Corporate Governance Issues Regarding “Stock Price Manipulation” and “Insider Trading” (and other matters) are coming to Third Party Financing

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This article was co-authored by Selvyn Seidel and Sandra Sherman.

The early stage industry that is Third Party Financing operates, to an extent, in something of a regulatory vacuum, particularly as to “corporate governance”.  In brief and in general, industry specific issues do not yet have industry specific rules as do an established industry, though we believe that is changing and inevitably will continue to change as third party financing  further matures.

A host of questions surround this change, however, with two pivotal threshold ones being: who will take the lead in developing the industry-specific corporate governance rules?   What should the start be?

From our perspective,  funders should lead, since (among other reasons) we have a better base of understanding of the industry.  Of course other stakeholders must participate, such as the government and defendants, so that final rules have all the necessary checks and balances.  But funders should shape and set the agenda the blueprint forward .

Where to start?  We suggest that identifying some undisputedly important areas, and proposing some rules in those areas, will kick things off nicely.  This is detailed further below.

A first topic to be addressed by industry specific corporate governance rules is, we suggest, disclosure when funding a US public company claimant.  What should public companies and funders disclose about the funding of a public company’s claim, and when?

Two appropriate focal areas are, we submit,  the Securities and Exchange rules that prohibit “stock price manipulation”  and/or “insider trading.” Under the first, the offender, through fraud or otherwise, manipulates the public price of a stock up or down to levels not justified by market conditions, buying or selling before the movement so as to turn a profit on its movement.  Under the second, the offender obtains inside information – unknown to the public – indicating in which direction the stock will move (with or without manipulation), and trades with the benefit of such information to make an illegal profit.  As is evident from headline stories over the past several years,  these rules have been invoked time and again by the SEC.  They are important in general, and will be important in the funding industry given the likely increasing demand by public companies for funding.

Oxus Gold v. Republic of Uzbekistan, a recent case, vividly illustrates this sensitive area, and is the first to illustrate the situation so well.

In August, 2011, Oxus Gold, a British public corporation, began arbitration proceedings against the Uzbek government. Oxus Gold alleged the government had treated the company and its subsidiaries unfairly, and failed to provide full protection and security for a gold mine that it built and operated in Uzbekistan.  Oxus Gold demanded damages of at least $400 million. The Uzbek government countered with a claim in British courts for around $10 million.

In March, 2012, the company announced  that a litigation funder had agreed to underwrite the costs of the arbitration proceeding.  The Funder is, the announcement noted, to receive a “material” portion of any settlement, depending upon a number of variables.  The company further stated that under the agreement, Oxus would retain control of the proceeding.  These announcements captured headlines in the media.

The company’s shares, which had been faring badly as had the company itself, soared almost 50%.   As Proactive Investors reported on March 14, 2012:

“The problem Oxus faced [when it began the arbitration proceeding] was that its limited cash position meant it was in a weak position to bargain for any kind of early cash settlement and similarly the costs associated with mounting a potentially protracted legal case should have been prohibitive. However, an innovative funding deal earlier this month [announced March 1, 2012] provided investors with a glimmer of hope.”

On May 30th, Proactive Investors further reported that:

“The funding deal with [the litigation funder] gave a boost to the  Company’s share price, which has more than doubled so far in 2012 . . . .”

In a more recent pronouncement, November 2012, the company remained optimistic.  Further, by that time its losses and damages had been calculated to be higher than before, well in excess of the $400 million originally claimed.  Despite the company’s optimism, its stock price had fallen considerably to a little more than half of what it had been a few months earlier.   That position has not had a material change subsequently.

The Oxus Gold case demonstrates that the fact of funding, at least as disclosed by Oxus Gold, can have a substantial impact on stock price – prompting a serious spike as well as being involved in a serious plunge.  (It must be emphasized that no issues of stock price manipulation or insider trading, or other corporate governance issues, have to our knowledge been raised in the Oxus Gold case itself.)  The impacts of disclosure might be short term and hard to predict.

Whenever a disclosure can have such an impact, both stock price manipulation and insider trading risks exist.  At least two types of risks exist: that such illegal activity could occur,  or that meritless lawsuits will be brought alleging it occurred. Also, two claimed culprits might be singled out: the Company and the Funder.

As a result, both Funders and public Claimants must wrestle with a host of disclosure issues, such as:

Should companies disclose that a case is funded? When?  Should a company disclose if funding has been declined?   What is the danger if premature comment is made (and what is “premature”)?

How aware or unaware of the industry, and what it does and means,  are investors and other stakeholders? How does this factor relate to the impact or non-impact of fact and details of the funding?  How do you measure the impact?

What about the confidentiality and disclosure rules that have already developed in the industry — and are continuing to develop, some of which are controversial and others which will be controversial?  How do they square with corporate governance rules under the SEC?  How do inconsistencies get reconciled, or harmonized?  Are there irreconcilable areas?

To what extent do the rules in other situations, and their family of concerns, yield intelligence for the funding situation?  For example, what about disclosure rules relating to mergers and acquisitions?  Restructuring?  Bankruptcy?  Insurance?  Hedge Funds?  Starting a new major lawsuit?

If there is to be disclosure, what should the details of the disclosure be?  How much or little needs to be disclosed?  On the one hand, there cannot be a need to disclose all the details about the funding terms, and the Funder.  On the other, the market will want to learn enough to understand certain basics concerning the relationship between the Funder, the claimant, and the claim, especially how the destiny of the claim might be impacted. For example, there was disclosure in Oxus Gold of the fact that on success, the Funder would realize a significant return from the recovery, and that the claimant would keep control of the case.  When must this be disclosed?  When might more be demanded, or less?

The issues are further complicated because it can be unclear what impact a disclosure of funding might have.   A few of the myriad reasons behind this fact are:

  • The industry is new,
  • Most of the funders are early stage, not well known, and often vary dramatically one to the next,
  • There are infinitely varying funding terms, and some can be important in one situation, but unimportant in another, and
  • The nature of the claimant, and that of the defendant, play a big part in the drama.

Four overarching issues, throughout,  are:

  • How consistent or inconsistent are the rules with the industry practices and rules about confidentiality and disclosure, and how best should inconsistencies be reconciled or harmonized?
  • What is the allocation of responsibilities among the claimant, the funder, the representatives, and others, for knowledge of and compliance with their own, and the others, responsibilities?
  • What if substantial changes occur during the course of the funding and litigation? What disclosure is required, if any?  When?
  • What kind and shape of “rules” should be enacted?  Industry wide and voluntary, something akin to the Code of Conduct initiated in the UK relating to third party funding?  Guidelines? Legislation?  Something else?

What is a Funder to do?

First, a Funder must take internal governance and compliance steps on its own to prevent and/or reduce the risk of illegal conduct by the Funder and its representatives.  Second, it may need  to assure itself, to an extent, that the claimant and its representatives has taken, and continue to take, proper precautions against illegal activity. To be sure, the Funder has to be able to rely on the Claimant to know and comply with the law, and other requirements.  That reliance, however, should be adequately founded.  Third, it needs to relate the governance requirements of confidentiality and disclosure to practices that have already developed in the industry, and address  possible inconsistencies or conflicts to the extent possible.

The claimant has of course similar responsibilities related to the Funder and its representatives.

These questions and requirements do not vanish once there is the first disclosure.  As indicated above, they stay alive, in varying degrees, as the litigation and the funding progress.

The role and scope of corporate governance as it might be relevant to the Third Party Financing industry is obviously far too wide and deep to cover in this presentation, except as a general, abbreviated matter.  Nonetheless, to push things out of the starting gate, we suggest beginning the conversation or debate of what rules should look like by considering the limited rules we propose below. We hope they will be considered, challenged, used to help identify issues for further study, and result in rules in these areas starting to become a reality:

[1]          A Funder has no responsibility for determining what the public claimant must do to protect against stock price manipulation and insider trading, before, during, and after funding, except as provided in Rules 2 and 3 below.

[2]          The Funder must take reasonable steps in these areas to satisfy itself that the claimant knows what it must do and has taken reasonable steps to do so.

[3]          The Funder must not undertake to start the funding process unless it is prepared, and able to do what it may need to do to meet requirements of Rules 1 and 2.

Regardless of whether starting with these proposals is the best way forward, the bottom line is that there has to be a start. The industry is growing too big, too fast,  for the industry, the market, the relevant defendant universe, and the regulators and legislators, to avoid addressing these disclosure questions and the funders’ and others related responsibilities. The Funding community can, by taking the first and follow up steps, steal a march on considering and enacting governance rules and guidelines.

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