SEC Enforcement Takes Another Blow in SEC v. Obus

The SEC’s most recent jury trial loss in its insider trading case SEC v. Obus et al., No. 06 Civ. 3150 (GBD), is another example of a poorly-conceived case going down in flames.  A jury conferred for less than a day and rejected the SEC’s claims of insider trading against all three defendants.  After being exonerated, hedge fund manager Nelson Obus said: “This is not just about me.  This is about systematic regulatory overreach without accountability.”

That the case was ill-conceived from the get-go is not really a matter of opinion, it is plain from the history of the case, which shows that the SEC overstated its allegations and revised its theory of the case to overcome serious evidentiary inadequacies.  The SEC’s Enforcement Division badly needs to learn that merely conjuring up hypothetical conversations and ignoring unhelpful facts is not enough.  The facts matter.  The evidence matters.  Obus was a case with bad facts and weak evidence.  Appropriate prosecutorial discretion would have sent it to the scrap heap.

Bear with me in reviewing the facts, which are critical.  Defendant Thomas Strickland had a junior job at General Electric Capital Corp. (GECC).  GECC became involved in the potential financing of transactions involving SunSource, Inc. (which sold nuts and bolts), including a possible management buyout of a SunSource subsidiary (STS Technologies), and the proposed acquisition of SunSource by Allied Capital Corp.  Strickland was assigned to perform due diligence on SunSource.  That involved learning about SunSource’s business and financial performance.  The financing discussions were preliminary; there was never an agreement requiring that GECC keep information about SunSource confidential.

In the course of due diligence, Strickland noticed that Wynnefield Capital, a hedge fund manager, was a significant SunSource shareholder.  He had a college friend who worked at Wynnefield, defendant Peter Black.  On May 24, 2001, he called Black to discuss SunSource.  The only evidence of that conversation was from Strickland and Black, who both testified that Strickland noted that GECC was considering doing work with SunSource and asked for general impressions of management and the company.  The SEC contended, however, that Strickland told Black that Allied was about to acquire SunSource.

After that call, still on May 24, Black went to his boss, defendant Nelson Obus, who was a principal of Wynnefield.  The only evidence of that conversation was from Black and Obus, who both testified that Black told Obus about a general interest of GECC in SunSource in connection with possible new business with that company.  GECC did lots of financing business, and Obus became concerned about a possible transaction in which SunSource could obtain capital by diluting its shareholders in a transaction similar to one with Allied Capital just a few months earlier (a so-called “PIPE” transaction).  The SEC contended that Black told Obus that SunSource was about to be acquired by Allied.

What happened next bore no resemblance to a fraudulent insider trading scheme.

Instead of going out quickly to buy SunSource stock, Obus called SunSource’s CEO, to whom he spoke regularly as a large shareholder.  The accounts of that conversation varied.  Obus said he told the CEO that he had heard about SunSource from a source in Connecticut (where GE is headquartered) and argued against doing another PIPE transaction,  The CEO and said that Obus told him he had heard from “a little birdie” in Connecticut that SunSource was being acquired by a “financial buyer.”  Whatever was actually said – on which there was contradictory evidence – was not consistent with a fraudulent insider trading scheme.  It is hard to imagine such a scheme being commenced by a call from the supposed “tippee” to the CEO of the subject company announcing he had been tipped to the planned transaction.  In his closing argument to the jury, Obus’s lawyer said Obus would be “the lamest insider trader in history” if he acted this way.

The remaining facts are likewise inconsistent with such a scheme.  Obus did not go out quickly after the May 24 call to buy more shares of SunSource stock.  Nothing happened for more than two weeks.  It wasn’t until June 8 that a Cantor Fitzgerald broker called the trader at Wynnefield, not vice versa, to inquire about possible interest in purchasing a block of SunSource stock at $5 per share.  Wynnefield negotiated for a lower price and ultimately bought 287,200 shares at $4.80 per share.  (This raised Wynnefield’s ownership of SunSource from 5.8% to over 10%.)  Three days later, Wynnefield sold 6,000 shares of SunSource stock.  After the Allied/SunSource merger was announced on June 19, Wynnefield did not sell its shares – it bought an additional 140,000 shares.  Nothing about this series of transactions smacks of insider trading, particularly that Wynnefield (1) did not seek out or initiate the block trade, and (2) then sold shares three days thereafter.

The SEC Staff plainly knew the facts did not present a convincing case.  They drafted a Complaint that that, at a minimum, bordered on being disingenuous by creating an impression of deceit and scheming that could not be supported.  For example, they alleged that Obus “directed the purchase of 287,200 shares of SunSource common stock based on a tip he had received” from Black (Complaint ¶ 1), and “directed Wynnefield’s trader to purchase” the block of shares, “which the trader then did” (id. ¶ 24).  The SEC knew, however, and intentionally omitted, that Obus never initiated a purchase of SunSource stock, and that Wynnefield bought the block of stock only after being approached by a trader shopping it.  The Complaint also alleged that a June 4 call by Black to Strickland “provided Black with the opportunity to receive an update on the progress of the transaction and to update Obus” (id. ¶ 23) with no evidence to support that the call had anything to do with SunSource.

The SEC also pursued a flawed theory from the outset.  The SEC’s Complaint, filed in April 2006, presented only one theory of insider trading, which was the so-called “classical theory” of insider trading.  Our ongoing post about the origins and development of insider trading law will describe the various mutations of insider trading theory that have occurred.  The “classical theory” is that the insider owes a “fiduciary duty” or fiduciary-like duty (whatever that may mean), to the company’s shareholders, and therefore cannot trade stock with the shareholders without disclosing material information he or she may have.  The notion is that the fiduciary duty creates a duty to disclose in transactions with beneficiaries of that fiduciary obligation.  That an insider owed fiduciary obligations to the company’s shareholders was inconsistent with most state laws, but was essentially a fiction created by the SEC and the federal courts to justify treating insider trading as an act of fraud.

In support of this theory, the SEC Complaint alleged that “Strickland owed a fiduciary or similar duty of trust and confidence to the shareholders of SunSource” based on his employment with GECC and GECC’s relationship with SunSource.  (Id. 34.)  Black was allegedly liable because he “knew or should have known” that Strickland breached a fiduciary duty to the SunSource shareholders and as a result “assumed Strickland’s duty” to them and breached that duty by communicating the information to Obus.  (Id. ¶ 37.)  Obus was allegedly liable because he “knew or should have known” that the information about SunSource had been communicated in breach of a fiduciary duty to the SunSource shareholders and “assumed the duty to the shareholders of SunSource” that Strickland owed and Black assumed.

There was a problem, however, that the SEC and its Staff “knew or should have known” from the outset: there was no evidence to support the contention that GECC owed any fiduciary-like duty to SunSource, and, as a result, neither could its employee, Strickland.  After four years of investigation, the Complaint adopted and pursued this theory with no serious evidence of any agreement between GECC and SunSource that created any such duty.  The defendants pointed this out in motions to dismiss the Complaint.  Although these motions were denied, the SEC litigators knew they had filed a complaint that the evidence would not support.

Not to worry.  The SEC decided to morph its case to a different form in midstream.  It filed an Amended Complaint to state a different theory of insider trading, the so-called “misappropriation theory.”  That theory was developed by the courts as a means of expanding the scope of “insider” trading to create a violation of the federal securities laws when any trusted person abuses his or her trust by using confidential information to make securities trades.  How this became part of insider trading will be addressed in our broader post on the development of “insider trading” law, but in 1997, the Supreme Court endorsed this extension of the law in United States v. O’Hagan, 521 U.S. 642 (1997).

The SEC’s Amended Complaint supported this theory by introducing a new allegation that “Strickland owed a fiduciary duty of trust and confidence to his employer, GE Capital, pursuant to which, inter alia, was the duty to not disclose material, nonpublic information learned during the scope of his employment to outsiders.”  (Amended Complaint ¶ 45.)  To hedge its bets, the SEC continued to pursue the “classical theory” as well.  (Id. ¶ 46.)  Black and Obus were now alleged to be liable because they “knew or should have known” that Strickland breached duties to both GECC and SunSource, and they assumed those same duties to both GECC and SunSource.  (Id. ¶¶ 51-52.)

There was still a problem, however.  GECC, which now purportedly was the “victim” of Strickland’s fraud, had itself conducted an investigation of Strickland’s conduct and concluded that his conversation with Black was an effort at underwriting, not a tip, and reprimanded him because he “made a mistake” by contacting third parties without prior approval.  Apparently, the evidence would show that the supposed “victim” did not believe it was victimized.  The SEC litigators’ approach to solving that problem was not to rethink its case, but instead to try to hide that fact from the jury by preventing it from coming into evidence.  It filed a motion in limine to ask the court to do just that.

We will never know what combination of flaws caused the jury to rule for the defendants.  Remember, in SEC enforcement actions, the burden of proof is only a preponderance of the evidence.  That means that the jury found that the SEC’s evidence couldn’t even barely tip the scales.

It should have been obvious from the beginning and as the case proceeded that there was very little there there.  (Apologies to Gertrude Stein.)  The SEC did not even have the benefit of significant circumstantial evidence of the type it normally has, like large, inexplicable trades, often in options, immediately following a suspect communication.  Instead, the SEC was placing all of its bets, including, no doubt, millions of taxpayer dollars in expense and resources, on the disputed recollections years after the fact about one telephone conversation – a purported communication that, on its face, made no sense, and refuted the very notion that Obus was trying to deceive anyone.  Somewhere along the way, some form of review or supervision should have been called into play to reconsider the wisdom of the case.  But as in other cases, the SEC Staff’s single-minded focus on victory, to the point of introducing fundamental changes in its theory of liability, apparently prevented them from reexamining the case and making the “right” call long before the jury forced it on them.  See our blog post “Why Isn’t the SEC Committed to a Just and Fair Enforcement Process?

Here is what Mr. Obus thought about the SEC enforcement lawyers: “What I see happening here is a totally unaccountable organization — run by a group of anonymous legal underperformers probably incentivized simply by putting scalps up on the wall, with no concerns about getting to the truth — being able to attack the growth fountain of our whole economy, which is small business.  The SEC goes after small people like myself. I have more in common with the guy who runs the candy store. These bullies are putting me in a position where I have to admit something I didn’t do and that I find reprehensible, and if I don’t do that, I’m busted; I’m out of business. To me, that is overreach.”  See “Obus Says SEC Attornyes Are “Bullies” in our link to the right.  The NY Times Dealbook blog on this case is “After Fighting Insider Trading Charges for 10 Years, a Fund Manager Is Cleared.

 Straight Arrow

June 3, 2014

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