We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.

The proposals leave two critical issues unaddressed.  The first concerns blank voting.   We have mentioned the problem on this Blog of blank votes.  When a shareholder executes a proxy but leaves an item blank, Broadridge apparently fills in the item.  Moreover, the software performing the function apparently votes  in favor of management.  According to a petitioned filed with the Commission by James McRitchie and a group of co-filers: "When a retail shareowner using Broadridge's proxyvote.com platform votes for or against at least one item on a proxy but fails to vote on other items, each item they fail to vote is cast in favor of the company's recommended position."  Thus, an unvoted item is really a vote for management.

The Commission should simply amend Rule 14a-4 and prohibit this practice.  There is no particular reason to believe that a shareholder leaving a matter blank is intending to transfer discretion to management.  Allowing companies to vote the shares is much like allowing brokers to vote uninstructed shares, something that was recently limited when the Commission amended NYSE Rule 452.  Moreover, at least Rule 452 limits voting to routine matters.  The blank voting problem allows shares to be voted on substantive matters where they can, in close cases, affect the ultimate outcome.

The other matter that requires consideration by the Commission is an added item to the current report on Form 8-K that would require companies to disclose decisions by boards not to accept a letter of resignation when a director does not receive a majority of the votes cast as required by an applicable bylaws, charter provision or guideline.  Moreover, the company should be required to set out the reasons for the refusal and the form should be signed by the directors who participated in the decision making process.

Some majority vote provisions set out that they will file a current report, but some do not.  Moreover, as the litigation in City of Westland v. Axcelis Technologies illustrates, there is no real guarantee that the same information can be obtained under state law inspection rights.  Rather than leaving matters to the pro-management courts in Delaware, it would be better to federalize the area and require affirmative disclosure that then becomes subject to the rigors of the antifraud provisions.

We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.

Public companies have to report the voting results of shareholder meetings.  The data must appear in the next quarterly report, which can sometimes result in substantial delay.  Moreover, there have been  cases where the company has opted to sit on results of director elections for protracted periods of time, without announcing whether insurgents actually won or lost.   

The Commission has proposed a more rapid disclosure regime.  Rather than wait for the quarterly report, companies in the future will be required to disclose the results in a current report withing four business days after the meeting has occurred.  From the Commission's perspective, the technology exists for a more rapid tally.  "We understand that technological advances in shareholder communications and the growing use of third-party proxy services have increased the ability of companies to tabulate vote results and disseminate this information on a more expedited basis than is currently required."

Even where not final, however, rapid disclosure must occur.

• We have included an instruction to the proposed item that states that if the matter voted upon at the meeting relates to a contested election of directors and the voting results are not definitively determined at the end of the meeting, companies should disclose on Form 8-K the preliminary voting results within four business days after the preliminary voting results are determined, and file an amended report on Form 8-K within four business days after the final voting results are certified.

The requirement will do two things.  First, it will require rapid notification to insurgents of the results of any contests.  There will no longer be any opportunity to sit on the results for months.  Insurgents will probably be able to assume their posts on the board more quickly. 

Second, as a practical matter, it will to some degree improve the integrity of the voting process.  With preliminary data disclosed, management will have a much heavier burden justifying any subsequent changes in the results, at least where more favorable to management.  Most likely the change will end up in court and be subjected to discovery.  This means that the reasons and motive for the change will be placed under a microscope.  In at least some cases, companies will forgo changing the results in order to avoid this level of examination. 

Yesterday, the 10^th Circuit panel reversed Nottingham’s “gain” and forfeiture determinations and remanded the case back to the district court to follow the 10^th Circuit’s instructions on the proper calculations. These instructions could have the effect of reducing the “gain” for federal sentencing purposes to reduce Nacchio’s six year sentence to 3 to 4 years and of reducing his forfeiture of approximately $52,000,000 to $44,600,000 representing the gross proceeds of $52,000,000 less the brokerage expenses and perhaps the cost of exercising the options. Unless the 10^th Circuit en banc reverses this same panel of judges (2 to 1 prior decision to grant Nacchio a new trial), today’s unanimous panel decision will create a conflict with the Mooney en banc decision in the 8^th Circuit triggering automatic review by the U.S. Supreme Court.  Currently, the Supreme Court is considering whether to hear Nacchio’s appeal for a new trial from the first 10th Circuit en banc decision upholding his original conviction.  The decision yesterday is at the 10^th Circuit’s website. I will analyze the “gain” for purposes of the federal sentencing guidelines first.

Determination of the “Gain” for Purposes of the Federal Sentencing Guidelines

A factor in sentencing Nacchio was the gain or total increase in value realized through insider trading. Before siding with Nacchio’s argument, the 10th Circuit’s decision explained how Nottingham adopted the majority decision in Mooney, (United States v. Mooney, 425 F.3d 10903 (8th Cir. 2005) (en banc, 9 judges for the majority, 3 dissented--cert. denied 2006). Nottingham determined this “gain” was approximately $28,000,000. This was based upon the government’s calculation of approximately $44,000,000 ($52,000,000 sales from insider trading less the cost of the options for the stock and brokerage fees). However, Judge Nottingham reduced the gain further by the $16,000,000 in income taxes that was withheld which I blogged at the time was inconsistent with Mooney. For background on how I viewed the error by Nottingham as a harmless one since his error still resulted in a sentence within the range of the government’s and my perspective, see my July 30th, 2007 post entitled: Judge Nottingham's Sentencing Error a Harmless One.

Nottingham’s determination of the gain from the insider trades resulted in a sentencing range under the Federal Sentencing Guidelines of 63 to 78 months and Nottingham sentenced Nacchio to 72 months (6 years or in the middle of range). As did majority in Mooney, Nottingham specifically pointed to the commentary to Section 2F1.2 of the sentencing guidelines that “because the victims and their losses are difficult if not impossible to identify” in insider trading cases, “the gain, i.e., the total increase in value realized through trading in securities by the defendant ... is employed instead of the victims’ losses.” The 10^th Circuit counters that this comment must be interpreted to mean the gain related to the insider trading deception to be consistent with the intent of the underlying federal sentencing guideline.

Nacchio appealed on the basis that the amount of gain is too high since it incorporates the permissible increase in value of Qwest stock before the illegal insider trades. Nacchio pointed to his expert’s calculation that the maximum amount of gain attributable to inside information was approximately $1.8 million which results in a sentencing range of 41 to 51 months (over three years to a little over 4 years).

The 10^th Circuit adopted the rationale of the dissent in Mooney on how “gain” was to be computed under the Federal Sentencing Guidelines and then stated the following under “Our Approach” heading:

We further determine that it was incumbent upon the district court to adopt a realistic, economic approach (1) that would take into account that Mr. Nacchio’s offense did not inhere in his sale of the shares itself, but in the deception intertwined with the sales due to his possession of insider knowledge, and (2) that consequently would endeavor to compute his gain for sentencing purposes based upon the gain resulting from that deception. (page 19 of the opinion). 

The 10^th Circuit then concluded that the civil disgorgement remedy provides an appropriate guidepost for computing how much of the gain is attributable to the “deception” of insider trading. Lastly, the court noted that its decision was consistent with the key objectives of federal sentencing policy—namely:

Federal sentencing is individualized sentencing: the sentencing court seeks to craft a sentence that fully reflects a particular defendant’s criminally culpable conduct, including the harm caused by it, and the defendant’s personal circumstances....However, if the impact of unrelated twists and turns of the market is ignored in the sentencing calculus then an insider trading defendant is likely to suffer a sentence that is detached from his or her individual criminal conduct and circumstances. And this detachment can have a profound, detrimental impact on another objective of federal sentencing—the elimination of unwarranted disparities between similarly situated defendants. (citing Booker) See pages 38-40 of the decision.

Certainly, the 10th Circuit's fundamental fairness sentiments are laudable.  However, while the 10^th Circuit’s professed concern for the market vagaries facing insider trading defendants and the consequential “unwarranted disparities between similarly situation defendants,” the government pointed out that Nacchio, by withholding the material nonpublic information, artificially kept the Qwest stock price higher and longer than it should have. Moreover, I could add that Nacchio, as is the case with any insider, was able to lock in his profits at the time of the insider sales when legally he was required to abstain. Granted the gain has some element of non-deception gain, but Nacchio’s insider trades effectively insulated him from the vagaries of the market place. Who knows how much the stock could have declined (due to industry and national economic trends, for example) while he abstained until the nonpublic information was announced by Qwest? Under this analysis, all the economic gain relates to the insider trading deception and is another rationale for the commentary to Section 2F1.2 under Federal Sentencing Guidelines that the total amount of the gain from the insider trades should be used.

Moreover, the 10^th Circuit makes the point that Nacchio should not have his prison term lengthened by the gain prior to the insider trades in 2001 (1997 to 2001). However, it is ironic that the SEC’s civil suit alleges that Nacchio committed Rule 10b-5 financial statement misrepresentation during those pre-insider trading years, but that lawsuit has been postponed during the criminal proceedings.

Finally, it is interesting to note that my prior blog post two years ago made the following observation:

[Nacchio’s position] is not completely without legal merit. In Mooney, there was well reasoned vigorous dissent based on the lack of uniformity that could result in applying the total gain, some of which might not be attributable to the material nonpublic information. Moreover, in the law journal article entitled “Reexamining 'loss' and 'gain' in the wake of Dura Pharmaceuticals v. Broudo -- New Ammunition for Securities Fraud Defendants” (30 Champion 10), the authors provide the following recommendation to legal counsel in Nacchio’s position:

The goal of uniformity in sentencing is clearly undermined by applying the Guidelines in a way that leads to such disparate sentences for defendants who engaged in identical conduct. "Such an application would create a through-the-looking-glass inversion of the Guidelines -- advising unequal sentences for identical crimes -- defeating the chief purpose of the Guidelines." While the "realistic economic approach" adopted in Olis advances the guidelines' goals of uniformity and fairness, the "brightline" rule applied in Mooney sacrifices those goals in favor of expediency.

For all of these reasons, it is difficult to reconcile Mooney with the Fifth Circuit's subsequent holding in Olis, or with the pragmatic approach adopted by the Supreme Court in Dura. Consequently, Mooney should not deter counsel from encouraging sentencing courts, when calculating the gain attributable to insider trading, to apply "thorough analyses grounded in economic reality," aimed at determining the economic impact that the "'defendant truly caused or intended to cause,'" "exclusive of other sources" of impact on the price of the security. (Emphasis added). To see the entire post, see my July 11, 2007 post entitled: The Extreme Importance of the Gain on Nacchio’s InsiderTrades.

Truly, the 10^th Circuit has squarely placed this issue front and center for consideration by the U.S. Supreme Court unless reversed by the entire 10^th Circuit.  This post is my initial analysis of the 50 pages the 10th Circuit devoted to this issue.  I plan to post a series on each of the critical arguments on both sides of this important legal issue.

Determination of the Amount of Forfeiture

On balance, the 10^th Circuit’s decision regarding a reduction of the amount of the forfeiture will probably be upheld, but winning this issue will likely save Nacchio only $60,081.09 out of the $52,007,545.47 forfeiture determined by Nottingham.

Nottingham determined that Nacchio’s insider trading sales should be classified under 18 U.S.C. § 981(a)(2)(A) as an unlawful activity involving “illegal goods, illegal services, unlawful activities, and telemarketing and health care fraud schemes” requiring forfeiture of the gross receipts from the unlawful activity or in Nacchio’s case: $52,007,5745.47. In contrast, the 10^th Circuit decided that 18 U.S.C. § 981(a)(2)(B) is the appropriate classification for the illegal insider trading sales since this provision provides:

In cases involving lawful goods or lawful services that are sold or provided in an illegal manner, the term “proceeds” means the amount of money acquired through the illegal transactions resulting in the forfeiture, less the direct costs incurred in providing the goods or services. . . The direct costs shall not include any part of the overhead expenses of the entity providing the goods or services, or any part of the income taxes paid by the entity. (Emphasis added.)

The 10th Circuit reasoned that since selling stock is a lawful activity, but sold in an illegal manner (insider trading), subparagraph (B) applies by its terms and is not covered under subparagraph (A) that “was meant to cover inherently unlawful activities such as robbery that are not captured by the words ‘illegal goods’ and ‘illegal services.’” Otherwise, the court reasoned that under Nottingham’s decision, the proceeds of every section 981(a)(1) offense would fall under the broad definition of subparagraph (A), and subparagraph (B) “becomes a null set.” Citing a more recent case from another judge from the same court that criticized All Funds (the case Nottingham relied upon), the 10^th Circuit found the latter case more persuasive. (United States v. Kalish, No. 06 Cr. 656(RPP), 2009 WL 130215, at * (S.D.N.Y. Jan. 18, 2009).

In footnote 27 of the opinion below, the 10^th Circuit declined to determine whether the $5 per share option price could also be used to lower the amount of Nacchio’s forfeiture, leaving that decision to the district court:

The government argues that even under § 981(a)(2)(B), it would be erroneous to deduct the exercise costs of the options Mr. Nacchio received as this amount was not “incurred” in the subsequent illegal sales. We express no opinion on whether the costs to exercise the options should be deducted alongside brokerage fees as the district court can revisit that issue in recalculating the forfeiture amount under the proper provision.

It will indeed be interesting to see whether the District Court includes in “direct costs” the $5.50 per share option price paid by Nacchio, but that outcome is far from certain. The calculation below shows the likely net amount Nacchio will save by winning this issue:

Nottingham’s Determination     $52,007,545.47
Less Brokerage Fees                     (60,081.09)
Net Forfeiture                       $51,947,464.38
Less Option Costs                   (7,315,000.00)    Unlikely
Less Income Taxes               (16,078,147.81)    Not allowed under 18 U.S.C. § 981(a)(2)(B)

The issues “Option Costs” and “Income Taxes” will be analyzed in depth in a subsequent post since Nacchio will most assuredly press for both reductions in his forfeiture calculation in district court. For example, at the trial, he asserted that the income taxes of approximately $16,078,147.81 should be allowed since he never received the total proceeds, only the net after the income taxes were withheld.

However, if you are anxious to get up to speed on these issues immediately, you can access my blog posts on these issues after the conviction, but before Nottingham’s sentence. For an extensive analysis of the calculation of Nacchio’s sentence that was later mirrored by the government’s calculation of the sentence for Nottingham to consider, see my April 23, 2007 post entitled: What Prison Term Range will Nottingham Consider? For an extensive analysis of the calculation of the sentence under the federal sentencing guidelines before Nacchio was sentenced, see my July 9^th, 2007 post entitled: Government's and Nacchio's Different Perspectives on His Sentence. For extensive background on the issues before Nottingham made his determinations, see my July 11, 2007 post entitled: The Extreme Importance of the Gain on Nacchio’s Insider Trades. For background on how I viewed the error by Nottingham as harmless one since his error still resulted in a sentence within the range of the government’s and my perspective: see my July 30th, 2007 post entitled: Judge Nottingham's Sentencing Error a Harmless One.

We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.

One of the most obvious areas of abuse concerns the resolute insistence by most public companies to have the CEO serve as chairman of the board.  (Some stats are here).  With the board responsible for supervising the CEO, the the combination of the two positions materially weakens the function. Moreover, the chairman has the authority to call meetings and exercise control over the issues placed on the agenda.

Nor is this the norm overseas.  Most other countries, including the United Kingdom, call for a separation.  Pressure is growing for this to occur in the United States.  Shareholders are agitating for a separation; a provision of the Shareholder Bill of Rights would require it for exchange traded companies.  This Blog called on the SEC to address the separation as part of its corporate governance agenda.  The call seems to have been answered.

The SEC's corporate governance proposals call for increased disclosure about a company's "leadership structure" and an explanation as to why "the company believes it is the best structure for it at the time of the filing."  In other words, those companies that combine the two positions will have to explain why this is in the best interests of shareholders.  As the release noted:

• Under the proposed amendments, companies also would be required to disclose whether and why they have chosen to combine or separate the principal executive officer and board chair positions. In some companies, the role of principal executive officer and board chairman are combined, and a lead independent director is designated to chair meetings of the independent directors. Those companies would also be required to disclose whether and why the company has a lead independent director, as well as the specific role the lead independent director plays in the leadership of the company.

The Commission has disavowed any attempt to influence the choice of management structure.  Yet in explaining why the disclosure was necessary, the release could only offer the thin justification that it would "increase the transparency for investors into how boards function."  In fact, for companies that separate the two positions, the disclosure will largely be meaningless.  For those that do not, however, they will find themselves having to justify the explanation, either to institutional investors, the Commission, or, perhaps, to a judge should they be sued for securities fraud under a theory that the justification was misstated.

Whether in fact this will affect practice depends upon the strength of enforcement.  To the extent the disclosure becomes boilerplate, it will end up being a few lines in the proxy statement that investors skip when looking for the CEO's total compensation.  If made meaningful, however, some companies will have a difficult time coming up with a meaningful justification, particularly for CEOs under challenge.  It may simply be easier to separate the two positions.

We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.

We have written a great deal on this Blog about the lack of diversity on corporate boards and the need to expand the applicable pool of candidates.  Diversity can include gender and race but it can also include directors who bring a different perspective to management.  Exxon-Mobile might have benefited from an outspoken environmentalist on the board.  In fact, most directors look much like their CEO, something we have called mirror image boards.  Some countries have grown impatient with the market and imposed quotas, with positive results.  Norway is an obvious example.

The current corporate governance proposals put out by the Commission dip gingerly into the area.   According to the proposing release:

• Currently, Item 407(c)(2)(v) of Regulation S-K requires disclosure of any specific minimum qualifications that a nominating committee believes must be met by a nominee for a position on the board. We are interested in understanding whether investors and other market participants believe that diversity in the boardroom is a significant issue.  As indicated below, we are requesting comment on whether additional disclosure in this area should be required.

It's only a question but one that deserves a serious response.  If companies are forced to start reporting percentages (something that can usually but not always be determined visually), it will facilitate the creation of tables that compare companies.  This was one of the advantages of the "total compensation" column required in the executive compensation table that goes into the proxy statement.  Companies with lots of zeros for diversity will get increased attention.  That in turn will likely put pressure on boards to improve their standing.

Disclosure in this area would be useful and would likely have some impact on board diversity.

We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.

The Commission has proposed significant increases in the amount of disclosure that must be provided for directors and nominees to the board.  The provisions will effectively require companies to increase the qualifications and expertise on the board of directors. 

The requirements address the qualifications of specific directors.  The SEC has proposed that companies disclose "the particular experience, qualifications, attributes or skills that qualify that person to serve as a director of the company . . . in light of the company’s business and structure."   Rather than assess the skills of individuals, however, the disclosure is designed to enable shareholders to assess the skill level of the entire board.  As the release noted:  "These revisions are aimed at helping investors determine whether a particular director and the entire board composition is an appropriate choice for a given company as of the time that a filing containing this disclosure is made with the Commission." 

Specifically, this means that shareholders will know whether the board has anyone with expertise in assessing risk.  While the proposal spoke in general terms, the release made the focus on risk assessment clear.  As the release noted: 

• "The types of information that may be disclosed include, for example, information about a director's or nominee’s risk assessment skills and any specific past experience that would be useful to the company, as well as information about a director's or nominee’s particular area of expertise and why the director's or nominee’s service as a director would benefit the company at the time at which the relevant filing with the Commission is made."

In effect, therefore, the disclosure requirement is largely an attempt to get risk assessment skills on the board.  SOX largely did the same thing with respect to financial expertise.  The Act stopped short of requiring directors with financial expertise but required companies to explain the absence.  This proposal will highlight boards that lack sufficient risk assessment skills, something that will likely encourage challenges under majority vote provisions or even contest when shareholders obtain access to management's proxy statement.

We are discussing Exchange Act Release No. 60280 (July 10, 2009), the SEC's recent set of rule proposals designed to improve disclosure in connection with the corporate governance process.

A significant portion of the release addresses the need to enhance disclosure of practices that relate to corporate risk taking. The current financial crisis arose in large part from excessive risk taking.  Excessive risk taking arose, at least in part, because of the executive compensation scheme (which encouraged short term profits) and the lack of affirmative obligations on the board of directors.

The latter was reaffirmed by the Delaware Chancery Court in In re Citigroup.  The case essentially exonerated directors from having any role in the oversight of systemic risk undertaken by a public company. The Chancery Court took the position that it would be a mistake to impose on directors the possibility of liability for failing to adequately assess risks within the company.

• To the extent the Court allows shareholder plaintiffs to succeed on a theory that a director is liable for a failure to monitor business risk, the Court risks undermining the well settled policy of Delaware law by inviting Courts to perform a hindsight evaluation of the reasonableness or prudence of directors’ business decisions. Risk has been defined as the chance that a return on an investment will be different that expected. The essence of the business judgment of managers and directors is deciding how the company will evaluate the trade-off between risk and return. Businesses—and particularly financial institutions—make returns by taking on risk; a company or investor that is willing to take on more risk can earn a higher return. Thus, in almost any business transaction, the parties go into the deal with the knowledge that, even if they have evaluated the situation correctly, the return could be different than they expected.

The amendments also, in a comply or explain fashion, effectively require constant monitoring of the relationship between risk and compensation.  Companies will be required to disclose the extent to which a company "monitors its compensation policies to determine whether its risk management objectives are being met with respect to incentivizing its employees."  This will effectively force companies to maintain a constant system of monitoring that presumably will result in notification if risk profiles in a large unit change.

In addition, however, the Commission has proposed additional disclosure requirements that related directly to the board's role in risk management. As the release noted:

• disclosure about the board’s involvement in the risk management process should provide important information to investors about how a company perceives the role of its board and the relationship between the board and senior management in managing the material risks facing the company. Given the role that risk and the adequacy of risk oversight have played in the recent market crisis, we believe it is important for investors to understand the board’s, or board committee’s role in this area. For example, how does the board implement and manage its risk management function, through the board as a whole or through a committee, such as the audit committee? Such disclosure might address questions such as whether the persons who oversee risk management report directly to the board as whole, to a committee, such as the audit committee, or to one of the other standing committees of the board; and whether and how the board, or board committee, monitors risk. We believe that this disclosure will provide key insights into how a company’s board perceives and manages a company's risks.

In exactly what the court in In re Citigroup refused to do, this will essentially force companies to define the role of the board in risk management.

The value of the disclosure will depend upon whether it is meaningful or evolves into boilerplate.  The boilerplate has long plagued the periodic reporting system.  The problem emanates from the lack of  a private right of action for violations.  Enforcement is, as a result, only as good as the effort the SEC is willing to devote.  Back in the 1990s, the Commission aggressively tried to improve disclosure in the MD&A, devoting considerable resources to the goal.  The approach met with limited success.  There have been no pure MD&A cases (those that do not otherwise involve fraud) in recent years, something that has not gone unnoticed to companies and practitioners in the area.  Without rigorous attention, the same will happen to disclosure of risk analysis in the CD&A and with respect to the role of the board of directors.

The SEC has put out a relatively massive proposal to improve corporate governance disclosure.  Exchange Act Release No. 60280 (July 10, 2009) prints off at a hefty 137 pages. The release contains a number of proposals, some centering around compensation, some around director disclosure. 

There are two broad points, however, to make about the release before delving into the specifics.  First, at least one portion of the Release would essentially preempt aspects of Delaware law, to some degree overturning the astounding decision in In re Citigroup, a Delaware decision that largely exonerated the board from having any involvement in systemic review of risk (even though the board already had a risk management committee).

Second, the release, as it must, focuses on disclosure, the area of governance unequivocally ceded to the SEC.  Much of the disclosure, however, seems to have less to do with information important to reasonable investors and more to do with altering substantive behavior within the corporation.  This has been discussed at length in Essay: Corporate Governance, the Securities and Exchange Commission, and the Limits of Disclosure.  In effect, the SEC is trying to fill gaps left by the pro-management decisions flowing out of Delaware.  Because the courts in that state impose few if any meaningful standards of behavior on directors, the SEC has had to use disclosure to try to require directors to do more.  Disclosure in this area at least sometimes forces directors to take additional steps or implement additional actions relating to their task of overseeing the corporation.  Moreover, false disclosure in this area is left to the federal courts under the ubiquitous Rule 10b-5.

We will write a few posts on this release, noting some of the high points.

With Rule 452 amended, are matters finished?  Not exactly. 

First, the rule applies to members of the NYSE.  Brokers that are not subject to the requirement are outside the rule's boundaries.  That means that brokers who hold shares for NYSE or Nasdaq companies but are not members of the NYSE (only members of FINRA) can vote in uncontested elections (or on any other matter).  The only limits are those imposed by state law.  As a result, management may still receive in each election a block of discretionary votes.  Having said that, it is likely that most discretionary votes are in the hands of NYSE brokers.  Moreover, non-NYSE brokers may follow Rule 452 anyway as a sort of safe harbor.

Second, the Rule continues to regulate discretionary voting in the negative.  There is no definition of routine.  Instead, there are 18 categories of non-routine and one catch-all category.  The catch-all provides:  

• the person in the member organization giving or authorizing the giving of the proxy has no knowledge of any contest as to the action to be taken at the meeting and provided such action is adequately disclosed to stockholders and does not include authorization for a merger, consolidation of any matter which may affect substantially the rights or privileges of such stock.

In other words, a proposal that has the potential to substantially affect the rights or privileges of stock would be included. 

Notwithstanding the list, the NYSE will note each matter that is or is not subject to discretionary voting in the weekly bulletin.  See Rule 452.11 (“When member organization may not vote without customer instructions.—In the list of meetings of stockholders appearing in the Weekly Bulletin, after proxy material has been reviewed by the Exchange, each meeting will be designated by an appropriate symbol to indicate either (a) that members may vote a proxy without instructions of beneficial owners, (b) that members may not vote specific matters on the proxy, or (c) that members may not vote the entire proxy."). 

This places extraordinary discretion in the hands of the NYSE in determining when discretionary votes can be cast.  Indeed, the NYSE has been criticized on occasion for its exercise of discretion in this area.  See Amy Goodman & John Olson, A practical guide to SEC proxy and compensation rules, at 12.3[1], n. 21 (2001).

Rule 452 should be amended to reverse the presumption.  All matters submitted to shareholders should be deemed non-routine, with discretionary voting not allowed.  Only if specifically listed as routine would discretionary voting be permitted (approval of the auditor, etc.).  This will reduce the discretion of the NYSE and ensure that shareholders and investors are aware of the matters considered routine.  It will put on public display the matters that brokers can influence with their discretionary votes, making the system more transparent.

The amendment to Rule 452 adopted by the Commission is a start but there is a long way yet to go.

We have occasionally written on this Blog about Starbucks.  Starbucks has had a rough time financially recently, even before the current crisis caused cutbacks among latte drinking professionals.  We noted that part of the problem came from the apparent decision by Starbucks to market itself as a commodity.  The problem with the approach is that there are others that make a decent latte.  Moreover, with the decision by McDonalds to insert baristas into its 14,000 shops, the commodity competition was going to get even worse.

Somehow, Starbucks needed to be anti-commodity.  There needed to be some unique reason to spend the extra amount for a latte at Starbucks rather than a cheaper version at McDonalds.  We suggested that the answer was Social Responsibility.  Customers of Starbucks coffee (at least some of them) would remain more loyal if they thought their purchase had some benefit that transcended a caffine jolt or a sugar burst.  While Starbucks has a page on its Internet site that trumpets social responsibility, we noted that there was little evidence of this in the assorted establishment (beyond the small sign above the Ethos Water bottles).

We don't know if management at Starbucks reads The Race to the Bottom, but we have to admit that much has changed.  In a recent visit to some Starbucks in Denver, it was subtly apparent that the Company was putting greater emphasis on Social Responsibility and on health.  One piece of evidence was a sign informing clients that:  "You buy more trade certified coffee than anyone in the world."  There was also a discrete yet noticeable placard that advertised how purchases at Starbucks would result in increased funding for Africa.  Purchases resulted in a contribution to the Global Fund.  Moreover, almost any purchase resulted in a contribution, including a 5 cent contribution for each use of a Starbucks card. The medium sized cup contained a message that 65% of its coffee purchased from farmers "who are good to their workers, community and planet" and that Starbucks was working on lifting the number to 100%.

With respect to the environment, the store announced that the purchase of a tumbler would result in a 10 cent discount and would save "another paper cup every time."  Their cups, by the way, note that they are made with 10% post-consumer recycled fiber.

There was also a sign that promised the food not only tastes better but that it is better.  This suggests that the Company is using healthy ingredients, although we'd like to know a bit more about this.  There is some information on the web site but it should be more apparent in the store.  The approach is a page from Chipotle that lets customers know the food is healthy and produced, generally, under humane conditions.

We will continue to watch.  Starbucks announced that it had a good third quarter so maybe the approach (along with many other changes) is already showing results (and showing that social responsibility can be good for the bottom line).  In the meantime, we would offer one additional suggestion.  Every store has a set of shelves that offer for sale assorted coffee paraphernalia, particularly ugly coffee mugs.  Can't a portion of the space be used to sell goods from crafts people in low income countries, perhaps in partnership with someone like 10,000 Villages?  If I knew my dollars were helping an artisan in Africa, I might buy the ugly coffee cup at full price rather than wait until it gets moved to the discount rack on the bottom shelf.

We are discussing the SEC's decision (by a 3-2 vote) to approve amendments to NYSE Rule 452 that prohibited brokers from voting uninstructed shares held by beneficial owners in uncontested elections for the board of directors.

Was there any good reason for opposing the amendment to Rule 452?  The only potential issue was, that by depriving brokers of the right to vote in uncontested elections, the shares would not be present at the meeting, making it harder to obtain a quorum.  In fact, however, this seemed like a relatively minor point.

Most states (if not all) presumptively provide that a quorum will be a majority of the outstanding shares.  They typically allow, however, the percentage to be lowered to as low as one-third, something probably almost universal among public companies.  As a result, even were the 19% of the uninstructed shares not present at the meeting, the relatively low percentage needed for a quorum would not seem to be a particularly difficult threshold.

More importantly, the problem could be eliminated by finding another reason why the 19% of the shares could still be voted at the meeting and counted for quorum purposes.  This would require the agenda to include a routine matter that was not in the prohibited categories listed in Rule 452.  The most obvious, least important routine matter?  Approving the outside accounting firm.  As the Commission noted:  "NYSE Rule 452 would continue to allow the broker to vote on other routine matters, such as the ratification of independent auditors, which will help companies meet quorum requirements, and therefore alleviate the efficiency concerns raised by commenters."  Exchange Act Release No. 60215 n. 34 (July 1, 2009).  Most companies do this but if they don't and they have quorum concerns, its easy enough to add to the agenda.

It took the SEC until July 2009 to authorize the proposed amendment to NYSE Rule 452 to designate uncontested elections to the board as a non-routine matter (thereby preventing brokers from voting uninstructed shares held by beneficial owners on the matter).  The matter had languished for years, with the original proposal filed back in October 2006.  The SEC has issued the release that accompanied its approval (by a 3-2 vote) of amendment.

Rule 452 is set up to allow for voting of any shares where instructions have not been received within ten days of the meeting.  The Rule includes a list of items, however, that are outside this right to vote.  Among other things, Rule 452 does not allow discretionary voting on a list of 18 matters, ranging from matters subject to a counter solicitation to appraisals and mergers to the creation of indebtedness or a class of preferred stock.   The provision covered contested elections to the board but not uncontested ones.  Moreover, under a cramped reading of the rule, an effort to defeat a director under a majority vote requirement was not considered a "contest." See NYSE Rule 452.11(2). 

The effect of discretionary voting was to give a decided advantage to incumbents in any uncontested election.  This occurred for two reasons.  First, brokers invariably used the shares to support management.  As the Release obliquely noted:  "In the view of some commenters, brokers tend to vote in accordance with management’s recommendation."

Second, the percentage of shares subject to broker control under Rule 452 was significant.  One commentator put the figure at 19%.  In short, the broker no votes could be outcome determinative.  In fact, in the 2004 "just say no" campaign at Disney, Michael Eisner only received a majority because of the discretionary votes cast by brokers.  As the Report of the Working Group for the NYSE that proposed the amendment noted:

• The impact of broker votes on such campaigns can be significant. For example, in the WaltDisney Company’s 2004 Annual Meeting, involving one of the best known and organized “just vote no” campaigns, Disney CEO Michael Eisner was re-elected to the board with 55% of the votes cast, while 45% of the shares voted were “no” votes. Had broker votes not counted in this election then Mr. Eisner would have received only 45% of the votes in favor of re-election, and a majority of the votes cast, 54%, would have been withheld from him.

In other words, the usually unstated reason to leave Rule 452 alone was to preserve an unfair advantage for incumbents in any uncontested election where a majority vote bylaw was in place. 

The importance of this advantage could be seen by the failure of opponents to aggressively support alternatives.  The most obvious alternative was a system of proportional voting (in fairness, it should be noted that a number of comment letters to the proposal did suggest this as an alternative).  This would entail brokers voting in proportion to the votes cast by street name owners who did return their voting instructions.  Thus, for example, Commissioner Paredes noted the practice.  See Remarks of Commissioner Paredes, July 1, 2009 ("With proportional voting — which some brokers already have implemented — the broker vote mimics the retail shareholder vote even more closely than when the broker votes with management entirely.").   He did not, however, push this as an alternative (in contrast to his negative vote against access where he did push an alternative).

Proportional voting would have solved the quorum issue but also would have removed the incumbent advantage.  In cases where retail investors favored the defeat of a director, proportional voting would continued and even enhanced this result.  With the incumbent management gone, the interest in the alternative also seemed to subside.

We are a bit late (as usual) in commenting on the Commission's decision (by a thin 3-2 margin) to amend Rule 452 of the NYSE to designate the uncontested election of directors as a controversial matter not subject to discretionary voting by brokers. 

Discretionary voting covers shares owned by broker clients where the clients do not submit voting instructions.  Brokers have a legal right to vote the uninstructed shares under state law (Of course, in actuality, it is the depositories that, as record owners, have the legal right to vote but these entities issue omnibus proxies to the brokers, transfering to them the voting rights; for more on this subject, see The Shareholder Communication Rules and the Securities and Exchange Commission: An Exercise in Regulatory Utility or Futility?)

The concept of discretionary voting is an odd one.  The brokers have no economic interest in the underlying shares or the company.  Thus, they can vote without any consideration of the consequences of the vote to shareholders or even to the business of the company.  Nonetheless, voting the shares does serve a purpose.  They can be voted present at the meeting for purposes of obtaining a quorum so that companies do not have to go through the cost and expense of holding another meeting. 

These votes, therefore, should be allowed to provide a certain degree of cost avoidance that benefits both management and shareholders.  They should not be used to tip the balance on an issue that can affect shareholders.  The decision to not allow discretionary voting in the case of uncontested elections for the board was a common sense change given the rise in the use of majority vote provisions.  The only odd thing about the Commission's action was that it took years and engendered the opposition of two commissioners.

In any event, the Commission has issued the Release on the matter.  We think it appropriate to highlight a bit of the analysis contained in the release and will do so in the next couple of posts.

We are discussing CITY OF WESTLAND POLICE & FIRE RETIREMENT SYSTEM v. AXCELIS TECHNOLOGIES, INC., a case involving the invocation of inspection rights to investigate the reasons why the board of directors of Axcelis did not accept the resignation of three directors who failed to receive majority support from shareholders voting in the election.

The case illustrates the burdens imposed by the Delaware courts on efforts by shareholders to inspect corporate records.  Under the reigning standard, plaintiff must allege the need to inspect and explore some type of impropriety and must present "credible" evidence of the impropriety.  While Delaware courts purport to describe this as a low standard, in fact they use it regularly to dismiss inspection requests made by shareholders with an obvious and legitimate reason to look into the board's behavior (a position that has earned us the umbrage of the Delaware Chancery Court).

Plaintiff in this case is trying to circumvent these restrictions by invoking the higher standards of review in Blasius (which imposed on the board an obligation to provide a "compelling justification" for its behavior) and Unocal.  In other words, the "credible basis" is essentially the failure of the Company to provide a "compelling justification."  This is not, however, a favored doctrine in Delaware, making a Chancery Court's willingness to apply it in these circumstances unclear. 

The problem in the end is that there shouldn't be a need to invoke a higher standard of review.  For matters that directly contradict the voting position of shareholders, shareholders ought to have an inherent right to know the reasons and explore any supporting documentation.  Only with the information can shareholders be certain that the board acted in a manner consistent with its fiduciary obligations.  In other words, there should be no need for "credible" evidence beyond the actions taken by the board to overturn the shareholder vote.

What will happen in this case? The Delaware courts and their pro-management bias will have a strong incentive to deny inspection rights.  If the inspection is allowed, it will open the door for shareholders to examine most decisions by the board to retain directors after they have been effectively voted out of office.  The courts will not want that to occur, preferring to render the decision unreviewable, thereby leaving the board with maximum discretion.

There is, however, a glint of hope. With talk of preemption in the air, the Chancery Court will not want to look too unfriendly to shareholders, less Congress decide to act.  In that case, Westland P&F better hope that the decision is made quickly, while the courts still have that concern.

If the Chancery Court does not allow inspection to occur in this case, it will be another area where the SEC will need to preempt and substantially increase the disclosure obligations on the company. It will be the only way for the owners of the company to obtain the information they need to assess the quality of the managers.

The complaint and other primary materials are posted on the DU Corprate Governance web site.

We are discussing CITY OF WESTLAND POLICE & FIRE RETIREMENT SYSTEM v. AXCELIS TECHNOLOGIES, INC., a case involving the invocation of inspection rights to investigate the reasons why the board of directors of Axcelis did not accept the resignation of three directors who failed to receive majority support from shareholders voting in the eleciton.

In the JOINT PRETRIAL ORDER, under the section on facts to be litigated, plaintiff asserted that only one other company with a Pfizer style majority vote bylaw has rejected a director who did not receive a majority of the votes cast.  Id. at 10 ("Besides Axcelis, only one other company – Pulte Homes – has used a Pfizer-style majority voting policy to reject the results of a shareholder vote for director elections.").

A Pfizer-style provision, sometimes referred to as "plurality plus" and other times as "majority voting lite," requires that a director receiving a plurality but not a majority resign.  The decision whether to accept the resignation becomes a discretionary decision for the board.  The provision (contained in the Company's Corporate Governance Principles) can be found here. 

It can be contrasted with the model first adopted by Intel where a nominee is not elected unless receiving a majority of the votes cast.  For those directors on the board who do not receive a majority of the votes, they must submit a letter of resignation (apparently in advance, see Guideline 12 of Intel Corporation Board of Director Guidelines on Significant Corporate Governance Issues).  It then falls to the board to decide whether or not to accept the resignation. 

Of course, not many directors have failed to receive a majority under either set of provisions.  According to RiskMetrics, only 32 directors at 17 companies in the Russell 3000 index did not receive a majority. Assuming each company has on average 8 directors, that means that 1/10th of a percent of directors did not receive a majority.  The stats are even more rare for S&P companies, as RiskMetrics notes ("It’s extremely rare for a director at an S&P 500 firm like Pulte to receive majority opposition in an uncontested board election. That happened at two S&P 500 companies (Cameron International and Boston Properties) in 2008"). 

All of these elections occurred before the recent amendment to NYSE Rule 452.  NYSE brokers will not be able to vote discretionary shares (those where street name owners did not return voting instructions) for directors.  This will result in the loss of a sizable and consistently pro-management block of votes.  As a result, the number of directors (both nominees and incumbents) not receiving a majority should increase, causing the letter of resignation issue to become even more important.

The complaint and other primary materials are posted on the DU Corprate Governance web site.

We are discussing CITY OF WESTLAND POLICE & FIRE RETIREMENT SYSTEM v. AXCELIS TECHNOLOGIES, INC., a case involving the invocation of inspection rights to investigate the reasons why the board of directors of Axcelis did not accept the resignation of three directors who failed to receive majority support from shareholders voting in the election.

Axcelis did not provide the requested information.  With respect to the resignation of directors, the Company characterized plaintiff's allegations as conclusory.  According to the Defendant's Opening Pre-Trial Brief:

• With regard to both the rejections of [Sumitomo's] proposals and the refusal to accept certain director resignations, the Complaint is peppered with conclusory references to disclosure shortcomings and entrenchment motives. Each of these allegations are so unreasonably speculative that they fail on their face. More importantly, however, each must fail because they are contradicted by many of the very documents and sources that Plaintiff itself relies on, and they are likewise contradicted by SEC filings and other public documents.

In effect, the argument, among other things, asserted that plaintiff had not met the credible evidence burden. 

As an alternative ground, the Company asserted that plaintiff had been told everything it needed to know about the reasons for refusing to accept the resignations.

• Regarding the Board’s decision to reject certain director resignations submitted under a Pfizer-style governance policy following a vote at the Company’s 2008 annual meeting, the Company, contrary to the aspersions cast by Plaintiff, did disclose the reasons why the Board (without participation by the directors whose resignations were tendered) determined that it would not be in the shareholders’ best interests to accept those resignations. Plaintiff’s conclusory allegations of entrenchment in connection with the decision, which are tied to absolutely no evidence that would even suggest a cognizable entrenchment motive, must fail for lack of any support.

In short, the Company had made adequate disclosure and the plaintiff had not presented sufficient "credible" evidence to allow for inspection of the Company's records.

The complaint and other primary materials are posted on the DU Corprate Governance web site.

We are discussing CITY OF WESTLAND POLICE & FIRE RETIREMENT SYSTEM v. AXCELIS TECHNOLOGIES, INC., a case involving the invocation of inspection rights to investigate the reasons why the board of directors of Axcelis did not accept the resignation of three directors who failed to receive majority support from shareholders voting in the eleciton.

The majority vote provision required the Nominating and Governance Committee to recommend to the Board the action to be taken with respect to such offer of resignation.  The Committee, which had been reduced to a single member (one of the resigning directors was on the committee but recused himself) recommended that the resignations not be accepted.  See DEFENDANT’S OPENING PRE-TRIAL BRIEF, at 16 ("Thereafter, Mr. Nettles, the sole remaining member of the Nominating and Governance Committee, after deliberation over the factors influencing the vote and the qualities of the three directors, recommended that the Board not accept the offers of resignation."). 

The board (with the three resigning directors recused) approved the resignation.  The press release issued by the Company explained that:

• In making there determination, the Board considered a number of factors relevant to the best interests of Axcelis. The Board noted that the three directors are experienced and knowledgeable about the Company, and that if their resignations were accepted, the Board would be left with only four remaining directors. One or more of the three directors serves on each of the key committees of the Company and Mr. Hardis serves as lead director. The Board believed that losing this experience and knowledge would harm the Company. The Board also noted that retention of these directors is particularly important if Axcelis is able to move forward on discussions with SHI following finalization of an appropriate non-disclosure agreement.

The decision spawned a request from Westland P & F for records relating to the decision not to accept the letters.  Having wisely opted to incorporate in Delaware (although having its principal executive offices in Beverly, Massachusetts), the Company refused to provide the requested documents.  As a result, the CWPFRS filed suit under Section 220 of the Delaware Code.  According to the complaint:

• Shareholders have reasonable grounds to believe that the Board may have breached its fiduciary duties to the Company and its shareholders in connection with recent acquisition proposals from Sumitomo Heavy Industries, Inc. (“SHI”), and in connection with the Board’s refusal to accept the resignations of three Board members whose candidacy was opposed by a majority of shareholders during the course of the Board’s consideration of SHI’s offers.

The complaint alleged that the board never disclosed the "steps it took" to determine that it was in the best interests of shareholders to support the retention of the directors.  Instead, the decision indicated "Board members were more interested in entrenching themselves on the Board than in guarding the best interests of shareholders." 

Finally, the complaint noted that Axcelis sold Sumitomo the 50% interest in the joint venture between the two companies, which was what Sumitomo "wanted all along."   As a result, Axcelis' sale of [the stake in the joint venture] to [Sumitomo] at a rock-bottom price, in an attempt to preserve control of the board."

The complaint and other primary materials are posted on the DU Corprate Governance web site.

Two United States Securities and Exchange Commission (“SEC”) employees are currently under investigation for suspected insider trading and other SEC regulatory violations. The investigation, which the SEC Office of the Inspector General (“SEC OIG”) turned over to the United States Attorney’s Office and the Federal Bureau of Investigation, focuses on two currently unnamed Enforcement Division attorneys.

The SEC opened its investigation after hearing of a “standing Monday lunch” among three SEC employees. The three agency staffers would discuss stocks, acquisitions, and companies under SEC investigation. The trio met approximately 40 times a year. The SEC chose not to investigate the third employee because she held very little stock and admitted to violating various SEC regulations.

During its investigation, the SEC discovered that the two employees regularly emailed each other during work hours seeking stock advice. Moreover, the male employee admitted sending to his brother and sister-in-law emails containing nonpublic information and advice on which stocks to trade. These email exchanges violate the SEC’s regulation concerning the proper use of government computers (SEC Regulation 24-4.3).

The report concludes that the female employee executed two stock trades that violated Rule 5 of the Commission’s Conduct Regulation (17 C.F.R. 200.735-5). The rule prevents SEC employees from using non-public information gained in the course of employment for trading purposes and, with limited exceptions, requires employees to hold purchased securities for six months.

The first violation occurred when she sold her shares in a large health care company two months before it underwent SEC investigation. The second occurred when she bought shares of an oil company and then sold them three weeks later, two days before the company underwent SEC investigation. The report suggests that she had knowledge of both investigations.

In investigating these two employees, the inquiry revealed that the SEC lacks a compliance system that can monitor employees’ stock portfolios and instead uses a system that relies almost entirely on the honor system. Additionally, the system appears to contradict the procedures contained in the previously mentioned Rule 5.

Currently, an employee who wants to buy or sell stock must apply to gain clearance to conduct the trade from the SEC’s Conduct Regulation Securities Transaction System (“CRSTR”). If the CRSTR clears the trade, the employee must then file Form 681 within five business days with the SEC’s Office of Administrative and Personnel Management. Rule 5, however, specifically states that Form 681 must be filed with the SEC’s Office of Human Resources. Alternatively, if the employee is notified that the stock is restricted then he or she is instructed to contact the SEC’s Ethics Office. That office may clear the trade, even though this loophole is not mentioned in the language of Rule 5. Certain higher-paid employees must also file Form 450 once a year, reporting all assets worth more than $1,000 or which have produced more than $200 in income. The two employees under investigation both fall into this category but failed to file these forms for all transactions.

Under this system, the female employee under investigation executed 247 trades between January 2006 and January 2008 and filed Form 681 for four CRSTR restricted transactions. Although she testified her portfolio was worth about $45,000 at the time of the investigation, her June 2008 brokerage account statement valued her portfolio at approximately $167,732. The male employee traded 14 times between January 2006 and January 2008 and holds a stock portfolio valued at more than $200,000.

Both employees testified they do not keep records of their transactions and recall information concerning their stock from memory. Surprisingly, neither employee agreed that their conduct could appear improper or that nonpublic information they acquire based on their position in the agency could influence their trading decisions.

The report notes that neither employee received appropriate training concerning Rule 5 or other SEC confidentiality regulations. When questioned, each employee had a different view on the exact conduct regulated by Rule 5. The only training SEC employees receive on the confidentiality of nonpublic information is in the New Hire Orientation Manual, which was not in existence when the two employees were hired.

The SEC OIG recommended in their investigation that there be an integrated, computerized system to track employee trading and other conduct regulated by Rule 5. Following this recommendation, Chairman Mary Schapiro announced that the SEC is contracting with an outside firm to develop a consolidated computer compliance system that will track, audit, and oversee employee securities transactions. The SEC also drafted a new set of internal rules governing employee transactions that will prohibit employees from trading in the securities of any company under SEC investigation, regardless of whether or not the employee has knowledge of the investigation. The new rules set forth additional limitations for employees engaging in personal trading, including requiring employees to provide the agency with duplicate trade confirmation statements and certifying that they do not possess non-public information about the company being traded. Chairman Schapiro also signed an order consolidating responsibility for overseeing employee transactions within the Ethics Office and is in the process of hiring a new chief compliance officer to help oversee the computer system.

The trial judge dismissed the Cuban case because the confidentiality agreement alleged to have been executed by Cuban did not inclue a ban on trading.

There are several problems with the analysis.  Despite the prodigious effort by the court to separate the concept of confidentiality and use, the two are not so clearly separated.  First, the purpose of confidentiality agreements is typically and inherently an attempt to prevent use.  Second, confidential information can easily be revealed through use.  Third, the interconnected nature of the concepts means that parties using the concept of confidentiality can easily have meant it as a synonym for use.  In other words, it is a matter of the intent of the parties. 

That the concept can encompass both can be seen by the language in Regulation FD, 17 CFR 243.100(b)(2).  Regulation FD prohibits intentional selective disclosure.  The regulation, however, exempts disclosure if made "To a person who expressly agrees to maintain the disclosed information in confidence";  the use of the term "confidence" in Regulation FD means that the recipient will not use the information to trade.  In other words, the concept of confidentiality encompasses use.

What will happen next?  Most likely, the SEC will file an amended complaint and allege that the parties intended the confidentiality agreement to encompass use.  To the extent the case remains good law, officers who disclose confidential information to shareholders will have to ask that it be kept confidential and not be used to trade.  In other words, the case will have limited impact.  Regulation FD may need to be amended.

Nonetheless, it shows the problems with the development of the law of insider trading.  The reality is that insider trading does not always encompass material non-public information deliberately passed along by corporate officers to someone they know will trade.  To ordinary investors, this looks terribly unfair and suggests that the trading markets are not open but fixed.

The issue was whether the alleged confidentiality agreement orally executed by Cuban before trading in the Company's shares was enough to create a duty of "trust and confidence" that meant he couldn't trade on the information.

The trial court found first that the matter was not controlled by state law (concerning the definition of duty). Second, the court found that the requisite duty of trust and confidence could in fact arise from an an agreement.  As the court noted:

• Because under O’Hagan the deception that animates the misappropriation theory involves at its core the undisclosed breach of a duty not to use another’s information for personal benefit, there is no apparent reason why that duty cannot arise by agreement. Further, recognizing that a duty analogous to the fiduciary’s duty of “loyalty and confidentiality” can be created by agreement fully comports with Chiarella’s teaching that the duty must arise out of a relationship between specific parties and not the mere possession of confidential information. The court therefore concludes that a duty sufficient to support liability under the misappropriation theory can arise by agreement absent a preexisting fiduciary or fiduciary-like relationship.

Ultimately, however, the court found that the alleged agreement was not sufficient to create the requisite duty of trust and confidence.  It had to be more than an agreement to keep the non-public information confidential.  There also had to be a component of the agreement that prohibited the use (read the right to trade on) the information.  As the court concluded:

• The agreement, however, must consist of more than an express or implied promise merely to keep information confidential. It must also impose on the party who receives the information the legal duty to refrain from trading on or otherwise using the information for personal gain. With respect to confidential information, nondisclosure and non-use are logically distinct.   A person who receives material, nonpublic information may in fact preserve the confidentiality of that information while simultaneously using it for his own gain. Indeed, the nature of insider trading is such that one who trades on material, nonpublic information refrains from disclosing that information to the other party to the securities transaction. To do so would compromise his advantageous position. See O’Hagan, 521 U.S. at 656 (“The misappropriation theory targets information of a sort that misappropriators ordinarily capitalize upon to gain no-risk profits through the purchase or sale of securities.”). But although conceptually separate, both nondisclosure and non-use comprise part  of the duty that arises by operation of law when a fiduciary relationship is created. Where misappropriation theory liability is predicated on an agreement, however, a person must undertake, either expressly or implicitly, both obligations. He must agree to maintain the confidentiality of the information and not to trade on or otherwise use it. Absent a duty not to use the information for personal benefit, there is no deception in doing so. As in the fiduciary context, the deception occurs when a person secretly trades on confidential information in violation of the source’s legitimate and justifiable expectation that the recipient will not  do so.

In other words, a confidentiality agreement wasn't enough.  It had to include, apparently, an express provision prohibiting the recipient from trading on the basis of the disclosed information. 

The Cuban agreement lacked this restriction, according to the court.  This was true even though Cuban allegedly responded to the information by saying:  “Well, now I’m screwed. I can’t sell.” As the court concluded:

• Thus while the SEC adequately pleads that Cuban entered into a confidentiality agreement, it does not allege that he agreed, expressly or implicitly, to refrain from trading on or otherwise using for his own benefit the information the CEO was about to share. Although at one point Cuban allegedly stated that he was “screwed” because he “[could not] sell,” this appears to express his belief, at least at that time, that it would be illegal for him to sell his Mamma.com shares based on the information the CEO had provided. This statement, however, cannot reasonably be understood as an agreement to sell based on the information. Further, the complaint asserts no facts that reasonably suggest that the CEO intended to obtain from Cuban an agreement to refrain from trading on the information as opposed to an agreement merely to keep it confidential.

In short:  "Outside a fiduciary or fiduciary-like relationship, a mere unilateral expectation on the part of the information source —one that is not based on the other party’s agreement to refrain from trading on the  information —cannot create the predicate duty for misappropriation theory liability."

We've posted the complaint and other primary material on the DU Corporate Governance web site.