The SEC Is Stretching The Definition Of Inside Information And Materiality Past The Breaking Point

BNA reports that:

In a case that could test the parameters of “insider” information, the Securities and Exchange Commission Jan. 28 told the U.S. District Court for the Northern District of Illinois that information shared by two railroad employees with relatives that led to “dramatically different” stock transactions constituted circumstantial evidence that they had engaged in insider trading (SEC v. Steffes, N.D. Ill., No. 1:10-cv-6266, 1/28/11).

The SEC, in a brief responding to the defendants’ motion to dismiss, asserted that the family members’ “well-timed trading” in the stock and call options of Florida East Coast Industries Inc. resulted in profits of nearly $1 million.

The complaint contains “numerous details” about the family’s communications with company insiders, and their trading and tipping activities, the SEC said. “[T]he very details of the Steffes Family’s communications and trading … may constitute evidence of the materiality of the information received and their scienter in trading.”

In September, the SEC charged W. Gary Griffiths and Cliff M. Steffes and four family members with insider trading in relation to the $3.5 billion takeover of FECI by Fortress Investment Group LLC (FIG) in 2007 (42 SRLR 1858, 10/4/10). Griffiths at the time was a vice president and chief mechanical officer, while Steffes was a rail yard worker, in Florida East Coast Railway LLC, a railway operated by FECI.

According to the complaint, the two employees learned about the impending acquisition of FECI through on-the-job observations, including the unusual number of tours of FECR’s Hialeah Yard by people dressed in business suits, and a trip by Fortress representatives in a special rail car reserved for visitors. In addition, other rail employees began expressing concern that FECI could be sold and their jobs could be at stake.

The SEC alleged that in the weeks preceding the acquisition, Griffiths and Steffes tipped family members. Collectively, the family bought more than $1.6 million worth of FECI stock and call options, and sold their purchases on the same day that the acquisition was announced. The news caused FECI’s stock to rise 15 per cent above the previous day’s trading price, the SEC said.

First, there is no inside information here. Inside information long has been defined as ” information intended to be available only for a corporate purpose and not for the personal benefit of anyone.” SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (C.A.2 1968). What you have here are educated guesses derived from observations of events. There’s nothing to suggest secrecy nor is there anything to suggest a communication conveying knowledge.

The Texas Gulf Sulphur case made clear that: ” An insider is not, of course, always foreclosed from investing in his own company merely because he may be more familiar with company operations than are outside investors. … Nor is an insider obligated to confer upon outside investors the benefit of his superior financial or other expert analysis by disclosing his educated guesses or predictions.” No need to disclose educated guesses based on familiarity with company operations, which is exactly what we have here.

Second, the SEC is bootstrapping the trades to prove materiality. Granted, a footnote in the Supreme Court’s Basic v, Levinson opinion flatly stated that “trading and profit making by insiders can serve as an indication of materiality.” But Basic was not an insider trading case. Hence, there remains a legitimate question as to whether the allegedly illegal insider trading behaviour can serve as proof that the facts on which the insider traded were material. The problem, of course, is the potential for bootstrapping: if the allegedly illegal trade proves that the information is material, the materiality requirement becomes meaningless—all information in the defendant’s possession when he or she traded would be material. Which would suit the SEC just fine, but is damned hard justify, especially in light of the draconian penalties for insider trading.

Third, the Supreme Court has held that plaintiff’s prima facie case must include proof defendant acted with scienter, which the court defined as a mental state embracing an intent to deceive, manipulate or defraud. Here the SEC is trying to conflate materiality and scienter, arguing that if the information is material they must have intended to defraud. This grossly compounds the SEC’s effort to endrun the materiality element. they basically want the fact of the trade to prove two elements of the offence.

The SEC has long tried to fudge and finesse the insider trading law. But this case is an especially egregious example of how the SEC seeks to stretch the law beyond any reasonable stopping point. This case should be dismissed and the SEC ought to be sanctioned for having brought it.

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