Mr. Doyle’s friend did not intentionally provide information to, or encourage any trading by, Mr. Doyle.  Therefore, the “classical” theory of an insider-trading claim was not applicable, because there was no “insider” of Tyco (or Brink’s) involved in the trading and no “tipper-tippee” relationship.  Mr. Doyle’s liability for insider-trading could only be based on the “misappropriation” theory of insider-trading liability, which requires a breach of fiduciary duty or a breach of trust or confidence.  Otherwise, inadvertent recipients of material non-public information who trade while in possession of that information would face liability.

It is apparent that Mr. Doyle had an improper intent – i.e., an intent to use the information for his own profit when he knew that the information was not intended for him or for that purpose.  Nevertheless, even on the misappropriation theory of insider-trading liability under existing case law, that does not appear to be sufficient to constitute insider-trading.  The misappropriation theory, applicable to “outsiders” like Mr. Doyle, requires not only that the material non-public information be misappropriated (i.e., used by someone for a purpose not intended to be used), but also that it be used fraudulently – i.e., in violation of a duty to another person and without disclosure of the proposed use.

The SEC’s complaint states that Mr. Doyle’s trading “breached a legitimate expectation of confidentiality” held by Mr. Doyle’s friend, but it does not describe in detail the facts supporting that “legitimate expectation of confidentiality.”  It is an interesting question whether a “legitimate expectation of confidentiality” is equivalent to, or sufficient to give rise to, the duty  of “trust and confidence” that is required for the misappropriation theory.  The further interesting question is what understanding or facts are sufficient to give rise to a “legitimate expectation of confidentiality.”  The SEC’s complaint states that Mr. Doyle knew that his friend “could not, and did not, share material nonpublic information with him.”  Was this knowledge the result of a conversation between the two regarding the information, or was it only more general knowledge about the nature of the work in which Mr. Doyle’s friend engaged?  If the latter, is that tantamount to the position that it was enough that Mr. Doyle’s friend subjectively believed that Mr. Doyle would not use or misuse the information?

OUR TAKE:  Although Mr. Doyle may have misused information that he was not supposed to have – and, perhaps, might be liable for theft of the information under state law – it is not clear that he should have been liable for insider-trading unless there were facts sufficient to establish a duty on his part.  Because the SEC’s complaint and settlement release do not describe those facts, it is difficult to tell what constituted that duty.

• A general “reasonable expectation” of a shareholder is that, in the absence of a contractual restriction, the shareholder may freely sell its shares “to a party of [the shareholder’s] choosing at a mutually acceptable price.” 
• The conduct of “directors or those in control of the corporation that substantially defeats the reasonable expectation of a minority shareholder” will often constitute shareholder oppression. 
• The refusal in this case of the board and management to meet with prospective purchasers constituted shareholder oppression.
• Requiring the corporation to repurchase a minority shareholder’s shares for their fair market value was a proper equitable remedy.

The decision prompts various general questions regarding (among other matters) the scope of a shareholder’s “reasonable expectations,” the balancing of a shareholder’s “reasonable expectations” with the board’s or management’s duties to the corporation and all of its other shareholders, the scope of a shareholder-oppression claim, and the availability of a buy-out as a remedy for oppression.  It also prompts a more particular question for counsel to a board or management:  Is the board or management required to expose themselves and the corporation to possible federal and state securities-law claims by meeting with prospective purchasers of a minority shareholder’s shares, even if there is no statutory or contractual obligation to do so and the corporation (and its other shareholders) would not receive any benefit from the sale?  From the Ritchie decision, it appears that if the board and management wish to avoid a shareholder-oppression claim, they must risk a securities-law claim.

The concern for the board and management is not that they would intentionally mislead any prospective purchaser, resulting in liability under federal and state securities laws.  Instead the concern is that even if they provide information to a prospective purchaser that they believe to be accurate, there is a possibility that they and the corporation will be required to defend securities-law claims from a purchaser who becomes unhappy with his purchase or his subsequent continued ownership of the shares.  Although the risk relating to securities-law claims can be limited to some extent – e.g., by a waiver of reliance from prospective purchasers or by an indemnification agreement from the selling shareholder in favor of the corporation and the board and management – the risk cannot be eliminated; and it seems odd that the corporation and (indirectly) all of its other shareholders, and its directors and management, should be required to accept that risk solely for the benefit of one shareholder.

OUR TAKE:  The Ritchie decision is the subject of a pending motion for rehearing of a denied petition for review submitted to the Texas Supreme Court, and a few of the leading corporate and securities lawyers in Texas have filed amicus papers encouraging the Texas Supreme Court to accept that petition.  It appears that, because of the questions that arise from the Ritchie decision, a review by the Texas Supreme Court would certainly benefit boards of directors and management of privately held Texas corporations and counsel who advise them.

OUR TAKE:  Investors should continue to monitor trends with respect to corporate governance deficiencies and accounting fraud.  This is still a developing area. The progress of talks regarding cross-border audit oversight, and whether shareholders are successful in efforts to obtain damages for the fraud, will likely have a significant impact on future investments in Chinese companies.

A number of Chinese companies have come under fire for accounting fraud stemming from corporate governance issues according to Forbes: “[i]n the past six months alone, more than 25 [NYSE and Nasdaq]-listed Chinese companies have disclosed accounting discrepancies or seen their auditors resign.”  In light of these discrepancies and departures, the need for increased transparency, strong risk management and broad financial oversight is greater than ever.  In particular, Chinese companies have been criticized for their relatively low number of independent directors (33% of the directors of Chinese-listed companies compared to 75% of the directors of U.S.-listed companies) and the lack of relevant industry experience these independent directors offer. 

In one recent case involving Chinese financial software company Longtop Financial Technologies Limited, auditor Deloitte Touche Tohmatsu handed Longtop a resignation letter, included as an exhibit to a Form 6-K filed by Longtop, that asserted financial statement fraud, bank corruption and threats against the auditors.  The New York Times explained the breakup as an investigation by Deloitte, after six years of clean audit opinions, into Longtop’s cash balances.  Longtop blocked Deloitte from following up with bank headquarters regarding cash balances (that bank branches had already confirmed) by telling the bank that Deloitte was not the company’s auditor and threatening to hold Deloitte staff captive unless Deloitte allowed Longtop to retain Deloitte’s audit files.  As described in the resignation letter, Longtop’s chairman Jia Xiao Gong, explained to a Deloitte partner why Deloitte could not find the cash:  “there were [sic] fake revenue in the past so there were [sic] fake cash recorded on the books.”  That is a disturbing clarification.

OUR TAKE:  Sound accounting practices and the independence and experience of directors are of paramount importance to sound corporate governance.  Foreign companies, which bring with them different regulatory, governance and financial backgrounds and standards, may pose unique risks for U.S. investors.  Investors should pay close attention to corporate governance and accounting issues generally, but especially with respect to less familiar foreign companies.  Reports identifying trends with respect to corporate governance deficiencies and/or accounting fraud especially raise investment red flags.

According to a report by Cornerstone Research in January 2011 (PDF), 12 securities class action complaints were instituted in 2010 against Chinese companies listed on U.S. stock exchanges.  This represents a whopping 42.9% of all class action filings against foreign issuers listed in the United States.

The disproportionately high number of class action complaints against Chinese issuers appears to be prompted by two factors.  First, Chinese companies listed both in the United States and China are subject to financial reporting requirements that vary significantly.  These differences often result in the same company reporting different earnings in China versus the United States and, in some cases, higher earnings in the United States than in China.  While these differences could more clearly be explained through appropriate footnote disclosure in their public filings, many Chinese issuers appear to be reticent to provide the additional disclosure.  While these differences are in most cases the result of differing reporting standards, they provide a natural attraction to plaintiffs’ attorneys.  The other factor that may explain this trend is the fact that many Chinese issuers are coming to market not through the traditional IPO, but rather through reverse mergers with already listed U.S. shell companies.  While this provides a significantly quicker and less expensive way to list in the United States, the lack of disclosure associated with this process in some cases leads to regulatory investigations and allegations from shareholders that material information was withheld prior to listing.

OUR TAKE:  Securities litigation against Chinese issuers is a natural byproduct of increasing numbers of Chinese companies choosing to list in the United States  As a result, Chinese issuers and their advisors must be cognizant of the important differences in disclosure regimes in the United States and China and fashion their public disclosure accordingly.