On May 15, we wrote about a jury determination in the SEC’s favor in one aspect of its case against the Wyly brothers, but noted that the more interesting decision in that case was yet to come. See SEC Is Victorious in Stage 1 of SEC v. Wyly, but the More Interesting Decision Awaits. The undecided issue involved the SEC’s aggressive claim that the Wylys engaged in insider trading by purchasing stock of a company they controlled (Sterling Software) after they discussed with each other a plan to sell that company in the future, but took no further steps in pursuit of that goal.
We wrote that an SEC insider trading theory focused on the inner thoughts – but not actions — of the Wylys represented a frightening extension of insider trading law:
Not a single actual action towards the sale of the company is alleged — no merger negotiations, no initial contacts with buyers, no Board discussions — just a personal decision that the sale of the company should be pursued. But according to the SEC, the mere fact that the Wylys formulated a personal plan for the future of the company barred them from buying company shares without first disclosing their inner thoughts. Putting aside the obvious materiality issue, can it be that a director’s or controlling shareholder’s “thoughts” outside of the Board room are “company” information? How strange is it to treat the shareholder (and his or her thoughts) as owned by the company and not vice versa?
This is truly a bizarre attempt to extend insider trading doctrine to the ultimate concept of equality of information — mere intentions formed in the minds of insiders trigger the so-called “disclose or abstain” rule, which precludes them from buying or selling stock without first disclosing inchoate thoughts or intentions. But, as we are in the midst of showing in our multi-part post on the development of insider trading enforcement (see The Myth of Insider Trading (Part I)), this represents the extension, arguably to the point of ridiculousness, of the SEC’s long-standing effort to morph section 10(b) into a mandate that fair markets require equal access to information. Should this theory of insider trading liability be accepted by the court, the SEC will have officially become the securities “thought police.” Let’s wait to see what Judge Scheindlin does.
On July 10, 2014, Judge Scheindlin decided the SEC’s insider trading claim against the Wylys based on the evidence previously presented in Phase I of the trial. Fortunately, she agreed that the SEC’s theory represented an unprecedented and significant proposed extension of insider trading law. The decision can be found here.
The technical issue Judge Scheindlin found determinative was whether the internal views of the Wyly brothers about the potential sale of Sterling Software, not communicated to others, were “material” information about the company that would subject the Wylys to the so-called “disclose or abstain” rule barring trading in the stock without first making their information public. Judge Scheindlin found that even though the Wylys effectively controlled the company, their private future plans for the company were immaterial as a matter of law and could not form the basis for insider trading liability.
Judge Scheindlin applied the standard discussed in Basic Inc. v. Levinson, 485 U.S. 224, 231-32 (1988), that materiality of uncertain information of a future event should be determined by examining the probability of the event and the importance of the potential event to the company. Because the sale of a company is extremely important, there could still be some uncertainty about that event with the information still being material. Judge Scheindlin examined Second Circuit cases applying these standards, but found that none of them extended to a circumstance where insiders formed an intention to pursue a transaction but took no concrete steps to pursue that intention: “The SEC bears the burden of proving by a preponderance of the evidence that the Wylys’ desire to sell Sterling Software constituted material nonpublic information on October 8 and October 20, 1999. But there is not enough in the record to justify that conclusion. The SEC is right that investors would probably ‘want to know if the chairman and vice chairman . . . of a company had agreed they were going to try to sell it.’ But a fact is not material ‘merely because a reasonable investor would very much like to know [it].’ Slip op. at 22.
Judge Scheindlin went on to describe the overbreadth of the SEC’s theory in stark terms:
The SEC contends that finding insider trading liability here is merely an application of existing precedent. I disagree. Accepting the SEC’s theory in this case would mean extending the definition of materiality to cover the thought process and personal desires of any director or shareholder with substantial control over a company. While it is difficult to draw the line between inchoate desire and something more material, that line must be drawn somewhere. Failing to do so would both impermissibly broaden civil and criminal insider trading liability and potentially extend the reach of other securities laws, which turn on materiality.
Slip op. at 26-27.
In my view, Judge Scheindlin was overly-kind to the SEC, even while shooting its theory down. The court should have rejected outright the very idea that the “thought processes and personal desires” of a control person could ever qualify as non-public company information, in addition to being immaterial as a matter of law. In addition, the judge’s focus on what the Wylys did not do suggests each case must be examined in detail to determine when plans not yet acted upon will be material inside information that would trigger a disclose or abstain rule: “The SEC argues that because the Wylys controlled at least five of the nine seats on Sterling Software’s Board of Directors, the sale was inevitable. It is true that the Wylys controlled the Sterling Software side of any potential transaction. But there is no evidence that the Wylys acted to exert that control to pursue a sale before November 1999. The Board of Directors did not convene to consider any strategic alternatives. The Wylys did not approach the members of the Board that they controlled … to explore a sale. Finally, as discussed earlier, there is insufficient evidence to find that the Wylys and Williams spoke about selling the company before the corporate retreat in mid-November. Critically, there is no evidence that the Wylys approached any necessary third party – an investment firm or a potential buyer – about selling Sterling Software before entering into the swap transactions on October 8 and 20.” Slip op. at 23.
In the real world, executives and directors need, and are entitled to, more explicit guidance on how to act if they are going to face penal sanctions and possible criminal liability for making the wrong decision.
At least for now, this decision may put an end to SEC efforts to act as “thought police.” It seems unconscionable that responsible public servants ever let the case go as far as it did. What conceivable public policy goal could the SEC accomplish by penalizing executives or directors for not revealing their inner thoughts? The unfortunate truth is that the SEC enforcement staff, with the acquiescence of the Commissioners, has for many years been determined to expand the range of potential insider trading liability well beyond the “fraud” limitations imposed by the Supreme Court in Chiarella v. United States. The SEC enforcement staff believes it should have the power to assure that market trading complies with its view of what is right or wrong, without identifiable limits in the form of standards that govern that decision. How many times has the SEC argued against drawing clear lines on what is permitted and not permitted to avoid allowing people to be creative in coming up with new forms of conduct they would consider unfair? Too many to count. But if people are going to be penalized, or imprisoned, for violating the law, they are entitled to know where the lines governing lawful and unlawful conduct are drawn. In our society that interest far surpasses concern over hypothetical sharp trading practices that SEC staffers may find distasteful or “unfair.” The lack of clear lines affords the SEC and its staffers far more power to prosecute practices they don’t care for that have never held unlawful or barred through administrative rulemaking (as in this case), or, even worse, persons they just don’t care for (also a possibility in this case).
July 16, 2014
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