Business Judgment Rule Problems
The Dodd-Frank Act requires public companies to hold an advisory shareholder vote on executive compensation every two years. Cincinnati Bell paid three of its top officers packages worth a few million dollars each at the same time that the companies share price and earnings dropped. (CEO $8.5 million – 71.7% increase in pay; CFO -- over $2 million – 80.3% increase in pay; Vice President $1.5 million – 54.3% increase in pay) 66% of the shareholders voted against the executive compensation packages. Should shareholders be able to sue on behalf of the corporation that the Board of Directors breached their fiduciary duties?
Under Ohio law, directors will face liability only if it is shown by clear and convincing evidence that their actions were undertaken with “a deliberate intent to cause injury to the corporation” or “reckless disregard for the best interests of the corporation.” Ohio Rev. Code Ann. Sect. 1701.59(D) (2011)
(NECA-IBEW Pension Fund v. Phillip R. Cox, et. al.)
Insider Trading
"Insider trading" is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders—officers, directors, and employees—buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. For more information about this type of insider trading and the reports insiders must file, please read "Forms 3, 4, 5" in our Fast Answers databank.
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.
Examples of insider trading cases that have been brought by the SEC are cases against:
• Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments;
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• Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information;
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• Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
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• Government employees who learned of such information because of their employment by the government; and
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• Other persons who misappropriated, and took advantage of, confidential information from their employers.
Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.
The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.
Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.
http://www.sec.gov/answers/insider.htm
September 22, 2011
NYTIMES Magazine
The War on Insider Trading: Market-Beaters Beware
By ROGER LOWENSTEIN
How much time should Raj Rajaratnam spend in prison? Rajaratnam is the hedge fund founder who was convicted in May of trading on illegal stock tips — tips that produced fantastic results for his Galleon Group. Federal authorities compare him with notorious white-collar crooks like Bernie Madoff and Jeffrey Skilling, and they argue for a long time behind bars. His lawyers, however, say Rajaratnam is a lesser-order felon — “not . . . as culpable as a defendant who affirmatively steals,” as they put it in a pre-sentencing memorandum. The lawyers raise a problem of culture and law: Is insider trading merely an illicit version of a common American cleverness, trading on gossip from a colleague or friend that helps the trader and hurts no one? Or is it the quintessential Wall Street crime, one that has undermined Americans’ faith in the markets?
Richard J. Holwell, a Manhattan federal judge, will give his answer to that question when he sentences Rajaratnam on Sept. 27. A lengthy sentence would go a long way toward validating not just the federal prosecutors who brought the case but also the Securities and Exchange Commission, which first investigated the hedge fund. Before and since the Rajaratnam trial, the S.E.C. has brought numerous cases, part of a campaign to root out insider trading and, in theory, make markets fairer for the average investor. In recent weeks alone, the S.E.C. filed complaints against traders who ran the gamut from celebrity to ordinary. It settled charges with Doug DeCinces, a former Baltimore Orioles third baseman who bought stock in Advanced Medical Optics after learning from a tipster that the company was about to be taken over; it reached an agreement with Hugh Hefner’s son-in-law, who blatantly ignored written warnings against trading in the stock of Playboy, where his wife was the chief executive; and it settled with a Denver businessman, who tipped his son, an investor, about a pending acquisition.
No one knows how much cheating of this kind occurs, but regulators have developed good tools for spotting it. Every time there is market-moving news, like a merger or an earnings report, computers at Finra, a regulatory body, scan millions of buy and sell orders, looking for suspicious trades, like a big stock purchase in advance of a takeover. Finra refers some 250 trades a year to the S.E.C. for a closer look. Getting a stock-market tip has always been a sort of all-American fantasy, and despite the risk of detection, the desire for an edge seems irresistible. “People are greedy,” says Robert Khuzami, the S.E.C.’s director of enforcement. “They think they won’t get caught.” Even those who should know better: Donald L. Johnson, an official at Nasdaq, was entrusted with confidential information from listed companies, and he used his privileged knowledge to trade in advance of news of drug trials and other results. Johnson dimly supposed that by trading in an account listed in his wife’s name, his behavior would go undetected. He was sentenced to three and a half years.
Not all cases are so black and white. The law on insider trading, which has developed over the years from judicial rulings and is not specifically found in a statute, is ambiguous enough to allow for a range of interpretations. And at a time when the government is accused of going easy on white-collar crime, Khuzami has pursued an aggressive approach, pushing the boundary of what is deemed illegal. Strengthening the S.E.C.’s long-running effort, Khuzami has focused, particularly, on the hedge fund industry, which for reasons related to its competitiveness, capital and connections, he sees as especially prone to insider trading. Wall Street has taken notice. For one thing, the Rajaratnam case, which was prosecuted by the United States attorney for the Southern District of New York, led to dozens of criminal convictions. Perhaps more important, the bread-and-butter civil actions brought by the S.E.C. is putting pressure on traders to refrain from using information that is even borderline illegal.
The dollar amounts involved in such cases tend to be small, which has led critics to question whether the S.E.C. shouldn’t be spending more of its resources on larger offenses like mortgage fraud. But in truth, insider trading is just the sort of activity the S.E.C. was created to combat. Not so very long ago, the public had a sense that the agency was watching out for small investors and keeping markets safe. Then in 2008 came a pair of cataclysmic failures: virtually the entire investment-banking industry, which the S.E.C. regulated, either failed or sought a bailout; then, having ignored explicit warnings about Madoff, the agency was further humiliated by the revelation that he’d been running a Ponzi scheme.
Some have criticized the emphasis on insider trading cases as a kind of quick fix to the S.E.C.’s battered image. “Nonsense,” says Khuzami, who joined the agency two months after the Madoff fiasco. But image actually is important; it’s part of providing an effective deterrent. To an unusual degree, respect for insider trading laws depends on the visibility of enforcement. In a survey of 2,500 traders taken in 2007, more than half said they would take advantage of an illegal tip if they were assured they wouldn’t be caught. Without S.E.C. enforcement, Wall Street would degenerate into a cesspool of conspiratorial tipping — as it was before the agency existed. If you think that doesn’t matter, ask yourself if you’d be comfortable investing in, say, Oracle, if Larry Ellison, its lavishly compensated C.E.O., were free to buy and sell the stock, and to clue in his friends, every time Oracle’s sales took an unexpected but not yet public twist. By bringing cases and challenging hedge funds, the S.E.C. aims, at very least, to remind investors that insider trading isn’t simply financial naughtiness — it’s a crime.
Over the past several months, I met with Khuzami and others at the S.E.C. and pored over some of the more controversial cases on the agency’s docket. There is no question that the agency is pushing the boundaries, and the definition of insider trading was blurry to begin with. Linda Thomsen, Khuzami’s predecessor, once remarked approvingly that “the genius of insider trading law . . . is its flexibility.” Though lawmakers have proposed legislation codifying insider trading in the statutes, the S.E.C. seems to prefer a common-law approach, on the theory that it will be a less fixed — thus a more worrisome — deterrent.
The courts have established that it is illegal to trade on “material” information in breach of a duty to keep the information private. The legal ambiguity arises on two fronts. First, the standard for “material”— any news that a trader would consider important — is fuzzy enough to recall Potter Stewart’s famously elusive definition (he would know it when he saw it) of pornography. Rumors and gossip circulate in the stock market every day; not all of it is “material.” Background information on an industry is clearly O.K. And it’s fine to ask the manager of a local Best Buy about the store’s iPod sales (this is called a channel check). Getting advance word on the entire chain’s sales, however, could be a problem. In general, investors are allowed to assemble pieces of information that, viewed collectively, give them a fuller picture of the whole. But if any one of the mosaic pieces is, in itself, too revealing, the S.E.C. looks askance.
Second, the question of who has a duty to keep the material information private is not always clear. In one influential case in the 1980s, Barry Switzer, the University of Oklahoma football coach, was sued for buying stock in a company run by a team booster — a company that was acquired shortly after he invested. At trial, Switzer claimed that he was sunbathing in the stands when he innocently overheard the booster describing the deal. Since the leak was inadvertent, the court ruled that Switzer did not have a duty not to trade.
One of the more contentious current cases also involves a sports mogul, Mark Cuban, the irreverent owner of the Dallas Mavericks basketball team. A few years ago, Cuban was a big shareholder in a Canadian search engine, Mamma.com, which needed to raise cash. The company decided to offer stock to large investors at a discounted price; so in June 2004, according to the S.E.C.’s complaint, the chief executive of Mamma.com called Cuban and asked if he would like to participate. The C.E.O. supposedly prefaced his offer by telling Cuban he was about to impart confidential information. Typically, when such private placements are disclosed, the market price falls — and for that reason, Cuban reacted angrily. At the end of the call, the S.E.C. claims, he snarled: “This means I’m screwed. I can’t sell.” But hours later, he phoned his broker; the next day, he dumped his stake. When the private offering was announced, the stock plunged; Cuban’s early sale saved him $750,000.
Cuban’s behavior was exactly what the insider trading rules should prevent: a mogul profiting from privileged information. But it isn’t clear that the rules do prevent it, at least in this case. The difficult part centers on Cuban’s relationship with the Mamma.com chief executive. According to the S.E.C., at some point during their eight-minute phone call, Cuban acquired a duty not to trade. Cuban has denied that he agreed to keep the information about the offering private; even if he did agree, his lawyers argue, he would still have been free to trade, because he and the C.E.O. were not in a relationship of trust. A district court agreed and dismissed the complaint; on appeal, however, the decision was reversed. The case may now go to trial. Cuban, who has been fined nearly $1.7 million for yelling at basketball officials over the years, has, through his lawyers, cried foul against the S.E.C., which he accuses of “a transparent plan to expand the scope of insider trading liability.” The billionaire is said to be fuming and is considering making a movie about the case when it is done.