Joshua M. Herman, Counsel

On December 13, 2021, a Virginia federal judge stunned SEC prosecutors by breaking with decades of precedent to hold that the mere statistical unlikelihood of an investor’s success, without more, was insufficient circumstantial evidence that the investor had engaged in insider trading. Whether this decision will catch on with other judges or impacts the SEC’s ability to drive quick settlements remains to be seen, but at the very least the SEC will have to reconsider its reliance on and presentation of data-driven analysis of statistically improbable trading.

According to the complaint filed by the SEC in the Eastern District of Virginia, the defendant Christopher Clark’s brother-in-law William Wright served as corporate controller of CEB Inc. Beginning in November 2016, Wright learned nonpublic information about Gartner, Inc.’s confidential discussions with CEB to acquire CEB through a potential merger. Meanwhile, Wright and Clark, whose homes were less than two miles apart, communicated by phone, text, and in person, including while Clark coached their daughters’ basketball team and at family holiday events. As of December 2016, Clark was deeply in debt.

As the SEC further alleged, for his non-CEB investments, Clark primarily traded in common stock, earning a return of only 16% between 2008 and 2019 from investments in 46 companies. However, on the same days that Wright and Clark spoke in December 2016 and January 2017, Clark purchased large volumes of out-of-the-money, short-term CEB call options—the first time in more than five years that Clark had taken a bullish position on CEB. Clark financed these transactions by liquidating his wife’s entire IRA account, borrowing $6,000 from a line of credit at his family credit union (nearly maxing out the $20,000 credit limit), and taking out a loan against the value of his car. Clark also had phone conversations with his son that were immediately followed by his son purchasing similar out-of-the-money, short-term CEB call options—the first time Clark’s son had ever taken a bullish position in CEB. As early January 2017 approached, the CEB call options Clark and his son purchased had increasingly shorter expirations, consistent with the expectation that CEB’s stock price would increase significantly in the near future. These option purchases were incredibly risky. For example, on January 4, 2017, Clark’s son purchased 30 CEB call options with a January 19, 2017 expiration, which would have required a 13% increase within 11 trading days to realize a profit. Clark and his son were the only investors purchasing these short-term options during this period.

Before the market opened on January 5, 2017, CEB and Gartner announced that they had entered into a merger agreement in which Gartner would acquire CEB for $77.25 per share, causing CEB’s stock price to close that day at $74.85 a share, and increase of 21% from the previous day’s close. Clark subsequently sold his call options for profits of $243,190 (a return of over 740%), and Clark’s son received profits of $53,050 (a return of over 1,000%).

Aside from the suspicious timing and profits of these option purchases, the SEC did not have any direct evidence of Clark receiving material, non-public information from Wright, such as emails, recordings, witnesses, or texts. (The SEC subpoenaed Clark’s phone, but after months of negotiations Clark claimed to have lost it two days before he was to turn it over.) But usually, the SEC does not even need this kind of direct evidence to proceed to trial. In opposing Clark’s summary judgment motion, the SEC cited decisions from the Court of Appeals across the country that circumstantial evidence—such as suspicious timing, riskiness of the trade, and the abnormally high amounts invested—could suggest insider trading.

But Judge Claude M. Hilton of the Eastern District of Virginia held that Clark’s suspicious, high-risk trading amidst regular communications with Wright were not suspicious enough to “give rise to an inference that he received the insider information.” According to Judge Hilton, Clark and Wright’s frequent communications were normal given their close relationship, and any inferences that could be drawn from the success of Clark’s CEB investments amounted only to “speculation” as to insider information.

Judge Hilton’s decision was surprising because the SEC usually prevails in cases where the improbable success of the trades was even less compelling. Until Judge Hilton’s decision, the SEC’s success relying on circumstantial evidence had been so consistent that most investors settle with the SEC before a suit is ever filed, especially where the amounts in dispute are under $300,000. Perhaps Judge Hilton’s decision will change that pattern. And for higher-dollar actions filed by the SEC, investors will now stand on somewhat firmer ground in arguing that trading success alone is not proof of wrongdoing.

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For more information on the issues in this alert, please contact:

Arthur G. Jakoby at +1 212 592 1438 or [email protected]
Howard R. Elisofon at +1 212 592 1437 or [email protected]
Joshua M. Herman at +1 212 592 1587 or [email protected]

© 2021 Herrick, Feinstein LLP. This alert is provided by Herrick, Feinstein LLP to keep its clients and other interested parties informed of current legal developments that may affect or otherwise be of interest to them. The information is not intended as legal advice or legal opinion and should not be construed as such.