Dirks v. SEC

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New York – The current definitions of insider trading owe much to a U.S. Supreme Court decision which capped a battle between Raymond L. Dirks and the Securities and Exchange Commission.  The story is interesting not only for what it tells us about inside information, but also about the vagaries of being a research analyst.

Equity Funding Corporation of America

In March 1973 Ray Dirks, an insurance analyst at now-defunct Delafield, Childs, Inc., received a call from a disgruntled employee at Equity Funding, which at the time was one of the top 10 U.S. insurance companies and a darling of Wall Street.  Equity Funding had been creating false insurance policies for years, which the company then turned around and packaged to reinsurers, pocketing the cash.  Dirks’ informant believed that selling pressure would cause the price of Equity Funding stock to ‘drop close to zero very quickly,’ and thus ‘reveal the fraud to the world’ and ‘prevent its continuation.’

Ray Dirks told his favored institutional clients of the scam, who were able to sell their shares before the scandal broke.  This caused the SEC to censure Dirks.  However, as a Justice Department amicus brief filed supporting Dirks in the Supreme Court case pointed out, Dirks also attempted to inform the Wall Street Journal and Equity Funding’s auditors and the SEC, to no avail.

Dirks contacted Equity Funding’s auditors and apprised them of the fraud allegations, hoping that they would withhold audited financials and seek a halt in the trading of Equity Funding securities. Instead, the auditors merely reported Dirks’ allegations to management.

Dirks also attempted to communicate his evidence to the Wall Street Journal.  Unlike the current scandals, the editors were not interested. William Blundell, the Wall Street Journal‘s Los Angeles bureau chief, doubted that the fraud could have been missed by an honest auditor and discounted the entire allegation.

After reaching out to the WSJ, Dirks contacted the SEC and voluntarily presented all of his information at the SEC’s L.A. office.

Meanwhile, the price of Equity Funding stock fell precipitously from $26 per share to less than $15. The NYSE halted trading in the stock and shortly thereafter, Illinois and California insurance authorities impounded Equity Funding’s records and uncovered evidence of the fraud. Only then did the SEC file a complaint against Equity Funding and only then did the Wall Street Journal publish a front page story written by Blundell but based largely on information assembled by Dirks.  (Bundell was subsequently nominated for a Pulitzer.) Three days later, Equity Funding filed for bankruptcy.

Dirks vs. SEC

The Securities and Exchange Commission charged Dirks with ‘tipping’ material inside information in violation of Section 10(b) of the Securities Exchange Act of 1934.  Dirks ended up being censured by the SEC for his actions and over the next ten years he fought the decision, all the way up to the U.S. Supreme Court.

The Supreme Court ruled that there are two requisites for inside information: 1) “access to inside information intended to be available only for a corporate purpose” and 2) a fiduciary relationship, or as Justice Powell put it, “the unfairness of allowing a corporate insider to take advantage of that information by trading without disclosure.  A duty to disclose or abstain does not arise from the mere possession of nonpublic market information.”  Further, there should be deception or manipulation involved:  “There must also be ‘manipulation or deception’ to bring a breach of fiduciary duty in connection with a securities transaction within the ambit of Rule 10b-5. Thus, an insider is liable under the Rule for inside trading only where he fails to disclose material nonpublic information before trading on it, and thus makes secret profits.”  Does not bode well for Raj or Don Longueuil.

So, how might an independent ‘tippee’, one not employed by a publicly traded company, breach a fiduciary relationship?  The fiduciary relationship gets passed on to the tippee if the tipper has breached their fiduciary relationship to shareholders.  “Tippees must assume an insider’s duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly. Thus, a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.”

A big factor in determining whether a tipper has breached their fiduciary duty is whether they profit by their tip.  “Whether disclosure is a breach of duty depends in large part on the personal benefit the insider receives as a result of the disclosure. Absent an improper purpose, there is no breach of duty to stockholders.”  In a recent example, the fact that the Big Lots store managers which provided information to Retail Intelligence Group did not profit from the exchange (they were not paid), would presumably been a big factor if the case had gone to trial.

In the case of Ray Dirks, the Court ruled that because Dirks’ sources at Equity Funding did not breach their fiduciary duty (they were doing shareholders a favor by blowing the whistle on the scam), Dirks had not duty to abstain from the non-public information he received.

The ruling also explicitly attacks the view, which seems to still live on at the SEC, that all market participants should have equal information. “The SEC’s position that a tippee who knowingly receives nonpublic material information from an insider invariably has a fiduciary duty to disclose before trading rests on the erroneous theory that the antifraud provisions require equal information among all traders. A duty to disclose arises from the relationship between parties, and not merely from one’s ability to acquire information because of his position in the market.”

Postscript

Ray Dirks has had a long and colorful career as an equity analyst.  He ran afoul of the SEC in the early ‘80s when he was a principal at John Muir, pushing the staid firm aggressively into the IPO market.  At Dirks’ direction, Muir focused on small-cap IPOs and issued 49 IPOs in a two year period.  There were allegations that the firm required issuers to invest part of their capital in other IPOs sponsored by Muir.  For example, Basic Energy Science invested $728,000 of its IPO equity in Digital Switch, another Muir offering.  This technique was subsequently perfected in the high yield bond market by Mike Milken.   John Muir failed in 1981 after over-extending itself and the SEC censured Dirks for negligence, suspending him for six months from being a supervisor at a brokerage firm.

In the ‘90s, he was affiliated with RAS Securities Corp, where there were allegations that Dirks aggressively pitched stocks in which he and RAS had substantial unpublicized positions.   The allegations, made by disgruntled former employees, were not substantiated.

Ray Dirks, now in his 60s, is still providing research.  Never one to shun controversy, a favorite tactic is to recommend stocks being heavily shorted by hedge funds.  He is a charter member of the ShortBusters Club.  He continues to provide research to institutions and individuals, and he manages money for some individual investors.  He contributes research reports to CorporateProfile.com.

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