Saturday, September 25, 2010
The law of insider trading under Rule 10b-5 is a law professor’s dream; it’s so much fun to come up with clever hypotheticals. For a doctrine that can result in loss of reputation and even criminal penalties, however, it is not a model of clarity and, indeed, presents difficult questions in application. The Supreme Court in U.S. v. Chiarella told us that a fiduciary relationship, or at least a relationship of trust and confidence, is required for “classic” insider liability, and, in U.S. v. O’Hagan, told us that “deception” is required to establish liability under the misappropriation theory. Meanwhile, the distinctions between the classic and misappropriation theories have become increasingly blurred; the SEC frequently alleges both theories in its complaints. While a legislative solution might seem the preferred method to clean up the law, Congress has not taken up the challenge, and the SEC has not advocated for Congressional action. Two recent decisions illustrate the difficulties.
In SEC v. Cuban (5th Cir. Sept. 21, 2010), the Fifth Circuit reversed the district court’s dismissal of the SEC’s action and held that the SEC had stated a claim. Cuban was a minority shareholder in Mamma.com when the company’s CEO called to ask if he would be interested in purchasing additional shares in a forthcoming PIPES offering. According to the SEC, the CEO began the conversation by telling Cuban he had confidential information for him, and Cuban agreed to keep the information confidential. Cuban became upset when the CEO told him about the PIPES offering and at the end of the conversation, Cuban told the CEO, “Well, now I’m screwed. I can’t sell.” Cuban asked for , and subsequently received, further information about the terms of the PIPES offering. Shortly thereafter, Cuban sold his holdings in Mamma.com. In dismissing the complaint, the district court acknowledged that Cuban’s “I’m screwed” statement appeared to express his belief that it would be illegal to sell his shares, but the statement could not be understood as a promise not to sell. Accordingly, the complaint alleged at best that the CEO intended to obtain an agreement to keep the information confidential and not an agreement to refrain from selling.
The Fifth Circuit agreed with the district court that the “I’m screwed” statement, read in isolation, did not express an agreement not to sell, but, emphasizing that it was reading the complaint in the light most favorable to the SEC, found that the additional allegations that Cuban obtained confidential information about the PIPES offering provide “more than a plausible basis” to find that the understanding between the CEO and Cuban was more than a confidentiality agreement. “It is at least plausible that each of the parties understood, if only implicitly, that Mamma.com would only provide the terms and conditions of the offering to Cuban for the purpose of evaluating whether he would participate in the offering, and that Cuban could not use the information for his own personal belief.” Had the SEC not alleged that Cuban asked for and received confidential information about the PIPES offering, the Fifth Circuit suggests it would have upheld the district court’s distinction between an agreement to keep information confidential and an agreement not to trade. Finally, the court expressly states it is taking no position on the merits of the SEC’s allegations, “given the paucity of jurisprudence on the question of what constitutes a relationship of ‘trust and confidence’ and the inherently fact-bound nature of determining whether such a duty exists.” In short, the Fifth Circuit’s reversal is not a robust showing of support for the SEC’s position.
A federal district in S.D.N.Y. recently granted summary judgment for defendants in SEC v. Obus (S.D.N.Y. Sept. 20, 2010). Strickland, an employee of GE Capital, was a member of the team that had discussions with SunSource about a financing in connection with an acquisition of the company by a third party. Strickland had at least one conversation about SunSource with a college friend, Black, an employee at Wynnefield Capital, which was a SunSource shareholder. Black, in turn, spoke with his boss, Obus, about SunSource. Shortly after that conversation, Obus spoke with SunSource’s CEO , saying that “a little birdie in Connecticut” told him that SunSource was going to be sold. Thereafter, Wynnefield’s trader received an unsolicited offer to purchase SunSource shares; after consulting with Obus, the trader purchased the SunSource shares. All this took place before any public announcement of the SunSource acquisition.
The SEC pursued both classic insider and misappropriation theories against Strickland, Black and Obus and also named Wynnefield entities as relief defendants. The district, however, dismissed all the counts.
As to the classic insider theory, the court rejected the argument that GE Capital, or its employee Strickland, became a temporary insider of SunSource when it held discussions with it about providing financing, for two reasons: (1) GE Capital did not sign a confidentiality agreement, and (2) the potential debtor-creditor relationship did not establish a relationship of trust and confidence.
As to the misappropriation theory, the court found insufficient evidence that Strickland breached a duty owed to his employer, GE Capital, despite the fact that GE Capital had reprimanded Strickland for violating its policies that preclude an employee from engaging in any tipping or trading on inside information. The court finds that Strickland’s conduct was not “deceitful,” noting GE Capital found only that Strickland made a “mistake.” It expressly rejected the SEC’s argument that “deception” could be established by the “breach, tip and trade” alone and did not require any additional deceptive conduct. The court also did not view Obus’s telling the SunShine CEO that he had information about a sale as the actions of someone acting deceptively.
These cases nicely illustrate the SEC’s difficulties in pleading and proving insider-trading cases under both the classic and misappropriation theories and perhaps reflect a judicial disinclination to extend these doctrines beyond the most obvious forms of insider trading. It might be time for the SEC to reconsider its longstanding disinclination to establish more certain guidelines in this very difficult area.