Securities Regulation - David K. Brown and Valerie D. Barton

• Publication year: 2005

Securities Regulationby David K. Brown^* and Valerie D. Barton^**

This Article examines significant securities regulation cases originating in the Eleventh Circuit Court of Appeals during 2003 and 2004. In particular, Part I of this Article addresses a recent decision in the area of insider trading and familial relationships. Part II analyzes two recent cases involving the definition of "security" under the Securities Act of 1933.¹ The three cases discussed below address two very different issues and draw from two separate areas of securities law, the Securities Act of 1933 and the Securities Exchange Act of 1934.² However, a common theme connects these cases: the preservation of flexibility within the securities laws. As demonstrated in the following holdings, courts have long recognized the overarching principle in federal securities laws to provide a flexible body of law that may be interpreted and applied to situations not originally contemplated by the laws' drafters and to situations conceived for the purpose of circumventing such laws. Although the courts temper such principles through application of certain general tests and the requirement of certain elements, the courts have, with little exception, refused to adopt bright-line or rigid tests when it comes to interpreting the securities laws.

I. The Eleventh Circuit Clarifies the Elements of Insider Trading Claims Brought Under the Misappropriation Theory of Liability

Although sharing confidences may strengthen the bonds of familial relationships, in the contentious realm of "insider trading," exchanging business-related confidences with family members could have the deleterious side-effect of triggering the attention, and then the wrath, of the Securities and Exchange Commission ("SEC"). In SEC v. Yun,³ the Eleventh Circuit clarified its position with respect to two of the elements of proof under the misappropriation theory of liability for securities fraud: (1) the establishment of a duty of loyalty and confidentiality owed to the source of confidential information in the context of non-business relationships, such as husband/wife or parent/child, and (2) the requisite showing that the tipper intended to benefit from her disclosure of confidential information.⁴ With respect to both matters, the Eleventh Circuit stopped short of adopting the SEC's position, apparently rejecting the SEC's attempts to lessen its burden of proof in insider trading cases brought under the increasingly popular misappropriation theory of liability.⁵

First, the court rejected the bright-line rule set forth in Rule 10b5-2 of the Securities Exchange Act of 1934 (the "Exchange Act"),⁶ which mandates that a duty of trust and confidence is presumed to exist when a person receives or obtains material, nonpublic information from spouses, parents, children, and siblings.⁷ The court instead concluded the existence of a duty of loyalty and confidentiality (a phrase used interchangeably with the duty of trust and confidence) turns on whetherthe confiding spouse granted access to confidential information to her spouse based upon (1) an express promise or (2) a reasonable reliance that she would safeguard the information when reliance would be proven by evidence of a history or pattern of sharing and keeping business confidences.⁸ Second, the court soundly rejected the SEC's attempt to lessen its burden of proof in insider trading cases by steadfastly requiring proof of tippers' intent to benefit from their disclosure of confidential information under the misappropriation theory of liability.⁹

A. The Misappropriation Theory of Liability for Insider Trading

In Yun the SEC brought charges against "tipper" Donna Yun and fellow real estate agent and "tippee" Jerry Burch for violations of Section 10(b) of the Exchange Act,¹⁰ which governs the disclosure of material, nonpublic or "insider" information, and Rule 10b-5 of the Exchange Act,¹¹ promulgated under the SEC's Section 10(b) rulemaking authority.¹² Allegations of Section 10(b) and Rule 10b-5 violations are typically categorized by the SEC under one of two complementary theories of liability, "each addressing efforts to capitalize on nonpublic information through the purchase or sale of securities," but distinguishable by the degrees of separation between the source of confidential information and the ultimate tipper and tippee.¹³ Insider tradingliability arises under the "traditional" or "classical theory" when a corporate insider trades in his company's securities on the basis of material, nonpublic (or, as used interchangeably herein, "confidential") information.¹⁴ This action violates the relationship of trust and confidence and breaches the attendant duties that exist between the corporation's shareholders and the corporation's insiders, who have obtained confidential information by reason of their corporate position.¹⁵

The misappropriation theory of liability, on the other hand, is designed to address "outsider" situations where the relationship between (1) the corporate shareholders injured by insider trading, (2) the corporate insider and source of confidential information, and (3) the tipper and the tippee is more attenuated.¹⁶ Under the misappropriation theory, a person commits fraud "in connection with" a securities transaction when she misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.¹⁷ As explained by the United States Supreme Court in United States v. O'Hagan,¹⁸ the rationale behind the misappropriation theory is as follows:

[A] fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-

turned-trader's deception of those who entrusted him with access to confidential information.¹⁹

Accordingly, the elements of a misappropriation claim include at a minimum: (1) the misappropriation of material, nonpublic information; (2) a breach of a duty arising out of a relationship of trust and confidence, regardless of whether such duty was owed to the shareholders of the traded stock; and (3) the use of the material, nonpublic information in a securities transaction.²⁰ Moreover, as more fully discussed below, the Eleventh Circuit (among other federal courts) requires proof of a fourth element: that the tipper derived a personal benefit, directly or indirectly, by communicating the material, nonpublic information in breach of his or her duty.²¹

B. SEC v. Yun

In February 1997, the SEC launched its investigation into certain trades of real estate agent Jerry Burch in Scholastic Corporation stock. Within a few hours, Burch realized a 1300 percent return on his investment and profits of $269,000 on Scholastic put options he purchased during the prior two days.²² The Burch investigation led theSEC to fellow real estate agent Donna Yun, who shared an eleven-by-thirteen-foot real estate sales trailer with Burch. Donna, in turn, was (or is) married to David Yun, president of Scholastic Book Fairs, Inc., which is a subsidiary of Scholastic Corporation, a publicly-traded company.

It appears undisputed that Donna learned material, nonpublic information regarding Scholastic's stock from her husband, David, in January 1997, following David's attendance at a management retreat. David learned that his company would post a loss for the current quarter and, as a result, would make a public announcement revising its earnings forecast downward. During this same period, Donna and David were in the process of negotiating "a post-nuptial division of assets."²⁴ David, therefore, explained to Donna that he had assigned a lower value to his Scholastic stock options in his list of assets than the current trading price because he believed that Scholastic's share price would decrease following the pending earnings announcement scheduled for February 20, 1997. David asked Donna not to disclose the news and Donna agreed to keep the nonpublic information confidential, with the exception of the necessary disclosure of David's explanation of his asset valuation to Donna's attorney.²⁵

Two days before the announcement of Scholastic's earnings forecast, Donna shared David's confidential information with her attorney during a telephone call, which took place in the small sales trailer she shared with Burch and others. Burch entered the office during her call andheard Donna tell her attorney about the impending earnings announcement and related price drop.²⁶ That evening, Donna, Burch, and another real estate agent attended a reception together, carpooled to the banquet, and stayed at the reception for three hours before departing.²⁷

Although Burch apparently had no experience dealing in put options, the next morning he phoned his broker requesting authority to purchase put options in Scholastic based upon information he had received at the cocktail party the night before.²⁸ Despite his broker's warnings about the risks involved with trading in options and about insider trading prohibitions, Burch nonetheless proceeded in spending the equivalent of two-thirds of his total income for the previous year, or nearly half the value of his entire investment portfolio, on the purchase of almost $20,000 in Scholastic put options, some of which were scheduled to expire within forty-eight hours.²⁹ On February 20, 1997, after Scholastic made its planned earnings forecast announcement, the stock price dropped by approximately forty percent, allowing for Burch's unprecedented success with trading in put options.³⁰

The SEC's complaint alleged that Donna violated Section 10(b) and Rule 10b-5 of the Exchange Act under the misappropriation theory of...