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Finance Big Wig Busted

From the NY Times:

John F. Marshall spent decades teaching at business schools and watching his students parlay his lessons into fortunes on Wall Street. But when he and another professor reached for some of those riches themselves, events took a startling turn, the authorities say.

Dr. Marshall, a retired professor at St. John’s University and a fixture on the Wall Street lecture circuit, was accused by the Securities and Exchange Commission in March of passing inside information about a multibillion-dollar corporate takeover to a professor at Pace University. The Pace professor, Alan L. Tucker, made more than $1 million trading on the tips in 2007, according to the S.E.C. The Justice Department has filed criminal charges.

The developments have stunned Dr. Marshall’s former colleagues and students, who describe him as a meticulous scholar and a generous, unassuming teacher. The accusations have also jolted Wall Street, where Dr. Marshall is considered one of the wise men of financial engineering. ...

Dr. Marshall retired from St. John’s in 2000 and went on to help form the International Securities Exchange, the electronic options exchange. He later became a member of its board and the chairman of its finance and audit committee.

The trouble began in late 2006, when Eurex, a German exchange, expressed interest in buying the I.S.E. According to the S.E.C., Dr. Marshall tipped off Dr. Tucker about the deal, sharing insider details of the proposed transaction through multiple phone calls.

Dr. Tucker later bought options giving him the right to buy I.S.E. stock, as well as shares in the American exchange, through an Ameritrade account, the S.E.C. said in its complaint. In e-mail exchanges, Dr. Tucker referred to the scheme as “the program,” according to the S.E.C. Dr. Marshall’s brother-in-law, Mark R. Larson, 45, bought shares of I.S.E. stock based on the tips, S.E.C. says.

When Eurex agreed to buy I.S.E. for $67.50 a share in 2007, the value of the I.S.E. stock and options soared, producing a profit of $1.1 million. It is unclear if Dr. Marshall profited personally. But the options trades set off alarms with market regulators because Dr. Tucker was the only person buying some of the instruments just before the takeover. ...

Manuchehr Shahrokhi, a finance professor at California State University at Fresno, said he was so surprised to hear about the allegations that he looked up the S.E.C. complaint to double-check. He could not reconcile the accusations with the man knew — someone he once heard speak on ethics in the derivatives markets.

“You know, sometimes greed takes over your knowledge and your skills and everything else. But he is not a greedy man,” Dr. Shahrokhi said. “Really, the only conclusion I can come up with is it must have been an accident. I do not believe that a person of his stature would do this.”

My first reaction to that last line was: How do you you tip by accident. That thought, of course, led immediately to SEC v. Switzer. It confirmed that not every disclosure by an insider to an outsider constitutes an illegal tip. Indeed, even a disclosure made made in violation of a fiduciary duty is not always an improper tip. This is so because what the Supreme Court proscribed in Dirks v. SEC is not just a breach of duty, but a breach of the duty of loyalty forbidding fiduciaries to personally benefit from the disclosure.

In SEC v. Switzer, the alleged tip concerned Phoenix Resources Company, an oil and gas company. One fine day in 1981, Phoenix’s CEO, one George Platt, and his wife attended a track meet to watch their son compete. Barry Switzer, then coach of the Oklahoma Sooners football team (and later the Dallas Cowboys), was also at the meet, watching his son. Platt and Switzer had known each other for some time. Platt had Oklahoma season tickets and his company had sponsored Switzer’s television show. Sometime in the afternoon Switzer laid down on a row of bleachers behind the Platts to sunbathe. Platt, purportedly unaware of Switzer’s presence, began telling his wife about a recent business trip to New York. In that conversation, Platt mentioned his desire to dispose of or liquidate Phoenix. Platt further talked about several companies bidding on Phoenix. Platt also mentioned that an announcement of a “possible” liquidation of Phoenix might occur the following Thursday. Switzer overheard this conversation and shortly thereafter bought a substantial number of Phoenix shares and tipped off a number of his friends. Because Switzer was neither an insider or constructive insider of Phoenix, the main issue was whether Platt had illegally tipped Switzer.

Per Dirks, the initial issue was whether Platt had violated his fiduciary duty by obtaining an improper personal benefit: “Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider [to his stockholders], there is no derivative breach [by the tippee].” The court found that Platt did not obtain any improper benefit. The court further found that the information was inadvertently (and unbeknownst to Platt) overheard by Switzer. Chatting about business with one’s spouse in a public place may be careless, but it is not a breach of one’s duty of loyalty.

The next issue is whether Switzer knew or should have known of the breach. Given that there was no breach by Platt, of course, this prong of the Dirks test by definition could not be met. But it is instructive that the court went on to explicitly hold that “Rule 10b-5 does not bar trading on the basis of information inadvertently revealed by an insider.”

Can Marshall contruct a Switzer defense? Hard to say on the facts available. But here’s one story that might work:

Marshall and Tucker are close personal friends. Marfshall has been very stressed lately. Over a fine dinner and a lot of wine, Tucker asks his friend what is troubling him. Marshall discloses that his work at ISE has become quite stressful. He explains about the pending acquisition and discloses that he is troubled by the impending sale of the company he helped found. Marshall continues to confide in his friend over several phone calls.

A breach of the duty of care? Yes? Self-dealing? Nope.

While this story would foreclose liability for both Marshall and Tucker under the classic disclose or abstain theory of Dirks, Tucker might still have problems under the misappropriation theory. I’m thinking here of Rule 10b5-2(b)(2), which provides that the requisite relationship of trust and confidence between the source of the information and the trader can be found where:

… the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality

To make the Switzer story work, you’d like to argue that their friendship and business partnership was such that Marshall would feel comfortable confiding in his friend. Oversell that story, however, and you create the pattern of “sharing confidences” that would give rise to misappropriation liability.

Unfortunately for Marshall and Tucker, the SEC complaint claims that Marshall knew about Tucker’s trades all along. Makes the Switzer story tough to sell, assuming the SEC can back it up.