Securities Update ~ May 15, 2000

One of these proposals, Regulation FD (fair disclosure) ("FD"), would give the Commission a new approach for attacking selective disclosure by issuers to analysts and others. The initiative would not replace the Commission's usual insider trading initiatives, but would supply them with a new weapon keyed to issuer disclosure responsibilities. Another proposal addresses whether the purchase or sale of a security with knowing possession of inside information alone violates insider trading prohibitions or whether it must be shown that the trader used the information in making the purchase or sale. The final proposal, which deals with the "misappropriation" theory of insider trading, seeks to clarify the liability of persons who receive inside information in a family or personal relationship.

SEC Chairman Arthur Levitt, who is adamantly opposed to selective disclosure, has adopted the longheld SEC position that the Federal securities laws embody a policy of equal access to material information. Selective disclosure to analysts and others prior to a public announcement violates this policy. These positions are contravened, however, by the Supreme Court decision in Dirks v. S.E.C.² The Dirks ruling limited the liability of corporate "tippers" for insider trading by "tippees" to cases where the insider personally benefitted from the disclosure of material, non-public information or traded on the basis of such information. The Court also specifically recognized that "the value to the entire market of [analysts'] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [analysts'] initiatives to ferret out and analyze information and thus the analysts' work redounds to the benefit of all investors."³

Dirks also recognized that disclosing non-public, material information could provide a "reputational benefit" to the insider. In S.E.C. v. Stevens (1991),⁴ the SEC sanctioned a corporate executive who had leaked poor earnings results to certain analysts; apparently because of his concern over losing credibility with them. The SEC staff translated that concern into the reputational benefit in Dirks and in its administrative order found a violation of Rule 10b5 for tipping material inside information. Commenting upon Stevens, Chairman Levitt stated:

In the Background section of FD,⁶ the Commission points with alarm to reports that analysts have spent less time with the laboring oar so richly commended in Dirks, relying instead upon access to corporate insiders, corporate forecasts of future earnings, and pressure on analysts to avoid being dropped by issuers from conference call lists.

The Commission also points out that even though Dirks has changed the playing field from one requiring equal access to material information by all investors to a requirement of some sort of personal benefit, investors should nevertheless receive timely access to material information that insiders choose to disclose. The Commission proposes Regulation FD to address this selective disclosure problem—not by denominating violation as a fraud, but by imposing, pursuant to Sections 13(a) and 15(d) of the Exchange Act, disclosure requirements similar to those found in the 1933 Act. This mandatory disclosure duty will, for the first time, be imposed upon issuers to publicly disclose material, non-public information. The duty would also apply to closedend investment companies (but not to openend funds).

The proposed Regulation FD consists of the following two rules:

Rule 100 requires an issuer subject to the periodic reporting rules "or person acting on its behalf" to make public material non-public information whenever such information is disclosed to anyone outside the issuer,⁷ unless the recipient owes a duty to maintain the confidentiality of the disclosure. The term "acting on behalf of the issuer" focuses upon employees and other agents acting within the scope of their authority. Such persons would, of course, be properly authorized or designated to speak to the analyst community and the media.

The public disclosure must be "simultaneous" in the case of intentional disclosures. Nonintentional disclosures must be publicly disclosed "promptly."

Rule 101, among other things, contains the following definitions:

• "intentional"—if the individual making the disclosure either knew prior to the disclosure or was reckless in not knowing, that he or she would be communicating information that was material and non public. Bear in mind that violation of FD could occur by statements in a speech, telephone call, fax or email, e.g., to an investor, PR firm or financial publication, i.e., anything that is short of "public" as defined below.

• "promptly"—as soon as reasonably practicable (but no later than 24 hours)⁸ "after a senior official . . . knows, or is reckless in not knowing, of the nonintentional disclosure."

• "public disclosure"—by filing an 8K or, instead, by either (i) disseminating the information through a widelycirculated news or wire service, or (ii) disseminating the information by "disclosure that is reasonably designed to provide broad public access" such as a press conference "to which the public is granted access (e.g. by personal attendance or by telephone or other electronic transmission)."

• "anyone outside the issuer"—the Rule does not apply to the receipt of material information by persons who are bound by duties of trust or confidence not to disclose or use the information for trading. These persons would include outside consultants such as the issuer's attorneys, investment bankers or accountants and any other person who has agreed in writing to maintain the information in confidence. Any misuse of the information for tipping or trading by that person would be covered either under the "temporary insider" or "misappropriation" theory. The foregoing categories are intended by the Commission to permit business transactions and technical analyses by analysts to proceed without requiring public disclosure under FD.⁹

There are categories of persons outside the issuer who would likely not be interested in signing a confidentiality agreement but who regularly receive material inside information as a necessary part of their relationship with the issuer. These would include, e.g., banks with a lender relationship with the issuer who is required by the lending agreement to provide the information.

In a mutual fund context, as suggested by Professor Coffee,¹⁰ or in a brokerdealer context in connection with a proposed debt placement with an issuer, the fund and the broker would not be likely to do the transaction without the receipt of all available information. They also would not be likely to sign a confidentiality agreement that would bind a trading department, which has no access to the information, from trading the stock in question. These issues are not addressed in the Release but the Commission requests comment concerning the need for expansion of the foregoing categories.¹¹

The winner or loser in antifraud private securities litigation and SEC enforcement proceedings is frequently determined by the court's definition of materiality. ¹² For Regulation FD purposes, the Commission proposes to adopt the definition of materiality currently in vogue in cases under the antifraud provisions generally, i.e. information is material if there is a substantial likelihood that a reasonable shareholder would consider it important in making an investment decision or if it would have significantly altered the total mix of information made available.¹³

In its Release, the Commission recognizes that "materiality judgements can be difficult;" that corporate officials may become chary of communicating with analysts or investors and might decline to say anything at all without counsel at their side. The Commission suggests, however, that even in the absence of a bright line for materiality decisions—and none is provided in the Release—there is still a spectrum of clarity.

The Commission's "spectrum" does not purport to deal with the profusion of issues that may arise on the road to complying with FD. The Commission states, however, that it does not believe these uncertainties will "chill the flow of corporate information." That is speculative at best. Issuers have already started to consider the elimination of analyst calls and inhouse attorneys are questioning their ability to deal with the need for spontaneous rapidfire legal opinions on materiality.

The Commission lists several suggestions for issuers to mitigate the problems that may be created by the proposed rules—particularly the determination of materiality:

The Release notes that no private liability is expected to result from an issuer's failure to file or make public disclosure as required by FD. FD is an issuer disclosure rule designed to create duties only under Exchange Act Sections 13(a) and 15(d) and Investment Company Act Section 30. It is not intended to create causes of action under the antifraud provisions. Notwithstanding the Commission's assurances on this point, the plaintiff's bar might very well disagree depending upon the movement of the stock and the prospective fee. Moreover, issuers who violate FD could be subjected to SEC enforcement proceedings including civil injunctive actions with monetary penalties, and administrative proceedings including cease and desist orders and fines. Individuals employed by the issuer could be named in such proceedings for "causing" or aiding and abetting violations of FD.

As discussed above, the usual antifraud rules would continue to apply to any false or misleading statements made to the public. Conceivably, an insider trading case could be combined with a proceeding alleging violation of FD as well as a criminal action under FD. To complete the enforcement menu, it is not inconceivable that issuer's counsel in an appropriate case could be named a "cause" in a 1934 Act administrative proceeding or for having aided and abetted a violation of FD under Rule 102(e) of the Commission's Rules of Practice.

The misappropriation theory of insider trading liability was finally confirmed, after a long germination period, by the decision in United States v. O'Hagan.¹⁹ While the SEC had consistently argued that possession of non-public information suffices to impose insider trading liability, O'Hagan hinges liability upon trading on the basis of such information.²⁰

In S.E.C. v. Adler,²¹ a civil insider trading enforcement proceeding, the Eleventh Circuit held that the "use" test was the appropriate standard. The court, in relieving somewhat the burden of proof imposed upon the SEC by its holding, added that "a strong inference arises that such information was used by the insider in trading." However, the court allowed the defendant to rebut the inference by proof that there was no causal connection between the information and the trade.

Adler was followed by a criminal case. In United States v. Smith,²² the Ninth Circuit held that Rule 10b5 entails a "use" requirement and rejected the Adler presumption which would have permitted the jury to draw a strong inference of use when an insider trades while in possession of non-public information. The court "excused" the holding in Adler as a civil enforcement proceeding but held that in a criminal case there was no basis for permitting an evidentiary presumption which would have had the effect of shifting the burden of proof to the defendant.

The Commission's proposed Rule 10b51 sets forth a general prohibition against trading on the basis of inside information and then defines "on the basis of" to include trading while the trader was "aware of the material non-public information" at the time of the purchase or sale. The proposed rule permits the defendant to avoid liability by showing that prior to the trading decision the trader had:

1. entered into a binding contract to purchase the security in the amount at the price and on the date of the purchase or sale;
2. provided instructions to another person to execute a purchase or sale for the trader's account in the amount, at the price, and on the date of the purchase or sale;
3. adopted and had adhered to a written plan specifying purchases or sales in the amounts, and at the prices and on the dates of the purchase or sale;
4. adopted and had previously adhered to, a written plan for trading securities that is designed to track or correspond to a market index, market segment, or group of securities and the amounts, prices and timing of the purchases or sales actually made were the result of following the plan.

These defenses are only available if entered into in good faith and not as part of a scheme to avoid the Rule. The Release provides an example of such a scheme.

An additional defense is proposed for trading entities, similar to a defense found in Exchange Act Rule 14e3(b). The defense requires a showing that the trader had no knowledge of the information and the entity had adopted reasonable policies and procedures such as so-called "Chinese Walls" and restricted lists.

It remains to be seen whether the proposed rule will be upheld, notwithstanding the strong argument that it exceeds the statute just as the Commission's interpretation of Rule 10b5 which resulted in the decision in Hochfelder ²³ now requiring the government to prove that the defendant acted with scienter.

It is also appropriate to note that there is no discussion of the affirmative defenses which may have been oral. Conceivably, if the written requirement of the defense is all that is missing, the Commission staff would take that into consideration in making any recommendation for enforcement action.

The Commission notes that it is proposing Rule 10b52 in response to the decisions in United States v. Reed ²⁴ and United States v. Chestman.²⁵ As noted above, O'Hagan, in upholding the misappropriation theory, required there to have been, in part, breach of a duty of loyalty and confidence, and that certain types of business relationships provide the necessary duty of trust or confidence. "It is not settled, however, under what circumstances . . . family and personal relationships may provide" the required duty.

In Reed the court refused to find a father-son relationship, by itself, sufficient to show a duty of confidence. Instead, to establish a basis for liability, it required an analysis of each family situation just as that conducted in business relationships including factors such as a prior history of sharing confidences.

In Chestman the Second Circuit reversed a broker's conviction. The broker had received and traded upon information received from Keith Loeb, the husband of a daughter of the Loeb family, the owners of Waldbaums, a publicly-traded food retailer with plans to sell control of the company to A&P. The daughter had learned about the proposed transaction from her mother, the sister of the then Chairman of Waldbaums.

The Second Circuit held that the government must prove that Keith Loeb had misappropriated the insider information in breach of a fiduciary relationship "or its functional equivalent" between Loeb and his wife, or between Loeb and the Waldbaum family. The court held that the Loebs' status as husband and wife, without more, did not establish a fiduciary relationship, nor did the evidence establish a fiduciary relationship with the family. The court noted "kinship alone does not create the necessary relationship."

The Commission is "dubitante":

In view of the decision in Chestman, the Commission deemed it appropriate, in the interests of investors and the markets, to clarify the law in the area of non-business relationships. Under proposed Rule 10b52 the recipient of confidential material information would owe a duty of trust or confidence to the provider of the information and therefore be potentially liable under the misappropriation theory if the person then were to trade in the following circumstances:

1. an explicit agreement by the recipient to maintain confidentiality; it need not be written;
2. the persons involved in the communication had a history, pattern, or practice of sharing confidences such that the person making the communication has a reasonable expectation that the other person would maintain its confidentiality. The confidences involved in the history of the relationship need not be business related.
3. when the person who provided the information was a spouse, parent, child or sibling of the recipient unless it can be shown, based on the facts and circumstances of that family relationships, that there was no reasonable expectation of confidentiality. This paragraph raises the same questions as those noted above in the discussion of Smith with respect to automatic burden shifting to the defendant, rather than requiring the government to prove the existence of a fiduciary relationship.

1 At the time of this writing the comment period for the proposals had been extended from March 29 to April 29, 2000. The staff will consider comment letters received after the end of the comment period.

2 463 U.S. 646 (1983).

3 463 U.S. at 654 n. 17 (1983).

4 SEC Lit. Rel. No. 12813, S.D.N.Y., March 19, 1991, reprinted in 48 SEC Docket No. 9 at 739.

5 1998 PLI Conference "SEC Speaks."

6 SA Rel. No. 337787, Selective Disclosure and Insider Trading at p. 4.

7 We have italicized terms that are defined below under Rule 101.

8 The 24 hour definition of "promptly" is not intended to change the different definitions of that word in other provisions of the Federal securities laws, e.g., Exchange Act Schedule 13D. See Rel. at n. 44.

9 Regulation FD would also impose requirements upon material communications, written or oral, that supplement the disclosures required by the Commission's new business combination rules. Regulation of Takeovers and Security Holder Communications, Sec. Act Rel. No. 7760 (Oct. 22, 1999). Issuers may use confidentiality agreements to protect communications made in the context of business combinations or other transactions not intended for public disclosure including e.g. "lockups."

During road shows after a registration statement has become effective, disclosures required by FD, but which would also violate Securities Act prospectus requirements, are proposed to be protected by proposed new 1933 Act Rule 181 from the requirements of Section 10 of the Securities Act for a prospectus, so long as the requirements of Regulation FD are satisfied.

10 John Coffee, "Securities Law Selective Disclosure," National Law Journal, March 13, 2000, p.B5.

11 Rel. p. 8.

12 A former Director of an SEC Division was fond of defining materiality by asking if the fact makes you want to run to the telephone.

13 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).

14 Rel. at p.7

15 The definition of materiality is somewhat complicated by the Commission staff's issuance of Staff Accounting Bulletin 99, 1999 SEC Lexis 1599, August 12, 1999, which announced guidance in applying materiality thresholds to the preparation of financial statements filed with the Commission and the performance of audits of those financial statements.

The SAB adopts the TSC Industries definition of materiality (discussed above) and continues:

The SAB then discusses the use of qualitative and quantitative factors in determining materiality. The Release proposing Regulation FD does not discuss this obviously material addition to any consideration of materiality for FD purposes.

16 In making this decision one would also have to take into account the possibility that some analysts might refuse to sign the confidentiality agreement and, instead, flash a sale signal. An extensive article by James J. Junewicz (Mayer, Brown &Platt partner) addresses problems of issuers in dealing with analysts. It is printed in Insights, January 1995, page 9. Copies may be obtained by contacting Mayer Brown.

17 The Release states at p.12: "Regulation FD does not affect or undermine any existing bases of liability under Rule 10b5."

18 The theory was given birth in Chiarella v. United States, 445 U.S. 222, 236374, n. 21 (1980). It was quickly tested and affirmed in United States v. Newman, 664 F.2d 12 (2d Cir. 1981).

19 521 U.S. 642 (1997).

20 Id. at 656.

21 137 F. 3d 1325, 133739 (11th Cir. 1998).

22 155 F.3d 1051 (1998).

23 Ernst & Ernst v. Hochfelder, 425 U.S. 185.

24 601 F. Supp. 685 (S.D.N.Y.), (rev'd on other grounds, 773 F.2d 447 (2d Cir. 1985).

25 947 F.2d 551 (2d Cir. 1991).