In Regents v. Credit Suisse, an appeal arising out of the Enron debacle, the 5th Circuit concluded that primary liability under Rule 10b-5 only extended to those persons with a duty to disclose. In general, this requires a fiduciary duty toward the shareholders of the affected company. Because the investment banking firms were found not to have the requisite duty, the Court of Appeals reversed the decision to grant class certification. A petition for certiorari is currently pending at the US Supreme Court.
In arriving at the remarkable conclusion, the 5th Circuit relied mostly on an entirely inapposite case, US v. Chiarella, an insider trading case. Insider trading cases are, by definition, non-disclosure cases and require proof that the bad actor had a duty to disclose. Primary liability (the issue in Credit Suisse) arises where a fraudulent misstatement or omission has already occurred and the court confronts the task of dilineating those responsible. The two areas are entirely different.
So, Chiarella is not good authority for resolving the boundaries of primary and secondary liability. Another reason that Chiarella ought to be avoided is that it contains analytically unsound reasoning. The Court, more or less out of whole cloth, concluded that a duty to disclose required proof of a fiduciary duty. As Professor Langevoort at Georgetown described: “Disingenuously citing state law to support a rule that had long since ceased to apply, the Court held that a duty of disclosure to the marketplace would not arise absent a pre-existing fiduciary relationship between buyer and seller.” Words From on High About Rule 10b-5: Chiarella's History, Central Bank's Future, 20 Del. J. Corp. L. 865 , 872 (1995).
In the area of insider trading, the reasoning of Chiarella left out more than it left in. Any number of persons routinely obtained inside information but lacked the requisite fiduciary obligation. This included, for example, law firms, investment banking firms and accounting firms hired by the issuer. Employees with those entities had a contractual relationship with the issuer but were not fiduciaries. Recognizing the size of this loophole, the Supreme Court filled some of it three years later in Dirks v. SEC when it made up the doctrine of temporary insider (see Footnote 14). Temporary insiders, a group that included third parties with some kind of confidential relationship with the issuer, were held to have a fiduciary relationship and a duty to disclose.
Even with this effort at back and fill, the Supreme Court’s reasoning in Chiarella and Dirks still left a gaping hole in insider trading law. Under the case law, officers or directors in an acquirer could buy shares in a target company without engaging in insider trading because they had no fiduciary obligation to the shareholders of the target company.
It was this gap that the SEC filled with the misappropriation doctrine (based in part upon the reasoning of Chief Justice Burger in his dissent in Chiarella). The doctrine provided that anyone with a duty of trust and confidence could not trade on material nonpublic information received as a result of that relationship. The Supreme Court approved the misappropriation theory in O’Hagan, a case involving a lawyer in a firm retained by an acquirer who traded in shares of the target.
We bring this up (and apologize to those who know this already) in the context of an SEC insider trading case settled last week, SEC v. Schwinger, Litigation Release No. 20152 (D DC June 13, 2007). The complaint is posted on the DU Corporate Governance web site.
Schwinger, the defendant, was the managing partner in the Washington, D.C. office of Katten Muchin Rosenman and had the responsibility for interviewing prospective hires. An in house attorney at Vastera, Inc. contacted Schwinger in May 2004 about possibly joining the firm. At a subsequent meeting a month of so later, Schwinger asked the attorney the reasons for leaving Vastera. According to the complaint, the in house attorney explained that "it was due in part to an anticipated strategic transaction involving Vastera that might impact on his future employment at the company."
Later that summer, in August 2004, Vastera retained Katten Muchin to "perform corporate work relating to the amendment of Vastera's credit facility with a bank." The complaint contains no other description of legal work, indicating that it was an isolated matter.
The in house lawyer continued the conversations with Schwinger about joining the firm. The complaint noted that he "spoke frankly" about the possibility of an acquisition and, by October 27, had informed Schwinger that an acquisition was imminent. On November 5, Schwinger bought 10,000 shares of Vastera at an average price of $1.70 a share. In January 2005, JP Morgan Chase announced an acquistion offer for $3 a share. Schwinger earned "imputed illicit profits of $13,027.00."
The SEC charged Schwinger with insider trading, relying upon the misappropriation theory. The SEC alleged that Schwinger violated a duty of trust and confidence to his law firm by trading on the information provided by the in house lawyer about the acquisition during the job interviews. The complaint stressed that Vastera was a client and that Schwinger knew this.
The facts in this case illustrate the analytical confusion that has arisen by the faulty reasoning in Chiarella and the bandaid provided by O'Hagan.
Schwinger did not obtain the information about the "imminent" acquisition in an improper manner. He did not obtain the information in a relationship of confidentiality. It did not come to him as a result of a client matter.
Moreover, the case could easily have been written to make others appear to be the wrongdoer. After all, it was the in house counsel who blurted out the highly confidential information about an imminent acquisition to someone outside the company.
The case, therefore, could easily have resulted in the SEC charging the in house counsel with insider trading by violating his fiduciary duty to Vastera when he told Schwinger about the acquisition. The SEC did not. Why not? Perhaps the SEC could not establish all of the elements required by Chiarella and Dirks. To violate his or her fiduciary duty, the insider had to gain some type of pecuniary benefit. So, despite leaking highly material information to persons outside the company, the SEC may not have been able to make the case. Had the SEC used the "classic" insider trading law from Chiarella, Schwinger would not have been guilty of insider trading. Dirks made clear that tippee liability required liability by the tipper.
So, despite exonerating the insider who tipped the information, the SEC chose to charge Schwinger, the interviewing partner, with insider trading. To do so, the agency had to establish that Schwinger violated a duty of trust and confidence to his employer, in this case the law firm. Ordinarily, this requires proof that the employee used information that belonged to the employer and was intended to be kept confidential. Is that the type of information used by Schwinger?
He got the information in an interview with a prospective employee. While keeping information learned in an interview confidential may be appropriate, it is unclear that this is always required. Moreover, information obtained in an interview is not automatically proprietary and subject to requirements of confidentiality. For example, had Schwinger learned from the in house counsel that there was a legal position open at Vastera, it would stretch credulity to argue that he had an obligation to give the information to the law firm and forego an application.
The complaint seemed to recognize this and stressed that Vastera was a client of the firm, as if Schwinger had a duty to keep the information confidential because it involved a client. The information, however, did not come in the context of a client matter. Moreover, Vastera was apparently a client for a single discrete matter. In other words, Schwinger had no duty to Vastera nor did the law firm with respect to the information provided by the in house counsel.
Schwinger may have shown very bad judgment in trading on the information given to him by the in house counsel at Vastera. But is it insider trading? Hardly. And, in any event, the analysis is made extraordinarily complex by the poor reasoning in Chiarella and the doctrines that sprang up to compensate for the deficient analysis.