Friday, September 9, 2005

When Does an Outsider Assume an Insider's Fiduciary Duty for Insider Trading Liability?

The SEC announced the settlement  of securities fraud action involving sales before disclosure of negative news about a company that presents an interesting issue on the scope of insider trading liability. In SEC v. Johnson,  David Johnson learned of a negative analyst report about PMA Capital Corp., and spoke with the chairman of the company's board of directors.  The chairman stated that the company was having financial difficulties and would likely have to eliminate its dividend.  The SEC's complaint (here) states that "[a]t no time during the conversation did the Chairman tell Johnson that he expected him to keep the information conveyed in their conversation confidential or that he should not trade based on this information."

Johnson then sold his substantial holdings in the company, and had his son sell his shares.  When PMA's stock dropped 62% after announcing the dividend elimination, Johnson avoided over $325,000 in losses, and his son avoided over $55,000.  The interesting point about the Commission's complaint is that it merely asserts that Johnson knew the information he received from the company's chairman was confidential, and that he then assumed the fiduciary obligation to maintain the confidentiality of the information and abstain from trading.  The complaint (here) states:

The information Johnson obtained from the Chairman concerning the loss reserve charge and the discontinuation of the common stock dividend was material and nonpublic. Johnson knew, or was reckless in not knowing, that the Chairman had provided confidential information to him. By disclosing this information to Johnson, the Chairman breached his fiduciary duty to PMA’s shareholders. Therefore, Johnson assumed this duty of trust and confidence to PMA and its shareholders not to trade, or to direct others to trade, in PMA securities. By trading and by tipping his family members, including his son and daughter, Johnson breached that duty.

I'm not sure how you get to the part after "therefore" without some evidence that the chairman intended to tip Johnson, or that Johnson accepted a responsibility to maintain the confidentiality of the information and then violated the "abstain or disclose" rule.  The complaint sure sounds like the "possession" theory of insider trading, ostensibly rejected by the Supreme Court in Chiarella and revived, as least somewhat, by the SEC in Rule 10b-5-1, an amendment that has never been tested in court.  As a settled matter, the assertions in the complaint will not be tested in court, but the SEC's position that an outsider can assume a duty to the company without any assertion that the person agreed to undertake that duty, or was a tippee under the more common Dirks analysis, is beyond anything I have seen the courts sanction regarding liability for insider trading. (ph)

Civil Enforcement, Insider Trading | Permalink

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