Securities Law - A Rare Loss For the SEC

A District Court case (Southern District Of New York) involves allegations of insider trading in violation of Section of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)-(5). The case is captioned SEC v. Nelson J. Obus, et. al., 06 Civ 3150, United States District Court for the Southern District of New York. The opinion was written by George B. Daniels, District Judge. The opinion can be found in the Pacer Systems. It is Document 77 and is dated September 20, 2010.

Following a SEC investigation, the SEC filed a Complaint alleging insider trading in violation of Section 10(b) and Rule 10(b)-5 against Tom Strickland, an employee of GE Capital Corp. The SEC alleged that Strickland tipped a friend, Peter Black, an analyst at Wynnefield Capital, about the potential acquisition of SunSource by a financial buyer. Black then, according to the SEC Complaint, passed the information to his superior, Opus, who purchased the stock of SunSource. The Court referred to the “Classical” and “Misappropriation” theories of insider trading.

Under each theory the SEC must prove five elements: (1) the tipper possessed material non-public information concerning a publicly traded company; (2) the tipper disclosed this information to the tippee; (3) the tippee traded in the company’s securities while in possession of the insider information; (4) the tippee knew or should have known that he tipper had violated a relationship of trust by providing the non-public material information and (5) the tippee benefited from the disclosure of the information. S.E.C. v. Warde, 151 F.3s 42, 47 (2d Cir. 1998). All of the Defendants filed a motion to dismiss the Complaint for failure to state a cause of action.

GE Capital sought to do business with SunSource. GE submitted a best effort proposal to provide 95 million dollars of financing in support of a potential buyer’s buyout of SunSource. Strickland was the front person for the GE underwriting team. Strickland learned that Wynnefield was an owner of SunSource stock and that his college classmate, Black, worked at Wynnefield. Following Strickland’s call to Black, Wynnefield purchased a block of SunSource Stock.

GE was subpoenaed by the SEC to testify pursuant to Federal Rule Of Civil Procedure 30(b)(6) about Strickland’s employment history. The GE employee testified that Strickland was trying to do some underwriting when he talked to his friend, Black.
The SEC based its insider trading allegations on the premise that by tipping Black about the impending SunSource merger, Strickland breached the fiduciary duty he owed to SunSource as a “temporary insider.” The District Court noted that neither Strickland nor his employer GE was a corporate insider of SunSource and that accordingly the classical theory of insider trading was not violated.

The Court said that the SEC cannot prove that GE or Strickland owed a duty of confidentiality to SunSource on the date of Strickland’s call to his friend Black and that summary judgment was rendered in favor or the Defendants in regard to the “classical” theory of insider trading.

The Court then considered whether the misappropriation theory applies when a person commits fraud in connection with the securities transaction. The Court concluded that Strickland engaged in no active deception. Such being the case the misappropriation theory did not apply.

Accordingly, the Court dismissed the SEC Complaint against all Defendants.

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Securities Law - Verdict Upheld by Seventh Circuit

RK Company sued Jackie R. See for violations of the Federal and State Securities Laws. The case is entitled RK Company v. Jackie R. See, No. 07-3984 decided September 22, 2010 by the Court Of Appeals for the Seventh Circuit.

The Seventh Circuit summarized the basis for the case as follows:

"Harvard Scientific Corporation and its founder Jackie R. See claimed to be developing a new product to treat male and female sexual dysfunction. Dr. See touted HSC's soon-to-be success in creating this product in a series of press releases and securities filings. This attracted an investment by RK Company..."

Plaintiffs invested $500,00 in Defendant’s LLC.

"Unfortunately, HSC's claims of success were not true, and following a bench trial, the court found Dr. See violated federal and state securities laws, state deceptive practices law, and committed common law fraud." The Seventh Circuit noted that the evidence showed that HSC's press releases included false statements and material omissions, "such as HSC's claims that the FDA had authorized clinical studies when it had actually suspended them..."

At trial, Plaintiffs sought damages equal to its investment of $500,000, prejudgment interest and attorneys’ fees. At trial, the plaintiff RK Company was successful. The opinion makes virtually no direct mention of the Securities Laws but rather discusses and rejects various claims of error by
Magistrate Judge Keys who presided.

Jackie See claimed to have a new product to treat sexual dysfunction of men and women. However, his company never received Federal Drug Administration approval and eventually went bankrupt. Defendant’s claim of FDA approval was false. The $500,000 investment by plaintiff was lost.

Following a bench trial, judgment was entered for plaintiff for the amount of the investment, prejudgment interest and attorneys’ fees.

The Seventh Circuit in an opinion by Judge Williams affirmed the ruling of the District Court. The Defendant claimed that the attorneys’ fees were excessive and that it had insufficient time to review the invoices. The invoices of the plaintiff’s attorney had been paid by his client which according to the Seventh Circuit was evidence of reasonableness. The Seventh Circuit noted that the Defendant received copies of plaintiff’s paid invoices on April 9, 2007 and had until August 2, 2010 to review and object to the invoices. The period of review was far in excess of the 15 days provided by the Local Rule.

A full victory for the Plaintiff.

Edward X. Clinton, Sr.

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Securities Law - Mark Cuban Fouls Out!

The SEC sued Mark Cuban, owner of the Dallas Mavericks and other businesses claiming that he wrongfully traded insider information in violation of § 17(a) of the Securities Act of 1933 and § 10 of the Securities Exchange Act by trading in the stock of Mamma.com in breach of his duty to the CEO of Mamma.com and Mamma.com amounting to insider trading under the misappropriation theory of liability. Cuban was a large minority stockholder of Mamma.com. In a telephone call from the CEO of Mamma.com, Cuban learned that Mamma.com was going to trade a public equity offering (PIPE). Cuban agreed in that call to keep the information confidential. Cuban then sold his stake in the Mamma.com to avoid losses from the inevitable fall in share price when the offering was announced. Cuban moved to dismiss.

The District Court found that the SEC Complaint alleged an agreement to keep information confidential, but did not include an agreement not to trade. The SEC appealed arguing that a confidential agreement creates a duty to disclose or abstain and that regardless the confidentiality agreement alleged in the Complaint contained an agreement not to trade on the information. (If interested, see our prior posts on this topic below).

The SEC alleges that Cuban’s trading constituted insider trading and violated Section 10(b) of the Securities Exchange Act. Section 10(b) makes it
unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange . . . [t]o use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Pursuant to this section, the SEC promulgated Rule 10b-5, which makes it unlawful to
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

The Supreme Court has interpreted Section 10(b) to prohibit insider trading under two complementary theories, the “classical theory” and the “misappropriation theory.” The Cuban case involved the misappropriation theory.

The misappropriation theory rests on the principle that if a person violates Section 10(b) when he misappropriates confidential information for securities trading purposes, in a breach of a duty owed to the source of information. This theory was adopted by the United States Supreme Court in United States v. O’Hagan, 521 U.S. 642 (1997). In O’Hagan, the Supreme Court held that a lawyer who traded on confidential information misappropriated that information breaching a duty of trust and confidence he owed to his law firm and the law firm’s client.

The CEO of the Mamma.com was instructed to contact Cuban and to preface the conversation by informing Cuban that he had confidential information to convey to him in order to make sure that Cuban understood before the information was conveyed that he would have to keep the information confidential. Cuban agreed to keep the information concerning the PIPE offering confidential. At the end of the call, after learning about the offer, Cuban said “Well, now I’m screwed. I can’t sell.” Cuban then had a call with a sales representative of the proposed offering to get details of the offering. Following that call he immediately sold his entire stake in the company consisting of over six percent (6%).

The District Court found that the Complaint asserted no facts that reasonably suggest that the CEO intended to obtain from Cuban an agreement to refrain from trading on the information as opposed to an agreement merely to keep it confidential.

The Fifth Circuit held that it was entirely plausible that the CEO understood that in addition to keeping the information confidential, Cuban would not sell. Accordingly, the Fifth Circuit without taking a stand on whether the disclosure by the CEO was intended to restrict Cuban from trading would only be determined following further proceedings in the District Court. Accordingly, the motion dismissing the case was vacated and the parties can proceed with discovery, a summary judgment motion and a trial, if necessary.

Edward X. Clinton, Sr.
Copyright 2010

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