Reference no: EM133198469 , Length: 4 pages

Case

Adair Company deals in baby care products. One of the company's R&D scientists, Walter, conducts tests on a synthetic material used to manufacture baby diapers to prevent rashes. He presents the preliminary findings to the CEO, Skylar, and expresses hope that advanced tests will confirm the preliminary findings. Skylar sends a memo to the employees requesting secrecy as to the tests. Later, the board grants 10,000 shares of the restricted stock in the company to Skylar. At the time she accepts these shares, the board is unaware of the tests. However, the preliminary test results are confirmed later, but Walter decides to tell his friend, Hank, about the tests before the breakthrough is made public. Hank works in a different company dealing with similar baby products. Therefore, Walter is sharing this information hoping that Hank would also share market-sensitive information about his company. Hank purchases shares of Adair's stock, and he never shares any information with Walter about his company's development or products.

Primary and Secondary Liability Under SEC Rule 10b.5

Rule 10b-5 by the Securities and Exchange Commission deals with insider trading. Under this rule, situations where an insider or a member of the executive uses nonpublic information for their own benefits are defined (Langevoort & Gulati, 2004). In this case, Adair Company is a profit-maximizing public company bound by this rule. The rule states that "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 securities. To determine if the individuals violated this rule, their liabilities in the company have to be defined.

The main issue is to determine whether Skylar, Walter, and Hank had primary or secondary liabilities in this company. Misstatements or fraudulent schemes define primary liability, while secondary liability is defined by aiding or abetting the scheme. In this case, Skylar can be accused of violating Rule 10b-5 by omission because she failed to disclose to the directors or investors that there were ongoing tests. She went ahead and accepted $10,000 shares without disclosing the test information, meaning that she benefitted financially from this scheme. Therefore, Skylar had primary liability in this company because her action amounts to an omission of important information about the ongoing tests. She should have informed the board of directors about the tests before accepting the $10,000 shares. As a result, her action was a misstatement by omission, which defines primary liability.

FEEDBACK: Why was she liable? What relationship did she have that would make it so? Was the information material to the company? need case law - there is a 2 prong test that the court looked to .the issue of whether the "scienter" element of a Rule 10b-5 insider trading case can be satisfied?

Hank purchased Adair's stock shares because he had prior information about the ongoing tests. Therefore, Hank had a scheme to use insider information for financial gain without revealing the information to the concerned parties. Walter aided his fraudulent scheme because he revealed all the information to him. Therefore, both Hank and Walter violated the provisions of SEC Rule 10b-5. However, they were not the initiators of the fraudulent scheme. This means Hank and Walter had secondary liability. Therefore, their actions also violated Rule 10b-5 because they used insider information for financial gain, which is a violation of Rule 10b-5.

In Lorenzo v. Securities and Exchange Commission, 578 US _ 2019, the Supreme Court ruled whether using a statement by someone who does not retain ultimate authority over the statement subjects the person to a fraudulent-scheme claim under SEC Rule 10b-5. Lorenzo was a company director and had invested in a start-up company named W2E. W2E claimed to have an innovative technology, and the company's valuation would be based on that technology. However, the technology never materialized, forcing W2E to offer $15,000 in debentures to avoid financial ruin. This debt was secured only by the debtor's earning power instead of tangible assets. Further, W2E failed to disclose the possible devaluation of its intangible assets when filing with SEC. After an audit, the company was devalued. On receiving the information, Lorenzo contacted two potential investors and informed them about the pending debenture offering by W2E instead of informing the investors that the company's intangible assets had been devalued. Lorenzo and his boss were charged for violating Rule 10b-5 and other SCE Act provisions. The judges ruled that dissemination of false information with the intent to defraud violates Rule 10b-5. FEEDBACK: Does this relate to Hank and or Walter?

This can be applied here to show how Skylar misrepresented the company by hiding important information from the directors and investors. She benefited financially from this fraudulent scheme because she was offered $10,000 shares without the directors knowing that some ongoing tests could increase the company's fortune.

Feedback: In the court of law, would Walter be held liable as he is a "tipper". Was Walter a fiduciary who "tipped" ?what that mean, what would it entail, and what would happen? Even though he didn't buy stock himself?