The SEC Settles A Long Running And Significant Insider Trading Case

The SEC settled a long running and significant insider trading case. The action was initially dismissed by the district court and was later reinstated by the Ninth Circuit Court of Appeals. With the entry of a final judgment against J. Thomas Talbot, former director of Fidelity National Financial, Inc., on March 9, 2009, the case came to an end about five years after it began. SEC v. Talbot, Case No. CV 04-04556 (C.D. Cal. Filed June 24, 2004). Mr. Talbot agreed to settle the case by consenting to the entry of a permanent injunction prohibiting future violations of Exchange Act Section 10(b) and Rule 10b-5. Mr. Talbot also agreed to the entry of an order requiring him to disgorge $67,881 along with $26,916 in prejudgment interest for a total of $94,797. In addition, he agreed to pay a civil penalty of $135,762. Although the complaint sought an officer and director bar, the settlement did not include this provision.

This case arouse out of the take-over of the LendingTree by USA Interactive in May 2003. Prior to that transaction, according to the Commission’s complaint, LendingTree was in negotiations to be acquired. The CEO of LendingTree, Douglas Libda, told a vice-president of Fidelity, Brent Bickett, about the proposed transaction. The consent of Fidelity would be required, since the company owned about 12% of LendingTree.

Subsequently, Mr. Bickett told William Foley, CEO of Fidelity, about the proposed transaction. Mr. Foley, in turn discussed the matter at a regular board meeting attended by Mr. Talbot. While the board was not told to keep the information confidential, one board member noted at the conclusion of the meeting that the information about LendingTree was inside information.

Two days after the board meeting Mr. Talbot purchased 5,000 shares of LendingTree at about $13.50 per share. Later he purchased an additional 5,000 shares at $14.50 per share. A few days later, on May 5, 2003, the acquisition of LendingTree was announced. Mr. Talbot sold his shares for a profit of over $67,000.

The district court granted summary judgment in favor of Mr. Talbot. The court held that the SEC had failed to establish a breach of duty because it did not demonstrate that there was a continuous chain of fiduciary relationships back from Mr. Talbot to the source of the information. The court read U.S. v. O’Hagan, 512 U.S. 642 (1997), which upheld the misappropriation theory, as requiring a continuous link.

The Ninth Circuit reversed. The circuit court held that under the misappropriation theory as defined by O’Hagan, a breach of duty is required since it supplies the key element of deception. That breach however, need not be to the shareholder involved in the trading. Rather, the breach of duty and deception runs to the source of the inside information. Stated differently, the breach runs to the source of the information who is deceived. Accordingly, a continuous chain back to the source of the information as the district court concluded is not required.

The ruling by the Ninth Circuit is significant for SEC enforcement. A ruling upholding the district court’s conclusion would have significantly narrowed the scope of liability under the misappropriation theory. In contrast, the ruling of the Ninth Circuit gives insider trading a far broader reach than the rejected continuous chain would have permitted.

The Impact of Tellabs: Another Suit Dismissed

The Supreme Court’s decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308 (2007) continues to have a significant impact on private securities actions. In Tellabs, discussed here, the Court construed Section 21D(b)(2) of the Private Securities Litigation Reform Act of 2005. That section requires that a strong inference of the “required state of mind” be pled as part of a cause of action for securities fraud in a suit for damages. The Fifth Circuit’s decision in Flaherty & Crumrine Preferred Income Fund Inc., v. TXU Corp., Case No. 08-10414 (5th Cir. Decided April 8, 2009) is the most recent circuit court decision to affirm the dismissal of a securities fraud complaint.

The complaint in TXU centers on plaintiffs’ claim that defendants misrepresented the dividend policy and an eventual dividend increase to induce them to tender their shares. Four months before a tender offer, TXU announced in a press release that the company did not anticipate a dividend increase until two years later when certain financial benchmarks were reached. The release did however, state that the board of directors might consider other factors in determining whether to authorize a dividend increase. The day before the expiration of the tender offer, the company made a presentation to certain credit rating agencies for the purpose of facilitating the agencies’ determination of whether an increase in the dividend would impact its credit rating.

Plaintiffs tendered their shares at the end of the offer period. Six days later, management furnished the board with materials proposing a dividend change, recommending a 350% increase in the annual dividend on common stock and a 400% increase in the stock repurchase program. Three days later, the board approved the recommendation, increasing the dividend from $0.50 to $2.25 and to repurchase about 50 million common shares. The share price jumped about 20% on the announcement.

Plaintiffs brought suit claiming that the company made false and misleading statements regarding the change in dividend policy to induce them to tender. The district court initially dismissed the complaint. During an initial appeal the Supreme Court decided Tellabs. Accordingly the circuit court remanded the case for reconsideration in view of the Supreme Court’s decision. After permitting plaintiffs to amend their complaint, the court again dismissed it. The Fifth Circuit affirmed.

The Fifth circuit read Tellabs as requiring essentially a four step test: 1) all allegations must be assumed to be true; 2) the facts must be viewed collectively and not in isolation; 3) the court must consider plausible inferences opposing as well as supporting a strong inference of scienter; and 4) omissions and ambiguities count against an inference of scienter.

In evaluating plaintiffs’ claims, the court began by noting that allegations of motive and opportunity — a component of the traditional Second Circuit test of the evidence of scienter — “standing alone will not suffice to meet the scienter requirement, [but] motive and opportunity allegations may meaningfully enhance the strength of the inference of scienter.” Essentially plaintiffs claim that they relied on the accuracy of the pre-tender press release regarding the dividend policy and that several subsequent statements were false and misleading which focused primarily on whether that policy was under review and if the company had made adequate disclosure of that fact. After reviewing each statement the court concluded that “it is not clear that Appellees [defendants] ever issued a materially misleading statement,” although the court noted that the timing of the announcement gave some support to plaintiffs’ claim.

The court went on to reject an argument that the disclosure stating that the policy “was under review” was not sufficient. In considering this question the court held that it “advises that a ‘middle course’ is proper when making disclosures concerning future plans which have not been fully determined in the context of a tender offer. … TXU could not have disclosed that a dividend increase was likely during the tender offer without running a risk of liability if the dividend increase was not ultimately approved.”

The court concluded by noting that Tellabs requires that it consider opposing inferences. Since the company disclosed that the dividend policy was under review during the tender period the court held that “the inference of non-fraudulent intent weights in favor of the” defendants.

The Fifth Circuit’s decision is consistent with those in other circuits. Since the Supreme Court decided Tellabs, most circuit courts have affirmed the dismissal of securities fraud suits after applying the teachings of the Supreme Court. A notable exception to this general rule is the Tellabs case on remand where the Seventh Circuit again determined that the complaint was sufficient. Makor Issues & Rights, Ltd. v. Tellabs, Inc., 513 F.3d 702 (7th Cir. 2008) (the case is now in discovery). Other exceptions are the decisions by the First and Sixth Circuits concluding that the Supreme Court lowered the pleading burden on plaintiffs. Mississippi Public Employees’ Retirement System v. Boston Scientific Corp., 2008 WL 173590 (1st Cir. April 16, 2008) (reversing dismissal and acknowledging lower standard); Frank v. Plumbers & Pipefitters National Pension Fund v. Dana Corp., Case No. 07-4325 (6th Cir. Decided Nov. 19, 2008) (acknowledging lower standard); but see ACA Financial Guaranty Corp. v. Advest, Inc., 512 F.3d 46 (1st Cir. 2008)(acknowledging lower standard but affirming dismissal).