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 derivativesuit 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.

 

 

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 responsibilityfor the violations, AND

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

 

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 yearafter 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 ofboththe 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 allcorps (not just those withregistered securities), recovery can be had againstany 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.

 

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