Duties of Officers, Directors, and Other Insiders

Question 1

What happens when officers, directors, and other insiders breach their fiduciary duties?

Answer 1

They become personally liable

Question 2

Obligations of Control: What is the Duty of Care?

Answer 2

• Duty of Care involves the directors’ obligation to apply the appropriate standard of care when making corporate business decisions.
  
  • A director has a duty to act in good faith (be honest, not have a conflict of interest and not approve or condone wrongful or illegal activity),
  • reasonable belief and
  • reasonable care, on the basis of the best information as they manage the corporation.
  • Duty of care is analyzed under the business judgment rule.
  • If a director learns of wrongdoing, he must:
    
    • (1) inquire and investigate;
    • (2) object to the behavior;
    • (3) resign;
    • (4) seek advice of counsel;
    • (5) threaten to sue.

Question 3

Duty of Care - What is Material Information?

Answer 3

Information a reasonable person would consider important in making an investment decision.

Question 4

In upholding their **duty of care, **who may Directors rely on?

Answer 4

experts, legal counsel, accountants, or other officers or employees that director believes to be reliable and competent.

Question 5

In order to comply with the duty of care, a director MUST:

Answer 5

1. continue to monitor the company,
2. obtain at least a rudimentary understanding of the business and the industry or walk away, and
3. know how to read basic financial statements.

Question 6

What are some examples of issues that fall under duty of care?

Answer 6

1. issuing dividends
2. too high of salary to corporate officers,
3. corporate waste
4. not maximizing income, reorganization, etc.

Question 7

What is the Business Judgement Rule?

Answer 7

• Rebuttable presumption that in making business decision the directors of a corporation:

1. acted on an informed basis (due care)
   
   • Informed basis: corporate directors must have informed themselves of all reasonably available material information about a proposed business decision before making that decision. Corporate directors do not need to personally investigate all information possibly available.
     ​
2. in good faith and in the
3. honest belief that the action taken was in the best interest of the company. Plaintiff-shareholder must show the director acted fraudulently or with gross negligence to overcome the presumption.

Question 8

What must π generally show to defeat the Business Judgment Rule?

Answer 8

Fraud or Gross Negligence

Question 9

What is the Duty of Loyalty?

Answer 9

• involves the directors’ obligation not to place their own interest ahead of those of the corporation and its shareholders and to avoid engaging in self-dealing activities.
• Because a breach of the duty of loyalty implies a conflict of interest, the business judgment rule does not apply to a breach of the duty of loyalty.
• A Defendant Director has the burden of proving the transaction was inherently fair and reasonable from the perspective of the corporation (ie. Made in Good faith).

Question 10

Corporate Opportunities ** - ALI**

Answer 10

• A corporate opportunity is any opportunity to engage in a business activity that a director or senior executive learns of
  
  • (1) during performance of his functions as director or senior executive or under circumstances where reasonable to believe the offeror expects it to be offered to the corporation or
  • (2) through use of corporate information or property. Or any opportunity for business of which a senior executive becomes aware and knows is closely related to the business in which the corporation is engaged.
• Under the ALI approach, a director or senior executive may not take advantage of a corporate opportunity unless the individual first offers the opportunity to the corporation with full disclosure and allows the corporation to reject it first, and that rejection must be fair.

Question 11

Corporate Opportunities - Delaware

Answer 11

• Has a narrower approach where in determining whether a corporate opportunity exists, the court looks to whether
  
  • (1) the corporation is financially capable of pursuing the opportunity,
  • (2) the opportunity is within the corporations line of business,
  • (3) the corporation has an interest or reasonable expectancy (i.e. the opportunity is not presented to the director or officer in their individual capacity), and
  • (4) whether the director engaged in self-dealing or self-interest (they have not wrongfully utilized corporate resources to take advantage of the opportunity).
• These are factors to consider when determining if there is a potential corporate opportunity.

Question 12

What is a Dominant Shareholder?

Answer 12

• Like a director, a dominant or controlling shareholder has a fiduciary relationship to the corporation and the minority shareholders.
• Their dealings with the corporation are subject to strict scrutiny, and the burden falls upon them to prove not only good faith, but the inherent fairness of their dealings as well.
• Such self-dealing occurs only when a transaction is to the detriment of the minority shareholders.
• The fiduciary duties attach to dominant shareholders because they have the control to elect the board, which owes such duty to the shareholders.

Question 13

Insider Information - 10b-5

Answer 13

• Requires that one in possession of material inside information (information a reasonable person would consider important in making an investment decision) must either:
  
  • disclose it to the investing public or
  • if he is unable to disclose it in order to protect a corporate confidence or chooses not to do so must abstain from trading in or recommending the relevant securities while such inside information remains undisclosed.
• The rule only applies to material information, which is information a reasonable person would consider important in making an investment decision (i.e. would affect the desire of investors to buy, sell, or hold the securities). With speculative information, the test balances the probability the event will occur and the magnitude of the event.

Question 14

Types of Insiders under 10b-5

Answer 14

1. Classic Insiders
2. Termpoary insiders
3. Tippees

Question 15

10b-5 - Classic Insiders

Answer 15

• Classic Insiders = directors and officers are always prohibited from trading on insider information.
  
  • Must disclose or abstain from trading.

Question 16

10b-5 - Temporary Insiders

Answer 16

• Temporary Insiders = may become fiduciaries of the shareholders because they have entered into a special confidential relationship with the corporation and given access to inside information.
  
  • E.g., Underwriters, lawyers, or consultants working for the corporation.
  • Must disclose or abstain.

Question 17

10b-5 - Tippees

Answer 17

• Tippees = liable if:
  
  • (1) The tipper breached his/her fiduciary duty to shareholders by disclosing the information to the tippee in order to derive a direct or indirect personal gain; and
  • (2) the tippee knows or reasonably should know that there had been a breach.

Question 18

10b-5(2) - Misappropriation

Answer 18

• Misappropriation theory holds that a person commits fraud in connection with a securities transaction when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.
  
  • A person has a duty of trust or confidence for purposes of the theory:
    
    • (1) when a person agrees to maintain such information in confidence,
    • (2) when the person communicating the material non-public information and the person to whom it was communicated have a history of sharing confidences, OR
    • (3) whenever a person receives a material nonpublic information from his or her spouse, parent, child or sibling. The agent would have to get the principal’s consent to trade on the information or engage in self-dealing, so this prevents the trade from happening at all.

Question 19

Misappropriation - Aider / Abetter Theory

Answer 19

Aider/Abetter Theory: to be liable as an aider or abetter, the tipper must owe a fiduciary duty of confidentiality to the corporation and the aider and abetter must know of the tipper’s breach of fiduciary duty. (SEC used the aider/abetter theory—but not an actual type of 10b-5; criminal law)

Question 20

**10b(5)-b - **False or Misleading Statements

Answer 20

• False or Misleading Statements: One must also refrain from making false or misleading statements or omissions of material fact with the intent to deceive one who relies on such statements to their detriment causing damages. (Fraud on the market theory: creates a rebuttable presumption of reliance. Stockholders rely on the integrity of the stock price as being the true and accurate reflection of all publicly-available information. While the corporation has a duty to correct false or misleading statements or omissions of material fact, it has no such duty to correct third party misinformation.
  
  1. False/ misleading statement
  2. Material
  3. Scienter: intent to deceive
  4. Plaintiff relied on the statement
  5. Fraud on the market theory is the presumption of reliance
  6. Caused harm

Question 21

Avoiding Liability under 10b(5)-b

Answer 21

Avoiding liability: To avoid liability under a misappropriation theory, a tippee must disclose his intent to trade to the source of the information (i.e. tipper). Whereas to avoid liability under a class theory, a tippee must disclose material, nonpublic information to the public.

Question 22

**14e-3 - **Tender Offer Rule

Answer 22

• Tender Offer (Rule 14e-3) prohibits anyone in possession of material information relating to a tender offer that has been commenced (or will be commenced) which he has reason to know is nonpublic and which he has reason to know has been acquired directly or indirectly from
  
  • (i) the offering person,
  • (ii) the issuer of the securities sought, OR
  • (iii) any officer, director, or employee acting on behalf of the offering person from purchasing or selling such securities, unless within a reasonable time prior to such purchase or sale such information and its source are publically disclosed.

Question 23

16b - Short Swing Profits

Answer 23

Short Swing Profits

• Under Rule 16(b) of the Securities Exchange Act of 1934, any beneficial owner, director or officer who profits from any low purchase and high sale transaction sequence within a period of less than 6 months must disgorge such profit to the issuer of the securities.
• A beneficial owner is someone with more than 10% of a corporation’s outstanding shares and must be a beneficial owner at the time of BOTH the time of the purchase and sale (e.g. a purchase transaction that newly qualifies one as a beneficial owner is not eligible for matching against any corresponding sales transaction).
• Everyone is strictly liable under this rule and intent doesn’t matter, even applies if there has been a net loss, so long as there is a “buy low and a sell high” transaction.