Should the Securities and Exchange Commission regulate based on the law or its view of what is ethical? Before May 20, 2016, the answer was the law, but to paraphrase Bob Dylan “the times [may be] a changing.”
Last week, the SEC charged William Walters and Thomas Davis with insider trading related to Dean Foods. Standing alone this may or may not be newsworthy. But throw professional golfer Phil Mickelson into the mix and the internet and news outlets were all abuzz.
In my opinion, commentators have focused on the wrong aspect of the SEC’s complaint. It is not the fact that the SEC named Mickelson in the complaint that should catch our collective attention. Nor the fact that the professional golfer was named only as a relief defendant. It is paragraphs 95 and 96 of the complaint (PDF: 425 KB) that are truly newsworthy. In these paragraphs the SEC alleged that Mickelson should have to disgorge the profit from his stock purchase even though the complaint does not allege that he committed insider trading. Yes, you read that right. The SEC claims that Mickelson – who is not charged with wrongdoing and who apparently violated no securities laws, should have to give up the proceeds of his profitable trading. Why? Because, according to the SEC “under the circumstances … it is not just, equitable, or conscionable for [him] to retain the funds.”
And there you have it, the oh-so subtle move from regulating securities laws to regulating morals.
Disgorgement is actually meant to deprive violators of securities laws of their ill-gotten gains. See SEC v First Jersey Sec., 101 F.3d 1450, 1474 (2d. Cir.1996). It was not intended to deprive unknowing participants in someone else’s fraud of profitable trading. This is because we, as a society, do not disgorge monies where the trader goes unaccused of violating the securities laws. Nevertheless, the SEC appears to allege that it can claw back money from an investor because a third-party violated the securities laws, unbeknownst to the investor. This feels not like a slippery slope, but like a full-on avalanche of bad precedent.
As has been discussed ad nauseam, the Second Circuit reaffirmed the notion that it is not a securities law violation for an individual to trade on material nonpublic information. See generally United States v. Newman. Dirks v. SEC held the same 30 years ago. And yet, here the SEC filed a federal district court action seeking money back from Mickelson because it would be unconscionable for him to keep it. This flies directly in the face of the actual laws the SEC is supposed to regulate.
Before overreacting, maybe the complaint contains some fact(s) that caused the SEC to allege that Mickelson “must disgorge the amount of [his] ill-gotten gains.” See SEC v. Walters, paragraph 96.
The alleged facts are simple. Walters received a tip from Dean Foods board member Davis that the company was set to spin-off a subsidiary, WhiteWave. Walters, a gambler to whom Mickelson allegedly owed an undisclosed amount of money, told Mickelson to buy Dean Foods. Mickelson did and after Dean Foods announced the spin-off, Mickelson sold his shares. Mickelson profited approximately $900,000 on the investment in a very short period of time.
The complaint does not allege that Walters informed Mickelson of the source of the information. It does, however, make a stab at personal benefit to Walters when it asserts that 30 to 60 days after the trade, Mickelson paid his outstanding gambling debt to Walters “in part with the proceeds of his trading.” Walters at paragraph 76. What evidence the SEC has that allowed it to claim Mickelson used a portion of his trading proceeds to pay an undisclosed debt is left unpled.
The natural question here is: does the alleged payment of a preexisting gambling debt sometime after the trading qualify as personal benefit in exchange for the tip? One might assume that the answer is “yes,” but since the SEC did not charge Mickelson with insider trading, apparently the answer is “no.” If the SEC determined that the payment qualified as personal benefit to Walters, Mickelson would have been named a defendant not a relief defendant. Nevertheless, even if Mickelson’s payment were a personal benefit to Walters, for liability to attach, the SEC would need to show some exchange of benefit between Walters and Davis, and Mickelson’s knowledge thereof, which does not appear anywhere in the complaint.
If Mickelson’s payment does not qualify as a personal benefit, he did not commit insider trading. And yet, the SEC has pleaded Mickelson must “disgorge the amount of [his] ill-gotten gains.” Here is where the SEC misses the boat: based on its own complaint, Mickelson has no ill-gotten gains to disgorge because the complaint does not allege he committed insider trading.
The law is very clear, unless Mickelson traded on material, nonpublic information obtained in breach of a fiduciary duty (of which he was aware, see Newman) Mickelson is entitled to keep the money he earned because he did not violate the securities laws. And yet, the SEC pleaded that he must disgorge it.
Now, returning to paragraph 95, the SEC alleged “under the circumstances … it is not just, equitable, or conscionable for [him] to retain the funds.” The circumstances to which the SEC refers are that Davis and Walters committed insider trading and Mickelson benefited because of it, even though he was unaware of the facts that make it insider trading.
Seeking to disgorge monies from Mickelson under these circumstances is not a legal judgment, it is a moral one. The law does not say that Mickelson is guilty of securities fraud, nor, for that matter, does the SEC. And yet, based on some sort of purported fairness analysis, the agency aspired to have a court deprive Mickelson of the proceeds of his trade, where his conduct was not alleged to be violative of any securities laws. This is enforcement by morality not by the law.
To be clear, Mickelson’s attorneys announced he would disgorge the money. Mickelson did not admit wrongdoing but his attorneys issued a statement that he “has no desire to benefit from any transactions that the SEC sees as questionable.” As a business decision, this makes sense. And as we all know, sometimes business decisions trump legal ones.
Above I noted that this not a slippery slope but a potential avalanche. It stems back to the famous example of conduct that is not and has never been insider trading. A passenger on a train overhears the CEO of a public company blurt out some material, nonpublic news during a phone call. The passenger has always been free to trade on that information because he did not engage in any fraud obtaining the information, nor did the CEO improperly divest the companies’ shareholders of the use of that information for her personal gain. The passenger who trades has not violated the securities laws, can trade and could reap a financial windfall. It has never been the case that the SEC could force the passenger to disgorge the proceeds of the trade, even though he seems unjustly enriched.
But if the SEC can compel disgorgement of gains that were not obtained by the traders’ improper conduct then all of the Supreme Court precedent that says it is not illegal to trade on material nonpublic information is for naught. Thus, watch out on your train ride home this evening. If the CEO of a public company lets slip some juicy secret and you trade and profit based on it, you just might have to write the SEC a big fat check – even though you did nothing wrong.
Gregory Morvillo is a partner in the New York office of Morvillo LLP. He specializes in insider trading and securities fraud cases.
Disclaimer
The views, opinions and positions expressed within all posts are those of the author alone and do not represent those of the Program on Corporate Compliance and Enforcement or of New York University School of Law. The accuracy, completeness and validity of any statements made within this article are not guaranteed. We accept no liability for any errors, omissions or representations. The copyright of this content belongs to the author and any liability with regards to infringement of intellectual property rights remains with them.