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Insider Trading Under Sarbanes-Oxley § 807 and 18 USC § 1348

In my article, Regulating Insider Trading in the Post-Fiduciary Duty Era: Equal Access or Property Rights, in Research Handbook on Insider Trading 80 (Edward Elgar Publishing; Stephen M. Bainbridge ed. 2013), I argued that:

In Chiarella and Dirks, the Supreme Court based insider trading liability on a breach of a disclosure obligations arising out of a fiduciary relationship. The resulting narrowing of the scope of insider trading liability met substantial resistance from the Securities and Exchange Commission (SEC) and the lower courts. Through both regulatory actions and judicial opinions, the SEC and the courts gradually chipped away at the fiduciary duty rationale. In recent years, the trend has accelerated, with several developments having substantially eviscerated the fiduciary duty requirement.

The current unsettled state of insider trading jurisprudence necessitates rethinking the foundational premises of that jurisprudence from first principles. This essay argues that the correct rationale for regulation insider trading is protecting property rights in information. Although that rationale obviously has little to do with the traditional concerns of securities regulation, this article further argues that the SEC has a sufficiently substantial advantage in detecting and prosecuting insider trading that it should retain jurisdiction over the offense.

In the course of that article, I discussed insider trading Under Sarbanes-Oxley § 807 and 18 USC § 1348:

Section 807 of the Sarbanes-Oxley Act added a new § 1348 to the US Criminal Code, which provides that:

Whoever knowingly executes, or attempts to execute, a scheme or artifice—

(1) to defraud any person in connection with any security of an issuer with a class of securities registered under section 12 of the Securities Exchange Act of 1934 or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934; or

(2) to obtain, by means of false or fraudulent pretenses, representations, or promises, any money or property in connection with the purchase or sale of any security of an issuer with a class of securities registered under section 12 of the Securities Exchange Act of 1934  or that is required to file reports under section 15(d) of the Securities Exchange Act of 1934

shall be fined under this title, or imprisoned not more than 25 years, or both.[1]

Neither the text nor its sparse legislative history shed much light on what Congress intended it to do. About all one can say for sure is that Congress intended to significantly increase the penalties in securities fraud cases and to make it easier for prosecutors to prove such cases by eliminating the so-called “technical elements” of existing provisions such as § 10(b) and Rule 10b-5.[2] Is Powell’s fiduciary duty requirement such a technical element?

In US v. Mahaffy,[3] defendant stockbrokers tipped nonpublic information to defendant day traders in return for cash. The case could and should have been prosecuted under the misappropriation theory.  In Mahaffy, however, the prosecutors charged the defendants with violating § 1348. In upholding the charge as a proper one, the district court did not require the prosecution to prove that the tippers had breached a duty of confidence arising out of a fiduciary relationship owed either to the source of the relationship or to the persons with whom the tippees traded. Indeed, of the Supreme Court trilogy, the district court mentioned only O’Hagan and only in passing.[4]

“The Mahaffy decision [thus] reflects the first step of a potential sea change in the elements required of the government to prove a criminal insider trading violation.”[5] It casts aside, albeit sub silentio, the need for the prosecution to show a breach of a duty to disclose arising out of a fiduciary relationship or similar relationship of trust and confidence. Instead, by analogizing “§ 1348 to an honest services fraud case,” Mahaffy “requires only a material misrepresentation, not a violation of confidence.”[6] Although the SEC will be unable to avail itself of § 1348 potentially significant gutting of the fiduciary duty requirement, since the SEC lacks power to bring criminal cases, § 1348 thus must nevertheless be counted as having knocked one more brick out of the wall.

Now Karen Woody has posted an article length treatment of Section 807:

Since Sarbanes-Oxley, there has been a sleepy provision of the criminal code that could present an end-around to the morass of insider trading precedents under Rule 10b-5. Under 18 U.S.C. §1348, the government can bring an insider trading case under the more general umbrella of securities fraud, which has scant jurisprudential precedent. In other words, the heavily-litigated personal benefit test found in Dirks may not apply to a charge of insider trading under §1348. The elements required to prove a charge under §1348 are similar to other fraud-based offenses such as mail and wire fraud, health care fraud, and bank fraud. Whether §1348 was intended to apply to insider trading in particular is an open question, and a broader question is whether the jurisprudential interpretation for the elements of the crime of insider trading as defined under Rule 10b-5 should be imported into the judicial interpretation of § 1348. In other words, if the conduct that constitutes criminal insider trading under Rule 10b-5 exists only if the elements of the Dirks test are met, then a §1348 charge for criminal insider trading may create an entirely new scheme and definition of the crime. This Article analyzes the potential of this dual paradigm, and argues that, given the uncertainty and shifting parameters of insider trading prohibitions, application of §1348 to insider trading should be afforded the rule of lenity.

Woody, Karen E., The New Insider Trading (October 1, 2019). Arizona State Law Journal, Forthcoming; Washington & Lee Legal Studies Paper No. 2019-22. Available at SSRN: https://ssrn.com/abstract=3474570 or http://dx.doi.org/10.2139/ssrn.3474570

Recommended reading.

Federal Express spanks The NY Times

This is truly wonderful:

Larry Hammermesh's F.G. Pileggi Distinguished Lecture on the last 40 years of Delaware corporate law

From Francis Pileggi's blog:

The law school professor widely regarded as the “dean” of Delaware corporate law told a gathering of the state’s bench and bar in Wilmington Nov. 8 that he was just fortunate to be in the right place at the dawn of the age of hostile takeover litigation.

At the 35th Annual Francis G. Pileggi Distinguished Lecture in Law at the Hotel duPont, Widener University Delaware Law School Professor Emeritus Lawrence A. Hamermesh presented his unique perspective on more than 40 years of legal trends in an interview with fellow Widener professor Paul L. Regan. The law school provided an excellent overview of the event on their website.

The post continues with a summary of the lecture.

Do a handful of corporate governance failures tell us whether the Chairman of the Board and the CEO jobs should be held by two people rather than one?

Joseph Mandato and William Devine:

Do recent events at Boeing and WeWork mean that American corporations can no longer afford to give the CEO job and the board chairman job to the same person?

To recap: during Dennis Muilenburg’s just-concluded tenure as both CEO and chairman of Boeing, Co., the nation’s 28^th largest corporation attempted to contain costs and speed regulatory approval by outfitting its flagship airliner with a flawed flight control system. It then failed to tell pilots and the FAA about the flaws, despite apparently knowing about them.

These choices resulted in two plane crashes, the grounding of almost 500 planes worldwide, company losses that will exceed $7 billion, and the loss of 346 lives. Apparently seeing a connection between these results and the decision to let one man try to perform two jobs, the board removed Muilenburg as board chairman.

Meanwhile, during the last three and a half years of Adam Neumann’s just-concluded tenure as both CEO and chairman of WeWork, the office subleasing start-up’s financial reports regularly showed it spending two dollars for every dollar earned. The corporation’s commitment to this burn rate during those years resulted in operating losses that exceed $4 billion. ...

It's a topic we have frequently addressed here at PB.com:

Remove the CEO/Chairman of the Board Provision of the Dodd Bill

Section 973 of the Dodd Wall Street reform bill mandates new disclosures from all firms -- Main Street as well as Wall Street -- explaining "the reasons why the issuer has chosen— (1) the same person to serve as chairman of the board of ...

Continue reading "Remove the CEO/Chairman of the Board Provision of the Dodd Bill" »

Posted at 03:49 PM in Corporate Law, Wall Street Reform | Permalink | Comments (0)

Disney may split CEO and Chairman posts

The NYT is reporting that Disney's board is reconsidering its refusal to split the CEO and Chairman of the Board positions, both of which are currently held by Michael Eisner. I pulled up Eisner's employment contract and confirmed my rec...

Posted at 04:00 PM in Business | Permalink | Comments (0)

Jamie Dimon Crushes Challenge from Politicized Shareholder Activists

JP Morgan shareholders decisively rejected an effort by a highly politicized group ofshareholder activists to divest CEO/Chairman of the Board Jamie Dimon of the latter title: Jamie Dimon won more investor support this year than in 2...

Posted at 07:59 PM in Business, Shareholder Activism | Permalink | Comments (0)

Section 973 of the Dodd Wall Street reform bill mandates new disclosures from all firms -- Main Street as well as Wall Street -- explaining "the reasons why the issuer has chosen— (1) the same person to serve as chairman of the board of ...

The NYT is reporting that Disney's board is reconsidering its refusal to split the CEO and Chairman of the Board positions, both of which are currently held by Michael Eisner. I pulled up Eisner's employment contract and confirmed my rec...

JP Morgan shareholders decisively rejected an effort by a highly politicized group ofshareholder activists to divest CEO/Chairman of the Board Jamie Dimon of the latter title: Jamie Dimon won more investor support this year than in 2...

Remove the CEO/Chairman of the Board Provision of the Dodd Bill

Section 973 of the Dodd Wall Street reform bill mandates new disclosures from all firms -- Main Street as well as Wall Street -- explaining "the reasons why the issuer has chosen— (1) the same person to serve as chairman of the board of ...

Disney may split CEO and Chairman posts

The NYT is reporting that Disney's board is reconsidering its refusal to split the CEO and Chairman of the Board positions, both of which are currently held by Michael Eisner. I pulled up Eisner's employment contract and confirmed my rec...

JP Morgan shareholders decisively rejected an effort by a highly politicized group ofshareholder activists to divest CEO/Chairman of the Board Jamie Dimon of the latter title: Jamie Dimon won more investor support this year than in 2...

Keith Paul Bishop spotted a problem with the shareholder derivative suit against weWork's board

He reports:

WeWork is a Delaware corporation, but the lawsuit was filed in the California Superior Court.  California Corporations Code Section 800 provides that no action may be instituted or maintained in the right of a domestic or foreign corporation unless specified conditions are met.  One of these conditions is:

"The plaintiff alleges in the complaint with particularity plaintiff’s efforts to secure from the board such action as plaintiff desires, or the reasons for not making such effort, and alleges further that plaintiff has either informed the corporation or the board in writing of the ultimate facts of each cause of action against each defendant or delivered to the corporation or the board a true copy of the complaint which plaintiff proposes to file."

Superficially, this appears to be a standard "demand futility" pleading requirement.  The California statute, however, adds an additional requirement that must be met before a derivative action is filed.  In Re v. Weksel, 130 A.D.2d 640 (1987), the Appellate Division of the New York Supreme Court applied the same language in former Section 15702(a)(2) (governing derivative suits by domestic or foreign limited partnerships) to dismiss a plaintiffs' suit:

Although the complaint alleges why the plaintiffs believe that a demand upon the general partner would be futile, it does not state that the limited partnership or the general partner were informed in writing concerning the ultimate facts of each action or that a true copy of the complaint was delivered to either the limited partnership or the general partner, as California law requires (see, Cal Corp Code § 15702 [a] [2]).  Therefore, the plaintiffs' first cause of action must be dismissed as against the appellants.

Kevin LaCroix has a lengthy and detailed analysis of the lawsuit here.

While there is a lot going on here, and while the events that occurred after the company withdrew its IPO initiative, at one level this lawsuit is a failure to launch claim. Among the claimant’s grievances is the company’s failure to complete the IPO. This aspect of the case is a reminder that a lot can happen to companies on an IPO track, and if a would-be IPO company hits an obstacle and fails to complete the hoped-for offering, the company can get hit was a failure to launch lawsuit. This is important to remember because in that situation, the D&O insurance policy that will respond to the claim (and indeed the D&O insurance policy that will be responding to WeWork’s new lawsuit) is a private company D&O insurance policy. The possibility of these kinds of lawsuits is important to take into account when the pre-IPO company’s insurance coverage is being structured. Among other things, the policy’s Securities Claim exclusion must be worded in a way that it does not preclude coverage for these kinds of claims.

Ann Lipton on WeWork, securities regulation, and capital allocation

Recommended reading.

Don't cry for ISS and Glass-Lewis

The Economist reports:

Proxy advisory services used to be an obscure feature of corporate America. No longer. These geeky outfits, which review mountains of proposals put forward by shareholders on topics ranging from mergers and executive pay to climate change and diversity, then issue recommendations, can sway how their clients vote. ...

Two of them dominate the business. Institutional Shareholder Services (ISS), owned by Genstar, an American private-equity firm, provides proxy recommendations on over 40,000 shareholder meetings in more than 100 countries each year. Glass Lewis informs some 20,000 votes in 100 countries. It is owned by two Canadian asset managers. Between them, ISS and Glass Lewis control 97% of America’s proxy-advice market. ...

In August America’s Securities and Exchange Commission (sec) ruled that voting recommendations made by the advisers amounted to “solicitations” under proxy rules, a higher regulatory standard than the firms faced before. They would, for instance, have to prove compliance with anti-fraud provisions. iss filed a lawsuit in response. On November 5th the sec proposed more rule changes, “to improve the accuracy and transparency of proxy voting advice”. Among other things, these would raise the minimum share of votes required for shareholder proposals to succeed and let target firms review proxy recommendations twice before investors see them. ...

Joseph Grundfest of Stanford Law School sees nothing wrong with giving firms the chance to challenge the factual basis of recommendations: “As long as iss is accurate in everything it does, it has no additional legal liability.”

Nonsense, say critics of the new provisions, who liken them to slapping a tax on advice critical of management. Charles Elson of the University of Delaware argues the sec proposal is “a punitive solution looking for a problem”.

As longtime readers know, I respect and admire both Joe and Charles but on this occasion I definitely come down with Joe. 

ISS was founded in 1985 to provide proxy advisory services to institutional investors.[1] The premise was that institutions could outsource to ISS the tasks of monitoring corporate governance at portfolio firms and making decisions about how to vote their shares.

ISS got a major boost in 1988 when the Department of Labor announced that ERISA pension plan fiduciaries had a fiduciary duty to make informed decisions about how they voted shares of portfolio companies. In response, pension plans began to rely on ISS for analysis of issues upon which a shareholder vote would be required and advice as to the best voting decision. A similar 2003 SEC ruling that mutual funds and other investment company advisors must adopt policies designed to ensure that shares of portfolio companies are voted in the best interests of their clients added a whole new class of institutions that outsourced their proxy decision making to ISS.

Today, ISS services some 1700 institutional investor clients, which collectively manage some $25 trillion in equity securities. The goal of reducing the expenses of activism through economies of scale thus seems well within reach.

ISS has proven highly successful at influencing shareholder voting. By some estimates, an ISS recommendation can effect a swing of 15 to 20% in a proxy vote.[2] Although competitors have entered the market for proxy advisory services, ISS remains the most powerful player in that market. Only one other advisory service, Glass, Lewis & Co., has a measurable effect on the outcome of shareholder votes and its impact remains minor compared to that of ISS.[3]

Despite its success (or, perhaps, because of it), ISS has been controversial. Some critics argue that ISS is too rigid and mechanical in its advice. Martin Lipton complains, for example, that ISS routinely recommends against reelection of a board’s nominating committee if those members allow the firm’s CEO to provide recommendations or advice:

It would be a totally dysfunctional process if input and advice from the CEO were prohibited until after the committee meets and makes its decisions. There is nothing in the NYSE rule or “best practices” that warrants restricting the CEO from voicing advice or opinion until after the committee has acted. [4]

A related example of excessive rigidity on these issues came in 2004, when ISS urged its clients to oppose reelecting Warren Buffett as a director of Coca-Cola because Buffett did not satisfy ISS’ strict definition of director independence. Shortly thereafter, CalPERS announced that it would oppose Buffett’s reelection on the same grounds. Critics of the ISS and CalPERS positions pointed out that Warren Buffett is probably the most respected investor of all time, with a long record of integrity. At the time in question, Buffet’s Berkshire Hathaway Company owned almost 10% of Coke’s stock, which meant that his personal financial interests were closely aligned with those of other shareholders (albeit not perfectly). Buffett qualified as an independent director under the NYSE’s listing standards. As I argued at the time, if “Buffett doesn’t qualify as independent under the ISS and CalPERS standards, the problem is with the standards not Mr. Buffett.”[5]

Critics link this sort of check the box mentality back to the very reason for outfits like ISS to exist; namely, the cost associated with making informed voting decisions about numerous issues posed on the proxy statements of the thousands of publicly traded companies. The globalization of institutional investor holdings has compounded the problem by forcing ISS to stretch its resources to include many foreign issuers. In 2009, for example, ISS had to prepare voting recommendations with respect to more than 37,000 issuers around the world. The constantly growing number of voting recommendations that must be made, most of which are concentrated into the three to four month annual meeting season, reportedly forces even ISS to automate decision making to the fullest possible extent and, accordingly, to rely one one-size-fits-all standards instead of giving careful consideration to the specific needs and circumstances of each individual firm.

Finally, there is the question of accountability. Ironically, until the SEC finally acted, market forces are the only thing holding ISS accountable; i.e., the same forces most shareholder power proponents claim do not work when it comes to holding management accountable.

Taken together, these concerns raise serious issues as to whether shareholder activism is an appropriate solution to the principal-agent problems of corporate governance. The view that institutional investor activists will carefully scrutinize portfolio companies to reach informed voting decisions is exposed as a fiction. Instead, shareholder activism depends on the whims of a single proxy advisor who offers limited transparency and is largely unaccountable, essentially unregulated, and poorly informed.[6]

"Artificial Intelligence, Finance, and the Law"

I think Tom Lin is doing a lot of interesting work on the intersection of technology, corporate finance, and securities regulation. His latest article is a case in point:

Artificial intelligence is an existential component of modern finance. The progress and promise realized and presented by artificial intelligence in finance has been thus far remarkable. It has made finance cheaper, faster, larger, more accessible, more profitable, and more efficient in many ways. Yet for all the significant progress and promise made possible by financial artificial intelligence, it also presents serious risks and limitations.

This Article offers a study of those risks and limitations—the ways artificial intelligence and misunderstandings of it can harm and hinder law, finance, and society. It provides a broad examination of inherent and structural risks and limitations present in financial artificial intelligence, explains the implications posed by such dangers, and offers some recommendations for the road ahead. Specifically, it highlights the perils and pitfalls of artificial codes, data bias, virtual threats, and systemic risks relating to financial artificial intelligence. It also raises larger issues about the implications of financial artificial intelligence on financial cybersecurity, competition, and society in the near future. Ultimately, this Article aspires to share an insightful perspective for thinking anew about the wide-ranging effects at the intersection of artificial intelligence, finance, and the law with the hopes of creating better financial artificial intelligence—one that is less artificial, more intelligent, and ultimately more humane, and more human.

Lin, Tom C. W., Artificial Intelligence, Finance, and the Law (November 4, 2019). 88 Fordham Law Review 531 (2019); Temple University Legal Studies Research Paper No. 2019-31. Available at SSRN: https://ssrn.com/abstract=3480607

California Board of Directors Gender Quota Law has Negative Effect on Stock Price of Covered Companies

Keith Paul Bishop:

Three researchers (two at Clemson and one the University of Arizona) recently announcedthe results of their study of the impact of California's board gender quota law (SB 826) on publicly traded [sic] firms headquartered in California.  They found that these companies experienced "a large negative stock market reaction" when the law was signed last year by then Governor Jerry Brown.  See Acknowledging Potentially "Fatal" Flaws, Governor Signs Board Gender Quota Bill.

The researchers also examined the costs of the law, finding bad news for smaller firms:

"The costs of board expansion are negligible for the largest firms but substantial for the smallest".  

They also observe that small firms may have a more difficult time attracting female directors. The Wall Street Journal was quick to note the study, labeling it in an editorial published on Saturday a "board diversity tax".

Yours truly cited again in a post-Kokesh opinion

Securities and Exch. Commn. v. Team Resources Inc., 2019 WL 5704525, at *4 n.4 (5th Cir. Nov. 5, 2019):

True, during the Kokesh oral argument some members of the Supreme Court questioned the source of courts’ authority to order disgorgement in civil enforcement proceedings. See, e.g., Oral Argument at 5:00, Kokesh v. S.E.C., ––– U.S. ––––, 137 S. Ct. 1635, 198 L.Ed.2d 86 (2017) (No. 16-529), https://www.supremecourt.gov/oral_arguments/audio/2016/16-529. And one scholar has argued that Kokesh “cast considerable doubt on the validity of the seemingly well-established disgorgement sanction.” Stephen M. Bainbridge, Kokesh Footnote Three Notwithstanding: The Future of the Disgorgement Penalty in SEC Cases, 56 Wash. U. J.L. & Pol’y 17 (2018). But neither oral argument questions nor academic literature constitutes an intervening change in the law that would liberate this panel from its obligation to follow circuit precedent.

Among Elizabeth Warren's many dubious policy proposals perhaps the most absurd is her revival of the concession theory of the corporation

Splendid analysis by Abdurrahman Kayıklık

Keith Paul Bishop on how the SEC's proposed Rule 14a-8 amendments interact with California corporate law

State Law And Shareholder Representatives

Did The SEC Misstate State Law In Proposing Changes To Shareholder Proposal Rule?

New SEC Guidance on the Ordinary Business Exception to the Shareholder Proposal Rule (Exchange Act Rule 18a-8(i)(7))

Shareholder Proposals: Staff Legal Bulletin No. 14K (CF):

Rule 14a-8(i)(7), the “ordinary business” exception, permits a company to exclude a proposal that “deals with a matter relating to the company’s ordinary business operations.” The purpose of the exception is “to confine the resolution of ordinary business problems to management and the board of directors, since it is impracticable for shareholders to decide how to solve such problems at an annual shareholders meeting.”[1] The Commission has stated that the policy underlying the “ordinary business” exception rests on two central considerations.[2] The first relates to the proposal’s subject matter; the second relates to the degree to which the proposal “micromanages” the company.

Under the first consideration, ... we believe the focus of an argument for exclusion under Rule 14a-8(i)(7) should be on whether the proposal deals with a matter relating to that company’s ordinary business operations or raises a policy issue that transcends that company’s ordinary business operations.

...

Under the Commission’s second consideration, a proposal may be excludable under the “ordinary business” exception if it “micromanages” the company. This prong of the Rule 14a-8(i)(7) analysis rests on an evaluation of the manner in which a proposal seeks to address the subject matter raised, rather than the subject matter itself. ...

In considering arguments for exclusion based on micromanagement, and consistent with the Commission’s views,[9] we look to whether the proposal seeks intricate detail or imposes a specific strategy, method, action, outcome or timeline for addressing an issue, thereby supplanting the judgment of management and the board. Thus, a proposal framed as a request that the company consider, discuss the feasibility of, or evaluate the potential for a particular issue generally would not be viewed as micromanaging matters of a complex nature. However, a proposal, regardless of its precatory nature, that prescribes specific timeframes or methods for implementing complex policies, consistent with the Commission’s guidance,[10] may run afoul of micromanagement.

All of which, of course, is idiotic. The SEC's "considerations" are vague to the point of being non-administrable. They provide no useful guidance to either directors or proponents. The considerations are detached from the state law rights and powers of corporate boards and shareholders.

In my article, Revitalizing SEC Rule 14a-8's Ordinary Business Exemption: Preventing Shareholder Micromanagement by Proposal, I put forward a test that is grounded in relevant state corporate law principles, while also being easier to administer than the existing judicial tests. Under it, courts first look to the state law definition of ordinary business matters. The court then determines whether the matter is one of substance rather than procedure. Only proposals passing muster under both standards should be deemed proper.

SCOTUS Grants Cert in Liu v. SEC: Disgorgement Back on the Menu

Bloomberg:

The U.S. Supreme Court agreed to consider whether the SEC can still pursue disgorgement as an equitable remedy after a 2017 ruling designating it a penalty for statute of limitations purposes.

The duo behind a regional immigrant investor center asked the Supreme Court to take up their case after a lower court ordered them to pay the Securities and Exchange Commission disgorgement of around $26.7 million. The court granted their petition Nov. 1 after relisting the case once.

Bainbridge:

Disgorgement of ill-gotten gains long has been a basic tool in the Securities and Exchange Commission’s (SEC) penalty toolkit, despite a paucity of statutory authorization. Because disgorgement lacked a statutory framework, courts have had to flesh out the sanction via interstitial rulemaking. In Kokesh v. SEC, the US Supreme Court took up the seemingly technical—but surprisingly important—question of what statute of limitations applies to SEC disgorgement actions. More important, at least for present purposes, the Court’s opinion cast into doubt the validity of the seemingly well-established disgorgement sanction.

Earlier cases based the SEC’s authority to seek and the courts’ power to impose disgorgement on the claim that it is a form of equitable ancillary relief. If disgorgement is a penalty, however, courts lack that power and the SEC lacks that authority. This conclusion follows necessarily from the basic premise that there are no penalties in equity and the complete absence of any statutory authority to impose disgorgement as a legal sanction. Now that the Supreme Court has made clear that disgorgement is, in fact, a penalty, the future of the disgorgement penalty looks bleak.