Private Company Shares, Valuation, and Employee Stock Repurchases

There has always been a theoretical discussion that there could be insider trading on private company shares. I have not seen the theory tested in court. However, a recent enforcement case by the SEC gets close to the theory. The case involves a company re-purchasing shares from employees at a discounted price.

The SEC makes the bold charge that from November 2006 through April 2009, Stiefel Laboratories Inc. defrauded shareholders out of more than $110 million, at the direction of Defendant Charles W. Stiefel, its then chairman and CEO. For example, in late 2008 and early 2009 while purchasing shares for less than $16,500 a share, Steifel did not inform them that the company was in the midst of negotiating the sale at a price of more than $68,000 per share.

The Stiefel family founded Stiefel Labs in 1847 and began to develop some of the world’s first medicated soaps and dermatology products in 1946. The Company has been privately-held, and since 1952 the Stiefel family has been the majority shareholder. Beginning in approximately 1975, Stiefel Labs’ employees began acquiring Stiefel Labs common stock as part of a defined contribution plan. All Stiefel Labs employees located in the United States became participants in the Plan after their first year of employment. Each year, Stiefel Labs made discretionary contributions to the Plan in the form of Stiefel Labs stock or cash. From 1975 to 2008, the Company made contributions of stock, but in 2008, for the first time in its history, the Company contributed only cash. At the time the company was the world’s largest private manufacturer of dermatology products. Charles W. Stiefel also served as the trustee of the plan.

Each year, the company would engage a third-party accountant to determine the price the company would pay shareholders for stock buy backs. According to the SEC complaint, this is where the trouble began. The SEC alleges that accountant used a flawed methodology and was not qualified to perform valuations. The SEC also alleges that Stiefel failed to disclose crucial information about offers and valuations the company received from investment firms. The valuation was only conducted once year.

According to the SEC complaint, the real trouble began in October 2008 when the company was at risk of violating some debt covenants. A part of the austerity measures, the company started buying back stock from current employees, not just from former employees. It’s also around this time that the company started seriously entertaining offers to purchase the company or at least a big chunk of the company.

From December 2008 to April 2009, while seeking bids for its sale the company purchased stock from employees at a price of $16,469 per share. An April 20, 2009 the company announced its sale to Glaxo and closed on July 22, 2009 resulting in a price of $68,131 for shares held in the retirement plan.

Assuming the facts in the SEC complaint are correct, I have some sympathy for the Stiefel. The negotiations with buyers had non-disclosure provisions that likely prevented them from disclosing the purchase price. On the other hand, some of the messages disclosed in the complaint indicate a grab for cash.

This does show that the SEC’s anti-fraud rule in 10b-5 of the Exchange Act can apply to private company transactions. That would prevent a party with material, non-public information from buying or selling those securities. In this case the private company had the information and the employees in the plan did not. Reliance on a third-party valuation is not enough.