#16463 - Insider Trading And Rule 10b 5 - Corporation

A. Rule 10b-5 and Securities Fraud

• Securities transactions are regulated by federal + state securities law

  • Securities Exchange Act of 1934 then SEC made rules accordingly

• Anti-fraud provisions bars deception/ misrep in securities transactions

• 10b-5 is a catch-all rule, governs disclosure in all purchase and sales of securities

• SEC Rule 10b-5: Employment of Manipulative and Deceptive Practices

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

• (a) To employ any device, scheme, or artifice to defraud,

• (b) To make any untrue statement of a material fact [lie] or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

• (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

• S.10(b) of 1934 Securities Exchange Act: Regulation Of The Use Of Manipulative And Deceptive Devices

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange

• (b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities- based swap agreement any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors

Elements of cause of action under Rule 10b-5 (see Part III’s discussion of Rule 14a-9)

1. Implied right of action (Borak, cited in Virginia Bankshares)

   • not stated under Rule 10b-5 and 14a-9

   • private party can sue, but additional condition for causation and reliance

2. Standing to sue (Blue Chip Stamps, cited in Virginia Bankshares)

   • Blue Chip: only actual purchasers and sellers can sue (not those who didn’t trade)

3. Materiality Basic Inc. v Levinson

4. Causation Basic Inc. v Levinson

5. Reliance Basic Inc. v Levinson

6. Scienter (intent/knowledge): P needs to show that D acted with the intent to deceive/ knew that a statement made was false (or that D showed reckless disregard for truth) [mere negligence is clearly not enough]

7. Pleading standard: s.21(D)(b)(1),(2) Exchange Act - How will P obtain the requisite info to meet the pleading standard before discovery

Basic Inc. v Levinson (1988) Supreme Court P.2 [Dec 3]

• Latitude of companies to deny rumors about important new developments which the company is not expressly required to disclose under the reporting provisions of the Securities Exchange Act

• Evidence necessary to establish reliance under Rule 10b-5 (c.f. treatment of reliance under Rule 14a-9 in Virginia Bankshares and Mills)

• Standard of materiality under Rule 10b-5

• Applying

  • (1) Rule 10(b) of the Securities Exchange Act of 1934, and

  • (2) Rule 10b-5 of the Securities and Exchange Commissions, in the context of preliminary corporate merger discussions

• Facts:

  • Board of Basic In. (previously a public co.) engage in merger negotiations with Combustion (acquirer)

  • Board of Basic issued 3 public statements denying that it was engaged in merger negotiations

  • Basic eventually enters into a merger agreement with Combustion, $46/share in Dec 1978

  • Shares of Basic increased (since there is always a premium in mergers, price usually increase afterwards)

  • Former Basic shareholders

    • who sold stock after Basic’s first public statement and before the suspension of trading, at an artificially depressed price, in reliance of D’s misleading statement

    • brought a class action against Basic and its directors, asserting that Ds issued 3 false and misleading public statements, in violation of s.10(b) of 1934 Act and of SEC Rule 10b-5

    • measure of damages – between the price they sold their stocks and what their stock worth now

  • Huge damages and serious consequences - potential jail time

  • Basic lied because

    • there were called by NYSE, which noticed the trading volume suddenly went up (which indicates rumors are floating around) Basic could have said nothing, but most companies would answer NYSE’s questions

    • Basic did not want to create false hope (if the deal didn’t go through, Board would be under pressure to increase share price)

    • Didn’t want to incur another bid + Combustion asked the deal to be kept silent

    • [No personal aim – e.g. insiders can buy shares and personally profit from the opportunity to buy]

• (1) Materiality of the misstatements

  • If misstatements not material no issue

  • Materiality: reasonable investor would consider important in making investment decisions

  • DC held misstatements were immaterial CA reversed: preliminary merger discussions are material once a statement is made denying the existence of any discussions, as it make the statement untrue.

    • ‘Fraud-on-the-market theory’ to create a rebuttable presumption that the shareholders relied on the company’s material misrep

  • Supreme Court Approach:

    • 1934 Act was to protect investors against manipulation of stock prices

    • Adopt the standard of materiality in TSC Industries v Northway (in proxy-solicitation context) for SEA s.10(b) and SEC Rule 10b-5 context:

      • An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote

      • Substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of info made available

    • Since merger negotiations are contingent/ speculative it’s difficult to ascertain whether the reasonable investor would have considered the omitted info significant at the time

  • Court rejected Plaintiff’s Third (and Seventh) Circuits’ Approach: preliminary merger discussions do not become material until price and structure of the transaction has been agreed info concerning any negotiation before this stage could be withheld/ misrep without violation of Rule 10b-5.

    • BUT: none of the rationales explain why draw the line at agreement-in-principle no valid justification for artificially excluding the definition of materially info for merger discussions:

    • (1) [Don’t want too much disclosures to confuse investors] Investor not overwhelmed by excessively detailed and trivial info, focuses on substantial risk that preliminary merger discussion may collapse (disclosure of its existence could mislead investors and foster false optimism Greenfield v Heublein)

      • Court disagrees: assumes investors are unable to appreciate that mergers are risky propositions up until closing Flamm v Eberstadt. Materiality requirement is to filter out useless info that a reasonable investor would into consider significant in making investment decision. [If determined that the info is important, such important info would not overwhelm investors]

    • (2) Secrecy - limit scope of disclosure obligation to preserve confidentiality of merger discussion, and to prevent prejudice

      • Court disagrees: irrelevant to the assessment whether their existence is significant to the trading decision of a reasonable investor

    • (3) Bright-line rule for determining when disclosure must be made

      • Court disagrees: seems to be directed solely at the comfort of the corporate managers – it is easier to follow than a standard that requires judgment of all the circumstances but no excuse for ignoring the purposes of the securities act and Congress’ policy decisions

  • Why should we have a law that forces Basic to disclose info that is harmful to their business

    • Court: not the right question to ask should ask whether Basic is entitled to lie – not forcing Basic to disclose info – Disclosure rule governs what and when Basic have to disclose, not decide by the court but the SEC (Congress)

    • Regardless of what Basic have to disclose Basic cannot lie – should not have make statements to dispel the rumors [silence is fine, but lying is prohibited]

  • Second Circuit’s explanation on the role of the material requirement of Rule 10b-5 for contingent/ speculative info or events

    • Maternity depend at any given time upon a balance of both the indicated probability that the event will occur, and the anticipated magnitude of the event in light of the totality of the company activity (SEC v Taxas Gulf Sulphur Co)

    • Applied by Second Circuit in context of preliminary merger negotiations

    • Whether merger discussion are material depends on the facts – interest in the transaction at the highest corporate level (looking at board resolution, instructions to investment bankers, actual negotiations between principals)

• (2) Reliance is an element of Rule 10b-5 cause of action

  • Reliance is distinct from causation of damages

    • Causation: what is value before and after differences would be damages (expert opinion on the values)

    • Reliance: provides the causal connection between D’s misrep & P’s injury (client to testify its reliance in the misstatements in selling their shares)

    • Since it is difficult to differentiate whether the member actually relied presumption of reliance based on the fraud-on-market presumption

  • ‘Fraud-on-market theory’

    • Price of a co.’s stock in an open securities market is determined by the available material info regarding the company and its business misstatements will defraud purchaser of stock, even...