As you may have heard by now, on January 27th a jury in the Northern District of Illinois sided with the defendants and against the SEC in an aggressive insider trading case. Here were the facts as alleged by the SEC and summarized by Gibson Dunn’s Joel Cohen in late 2010:
Defendant Gary Griffiths worked in a rail yard as a vice president and mechanical engineer of a subsidiary of Florida East Coast Industries, Inc. (“FECI”), and his nephew, defendant Cliff Steffes, worked as a trainman in another rail yard. Both defendants allegedly signed FECI’s Code of Conduct prohibiting them from trading or tipping in FECI securities if they possessed material nonpublic information about FECI, including merger or acquisition information.
According to the SEC, once FECI put itself in play, several bidders met with FECI management and toured FECI properties, including the rail yards where Griffiths and Steffes worked. The SEC claims Griffiths knew about the sale because the CFO asked him for asset valuations, he noticed an unusually high number of rail yard tours, and employees questioned him about a possible takeover. Likewise, Steffes noticed an uptick in tours by people in business attire, and his co-workers were discussing the possible sale. Steffes allegedly purchased FECI call option contracts in an amount equal to his net worth and sold them after the takeover announcement, making a 350% profit. Steffes and Griffiths also allegedly tipped Steffes’s father, brothers, and another uncle, who settled with the SEC at the end of October for $225,000. Collectively, the tippees netted more than $1 million in gains.
At the end of the day it wasn’t enough for the jury, which found no liability for the non-settling defendants. Some thought the SEC had filed its case with the hopes of finding more incriminating evidence than it started with. Others thought the Commission had stretched materiality beyond recognition, and based on the complaint, I’m not sure that’s a crazy thought.
Anyway, two thoughts here:
First, this isn’t a total loss for the SEC. I thought it might not happen, but the Commission did survive a motion to dismiss on the materiality point. The district court’s opinion is quite gracious to the SEC’s position, and I could envision the agency citing it in other cases at some point down the road.
Second, without a specific statutory prohibition, the SEC has relied on notions of unfairness for the development of insider trading law for over 50 years. In the SEC’s very first insider trading case, In re Cady, Roberts & Co. in 1961, the Commission pointed to two key elements in describing where liability would be appropriate: (1) the existence of a relationship affording access to inside information intended to be available only for a corporate purpose, and (2) the unfairness of allowing a corporate insider or tippee to take advantage of that information by trading without disclosure.
But as Don Langevoort asks in his comprehensive treatise, how is it that, absent any real inducement of shareholder trading (i.e., in a faceless electronic transaction, and not a face-to-face deal), such unfair conduct could properly be termed fraud? Cady implicitly rests on the insider’s duty to act affirmatively to prevent the other party’s disadvantageous trade. In theory, had disclosure been made to the public, marketplace buyers and sellers would not have traded (at least not at that price), and that’s how the Commission got to the deception necessary for a violation of Rule 10b-5.
I think the absence of unfairness was doubly risky to the SEC in the Steffes case. What the defendants did just doesn’t seem that unfair. It seems like a bunch of dudes piecing together information and making a bet on it. From a purely legal perspective, the Commission was able to survive the defendants’ motion to dismiss. But on the facts, the jury doesn’t seem to have cared. I think the lack of injustice in the facts is why the SEC had trouble with the jury, and will continue to in marginal cases like this one.