David is the CEO of FactsNow, Inc. (not a real company), aconsumer research and crisis management organization located inGreenville, SC. FactsNow has contracts with several Fortune 500organizations and has a reputation for uncovering future trends andhandling any number of major crises with great success. Recently,David was approached by his friend Jason, who is the vice presidentof manufacturing for child clothing manufacturer Baby Gaits (alsonot a real company). Jason told David he needed to speak to himimmediately regarding a matter of a "serious nature," and the twoagreed to meet for dinner the following evening. Knowing that Jasonhad recently received a huge bonus and stock options for meetingproduction cost ceilings, David felt sure that Jason was going tofinally give in and buy that lake house that he had alwayswanted.
During their dinner, Jason revealed that the FDA is about torelease a report revealing that Baby Gaits knowingly participatesin the practice of manufacturing clothes with legal products thatcontain levels of cancer causing agents described as "toxic andextremely dangerous." The FDA report is expected to confirm thatthe practice is not illegal, but that it results in a product thatcould be extremely dangerous to children. Jason wants to hireFactsNow to assess what steps should be taken to reduce the impactthis will have on Baby Gaits' stock price and market share. Davidneeds more information and asks Jason when he first became awarethe products used in manufacturing are dangerous. When Jason sayshe's known for more than three years, David explodes and asks whyJason didn't immediately discontinue the use of these products.Jason explained that he was directed to continue using the productsby Baby Gaits' chief operations officer, Linda Watts, even after hehad recommended using alternative solutions. Further, Jason statedthat he was told by Linda to, "keep this information to himself."David warned Jason that the report will bring with it severefallout for Baby Gaits stock as well as all of its seniormanagement personnel, and told him he would begin drafting aproposed public relations response. Out of curiosity, David askedJason if he still continued to allow his children to wear BabyGaits products, to which Jason replied incredulously, "What do youthink?"
David went home and discussed this shocking information with hiswife, Annabelle. David told Annabelle he was heading back to hisoffice to begin developing a crisis management approach whenAnnabelle reminded him that a significant portion of their personalinvestment portfolio was invested in Baby Gaits' stock. Davidcringed when reminded, called his broker immediately and orderedhim to dump the stock first thing in the morning. David felt badabout this decision since he owned more than 15 percent of BabyGaits' stock, but knew he had to put his family first.
Three days later, the FDA released the report, which did containthe information Jason and David expected it to contain. Chaosensued at Baby Gaits and FactsNow as both companies worked to dealwith the fallout. During this time, David was pleased with hisdecision to sell his Baby Gaits holdings as the stock priceplummeted to one-tenth of its previous value. Within one week ofthe FDA's report, lawsuits began trickling in and the Securitiesand Exchange Commission called and wanted to speak to David about a"serious matter." David cringed thinking back to the last time hehad heard that term and wondered what could be next as he picked upthe phone to call you, his lawyer.
A. The SEC speaks with you and indicates they believe David mayhave conducted a transaction in violation of applicable insidertrading regulations. Describe insider trading and make adetermination as to whether or not David's actions constitutedinsider trading.
B. David was recently told by Jason that shareholders are suingLinda for violating the actual authority rule. Jason comes to youand asks you what this is. Based on the information provided, didLinda violate this rule? Why or why not?
C. Angry that the SEC is now banging down his door, David isbeginning to resent Jason for failing to honor his responsibilityto ensure manufacturing is done properly. David comes to you andasks if he can sue Jason for violating the business judgment rule.What is this rule? Did Jason violate this rule? Why or why not?
