.

Activists also objected to the Pfizer-style approach because it typically was effected by changing board of directors corporate governance policies rather than by amending the bylaws or articles. As such, continuation of the policy was subject to the discretion of the directors.

Shareholder activists therefore began using Rule 14a-8 to put forward bylaw amendments mandating true majority voting. A bylaw voluntarily adopted by Intel received wide activist support as a model for bylaw amendments at other issuers. Under it, a director who fails to receive a majority of the votes cast is not elected. In the case of an incumbent director who fails to receive a majority vote in favor of his reelection, there is the complication that, under DGCL § 141(b), a director’s term continues until his successor is elected. The Intel (a.k.a. majority-plus) model requires resignation of such a director.

Shareholder activists preferred a bylaw approach to one based on the articles of incorporation because of the latter’s board approval requirement. In most states, however, a shareholder-adopted bylaw would be vulnerable to subsequent board amendment or even repeal. Recall that DGCL § 109(a) provides that the articles of incorporation may confer the power to amend the bylaws on the board of directors, but that such a provision does not divest the shareholders of their residual power to amend the bylaws.

The resulting concurrent power of both shareholders and boards to amend the bylaws raises the prospect of cycling amendments and counter-amendments. Suppose the shareholders adopt a majority vote bylaw. The board then repeals the new bylaw provision using its concurrent power to amend the bylaws. The MBCA allows the shareholders to forestall such an event. MBCA § 10.20(b)(2) authorizes the board to adopt, amend, and repeal bylaws unless “the shareholders in amending, repealing, or adopting a bylaw expressly provide that the board of directors may not amend, repeal, or reinstate that bylaw.” In the absence of such a restriction, however, the board apparently retains its power to amend or even repeal the bylaw. If the board does so, the shareholders’ remedies presumably are limited to readopting the term limit amendment, this time incorporating the necessary restriction, and/or electing a more compliant board.

Delaware § 109 lacks any comparable grant of power to the shareholders. Worse yet, because the board only has power to adopt or amend bylaws if that power is granted to it in the articles of incorporation, a bylaw prohibiting board amendment arguably would be inconsistent with the articles and, therefore, invalid.

In American Int’l Rent a Car, Inc. v. Cross, 1984 WL 8204 (Del. Ch. 1984), the Delaware Chancery Court suggested that, as part of a bylaw amendment, the shareholders “could remove from the Board the power to further amend the provision in question.” Dicta in several other Delaware precedents, however, was to the contrary. In General DataComm Industries, Inc. v. State of Wisconsin Investment Board, 731 A.2d 818, 821 n.1 (Del. Ch. 1999), for example, Vice Chancellor Strine noted the “significant legal uncertainty” as to “whether, in the absence of an explicitly controlling statute, a stockholder-adopted bylaw can be made immune from repeal or modification by the board of directors.” In Centaur Partners, IV v. National Intergroup, Inc., 582 A.2d 923, 929 (Del. 1990), the Delaware Supreme Court addressed a shareholder-proposed bylaw limiting the number of directors. As proposed, the bylaw contained a provision prohibiting the board from amending or repealing it. Noting that the corporation’s articles gave the board authority to fix the number of directors through adoption of bylaws, the Supreme Court opined that the proposed bylaw “would be a nullity if adopted.” Consequently, it seemed doubtful that restrictions on the board’s power over the bylaws would pass muster in Delaware or other states likewise lacking a MBCA-style provision.

In response to activist shareholder pressure, however, Delaware amended § 216 by adding the following sentence: “A bylaw amendment adopted by stockholders which specifies the votes that shall be necessary for the election of directors shall not be further amended or repealed by the board of directors.” It is curious that the legislature did not adopt a more explicit validation of bylaw provisions requiring that a director receive a majority vote in order to be elected. Section 216, however, clearly seems to imply their validity and, if so, ensures that such bylaws could not be undercut by subsequent unilateral board action.

Like Delaware, the ABA Committee on Corporate Laws has amended the Model Business Corporation Act so as to permit the use of majority voting. MBCA § 7.28 sets out the default rule: “Unless otherwise provided in the articles of incorporation, directors are elected by a plurality of the votes cast by the shares entitled to vote in the election at a meeting at which a quorum is present.” Notwithstanding the proviso, the Committee has also adopted § 10.22, which provides for a majority vote option to be effected by the bylaws:

(a) Unless the articles of incorporation (i) specifically prohibit the adoption of a bylaw pursuant to this section, (ii) alter the vote specified in section 7.28(a), or (iii) provide for cumulative voting, a public corporation may elect in its bylaws to be governed in the election of directors as follows:

(1) each vote entitled to be cast may be voted for or against up to that number of candidates that is equal to the number of directors to be elected, or a shareholder may indicate an abstention, but without cumulating the votes;

(2) to be elected, a nominee must have received a plurality of the votes cast by holders of shares entitled to vote in the election at a meeting at which a quorum is present, provided that a nominee who is elected but receives more votes against than for election shall serve as a director for a term that shall terminate on the date that is the earlier of (i) 90 days from the date on which the voting results are determined pursuant to section 7.29(b)(5) or (ii) the date on which an individual is selected by the board of directors to fill the office held by such director, which selection shall be deemed to constitute the filling of a vacancy by the board to which section 8.10 applies. Subject to clause (3) of this section, a nominee who is elected but receives more votes against than for election shall not serve as a director beyond the 90-day period referenced above; and

(3) the board of directors may select any qualified individual to fill the office held by a director who received more votes against than for election.

All of which brings us up to date. Now BNA reports that:

The American Bar Association's Corporate Laws Committee declined a request from Council of Institutional Investors' general counsel Jeffrey Mahoney to revise the Model Business Corporation Act (MBCA) to make majority voting the default legal standard for uncontested director elections. A. Gilchrist Sparks, chairman of the Corporate Laws Committee, said in an Oct. 25 letter to Mahoney that the committee decided that a new review of the act is not warranted at this time. The MBCA is the basis for the corporate laws of most states, except Delaware, according to the CII. Section 7.28(a) of the MBCA sets plurality voting as the default standard for director elections unless a company's articles of incorporation call for a different standard.

I think the Committee made the right call. Critics of majority voting schemes correctly contend that failed elections can have a destabilizing effect on the corporation. Selecting and vetting a director candidate is a long and expensive process, which has become even more complicated by the new stock exchange listing standards defining director independence. Suppose, for example, that the shareholders voted out the only qualified financial expert sitting on the audit committee. The corporation immediately would be in violation of its obligations under those standards.

Critics also correctly complain that qualified individuals will be deterred from service. The enhanced liability and increased workload imposed by Sarbanes-Oxley and related regulatory and legal developments has made it much harder for firms to recruit qualified outside directors. The risk of being singled out by shareholders for a no vote presumably will make board service even less attractive, especially in light of the concern board members demonstrate for their reputations.

Finally, critics correctly claim that, at least as it is being implemented so far, majority voting is “little more than smoke and mirrors.”  William Sjostrom and Young Sang Kim conducted an event study of firms adopting some form of majority vote bylaw. William K. Sjostrom Jr. & Young Sang Kim, Majority Voting for the Election of Directors, 40 Conn. L. Rev. 459 (2007). They found no statistically significant market reaction to the adoption.  The implication is that the campaign for majority voting has created little shareholder value.

There thus is no case for making majority voting the default rule.

Christian Ethics and Capital Markets

Interesting new paper by Seth Payne argues that:

The financial turmoil of the past several years has caused many to question the integrity, stability, and very purpose of financial systems which, in today’s world, represent a unique blend of primarily capitalism but also aspects of socialism and collectivism as well. A key factor contributing to this sustained period of economic upheaval has been the uncertainty surrounding capital markets – the fuel that powers all modern economies. Capital markets have, in the minds of many, come to represent the embodiment of greed, unrestrained egoism, and exploitation of the vulnerable – conceptions at complete odds with the central values of social justice as set forth in both Christian and Jewish primary sources: caring for the poor, protecting the weak, and the promotion of justice.

In this paper I argue that capital markets, rather than being a means for the powerful to exploit the weak, have in fact become a force for social good in the aggregate. Indeed capital markets are, in fact, a social contract and as such must be governed by a set of normative ethical principles – both self imposed, and imposed by government regulation. I explore the ethical difficulties that have led to the systemic problems and market failures that lead to not only this current financial crisis, but literally all financial crises over the past eight hundred years. Capital markets, left to their own devices and without both self and governmental oversight, quickly become hotbeds of manipulation and exploitation. In order for markets to function properly, principles of basic fairness must become normative. It is when capital markets become unfair and unjust, that they fail. Thus, these markets must be structured in such a way as to 1) promote Rawl’s “Justice as Fairness” principle and 2) align the interests of market participants to produce universally beneficial market efficiency and stability.

Finally, I propose concrete ways in which the power of capital markets may be harnessed to promote the central moral values of Christian tradition and be used by people of faith to promote the ideals of social justice.

Payne, Seth R., Christian Ethics and Capital Markets (March 18, 2011). Available at SSRN: http://ssrn.com/abstract=1952030

 

Bainbridge Joins Comment to ISS on Corporate Political Spending

Along with former California Commissioner of Corporations and Manhattan Instiutute Center for Legal Policy Director, I today submitted a comment letter to Institutional Shareholder Services with regard to ISS' proposed change in policy on corporate political spending. As Commissioner Bishop explains:

The ISS Global Policy Board recently solicited comments with respect to its proposed updates to its benchmark proxy voting guidelines. One of the policy changes under consideration relates to corporate political spending disclosure proposals. Under ISS’ current guidelines, these proposals are evaluated on a case-by-case basis. ISS is now proposing to change its position to a “generally vote FOR recommendation”.

This week, I joined Professor Stephen Bainbridge (UCLA Law School) and James Copland (Director, Center for Legal Policy at the Manhattan Institute) in submitting this comment letter
opposing the change. ISS’ proposed change is unwarranted for a number of reasons, including:

• From 2008 through August 1, 2011, no shareholder proposal concerning political speech came close to achieving majority support;

•  All public companies are not similarly situated with respect to either the potential beneficial or negative impacts of disclosures;

• The actual proposals submitted to date differ materially; and

• The evidence suggests that nearly all of these proposals have been “sponsored by funds affiliated with labor unions or social or religious interests—investors who either may or expressly do seek goals apart from investment return”.

I hope that ISS eschews a “one size fits all” approach corporate spending proposals. 

Ditto.

Somebody needs to teach Occupiers the TANSTAAFL

Local news report:

A pair of Southland street cart vendors who were forced to shut down their businesses after “Occupy” protesters vandalized their carts are hoping to get some help from local residents. ...

Coffee cart owner Linda Jenson and hot dog cart operators Letty and Pete Soto said they initially provided free food and drink to demonstrators, but when they stopped, the protesters became violent.

And according to one city councilman, bodily fluids were used in the attacks.

“Both carts have had items stolen, have had their covers vandalized with markings and graffiti, as well as one of the carts had urine and blood splattered on it,” said Councilman Carl DeMaio.

What we have in #OWS is a bunch of childish narcissists who have never learned that there is no such thing as a free lunch. Round 'em up and make them read Robert Heinlein's The Moon Is a Harsh Mistress.

Update: The New York outpost of Occupy appears equally prepared to use violence to get a free lunch:

A business owner near the Occupy Wall Street encampment claims she has been repeatedly harassed and threatened with bodily harm by protesters after she and her employees refused to give in to their outlandish demands.

“I’ve been told, ‘Watch your back!’ 10 times,” Stacey Tzortzatos, owner of Panini & Co. Breads, located across from Zuccotti Park, told The Post yesterday.

She and her employees are terrified by the constant threats, which she said began after she demanded the protesters stop using her shop’s restroom as a place to bathe every day.

The final straw came about two weeks ago, when the demonstrators broke a bathroom sink, flooding the shop, and clogged the toilet -- setting her back $3,000 in damages.

You might remember that Massachusetts Senate Candidate Elizabeth Warren recently claimed to have "created much of the intellectual foundation" for Occupy Wall Street. Somebody needs to ask her how she feels about OWS now and whether she believes in free lunches.

Corporate Governance After the Financial Crisis gets a cover

My forthcoming book Corporate Governance after the Financial Crisis is rapidly approaching publication. The final proofs have been approved and the cover has been chosen.

As Oxford University Press' website explains,

The first decade of the new millennium was bookended by two major economic crises. The bursting of the dotcom bubble and the extended bear market of 2000 to 2002 prompted Congress to pass the Sarbanes-Oxley Act, which was directed at core aspects of corporate governance. At the end of the decade came the bursting of the housing bubble, followed by a severe credit crunch, and the worst economic downturn in decades. In response, Congress passed the Dodd-Frank Act, which changed vast swathes of financial regulation. Among these changes were a number of significant corporate governance reforms. 

Corporate Governance after the Financial Crisis asks two questions about these changes. First, are they a good idea that will improve corporate governance? Second, what do they tell us about the relative merits of the federal government and the states as sources of corporate governance regulation? Traditionally, corporate law was the province of the states. Today, however, the federal government is increasingly engaged in corporate governance regulation. The changes examined in this work provide a series of case studies in which to explore the question of whether federalization will lead to better outcomes. The author analyzes these changes in the context of corporate governance, executive compensation, corporate fraud and disclosure, shareholder activism, corporate democracy, and declining US capital market competitiveness.

You can order it here

"Can You Be Guilty of Insider Trading Without Personal Gain?" Yes

Megan McArdle posed the titular question, observing that:

Rajat Gupta, formerly a director at Proctor and Gamble and Goldman Sachs, has been indicted on multiple counts of passing insider information about the companies he was supposed to be helping to oversee.  He is alleged to have delivered this information to Raj Rajaratnam, the hedge-fund manager who just got 11 years for insider trading.

Ho-hum! Yawn.  More corruption on Wall Street, right?

Not quite. This is a very interesting case, because Gupta is not accused of having directly profited from the tips.  He's accused merely of having used them to build his relationship with Rajaratnam.

Why is this interesting?

Well, for starters, because insider trading cases usually require proving that the insider who delivered the information did so for some gain.  That gain doesn't have to be immediate, or in cash, but it does have to be something that you can point to and say "That's what he got out of it".

"Rajaratnam's goodwill" is slightly more nebulous than I believe usually goes to trial.  And that's not just because you have to spend hours in court arguing about whether this is actually valuable.  It's also because without a gain, there's less in the way of a paper trail. ...

I'm no lawyer, but I suspect that this case will ultimately prove a stiff uphill slog.  Nebulous securities cases don't seem to do well in front of juries; either the jury gets mad at the prosecutor for boring them, or they err on the side of the defendant because the whole thing was too hard to understand.  (This is what a securities litigator told me, anyway.)  Much-lionized "tough on Wall Street" prosecutors like Spitzer and Giuliani tended to lose any case they took to trial.

I am a lawyer. Moreover, I wrote the book on the topic (okay, a book on the topic) in Securities Law: Insider Trading. And I don't think this aspect of the case against Gupta will prove much of a problem for the government.

To be sure, McArdle's not the only observer who thinks that this aspect of the Gupta case is problematic. University of Chicago law professor Randal Picker has written that:

According to Wayne State University Law School professor Peter J. Henning in a recent New York Times article, there are complications to each aspect of this case. ...

Proving Gupta received a personal benefit from his alleged tips to Rajaratnam is likely the hardest aspect of the case for the Department of Justice. In Dirks vs. SEC, the Supreme Court said that to prove insider trading by a tipper, “the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.” The indictment itself is surprisingly muted on this aspect, merely stating that Gupta “provided the inside information to Rajaratnam because of Gupta’s friendship and business relationships with Rajaratnam. Gupta benefitted and hoped to benefit from his friendship and business relationships with Rajaratnam in various ways, some of which were financial”. Gupta’s lawyer, in contrast, stated that during the time in question his client lost his entire investment in the Galleon Fund. It will be interesting to see what evidence prosecutors have to demonstrate how exactly Gupta benefitted (especially since the financial relationships between Gupta and Rajaratnam cited in the indictment occurred mostly from 2003 through 2006, well before 2008). 

But did he write the book on the topic? Nope. I did. And I've got another one in the works. So trust me. The personal benefit part of the case is not going to be a problem.

In the first place, it's important to understand that Gupta is not charged with insider trading as such. Instead, he is charged with the related offense of tipping information to an outsider who then used it to trade.

The framework for tipping liability was established by the US Supreme Court in a case called Dirks v. SEC, 463 U.S. 646 (1983). As I explain in Securities Law: Insider Trading:

Raymond Dirks was a securities analyst who uncovered the massive Equity Funding of America fraud. Dirks first began investigating Equity Funding after receiving allegations from Ronald Secrist, a former officer of Equity Funding, that the corporation was engaged in widespread fraudulent corporate practices. Dirks passed the results of his investigation to the SEC and the Wall Street Journal, but also discussed his findings with various clients. A number of those clients sold their holdings of Equity Funding securities before any public disclosure of the fraud, thereby avoiding substantial losses. After the fraud was made public and Equity Funding went into receivership, the SEC began an investigation of Dirk's role in exposing the fraud. One might think Dirks deserved a medal (one suspects Mr. Dirks definitely felt that way), but one would be wrong. The SEC censured Dirks for violating the federal insider trading prohibition by repeating the allegations of fraud to his clients.

Dirks appealed all the way to the Supreme Court.

... the court held that a tippee's liability is derivative of that of the tipper, "arising from [the tippee's] role as a participant after the fact in the insider's breach of a fiduciary duty." A tippee therefore can be held liable only when the tipper breached a fiduciary duty by disclosing information to the tippee, and the tippee knows or has reason to know of the breach of duty.

On the Dirks facts, this formulation precluded imposition of liability. To be sure, Secrist was an employee and, hence, a fiduciary of Equity Funding. But the mere fact that an insider tips nonpublic information is not enough under Dirks. What Dirks effectively proscribes is not merely a breach of confidentiality by the insider, but rather the breach of a fiduciary duty of loyalty to refrain from profiting on information entrusted to the tipper. Looking at objective criteria, courts must determine whether the insider-tipper personally benefited, directly or indirectly, from his disclosure. Secrist tipped off Dirks in order to bring Equity Funding's misconduct to light, not for any personal gain. Absent the requisite personal benefit, liability could not be imposed.

...  Note that, at least in theory, it is possible for a tipper to be liable even if the tippee is not liable. The breach of duty is enough to render the tipper liable, but the tippee must know of the breach in order to be held liable.

Gupta is the tipper. He therefore can be held liable if the government shows that he (a) disclosed material nonpublic information to Rajaratnam (b) in return for a personal benefit (c) expecting Rajaratnam to trade. The question raised by mcArdle goes to the second prong; namely, whether Gupta's making tips "to build his relationship with Rajaratnam" rises to the requisite personal benefit. I think the answer to that question is easy and affirmative.

Dirks itself held that the tipper can be held liable when he "“receive[s] a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.” 463 US at 663. The court further explained that "The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient." Id. at 664. As the Second Circuit later explained, by this formulation "the Supreme Court has made plain that to prove a § 10(b) violation, the SEC need not show that the tipper expected or received a specific or tangible benefit in exchange for the tip." SEC v. Warde, 151 F.3d 42, 48 (2d Cir. 1998). In that case, the court held that "The close friendship between [tipper] Downe and [tippee] Warde suggests that Downe's tip was 'inten[ded] to benefit' Warde, and therefore allows a jury finding that Downe's tip breached a duty under § 10(b)." Id. at 49. If a "close friendship" is not too nebulous, getting on the good side of a major player in the hedge fund industry is a very easy case.

The Gupta case thus can be instructively contrasted with SEC v. Maxwell, 341 F. Supp. 2d 941 (S.D. Ohio 2004), which rejected tipper liability on grounds that the alleged tipper was unlikely to receive any future pecuniary or reputational benefit from giving tips to his barber. Rajaratnam was no barber!

I therefore readily endorse the analysis of the issue offered up by Thomson Reuters Accelus' Staff:

In S.E.C. v. Sekhri, the court both distinguished and refined the concept of personal benefit as an element of insider trading:

The first part of Sehgal's argument fails because it is based on an overly narrow interpretation of the rule stated in Dirks. While Sehgal is correct in arguing that the evidence must show that Sekhri sought some personal benefit from disclosing the nonpublic information to Sehgal in order to have breached his fiduciary duty, he ignores the remainder of the Court's statement.… While noting that the insider must seek to benefit from disclosing inside information, the Supreme Court noted that “[t]here are objective facts and circumstances that often justify [the] inference” that the insider benefitted from the disclosure…. For example, “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.” …. (emphasis added (by Court)). Thus, when Sekhri disclosed insider information to his father-in-law, Sehgal, it may be inferred that Sekhri received some personal benefit from the gift of information. Likewise, the burden of proof shifts from the SEC to Sehgal, and Sehgal must prove that his son-in-law derived no benefit from the disclosure in order to negate the inference that Sekhri benefitted from the transaction.

In the case of Gupta and Rajaratnam, the two men, in addition to years-long friendship, had a number of investments together.

The SEC therefore will get precisely the same inference and resulting shift in the burden of proof in the Gupta case that it got in Sekhri. That's particularly significant, because it means the jury instructions likely will spell out rather precisely the path for the jury to find the requisite personal benefit.

In sum, aspects of the Gupta case may pose proof problems for the government, but the personal benefit requirement is unlikely to be the source of those problems.