Illinois Commercial Litigation

Illinois Adopts A New Citation System For Cases Decided By its Courts

2012-01-22T08:57:00.000-08:00

Illinois Supreme Court « Illinois Lawyer Now

Illinois is finally abandoning the old reporting system for Illinois cases. Apparently, no more books will be issued. Instead, the Illinois Courts will issue opinions online with a new citation system. This will also abolish the often-confusing distinction between published and unpublished opinions.

U.S. Supreme Court Upholds Arbitration Clause In Credit Card Agreement

2012-01-20T19:15:00.000-08:00

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The case is captioned CompuCredit Corp. v. Greenwood, No. 10-948.

Over the past 20 years, the United States Supreme Court has upheld arbitration clauses from many challenges. The latest, upholding an arbitration clause in a credit card agreement, will force those who want to make claims against credit card companies to file arbitration proceedings. Business groups currently prefer arbitration to claims in the court systems. How this will work over the long-term in anybody's guess.

One result is that the plaintiff's class action against the credit card company will soon be a thing of the past. Each wronged plaintiff must now file for arbitration.

Sometimes defendants are shocked when they force people to arbitration. The fees can be steep and most arbitration organizations make the defendants pay the bulk of the fees. Often the fees exceed the amount at issue.

Edward X. Clinton, Jr.

Illinois Supreme Court Upholds Noncompetition Agreements

2011-12-12T23:09:00.000-08:00

RELIABLE FIRE EQUIPMENT COMPANY v. Arredondo, Ill: Supreme Court 2011 - Google Scholar:

This case was recently decided by the Illinois Supreme Court to "correct" a misconception that Illinois no longer recognizes that a noncompetition agreement must support a legitimate business interest of the employer.

The Court described the three-prong test as follows: "¶ 17 "The modern, prevailing common-law standard of reasonableness for employee agreements not to compete applies a three-pronged test." BDO Seidman v. Hirshberg, 712 N.E.2d 1220, 1223 (N.Y. 1999). A restrictive covenant, assuming it is ancillary to a valid employment relationship, is reasonable only if the covenant: (1) is no greater than is required for the protection of a legitimate business interest of the employer-promisee; (2) does not impose undue hardship on the employee-promisor, and (3) is not injurious to the public. Id.;Restatement (Second) of Contracts § 187 cmt. b, § 188(1) & cmts. a, b, c (1981).^[2] Further, the extent of the employer's legitimate business interest may be limited by type of activity, geographical area, and time. Restatement (Second) of Contracts § 188 cmt. d (1981). This court long ago established the three-dimensional rule of reason in Illinois and has repeatedly acknowledged the requirement of the promisee's legitimate business interest down to the present day."

The Court explained that Illinois recognizes the legitimate business interest test. It noted: "¶ 43 In sum, the legitimate business interest test is still a viable test to be employed as part of the three-prong rule of reason to determine the enforceability of a restrictive covenant not to compete. However, the two-factor test created in Kolar, in which a near-permanent customer relationship and the employee's acquisition of confidential information through his employment are determinative, is no longer valid. Rather, we adopt the position of Justice Hudson's special concurrence, which is: whether a legitimate business interest exists is based on the totality of the facts and circumstances of the individual case. Factors to be considered in this analysis include, but are not limited to, the near-permanence of customer relationships, the employee's acquisition of confidential information through his employment, and time and place restrictions. No factor carries any more weight than any other, but rather its importance will depend on the specific facts and circumstances of the individual case."

The court then remanded the case to the Circuit Court to allow that court to apply the proper test.

Comment: it appears that this opinion resolves a debate in the caselaw concerning the legitimate business interest test. Although it is far from certain, considering the legitimate business interest of the employer would appear to strengthen the employer's ability to enforce a reasonable noncompetition agreement.

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Illinois Company Held Liable For Agent Who Wrongfully Obtained Employee's Phone Records

2011-12-12T22:57:00.000-08:00

Lawlor v. North American Corp. of Illinois, 949 NE 2d 155 - Ill: Appellate Court, 1st Dist., 4th Div. 2011 - Google Scholar:

This is an Illinois case in which the plaintiff, Kathleen Lawlor, obtained an award of compensatory and punitive damages against her former employer.

The court characterized Lawlor's claim as follows: "The parties engaged in four years of bruising discovery, but the testimony at the six-day trial was relatively uncomplicated. Lawlor was aggrieved that North American, through surreptitious means, acquired her mobile and home phone records in a failed effort to prove that she breached the company's noncompetition agreement. Painted with a broad brush, Lawlor presented evidence at trial to the effect that North American, through counsel and at least two independent investigators, set about the tasks of personal surveillance and getting her private phone records."

Again the bad conduct of the defendant supported the Appellate Court's decision to reinstate the punitive damages award of $1.75 million.

The court wrote: "Here, we conclude that the jury's award of $1.75 million was reasonable given North American's reprehensible conduct. The nature and the inappropriateness of the intrusive conduct in meddling with plaintiff's personal records was sufficiently malevolent to warrant punitive damages, especially considering that North American on multiple occasions, over a five-month period, specifically utilized the wrongfully obtained phone records. While several of its officers and employees testified that they were unaware of the methodology of how the records were obtained and whether unethical or illegal means were utilized, North American points to no evidence showing it was uncomfortable with the receipt or the use of this private information. To the contrary, North American employees testified that they had no hesitancy in using the phone records and that they never inquired how they were obtained. In terms of the size of the award, the jury heard that North American's net worth was approximately $50 million. It can scarcely be argued that the amount awarded by the jury was egregiously high, given both the nature of the conduct and the extent of defendant's net worth."

Edward X. Clinton, Jr.

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Seventh Circuit Weighs In On Unjust Enrichment Debate

2011-11-16T19:45:00.000-08:00

Cleary v. PHILIP MORRIS INCORPORATED, Court of Appeals, 7th Circuit 2011 - Google Scholar:

The Seventh Circuit recently affirmed the dismissal of an "unjust enrichment" class action against Philip Morris. Plaintiffs alleged that Philip Morris was unjustly enriched because it conspired to conceal the facts about the addictive and dangerous nature of cigarettes.

The Seventh Circuit frames the issue as follows: "A preliminary matter argued by the parties is whether Illinois law recognizes an independent cause of action for unjust enrichment, or whether unjust enrichment must always be tied to another underlying claim found in tort, contract, or statute."

The Court then notes that the Illinois cases are not entirely clear on whether unjust enrichment is a separate cause of action or whether it must be tied to an underlying cause of action, such as fraud or breach of fiduciary duty.

The Seventh Circuit summarizes the conflicting cases as follows: "The Illinois Supreme Court appears to recognize unjust enrichment as an independent cause of action. In Raintree Homes, Inc. v. Vill. of Long Grove, 807 N.E.2d 439, 445 (Ill. 2004),the plaintiffs were seeking the refund of overpaid fees under an unjust enrichment theory. No other underlying cause of action was alleged. The Court noted: "Here, plaintiffs have no substantive claim grounded in tort, contract, or statute; therefore the only substantive basis for the claim is restitution to prevent unjust enrichment." Id. Similarly, in another case before theIllinois Supreme Court, Indep. Voters v. Ill. Commerce Comm'n, 510 N.E.2d 850, 852-58 (Ill. 1987), the plaintiffs had filed suit to recover refunds for excessive utility charges and their claim for restitution of the charges was not tied to another cause of action. Finally, the IllinoisSupreme Court has articulated the elements of unjust enrichment without reference to a separate underlying claim in tort, contract, or statute. See HPI Health Care Servs., 545 N.E.2d at 679; see also Peddinghaus v. Peddinghaus, 692 N.E.2d 1221, 1225 (Ill. App. Ct. 1998)(ruling that Illinois recognizes an independent cause of action for unjust enrichment based on HPI Health Care Services). From these cases, it appears that the Illinois Supreme Court recognizes unjust enrichment as an independent cause of action.

In contrast to this case law, there is a recent Illinois appellate court that suggests the opposite, namely, that an unjust enrichment claim cannot stand untethered from an underlying claim. See Martis v. Grinnell Mut. Reinsurance Co., 905 N.E.2d 920 (Ill. App. Ct. 2009). The Martis court stated the following:

The doctrine of unjust enrichment underlies a number of legal and equitable actions and remedies. Unjust enrichment is not a separate cause of action that, standing alone, will justify an action for recovery. Rather, it is a condition that may be brought about by unlawful or improper conduct as defined by law, such as fraud, duress, or undue influence, and may be redressed by a cause of action based upon that improper conduct. When an underlying claim of fraud, duress or undue influence is deficient, a claim for unjust enrichment should also be dismissed.

Id. at 928 (internal quotation and citations omitted) (emphasis added)."

The Seventh Circuit then offers its own suggested resolution to the debate: "Without setting out a comprehensive treatise on Illinois unjust enrichment law in an attempt to resolve the apparently conflicting language of the Raintree Homes and Martis cases, we suggest one way to make sense of it. Unjust enrichment is a common-law theory of recovery or restitution that arises when the defendant is retaining a benefit to the plaintiff's detriment, and this retention is unjust. What makes the retention of the benefit unjust is often due to some improper conduct by the defendant. And usually this improper conduct will form the basis of another claim against the defendant in tort, contract, or statute.^[2] So, if an unjust enrichmentclaim rests on the same improper conduct alleged in another claim, then the unjustenrichment claim will be tied to this related claim—and, of course, unjust enrichment will stand or fall with the related claim. See, e.g., Ass'n Benefit Servs. v. Caremark Rx, Inc., 493 F.3d 841, 855 (7th Cir. 2007) ("[W]here the plaintiff's claim of unjust enrichment is predicated on the same allegations of fraudulent conduct that support an independent claim of fraud, resolution of the fraud claim against the plaintiff is dispositive of the unjust enrichment claim as well.")."

After offering this suggestion to resolve the conflicting cases, the Seventh Circuit affirms the dismissal of the unjust enrichment claim on the ground that the plaintiffs failed to state a claim because they failed to allege a detriment tied to the wrongful conduct of the defendant.

The Illinois Supreme Court may ultimately weigh in on this issue. The Seventh Circuit's opinion offers a possible resolution to the debate.

Edward X. Clinton, Jr.

Warning Extortion Scam - "Sam Wilson"

2011-11-16T11:52:00.001-08:00

This is another warning from this firm that a criminal extortion ring is using our name to threaten people to collect nonexistent debts.

If you are contacted by a "Sam Wilson" please note that we employ no such person.

These are criminals who are using our name wrongfully and using throw away cell phones. We have contacted law enforcement to no avail. We will continue to do everything in our power to stop these people.

The number they use is 872-213-9369.

Please contact law enforcement immediately if these people contact you.

Ed Clinton, Jr.

Criminal Case Glut Impedes Civil Suits - Consider Mediation

2011-11-10T12:52:00.000-08:00

Criminal Case Glut Impedes Civil Suits - WSJ.com:

In Chicago, civil cases still move faster in federal court. However, they are often bumped to make room for federal criminal cases. This results in somewhat long delays if you insist on going to trial.

What the federal court does a great job of is mediating cases - many cases are resolved by the magistrate judges who do a great job of holding mediations and forcing the parties to attend.

I haver participated in numerous federal mediations over the years - only one case failed to reach a settlement. That case settled one week later. The Magistrate Judges of the Northern District of Illinois do a great job in resolving disputes.

The Seventh Circuit also does mediations - it too does a great job in getting rid of small cases and cases that are not worth the effort of the judges.

In my opinion, the mediation programs of the Northern District of Illinois and the Seventh Circuit are among the most useful tools for litigators in the world of litigation. They also save clients lots of legal fees.

Edward X. Clinton, Jr.

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Under Uniform Commercial Code Supplier Can Terminate Distributor

2011-10-30T11:59:00.000-07:00

ECHO, INCORPORATED v. TIMBERLAND MACHINES & IRRIGATION, INC., Court of Appeals, 7th Circuit 2011 - Google Scholar:

This is a commercial case in which Echo terminated its business relationship with Timberland Machines & Irrigation, Inc. (TMI) a distributor. Echo then turned that particular sales territory over to another distributor.

Echo sued TMI to recover on unpaid invoices and TMI sued Echo claiming that the distributor agreement was improperly terminated.

The easy issue is the unpaid invoices. Echo brought an account stated claim under Illinois law. The district court granted summary judgment in favor of Echo. As is typical in these cases, the issue was delivery and acceptance. Because the goods were delivered to TMI and accepted by TMI, TMI was obligated to pay under the UCC. As the court holds:

"TMI accepted the goods at issue, and thus is contractually obligated to pay the interest stated on the invoice under the Uniform Commercial Code, codified at 810 Ill. Comp. Stat. 5/2-207 (West 2011); See K-Koncrete, Inc. v. Mack Trucks, Inc., No. 85 C 9538, 1987 WL 9337, at *7 (N.D. Ill. Apr. 3, 1987) ("Illinois law . . . impose[s] a contractual duty to pay interest on a party who (1) accepts goods accompanied by an invoice stating an interest obligation and (2) offers no objection to the stated terms") (referencing U.C.C. § 2-207(2)(c)); Inspec Foams, Inc. v. Claremont Sales Corp., No. 01 C 8539, 2002 WL 1765630, at *3 (N.D. Ill. July 30, 2002) (under section 5/2-207, "overdue payment interest penalty clauses in a seller's shipping documentation are not considered material alterations of the parties' contract and thus are incorporated into the parties' contract terms"); Extel Corp. v. Cermetek Microelectronics, Inc.,539 N.E.2d 320, 323 (Ill. App. Ct. 1989) (buyer required to pay interest pursuant to the terms set forth in seller's invoices where "there was no showing that acceptance was limited to the terms of the offer or that plaintiff objected to the interest provision within a reasonable time"). We affirm the interest award."

Comment: as always, the account stated claim is very difficult to resist when the buyer takes delivery of the goods and uses them in its business.

Edward X. Clinton, Jr.
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AGRI-BEST HOLDINGS, LLC v. ATLANTA CATTLE EXCHANGE, INC, Dist. Court, ND Illinois 2011 - Google Scholar

2011-10-12T21:30:00.000-07:00

AGRI-BEST HOLDINGS, LLC v. ATLANTA CATTLE EXCHANGE, INC, Dist. Court, ND Illinois 2011 - Google Scholar:

The District Court for the Northern District of Illinois has held that a secured creditor has the right - under the Uniform Commercial Code - to step into the shoes of the debtor and pursue collection of outstanding receivables.

This entry cannot begin to do proper justice to the excellent opinion of the District Judge.

Edward X. Clinton, Jr.
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Corporate Law - LLC Statute Shields Member From Personal Liability

2011-10-05T21:45:00.000-07:00

Carollo v. Irwin, Ill: Appellate Court, 1st Dist., 4th Div. 2011 - Google Scholar:

The Illinois Appellate Court recently decided the above-captioned case. The case is routine - plaintiff was to receive certain funds if a parcel of real estate did not sell in a specific time period. The court concluded that there was no sale, and thus the plaintiff was entitled to the additional money.

The Court also included a lengthy and thoughtful discussion of the Illinois Limited Liability Company Act - specifically the Act's provision regarding the personal liability of a member who signs a contract on behalf of the LLC.

The Court attempted to determine whether a third party - Scott Mason - who signed a contract on behalf of an LLC that was never formed could be held personally liable on that contract. The Court comments: "Second, we also hold that there was no sale because there was no enforceable contract due to the fact that there was no party who could be held liable as a buyer. The LLC was never formed and thus never ratified the contract on behalf of the LLC or gave Scott Mason authority to enter into the contract."

The Court then held that the Limited Liability Company Act gives greater protection to the person who signs a contract on behalf of an LLC that is never formed than a person who signs on behalf of a corporation that is never formed:

"48 Defendants argue that the articles of agreement were valid even if the unformed LLC could not be held liable because the individual who signed, Scott Mason, would then be personally liable. However, here there is an important distinction between corporations and LLC's that neither party recognizes which is dispositive of this issue. We explain that, by statute, as a matter of law Scott Mason cannot be personally liable.

¶ 49 Defendants contend that H.F. Philipsborn, Tin Cup Pass, and Estate of Plepel all stand for the proposition that courts will impose personal liability on individuals who incur corporate debts prior to corporate formation. However, we note that the result in H.F. Philipsborn andTin Cup Pass was the opposite of the result sought here by defendants; the corporations were held liable, not the individual, because the corporations were ultimately formed and adopted and ratified the contracts. See H.F. Philipsborn, 59 Ill. 2d at 472; Tin Cup Pass, 195 Ill. App. 3d at 851. In Estate of Plepel, on the other hand, the decedent's estate was liable because there was no evidence that the parties intended to hold the corporation liable, or that the claimants even knew they were dealing with a corporation. Estate of Plepel, 115 Ill. App. 3d at 807-08.

¶ 50 In determining whether a corporate officer has contracted in his own behalf, we apply the general rules of agency. Polivka v. Worth Dairy, Inc., 26 Ill. App. 3d 961, 966 (1974). The question of whether an agency relationship exists is normally a question of fact; however, a court may decide the issue as a matter of law if only one conclusion may be drawn from the undisputed facts. Ioerger v. Halverson Construction Co., 232 Ill. 2d 196, 202 (2008) (citingChurkey v. Rustia, 329 Ill. App. 3d 239, 243 (2002)). The common law rule is that where an agent signs contract in his own name and the contract nowhere mentions the existence of agency or the identity of the principal, the agent is personally liable and parol evidence is not admissible to rebut the presumption of the agent's personal liability. Bank of Pawnee v. Joslin, 166 Ill. App. 3d 927, 935 (1988). A corporate officer who signs his name on a contract, without more, is individually liable on the contract. 84 Lumber Co. v. Denni Construction Co.,212 Ill. App. 3d 441, 443 (1991).

¶ 51 On the other hand, when an agent signs a document and indicates next to his signature his corporation affiliation, then, absent evidence of contrary intent in the document, the agent is not personally bound. Central Illinois Public Service Co. v. Molinarolo, 223 Ill. App. 3d 471, 475 (1992) (citing Knightsbridge Realty Partners, Ltd-75 v. Pace, 101 Ill. App. 3d 49, 53 (1981)). Directors or other officers of corporations are not liable for the debts contracted in the name of, and on behalf of, the corporation and which are binding upon it unless they are expressly made liable by statute or unless they also contract on their own behalf. Polivka, 26 Ill. App. 3d at 966. "`One of the purposes of a corporate entity is to immunize the corporate officer from individual liability on contracts entered into in the corporation's behalf.'" People ex rel. Madigan v. Tang, 346 Ill. App. 3d 277, 284 (2004) (quoting National Acceptance Co. of America v. Pintura Corp., 94 Ill. App. 3d 703, 706 (1981)). However, an unauthorized agent purporting to enter into a contract for a principal is personally liable. Polivka, 26 Ill. App. 3d at 966.

¶ 52 Here, Scott Mason clearly indicated he was signing the articles of agreement on behalf of Cal City Apartments, LLC, thus seemingly insulating himself from liability. See Baker v. Daniel S. Berger, Ltd., 323 Ill. App. 3d 956, 969 (2001) (holding that the individual's signature on the face of the agreement was clear that he signed the agreement in his representative capacity on behalf of the corporation and therefore would not be personally bound). However, the LLC was never formed and so it never adopted and ratified the articles of agreement for deed. Thus, it would appear that Scott Mason should be liable on the contract, as he acted without authority of the LLC because the LLC was never formed and therefore never ratified his action in entering the articles of agreement.

¶ 53 However, there is an important statutory distinction between LLC's and corporations that provides members or managers of unformed LLC's with more protection from personal liability than officers of corporations in this context. Section 3.20 of the Business Corporation Act of 1983 specifically directs:

"All persons who assume to exercise corporate powers without authority to do so shall be jointly and severally liable for all debts and liabilities incurred or arising as a result thereof." 805 ILCS 5/3.20 (West 2006).

¶ 54 The Limited Liability Company Act had a provision similar to section 3.20 of the Business Corporation Act. Prior to its amendment, section 10-10 provided:

"(b) A manager of a limited liability company shall be personally liable for any act, debt, obligation, or liability of the limited liability company or another manager or member to the extent that a director of an Illinois business corporation is liable in analogous circumstances under Illinois law." 805 ILCS 180/10-10(b) (West 1996).

¶ 55 However, when the legislature amended section 10-10 of the Limited Liability Company Act in 1997, it specifically removed the provision that allowed a member or manager of an LLC to be held personally liable for the unauthorized exercise of corporate powers in the same manner as provided in the Business Corporation Act. Puleo v. Topel, 368 Ill. App. 3d 63, 69-70 (2006). See Pub. Act 90-424 (eff. Jan. 1, 1998) (deleting 805 ILCS 180/10-10(b) (West 1996)).

¶ 56 In addition, the remaining provisions of the Limited Liability Company Act provide that a member or manager is not liable for acting on behalf of an LLC:

"A member or manager is not personally liable for a debt, obligation, or liability of the company solely by reason of being or acting as a member or manager." 805 ILCS 180/10-10(a) (West 2006).

¶ 57 Section 10-10(a) of the Limited Liability Company Act provides the only means by which an individual can be liable for contracts entered into on behalf of an LLC:

"(a) Except as otherwise provided in subsection (d) of this Section, the debts, obligations, and liabilities of a limited liability company, whether arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the company." 805 ILCS 180/10-10(a) (West 2006).

¶ 58 Subsection (d) in turn provides that an LLC member can be liable to a third party for debts or obligations only if: (1) there is a provision to that effect in the LLC's articles of organization; and (2) the member has consented in writing to that provision. 805 ILCS 180/10-10(d) (West 2006).

¶ 59 Subsection (c) further provides that "[t]he failure of a limited liability company to observe the usual company formalities or requirements relating to the exercise of its company powers or management of its business is not a ground for imposing personal liability on the members or managers for liabilities of the company." 805 ILCS 180/10-10(c) (West 2006).

¶ 60 We have recognized the clear legislative intent to shield individuals from personal liability in transactions on behalf of LLCs, where the LLC did not exist because it was dissolved. In Puleo, we held that a managing member was not personally liable for debts that an LLC incurred after its dissolution because there was no evidence of a provision establishing the managing member's personal liability was contained in the LLC's articles of organization or that the managing member consented in writing to the adoption of such a provision, which are the requirements of section 10-10(d) of the Limited Liability Company Act. Puleo, 368 Ill. App. 3d at 68. We declined to imply into the Limited Liability Act a provision similar to section 3.20 of the Business Corporation Act that would hold an individual member liable for obligations incurred when the member was without authority because the LLC was not in existence. Puleo, 368 Ill. App. 3d at 69. We held that "[a]s we have not found any legislative commentary regarding that amendment, we presume that by removing the noted statutory language, the legislature meant to shield a member or manager of an LLC from personal liability." Puleo, 368 Ill. App. 3d at 69. Thus, other than the very limited circumstances specified in section 10-10(d), there is no individual liability for members for any debts and obligations entered into on behalf of an LLC even where, as here, such acts were unauthorized due to the fact that the LLC had not yet been formed.

¶ 61 Here, there is no evidence that the requirements of section 10-10(d) were met, and thus there is no basis for holding Scott Mason bound by the contract. While in Puleo the LLC was dissolved at the time the contract was entered into, whereas here the LLC was never formed in the first place, the holding of Puleo is equally applicable, as in both instances the LLC was not in existence at the time of contract. In this case it is undisputed that the LLC was never formed, and there is no evidence offered by defendants that there were articles of organization providing for Mason's liability, nor any writing in which Scott Mason agreed to be liable. See Puleo, 368 Ill. App. 3d at 68 (independent contractors could not establish a managing member's personal liability for debts that the LLC incurred after its dissolution without showing that a provision establishing the managing member's personal liability was contained in the LLC's articles of organization and that the managing member consented in writing to the adoption of such a provision). Thus, Scott Mason could not be held individually liable for the articles of agreement for deed because he is statutorily shielded from liability. Therefore, neither the unformed LLC nor Scott Mason could be held liable on the contract and the articles of agreement could not be enforced."

This is an interesting and thoughtful discussion on the Limited Liability Company Act that demonstrates a close reading of the statute.

Edward X. Clinton, Jr.

www.clintonlaw.net

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Warning - Collection Scam

2011-09-29T12:10:00.000-07:00

We have learned that certain scam artists are using our name and calling individuals to attempt to collect nonexistent obligations. The calls are coming from area code 872. We do not collect debts owed by individuals and warn anyone receiving such communications to disregard them and to notify local law enforcement. We do not contact any individual debtors ever - so if someone is using our name to collect from individuals you can be certain that the caller is involved in a scam.

One of the numbers used was 872-213-9369.

Sadly, this scam has continued. Now victims are being contacted by an edwardclinton@live.com. This is not us and we do not collect from individuals or make any threats.

We have reported this to various law enforcement agencies to no avail.

Seventh Circuit Construes Written Contract With Confusing Handwritten Amendment

2011-09-27T17:15:00.000-07:00

QUALITY OIL, INCORPORATED v. KELLEY PARTNERS, INCORPORATED, Court of Appeals, 7th Circuit 2011 - Google Scholar:

This is a classic case of contract interpretation. Lawyers often become alarmed when they learn that their clients have made handwritten amendments to their written contracts. Here Quality Oil and Kelley Partners entered into a transaction under which Quality loaned Kelley $150,000. The loan was to be forgiven over a five year period as Kelley purchased certain motor oil products from Quality.

The confusion was created when the clients added a handwritten clause to the Agreement as follows:

"On July 1, 2003, Quality Oil, an Indiana auto-lubricants distributor for Exxon Mobil Corp., and Kelley Partners, an independent operator of automotive quick-lube facilities in Illinois, entered into a "Product Payback Loan and Supply Agreement." Under the Agreement, which by its terms is governed by Indiana law, Quality Oil agreed to loan Kelley Partners $150,000 "at no cost," and Kelley Partners in turn agreed to purchase its motoroil requirements from Quality Oil.^[1] Specifically, in Paragraph 4 of the Agreement, Kelley Partners agreed to

purchase from Quality Oil . . . at least eighty-five percent (85%) of [Kelley Partners'] requirements of motor oils during the term of this Agreement. [Kelley Partners] further agrees to purchase not less than two hundred twenty-five thousand (225,000) gallons of Mobil motor oil and 225,000 Mobil branded filters within 60 months from the date hereof.

Immediately following this language in the typewritten contract is the handwritten notation that is central to Kelley Partners' appeal. It states as follows: "This Supply Agreement will terminate after 225,000 gallons and 225,000 filters of Exxon/Mobil is purchased or 60 months, whichever comes first." The president of Kelley Partners and owner/general manager of Quality Oil initialed this handwritten provision and signed the Agreement in two places."

Quality Oil sued Kelley and the district court entered summary judgment in favor of Quality Oil. The Seventh Circuit affirmed and explained its reasoning as follows:

"The same is true of Kelley Partners' interpretation of the contract at issue here. It would make no commercial sense for Quality Oil to forgive its loan to Kelley Partners after five years regardless of how much motoroil product Kelley Partners purchased. This was a loan and supply contract, after all. Under Paragraph 4 of the Agreement, Kelley Partners bound itself to purchase at least 85% of its motor-oil needs from Quality Oil during the term of the Agreement. Paragraph 6 and Exhibit A imposed a Premature Termination Penalty on any early termination, and Paragraph 7 required that if Kelley Partners sold its business, it was to assign its obligations to its successor or remain liable under the Agreement. Reading the contract as a whole and harmonizing all of its provisions shows that Kelley Partners' literal interpretation of the handwritten provision is commercially absurd."

Kelley argued that the contract expired in 60 months so it had no duty to repay the loan. The Seventh Circuit held that this was incorrect and would make the contract commercially unreasonable.

Comment: cases like this one cause corporate lawyers to tear their hair out - but the Court did an excellent job of deciphering the true meaning of the contract.

Edward X. Clinton, Jr.

The Necessary Steps To Collect a Business Debt

2011-09-16T21:18:00.000-07:00

1. Before selling any goods or rendering a service, make the customer/debtor sign a written agreement, preferably one providing that the customer must pay legal fees if he does not pay.

2. Deliver the goods or service and make sure that the debtor acknowledges the receipt of same.

3. Invoice the debtor.

4. Send a reminder invoice.

5. Send emails or written correspondence to the debtor that support your position that the debtor accepted the goods and/or services.

6. Try to negotiate a resolution with the debtor, including offering a payment plan.

7. Initiate collection action.

By far the most important step is to document the transaction in writing so that the debtor cannot claim that the goods and/or services were not delivered.

Edward X. Clinton, Jr.

Asset Exchange II, LLC v. First Choice Bank, Illinois Appellate Court

2011-09-03T20:45:00.000-07:00

In this recent decision of the Illinois Appellate Court for the First District, the Court rejected a claim by a borrower that the 365/360 interest calculation method violated the Illinois Interest Act.According to the Court, Asset Exchange is a limited liability company owned by "two sophisticated businessmen." On December 14, 2007, Asset Exchange entered into a commercial loan agreement with the Defendant Bank whereby the Bank agreed to loan $1,250,000 to Asset Exchange.The interest rate was 8.25%, computed on a 365/360 basis. The loan states: "'the annual interest rate for this Note is computed on a 365/360 basis; that is by applying the ratio of the annual interest rate over a year of 360 days, multiplied by the outstanding principal balance, multiplied by the actual number of days the principal balance is outstanding.'" Plaintiff claimed that, by using a year of less than 365 days, the Bank was wrongfully using a definition of "year" that was in violation of the Illinois Interest Act and thus charged and received more interest than was due.The Bank moved to dismiss on the ground that the Interest Act does not apply to commercial loans. The trial court agreed and the Appellate Court affirmed.The Appellate Court noted that prior Illinois decisions have held that the Interest Act does not apply to corporations. See Computer Sales Corp. v. Rousonelos Farms, Inc., 190 Ill. App. 3d 388, 392 (1989). The Appellate Court rejected the breach of contract claim because (a) the terms of the Note were unambiguous and (b) the Bank complied with the terms of the Note.Comment: this is a victory for Banks as the 365/360 interest calculation method is commonly used in commercial transactions.Edward X. Clinton, Jr.

What Statute of Limitations Applies to A Claim That A Mortgage Was Unconscionable?

2011-08-21T16:55:00.000-07:00

Estate of Davis v. Wells Fargo Bank, 633 F. 3d 529 - Court of Appeals, 7th Circuit 2011 - Google Scholar

The Seventh Circuit affirmed the dismissal of the plaintiff's claim against Wells Fargo Bank, which took over the servicing of a predatory mortgage loan.

The plaintiff asserted claims for unconscionability and fraud under Illinois law. The Seventh Circuit noted that the fraud and unconscionalbility claims were subject to a five-year statute of limitations. See 735 ILCS 5/13-205.

The dismissal of the fraud claim was affirmed by the Seventh Circuit on the ground that Davis disputed the charges and failed to pay them.

The Court explained: "On appeal, Mrs. Davis contends that the district court erred in not also considering the defendants' demands that she pay her loan, demands that continued even after the defendants knew that the Kankakee County court had ruled that her loan was based in part on Mortgage Express's fraud. We agree that overlooking this allegation was incorrect. Statements made to induce someone to pay a purported debt that they do not actually owe, if made with the requisite knowledge and intent, can support an allegation of fraud. See Hartigan v. E & E Hauling, Inc., 153 Ill.2d 473, 180 Ill.Dec. 271, 607 N.E.2d 165, 175-77 (1992) (allegations that contractor's letter sent to a metropolitan authority contained material misrepresentations as to contractor's compliance with minority business enterprise contract requirements, made for purpose of inducing authority's reliance in paying contract installment, supported allegation of common-law fraud). However, we agree with the district 537*537 court that Davis's fraud claim still fails for a different reason. Even though Mrs. Davis alleged that the defendants attempted to induce her to pay money that they knew she did not owe, Mrs. Davis did not allege that she had relied on the defendants' demands for payment or that she had suffered any damages as a result of those demands. To the contrary, with the help of her attorney, she fought those unjustified demands. Without reliance or damages, Mrs. Davis does not have a viable claim for fraud. We affirm the district court's dismissal of Mrs. Davis's fraud claim."

Comment: Illinois does not recognize attempted fraud. To sue for fraud the aggrieved party must allege damages.

The Breach of Contract claim of unconscionability was barred by the five-year statute of limitations.

The court reasoned: "Under Illinois law, a contract may be found to be unconscionable as a matter of law on either a "procedural" or "substantive" basis, or both. Razor v. Hyundai Motor America, 222 Ill.2d 75, 305 Ill.Dec. 15, 854 N.E.2d 607, 622 (2006). Procedural unconscionability refers to a situation in which a term is so difficult to find, read, or understand that the party could not fairly be said to have been aware she was agreeing to it. Procedural unconscionability also takes into account the party's relative lack of bargaining power. Razor, 305 Ill.Dec. 15, 854 N.E.2d at 622, citing Frank's Maintenance & Engineering, Inc. v. C.A. Roberts Co., 86 Ill.App.3d 980, 42 Ill.Dec. 25, 408 N.E.2d 403, 410 (1980). Substantive unconscionability, on the other hand, refers to contractual terms which are inordinately one-sided in one party's favor. Razor, 305 Ill.Dec. 15, 854 N.E.2d at 622, citing Rosen v. SCIL, LLC, 343 Ill.App.3d 1075, 278 Ill.Dec. 770, 799 N.E.2d 488, 493 (2003).

Mrs. Davis has not shown that the district court erred when it barred consideration of the formation of her mortgage contract in September 1999 on statute of limitations grounds. In this federal lawsuit, Mrs. Davis was not using the doctrine of unconscionability in its most familiar way, as an affirmative defense to bar enforcement of a contract or a particular term of a contract. See, e.g., Razor, 305 Ill.Dec. 15, 854 N.E.2d at 622-24 (holding that exclusion of consequential damages in limited warranty was not enforceable because it was unconscionable). Mrs. Davis instead sought damages from the successors in interest to the original lender. We do not address here whether unconscionability gives rise to a standalone claim for damages under Illinois law, as Mrs. Davis asserts here. We do not address that issue because even if such a claim is cognizable in Illinois, it is clear that such a claim would be barred by the five-year statute of limitations."

Edward X. Clinton, Jr.

Illinois Court Holds That Judgment Obtained By Unlicensed Bill Collector is Void

2011-07-29T21:19:00.000-07:00

LVNV FUNDING, LLC v. Trice, Ill: Appellate Court 2011 - Google Scholar

This case could have a broad ranging impact on the debt collection industry as it holds that an unlicensed bill collection firm's judgment against a debtor is void as a matter of law.

The Court held that the judgment debtor can attack a void judgment under Section 2-1401 without showing diligence. It wrote:"Trice has adequately alleged that before it filed the lawsuit, LVNV had not registered as a collection agency, as required by the Illinois Collection Agency Act (Act) (225 ILCS 425/14, 14b (West 2008)). But Trice did not raise this issue before the trial court entered a final judgment against him on LVNV's complaint. Trice raises the issue only in a section 2-1401 petition for relief from the judgment. Finally, Trice claims that LVNV's failure to register makes the judgment in its favor void, and not merely voidable.

When the trial court enters a void judgment, a party aggrieved by the judgment may attack it in a section 2-1401 motion without showing diligence. "[T]he allegation that the judgment or order is void substitutes for and negates the need to allege a meritorious defense and due diligence." Sarkissian v. Chicago Board of Education, 201 Ill. 2d 95, 104 (2002)."

The Appellate Court then reasoned that because the collection agency had committed a crime in attempting to collect without a license, the judgment was void.

"A party who acts as a collection agency without proper registration commits a Class A misdemeanor and must also pay a civil penalty. 225 ILCS 425/4.5, 14, 14b (West 2008).

Assuming the truth of the allegations in Trice's section 2-1401 motion, that LVNV had not registered as a collection agency before it sued Trice, LVNV committed one crime when it purchased the debt from Citibank (see 225 ILCS 425/3(d) (West 2008)), and it committed a second crime when it filed the complaint. See 225 ILCS 425/14 (West 2008).

Williston states the general rule that applies here:

"When a contracting party is required to have a license to engage in a business and violation of required licensing statute is made a crime, a contract calling for performance in violation of this requirement is illegal and void." 10 Samuel Williston & Richard A. Lord, A Treatise on the Law of Contracts §19.47, at 562 (4th ed. 1993).

The rule follows from the "elementary principle[] of contract law *** that an illegal contract is void ab initio." People v. Caban, 318 Ill. App. 3d 1082, 1089 (2001). In support of the general rule, Williston cites Reilly v. Clyne, 234 P. 35, 37 (Ariz. 1925), for the proposition that "where a statute pronounces a penalty for an act, a contract founded on the act is void.""

Comment: this decision is consistent with the current trend of courts attempting to rein in collection agencies. There have been reports in the press and in the cases of debt collectors attempting to obtain a judgment where the debt collector does not own the debt.

Edward X. Clinton, Jr.

Greenberger v. GEICO General Ins. Co., 631 F. 3d 392 - Court of Appeals, 7th Circuit 2011 - Google Scholar

2011-07-29T21:06:00.000-07:00

Greenberger v. GEICO General Ins. Co., 631 F. 3d 392 - Court of Appeals, 7th Circuit 2011 - Google Scholar

The Seventh Circuit has affirmed the dismissal of a proposed class action by a policyholder against GEICO insurance.

Plaintiff alleged that GEICO had a practice of omitting necessary repairs from auto collision damage estimates and that he was damaged thereby.

The Seventh Circuit summarized the allegations and procedural history as follows:

"Though legally distinct, Greenberger's contract and fraud claims are all premised on the same basic factual allegation: that GEICO systematically omits necessary repairs from its collision-damage estimates in violation of the promise to restore the policyholder's vehicle to its preloss condition. The district court sidestepped the class-certification question, dismissed the statutory consumer-fraud claim, and then entered summary judgment for GEICO on 395 *395the breach-of-contract and common-law fraud counts. Greenberger appeals."

The Seventh Circuit affirmed the dismissal of the case in all respects, finding that the fraud claims were really breach of contract claims dressed up as fraud claims.

"We affirm. All of Greenberger's claims are foreclosed by the Illinois Supreme Court's comprehensive decision in Avery v. State Farm Mutual Automobile Insurance Co., 216 Ill.2d 100, 296 Ill.Dec. 448, 835 N.E.2d 801 (2005). Among other important holdings, Averyestablished the common-sense proposition that a policyholder's suit against his insurer for breach of its promise to restore his collision-damaged car to its preloss condition cannot succeed without an examination of the car. Id., 296 Ill.Dec. 448, 835 N.E.2d at 826. Greenberger gave away his car, and without it, he cannot prove that what GEICO paid him was inadequate to restore the car to its preloss condition.

Avery also made clear that fraud claims must contain something more than reformulated allegations of a contractual breach. Id., 296 Ill.Dec. 448, 835 N.E.2d at 844. Greenberger alleges that GEICO never intended to restore his car to its preloss condition and failed to disclose that it regularly breaches this contractual promise. These are breach-of-contractallegations dressed up in the language of fraud. They cannot support statutory or common-law fraud claims."

Comment: this was an attempt to resurrect a type of class action against an auto insurer. In Illinois, these claims do not work. They can be brought on an individual basis, but the plaintiff must retain the car for examination to determine if the insurance company acted appropriately.

Edward X. Clinton, Jr.

Harvard Law Society of Illinois

2011-07-28T12:04:00.000-07:00

Thanks to the Harvard Law Society of Illinois for hosting today's lunch to discuss small firm practice.

Thanks to Daniel Ebner and Stacy Austin, the hosts of today's event.

Edward X. Clinton, Jr.

Seventh Circuit Interprets A "Best Efforts" Clause In a Contract

2011-06-12T09:58:00.000-07:00

Peter Denil and Gerald Nardella v. Deboer, Inc.,Et Al - The American Lawyer

The Seventh Circuit has issued a decision interpreting a series of contracts involving the aborted sale of a business.

Ronald DeBoer started a trucking business known as deBoer Transportation in 1967. In 2007, he and the other family members wanted to sell the business and retire. (Given what happened, it appears that DeBoer was not willing to retire or sell the business.)

There were two contracts (a) an employment agreement and (b) a stock-purchase contract.

The employment contract provided that one of the plaintiffs, Peter Denil, would become the CEO of DeBoer. The other plaintiff, Gerald Nardella, would become the Executive Vice President. DeBoer became an Executive Vice President. He held the right to discharge the plaintiffs with or without cause. If the discharge was without cause, plaintiffs would receive additional payments.

The stock-purchase contract called for Denil to buy 4% of DeBoer's stock for $500,000 and for Nardella to buy 2% for $250,000. The closing date was set for April 15, 2009. The parties agreed that the failure to purchase the stock by April 15, 2009, the plaintiffs' employment would be terminated. The parties also agreed that the signing of a buy-sell contract "would be a condition precedent to the obligation to purchase the 4% and 2% interests. The stock-purchase contract contained a clause in which the parties promised to use their best efforts to conclude the buy-sell contract."

The buy-sell contract was never signed. The parties had a dispute about how the purchase price would be allocated among the shareholders.

When April 15, 2009 arrived, the negotiations were stalled. Denil and Nardella refused to purchase the 4% and 2% interests in the company. They also failed to put the $750,000 purchase price into an escrow. DeBoer then fired the plaintiffs and they sued, seeking reinstatement, the opportunity to invest in DeBoer and damages for tortious interference. DeBoer filed a counterclaim. The case was decided under Wisconsin law. The district court entered summary judgment on all claims and the case was appealed to the Seventh Circuit, which affirmed in an opinion by Judge Easterbrook.

Plaintiffs contended that DeBoer did not use "best efforts" to conclude the Buy-Sell Agreement. The Seventh Circuit disagreed. Neither side violate cdd the best efforts clause because both exchanged many proposals. As the court stated: "[Plaintiffs] were free to buy the sock, with or without a buy-sell agreement; they just shoe not to do so. They agreed that they can't complain about the termination of their management positions. Ronald DeBoer wanted to ensure that the new managers' interests were aligned with those other shareholders. Plaintiffs were not entitled to retain the positions without making the investment essential to that end."

The Seventh Circuit also rejected the tortious interference with contract claim and the bad faith claim. "No one interfered with any contract: DeBoer simply enforced the contracts it had negotiated."

There was no lack of good faith because DeBoer did what it was entitled to do under the contract. As the court noted, "'good faith' in contract law means honesty plus refraining from opportunistic conduct that exploits the other side's sunk costs." See Market Street Associates L.P. v. Frey, 941 F.2d 588 (7th Cir. 1991). The court described bad faith - an actor who sulks in his dressing room during a movie production. The conduct is bad faith because the producer has already invested a great deal of money in the production and cannot afford to start with a new actor.

Because DeBoer complied with the terms of the contract, he did breach.

Edward X. Clinton, Jr.

Opinion analysis: Attorney’s fees for frivolous claims : SCOTUSblog

2011-06-08T13:28:00.000-07:00

Opinion analysis: Attorney’s fees for frivolous claims : SCOTUSblog

Contract Law - The Seventh Circuit Has Enforced A Software Contract - DIGITECH COMPUTER INC v. TRANS CARE INC - US 7th Circuit

2011-05-24T21:55:00.000-07:00

Nos. 10–1525, 10–1652. - DIGITECH COMPUTER INC v. TRANS CARE INC - US 7th Circuit

Trans-Care, an Indiana company in the medical transportation business, licensed dispatch and billing software from Digitech. Unfortunately, the software "did not work as Trans-Care expected, and so Trans-Care attempted to exercise an option to terminate the agreement." Digitech brought a claim for breach of contract. Trans-Care then brought a counterclaim for fraud.

The district court dismissed the fraud claim and found in favor of Digitech on the computer contract claim.

In its initial proposal to Trans-Care, Digitech explained its pricing and included a guarantee. The Court described the guarantee as follows: "This guarantee stated that during the first 90 days, billing would be limited to programming charges; within that period, if Trans–Care was not completely satisfied, it could walk away from the contract without paying any software licensing fees."

The parties then negotiated a written software license. However, the 90 day guarantee was not included in the written software license. The Seventh Circuit summarizes the software licenses as follows:

"The Agreement stated that it was to run for three years starting May 8, 2006. Trans–Care's obligation to make monthly software licensing payments was to begin 90 days after the software was installed. For its part, Digitech could “suspend or terminate” the software products and services in the event that Trans–Care was delinquent in payment for 60 days. The Agreement provided that Digitech could recover attorneys' fees for “collections of any unpaid balances.” Finally, it required notice and the opportunity to cure before termination."

Digitech struggled to install the software. When the software was finally installed in January 2007 it did not work to the satisfaction of Trans-Care and was allegedly "plagued with malfunctions."

On March 1, 2007, Trans-Care attempted to exercise the 90-day right to cancel. Because the provision was not included in the agreement, Digitech refused to honor it.

On April 3, 2007, Digitech locked the software because of Trans-Care's failure to make payment.

The main issue on appeal was whether the 90-day cancellation provision was part of the contract even though it was not included in the final draft of the contract.

The Seventh Circuit agreed that the 90-day cancellation provision is not included in the agreement. Moreover, parol evidence could not be used because there was no evidence the provision was part of the contract. The Court holds: "The negotiations went on for some time, and Digitech's last mention of the 90–day satisfaction guarantee occurred two-and-a-half months prior to the conclusion of the final agreement. Even without a formal integration clause, we would need some clue in the final agreement that the parties meant to carry this important provision forward. There is none."

Trans-Care also argued that the 90-day provision was referenced in its first purchase order under the Agreement and that, therefore, the 90-day provision was included in the Agreement. The Court rejected this argument. It writes: "If one reads the purchase order as Trans–Care does, it is an attempt at a modification of the Agreement. “The modification of a contract, since it is also a contract, requires all the requisite elements of a contract.” Hamlin v. Steward, 622 N.E.2d 535, 539 (Ind.Ct.App.1993). In order for the modification to be effective, Section VI of the Agreement required written evidence that Digitech accepted the new term. No such evidence exists: Digitech did not sign the purchase order or take any other action indicating its acceptance. The purchase order was therefore at most a proposal for a modification that was never accepted, and thus its terms did not become part of the overall agreement between the parties. Trans–Care thus cannot justify its repudiation of the contract on this basis."

The Court affirmed the judgment for Digitech, but reversed most of the damage award on the ground that Digitech locked the software one month after Trans-Care attempted to cancel. Once Digitech terminated the contract by locking the software, it could no longer collect payment. Thus, Digitech was entitled to payment for the period from January 2007 to April 3, 2007 and no more.

The case was decided under Indiana law, which appears to be identical to Illinois law.

Comment: this case is a sad lesson in contract drafting. The parties failed to carefully include the 90-day cancellation provision in the final software license and, thus, they were not able to rely on it. Trans-Care was fortunate that Digitech locked the software and thereby terminated the contract.

Edward X. Clinton, Jr.

Contract Law - Discovery Rules Applies to Breach of Contract Claim

2011-05-21T15:13:00.000-07:00

Newell v. Newell, Ill: Appellate Court, 3rd Dist. 2011 - Google Scholar

This case holds that the discovery rule applies to a breach of contract claim.

Jared Newell filed a lawsuit against his mother Ruth Newell and First Midwest Bancorp alleging conversion and breach of contract alleging that Ruth had improperly withdrawn funds from a savings account in his name.

In 1993, while a minor, Jared received a settlement from a lawsuit involving a motor vehicle accident. A court order entered in the lawsuit provided that: "No funds shall be withdrawn from the minor's account without prior court order."

In 1994, Ruth opened a guardianship account in Jared's name. The signature account contained the following statement: "Minor account. No minor withdraw until 18 years old on 5-18-00 per court order — See Louise McLaren." Ruth's attorney, Thomas Cowgill, gave bank personnel a copy of the court order when Ruth opened the account.

Unfortunately Ruth removed the balance of the account without a court order.

In 2005 or 2006, after graduating from college Jared learned that his mother had drained the account. He filed suit against his mother and the bank in 2007. The bank moved for summary judgment on the ground that the lawsuit was barred by the three-year statute of limitations set forth in the Uniform Commercial Code. (810 ILCS 5/4-111). The trial court agreed and granted the motion for summary judgment.

The Appellate Court reversed and reinstated the case. The court reasoned that the discovery rule applied to the case: "

An action for breach of contract accrues when the breach of the contractual duty or obligation occurs. ABF Capital Corp. v. McLauchlan, 167 F. Supp. 2d 1011 (N.D. Ill. 2001). The discovery rule is an equitable exception that tolls the statute of limitations period until the plaintiff discovers, or has reason to discover, the cause of action. Knox College v. Celotex Corp., 88 Ill. 2d 407 (1981). The rule was created to alleviate the harsh consequences that result from a strict application of a limitations period. Continental Casualty, 329 Ill. App. 3d at 701. It typically applies in cases where the relationship between the injury and the alleged wrongful conduct is obscure. Rodrigue v. Olin Employees Credit Union, 406 F.3d 434 (7th Cir. 2005). Thus, under the discovery rule, the statute of limitations does not begin to run until the plaintiff knew, or in the exercise of reasonable diligence should have known, that he was injured, the cause of his injury, and that there was some indication of wrongdoing. Belleville Toyota, Inc. v. Toyota Motor Sales, U.S.A., Inc., 199 Ill. 2d 325 (2002)."

Jared argued that before 2005 or 2006 he could not have discovered the unauthorized withdrawal because his mother was in a position of trust.

The Court then distinguished several cases where Illinois courts have held that the discovery rule did not apply to UCC or breach of contract claims. The Newell Court noted that other Illinois cases have applied the discovery rule where there were circumstances of fraudulent concealment.

The court reasoned that Jared's mother concealed the unauthorized withdrawals from him and the Bank was in the best position to block the unauthorized withdrawals. "[F]raudulent concealment by a third party tolls the statute of limitations where the person fraudulently concealing the cause of action is in privity or has an agency relationship with the defendant. Serafin v. Seith, 284 Ill. App. 3d 577 (1996). This case involves allegations of fraud committed by Jarred's mother, someone in a position of trust and the guardian of the FMB account. Because Ruth was the guardian of the savings account and Jarred resided with her, account statements were mailed to Ruth. Thus, while the victim of a conversion of negotiable instruments case is typically in the best position to easily and quickly detect the loss and take action (see Haddad's of Illinois, 286 Ill. App. 3d at 1073), it would have been difficult for Jarred to uncover any wrongdoing that may have been apparent in the account records (see Continental Casualty, 329 Ill. App. 3d at 702). In this case, the bank was in a better position than Jarred to enforce the depository agreement and monitor any unauthorized withdrawal of funds."

Comment: this is an area of some debate and uncertainty in the law and one that this blog will attempt to cover in the future.

Edward X. Clinton, Jr.

Fraudulent Misrepresentation On the Internet is recognized by Illinois

2011-05-19T21:53:00.000-07:00

BONHOMME v. St. James, Ill: Appellate Court, 2nd Dist. 2011 - Google Scholar

This is not a commercial case, but the topic is novel and important and could have implications for the commercial world.

The Illinois Appellate Court for the Second District held that the plaintiff, who was duped by a fake persona on the internet, could maintain a cause of action for fraudulent misrepresentation.

Plaintiff alleged that the defendant developed a fake persona to lure the plaintiff to make expensive gifts. Eventually, plaintiff gave the defendant and her friends about $10,000 in gifts and other items. Plaintiff and Defendant began on-line conversations in a chat room for the HBO show Deadwood. The court summarizes the "relationship" as follows: "In June, defendant registered again, posing as a man named Jesse James and under the user name of "Auboy." "Jesse" began chatting with and e-mailing plaintiff in July 2005. Defendant, in her own name, also began e-mailing plaintiff in July. ... Plaintiff and "Jesse" began an on-line romantic relationship that lasted until July 2006."

The Court explained why it believed it was appropriate to expand the law of fraudulent misrepresentation:

It is clear, then, that while the "typical case" of fraudulent misrepresentation arises in a commercial context, our supreme court has acknowledged that this tort may, in the appropriate circumstances, be expanded to cover areas outside of the commercial context. We conclude that this is an appropriate circumstance in which to expand the application of fraudulent misrepresentation. We first note that this case is "one in which the plaintiff has parted with money, or property of value, in reliance upon the defendant's representation" (W. Page Keeton et al., Prosser & Keeton on Torts §105, at 726-27 (5th ed. 1984)), so it is not, all at once, an expansion of the tort into "purely personal settings." See Doe, 228 Ill. 2d at 348. Plaintiff clearly pleaded that she spent over $10,000 on gifts, some of which were for defendant, but some of which were for "Jesse" and other characters invented by defendant, and $700 for preparations for a move to live with "Jesse." Clearly, these are economic losses alleged to have resulted from defendant's misrepresentations. Plaintiff has also alleged other damages, including bills for therapy and medical expenses "to recover from Defendant's false representation regarding the fictitious characters and their activities." However, as this case involves a motion to dismiss during the pretrial stage, we need not address whether such damages could be recovered here.

Looking again to the elements of this cause of action ((1) a false statement of material fact; (2) knowledge or belief of the falsity by the party making it; (3) intention to induce the plaintiff to act; (4) action by the plaintiff in justifiable reliance on the truth of the statement; and (5) damage to the plaintiff resulting from that reliance), we conclude that plaintiff has alleged sufficient specific facts to establish a cause of action for fraudulent misrepresentation. Plaintiff alleged that defendant posed as at least 20 fictional characters between June 2005 and April 2007, the most important of which was "Jesse," with whom plaintiff started "chatting" in the Deadwood chatroom in July 2005. Defendant also communicated with plaintiff in her own name and represented to plaintiff that "Jesse" and the other characters were real persons she knew. Thus began an almost-two-year masquerade of false statements from defendant to plaintiff, statements that defendant obviously knew were untrue. The complaint is filled with specific dates of, and quotes from, e-mails from defendant, "Jesse," and other characters.

Comment: I agree with the Court's decision. The plaintiff was duped by the defendant (who created phony online profiles) to part with her hard earned money. The creation of each of the phony online personalities involved making false statements to Plaintiff. The false statements were designed to convince plaintiff that internet persona "A" was really somebody else.

Edward X. Clinton, Jr.

Northern District of Illinois Enforces Personal Guaranty

2011-05-09T06:03:00.000-07:00

GE BUSINESS FINANCIAL SERVICES INC. v. Schiffman, Dist. Court, ND Illinois 2011 - Google Scholar

This is a case where GE loaned money to a business and sought to collect on a guarantee by two individual defendants.

The court entered summary judgment in favor of GE, after noting that the individual defendants did not file a response to the Motion for Summary Judgment. This case demonstrates that contract cases can often be resolved with summary judgment.

"Under Illinois law, for a breach of contract cause of action, a plaintiff must establish: "(1) an offer and acceptance; (2) consideration; (3) definite and certain terms; (4) performance by the plaintiff of all required conditions; (5) breach; and (6) damages caused by the breach." Cogswell v. CitiFinancial Mortg. Co., Inc., 624 F.3d 395, 398 (7th Cir. 2010).

...

GE has pointed to sufficient evidence to show that, as a matter of law, the Guaranty was a valid contract, based on offer and acceptance, consideration, and definite and certain contract terms. In addition, it is undisputed that GE made the Loan on August 8, 2007 and performed all of its obligations under the Guaranty. (SF Par. 4, 14). Thus, GE has also pointed to sufficient evidence to show that, as a matter of law, GE performed the conditions required under the contract."

Edward X. Clinton, Jr.

www.clintonlaw.net

Contract Law - Failure to Revoke Agency Leads to Compensation For Agent

2011-05-09T05:59:00.000-07:00

Harmon v. Gordon, Dist. Court, ND Illinois 2011 - Google Scholar

This is a contract law issue - the principal allegedly revoked the agent's authority before the term of the agency had been completed.

Under Illinois law, this constitutes a repudiation of the contract, and allows the dismissed agent to sue for damages.

The Court explained its holding as follows:

Under Illinois law, when a principal and an agent enter into a contract for a specific term, the principal may still revoke the agent's authority "at any time and under any circumstances." Lehman v. Eugene Matanky & Assoc. Inc., 438 N.E.2d 614, 619 (Ill. App. Ct. 1982). However, a principal who agreed to employ the agent for a certain length of time cannot revoke the agency "rendering himself legally liable for such damages." Kenilworth Realty Co. v. Sandquist, 371 N.E.2d 936, 939 (Ill. App. Ct. 1977). Such a revocation results in a repudiation of the principal's contractual obligations. Id. Here, LHA has alleged that Gordon agreed to use LHA's financial and consulting services on an exclusive basis for the entire duration of his NBA playing career, and that Gordon fired LHA while he was still an active player. Assuming, as we must, that these allegations are true, Gordon's premature revocation would constitute a breach of contract under Illinois law. Accordingly, dismissal of Count I is not warranted under Rule 12(b)(6).

Edward X. Clinton, Jr.

Is That Contract Provision A Penalty or a Liquidated Damages Clause?

2011-04-18T18:59:00.000-07:00

READINESS MANAGEMENT SUPPORT LC v. JESCO CONSTRUCTION CORP., Dist. Court, CD Illinois 2011 - Google Scholar

Illinois law enforces liquidated damages clauses, but will not enforce a clause deemed a penalty. The distinction is often difficult to draw as it can be difficult to determine whether a clause provides for a penalty or liquidated damages.

As the court noted: "In interpreting contract provisions that specify damages, Illinois law draws a distinction between liquidated damages, which are enforceable, and penalties, which are not. Checkers Eight Ltd. Partnership v. Hawkins, 241 F.3d 558, 561-562 (7th Cir. 2001), citing Lake River Corp. v. Carborundum Co., 769 F.2d 1284, 1289 (7th Cir.1985). See also, Bauer v. Sawyer, 134 N.E.2d 329, 333-34 (Ill.1956). To be valid under Illinois law, a provision for liquidation of damages must "be a reasonable estimate at the time of contracting of the likely damages from breach, and the need for estimation at that time must be shown by reference to the likely difficulty of measuring the actual damages from a breach of contract after the breach occurs. If damages would be easy to determine then, or if the estimate greatly exceeds a reasonable upper estimate of what the damages are likely to be, it is a penalty." Lake River, 769 F.2d at 1290, citing M.I.G. Investments, Inc. v. Marsala, 414 N.E.2d 1381, 1386 (1981). Accord, Checkers, 241 F.3d at 562, citing American Nat'l Bank & Trust Co. of Chicago v. Regional Transp. Auth., 125 F.3d 420, 440 (7th Cir.1997)."

Here the court deemed the clause a penalty because the cost incurred by the breaching party was far greater than the cost of nonpayment. Thus, the Court granted summary judgment for the defendant County on plaintiff's attempt to enforce the penalty provision.

Comment: the lesson of these cases is to be careful not to ask for too much in a penalty/liquidated damages clause. If you overreach, the provision may be labeled a penalty and become unenforceable.

Edward X. Clinton, Jr.

Business Law (Illinois): Miscellaneous Operating Issues 2011 Edition - IICLE - Illinois Institute for Continuing Legal Education | Shop IICLE Product Description

2011-04-12T13:34:00.000-07:00

Business Law (Illinois): Miscellaneous Operating Issues 2011 Edition - IICLE - Illinois Institute for Continuing Legal Education | Shop IICLE Product Description

We recommend this excellent book published by the Illinois Institute of Continuing Legal Education. Ed Clinton, Sr. has been the principal author of this chapter since the 1970's. The chapter is a testament to his hard work and persistence.

Edward X. Clinton, Jr.

Securities Law - SEC Approves Shareholder Advisory Votes on Executive Compensation

2011-04-03T18:03:00.000-07:00

The Securities and Exchange Commission by a 3-2 vote approved rules providing for shareholder advisory votes on executive compensation. The final rules as adopted largely follow the rules as proposed by the Commission.

Final Rule 14a-21(b) provides that companies are required at least once every six years to give shareholders an advisory vote as to whether the company’s “Say On Pay” vote will occur every one, two or three years. The votes are advisory only and as such are not binding on the company or the Board of Directors. The compensation of directors is not subject to Say On Pay vote. Results of the vote must be set forth in a Form 8-K within four business days after the shareholders meeting. Brokers are not permitted to vote uninstructed shares in a Say On Pay or Say On Frequency proposals.

The two negative votes were cast by the Republican members of the Commission.

Author’s Commentary
It appears to the author that the issue is over-analyzed, and, to a significant extent, a waste of time. For example, assume that shareholders of a given company over a period of years vote that the executive compensation is excessive and a shareholders’ lawsuit is filed claiming that the compensation is excessive and makes reference to the adverse votes by shareholders. It is unlikely that such a lawsuit would be successful. Existing precedent is to the effect that courts are not the best forum to determine the compensation and benefits of officers. Shareholders routinely lose such lawsuits.

The real concern is that the directors will acknowledge pressure to reduce or hold compensation down after votes suggesting the compensation is excessive.

In this proxy season companies have approached the new issue with a variety of approaches.

The author notes that Northern Trust gave the shareholder the right to select when the subject should be revisited. It states directors recommend you vote each year on the frequency of advisory votes on executive compensation.

The AT&T proxy card states that the Board of Directors recommends you vote every three years on executive compensation.

Northern’s direction is straight forward – “A vote every year is O.K. We can handle criticism.”
AT&T’s director approach is that executive compensation is for directors to set. AT&T wants as few votes on executive compensation as possible.

In sum, this issue is not nearly as important as the media reports have suggested.

Edward X. Clinton, Sr.

Should Dodd-Frank Be Applied Retroactively?

2011-03-30T10:01:00.000-07:00

The SEC is seeking civil penalties from Rajat K. Gupta, a former director of Goldman Sachs for alleged insider trading. The SEC has not sued in federal court, but, rather has filed an administrative proceeding against Mr. Gupta as authorized by the new Dodd-Frank Act.

Rajat K. Gupta, a former director of Goldman Sachs, sued the SEC in the U.S. District Court for the Southern District Of New York, 11-CV-1900 on March 18, 2011, claiming that the administrative action by the SEC against him is unconstitutional because it seeks to retroactively apply provisions of Dodd-Frank § 929P, which amended § 8A of the Securities Act of 1933. In other words, Mr. Gupta is arguing that the alleged violations took place before Dodd-Frank was enacted so the SEC cannot use an administrative proceeding.

According Mr. Gupta's Complaint, there is no expression of Congressional Intent that civil penalties provision of Dodd-Frank can be applied retroactively. Section 4 of Dodd-Frank provides that “except as otherwise provided this Act shall take effect one day after the enactment of the Act.” Dodd-Frank became law on July 21, 2010. All of the conduct alleged occurred prior to that date. Without retroactive application of Dodd-Frank, the Commission could have sought civil penalties against Gupta in a Federal District Court.

The SEC alleged that Mr. Gupta engaged in a trading scheme by providing material non-public information that he obtained in the course of his duties as a member of the Board of Directors of The Goldman Sachs Group, Inc. and Procter & Gamble to Raj Rjaratnam, the manager of a hedge fund called Galleon Management, LP. Currently, Mr. Rjaratnam is on trial for criminal charges brought against him by the U.S. Attorney of the Southern District of New York.

Mr. Gupta claims that the actions brought against him should be determined by a jury. He points out that an appeal from an adverse administrative finding would first be to the Commission itself before any further judicial review. Mr. Gupta claims that he would be deprived of the application of the Federal Rules of Evidence which preclude unreliable evidence such as multiple layers of hearsay that Commission would seek to offer in an administrative proceeding. Also it would impede Mr. Gupta’s ability to seek indemnification for contribution thereby unfairly enhancing the magnitude of the amounts for which he would be exposed. These charges resulting from retroactive application of Dodd-Frank impose new legal consequences on Mr. Gupta even though arising from pre-Dodd-Frank conduct. Mr. Gupta points out that at least one Commissioner, Kathleen L. Casey, has publicly questioned the retroactive application of Dodd-Frank.

Mr. Gupta alleges that his attorney filed a 35-page response to a Wells Notice on Monday February 28, 2011. By that afternoon the staff received authorization to proceed against Mr. Gupta even though there is no record that the Commission met to consider the submission of the Wells response. Further, Mr. Gupta alleges that a copy of the submission was turned over by the Staff to the United States Attorney’s Office for use in the prosecution of Mr. Rajaratnam. Mr. Gupta seeks as a remedy (a) that Dodd-Frank provisions prospectively empowering the Commission to seek civil penalties against non-registered persons in administrative proceedings in lieu of a plenary action in Federal Court cannot be applied against him, and (b) the Commission is acting in bad faith and a discriminatory manner against him.

Mr. Gupta has raised significant legal issues which will apparently be decided in the very near future.

Edward X. Clinton, Sr.

Matrixx Initiatives, Inc. et al v. Siracusano, et al, 09-1156

2011-03-28T09:55:00.000-07:00

SUPREME COURT UNANIMOUSLY REJECTS NARROW INTERPRETATION OF §10B(5)

On March 22, 2011 the United States Supreme Court decided Matrixx Initiatives, Inc. et al v. Siracusano, et al, 09-1156, which reaffirmed its holding in Basic Inc. v. Levinson, 485 U.S. 224 (1988).

In Basic the defendant made misleading statements denying that it was engaged in merger negotiations when, in fact, it was conducting preliminary negotiations. Basic urged a bright-line rule that preliminary negotiations are material only when the parties to merger negotiations reach an agreement in principal. The Supreme Court in Basic rejected that bright-line rule. Accordingly, a claim was stated under Section 10b(5).

The Plaintiffs alleged in Matrixx that Matrixx and three executives failed to disclose a possible link between its leading product, Zicam, a cold medicine, and the loss of smell. Matrixx became aware of several complaints by users of Zicam but contended that the complaints were not statistically significant and accordingly that disclosure was not necessary. Matrixx also sought to defend its turf in other ways. It learned that a research doctor was going to deliver a lecture in which he would reference the fact that various complaints were made by other users of Zicam. Matrixx learned of the proposed presentation and informed the doctor that it did not have permission to use its name. The doctor proceeded with the presentation without mentioning Matrixx.

Plaintiffs complained that Matrixx violated Section 10b(5) by making untrue statements of fact and failing to disclose material facts necessary to make the statements not misleading in an effort to maintain artificially high prices for its leading product Zicam. The Supreme Court rejected that narrow approach and held that other facts could be considered, including other studies providing a link between Zicam and loss of smell.

The unanimous Supreme Court opinion written by Justice Sotomayor represents an affirmation and expansion of Basic. A very important case.

Edward X. Clinton, Sr.

Contract Law - Repudiation

2011-03-13T23:21:00.000-07:00

ARLINGTON LF LLC v. ARLINGTON HOSPITALITY INC., Court of Appeals, 7th Circuit 2011 - Google Scholar

This case holds that a finance company breached an agreement with a bankruptcy debtor when it refused to lend further funds to the debtor. The Seventh Circuit held that because the finance company repudiated the contract, it could not obtain any further relief under that contract.

Arlington Hospitality was the manager of the Ameriquest hotel chain. The Finance company agreed to lend Hospitality the sum of $11 million under a revolving line of credit.

The Bankruptcy court approved the term sheet and Hospitality drew 3.53 million on the credit line.

After the loan was made the finance company decided to terminate its relationship with Hospitality. It notified Hospitality that it would no longer advance any more funds to Hospitality. Slip Opinion at 7.

Several months later Hospitality repaid the $3.5 million loan, but did not pay the fees associated with the loan. The finance company sought an award of those fees from the Bankruptcy Court.

The Seventh Circuit held that when the finance company stated that it would not advance further funds under the "DIP loan" (debtor in possession loan) it "committed an anticipatory breach of the parties' lending agreement.

Under Illinois law, "when one party has committed a repudiation, the other party can treat the contract as ended." Slip Opinion at 15 (citing Timmerman v. Grain Exch. LLc, 915 N.E.2d 113, 124 (Ill. App. 2009); Truman L. Flatt & Sons, Co., Inc., v. Schumpf, 649 N.E.2d 990, 994 (Ill. App. 1995).

A party commits an anticipatory repudiation when it manifests a clear, unequivocal intent not to perform under the contract when performance is due. Id. citing In re Marriage of Olsen, 428 N.E.2d 684, 686 (Ill. 1988); Draper v. Frontier Ins., Co., 638 N.E.2d 1176, 1181 (Ill. App. 1994).

There was no retraction of the repudiation.

Thus, when it repudiated the contract, the Finance Company lost the right to any future performance by Hospitality.

Comment: this case is an excellent summary of the law of contract and repudiation.

Contract Law - Seventh Circuit Upholds Verdict Based On Oral Contract

2011-03-13T22:32:00.000-07:00

MMG FINANCIAL CORPORATION v. MIDWEST AMUSEMENTS PARK, LLC, Court of Appeals, 7th Circuit 2011 - Google Scholar

This case was decided by the Seventh Circuit on January 5, 2011.

The Plaintiff, MMG Financial, brought suit against Midwest Amusements Park, LLC on the ground that Midwest has failed to pay for 24 go-karts that Midwest financed. The go-karts were originally sold by another company, Team Hurricane, but they were financed by MMG Financial. Thus, this is a routine equipment financing transaction. What makes the case unusual is that the parties drafted, but did not sign, a comprehensive written agreement which laid out the terms of the deal.

The sales agreement identified Midwest as the purchaser of the go-karts; MMG Financial as the finance company and Team Hurricane as the dealer. The price was to be $89,502.12 and the balance was to be paid over 24 months at an interest rate of 24%.

Midwest (which did business under the name Gronvall) did not sign the agreement, but it took delivery of the go-karts.

Midwest never made any payments for the go-karts.

MMG filed suit and Midwest filed a counterclaim alleging that MMG had never paid the original vendor of the go-karts.

At trial Midwest disputed that there was a contract. It also argued that MMG breached the contract by failing to pay for the go-karts. The evidence of the breach was an email from a CRG (the manufacturer of the go karts) that MMG had failed to pay for the go-karts. The district court excluded the email on the ground that it was hearsay.

The district court granted summary judgment to MMG on Midwest's counterclaim because Midwest was unable to point to any admissible evidence that MMG had breached the financing agreement. As the Seventh Circuit noted, "the evidence Midwest offered to establish that MMG had failed to pay Cameron Motorsports for the go-karts is classic hearsay...the testimony of its own employees repeating what Cameron Motorsports had told them." The statements were offered "to prove the truth fo the matter asserted, namely that MMG had not paid Cameron Motorsports for the go-karts shipped to Midwest." Slip Opinion at 8. Thus, Midwest was unable to point to any evidence showing that MMG breached the contract.

Comment: the plaintiff was able to prove to the jury that the parties accepted the draft sales agreement, even though it was never signed. This demonstrates that, in a rare case, the failure to obtain the signature on an agreement can be overcome with testimony and proof.

Edward X. Clinton, Jr.

First Bank v. UNIQUE MARBLE AND GRANITE CORPORATION, Ill: Appellate Court, 2nd Dist. 2010 - Google Scholar

2011-03-09T20:22:00.000-08:00

First Bank v. UNIQUE MARBLE AND GRANITE CORPORATION, Ill: Appellate Court, 2nd Dist. 2010 - Google Scholar

This case is significant because it holds that an assignee for the benefit of creditors can recover fees even where another creditor has a valid security interest in all of the assets.

Unique Marble was a fabricator of marble and granite countertops. It fell upon hard times and, on November 18, 2008, it entered into an assignment for the benefit of creditors. James Gallo was the assignee and he took title to all of the assets of Unique Marble.

Three days later Gallo personally delivered a copy of the assignment to First Bank.

On December 23, 2008, First Bank obtained a judgment against Unique Marble in the amount of $451,568.08.

First Bank then brought collection proceedings against Unique Marble and its corporate officer.

On May 22, 2009, Gallo petitioned to intervene in the First Bank v. Unique Marble lawsuit. He sought $35,000 in fees and expenses.

First Bank argued that Gallo could not collect fees and expenses because of its prior security interest (which it had perfected on October 22, 2004).

The trial court granted First Bank summary judgment against Gallo. Gallo appealed and the Illinois Appellate Court for the Second District reversed.

The court reasoned that an assignment for the benefit of creditors is a "unique trust arrangement in which the assignee (or trustee) holds hte property for the benefit of a special group of beneficiaries, the creditors." Illinois Bell Telephone Co. v. Wolf Furniture House, Inc. 157 Ill. App. 3d 190, 194-95 (1987). The assignee owes a fiduciary duty to the creditors. Some debtors prefer to use an assignment for benefit of creditors (as opposed to bankruptcy) because the assignment process is much cheaper.

First Bank argued that it had priority over Gallo because First Bank had perfected its security interest before Gallo perfected his security interest.

The Court held that Gallo had a common law right to fees and expenses. As the Court noted "if assignees were required to forgo payment in favor of perfected security interests, no assignee would take on the risk of liquidating assets, and assignments for the benefit of creditors would cease to be available as an efficient method of maximizing the liquidation value of troubled companies."

Finally, the court held that Gallo could be compensated on the basis of quantum meruit principles. In so holding the Court ruled that Gallo had conferred a benefit on the Bank as well as all creditors.

Delaware Court Approves a Poison Pill

2011-02-17T06:54:00.000-08:00

Two Important Securities Cases Accepted by Supreme Court

2011-02-16T09:37:00.000-08:00

The U.S. Supreme Court has agreed to hear two significant cases. The first, Matrix Initiatives Siracusano, No. 09-1158 presents a question regarding materiality. The complaint alleges that Matrixx made false statements about its product Zicam, a nasal spray. Product liability suits had been filed against the company.

Matrixx denied press reports discussing complaints about a loss of smell. A report of an FDA investigation was followed by a drop in the share price despite statements by the company that it was not aware of any such inquiry.

A shareholder complaint suit was filed alleging securities fraud based on claims that the denials of the company were false and misleading. The district court dismissed the complaint and held that adverse product reports regarding a loss of smell did not have to be disclosed because they were not material. The court based its decision on In re Carter-Wallace, Inc., 220 F.3d 36 (2nd Cir. 2000). That rule has also been adopted by the First and Third Circuits.
The Ninth Circuit reversed. Siracusano v. Matrixx Initiatives, Inc., 585 F/3d 1167 (9th Cir. 2009) Citing Basic v. Levinson, 485 U.S. 224 (1988) the Court rejected the statistically significant test used by the district court. Materiality, the court stated, is a question generally reserved for the fact finder. The question is whether the allegations are properly pleaded under the Private Securities Litigation Reform Act (“PSLRA”) and state a cause of action under Bell Atlantic Corp. v. Twombly, 550 U.S. 5543 (2007). The question before the Supreme Court is the test for materiality.

The second securities case focuses on the question of primary liability. Janus Capital Group v. First Derivative Traders, No. 09-525. Defendant Janus Capital Group, Inc. (“JCG”) is a publicly traded asset management firm. It sponsors the Janus Funds. Janus Capital Management LLC (“JCM”) is a wholly owned subsidiary of Janus Capital.

Plaintiffs claim that JCG and JCM violated Section 10(b) of the Securities Exchange Act on the ground that the prospectuses for the funds created the misleading impression that steps would be taken to curb market timing. In fact, the complaint claims there were secret agreements which permitted market timing. As a result, plaintiffs claim they purchased their shares at an inflated price. Following the revelation of the truth, the share price dropped.

The district court dismissed the complaint on the ground that the complaint did not contain any allegations that JCG actually made or prepared the prospectuses or that any of the statements were attributable to it. As to JCM, the court held that the investment adviser did not owe any duty to the shareholders of its parent company when they have not purchased shares of the mutual fund.

The 4th Circuit reversed. In re Mutual Funds Investment Litig., 556 F.3d 111 (4th Cir. 2009). The Court held that the defendants adequately alleged that defendants “made” the misleading statements and that they were properly attributed to JCM the court held.

The allegations as to JCG, however, are insufficient to state a claim for primary liability the court concluded. Its limited role here was not sufficient to cause interested investors to believe that JCG had prepared or approved the Janus fund prospectuses. The court did find that plaintiffs had adequately pleaded a claim for control person liability.

The question of primary liability in Janus traces back to the Supreme Court’s decision in Central Bank Of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994). There, the Court held that there is no liability for aiding and abetting under Section 10(b) Since that time the courts have struggled with the question of what constitutes primary liability. Congress restored aiding and abetting for the SEC in the Private Securities Litigation Reform Act but not for private actions. A decision in both cases will come by the end of June 2011.

Contract Law - Cryptic Promissory Note Is A Written Contract

2011-02-02T11:32:00.000-08:00

The case was captioned Kranzler v. Saltzman, 07 L 6809.

Kranzler loaned Saltman $100,000 on March 10, 1997. Saltzman signed a written "memo" that stated, "Loaned, to Lewis Saltzman $100,000 to be paid back with interest." Saltzman made partial payments, but did not pay the entire balance of the loan. Saltzman's last payment was dated July 5, 2005.

In November 2007, Kranzler sued Saltzman for breach of contract. The trial court found in favor of Kranzler and entered a judgment in his favor in the amount of $81,344.12.

Saltzman appealed on several grounds. Saltzman argued that the lawsuit was governed by the five year statute that applies to unwritten contracts (735 ILCS 5/13-205). Kranzler argued that the applicable statute of limitation was the ten year statute which applies to written contracts (735 ILCS 5/13-206).

The Court concluded that the promissory note was a written contract. Under Illinois law, "where the writings attached to the complaint do not contain the essential terms of the contract, even if the essential terms may be easily ascertained elsewhere, the contract is not written but oral." Clark v. Western Union Telegraph Co., 141 Ill. App. 3d 174, 176 (1986). A writing is considered "complete" "when the language of the instrument may fairly be construed to contain a promise to pay money or contains facts from which the law implies a promise to pay, so long as parol evidence is not necessary to establish any essential elements." Toth v. Mansell, 207 Ill. App. 3d 665, 670 (1990).

The required elements to prove a promise to pay are "(1) the parties to the agreement, (2) the nature of the transaction, (3) the amount in question, and (4) at least a reasonable implication of an intention to repay the debt." In re Estate of Garrett, 24 Ill. App. 895 (1975).

The Court found the instrument contained all of the required elements to establish a promise to pay under Illinois law.

The Court also held that the statute of limitations began to run on the date of the last payment made on the debt. The statute began to run when a payment is due but remains unpaid. Thus, the lawsuit was timely.

Comment: the defendant's position was unsympathetic. The defendant wanted to be excused from the obligation based on the statute of limitations. Furthermore, the case shows that even crude and simple documentation can be sufficient to provide a creditor with legally enforceable rights. Plaintiff would have been better to hire a lawyer, but his own simple note was enforceable.

Edward X. Clinton, Jr.

Benson v. Stafford, Nos. 1-09-1361, 1-09-3173 (Cons.) The Nonreliance Clause Bars A Fraud Claim

2011-01-28T22:26:00.000-08:00

The Illinois Appellate Court recently considered whether or not a party, which signs a written contract that specifically disclaims any representations and warranties, can sue for fraud?

The answer, once again, is a resounding no. The case, like the other cases it follows, is significant.

The plaintiffs brought a claim for "affirmative fraud" against the Defendant. They argued that the Defendant made affirmative misrepresentations to them to induce them to participate in the transaction.

Defendant argued that the nonreliance clause barred any recovery. The opinion sets out the text of the clause as follows:

In the case at bar, the trial court dismissed the affirmative fraud component of count II of plaintiffs’ fourth amended complaint due to the presence of a nonreliance clause in the SPAs that plaintiffs signed. The clause, located in section 6.7 of the SPAs, provided:

Nos. 1-09-1361, 1-09-3173 (Cons.) “6.7 Entire Agreement. This Agreement (including the
documents referred to herein) constitutes the entire agreement among the Parties with respect to the subject matter hereof. There are no warranties, conditions, or representations (including any that may be implied by statute) and there are no agreements in connection with such subject matter except as specifically set forth or referred to in this Agreement. No reliance is placed on any warranty, representation, opinion, advice or assertion of fact made either prior to, contemporaneous with, or after entering into this Agreement, or any amendment or supplement thereto, by any Party or its directors, officers, employees or agents, to any other Party or its directors, officers, employees or agents, except to the extent that the same has been reduced to writing and included as a term of this Agreement, and none of the Parties has been induced to enter into this Agreement or any amendment or supplement by reason of any such warranty, representation, opinion, advice or assertion of fact. Accordingly, there shall be no liability, either in tort or in contract, assessed in relation to any such warranty, representation, opinion, advice or assertion of fact, except to the extent contemplated above.” (Emphasis added.)

Additionally, although the trial court did not discuss it, defendant claimed that section 28
Nos. 1-09-1361, 1-09-3173 (Cons.) 3.1(d)(viii) of the TD Options agreement also provided a nonreliance clause:

“(d) Representations and Warranties of Members. Each Member hereby represents and warrants to the Company and to each other Member and acknowledges that: *** (viii) the determination of such Member to acquire Units in the Company has been made by such Member independent of any other Member and independent of any statements or opinions as to the advisability of such acquisition or as to the properties, business, prospects or condition (financial or otherwise) of the Company and its Subsidiaries which may have been made or given by any other Member or by any agent, employee or other Affiliate of any other Member.”

Defendant relied on the case captioned, Tirapelli v. Advanced Equities, Inc., 351 Ill. App. 3d 450. In Tirapelli, the plaintiff purchased securities from the defendant. Plaintiff's claims of affirmative fraud were dismissed by the Court and the dismissal was affirmed by the Appellate court on the ground that the plaintiffs were "sophisticated parties" who had signed a nonreliance clause. The plaintiffs, therefore, could not rely on Defendant's oral representations that were not contained in the contract. The Appellate Court in Tirapelli, held that the nonreliance clause barred the plaintiffs from stating a cause of action for fraud, stating that “[h]aving agreed in writing that they did not rely on any representations found outside the subscription documents, plaintiffs cannot be allowed to argue fraud based on such representations.” Tirapelli, 351 Ill. App. 3d at 457. We also noted that as sophisticated business people, plaintiffs could have negotiated for the inclusion of any representations that they thought were important. Tirapelli, 351 Ill. App. 3d at 457."

In the Benson case, Defendant argued, and the trial court agreed, that the presence of a nonreliance clause barred plaintiffs from bringing a claim for affirmative fraud as a matter of law.

The appellate Court held that the nonreliance clause barred the affirmative fraud claim because the plaintiffs could not establish justifiable reliance, an element of fraud.

The Court wrote: In the case at bar where there were sophisticated parties to a securities transaction, and in the presence of a non-reliance clause, we will follow Tirapelli and find that plaintiffs cannot state a claim for affirmative fraud because they cannot show reasonable reliance on defendant’s oral representations as a matter of law due to the non-reliance clause in section 6.7 of the SPAs.

Comment: Tirapelli and Benson hold that sophisticated persons who sign a contract with a nonreliance clause are bound by that clause and cannot later claim fraud or fraudulent inducement based on representations outside of the four corners of the contract.

Edward X. Clinton, Jr.

A Brief Review of Insider Trading Law - Rule 10b-5

2011-01-28T08:50:00.000-08:00

Insider trading law is highly complex. This is a brief summary of the law.

Rule 10b-5

1. Insider Trading

15 U.S.C. §78j(b) provides that it is unlawful “[t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” In 1942, the SEC adopted Rule 10b-5, 17 C.F.R. §240.10b-5, which provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Although 15 U.S.C. §78j(b) and Rule 10b-5 were originally intended to supplement other antifraud provisions of the federal securities laws, they have become the most important provisions with regard to insider trading.

In the typical insider trading case, an insider who is aware of material information not available to the other party to the transaction or the public purchases or sells a security. In both instances, the cases under Rule 10b-5 focus on the accurate disclosure of material information by one who has such information or the abstention from trading until the information becomes public. For example, in Kardon v. National Gypsum Co., 73 F.Supp. 798 (E.D.Pa. 1947), the court ruled that corporate officers breached their fiduciary duty to selling shareholders and violated Rule 10b-5 when they purchased stock from shareholders without informing the shareholders that the stock was about to be acquired by a third party for a higher amount. Kardon is a classic example of prohibited insider trading.

Rule 10b-5 requires that those who possess inside information either refrain from trading in the security while the information is not public or disclose the information to the public themselves. Speed v. Transamerica Corp., 99 F.Supp. 808, supplemental op., 100 F.Supp. 461, petition denied, 100 F.Supp. 463 (D.Del. 1951). In Speed, 99 F.Supp. at 829, the court commented on the rationale for this duty of disclosure shortly after the enactment of Rule 10b-5:

The duty of disclosure stems from the necessity of preventing a corporate insider from utilizing his position to take unfair advantage of the uninformed minority stockholders. It is an attempt to provide some degree of equalization of bargaining position in order that the minority may exercise an informed judgment in any such transaction.

Nondisclosure or inaccurate disclosure of material information, combined with trading by one with inside information, may result in liability under one of the rule’s three clauses: as a scheme to defraud, as an untrue statement or misleading omission, or as an act or practice that operates as a fraud or deceit on someone in connection with the purchase or sale of a security.

The Seventh Circuit addressed insider trading in the context of the penalty provided in SEC v. Lipson, 278 F.3d 656 (7th Cir. 2002). The court held that the former chairman and chief executive officer of Supercuts, Inc., had properly been found liable for selling his company stock while in possession of material nonpublic information about disappointing revenues and high expenses.

Lipson sold 365,000 shares of Supercuts’ stock shortly before the company announced disappointing earnings. The earnings for the quarter amounted to 7 cents per share, significantly below the analysts’ projection of between 17 and 18 cents per share. Judge Ronald Guzman ordered Lipson to pay $2.8 million, which represented disgorgement of $621,000 in losses avoided by selling Supercuts’ stock, prejudgment interest of $348,000, and $1.8 million as punitive damages, which was three times the amount ordered disgorged.

Lipson contended that the jury improperly was instructed that, if it decided Lipson possessed insider information, it could infer that he used the information in selling his stock, and that accordingly, it improperly shifted the burden of persuasion from the SEC to himself. The Seventh Circuit agreed that such would have been improper but said that the jury was entitled to infer that, if Lipson had inside information, his securities trading was influenced by it. The court stated that common sense indicated that Lipson’s decision to sell when he did and to sell how much he did was influenced by the fact that he had possession of insider information that was unfavorable and likely to affect the market price of the stock.

In United States v. Bhagat, 436 F.3d 1140 (9th Cir. 2006), Atul Bhagat challenged his conviction for insider trading, securities tipping, and obstructing the course of an SEC investigation. Bhagat’s employer, Nvidia Corporation, successfully competed for a large contract to develop a video game console (the X-Box) for Microsoft. Nvidia’s CEO then sent a company-wide e-mail late on a Sunday night announcing the contract award. The next morning, Nvidia sent a number of follow-up e-mails. The first e-mail advised Nvidia employees that the X-Box information should be kept confidential. The other e-mails imposed a trading blackout on the purchase of Nvidia stock for several days and required Nvidia’s employees to cancel any open or outstanding orders for Nvidia stock. Bhagat purchased a large quantity of Nvidia stock — his largest purchase in nearly three years — roughly twenty minutes after the final company-wide e-mail. The government contended that Bhagat read the CEO’s Sunday night e-mail prior to purchasing the Nvidia stock.

There was no direct evidence that Bhagat read any of the e-mails prior to making his purchase. The government asked the jury to infer Bhagat’s knowledge of the contract award by virtue of the fact that he had probably read the original e-mail upon entering the office as a “normal, reasonable person” would. 436 F.3d at 1143. The Ninth Circuit upheld the trial court’s conviction of Bhagat, saying that the evidence presented was significant enough to support the jury’s conclusion that Bhagat was aware of the confidential information before he executed his trades.

In 2000, the SEC adopted Rule 10b5-1 to further define what it means to trade securities “on the basis of” material nonpublic information. Rule 10b5-1 addresses the issue of when insider trading liability arises in connection with a trader’s “use” or “knowing possession” of material nonpublic information. This rule provides that a person trades “on the bases of” material nonpublic information when the person purchases or sells securities while aware of the information. However, the rule also sets forth several affirmative defenses, which have been modified to permit persons to trade in certain circumstances when it is clear that the information was not a factor in the decision to trade. Specifically, there is no violation if the trade was made pursuant to a prearranged plan. For further information, see Allan Horwich, The Origin, Application, Validity, and Potential Misuse of Rule 10b5-1, 62 Bus.Law. 913 (2007).

a. What Information Is Material?

In TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 48 L.Ed.2d 757, 96 S.Ct. 2126, (1976), the Supreme Court concluded in the context of proxy solicitations under Rule 14a-9, 17 C.F.R. §240.14a-9, that a fact is material if there is a “substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder.” In 1988, the Supreme Court held that the materiality test announced in TSC Industries applied to actions brought pursuant 15 U.S.C. §77j(b) and Rule 10b-5, 17 C.F.R. §240.10b-5. See Basic Inc. v. Levinson, 485 U.S. 224, 99 L.Ed.2d 194, 108 S.Ct. 978 (1988).

In Basic, the plaintiffs argued that merger discussions between Basic and another company were “material.” Over a two-year period, Basic’s officers met with representatives of Combustion Engineering, Inc., to discuss a possible merger of the two companies. After heavy trading in Basic’s stock, the company issued press releases to the effect that the company was unaware of any corporate developments that would explain the trading volume. Basic and Combustion agreed to merge in December 1978. Basic shareholders who sold their shares during the period from the first public denial of merger activities up to the trading halt imposed before the merger announcement brought a suit against Basic and certain of its directors, alleging that the public statements were false or misleading in violation of Rule 10b-5 and artificially depressed the stock prices. The district court granted summary judgment for Basic. The Sixth Circuit reversed, holding that, even if the discussions with Combustion Engineering were not “material” when they occurred, they became material when the corporation claimed that it was unaware of any corporate developments that would explain the trading volume. The Supreme Court held that “[m]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information.” 108 S.Ct. at 988.

Smith v. Shell Petroleum, Inc., Fed.Sec.L.Rep. (CCH) ¶95,316 (Del.Ch. 1990), is an example of how courts determine whether an omitted fact is “material.” In Smith, Shell Petroleum initiated a short-form merger with a subsidiary. Shell wanted to obtain exclusive ownership of the subsidiary by purchasing the interests of the minority shareholders. The plaintiffs were minority shareholders of the subsidiary. Shell sent disclosure materials to each plaintiff. Each had the option to accept Shell’s offer for the shares or to seek an appraisal of the shares in court. The plaintiffs sued Shell, alleging that Shell’s disclosure materials understated the value of the oil and gas reserves owned by the company by the sum of $1 billion. Shell admitted that the disclosure materials were inaccurate but argued that the $1 billion understatement was not “material.” The Delaware chancery court disagreed, holding that “there is a likelihood that the misdisclosure would have assumed actual significance in the deliberations of a reasonable shareholder in deciding whether to accept the consideration from the short-form merger or whether to seek an appraisal.” Fed.Sec.L.Rep. (CCH) ¶95,316 at p. 96,506. See also Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995) (“If the court determines that there is a substantial likelihood that disclosure of the information would have been viewed by the reasonable investor to have significantly altered the total mix of information, the statement is material.”); SEC v. Maio, 51 F.3d 623, 637 (7th Cir. 1995) (same standard). See also Allan Horwich, The Neglected Relationship of Materiality and Recklessness in Actions Under Rule 10b-5, 55 Bus.Law. 1023 (2000).

b. To Whom Does the Duty To Disclose Apply?

Rule 10b-5, 17 C.F.R. §240.10b-5, applies to “any person” and to securities of all issuers, whether they be small closely held corporations or publicly owned companies. The duty to disclose under Rule 10b-5 is not limited to officers, directors, or controlling shareholders of the issuer who are ordinarily considered to be “insiders.” There are two theories under which a person who trades a security on the basis of confidential information without disclosing that information will be held to have violated Rule 10b-5: (1) the classical theory and (2) the misappropriation theory.

(1) The classical theory

“Under the classical theory, a person violates [Rule 10b-5, 17 C.F.R. §240.10b-5] when he or she buys or sells securities on the basis of material, non-public information and at the same time is an insider of the corporation whose securities are traded.” SEC v. Maio, 51 F.3d 623, 631 (7th Cir. 1995), quoting SEC v. Cherif, 933 F.2d 403, 408 (7th Cir. 1991). “Classical theory applies to trading by insiders (or their tippees) in the stocks of their own corporations.” [Emphasis in original.] Maio, supra, citing Cherif, supra.

An example of insider trading under the classical theory occurred in In re Cady, Roberts & Co., [1961 – 1964 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶76,803 at p. 81,013 (Nov. 8, 1961) (1934 Act Release No. 6668). In Cady, an SEC enforcement proceeding, the respondent was a director of a corporation and an employee of a securities brokerage firm. In his capacity as a director, he learned that the corporation intended to reduce the dividend on its common stock. The respondent disclosed that information to the brokerage firm. The brokerage firm sold the common stock for its customers prior to public disclosure of the dividend reduction. The SEC ruled that the broker had a duty either to disclose the reduction in the dividend rate or to refrain from trading until such disclosure occurred. The holding was based on two principles: (a) the existence of a relationship giving access to information intended to be available for a corporate purpose and not for personal benefit and (b) the “inherent unfairness” when a person uses information knowing it is unavailable to others with whom he is dealing. Thus, the respondent had a duty to existing stockholders and to members of the public who purchased stock before the announcement of the dividend reduction.

SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 89 S.Ct. 1454 (1969), is the leading case under the classical theory of insider trading. In Texas Gulf Sulphur, the company discovered a rich ore strike. The company issued a press release stating that it was premature to draw conclusions about the magnitude or quality of the ore strike. At the same time, employees and officers of Texas Gulf purchased substantial amounts of the company’s stock. They made large profits when the value of the strike was fully disclosed. The court held that the company and the officers violated Rule 10b-5. In effect, the court found a duty to the market generally (and not merely to the shareholders of the corporation involved).

Texas Gulf Sulphur is properly viewed as a major expansion of insider trading liability. The court referred to the responsibility of “anyone in possession of material inside information” and an overall duty to shareholders in the marketplace. 401 F.2d at 848, 851 – 852. The court also commented that one who passes information on to another (the tipper) who buys or sells stock is as culpable as one who uses the information for his own benefit (the tippee). 401 F.2d at 852.

(2) The misappropriation theory

Under the misappropriation theory, a person violates Rule 10b-5, by “misappropriating and trading upon material information entrusted to him by virtue of a fiduciary relationship.” SEC v. Maio, 51 F.3d 623, 631 (7th Cir. 1995), quoting SEC v. Cherif, 933 F.2d 403, 410 (7th Cir. 1991). “Misappropriation theory ‘extends the reach of Rule 10b-5 to outsiders [or their tippees] who would not ordinarily be deemed fiduciaries of the corporate entities in whose stock they trade.’ ” [Emphasis in original.] Maio, supra, quoting Cherif, supra. Under the misappropriation theory, the person trading in the stock need not be an insider of the corporation (or a tippee of an insider) whose stock was traded for the conduct to violate Rule 10b-5. As the court explained in Maio, supra, “the misappropriation of material non-public information from its lawful possessor is regarded as a sufficient breach of fiduciary duty ‘in connection with’ the purchase or sale of a security to justify liability under Rule 10b-5.”

The misappropriation theory arose out of the Supreme Court’s holding in Chiarella v. United States, 445 U.S. 222, 100 S.Ct. 1108 (1980). In Chiarella, the defendant, an employee of a financial printing house hired to print certain documents related to a tender offer, was able to deduce the identities of the target companies. He then purchased stock in those companies and sold the stock at a profit after the tender offers were announced. He was convicted of securities fraud. The Supreme Court reversed his conviction for violating Rule 10b-5 and held that “liability is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.” 100 S.Ct. at 1115. The Court held that Chiarella had no duty to disclose the information because he did not owe a duty to the target company or its shareholders.

Chief Justice Burger dissented in Chiarella. The Chief Justice quoted with approval a commentator who stated, “Any time information is acquired by an illegal act it would seem that there should be a duty to disclose that information.” [Emphasis in original.] 100 S.Ct. at 1121, quoting W. Page Keeton, Fraud, Concealment and Non-Disclosure, 15 Tex.L.Rev. 1, 25 – 26 (1936). The concept became known as the “misappropriation theory.”

Shortly after Chiarella, the SEC promulgated Rule 14e-3, 17 C.F.R. §240.14e-3, which prohibits insiders and others with material nonpublic information from trading in corporate tender offers. See §1.103 below.

Several courts have followed Chief Justice Burger’s dissent in Chiarella and have applied the misappropriation theory to find violations of Rule 10b-5 when a person who was not in a confidential or fiduciary relationship with the issuer traded based on material nonpublic information.

In United States v. Newman, 664 F.2d 12 (2d Cir. 1981), two employees of investment banking firms misappropriated confidential information about mergers and acquisitions proposed by clients of their firms. The employees gave that information to Newman, who purchased stock in the takeover targets. When the merger plans were announced to the public, Newman sold the shares at a substantial profit. He shared the profits with the employees of the investment banking firms. The court held that Newman could be held criminally liable under Rule 10b-5 because he misappropriated material nonpublic information.

Dirks v. SEC, 463 U.S. 646, 77 L.Ed.2d 911, 103 S.Ct. 3255 (1983), made clear that the tipper must breach a fiduciary duty or the tippee has not breached Rule 10b-5. Dirks was an investment analyst who learned from a former employee of Equity Funding that that company had been fraudulently issuing insurance policies and recording the proceeds as income. Dirks tipped several institutions, which then sold $16 million in common stock before the fraud was exposed. He then contacted the SEC and the Wall Street Journal, and the fraud was eventually exposed. Dirks did not use the information himself and did not receive any direct personal benefit. However, the SEC censured Dirks for tipping his inside information. The Supreme Court reversed the censure. According to the Court, the employee’s purpose in informing Dirks was to expose the fraud, not to profit by using the information, so the tipper breached no duty to Equity Funding.

In SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), cert. denied, 105 S.Ct. 2112 (1985), an employee of a financial printing company learned the identity of certain target companies and purchased their stock before information relating to the tender offers became publicly available. Following Newman, supra, the Second Circuit affirmed. It held that “one who misappropriates nonpublic information in breach of a fiduciary duty and trades on that information to his own advantage violates Section 10(b) and Rule 10b-5.” 745 F.2d at 203.

In United States v. Winans, 612 F.Supp. 827 (S.D.N.Y. 1985), aff’d in part, rev’d in part, 791 F.2d 1024 (2d Cir. 1986), a writer for the Wall Street Journal was convicted of an insider trading scheme. Winans used information about the contents of future columns for his own trading, and he tipped the information to others who also used the information. The Second Circuit affirmed Winans’ conviction. Winans argued that he was not guilty because he was not a corporate insider and did not misappropriate information from insiders. However, the Second Circuit held that the misappropriation of nonpublic information from his employer in connection with a scheme to purchase and sell securities constituted a violation of Rule 10b-5. 791 F.2d at 1031 – 1032. The decision of the Second Circuit was affirmed by an equally divided Supreme Court in Carpenter v. United States, 484 U.S. 19, 98 L.Ed.2d 275, 108 S.Ct. 316 (1987).

In United States v. O’Hagan, 521 U.S. 642, 117 S.Ct. 2199 (1997), the Supreme Court formally recognized the validity of the misappropriation theory. The defendant, O’Hagan, was a partner of a law firm. He learned that one of the firm’s clients was preparing a tender offer of the common stock of Pillsbury Company. O’Hagan purchased Pillsbury stock and options on Pillsbury stock. When the tender offer was announced to the public, O’Hagan sold the securities for a profit of $4.3 million. He was convicted of violating 15 U.S.C. §78j(b). The Supreme Court held that “criminal liability under [15 U.S.C. §78j(b)] may be predicated on the misappropriation theory.” 117 S.Ct. at 2206. Under the misappropriation theory, “a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.” 117 S.Ct. at 2207.

To establish guilt, the government must show that the tipper breached a fiduciary duty. When there is no breach of a fiduciary duty by the tipper, the tippee cannot be prosecuted under Rule 10b-5. In United States v. Chestman, 947 F.2d 551 (2d Cir. 1991), cert. denied, 112 S.Ct. 1759 (1992), the defendant was a stockbroker. One of his clients informed him that a public company, a majority of which was owned by a member of the client’s family, would soon be acquired. The defendant then purchased 3,000 shares of the company’s stock. After the deal was announced, the stock doubled in value. The defendant was convicted of violating Rule 10b-5. The Second Circuit reversed the conviction because the client (the tippee) did not breach a fiduciary duty to his family members and thus did not commit fraud, so the defendant “could not be derivatively liable as [client’s] tippee or as an aider and abettor.” 947 F.2d at 571.

The most significant case discussing the misappropriation theory in recent years is SEC v. Mark Cuban, 09-10996 (5th Circuit 2010). The SEC sued Mark Cuban, a noted entrepreneur for allegedly violating Section 10(b), Rule 10b-5 and Section 17(a) of the 1933 Act. The SEC alleged that Cuban was a large minority shareholder of Mamma.com, a Canadian company and that he received confidential information from the CEO of Mamma.com and agreed not to disclose that information. According to the SEC, Cuban violated the confidentiality agreement by selling his stock before the company announced an additional stock offering that would dilute his stake in the company. The district court dismissed the complaint but the Fifth Circuit reversed holding that Cuban could be held liable under the misappropriation theory because he assumed a duty of trust and confidence when he agreed to keep the information confidential.

Also significant is SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009). The Dorozhko case extends insider trading liability under the misappropriation theory to outsiders who did not have a fiduciary relationship with the company where the outsiders wrongfully obtained the inside information through an affirmative misrepresentation.

c. When Does the Duty To Disclose Arise?

An implicit duty to disclose material information arises when a company or its insiders are trading in the company’s securities while in possession of material information that has not already been disclosed to the public. See, e.g., SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 853 – 854 (2d Cir. 1968) (en banc), cert. denied, 89 S.Ct. 1454 (1969). The Texas Gulf Sulphur court held that “[b]efore insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to insure its availability to the investing public.” 401 F.2d at 854.

d. Scienter Requirement

In an action for insider trading under the classical theory, the plaintiff must prove scienter. SEC v. Adler, 137 F.3d 1325, 1332 (11th Cir. 1998). In Adler, an insider sold thousands of shares of company stock prior to the company’s public disclosure that a major customer had ordered fewer of the company’s products than it had anticipated and that this shortfall in orders would reduce the company’s revenue and earnings for the next fiscal quarter. The SEC argued that the insider’s possession of material nonpublic information when he made the sale established scienter. The court disagreed. It held that scienter is established when the investor used inside information in making the trade. 137 F.3d at 1337. Under this test, “mere knowing possession — i.e., proof that an insider traded while in possession of material nonpublic information — is not a per se violation.” Id. The court explained that

when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade — i.e., that the information was not used. The factfinder would then weigh all of the evidence and make a finding of fact as to whether the inside information was used. Id.

In Elkind v. Liggett & Myers, Inc., 635 F.2d 156 (2d Cir. 1980), the company tipped a financial analyst that its earnings for the second quarter would be lower than expected. A customer of the brokerage firm that employed the analyst sold his shares before the announcement and avoided the loss. The court found that the company had scienter. It held:

One who deliberately tips information which he knows to be material and non-public to an outsider who may reasonably be expected to use it to his advantage has the requisite scienter. 635 F.2d at 167.

A plaintiff must also prove that a tippee had scienter. In United States v. Libera, 989 F.2d 596 (2d Cir. 1993), the defendants obtained information contained in new issues of Business Week prior to the publication of the issues by paying employees of the printer for copies of the proofs of the magazine, and the defendants made significant profits from trading on that information. The defendants were convicted of insider trading because the evidence demonstrated that the tippers breached duties owed to the publisher and the printer and that the tippees (the defendants) were aware that the tippers had breached their duties to the printer and the publisher. 989 F.2d at 600.

In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 47 L.Ed.2d 668, 96 S.Ct. 1375 (1976), the Supreme Court held that scienter, or the intent to deceive, manipulate, or defraud, is an essential element in a private cause of action under Rule 10b-5. Mere negligence does not violate Rule 10b-5. In Ernst & Ernst, the accounting firm was retained by a small brokerage firm to perform periodic audits. In its audits, Ernst & Ernst failed to detect a fraudulent securities scheme being carried out by the president of the brokerage firm, who had been regularly converting funds obtained from clients to his own use. Clients of the brokerage firm filed suit under Rule 10b-5 against Ernst & Ernst for negligently failing to detect and disclose the fraud. The court held that the accounting firm was merely negligent and thus could not be held liable under Rule 10b-5.

In Ernst & Ernst, the Court reserved the question of whether mere recklessness is sufficient to meet the scienter requirement in 15 U.S.C. §78j(b) and Rule 10b-5. 96 S.Ct. at 1381 n.12. Since that time, several circuits have concluded that recklessness will suffice. Several circuits have adhered to a “highly reckless” standard, defined as conduct showing “an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.” Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir.), cert. denied, 99 S.Ct. 642 (1978), quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977). In Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995), the court formulated the test as follows: “The plaintiff must also demonstrate that the deceit was committed with the intent to mislead or at least with recklessness so severe that it is the functional equivalent of intent.”

The Private Right of Action Under Section 10(b) and Rule 10(b)5

2011-01-17T18:22:00.001-08:00

Sometimes it is worth reviewing the basics. How is it that an investor can bring a Section 10b-5 claim against a company and/or its officers and directors where Section 10(b) does not mention the right to sue?

15 U.S.C. §78j(b) provides that it is unlawful “[t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” In 1942, the SEC adopted Rule 10b-5, 17 C.F.R. §240.10b-5, which provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Neither the Section nor the Rule provides for a private right of action.

However, the United States Supreme Court provided for such a private right of action in a footnote in a 1971 case!

As the Court recently wrote in the Stoneridge decision,

"Though the text of the Securities Exchange Act does not provide for a private cause of action for §10(b) violations, the Court has found a right of action implied in the words of the statute and its implementing regulation. Superintendent of Ins. of N. Y. v. Bankers Life & Casualty Co., 404 U. S. 6, 13, n. 9 (1971). In a typical §10(b) private action a plaintiff must prove (1) a material misrepresenta- tion or omission by the defendant; (2) scienter; (3) a con- nection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation. See Dura Pharmaceuticals, Inc. v. Broudo, 544 U. S. 336, 341–342 (2005)."

Thus, the private right of action, one of the most important claims litigated in federal courts today rests on a single footnote in a Supreme Court opinion.

Edward X. Clinton, Jr.

What Is A Security Under The Federal Securities Laws?

2011-01-16T20:06:00.000-08:00

We thought it would be a good time to review one of the basic concepts of the securities laws: What Constitutes A Security?

The term “security” means

any note, stock, treasury stock, security future, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a “security,” or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing. 15 U.S.C. §77b(a)(1).

The importance of the definition of “security” becomes apparent in the area of private actions for securities fraud because the standard for establishing securities fraud is much lower than that for common law fraud.

The Supreme Court has adopted a flexible and liberal approach in determining what constitutes a security. In its famous decision of SEC v. W.J. Howey Co., 328 U.S. 293, 90 L.Ed. 1244, 66 S.Ct. 1100 (1946), the Court held that land sales contracts for citrus groves in Florida, coupled with warranty deeds for the land and a contract to service the land, were “investment contracts” and thus securities. The Court stated that

[a]n investment contract for purposes of the Securities Act means a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or a third party. 66 S.Ct. at 1103.

According to the Court, it is immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise. 66 S.Ct. at 1104.

The Howey investment contract analysis has been the starting point in determining the status of transactions in the securities area. In applying this analysis, courts have traditionally looked to the substance of the transaction to decide whether a security is involved and have made the determination regardless of the label placed on the interest by the parties to the transaction. Courts have found that countless schemes designed to produce profits for the participants, such as the sale of franchises, fur-bearing animals, and shares in fishing boats and cemetery lots, were covered by the 1933 Act. See 2 Louis Loss and Joel Seligman, SECURITIES REGULATION, pp. 948 – 956 (3d ed. 1989); Carl W. Schneider, The Elusive Definition of a Security — An Examination of the “Investment Contract” Concept and the Propriety of a Risk Capital Analysis Under Federal Law, 12 Tex.Tech.L.Rev. 911 (1981).

One significant question is whether an interest in a limited liability company is a security. In Robinson v. Glynn, 349 F.3d 166 (4th Cir. 2003), the Fourth Circuit held that an interest in an LLC is not a security. The Fourth Circuit held that the plaintiff investor was not seeking to profit “solely” from the efforts of others. The court claimed that he had significant control over the company, including the right to appoint two board members. However, in SEC v. Merchant Capital, 483 F.3d 747 (11th Cir. 2007), the Court held that interests in limited liability partnerships were “investment contracts” under Howey. Also, see United States v. Leonard, 529 F.3d 83 (2d Cir. 2008) (affirming criminal convictions for violating the securities laws and holding that interests in an LLC sold by Defendants were securities under the Howey investment contract test.). As the Leonard court noted, an LLC requires a case by case analysis to determine whether the purchaser had significant control over the operations of the company. 529 F.3d. at 89.

In SEC v. Edwards, 540 U.S. 389, 157 L.Ed.2d 813, 124 S.Ct. 892 (2004), the Supreme Court reaffirmed the validity of Howey, supra. In Edwards, the defendant controlled ETS Payphones, Inc., which sold payphones to the public. The payphones were sold under a sale and leaseback agreement, under which the investor would “purchase” the payphone and then lease it back to ETS in exchange for a payment of $82 each month. For each investor, the $82 payment represented a 14-percent return on the investment. After ETS filed for bankruptcy protection, the SEC filed a civil enforcement action against Edwards, alleging that he had violated the registration requirements of 15 U.S.C. §§77e(a) and 77e(c). The Eleventh Circuit in SEC v. ETS Payphones, Inc., 300 F.3d 1281 (11th Cir. 2002), held that the sale and leaseback scheme was not a “security” because it offered a “fixed rate of return.” The Eleventh Circuit also held that the Howey test “that the return on the investment be ‘derived solely from the efforts of others’” did not apply because the investor had a contractual right to the $82 payment each month. 124 S.Ct. at 896, quoting ETS Payphones, supra, 300 F.3d at 1285. The Supreme Court reaffirmed Howey and held that “an investment scheme promising a fixed rate of return can be an ‘investment contract’ and thus a ‘security’ subject to the federal securities laws.” 124 S.Ct. at 898 – 899.

Some items that give their holders a right of use do not constitute securities. In United Housing Foundation, Inc. v. Forman, 421 U.S. 837, 44 L.Ed.2d 621, 95 S.Ct. 2051 (1975), the Supreme Court found that “stock” entitling its holder to purchase an apartment from a cooperative was not a security because the purchasers were acquiring a right to purchase an apartment. The purchasers were not seeking the benefits accruing to investors. Rather, they were seeking the use of an apartment.

Ordinary commercial paper, even when described as a “note,” is not a security. In C.N.S. Enterprises, Inc. v. G. & G. Enterprises, Inc., 508 F.2d 1354 (7th Cir.), cert. denied, 96 S.Ct. 38 (1975), the court held that certain notes were not securities because the notes were ordinary commercial paper. The bank holding the notes was not acting as an investor or business partner. See also American Fletcher Mortgage Co. v. U.S. Steel Credit Corp., 635 F.2d 1247 (7th Cir. 1980), cert. denied, 101 S.Ct. 1982 (1981).

Bank certificates of deposit are not securities. Marine Bank v. Weaver, 455 U.S. 551, 71 L.Ed.2d 409, 102 S.Ct. 1220 (1982). In the Court’s view, because the banking laws amply protect investors in bank CDs, it is unnecessary to subject the issuer banks to liability under the antifraud provisions of the securities laws.

The sale of 100 percent of the outstanding stock of a company involves the sale of a security. Landreth Timber Co. v. Landreth, 471 U.S. 681, 85 L.Ed.2d 692, 105 S.Ct. 2297 (1985). In so holding, the Supreme Court expressed its view that the instrument involved was stock under the plain language of the statute.

A real estate contract may also be a security. In Adams v. Cavanagh Communities Corp., 847 F.Supp. 1390 (N.D.Ill. 1994), investors who had purchased Florida real estate interests on land sales contracts sued the developers for securities fraud. The court held that the land sales agreements were investment contracts. Moreover, since the installment contracts called for a repeated series of decisions to invest, each term payment was a separate offer and sale for determining the statute of limitations. Other courts have held that mortgage participations (Pollack v. Laidlaw Holdings, Inc., 27 F.3d 808 (2d Cir. 1994)) and joint venture interests purchased in reliance on the expertise of the venture’s manages to generate profits (Stone v. Kirk, 8 F.3d 1079 (6th Cir. 1993)) are securities.

Whether a contract or other economic right is a security essentially depends on whether the holder of the contract is acting as an investor who seeks financial benefits based on the work of a promoter or a third party.

The statute makes it clear that a promissory note or share of stock in a small closely held corporation is a security. 15 U.S.C. §77b(a)(1).

Edward X. Clinton, Jr.

Excellent Summary of Dodd-Frank Act

2011-01-04T22:02:00.000-08:00

We recommend an excellent and pithy summary of the Dodd-Frank Act that appears in the most recent issue of the Loyola Consumer Law Review.

The article is titled "The Wall Street Reform Act of 2010 and What it Means for Joe & Jane Consumer," by Cody Vitello.

The Dodd-Frank Act Has Changed The Definition of an "Accredited Investor"

2011-01-04T20:29:00.000-08:00

The Dodd-Frank Act has made a significant change to the definition of an "accredited investor." Under SEC rules (particularly Regulation D) an accredited investor is not entitled to the same protections as other investors in private offerings.

Before the enactment of the Dodd-Frank Act a person was considered an accredited investor under Section 501(a)(5) of the Securities Act if:

in each of the two most recent years he had income in excess of $200,000, or in excess of $300,000 jointly with a spouse, and had a reasonable expectation of reaching that same income level in the current year; or

he had a net worth, individually or jointly with a spouse, in excess of $1,000,000.

Section 413(a) of the Dodd-Frank Act adjusts this second standard by requiring that any calculation of net worth exclude the value of a person’s primary residence. Section 413(a) also requires that the person's net worth be reduced by any negative equity in the primary residence. For example, if the potential investor has a home worth $600,000, but with a mortgage on the home of $800,000 that potential investor would subtract $200,000 from his net worth.

Comment: this is an excellent change because it (a) reduces the number of accredited investors and (b) prevents an illiquid asset (a home) from counting in the definition of accredited investor. This is designed to protect investors.

The Dodd-Frank Act Has Expanded SEC Enforcement Powers

2010-12-29T20:44:00.000-08:00

The Dodd-Frank Wall Street Reform and Consumer Protection Act has significantly expanded SEC enforcement powers. All of the expanded powers are designed to give new protections to investors.

Previously, the SEC had the power to order a respondent to cease and desist certain activity. 1933 Act Section 8A. The SEC also had the power to file lawsuits seeking injunctive and other relief against market participants. 1933 Act Section 22. The Dodd-Frank Act has significantly expanded the SEC’s enforcement powers in several ways.

1. The Dodd-Frank Act amends Section 22(c) of the 1933 Act and Section 27(b) of the 1934 Act to allow the SEC and the United States to bring civil and criminal law enforcement proceedings involving transnational securities frauds. See Section 929Y of the Dodd-Frank Act. Thus, the holding of Morrison v. National Australia Bank, Ltd., 130 S.Ct. 2869 (2010) (holding that the securities law do not have extraterritorial application) applies only to lawsuits brought by private plaintiffs. 1933 Act Section 22(c).

2. Nationwide Service of Process in SEC Enforcement Actions.

The SEC now has the power to serve subpoenas nationwide in SEC enforcement actions. Previously, the SEC was limited to the subpoena power of the federal district court, which extends 100 miles. See 1933 Act Section 22(a); 1934 Act Section 27; Investment Company Act Section 44; Investment Advisers Act Section 214. For the SEC this is very important as it will allow the SEC to require a person who lives in California to appear at a trial in Illinois.

3. Aiding and Abetting Violations.

The Dodd-Frank Act authorized the SEC to bring claims and seek statutory penalties against persons who “knowingly” or “recklessly” aid and abet violations of the securities laws. See 1933 Act Section 15(b); Investment Company Act Section 48(b) and Investment Advisers Act Section 209(f). The Supreme Court has held that private plaintiffs may not bring aiding and abetting claims against lawyers and accountants (and others) who aid and abet a violation of the securities laws. The Dodd-Frank Act now allows the SEC to pursue such violations.

4. Cease And Desist Authority Expanded.

Under Section 8A of the 1933 Act, the Commission has broad powers to obtain a cease and desist order against anyone who has or may intend to violate the Securities Laws. The Dodd-Frank Act amended Section 8A to expand the Commission’s powers to seek and obtain cease and desist orders. Under the amended Section 8A(c)(1) the Commission has the power to issue a temporary cease and desist order when the Commission finds that “the alleged violation or threatened violation specified in the notice instituting proceedings pursuant to subsection (a), or the continuation thereof, is likely to result in significant dissipation or conversion of assets, significant harm to investors, or substantial harm to the public interest, including, but not limited to, losses to the Securities Investor Protection Corporation, prior to the completion of the proceedings.”

The respondent has an opportunity to seek judicial review of the temporary cease and desist order in the federal courts. See Section 9(a) of the Securities Act of 1933 as amended.

Subsection (g) now allows the SEC to assess civil penalties against market participants in connection with a cease and desist order. The SEC must find that the respondent (i) is violating or has violated any provision of thistitle, or any rule or regulation issued under this title; or (ii) is or was a cause of the violation of any provi sion of this title, or any rule or regulation thereunder; and (B) such penalty is in the public interest." The penalties increase with successive violations. Section 8A(g).

Under Section 15(b, “any person that knowingly or recklessly provides substantial assistance to another person in violation of a provision of this Act, or of any rule or regulation issued under this Act, shall be deemed to be in violation of such provision to the same extent as the person to whom such assistance is provided.”

Edward X. Clinton, Jr.

Civil Procedure - Requests To Admit - Illinois Supreme Court Rule 219(b)

2010-12-05T14:26:00.000-08:00

A recent decision by the Illinois Appellate Court for the Second District, in the case captioned McGrath v. Botsford, 2-09-0235, will prove useful in commercial cases.

Illinois Supreme Court Rule 216 allows one party to serve requests to admit on the other party. If the requests are not admitted or denied in 28 days, they are deemed admitted. "The purpose of a request to admit pursuant to Supreme Court Rule 216 is to enable the parties and the court to limit the issues and to reduce unnecessary production of proof at trial." The answering party has a "good-faith obligation to make a reasonable effort to secure answers to a request to admit, not only from the facts within its own knowledge but also from persons and documents within its reasonable control."

Under Rule 219(b), the court may award reasonable expenses including attorney's fees for the wrongful denial of requests to admit.

In this case, McGrath denied all of the requests to admit, but later lost at trial. Moreover, McGrath contradicted his denials in deposition testimony.

After the trial, Botsford moved, pursuant to Rule 219(b) for an award of reasonable attorney fees. The trial court denied the award.

The Appellate Court reversed. The Appellate Court found that the denials were unjustified and that the trial court had abused its discretion in denying fees.

To prevail on a Rule 219(b) motion, the moving party must show: "(1) proof of the truth of the matters asserted that were denied by the nonmovant; (2) that the nonmovant lacked good reason to deny the facts asserted; and (3) the materiality to the litigation of the facts as to which admissions were sought." Citing, Exchange National Bank of Chicago v. DeGraff, 110 Ill. App. 3d 145, 160 (1982).

This is an excellent cases for commercial litigators as it allows the recovery of attorney fees for the wrongful denial of requests to admit.

Edward X. Clinton, Jr.

Securities Law - Does Rule 10(b)(5) Have An Extraterritorial Effect?

2010-11-16T17:35:00.000-08:00

Respondent, National Australia Bank Ltd. (“National”), the largest bank in Australia, has its shares traded on the Australian Stock Exchange and on other foreign securities exchanges but not on any exchange in the United States. National bought the stock of HomeSide and operated it as a subsidiary. HomeSide’s business was to receipt fees for servicing mortgages. These services are a valuable asset and the more valuable it is, is a function of period in which the fees will be paid. HomeSide calculates the present value of the mortgage servicing rights by using a valuation model designed to take the likelihood of prepayment into account. In other words, if mortgages are prepaid, the service fees stop to the extent of such repayment.

From the allegations in the Complaint, it is alleged that National’s Managing Director and Chief Directing Officer plotted the benefits of National but it also alleged that they did not take into account the write-downs necessary because of prepayments.

In July 2001, National wrote down HomeSide’s assets by $450,000 million and then again on September 3, 2001 by another $1.75 billion. The shares dropped in value. These plaintiffs alleged that the executives manipulated HomeSide’s financial models to make the rates of early repayment unrealistically low in order to cause the mortgaging servicing rights to appear more valuable than they actually were. Two Australians purchased ordinary shares in 2000 and 2001 before the write-downs. They sued National and HomeSide in the United States District Court for the Southern District of New York for violations of §10(b) and §20(a) of the Securities Exchange Act of 1934, and Rule 10(b)(5). They sought to represent a class of foreign purchasers of National’s ordinary shares up to the September write-downs.
Plaintiffs, the Australians, according to the Complaint, invested based on false information. The Second Circuit held that the specific language of §30(b) does not show Congressional intent to preclude application of the Exchange Act to transactions regarding stock traded in the United States which are affected outside the United States.

The Supreme Court in an opinion by Justice Scalia stated that there is no affirmative indication in the Exchange Act that §10(b) applies extra-territorially and that “we, therefore, conclude that it does not.”

The Court further stated that it is our view that only transactions of securities listed under domestic exchanges and domestic transactions and other securities to which §10(b) applies. Thus, §10(b) reaches the use of a manipulative or deceptive device or contrivance only in connection with the purchase or sale of a security listed an American stock exchange and the purchase or sale of any such security in the United States.

Justice Stevens, with whom Justice Ginsberg joined, concurred in the judgment.

Justice Stevens stated that he took exception to the statements in the majority opinion that the decision rested on the construction of the statutory text. “I happen to agree with the result the court reaches in this case. But, ‘I respectfully dissent,’ once again from the Court’s continuing campaign to render the private cause of action under Section 10(b) toothless.

Edward X. Clinton, Sr.

Securities Law - Use of Insider Information

2010-11-11T11:38:00.000-08:00

The SEC on October 30, 2010 filed a complaint against Dr. Yves M. Benhamou in the U.S. District Court for the Southern District of New York (10-CV-8266 (DAB)) alleging that Dr. Benhamou engaged in insider trading by providing confidential non-public information to several hedge funds.

According to the Complaint, six healthcare related hedge funds sold about 6,000,000 shares of Human Genome Sciences, Inc. (“HGSI”) and at the time the portfolio manager of the hedge funds possessed material negative non-public information concerning a clinical trial of the drug Albumin Interferon Alfa 2-a (“Albuferon”, a drug to treat ashtma). Benhamou was an advisor to the portfolio manager of the hedge funds. Benhamou, a citizen and resident of France, was one of five members of the Steering Committee overseeing the Albuferon clinical trial.

According to the Complaint, in January 2008, HGSI announced that all patients who had been administered a higher dosage level of Albuferon in its clinical trial would be moved to the lower dosage level because of safety issues with the most recent clinical trial. The Complaint alleges that Benhamou learned this negative material non-public information about the drug as a member of the Clinical Steering committee which had negative implications for commercial potential and that Benhamou passed the negative information to the portfolio manager of the hedge funds before the announcement was made public. When the information became public, the market price of HGSI’s common stock fell about 44%.

The hedge funds sold about 6,000,000 shares of HGSI representing all of its holdings before the announcement and avoided a $30 million loss. The market price of the drug went down 44% after the announcement.

It is alleged that Benhamou communicated this negative information in violation of his duty as a member of the Steering Committee and that the portfolio manager of the hedge funds knew or should have known that Benhamou served on the Drugs Trial’s Steering Committee and owed a duty of confidentiality.

The SEC charged that Benhamou violated § 17(a) of the Securities Act of 1933 by (a) employing a device scheme or artifice due to fraud; (b) obtaining money or property by means of untrue statements of a material fact or omitting a material fact in order to make the statements made in the light of the circumstances under which they were made not misleading, or (c) engaging in a practice or course of business that operated or would operate as a fraud or deceit.

The SEC seeks a permanent injunction enjoining the Defendant from violating (a) § 20(e) and (b) § 21(d)(1) of the Exchange Act and (b) from violating § 17(a) of the Securities Act, and (c) § 10(b)(5) of the Exchange Act. The SEC seeks to have (a) Benhamou disgorge with prejudgment interest all illicit trading profits or losses avoided as a result of the conduct alleged in the Complaint, and (b) ordering the Defendant to pay civil penalties pursuant to Securities Act and the Exchange Act.
According to the Wall Street Journal, the Defendant was also charged criminally and was arrested in New York

Evidence - The Admissibility of Hearsay Statements By A Party Opponent

2010-11-03T21:14:00.000-07:00

HEARSAY: STATEMENTS BY THE AGENT OF A PARTY-OPPONENT

By
Edward X. Clinton, Jr.
The Law Offices of Edward X. Clinton, P.C.
30 North LaSalle Street, Suite 3400
Chicago, IL 60602

Statements by an agent of a party-opponent are under certain circumstances hearsay admissions of the party-opponent.

This article will describe how to introduce or resist the introduction of statements by a party's agent under Rule 801(d)(2)(D) of the Federal Rules of Evidence and will discuss the debate concerning whether the declarant must have knowledge concerning the underlying facts and the exception for statements by government agents. These issues often arise in personal injury and employment litigation.

Some recent cases suggest that it is becoming more difficult to obtain admission of a statement by a party opponent.

To review: Hearsay is an out-of-court statement by the declarant admitted for the truth of the matter asserted. Rule 801(c). Under Rule 801, admissions of a party-opponent are not hearsay. One type of admission by a party opponent is a statement by an agent of the party-opponent. According to Rule 801(d)(2)(D), a statement is not hearsay if it is offered against a party and was made by "the party's agent or servant concerning a matter within the scope of the agency or employment, made during the existence of the relationship." The rationale is that "an agent or servant who speaks on any matter within the scope of his agency or employment during the existence of that relationship, is unlikely to make statements damaging to his principal or employer unless those statements are true." Nekolny v. Painter, 653 F.2d 1164, 1172 (7th Cir. 1981), cert. denied, 455 U.S. 1021 (1982).

I. A Three Part Showing Is Required

To prove that a statement is admissible a party must make a three-part showing. The offering party must demonstrate (1) the existence of an employment or agency relationship "independent of the declarant's statement offered as evidence;" (2) that the statement was "made during the existence of the declarant's `agency or employment" and (3) that the statement concerns a matter within the scope of declarant's employment or agency relationship. Boren v. Sable, 887 F.2d 1032, 1038 (10th Cir. 1989). I will now discuss each requirement in detail.

II. Is The Declarant The Agent or Servant of the Party Opponent?

Under the Rule the proponent must first establish that the declarant is the agent of the party opponent. Whether Rule 801(d)(2)(D) applies depends on the relationship between the declarant and the defendant. Zaken v. Boerer, 964 F.2d 1319 (2d Cir. 1992), cert. denied, 113 S.Ct. 467 (1992). In employment litigation one employee may sue a colleague and attempt to introduce a hearsay declaration by another employee. It is not dispositive that both the declarant and the defendant work for the same employer. Id. at 1323. In Zaken, plaintiff alleged that she was fired by the defendant, the president of a corporation, on the basis of her pregnancy. She sought to introduce the hearsay statement of a company vice president that another employee was fired because she was pregnant. The declaration was admissible because the vice president was directly responsible to the defendant and was therefore the defendant's agent. Id. See also Boren v. Sable, 887 F.2d 1032, 1039 (10th Cir. 1989) (in a personal injury action against a co-employee the court excluded a statement by the shop foreman because he was not the agent of the co-employee). If the foundational requirements are met, it may not even be necessary to identify the declarant. Pappas v. Middle Earth Condominium Ass'n., 963 F.2d 534, 537-38 (2d Cir. 1992) (in slip and fall case the statement by an unidentified employee was admissible to show that the defendant was aware of an icy patch on a walkway).

It is possible for an attorney to be the agent of a party. See United States v. Harris, 914 F.2d 927, 931 (7th Cir. 1990) (defendant's former attorney's statements were admissible but the court noted that "the unique nature of the attorney-client relationship, however, demands that a trial court exercise caution in admitting statements that are the product of this relationship."); United States v. Brandon, 50 F.3d 464, 468 (7th Cir. 1995) (important policies "concerning the effective assistance of the counsel of one's choosing" must also be preserved). In Harris, the court found that the conflict between the attorney-client relationship and the rule was not serious because the former attorney did not represent the defendant at trial.

III. Was the Statement Made During the Existence of The Agency?

Next, the proponent must demonstrate that the statement was made during the existence of the agency or employment relationship. This requirement is straightforward and prevents the admission of statements made after the agency relationship terminated. See Blanchard v. Peoples Bank, 844 F.2d 264, 267 n.7 (5th Cir. 1988) (statement by former employee inadmissible because the employee was not employed by defendant when the statement was made); Corley v. Burger King Corp., 56 F.3d 709, 709 (5th Cir. 1995) (statement by manager of Burger King admissible to show he was acting within scope of employment when he was driving a car involved in an auto accident).

IV. Does The Statement Concern A Matter Within The Scope of The Agency?

The proponent must also demonstrate that the statement concerns a matter within the scope of the agency or employment relationship. The Rule does not require that the declarant "have authority to bind its employer," because few employers will authorize employees to make binding admissions in litigation. Big Apple BMW Inc. v. BMW of North America, Inc., 974 F.2d 1358, 1372 (3d Cir. 1992), cert. denied, 113 S.Ct. 1262 (1993); see also Advisory Committee Note to Rule 801(d)(2)(D); Woodman v. Haemonetics Corp., 51 F.3d 1087, 1094 (1st Cir. 1995) (same).

Courts analyzing this requirement apply a common sense approach to the scope of employment. In Nesbit v. Pepsico, Inc., 994 F.2d 703 (9th Cir. 1993), plaintiffs alleged that they had been terminated because of their age. At trial, plaintiffs introduced a statement by the defendant's senior vice president of personnel that: "We don't want unpromotable fifty-year olds around." Id. at 705. The district court held the statement inadmissible because plaintiffs failed to show that the vice president was acting within the scope of his employment. The Ninth Circuit conceded that the ruling was error, but found the error harmless because "the statement was very general and did not relate in any way, directly or indirectly, to the terminations of Nesbit or Selby." Id. It is readily apparent that a personnel manager's duties include hiring and firing. Thus, the manager's comments were within the scope of employment. See also Woodman v. Haemonetics Corp., 51 F.3d 1087 (1st Cir. 1995) (in ADEA claim, statements by a supervisor that new management wanted to bring in younger employees were admissible because the statements concerned matters within the scope of the supervisor's employment); EEOC v. Watergate At Landmark Condominium, 24 F.3d 635, 640 (4th Cir. 1994) (comments of members of condominium committees concerning age of employee were admissible in ADEA action because the members had input in the decisional process).

Where the declarant has nothing to do with employment decisions, the court will exclude the hearsay statement. In Staheli v. University of Mississippi, 854 F.2d 121 (5th Cir. 1988), the court excluded statements by a colleague of a professor who was denied tenure because the colleague was not involved in the tenure decision. At trial, the plaintiff sought to testify that an accounting professor told him that the university's chancellor was unhappy about an incident involving laboratory animals. The accounting professor's statements were excluded because he had nothing to do with the denial of tenure. The statement had no relationship to the scope of his duties for the school. Id. at 127.

What about the comments of an agent of a subsidiary? Can those statements be held to be admissions of the parent corporation? In Big Apple BMW, the court found that statements by an employee of BMW credit and leasing could be attributed to the parent corporation because the parent dominated the activities of the subsidiary. 974 F.2d at 1373.

V. Exception For Statements By Agents of the Government

The rule does not apply to government employees. United States v. Prevatte, 16 F.3d 767, 778 (7th Cir. 1994). According to the Seventh Circuit, the rationale for this exception is that "no individual can bind the sovereign." Id. at 779. In United States v. Kampiles, 609 F.2d 1233, 1246 (7th Cir. 1979), cert. denied, 446 U.S. 954 (1980), the court explained that "because the agents of the Government are supposedly disinterested in the outcome of a trial and are traditionally unable to bind the sovereign, their statements seem less the product of the adversary process and hence less appropriately described as admissions of a party." In criminal cases, introducing statements of other Government agents (say FBI agents) could prejudice the Government and require the Government to call additional witnesses to rebut the alleged statement.

One commentator has criticized this exception. See Edward J. Imwinkelreid, "Of Evidence and Equal Protection: The Unconstitutionality of Excluding Government Agents' Statements Offered as Vicarious Admissions Against the Prosecution," 71 Minn. L. Rev. 269 (1986). However, there appears to be no effort in the courts or in Congress to abolish the exception.

VI. Recent Caselaw – Statements Are Often Excluded Based on Other Evidentiary Rules.

In Keri v. Board of Trustees of Purdue University, 458 F.3d 620 (7th Cir. 2006), the Seventh Circuit affirmed a grant of summary judgment to Purdue University on Plaintiff’s racial discrimination claims. Plaintiff sought to admit the statements of two professors who had previously complained that “most students were not taught by black faculty.” Neither witness provided testimony on why plaintiff was not retained by the employer. The witnesses simply gave their opinions concerning the racial climate on campus.

The District Court excluded the statements on the ground that neither professor had any decision-making authority in the employment area and that the statements were not within the scope of their agency. Moreover, the statements were improper under Rule 701 which bars a witness from expressing an opinion unless the opinion is based on first-hand knowledge.

Similarly, in Williams v. Pharmacia, 137 F.3d 944 (7th Cir. 1998), the Seventh Circuit held that it was error (in a sex discrimination case) to admit statements of other employees who were also allegedly subjected to discrimination by a particular supervisor. As the court noted, the complaints made by the women did not fall within the scope of their employment. As the Court noted, “they were the subjects of the decisions; they did not make them.” There was no evidence that the declarants had any involvement in the decision to terminate the Plaintiff. See also Hill v. Spiegel, 708 F.2d 233, 237 (6th Cir. 1983).

In Mister v. Northeast Illinois Commuter Rail Road, 571 F.3d 696 (7th Cir. 2009), the Seventh Circuit affirmed a decision excluding statements of a party opponent on Rule 403 grounds, even though it disagreed with the District Court’s analysis.
Mister was a railroad employee who was injured when he slipped and fell. The Defendant’s inspector prepared a report which included a statement that another employee had falled the previous week at the same spot. The District Court excluded the statement because the investigator had no personal knowledge of the events described.

The Seventh Circuit held that there was no requirement that the declarant (the author of the report) have personal knowledge of the events. As the Court noted, the Rule “’simply requires that the statement be made by an individual who is an agent, that the statement be made during the period of the agency, and that the matter be within the subject matter of the agency.’” quoting Young v. James Green Mgmt., Inc., 327 F.3d 616, 621 (7th Cir. 2003). However, the Seventh Circuit held that it “was not improper” to exclude the report because the report appeared to be unreliable and it lacked precise factual statements.

Statements may also be excluded when they would act as improper expert testimony. In Aliotta v. National Railroad Passenger Corp., 315 F.3d 756 (7th Cir. 2003), the plaintiff was killed by a train. The District Court excluded the statements of a risk manager of the defendant, who stated that fast trains can cause vacuums that suck nearby people underneath their wheels. The testimony was excluded on the ground that it was scientific testimony that was unreliable under Daubert and Rule 702, which require the judge to determine if scientific testimony is relevant and reliable.

On appeal the Seventh Circuit agreed that the statements of the risk manager were classic statements by a party opponent within the scope of the agency. The Seventh Circuit held that the statements were properly excluded because they were improper expert or opinion testimony that was not based on the scientific method. As the court concluded, “we see no good reason why unqualified and unreliable scientific knowledge should be exempted from the expert evidence rules simply because the speaker is an employee of a party-opponent.” The holding of Aliotto that a statement that is an admission of a party opponent is not admissible because it is unfounded and unqualified expert testimony is highly significant. In my experience, lay witnesses often attempt to offer opinions that they are not qualified to offer.

VIII. Conclusion

In sum, Rule 801(d)(2)(d) is relatively straightforward and easy to apply to most factual situations. However, a party hoping to introduce a hearsay admission by an agent of a party-opponent should make sure that it can satisfy all three foundational requirements. As I have noted, Rule 801(d)(2)(D) can be of great significance in employment litigation, where employees may comment on a termination, and in personal injury suits arising out of injuries on the jobsite, where employees may witness the accident or corrective measures. Obviously, an employer desiring to protect itself from litigation should caution employees to refrain from commenting on terminations or other adverse employment actions.

Contract Law - An Oral Buy Sell Agreement Is Upheld

2010-10-20T22:58:00.000-07:00

The case captioned, Prignano v. Prignano, 2-09-0439, (Illinois Appellate Court, Second District) is significant in that it recognizes a vague oral buy-sell agreement between two brothers, one of whom had passed away.

George and Louis Prignano owned several businesses together. At some point they appear to have agreed the upon the death of either of them, the survivor would buy out the other's share of the business from his heirs, using the proceeds from three life insurance policies purchased for that purpose.

The brothers discussed the arrangement, purchased the insurance, but never formalized it with a written contract signed by both of them. The case is significant because George's widow, Nancy Prignano, met the burden of proving the existence of the agreement with testimony of third parties, the insurance policies and the draft buy-sell agreement. The Appellate Court affirmed a verdict in Ms. Prignano's favor, which essentially enforced the oral agreement. Louis obtained the entire business and George's widow, Nancy, obtained the insurance proceeds.

Comment: this case again shows the importance of documenting business relationships. All too often the undersigned learns of an "agreement" between two partners that was never documented. The agreement is often very difficult to prove up at a later date. Usually unsigned documents are not worth the paper they were printed on. The buy-sell area of the law is one in which timely legal advice is invaluable. Those who try to do it themselves inevitably suffer.

Securities Law - Recent Developments Concerning SEC v. Howey, 328 U.S. 293 (1946)

2010-10-20T22:22:00.000-07:00

SEC v. Howey, 328 U.S. 293 (1946) is one of the most important cases interpreting the securities laws.

The Defendants offered "units of a citrus grove development coupled with a contract for cultivating, marketing and remitting the net proceeds to the investor."

The SEC sued and alleged that the Defendants had failed to register the unit offering. The Defendants responded that they were not offering securities - rather they were offering the right to engage in citrus farming.

The Supreme Court held that the units were "investment contracts" under the Securities Law. 15 U.S.C. Section 77b(a)(1). The Court defined the investment contract as "a contract, transaction or scheme whereby a person invests his money in a common enterprise and is led to expect profits solely from the efforts of the promoter or third party, it being immaterial whether the shares in the enterprise are evidenced by formal certificates or by nominal interests in the physical assets employed in the enterprise." Id at 299.

The Supreme Court held that the interests in the citrus farm were investment contracts because the contracts were "an opportunity to contribute money and to share in the profits of a large citrus fruit enterprise managed and partly owned by respondents." Moreover, the purchasers were not seeking to own land. They hoped to obtain a return on their investment. As the Court noted, "all the elements of a profit-seeking business venture are present here. The investors provide capital and share in the earnings and profits; the promoters manager, control and operate the enterprise."

The holding of Howey is crucial to the operation of the Securities Laws. Without this holding, promoters could design investment contracts that would be exempted from regulation under the Act.

Recent Developments:

Two recent decisions have reaffirmed the long-standing principles set forth in Howey.

In Warfield v. Alaniz, 569 F.3d 1015 (9th Cir. 2009), the Ninth Circuit held that certain charitable gift annuities were investment contracts under the federal securities laws.

The promoter, Robert Dillie, sold charitable annuities that promised an investment return to investors during their lifetimes and gifts to charities when the passed away. The Foundation raised $55 million from investors. Unfortunately it was a Ponzi scheme and had no investments. Ultimately, the Foundation collapsed. A receiver was appointed to recover assets for the victims. The receiver filed a lawsuit seeking the return of commissions paid to agents who sold the charitable annuities. After a trial the District Court entered judgment in favor of the receiver and against the agents.

The agents appealed on the ground that the charitable annuities were not investment contract and, thus, not securities.

The Ninth Circuit rejected their arguments and affirmed the judgment. The Court held that the annuities were investment contracts because there was "(1) an investment of money (2) in a common enterprise (3) with an expectation of profits produced by the efforts of others."

The annuities were investments because the promoter promised a substantial return on the investment to the participants.

The second decision we will review is Liberty Property Trust v. Republic Properties Corporation, 577 F.3d 335 (D.C. Cir. 2009).

The Plaintiffs brought claims under the securities laws against the Defendant Republic that marketed certain limited partnership units.

The two main defendants controlled the defendant and, in exchange for limited partnership units, transferred a valuable contract to the limited partnership. Later, as a result of a scandal, that contract was terminated by city of West Palm beach. The limited partnership interests became worthless.

The Defendants argued that the limited partnership interests were not investment contracts because they were on both sides of the transaction (they owned the Defendant and some of the limited partnership interests.) The court held that the limited partnership interests were securities because two of the defendants "expected to profit from the efforts of [others]." The two defendants lacked sufficient control over the limited partnership, so they were clearly trying to profit from the work of other people.

In sum, the Howey decision remains good law and is as relevant today as it was in 1946.

Edward X. Clinton, Jr.

Does Illinois Permit Lawsuits By Those Who Merely "Hold" Securities?

2010-10-19T06:36:00.000-07:00

The United States Supreme Court in Blue Chip Stamps v. Manor Drugstores, 421 U.S. 723 (1975) held that investors injured by fraud may recover under the Federal Securities Law only if the deceit caused them to purchase or sell securities. In the Blue Chips case, the Supreme Court stated that states may supply the remedy when Federal Law does not. California has done so. It authorizes “holder actions” which are suits by investors who contend that the fraud caused them to hold their shares when they would have sold them had they known the truth. See, Small v. Fritz Companies, Inc., 30 Cal. 4th 167 (2003).

Plaintiff, Anderson, the holder of about 95,000 shares of Aon Corporation claimed in a U.S. District Court case that he would have sold his stock in Aon if he known earlier of fraud by the Company. When the financial information was discovered the stock dropped from about $69.00 a share to about $14 a share. Anderson’s claim was under the Illinois Securities Law and the District Judge held that the Illinois law supplies the rule of decision. Securities law in Illinois tracks federal law when the statutes use the same language, see Tirapelli v. Advanced Equities, Inc., 351 Ill.App. 3d 450, 455, 813 N.E. 2d 1138, 1142 (2004), which means that Illinois may follow the purchaser-seller rule of Blue Chip Stamps. The District Court concluded that the Plaintiff does not have a claim under Illinois law.

The Seventh Circuit in Anderson v. Aon Corporation, No. 09-1144 decided July 26, 2010, after sorting out various procedural maneuvers by plaintiff, in effect held that it was not clear if Illinois will permit holder actions, but it reversed the District Court that had dismissed Plaintiff’s complaint and remanded so that Plaintiff could pursue his claim.

Does Plaintiff have a holder claim under Illinois law? The final determination of this issue will await a trial.

Contract Law - Illinois Court Rejects Impossibility of Performance Defense

2010-10-05T20:31:00.000-07:00

The case captioned, YPI 180 N. LaSalle Owner, LLC, v. 180 N. LaSalle II, LLC, 1-09-1797, provides an interesting discussion of the impossibility of performance doctrine.

The Plaintiff was an assignee of a contract to purchase real estate. It argued that the 2008 financial crisis following the failure of Lehman Brothers made it impossible to obtain financing and therefore it was excused from performance.

The Court, like the trial court, rejected the rescission claim. The court noted that "Rescission is an equitable remedy that seeks to restore the contracting parties to their precontract positions." Opinion at 5.

The Court noted that "impossibility of performance as a ground for rescission of a contract refers to those factual situations where the purposes for which the contract was made have, on the one side, become impossible to perform." See 30 R. Lord, Williston on Contracts, Section 77:95 (2004). The court noted that the impossibility defense is limited "to the destruction of the means of performance by an Act of God, vis major, or by law" and that performance should only be excused in extreme circumstances. Seaboard Lumber Co. v. United States, 308 F.3d 1283, 1294 (Fed. Cir. 2002); Kel Kim Corp. v. Central Markets, Inc., 70 N.Y.2d 900, 902, 519 N.E. 2d 295, 296 (1987). More importantly, "where a contingency that causes the impossibility might have been anticipated or guarded against in the contract, it must be provided for by the terms of the contract or else impossibility does not excuse performance.

Here, Plaintiff's claim was rejected because it was foreseeable that a commercial lender might not provide the required financing to complete the real estate purchase.

Comment: this is a novel and creative attempt by the plaintiff's lawyer to rescind a real estate contract, but it did not convince the trial court or the Illinois Appellate Court. As the court noted, if the inability to obtain commercial financing, standing alone, were sufficient to excuse performance...., then the law binding contractual parties to their agreements would be of no consequence." The Court is correct, the Plaintiff could have negotiated for a financing contingency in the contract, but apparently failed to do so. Opinion at 10.

Edward X. Clinton, Jr.

Contract Law - Seventh Circuit Blocks An Attempt to Hold Shareholders Liable For Corporate Debts

2010-10-05T20:06:00.000-07:00

On August 2, 2010, the Seventh Circuit issued an opinion (written by Judge Easterbrook) in the case captioned Fusion Capital Fund II, LLC v. Richard Ham and Carla Aufdenamp, 09-3723, reversing a decision by Judge Shadur, holding that corporate shareholders could be liable for the corporation's debts.

The Plaintiff sought to collect a debt incurred by a corporation directly from the corporation's shareholders. The debt arose as a result of an ill-fated merger transaction.

Millenium Holding corporation was insolvent. However, it had previously gone public and its stock was tradeable. Another company, Sutura, Inc., sought to go public by merging into Millenium. As the Court noted, "Sutura wanted to go public without all the fuss and bother (and expense) of a registration statement and the release of audited financials." As a part of the merger agreement, Millenium agreed to raise $15 million in new capital. Later, Plaintiff Fusion and Millenium signed a contract and agreed to provide the $15 million.

When the merger with Sutura failed to close, Fusion "wrote to Millenium that the money would not be forthcoming." Sutura then terminated the merger agreement.
Fusion prevailed in contract litigation and later sued in the Northern District of Illinois to collect its legal fees incurred.

Fusion brought its claim against Ham and Aufdenkamp, Millenium's controlling shareholders. The District Court held that the Ham and Aufdenkamp were personally liable for the debt under Nevada law. The District Court ruled that Ham and Aufdenkamp became the "alter ego" of the corporation because (a) they influenced and governed it; (b) there was a "unity of interest" between the shareholders and the corporation; and (c) "adherence to the corporate fiction of a separate entity would sanction fraud or promote manifest injustice." Opinion at 4.

The Seventh Circuit agreed with the analysis with respect to the first two elements of the alter ego test. However, there was no fraud because Fusion was well aware - when it entered into the contract - that Millenium had no assets and was insolvent.

The Court reasoned that Fusion should have been aware that it could never enforce its contract (for the payment of legal fees) because Millenium was broke.

"When Millenium signed a contract promising to reimburse Fusion's legal expenses if litigation ensued, Fusion knew beyond a doubt that Millenium would be unable to keep that promise - unless the merger closed. Someone who wants to protect himself against the possibility that a thinly capitalized corporation will be unable to pay its debts asks the investors for a guaranty. It is feckless to do business with a corporation such as Millenium without one. Yet Fusion did not get a guaranty but also did not even ask for one....A business such as Fusion that neglects to arrange for payment if the worst comes to pass is not well positioned to seek judicial aid....Fusion wants to be protected from this asymemetry [the risk that Millenium would not be able to pay], but to get this protection Fusion should have negotiated for a guaranty and refused to deal if the Hams would not give one."

The Court distinguished the situation where the debtor is solvent when the contract is signed, but later siphons off its assets to avoid payment.

Comment: This is a thoughtful opinion that takes the polar opposite view of the District Court. It is a reminder to lawyers that anything can happen on appeal and that the underlying economics of a transaction are often far more persuasive than case citations and three-factor tests.

Edward X. Clinton, Jr.

Securities Law - A Rare Loss For the SEC

2010-09-30T12:49:00.000-07:00

A District Court case (Southern District Of New York) involves allegations of insider trading in violation of Section of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)-(5). The case is captioned SEC v. Nelson J. Obus, et. al., 06 Civ 3150, United States District Court for the Southern District of New York. The opinion was written by George B. Daniels, District Judge. The opinion can be found in the Pacer Systems. It is Document 77 and is dated September 20, 2010.

Following a SEC investigation, the SEC filed a Complaint alleging insider trading in violation of Section 10(b) and Rule 10(b)-5 against Tom Strickland, an employee of GE Capital Corp. The SEC alleged that Strickland tipped a friend, Peter Black, an analyst at Wynnefield Capital, about the potential acquisition of SunSource by a financial buyer. Black then, according to the SEC Complaint, passed the information to his superior, Opus, who purchased the stock of SunSource. The Court referred to the “Classical” and “Misappropriation” theories of insider trading.

Under each theory the SEC must prove five elements: (1) the tipper possessed material non-public information concerning a publicly traded company; (2) the tipper disclosed this information to the tippee; (3) the tippee traded in the company’s securities while in possession of the insider information; (4) the tippee knew or should have known that he tipper had violated a relationship of trust by providing the non-public material information and (5) the tippee benefited from the disclosure of the information. S.E.C. v. Warde, 151 F.3s 42, 47 (2d Cir. 1998). All of the Defendants filed a motion to dismiss the Complaint for failure to state a cause of action.

GE Capital sought to do business with SunSource. GE submitted a best effort proposal to provide 95 million dollars of financing in support of a potential buyer’s buyout of SunSource. Strickland was the front person for the GE underwriting team. Strickland learned that Wynnefield was an owner of SunSource stock and that his college classmate, Black, worked at Wynnefield. Following Strickland’s call to Black, Wynnefield purchased a block of SunSource Stock.

GE was subpoenaed by the SEC to testify pursuant to Federal Rule Of Civil Procedure 30(b)(6) about Strickland’s employment history. The GE employee testified that Strickland was trying to do some underwriting when he talked to his friend, Black.
The SEC based its insider trading allegations on the premise that by tipping Black about the impending SunSource merger, Strickland breached the fiduciary duty he owed to SunSource as a “temporary insider.” The District Court noted that neither Strickland nor his employer GE was a corporate insider of SunSource and that accordingly the classical theory of insider trading was not violated.

The Court said that the SEC cannot prove that GE or Strickland owed a duty of confidentiality to SunSource on the date of Strickland’s call to his friend Black and that summary judgment was rendered in favor or the Defendants in regard to the “classical” theory of insider trading.

The Court then considered whether the misappropriation theory applies when a person commits fraud in connection with the securities transaction. The Court concluded that Strickland engaged in no active deception. Such being the case the misappropriation theory did not apply.

Accordingly, the Court dismissed the SEC Complaint against all Defendants.

Securities Law - Verdict Upheld by Seventh Circuit

2010-09-29T10:38:00.000-07:00

RK Company sued Jackie R. See for violations of the Federal and State Securities Laws. The case is entitled RK Company v. Jackie R. See, No. 07-3984 decided September 22, 2010 by the Court Of Appeals for the Seventh Circuit.

The Seventh Circuit summarized the basis for the case as follows:

"Harvard Scientific Corporation and its founder Jackie R. See claimed to be developing a new product to treat male and female sexual dysfunction. Dr. See touted HSC's soon-to-be success in creating this product in a series of press releases and securities filings. This attracted an investment by RK Company..."

Plaintiffs invested $500,00 in Defendant’s LLC.

"Unfortunately, HSC's claims of success were not true, and following a bench trial, the court found Dr. See violated federal and state securities laws, state deceptive practices law, and committed common law fraud." The Seventh Circuit noted that the evidence showed that HSC's press releases included false statements and material omissions, "such as HSC's claims that the FDA had authorized clinical studies when it had actually suspended them..."

At trial, Plaintiffs sought damages equal to its investment of $500,000, prejudgment interest and attorneys’ fees. At trial, the plaintiff RK Company was successful. The opinion makes virtually no direct mention of the Securities Laws but rather discusses and rejects various claims of error by
Magistrate Judge Keys who presided.

Jackie See claimed to have a new product to treat sexual dysfunction of men and women. However, his company never received Federal Drug Administration approval and eventually went bankrupt. Defendant’s claim of FDA approval was false. The $500,000 investment by plaintiff was lost.

Following a bench trial, judgment was entered for plaintiff for the amount of the investment, prejudgment interest and attorneys’ fees.

The Seventh Circuit in an opinion by Judge Williams affirmed the ruling of the District Court. The Defendant claimed that the attorneys’ fees were excessive and that it had insufficient time to review the invoices. The invoices of the plaintiff’s attorney had been paid by his client which according to the Seventh Circuit was evidence of reasonableness. The Seventh Circuit noted that the Defendant received copies of plaintiff’s paid invoices on April 9, 2007 and had until August 2, 2010 to review and object to the invoices. The period of review was far in excess of the 15 days provided by the Local Rule.

A full victory for the Plaintiff.

Edward X. Clinton, Sr.

Securities Law - Mark Cuban Fouls Out!

2010-09-24T12:35:00.000-07:00

The SEC sued Mark Cuban, owner of the Dallas Mavericks and other businesses claiming that he wrongfully traded insider information in violation of § 17(a) of the Securities Act of 1933 and § 10 of the Securities Exchange Act by trading in the stock of Mamma.com in breach of his duty to the CEO of Mamma.com and Mamma.com amounting to insider trading under the misappropriation theory of liability. Cuban was a large minority stockholder of Mamma.com. In a telephone call from the CEO of Mamma.com, Cuban learned that Mamma.com was going to trade a public equity offering (PIPE). Cuban agreed in that call to keep the information confidential. Cuban then sold his stake in the Mamma.com to avoid losses from the inevitable fall in share price when the offering was announced. Cuban moved to dismiss.

The District Court found that the SEC Complaint alleged an agreement to keep information confidential, but did not include an agreement not to trade. The SEC appealed arguing that a confidential agreement creates a duty to disclose or abstain and that regardless the confidentiality agreement alleged in the Complaint contained an agreement not to trade on the information. (If interested, see our prior posts on this topic below).

The SEC alleges that Cuban’s trading constituted insider trading and violated Section 10(b) of the Securities Exchange Act. Section 10(b) makes it
unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . [t]o use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Pursuant to this section, the SEC promulgated Rule 10b-5, which makes it unlawful to
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

The Supreme Court has interpreted Section 10(b) to prohibit insider trading under two complementary theories, the “classical theory” and the “misappropriation theory.” The Cuban case involved the misappropriation theory.

The misappropriation theory rests on the principle that if a person violates Section 10(b) when he misappropriates confidential information for securities trading purposes, in a breach of a duty owed to the source of information. This theory was adopted by the United States Supreme Court in United States v. O’Hagan, 521 U.S. 642 (1997). In O’Hagan, the Supreme Court held that a lawyer who traded on confidential information misappropriated that information breaching a duty of trust and confidence he owed to his law firm and the law firm’s client.

The CEO of the Mamma.com was instructed to contact Cuban and to preface the conversation by informing Cuban that he had confidential information to convey to him in order to make sure that Cuban understood before the information was conveyed that he would have to keep the information confidential. Cuban agreed to keep the information concerning the PIPE offering confidential. At the end of the call, after learning about the offer, Cuban said “Well, now I’m screwed. I can’t sell.” Cuban then had a call with a sales representative of the proposed offering to get details of the offering. Following that call he immediately sold his entire stake in the company consisting of over six percent (6%).

The District Court found that the Complaint asserted no facts that reasonably suggest that the CEO intended to obtain from Cuban an agreement to refrain from trading on the information as opposed to an agreement merely to keep it confidential.

The Fifth Circuit held that it was entirely plausible that the CEO understood that in addition to keeping the information confidential, Cuban would not sell. Accordingly, the Fifth Circuit without taking a stand on whether the disclosure by the CEO was intended to restrict Cuban from trading would only be determined following further proceedings in the District Court. Accordingly, the motion dismissing the case was vacated and the parties can proceed with discovery, a summary judgment motion and a trial, if necessary.

Edward X. Clinton, Sr.
Copyright 2010

Seventh Circuit Approves Securities Class Certification in Conseco Case

2010-08-31T10:09:00.000-07:00

The United States District Court for the Seventh District of Indiana approved class certification for a class of Conseco Investors. (Later Conseco changed its name to CND Financial Group.) Defendant challenged the granting of class certification to the investor class and appealed to the Seventh Circuit in the case of Schleicher v. Wendt, et al., No. 09-2154 (decided August 20, 2010). The Seventh Circuit affirmed the decision to certify a class.

The Court states that class treatment is appropriate when issues common to class members dominate over those that affect them individually. Fed.R.Civ.P. 23(b)(3). The necessary elements under Rule 23(b)3 are: (1) whether the statements were false; (2) whether the false statements are intentional; (3) whether the stock’s price was affected, and (4) whether the magnitude of such effect shows that the false information was material.

The elements of a claim under §10(b) of the Securities Exchange Act of 1934 and the SEC’s Rule 10b-5 are falsehood in connection with the purchase or sale of securities, scienter, materiality, reliance, causation, and loss. Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005). Reliance usually shows how the false statements caused the loss. Until Basic Inc. v. Levinson, 485 U.S. 224 (1988), defendants tried to resist class certification by contending that each investor was bound to have received different information about the company, and that many investors would not have read the supposedly false statements at all. Thus it was argued that each investor’s fund of information differed from every other investor’s. But Basic concluded that the price of a well-followed and frequently traded stock reflects the public information available about a company.

The opinion discusses the fraud-on-the-market doctrine and states that when a statement that adds to the supply of available information that news passes on to each investor through the price of the stock. As stated, the price transmits the information and causes the change in the stock’s price. The approach supplants “reliance” as an independent element by establishing a more direct method of causation. When a stock trades in an efficient market, the contestable elements of Rule 10(b)(5) reduce to falsehood, scienter, materiality, and loss. Therefore, each investor’s loss can be established mechanically – common questions predominate and class certification is routine.

The Defendants mounted an aggressive and comprehensive defense. For example, the Defendants contend that before certifying a class, the District Court must determine that the contested statements actually caused material changes in stock prices.
Defendants also contended that even if the evidence shows scienter, materiality, causation, and loss, individual damages questions still predominate and prevent class certification.

Judge Easterbrook who wrote the opinion for the Seventh Circuit acknowledged the aggressive efforts of the defendants by stating “a more thoroughgoing challenge to class treatment of securities litigation is hard to imagine.”

In other words, the merits of the case must be proven to obtain class certification. As the Court stated, if the Defendants’ arguments were accepted, it would end the use of class actions in securities cases.

Defendants in effect contended that before certifying a class the district judge must first determine that the contested statements actually caused material changes in
stock prices.

The opinion points out that the fact that the Conseco stock was falling during the class period is irrelevant; fraud could have affected the speed of the fall. That is to say if a firm says it lose one hundred million when it actually lost two hundred million, then the announcement of the two hundred million will cause the price to continue to fall.

The Defendant’s contention that before certifying a class, a court must determine whether false statements materially affected the price, but whether the statements were false or whether the effects were large enough to be called material are questions on the merits. The Court expressly stated that the contention of Defendants that class certification is proper only when the class is sure to prevail on the merits, the opinion concluded that the chances, even the certainty that a class will lose on the merits does not prevent certification of the class.

In the writer’s opinion this case will be followed closely because there is a comprehensive review of the elements necessary for class certification and a rejection of various defensive arguments.

The lawyers for the plaintiffs were The Wagner Firm and the Law Offices of Brian Barry, Glancy Binkow & Goldberg LLP, among others and the lawyers for the defendants were Kirkland & Ellis, LLP, Baker & McKenzie, LLP and Barnes & Thornburg LLP, among others.

Edward X. Clinton, Sr.

Evidence - Admissibility of Business Records

2010-08-04T14:41:00.001-07:00

Obtaining the admission of business records is a often a critical component of any trial. It is a must in any business litigation and can cause problems if it is not carefully considered. Obviously, if you cannot obtain the admission in evidence of business records, such as invoices, you can't win even the most simple collection lawsuit.

Under Rule 803(6) if a document qualifies as a business record, it is not hearsay. The rule applies whether or not the declarant is available as a witness. The Rule presupposes that a business will have strong incentives to keep accurate records. Timberlake Construction Co. v. U.S. Fidelity and Guaranty Co., 71 F.3d 335 (10th Cir. 1995). I will discuss several recent decisions discussing the admission of business records.

I. The Rule

The Rule defines a business record as "a memorandum, report, record, or data compilations, in any form, of acts, events, conditions, opinions, or diagnoses, made at or near the time by, or from information transmitted by, a person with knowledge." Rule 803(6) is not limited to businesses. The Rule specifies that "the term 'business' as used in this paragraph includes business, institution, association, profession, occupation, and calling of every kind, whether or not conducted for profit." Rule 803(6).

A business record is admissible if it is "kept in the course of a regularly conducted business activity, and if it was the regular practice of that business activity to make the [record]." Id. A business record is not admissible where "the source of information or the method of circumstances of preparation indicate lack of trustworthiness." Rule 803(6).

The Ninth Circuit summarizes the Rule's requirements as follows: "a business record is admissible when (1) it is made or based on information transmitted by a person with knowledge at or near the time of the transaction; (2) in the ordinary course of business; and (3) is trustworthy, with neither the source of information nor method or circumstances of preparation indicating a lack of trustworthiness." The Monotype Corporation PLC v. Int'l Typeface Corp., 43 F.3d 443, 449 n.6 (9th Cir. 1994).

II. Regularly Conducted Business Activity

The key foundational inquiry is whether the document was prepared in the course of "a regularly conducted business activity." The document must concern business activity. In Hargett v. National Westminster Bank, 78 F.3d 836 (2d Cir. 1996), plaintiff, an african-american, was terminated from his position as an executive of the defendant bank after he allegedly retained a stripper to perform at an office meeting. Plaintiff alleged that he was terminated by reason of his race. At trial, he sought to introduce a handwritten note allegedly prepared by a co-employee of the defendant bank in which the co-employee admitted that he had procured the services of the stripper. The note was unsigned. The district court denied plaintiff's offer of admission because plaintiff could not establish a foundation for its admissibility as a business record. Indeed, it is hard to imagine that the letter was "a record of regularly conducted activity." Moreover, plaintiff could not offer testimony concerning when and where the handwritten letter was prepared.

The business activity must also be regular. In The Monotype Corporation, the defendant and plaintiff entered into a licensing agreement to allow plaintiff to distribute several of defendant's typefaces. Plaintiff developed several typefaces independently and began selling them to purchasers. Defendant claimed that plaintiff's typefaces were copies of its typefaces. Plaintiff sued to bar defendant from making such claims to plaintiff's customers, including Microsoft. At trial, defendant sought to admit a report prepared by an employee of plaintiff's customer Microsoft concerning the similarities in several typefaces sold by plaintiff and defendant. The report was not a business record because it was not Microsoft's regular practice to prepare such reports. Id. at 449-50 (also excluding an electronic mail message which was a one-time event).

III. The Chain Of Knowledge

The proponent must establish a chain of knowledge. According to Weinstein's Evidence, "Each participant in the chain producing the record -- from the initial observer-reporter to the final entrant -- must be acting in the course of the regularly conducted business." 4 Jack B Weinstein & Margaret A. Berger, Weinstein's Evidence P803(6) [04] (1994). In United States v. Warren, 42 F.3d 647 (D.C. Cir. 1994), the defendant was found in a room containing drugs and a handgun. The defendant sought to introduce a statement from a police report that two other occupants of the apartment were dealing drugs and carried handguns. The police report did not qualify as a business record because the defendant could not show that the report's author had personal knowledge concerning the activity of the other occupants of the apartment or had based the statement on information provided to him by a person with personal knowledge acting in the regular course of business. Id. at 656.

IV. The Custodian's Knowledge

The custodian of business records need not have detailed knowledge concerning who prepared a particular business record. The custodian need only show that he is "sufficiently familiar with the business practice" of the business and show that the record was made pursuant to that practice. Phoenix Associates III v. Stone, 60 F.3d 95 (2d Cir. 1995). In Phoenix Associates, the plaintiffs claimed that they had an oral contract with defendant. At trial, plaintiffs sought to introduce a record of a wire transfer to substantiate the claimed oral contract. Plaintiff's witness, its records custodian, testified that plaintiff's accounting department regularly compiled records of every wire transfer it received or issued. The district court denied plaintiff's offer of the exhibit on the ground that the records custodian worked for both the plaintiff and another company which made the wire transfer. The Court of appeals reversed. The custodian's source of employment was irrelevant "as long as his testimony can supply a sufficient foundation." Id. at 101. Moreover, the custodian was not required to demonstrate personal knowledge of the actual creation of the document. Nor was he required to identify the specific employee who prepared the document. The Rule required only that the proponent prove that the business entity's regular practice was to obtain the information from the person who created the document. Id.

V. Is The Document Trustworthy?

The Rule requires the court to determine whether the source of the information or the method or circumstances of the preparation of a document cast doubt on its trustworthiness. In Hoselton v. Metz Banking Co., 48 F.3d 1056 (8th Cir. 1995), plaintiffs, minority shareholders in defendant's business, claimed that defendants breached their fiduciary duties when they were excluded from a sale of the business to a third party. Notes taken by plaintiffs' accountant were properly admissible because they were prepared in the regular course of the accountant's activity. The notes appeared to be trustworthy because the accountant had professional duties to his clients which would give him strong motivation to make accurate notes. Id. at 1061.
Information provided by the customers of a business can create problems under the Rule because many businesses do not verify information received from customers. Such information may be admissible under Rule 803(6) if the proponent can show that "the business entity has adequate verification or other assurance of accuracy of the information provided by the outside person." United States v. McIntyre, 997 F.2d 687 (10th Cir. 1993), cert. denied, 114 S.Ct. 736 (1994). In McIntyre, the court listed two ways to demonstrate reliability: (1) proof that the business has a policy of verifying patrons' identities by examining their credit cards and other forms of identification; or (2) "proof that the business possesses 'sufficient self-interest in the accuracy of the [record]' to justify an inference of trustworthiness." United States v. Cestnik, 36 F.3d 904, 908 (10th Cir. 1994) (quoting McIntyre, 997 F.2d 687, 700 (10th Cir. 1993). In McIntyre, the court held it was improper to admit a hotel's guest registration cards because it was unclear whether the hotel had procedures to verify the accuracy of the cards. 997 F.2d at 701.

VI. Documents Prepared In Anticipation of Litigation

Documents prepared in anticipation of litigation are usually not admissible because they were not prepared in the regular course of business. Timberlake Construction Co., 71 F.3d 335; Fed. R. Evid. 803(6) Advisory Committee Note. In Timberlake Construction, the plaintiff claimed that the defendant insurer wrongfully denied insurance coverage. At trial, plaintiff introduced several letters written by plaintiff's president and by plaintiff's attorney containing legal conclusions claiming the existence of insurance coverage. The court of appeals reversed on the ground that the letters were written in anticipation of litigation and therefore did not fall within Rule 803(6).

However, an auditor's report prepared in anticipation of litigation may also qualify as a business record. In United States v. Frazier, 53 F.3d 1105 (10th Cir. 1995), the defendant was convicted of falsely describing his use of government funds on official forms. At trial, the Government admitted the report of a government auditor as a business record. The defendant objected that the report was prepared in anticipation of litigation. The court found that the report was trustworthy because the auditor prepared it pursuant to a contract with the government, the auditor had ten years experience in preparing that type of audit report and the auditor was a "neutral party" who had "nothing to gain" from litigation against the defendant. Id. at 1110.

VII. Laying A Foundation

The lawyer seeking to admit the business record must, however, lay a foundation that the record was, in fact a business record. A recent Seventh Circuit case discusses the requirement that a foundation be laid. In United States v. Adrianoros, 578 F.3d 703 (7th Cir. 2009), the Government obtained the admission of a summary of telephone and bank records of the illegal activity. The Government called a policeman to testify that he obtained records by serving a subpoena. The Government sought to admit the records under FRE 1006, which allows a party to present, and enter into evidence, a summary of voluminous writings, recordings or photographs. However, the Seventh Circuit held that the records were improperly admitted because there was no testimony to establish that the records were kept in the course of regularly conducted business activity and there was no certification by the custodian of the records. Thus, no foundation was laid and it was error for the district judge to admit the document in evidence.

A foundation must even be laid in the summary judgment context. The party seeking admission of the business record need not have secured the deposition testimony of the records custodian. The proponent of the document must establish sufficient indicia of reliability. Thanongsinh v. Board of Education, 462 F.3d 762 (7th Cir. 2006).

VIII. Specific Types of Documents

1. Laboratory Reports

It is well established that a laboratory report identifying a substance as a narcotic is admissible as a business record because such reports are routinely prepared by government lab technicians. United States v. Roulette, 75 F.3d 418 (8th Cir. 1996). Additionally, in Roulette, the defendant argued that under the Confrontation Clause, the government should be required to provide proof of the unavailability of the lab technician when admitting the report. The court disagreed reasoning that the exception to the hearsay rule was "firmly rooted." Id. See also Sherman v. Scott, 62 F.3d 136, 140-41 (5th Cir. 1995).

2. Computer Records

Computer business records are admissible if (1) they are kept pursuant to a routine procedure designed to assure their accuracy, (2) they are created for motives that tend to assure accuracy (e.g., not including those prepared for litigation), and (3) they are not themselves mere accumulations of hearsay." United States v. Hernandez, 913 F.2d 1506, 1512 (10th Cir. 1990), cert. denied, 499 U.S. 908 (1991). Computer records are thus treated no differently than other business records.

VIII. Conclusion

The business records exception is commonly used to admit documents which contain hearsay declarations. The rule presupposes that a business has strong incentives to keep accurate records. Thus, it is difficult to resist the admission of a business record, unless the record was prepared in anticipation of litigation or its trustworthiness can be legitimately questioned.

Securities Law - The Dodd-Frank Wall Street Reform and Consumer Protection Act

2010-08-02T15:30:00.001-07:00

The Dodd-Frank Wall Street Reform And Consumer Protection Act (the “Act”) is a massive revision of the way in which financial services are furnished. The Act was signed by President Obama on July 23, 2010.Many of the changes become law on the effective date. However, the Act promulgates various studies which could lead to other changes. Some changes may not go into effect but will become bogged down in contentious disputes. If control of Congress should change in November, some changes may never go into effect. The Act will cause a disruption in the way various issues are perceived.

Mayer Brown has published a complete summary of the Act. It was a massive undertaking. At least eight Mayer Brown lawyers worked on the summary.

The securities section of the Act sets forth a significant number of investor protection measures. Those sections of the Act dealing with Securities Law changes will be referred to as the “Amendments.” The Amendments require the SEC to conduct a six-month study of the need to impose a fiduciary duty on brokers providing personalized investment advice to retail customers. Various factors must be taken into account in determining the effectiveness of existing standards of care.

The Amendments establish within the SEC an Investment Advisory Committee composed of (1) an investor advocate who reports directly to the Chairman of the SEC, (2) a representative of State Securities Commissionaires, (3) a representative of the interest of senior citizens and (4) between ten and twenty additional members appointed by the SEC. The Committee has a responsibility of consulting with the SEC on regulatory priorities, the substance of proposed regulations and initiatives by the SEC to protect investors and promote investor confidence in the market.
The Chairman of the SEC will appoint an Investor Advocate to lead a new office within the SEC. An ombudsman will act as liaison between retail investors and the SEC in resolving issues with the SEC and/or the securities Self-Regulatory Organizations (“SRO”). The Chairman of the SEC is responsible to take action to address deficiencies identified by a report of investigation by the SEC.
The stock exchanges must, as directed by the SEC, enforce requirements in the Amendments for clawing back incentive compensation paid to executives mistakenly paid based on erroneous results later corrected and restated within three years of such payment.

The SEC must hire a consultant to study its operations and the possible need for reform of the agencies and furnish within 150 days a report to the SEC and Congress making legislative regulatory and administrative recommendations for improvement in the SEC.

The Controller General of the United States is to issue rules surrounding employees who leave the SEC for employment with regulated firms in the securities industry and report to the SEC and the House Financial Services Committee (“HFSC”) within one year of enactment of the Act.

The SEC must establish an Investor Protection Fund from revenues from certain sanctions. The Fund to be used among other things to pay whistle-blowers who provide original information in a SEC action.

The SEC will be authorized to make nationwide service of subpoenas of civil actions filed in federal court.

The Amendments change who qualifies as an “accredited investor”. These investors must now have $1 million excluding the value of their primary residence, whereas the old standard was simply a $1 million net worth.

The Amendments also authorize the SEC to limit or prohibit the mandatory predispute arbitration clauses that apply to most brokerage accounts. Such clauses force brokerage customers to take any disputes that may arise with their broker before arbitration panels, which critics claim often favor the brokerage industry, rather than taking their claims to court.

The Anti-Fraud provisions of the Federal Securities Laws were extended to apply to “conduct within the United States that constitute significant steps in the furtherance of a violation even if the securities transactions occur outside of the United States and involve only foreign investors.”

The Government Accountability Office (“GAO”) must report to Congress within one year regarding the potential consequences of authorizing a prior right of action against any person who aids or abets another person in violation of the Federal Securities laws. In other words, the new statute reverses the Stoneridge ruling. Stoneridge Investment Partners, LLC v. Scientific Atlantic, Inc., 522 U.S. 148 (2008). In Stoneridge, the U.S. Supreme Court held that those who aid or abet securities fraud are not liable.

Various changes regarding the regulation of credit rating agencies are prescribed. For example, the SEC must establish an office of credit ratings designed to administer the SEC rules applicable to Nationally Recognized Statistical Rating Organizations (“NRSRO). It can make exceptions for smaller NRSRO’s as it considers appropriate. At least two persons on the Board of Directors of NRSRO’s must be independent directors.
Not later than 270 days after the enactment of the Amendments, the SEC, Federal Reserve Board (“FRB”), Federal Deposit Insurance Corporation (“FDIC”) and (Office of the Comptroller of the Currency (“OCC”) must issue rules requiring a securitizer of an asset backed security (other than a residential mortgage-backed security) to retain at least 5% of the credit risk in any asset that the securitizer transfers or sells to a third party. The rules become effective two years after the final version is published in the Federal Register.

Executive compensation is to be revised as follows:

Effective six months after enactment of the Amendments, publicly traded companies must hold a non-binding vote to approve the compensation of executives who are among those disclosed in public filings pursuant to SEC rules (i.e., say-on-pay votes) at least once every three years, and a separate resolution must be offered at least once every six years for a vote to determine whether say-on-pay votes should occur every one, two or three years. Although a “no vote” is not binding, it would likely cause the Board of Directors to take some action to adjust compensation standards.

The Conference Committee also agreed to require these companies to provide a non-binding vote to approve golden parachutes (effective six months after enactment). Institutional investment managers subject to Section 13(f) of the Exchange Act must annually disclose how they vote on say-on-pay and golden parachute matters unless their votes are otherwise publicly reported under SEC rules. The Amendments place ultimate responsibility for compensation decisions for executives with the respective Compensation Committees, which must be comprised of independent directors and advised by compensation consultants, legal counsel, and other advisers who are independent as well.

The SEC is required to amend item 402 of Regulation S-K under the Securities Act to require companies to disclose the relationship between executive compensation and financial performance and the ratio between the CEO’s compensation and the median compensation of all other employees.

The SEC must issue a rule requiring publicly traded companies to disclose whether executives are permitted to hedge the value of any equity securities granted to such executives as compensation.

The SEC must conduct a study, and report to Congress within two years of enactment, regarding the use by publicly traded companies of compensation consultants.

The FRB, in consultation with the OCC and FDIC, has the responsibility of establishing standards making it an unsafe and unsound practice for the holding companies of depository institutions to pay compensation that is excessive or could lead to material financial loss to the holding companies.

There will be many 3 – 2 notes by the SEC with the Commissioners nominated by the democrats winning the contentious issues but only after delays and many dissents.

Securities Law - State Jurisdiction Issue

2010-07-20T11:20:00.000-07:00

STATE SECURITIES LAW - JURISDICTION

Bulldog Investors and its principal, operating a group of hedge funds, by offering an unregistered security through Bulldog’s website and an email to a Massachusetts resident violated the Massachusetts Uniform Securities Act. Bulldog and its principal officer Goldstein denied violating the Act and asserted that its actions were protected under the First Amendment and that personal jurisdiction was lacking. The Administrative Hearing Officer stated that he lacked authority to consider the constitutional question. Bulldog then proceeded to court to enjoin the Secretary of State’s enforcement action. In the meantime, the Hearing Officer continued the administrative proceeding and found that Bulldog and Goldstein made an offer of an unregistered security that was not exempt. The hearing officer’s finding consisted of a cease and desist order and a $25,000 fine.

Plaintiffs’ in the Superior Court, Bulldog Investors General Partnership, et al v. Secretary of the Commonwealth Of Massachusetts, SJC 10589 (07/02/2010) asserted that the Secretary of State lacked personal jurisdiction and filed a motion for judgment on the pleading. The Court concluded that personal jurisdiction was appropriate and denied Plaintiffs’ motion.

The Bulldog Firm appealed and contended that the maintenance of a website and the sending of this email to a Massachusetts resident was not sufficient contact with the Commonwealth to create personal jurisdiction. The Court agreed with the Secretary Of State that the Massachusetts Uniform Securities Act authorized the Secretary Of State to exercise personal jurisdiction over non-residents in an administrative proceeding. According to the Court, the purpose of the Act, was to protect Massachusetts residents from offers of unregistered securities directed at them from other jurisdictions, and that the Secretary Of State’s authority to conduct investigations outside the Commonwealth would be meaningless if it did not have the authorization to subject non-residents to enforcement proceedings. Plaintiffs’ rights to due process were not violated according to the Court because Plaintiffs availed themselves of the privilege of conducting business activities in Massachusetts and came within the reach of its laws.

The Appellate Court declined to consider the First Amendment argument because the issue had not been raised on appeal. The Court reaffirmed that Plaintiffs’ email message to a Massachusetts resident offering a non-exempt unregistered security was a violation of the Massachusetts Uniform Securities Act.

Bulldog, by sending one email, voluntarily subjected itself to the Massachusetts Uniform Securities Act.

This case is significant because it illustrates how a company can become subject to a state securities law.

Look for an appeal by Bulldog to the United States Supreme Court. Bulldog would argue that there were insufficient contacts to allow Massachusetts to assert jurisdiction over it.

Edward X. Clinton, Sr.

Securities Law - Noncompetitive Trading

2010-07-20T11:17:00.000-07:00

NON-COMPETITIVE TRADING

The United States District Court for the Northern District of Illinois froze the assets on records of a man who claims to be a Russia national after the Commodity Futures Trading Corporation (“CFTC”) charged him with trades on the Chicago Mercantile Exchange (“Exchange”) which were not competitive (CFTC v. Yunuso, N.D. Ill., 10-3619, Judge Bucklo). According to the CFTC, Yunuso controlled two firms: Open E Cry, LLC and Velocity Futures, LLC to enter a buy or sell contract for one of his accounts and then within seconds enter an opposite or equal quantity buy or sell contract for the other account. Because the commodities were thinly traded his orders were marketed against each other. Then Yunuso would enter orders to offset the initial position and complete an equal but opposite round turn trade for each account. His trading according to the Exchange resulted in more than $7.8 million in lawsuits and an approximate $7.2 million profit in the Velocity Futures, LLC account. At the end of the trading session, Yunuso had a debit balance of about $8,000 with Open E Cry, LLC and thus no money to cover the losses.

According to CFTC, Yunuso by consistently executing trades between the Open E Cry account and the Velocity account during periods of low volume, Yunuso in effect entered into transactions without intent to take a genuine bona fide position in the market.

The CFTC is seeking restitution, fines, a trading registration ban and a permanent injunction against Yunuso and his entities.

Securities Law - Illinois Securities Law Statute of Limitations

2010-07-01T20:33:00.000-07:00

This case is interesting because the plaintiffs abandoned claims under the Illinois Securities Law - to avoid a dismissal on the ground that the action was time-barred.

Plaintiffs in the case captioned Carpenter, et al. v. Exelon Enterprises Company, LLC, and Exelon Corporation, Appeal No. 1-09-1222 (4th Circuit), sued Exelon claiming that Exelon abused its position as majority shareholder of InfraSource in such a way that the rights of the minority shareholders were violated and not represented fairly in a merger and sale transactions.

Exelon filed a motion to dismiss on the grounds that it was barred by the three-year Illinois Statute Of Limitations. The trial court denied Exelon’s motion to dismiss determining that the Illinois Securities Law limitation period was inapplicable and plaintiffs’ suit was therefore timely filed within the residual five-year limitation period found in § 13-205 of the Code Of Civil Procedure. However, the trial court stayed the proceedings and certified the issue of the appropriate statute of limitations for an interlocutory appeal.

Exelon filed a motion to dismiss on the grounds that the Statute Of Limitations under the Illinois Securities Law of three years was applicable and the case should be dismissed. The Plaintiffs did not respond to the motion choosing to voluntarily dismiss their initial complaint and they refiled an amended complaint. In the amended complaint, the plaintiffs abandoned their Illinois Securities Law claims and proceeded under Delaware law instead.

The amended complaint contained additional allegations of the conduct of Exelon and contained an explicit statement that it purported to be brought under Delaware law and did not allege that defendants’ conduct constituted a violation of the Illinois Securities Law. Plaintiffs sought damages in excess of $11,000,000. Exelon again filed a motion to dismiss complaining, notwithstanding the changes in the amended complaint, that the manner for which relief was sought was still provided under the Illinois Securities Law and it was therefore barred by the three-year statute of limitations. The trial court disagreed and found that the suit was properly filed within the five-year limitation of § 13-305 of the Code. The trial court entered an order denying Exelon’s Motion To Dismiss but stayed further proceedings and certified the following question for interlocutory appeal, as the trial court found this issue involving the question of law upon which substantial ground for difference of opinion existed:
“Whether plaintiffs’ claim that Exelon Enterprises Company, LLC, as majority shareholder of InfraSource, Inc., breached its fiduciary duties in connection with InfraSource, Inc.’s 2003 merger transaction is governed by the three year statute of limitations contained in the Illinois Securities Law of 1953, 815 ILCS 5/13(d).”

The trial court granted Exelon’s petition for leave to appeal the interlocutory order of the trial court denying the motion to dismiss.

The trial court made reference to of § 13 of the Illinois Securities Law which delineates the private and other civil remedies available for violations of the Law. It pointed out that of § 13(A) provides that every sale in violation of the provisions of the Act is voidable at the election of the purchaser and that § 13(B) and § 13(C) outline various notice and mitigation requirements that a purchaser must fulfill before electing the option of rescission. Subsection 13(D) provides a three-year statute of limitation.

Exelon cited various federal cases which held that the Illinois three-year statute of limitation provided a bar to certain claims for relief. On the other hand, Plaintiff states that the claim is one of minority shareholder oppression and not covered by the Illinois Securities Law or the statute of limitations.

The Defendant, Exelon, argued that of § 13(F) and of § 13(G) provides injunctive relief as well as a right of rescission to “any party in interest”. The Court while acknowledging a contrary holding by a federal court in Klein v. George G. Kerasotes Corp., 500 F.3d 669 (7th Cir. 2007) held that plaintiffs were not barred by the three-year statute of limitations.

The Appellate Court held that the three-year limitation contained in of § 13 applies to relief under § 13 for which relief is granted by § 13. Section 13 provides only for (1) a retroactive right of rescission to purchase under subsection 13(A) and (2) a prospective remedy to the Illinois Secretary Of State and “any party in interest” under of § 13(F) and of § 13(G). Section 13 does not concern retroactive common law damage claims for breach of fiduciary duty both by sellers of securities in general or minority shareholders in particular. For the three year limitation contained in § 13(D) does not apply does not apply to claims of the plaintiffs against Exelon. Therefore the certified question is answered in the negative. Such being the case, the five-year of limitations applies and the case is timely.

Abandoning a claim for relief under the Illinois Securities Law was successful.

Securities Law - Statute of Limitations Merck v. Reynolds

2010-06-22T10:09:00.000-07:00

On April 27, 2010, the United States Supreme Court issued its decision in Merck & Co v Reynolds, 08-905. The issue was whether the plaintiff's claim was barred under the applicable statute of limitation. The Statute of Limitations for securities claims alleging fraud, deceit or contrivance is that the claim must be filed not later than 2 years after disclosure of facts constituting the violation or 5 years after the violation. 28 U.S.C. Section 1658(b).

There have been division in the circuits on when a claim accures and whether a plaintiff had to have notice of scienter. Scienter has been defined as a mental state embracing intent to deceive, manipulate, or defraud. Ernest & Ernest, .v Hochfelder, 425 U. S, 185. In a 10b-5 case the plaintiff must prove that a defendant made a material misstatement with intent to deceive, not merely innocently or negligently.

The case arose out of the controversy involving the drug Vioxx. The District Court held that the state of Limitations barred the claim because investors were placed on inquiry notice of the claim more than 2 years before they filed suit. Inquiry notice exists when the victim is aware of facts that would lead a reasonable person to investigate and consequently acquire knowledge of the defendants misrepresentations, Great Rivers Cooperative v Farmland Industries, Inc. 120 Fed. 3rd 893

In September 2001 the FDA released a letter that stated that Merck had misstated the safety of the drug. The District Court referred to various press articles to support that proposition because of the widespread adverse publicity the investors were on notice more that 2 years before the lawsuit was filed The Third Circuit reversed and said that was not sufficient t to establish inquiry notice. The Court also stated that Merck at about the same time issued notices describing the drugs safety.

The Supreme Court granted certiorari and said that a plaintiff was required to discover facts of scienter. It started with the statutory language that the limitations period begins to run once there has been discovery of facts constituting the violation and noted that scienter was both a fact and an element of a Sec.10 (b) 5 violation. The Court concluded that facts of scienter can be distinct from establishing that there has been a material misrepresentation because an incorrect prediction does not show whether the speaker deliberately lied or just made an in an innocent error. The Court held that the statute of limitations does not begin to run until the plaintiff discovers or a reasonably diligent plaintiff would have discovered facts constituting the violation. Thus, the plaintiff's claims were not barred by the statute of limitations.

The Supreme Court affirmed the decision of the Third Circuit to the effect that Plaintiff’s claim was not barred by the statute of Limitations.

The case is also interesting because the decision of the Supreme Court was unanimous.

Edward X. Clinton, Sr.
www.clintonlaw.net

Corporate Law - Agent Lacks Authority to Bind Company

2010-06-17T09:29:00.001-07:00

CORPORATE LAW - COURT HOLDS THAT PURPORTED AGENT LACKED AUTHORITY TO BIND CORPORATION TO SUSPICIOUS TRANSACTIONS WHICH WERE HARMFUL TO THE CORPORATION.

Herbert W. Fritzsche, et al. v. Gregory LaPlante and M. Christine Rock, 2-09-0329, Illinois Appellate Court Second District.

This issue raised in this case is whether or not a corporate officer had the authority to bind the corporation to some highly unusual transactions. The backstory is that the corporate officer was the daughter of the founder and President of the company and that she was apparently involved a feud with her siblings.

M. Christine Rock, acting as secretary/treasurer of a family corporation, Fritzsche Industrial Park (FIP) and as holder of a power of attorney for her father, Herbert W. Fritzsche, signed a lease agreement with her live-in boy friend, Gregory LaPlante. The lease named the Industrial Park as lessor and Gregory as lessee. The premises included 16 properties within the Industrial Park. Christine Rock owned 60 shares of a total of 1,000 shares that were issued and outstanding. Her father owned the majority of 685 shares. Christine Rock, at about the same time, also signed a promissory note in favor of Gerald Shaver in the principle amount of $450,000. The maker of the note was listed as Fritzsche Industrial Park and Park National Bank as Trustee under a Land Trust.

Plaintiffs, the corporation and other family members, filed this lawsuit alleging that Christine acted without Corporate authority and entered into the lease and note and without any authority as her father’s power of attorney in entering into the Lease Agreement. Because Christine refused to furnish records of rents and expenses, the shareholders informed her that she would be removed as Secretary/Treasurer. The suspect transactions were entered into after Christine learned that she would soon be removed as Secretary/Treasurer.

Plaintiffs filed a motion for summary judgment alleging that even if Christine had been the true Secretary/Treasurer of FIP and Herbert’s power of attorney, she still would not have had the authority to enter into the lease or the note. Plaintiffs allege that Christine did not have the authority to enter into the lease under either the common law or a statute. An affidavit was attached to the Plaintiff’s Motion For Summary Judgment which stated that at no time did the shareholders of FIP or the Board meet to vote on the lease or the note and that the Board never authorized Christine to act on behalf of FIP with regard to the lease or the note. Because there was no approval by the Board of Directors Ms. Rock lacked authority to cause the corporation enter into the lease or the note.

Ms. Rock and her boyfriend argued that Board approval and other corporate formalities were not required in order to allow Christine to execute the lease. Defendants stated that some of the properties included in the lease were not owned by Fritzsche but were owned by Herbert or some other member of the Fritzsche family and, therefore, corporate formalities were not necessary.

The trial court granted summary judgment for the plaintiffs - the corporation and Herbert W. Fritzsche.

Defendants appealed the grant of summary judgment. The Appellate Court affirmed the grant of summary judgment in all respects. The Appellate Court held that the Trial Court was correct in ruling that Christine did not have authority to enter into the lease or the note.

Under common law, the mere fact that a corporation has the power to make a certain type of contract does not, of itself, clothe even the highest officer of the corporation with the apparent authority to bind the corporation to such a contract. Corn Belt Bank v. Lincoln Savings & Loan Ass’n, 19 Ill.App. 3d 238, 245 (1983). Further, officers have no apparent authority to make unusual or extraordinary contracts on behalf of a corporation. Corn Belt Bank, 119. Ill.App. 3d at 245. “’If the president of a corporation were authorized to make contracts of this character without action of the directors and without notice to or knowledge of anyone, the directors would not at any time know whether it was headed for bankruptcy.’” Sacks v. Helene Curtis Industries, Inc., 340 Ill. App. 76, 91 (1950), quoting Warszawa v. White Eagle Brewing Co., 299 Ill. App, 509. Plaintiffs further argued that the Lease of the entire industrial park was an extraordinary transaction and that Illinois common law and its statutes prohibit an officer from entering into extraordinary and unusual contracts and/or contracts involving substantially all of the corporations assets, outside the ordinary course of business, without the board's consideration and approval.

The Court concluded that the Lease was an extraordinary transaction and, it implied, one that no rational corporation would approve. "Here, FIP/Christine transferred numerous properties contained int he Fritzsche Industrial Park to Gregory, a nonfamily member and a nonofficer/nonshareholder. The Lease does not specify Gregory's obligations to FIP's existing tenants. Although the Lease includes properties under trust, no trustees ever signed the Lease. Although the Lease involved 26 different properties (PINs), it seems no professionals, such as attorneys or realtors, were involved in drafting the Lease; defendants are the only signatories and/or witnesses to the Lease. Perhaps most strangely, the Lease seems to provide Gregory profit with little to no risk or investment. If he generates income, he pays a relatively small percentage of that income to the corporation; if he generates no income, he pays the corporation only taxes due to the government. As such, under common law, the Lease is the sort of transaction that would require authorization by the Board."

The Court also made specific reference to the Illinois Compiled Statutes, § 805 ILCS 5/11.55 which provides that where a sale, lease or exchange of assets involves, 'all, or substantially all, the property and assets ...of a corporation,' the board of directors must adopt a resolution recommending the transaction, whereupon said resolution shall be submitted to a vote by the shareholders at a meeting. § 805 ILCS 5/11.60(1).

The court held that the Lease essentially put the corporation out of business and, thus, was an extraordinary transaction.

In regard to the note that was executed, the Court made specific reference to Fritzsche’s by-laws entitled “Contracts, Loans, Checks and Deposits” which states “No loan shall be conducted on behalf of the Corporation and no evidence of indebtedness shall be issued in its name unless authorized by a resolution of the Board of Directors." Of course, the promissory note was never submitted to the Board for its consideration. The Court held that Christine was not permitted to bind the corporation by executing the note and that the note was void and unenforceable.

Thus, the Appellate Court found that Christine was not authorized to enter into the lease or make the note and, accordingly, affirmed the Trial Court’s grant of summary judgment to plaintiffs. The opinion contains a through discussion of corporate formalities and the need to comply.

Edward X. Clinton, Sr.

Securities Law - Wells Notice

2010-05-21T10:09:00.000-07:00

A Wells Notice advises a public company or a principal officer of a public company that the Securities & Exchange Commission is considering enforcement action because of some alleged violation of the Securities Laws. The company or individual is given a chance to respond and explain why enforcement action should not be brought. Not all Wells’ Notices lead to enforcement action. The term “Wells Notice” is named after Senator John Wells, who in 1972 chaired a committee to review SEC enforcement procedures.

Goldman Sachs received a Wells Notice in July 2009 in connection with the sale by Goldman Sachs of a synthetic collateralized debt obligation known as Abascus 2007-AC-1. The notice was not disclosed to shareholders or otherwise made public. Corporate lawyers believe that it depends on the facts whether a Wells Notice should be disclosed. Plaintiff’s lawyers generally take the position that such notices should be disclosed because they are material. In other words an SEC investigation has proceeded to the point that the staff is considering proceeding against the company or a principle officer. Two class actions have been filed so far against Goldman Sachs alleging, among other things, that the Wells Notice was concealed from investors.

According to an article in the Wall Street Journal dated April 10, 2010, five Senior Executives of Goldman Sachs Group Inc., including the firm’s co-general counsel, sold $65.3 million worth of stock after the firm received notice of possible fraud charges, which later drove its stock down 13%. There is no suggestion in the article that those executives had any knowledge of the Wells Notice.

The SEC has alleged in the well-publicized case against Goldman Sachs that the firm made misrepresentations and material omissions in the marketing in 2007 of a collateralized debt obligation known Abascus 2007 AC-1.

The public will learn much more about Wells Notices after there is further disclosures by either Goldman Sachs or the SEC.

Ira Schochet, a partner in the New York law firm of LaBaton, Sucharow LLP, responded to the argument that disclosing Wells Notices just repeats unproven allegations.
However, Schochet stated that if there is a substantial defense, issuers can disclose that as well. Schochet is also President of the National Associations of Shareholder and Consumer Attorneys, a group of about 100 law firms that represent investors and consumers.

Business Debts - The Bankruptcy Court Will Not Discharge A Debt Where The Underlying Loan Was Procured Through Fraud

2010-05-12T09:09:00.000-07:00

In Ojeda v. Goldberg, No. 09-2008, the Seventh Circuit affirmed a determination of the District Court (Judge Gottschall) that a debt was not dischargeable because the underlying loan was procured through fraud.

This case is of interest even to those who do not practice in the bankruptcy area as bankruptcy considerations often govern corporate transactions.

Facts:

The Goldbergs were creditors of Ernest and Beverly Ojeda. The parties executed a short-term high-interest-rate loan in August 1998. The Ojedas were unable to pay the principal when the loan came due. However, they obtained numerous extensions of the loan's maturity date until January 2006 when the Ojedas defaulted.

In February 2006, the Ojedas filed for bankruptcy. Gail Goldberg filed an adversary proceeding against the Ojedas seeking a declaration that the $600,000 loan was not dischargeable because it was procured fraudulently.

The Ojedas owned (through corporations) two McDonald's restaurants. The Ojedas later sold the McDonald's franchises.

When the loan came up for renewal, the Ojedas did not disclose to the Goldbergs that they had sold the McDonald's restaurants. The District Court held that the entire debt $600,000 should be exempt from discharge because the Ojedas led Gail Goldberg to believe that they still owned the McDonald's restaurants when they did not. In fact, the district court noted that the Ojedas continued to use the checkbook for the McDonald's restaurants to pay interest long after the restaurants were sold.

The Seventh Circuit, in an opinion by Judge Kanne, affirmed. The legal standard is as follows:

For a creditor to receive an exception from discharge under 11 U.S.C. Section 523(a)(2)(A), the creditor must show that (a) the debtor made a false representation; (b) that the debtor knew was false and was made with intent to deceive; (c) upon which the creditor justifiably relied.

The Seventh Circuit agreed with the Bankruptcy and District Court that the Ojedas had made false representations with the intent to deceive the Goldbergs. The more difficult question was whether Gail Goldberd had justifiably relied on the Ojedas representations that they still owned the McDonald's restaurants. As the Court noted, "justifiable reliance is a less demanding standard than reasonable reliance" and Ms. Goldberg met that standard.

The Court noted that the Ojedas continued to use checks bearing the McDonald's information. Unless the Plaintiff possessed outside information, "there was no conceivable way that [Ronald Goldberg] could have been alerted to the sale (of the restaurants) when the Ojedas continued to give the impression that the sale never occurred." In sum, the Seventh Circuit was satisfied that the sale of the McDonald's restaurants was concealed and that the Goldbergs justifiably relied on the misrepresentations.

The Seventh Circuit further held that "a fraudulently induced forbearance constitutes an extension or renewal of credit for purposes of Section 523." The Goldbergs met their burden of proving that the forbearance was fraudulently induced in that (a) they had valuable collection remedies at the time of the misrepresentation; (b) they did not exercise those remedies based upon the misrepresentation; and (c) the remedies lost value during the extension period." Opinion at page 13.

Comment: Clients often believe that filing bankruptcy will wipe away their debts. However, bankruptcy courts often scrutinize transactions to determine if they were fair to all parties. Here, the debtors' trickery (hiding the fact that two fast food restaurants were sold) proved to be their undoing.

Edward X. Clinton, Jr.

Securities Law - Statute of Limitations Decision - Merck & Co., v. Reynolds, 08-905

2010-05-03T14:37:00.000-07:00

SECTION 10(b)-5 STATUTE OF LIMITATIONS

The U.S. Supreme Court on April 27, 2010 has furnished clarity to the question of when does the statute of limitations begin to run § 10(b)-5 Securities lawsuits. Plaintiffs filed a securities fraud action under § 10(b)-5 on November 6, 2003. The District Court dismissed the complaint on the ground that the filing was not timely because the plaintiff should have been alerted to the possibility of Merck’s misrepresentation prior to November 3, 2001 because of a study (the VIGOR study) showing adverse cardiovascular results when the Merck Drug Vioxx was used. The applicable statues of limitations provides in part “private right of action involving a claim for fraud, deceit, manipulation or contrivance in contravention of a regulatory requirement concerning the securities laws … may be brought not later than the earlier of (1) two years after the discovery of facts constituting the violation; or, (2) 5 years after such violation. 29 U.S.C. § 1658(b)(1).

The Complaint alleged that Merck defrauded investors by promoting the drug Vioxx when it knew of the serious safety issues of Vioxx. In 1998, internal Merck clinical trials showed that serious cardiovascular events occurred six times more frequently in patents given Vioxx. Merck claimed that the plaintiff should have known more than two years before filing the Complaint and the District Court agreed.

The Third Circuit reversed and said that although there were storm warnings about the use of Vioxx, they did not put plaintiff on inquiry. Merck sought review in the United States Supreme Court because of disagreements in the Circuits.

Justice Breyer wrote the opinion of the Supreme Court which unanimously affirmed the decision of the Third Circuit. Judge Breyer in his opinion states that the parties and the Solicitor General agree that § 1658(b)(1)’s word “discovery” refers not only to plaintiff’s actual discovery of certain facts, but also to the facts that a reasonably diligent plaintiff would have discovered. The opinion discusses the use of the word “discovery” by various authors and by the Supreme Court itself. In Lampf, Pleva, Lipkind, Prupis & Petigrow v. Gilbertson, 501 U.S. 350 (1991), the court said that private sections under 10(b)-5 actions “must be commenced within one year after the discovery of the facts constituting the violation and within three years after such violation.” The opinion went on to state that the word “discovery” as used in the statute encompasses not only those facts the plaintiff actually knew, but also those facts a reasonably diligent plaintiff would have known.

The Court then considered and dismissed various arguments suggesting that plaintiffs had knowledge more than two years prior to the filing of its Complaint. The Court concluded that the limitation period in § 1658(b)(1) begins to run once the plaintiff did discover or a reasonably diligent plaintiff would have discovered the facts constituting the violation, whichever comes first.

In determining the time at which ”discovery” of those “facts” occurred, such terms as “inquiry notice,” and “storm warnings” may be useful to the extent they identify time when the facts would have prompted a reasonably diligent plaintiff to begin investigating. But the actual limitation period does not begin to run until the plaintiff thereafter discovers or a reasonably diligent plaintiff would have discovered “the facts constituting the violation,” including scienter, irrespective of whether the actual plaintiffs undertook a reasonably diligent investigation.

Judge Stevens wrote a concurring opinion and Justice Scalia wrote a concurring opinion joined by Justice Thomas.

A big defeat for Merck but important clarity when analyzing the § 10(b)-5 Statute Of Limitations.

Securities Law - Investment Company Act - Supreme Court Reverses Seventh Circuit And Follows Judge Posner's Dissent

2010-04-16T15:46:00.001-07:00

SUPREME COURT UPHOLDS POSNER DISSENT

On March 30, 2010 The United States Supreme Court unanimously reversed the Seventh Circuit Court Of Appeals in the case of Jones et al. v. Harris Associates, L.P. Harris Associates, No. 08-586. Harris Associates is a mutual fund case involving investment advisory fees that can be charged by an advisor to Oakmark, a captive mutual fund which Harris Associates organized. For about 30 years the principle set forth in Gartenberg v. Merrill Lynch Asset Management, Inc., 694 F. 2d 923, a Second Circuit case was considered the settled law. Gartenberg set forth two versions of a test to determine whether fees charged a mutual fund violates § 36(b) of the Investment Company Act of 1940: (1) whether the fee schedule represents a charge that was within the range of what would have been negotiated at arm’s-length in the light of all of the surrounding circumstances, and (2) to be guilty of a violation of § 36(b), the advisor must charge a fee that is so disproportionately large that it bears no reasonable relation to the services rendered and could not have been the product of arm’s-length bargaining.

In the United States District Court Judge Kocoras held that the fees charged were proper under the Gartenberg test and granted summary judgment in favor of Harris Associates. Plaintiffs’ mutual fund investors appealed to the Seventh Circuit, 527 F.3d 629 (May 2008). The Seventh Circuit in an opinion by Judge Easterbrook held that the Seventh Circuit disapproves the Gartenberg approach and stated that “a fiduciary must make full disclosure and play no tricks but it is not subject to a cap on compensation.” “The Trustees of a mutual fund, rather than a judge or jury, determine how much an advisory service is worth.” The judgment of the District Court granting summary judgment in favor of Harris Associates was affirmed.

The case then becomes even more interesting. There was a petition for rehearing. The panel voted unanimously to deny the petition. A Judge called for a vote on the suggestion for rehearing en banc but the majority did not favor such rehearing and it was denied. Judge Posner with Judges Rovner, Wood, Williams and Tinder dissented. Judge Posner wrote a dissent to the denial. The dissent quotes the Oakmark Prospectus and states “Subject to the overall authority of the board of trustees, [Harris Associates] furnished continuous investment supervision and management to the Funds and also furnishes office space, equipment and management personnel.” The Oakmark Fund, “Prospectus,” Jan. 28, 2008, p. 36. Recall Professor Kuhnen’s observation that “when directors and the management are more connected, advisers capture more rents and are monitored by the board less intensely.”

There now being a split in the Circuits, the Supreme Court granted certiorari. 559 U.S. ____ (2010). On March 30, 2010 Judge Alito wrote for the unanimous court and reversed the judgment of the Seventh Circuit. The Supreme Court concluded that Gartenberg was correct in its formulation of what § 36(b) requires: to face liability under § 36(b) an investment advisor must charge a fee that is so disproportionately large that it bears no reasonable relationship to the services rendered and it could not have been the product of arm’s-length bargaining. The Supreme Court stated that the Investment Company Act modifies fiduciary duty in a significant way: it shifts the burden of proof from the fiduciary to the party claiming breach, 15 USC, § 88-35(b)(1) to show that the fee is outside the range that arm’s length bargaining would produce.

Judge Alito went on to state that by focusing almost entirely on the element of disclosure the Seventh Circuit Panel erred. See, 527 F.32 at 632 (An investment provider “must make full disclosure and play no tricks but is not subject to a cap on compensation”). Judge Alito stated that although the Gartenberg standard may lack sharp and analytical clarity, it had provided a workable standard for nearly three decades. The judgment of the Seventh Circuit was vacated and the case remanded.
In the writer’s opinion, the reversal of the Seventh Circuit was important for another reason.

Had the ruling of the Seventh Circuit not been overturned businesses would argue in unrelated matters that accurate disclosure would justify other actions without further examination.

Edward X. Clinton, Sr.

Securities Law - Illinois Securities Law

2010-03-24T14:55:00.000-07:00

There has been much attention recently to the Securities Act of 1933 and the Securities Exchange Act of 1934. The actions and prosecution of Bernard Madoff increased interest.

The Illinois Securities Law (the “Act”) 815 ILCS 5, also merits attention because it is sometimes overlooked.

The Act is administered by the Secretary of State. It provides for remedies and attorneys’ fees for violations of the Act. Violations are set forth in Section 12 of the Act and remedies are described in Section 13. Section 13 also has to be followed carefully because it sets forth the procedures to pursue a remedy.
Section 12 provides generally that it is a violation of the Act to offer or sell a security except in accordance with the provisions of the Act. Violations include: (1) failure to deliver to a purchaser any security required to be registered without accompanying that security with a prospectus that meets the registration provisions; (2) failure to act as a dealer, sales person or investment advisor unless properly registered; (3) filing any document that is false or misleading, with respect to material fact, (4) engaging in any transaction which works or intends to work a fraud or deceit upon the purchaser or seller of a security; and (5) obtaining money through the sales of a security by means of an untrue statement of a material fact.
Section 13 of the Act provides that every sale in violation of the Act is voidable at the election of the purchaser. Persons who are liable are the insurer, controlling persons, underwriters, dealers or other persons who shall have participated or aided in the sale. Damages include the amount paid with interest from the date of payment. There must be a tender to the seller or tender to the Court of the securities sold. It the purchase prevails then the Court shall assess costs together with reasonable fees and expenses of the purchaser’s attorney.

There is a dual statute of limitations. First of all, a notice of election to rescind must be given within six months after the purchaser has knowledge that the sale is voidable. Notice is given served by registered or certified mail.

There is a three-year statue of limitations from the date of sale provided that if the person who brings the action knew or in the exercise of reasonable diligence should have known the violation. The three year period begins to run upon the earlier of (1) the date the person has actual knowledge, or (2) the date upon which the person bringing the action has notice of facts which in the exercise of reasonable diligence would lead to actual knowledge. The period is not extended in any event more than two years.

The Court also has the power on application by the Secretary of State when it learns that a person has engaged or is about to engaged in a violation to grant an injunction and if the proposed sale is determined to be unlawful the Court may assess costs against the defendant.

Therefore, although it is not widely understood, the Illinois Securities Law does provide several remedies including attorneys’ fees.

The Illinois Securities Law of 1953 was drafted by Samuel H. Young, former Republican Congressman for the Tenth Congressional District while he was acting as First Assistant Secretary of State. The Act of 1953 provided comprehensive investor protection including detailed provisions before securities could be offered or sold in Illinois.

During the reign of Jim Edgar as governor, the law was revised to remove many of the investor safeguards, particularly, in the area of the registration of securities. Mr. Young traveled to Springfield, Illinois at his own expense to testify before a House Committee to oppose the Edgar Amendments to the Illinois Securities Law. Unfortunately, he was not successful.

Edward X. Clinton, Sr.
Copyright 2010

Securities Law - Section 10b-5 Insider Trading

2010-03-24T14:52:00.000-07:00

Notwithstanding its incompetence in the handling of the Madoff Ponzi Scheme, the SEC can be thorough and aggressive, as indicated in the lawsuit filed by the SEC on March 11, 2010, SEC v. Berrettini and Pirtle, 1:10-cv-01614, in the U.S. District Court in the Northern District Court of Illinois.

In the Berrettini and Pirtle Complaint, the SEC charges both defendants with violations of Section 10b5. This Complaint also alleges that Pirtle, who tipped Berrettini, profited in the amount of $246,000.

Pirtle was an employee of a subsidiary of Royal Philips, a corporation organized in the Netherlands. Between 2001 and May 2006, Pirtle was employed as Director of Real Estate for Phillips Electronics North America, a wholly- owned subsidiary of Philips. Berrettini was a real estate broker with offices in Park Ridge, Illinois and a resident of Lake Forest, Illinois. The Complaint alleges, among other things, that Berrettini on 17 occasions transferred money to Pirtle which Pirtle described as loans, but according to the SEC they were kickbacks for confidential information furnished to Berrettini by Pirtle. The SEC Complaint gives several examples of the improper transfer of information to Berrettini by Pirtle in violation of his duties to his employer, Philips.

The Complaint alleges that Pirtle on several occasions misappropriated insider information from his employer Philips and provided it to Berrettini with the intent to enable Berrettini to trade on the information.

According to the Complaint, the improper activities started with an alleged joint venture between Berrettini and Royal. Eventually an agreement was reached to settle a dispute between Berrettini and Pirtle. Apparently that agreement was documented in a written agreement signed by Pirtle and Berrettini. Shortly after the agreement was signed, Berrettini bought a $36,000 car for Pirtle and sent him $15,000 allegedly for a gambling trip to Las Vegas.

According to the Complaint, Pirtle tipped Berrettini of three acquisitions of public companies. Berrettini in each case allegedly bought stock in advance of the public announcement of the acquisitions.

The SEC in its prayer for relief seeks a permanent injunction enjoining Pirtle and Berrettini from further violating Section 10(b) of the Exchange Act and Rule 10b-5 and to order the defendants Pirtle and Berrettini to pay to the Commission disgorgement of Berrettini’s ill-gotten gains from the alleged illegal trading, prejudgment interest and to order Pirtle and Berrettini to pay civil penalties pursuant to Section 21(A) of the Exchange Act in the amount of three times Berrettini’s ill-gotten gains resulting from the alleged illegal trading.

The Defendants have not as yet had the opportunity to respond to the Complaint by the SEC.

In conclusion, this is a thorough well-prepared Complaint by the local Branch office of the SEC in Chicago.

Special Note

The SEC alleges in the Complaint that its investigation is not complete.

Edward X. Clinton, Sr.
Copyright 2010

Securities Law - Section 10b-5 and Investment Company Act

2010-03-09T13:21:00.000-08:00

An important § 10b-5 case was decided by the Second Circuit on February 16, 2010. Operating Local 649 Annuity Trust Fund and certain individuals as class plaintiffs vs. Smith Barney, LLC et al., (Second Circuit, Docket No. 07-5125-cv). The main plaintiff, Local 649, purchased shares in 105 mutual funds sponsored and managed by affiliates of Citigroup. Plaintiffs claimed violations of § 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 and breaches of fiduciary duty in violation of § 36(b) of the Investment Company Act of 1940. The affiliates of Citigroup included Smith Barney, Citigroup Global Markets (CGMI) and Citigroup Asset Management (CAM).
The main question was, did Smith Barney negotiate a contract for transfer services that saddled the Funds with excessive fees, a portion of which were for kickbacks to Smith Barney?

An outside contractor, First Data, had provided transfer agent services for the Funds. These services included calculating daily asset values, share prices and commissions, distributing proxies and certain accounting functions. CAM disclosed the total fees paid in Fund Prospectuses. At some point, it was decided to renegotiate the contract with First Data. CAM organized a new subsidiary CTB which contracted with the Funds to provide transfer agent services and then CTB contacted with First Data to provide most of the same services at a much lower rate. That negotiation resulted in a subcontract with First Data in a “side letter.” CTB charged the funds more in transfer agent fees than it paid First Data. It kept the money, which would later be argued belonged to the Funds.

The important aspects were concealed from the Funds’ Board of Directors. The Board was told that the goal of the new contract with CTB was to reduce fees and promote future growth.

CAM concealed its scheme from investors. The fees were disclosed in Funds prospectuses but CAM did not disclose that the transfer agent, CTB, would perform only minimal functions, but would pocket the difference between what it charged the Funds
and what it paid for its data.

A whistleblower reported to the SEC about CAM’s failure to disclose the arrangement to the Funds’ Board. Three months later CAM issued supplements to the Funds’ Prospectus disclosing the existence of the side letter and disclosing that CAM had not informed the Funds’ Board at the time of the transfer agent contract. The SEC investigated the violations of the Investment Company Act. According to the SEC the effect was to provide CTB with pre-tax revenues of approximately $100 million, offset by expenses of $10.5 million and to funnel to CAM $17 million in additional revenue. The SEC settled with Smith Barney and CTB who agreed to pay $200 million in fines and to disclose the process generated by the scheme. Various lawsuits were filed after the public disclosure of the SEC action and settlement. They were consolidated into the subject case. The District Court granted defendants’ motion to dismiss the Complaint, holding that the mischaracterization of the fees paid to CTB as transfer agent fees was not a false material representation under § 10(b).

The District Court also dismissed Local 649’s § 36(b) claims on the grounds that such a claim can only be brought derivatively. The Second Circuit said that the District Court dismissed Local 649 § 10(b) claims because it concluded that when an advisor discloses a total amount of fees paid by a fund for various services neither the fees allocation nor the transfer agent profit margin is material and that the amount of fees is relevant to the price of value and finding that an investor who knows the amount of fees the Funds pays can, when deciding to invest, compare the fees to those of its competitors. Because the total amount of fees was disclosed, plaintiffs were in possession of all material information and that “it is the amount of fees, not their allocation or a transfer agent’s transfer profit margin that is relevant to the price and value of the Funds.”

The Second Circuit pointed out that although a statement may be literally true, if susceptible to another interpretation by a reasonable investor, it may properly be considered a material misrepresentation. The determining factor is that for a fact to be considered material, there is substantial likelihood that a reasonable investor would consider it important in deciding whether to buy or sell shares.
Plaintiffs argued that the defendants’ misrepresented the services that CTB performed because investors were not told that CTB was limited to operating a small call center, that First Data would provide the majority of the services or that First Data would charge only a fraction the fees that would be drained from the Funds. Accordingly, the Court held that CAM’s misrepresentations were material and that a substantial likelihood existed that a reasonable investor would view them as significant alterations of the total mix of information available. The Court also stated that CAM acting through investment advisor Smith Barney owed a duty of uncompromising fidelity and undivided loyalty to the Funds’ shareholders. The Defendants had an obligation to negotiate the best possible arrangement for the funds. In addition, they were obligated to disclose candidly to shareholders the material features of the arrangements they crafted. The Defendants’ misrepresentations were material because there was a substantial likelihood that a reasonable investor would consider it important that its fiduciary was in essence receiving kickbacks.

The Court concluded that the dismissal by the District Court of Local 649’s Section 36(b) claim under the Investment Company Act was proper. Such a claim must be plead derivatively on behalf of the funds with damages going to the Funds rather than directly to the shareholders.

The dismissals of Local 649’s claims under 10(b) and Rule 10b-5 were vacated and remanded while the ruling by the District Court of Local 649’s claims under § 36(b) were affirmed.

Special Notes

1. There are clear similarities between the Local 629 case and Judge Easterbrook’s decision in Jones et al v Harris Associates, L.P., 527 F.3d 629 (May, 2008) described in the Clinton Firm Blog dated September 24, 2009. In the Jones case, Judge Easterbrook said courts should not second guess the setting of fees. The U.S. Supreme Court has granted certiorari in the Jones case. If the Supreme Court affirms the Jones case it, on application, may order a remand of the Second Circuit case for reconsideration of the Local 629 case.

2. It is also interesting that the SEC paid serious attention to the whistleblower in the Local 649 case, but failed in the Madoff case to follow up with careful analyses.

Securities Law - Illinois Securities Law

2010-03-09T10:32:00.000-08:00

Can holders of securities seek damages based on a claim that they retained a stock in a corporation based on a fraudulent financial report?

Murphy Finance Corp. was a consumer finance company engaged in the purchasing of individual installment sales contracts from automobile dealers. KPMG was the accounting firm that audited the Mercury reports. In 1997, Mercury publicly reported that the financial reports from 1993 to 1996 had been overstated due to accounting errors. The New York Stock Exchange suspended trading and the Mercury stock dropped from $14.87 to $2.12 per share.

Plaintiffs filed a class action against Mercury’s chief executive officers and directors and KPMG alleging negligence, breach of duty and common law fraud. Mercury was later dismissed and filed for bankruptcy protection. The trial court eventually dismissed plaintiff’s fourth amended complaint on the ground that plaintiff could not allege any damage that was approximately caused by KPMG’s misrepresentations.
The Appellate Court in the case of Dloogathi and others similarly situated v. KPMG, et al., No. 1-08-0168, decided December 16, 2009, stated initially that no court in Illinois had decided whether holders of securities even have a cognizable claim based on common law fraud.

The U.S. Supreme Court considered whether a private cause of action exists for holders alleging violations of SEC Rule 10b-5, where they have neither purchased nor sold any shares. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). The Supreme Court in Blue Chip refused to recognize such a claim. The Appellate Court stated that although Blue Chip Stamps concerns the viability of a holder claim for violations of federal law and not common law fraud, the United States Supreme Court’s reasoning for prohibiting such a cause of action is relevant to the present case. In Blue Chip Stamps the Supreme Court stated in part:

“The manner in which the defendant’s violation caused the plaintiff to fail to act could be as a result of the reading of a prospectus, as respondent claims here, but it could just as easily come as a result of a claimed reading of information contained in the financial pages of a local newspaper. Plaintiff’s proof would not be that he purchased or sold stock, a fact which would be capable of documentary verification in most situations, but instead that he decided not to purchase or sell stock. Plaintiff’s entire testimony could be dependent upon uncorroborated oral evidence of many of the crucial elements of his claim, and still be sufficient to go to the jury.

* * *

The very risk in permitting those in respondent’s position to sue under Rule 10b-5 is that the door will be open to recovery of substantial damages on the part of one who offers only his own testimony to prove that he ever consulted a prospectus of the issuer, that he paid any attention to it, or that the representations contained in it damaged him.” Blue Chip Stamps, 421 U.S. at 746 (1975)

The Appellate Court stated that they have found no case throughout the United States that directly supports a “holder” claim such as in the case of the plaintiffs, owners of Mercury Finance Stock.

The Appellate Court concluded that plaintiffs failed to adequately plead both reliance and damages and, therefore, failed to state a cause of action upon which relief could be granted. Thus, the principle decided in Blue Chips was upheld in Illinois.

One Justice concurred in part and dissented in part. Justice Murphy stated that he would hold that a “holder” cause of action exists in Illinois quoting § 525of the Restatement Of Torts that provides, “One who fraudulently makes a misrepresentation of fact, opinion, intention or law for the purpose of inducing another to act or to refrain from action in reliance upon it, is subject to liability to the other in deceit for pecuniary loss caused to him by his justifiable reliance upon the misrepresentation.” Judge Murphy did agree with the portion of the Appellate Court opinion that plaintiffs failed to plead reliance on the false statements.

The writer agrees with the majority opinion that plaintiff failed to state a claim upon which relief could be granted.

Edward X. Clinton, Sr.
Copyright 2010

Securities Law - Should Congress Enact Legislation Allowing Those Who Aid And Abet Securities Law Violations To Be Held Liable?

2010-02-18T09:32:00.000-08:00

A recent survey was distributed by Opinion Research Corporation to determine if investors in securities markets should have additional rights. About 1,000 people responded. Seventy-four percent (74%) stated that there should be additional rights to seek redress for losses as a result of corporate wrongdoing. Ninety percent (90%) believe that those who participate in financial fraud such as knowingly engaging in sham transactions should be held accountable to investors.

The President of the National Association Of Shareholder And Consumer Attorneys, Ira Schochet, in a press release stated, “America must understand that Congress and the Administration must substantially increase accountability in our financial markets in order to protect investors and reduce the likelihood of systemic crisis.” Schochet, a partner in the New York law firm of Labaton Sucharow, is an experienced securities class action lawyer. Schochet also stated that the survey results show an overwhelming support for Congress to restore liability for those who aid and abet securities fraud and for those who manipulate public disclosures. Schochet said that Congress can accomplish these goals in part by reversing the principles set forth in Stoneridge Investment Partners, LLC v. Scientific-Atlantic, Inc., 522 U.S. 148 (2008) and Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) In Stoneridge, the U.S. Supreme Court held that those who aid and abet securities fraud are not liable. In that case, customers and suppliers of a cable company helped Stoneridge inflate its revenue by engaging in sham transactions to mislead the issuers’ auditors. The U.S. Supreme Court held that because the customers and suppliers owed no duty to the investors, they were not primarily liable for the fraud.
In Central Bank the U.S. Supreme Court held that the delay in updating an old land appraisal until after a closing was aiding and abetting unlawful conduct but did not give rise to primary liability under Section 10(b)(5). Specifically, the Court stated at p. 179: “[f]rom the fact that Congress did not attach private aiding and abetting liability to any of the express causes of action in the securities Acts, we can infer that Congress likely would not have attached aiding and abetting liability to § 10(b) had it provided a private § 10(b) cause of action.”

Senator Arlen Specter recently introduced legislation to give litigants a cause of action against aiders and abettors of securities fraud. Senator Specter recommended that the Securities Exchange Act of 1934 be amended to provide for private civil actions. Specter also stated that fraud involving companies such as Enron, Refco, Tyco and Worldcom have shown that secondary actors such as lendors, bankers, business affiliates and lawyers actively participate on occasion in actions that enable securities fraud. He went on to make reference to a decision by United States District Court Judge, Gerald Lynch in In re Refco Inc. Sec. Litig., SD NY No. 1-05-CV-08628 (March 2009) in which Judge Lynch suggested Congress reexamine the aiding an abetting issue. The Refco case involved a securities class action against Chicago law firm Mayer Brown LLP over its alleged role in the Refco fraud. The claims against Mayer Brown were dismissed.

Judge Lynch stated that:
“While the impulse to protect professionals and other marginal actors who may too easily be drawn into securities litigation may well be sound, a bright line between principals and accomplices may not be appropriate....There are accomplices and there are accomplices … some civil accomplices are deeply and indispensably implicated in wrongful conduct.”

The U.S. Better Business Bureau quickly issued a statement opposing the proposed legislation. Doubtless the proposed legislation will be opposed by the Republican members of the senate.

Securities Law - SEC Appeals Adverse Mark Cuban Ruling

2010-02-09T12:51:00.001-08:00

Earlier this year, see below entry of September 18, 2009, the Northern District of Texas dismissed the SEC’s complaint, alleging insider trading, against Mark Cuban the colorful owner of the Dallas Mavericks basketball team. The undersigned respectfully disagrees with the ruling of the District Court, as does the SEC.

Mamma.com, a public company decided to have a public offering of common stock. A few days before the public announcement, the CEO decided to call Mark Cuban, a 6% stockholder of Mamma.com to determine if he wished to buy stock in the offering. Before telling Cuban, the CEO asked Cuban to keep the information confidential and Cuban agreed. When Cuban learned from the CEO of the common stock offering, he said he was not in favor of the offering because it would dilute current stockholders and said “Well, now I’m screwed. I can’t sell.” A couple of days later Cuban sold his entire 6% holding of common stock. By selling, Cuban avoided a loss of Seven Hundred Fifty Thousand Dollars ($750,000.00). Cuban did not inform Mamma.com that he was going to sell his stock.

The SEC filed a civil law enforcement action charging Cuban with claims under Section 21(d), 21(e) and 27 of the Securities Exchange Act of 1934. Cuban filed a motion to dismiss on the grounds that he did not agree he would not sell.

The District Court granted the motion to dismiss and the SEC appealed to the Fifth Circuit. The SEC argues in its brief on appeal that Cuban misused confidential information in a breach of a duty established by the United States Supreme Court in U.S. v. O’Hagan, 521 U.S. 642 (1997), which adopted the misappropriation theory of insider trading. Under that theory a person commits fraud “in connection with a securities transaction, and thereby violates Section 10(b) and Rule 10(b)(5), when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.” p. 652. Following that decision, the SEC issued Rule 10(b)5-2(b)(1), which in part states that a duty of trust and confidence exits when “a person agrees to maintain confidentiality of information.” Cuban had argued that the SEC did not allege in its complaint that he agreed not to trade.

In its brief, the SEC also argues that the District Court failed to give proper deference to Commission Rule 10(b)5-2(b)(1). which provides that an agreement to maintain information in confidence gives rise to a duty that makes trading on confidential information without disclosure deceptive. The SEC stated because that interpretation of Section 10(b) is reasonable the Rule is entitled to Chevron deference. Chevron, U.S.A., Inc. v. Natural Resources Defense Council, Inc., 467 U.S. 837 (1984) which held that courts must defer to the Commission’s interpretation of Section 10(b) if Congress has not “unambiguously forbidden [the interpretation] and it is *** based on a permissible construction of the statute.”
The SEC also argued that the District Court’s interpretation is incorrect even apart from Rule 10(b)5-2(b)(1). According to the SEC, trading on material non-public information after agreeing to maintain it in confidence is deceptive under the general terms of Section 10(b) and Rule 10(b)(5).

In the writer’s opinion, if the case were to be decided by the Second Circuit Court Of Appeals, it would be reversed. To the writer, the issue is simple. Cuban’s first reaction was correct. “Well now I’m screwed. I can’t sell.” The information belonged to the Company. The CEO called Cuban for a proper corporate purpose to sell stock to Cuban. The Company did not intend to give the information to Cuban. Cuban knew no gift was intended. Yet, he took the information for personal profit. That opportunity was not given to the stockholders holding the other 94% of the Company.

The Fifth Circuit however has few Securities cases and the SEC could lose.

The SEC has submitted a well-written brief. The authors of the brief are David M. Becker, General Counsel, Mark D. Chan, Deputy General Counsel, Jacob H. Stillman, Solicitor, Randall W. Quinn, Assistant General Counsel and Michael L. Post, Senior Litigation Counsel.

Cuban is represented by Lyle A. Roberts, Dewey & LeBoeuf, L.L.P.

Edward X. Clinton, Sr.
Copyright 2010

Contract Law - The Duty of Good Faith Does Not Apply To The Bank's Decision To Call A Loan

2010-02-05T08:03:00.000-08:00

In Reger Development, LLC v. National City Bank, No. 09-2821, the Seventh Circuit affirmed the dismissal of the Borrower's complaint against its Lender.

Reger Development alleged that it was an Illinois limited liability company involved in the development of real estate. On June 25, 2007, Reger's Principal, Kevin Reger, met with National City and executed loan documents for a revolving line of credit in the amount of $750,000. The terms of the note allowed National City to demand payment at will. Reger Development made all interest payments that were due and owing.

On August 18, 2008, National City asked Reger to pay down $125,000 towards the principal of the line of credit, which Reger did the next business day.

On September 9, 2008, National City requested that Reger "term out" $300,000 of the Note by having one of Kevin Reger's other businessess agree to take out a three-year loan in that amount secured by a second mortgage on some real estate. National City also notified Reger that it would be reducing the amount of available credit on the line of credit to between $400,000 and $500,000.

According to the complaint, Kevin Reger expressed surprise at these developments and asked if the bank would "call the line of credit if Reger Development did not agree to the requests." Opinion at 5.

Reger Development then filed a complaint alleging that (a) National City breached the contract; and (b) National City engaged in a fraudulent scheme to deceive "people into taking out loans by concealing the fact that the principal could be called on demand." Opinion at 5. Reger Development initially filed the case in the State Court, but it was removed to the Northern District of Illinois by National City.

The district court dismissed the Complaint for failure to state a cause of action.

Under Illinois law a plaintiff alleging a breach of contract must allege four elements: "(1) the existence of a valid and enforceable contract; (2) substantial performance by the plaintiff; (3) a breach by the defendant; and (4) resultant damages." Opinion at 7 (quoting W.W. Vincent & Co. v. First Colony Life Ins. Co., 814 N.E.2d 960, 967 (Ill. App. Ct. 2004). As the Court noted, "during our review we do not look at any one contract provision in isolation; instead, we read the document as a whole." Opinion at 8.

Reger Development argued that Illinois law holds that "a covenant of fair dealing and good faith is implied into every contract absent express disawoval." Opinion at 8, citing Foster Enterprises, Inc. v. Germania Federal Savings and Loan, 421 N.E.2d 1375, 1380 (Ill. App. 1981).

According to the Seventh Circuit, Reger Development's claim had a fatal flaw, namely "the duty to act in good faith does not apply to lenders seeking payment on demand notes." Opinion at 8 (citing N.W.I. Int'l, Inc. v. Edgewood Bank, 684 N.E.2d 401, 409 (Ill. App. Ct. 1997).

Thus, Reger Development could not claim that National City acted in bad faith in calling the loan. "Viewed as a whote in the light most favorable to the nonmoving party, the Note before us is plainly a demand instrument entitling National City to collect its loan whenever it wants." Thus, the demand for repayment was not a breach of contract and Reger Development could not allege a breach of contract by National City.

Comment: in the author's experience it is almost impossible to challenge bank forms and demand notes. This case illustrates that principal. Those who sign such documents need to read them and understand them.

Edward X. Clinton, Jr.
Copyright 2010

Securities Law - Self Incrimination In SEC Investigation

2010-02-04T14:09:00.000-08:00

The Fifth Amendment to the U.S. Constitution provides that no person shall be compelled in any criminal case to be a witness against himself. The privilege applies to both criminal and civil cases. (McCarthy v. Arndstein, 266 U.S. 34). The only limitation on this right is that the person claiming the privilege must have reasonable cause to believe that she or he could incur a prosecution or conviction from a response. The Courts have also stated that there can be no adverse inference when the privilege is asserted in a criminal case.

In a civil case, however, there can be significant risks. A 1976 U.S. Supreme Court case (Baxter v. Palmigiano, 425 U.S. 308) held that a prisoner could assert the privilege at a disciplinary hearing, but prison officials could draw an adverse inference. The proceeding was considered civil but could lead to criminal action. The claim was that the prisoner was attempting to encourage other prisoners to disobey prison rules which could lead to a riot.

The Securities and Exchange Commission began to claim that an adverse inference can be made against individuals who claim the privilege. The SEC has a manual for staff use that provides during an investigation the Commission can assert that an adverse inference can be drawn against an individual who asserts the Fifth Amendment privilege.

In a SEC investigation the Commission will inform those about to be interrogated that they do not have to answer questions based on their Constitutional right under the Fifth Amendment. But, the Commission staff does not inform those persons that an adverse inference can be made if the person is to be interrogated claims the privilege. Although the SEC investigation is not criminal in nature, the results can be serious. The SEC investigation could, after a hearing, lead to a civil monetary penalty or an order barring the person from employment in the securities industry
Further, proposed witnesses are not informed that information obtained can be sent to other governmental agencies that administer criminal statues.

Can the government insist that a corporate employer not pay legal fees for employees until there is cooperation with the government? U.S. v. Stein v. Jones, 541 F.3d 130 answers this question in the negative. In Stein, a U.S. Attorney distributed a memorandum which stated:…whether the corporation appears to be protecting its culpable employees and agents and a corporation’s promise of support to culpable employees and agents, either through the advancing of attorneys fees, through retaining the employees without sanction for their misconduct, or through providing information to the employees about the government’s investigation pursuant to a joint defense agreement, may be considered by the prosecutor in weighing the extent and value of a corporation’s cooperation.

The Second Circuit in the Stein case dismissed indictments against thirteen (13) individuals because those individuals had a Sixth Amendment right to counsel and the action of the employer interfered with the right to counsel protected by the Sixth Amendment. The Stein Court did not consider the Fifth Amendment question.
Individuals faced with the prospect of testifying in a SEC investigation have to carefully consider their options, if he or she cooperates in the hope or expectation that the government agency will accept cooperation and not pursue them further. Even if that occurs and sanctions are not imposed in that investigation, is that the end of the story? If the information is passed on to others such as the U.S. Attorney, a prosecution could result if the conduct violates other laws.

In short, a person called upon to testify in an agency investigation should seek experienced counsel to help guide them through the treacherous path.

Edward X. Clinton, Sr.
Copyright 2010

Securities Law - College Fund Losses In Bright Start Plan

2010-01-22T08:31:00.000-08:00

Do not assume that just because you invested in what you consider a conservative college fund for the education of your children that your investment is safe.

Lisa Madigan, the Illinois Attorney General, was a leader in obtaining a 77.2 Million dollar settlement from Oppenheimer Fund due to Oppenheimer’s alleged mismanagement of a fund with Illinois 529 College Savings Program. Lisa Madigan, the Illinois Attorney General, and the State Treasurer, Alexi Giannoulias, reached a settlement with Oppenheimer resolving an investigation into the firm’s mismanagement of the “Core Plus Fixed Income Strategy” fund. Illinois began to investigate Oppenheimer’s investment strategy after Core Plus lost about 38% of its value in the year 2008. The settlement means a recovery of about 50 cents on each dollar lost. Core Plus investors who incurred losses between January 1, 2008 and January 25, 2009 are eligible to participate in the recovery.

On December 22, 2009, Lisa Madigan stated “As a result of this agreement, Illinois families who invested in the funds will be able to recover substantial losses in their college savings account in a timely manner while avoiding the uncertainty of delay that would accompany lengthy and expensive litigation.” Five other states are negotiating settlement agreements with Oppenheimer. Those settlements so far range between 67 million and 20 million.

The Core Plus program was marketed as a conservative investment option for families with children near college age. However, suspicions emerged when Core Plus suffered losses of about 40% compared to the Bond Index used to benchmark the fund. The Bond Index showed gains of more than 5%.

Oppenheimer acknowledged the Illinois settlement but admitted no wrongdoing. It stated “Oppenheimer funds agreed to the settlement to resolve the investigation that commenced after the severe market volatility that impacted all investments in 2008, to enable the company to move ahead with its mission to provide high quality investment management services.” High quality management services! Why did they settle for $164 Million?

Investigators determined that Core Plus actually contained serious and risky investments and was leveraged by Oppenheimer’s management team. The risks were never disclosed to Illinois officials. Not surprising, the Investment Team at Oppenheimer responsible for the Core Plus strategy is no longer with Oppenheimer. Core Plus has been liquidated and replaced with alternate fixed-income investment options.
The lesson - monitor investment results frequently. Don’t wait for Lisa Madigan to bail you out.

Edward X. Clinton, Sr.
Copyright 2009

Securities Law - Accounting and Legal Malpractice Claims

2010-01-13T14:25:00.000-08:00

True Value, as a public company, is required to file its financial statements with the SEC pursuant to the Exchange Act. According to the SEC, there were accounting errors in the financial statements of True Value of about One Hundred Thirty Million Dollars ($130,000,000) and that for the year 1999 such loss was to be recognized. Accordingly, such statements had to be recast. Undoubtedly, the True Value stock which is publicly traded, took a hit when the news became public. That was only the start of True Value’s problems.

Management of True Value decided to pursue a remedy against its former accountants, Ernst & Young and decided that it would interview two law firms to sue Ernst & Young. The Firm of Goldberg, Kohn, Bell, Black, Rosenbloom & Moritz, Ltd. made the successful presentation to True Value and was selected. The Goldberg Firm filed an arbitration claim against Ernst & Young. The Ernst & Young Engagement Agreement with True Value required arbitration.

After four years and expenses of approximately twelve million dollars ($12,000,000) an arbitration panel ruled against True Value and ordered that True Value pay the fees and costs incurred by Ernst & Young. The panel found that True Value, through the Goldberg Firm’s actions, had exhibited “bad faith” because it failed to consider the extent of the audit work done by Ernst & Young and pressing its lawsuit on several issues where it had no chance of success. True Value opposed an Eighteen Million Dollars ($18,000,000) fee demand by Ernst & Young and ended up by paying about Eleven Million Dollars ($11,000,000) to Ernst & Young and new counsel. True Value then in December 2009 sued the Goldberg Firm in the Circuit Court of Cook County for legal
malpractice.

According to the Complaint, among other things, the Goldberg Firm advised True Value to sue its former auditors for accounting malpractice and, also, that the Goldberg Firm failed to analyze the merits of the claim and did not obtain at an early point an accounting expert.

Also True Value alleged that the Goldberg Firm failed to advise True Value that if it did not prevail in the case, it could be liable for the costs and fees to defend the accounting malpractice case. It alleged that the Goldberg Firm failed to inform True Value at an early stage that the malpractice claim would have to be arbitrated in accordance with the engagement letter and that the arbitration panel likely would consist of auditors.

The current lawsuit against the Goldberg Law Firm seeks to impose the costs incurred by Ernst & Young on the Goldberg Firm and seeks approximately Twenty Million Dollars ($20,000,000) in damages. Also, Goldberg, according to the Complaint gave negligent Securities Law advice, contributing to the above damages for which Goldberg was charged about One Million Dollars. True Value also seeks a recovery of that expense.
What started as an almost routine need to restate earnings ended up in a protracted arbitration by True Value against its former accountants and, now, in furtherance of the fiasco, True Value sues its former lawyers for legal malpractice.

Edward X. Clinton, Sr.
Copyright 2010

Business Law - Why Incorporate?

2010-01-12T11:01:00.001-08:00

Every now and then someone asks us why they should incorporate their business. After all, they say, why not just continue in business and use Schedule C of the IRS 1040 form to pay taxes on the business. Moreover, to incorporate invariably costs money - fees are paid to the Secretary of State (at least for an Illinois corporation) and annual fees are paid thereafter. There is also a modest legal fee as well.

Incorporation, however, is an absolute must for every business.

First, in most cases incorporation prevents a creditor from seeking to hold the owner of the business personally liable. If you are in business without a corporation, and something goes wrong, the creditor can seek to collect from your personally. This is the primary reason for the use of corporations. It is the oldest (several hundred years in the United Kingdom) and best form of "asset protection."

Second, incorporation separates the business from the owner's personal life. Your personal finances do not get mixed in with the business finances. This is an advantage.

Third, corporations provide additional flexibility and greater control. The owner may decide to reward an employee or business partner with a portion of the stock. With a corporation, provided that these decisions are properly documented, the owner may retain control by keeping the majority of the stock of the business. On the other hand, if the owner is in business without a corporation and then adds a "partner," a court may find that the owner has given away 1/2 of the business to this "partner." Worse still, both of the partners may be held personally liable for a debt of the business.

Recently we have seen advertisements on television for do-it-yourself corporations. Not surprisingly, we recommend against the do-it-yourself approach. The main reason why it is not a good idea for a nonlawyer to establish a corporation is that the nonlawyer may make a small technical mistake - which then voids the corporation. We have reviewed many do-it-yourself attempts that did not successfully form and maintain the corporation and were simply a waste of the owner's money. The Courts rarely give partial credit for a bungled attempt at incorporation.

If you have incorporated on your own, without legal advice, we recommend that you show your papers to a lawyer to obtain a professional opinion.

Edward X. Clinton, Jr.
Copyright 2010

Fraudulent Transfer - Munson v. Rinke, 1-08-2998, Illinois Appellate Court November 20, 2009

2009-12-09T13:57:00.000-08:00

Plaintiffs, Lester and Judith Munson, brought a fraudulent transfer action against the Defendants, Susan Rinke and her husband James P. Whitmer, alleging constructive fraud. The Munsons obtained a judgement against Rinke for $38,000 and Rinke appealed.

The fraudulent transfer case arose out of a previous lawsuit between Whitmer and the Munsons that was also filed in State Court. In 1994, the Munsons sought sanctions against Whitmer. The motion was denied. On November 27, 2002, the Illinois Appellate Court reversed the denial of sanctions and ordered the trial court to determine the correct amount of sanctions against Whitmer.

On February 13, 2003, Whitmer transferred the title of two cars from himself to his wife, Rinke. Rinke wrote two checks to Whitner in the amount of $29,000 for the two vehicles. At around the same time she withdrew $36,550.37 from her IRA to cover the checks. Whitner then wrote Rinke a check for $36,551, which Rinke used to purchase an annuity. (Thus, Ms. Rinke was not out of pocket for the purchase of the two cars. When the transaction concluded she paid $0 for the cars). Whitmer obtained the $36,551 by borrowing from his home equity line of credit. Whitmer and Rinke then executed a promissory note under which Rinke was to pay Whitner back the $36,551 without interest. Rinke never paid Whitmer back, but, instead made payments to satisfy Whitmer's home equity loan.

In August 2003, the trial court awarded the Munsons sanctions in the amount of $173,253.14 against Whitmer.

In October 2003, Whitmer filed a Chapter 11 bankruptcy petition. The Munsons intervened in the bankruptcy proceeding and obtained a declaration that the sanctions award of $173,253.14 was nondischargeable.

In February 2006, the Munsons filed a complaint for the avoidance of the transfers of the two vehicles on the ground that the transfers constituted actual fraud or constructive fraud.

After trial, the Court held that the transfers amounted to constructive fraud and entered judgment against Whitmer and Rinke.

Rinke appealed on the ground that the fraudulent transfer action was barred by the bankruptcy proceeding. The Court found that, although the bankruptcy trustee had the right to pursue the fraudulent transfer action and chose not to do so, that decision did not bar the fraudulent transfer action. Once the bankruptcy ended the Munsons had the right to proceed on the fraudulent transfer claim, which the bankruptcy court found to be nondischargeable.

Finally, the Court found that there was sufficient evidence to support the finding of constructive fraud under Section 5(a)(2) because there was evidence that the debtor made the transfer "'without receiving a reasonable equivalent value in exchange for the transfer,'" and the debtor "'intended to incur, or believed or reasonably should have believed that he would incur, debts beyond his ability to pay as they became due.". 740 ILCS 160/5(a)(2). The Court noted that the transactions occurred shortly after it became apparent that sanctions would be awarded and that Rinke had no real out of pocket cost for buying two cars. Thus, Whitmer ended up with more debt and received nothing for the cars.

The case illustrates that any transfers of property when an adverse lawsuit is pending are suspect.

Edward X. Clinton, Jr.
Copyright 2009

Securities Law - SEC Acts On Proxy Voting Proposal

2009-12-04T15:56:00.000-08:00

At the present time shareholders can hold corporate shares directly or indirectly through financial intermediaries such as brokers. Current New York Stock Exchange Rule 452 provides “in uncontested elections brokers can vote shares they hold in street name on behalf of customers when customers do not return voting instructions.”

The SEC in a divided vote approved the New York Stock Exchange proposal to halt brokers voting of customer shares in uncontested elections if voting instructions have not been received. Although the Rule is a NYSE rule, broker members would be required to comply with the Rule no matter where the shares are listed.

According to the SEC staff, this will improve corporate governance and accountability by helping to insure that only those with an economic interest in listed companies vote in director elections. However, there is concern about the effect of that amendment on shareholder participation because shareholders ordinarily expect the brokers to vote their shares [almost always in favor of current management]. Now that those shares will not be voted without specific instructions, what will it mean to the voting process? In other words, companies will have to find ways to communicate with shareholders more aggressively to get shareholders to vote their shares. The failure to get a sufficient number of votes might mean that quorum limits are not met and director elections might fall short of voting requirements. In other words, companies will be put to substantial greater cost to see to it that the requisite number of shareholders vote at elections.

The Amended Rule will be effective January 1, 2010.

Edward X. Clinton, Sr.
Copyright 2009

Securities Law - Trading On Inside Information - The Penalty

2009-12-02T07:48:00.000-08:00

The SEC sued Khaled Al Hashemi, a citizen of Abu Dhabi, United Arab Emigrates and a current technology manager at an Abu Dhabi oil refinery, charging that he engaged in unlawful trading on the basis of material non-public information concerning the acquisition of Nova Chemicals Corp. by International Petroleum Investment Co.

The case was filed in the Federal Court for the Southern District of New York, Civil Action no. 09-CIV-6650, on November 19, 2009.

The SEC alleged that Al Hashemi purchased approximately 120,000 shares of Nova at an average price of $1.41 per share shortly before a merger was announced and then sold those shares on the day the merger was announced. The price per share of the sale was $5.24, realizing a profit for Al Hashemi of $458,760. It is interesting to note that he purchased 50% of his Nova stock on the last trading day before the announcement of the acquisition by International.

Nova headquartered in Canada, with an office in Pennsylvania, produces plastics and chemicals. The Nova stock was registered with the SEC pursuant to Section 12(b) of the Exchange Act and is traded on the New York Stock Exchange.

International made a cash offer to acquire Nova for $6.00 per share. On the day following the announcement the stock of Nova increased to $5.21 per share, or a 289% increase with a substantially greater volume on the New York Stock Exchange.
Al Hashemi’s sold his entire 120,000 shares of Nova and received a return of 270%, equal to a profit of $458,000.

The SEC in its Complaint alleged that the sale by Al Hashemi of his other securities in order to find sufficient funds to purchase the Nova stock strongly suggested that he knew that the Nova common stock would rise on the news of the prospective purchase. It is further interesting to note that Al Hashemi incurred a loss of 66% on his other investments when he liquidated them (presumably to raise cash for the Nova stock purchase). The SEC alleged that Al Hashemi traded on the basis of material inside information that he misappropriated in violation of his fiduciary duty or similar duty of trust and confidence to the shareholders of Nova, or, to the source of whom he received such inside information.

Specifically, the SEC alleged that Al Hashemi employed devices, schemes or artifices to defraud, made untrue statements of material facts, or engaged in acts to operate as a fraud or deceit in connection with the purchase or sale of a security. Moreover, the SEC alleged that Al Hashemi violated a Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. The SEC prayed for a permanent injunction to prevent him from violating Section 10(b) and to order Al Hashemi to disgorge unlawful trading profits and to pay a civil penalty pursuant to the Exchange Act.

Al Hashemi did not admit or deny wrongdoing, but did agree to the injunction and the penalties, including disgorgement of $558,760, $9,620 in pre-judgment interest, and a $406,620 civil penalty.

The SEC typically notices unusual trading volume shortly before the announcement of a cash offer for stock or a merger.

Edward X. Clinton, Sr.
Copyright 2009

Contract Law - Lewitton v. ITA Software, Incorporated (Seventh Circuit 08-3725)

2009-11-25T10:01:00.000-08:00

The Seventh Circuit Holds that An Employer Breached An Employment Contract When It Blocked A Former Employee From Exercising Options To Purchase Stock.

Lewitton was an employee of ITA Software, the Defendant. Three months after he stopped working for ITA Lewitton attempted to exercise options to purchase 138,900 shares of ITA's stock. ITA allowed Lewitton to purchase 34,722 shares, but blocked his effort to exercise the remaining options.

In April 2005, ITA and Lewitton entered into an employment contract under which Lewitton was to serve as ITA's vice president of sales. The contract granted Lewitton the right to purchase up to 200,000 shares of stock. According to the contract the options "'will vest...in equal monthly installments of 4,556 shares each... except that the first twelve months of options will all vest at Lewitton's one-year anniversary.'" The contract also provided that certain of the options were subject to forfeiture depending on whether ITA met certain performance goals. Under the contract, there was to be an assessment period during which sales would be calculated to determine if the company met its revenue goals. However, the contract also specified that the Assessment period would not apply if it were "materially deferred."

Lewitton's job was to supervise the development of the 1U program, a computer program that would apparently allow users to make online reservations for air travel. The software program was not successful and was not accepted by either travel agents or airlines.

The District Court granted summary judgment for Lewitton, holding that the contract unambiguously granted him the right to exercise the options. Under Illinois law, "our primary goal in construing the contract is to give effect to the parties' intent as expressed in the terms of their written agreement." The Court stated: "We first ask if the language of the contract is ambiguous, which is a question we determine as a matter of law...A contract is ambiguous if its terms are indefinite or have a double meaning...If the contract is unambiguous, we must enforce it as written."

ITA argued that the options were subject to forfeiture because the U1 software program did not meet performance goals.

The District Court and the Court of Appeals disagreed. They held that the Assessment Period did not apply (to allow forfeiture) because the U1 program was "materially deferred." "As the district court noted, 'materially deferred' is not a technical term; its ordinary meaning is 'significantly delayed.'" Because the U1 program was not rolled out on time, "the Assessment Period never began and, accordingly, ...the forfeiture provision does not apply."

Accordingly, Lewitton was entitled to exercise the options.

Edward X. Clinton, Jr.
Copyright 2009

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Securities Arbitration - Stern v. Charles Schwab & Co., Inc. (D. Ariz., No. CV-09-1229, October 16, 2009)

2009-11-25T09:18:00.000-08:00

COURT REJECTS SECURITIES ARBITRATION WHERE THE BROKER FAILED TO OBTAIN THE CLIENT'S SIGNATURE ON THE ARBITRATION AGREEMENT

Plaintiffs who seek to avoid arbitration and have their claims adjudicated in court are not often successful. There is a recent United States District Court, the District of Arizona, which did not follow the trend. In the case of Stern v. Charles Schwab & Co., Inc. (D. Ariz., No. CV-09-1229-PHX-DGC, 10/16/09), the defendant Schwab filed a Motion To Dismiss and To Compel Arbitration pursuant to the Arizona and Federal Arbitration Acts. In the case, the Sterns invested One Million Nine Hundred Thousand Dollars ($1,900,000.00) with Debra Bennett and Elva Bennett. The Bennetts then transferred the Sterns’ money to a Charles Schwab Brokerage Account and used that account to invest in various investment transactions. The Sterns suffered serious financial losses and alleged that the Bennetts committed fraud, violated various securities law and ran a Ponzi scheme. The case was transferred to the Federal Courts because of diversity of citizenship. The Bennetts opened the Schwab account about one year before the Sterns began investing. The account between the Bennetts and Schwab contained a somewhat standard arbitration clause in which the Schwab account holders agreed to arbitration. The Sterns never signed the Schwab-Bennett contract, but nonetheless Schwab asked the Court to enforce the arbitration provision against them.

The Court noted that to compel arbitration the Court needed to find that the party actually signed a written agreement. A non-signatory may be bound to arbitrate based on “ordinary contract and agency principles” such as a corporation by reference, assumption, agency, veil piercing and equitable estoppel. Schwab also argued that the principles of equitable estoppel and agency bind the Sterns to the arbitration clause of the Schwab-Bennett contract. The court noted that when a non-signatory receives a direct benefit from the underlying contract, Arizona courts apply the doctrine of equitable estoppel and enforce the contract, including arbitration. World Group Secs., Inc., v. Allen, 2007 WL 4168572, *3 (D.Ariz. 2007) (quoting Zurich Am. Ins. Co. v. Watts Indus., Inc., 417 F.3d 682, 688 (7th Cir. 2005). Schwab argued that the Sterns received a direct benefit from the Schwab-Bennett Contract because the contract allowed the Sterns to invest the Bennett’s money.

The Court noted that arbitration can be ordered when a party has received a direct benefit from the arbitration contract. However, the Court stated that the Schwab-Bennett contract merely provided a vehicle through which the Bennetts implemented their investment business. It conferred no direct benefit on the Sterns. All the allegations and evidence suggested that the Sterns elected to invest with the Bennetts, not with Schwab and did so because of the Bennetts’ purported investment expertise and the Bennets’ promise of substantial returns. Because the Sterns received no direct benefit from the Schwab-Bennett contract equity does not require that the Sterns be subject to the arbitration provision which they never signed.
Schwab also argued that an agency relationship existed between them and the Bennetts. The response of the Sterns was that no agency relationship existed when the Schwab-Bennett contract was signed, the Bennetts could not be said to have acted on behalf of the Sterns in signing the contract. Therefore, agency principles also do not bind the Sterns to arbitration.

Accordingly, the Court held that the motion of Schwab to dismiss would be denied and the Sterns could proceed with the case in the U.S. District Court.

Edward X. Clinton, Sr.
Copyright 2009

Securities Law - Proposed Amendments to the Investor Protection Act

2009-11-25T09:17:00.001-08:00

The House Financial Services Committee voted strictly along party lines on November 4, 2009 to recommend an amendment to the Investor Protection Act that would double the authorized funding of the SEC and increase its enforcement authority. Further, a fiduciary duty would be imposed on all providers of financial advice, create a whistle-blower “bounty” and protection program and end mandatory arbitration of claims against broker-dealers. If this proposed amendment is adopted it would represent a boom to plaintiffs’ lawyers. This bill will be vigorously opposed by the Republicans in the House and, further, even it passes in one form or another, its passage in the more conservative Senate will be much more difficult.

Edward X. Clinton, Sr.
Copyright 2009