SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law

Two recent insider trading cases show that the SEC still has the pedal to the metal on insider trading cases that are at — or over — the edge of the law.

One is a newly-filed administrative proceeding charging insider trading against two respondents who allegedly learned about Bill Ackman’s plans to charge that Herbalife Ltd. was running a Ponzi scheme and accumulate short positions in advance of doing that.  The SEC charges that one of those folks roomed with an employee of Ackman’s Hedge Fund, Pershing Square Management LP, who was working with Ackman on Herbalife, and told the other about what he learned, who bought Herbalife put options.  The cases are In re Szymik (In re Szymikand In re Peixoto (In re Peixoto).  Szymzik, the roommate, settled; Peixoto, the trader, did not.  The SEC apparently contends that roommates should be treated as if they have fiduciary-like confidentiality obligations to each other, and their friends should somehow understand that.

I guess the SEC enforcement folks don’t watch Seinfeld.  If they did, they would know that even close friends can’t really be expected to keep hot information “in the vault.”  If you don’t understand that reference, check this out.  In short, Jerry completely understood that close friends are a long way from fiduciaries (“Elaine Benes: You slept with Nina. What are you gonna tell George?  Jerry Seinfeld: Nothing – and neither will you. George can never know about this: It’ll crush him.  Elaine Benes: All right, all right; I’ll put it in the vault.  Jerry Seinfeld: No good. Too many people know the combination.”).  There is an interesting NY Times Dealbook article on this case, right here.

Since 1961, the SEC has consistently pursued a policy that people trading with access to nonpublic information are committing fraud regardless of how they obtained the information.  That is because ever since that time the SEC has viewed insider trading civil prosecutions as a means to ensure that all investors get equal access to information.  See our previous post on this issue here.  But that is not, and has never been, the law.  Since insider trading is supposed to be a violation of section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 thereunder, a person must engage in fraud to commit an insider trading violation.  And to commit fraud, you either need to misrepresent something material or fail to disclose something material when you have a legal duty of disclosure.  The Supreme Court tried to rein in insider trading charges when there was no duty of disclosure in Chiarella v. United States, 445 U.S.  222 (1980), when it made clear that someone who trades on nonpublic information but was under no disclosure duty was not committing fraud, and therefore did not violate section 10(b) or Rule 10b-5.  The Court said: “But one who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so. And the duty to disclose arises when one party has information ‘that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.'”  Id. at 228.  In other words, if you trade securities in possession of inside information but have not violated a fiduciary or fiduciary-like duty in doing so, you have not committed fraud and do not violate section 10(b) or Rule 10b-5.

The SEC has never thought much of the fiduciary or fiduciary-like disclosure requirement set forth in Chiarella and generally ignores it.  Instead, it considers fraud to be committed when it believes the trader was expected to keep the information confidential, even if there was no fiduciary or fiduciary-like relationship.  Remember, a fiduciary relationship is the equivalent of a trustee/beneficiary relationship.  Pardon me for saying so, but that doesn’t describe roommates.  It is merely impolite or disappointing if a roommate fails to keep a confidence, not a breach of a fiduciary or fiduciary-like duty.  (The SEC contends that if one person tells another person that information should be kept confidential, that’s enough to create a fiduciary-like relationship.  Someone should give a little “Trusts” primer over at Union Station.)

Hopefully, Peixoto will stay the course and fight his case.  Even in the SEC’s home administrative forum — itself a bogus way to charge people with insider trading (see here)– the SEC will have a hard time proving that roommates are the equivalent of trustees.

The second case is the second time around in an action brought by the SEC against two traders in Dubai, SEC v. One or More Unknown Traders in the Securities of Onyx Pharmaceuticals, Inc., 13-CV-4645 (SDNY).  The SEC enforcement staff did not like it when two unknown people traded Onyx stock options just before a news article was released disclosing merger discussions with Amgen.  They had no idea what the circumstances were, but they went in and froze the assets related to those trades and accused the unknown traders of insider trading.  That complaint was dismissed because the SEC actually could not allege any facts about the trades.  The SEC amended its complaint, and the federal district court ruled that the new complaint was sufficient even though the SEC still could not allege basic facts about why the trades were unlawful.  Judge Oetken was not willing to allow the first case to proceed, but in the new opinion, he gave the SEC a pass on having to allege key elements of insider trading after being convinced that the trades were unusual and “suspicious.”  See SEC v. One or More Unknown Traders in the Securities of Onyx Pharmaceuticals.

The problem was that the SEC had no idea how their defendants actually learned confidential nonpublic information that later was released by a writer in the Financial Post.  No problem.  They went ahead and alleged that a fraud occurred without the required supporting facts.  The court did a good job of explaining what had to be alleged to state a claim, but then punted on actually applying those standards (probably because the judge really did not want to unfreeze the assets, even if a proper claim had not been stated).  The remarkable complaint alleges that the Dubai traders were tipped, but does not identify the tipper, does not allege facts showing that the tipper breached a duty of confidentiality in whatever communication occurred, and does not allege facts showing the traders knew about this breach of duty.  Although those are key aspects of liability (as the court recognized), and the case should not go forward if the SEC cannot allege them “with particularity” (as the court also recognized), the court in the end found the suspiciousness of the trades alone sufficient to state a claim (and thus allow the asset freeze to continue).  In truth, such claims should never be brought until the SEC can fill in those key blanks — they are, after all, elements of the claim — but the court decided to let that slide.

Once again, this reflects SEC disdain for legal requirements set by the Supreme Court to help separate fraudulent conduct, which is required to violate section 10(b) and Rule 10b-5, from just improper conduct, which is not fraudulent and therefore cannot form the basis for an insider trading claim.  As discussed above, the breach of a fiduciary or fiduciary-like duty in connection with the challenged securities trade is crucial to showing fraud.  Here, the SEC could not do so because it could not even describe how the traders obtained the information in question.  Yet, nonetheless, they proceeded with the complaint, and an asset freeze as well.

Only the courts can prevent the SEC from overstepping the bounds set by the Supreme Court, yet they are sometimes surprisingly reluctant to do so.  Here, Judge Oetken well knew that the SEC had not alleged facts showing the trades flowed from a breach of a fiduciary or fiduciary-like duty, but ultimately allowed the case to proceed, and to keep the defendants’ assets frozen as well!  Sadly, Judge Oetken needs to learn a little more about the importance of an independent judiciary.

Straight Arrow

October 1, 2014

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