United States v. Chestman

United States Court of Appeals for the Second Circuit · 1991 · Corporations

CorporationsInsider tradingTender offersSecurities fraudMail fraudRule 14e-3(a)Section 14(e)Rule 10b-5

Facts

Chestman, a stockbroker, handled trades for Keith Loeb, whose wife was part of the Waldbaum family. After Ira Waldbaum agreed to sell Waldbaum to A & P in a tender offer, the confidential information traveled from Ira to Shirley Witkin, to Susan Loeb, and then to Keith Loeb, who told Chestman he had definite and accurate information that Waldbaum was about to be sold at a substantially higher price. That same day Chestman bought Waldbaum stock for his own account and for discretionary client accounts, including Loeb's account, before the tender offer was publicly announced. The stock price rose sharply after the announcement, and the government prosecuted Chestman on tender-offer, securities-fraud, and mail-fraud theories.

Issue

Whether Rule 14e-3(a) was a valid exercise of the SEC's authority under section 14(e), whether the evidence was sufficient to support Chestman's convictions under Rule 14e-3(a), and whether the evidence was sufficient to support his Rule 10b-5 and mail fraud convictions under the misappropriation theory. Also at issue was whether Rule 14e-3(a) gave fair notice consistent with due process.

Rule

Section 14(e) authorizes the SEC to define fraudulent practices and to prescribe means reasonably designed to prevent them in the tender-offer context; therefore Rule 14e-3(a), which requires abstain-or-disclose conduct by those trading on material nonpublic tender-offer information obtained directly or indirectly from specified insider sources, is valid even without proof of a preexisting fiduciary duty. By contrast, Rule 10b-5 misappropriation liability requires a breach of a fiduciary duty or a similar relationship of trust and confidence, and such a similar relationship must be the functional equivalent of a fiduciary relationship, marked by dependency, discretionary authority, dominance, or a history of sharing business confidences; mere kinship, marriage, or entrusting confidential information alone is not enough.

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One of 10 multiple-choice questions for this case. Pick an answer to see why.

In Chicago, broker Nina Flores learns from her client Adam Reece that Adam has "reliable, nonpublic" information that his aunt's company, Prairie Lantern Foods, will soon be the target of a tender offer at a large premium. Nina knows Adam's aunt is a director of the company, and before any public announcement Nina buys shares for herself.

If Nina is prosecuted for trading on tender-offer information, which statement is most accurate?

Explanation. Rule 14e-3(a) validly imposes an abstain-or-disclose duty in the tender-offer context without requiring proof of a preexisting fiduciary duty. Liability turns on possession of material nonpublic tender-offer information and knowledge or reason to know that it came directly or indirectly from the offering person, issuer, or listed insider/agent source. That is the majority rule.