Court of Chancery Comes Down Hard on Trading by Plaintiffs in Representative Litigation
Defendants in class and derivative litigation often view the plaintiffs in those cases, especially the repeat players whose names are familiar to devoted readers of Court of Chancery opinions, as minor investors with little directly at stake in the litigation. Sometimes, however, the plaintiffs have significant equity stakes in the companies whose transactions they seek to enjoin. In those cases, the plaintiffs may be sharp investors who value the investment more than the principle at stake. What happens, then, to these investors when they see the chances at success in litigation passing them by? In any other circumstance, they might be inclined to trade out of their position or arbitrage the risk appropriately. When, however, these investors have chosen to be the plaintiff in a case seeking to halt the challenged transaction, the ability to act like an ordinary investor is severely restricted.
Over the last few months, the Court of Chancery has been made aware of more than one instance in which plaintiffs in putative representative litigation traded in the common stock of the company whose stockholders they purport to represent while they had access to confidential information obtained in the litigation. Although the issue had been addressed in several transcript rulings, the court had not issued a written opinion on the topic.
As a result, the court included specific language in its recently released "Guidelines To Help Lawyers Practicing in the Court of Chancery" addressing the issue. In the guidelines, the court makes it plain that litigants who engage in this type of behavior should expect to be subject to "intensive scrutiny" and face a host of possible penalties. The lack of written precedent was obviated by the court's Jan. 6 opinion in Steinhardt v. Howard-Anderson, in which the court ordered the plaintiffs it had found to have traded while in possession of confidential, nonpublic information to (i) self-report to the Securities Exchange Commission; (ii) disclose their improper trading in any future application to serve as lead plaintiff; and (iii) disgorge any profits made from the trades. The court then dismissed the trading plaintiffs from the case with prejudice and barred them from receiving any recovery from the litigation. While these remedies are consistent with the court's prior oral rulings on the issue, they are now found in a written opinion, easily accessible by the public, that should put any putative class representative on notice of the court's view on the issue.
The facts of the case detailed in the court's opinion are simple enough. On Oct. 6, 2010, Michael Steinhardt and certain funds affiliated with him, Herbert Chen and another stockholder, who collectively held approximately 19 percent of Occam Networks Inc., filed a complaint in the Court of Chancery challenging the proposed merger between Occam and Calix Inc. Pursuant to their merger agreement, Occam would merge with a wholly owned subsidiary of Calix, and each share of Occam common stock would be converted into the right to receive $3.8337 in cash and 0.2925 shares of Calix common stock. On the date the merger was announced, the implied value of this consideration was $7.75 per Occam share.
During the proceedings, Chen was actively involved in reviewing document discovery and deposition transcripts. Chen gave Steinhardt oral and written updates on the litigation, including the information that was being uncovered through document discovery. When the document production was nearly complete, but before the depositions of the defendants, Steinhardt began short-selling shares of Calix common stock. As discovery progressed and the plaintiffs deposed the defendants, Chen gave Steinhardt updates. Steinhardt continued to short-sell Calix common stock. Steinhardt intended to cover his short sales with shares of Calix common stock he would receive in the merger even though he was asking that the merger be enjoined. Steinhardt took this risk because "based upon everything that [he] knew, there was a very high probability of that merger occurring," the opinion said. Steinhardt also testified that he used the short-selling as a way to exit his Occam position because he was not interested in investing in Calix and he could take advantage of the arbitrage spread that existed between Calix and Occam stock.Due to Steinhardt's short-selling, by the time of the merger, Steinhardt effectively held only 30 percent of the Occam shares he held when he commenced his plan. At no time did Steinhardt inform class counsel of his trades.
On Jan. 24, 2011, the court held an open hearing, available to the public on the Courtroom View Network, on the plaintiffs' motion for a preliminary injunction. The court enjoined the merger temporarily, pending the issuance of supplemental disclosures and the deposition of a lead banker from Occam's financial adviser. On Feb. 22, 2011, at a reconvened special meeting, the Occam stockholders approved the merger.
After the injunction hearing, Steinhardt attempted to extract himself from the situation, but the defendants would not permit him. The defendants insisted on obtaining trading information from all of the plaintiffs, including Steinhardt. As a result of this discovery, the defendants learned of Steinhardt's trading and filed a motion for sanctions against him (the defendants also moved for sanctions against Chen, but the court denied that motion), even though Steinhardt agreed to step down as a class representative.
Given Steinhardt's admission that his trading was influenced by the information he received from Chen, the court had no difficulty concluding that Steinhardt had violated the restrictions in the confidentiality order. The court also confirmed that Steinhardt need not have direct access to the confidential information to be found to have violated his obligations as a putative fiduciary for the class. Summarizing the numerous transcript rulings that have addressed this issue, the court stated:
"Trading by plaintiff-fiduciaries on the basis of information obtained through discovery undermines the integrity of the representative litigation process. Consequently, it is unacceptable for a plaintiff-fiduciary to trade on the basis of nonpublic information obtained through litigation."
On top of this strong language, the court then summarized the remedies available to it based on prior precedent - and applied all of them. The court found that by choosing to exit his Occam position, Steinhardt had abandoned the class, acquiesced in the merger and waived his claims, so he was dismissed with prejudice from the case. The court also required Steinhardt to self-report to the SEC, advise the judge in any future representative litigation of this decision and disgorge profits obtained from trading in breach of his duties. So the disgorgement penalty would not be disproportionate, the court calculated the profits not based on Steinhardt's historical basis in the stock (which was obtained at a distressed price from fellow plaintiff Chen), but rather at implied purchases. The court also did not order disgorgement of profits from any trade after the public hearing on the preliminary injunction. The court reached this conclusion by holding that after the public injunction hearing, Steinhardt did not have a meaningful advantage from serving as a fiduciary for the class.
The court's decision makes a few things quite clear going forward. First, the unequivocal language used by the court to denounce trading by a plaintiff-fiduciary on the basis of nonpublic information makes clear that the existence of the specific restriction on trading in the confidentiality order was not material to the court's conclusion. That is, it does not matter whether the confidentiality order contains an explicit restriction on trading - the putative class representative's standing as a fiduciary precludes trading as well.
Second, the doctrine that the scope of recovery for breach of the duty of loyalty will not be determined narrowly, which plaintiffs ordinarily seek to apply to defendants, can and will be applied to plaintiffs who violate their duties as putative class representatives. The court applied the same methodology of determining damages to the disgorgement remedy here as it would have to any other claim against a director or any other fiduciary found to have breached his duty of loyalty. The message is clear - fiduciary principles are applied the same, whether it be to a director breaching his duty of loyalty to a corporation or a stockholder plaintiff breaching his duty to a class.