A more responsible blogger would have covered this case well before now. But you take your bloggers as you find them, and I do think it important even two months later to address SEC v. Obus, 693 F.3d 276 (2d Cir. 2012). In that case, the U.S. Court of Appeals for the Second Circuit reversed the grant of summary judgment to three individuals whom the SEC had accused of insider trading ahead of Allied Capital Corporation’s 2001 acquisition of SunSource, Inc.
Here is a brief summary of the fairly extraordinary facts, as reported by the Second Circuit:
In the spring of 2001, Allied Capital approached GE Capital about financing the SunSource acquisition. Thomas Bradley Strickland, an assistant VP at GE Capital, was assigned to perform due diligence on SunSource in May of that year. In doing that work, he learned non-public information about SunSource, including the basic fact that Allied was about to acquire it. Strickland was bound by GE Capital’s employee code of conduct, which required employees to “safeguard company property [including] confidential information about an upcoming deal.” GE Capital also maintained a transaction-restricted list containing the companies about which it had material, nonpublic information, and therefore were off-limits for securities trading. The parties dispute whether SunSource should have appeared on that list before June 19, 2001, and whether Strickland himself should have put SunSource on the list.
Strickland’s college buddy Peter Black worked at the hedge fund Wynnefield Capital, a large SunSource shareholder, in 2001. On May 24 of that year, he and Strickland had a conversation about SunSource, but the parties disagree about what was actually discussed. The defendants maintain that Strickland merely asked Black his opinion of SunSource’s management as part of Strickland’s due diligence work. The SEC maintains that Strickland revealed material non-public information by telling Black that Allied was about to acquire SunSource. The SEC also presented evidence that Strickland’s superiors at GE Capital stated that contacting shareholders was not part of the normal due diligence process, and that Strickland had never done so in the past.
Immediately after the Strickland-Black conversation, Black relayed the information to Nelson Obus, Wynnefield’s principal and Black’s boss. Black maintains that Strickland’s general questions led Black to suspect (based on SunSource’s prior public actions) that SunSource was considering a transaction that would dilute existing shareholders, and that he relayed that suspicion to Obus. The SEC contends that Black told Obus that SunSource was about to be acquired by Allied.
Obus had a number of options at that point, the vast majority of which did not involve calling SunSource’s CEO, Maurice Andrien. But later that day, that is what he did. The actual contents of that conversation are in dispute as well. Obus says he relayed Black’s shareholder dilution concerns to Andrien. According to Andrien, Obus said, “[W]ell, a little birdie told me that you guys are planning to sell the company to a financial buyer.” Andrien says Obus then clarified that the “little birdie” was from Connecticut, and even more specifically, at GE. Black overheard this conversation, and was “shocked” to hear it. He pointed out to Obus that once Andrien put the pieces together and called GE Capital to find out why it was leaking SunSource’s confidential information to unrelated hedge funds, Strickland was likely to be fired. “Obus then became ‘ashen’ and ‘very upset’ because he realized ‘it was a kind of call that could be traced back to’ Strickland.” He then said he would hire Strickland at Wynnefield or help him get another job on Wall Street if Strickland were actually fired.
On June 8, 2001, Wynnefield Capital bought 287,200 shares of SunSource at $4.75 per share. Eleven days later, Allied publicly announced it was acquiring SunSource for $10.38 per share in cash or stock. SunSource’s stock closed on June 19th at $9.50 per share, a 91% increase over the prior day’s closing price. Wynnefield’s June 8 purchase therefore nearly doubled in value and yielded a paper profit of over $1.3 million.
Again, at that point the options available to Obus were nearly limitless. He did not have to call Allied to ask when the merger was going to close. But he did, and was routed to Allied’s CFO, Daniel Russell. Again, the details of this discussion are in dispute. Obus says he called to express his preference to be paid in Allied stock, rather than in cash, and to ask that Allied extend the merger’s closing date to lower Wynnefield’s tax liabilities. According to Russell, Obus said he’d been “tipped off to the [SunSource] deal” and when Russell asked what he meant, Obus changed the subject.
The SEC issued subpoenas regarding Wynnefield’s SunSource trades in July and August of 2002, and GE Capital soon began an internal investigation into Strickland’s conduct. The internal investigation did not go beyond interviewing Strickland and other GE Capital employees and thus did not include statements from Andrien or Russell. The investigation concluded that while Strickland had “disclosed information outside of [GE Capital] pertaining to” SunSource, he “did not discuss the nature of the specific transaction being contemplated.” Still, his conduct demonstrated a “disregard” of GE Capital’s “confidentiality restrictions.” After the investigation Strickland was denied a bonus and salary increase, but he wasn’t terminated. He instead received a letter of reprimand saying he should have consulted a manager or counsel before discussing SunSource with a third party. A GE Capital representative later testified that the investigation concluded Strickland had made a mistake, but that he was “trying to do some underwriting” when he called Peter Black.
The SEC sued Strickland, Black, and Obus under both the classical and misappropriation theories of insider trading in April 2006. Under the misappropriation theory, the SEC argued that Strickland had a duty to GE Capital, his employer, to keep information about SunSource’s acquisition confidential, and that he breached that duty by tipping Black. The district court granted the defendants’ motion for summary judgment on both theories. In doing so, the district court found no genuine issue of material fact as to whether Strickland breached a fiduciary duty to GE Capital. The district court based this finding on GE Capital’s internal investigation, which concluded that Strickland had not breached a duty to his employer, and on the fact that SunSource had not been placed on GE Capital’s transaction-restricted list until after the acquisition was publicly announced. Because Strickland had not breached a duty, neither Black nor Obus could have inherited that duty, and thus they also could not be held liable under the misappropriation theory.
The Second Circuit’s Take
The court of appeals held that the SEC presented sufficient evidence for a jury to find that Strickland knew the material non-public information was “ammunition” that Black was in a position to use. Strickland knew that Black worked for a hedge fund that traded in stocks (sufficient knowledge in itself) and also that Black’s hedge fund traded in SunSource shares. This evidence easily supported a finding of knowing or reckless tipping to someone who likely would use the information to trade in securities.
The Second Circuit also held that the district court erred in relying on GE Capital’s internal investigation to determine that Strickland breached no duty by tipping Black and reasoning that the alleged victim of the breach did not consider itself a victim. This was error because the internal investigation was not indisputably reliable, and because its conclusions were contradicted by other evidence. GE Capital’s investigation was based only on interviews with Strickland and other GE Capital employees; it did not consider outside sources such as Andrien or Russell, the SEC’s primary witnesses. More broadly, 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.
I think this is the right result. It would be hard to regard a limited internal investigation like the one described here as dispositive of whether Strickland breached a duty to GE Capital or not. Also, corporations involved in potential insider trading investigations are going to be inherently inclined to limit the scope of those investigations if they can. These investigations can be expensive and distracting. If a company could cut one off by simply denying that an employee breached a fiduciary duty to it, less ethically grounded companies might do so. I don’t suggest at all that such considerations entered into GE Capital’s conclusion. Indeed, GE Capital would not have had subpoena power over non-employees Andrien and Russell, and would not have been able to compel statements from them even if it had wanted to take them. But if establishing fiduciary duty were left up to the companies at issue, the incentives would run that way. As the court said, those incentives “may not coincide with the public interest in unearthing wrongdoing and affording a remedy.”
Separately, the opinion offers a taut summary of insider trading law generally, and even cites the namesake of this blog. I recommend it.