Seal of the United States Court of Appeals for the Second Circuit. (Photo credit: Wikipedia)
Under the “misappropriation theory” of insider trading, a person violates the securities laws by breaching a fiduciary duty to keep information confidential. But what happens when the entity to whom the fiduciary duty was owed concludes, after the fact, that the person at issue did not violate any fiduciary duty? Can the SEC still sue that person for insider trading?
The answer is “yes,” as was made clear last month by the Second Circuit Court of Appeals in a fascinating insider trading case entitled SEC v. Obus. In that case, an Assistant Vice President and underwriter at General Electric Capital Corp. (Thomas Strickland) was accused of tipping a friend at a hedge fund (Peter Black at Wynnfield Capital, Inc.) that GE Capital was going to help finance an acquisition of SunSource by Allied Capital Corp. According to the SEC, Black then told his boss at Wynnfield Capital, Nelson Obus, about the potential acquisition. Two weeks after the conversation between Strickland and Black, Wynnfield Capital bought about five percent of SunSource’s outstanding common stock.
When the trades received regulatory scrutiny, GE Capital conducted an internal investigation and concluded that no fiduciary duty had been violated. The SEC disagreed with that conclusion and sued based on the “misappropriation theory.” After discovery was concluded, the District Court judge assigned to the case ruled in favor of the defendants prior to trial, ruling that the SEC had not come forward with enough evidence to present to a jury.
The Court of Appeals reversed, finding that the SEC had raised material issues of fact for a jury to decide. According to the Court of Appeals, the District Court erroneously relied on GE Capital’s internal investigation to determine that Strickland breached no duty by tipping Black, “reasoning that the alleged victim of the breach of fiduciary duty did not consider itself a victim.” The Court of Appeals concluded that the District Court’s analysis was in error “because the internal investigation was not indisputably reliable, and because its conclusions were contradicted by other evidence.”
The issue of fact that the Court of Appeals left to the jury was the substance of what Strickland told Black in their key conversation. GE Capital’s internal investigation had concluded that Strickland had not told Black about the potential acquisition. However, as the Court of Appeals pointed out, there was circumstantial evidence to the contrary that the internal investigation did not have. Clearly, then, the Court of Appeals was correct in observing that the factual conclusion of the incomplete internal investigation was not binding on a jury.
But what if the internal investigation had learned everything that the SEC learned and still concluded that Strickland did not tell Black of the potential acquisition? Again, the internal investigation’s conclusion would not bind the jury because, as the Court of Appeals said, “the GE investigation was motivated by corporate interests that may or may not coincide with the public interest in unearthing wrongdoing and affording a remedy.”
This is an important point. It is entirely possible that, for any number of reasons, a corporation might not want to conclude that it was a victim of one of its employee’s breach of fiduciary duty to the corporation. Therefore, it is possible that the SEC’s interest in deterring insider trading might conflict with the corporation’s interest in letting the employee off the hook.
Of course, this principle is not limited to insider trading cases, or even white collar criminal cases. One can envision any number of hypothetical scenarios where a victim of a crime might not want the wrongdoer prosecuted. Under such circumstances, like in the Obus case, regulators and prosecutors must weight the victim’s desires against the public interest.