Monthly Archives: July 2009

Does Skin in the Game Matter?

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Monday, July 27, 2009
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This post comes to us from Martijn Cremers of Yale University, Joost Driessen of the University of Amsterdam, Pascal Maenhout of INSEAD and David Weinbaum of Syracuse University.

In our forthcoming Journal of Financial and Quantitative Analysis paper, Does Skin in the Game Matter? Director Incentives and Governance in the Mutual Fund Industry, we investigate whether effective governance, particularly director ownership, is associated with superior mutual fund performance, and if so, what economic mechanism could explain that.

We assemble a unique database on the fund holdings of the members of the largest equity mutual fund boards of directors, and investigate whether mutual fund performance is related to the ownership stakes of the directors overseeing those same funds. Specifically, for all actively managed equity funds that belong to the top 25 equity mutual fund families as of January 1996, we collect information on the ownership stakes of all independent and non-independent directors.

We find that directors’ ownership stakes in the funds they oversee are related to the subsequent performance of the funds: funds with low director ownership perform poorly. This underperformance has sizeable statistical significance and is economically large. This is true for ownership both at the fund family level and at the individual fund level. Funds in mutual fund families in which ownership by independent directors is low generate average annual abnormal returns of -2.54%. Similarly, funds with low ownership by non-independent directors generate average annual abnormal returns of -2.48%, and funds with low ownership by independent directors generate annual abnormal returns of -2.01%. The relation between ownership and performance is not linear, rather it is driven by the significant underperformance of low (and often zero) ownership funds. We do not find significant underperformance for funds with intermediate or high ownership.

In order to interpret our results, we distinguish between the monitoring and private information hypotheses by considering the performance of directors’ investments in the funds they oversee. In contrast to the results at the fund level, we find no link between lack of ownership and underperformance at the director level, which is evidence against the private information hypothesis. Further, we use various proxies for the importance of monitoring to show that the relation between director ownership and fund performance is driven by the underperformance of funds where monitoring is important, but ownership by directors is low. Third, we investigate the extent to which our results are driven by fees. We find that while fees are indeed higher in low director-ownership funds, and this does explain part of our results, it in fact explains a surprisingly small fraction of the results. This suggests that the role of mutual fund boards of directors extends well beyond fee negotiations.

The full paper is available for download here.

Delaware Supreme Court Establishes Equitable Relief in Short Form Mergers

Posted by Andrew J. Nussbaum, Wachtell, Lipton, Rosen & Katz, on
Sunday, July 26, 2009
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This post is by Andrew J. Nussbaum, William Savitt, and Ryan A. McLeod of Wachtell, Lipton, Rosen & Katz. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In a decision that could increase the litigation risk associated with short-form mergers under 8 Del. C. § 253, the Delaware Supreme Court has ruled that where there is a breach of the duty of disclosure in connection with a short-form merger, the appropriate remedy is an automatic “quasi appraisal” action in which the minority shareholders may adopt an “opt-out” class approach and need not escrow any of the merger consideration they have already received. Berger v. Pubco Corp., No. 509, 2008 (Del. July 9, 2009).

Under Delaware’s short-form merger statute, a parent corporation that owns at least
90% of its subsidiary’s outstanding stock may summarily cash out the minority holders by the unilateral adoption of a resolution setting forth the consideration to be given. In 2001, the Supreme Court ruled that controlling stockholders owed no duty to pay a fair price in a short-form merger, and a minority stockholder’s only recourse is to seek appraisal. Consequently, the only obligation of a company effecting a short-form merger is to provide minority shareholders with all information material to the decision of whether or not to seek appraisal. Glassman v. Unocal Exploration Corp., 777 A.2d 242, 248 (Del. 2001).

The Court of Chancery in Berger found several inadequacies in the parent’s disclosure notice, including that it had failed to provide any information about the method used to determine the consideration offered. Because the merger had already been effected and consideration had already been paid, the Court of Chancery ordered a “quasi appraisal,” which would replicate a statutory appraisal action by requiring minority shareholders to “opt-in” to the proceeding and place in escrow a portion of the consideration they had already received.

Reversing, the Supreme Court held that principles of “fairness” dictated that “majority stockholders that deprive their minority shareholders of material information should forfeit their statutory right to retain the merger proceeds payable to shareholder who, if fully informed, would have elected appraisal.” Consequently, the Court held that the proper remedy for disclosure violations in a short-form merger is a quasi appraisal action on behalf of an automatic class of all minority stockholders with no escrow requirement.

Because the Supreme Court’s remedy removes the ordinary downside risks of an appraisal action and facilitates class action-style proceedings, this decision may encourage increased litigation following short-form mergers. At the same time, however, Berger reemphasizes the limited fiduciary remedies available to minority stockholders in a short-form merger, and its holding applies only in circumstances where the merger was accompanied by material disclosure violations. The decision thus serves as a useful reminder to Boards and controlling shareholders pursuing shortform mergers that appropriately complete disclosure is critical to obtaining the statutory benefits to acquirors of the Delaware short-form merger and appraisal provisions.

D.C. Circuit Adopts Expansive Meaning of Underwriter

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Saturday, July 25, 2009
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This post is by Annette L. Nazareth’s colleagues James T. Rothwell, Mark M. Mendez, and Katia Brener.


In Zacharias v. SEC, the U.S. Court of Appeals for the District of Columbia Circuit affirmed an SEC order finding that two officers and directors of a public company and an unaffiliated third party engaged in a “scheme” to sell securities in violation of the registration requirement of Section 5 of the Securities Act, despite the fact that the only shares sold to the public were freely tradable shares owned by the third party. The Court’s praise of the SEC decision as “a triumph of substance over form” [1] and the reasoning of the case (as well as the result) stand in contrast to the recent decisions of three U.S. District Courts that rejected the SEC’s claims of Section 5 violations in the hedging of “PIPEs” securities. [2]

The “Swap” Transactions

Christopher Zacharias and John Carley (the “Option Holders”) were officers and directors of Starnet Communications International, Inc. (“Starnet”) and held options to purchase Starnet shares. Starnet registered the exercise of the options on Form S-8, but the registration statement did not cover resales of underlying shares. Thus, the Court stated that “[s]ales to the public of shares acquired by exercise of their options would have been illegal unless a registration statement under § 5 had been in effect” but noted that the Option Holders “did not . . . have a registration statement filed.” [3]

Separately, Alfred Peeper controlled foreign entities (the “Peeper Entities”) that held several million Starnet shares that “they could lawfully resell to the public.” [4] The Peeper Entities also held warrants to purchase several million additional shares that had not yet been exercised.

The “scheme” consisted of two transactions:

Transaction 1: The Peeper Entities sold their shares of Starnet to the public, and also exercised their warrants and sold the resulting shares to the public. It appears that absent the other facts of the combined transactions, the sale of the shares initially owned by the Peeper Entities would have been legal, and the sale of the shares issued upon exercise of the warrants “would likely have been legal as well.” [5]

Transaction 2: Shortly after these sales by the Peeper Entities, the Option Holders exercised their options and sold the underlying shares to the Peeper Entities in a private placement. [6] The number of shares the Option Holders so sold to the Peeper Entities was apparently equal to the number of shares the Peeper Entities sold in Transaction 1 (hence the SEC’s characterization of the transactions as a “swap” of the shares sold by the Peeper Entities for the shares purchased by the Peeper Entities). It appears that this sale also would not have been problematic absent
Transaction 1 – the Court explained that a “simple sale to the Peeper Entities . . . would likely have been lawful had such a sale . . . not been part of any ‘chain of transactions . . . involving any public offering.’” [7]

The apparent purpose of the two transactions was to enable the Option Holders to sell their option shares at a price that reflected little or no “liquidity discount” to the prevailing market price for freely tradable shares, without having to file a registration statement. If the Option Holders had sold their shares to a buyer who did not have other shares to sell to the public, that buyer would have paid a discounted price because the shares would be “restricted” under the Securities Act and therefore illiquid. However, the Peeper Entities (a) currently owned shares, and (b) presumably intended to remain invested (but not increase their investment) in the company for the long term. Therefore, the Peeper Entities likely cared less about liquidity than a typical investor and thus were willing to pay a price that was closer to the prevailing market price. By buying shares from the Option Holders and selling an equal number of shares to the public (albeit in reverse order in this case), the Peeper Entities maintained their level of investment in Starnet.

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Paying for Performance at Goldman

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Friday, July 24, 2009
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Editor’s Note: This post is based on an op-ed piece by Lucian Bebchuk published today on Wall Street Journal online and available here.

Last week, after reporting stellar second-quarter profit of $3.4 billion, Goldman announced the setting aside of $11.4 billion for compensation – which, broken down per employee, is similar to what Goldman set aside in the first half of the boom year of 2007.

Goldman’s CFO argued that its pay decisions reflect the firm’s “pay for performance culture.” However, if Goldman proceeds to pay record cash bonuses this year, as many now expect, these payments would reflect a return to flawed pay structures, as well as a failure to implement effectively the compensation principles Goldman recently put forward.

The setting aside of $11.4 billion for compensation, it should be stressed, doesn’t yet commit Goldman to any amounts of cash bonuses. Goldman still has time to determine the magnitude and structure of its 2009 compensation. In doing so, it should give substantial weight to lessons drawn from the financial crisis.

The crisis has highlighted a substantial flaw in compensation structures that provide rewards for short-term performance – which is what Goldman’s paying super cash bonuses for 2009 would do. Such rewards can over-compensate executives as well as produce excessive incentives to take risks.

Rewards for short-term results can produce over-compensation by enabling executives to cash out large amounts of compensation on account of results that are subsequently reversed. In many financial firms whose aggregate earnings over the past several years are negative, executives have still been able to cash out large amounts of bonus compensation during the first part of this period – and they kept these amounts despite the large losses subsequently borne by the firms.

In addition, and perhaps most importantly, bonuses for short-term results provide incentives to seek improvements in short-term results even at the expense of excessive taking of risks of an implosion later on. The short-term distortion caused by standard compensation structures, which Jesse Fried and I first highlighted in our “Pay without Performance” book, has recently become widely accepted. Treasury Secretary Geithner stated last month that “[s]ome of the decisions that contributed to this crisis occurred when people were able to earn immediate gains without their compensation reflecting the long-term risks they were taking for their companies and their shareholders.”

Indeed, the flaws in the standard compensation structures of financial firms have been explicitly recognized by Goldman’s own leaders. Last April, in a widely praised speech before the Council of Institutional Investors, Goldman’s CEO Lloyd Blankfein called for compensation reform, stating that “[financial firms’] decisions on compensation … look self-serving and greedy in hindsight.” Evaluation of employees’ performance, Blankfein stressed, “must be made on a multi-year basis to get a fuller picture of the effect of an individual’s decisions.”

Goldman subsequently adopted compensation principles and announced them in its annual shareholder meeting last May. According to these principles, “cash compensation in a single year should not be so much as to overwhelm the value ascribed to longer term stock incentives that can only be realized through longer term responsible behavior.”

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A critique of the President’s financial regulation reforms

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Thursday, July 23, 2009
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Editor’s Note: This post is the first part of a two-part series by Richard A. Posner, and is based on a recent article in Lombard Street.

On June 17, the Treasury Department issued an 88-page report entitled Financial Regulatory Reform: A New Foundation: Rebuilding Financial Supervision and Regulation. The Report (as I’ll call it) is a blueprint for reform of financial regulation, with the aim of preventing another financial crisis. In this first part of a two-part article, I discuss weaknesses in the overall approach that the Report takes to the problem of reform, as well as weaknesses in the Report’s proposals for limiting “systemic risk.” Part II (which will be published in August) will discuss the proposals concerning executive compensation and consumer and investor protection, and will also suggest some alternative proposals for regulatory reform.

The Report’s fundamental weaknesses are its prematurity, overambitiousness, reorganization mania, and FDR envy. Let me start with the last. It is natural for a new President, taking office in the midst of an economic crisis, to want to emulate the extraordinary accomplishments of Franklin D. Roosevelt’s initial months in office. Under Roosevelt, within what seemed the blink of an eye, the banking crisis was resolved, public-works agencies that hired millions of unemployed workers were created, and economic output rose sharply. But that was 76 years ago. The federal government has since grown fat and constipated. The program proposed in the Report cannot be implemented in months or years, or perhaps even in decades—as would be apparent had the Report addressed costs, staffing requirements, and milestones for determining progress toward program goals and had the Report attempted an overall assessment of feasibility.

The Report is premature in two respects. The first is that it advocates a specific course of treatment for a disease the cause or causes of which have not been determined. Now it is not always necessary to understand the cause of something you don’t like in order to be able to eliminate the effect. If you have typical allergy symptoms you may get complete relief by taking an antihistamine; it is not necessary to find out what you’re allergic to. But generally, and in the case of the current economic crisis, unless the causes of a problem are understood, it will be impossible to come up with a good solution. The causes of the crisis have not been studied systematically, and are not obvious though they are treated as such in the Report. (Remember, the Great Depression of the 1930s ended 68 years ago and economists are still debating its causes.) We need some counterpart to the 9/11 Commission’s investigation of an earlier unforeseen disaster.

The Report asserts without evidence or references that the near collapse of the banking industry last September was due to a combination of folly—a kind of collective madness—on the part of bankers (in part reflected in their compensation practices), of credit-rating agencies, and of consumers (duped into taking on debt, particularly mortgage debt, that they could not afford), and to defects in the regulatory structure. This leaves out many potential causes that other students of the crisis have emphasized. The Report does not mention the errors of monetary policy by the Federal Reserve that pushed interest rates down too far in the early part of this decade. Because houses are bought mainly with debt (for example, an 80 percent mortgage), a reduction in interest rates reduces the cost of owning a house and can and did cause a housing bubble, which when it burst took down, along with the homeowners, the banks and related institutions that had financed the bubble. Mortgage debt is huge—$12 trillion—and the banks (a term I use broadly, to include other financial intermediaries as well) were therefore deeply invested in the housing industry and incurred substantial losses when housing values fell precipitously.

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Administration Proposes Regulations for Private Fund Investment Advisers

Posted by John F. Olson, Gibson, Dunn & Crutcher LLP and Georgetown Law Center, on
Thursday, July 23, 2009
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This post is by John F. Olson’s colleague Susan Grafton.

On July 15, 2009, the Obama administration (the “Administration”) delivered to Congress draft legislation, the Private Fund Investment Advisers Registration Act of 2009. Under the proposed legislation, managers of most hedge funds, private equity funds and venture capital funds in the U.S. would be required to register with the Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940 (the “Advisers Act”). The existing exemption for investment advisers with fewer than 15 clients would be eliminated, and specific information reporting would be required for advisers to any “private fund.” A limited exemption will continue to apply to certain “foreign private advisers.” The existing threshold of $30 million of assets under management for mandatory SEC registration would continue to apply.

Andrew Donohue, the SEC’s Director of Investment Management, discussed these and other potential regulatory reforms in his testimony on July 15, 2009, before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs concerning the regulation of hedge funds and other private investment pools.

Applicability to Advisers to Private Funds

The new reporting requirements will generally apply to investment advisers to any “private fund,” which would be any investment fund that is relying on Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 for exemption from registration, and that is either organized in or created under the laws of the U.S. or has 10 percent or more of its outstanding securities owned by U.S. persons.

Additional Reporting to the SEC

In addition to the existing regulatory obligations of registered investment advisers to private funds, the draft legislation would require all registered investment advisers to private funds (including newly registered advisers) to submit reports to the SEC as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Federal Reserve Board (the “Federal Reserve”) and the proposed Financial Services Oversight Council (the “FSO Council”).

The reports would include at least the following information for each private fund:

1. Amount of assets under management;
2. Use of leverage, including off-balance sheet leverage;
3. Counterparty credit risk exposures;
4. Trading and investment positions;
5. Trading practices; and
6. Such other information as the SEC and the Federal Reserve determines are necessary or appropriate.

These records and reports would be deemed records and reports of the investment adviser, which would be required to maintain and keep them in accordance with retention requirements prescribed by the SEC. The SEC would be required to make the new systemic risk data and reports available to the Federal Reserve and the FSO Council. In addition, because the private fund’s records would be deemed records of the investment adviser, they would be subject to periodic examination by the SEC and its staff.

Although the draft legislation provides that the SEC would not be required to disclose the reports or their content, the SEC would not be permitted to withhold information from Congress or any federal agency or self-regulatory authority. Accordingly, confidentiality would not be completely safeguarded.

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Shareholder Lawsuits and Stock Returns

Posted by Jim Naughton, co-editor, HLS Forum on Corporate Governance and Financial Regulation, on
Wednesday, July 22, 2009
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This post comes to us from Amar Gande of the Edwin L. Cox School of Business, Southern Methodist University, and Craig M. Lewis of the Owen Graduate School of Management, Vanderbilt University.

In our forthcoming Journal of Financial and Quantitative Analysis paper, Shareholder Initiated Class Action Lawsuits: Shareholder Wealth Effects and Industry Spillovers, we analyze shareholder initiated class action lawsuits and the associated stock price reaction. Our analysis uses a comprehensive sample obtained from the Securities Class Action Lawsuit Clearinghouse (see here) at Stanford University (which tracks federal securities class action lawsuits since 1996). This service reports that 1,915 class action lawsuits were filed over the period 1996 through 2003 with litigation peaking in 2001 when 493 suits were filed. Not only do we examine price reactions on the lawsuit filing date, but we consider the possibility that these lawsuits signal that comparable firms are susceptible to similar lawsuits. If true, we expect these comparable firms to have negative stock price reactions that are significantly related to the probability of being sued.

We develop an econometric model for the propensity to be sued based on both firm and industry-specific factors. We show that shareholder wealth losses on the date that the filing of a lawsuit is announced are understated because investors partially anticipate these lawsuits and capitalize part of the losses in advance. In this regard, our methodology is consistent with the literature on conditional event study methods that emphasizes the role of explicitly conditioning for the expected information (i.e., partial anticipation of lawsuits) in estimating announcement effects, and suggests that the probability of an event (i.e., of being sued) is, as we find in this study, significantly related to the event date announcement effect. While other studies have examined whether investors partially anticipate corporate events, such as acquisitions and debt offerings, they are based only on firm-specific information. In contrast to these studies, we incorporate spillover effects based on industry specific information, such as the litigation environment, to determine both the propensity of a firm to be sued and the associated shareholder losses. We focus on the relation between investor reactions and the probability of being sued and demonstrate that prior expectations about the likelihood of being sued are significant determinants of the anticipated losses prior to the filing of an actual lawsuit and on the lawsuit filing date.

Our main findings are as follows. First, we find that investors partially anticipate lawsuits based on firm-specific and industry-specific information and capitalize losses prior to the filing of a lawsuit. Second, we show that filing date effects understate the magnitude of shareholder losses on average by approximately a third. Finally, we demonstrate that prior expectations about the likelihood of being sued are important determinants of the losses that investors capitalize in anticipation of being sued and of the losses on the lawsuit filing date. In particular, we show that the more likely a firm is to be sued, the larger is the partial anticipation effect (shareholder losses capitalized prior to a lawsuit filing date) and smaller is the filing date effect (shareholder losses measured on the lawsuit filing date). Our evidence suggests that previous research that typically focuses on the filing date effect understates the magnitude of shareholder losses, and such an understatement is greater for firms with a higher likelihood of being sued.

The full paper is available for download here.

What Happens When The Government Enters The Ring?

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, July 21, 2009
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Editor’s Note: This post by Professor Mark Roe appears today on Forbes.com

Bernanke and Paulson are still taking heat from Congress for pressing Bank of America’s Lewis into going forward with the Merrill Lynch purchase, a deal that shackled Bank of America with significant losses. And Bank of America’s Lewis took considerable heat from its shareholders for not telling them how bad Merrill looked at the time of the purchase.

Eventually, the Treasury put another $20 billion into Bank of America and documents now indicate that the government raised the possibility of ousting the bank’s senior management if the deal had not gone through.

Several core transactions in the financial crisis have the government in a dual role, as simultaneously being a regulator and a market-like player. It’s as if the referee in a sport started fielding his own team. Even first-rate refs doing their job well, and as fairly as they can, can distort how everyone else plays the game, once the referee becomes a player too. This problem also emerges when the governmental regulator becomes a market player too, as was the case three times in the past year: with Bank of America’s purchase of Merrill Lynch, when the government was standing behind Bank of America as a vital lender; with Morgan’s purchase of a failing Bear Stearns last year with the Fed and the Treasury brokering the deal; and with Chrysler’s rescue via government loans.

A standard objection to the government as market player–as, say, an owner of companies like GM and Chrysler–is that it’s a bad manager. It wastes resources, makes mistakes and misallocates capital. It’s insulated from market incentives.

But recent evidence suggests it might not be so bad as a manager. And when the government meddles with or replaces failed managements–viz. the American auto industry–it’s not replacing America’s most admired management teams, but its worst. The bar for it to clear is not all that high.

The government’s goals are usually seen as the bigger issue. Rather than profits, the government-as-owner seeks to maintain employment or another nonprofit goal. Sometimes these further sensible social policy. But because it isn’t focused on profits, the government often puts capital where it’s less effective in the long run. These reservations to the government as market player are standard.

There’s a third issue with the government as market actor, one that’s potentially as insidious as any of the others, but less vivid.

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Why re-regulating derivatives can prevent another disaster

Posted by the Harvard Law School Forum on Corporate Governance & Financial Regulation, on
Tuesday, July 21, 2009
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Editor’s Note: This post is by Lynn A. Stout of UCLA School of Law.

When credit markets froze up in the fall of 2008, many economists pronounced the crisis both inexplicable and unforeseeable. That’s because they were economists, not lawyers.

Lawyers who specialize in financial regulation, and especially the small cadre who specialize in derivatives regulation, understood what went wrong. (Some even predicted it.) [1] That’s because the roots of the catastrophe lay not in changes in the markets, but changes in the law. Perhaps the most important of those changes was the U.S. Congress’s decision to deregulate financial derivatives with the Commodity Futures Modernization Act (CFMA) of 2000.

It was the deregulation of financial derivatives that brought the banking system to its knees. The leading cause of the credit crisis was widespread uncertainty over insurance giant AIG’s losses speculating in credit default swaps (CDS), a kind of derivative bet that particular issuers won’t default on their bond obligations. Because AIG was part of an enormous and poorly-understood web of CDS bets and counter-bets among the world’s largest banks, investment funds, and insurance companies, when AIG collapsed, many of these firms worried they too might soon be bankrupt. Only a massive $180 billion government-funded bailout of AIG prevented the system from imploding.

This could have been avoided if we had not deregulated financial derivatives.

Derivatives “De”regulation?

Wait a minute, some readers might say. What do you mean, “de”regulated derivatives? Aren’t derivatives new financial products that have never been regulated?

Well, no. Derivatives have a long history that offers four basic lessons. First, derivatives contracts have been used for centuries, possibly millennia. Second, healthy economies regulate derivatives markets. Third, derivatives are regulated because while derivatives can be useful for hedging, they are also ideal instruments for speculation. Derivatives speculation in turn is linked with a variety of economic ills—including increased systemic risk when derivatives speculators go bust. Fourth, derivatives traditionally are regulated not through heavy-handed bans on trading, but through common-law contract rules that protect and enforce derivatives that are used for hedging purposes, while declaring purely speculative derivative contracts to be legally unenforceable wagers.

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Cuban Decision Casts Doubt on SEC Position on Insider Trading

Posted by Annette L. Nazareth, Davis Polk & Wardwell LLP, on
Monday, July 20, 2009
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The recent decision of the Court of Appeals for the Second Circuit in SEC v. Dorozhko further illustrates the uncertain state of the limits of insider trading. Reversing an earlier District Court decision, the Court held that while a breach of a fiduciary duty is required where the fraud is premised on silence, no such breach is required where there has been an affirmative misrepresentation. A memo by Davis Polk & Wardwell LLP, available here, discusses the decision.)

Editor’s Note: This post is by Annette Nazareth’s colleagues William M. Kelly, Joseph A. Hall, Michael Kaplan, William J. Fenrich, and Janice Brunner.

On Friday, a federal district court in the Northern District of Texas dismissed the SEC’s insider trading case against Dallas Mavericks owner Mark Cuban. While the celebrity of the defendant has undoubtedly contributed to the widespread publicity of the dismissal, the real news is that the SEC has, for the moment at least, lost a case on what might seem to have been slam-dunk facts:

• Company shares material nonpublic information with its largest shareholder, who agrees to keep the information confidential.• The shareholder, upon learning the information, says “Well, now I’m screwed. I can’t sell”.

• Shareholder nonetheless turns around and dumps all of his shares, sparing himself a $750,000 loss when the material nonpublic information is later disclosed.

What’s missing here? Mr. Cuban, abetted by a group of law professor amici, argued that Rule 10b-5 liability requires a fiduciary or fiduciary-like relationship with the provider of the information, and that a mere agreement cannot provide a basis for liability. The court rejected this view, but it also rejected the SEC’s long-held view, reflected in its adoption of Regulation FD and Rule 10b5-2, that third parties who accept material nonpublic information from a company on a confidential basis are precluded from trading on the information. The court held that Mr. Cuban’s oral agreement to maintain confidentiality, without an agreement not to trade, was not enough.

What does this decision mean for potential providers and recipients of material nonpublic information?

For providers—for example, companies interested in sharing information with potential investors or acquirers—the case says that if you want the recipient not to trade, you had better be specific. The safest approach, of course, is to seek a written contractual standstill from recipients. But agreements of this sort are often difficult to get parties to agree to, especially where, as in this case, the recipient would be asked to sign the agreement “blind”, without knowing the nature of the information. As a practical matter, providers may have to content themselves with a “sole use” provision, along the lines of “recipient agrees to use the information solely for the purpose of considering an investment”. Had such a provision been in place, the result in this case might well have been different.

For recipients of material nonpublic information, our advice is not to rely on this decision. The case was decided at the trial court level, is not binding on other courts, and the SEC has been given the right to file an amended complaint. Whether or not the SEC chooses to replead the case or to appeal the decision, we are certain that it will not accept the case as the final word and will continue to seek enforcement action on facts like these. Thus, while the decision will provide comfort to parties who have to defend themselves for what they have done, we would not use it as a basis for deciding what you should do. The prudent judgment continues to be that if you have agreed to keep information confidential, you should not use it as a basis for trading.

Lastly, the case highlights the curious fact that, 75 years after the enactment of the Securities Exchange Act and the creation of the SEC, and after decades of judicial exegesis of the Delphic text of Section 10(b), we still don’t quite know when insider trading is illegal.

See S.E.C. v. Cuban, No. 3:08-CV-2050-D (N.D. Tex. July 17, 2009)

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