Would David Einhorn Be Liable for Insider Trading under U.S. Law?

As you might have read, the U.K. Financial Services Authority last week fined David Einhorn, the founder and president of hedge fund Greenlight Capital, about $11 million for insider trading in the shares of British issuer Punch Taverns Plc.  The matter was settled, so the actual facts are somewhat unclear, but you can find the FSA’s Decision Notice, and a fair recounting of Einhorn’s response here.

Here is a short version of the facts:  In June 2009, Greenlight held 13% of Punch’s outstanding shares.  On June 9 of that year, Einhorn participated in a conference call in which he learned that Punch was planning a secondary offering.  Concerned that such an equity raise would dilute Punch’s existing shareholders and drive down the price of Punch stock, Einhorn sold almost 12 million shares over the next four days.  On June 15, Punch announced a fundraising of £375 million, and Punch’s share price promptly plunged by almost 30%.  The FSA “accepted that Einhorn’s trading was not deliberate because he did not believe that it was inside information.”  But because Einhorn was an “experienced professional with a high profile in the industry,” this “was not a reasonable belief.” Einhorn, as you might imagine, has a different perspective.  He says that Punch’s investment bank approached Greenlight about signing a non-disclosure agreement regarding the secondary offering, and that Greenlight declined to enter into such an agreement.  “We had no interest in becoming an insider,” he said recalling that he told the company he would be“happy to talk to management, but not interested in receiving information to trade stock.”  While the banker raised the non-disclosure agreement more than once, Einhorn declined each time.

Let’s assume Einhorn’s version of the facts is right.  Would he be liable for insider trading under U.S. law?  I’m not sure he would be.  A fairly rough definition of insider trading is trading in securities on the basis of material, nonpublic information in breach of a duty to do so.  And there are two basic theories under which one can become liable for insider trading: the classical theory, and the misappropriation theory.

Classical Theory

Under the classical theory, a corporate insider breaches his duty to the company’s shareholders by buying or selling the company’s shares on the basis of material, nonpublic information.  Was Einhorn an insider?  He wasn’t a controlling shareholder of Punch, and a noncontrolling shareholder is not deemed to have a fiduciary duty to the company unless he takes on some additional role that would imply such a duty. Could he have been regarded as a temporary insider?  Probably not.  The SEC has occasionally taken a very aggressive approach to temporary insiders, including in a pair of cases from the 1980s: SEC v. Lund, 570 F. Supp. 1397 (C.D. Cal. 1983) and SEC v. Ingram, 694 F. Supp. 1437 (C.D. Cal. 1988). In Lund, a corporate insider called his friend to tell him about an imminent joint venture and asked if the friend would invest in the venture. On that basis, the friend bought shares in the company, realizing a $12,500 profit. The court found liability, seemingly saying that any time a person is given information by an issuer with an expectation of confidentiality or limited use that he becomes an insider of the issuer.  But under Dirks v. SEC, 463 U.S. 646 (1983), this is not enough. 

There must also be an express or implied assent to fiduciary status with respect to the issuer. In Ingram, the defendant was invited to look for a merger partner for an issuer, sat in on company negotiations, and then passed along inside information to a number of his brokerage customers. The court found an implied understanding that the defendant would act in the issuer’s interests. But the court also criticized Lund, noting that under Dirks there has to be an agreement to keep corporate information confidential, not just a one-way expectation. According to Einhorn, he was repeatedly asked to enter into a non-disclosure agreement and thereby become a fiduciary of Punch, but he declined the opportunity. Could Einhorn be construed as a classical theory tippee?  It seems unlikely, as one requirement under Dirks is that the tipper reap a personal benefit from the tip. Here, Punch Taverns would not have benefited at all from Greenlight’s selling its Punch shares. If anything, one might construe the overtures regarding the non-disclosure agreement as an attempt to lock up Einhorn and prevent him from selling before the secondary offering.

Misappropriation Theory

What about the misappropriation theory? Under that theory, a person secretly converts information given to him for legitimate reasons by trading on the basis of it for personal benefit, in violation of a duty to refrain from such a benefit. Here, the fraud is not on the person with whom the defendant trades, but rather on the person who gave him access to the information. Looking at Einhorn’s situation through the lens of the ongoing Mark Cuban case is instructive. In March 2004, Cuban bought a 6.3% of Mamma.com, a Canadian company that operated an Internet search engine. Later that spring, the company planned a private investment in public equity, or PIPE, offering, and decided to inform Cuban and invite him to participate. Before learning of the PIPE, Cuban agreed to keep whatever information the CEO shared with him confidential. Upon actually hearing the news, Cuban reacted angrily, saying, “Well, now I’m screwed. I can’t sell.” Several hours later, Cuban approached Mamma’s investment bank to seek more information about the PIPE. According to the SEC’s complaint, a bank sales representative then “supplied Cuban additional confidential details about the PIPE.” Then, without informing Mamma of his plans, Cuban instructed his broker to sell all of his Mamma.com shares over the next two days.  See SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009).

The SEC is trying to find liability based on Cuban’s agreement to keep the CEO’s information in confidence, hinging its case on Rule 10b5-2(b)(1). That rule says that for misappropriation cases, a “duty of trust or confidence” exists “[w]henever a person agrees to maintain information in confidence.” The district court found evidence to show that Cuban agreed to keep Mamma’s information confidential, but did not find evidence showing that he agreed not to trade. The Fifth Circuit thought the factual record was too sparse to sustain a motion to dismiss on that basis, so the case is ongoing. But under Einhorn’s version of the facts of his own case, he repeatedly declined even to agree to keep Punch’s information confidential. Rule 10b5-2(b)(1) therefore would not suffice as a source of a duty of trust and confidence on which insider trading liability could attach. I don’t see another basis under U.S. law to sue Einhorn for insider trading. Do you?