As Lisa Fairfax notes over at the Glom (see here), Martha Stewart has decided to fight the civil insider trading charges filed against her by the SEC in June 2003 (more here). The complaint had been stayed pending resolution of the related criminal proceedings. With those proceedings resolved, the SEC lifted the stay last month. The complaint also named Stewart’s Merrill Lynch broker, Peter Baconovic, as a defendant. While from Stewart’s perspective there is not a lot of money at stake (the SEC alleges she avoided losses of $45,673 by engaging in insider trading), in addition to disgorgement of losses avoided and civil penalties, the complaint seeks an order barring Stewart from “acting as a director of, and limiting her activities as an officer of,� any public company.
The SEC is trying to nail Stewart as a tippee under the misappropriation theory of insider trading. Under this theory, the SEC has to prove, among other things, that:
1. The tipper (Bacanovic) acquired material non-public information in breach of a fiduciary duty/duty of trust and confidence owed by him to the information source (Merrill Lynch);
2. The tipper passed the information to the tippee (Stewart), and the tippee knew or should have known that the information was passed in breach of the requisite duty to the information source; and
3. The tippee traded on the basis of the information.
Note that courts are divided on whether for tipper/tippee liability under the misappropriation theory the tipper has to receive a personal benefit from making the tip (this is a required element under the classical theory).
Here’s relevant excerpts of the complaint setting forth how the SEC alleges these elements are met:
29. On December 27, 2001, Bacanovic, in breach of a fiduciary duty, or other duty arising out of a relationship of trust and confidentiality that he owed to Merrill Lynch, conveyed to Stewart, through Faneuil, that the Waksals were selling or attempting to sell all of their ImClone stock at Merrill Lynch.
30. While in possession of the information that the Waksals were selling or attempting to sell their ImClone stock, Stewart sold 3,928 shares of ImClone stock on December 27, 2001.
31. The information that Stewart possessed on December 27, 2001, that the Waksals were selling or attempting to sell their ImClone stock, was material and nonpublic.
32. When Stewart sold ImClone securities on December 27, 2001, Stewart knew or acted in reckless disregard of the fact that: (1) she possessed confidential information that the Waskals were selling or attempting to sell their ImClone stock; and (2) Bacanovic’s conveyance of this material and confidential information to her constituted a breach of fiduciary duty, or other duty arising out of a relationship of trust and confidence, that Bacanovic owed to Merrill Lynch.
As for why Bacanovic’s tip constituted a breach of fiduciary duty owed to Merrill by Bacanovic, the SEC points to Merill’s policies that specifically require employees to keep information about client trades confidential. As for why the information was material, the SEC alleges as follows:
The information that Waksal and his daughter were selling, or attempting to sell, all their ImClone stock at Merrill Lynch was material. For example, against the total mix of information publicly available about ImClone during December 2001, knowledge of efforts by ImClone’s CEO and his daughter to sell their ImClone stock would have signaled to the reasonable investor insider pessimism about the FDA’s anticipated decision, the prospects for Erbitux, and the future of ImClone. The information about the Waksals’ efforts to sell their ImClone stock is the type of information that ordinarily derives its utility from securities trading. For example, the Merrill Lynch policies set forth in paragraph 16 above, and the media – including The Wall Street Journal’s periodic column “Insider Trading Spotlight” and investor newsletters and websites – recognize that investors look to information about trading by insiders at a company to inform their investment decisions about a company.
As for personal benefit, the SEC alleges that “Bacanovic benefited from his illegal tip by, for example, improving his relationship with Stewart, an important client of Bacanovic.�
Presumably, Stewart will stick with her story that she sold her Imclone shares pursuant to a pre-existing plan and therefore did not trade on the basis of inside information (although I’m not sure if this is still an option in light of her criminal conviction). Rule 10b5-1 provides for this sort of affirmative defense.