Question

David is the CEO of FactsNow, Inc. (not a real company), a consumer research and crisis management organization located in Greenville, SC. FactsNow has contracts with several Fortune 500 organizations and has a reputation for uncovering future trends and handling any number of major crises with great success. Recently, David was approached by his friend Jason, who is the vice president of manufacturing for child clothing manufacturer Baby Gaits (also not a real company). Jason told David he needed to speak to him immediately regarding a matter of a "serious nature," and the two agreed to meet for dinner the following evening. Knowing that Jason had recently received a huge bonus and stock options for meeting production cost ceilings, David felt sure that Jason was going to finally give in and buy that lake house that he had always wanted.

During their dinner, Jason revealed that the FDA is about to release a report revealing that Baby Gaits knowingly participates in the practice of manufacturing clothes with legal products that contain levels of cancer causing agents described as "toxic and extremely dangerous." The FDA report is expected to confirm that the practice is not illegal, but that it results in a product that could be extremely dangerous to children. Jason wants to hire FactsNow to assess what steps should be taken to reduce the impact this will have on Baby Gaits' stock price and market share. David needs more information and asks Jason when he first became aware the products used in manufacturing are dangerous. When Jason says he's known for more than three years, David explodes and asks why Jason didn't immediately discontinue the use of these products. Jason explained that he was directed to continue using the products by Baby Gaits' chief operations officer, Linda Watts, even after he had recommended using alternative solutions. Further, Jason stated that he was told by Linda to, "keep this information to himself." David warned Jason that the report will bring with it severe fallout for Baby Gaits stock as well as all of its senior management personnel, and told him he would begin drafting a proposed public relations response. Out of curiosity, David asked Jason if he still continued to allow his children to wear Baby Gaits products, to which Jason replied incredulously, "What do you think?"

David went home and discussed this shocking information with his wife, Annabelle. David told Annabelle he was heading back to his office to begin developing a crisis management approach when Annabelle reminded him that a significant portion of their personal investment portfolio was invested in Baby Gaits' stock. David cringed when reminded, called his broker immediately and ordered him to dump the stock first thing in the morning. David felt bad about this decision since he owned more than 15 percent of Baby Gaits' stock, but knew he had to put his family first.

Three days later, the FDA released the report, which did contain the information Jason and David expected it to contain. Chaos ensued at Baby Gaits and FactsNow as both companies worked to deal with the fallout. During this time, David was pleased with his decision to sell his Baby Gaits holdings as the stock price plummeted to one-tenth of its previous value. Within one week of the FDA's report, lawsuits began trickling in and the Securities and Exchange Commission called and wanted to speak to David about a "serious matter." David cringed thinking back to the last time he had heard that term and wondered what could be next as he picked up the phone to call you, his lawyer.

A. The SEC speaks with you and indicates they believe David may have conducted a transaction in violation of applicable insider trading regulations. Describe insider trading and make a determination as to whether or not David's actions constituted insider trading.

B. David was recently told by Jason that shareholders are suing Linda for violating the actual authority rule. Jason comes to you and asks you what this is. Based on the information provided, did Linda violate this rule? Why or why not?

C. Angry that the SEC is now banging down his door, David is beginning to resent Jason for failing to honor his responsibility to ensure manufacturing is done properly. David comes to you and asks if he can sue Jason for violating the business judgment rule. What is this rule? Did Jason violate this rule? Why or why not?

Answer 1

A. Insider Trading is related trading (buying/selling) of stocks based on crucial information about a company's internal management/administrative matters. This trading a done privately immediately after hands on information of the internal of the comapny without it being made available to public.

In this case David's action of offloading all his stock of Baby Gates immediately after gaining the internal private news from the company's vice president Mr. Jason that FDA is about to release the news that Baby Gear uses ingredients which are toxic and carcinogenic for cloth manufacturing.

B. Yes Linda Watt had violated the rule by continuing to permit the manufacture of clothes using toxic and carcinogenic product, even though it was communicated to her some 3 years back. COO of Baby Gates Ms Linda Watt had gven business profit an edge over human values and had allowed to put dangerous fabric in the market which were very harmful for children. Even though involvement of Linda in this matter is just an oral confirmation by Jason which can completely be denied by Linda but that is a matter of internal investigation by the company.

C. Business Judgement rule is a presumptious rule that any crucial business decision is taken by the directors/board of the company with utmost honesty for business ethics, by incorporating all facts and in good faith towards society at large.Jason is at fault by keeping mum on such a grave information about the company's product line being toxic. He has totally violated Business Judgement Rule wherein the Chief Pertaing Officer of the company ordered him to keep silent and he was cajoled to be part of such a crime. He is now worried only for the stock price of the company as the information after such long period is now going to be made public by FDA.