Tag Archives: securities transactions

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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Does High Frequency Trading (HFT) “Rig” the Market?

Michael Lewis’s “Flash Boys” purports to reveal a system of “market-rigging” by the intervention of high frequency traders into executions of market orders.  Using some of the same sources that he used to source his highly misleading book “The Big Short,” he created a “sky is falling” atmosphere by promoting his book as the revelation of rigging the market.  He portrays a supposed fraud on ordinary traders by high frequency traders because of their ability to step in front of a trade and execute it for themselves at that price and then resell to the trader with a miniscule mark-up, thereby gaining huge profits when these miniscule mark-ups are repeated millions of times.

This has been labeled “insider trading” by many uninformed people, but it almost surely is not, because the high frequency traders do not appear to possess material non-public information when they trade.  I have not yet seen evidence suggesting they were engaged in committing any form of fraud, or breaching any fiduciary or fiduciary-like duty of confidentiality through the process by which they gain access to trade order information before it gets from the exchanges to market-makers responsible for trade execution.  They certainly do not have material non-public information about the public company whose stock is being traded, which is the standard fare of insider trading violations.

Whether this is a form of “front-running” is another issue.  Front-running is a description of trading that occurs when someone learns about an impending trade order, knows that this order will “move the market price,” and steps in front of the order to make a trade before the order hits the market (and moves the price), then usually pockets the profit by selling at the new market price.  This typically would be seen only when people have access to confidential order information involving large block orders of a stock that could conceivably move the market price enough to allow for a front-running profit after costs of order execution are taken into account.  What Lewis describes as high frequency trades are not this type of front-running because they do not involve large block, market-moving, trades.  And it is not at all clear, as compared to front-runners who misuse confidential access to trading information for their own benefit, whether the high frequency traders are engaging in an impropriety at all, since, once again, there is no apparent source of a duty of confidentiality they would be breaching.

Finally, the “market rigging” aspect of HFT would seem to be a hyperbolic, publicity-grabbing description, at best.  The focus appears to be on cumulative profits allegedly gained by the high frequency traders, but the actual impact on specific trades is so small as to be immaterial to the person who entered the order.  How many of us, or even institutional traders, care very much whether our trade is executed at $1 per share or $1.001 per share?  To be sure, the SEC should be making  efforts to try to assure best execution of trade orders, but the real question to ask is what costs we are willing to incur to prevent  that $.001 mark-up from occurring?  In some instances, analysts appear to be showing that there could be an issue of phantom liquidity that may be worth pursuing, not because it is a fraud, but because it may be allowing incorrect liquidity expectations to impact market executions.  I’ve included one interesting such analysis in the “securities markets” links to right (Nanex.net analysis of HFT trade cancellations), which appears to show that HFT sometimes results in unreliable reports by exchanges of trade offers because of high frequency traders cancelling offers before executions can occur.  Whether spending, and causing others to spend, hundreds of millions of dollars or more to address such an issue in investigations and “settlements” of enforcement actions addressing what appear to be lawful practices may make little sense.  Moreover, if this is an issue, it would appear to be a regulatory one, not an enforcement one, and the SEC’s experts on market practices, not the enforcement division, should lead the way.  The politically-oriented state Attorneys-General with no market expertise and no authority to regulate markets should be excluded from the process altogether.

The main problem here is a common one that people like Michael Lewis, many commentators, and, unfortunately often the SEC itself, get in a huff when financial market participants find even lawful ways to make a lot of money.  They seem to forget that the entire market process is, and must be, driven by the ability to garner lawful profits from trading, because that is what creates market efficiency, which is the driver of the market system.  The huge ruckus created by “The Big Short” was just such a mistake.  The fact that some people made a lot of money by betting on the housing market to decline, and huge institutions lost a lot of money by failing to protect themselves against a massive decline in housing values, is what markets are all about.  The short trades Lewis described typically were not unlawful (the contrary verdict in the Fab Tourre case was, in my view, a travesty, because it is plain that the counter-party was not defrauded in any meaningful respect).  They were either very good bets based on informed judgments about over-exuberance in housing markets, or, in many cases, very good luck when short positions put on as a hedge became wildly, and unexpectedly, profitable.  The SEC wasted millions of taxpayer dollars investigating these matters for more than five years, and caused billions of dollars of expenses and “settlements” for no good reason other than to punish financial institutions for allowing a marketplace driven by huge, well-informed, institutional investors to function as intended.

Whether the same is true for the now-blossoming HFT investigations will remain to be seen, but the hype and hyperbole attendant to the investigations and commentating on this issue suggests we are moving down a similar path.

Straight Arrow

July 20, 2014

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The Myth of Insider Trading Enforcement (Part I)

For Insider Trading, Mr. Bumble Was Right — “The Law Is a Ass”

In Oliver Twist, Mr. Bumble, whose wife was of a type that John Mortimer later immortalized as “she who must be obeyed,” was told that “the law supposes that your wife acts under your direction,” his response was apt:

“If the law supposes that … the law is a ass – a idiot.”

Charles Dickens, Oliver Twist.

I read with interest Henry Manne’s op-ed piece in the April 29, 2014 Wall Street Journal, Busting Insider Trading: As Pointless as Prohibition, a link to which can be found to the right.  Dean Manne, a devoté of the application of economic principles in the law, discusses the pointlessness of our current insider trading legal regime.  He focuses on the fecklessness of devoting major enforcement resources to this effort, but also notes towards the end that: “Insider trading not only does no harm, it can have significant social and economic benefits including a more accurate pricing of stocks.”  How true, and how generally ignored, that is.

The law of insider trading is a mess.  Even highly-experienced securities lawyers can disagree about whether particular trading scenarios are lawful or unlawful.  The result is that uncertainty over what is permitted causes securities investors who want to comply with the law — and to avoid costly and potentially debilitating SEC investigations of trading activity — to refrain from participating in market transactions that, as part of overall market activity, would help make the securities markets more efficient, at least in the sense that security values truly reflect available information.  Any securities lawyer who has advised clients in this area knows that what often is the critical consideration is not whether a trade is lawful or unlawful, but whether the SEC might become interested and commence an investigation, the costs of which would obliterate any possible profit.

In the next several posts, we will examine how this area of law became such a mess.  It is a tale that shows how statutory law can stray far from the legislative enactment that creates it, and also shows the enormous power of unelected officials — chiefly administrative government employees and appointed judges — to mold the law in a form they choose, even if it becomes a gerry-built embarrassment.

Part I:  The Securities Exchange Act of 1934 Signed Into Law Gets Revised by Administrative Fiat and a New Version Gets Embraced by the Courts

For years, the SEC’s insider trading enforcement program has been driven by the purported concept of equal access to information – that the securities markets must be (or be perceived to be) fair to all participants, and to accomplish that, we have to eliminate informational advantages available only to some market participants.  Of course, that is not, and has never been, the law, nor should it be.  (More on that below.)  But it is the vision that has driven SEC policy-making and enforcement for fifty years.

Yet, this concept that the sine qua non of fair markets is that all participants must come to the marketplace as informational equals is facially inconsistent with the economic principles on which the financial markets are founded.  If they could be forced to confront the issue head-on, even SEC decision-makers would have to agree with this, because they fully understand that an efficient securities market requires price-setting mechanisms that depend on the effect of incorporating unequal information sources into the buy and sell process.  A “fair” market requires a mechanism that delivers a “fair” price for goods (or securities) being bought and sold.  In the securities markets, it means that the relative prices among various securities available for investment should, to the extent possible, reflect the value of those securities to investors.  (See Smolowe v. Delendo Corp., 136 F.2d 231, ___ (2d Cir. 1943) (The goal of the 1934 Act, as reflected in §2, “was to insure a fair and honest market, that is, one which would reflect an evaluation of securities in the light of all available and pertinent data”).)

Although “insider trading” (however that might be defined) is viewed by many as improper, it was accepted as a part of securities trading when the Securities Exchange Act of 1934 was enacted.  The 1934 Act sought “to insure the maintenance of fair and honest markets” for securities transactions (Section 2), but Congress never thought that encompassed preventing “insider trading.”  The only forms of “insider trading” targeted in the 1934 Act as improper were short-term trades by officers or directors (purchases and sales within a six-month period).  What is now section 16(b) of the 1934 Act provided that profits from such purchases and sales (“short-swing profits”) had to be paid to the Company.  This was true whether or not the trades were based on, or made in possession of, material nonpublic information about the Company.  It was plainly understood at the time that the statute did not otherwise address insider trading, and certainly did not prohibit it.  (See Hearings Before the House Committee on Interstate Banking and Foreign Commerce, H.R. 7852 & H.R. 8720, 73rd Cong., 2d Sess. (1934) (testimony of Tommy Corcoran).)

Why were our securities law forefathers so insensitive to this issue?  They weren’t.  They simply understood that the misuse of nonpublic corporate information by corporate insiders was an issue addressed by corporate law, governed by state law corporation statutes or common law principles.  The courts were in the midst of addressing the circumstances under which a corporate insider’s securities transaction based on nonpublic corporate information violated any duties or provided the other party to the transaction, or the corporation itself, grounds to assert a cause of action.  In 1909, the Supreme Court ruled in Strong v. Repide, 213 U.S. 419 (1909), that a shareholder approached by an insider to sell her shares when the insider knew about, but kept secret, business negotiations that would enhance the value of those shares, could have a cause of action even though the insider technically did not owe fiduciary duties to the shareholder (as opposed to the company).  State courts ruled in varying ways on such claims, in part depending on the specific facts of the interactions, if any, between insiders and shareholders.  Those courts were sensitive to the concern that “An honest director would be in a difficult situation if he could neither buy nor sell on the stock exchange shares of stock in his corporation without first seeking out the other actual ultimate party to the transaction and disclosing to him everything which a court or jury might later find that he then knew affecting the real or speculative value of such shares.”  Goodwin v. Agassiz, 283 Mass. 358, 362,186 N.E. 659, 661 (Sup. Jud. Ct. Mass. 1933).

In 1934, Congress was well aware of the fact that some corporate directors and officers “used their positions of trust and the confidential information which came to them in such positions, to aid them in their markets activities.”  S. Rep. No. 1455, 73rd Cong., 2d Sess. (1934).  It ultimately concluded that the best approach to that problem was not to enact a federal law barring such trading, but to require prompt disclosure of insider trades so the public could learn of them, and provide that the corporation was entitled to recover profits from short-swing trades under section 16.  See H.R. Rep. No. 1383, 73rd Cong., 2d Sess. (1934).  Even so, it was well-understood that “the unscrupulous insider may still, within the law, use inside information for his own advantage.”  Id. So, even though the chief antifraud provision of the 1934 Act, section 10(b), was incorporated into the original statute in essentially the same form it takes today, it was generally understood that the “manipulative or deceptive device[s]” it prohibited did not bar corporate insider trading.

Although state law on this issue continued to vary in the ensuing years, it was recognized in the key corporate law jurisdiction of Delaware that officers, directors, or employees of a corporation who profit from the use of proprietary corporate information in securities trading, whether or not they owe a “fiduciary duty” to refrain from such trading, can be required to pay the corporation any profits from such trading in an action for disgorgement.  See Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949).  The concept is that it is the corporation, not the counter-parties to the trades, to which a duty may be owed, and which is harmed by the unauthorized use of confidential corporate information.  This remains a valid corporate claim to this date.

It was not until many years later that the concept was introduced that a “fair and honest market” incorporated some sense of equal opportunity for investors to profit on securities trading, and that a person may be precluded from trading if he or she has an informational advantage.  And this was not legislated, it was announced by the SEC in an enforcement fiat (not even an administrative rulemaking), and then promoted and advanced by federal courts which elevated their concept of investment egalitarianism above the state laws that normally govern the relationships and duties between corporate officers, directors, and shareholders.

It is reported that when William Cary was appointed SEC Chairman in 1961 (27 years after enactment of the 1934 Act), it was near the top of his agenda to have the SEC effectively overturn Goodwin v. Aggasiz.  The fact that this was a long-standing matter governed by state law was, in his view, unfortunate.  Chairman Cary personally found it “shocking for either courts or business executives to believe that it was permissible conduct for executives to use inside information for their personal benefit,” and was committed to using the SEC to create federal law “guaranteeing, as far as the law could, that all investors trading on stock exchanges have relatively equal access to material information.”  (J. Seligman, Memories of Bill Cary, The CLS Blue Sky Blog, Jan. 24, 2013) (see link to the right).William L. Cary, SEC Chairman

Bill Cary did, in fact, lead the SEC down a new path enshrining equal access to information as the “Holy Grail” of securities markets.  He did this in an administrative enforcement proceeding involving a broker who sold shares of stock for clients after being told by a Board member that the company had reduced its dividend, but before that news was released to the public.  In the Matter of Cady, Roberts & Co., 40 S.E.C. 907 (1961).  Cary effectively ignored corporate state law, as well as the plain history of the 1934 Act, when he envisaged the federal securities acts as generating “a wholly new and far-reaching body of federal corporation law”  (id. at 910), something well beyond the articulations of Tommy Corcoran and the 73rd Congress.  Cary went on to declare: “We, and the courts, have consistently held that insiders must disclose material facts which are known to them by virtue of their position but which are not known to persons with whom they deal and which, if known, would affect their investment judgment.”  Id. at 911.  He cited three district court cases in the previous 27 years, but acknowledged in the same footnote that this was not, in fact, the “majority” rule.  Id. at 911 n.13.  He went on to announce that there was an “inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing” (id. at 912), and that it did not matter that the transaction occurred in an impersonal exchange because “[i]t would be anomalous indeed if the protection afforded by the antifraud provision were withdrawn from transactions effected on exchanges.”  Id. at 914.  After all, he reasoned, we can assume these investors would not have offered the same price if they had known of the negative nonpublic information.  Id.

In one fell swoop, the SEC promulgated (without notice or comment) a new “federal corporation law” governing trading by officers or directors on nonpublic corporate information, and overturned years of state law holdings that officers and directors owed duties to the corporation, but not to shareholders, in impersonal open market transactions.  And he did so without any effort to analyze how these new legal precepts might affect the balance of power between federal and state authorities over corporate conduct, or how it might impact overall pricing of securities in the marketplace (by withholding from the market buy and sell transactions needed to move market price to a “fair” valuation of the security).  In short, in Cady, Roberts the SEC (1) elevated the desire for equal access to information above the need for fair pricing of securities on the exchanges, and (2) elevated its own views on this issue above contrary state law, all without any legislative act endorsing these choices.

As noted, the federal courts generally welcomed the opportunity to follow the SEC’s lead.  The influential Second Circuit Court of Appeals took on the issue in the landmark case SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).  The case involved stock purchases by insiders after they learned of a potential large mineral discovery on company property, but before that information was disclosed to the public.  The SEC brought an enforcement action alleging this trading was fraudulent under section 10(b), and sought to compel rescission of these transactions.  The district court tried the case and found liability on some section 10(b) claims (ruling against others on materiality grounds).  The appellate court affirmed the section 10(b) violations (and reversed the finding of immateriality on other claims).  In doing so, the court adopted a broad legal standard endorsing the equal access to information theory in Cady, Roberts.

Right out of the box, the court stated a new vision of what section 10(b) was about, saying: “By that Act Congress purposed to prevent inequitable and unfair practices and to insure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on the exchanges….  Whether predicated on traditional fiduciary concepts … or on the ‘special facts’ doctrine [of Strong v. Repide] … Rule [10b-5] is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information….  The essence of the Rule is that anyone who, trading for his own account … has ‘access … to information intended to be available only for a corporate purpose and not for the personal benefit of anyone’ may not take ‘advantage of such information knowing it is unavailable to those with whom he is dealing,’ i.e. the investing public.”  401 F.2d at 848 (quoting Cady, Roberts).  The court then announced a so-called “disclose or abstain” rule: “Thus, anyone in possession of material inside information must either disclose it to the investing public, or … must abstain from trading….”  Id.  This single pronouncement, which did not even purport to be anchored in any statutory underpinning, became the foundation of “equal access to information” insider trading dogma for the next 50 years.  To drive home its New Order and revisionist history, the court later restated: “The core of Rule 10b-5 is the implementation of the Congressional purpose that all investors should have equal access to the rewards of participation in securities transactions.  It was the intent of Congress that all members of the investing public should be subject to identical market risk….  The insiders here were not trading on an equal footing with the outside investors.”  Id. at 851-52.

Texas Gulf Sulphur became the rallying point for proponents who supported more and more extensive legal standards to assure that the Holy Grail of equal access to information for all securities investors could be approached, if not fully achieved.  The law of “insider trading” would be expanded in leaps and bounds, usually at the behest of the SEC.  The distinction between insiders and non-insiders was effectively obliterated, laying waste to the concepts of fiduciary duty which even Cady, Roberts and Texas Gulf Sulphur nodded to as the foundation for their extensions of the law.  “Tippees” were deemed to violate the insider trading prohibition even though they plainly owed no fiduciary duty to either the corporation about which they possessed nonpublic information or the person who happened to be on the other side of their securities trade.  What legal theory was used to support this extension of the law?  No more was required, said the SEC and the courts, beyond the “abstain or disclose” rule pronounced in Texas Gulf Sulfur, and the outrage that would occur if these tippees were permitted to gather profits based on nonpublic information not available to other market participants.  The mere possession of this information created a “duty” — essentially out of thin air — by the tippee not only to the “actual” person on the other side of the transaction, but “to all persons who during the same period” were on the other side of similar transactions.  Shapiro v. Merrill Lynch, Pierce Fenner & Smith, Inc., 495 F.2d 228, 237 (2d Cir. 1974).  The Shapiro decision even created a private cause of action for all of those people against the tippee, without deigning to explain how someone merely in the vicinity of a transaction should be entitled to compensation for his or her unwise investment decision.

Shapiro is a fine example of how far the courts strayed from any anchor in the law, and their complete disregard for the key role of unequal information in achieving fairly-priced markets.  That court expanded the law to create a “disclose or abstain” duty for tippees merely because they “knew or should have known” that information they received originated from a confidential corporate source.  Id. at 239.  It also gave the back of the hand to the long-standing concept, going back at least to the Supreme Court decision in Strong v. Repide, that the liability of an insider to a counterparty in a securities transaction must be founded on facts showing a special relationship between them that created a duty to disclose.  Id. at 239.  And, in the court’s own words, the rationale supporting this upheaval in the law was “based chiefly on our decision in SEC v. Texas Gulf Sulphur … where we stated” the abstain or disclose rule.  Id. at 236.  In deference to a “disclose or abstain” rule the court itself created, and “the strong public policy considerations behind” that rule, the Shapiro court scorned legal arguments founded in long-standing state law principles simply because they “would make a mockery of the ‘disclose or abstain’ rule.”  Id.  The fact that Congress never suggested, and plainly did not enact, a “disclose or abstain” rule was not worthy of mention.  The New Order was to be founded purely on the “strong public policy considerations” anointed by the Texas Gulf Sulphur court.

The Shapiro (and Texas Gulf Sulphur) courts “enacted” the Cady, Roberts “equal access to information” concept of market fairness in complete disregard of economic market principles.  The chosen “policy considerations” of the SEC and the Second Circuit focused on populist visions of equality among investors rather than economic principles about how fair and efficient markets function.

This was made plain in Shapiro, in which the court actually held that it was harmful for the securities markets to move toward a fair price for a security.  In its zeal to assure that no investor should profit from nonpublic information (which, to repeat, was not what Congress envisioned), the court turned upside down the concept of market integrity.  The court accepted allegations that the sales of stock by tippees with negative inside information caused a substantial drop in stock price days before the information was made public, and concluded that this stock price impact undermined the “integrity and efficiency” of the market.  But exactly the opposite is true.  A “market” has neither integrity nor efficiency when trading occurs at artificially high prices — prices that remain elevated while the holders of secret information are not permitted to assist in bringing the value of a security to its economically justifiable level.  The tippees in Shapiro may have lacked personal integrity when they opted to trade based on this information, but they surely assisted in improving market integrity and efficiency by starting the process of bringing stock valuation to levels fairly reflecting the true value of the security.  The court lingered on, and created a claim for compensation for, investors who bought the stock before its price declined, but ignored the fact that in the absence of the tippees’ trading, many additional investors would have suffered by being limited to a market that maintained an artificially high stock price for the security they bought.  The court found it better that all investors should pay the artificially high price until the earnings information was released publicly.  When the tippee arbitrageurs bid that price down, the market as a whole benefited, but the court chose not to consider that “public policy consideration.”  From the standpoint of the law, the court had no business imposing an idea of fairness that, as we have seen, had no foundation in the statute it was purporting to apply.

In Part II, we will look at how the Supreme Court started the pendulum swinging away from the New Order of “equal access to information” by returning to statutory principles, and the SEC’s persistent efforts to push back.

Straight Arrow

May 7, 2014

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