In the D&O insurance world, private company liabilities, exposures, and insurance are viewed as categorically distinct from public company liabilities, exposures, and insurance. There are completely separate and distinct insurance policy forms for each of the two categories of companies. In this traditional view, one of the key distinctions between two kinds of companies is the potential liability of public companies and their directors and officers under the federal securities laws. However, it has recently become apparent to me that this perceived difference between the two categories of companies may be less distinct than I had perceived. For example, as I noted in a recent post, the SEC has recently made it clear it is watching private companies, and is particularly concerned with so-called “unicorns” (private start-up firms with valuations greater than $1 billion).
This issue of the potential private company liabilities under the federal securities laws came up again for me recently when I read about a petition for a writ of certiorari that a securities claim plaintiff has filed in the U.S. Supreme Court. As discussed in a June 8, 2016 post on Jim Hamilton’s World of Securities Litigation (here), the petition asks the Court to address the question whether a privately held corporation trading in its own stock has an Exchange Act duty to disclose all material information or abstain from trading. As discussed below, the petition and the underlying claim raise important questions about the potential liabilities of private companies under the federal securities laws. The May 31, 2016 cert petition in the case of Fried v. Stiefel Laboratories, Inc. can be found here.
Richard Fried was the CFO of Stiefel Laboratories, Inc. from 1987 to 1997. SLI at the time was a privately held company. Fried held a number of SLI shares, which he retained after he left the company. Since its inception, the company had been closely held and controlled by members of the Stiefel family. Throughout its history, the family and the company had maintained that the company would never be sold. In November 2007, Fried read in a Miami Herald article that SLI had received a $500 million investment from the Blackstone Group. At the same time, the company reiterated its long-term commitment not to sell itself or conduct an IPO. In the fall of 2008, while in a conversation with a member of the Stiefel family, Fried thought he heard a “kind of a sell signal,” and so he arranged to sell his shares back to the company. He completed the sale of his shares to the company in January 2009, at a price of $16,469 per share.
Unbeknownst to Fried, members of the family had “secretly decided to pursue” opportunities to sell the company and began negotiations to complete a sale. In April 2009, an agreement was reached to sell the company to GlaxoSmithKline for roughly $70,000 a share, or more than four times more than Fried had received in his share sale to the company.
Fried sued the company and certain individuals alleging among other things that the company’s had violated the federal securities laws. He proceeded on two theories of liability; first, that the company had a duty to update the information in the press release the company put out at the time of the Miami Herald article, and, second, that the company had an independent duty to disclose the plan to sell the company or abstain from buying back the shares. Fried’s case ultimately went to the jury, which ruled in favor of the defendants.
Fried filed an appeal to the Eleventh Circuit on a single issue, whether the trial court had erred in refusing to give a jury instruction that he had requested, which would have instructed the jury, among other things, that the defendants “had a duty to disclose” material information or abstain from trading. The Eleventh Circuit affirmed the district court. Fried then filed his petition for a writ of certiorari.
The Cert Petition
In seeking the writ, Fried contends that every circuit court that has addressed the issue has held that Section 10(b) of the Exchange Act and Rule 10b-5 require a privately held corporation to disclose material information to shareholders before purchasing its stock directly from them, or to abstain from trading. (In making this assertion, Fried cites cases from the First, Second, Sixth, Seventh, and Ninth Circuits). Fried contends that his requested jury instruction simply followed this long line of cases.
Fried asserts that the Eleventh Circuit failed to follow this line of cases because, the appellate court said, the instruction “did not adequately state the elements of a claim of insider trading” under sections (a) and (c) of Rule 10b-5 and because the instruction did not require the jury to find that Stiefel Laboratories traded ‘on the basis of’ material information.
In his petition, Fried asks the Court to address the question whether the elements of a Section 10(b) and Rule 10b-5 private securities fraud claim based on the failure of a privately held corporation to disclose material information to shareholders before directly purchasing their stock are the same six elements that the Supreme Court has said that comprise a private securities fraud claim. According to Fried, his petition and this case provides the Court with an opportunity to clarify the outlines of an Exchange Act fraud claim based on the duty to disclose.
Fried’s also presents a separate question. He contends that even if the Eleventh Circuit was correct that an omissions-based theory was unavailable in this case, and that Fried’s only viable theory was a classic insider-trading claim, the Court can clarify the standard defining what conduct constitutes insider trading. The Eleventh Circuit had held, citing its own precedent, that mere possession of material nonpublic information alone is not sufficient to support a finding of liability; rather, an insider must “use” the information. Fried contends the Eleventh Circuit’s “use” requirement to define insider trading conflicts with Second Circuit’s “knowing possession” standard. The Second Circuit standard, which is also echoed in the requirements of Rule 10b5-1, provides that a corporate insider who trades while in knowing possession of nonpublic material information can be held liable for insider trading.
It remains to be seen whether or not the U.S. Supreme Court will take up this case. However, as the blog post linked above emphasizes, the case provides the Court with an opportunity to address questions concerning the contours of a securities fraud claim in a context that the Supreme Court has yet to address – that is, in the context of a privately held corporation trading its own stock.
If the Court takes up the case, it will be interesting to watch this case unfold and to see what the Court comes up with. But even if the Court does not take up the case, the legal theories discussed in this petition raises issues that apparently have been around but about which I have previously been unaware. That is, there apparently is extensive federal appellate court case law authority supporting the proposition that a privately held company can be held liable under the federal securities laws for omissions in connection with the purchase of its own shares. Among other things, this case law holds (or at least so Fried argued in his cert petition) that the federal securities laws requires privately held companies purchasing its own shares in these circumstances to disclose material information or to abstain from trading.
In other words, a private company purchasing its own stock potentially can be held liable for violations of the federal securities laws. This may or may not represent news to the larger world, but it is an eye-opener for me, as I suspect it is for many others in the D&O arena. This proposition, that private companies can be held liable under the federal securities laws under these circumstances, is at odds with the D&O insurance industry’s traditional categorization of companies that I discussed at the outset. In this traditional categorization, public companies are different from private companies in part because of the fact that public companies have potential federal securities law liabilities. However, at least according to the case authority Fried cites in his petition, it appears that private companies have potential liability exposures under the federal securities laws.
As I said, this proposition may not be news to the larger world, but it is news to me, and it raises some practical issues. Among other things, it potentially has implications for private company D&O insurance policies. In particular, it may have important implications for the wording of the securities laws exclusion typically found in most private company D&O insurance policies. This proposition also has important implications for the scope of the potential public company liability exposure that D&O insurers may be undertaken when they accept a private company D&O risk. I suspect that for others, as for me, the idea of private companies potentially being held liable under the federal securities laws is a notion that will take some time to get used to thinking about.
It may be that everybody else on the planet already knows all about this and I am just now figuring out something that everybody else knows. However, I am guessing I am not the only one to whom these considerations represent something new. All of these considerations need to be taken along with all of the ideas that accompany the SEC’s recent initiative to closely watch highly valued private companies, which is discussed here.