The SEC continues to struggle with its swagger. The claim that it has returned is, at best, debatable. Clearly prevailing in the SEC v. Wyly, 10 Civ. 5760 (S.D.N.Y. Verdict May 12, 2014) earlier this month was a major and much need courtroom win for an agency. Yet on the same day the Commission lost what may be a more significant case in SEC v. Graham, Case No. 13-1001 (S.D. Fla. Ruling May 12, 2014) when the Court dismissed all of its claims on jurisdictional grounds, citing the five year statute of limitations in 28 U.S. C. Section 2462. If Wyly was one step forward, then Graham was two back (here).
Now the backward trend may be accelerating. On Friday a jury in Manhattan returned a verdict against the SEC and in favor of the three defendants in the long running, and high profile insider trading case, SEC v. Obus, Civil Action No. 06-03150 (S.D.N.Y.).
Obus centered on the acquisition of SunSource, Inc. by Allied Capital Corporation in June 2001. Following the acquisition the SEC brought an insider trading action against Nelson Obus, Peter Black and Thomas Strickland. Mr. Strickland had been employed as an assistant vice president and underwriter at GE Capital Corporation. His college friend, Peter Black ,worked as an analyst at Wynnefield Capital, Inc. which managed a group of hedge funds. His supervisor was Nelson Obus.
In May 2001 Allied approached GE Capital about financing its acquisition of SunSource. Mr. Strickland was assigned to perform due diligence on SunSource. While doing that work he learned about the proposed deal. He also learned that Wynnefield was a large SunSource shareholder. Although he understood the information was confidential, SunSource and Allied were not placed on the restricted list until after the GE Capital team had completed its work.
Later that same month Mr. Strickland discussed SunSource with his friend Peter Black. Both men claim that there was no tip, only a routine due diligence conversation. Mr. Black did, however, come to suspect that SunSource was considering a transaction that would dilute existing shareholders. He conveyed this suspicion to his boss, Mr. Obus who later called Maurice Andrien, the president of SunSource. Mr. Andrien would subsequently claim he learned during the conversation that Mr. Obus had been tipped. Mr. Obus denied this.
On June 8, 2001 Wynnefield purchased 287,200 shares of SunSource at $4.50 per share. This was about two weeks after the Strickland-Black conversation. The transaction was initiated by Cantor Fitzgerald which called and initially offered a 50,000 share block at $5 per share. The purchase was about the same size as an earlier Wynnefield transaction in the stock. Nine days later the deal was announced and the share price doubled, giving the hedge fund a profit of about $1.3 million.
The SEC claimed Mr. Strickland illegally tipped Mr. Black who in turn tipped Mr. Obus. In the District Court the defendants prevailed on summary judgment. The Court found that Mr. Strickland had not breached any duty to GE Capital. The ruling was based on the theory that GE Capital’s internal investigation had found no breach of duty and the fact that SunSource had not been on the firm’s restricted list until after the due diligence was complete. The Court also found that the facts were insufficient for the jury to conclude that Mr. Strickland’s conduct was deceptive.
The Second Circuit reversed. The SEC relied on the misappropriation theory of insider trading. That theory, the Circuit Court noted, is premised on a breach of fiduciary duty to the source of the information rather than the company as with the classic theory. Unlike the classic theory, under which the holder of the information can abstain from trading or disclose, under the misappropriation theory disclosure can only be made to the source or the holder can abstain from trading.
To hold a tipper liable there must be: 1) a tip, 2) material non-public information, 3) in breach of a fiduciary duty 4) for the personal benefit to the tipper. The required scienter corresponds to the first three elements. While the tipper is not required to have specific knowledge of the legal nature of a breach of fiduciary duty, he “must understand that tipping the information would be violating a confidence” the Court held. The tippee must also know that the information conveyed is material and non-public.
After outlining these principles, Second Circuit made two significant rulings, favoring the SEC. First, it resolved a question regarding the application of Dirks v. SEC, 463 U.S. 646 (1983) on the scienter of a tippee. In Dirks the High Court stated that while the tippee is a participant in the tipper’s breach of fiduciary duty, “a tippee has a duty to abstain or disclose only when the insider has breached his fiduciary duty . . . and the tippee knows or should know that there has been a breach.” This statement, expressing a negligence standard, contrasted with the requirement of Ernst & Ernst v. Hochfelder425 U.S. 185 (1976) which held that there must be scienter. The Second Circuit harmonized the apparent inconsistency, holding that Hochfelder scienter applies to the tippee’s use of the information in trading while the Dirks negligence language applied to that person’s knowledge that the tipper breached a duty.
Second, the Court concluded that despite the findings of the internal investigation that there was no breach of duty, and the facts regarding the restricted list, there could still be a breach of duty and liability. Based on these principles the Court concluded that there was sufficient evidence that Mr. Strickland knew he owed GE Capital a duty to keep the information confidential and not to convert it to his own profit. Furthermore, the District Court erred in requiring the SEC to make an additional showing of deception as to Mr. Strickland beyond the tip. The tip is sufficient, the Circuit Court concluded.
Mr. Black’s liability is derivative of Mr. Strickland, the Circuit Court concluded. The critical point is if he knew or should have known that Mr. Strickland breached his fiduciary duty. He is a sophisticated financial analyst who knew that his friend was involved in developing financing packages for other companies and performing due diligence He also knew that information about an acquisition would be material non-public information. This, the Court held, is sufficient.
Finally, the same question is critical as to Mr. Obus. Here the Court found it sufficient that Mr. Obus determined the information he obtained to be credible and knew that it originated from a person with a duty of confidentiality. Accordingly, the Second Circuit remanded the case for trial.
Despite the favorable rulings on duty and the knowledge of tippees, which in some ways tends to eliminate the statutory element of deception (here), the SEC was unable to prevail in this major, high profile trial. The jury rejected its claims, finding in favor of each defendant. The month of May thus came to an end for the Commission with one step forward in Wyly, two back in Graham and even more back with Obus.