Law’s Limits on the Search for Acquisition Information

Law’s Limits on the Search for Acquisition Information Chapter 12 Part 2

Legal and Economic Bounds on the Search for Information • Information is the principal raw material in the arbitrage business • It can be useful for purchasing stock in takeover targets prior to merger announcement (which can be insider trading) or merger arbitrage--purchase of acquirer/target stock after deal announcement. • A legal boundary as much as economic.

Insider Trading • Where is the 10b-5 violation? • Lie? • Half-truth? • Silence? You have committed fraud (for 10b-5) if you trade while in possession of material inside information without disclosing (i.e. silence) and you have a duty to speak • Who has a duty to speak? (i.e. their silence becomes fraud) • Chiarella (1980)- not this printer! • Arbitrageur's goal to gain info that is not within the prohibited categories

Prohibited Categories • A “classic” insider: • director, officer, employee breaching duty to shareholder who traded • A tippee • (wrongful transfer) tipper benefited from breach and you knew/ should have known • A constructive insider • original transfer proper to attorney, accountant, IB then used improperly • A misappropriator • breaching a duty to someone other than the trading shareholder • Anyone with info in a tender offer (Rule 14e-3)

Chiarella v. United States • five deals -- used decoy names or blanks spaces to conceal the names until the night of the final printing • Vincent Chiarella was able to deduce the names of the target, purchased shares in the target prior to the announcement and then sold after the announcement and jump in price, making $30,000 • His was the first criminal conviction for insider trading under Rule 10b‐5

Chiarella • holding -- duty to speak “does not arise from the mere possession of nonpublic market information.” • retrenchment in reach of Rule 10b‐5 and its judicially implied private cause of action after Justices Powell and Rehnquist joined the court • expansive interpretations of securities law from FDR’s second term through the early 1970s gave way to a string of restrictive interpretations of which Chiarella is a part

Chiarella (cont.) • The Chiarella court notes that 10b‐5 liability is premised on • “a duty of disclosure arising from a relationship of trust and confidence between parties to a transaction” and refers specifically to “corporate insiders who have an obligation to place the shareholder’s welfare before their own.” • Focus on the fiduciary’s relationship with the sellers of the target company security, • Tie takes in insiders on the target side, but not insiders on the bidder side of the takeover transaction. • insider trading liability would cover only a portion of those with information in a takeover setting

Classic Insider Trading- Chiarella • If not the printer, Who? • Why does their silence become fraud? • What branch of law is the source of this duty? • Who, in a takeover context will have this duty?

Tippee Liability and Constructive Insiders -- Dirks • Chiarella left open possibility that liability could extend to a tippee as a participant after the fact in the insider’s breach of a fiduciary duty. See footnote 12. • Three years after Chiarella, the Supreme Court returns to question with Justice Powell again writing the majority and reinforcing core message • Court holds that tippee can inherit duty owed by another to target shareholders when information is made available to the tippee improperly • The court looks to tipper’s monetary or personal benefit as a proxy for improper transfer and that the recipient knows or should know that there had been a breach

Dirks (cont.) • While many tips have such a personal gain it was not shown in Dirks since the tipper was a whistle blower tiring to expose the fraud, not make money from tip • Mr. Chiarella’s conduct likewise would not be covered, since there was no benefit to the source from whom Mr. Chiarella got the information • larger problem -- Chiarella’s source of information would have come from the acquirer side of the deal who likely hired the financial printer, and those parties would have no traditional fiduciary duties to shareholders of target company • So even if tippee is added to classic, the range of coverage is still only a portion of information sources in a takeover transaction

Misappropriation • How does conduct violate 10b-5? • Lies, half-truths, or silence? • How different from Chiarella/Dirks? • The source of the duty • Corporate law? • Who in a takeover context will come within this category?

Rule 14e-3 • What conduct violates the Rule? • Lies, half-truths or silence? • How is it different from Chiarella? • What is the source of the duty? • Who in a takeover context will come within this category (who would not fit in the prior categories?)

Misappropriation and Rule 14e3 Liability United States v. O’Hagan • The Supreme Court did not take up the SEC’s post‐Chiarella rule‐making until 1997. • Grand Met, a UK company, was making a bid for Pillsbury • The defendant was an attorney for the Minneapolis firm retained to work for Grant Met (i.e. the bidder, not the target), although Mr. O’Hagan not part of the team working on the case • The defendant needed money (court’s footnote reports he was later convicted of theft and disbarred), learned about the deal, bought options in target, and made a profit of more than $4.3 million.

United States v. O’Hagan • Court upholds the two separate bases of insider trading liability. • First, in Part II Rule 10b‐5 held to include silence when one has a duty to the source, even if that person is not the person with whom the inside trader trades. • This opens up duty beyond the corporate governance context of the directors and officers of the target company, to include a variety of persons who have fiduciary duties under agency law • majority and dissenting opinions differ on whether such trading can be in connection with the fraud, but the result is an expansive view of liability • Second, court also upholds the Commission’s rule‐making authority under Section 14(e), added by the Williams Act, to proscribe insider trading in a tender offer as a means reasonably designed to prevent fraud.

The cast of characters Sam Waksal, CEO AlizaWaksal, Sam’s daughter Peter Baconovic, Merrill Lynch broker Martha Stewart (avoided $45,000 loss) Inside information: ImClone drug denied FDA approval Bases for Liability Classic Tippee Constructive aka “Temporary” Misapporporiator Tender Offer Insider Trading Applied- the ImClone Example

Insider trading in M&A setting • All the theories could apply to the insiders of the target • classic theory originally designed to apply to them (see Chiarella) and the tippee and constructive insider categories , who both got their information from insiders of target • For tippee, the info conveyance is wrongful; and in the second info conveyance is appropriate but the subsequent use is not • In contrast, misappropriation and 14e‐3 were needed because of the perceived limitations in prior categories as applied to acquiring side (illustrated by O’Hagan) • important question -- can theories be applied with other grounds such as misappropriation? Answer from lower courts so far has been yes. • Tender offer is broader than mergers because of the absence of a need to tie to fiduciary duty, so there will likely be less room to use inside information by anyone, arbitrageurs or not, in a tender offer

Insider Trading Applied--Acquisitions • Tender offers are different than mergers • Classic insiders covers insiders of target • Tippee covers info conveyed in breach of duty (i.e. for money) • Constructive covers info conveyed for legitimate corporate purpose (i.e. to lawyer, banker) • Misappropriation covers those who learn from bidder/others if relationship of trust • What is left?

U.S. Government Cracks Down On Insider Trading • http://www.sfgate.com/cgi-bin/article.cgi?f=/g/a/2012/03/28/investopedia76532.DTL • “The most significant recent insider trading case and one of the biggest in history was the conviction of billionaire hedge fund operator Raj Rajaratnam. He was sentenced to 11 years in prison, ordered to forfeit $53.4 million and pay a $10 million fine. Rajaratnam's prison sentence was the longest ever imposed on an insider trading conviction and demonstrates the government's new resolve in ending these widespread crimes.”

Law’s Limits on the Search for Acquisition Information