Tag Archives: securities trading

Michael Lewis Saved from Paying the Piper for False Portrayal in “The Big Short”

By virtue of a poorly reasoned opinion from Second Circuit Judge Richard Wesley, author Michael Lewis narrowly escaped answering to a jury for blatantly inaccurate and unfair descriptions of CDO manager Wing Chau in Lewis’s apocryphal book, The Big Short.  On November 14, 2014, a majority of the three-judge panel in Chau v. Lewis, No. 13-1217, affirmed a district court grant of summary judgment to Lewis on Chau’s claims that descriptions of him in The Big Short were libelous.  Although the majority’s ruling for Lewis was hardly a vindication – it acknowledged the falsity of Lewis’s statements but merely inoculated them against liability in a libel action – it also reflected a myopic elevation of legal nicety over the real world.  A copy of the majority opinion can be found here: Chau v. Lewis 2d Circuit Opinion (Opinion”) .

Courtesy Lucas Jackson/Reuters

Michael Lewis (Courtesy Lucas Jackson/Reuters)

Senior Judge Ralph Winter, a dean of the 2d Circuit bench and author of many securities law opinions over the years, tried to restrain himself, but could not avoid a satiric tinge in a dissenting opinion lambasting the majority for using trees to obscure the forest, even while claiming they were deciding the case based on “the context of the publication as a whole, not just the paragraph or chapter containing them.” Opinion, slip op. at 14.  A copy of Judge Winter’s dissent can be found here: Chau v. Lewis 2d Circuit Dissent (“Dissent”).  Perhaps the great disappointment was that Senior Judge Amalya Kearse, who is highly respected, joined in Judge Wesley’s weak effort.

For those who may be interested in looking at what the lawyers of Chau and Lewis had to say on appeal, copies of their briefs filed in redacted form (to omit the most juicy stuff) can be found here (Appellant Brief in Chau v Lewis) and here (Appellee Brief in Chau v Lewis).

The case originated in Lewis’s blockbuster work of purported non-fiction about the underpinnings of the 2007-2008 financial crisis in the massive market of mortgage-backed securities offerings, and in particular collateralized debt obligations built on subprime mortgages.  Lewis’s book was on the New York Times bestseller list for 28 weeks, but over time has been shown to be far from accurate in key respects.  Nevertheless, as is the way of the world nowadays, the book created impressions that last and are taken as fact, regardless of its degree of accuracy or inaccuracy.  The district court record in Chau v. Lewis includes an expert report from a Northwestern University Medill School of Journalism professor stating: ““Lewis’ methodology in researching, drafting, and fact-checking The Big Short fell far below the standard required by this profession.”  Lewis chose not to have an expert defend his work.  Revelations about Lewis’s factual sloppiness (to be kind) in The Big Short do not bode well for verity-checks of Lewis’s new tabloid-like charges in Flash Boys that the stock market is “rigged” for the benefit of high frequency traders. 

Wing Chau’s company Harding Advisory LLC served as collateral manager for many CDO offerings.  Lewis dwelled in particular on an attack on Wing Chau in Chapter 6 of the book, entitled Spider-Man at the Venetian.  Relying on a report from co-defendant Steven Eisman of a supposed conversation between Chau and Eisman at a dinner in Las Vegas, Lewis presented a no-holds-barred indictment of CDO managers in general, and Wing Chau in particular, for having fostered the origination of worthless mortgage loans which were packaged to create also-worthless CDOs, all to satisfy the wealth and greed of Wall Street, CDO managers, and Wing Chau himself.

Any person who read Chapter 6 came away from the book believing Wing Chau was an idiot, moron, fool, greedy bloodsucker, and fraudster.  That was Lewis’s plain intent and the obvious import of what he wrote.  It ruined Chau’s career, and is a picture he will never live down.  The problem is, Lewis based it on hyperbole, insidious mockery, Eisman’s questionable portrayals, and plainly false statements.  Presumably he relied on Eisman and did little in the way of independent analysis.  I don’t know what steps he took before deciding to commit Chau to a public pillory, but one thing we do know, at least if Judge Winter is reliable, is that Lewis “admits that he does not use a fact checker.”  Dissent, slip op. at 5.  No surprise there.

Judge Wesley decided that just because Lewis ridiculed and demeaned Chau professionally and personally with false statements is not an adequate reason to force him to explain to a jury why he did what he did.  Instead, Wesley wrote down the 26 nasty, snarky, and sometimes false things Lewis said (or Lewis said that Eisman said) and, one by one, explained why each one, standing alone, was not a valid basis for a libel claim.  His opinion is the definition of myopia.  It is as far as you can get from what Wesley portrayed as the correct approach, which requires examining “the context of the publication as a whole, not just the paragraph or chapter containing them.”  Opinion, slip op. at 14.  Somehow he decides that pages and pages of statements that disparaged Chau, portrayed him as a greedy profiteer who made tens of millions of dollars for doing nothing, and accused him of being a fraudster, was not libelous because each statement taken alone was either “opinion” or not sufficiently harmful to qualify as being defamatory.  How frightening that an appellate judge tucked away in his robes and life-tenured position could be so clueless.  By deciding in his view what “an average reader” would and would not view to be defamatory – a plain invasion of the province of the jury – Judge Wesley deprived Chau of his only chance to regain dignity and a future: a decision from a jury of his peers.

As Judge Winter pointed out in dissent, the opinion is just plain wrong.  Lewis used statements that were admittedly false, or in some instances could be proved to be false, to portray Chau as lawless, stupid, greedy, unethical, and immoral.  For example:

  • He wrote that Chau “spent most of his career working sleepy jobs at sleepy life insurance companies” before turning to CDO investing, to make the point that Chau lacked the skills to work as a CDO Manager.  This is now admitted to be false.
  • He said Chau invested in only “dog shit” subprime CDOs when in fact 40 percent of his CDOs were not in that category.  Faced with this, Judge Wesley lamely opined: that this was a “fine and shaded distinction[]” that would not matter to a reader.  Opinion, slip op. at 24.  That’s what juries are supposed to decide.
  • He said Chau “made it possible for tens of thousands of actual human beings to be handed money they could never afford to repay.”  There’s so much wrong with that statement it’s hard to know where to start.  Suffice it to say that there is an ample likelihood that it would be proved false at trial.
  • He said Chau “didn’t do much of anything” as a CDO manager, which almost certainly is inaccurate.
  • He said Chau was a “double agent” who “represented the interests of Wall Street bond trading desks” and not that of investors.  He surely had no facts to support that beyond Eisman’s meanderings, but its truth or falsity is certainly a jury issue.  Judge Wesley exonerates Lewis for this and some other statements because he cloaked them by referring to “CDO Managers” generally, but not Chau in particular.  Opinion, slip op. at 21.  But that is laughable, since the whole chapter is about Chau as a CDO Manager and Eisman’s purported discussion with Chau, as Judge Winter points out (Dissent, slip op. at 3).
  • He said Chau didn’t care about what his CDOs invested in because he “simply passed all the risk that the underlying home loans would default on to the big investors.”  The point is that he allegedly failed in his duties to investors because he passed on risk to others.  Another clear jury issue.
  • He said Chau served “as a new kind of front man for the Wall Street firms,” i.e., that Chau allegedly committed fraud on investors by favoring the Wall Street firms.  That could be true or false, but is again a jury issue.  Judge Wesley gave Lewis a pass on this because he viewed calling someone a “front man” for others is a matter of “opinion.”  Opinion, slip op. at 20.  Far from it.  It is an accusation that someone falsely portrayed himself as protecting investor interests when he was not doing so, in other words, that he committed mail, wire, and securities fraud.  Accusing someone of criminal conduct is not “opinion,” as Judge Winter recognized.  See Dissent, slip op. at 10 (“This description could easily serve as the opening statement in a civil or criminal fraud trial.”).
  • He said Chau took home $26 million in a single year for doing all this but “didn’t spend a lot of time worrying about what was in CDOs.”  That is patently false as to what he earned (by a factor of ten), and likely is false as to the rest.  It suggests, falsely, that Chau earned $26 million in return for betraying his duties to investors.

How an appellate judge could declare that pages of such statements were not actionable “because an ordinary person would not take the statement (albeit incorrect) in context to be sufficiently derogatory to make an actionable claim for defamation” is totally beyond comprehension.  Judge Wesley said that a statement is defamatory if it exposes an individual to, among, other things, “shame, obloquy, contumely, odium, contempt, ridicule, aversion, ostracism, degradation or disgrace.”  Opinion, slip. op. at 15 (emphasis added).  Let’s see.  Obloquy is “the condition of someone who lost the respect of other people.”  That seems pretty clear here.  Shame means “dishonor or disgrace.”  Ditto.  Ostracism — “exclusion by general consent from common privileges or social acceptance” — was actually reflected in evidence in the district court record.  Ridicule is patently apparent on the face of the publication.  Judge Wesley either didn’t read what he wrote or didn’t bother to take it seriously.  His only role was to decide whether a reasonable jury (not him) could look at the evidence and find any of those impacts on Chau, and it really seems beyond debate that the evidence would permit that.  

Judge Winter certainly thought so.  He wrote:

Michael Lewis’s book describes appellant as admitting to acts that a jury could easily find to have breached his obligations to investors in the fund that employed him and to have constituted civil or criminal fraud. . . .  [T]heir conclusion that certain statements are not defamatory is reached only by evaluating those statements in hermetic isolation from the context in which they were made.  They conclude that certain statements can have only a single and non-defamatory meaning even where the book clearly conveyed a different and defamatory meaning that was adopted by the book’s readership. . . .

*          *          *

 A trier of fact could easily find the following.

. . .  Appellant is portrayed as lining his own pockets and foisting doomed-to-fail portfolios upon investors.  Although he was paid to monitor the amount of risk in the fund’s portfolio, he worried only about volume because he was paid by volume.  And, knowing that the default rate of residential mortgages was sufficient to wipe out the fund’s holdings, appellant sold all his interests in the fund, passing all the risk to the fund’s investors, who believed he was monitoring that risk. The portrayal of the appellant is particularly graphic because it purports to show his state of mind and his actions out of his own mouth. . . .

 The book’s author admits that he does not use a fact checker, and much of what the book says about the appellant is known even now (before a trial) as false. . . .  These falsehoods provide the scenic background for the portrayal of the appellant as engaging in conduct that a trier of fact could find amounted to fraud in order to line appellant’s own pockets.  This portrayal can be described as non-defamatory only by declining to view it as a whole; by taking some of the statements and quotations entirely out of the context in which they were made; by finding that some statements have only a single and non-defamatory meaning when the book clearly intended a different and defamatory meaning, one adopted by readers, or so a trier could find; and by labeling some statements as opinion without regard to the facts that they imply.

Dissent, slip op. at 1, 3-4, 5-6.

Perhaps Judge Wesley’s willingness to give short shrift to the allegations of defamation here derive from an excessive willingness to see people in the financial business as acceptable targets of ridicule, hyperbole, and false accusations simply because they are involved in a big money business.  Remember, Wing Chau was not a public figure when Lewis savaged him; he was just a bit player in the huge financial markets.  Let’s do a little fictional mind experiment.  Imagine a self-absorbed author decided to try to make money writing a book sensationalizing sordid legal practices in upstate New York (I know this is far-fetched, but stick with me).  As part of this book, he decided to personalize the charges by including accusations he heard about a lawyer who practiced in a well-known firm in Rochester and then became a partner in a small firm outside of Rochester with a varied practice.  He accused all upstate lawyers of breaching fiduciary duties and used this lawyer as a poster child.  Without doing any fact-checking, he accused the lawyer of breaching fiduciary duties to his clients in order make big bucks by knowingly ignoring his clients’ needs.  The accusations were false.  The lawyer didn’t make such big bucks and didn’t ignore his clients’ needs.  The lawyer tried to save his reputation but was stymied when a judge said he hadn’t actually been defamed.  As a result he was unable to continue work as a lawyer, could not become elected an assemblyman, could not be elected to serve as a judge, and could never get appointed to the federal bench.  Instead, he got hauled before the Bar on charges that he violated the law (as Wing Chau has been hauled before an SEC administrative law court).  I have little doubt Judge Wesley would not look so skeptically at the claims that the lawyer was injured by a defamatory publication.

Judge Wesley’s error was to diminish the significance of the accusations made against Chau while showing excessive deference to allowing false publications, in an effort support “the free exchange of ideas and viewpoints.”  Opinion, slip op. at 27.  But Lewis wasn’t doing that.  He set out to make money on sensational “non-fiction” revelations.  Wing Chau became a vehicle for doing this — an exemplar villain of the financial markets who met face-to-face with Lewis’s faux anti-hero, Eisman.  Lewis skillfully went about crucifying Chau based on false accusations to promote Lewis’s own personal benefit, and should sit in the dock and face the music for doing so.  The majority opinion disingenuously diminishes the substance of what happened here.  This involves more than “simple slights” or “wound[ing] one’s pride.”  Id.  What Chau suffered is a lot more than “hurt feelings.”  Id.  He is professionally disgraced; his ability to support himself and his family is shattered.  That the court deprives him of his chance to stand up for his name and dignity is an affront to the legal process.

Michael Lewis is the villain here, and Judges Wesley and Kearse are accessories after the fact.

 Straight Arrow

November 17, 2014

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How the SEC Helps High Frequency Traders (Redux)

The Wall Street Journal reported previously on a new study revealing that the SEC was providing a special advantage to high frequency traders (HFT) by allowing them to get information filed with the SEC more quickly than most investors.  The Journal recently updated its earlier report here, and tells us that although the SEC appears to have reduced that advantage following the publication of this information, it still retains a 2-3 second timing advantage for early recipients of its data.

For those of you interested in the study, which reveals SEC conduct similar to possible similar arrangements in the private sector that the SEC Enforcement Division is investigating as potentially fraudulent securities trading, a copy is available here: How the SEC Helps Speedy Traders, a Columbia Law School Millstein Center for Global Markets and Corporate Ownership paper written by Robert J. Jackson, Jr. and Joshua R. Mitts of the Columbia Law School.

Straight Arrow

November 10, 2014

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SEC Found To Be Assisting High Frequency Traders

As they say, you couldn’t make this stuff up!

The Wall Street Journal reported today (October 29, 2014) that a new study confirms that the Securities and Exchange Commission (SEC) is feeding information to high frequency traders (HFT) before it goes to the general investment public.  What?  Could you say that again?

Yes, it’s true.  Your SEC — the U.S. government agency tasked with assuring a fair and efficient securities marketplace — provides special information access to favored investors, including the much ballyhooed high frequency traders.  Read about it here in this article: Fast Traders Are Getting Data From SEC Seconds Early.

The Journal reports that:

Hedge funds and other rapid-fire investors can get access to market-moving documents ahead of other users of the Securities and Exchange Commission’s system for distributing company filings, giving them a potential edge on the rest of the market.  Two separate groups of academic researchers have documented a lag time between the moment paying subscribers, including trading firms, newswires and others, receive the filings via a direct feed from an SEC contractor and when the documents are publicly available on the agency’s website….

When a company submits a document, the contractor forwards it to the Edgar subscribers and to the SEC website “at the same time,” according to the SEC. But the studies suggest that the SEC website can take anywhere from 10 seconds to more than a minute to post the documents, giving an advantage to the Edgar subscribers or their customers, who are often professional investors. Mom-and-pop investors can download the documents from the SEC website, but the information may already be known to others in the market, the studies indicate….

[A] forthcoming paper will document that investors could make about several cents a share, on average, on market-moving filings by receiving it in advance of those who rely on grabbing the document from the SEC website.

Straight Arrow

October 29, 2014

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SEC HFT Enforcement Action Looks Nothing Like “Flash Boys”

On October 16, 2014, the SEC entered into an administrative settlement of an enforcement proceeding involving a high frequency algorithmic trader — Athena Capital Research, LLC.  But if you review the Administrative Order, which is available here (In re Athena Capital Research), don’t expect to see anything like the fanciful musings of Michael Lewis in “Flash Boys.”  In fact, there is no suggestion that high frequency trading might be unlawful outside of the complex, labyrinthine alleged manipulation scheme described in the SEC’s charges.

I won’t bother to try to describe the charges here because they are so complex.  But they involve an algorithm of multiple high speed buy and sell transactions at the close of the trading day designed to create a favorable price increase for Athena Capital in the after-closing auction.  The important thing is that the SEC did not assert that the problem was high frequency trading (HFT), but that HFT was a vehicle for pursuing “a familiar, manipulative scheme: marking the closing price of publicly-traded securities.”

SEC Chair Mary Jo White made it clear that it was the manipulative conduct that was key: “When high-frequency traders cross the line and engage in fraud we will pursue them as we do with anyone who manipulates the markets.”  SEC officials in the division of the SEC tasked with examining trading systems and practices previously expressed skepticism about Michael Lewis’s accusations and follow-on proceedings by New York Attorney General Eric Schneiderman.  See SEC’s Berman Says Critics Like Schneiderman Misjudge Regulator and SEC official suggests order cancellations not currently a problem.

Another interesting aspect of this proceeding is that the settlement occurred based on the respondent neither admitting nor denying the charges — meaning the SEC did not have the leverage to insist on an admission of liability — and, although there was a $1 million penalty imposed, the SEC did not seek any “disgorgement” of alleged unlawful profits — probably meaning they had a hard time proving significant profits actually occurred.

Straight Arrow

October 21, 2014

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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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High Frequency Trading, and Proof that the SEC Approach to Insider Trading is Completely Wrong

Some interesting thoughts by Mark Cuban on the SEC’s approach to high frequency trading and insider trading.

blog maverick

Got to love Mary Jo White, the Chairwoman of the SEC.  While Michael Lewis’s book Flash Boys was getting all the headlines and was the topic of some of the best television  on CNBC, ever, Ms White used the firestorm to ask for more money for the SEC.

Shocking ? The only shock would be if she didn’t use any occasion the SEC was in the public eye to ask for more money. It is unfortunate because there is no greater waste of money than what the SEC spends trying to enforce  insider trading laws.

Let me give you some examples of just how poorly the SEC manages our tax dollars when it comes to insider trading:

1. Did you hear the one about Gary and Clif of the Florida East Coast Railroad ? Gary and Clif noticed that there were a lot of tours of the company…

View original post 768 more words

SEC Loses Another Case, but SEC Decision To Pursue Moshayedi Case Does Not Seem Unreasonable

On June 6, 2014, the SEC lost another enforcement action jury trial in SEC v. Moshayedi, Case No. 12-CV-01179, in federal court for the Central District of California.  Moshayedi was an insider trading case; it followed the loss just a week earlier in another insider trading case, SEC v. ObusSee SEC Enforcement Takes Another Blow in SEC v. Obus.

Moshayedi, however, was a very different kind of case than Obus.  It involved alleged stock trading by an insider himself – indeed, by the CEO and his brother, who were co-founders of sTec, Inc., which manufactured and sold to solid state drives (SSDs) to computer makers.  The SEC alleged that the CEO knew that one of sTec’s key customers bought more SSDs than it needed in the third quarter of 2009 (under pressure from sTec to do so) and was going order fewer SSDs going forward, at least in the short run.  The CEO and his brother went ahead and sold $268 million in shares in a secondary stock offering without disclosing this alleged knowledge.  The SEC alleged that when the customer’s decreased demand for SSDs was revealed, sTec’s stock price dropped precipitously, which showed how important the information was.

Based on the information available in the court records, it is hard to take issue with the SEC’s decision to bring the case and take it to trial.  Unlike Obus, the facts and circumstances did not, on their face, undercut the insider trading theory.  (In Obus, the supposed culprit was an investor who allegedly revealed his nonpublic information in a call to the CEO, which made no sense at all if he was a supposed insider trading schemer.)  As far as one can tell in reviewing the court record, there was substantial evidence that the CEO may have known about a likely change in future SSD orders from its key customer when he sold his stock.  To be sure, there were legitimate disputes about what he precisely knew and how important that was to investors, but the fact pattern and the arguably huge loss avoided by the CEO provided strong reasons for the SEC to take the matter to the mat.  Without some highly disputed issues of fact, cases like this never go to trial.  But overall, this case seems like one the SEC is justified in bringing.

At this stage, it is hard to know why the jury rejected this SEC’s claims, finding the CEO and his brother not liable.  It is certainly troubling that in a case in which the cards seem to be stacked in the SEC’s favor, it was unsuccessful.  One would not expect the CEO’s argument in these circumstances – that what he knew was not that important, or that what appeared to have a large stock price impact was really something he didn’t know – would have a lot of jury appeal.  It is possible that most of the witnesses, many of whom were former sTec employees (sTec has since been acquired by Western Digital) were well-disposed to the defendants and made it difficult for the SEC lawyers to make their case.  The SEC is essentially forced to make its case through the testimony of company employees, and one should not underestimate the importance of whether witnesses appear willing, or reluctant, to present the SEC’s evidence.  But at least based on what we can tell now, this does not appear to be another example of inexplicable overreaching by the SEC’s Enforcement Division.  It would probably be a mistake simply to add this case to the growing list of recent SEC enforcement trial losses as evidence that the SEC enforcement litigation program is seriously askew.

Straight Arrow

June 9, 2014

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