Chapter 7 - How do Owners of a Corporation Make Money 1 Chapter 7 - How do Owners of a Corporation Make Money A.

Receiving Salaries From the Corporation 1. Who Decides which shareholders get salaries a. Hollis v Hill Facts Issues Holdings Rules Analysis Policy Dissent 2. What are the legal limitations on salaries a. Giannotti v. Hamway Facts Issues Holdings Rules Analysis Policy Dissent B. Buying and Selling Stock at a profit 1. The Individual Defendants a. Introductory b. Material Inside Information c. Facts Issues Holdings Rules Rule 10b-5, 17 CFR 240.10b-5, on which this action is predicated, provides: It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange, o (1) to employ any device, scheme, or artifice to defraud, o to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or o (3) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security. The essence of the Rule is that anyone who, trading for his own account in the securities of a corporation, has "access, directly or indirect- ly, to

Chapter 7 - How do Owners of a Corporation Make Money 2 information intended to be available only for a corporate purpose and not for the personal benefit of anyone" may not take "advantage of such information knowing it is unavailable to those with whom he is 3aling," i.e., the investing public., Insiders, as directors or management officers are, of mrse, by this Rule, precluded from so unfairly dealing, but the Rule is Iso applicable to one possessing the information who may not be strictly ermed an "insider" within the meaning of Sec. 16(b) of the Act.* , anyone in possession of material inside information must eith her disclose it to the investing public, or, if he is disabled from disclosing it in order to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed. S' B. Material Inside Information o s. An insider's duty to disclose infor- mation or his duty to abstain from dealing in his company's securities arises only in ' 'those situations which are essentially extraordinary in nature and which are reasonably certain to have a substantial effect on the market price of the security if (the extraordinary situation is) dis- dosed." o Nor is an insider obligated to confer upon outside investors the benefit of his superior financial or other expert analysis by disclosing his educated guesses or predictions. The only regulatory objective is that access to material information be enjoyed equally, but this objective requires nothing more than the disclosure of basic facts so that outsiders may draw upon their own evaluative expertise in reaching their own investment decisions with knowledge equal to that of the insiders. o The basic test of materiality * * * is whether a reasonable man would attach importance * * * in determining his choice of action in the transac- tion in question. o , whether facts are material within Rule 10b-5 when the facts relate to a particular event and are undisclosed by those persons who are knowledgeable thereof will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity. The core of Rule 10b-5 is the implementation of the Congressional purpose that all investors should have equal access to the rewards of participation in securities transactions. It It was the intent of Congress that all members of the investing public should be subject to identical market risks, which market risks include, of course, the risk that one's evaluative capacity or one's capital available to put at risk may exceed another's capacity or capital. 1 d. e. Chiarella v. United States Facts Printer prosecuted for trading on the merger of a company that he was able to deduced from the printing work. Printer returned the profit and was charged for violating the SEC 10b-5 Issues whether silence in such circumstances violates 10(b), Holdings Rules a corporate insider must abstain from trading in the shares of his corporation unless he has first disclosed all material inside information known to him. The The obligation to disclose or abstain derives from "[an] affirmative duty to disclose material information, [which] has been traditionally imposed on corporate 'insiders,' particularly officers, directors, or controlling stockholders. j insiders must disclose material facts which are nown to them by virtue of their position but which are not known to persons with whom they deal and which, if known, would affect their investment judgment." It the duty arose from (i) the exis- :ence of a relationship affording access to inside information intended to e available only for a corporate purpose, and (ii) the unfairness of allowing a corporate insider to take advantage of that information by trading without disclosure.

Chapter 7 - How do Owners of a Corporation Make Money 3 That the relationship between a corporate insider and the stockhold- of his corporation gives rise to a disclosure obligation At common law, misrepresentation made for the purpose of inducing reliance upon the false statement is fraudulent. B ;. But one who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so. A duty to disclose arises when one party has information "that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them."* [: a relationship of trust and confidence between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation. T This relationship gives rise to a duty to disclose because of the "neeessityof preventing a corporate insider from ... [taking] unfair advantage of the uninformed minority stockholders." purchaser of stock who has no duty to a prospec- tive seller because he is neither an insider nor a fiduciary has been held to have no obligation to reveal material facts. that silence in connection with the purchase or sale of securities may operate as a fraud actionable under 10(b) But such liability is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a 'ansaction. A o Application of a duty to disclose prior to trading guarantees that corporate insiders, who have an obligation to place the shareholder's welfare before their own, will not benefit personally through fraudulent use of material, nonpublic information. that "[any- one]corporate insider or notwho regularly receives material nonpublic nformation may not use that information to trade in securities without incurring an affirmative duty to disclose." A Section 10(b) is aptly described as a catchall provision, but what it catches must be fraud. When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak. : a duty to disclose under 10(b) does not arise from the mere possession of nonpublic market information. Misappropriation o general rule, neither party to an arm's-length business transac- tion has an obligation to disclose information to the other unless the parties stand in some confidential or fiduciary relation. T! o . This rule permits a businessman to capitalize on his experience and skill in securing and evaluating relevant information; it provides incentive for hard work, areful analysis, and astute forecasting. o 10(b) and Rule 10b-5 to encompass and build on this principle: to mean that a person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading. o An investor who purchases securities on the basis of misappropriated nonpublic information possesses just such an "undue" trading advantage; his conduct quite clearly serves no useful function except his own enrichment at the expense of others. o Misappropriation -- acquired by means of some tortious action on his part Analysis printer has no duty to disclose no relationship to the seller Policy Dissent 1. Notes a. 14(e) of the '34 Act (added in the Williams Act) ig Act) is aimed at fraud in connection with tender offers. Under this statute, he SEC promulgated Rule 14e-3(a), which makes it unlawful to trade on material nonpublic information

Chapter 7 - How do Owners of a Corporation Make Money 4 concerning a tender offer. Under that Rule, the information might come from the acquiring company or the target or insiders or others working for either the acquiring or target companyjust so the defendant knows or should know that the information is nonpublic. f. Dirks. SEC Facts D obtained insider information from another without a connection. D disclosed the information to investor. D got the information from a disgruntled officer of the company. Issues whether Dirks violated the antifraud provisions of the federal securities laws by this disclosure. Holdings Rules "Where 'tippees'regardless of their motivation or occupationcome into possession of material 'cor- porate information that they know is confidential and know or should know came from a corporate insider,' they must either publicly disclose that information or refrain from trading." "corporate 'insiders,' particularly officers, directors, or controlling stock- holders" an ''affirmative duty of disclosure ... when dealing in securities." Th not only did breach of this common-law duty also establish the elements of a Rule 10b-5 violation, but that individuals Dther than corporate insiders could be obligated either to disclose material nonpublic information before trading or to abstain from trading altogeth- er. I two elements set out in Cady, Roberts for establishing a Rule 10b-5 violation: "(i) the existence of a relationship affording access to inside information intended to be available only for a corporate purpose, and (ii) the unfairness of allowing a corporate insider to take advantage of that information by trading without disclosure." "a duty to disclose under 10(b) does not arise from the mere possession of nonpublic market information." I ' Such a duty arises rather from the existence of a fiduciary relationship. , an insider will be liable under Rule 10b-5 for inside trading only where he fails to disclose material nonpublic information before trading on it and thus makes "secret profits." : there can be no duty to disclose where the person who has traded on inside information "was not [the corporation's] agent, ... was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence.' Insiders who have independent fiduciary duties to both the corporation and its shareholders, th tippee "inherits" the obligation to shareholders whenever he receives inside information from an insider: Tippees such as Dirks who receive non-public, material information from insiders become 'subject to the same duty as [the] insiders." Such a Such a tippee reaches the fiduciary duty which he assumes from the insider when the tippee^knowingly transmits the information to someone who will probably trade on the basis thereof.. " [anyone]corporate insider or notwho regularly receives material non- public information may not use that information to trade in securities without incurring an affirmative duty to disclose." anyone who knowingly receives nonpublic material information from an insider has a fiduciary duty to disclose before trading.* [ Because the disclose-or-refrain duty is extraordinary, it at- taches only when a party has legal obligations other than a mere duty to comply with the general antifraud proscriptions in the federal securities aws." VV reaffirm today that ''[a] duty [to disclose] arises from the relationship between parties ... and not merely from one's ability to acquire information because of his position in the market." . Not only are insiders forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but

Chapter 7 - How do Owners of a Corporation Make Money 5 they also may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain. the tippee's duty to disclose or abstain is derivative from that of the insider's duty. "[the] tippee's obligation has been viewed as arising from his role as a partici- >ant after the fact in the insider's breach of a fiduciary duty." RULE: a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclos- ing the information to the tippee and the tippee knows or should know that there has been a breach. "[Tippee] responsibility must be related back to insider responsibility by a necessary finding that the tippee knew the information was given to him in breach of a duty by a person having a special relationship to the issuer not to disclose the information... ripping thus properly is viewed only as a means of indirectly violating the disclose-or-abstain rule. In determining whether a tippee is under an obligation to disclose abstain, it thus is necessary to determine whether the insider's "tip" constituted a breach of the insider's fiduciary duty. All All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders. Ir 5, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And ibsent a breach by the insider, there is no derivative breach. But to determine whether the disclosure itself "[deceives], [manipulates], or [defrauds]" shareholders, Aarc the initial inquiry is whether there has been a breach of duty by the insider. This requ This requires courts to focus on objective criteria, i. e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings. :There^u are objective facts and circumstances that often justify such an inference. For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. 1 The elements of fiduciary duty and" exploitation of nonpublic information also exist when an insider makes a jift of confidential information to a trading relative or friend. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient. Analysis No relationship No personal gain No inducement to invest Policy Dissent 1. Notes g. US v. OHagan (misappropriation) Facts Accused learned about the acquisition of company A. Accused acquired stocks in company A and sold it after the merger. Accused profited 4.3M and used some to replenished client trust fund (which he withdrawed in advanced.) Accused was a partner of the firm handling the merger. Issues Whether accused violated 10b-5? Holdings that criminal liability under 10(b) may be predicated on the misappropriation theory.* [4] Rules Under the "traditional" or "classical theory" of insider trading liabili- ty, 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a "deceptive device" under 10(b), we have affirmed, because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation."

Chapter 7 - How do Owners of a Corporation Make Money 6 That relationship, we recognized, "gives rise to a duty to disclose [or to abstain from trading] because of the 'necessity of prevent- ing a corporate insider from ... taking unfair advantage of ^ . un- informed ... stockholders.' " The classical theory applies not only to officers, directors, and other permanent insiders of a corporation, but also to attorneys, accountants, consultants, and others who temporarily become fiduciaries of a corporation. The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities tradJn& Purposes, in breach of a duty owed to the source of the information. * Under this theory, a fiduciary's undisclosed, self- serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. . In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information. The classical theory targets a corporate insider's breach of duty to shareholders with whom the insider transacts; the misappropriation theory outlaws trading on the basis of nonpublic information by a corpo- rate "outsider" in breach of a duty owed not to a trading party, but to the source of the information. T . The misappropriation theory is thus designed to "protect the integrity of the securities markets against abuses by 'outsid- ers' to a corporation who have access to confidential information that will affect the corporation's security price when revealed, but who (owe no fiduciary or other duty to that corporation's shareholders." , that misappropriation, as just defined, satisfies 10(b)'s requirement that chargeable conduct involve a "decep- tive device or contrivance" used "in connection with" the purchase or sale of securities. W \, that misappropriators, deal in deception. A fiduciary who "[pretends] loyalty to the principal while secretly converting the principal's information for personal gain," * * * "dupes" or defrauds the principal, * satisfy the common law rule that a trustee may not use the property that [has] been entrusted [to] him, there would have to be consent. To satisfy t requirement of the Securities Act that there be no deception, there would Dniy have to be disclosure."* [6] r, full disclosure forecloses liability under the misap- propriation theory: Because the deception essential to the misappropria- tion theory involves feigning fidelity to the source of information, if the fiduciary discloses to the source that he plans to trade on the nonpublic information, there is no "deceptive device" and thus no 10(b) viola- tionalthough the fiduciary-turned-trader may remain liable under state law for breach of a duty of loyalty. We turn next to the 10(b) requirement that the misappropriator's deceptive use of information be "in connection with the purchase or sale ? [a] security." 1 o This element is satisfied because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities. A misappropriator who trades on the basis of material, nonpublic information, in short, gains his advantageous market position through deception; he deceives the source of the information and simultaneously harms members of the investing public. . Should a misappropriator put such informa- tion to other use, the statute's prohibition would not be implicated. The theory does not catch all conceivable forms of fraud involving confidential information; rather, it catches fraudulent means of capitalizing on such information through securities transactions. Analysis

Chapter 7 - How do Owners of a Corporation Make Money Policy Dissent 1. Notes