Lack of Judgment does not Constitute Insider Trading: SEC v. Obus

In Securities and Exchange Commission v. Obus, 2010 WL 3703846 (S.D.N.Y. Sept. 20, 2010), the Securities and Exchange Commission (“SEC”) alleged that defendant Nelson J. Obus (“Obus”) along with codefendants Peter F. Black and Thomas Bradley Strickland were guilty of insider trading – a violation of the prohibition of deceptive conduct under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5.  

The SEC claimed that Strickland, while an employee at GE Capital Corp. (“GE”), tipped off Black who at the time worked as an analyst at Wynnefield Capital, Inc. about the potential acquisition of SunSource, Inc. (“Sunsource”).  Black allegedly alerted his superior, Obus, who in turn executed a purchase order of SunSource stock. The SEC asserted two theories of insider trading: the “classical” theory and the “misappropriation” theory.

Under either theory, the parties agreed that the tipper must have possessed material, non-public information about the publicly traded corporation, that the tipper divulged this information to the tippee, that the tippee in question traded in the particular corporation’s stock while privy to this information, that the tippee violated the trust of the corporation in question by sharing the information, and that the tippee benefited from the disclosure.  The issue in the case concerned the fourth element, the need for a breach of a duty. 

The “classical” theory of insider trading applies not only to officers, directors, and other permanent insiders of a corporation, but also to "temporary insiders" such as third party consultants, accountants, or attorneys. Under this theory, the SEC would have to prove that Strickland became a temporary fiduciary and subsequently violated that duty. The court acknowledged that "[f]inancial consultants, including underwriters such as GE Capital, working for a corporation may become "temporary insiders" of a corporation." 

For temporary insider status to arise, however, it was not enough to allege possession of nonpublic information.  "Instead, "a fiduciary relationship, or its functional equivalent, exists only where there is explicit acceptance of a duty of confidentiality or where such acceptance may be implied from a similar relationship of trust and confidence between the parties." Id. To establish acceptance, the plaintiff must show defendant was on notice of his duty not to use or disclose the material non-public information."

Because, however, GE Capital had not admitted having accepted a fiduciary duty, the court had to resolve whether "a duty can be implied, and acceptance inferred, from the parties' relationship absent a transaction-specific, written, confidentiality agreement?"  The court concluded that under the facts of the case, no duty had arisen.

• In the instant case, there is a lack of a specific confidentiality agreement or a retainer payment, and the dearth of facts sufficient to imply communication of an expectation by SunSource or acceptance of a fiduciary duty by GE Capital  vis-a-vis the borrower/lender relationship. Additionally, the fact that SunSource was negotiating  with other lenders as of the May 24, 2001, date of the alleged tip, establish that no reasonable fact-finder could find the existence of the required fiduciary relationship or its functional equivalent. Even if, as alleged, GE Capital  received confidential information, and SunSource unilaterally expected it to remain as such, the absence of any ascension on the part of GE Capital  to accept such a duty precludes a finding of liability under Section 10b and Rule 10b-5.  The "absence of any expectation of confidentiality or breach of a duty of confidentiality is fatal to the SEC's claim." . . . Even after independently searching the record and resolving any and all inferences in favor of the SEC, the Court cannot identify the critical facts required to establish the existence of an enforceable duty. The SEC cannot prove from the facts on record that GE Capital  or Strickland owed a duty of confidentiality to SunSource as of May 24, 2001. Accordingly, judgment must be entered in favor of the Moving Defendants and Strickland with regards to the SEC's claims under the "classical" theory of insider trading.

As for the “misappropriation” claim, the SEC had to show that the defendant breached a duty of trust and confidence.  The court conceded that the defendant had a fiduciary relationship with GE Capital.  Nonetheless, the defendant did not act with scienter when he violated the duty by disclosing the nonpublic information.  In effect, the court held that no deliberate breach of the duty of trust and confidence occurred. 

In reaching the determination, the court looked to the actions of the employer, GE Capital.  The company, according to the court, "did not find that Strickland breached this duty, stating, following an investigation, 'that Brad Strickland made a mistake by. . . inquiring about the borrower that GE Capital  was looking to provide the financing for, and that he did not do it with any sort of malice or intent.'"  The SEC, according to the court, could show no deception "beyond the trade itself." 

As a result of these findings, the court granted the defendant's motion for summary judgment.

The primary materials for this case may be found on the DU Corporate Governance website. 

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[Banking News]

Judgment is genuin.