May 8, 2019

Insider Trading: Facebook Directors Tagged in Derivative Suit

This Steve Quinlivan blog summarizes a recent derivative action filed against Facebook’s directors in connection with alleged insider trading involving sales of stock by Facebook’s CEO Mark Zuckerberg, its COO Sheryl Sandberg, and its former director & WhatsApp co-founder Jan Koum.  Here’s an excerpt from the blog addressing the insider trading allegations:

In a wide ranging derivative action, a Facebook shareholder has filed a 193 page complaint in the Delaware Court of Chancery alleging three Facebook directors sold a total of $1.5 billion of stock while in possession of inside information.  Specifically, the complaint alleges that at the time of the stock sales Facebook faced a looming crisis over privacy concerns and that the value of Facebook equity shares did not reflect such “inside information.” According to the complaint, when the directors sold their respective shares of Facebook stock, Facebook had been aware of the activities of Cambridge Analytica and the other misconduct referred to in the complaint.

The complaint also alleges violations of the proxy rules and breaches of fiduciary duty by the board in connection with Facebook’s repurchases of stock during the relevant period.  In addition to 10b-5 claims against the three directors who traded during the relevant period, the complaint also alleges that “The sales of defendants Zuckerberg, Sandberg and Koum’s shares of Facebook common stock while in possession and control of this material adverse non-public information was a breach of their fiduciary duties of loyalty and good faith.”

Bringing fiduciary duty claims based on insider trading may seem somewhat incongruous given the pervasiveness of federal law in this area, but Delaware has recognized these so-called “Brophy claims” ever since the Delaware Supreme Court’s 1949 decision in Brophy v. Cities Service.

After a long period of relative dormancy, Brophy claims have become increasingly popular among plaintiffs in recent years.  Part of the reason for that is a 2011 Delaware Supreme Court decision holding that disgorgement of all gains from insider trading is a potential remedy for the breach of fiduciary duty.  But as this 2014 Business Law Today article suggests, there’s more to its increasing popularity than that:

The incentives of stockholder plaintiffs and their counsel to bring Brophy claims would seem to have increased with the confirmation that disgorgement of all gain by the alleged wrongdoer is a potential measure of damages. And, not only are the potential awards higher, but in certain circumstances, successfully pleading a Brophy claim will be less of a burden than a federal securities claim which is subject to the heightened pleading standards imposed by PSLRA.

Like other derivative claims, Brophy claims are generally subject to the heightened standard of pleading demand futility. But when it comes to the demand futility requirement, one of the interesting aspects of the Facebook complaint is that the plaintiffs allege that they made a demand on Facebook’s board – and received no response to that demand letter during the more than 10 months preceding the filing of the complaint.

IPOs: Founder’s Letters Get Some Love

If you’ve read my recent blog on Uber’s IPO, you know that I’m not a fan of founder’s letters in IPO prospectuses. I think they’re one of the many tech IPO clichés that investors could do without. But others hold them in much higher esteem than I do. This recent Olshan blog mounts a spirited defense of the founder’s letter & also reviews how the SEC looks at them during the comment process:

Based on our review of publicly available SEC comments, the SEC has frequently remarked in its comment letters that IPO letters need to serve a supplementary purpose that is meaningful to investors and directly relevant to the public offering. Given that the SEC’s prescriptive disclosure regime is designed to capture all material disclosures necessary for an investment decision, the SEC staff appears to have carefully reviewed the content and bounds of IPO letters.

Without specific rules applicable to such letters, however, the SEC appears to look primarily to the closest regulatory guidance, which is Item 503 of Regulation S-K. Item 503 requires a brief, clear and plain English business overview for the prospectus summary and risk factors touching on the most significant aspects of the company’s business and the offering.

In its reviews of IPO filings, the SEC has commented that IPO letters should be limited to a discussion of the company’s current business (particularly if the issuer is in its preliminary stage of development) and the risks of investing in the offering. The IPO letter must present a balanced summary of the business including, if presented, its current financial condition, future prospects and challenges.

The blog also discusses specific SEC comments on founder’s letters – including directives to discuss topics addressed only in those letters in other relevant prospectus sections, such as MD&A, as well as comments focusing on perceived inconsistencies between those letters and the other information in the filing.

IPOs:  Here’s Why Founders Like High Vote Stock

Speaking of both Uber & founders, this recent letter from CtW Investment Group to Uber’s Board Chair Ronald Sugar is “Exhibit A” when it comes to why founders are so fond of sticking the public with low vote stock.  After first acknowledging that “the company has a single voting structure, annual director elections, and a separate Chair and CEO,”  the letter goes on to demand sweeping changes to its board over the course of the next 3 single-spaced pages.

Specific demands include the removal of John Thain as a director & that Sugar reduce his outside board commitments “prior to Uber’s stock being listed on the NYSE.”  CtW also wants an overhaul of the board so that it is “more representative of its potential investor base.”  I guess that’s not as urgent as the other stuff though – CtW gives the company until September 1, 2019 to get its act together on this.

It’s not lost on founders that while Uber’s shareholder-friendly governance structure is rewarded with investor ultimatums even before the IPO launches, a dual class company that received a letter like this could simply crumple it up & throw it in the waste basket. Investor advocates may find that appalling. Many entrepreneurs find it very reassuring.

John Jenkins