V.MANAGEMENT AND CONTROL

 

A.ALLOCATION OF POWERS BETWEEN DIRECTORS AND SHAREHOLDERS

 

     1.MANAGEMENT OF CORPORATION’S BUSINESS--corporate statutes vest the power to manage in the board of directors, except as provided by valid agreement in a close corp. He board’s power is limited to proper purposes.

 

     2.SHAREHOLDER APPROVAL OF FUNDAMENTAL CHANGES--shs must approve certain fundamental changes in the corp, e.g., amendment of articles, merger, sale of substantially all assets, and dissolution.

 

     3.POWER TO ELECT DIRECTORS--shs have the power to elect dirs and to remove them for cause, absent provisions for removal without cause in the certificate, bylaws, or in statutes. Some statutes also permit the board or the courts to remove a dir for certain specific reasons (e.g., felony conviction).

 

     4.POWER TO RATIFY MANAGEMENT TRANSACTIONS--shs have the power to ratify certain management transactions and insulate the transactions against a claim that managers lacked authority, or shift the burden on the issue of self-interest.

 

     5.POWER TO ADOPT PRECATORY RESOLUTIONS--shs may also adopt advisory but nonbinding (precatory) resolutions on proper subjects of their concern.

 

     6.BYLAWS--shs usually have the power to adopt and amend bylaws, although some statutes give the board of dirs the concurrent power to do this.

 

     7.CLOSE CORPORATION--this is a corp owned by a small number of shs who may actively manage; it has no general market for its stock, and it has some limitations regarding transferability of stock.

 

     8.STATUTORY CLOSE CORPORATION STATUS--the basic requirements to qualify for special treatment under the statutes are that, in its cert of incorp’n, a statutory close corp must identify itself as such, and must include certain limitations as to the number of shs, transferability of shares, or both.

         a)Functioning As a Close Corporation--there may be sh agreements relating to any phase of the corp affairs.

               

B.DIRECTORS

 

     1.APPOINTMENT OF DIRECTORS--initial dirs are either designated in the articles of incorporation or elected at a meeting of incorporators. Subsequent elections are by shs at their annual meetings. The number of dirs is usually set by the articles or bylaws.

         a)Qualifications--absent a contrary provision in the articles or bylaws, dirs need not be shs of the corp or residents of the state of incorporation.

         b)Vacancies--statutes vary, but under Model Act, a vacancy may be filled by either the shs or dirs.

            1)Compare--removal: some statutes require that vacancies created by removal of a dir be filled by the shs unless the articles or bylaws provide otherwise.

 

     2.TENURE OF OFFICE

         a)Term of Appointment--under most statutes, office is held until the next meeting, although on a classified board, dirs may serve staggered multi year terms.

         b)Power to Bind Corporation Beyond Term--unless limited by the articles, the board has the power to make contracts biding the corp beyond the dirs’ term of office.

         c)Removal of Director During Term--at common law, shs can remove a dir for cause (e.g., fraud, incompetence, dishonesty) unless an article or bylaw provision permits removal without cause. a dir being removed for cause is entitled to a hearing by shs before a vote to remove. a number of statutes permit removal without cause.

            1)Removal by Board--board can NEVER remove a dir unless authorized by statute;

            2)Removal by Court--there is a split authority as to whether a court can remove a dir for cause.

                I)Statutes--some statutes permit courts to remove a dir for specified reasons. Usually, a petition for removal can be brought only by a certain percentage of shs or the attorney general.

     3.FUNCTIONING OF BOARD

         a)Meetings--absent a statute, dirs can act only at a duly convened meeting consisting of a quorum. In most jurisdictions, a meeting can be conducted by telephone or other means whereby participants can hear each other simultaneously. Most statutes also allow board action by unanimous written consent without a meeting.

            1)Notice--although formal notice is unnecessary for a regular meeting, special meetings require notice to every dir of date, time, and place. Usually, notice can be waived in writing before or after a meeting. Attendance waives notice unless the dir attends only to protest the meeting.

            2)Quorum--a majority of the authorized number of dirs constitutes a quorum. Many statutes permit the articles or bylaws to require more than simple majority or less than that.

            3)Voting--absent a contrary provision, an affirmative vote of a majority of those present, not a majority of those voting, is required for board action.

         b)Effect of Noncompliance With Formalities--today, most courts hold that informal but unanimous approval of a transaction is effective, as is a matter receiving the explicit approval by a majority of dirs without a meeting, plus acquiescence by the remaining dirs.

         c)Delegation of Authority--the board has the power to appoint committees of its own members to act for it either in particular matters or to handle day-to-day management between board meetings. Typically, these committees cannot amend the articles or bylaws, adopt or recommend major corporate changes (e.g., merger), recommend dissolution, declare a dividend, or authorize issuance of stock unless permitted by the articles or bylaws. Note that while the board may delegate operation of the business to an officer or management company, the ultimate control must be retained by the board.

         d)Provisional Directors--some statutes allow them to be appointed by court if the board is deadlocked and corporate business is endangered. a provisional dir serves until the deadlock is broken or until removed by a court order or by majority of shs.

         e)Voting Agreements--an agreement in advance among dirs as to how they will vote is void as contrary to public policy. There are certain exceptions for statutory close corps.

 

     4.COMPENSATION--dirs are NOT entitled to compensation unless they render extraordinary services or such compensation is otherwise provided for. Officers are entitled to reasonable compensation for services.

 

     5.DIRECTORS’ RIGHTS, DUTIES, AND LIABILITIES

         a)Right to Inspect Corporate Records--if done in good faith for purposes germane to his position as dir, this right is absolute.

         b)Duty of Care--dirs must exercise the care of an ordinarily prudent and diligent person in a like position, under similar circumstances. There is no liability (absent a conflict of interest, bad faith, illegality, or gross negligence) for errors of judgment (business judgment rule--the rebuttable presumption that action was taken on an informed basis, in good faith and exercising reasonable care), but the dir must have been reasonably diligent before the rule can be invoked (Shlensky)

            1)The duty of care requires:

                I)Education--a dir should acquire at least a rudimentary understanding of the business of the corporation;

                ii)Information--a dir is under a continuing obligation to keep informed about the activities of the corp;

                iii)Participation--dirs must “generally monitor” corporate affairs, but need NOT involve themselves in the day-to-day operations; (i.e. they should attend board of dirs meetings with reasonable regularity).

                iiii)Inquiry--a dir has a duty to inquire when circumstances would alert a reasonable person for the need of inquiry.

                iiiii)Action--where wrongdoing is revealed, a dir should object, correct, or resign. Object to the course of conduct, steer toward correction, and resign if it isn’t corrected.

            2)Extent of liability--dirs are personally liable for corporate losses directly resulting from their breach of duty or negligence in falling to discover wrongdoing. a director may seek to avoid being held personally liable for acts of the board by recording his dissent.

                I)Many statutes permit the articles to abolish or limit dir’s liability for breach of the duty of care absent bad faith, intentional misconduct, or knowing violation of law.

               3)Defenses to liability--these include good faith reliance on management or expert’s reports. Disabilities may be considered in determining whether the dir has met the standard of care.

         c)Duty of Loyalty--a catch-all duty designed to prevent unfairness--the duty to act in good faith (BJR applies). Application:

            1)Self-dealing transactions

                I)Common Law:

                   (1)early absolute prohibition against self-dealing renders transactions void or                                 voidable;

                   (2)permissive self-dealing: dirs and officers may contract with the corp if (a)done                   in “strictest good faith.”; (b)with full disclosure; and (c)consent of “all concerned.”

                        [1]--burden of proof is on the dir to establish good faith, honesty & fairness;

                        [2]--courts weigh self-dealing transactions with “closest scrutiny”

                   (3)self-dealing prohibition also applies to intercorporate transactions where dirs                             are common.

                ii)Statutory (example):

                   (1)quasi-safe harbor approach (Iowa statute)--transaction is not void or voidable                             because of dirs’ interest, if either:

                        [1]--interest is disclosed and approval is made without counting the vote of the                                 interested dir.

                        [2]--interest is disclosed to shs and shs authorize

                        [3]--transaction is fair and reasonable

                   (2)Note--dir must still establish that he acted in good faith, honesty, and fairness

            2)Domination of subsidiary by parent--courts look at the transaction to see if self-dealing has occurred. Example (Sinclair Oil):

                I)declaration of dividends shared pro rata was NOT self-dealing; BJR applies

                ii)contract between parent and sub was self-dealing; apply intrinsic fairness test

            3)Manager’s compensation:

                I)Ordinary corporations--conflicts are inevitable but all firms need to set compensation. The burden of proof is placed on challengers as a matter of convenience.

                ii)Close corporations--the income generated by the firm may be diverted to salaries, so there is an option for self-dealing by the parties in control to take tax-advantaged compensation in the form of salaries (taxed once) as opposed to dividends (taxed twice).

                   

         d)Statutory Duties and Liabilities--in addition to general duty of care, federal and state laws also impose certain duties and liabilities, e.g., registration requirements under the Securities Act of 1933, liability for rule 10b-5 violations, liability for illegal dividends. Some statutes also impose criminal liability on corporate managers for unlawful corporate actions.

 

 

 C.OFFICERS

 

     1.ELECTION--officers are usually elected by the board of dirs. Some statutes permit election of officers by shs.

 

     2.AUTHORITY OF CORPORATE OFFICERS (liability of corp to outsiders)--only authorized officers can bind the corp. Authority may be: actual (expressed in bylaws or by valid board resolution), apparent (corp gives third parties reason to believe authority exists), or power of position (inherent to position). If ratified by the board, even unauthorized acts can bind the corp.

         a)Authority of President--the majority rule is that the president has the power to bind the corp in transactions arising in regular course of business.

    

     3.DUTIES OF CORPORATE OFFICERS--the duty of care owed by a officer is similar to that owed by dirs ( and sometimes higher).

 

 

D.CONFLICTS OF INTEREST IN CORPORATE TRANSACTIONS.

 

     1.DUTY OF LOYALTY--because of their fiduciary relationship with the corp, officers and dirs have the duty to promote the interests of the corp without regard for personal gain.

 

     2.BUSINESS DEALINGS WITH THE CORPORATION--conflict of interest issues arise when a corp transacts business with one of its officers or dirs, or with a company in which an officer or dir is financially interested.

         a)Effect of Self-Interest on Right to Participate in Meeting--most statutes permit an “interested” dir to be counted toward quorum, and interested dir’s transactions are NOT automatically voidable by the corp because the interested dir’s vote was necessary for approval.

         b)Voidability Because of Director’s Self-Interest--today, such transactions are voidable only if unfair to the corporation. The burden of establishing fairness is on the interested director. Note that a dir’s failure to fully disclose material facts may be per se unfair.

            1)Unanimous shareholder ratification--if, after full disclosure, shareholder ratification is unanimous, the corp will be estopped from challenging the transaction with the interested dir (except at to creditors).

                I)Less-than-unanimous ratification--courts then will look at whether the majority shares were owned or controlled by the interested director. Courts are more likely to uphold ratification by a disinterested majority so as to preclude the transaction from being attacked by the corp or by a sh in a derivative suit.

            2)Statutes--most statutes provide that such transactions are NOT voidable if: (1)approved, after full disclosure, by a disinterested board majority or by majority of shs, or (2)the transaction is fair to the corp notwithstanding disclosure.

                I)”Interested”--an “interested” dir or officer is one who has a business, financial, or familial relationship with a party to the transaction that would reasonably affect the person’s judgment so as to adversely affect the corp.

         c)Remedies--the corp may rescind, or affirm and sue for damages.

     3.INTERLOCKING DIRECTORATES--generally, transactions between corps with common dirs are subject to the same rules of interested director transactions. There is no conflict of interest if one corp is the wholly owned subsidiary of the other. However, a question of fairness arises where the parent owns only a majority of the subsidiary’s shares.

 

     4.CORPORATE OPPORTUNITY DOCTRINE (Also see duty of loyalty)

         a)Definition--COD bars dirs from taking any business opportunity belonging to the corp without first offering it to the corp.. If the corp is unwilling to pursue an opportunity (after an independent board is fully informed of the opportunity), then the dir may pursue it.

         b)Defenses (available in most, but not all jurisdictions):

            1)Inability--If the corp is legally or financially unable to take the opportunity, then the dir generally may take advantage of it. (But the question of who caused the financial inability is quite relevant. Example: Irving Trust Co--the defense of inability was rejected).

            2)Rejection, abandonment, or approval--then the fiduciary has a valid defense.

         c)Remedies--constructive trust or damages--the fiduciary must account to the firm for all the profits he has made as a result of usurpation.

         d)Definition of a Corporate Opportunity:

            1)Line of business test--does the firm have fundamental knowledge, practical experience, and ability to pursue the opportunity? If yes, then it is within the firm’s line of business. It should be a natural fit, and not a mere desire by a firm to pursue the opportunity.

            2)Interest/expectancy test

         e)Application--Guth Rule and Corollary:

            1)Guth rule (offered in corporate capacity)--if there is presented to O/D a business opportunity which the corp is (1)financially able to undertake, which is from its nature (2a) in the line of business and is of practical advantage to it OR (2b)is one in which the corp has an interest or reasonable expectancy (under an established corporate policy or plan), and, (3)by embracing the opportunity the self-interest of the dir will be brought into conflict with that of his corp, then officer or dir may NOT take the opportunity.

            2)Guth corollary (a safe harbor; satisfy all provisions and dir can take)--if a business opportunity (1)comes to O/D in his individual capacity and (2) is not essential to the corp and is (3)one in which corp has no interest or expectancy, then the O/D can treat it as his own, IF he has not taken corporate resources to pursue the opportunity.

                I)”Essential”--indispensably necessary to the continued viability of the firm;

                ii)Individual or corporate? Look at O/D capacity to determine how offer was made

                

 

     5.COMPETING WITH CORPORATION--such competition by a dir or officer may be a breach of fiduciary duty even when the competing business is not a corporate opportunity

 

     6.COMPENSATION FOR SERVICES TO THE CORPORATION--the compensation plan must be duly authorized by the board, and its terms must be reasonable. Good faith and the BJR ordinarily protect disinterested dirs from liability to the corp for approving compensation.

         a)Publicly Held Corporations--The SEC has authorized shs to make proposals about executive pay in management’s proxy statements. Further, the tax code now limits expense deductions for executive pay over $1mln, unless it is tied to the corp’s performance.

         b)Past and Future Services--compensation for past services is generally invalid. Compensation for future services is proper if there is reasonable assurance that the corp will receive the benefit of the services.

VI.INSIDER TRADING--purchase or sale of securities by someone with access to material

nonpublic information. It may be illegal. It affects corps with more than $1 mln in total assets and with at least 500/750 shs.

         a)Who may be hurt by insider trading:

            1)Target shareholders--they sell too early;

            2)Other arbitrageurs--they lose a portion of the gain that they make from honest effort

            3)Other issuers--they lose confidence in the stock market

            4)The acquiring company--insider trading drives up their cost of acquisition, since the target may adopt defensive measures otherwise not in place.

         b)Possible Sources of Liability:

            1)Common Law;

            2)10b-5 traditional;

            3)10b-5 misappropriation theory (O’Hagan);

            4)Mail or wire fraud;

            5)14e-3;

            6)Statutory liability under 16(b)--insiders are forced to give their profits to the corp, if the y buy and sell securities within a 6-month period regardless of whether they are using insider info. (Need to know 2, 3, 6)

         c)O’Hagan--insider trading violation where a partner in law firm took info rom his firm regarding the firm’s client’s plans for acquisition of Pillsbury and used that info to buy shares in Pillsbury

         d)Penalties For Insider Trading--ITSA (Insider Trading Sanctions Act)--3 measures:

            1)Out-of-pocket measure--if a sh buys a share for $10, while in fact it costs $9, his out-of-pocket expense is $1.

            2)Causation-in-fact--because an insider engaged in insider trading, it caused a loss

            3)Disgorgement--we look at D’s profit. ITSA measures the damage to sh by the amount of profit that D received from the transaction.

            2)SEC civil penalties--treble damages; SEC may seek penalty capped by three times profit gained or loss avoided.

 

           

A.COMMON LAW--under the majority rule, there was no duty to disclose to the shs inside info affecting the value of shares. Therefore, the protection of investors was very weak.

         a)For lability to exist there should be:

            1)At least fraud or deceit upon purchasers;

            2)May also be a device or scheme;

            3)May also be an implied misrepresentation.

         b)Two Elements (relationship and unfairness):

            1)Relationship--existence of a relationship giving access, directly or indirectly, to              information intended to be available for a corporate purpose and no other.

                I)Insiders include at least officers, dirs, controlling shs (In re Cady Roberts)

               ii)Persons charged with confidentiality by contractual or fiduciary relationship

            2)Unfairness--inherent unfairness that results when a party takes advantage of such information knowing it is unavailable to person with whom he is dealing.

 

B.SECURITIES EXCHANGE ACT OF 1934--IN GENERAL--the act superseded common law. Section 12 of the Act requires registration of any security traded on a national exchange, or any equity security (held by 500 or more persons) of a corp with assets exceeding $5 million.

 

C.SECTION 10(B) AND RULE 10B-5--section 10(b) prohibits any manipulation or deception in the purchase or sale of any security, whether or not it’s registered. Rule 10b-5 prohibits the use of the mails or other instrumentality of interstate commerce to defraud, misrepresent, or omit a material fact in connection with a purchase or sale of any security.

        

     1.COVERED CONDUCT--rule 10b-5 applies to nondisclosure by dirs or officers, as well as to misrepresentations. It applies not only to insider trading but also to any person who makes a misrepresentation in connection with a purchase or sale of stock.

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

 

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

 

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

 

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

         a)Recklessness Defined:

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

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

         b)Recklessness Under PSLRA:

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

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

 

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

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

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

 

     7.WHEN NONDISCLOSURE CONSTITUTES a VIOLATION

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

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

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

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

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

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

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

        

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

 

 

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

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

            1)Correct misleading statements (even if unintentional);

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

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

 

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

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

 

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

 

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

 

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

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

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

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

 

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

 

 

     15.DEFENSES

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

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

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

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

 

     16.REMEDIES

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

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

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

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

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

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

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

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

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

 

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

 

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

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

 

 

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

 

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

 

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

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

 

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

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

 

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

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

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

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

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

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

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

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

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

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

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

 

 

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

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

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

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

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

 

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

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

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