On June 30, 2008, the SEC won a significant decision in the Ninth Circuit Court of Appeals in an insider trading case which had been previously dismissed by the district court. At the same time, the SEC filed a partially settled options backdating case – the company settled, but two former senior officers named as defendants are contesting the action against them.

Insider trading

In SEC v. Talbot, Case No. 06-55561 (9th Cir. June 30, 2008), the Ninth Circuit Court of Appeals reversed the dismissal of an SEC insider trading action. The district court had dismissed the SEC’s complaint, concluding that the SEC had failed to establish the breach of duty necessary to sustain a claim of insider trading.

Mr. Talbot was a director of Fidelity National Financial, which owned 10% of LendingTree, another public company. According to the complaint, LendingTree was in negotiations to be acquired. The CEO of Lending Tree, Douglas Libda, informed Brent Bickett, a vice president of Fidelity, about the proposed transaction, noting that LendingTree would need the consent of Fidelity. Mr. Libda also requested that the information be kept confidential. In the conversation he did not disclose the identity of the potential acquirer or the price.

Subsequently, Mr. Bickett told William Foley, CEO of Fidelity about the potential transaction. Mr. Foley later discussed it with the board at its regular meeting. The board was not told to keep the information confidential, although one of the directors stated at the conclusion of the meeting that this was inside information. Mr. Talbot later purchased shares of Lending Tree prior to the public announcement of the acquisition. Following the announcement the share price of Lending Tree rose about 41%.

The SEC’s complaint claimed that Mr. Talbot violated Section 10(b) by trading on inside information. The district court granted summary judgment in favor of Mr. Talbot. In its opinion the court held that had the SEC had failed to establish a breach of duty because it failed to establish 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 such a continuous link.

The Ninth Circuit reversed. In its opinion, the court noted that under the classic theory of insider trading the insider breaches a duty by using company information to trade. That breach of duty is a deception on the shareholders. Under O’Hagan and the misappropriation theory, there was also a breach duty and deception, but not to the shareholders involved in the trading. Rather, the breach of duty and deception was to the source of the inside information. The circuit court rejected the district court’s conclusion that there had to be a continuous chain between the source of the information and the trader. Under this theory, the breach would run to the information source who would be deceived.

Here, Mr. Talbot breached a duty to his company by trading on the information. That breach is sufficient. It is not necessary for the SEC to establish a continuous chain back to the Lending Tree official that initially supplied the information. While that chain is present in many cases, the court did not read O’Hagan as requiring such a chain.

Backdating

The SEC also filed a partially settled option backdating case on Monday, SEC v. Microtune, Inc., Case No. 3:08cv1105-B (N.D. Tex. June 30, 2008). This case named the company, as well as its former CEO Douglas Bartek and former CFO Nancy Richardson as defendants. Essentially, the complaint alleged a years-long option backdating scheme. Grants were backdated for new hires by looking back over a window of time. Other grants were backdated for executives. In some instances when the price fell, the grants were canceled and new backdated grants were made. That scheme was covered up by fraudulently backdating various documents such as offer letters, agreements and similar documents.

The company settled the action by consenting to the entry of a permanent injunction prohibiting future violations of the antifraud and books and records provisions. The two individual defendants are litigating the case.

The precise impact of Dura is controversial. While most commentators agree that Dura has had an impact on securities litigation, some argue that it left open more issues than it resolved. This renders the impact of the decision difficult to determine. See, e.g., Tom Baker and Sean J. Griffith, How The Merits Matter: D& O Insurance and Securities Settlements, forthcoming, (March 2, 2008), Abstract available here (“What exactly plaintiffs must plead to establish loss causation after Dura, however, remains unclear. … Our participants regularly noted the importance of Dura, but also acknowledged that it remains to be seen what effect Dura and its progeny will ultimately have on securities settlements.” See also Merritt B. Fox, After Dura Causation in Fraud-on-the-Market Actions, 31 J. Corp. L. 829 (2006).

Dura is clearly having an impact on pleading. Not only does it impose loss causation pleading requirements as discussed below, but it has impacted Rule 8(a) notice pleading standards as Twombly made clear and as discussed in an earlier segment of this series here.

The decision is also beginning to have an impact on class certification. See, e.g., Oscar Private Equity Investments v. Allegronice Telecom, Inc., 487 F.3d 262 (5th Cir. 2007) (vacating class certification order because plaintiffs had not shown loss causation); see also Allen Ferrell and Atanu Saha, The Loss Causation Requirement For A Rule 10b-5 Cause of Action: The Implication of Dura Pharmaceuticals v. Brouder, Discussion paper No. 0812007, Harvard Law School, Abstract available here (discussing open issues following Dura).

As to pleading loss causation, essentially three views have emerged. First, some courts have held that Dura did not establish what is sufficient, but only what is not adequate. See, e.g., In re Initial Publ. Offering Sec. Litig., 2005 WL 1529659 (S.D.N.Y. June 28, 2005); In re The Warnaco Group, Inc Sec. Litig., 388 F. Supp. 2d 37, 317 (S.D.N.Y. 2005); In re Coca-Cola Enterprises, Inc., Sec. Litig., 2007 WL 472943 (N.D. Ga. Feb. 7, 2007); Marsden v. Select Medical Corp., 2007 WL 1725204 (E.D. Pa. June 12, 2007).

Second, other courts have held that there are theories beyond the price inflation theory discussed in Dura. Ray v. Citigroup Global Markets, 482 F.3d 991 (7th Cir. 2007).

Finally, an analysis of post-Dura cases suggests that three theories of loss causation have emerged:

1) Fraud on the market: This is the standard theory used in Dura. It requires proof of an artificial price and a decline in value when the truth is revealed.

2) Materialization of risk: Under this theory, a plaintiff must prove that it was the very facts about which the defendant lied which caused its injuries.

3) Representation that the investment is risk free: This theory requires an explicit representation that the investment is risk free.

Next: Cases applying Dura