United States v. Chestman

Brief Fact Summary.

A stockbroker, Chestman (Defendant), was indicted and convicted of violating the Securities Exchange Act of 1934 when he purchased shares of a corporation after he acquired nonpublic inside information.

Synopsis of Rule of Law.

Rule 10b-5 of the Securities Exchange Act of 1934 is violated when a person misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence by using that information in a securities trade.

Facts.

Waldbaum, the controlling shareholder of Waldbaum’s, Inc., told some members of the family that he was going to sell the corporation.  Chestman (Defendant) learned from Loeb, who was married to Waldbaum’s niece, Waldbaum was to be sold to A & P for significantly more than the market price.  Defendant was a broker for the junior members of the Waldbaum family.  After receiving the information, but before the sale was announced publicly, Chestman (Defendant) purchased Waldbaum stock for himself and several of his customers, including Loeb.  Loeb cooperated with the Securities and Exchange Commission (SEC) (Plaintiff) during its investigation, and ejected his profits and paid a fine.  Defendant was indicted and convicted for violating Rules 10b-5 and 14e-3(a), for mail fraud and perjury.  On appeal, a panel of the Second Circuit set aside Defendant’s conviction entirely.  The United States (Plaintiff) appealed, resulting in this en banc rehearing by the Second Circuit.

Issue.

Is rule 10b-5 of the Securities Exchange Act of 1934 violated by a person who misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence by using that information in a securities trade?

Held.

(Meskill, J.) Rule 10b-5 of the Securities Exchange Act of 1934 is violated when a person misappropriates material nonpublic information in breach of a fiduciary duty or similar relationship of trust and confidence by using that information in a securities trade.  Nevertheless, a fiduciary duty cannot be imposed unilaterally by entrusting a person with confidential information, and kinship alone does not establish a confidential relation.  In addition, a similar relationship of trust and confidence is the functional equivalent of a fiduciary relationship.  In this case, the evidence is not sufficient to establish a fiduciary relationship or its functional equivalent between Loeb and the Waldbaum family.  Without an act of fraud by Loeb, Chestman (Defendant) cannot be derivatively liable as Loeb’s tippee or as an aider and abettor.  Therefore, Defendant’s mail fraud convictions, based on the same theory as his 10b-5 convictions, cannot stand.  Reversed as to the Rule 10b-5 and mail fraud convictions, affirmed as to the Rule 14e-3(a) convictions.

Dissent.

(Winter, J.) Chestman’s (Defendant) convictions under both Rule 14e-3 and Rule 10b-5 should be affirmed.  When members of a family have benefited from the family’s control of a corporation and are in a position to acquire such information in the ordinary course of family interactions, that position carries with it a duty not to disclose.

Concurrence.

(Miner, J.) I agree with the majority opinion.  As for J. Winter’s “family relationship†rule, family discourse would be inhibited rather than promoted by a rule that would automatically assure confidentiality on the part of a family member receiving nonpublic corporate information.

Discussion.

The excerpt omits the majority’s discussion of Chestman’s (Defendant) Rule 14e-3(a) convictions.  The traditional theory of insider trader liability stems primarily from the Supreme Court’s holdings in Chiarella v. U.S., 445 U.S. 222 (1980), and in Dirks v. SEC, 463 U.S. 646 (1983).  The misappropriation theory has not yet been the subject of a Supreme Court holding but has been adopted in the Second, Third, Seventh, and Ninth Circuits.  In contrast to Chiarella and Dirks, the misappropriation theory does not require that the buyer or seller of securities be defrauded.