The SEC, An Idea, Insider Trading And The Wyly Case
The SEC got a much needed courtroom win with a jury verdict in the Wyly case. The insider trading claim, however, was not submitted to the jury because any penalty was time barred. That claim, which was little more than the “personal desires” of the brothers was rejected by the Court which concluded that the Commission’s theory of materiality would “impermissibly broaden civil and criminal insider trading liability and potentially extend the reach of other securities laws . . .” SEC v. Wyly, Civil Action No. 10-cv-5760 (S.D. N.Y. Opinion issued July 11, 2014).
The claim centered on arrangements to sell Sterling Commerce in the Fall of 1999 and the idea of the Wyly brothers from the summer of that year that they would sell Sterling Commerce and Sterling Software. Between 1992 and 1996 Sam and Charles Wyly created a number of IOM trusts, each of which owned several subsidiary companies. Employees of the Wyly Family Office served as protectors of the trusts. The Wylys’ investment recommendations were communicated to the trusts and most, if not all, were implemented.
The Wyly brothers had also co-founded Sterling Software in 1981. Fifteen years later that company spun off its electronic commerce division which became Sterling Commerce. Both brothers continued as board members for each company.
In September 1999 there were discussions about taking a long position in Sterling Software among advisors to the brothers. While there was some dispute as to whether one of the brothers or others originated the idea, in October the first step to implement it was taken. Three of the trusts entered into the first swap agreements with Lehman Brothers as the counterparty. The transactions reference 1.5 million shares of Sterling Software. Additional, similar agreements were entered into involving other trusts. In the end the swap agreements, with a notional value of over $30 million, became the functional equivalent of the IOM entities purchasing 2 million shares of Sterling Software stock on the open market in October 1999.
During the summer of 1999 Sam Wyly decided he wanted to sell both Sterling Software and Sterling Commerce. It was his belief that the that the tech area had reached “euphoric proportions.”
No significant steps were taken to sell Sterling Software until November 1999, after which it merged with Computer Associates. In contrast, there were significant efforts to sell Sterling Commerce dating to the Summer 1999. In late summer Goldman Sachs was contacted about a possible sale of Sterling Commerce. On September 15, 1999 the board of that company considered the possibility and later that month formally retained the investment banker for “strategic third party transaction alternatives.”
The insider trading claim, however, was tied to the sale of Sterling Software and the stock purchases. The agency argued that at the time of the swap agreements in October 1999 the Wylys were in possession of material non-public information. Specifically, the SEC claimed that “as Chairman and vice-Chairman of Sterling Software . . . [they] had agreed and resolved that the sale of Sterling Software to an external buyer should be pursued.” Stated differently, the brothers had an idea. The Court rejected this claim, concluding as a matter of law that the information was not material and thus could not be the predicate for an insider trading claim.
Materiality in this context is not based on a bright line test. Nor is a fact material simply because a reasonable investor would like to know it. Rather “it requires a balancing between the probability of a future event and its potential impact . . .” Judge Scheindlin held. In this context it means that “something beyond desire to transact is necessary.”
Here there is no evidence that the Wylys approached any third party such as an investment banker or a potential buyer about selling Sterling Software before entering into the swap transactions in October. Goldman Sachs was retained by Sterling Commerce, but there is no evidence that the firm was asked to work on a transaction for Sterling Software. While the SEC claimed that the sale of Sterling Commerce cannot be separated from a sale of Sterling Software, there is nothing to suggest that the sale of one company was contingent on a sale of the other.
Likewise, the fact that in late October the Sterling Software board entered into a change of control agreement does not support the SEC’s theory. At best, the Court found, the agreement confirmed the desire of the Wyly brothers to sell. But the agreement did not change the probabilities about entering into a transaction.
Finally, while the SEC is correct, the Court noted, that the huge equity swaps were the first transactions of that kind in which the brothers were involved, the fact does not support its claim. It is clear that the brothers had made large investments before. In the end, while the agency argued that the application of existing law supported its claim that the brothers engaged in insider trading, the Court disagreed, concluding that the Commission was seeking an unprecedented expansion of the law on a record where there is “no evidence that the Wylys acted to exert . . . [their] control to pursue a sale before November 1999.”