This Week In Securities Litigation (July 3, 2008)

This week the SEC continued to focus on insider trading and option backdating. The Commission prevailed in an important decision by Ninth Circuit construing the breach of duty requirement in insider trading cases based on the misappropriation theory. It also filed another option backdating case, a portion of which is in litigation.

Foreign regulators also continued to focus on insider trading. In Canada, the Ontario Securities Commission imposed a substantial fine on a legal secretary who traded on information obtained from her law firm. In a practice which the SEC might consider, the OSC noted in the papers filed that the defendant had acted contrary to the public interest, rather than detailing her insider trading activities because of her extensive cooperation. U.K. regulators also continued to focus on insider trading, while Australian authorities released the results of a study of trading by corporate directors.

Finally, three new articles of interest discuss loss causation, springloaded options and the merits of private securities litigation.

Insider trading

In SEC v. Talbot, Case No. 06-55561 (9th Cir. June 30, 2008) the Court of Appeals reversed the dismissal of an SEC insider trading action as discussed here. The district court had dismissed the SEC’s complaint. That complaint alleged that defendant Talbot, a long time Fidelity National Financial director, purchased shares of LendingTree after learning at a Fidelity board meeting that the company was in negotiations to be acquired. Fidelity had been informed about the negotiations because it then owned 10% of LendingTree. Since the SEC failed to prove a direct, continuous link between the communication of the inside information by LendingTree and Mr. Talbot, the district court concluded there was no breach of duty as required by the misappropriation theory and dismissed the case.

The Ninth Circuit rejected the district court’s conclusion. Rather, the circuit court concluded that Mr. Talbot breached a duty to Fidelity. That breach, the circuit court concluded, was sufficient, although it admitted that other cases had the causal link the district court found lacking. This holding potentially broadens the reach of the misappropriation theory.

Backdating

The SEC filed a partially settled option backdating case on Monday (also discussed here), SEC v. Microtune, Inc., Case No. 3:08cv1105-B (N.D. Tex. June 30, 2008). The case named the company, as well as its former CEO Douglas Bartek and former CFO Nancy Richardson as defendants. The complaint alleged a years-long option backdating scheme tied to the hiring and executive compensation practices of the company covered up by fraudulently documents.

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

Other jurisdictions

The Ontario Securities Commission approved a settlement with former legal secretary Betty Leung under which she agreed to pay a financial penalty of $103,000 based on settlement papers which alleged that she had acted contrary to the public interest. The settlement reflected credit given to Ms. Leung for her substantial cooperation with the staff.

The underlying facts of the case established that Ms. Leung had been employed as a secretary at the law firm of Bennett Jones LLP since 1989. From April 2005 to March 2008 she traded small amounts of shares – typically 200 to 800 at a time – in eight companies based on confidential information she learned at the law firm about possible takeover deals. The trades were placed in her accounts as well as those of her husband and parent. The fine was twice her trading profits. The settlement papers did not allege insider trading or the details of the transactions in view of the fact that when contacted she immediately acknowledged her actions and fully cooperated with the staff.

The Financial Services Authority in the U.K imposed a fine of £85,000 on John Shevlin a former IT worker at The Body Shop for what it called market abuse – insider trading. The fine represented more than twice the trading profit from a short position. Mr. Shevlin obtained information that the company would miss its financial targets for the period from confidential internal e-mails. At the time, Mr. Shevlin had significant trading losses in his securities account.

The Australian Securities Exchange released a comprehensive review of disclosure of Directors’ Interest Notices (securities transactions by directors in shares of their company). According to the study, of 4,137 Notices filed over a three month period, 538 or 13% were filed late. During the same period, 795 trades were made during blackout periods, that is, between the close of the entity’s financial period and the release of the results. Approximately 7% of those trades contravened the trading policies of the entities.

Recent articles of interest

Shareholder Class Actions and The Counterfactual, by Dr. Frederick Dunbar and Dr. Arun Sen (NERA Economic Consulting). This article discusses the application of counterfactual analysis, a social science approach to causation, to the standards now required in securities damage cases by the Supreme Court’s decision in Dura (discussed here). According to the authors, this approach has significant implications for estimating damages.

Stock Option “Springloading”: An Examination of Loaded Justifications and New SEC Disclosure Rules, by William Hughes, 33 Journal of Corporation Law 770 (2008). The article discusses the concept of springloaded options. It argues that while this type of option does not fit squarely within traditional insider trading analysis, it rejects the conclusions of SEC Commissioner Atkins that they should be permitted.

The Missing Link Between Insider Trading and Securities Fraud by Professor Richard A. Booth, 30 Corporate Governance 42 (Winter 2007/2008). The author explores the frequently stated notion that private securities litigation is an indispensable tool for defrauded investors to recover their losses and that these suits are critical to the integrity of the domestic capital markets.

A Significant Win In The Court of Appeals And Another Backdating Case

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.