Defining Misappropriation: the Spousal Duty of Loyalty and the Expectation of Benefit - M. Anne Kaufold

• Publication year: 2004

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Defining Misappropriation: The Spousal Duty of Loyalty and the Expectation of Benefit^*

In a case of first impression, SEC v. Yun,¹ the United States Court of Appeals for the Eleventh Circuit settled two disputed aspects of insider-trading liability.² First, a duty of loyalty and confidentiality between spouses may be shown if the spouses have a history or practice of sharing and maintaining business confidences or, if in disclosing the confidential information, the spouse breaches an agreement³ to maintain the other spouse's business confidences.⁴ Second, in a misappropriation theory of insider-trading liability action, the Securities and Exchange Commission ("SEC") must prove that the misappropriator expected to benefit from the tip.⁵ The decision in Yun creates a split with the Second Circuit Court of Appeals by more broadly defining the spousal duty of loyalty and confidentiality.⁶ Furthermore, the court increased the commonality between the classical theory and the misappropriation theory of insider-trading liability by holding that theSEC must prove that the misappropriating outsider or "tipper"⁷ had an intent to benefit from the tip.⁸

I. Factual Background

During a post-nuptial⁹ division of assets, Donna Yun learned from her husband, an executive at a subsidiary of Scholastic Corporation ("Scholastic"), that he believed the price of Scholastic shares would drop following the upcoming earnings announcement.¹⁰ Yun agreed to keep this information confidential at the request of her husband.¹¹ However, while at work, Yun called her attorney to discuss her husband's statement of assets. While Yun was on the phone, Jerry Burch, Yun's business associate and friend, entered her small office to gather materials for a client and heard Yun tell her attorney what her husband had said about Scholastic's impending earnings announcement. Later that evening, Yun, Burch, and another co-worker attended an awards banquet together.¹² The next morning Burch called his broker to request authority to purchase "put options"¹³ in Scholastic based on information he had obtained "at a cocktail party."¹⁴ Despite the warnings of his broker regarding the risks of options trading and insider trading prohibitions, Burch purchased Scholastic put options in an amount equal to nearly half the value of his investment portfolio. Scholastic announced that its earnings would be well below analysts' expectations; Scholastic shares dropped. Burch sold his Scholastic put options, realizing a profit of $269,000, a 1300 percent return on his investment.¹⁵

After investigating the trades, the SEC brought an insider-trading action against Yun and Burch as recipients of stock tips, alleging insider trading in violation of section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act"),¹⁶ and Rule 10b-5.¹⁷ The trial court denied the motion for summary judgment filed by Yun and Burch.¹⁸ At trial the "jury found that [Yun and Burch] had 'violated [section] 10(b)' under the 'misappropriation theory' of liability."¹⁹ Following the jury verdict, Yun and Burch moved for judgment as a matter of law or for a new trial.²⁰ The district court denied these motions.²¹ Accordingly, judgments were entered against Yun and Burch holding them jointly liable for the profits generated by the prohibited trading, plus prejudgment interest, and individually liable for a penalty.²² Yun and Burch appealed, arguing that the district court erred in denying their motions for judgment as a matter of law and in instructing the jury on elements of the misappropriation theory of insider-trading liability.²³

The Eleventh Circuit affirmed the district court's decision denying appellants' motions for judgment as a matter of law.²⁴ However, the court vacated the district court's judgment and remanded the case for a new trial because the district court's jury instructions on the elements of the misappropriation theory of liability were erroneous.²⁵

II. Legal Background

Section 10(b) of the Exchange Act makes insider trading unlawful by prohibiting "any person" from "us[ing] or employ[ing], in connection with the purchase or sale of any security . . . , any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe."²⁶ one purpose of section 10(b) is "to eliminate 'use of inside information for personal advantage.'"²⁷ To violate section 10(b), an individual trading in securities with material, nonpublic information must breach a fiduciary duty by failing to disclose to the other trading party the confidential information or by failing to abstain from trading on the confidential information.²⁸ Historically, the obligation to disclose arises from "[(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 to take advantage of that information by trading without disclosure."²⁹

Insider trading can be prosecuted under section 10(b) and Rule 10b-5 using two theories: the classical theory and the misappropriation theory.³⁰ Under the classical theory, corporate insiders are liable when they trade on the basis of confidential material, nonpublic information gained by reason of their corporate position.³¹ In contrast, the misappropriation theory imposes liability on "outsiders" when they trade in breach of a duty owed to the source of the confidential information.³²

A. The Classical Theory

In Chiarella v. United States,³³ the United States Supreme Court held that "there can be no fraud [for non-disclosure] absent a duty to speak"³⁴ and that a duty to disclose under section 10(b) arises from a relationship of trust and confidence, not from the mere possession of confidential information.³⁵ In clarifying when "tippees"³⁶ violate section 10(b), the Court in Dirks v. SEC³⁷ reaffirmed that a duty arises from a fiduciary relationship between an insider and a tippee and not from one's ability to obtain confidential information.³⁸ Therefore, in Dirks, the Court held that:

a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when [(1)] the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and [(2)] the tippee knows or should know that there has been a breach.³⁹ @@@

The Court concluded that not all disclosures are a breach of duty; therefore, to determine whether the disclosure is a breach, the purpose of the disclosure must be examined.⁴⁰ The Court held that "the test is whether the insider personally will benefit, directly or indirectly, from his disclosure."⁴¹

B. The Misappropriation Theory

In 1997 the Court decided in United States v. O'Hagan⁴² that the misappropriation theory could provide a basis for a criminal conviction under section 10(b).⁴³ The Court characterized the misappropriation theory as "hold[ing] that a person commits fraud 'in connection with' a securities transaction, and thereby violates [section] 10(b) . . . when [a person] misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information."⁴⁴ According to the Court, misappropriation is the necessary complement to the classical theory defined in Chiarella.⁴⁵ Under the misappropriation theory, the section 10(b) deception requirement is met because the trader deceives the source by not disclosing the scheme to trade securities to the source of the information.⁴⁶ The fraud is committed "in connection with the purchase or sale of [a] security"⁴⁷ because the fraud is accomplished when the outsider uses the confidential information to purchase or sell securities without disclosing the use of the information to the insider in breach of a fiduciary or fiduciary-like relationship.⁴⁸

1. The Duty of Loyalty and Confidentiality Between Spouses.

To prevail in an insider-trading action, the SEC must first establish that a breach of loyalty and confidentiality occurred between the misppropriator and the source of the inside information.⁴⁹ Historically, business relationships, such as employer-employee⁵⁰ or attorney-client,⁵¹ have provided the requisite duty of loyalty and confidentiality.⁵² Conversely, whether nonbusiness relationships—such as familial and spousal relationships—provide the requisite duty of loyalty under the misappropriation theory has remained largely unsettled.⁵³

The mere existence of a family relationship does not provide a basis to find a confidential relationship.⁵⁴ To determine whether a fiduciarylike relationship exists, the quality of the relationship matters.⁵⁵ Generally, state courts do not find a legally enforceable relationship of trust and confidence between all family members.⁵⁶ To presume that family relationships are fiduciary in nature would conflict with the Supreme Court's requirement that a pre-existing relationship of trust and confidence be expressly established.⁵⁷

The leading Rule 10b-5 case defining the existence of a duty of loyalty and confidentiality in the context of family members is United States v. Chestman.⁵⁸ In 1991, in a divided en banc decision, the Second Circuit Court of Appeals held that (1) entrusting a person with confidential information does not unilaterally create a fiduciary duty;⁵⁹ and (2) marriage alone does not create a relationship of loyalty and confidentiality.⁶⁰ To determine what is required to create a fiduciary relationship or a similar relationship of trust and confidence, the court looked at other securities fraud precedents and the common law.⁶¹ The court concluded that a fiduciary relationship involves discretionary authority and dependency, whereby the beneficiary entrusts the fiduciary with custody over property.⁶² Because the fiduciary gains access to the property to serve the fiduciary relationship, the fiduciary becomes bound not to appropriate the property for the...