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Trading Shares While Serving as Representative Plaintiffs

Potter Anderson & Corroon LLP


Peter J. Walsh, Jr., T. Brad Davey, Thomas A. Mullen, and David B. DiDonato of Potter Anderson & Corroon LLP

Original Title: Steinhardt, Chen, et al. v. Occam Networks, Inc., C.A. No. 5878 (Del. Ch. Jan. 6, 2012) (Laster, V.C.)


Michael Steinhardt ("Steinhardt") and Herbert Chen ("Chen" and collectively with Steinhardt, the "Plaintiffs") traded shares of Occam Networks, Inc. ("Occam") while serving as representative plaintiffs in a class action challenging the merger of Occam with and into Calix, Inc. ("Calix"). Vice Chancellor Laster granted defendants' motion for sanctions with respect to Steinhardt, who actively traded on confidential information obtained from Chen, but denied the motion with respect to Chen, who inadvertently traded a small amount of Occam stock but had otherwise proven himself to be an effective class representative. The Vice Chancellor dismissed Steinhardt and his funds as class representatives, barred them from recovery in this litigation, required self-reporting to the Securities and Exchange Commission (the "SEC"), directed disclosure of their improper trading upon any future application to act as lead plaintiff, and ordered disgorgement of related illicit profits.

On September 16, 2010, Occam and Calix announced that the parties had entered into a merger agreement pursuant to which each share of Occam common stock would be converted into the right to receive $3.8337 in cash and 0.2925 shares of Calix common stock. The Plaintiffs wrote to the Occam board of directors setting forth their objections to the merger, and, in particular, the merger consideration. On October 6, 2010, the Plaintiffs commenced this action in the Court of Chancery, alleging that the Occam directors breached their fiduciary duties by approving the merger at an unfair price. Between October 29 and November 2, 2010, Chen sold 31,000 Occam shares at less than the announced merger price in an effort to generate liquidity in anticipation of entering into a confidentiality order that would limit his ability to trade. On November 12, 2010, the Vice Chancellor approved a stipulation and order requiring that confidential discovery material be used only for purposes of this litigation, and restricting the purchase, sale, or trades in the securities of any company, including but not limited to Occam and Calix, on the basis of confidential information contained in the confidential discovery material. Shortly thereafter, the Plaintiffs amended their complaint to include disclosure claims and moved to preliminarily enjoin the consummation of the merger. Thereafter, document production and depositions commenced. On December 28, 2010, when the defendants had nearly completed their document productions, Steinhardt began short selling his Calix common stock to both exit his position in Occam stock, and take advantage of the arbitrage spread that existed between Calix and Occam at the time. In total, he sold 589,097 shares of Calix common stock, which equated to selling 2,014,007 shares of Occam common stock based on the exchange ratio set forth in the merger agreement.

Steinhardt testified that he based his decision to short sell his shares of Calix common stock on his view that the hype surrounding Calix common stock from its IPO had inflated its share price and was unsustainable. However, at the time he decided to sell, Steinhardt was also receiving non-public information regarding the litigation from Chen. Because of his extensive knowledge and investment in Occam, Chen became actively involved in the document production, from which he learned information about the status of the litigation that he communicated to Steinhardt both orally and through written summaries. Chen was aware that Steinhardt was selling Calix shares short and disagreed with his decision to do so, but Chen did not inform Plaintiffs' counsel about the short sales. On January 24, 2011, the Vice Chancellor held a hearing in open court and granted Plaintiffs' motion to enjoin the merger pending the issuance of supplemental disclosures and the deposition of one of the lead bankers.

On January 25, 2010, Chen sold 2,500 shares of Occam stock to satisfy a margin call on his brokerage account. Chen testified that he accidentally sold Occam shares, which amounted to less than 0.5% of his holdings in Occam, because he was multi-tasking while executing the trade. He further testified that when he discovered that he had sold Occam shares by mistake, in violation of the confidentiality order, he chose not to violate it a second time by buying shares back. However, he failed to inform Plaintiffs' counsel of the sale. Occam convened and adjourned its stockholder meeting, disclosed additional information, and, on February 22, 2011, obtained stockholder approval of the merger at the reconvened meeting. Thereafter, defendants requested discovery regarding the Plaintiffs' trading activities. Steinhardt sought to avoid the requests by offering to step down as class representative, but defendants declined the offer and Chen moved for class certification without Steinhardt.

Vice Chancellor Laster first analyzed the motion for sanctions against Steinhardt by noting that when a stockholder of a Delaware corporation files suit as a representative plaintiff he voluntarily assumes the role of fiduciary for the class, thereby making it unacceptable for the plaintiff-fiduciary to trade on the basis of non-public information obtained through litigation. The Court found that Steinhardt sold Calix shares short with the benefit of information he received from Chen, whose insights were based on the discovery record and discussions with counsel, which allowed Steinhardt to conclude that the merger would be consummated without a change in the merger consideration. Thus, the Court concluded that Steinhardt used non-public information for his personal benefit, actions which constituted a breach of this fiduciary obligations as a representative plaintiff and in violation of the terms of the confidentiality order. The Court further determined that Steinhardt's offer to step down as class representative did not moot the breaches. Consistent with prior rulings, the Vice Chancellor dismissed Steinhardt and his funds, barred them from receiving any recovery in the litigation, required them to self-report to the SEC, directed their disclosure of improper trading in any future application to serve as lead plaintiff, and ordered them to disgorge trading profits. The Vice Chancellor noted that while he could order disgorgement of all profits from trading on Occam and Calix shares, based on the facts of this case, that would constitute a disproportionate and punitive sanction. Thus, he limited the sanction to any advantage gained by Steinhardt's position as representative plaintiff and trading before the injunction hearing, and calculated the amount to be disgorged by subtracting the merger cash consideration from the profits on trading on Occam and Calix shares and ordered Steinhardt to disgorge $534,071.45 as a sanction for the improper trades.

The Court found Chen's trades to be materially different than Steinhardt's trades. Chen first traded Occam shares before execution of the confidentiality order and before the defendants produced any non-public information. He later accidentally traded a small fraction of Occam shares by "fat finger error" soon after the preliminary injunction hearing which eliminated the principal benefit Chen obtained from accessing confidential discovery information. The Vice Chancellor further stated that he was troubled by Chen's decision to continue providing Steinhardt with confidential information despite knowing that Steinhardt was shorting the Calix stock, but found that Chen had become very knowledgeable about Occam and the merger and had proven himself to be a motivated and effective representative plaintiff, and thus removing him from the litigation would significantly harm the class.

Delaware Case Law Relevant to Venture Capital Community

In this buzz article Potter Anderson & Corroon LLP attorneys will provide an update on decisions of the Delaware Court of Chancery and the Supreme Court of Delaware that are particularly relevant to the venture capitalist community. These courts are among the most influential tribunal in the world regarding corporate matters and alternative entities and therefore contribute significantly to shaping the law that affects sophisticated venture capitalist transactions.

Peter J. Walsh, Jr., Partner, Corporate Group, pwalsh@potteranderson.com

Mr. Walsh is a corporate and commercial litigator. He has first-chaired many trials in the Delaware courts, and has successfully argued cases before the Supreme Court of Delaware and in the United States Court of Appeals for the Third Circuit. He regularly handles Delaware Court of Chancery proceedings, including stockholder class and derivative actions, summary proceedings pursuant to the General Corporation Law of the State of Delaware, and hostile takeover proceedings. Mr. Walsh also frequently counsels officers and directors, committees of the board and the Delaware corporations they serve in matters of Delaware corporate law, primarily as such matters bear upon ongoing or anticipated litigation.

Full Bio (http://www.potteranderson.com/attorney/walsh-peter)

T. Brad Davey, Partner, Corporate Group, bdavey@potteranderson.com

Mr. Davey's practice focuses primarily on business and corporate litigation in the Delaware Court of Chancery. Mr. Davey represents directors, stockholders and special committees in corporate governance and mergers and acquisition litigation involving a broad range of industries including communications, software, energy, private equity and financial institutions.

Full Bio (http://www.potteranderson.com/attorney/davey-t-brad)

Thomas A. Mullen, Partner, Business Group, tmullen@potteranderson.com

Mr. Mullen's practice focuses on business transactions, particularly the structure and use of Delaware corporations, partnerships, limited liability companies and statutory trusts. Mr. Mullen's practice includes counseling corporations, investors, directors and board committees on matters involving the General Corporation Law of the State of Delaware and related fiduciary duty issues arising in a variety of transactions and circumstances, including mergers and acquisitions, defensive planning, recapitalizations and liquidations. Mr. Mullen also advises on the use of Delaware LLCs, partnerships and statutory trusts in a broad range of transactions, including structured financings, formation of private equity funds and joint ventures, and mutual fund reorganizations. He frequently provides legal opinions concerning Delaware business entity statutes and corporate law issues.

Full Bio (http://www.potteranderson.com/attorney/mullen-thomas)

David B. DiDonato, Associate, Corporate Group, ddidonato@potteranderson.com

Mr. DiDonato's practice involves counseling Delaware corporations on corporate law and governance issues. His practice also focuses on corporate and commercial litigation in the Delaware Court of Chancery.

Full Bio (http://www.potteranderson.com/attorney/didonato-david)

Potter Anderson & Corroon LLP

Potter Anderson & Corroon LLP represents Fortune 500 companies, some of the largest national law firms, and individuals in connection with complex corporate and commercial litigation in the Delaware Court of Chancery and Supreme Court of Delaware while also counseling such clientele on corporate law and governance issues under Delaware law.

For additional information about any of the summaries or information provided in this book, please contact Peter Walsh at 302-984-6037; pwalsh@potteranderson.com, Brad Davey at 302-984-6021; bdavey@potteranderson.com, David B. DiDonato at 302-984-6191; ddidonato@potteranderson.com, or Thomas Mullen at 302-984-6204; tmullen@potteranderson.com at Potter Anderson & Corroon LLP. The contents of these summaries are not intended, and should not be considered, as legal advice or opinion.

Material in this work is for general educational purposes only, and should not be construed as legal advice or legal opinion on any specific facts or circumstances, and reflects personal views of the authors and not necessarily those of their firm or any of its clients. For legal advice, please consult your personal lawyer or other appropriate professional. Reproduced with permission from Potter Anderson & Corroon LLP. This work reflects the law at the time of writing.

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