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MICHIGAN STATE UNIVERSITY

COLLEGE OF LAW

BUSINESS ENTERPRISES FALL 2008

Professor Bruce W. Bean

Game Plan for Week 6

Pages 299-327; The Limited Liability Company

Pages 447-493: SEC Rule 10b-5; Securities Act of 1933 and Securities Exchange Act
of 1934

Read the Delaware LLC Law and Partnership Law. They are much easier to follow
than the DGCL, even if the Court in Elf describes the LLC law as “prolix” and “oddly
organized.” It is a great deal better than many of the documents lawyers deal with.
The LLC is an increasingly popular, statutorily created vehicle for conducting
business. It has some of the simplicity and flexibility of a partnership while attempting
to also provide the liability limiting features of a corporation. While LLC’s are very
new, it has become clear (at least to me) that courts will be applying analogous
corporate principles to areas not yet litigated with respect to LLC’s. This should give
those choosing the LLC form the comfort of dealing in an area where the law should
be predictable.

Goals:
Identify situations where an LLCV is like (1) a corporation, (2) a partnership, (3) none of
the above.

Piercing the LLC Veil

The Operating Agreement for an LLC

Dissolution of an LLC

Role of Shareholders, Board and Management

[Lifted from Professor Barnhizer]

I. Overview
A. Limited Liability Companies, Limited Liability [General] Partnerships, and
Limited Liability Limited Partnerships are relatively new forms of business
organization.

1. Technically, Wyoming had its LLC statute in 1977, but this business form
did not become even marginally useful until 1988 (IRS Ruling 88-76).

2. Likewise, LLPs and LLLPs only started in 1991 and only became
significant in the mid- to late-1990s.

B. Three primary characterizations:

1. All three forms afford their members some form of limited liability and
partnership-style pass-through taxation.

2. All three are solely creatures of state organic statutes and require the filing
of some form of public document / registration statement with the
Secretary of State or other designated state office to commence their
existence.

a. Some jurisdictions have adopted doctrines similar to “de facto


corporation” or “corporation by estoppel” with respect to these
entities.

3. All three are still developing (which is good for young lawyers since the
old guys will not have time to be “bothered”) and are subject to wide
variations in financial structure and governance.

C. LLCs

1. Pass-through tax status versus limited liability

2. History – Wyoming LLC Act (1977); Revenue Ruling 88-76 (applying 4


factor Kintner Regulations test for determining whether entity taxed as
partnership or corporation: (1) limited liability; (2) perpetual existence; (3)
centralized management; (4) freely transferable interests); growth of state
LLC statutes; “Check-The-Box” Regulations 1997; faster growth and
variation of LLC statutes.

3. Common Characteristics of LLCs

a. Formed under state organic statute following filing of articles of


organization;

b. Separate existence;
c. Member-managed or Manager-Managed;

d. Broad flexibility as to events causing dissolution (approaching


perpetual existence)

4. Formation:

a. File certificate or articles of organization with Secretary of State.

i. “De facto LLC” and “LLC by estoppel” might be available.

ii. Some cases suggest that the same promoter liability rules that
apply to pre-incorporation liabilities of the promoter may be
imported in the LLC context.

b. LLC statutes often provide that general partnerships and LPs to


convert to LLCs.

i. Note that this will raise problems for creditors who may have
structured their credit agreements on the assumption that all
general partners would be personally liable for the debts of the
partnership.

ii. Limited Liability and Veil Piercing


(A) Limited Partnership – no common law overlay, solely a
creature of statute (RULPA & ULPA (2001).

5. Limited Liability and Veil Piercing

a. Importation of corporate veil piercing doctrine to LLC form.

i. Main difference is that one of the elements of corporate veil


piercing, “failure to follow corporate formalities,” just doesn’t
make sense in the LLC form since there are not that many
formalities that need to be followed.

ii. Courts are looking for a combination of thin capitalization plus


some form of abuse of the form such as using the LLC form and
limited liability to achieve fraud or other injustice.

(A) Remember that, to satisfy the injustice element, you need to


show more than that the entity is judgment proof against a
valid claim by an injured party.
iii. Kaycee Land and Livestock v. Flahive– equitable basis for veil
piercing doctrine, application to any limited liability business form,
ad hoc nature of the inquiry, purpose of limited liability.

6. Members’ Financial Rights and Obligations

a. Default rule varies by jurisdiction:

i. Some jurisdictions use general partnership allocation (equal


sharing of profits, pro rata sharing of losses) as default.

ii. Some jurisdictions use limited partnership / corporation allocation


as default (pro rata sharing of profits & losses).

b. Operating agreement defines contribution obligations for initial


contributions and interim contributions.

7. Governance of LLCs

a. Most LLCs default to a general partnership model of member-


management.

i. Raises questions for operating agreement about (1) when members


are able to bind the LLC as agents, (2) percentage required for
votes on ordinary matters, (3) percentage required for votes on
extraordinary matters.

b. Some states adopt a default rule (and many LLCs adopt this model in
their operating agreement) of manager-managed LLCs.

i. Corporate or LP style structure of officers who manage and are


agents for LLC.

ii. Note that LLC statutes generally require third parties to check the
public record to determine whether the LLC is member-managed
or manager-managed to determine whether the member or manager
with whom they are dealing actually has authority to undertake the
transaction at issue. (Compare publicly filed statement of
partnership authority available to general partnerships operating
under RUPA §303.)

iii. Some LLC statutes do not require this election in the publicly filed
certificate / articles of organization, meaning that third parties
cannot find out in the public record.
D. LLPs & LLLPs

1. Like LLCs, these business forms only became popular after Revenue
Ruling 88-76 and came into their own with the 1997 adoption of LLP
provisions in RUPA (and IRS check-the-box regulations).

2. LLPs are general partnerships that have elected to become limited liability
firms by filing a registration statement with the Secretary of State or
appropriate state agency.

a. LLLPs are limited partnerships that have made the same election.

3. General Partnerships can convert to LLP status by filing a registration


statement.

a. This does not dissolve the partnership.

b. Requires vote of partners, usually a simple majority.

c. Partners have limited liability from the time of registration.

d. Pre-registration contracts continue to bind the LLP post-registration.

II. Pre-1988, essentially 4 business forms:

A. Sole Proprietorship

B. General Partnership

C. Limited Partnership

D. Corporation

1. Close Corp. / S Corp.

III. New orgs began to develop after 1988:

A. Limited Liability Companies (LLC’s)

B. Limited Liability [General] Partnerships (LLP’s)

C. Limited Liability Limited Partnerships (LLLP’s)

The Limited Liability Company Operating Agreement; Duty of Care

Elf Atochem North America Inc. v Jaffari p. 305


Who wanted to be in Delaware?

What is a derivative suit, anyway? This is an LLC, not a corp.

Wasn’t this just a cheap, pettifogging lawyer trick where the sleazy corporate lawyer
attempts to screw the little guy by taking advantage of an unimportant technical
oversight?

Do you arrive at the same answer if Elf is your client and it was your brilliant
masterstroke to take advantage of an obvious slipup and the uncertain nature of the
developing law?

Was this a dispute with the LLC which had not signed?

Was the Operating Agreement a mere formality or had some attention been paid to it?

What does the Delaware ct say about the legislative policy re the amount of discretion
members have in drafting Operating Agreements?

Which provisions of the Agreement proved fatal to Elf’s efforts?

Which sections of the Delaware LLC law are applicable here?

What happened to Elf’s rights under Delaware law?

Piercing the LLC Veil

Kaycee Land and Livestock v. Flahive p 312.

Is piercing the corporate veil doctrine applicable to an LLC where the statute is silent and
other states’ LLC laws are much clearer?

Note here that the court says that the statute is very short. It was the first passed (1977)
and had not been updated in 25 years, despite tremendous changes in the field in that
time. Contrast this with Delaware’s policy of legislatively updating its corporation and
other laws at least every two years to remove ambiguities and accommodate
developments as they occur.

Fiduciary Obligations [again]

McConnell v. Hunt Sports Enterprises p. 317

This case demonstrates the wide flexibility permitted in establishing an LLC. It is the
lawyer’s task to cover all conceivable future problems in the initial organizing documents
Is Hunt’s position just that taken by a guy who can afford to litigate and is mad because
his negotiating style did not work? (I did mention colossal egos, didn’t I?)

Is the language of the Agreement clear and unambiguous?

Does it depend upon what “any” and “other” mean?”

Could you have drafted it more clearly? In English, I mean.

This is a fiduciary relationship case. Court says obligation is same as in a partnership


(“utmost trust and loyalty”). What would Cardozo have said about McConnell here?
[McConnell is a fellow alumnus]

Why was there no tortious interference by McConnell? Why not against Hunt?

As the judge would you have awarded legal fees to McConnell?

Pages 447-493 SEC Rule 10b-5; Securities Act of 1933 and Securities Exchange
Act of 1934

The Securities Act of 1933 (’33 Act”) governs the offering and sale of “securities” to the
public. It is pursuant to the ’33 Act that companies file a “registration statement” with
the Securities and Exchange Commission and make their “initial public offering.” The
registration statement includes the “prospectus” which is distributed to prospective
investors when a company “goes public” or makes a later “secondary offering” of its
securities. We ignore it in this course except to note that the definition of “security” can
be extraordinarily broad.

The Securities Exchange Act of 1934 (the “’34 Act”) focuses upon public reporting and
other obligations of “public companies” and upon secondary trading markets (typically
we think of these as institutions like the NYSE and NASDAQ).

The ’34 Act includes several disclosure and regulatory provisions:

• Securities Fraud (§10(b) & Rule 10b-5 promulgated thereunder);


• Ban on “short swing” profits by “corporate insiders” (§16(b));
• Annual disclosure of financial information (Form 10K);
• Quarterly disclosure of financial information (Form 10-Q);
• Rules for proxy solicitations (seeking votes from public shareholders) §14;
• Establishes rules for tender offers, repurchases of securities by issuers, exchange
offers and much else which we do not deal with in this course.

Section 10b and Rule 10b-5. These are VERY important. If you memorize them
you will not need to search for them later.
Section 10b: “It shall be unlawful for any person, directly or indirectly, by the use
of any means or instrumentality of interstate commerce or of the mails, or of any
facility of any national securities exchange - * * * * (b) To use or employ, in
connection with the purchase or sale of any security registered on a national
securities exchange or any security not so registered, or any securities based swap
agreement . . . any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the Commission may prescribe as
necessary or appropriate in the public interest or for the protection of investors.”

Rule 10b-5: “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,

to employ any device, scheme, or artifice to defraud,

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

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.”

Courts have created a private cause of action with respect to these provisions of
the ’34 Act. Thus develops “federal common law.”

Two primary issues:

1. Material misstatement or omission in connection with the sale


or purchase of any security.

2. Insider trading – trading while in possession of material non-


public information.

Disclosure obligations under Exchange Act

Exchange Act requires periodic disclosures of financial status and other


significant events for certain "public companies" that meet given thresholds: (a)
more than $10 million in assets, or (b) more than 500 shareholders.

Exchange Act §10(b) and Rule 10b-5 – Anti-fraud and Insider Trading

§10(b) applies to any security, not just registered or publicly traded securities.
What does one need to establish to make a claim for fraud?
• Economic loss
• Scienter (“wrongful state of mind; intent to deceive, manipulate or defraud”)
• Proximate cause of the loss by the misrepresentation
• Material misrepresentation
• “in connection with a purchase or sale of a security”
• Reliance on the transaction

Basic Inc. v. Levinson – p. 450 (CRITICAL CASE)

“Make sure you understand it. It’s a biggie.” –Brent L. Domann

What balance is necessary between the trivial and the material in periodic disclosure
regimes versus continuous disclosure regimes?

When do preliminary merger negotiations become material?


• We know the stock price of the proposed target jumps a great deal when there
is a rumor, or an announcement, of a merger.
• If this information “leaks” and the necessary “premium” over the “market”
price virtually disappears, the putative acquirer will walk away.
• And yet, there are many discussions of mergers which never lead to actual
acquisitions.
• “Where the event is contingent or speculative in nature, it is difficult to
ascertain whether the 'reasonable investor' would have considered the omitted
information significant at the time.”
o Why does court reject this argument here?

The need for secrecy in merger negotiations is irrelevant in the statutory disclosure
regime.
• Materiality doesn't care about the desirability of a bright line rule for
corporate convenience.
o Is this a good idea?

Test: “Materiality 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 company activity.”
• Probability and magnitude.
• “Generally, in order to assess the probability that the event will occur, a
factfinder will need to look to indicia of interest in the transaction at the
highest corporate levels. * * * [B]oard resolutions, instructions to investment
bankers, and actual negotiations between principals or their intermediaries
may serve as indicia of interest.”
• “To assess the magnitude of the transaction to the issuer of the securities
allegedly manipulated, a factfinder will need to consider such facts as the size
of the two corporate entities and of the potential premiums over market
value.”
o Rejection of bright line rules: “No particular event or factor short
of closing the transaction need be either necessary or sufficient by
itself to render merger discussions material.”

Fraud on the Market Theory


• “The fraud on the market theory is based on the hypothesis that, in an open
and developed securities market, the price of a company’s stock is determined
by the available material information regarding the company and its
business…. Misleading statements will therefore defraud purchasers of stock
even if the purchasers do not directly rely on the misstatements…. The causal
connection between the defendants’ fraud and the plaintiffs’ purchase of stock
in such a case is no less significant than in a case of direct reliance on the
representations.” (Citing Peil v. Speiser, 806 F.2d 1154, 1160-61 (3d Cir.
1986)).
• Was it proper for the lower court to apply a rebuttable presumption of
reliance, supported by the fraud on the market theory?
o Depends on whether this is an efficient capital market – broad
based market, numerous impersonal transactions, material
information capable of being incorporated into valuations nearly
instantaneously.
• If yes, then the theory makes sense.
• If no, then the court should have required individualized
reliance.
• This is a burden shifting mechanism.
o Realization that in some markets, investors rely more on market
integrity than on actual representations.
• Investors rely on brokers, market makers, and institutional
investors to price the stock accurately.
• In that case, we can presume they relied upon the
misstatements because those representations are
automatically incorporated into the market price.
o In small, inefficient markets with few participants, the burden of
proof stays with the plaintiff to show actual reliance.
• Can be rebutted.
o Truth on the market – corrective statements dissipate the effect of
the alleged misrepresentations.
o Defendant can prove that individual plaintiffs would have divested
regardless of representations (i.e., bankruptcy, potential antitrust
problems, political pressures to divest, etc.)
• FYI - Former Secretary of the Treasury, ever so briefly, President of Harvard,
Lawrence Summers, and, despite all, a widely respected economist, has said:
"The efficient market hypothesis is the most remarkable error in the history of
economic theory." p. 74 Lowenestein, When Genius Failed, quoted from WSJ without
citation detail.
o Was Whizzer White wrong in his mild dissent?

Were the statements issued by Basic calculated to mislead? (i.e., made with scienter – a
knowing intent to deceive))

What about the individual who does not actually believe the statements issued by the
company (i.e., thinks they are false) but has to sell anyway – was s/he defrauded?

West v. Prudential Securities, Inc. p. 463

How do Hofman’s statements differ from those made in Basic?

§10(b) and Rule 10b-5 apply to anyone who makes a false statement or omission in
connection with the sale of a security. Did Hofman do this?

Of the elements needed to establish fraud, what is missing here?


• Economic loss
• Scienter (“wrongful state of mind; intent to deceive, manipulate or defraud”)
• Proximate cause of the loss by the misrepresentation
• Material misrepresentation
• “in connection with a purchase or sale of a security”
• Reliance on the transaction

What did Judge Easterbrook decide?

Easterbrook: “The theme of Basic . . . is that public information reaches professional


investors, whose evaluations of that information and trades quickly influence securities
prices.”

Financial instruments are entirely fungible within given risk/reward ranges. ???

What was the plaintiff’s causation problem here?

What role should economic / finance theory play in law making? (This is a recurring
debate/theme in corporations law: think BJR, waste, dividend policy, etc.)
• Assuming there is debate both on the principle that stock markets are efficient and
that the demand curve for stocks is perfectly elastic, is it proper for courts to make
law based upon these theories?

Dura Pharmaceuticals, Inc. v. Brouda 2007 Supplement


With the over-editing which occurred for this Dura excerpt, this case is either simple or
simply confusing.

Facts:
• Dura stock prices at various announcements:
o 4-15-1997, approximately $34
o 2-24-1998 approximately $39 and dropped to $22 w/ announcement
o 11-4-1998 approximately $10
• Class certified by the ever-predictable Ninth Circuit: All purchasers who acquired
shares between 4-15-1997 and 2-24-1998.

Of the six elements required to establish a 10b-5 fraud claim, which is addressed by the
Supreme Court in this case?
• Economic loss
• Scienter (“wrongful state of mind; intent to deceive, manipulate or defraud”)
• Proximate cause of the loss by the misrepresentation
• Material misrepresentation
• “in connection with a purchase or sale of a security”
• Reliance on the transaction

Notes pp. 467-468

This is not a securities regulation course, but the cases which marked the development of
10b-5 actions do help us understand the Rule and how it is applied:

• Blue Chip Stamps v. Manor Drug Stores 1975


o The court takes the language of the Rule – “in connection with a purchase
or sale” - quite literally. A clear wrong occurred which cannot be cured
under 10b-5.
• Ernst & Ernst v Hochfelder 1976
o The “scienter” requirement – a question of what was the defendant’s “state
of mind” – bolstered by clarifying that the omission or false statement
must have been made with the “intent to deceive, manipulate or defraud.”
• Central Bank of Denver v. First Interstate Bank. 1994
o Although the Federal courts have long upheld the implied right of a
private action for Section 10(b) actions, Central Bank limited such actions
to the primary actors and held there is no right of private action against
“aiders and abettors.”

Santa Fe Indus. v. Green p. 468


A little more standard corporate law. The short form merger provisions of the corporate
laws of Delaware (sec 253) and Michigan (sec. 450.1711) permit the holder of a very
large majority of the shares of a company to “eliminate, “freeze-out,” “squeeze out”
inconvenient minority shareholders. There may be many reasons to do this, including,
avoiding having your General Counsel constantly reminding you that the directors of this
almost wholly-owned subsidiary as well as the majority shareholder itself, owe fiduciary
duties to that small minority of shareholders.

It is often the case that a minority, too small to block any corporate action, is simply left
to rot. They have no meaningful role or vote and, so long as dividends are not to be paid
(remember the aberrant ruling in Dodge), why not let them sit? But if, as here, there is
hidden, or at least unrealized, value in the corporation ($640 here), squeezing out the
minority (at $150 here) puts them to the test of jumping through the many hoops required
to get an appraisal (the "appraisal" remedy – aka dissenter's rights - is available to
shareholders in certain situations, see DGCL 262 ; MCL 450.1762). This is an
inconvenient, but by no means impossible task – especially for a shareholder properly
advised by a lawyer who will read the corporate law carefully.

It may be that the public market for such a minority’s shares (if it even exists) will reflect
the fact that this rump position has little value by discounting the shares very significantly
from their “liquidation value, here.” This could explain the apparently meager value
($254.40) awarded by the court in the actual appraisal action which was brought by Kirby
shareholders.

I like this case because it brings us back to the principal theme of this course, state law
fiduciary duties, and reminds us that we are dealing here with corporations created under
state law and not with the inexorable advance of federal law into the reserved domain of
state legislation.

What did the court decide here regarding the elements of a 10b-5 fraud action?

Was there “deception” here? Fraud?

Does the Court in effect hold that it is permissible to steal if the theft is fully disclosed?

====
Please Note that this case arose in the Second Circuit.

“My” judge, Leonard P. Moore dissented, as was often his practice, from the
Court’s opinion. The Supreme Court was wise enough to take Judge Moore’s
position.

Clerking is a fantastic experience, even for non-litigators.

MOORE, Circuit Judge (dissenting):


I most strongly dissent from the use of their powers by two judges of one of the
eleven judicial Circuits to override and nullify not only the corporate laws of
Delaware with respect to short-form corporate mergers, but also, in effect,
comparable laws in an additional thirty-seven States.
....
My agreement with the majority starts and stops on the first page of its opinion.
The case is "important, (and) interesting"; it is not "complicated". Although legal
issues are frequently clothed in dark and light shades of gray, the case at bar is a
study in the stark contrast of black and white. The majority's conjury in holding
that this case presents a violation of Section 10(b) of the Securities and Exchange
Act and Rule 10b-5 promulgated thereunder is totally without factual anchor, and
I cannot refrain at the outset from objecting to the frailty of their factual
foundation, which is truly of the character of bricks without straw and an
omission that warrants immediate correction.

533 F.2d 1283, 1299

No, I had no role in this dissent!

Deutschman v. Beneficial Corp. p. 474

A “call” (example below) is the right to purchase a specified number of shares of a


particular security at an agreed price. Those who held such options on Yahoo shares did
very well last week. Yahoo was trading under $20 dollars prior to the announcement by
Microsoft, at which point it jumped to $28. Calls are a very inexpensive way to lock in a
profit when the share price of the underlying security rises. If it does not rise, not that
much, relatively speaking, has been lost. When a call does yield such a nice windfall, the
call is generally sold at a price reflecting the new, higher price. The profit from the
transaction is thus realized without any purchase or sale of the underlying shares (here
beneficial =common stock).

In Blue Chip Stamps we learned (the Supreme Court decided in any case) that there was
no 10b-5 cause of action for one who was discouraged from purchasing by alleged
misrepresentations, because there was no “purchase or sale” of securities. Deutschman
raises the question: Is a right to purchase Beneficial shares, when no purchase or sale is
actually effected, sufficient to state a 10b-5 cause of action? Plaintiffs never owned
Beneficial stock and the defendants never sold any Beneficial shares. Do plaintiffs have
standing to bring the action under 10b-5?

The decision simply means the case may proceed. What further burdens must
Deutschsman meet?
In many cases, exercise of an option does not result in actual transfer of ownership of the
thing upon which the option is held. This is most common in commodities, but also in
stock –

Put: Right to sell stock at option / strike price ($25). If market price goes to $20 on
exercise date, you buy stock at $20 and sell at $25. (if you already own it, you just
sell your stock). If market price goes to $30, your option is “under water” or
worthless.
Call: Right to buy stock at option / strike price ($25). If the market price goes to $20
on the exercise date, your option is worthless. If the market price rises to $30, you
have a right to buy at $25 and immediately resell for $30, giving a $5 profit.
=

Folks: Unlike prior ones, these case assignments are broken up into “Basic
Understanding” (easy) and “Discussion” (medium to hard) questions. Lecture will
primarily focus on the discussion questions; however, we will spend a very brief time at
the beginning of class on the basic understanding questions to make sure that we are all
on the same page.

Read:
- Exchange Act § 10(b) (15 U.S.C. § 78j(b)) and SEC Rule 10b-5
- Goodwin v. Agassiz, 186 N.E. 659 (Mass. 1933) (p. 478)
- SEC v. Texas Gulf Sulphur Co., 394 U.S. 976 (1969) (p. 482)
- Dirks v. SEC, 463 U.S. 646 (1983) (p. 494)
- U.S. v. O’Hagan, 521 U.S. 642 (1997) (p. 501)

Basic Understanding Questions:


- Goodwin v. Agassiz pg. 478
o Who are the plaintiff and defendants?
o What is plaintiff’s theory of the case (i.e. cause of action)?
o When did the alleged wrong-doing occur? Why is that significant?
o What rule did the court announce in regards to insider trading?
- SEC v. Texas Gulf Sulphur Co. pg. 482
o Who are the plaintiff and defendants? Π is SEC – enforcer of the rules! Δs
are Richard Mollison & Richard Clayton.
o Draw up a timeline of the events from Oct. 29, 1963 – May 15, 1964 as
described in pp. 483-86.
o What was the estimated value of ore found? 161,200,000 – 240,700,000.
o To whom does Rule 10b-5 apply? Anyone with material info.
o What is the Court’s test for materiality in Texas Gulf? Whether reasonable
man would use the info when deciding when to trade.
o How did the defendants’ purchase of short-term calls bear on the question
of whether the information was material?
o How did the court hold as to:
 Darke (traded before announcement)?
 Coates (traded 40 minutes after announcement)?
 TGS (issued April 12th press release)?
- Dirks v. SEC pg. 494
o Who is Dirks and what is his involvement in this insider trading case?
Dirks worked in a broker dealer firm that analyzed insurance co securities.
 Who is the insider? Ronald Secrist had info that the assets of
Equity Funding were overstated. He told Dirks to investigate.
 Who traded on the information? Dirks discussed the info with
clients and investors in the public, and they traded on it.
o Who generally has a duty to disclose when trading on non-public material
information? (See also Notes on pp. 493-94) Tippees do, if trading on it.
o When does a tippee have a duty to disclose when trading on non-public
material information? When they come into possession of it, if they are
trading.
o How did the court hold as to Dirks? No actionable violation by Dirks.
- U.S. v. O’Hagan pg. 501
o Who is O’Hagan and what is his involvement in this insider trading case?
Partner in law firm. A co. in London retained that firm regarding a
potential tender offer for common stock of Pillsbury. O’Hagan started
buying stock himself as the price rose. He sold later and made 4.3 million.
o What is the underlying financial transaction at issue here?
o Why is it questionable as to whether this type of transaction falls under
10b-5? (Hint: compare Rule 10b-5 to Rule 14e-3) Go to rule in Dirks.
There needs to be a fiduciary duty on the part of the insider that trades.
He doesn’t have a specific fiduciary duty to the shareholders, though he
has one to the company and to the law firm.
o How do the “traditional” and “misappropriation” theories of insider
trading liability differ? Trad Inside, material, nonpublic info to trade.
Fiduciary duty to shareholders. Self-serving use of info by outsider.
 Was Texas Gulf a traditional or misappropriation case? Traditional
 Was Dirks a traditional or misappropriation case?
Misappropriation
o Who did O’Hagan “deceive” in this case? Law firm and his client.

Discussion Questions:

- Insider Trading - Generally


o Why does the law prohibit the practice of insider trading?
o Are insider trading laws desirable / undesirable?
 Who/what is harmed by insider trading?
 Who/what benefits from insider trading?
o What fiduciary duty is implicated in insider trading cases? Duty of loyalty.
Loyalty to shareholders. ASK: so if directors use insider trading, e.g. in a
corporation whose business is trading, and that benefits all of the
shareholders, is the duty violated? That is, can deception be part of
maintaining one’s duty of loyalty?
 How is this duty implicated?
- Insider Trading Under the Common Law
o What are the common law alternatives to a Rule 10b-5 action where the
defendant has engaged in insider trading?
o Do these alternatives adequately address the evils that Rule 10b-5 seeks to
cure?
- Insider Trading Under 10b-5
o How will an insider know when publicly disclosed information has cleared
the market, such that the insider can safely trade on the information?
o Should the tipper’s fiduciary duties indeed be transferred to a tippee for
the purposes of Rule 10b-5?
o Why shouldn’t we just always punish the tipper for disclosing the
confidential information to the tippee, instead of seeing whether the tippee
knows or should have known of the tipper’s fiduciary duties?

Also of Note
- Notice the interaction between the BJR and Rule 10b-5 on p. 488 (FN 12)