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he Securities and Exchange Commission continues to maintain an aggressive effort against insider trading. The SEC brought 57 insider trading actions in the fiscal year ending Sept. 30, 2011. Much of the attention centered on the cases involving socalled expert networks and the governments use of blue-collar tactics, such as wiretaps, that were traditionally associated with combating organized crime. But away from the headlines, the SEC has sought to extend the boundaries of insider trading law in ways that could have far-reaching consequences.
INSIDER TRADING
Insider trading is a violation of 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Insider cases generally fall into two categories. Under the classical theory, a person violates 10(b) and Rule 10b-5 when he trades securities on the basis of material, nonpublic information and is an insider of the corporation whose securities are traded, therefore violating a fiduciary duty owed to that corporation and its investors. Under the misappropriation theory, an individual violates 10(b) and Rule 10b-5 by trading in securities of a corporation in which the person is not an insider, on the basis of material, nonpublic information that has been misappropriated from another person or entity with whom there was a duty of trust or confidence that precluded the use of the information for personal benefit. The SEC also should not simply allege
Jared L. Kopel is a partner at Wilson Sonsini Goodrich & Rosati in Palo Alto.
The litigation since has focused on discovery disputes and Cubans so-far unsuccessful allegations that the SEC engaged in improper conduct. But barring a settlement, the courts eventually should determine whether the misappropriation theory encompasses a passive investor who, rather than seeking confidential corporate information, was the recipient of unsought information deliberately conveyed to him by corporate management trying to solicit an additional investment. The Cuban matter also shows that companies should ensure that any communication of confidential information to a shareholder should include an express agreement that the investor will not use the information for personal benefit (which is also important for Regulation FD compliance). Another attempted use of the misappropriation theory was rejected in SEC v. Obus, 06 Civ. 3150 (GBD) (S.D.N.Y. Sept. 20, 2010). The SEC alleged that an employee of GE Capital Corp. tipped a securities analyst about a proposed acquisition that GE Capital was financing, and that the analyst tipped his boss, Nelson Obus, who made approximately $1.34 million trading in the shares of the acquired company. The court dismissed the action, holding that the employee of GE Capital was not an insider of the acquired company, and that the misappropriation theory was inapplicable because GE Capital had no confidentiality agreement with the employee. The SEC also has relied on the so-called mosaic theory, which provides that scattered bits of information, not individually significant, when pieced together provided the defendants with material nonpublic information. A leading example is SEC v. Steffes, 10-CV-6266 (N.D. Ill. Aug. 3, 2011). The SEC alleged that an executive of a railway company knew that the CFO asked him to prepare a list of company-owned equipment; there were an unusual number of yard tours; and there were rumors that the company was being sold. The executives nephew, a trainman on the railway, allegedly saw numerous yard tours by people wearing business suits and was aware that employees expressed concern about losing their jobs. Both the executive and the nephew were aware of a tour of one yard by representatives of another company, which happened to be a potential acquirer. The ex-
ecutive and the nephew allegedly disseminated the information to members of their family, who in turned shared the information with business associates. All of these individuals allegedly earned more than $1 million in profits by trading prior to the disclosure of the acquisition. Denying the defendants motions to dismiss, the court stated that although the SECs allegations are not robust, the complaint sufficiently alleged that the defendants possessed material nonpublic information and had acted with scienter. In a settled action, the SEC alleged that a man visiting his sister at her office became aware that she was very busy and heard her speak on the telephone with words such as due diligence file and merger structure. The SEC alleged that the brother later purchased stock and call options in his sisters company. The SEC did not bring any action against the sister, but accused the brother of trading while in possession of material nonpublic information he had misappropriated from his sister by violating a duty of trust and confidence that was owed to her. The brother consented to entry of an injunction and payment of approximately $315,000 in disgorgement, prejudgment interest and penalty. SEC v. Ni, CV 11 0708 (N.D. Cal. 2011). SEC v. Acord (S.D.Fla. Filed July 15, 2009) is an example of the SEC alleging, with mixed results, that individuals had access to material nonpublic information without expressly identifying how the defendants obtained the information. The case concerned allegations that defendants traded with knowledge of a pending acquisition of Neff Corp. by Odyssey Investment Partners LLC. Several defendants settled with the SEC. The SEC alleged that another defendant, Thomas Borell, had access to confidential information due to his close relationship with a Neff director and that he made significant purchases of Neff stock just prior to the acquisition announcement. The court, however, granted summary judgment for Borell. The SEC charged that another defendant, Sebastian De la Maza, learned of the proposed acquisition from contact with his daughter, who was married to Neffs CEO, without identifying the precise conversation in which the information was communicated. A jury found De la Maza
not liable. Another defendant, Alberto Perez, was alleged to have a close relationship with Neffs CEO and had his office at Neffs headquarters on the same floor as the executive management. The SEC alleged Perez learned of the acquisition from this constant access to confidential information without identifying the source of the information. The jury found Perez liable. However, a magistrate judge, apparently skeptical of the SECs allegations notwithstanding the jurys verdict, denied the SECs request for an injunction, and while ordering disgorgement of approximately $562,000 in trading profits, imposed only a $50,000 penalty, far less than the $1.2 million sought by the SEC. SEC v. Perez, 09-CV-21977-MCALILEY (S.D.Fla. 2011). The SEC also has brought claims based on merely suspicious trading, usually in situations where the SEC sought to freeze accounts where there was heavy overseas trading immediately prior to the announcement of a major transaction. Perhaps the most controversial recent insider trading action was the initial proceeding in March 2011 against Rajat Gupta, a former director of Goldman Sachs. Instead of filing a federal suit, the SEC instituted an administrative cease-anddesist proceeding, utilizing a provision of the Dodd-Frank Act that expanded the SECs ability to impose monetary penalties in C&D actions. The defense bar protested that an administrative proceeding in an insider trading action raised serious issues, including the limited discovery permitted, the lack of a jury trial and less restrictive rules of evidence than in federal court. Gupta filed a federal court action to block the C&D proceeding, and after a federal judge refused to dismiss, the SEC dropped the C&D proceeding, agreeing that any future insider trading action against Gupta would be filed in federal court in New York. The SEC subsequently filed such an action against Gupta in October, simultaneous with a criminal indictment. But the issue remains whether the SEC still has the appetite for bringing administrative insider trading actions, particularly against market professionals over whom it has regulatory authority. See In the Matter of David W. Baldt, 3-13887 (May 11, 2010).
Reprinted with permission from the January 11, 2012 online edition of The Recorder. Copyright 2012. ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited. For information, call 415.490.1054 or cshively@alm.com.