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Securities law: Suit raises public-company issue in privately held world

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The case of Fried vs. Stiefel Laboratories Inc. doesn't have the ring of a page-turner.

But some say the unlikely case of insider trading should prompt private-company leaders everywhere to take stock in how they’re doing business.

At issue is what privately held companies are obliged to disclose when they buy back their own stock. Private companies are not subject to the same rules as their publicly traded peers, but it doesn’t mean they may be entirely free of potential liability should shareholders become upset.

Fried’s case has securities law experts scratching their heads ­— not because of its potential to set a legal precedent as much as the claim by Fried’s attorneys that the Stiefel defendants violated insider trading rules, which courts have historically applied only to publicly traded companies.

 “It’s a fool’s errand,” said Michael Hund, an attorney at Harrisburg law firm McNees Wallace & Nurick LLC. He counsels privately held companies on compliance with federal securities laws.

Lower court decisions have generally gone against Fried, but on technical grounds, not on the questions of insider trading. Now, his lawyers are seeking a hearing in the U.S. Supreme Court.

Hund didn’t expect to see any major changes in the law as a result of the case, but Hund said it reinforces another universal truth he tells clients.

“If there’s a lesson to be learned here, it’s that private companies buying their own stock need to be careful and look over their shoulder,” Hund said. “We always advise people in a closely held company context there’s always an issue about repurchase price. If they discover gold the next day, a redeemed shareholder is not going to be happy and will find a creative way, legitimately or not, to claw the money back. But that was true long before this case ever came down.”

How it started

Richard Fried was Stiefel’s CEO from 1987 until his retirement in 1997. He claims he should have gotten more for shares he sold back to the company between December 2008 and January 2009. Shortly after he sold the shares, the company was bought by pharmaceutical giant GlaxoSmithKline for $2.9 billion.

Fried missed out on a bigger payday. According to the lawsuit, Fried was paid $637,000 for his 40 shares. When Glaxo closed the deal to buy Stiefel, Fried’s shares would have been worth more than $2 million. And Fried wasn’t the only one. During the same time period, Stiefel repurchased 800 shares, the price of which was based on the latest internal share-price valuation.

Fried argues that Stiefel’s former chairman and CEO, Charles Stiefel, was obliged to disclose that Stiefel owners were actively negotiating to sell the company when they repurchased Fried’s 40 shares.

Before its acquisition by Glaxo, Stiefel was the world’s largest privately held maker of skin care products. A stock plan begun in 1975 allowed employees to purchase shares.

In another lawsuit against Stiefel, former company vice chairman Richard MacKay cited a 2007 investment by the private-equity firm Blackstone Group LP. It paid $60,000 a share for Stiefel stock when it acquired 19 percent of the company for $500 million. MacKay alleged that non-family board members were never told what Blackstone paid. MacKay sold back 750 shares of Stiefel stock for $8.95 million in June 2008. Had MacKay waited until Glaxo acquired Stiefel, the buyback would have been worth $53 million.

Ann Lipton, an associate law professor at Tulane University Law School, said what complicates Fried’s insider trading argument is that the defendant is a private company buying back its own stock – not an individual selling stock on an open market.  

“It’s a different set of rules,” she said. “There’s a very complex scheme of what companies have to disclose when they sell their stock. When a lower-level employee owns stock and finds out about a bad sales quarter and sells their stock, that’s insider trading and it’s obvious. But it’s not obviously insider trading when a corporation does that in a private sale. All case law regarding insider trading has been developed in public companies with open-market trading.”

However it ends, Fried’s lawsuit points to the question of how exposed officers and directors may be as they steer larger companies through rounds of financing.

Insurance policies for private companies often don’t cover violations of securities law, said attorney Paul Mattaini, a partner in law firm Barley Snyder’s Lancaster office. “Maybe these companies also need to have insurance in this area now. I don’t think this issue will come up that often with private companies, but it will come up more often for private equity firms. They need a management team to run the company for them, so they’ll have managers with equity interest in the company as well.”

At the very least, Mattaini advises owners of privately held companies to consider disclosure obligations when deciding to offer stock options to employees.

“If companies are adopting benefit plans that are tied to their stock, they should think about whether they’re comfortable giving information out to employees,” Mattaini said. “You want people to have their interests aligned. If I’m an employee (with stock ownership), arguably I have a right to more information about the thing I own.”

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