2.COVERED SECURITIES--rule 10b-5 applies to the purchase or sale of any security, registered or unregistered. a jurisdictional limitation requires that the violation must involve the use of some instrumentality of interstate commerce.

 

3.WHO CAN BRING SUIT UNDER 10B-5--private plaintiffs and the SEC. Private plaintiffs must be either purchasers or sellers of security.

 

4.MATERIALITY--for rule 10b-5 to apply, the information misrepresented or omitted must be material (i.e., a reasonable sh would consider it important in deciding whether to buy or to sell).

 

5.FAULT REQUIRED (SCIENTER)--a defendant is not liable under rule 10b-5 if he was without fault or merely negligent. The scienter requirement is satisfied by recklessness or an intent to deceive, mislead, or convey a false impression. Scienter is also required for injunctive relief.

a)Recklessness Defined:

1)D knew the hazard and proceeded nonetheless (subjective test);

2)D proceeded despite what a reasonable person would perceive (objective test);

b)Recklessness Under PSLRA:

1)Knowing conduct-- yields jointly and severally liable;

2)Non-knowing conduct (e.g., recklessness)--yields fair share (proportionate liability), found in accordance with special interrogatories.

 

6.CAUSATION AND RELIANCE--a plaintiff must prove that violation caused a loss (i.e., he must establish reliance on the wrongful statement or omission). However, in omission cases, there is a rebuttable presumption of reliance once materiality is established.

a)Fraud On The Market--where securities are traded on a well-developed market (rather than in a face-to-face transaction), reliance on a misrepresentation may be shown by alleging reliance on the integrity of the market.

b)Face-to-Face Misrepresentations--a plaintiff can show actual reliance in these cases by showing that the misrepresentation was material, testifying that he relied upon it, and showing that he traded soon after misrepresentation.

 

7.WHEN NONDISCLOSURE CONSTITUTES a VIOLATION

a)Mere Possession of Material Information--generally, nondisclosure of material, nonpublic information violates rule 10b-5 only when there is a duty to disclose independent of rule 10b-5

b)Insider Trading--insiders (dirs, officers, controlling shs and corporate employees) violate rule 10b-5 by trading on the basis of material, nonpublic info obtained through their positions. They have a duty to disclose before trading.

c)Misappropriation--the liability of noninsiders who wrongfully acquire (misappropriate) material nonpublic info has not been ruled upon by the US Supreme Court, although some lower level federal courts have imposed criminal liability.

1)Duty to Employer--using the misappropriation theory, criminal liability under rule 10b-5 has been imposed where an employee trades on info used in violation of the employee's fiduciary duty to his employer. An employee's duty to “abstain or disclose” with respect to his ER does NOT extend to the general public. However, the Insider Trading and Securities Fraud Enforcement Act of 1988 makes any person who violates rule 10b-5 by trading while in possession of material, nonpublic info liable to any person who, contemporaneously to the transaction, purchased or sold securities of the same class. Liability is limited to the defendant's profit or avoided loss.

2)Mail and wire fraud--the application of the federal mail and wire fraud statute to this situation lessens the importance of the misappropriation theory in imposing criminal liability under rule 10b-5.

3)Special rule for tender offers--once substantial steps toward making a tender offer have begun, it is a fraudulent, deceptive, or manipulative act for a person possessing material information about the tender offer to purchase or sell any of the target's stock, if that person knows that the info is nonpublic and has been acquired from the bidder, the target, or someone acting on the bidder's or the target's behalf.

d)”Disclose or Abstain”--nondisclosure by a person with a duty to disclose violates rule 10b-5 only if he trades (Cady rule)

8.LIABILITY OF NONTRADING PERSONS FOR MISREPRESENTATION--a nontrading corp or person who makes a misrepresentation that could cause reasonable investors to rely thereon in the purchase or sale of securities is liable under rule 10b-5, provided the scienter requirement is satisfied.

 

 

9.LIABILITY OF NONTRADING CORPORATION FOR NONDISCLOSURE--the basic principle is “disclose or abstain.” Thus, a nontrading corp is generally not liable under rule 10b-5 for nondisclosure of material facts.

a)Exceptions--a corp has a duty to:

1)Correct misleading statements (even if unintentional);

2)Update statements that have become materially misleading by subsequent events; 3)Correct material errors in statements by others (e.g, analyst's report) about the corp, but only if the corp was involved in the preparation of the statements; and

4)Correct inaccurate rumors resulting from leaks by the corp or its agents.

 

10.TIPPEE AND TIPPER LIABILITY--a person, not an insider, who trades on info received from an insider is a tippee and may be liable under rule 10b-5 if he received info through an insider who breached fiduciary duty in giving the info, AND the tippee knew or should have known of the breach (Dirks)

a)Breach of Insider's Fiduciary Duty--whether an insider's fiduciary duty was breached depends largely on whether the insider communicated the info to realize the gain or advantage. Accordingly, tips to friends or relatives and tips that are a quid pro quo for a past or future benefit from the tippee result in fiduciary breach. Note that if a tippee is liable, so is the tipper.

 

11.”TEMPORARY INSIDERS”--corporate info legitimately revealed to a professional or consultant (e.g., accountant) working for the corp may make this person a fiduciary of corp

 

12.AIDERS AND ABETTORS--liability cannot be imposed solely because a person aided and abetted the violation of the rule.

 

13.APPLICATION OF RULE 10B-5 TO BREACH OF FIDUCIARY DUTY BY DIRECTORS, OFFICERS, AND CONTROLLING SHAREHOLDERS.

a)Ordinary Mismanagement--a breach of fiduciary duty not involving misrepresentation, nondisclosure, or manipulation does NOT violate rule 10b-5;

b)Misrepresentation or Nondisclosure--if this is the basis of a purchase from or sale to the corp by a dir or officer, the corp can sue the fiduciary under rule 10b-5 and also for breach of fiduciary duty. If the corp doesn't sue, a minority sh can maintain a derivative suit on the corporations behalf.

c)Purchase or Sale By Controlling Shareholder--when a corp purchases stock from or sells stock to a controlling sh at an unfair price, and material facts aren't disclosed to minority shs, a derivative action may lie if the nondisclosure caused a loss to the minority shs. The plaintiffs must establish causation by showing that an effective state remedy (e.g., injunction) was foregone because of nondisclosure.

 

14.BLUE CHIP RULE--PRIVATE PLAINTIFF--a plaintiff can bring a private cause of action only if he actually purchased or sold the relevant securities. “Sale” includes an exchange of stock for assets, mergers and liquidations, contracts to sell stock, and pledges. The SEC can bring action under rule 10b-5 even though it has neither purchased or sold securities.

 

 

15.DEFENSES

a)Due Diligence--if a plaintiff's reliance on a misrepresentation or omitted fact could have been prevented by his exercise of due diligence, recovery may be barred. Mere negligence does NOT constitute a lack of due diligence, although a plaintiff's intentional misconduct and his own recklessness (if D was merely reckless) will bar recovery.

b)In pari delicto--a private suit for damages under rule 10b-5 will be barred if:

1)The plaintiff bears substantially equal responsibility for the violations, AND

2)Preclusion of the suit would not significantly interfere with the enforcement of securities law.

 

16.REMEDIES

a)Out-of-pocket Damages--this is the difference between the price paid for stock and its actual value.

1)Compare--benefit-of-the-bargain damages--these are measured by the value of the stock as it really is and the value it would have had if a misrepresentation had been true.

2)Standard measure of conventional damages--out-of-pocket damages is the standard measure in private actions under rule 10b-5; benefit-of-the-bargain damages are usually not granted.

b)Restitutionary Relief--this may be sought instead of conventional damages:

1)Rescission--returns the parties to their status quo before the transaction

2)Rescissionary or Restitutionary damages--money equivalent of rescission

3)Difference between conventional damages and Restitutionary relief--out-of-pocket damages are based on the P's loss, while Restitutionary relief is based on the D's wrongful gain. Rescission or Rescissionary damages may be attractive remedies when the value of the stock changed radically after the transaction. However, Restitutionary relief is usually unavailable in cases involving publicly held stock.

c)Remedies Available to the Government--although the SEC cannot sue for damages, it can pursue several remedies including special monetary remedies:

1)Injunctive Relief--the SEC often seeks injunctive relief accompanied with a request for disgorgement of profits or other payments that can be subject to criminal sanctions (fines and jail sentences) and civil penalties (up to three times the profit gained or loss avoided).

 

17.JURISDICTION, VENUE, AND SERVICE OF PROCESS--suits under 10b-5 are based on the 1934 Act, and exclusive jurisdiction is in the federal district courts. State claims arising out of the same transactions may be joined with the federal claim under the supplemental jurisdiction doctrine. Venue can be wherever any act or transaction constituting a violation occurred, or where the D is found or transacts business. Process can be served where the D can be found or where he lives.

 

18.STATUTE OF LIMITATIONS--the 1934 Act contains no SOL; however, the SCt has held that private actions must be brought within one year after discovery of the relevant facts and within three years following accrual of the cause of action. The tolling doctrine is inapplicable.

a)Exceptions--the time limitations don't apply to all rule 10b-5 private actions, e.g., SEC limitations period of five years for private suits by contemporaneous traders against purchasers or sellers who violate rules regarding trades while in possession of material, nonpublic information. Further, the SEC is not subject to any limitations period in civil enforcement actions.

 

 

D.SECTION 16 OF THE 1934 ACT--Section 16 concerns purchases followed by sales, or sales followed by purchases, by certain insiders, within a six-month period.

 

1.FIRMS AND SECURITIES AFFECTED UNDER SECTION 16--Section 16 applies to those firms and securities that must be registered under section 12 of the 1934 act.

 

a)Reason--16(a) references registered securities under S12; S12(a) and 12(g) create the registration requirement for securities; S12(g)creates an asset ($1 mln total) and distribution (500 to 700 depending on timing); 16(b) references “such” officers, etc., which refers to sub(a)

b)Note--trading in all of a corp's equity securities is subject to section 16 if any class of its securities is registered under section 12.

 

2.DISCLOSURE REQUIREMENT--Section 16(a) requires every beneficial owner of more than 10% of the registered stock and directors and officers of the issuing corp to file periodic reports with the SEC showing their holdings and any changes in their holdings.

a)Who is an Officer (16a-1f)--issuer's president, principal financial director, principal accounting officer, any vice-president of the issuer in charge of a principal business unit, any other officer who performs similar policy-making functions for the issuer.

 

3.LIABILITY--to prevent the unfair use of information, section 16(b) allows a corp to recover profits made by an officer, dir, or more-than-10% beneficial owner on the purchase and sale or sale and purchase of its securities within a six-month period.

a)Coverage--Section 16(b) does NOT cover all insider trading and is NOT limited to trades based on inside info. The critical element is short-swing trading by officers, dirs, and more-than-10% beneficial owners.

1)Note--beneficial owner must own 10% or more BOTH at he time of sale and purchase to be liable under 16(b).

b)Calculation of short-swing profit--the profit recoverable is the difference between the price of the stock sold and the price of the stock purchased within six month before or after the sale.

1)Multiple transactions--if there is more than one purchase or sale transaction within the six-month period, the transactions are paired by matching the highest sale price with the lowest purchase price, the next highest price with the next lowest price, etc. a court can look six month forward or backward from any sale to find a purchase, or from any purchase to find a sale

c)Who May Recover--the profit belongs to the corp alone. Although not a typical derivative action, if the corp fails to sue after a demand by a sh, the sh may sue on the corp's behalf. The cause of action is federal, so there is no posting of security requirement, and no contemporaneous sh requirement. Remedy:

1)All sales and purchases within 6 months are included;

2)Damages calculated as to maximize the gain to he company;

3)Match highest sale price against lowest purchase price within relevant period; continue until you can go no further.

d)Insiders--insiders are officers (named officers and those persons functioning as officers), dirs (actually serving or who authorized deputization of another), and beneficial owners of more than 10% of the shares. Insider status for officers and dirs is determined at the time they made a purchase or sale. Transactions made before taking office is NOT within section 16(b), but those made after leaving office are subject to the statute if they can be matched with a transaction made while in office. Liability is imposed on a beneficial owner only if he owned more than 10% of the shares at the time of both the purchase and sale.

e)”Purchase or Sale”--this includes any purchase of stock. Unorthodox transactions that result in the acquisition or deposition of stock (e.g., merger for stock, redemption of stock) are also purchases and sales.

 

 

E.SECTION 16(B) COMPARED TO RULE 10B-5:

a)Covered Securities--Section 16(b) applies to securities registered under the 1934 act; rule 10b-5 applies to all securities.

b)Inside Information--Section 16(b) allows recovery for short-swing profits regardless of whether they are attributable to misrepresentations or inside info; rule 10b-5 recovery is available only where there was a misrepresentation or a trade based on inside info.

c)Plaintiff--recovery under section 16(b) belongs to the corp, while rule 10b-5 recovery belongs to the injured purchaser or seller.

d)Overlapping Liability--it is possible that insiders who make short-swing profits by use of inside info could be liable under both section 16(b) and rule 10b-5.

 

F.COMMON LAW LIABILITY FOR INSIDER TRADING--insider trading constitutes breach of fiduciary duties owed to the corp, so the corp can recover profits made from insider trading

a)Common Law Liability Compared To Section 16(b) Liability--both common law and section 16(b) liability run against insiders and in favor of the corp. However, unlike section 16(b), the common law theory applies to all corps (not just those with registered securities), recovery can be had against any corporate insider, the purchase and sale is NOT limited by a six-month period, and the transaction must be based on the inside info.

b)Common Law Liability Compared to Rule 10b-5 Liability--the theories of recovery are similar except that under the common law recovery runs to the corp (not to the injured purchaser or seller), there is no purchaser or seller requirement, and noninsiders (tippees) have not yet been held liable.

  

VII.RIGHTS OF SHAREHOLDERS

 

A.VOTING RIGHTS

1.RIGHT TO VOTE IN GENERAL--shs may generally vote for the election and removal of dirs, to amend the articles or bylaws, and on major corporate action or fundamental changes.

a)Who May Vote--the right to vote is held by shs of record as of the record date;

b)Restrictions on Right--shares may be either voting or nonvoting, or have multiple votes per share.

 

2.SHAREHOLDER MEETINGS--generally, shs can act only at meetings duly called and noticed at which a quorum is present.

a)Compare--informal action--statutes permit sh action without a meeting if there is unanimous written consent of all shs entitled to vote.

3.SHAREHOLDER VOTING

a)Straight Voting--this system of voting allows one vote for each share held and applies to all matters other than director elections, which may be subject to cumulative voting. Certain fundamental changes (e.g., merger) frequently require higher shareholder approval.

b)Cumulative Voting For Director--this system allows each share one vote for each director to be elected, and the votes may be cast all for one candidate or divided among candidates as the sh chooses, thereby helping minority shs to elect a dir. Cumulative voting may be mandatory or permissive.

 

4.VOTING BY PROXY--a proxy authorizes another person to vote a shareholder's shares. The proxy usually must be in writing, and its effective period is statutorily limited unless it is validly irrevocable.

a)Revocability--a proxy is normally revocable by the sh at any time, although it may be made irrevocable if expressly stated and coupled with an interest in the shares themselves. Absent written notice to the corp, the death or incapacity of a sh does NOT revoke a proxy. a sh may revoke a proxy by notifying the proxy holder, giving a new proxy to someone else, or by personally attending the meeting and voting.

b)Proxy Solicitation--almost all shs of publicly held corps vote by proxy. Solicitations of proxies are regulated by the Securities Exchanges Act of 1934 Section 14a, federal proxy rules and, in some cases, state law. Federal proxy rules apply to the solicitation of all proxies of registered securities, but NOT to nonmanagement solicitation of 10 or fewer shs. The term “solicitation” is broadly interpreted by the SEC to include any part of a plan leading to a formal solicitation, e.g., inspection of shareholder list.

1)1992 amendments--the SEC revised the proxy rules to make it easier for shs to communicate with each other. Significant changes include: a safe harbor for communications that don't involve solicitation of voting authority, relaxation of requirements involving broadcast of published communications, relaxed preliminary filing requirements for solicitations, and removing communications between shs concerning proxy voting from definition of “solicitation.”

2)Requirement of Full Disclosure--the proxy rules require full and accurate disclosure of all pertinent facts and the identities of all proxy participants, disclosure of compensation paid to certain officers and dirs, and disclosure of conflict-of-interest transactions involving more than $60, 000.

3)Inclusion of Shareholder Proposal--shareholder proposals must be included in corporate proxy materials if the proponent is a record owner or beneficial owner of at least 1% or $1000 worth of securities entitled to vote on the matter. The proposal must not exceed 500 words.

I)Exceptions--a proposal need NOT be included if it: is not a proper subject for shareholder action, would be illegal, is false or misleading, seeks redress of a personal claim, relates to operations accounting to less than 5% of the corp's total assets and is not otherwise related to the corp's business, concerns a matter beyond the corp's power to effectuate, relates to ordinary business operations, relates to an election to office, is counter to a proposal submitted by the corp at the same meeting, is moot or duplicate, deals with the same subject matter as a very unsuccessful prior proposal, or relates to specific amounts of cash or stock dividends.

ii)Private right of action--a private right of action is available to a sh whose proposal was rejected by the corp on the ground that it fails within one of the exceptions.

iii)Providing shareholder lists--a sh has a right to obtain a list of shs or to have his communication included with the corporate proxy materials.

4)Remedies for violation of proxy rules--these include suit by the SEC to enjoin violations or to set aside an election and individual suits, class actions, or derivative suits by the shs (In a private suit, the P must show materiality and causation, but causation is normally presumed from materiality. Fairness to the corp is NOT a defense to a violation of proxy rules ). The court may rescind corporate action resulting from a misleading proxy solicitation or award damages.

c)Expenses Incurred In Proxy Contests--corporate funds may be used by management with respect to reasonable proxy solicitation expenses incurred in order to obtain a quorum for the annual meeting or regarding controversy over corporate policy (as opposed to a personnel controversy). The corp may, with sh approval, voluntarily pay the reasonable expenses to insurgents who win a proxy contest involving policy.

 

5.OTHER METHODS TO COMBINE VOTES FOR CONTROL (CLOSE CORPORATIONS)--other methods include shareholder voting agreements which may be enforced by specific performance, agreements regarding greater-than-majority approval, shareholder agreements binding the discretion of dirs, and voting trusts.

 

 

B.RESTRICTIONS ON TRANSFER OF SHARES--although most frequently used in close corps, stock transfer restrictions may also be imposed by larger corps (e.g., to restrict ownership to employees). The two most common types of restriction are a right of first refusal and a mandatory sell-buy provision. Restrictions must be reasonable and will be strictly construed.

a)Notice Requirements--a lawful stock transfer restriction is of no effect unless noted conspicuously on the stock certificate. If there is no such notice, an innocent transferee is entitled ti have the shares transferred to him.

 

C.SHAREHOLDERS' INFORMATIONAL RIGHTS:

 

1.TYPES OF BOOKS AND RECORDS--these include shareholder lists, minutes, financial records, and business documents.

 

2.COMMON LAW--at CL, a sh has a right to inspect records for proper purpose.

 

3.STATUTES--statutes govern these rights in most states. Many statutes apply only to certain shs but are usually interpreted to supplement the common law. Most statutes preserve the proper purpose test, but place the burden on the corp to prove improper purpose.

 

4.PROPER VERSUS IMPROPER PURPOSES--the test is whether the sh is seeking to protect the sh interest. Multiple purposes that include a proper one usually will not preclude inspection. Generally, a sh can inspect the sh list because it is often necessary to the exercise of other rights like proxy fights, sh litigation, etc. Inspection of a sh list for proxy contest is a proper purpose. However, it has been held that corporate records cannot be examined solely for the purpose of advancing political and social views or to aid a sh as a litigant on a personal, non-shareholder claim.

 

5.COMPARE--MANDATORY DISCLOSURE OF INFORMATION--a sh's inspection right is separate and distinct from the statutory requirements governing the affirmative disclosure of certain information by corps (e.g., Section 12 of Securities Exchange Act of 1934, proxy rules, state statutes).

 

 

D.FIDUCIARY OBLIGATIONS OF CONTROLLING SHAREHOLDERS--a controlling sh owes a fiduciary duty in his business dealings with the corp, in taking advantage of corp opportunities (rules more lenient than those applied to dirs and officers), and in causing fundamental changes.

 

1.ACTIONS ENTIRELY IN SHAREHOLDER CAPACITY--a controlling sh must NOT act to benefit himself at the expense of the minority shs; i.e., in a transaction where control of the corp is material, he must act with good faith and inherent fairness toward the minority.

 

2.OBLIGATIONS OF SHAREHOLDERS IN CLOSE CORPORATIONS--both majority and minority shs owe each other an even stricter duty (utmost good faith and loyalty) than is owed by controlling shs in publicly held corps. This duty has been interpreted to mean that there must be equal treatment of all shs, i.e., they must be afforded equal opportunities.

 

3.DISCLOSURE--a controlling sh must make full disclosure when dealing with minority shs.

 

4.SALE OF CONTROL--in most jurisdictions, a controlling sh is permitted to sell his stock at a premium, i.e, a price not available to other shs. Exceptions to these rule include a bare sale of office (invalid), the corporate action theory, sales involving fraud or nondisclosure, and knowing sales to transferees who plan to loot or deal unfairly with the corp.

 

 

E.SHAREHOLDER SUITS

 

1.DIRECT (INDIVIDUAL) SUITS--a direct suit may be brought by a sh on his own behalf for injuries to sh interests. If the injury affects a number of shs, the suit may be brought as a class action.

 

2.DERIVATIVE SUITS--if a duty owed to the corp has been abridged, suit may be brought by a sh on behalf of the corp.

a)Distinguish Direct From Derivative Suits--the test is whether the injury was suffered by the corp directly or by the sh, and to whom the D's duty was owed

1)Close corporations--in some cases, minority shs have been allowed to bring a direct action against controlling shs for breach of fiduciary duty

b)Prerequisite to Suit--Exhaustion of Corporate Remedies--the P-sh must specifically plead and prove that he exhausted his remedies within the corporate structure

1)Demand on directors--the P-sh must make a demand on the dirs to remedy the wrong, unless such demand would have been futile. Note that in the absence of negligence, self-interest, or bias, the fact that a majority of dirs approved the transaction does NOT itself excuse the demand.

I)Model statutes--under both model statutes, demand should be excused only if it is shown that irreparable injury to the corp would result;

ii)Effect of rejection of demand--if the matter complained of does not involve wrongdoing by the dirs, the board's good faith refusal to sue bars the action, unless the P-sh can raise a reasonable doubt that the board exercised reasonable business judgment in declining to sue. If the suit alleges wrongdoing by a majority of dirs, the board's decision not to sue will NOT prevent the derivative suit.

2)Demand on shareholders--in most states, the p-sh must also make a demand on shs unless excused (e.g., the alleged wrongdoing is beyond the power of the shs to ratify). Where demand on shs is required, a good faith refusal to sue by the majority of disinterested shs will preclude the suit.

c)Qualifications of Plaintiff--a few states require the P to be a registered sh; most states also allow a beneficial owner of shares to bring suit. Also, a sh of a parent corp can bring a derivative suit on a subsidiary's cause of action. Shs cannot complain of wrongs committed before they purchased their shares except:

1)where the P acquires shares by operation of law;

2)in section 16(b) violations;

3)where serious injustice will result;

4)where the wrong is continuing in nature.

The P must fairly and adequately represent the interests of all shs

d)Securities For Expenses--in a number of states, the P, under certain circumstances, must post a bond to indemnify the corp against certain of its litigation expenses, including attorney's fees, in the event the P loses the suit. a p-sh who loses may also be liable for the court costs incurred by the parties.

e)Defenses--defenses to derivative suit include the SOL and equitable defenses (laches, unclean hands, etc);

f)Settlement And Recovery--any settlement or judgment belongs to the corp, absent special circumstances. Settlement or dismissal of the suit is generally subject to court approval after notice to all shs.

g)Reimbursement to Plaintiff--a victorious plaintiff may be entitled to reimbursement from the corp for litigation expenses;

h)Indemnification of Officers And Directors--indemnification issues arise when officers and dirs are sued for conduct undertaken in their official capacity. If the officer or dir wins on the merits, he may be indemnified. Most statutes also authorize the corp to advance (not pay) expenses in defending against the claim. Statutes vary where the officer or dir settles or loses; they are most liberal concerning indemnification in a third-party suit as opposed to a derivative suit.

I)Liability Insurance--in most states, a corp can obtain liability insurance for its indemnification costs and for any liability incurred by its officers in serving the corporation.