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Securities and Exchange Commission v. Wyly


March 31, 2011


The opinion of the court was delivered by: Shira A. Scheindlin, U.S.D.J.



On July 29, 2010, following a six-year investigation into matters spanning almost two decades, the Securities and Exchange Commission ("SEC") filed this suit alleging thirteen Claims for securities violations by billionaire brothers Samuel Wyly and Charles J. Wyly (together, the "Wylys"), their attorney Michael C. French ("French"), and their stockbroker Louis J. Schaufele III ("Schaufele"). The gist of the fraud alleged is that, from 1992 through at least 2005, the Wylys hid their ownership of and trading activity in the shares of four public companies*fn1 on whose boards of directors they sat*fn2 by creating a labyrinth of offshore trusts and subsidiary entities in the Isle of Man and the Cayman Islands (the "Offshore System"); transferring hundreds of millions of shares of the Issuers' stock to those entities; and installing surrogates to carry out their wishes regarding the disposition of the stock -- all while preserving their anonymity and evading federal securities laws governing trading by corporate insiders and significant shareholders.*fn3 Attorney French and stockbroker Schaufele were allegedly essential to the success of this scheme, which also included a singular instance of insider trading by the Wylys and Schaufele in 1999. The SEC seeks penalties, injunctive relief, and disgorgement of roughly $550 million in gains and prejudgment interest.

Defendants now move to dismiss Claims One through Four of the Complaint, which allege that, through the use of the Offshore System, the Wylys and French committed primary violations of section 10(b) of the Exchange Act (Claim One) and section 17(a) of the Securities Act of 1933 (the "Securities Act") (Claim Four); that French and Schaufele aided and abetted the fraud alleged in Claim One under section 10(b) (Claim Three); and that the Wylys and Schauefe engaged in insider trading, also in violation of section 10(b) of the Exchange Act (Claim Two). The most interesting and complicated questions raised by the defendants' motions, however, have nothing to do with the substance of the federal securities laws' antifraud provisions; rather, they concern the applicability and interpretation of various limitations periods purportedly governing the SEC's claims for monetary penalties for both their fraud claims (Claims One through Four) and their non-fraud claims (Claims Five through Thirteen). I first address these threshold questions before turning to the defendants' more substantive arguments.


A. False Filings

The Complaint identifies dozens of false securities filings which serve as the foundation for the defendants' alleged fraudulent scheme.*fn5 Those filings fall broadly into three groups: (1) filings of one or both of the Wylys personally (such as Schedule 13Ds, Schedule 13Gs, or Form 4s (described below)) that understate their shareholdings and stock trading; (2) corporate filings by the Issuers (such as Form 10-Ks, proxies, or registration statements) that also understate the Wylys' (and/or French's) shareholdings in the particular Issuer making the filing; and (3) filings by "Offshore Trustees" (see below) falsely claiming they have sole dispositive power over their shares.*fn6

Schedule 13D is a disclosure report required under section 13(d) of the Exchange Act to be filed by any person who "is directly or indirectly the beneficial owner of more than five percent" of the stock of any class of a public company's outstanding stock.*fn7 A person beneficially owns a security if such person directly or indirectly, through any contract, arrangement, understanding, relationship or otherwise, has or shares (i) voting power, which includes the power to vote, or to direct the voting of, such security; and/or (ii) investment power, which includes the power to dispose, or to direct the disposition of, such security.*fn8

Form 4 is a disclosure report required under Exchange Act section 16(a) to be filed by every public company officer, director and greater-than-ten-percent shareholder reporting any changes to their beneficial ownership of their company's securities.*fn9

B. The Offshore System Scheme

The Complaint alleges that between March 1992 and January 1996, in the Isle of Man, a self-governing British crown dependency located between Scotland and Northern Ireland in the Irish Sea, the Wylys established seventeen trusts, the beneficiaries of which were Sam or Charles Wyly, their respective family members, or both.*fn10 Initially, they selected a single Isle of Man-based trust management company to serve as their Offshore Trusts' trustee, but between 1992 and 2004 selected numerous additional "Offshore Trustees."*fn11 Employees of the various Offshore Trustees served as directors of more than thirty Isle of Man-based shell companies that were wholly-owned by the various respective Offshore Trusts ("Offshore Companies").*fn12 The Offshore Companies, along with the Offshore Trusts, together comprised the Wylys' "Offshore System."*fn13

The trust agreements governing the Wylys' Offshore Trusts purported to confer upon the Offshore Trustees broad and exclusive authority to manage trust assets, but in practice the Offshore Trusts were controlled by trust "Protectors,"*fn14

Wyly-appointed loyalists who did the Wylys' bidding.*fn15 Thus, the offshore trusts were paper facades used by the Wylys to hide their beneficial ownership of and trading in the Issuers' shares they held in their Offshore System and to evade the federal securities laws' insider-transaction reporting provisions, beneficial-ownership reporting provisions, or both.*fn16 At various times during the course of their thirteen-year scheme, the Wylys allegedly controlled more than twice as many shares in certain of the Issuers as they disclosed publicly,*fn17 which included directing the voting and disposition of shares in the four Issuers held in the offshore trusts.*fn18 Through their conduct, the Wylys -- with awareness of its unlawfulness*fn19 -- allegedly deprived the markets and investors of information reflective of potential shifts or changes in corporate outlook important to investment decisions.*fn20 These unlawful nondisclosures also enabled the Wylys freely to sell millions of shares of the Issuers' stock while avoiding the adverse market reaction and decrease in value often attending the required public disclosure of such trading by insiders.*fn21

1. French

French, who acted as the Wylys' lawyer, also served on the boards of three of the Issuers and as a trust Protector of the Offshore System.*fn22 French provided cover to the Wylys' scheme that was essential both to its concealment and its continuation.*fn23 In his role as a trust Protector, he coordinated with the trusts to communicate the Wylys' investment and voting instructions, which without exception were carried out by the Offshore Trustees.*fn24 Despite having intimate knowledge of the Wylys' control over their Offshore System, French repeatedly (and falsely) told the Issuers and their counsel that the Offshore System was "independent of the Wylys."*fn25 While participating in the Wylys' fraud, French also established offshore entities of his own, which he, like the Wylys, used to control and trade Issuer securities without disclosing that ownership or trading.*fn26

French received an annual salary of 1.5 million dollars over the course of eight years and a sixteen million dollar share in a hedge fund established by the Wylys.*fn27

2. Schaufele

Schaufele served for over fifteen years as the registered representative for various accounts established by the Wylys, including those of the Wylys' offshore entities,*fn28 and helped carry out the Wylys' "protocol" for effecting certain transactions in the Offshore System: conveying instructions to the trust Protectors who in turn conveyed the instructions to the appropriate Offshore Trustee, who then faxed the necessary trading instructions to Schaufele or his assistants.*fn29

Schaufele made misrepresentations to his brokerage firm superiors and in-house attorneys about the Wylys' relationship to and control over the offshore entities (of which he had full knowledge), which were allegedly vital to the scheme's operation and continuation.*fn30

C. 1999 Insider Trading Violations

Around June 1999, Sam Wyly personally decided that both Sterling Software and Sterling Commerce should be sold.*fn31 He obtained Charles Wyly's concurrence, and the two agreed that the sale of Sterling Commerce should proceed first.*fn32 At that time, the Wylys comprised two-thirds of Sterling Software's executive committee and, along with other family members and French, comprised half of Sterling Software's Board of Directors.*fn33

In late September 1999 -- when the plan to sell both Sterling entities was "already underway"*fn34 and when Goldman Sachs had already been retained by Sterling Commerce as an advisor (and had compiled a list of potential acquirors)*fn35

-- Sam Wyly instructed the Wyly Family CFO to determine the cost of purchasing from Lehman Brothers up to four million Sterling Software call options at the company's current trading price, with expiration dates of between twelve and twenty-four months in the future.*fn36

On September 28, 1999, Schaufele provided the Wyly Family CFO with the requested pricing information, but recommended that the Wylys consider a swap agreement*fn37 as an alternative because it would be easier to unwind than call options.*fn38 Sam Wyly concurred and, between September 30 and October 6, 1999, he directed his son Evan -- at the time a fellow board member of three of the Issuers, including Sterling Software -- to negotiate the terms of the transaction with Schaufele.*fn39 Charles Wyly agreed to participate for one-third of the transaction.*fn40

In order to minimize the borrowing costs imposed by Lehman's credit department, the Wylys followed Schaufele's advice and agreed to limit the initial size of the transaction to 1.5 million shares with an eighteen-month term, and to later seek to increase its size.*fn41 The transaction documents called for the Wyly offshore entities participating in the transaction to pay a fee of six cents per share (for a total of $120,000) based on Lehman's hedging purchases of Sterling Software common stock.*fn42

On October 1, 1999, days after learning of Sam Wyly's trading intentions, Schaufele purchased four thousand shares of Sterling Software at $20.359 per share, for a total investment of more than $80,000.*fn43 He divided the purchases among four different brokerage accounts all held in his wife's name.*fn44

On October 18, 1999, eleven days before Lehman's trading to hedge the transaction and establish its notional price was complete, Morgan Stanley furnished Sam Wyly with an analysis entitled "Operation Windfall" specifically identifying Computer Associates as a potential acquiror for Sterling Software; and on October 22, 1999, five days before Lehman's trading to hedge the transaction and establish its notional price was complete, Sterling Software amended its employment agreements to provide for enhanced payouts to the Wylys in the event of a change in control.*fn45

Following the swap's execution, from November 15 to 17, 1999, Sterling Software's senior managers met and formally agreed to pursue the sale of the company.*fn46 In late November, Sam Wyly summoned several Morgan Stanley investment bankers to his Dallas office to indicate his interest in selling Sterling Software, after which Morgan Stanley notified Computer Associates, whose then-president and Chief Operating Officer made an "overture" to Sam Wyly.*fn47 The two met on January 18, 2000, in Sam Wyly's Dallas home to discuss the acquisition,*fn48 and on February 14, 2000, Computer Associates announced that it had reached an agreement to acquire Sterling Software in a stock swap valued at approximately four billion dollars.*fn49 Based on that day's closing price of Sterling Software, the Wylys' imputed profits from their two-million-share swap transaction exceeded $31.77 million,*fn50 and Schaufele's imputed profits totaled $63,564.*fn51 In March of 2000, both Sterling Software and Sterling Commerce were formally acquired.*fn52

C. The Commission's Investigation

On November 16, 2004, Bank of America reported to the Commission's Enforcement staff that the Wylys' offshore accounts at that institution -- where Schaufele had moved from Lehman Brothers along with the Wylys' accounts in 2002*fn53 -- had been terminated for failure to disclose information regarding their relationship to a web of offshore entities.*fn54 In response, the Commission commenced an investigation, during the course of which the Wylys executed a tolling agreement that remained in place from February 1, 2006, through July 2010.*fn55 French and Schaufele signed tolling agreements dated August 1, 2009, and October 29, 2009, respectively, both of which continued through July 2010.*fn56 The Complaint was filed against Defendants on July 29, 2010.


A. Motion to Dismiss

On a motion to dismiss under Federal Rule of Civil Procedure 12(b)(6), the court must "accept as true all of the factual allegations contained in the complaint"*fn57 and "draw all reasonable inferences in [the] plaintiff[s'] favor."*fn58 However, the court need not accord "[l]egal conclusions, deductions or opinions couched as factual allegations . . . a presumption of truthfulness."*fn59 To survive a Rule 12(b)(6) motion to dismiss, the allegations in the complaint must meet a standard of "plausibility."*fn60 A claim is facially plausible "when the plaintiff pleads factual content that allows the court to draw the reasonable inference that the defendant is liable for the misconduct alleged."*fn61

B. Federal Rule of Civil Procedure 9(b)

Federal Rule of Civil Procedure 9(b) provides that "the circumstances constituting fraud . . . shall be stated with particularity." To satisfy the particularity requirement, a complaint must: "'(1) specify the statements that the plaintiff contends were fraudulent, (2) identify the speaker, (3) state where and when the statements were made, and (4) explain why the statements were fraudulent.'"*fn62

However, "intent, knowledge, and other conditions of mind may be averred generally."*fn63


A. Applicable Law

1. Section 21(d)(3) of the Exchange Act

Section 21(d)(3) of the Exchange Act authorizes the SEC to seek civil monetary penalties "[w]henever it shall appear to the Commission that any person has violated any provision of" the Exchange Act "other than by committing a violation subject to a penalty pursuant to [section 21A*fn65 for insider trading]."*fn66 Section 21(d)(3) does not contain a statute of limitations. Therefore, the catch-all five-year statute of limitations of 28 U.S.C. § 2462 ("catch-all statute of limitations") governs punitive relief sought by the SEC under section 21(d)(3).*fn67

That section provides that [e]xcept as otherwise provided by Act of Congress, an action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise, shall not be entertained unless commenced within five years from the date when the claim first accrued

2. Section 21A of the Exchange Act

Section 21A authorizes the SEC to seek treble civil penalties specifically for violations of the Exchange Act that constitute insider trading, as defined in section 21A.*fn68 Unlike section 21(d)(3) of the Exchange Act, section 21A contains an express, five-year "Statute of limitations," providing that [n]o action may be brought under this section more than 5 years after the date of the purchase or sale. This section shall not be construed to bar or limit in any manner any action by the Commission or the Attorney General under any other provision of this chapter, nor shall it bar or limit in any manner any action to recover penalties, or to seek any other order regarding penalties, imposed in an action commenced within 5 years of such transaction.

3. The Discovery Rule

The "'discovery rule' of federal common law" is "[t]he rule that postpones the beginning of the limitations period [the "accrual" date] from the date when the plaintiff is wronged to the date when he discovers he has been injured."*fn69

The discovery rule applies "where a plaintiff has been injured by fraud and remains in ignorance of it without any fault or want of diligence or care on his part."*fn70 In such cases, "the bar of the statute does not begin to run until the fraud is discovered, though there be no special circumstances or efforts on the part of the party committing the fraud to conceal it from the knowledge of the other party."*fn71

This equitable doctrine is "read into statutes of limitations in federal-question cases . . . in the absence of a contrary directive from Congress"*fn72 "in cases of fraud or concealment."*fn73 As the Supreme Court recently explained in a private securities fraud class action,

The [discovery] rule arose in fraud cases as an exception to the general limitations rule that a cause of action accrues once a plaintiff has a complete and present cause of action. This Court long ago recognized that something different was needed in the case of fraud, where a defendant's deceptive conduct may prevent a plaintiff from even knowing that he or she has been defrauded. Otherwise, "the law which was designed to prevent fraud" could become "the means by which it is made successful and secure."*fn74

The date of "discovery," for purposes of the discovery rule, is the earlier of "when the litigant first knows or with due diligence should know the facts that will form the basis for an action."*fn75 The Second Circuit recently clarified, in a private securities fraud case, that under Merck v. Reynolds, a fact is not deemed "discovered" until a reasonably diligent plaintiff would have sufficient information about that fact to adequately plead it in a complaint. In other words, the reasonably diligent plaintiff has not "discovered" one of the facts constituting a securities fraud violation until he can plead that fact with sufficient detail and particularity to survive a 12(b)(6) motion to dismiss.*fn76

In section 10(b) actions, scienter is a fact subject to discovery.*fn77

4. Fraudulent Concealment

Fraudulent concealment is a doctrine of equitable estoppel that "comes into play if the defendant takes active steps to prevent the plaintiff from suing in time, as by promising not to plead the statute of limitations."*fn78 Rather than postpone the date of accrual (like the discovery rule), tolling doctrines such as fraudulent concealment "stop the statute of limitations from running even if the accrual date has passed."*fn79

To invoke fraudulent concealment, a plaintiff must allege that: (1) defendant concealed the cause of action; (2) plaintiff did not discover the cause of action until some point within five years of commencing the action; and (3) plaintiff's continuing ignorance was not attributable to lack of diligence on its part.*fn80 "[A] plaintiff seeking to toll the applicable statute of limitations due to fraudulent concealment . . . must meet the particularity standard of Rule 9(b)."*fn81

To establish the first element, a plaintiff must allege that: (1) defendant took affirmative steps to prevent or frustrate discovery of the alleged violation by depriving plaintiff of the information it needed to pursue its claims in a timely fashion; or (2) the alleged wrong was self-concealing.*fn82

"[T]he case law regarding the third prong [of fraudulent concealment] is not entirely consistent."*fn83 It has been characterized (1) as requiring a showing that the plaintiff's ignorance of the claim "was not the result of lack of diligence"*fn84 and also (2) as a requirement that a plaintiff show "due diligence in pursuing discovery of the claim."*fn85 With respect to the first formulation, some courts have found allegations that due diligence would not have uncovered the violations sufficient.*fn86 Under the second formulation, however, "[g]eneral assertions of ignorance and due diligence without more specific explanation . . . will not satisfy the[ ] pleading requirements;"*fn87 due diligence is not adequately pled if plaintiffs "did not allege in the [Complaint] that they exercised due diligence" or if they "make no allegation of any specific inquiries of [defendants], [or] detail when such inquiries were made, to whom, regarding what, and with what response."*fn88

B. Discussion

1. Section 21(d)(3) of the Exchange Act

Defendants argue that all of the SEC's claims for civil monetary penalties under section 21(d)(3) that "first accrued" prior to five years before the effective date of defendants' tolling agreements are barred by the catch-all statute of limitations to which, they argue, the discovery rule does not apply. Moreover, "to the extent" the doctrine of fraudulent concealment is "available," the SEC has not adequately pled it.*fn89 Meanwhile, the SEC contends that the doctrine of fraudulent concealment is inapplicable to its fraud claims, which are instead governed by the discovery rule. Under that theory, according to the SEC, it need only plead that it did not "discover" (and with diligence could not have discovered) defendants' fraud until November 16, 2004 -- the earliest date that it was "even on inquiry notice about these matters."*fn90

The Second Circuit has not yet addressed whether the discovery rule applies to SEC enforcement actions seeking penalties for fraud claims, though it will soon.*fn91 However, there does not appear to be a genuine dispute between the parties that, even if the discovery rule is inapplicable, the doctrine of fraudulent concealment applies.*fn92 Nor does the case law on which defendants rely for the proposition that the discovery rule is inapplicable to section 2462 foreclose the applicability of the doctrine of fraudulent concealment.*fn93 Therefore, because I find that the SEC has adequately pled fraudulent concealment, and because the parties appear to be in agreement that the SEC faces a higher pleading bar for fraudulent concealment than for the discovery rule,*fn94 I need not address whether the discovery rule applies to section 2462 in SEC actions for fraud.*fn95

I note, however, the confusion in the case law in this area. District courts addressing this question -- and cited by the SEC for the proposition that the discovery rule applies to section 2462 -- have required plaintiffs to plead fraudulent concealment with no discussion of the discovery rule,*fn96 applied the discovery rule with no discussion of fraudulent concealment,*fn97 or conflated the two doctrines.*fn98 Even the "foundational" cases upon which the SEC relies for the proposition that "[t]he Supreme Court repeatedly has held that the 'discovery rule' governs when a claim accrues for statute of limitations purposes in cases involving fraud or concealment"*fn99 are not so clear; as counsel for French explained at oral argument, at least one Second Circuit case describes Holmberg, Bailey, and Exploration Company as "fraudulent concealment" cases despite the absence of those words in any of the opinions.*fn100 Moreover, the statutes at issue in "Merck and TRW . . . expressly incorporate[d] the discovery rule in the statute of limitations . . . being construed by the Court,"*fn101 somewhat obscuring their applicability to cases where, as here, a court is asked to read a discovery rule into a federal statute.

One final note: defendants are also arguing that the SEC's claims for penalties as to the non-fraud violations should be dismissed as time-barred.*fn102 For these claims, the SEC contends that the fraudulent concealment doctrine tolls the statute of limitations for its claims for penalties under section 21(d)(3).*fn103 Because I find that the SEC has pled fraudulent concealment with respect to its fraud claims -- for which the collection of non-fraud reporting violations forms the basis -- defendants' motion to dismiss the non-fraud claims is also denied.

a. The SEC Has Adequately Pled Acts of Concealment

by Defendants

The SEC alleges that the Wylys engaged in numerous deceptive acts to conceal their control over the offshore entities, which in turn frustrated the SEC's ability to discover their violations.*fn104 Those deceptive acts included (i) the making of hundreds of false and materially misleading statements to the Issuers, the Issuers' attorneys, investors, the Commission, and, in the case of Schaufele, to brokerage firm intermediaries, (ii) the establishment and operation of an offshore "Wyly family office" in the Cayman Islands as a conduit and repository for the communications and records "which should not be seen in the USA," and (iii) the allocation of the Wylys' offshore holdings of Issuer Securities among different, and often newly created, offshore entities, all under the Wylys' control, solely to avoid making required Commission filings.*fn105

Moreover, the Wylys' sporadic "disclosures" to the SEC disclaiming beneficial ownership of millions of Issuer shares do not "flatly refute any notion that [defendants] prevented or frustrated the SEC's discovery of its belatedly asserted claims."*fn106 If anything, such (false) disclaimers constituted additional acts of concealment, because they were affirmative misrepresentations as to the Wylys' control over the trading and holding of securities in the Offshore System.

The Wylys argue that the SEC fails to allege conduct "beyond the alleged misconduct alleged to give rise to the underlying violations" and that it has not alleged that the violations were self-concealing.*fn107 First, with respect to the reporting-based violations (the non-fraud claims), defendants are simply wrong; the SEC has alleged dozens of acts of concealment beyond the making of false and materially misleading statements, as noted above. Second, "[w]here a plaintiff raises fraud-based claims, the allegations supporting the merits of those claims are often very similar to the allegations that support fraudulent concealment. This similarity does not prevent a plaintiff from pleading equitable tolling."*fn108

Defendants cite Gabelli for the proposition that fraudulent concealment "does not apply 'where the misrepresentation or act of concealment underlying the estoppel claim is the same act which forms the basis of plaintiff's underlying causes of action.'"*fn109 However, the case upon which the Gabelli court relied for that proposition concerned (not surprisingly) equitable estoppel under New York law, which, as discussed earlier, tolls the statute of limitations when one party "induces the opposing party to postpone bringing suit on a known cause of action"*fn110 by, for example, promising not to plead the statute of limitations.*fn111 It makes sense to require a party pleading equitable estoppel to plead affirmative acts of concealment separate from any underlying fraud. The SEC, however, is not pleading equitable estoppel.

b. The SEC Has Alleged that It Did Not Discover Its Claims Until November 16, 2004

The SEC has alleged that it was not even placed on inquiry notice of any of the defendants' alleged frauds until November 16, 2004, when Bank of America reported to staff members of the SEC's Division of Enforcement that it had terminated securities accounts held in the name of numerous Isle of Man entities because those entities refused to disclose information regarding their beneficial ownership.*fn112 The Complaint also alleges that each of the defendants executed a tolling agreement with the SEC prior to November 16, 2009, and that those tolling agreements were in effect through the filing of the Complaint on July 29, 2010.*fn113

Defendants suggest that the very making of the allegedly false and misleading SEC filings placed the SEC on notice of the defendants' fraud before November 16, 2004, and therefore on notice of their underlying reporting violations.*fn114 Indeed, as early as 1994, numerous SEC filings disclosed that the Wylys and French disclaimed beneficial ownership of millions of shares of Issuer stock and stock options that had been transferred to multiple irrevocable trusts established by the Wylys and French.*fn115 To offer just one example (of literally dozens) of such disclaimers, Michaels disclosed in 1996 that French disclaimed beneficial ownership of 45,000 Michaels stock options "owned by an independent irrevocable trust of which Mr. French and certain of his family members are beneficiaries."*fn116 "Against the backdrop of these public filings," defendants argue, "the SEC cannot plausibly claim that [defendants] frustrated or prevented discovery of the information necessary to bring its claims within the limitations period."*fn117

However, defendants' argument wholly overlooks that it was the Wylys' control of the offshore trusts that the SEC claims it was prevented from discovering throughout the limitations period -- control that led it ultimately to discover the violations for which it brings suit today. In fact, one of the "disclaimers" to which French points as evidence that the SEC was not "prevented from discovering the nature of its claims against Mr. French within the applicable limitations period" expressly denies such control.*fn118 And the "fact" of the Wylys' control over the offshore trusts is integral to the SEC's allegations of scienter, a "fact"*fn119 that a reasonably diligent plaintiff is not deemed to have "discovered" "until he can plead that fact with sufficient detail and particularity to survive a 12(b)(6) motion to dismiss."*fn120

Moreover, defendants' argument is highly fact-based and ill-suited for a motion to dismiss.*fn121 SEC filings must disclose a fraud on their face -- or at least present "storm warnings" -- before courts will deem them sufficient to trigger inquiry notice.*fn122 Thus, even where public filings contain statements that later form the basis for fraud claims, the false filings alone are not deemed to have placed plaintiffs on inquiry notice unless they provided specific information indicating a probability of fraud.*fn123 Plaintiffs are entitled to rely on the statements in public filings unless there are some other indicia that the statements are false.*fn124

c. The SEC Has Adequately Alleged Due Diligence

The Wylys argue that the SEC "alleges nothing more than the conclusory statement that it 'proceeded with due diligence during the limitations period' (Compl. ¶ 118)" and that it "does not plead any facts regarding any of the steps it purportedly took during the limitations period to exercise diligence to discover the alleged fraud."*fn125 Of course, this argument assumes -- notwithstanding the language of many courts in this Circuit -- that it is insufficient for a plaintiff to allege that its ignorance of a claim "was not the result of lack of diligence"*fn126 or that due diligence would not have uncovered the violations because of "the affirmative, deceptive practices and techniques of secrecy employed by Defendants."*fn127 In cases of equitable estoppel, I am inclined to agree with the Hinds County court (and, presumably, defendants) that "[t]his standard is problematic because it allows the allegations required to satisfy the first prong of fraudulent concealment to also satisfy the third prong."*fn128 On the other hand, if fraud is so meticulously concealed that a plaintiff could not possibly have thought even to inquire about it, how could a plaintiff do anything but regurgitate the first prong of fraudulent concealment?*fn129 Again, the inconsistency with which courts have applied the "due diligence" prong may stem in part from their attempt to fit a square peg (claims to which the discovery rule applies) into a round hole (the doctrine of fraudulent concealment).

This Court need not resolve the issue, however, because the SEC has satisfied both formulations of "due diligence" as articulated by courts in this district. In addition to pleading multiple acts of concealment,*fn130 the SEC has alleged at least one "specific inquir[y]" it made of defendants, including "when [it was] made, to whom, regarding what, and with what response."*fn131 In particular, in August, 1998, the SEC's Division of Corporate Finance questioned whether the offshore trusts were truly independent of French and the Wylys.*fn132 In response, French assured the lawyers responding to the SEC that they were.*fn133 Thus, crediting the SEC's allegations that the Wylys did in fact control the offshore trusts, the Complaint adequately alleges that it exercised due diligence throughout the limitations period.*fn134

One final note: at oral argument, counsel for Schaufele urged this Court to consider the possibility that, even if section 2462 is subject to equitable tolling under the doctrine of fraudulent concealment, the SEC should not necessarily be afforded the full five-year limitations period to bring suit.*fn135 In Cada, Judge Posner entertained such a possibility, reasoning that "the statute of limitations is not automatically delayed by the time it takes to obtain [the information necessary to bring suit]," holding instead that "a plaintiff who invokes equitable tolling to suspend the statute of limitations must bring suit within a reasonable time after he has obtained, or by due diligence could have obtained, the necessary information."*fn136 On a more fully developed factual record, this argument may be ripe for consideration.*fn137

2. Section 21A of the Exchange Act (Civil Penalties for Insider Trading)

The SEC seeks penalties for the Wylys' and French's alleged 1999 insider trading violations under section 21A, a statute which allows for treble damages. The Wylys argue that section 21A's five-year "Statute of limitations" is an "explicit statute of repose" that "runs from 'the date of the purchase or sale,' without qualification," and therefore "does not permit equitable tolling."*fn138 The SEC argues that, because section 21A suggests no restriction on the application of the discovery rule, "there is no indication that Congress intended in [s]section 21A to override the long-standing rule of Holmberg that the discovery rule 'is read into every federal statute.'"*fn139 Whether section 21A is a statute of repose, or a statute of limitations subject to the discovery rule (or the doctrine of fraudulent concealment), appears to be a matter of first impression.

a. Section 21A Is Not a Statute of Repose

In holding that section 13 of the Securities Act*fn140 contained a three-year statute of repose, the Second Circuit in P. Stolz Family Partnership v. Daum devoted considerable discussion to the differences between statutes of repose and statutes of limitation. First, "[i]n general, a statute of repose acts to define temporally the right to initiate suit against a defendant after a legislatively determined time period."*fn141 Thus, "unlike a statute of limitations, a statute of repose is not a limitation of a plaintiff's remedy, but rather defines the right involved in terms of the time allowed to bring suit."*fn142 Section 21A's five-year statute of limitations is clearly a limitation on one of several "remedies" the SEC may seek for insider trading; it does not prevent the SEC from bringing suit for injunctive and other equitable relief under section 21(d) no matter how much time has elapsed since the violation occurred. Indeed, section 21A itself provides that it should "not be construed to bar or limit in any manner any action by the Commission . . . under any provision of this title."*fn143 And although section 21A in a sense "defines the right" to bring suit for a particular type of relief (treble penalties) and for a particular type of behavior that violates the Exchange Act,*fn144 such behavior would be actionable under the federal securities laws even without section 21A.

Second, when discussing the purported inequities of statutes of repose -- such as the opportunity they afford defendants to "secur[e] a sort of immunity to continue illicit [behavior] without civil liability" -- the P. Stolz court explained that plaintiffs' "remedial results may best be furthered, without losing one of the principal benefits of a statute of repose -- to provide an easily ascertainable and certain date for the quieting of litigation -- by lengthening the period before repose takes effect."*fn145 As an example, the court cited the Sarbanes Oxley Act, "which extend[ed] the effective date of the statute of repose from three years to five years."*fn146 Section 20A of the Exchange Act, which provides "express private rights of action for those who traded securities contemporaneously with, and on the opposite side of, a transaction from the insider trader,"*fn147 also provides a five-year limitations period. Moreover, the Supreme Court has described section 20A as "a statute of repose"*fn148 and, to this Court's knowledge, no court has ever applied the discovery rule or equitable tolling doctrines to it.*fn149 In fact, consistent with P. Stolz's reasoning that Congress might lengthen a period of repose to counteract its seemingly inequitable effects, the Supreme Court in 1991 characterized section 20A's five-year limitations period as providing "enhanced protection"*fn150 to private litigants injured by insider trading -- compared to the two- and three-year statutes of repose that applied to nearly every other private right of action under the Securities Act and the Exchange Act at that time. Similarly, the Second Circuit has opined that "Congress perhaps specified a five-year limitations period in [section 20A] in recognition of the [difficulties of ferreting out evidence sufficient to prosecute insider trading cases]."*fn151

However, if section 20A is a statute of repose, it complicates this Court's analysis somewhat; for, aside from the caveat that section 21A should not be construed to bar or limit any other action by the SEC under the Exchange Act, sections 21A and 20A contain nearly identical five-year limitation periods, suggesting section 21A, too, is a statute of repose:

Section 20A (private right of action): "No action may be brought under this section more than 5 years after the date of the last transaction that is the subject of the violation."*fn152

Section 21A (SEC action): "No action may be brought under this section more than 5 years after the date of the purchase or sale."*fn153

Moreover, as with section 20A, no court has ever held that section 21A is anything but a statute of repose.*fn154 And the SEC concedes that it has not always taken the position, as it does in this action, that section 21A*fn155 (or section 20A, for that matter*fn156 ) is subject to the discovery rule.

Nevertheless, this Court now holds that section 21A is not a statute of repose. First, even if section 20A is a statute of repose, "Congress itself has cautioned that the same words may take on a different coloration in different sections of the securities laws."*fn157 Thus, "[w]hatever [the language of section 21A] may mean in the [] context[] [of section 20A], only [] one narrow question is presented here."*fn158 Second, section 20A applies to private litigants' actions for insider trading violations, while section 21A applies to the SEC, and "[s]tatutes of limitation sought to be applied to bar rights of the Government, must receive a strict construction in favor of the Government."*fn159 Indeed, the P. Stolz court acknowledged the "touch of hyperbole" in its hypothetical that the statute of repose in section 13 of the Securities Act would "secur[e] a sort of immunity [for a defendant] to continue illicit offers without civil liability," noting that "it is likely that the SEC is not subject to the [section] 13 statute of repose and would be able to bring its own civil enforcement action against such a defendant under [section] 20(b) of the [Securities Act's analog of section 21(d) of the Exchange Act]. Therefore, it is unlikely that an offeror could ever operate with unfettered immunity."*fn160 Third, this result is consistent with the principle that section 2462 -- which applies to SEC actions for civil penalties for violations of every other provision of the Exchange Act -- is a statute of limitations to which equitable principles apply.*fn161 It would be an absurd result indeed if the SEC's right to seek penalties under the Exchange Act were most circumscribed for the one type of behavior (insider trading) for which Congress has explicitly "[r]ecogniz[ed] [] unique difficulties in identifying evidence"*fn162 -- arguably the epitome of the sort of self-concealing conduct for which courts often apply the discovery rule.*fn163

b. The SEC's Insider Trading Claims Did Not Begin Accruing, or the Statute of Limitations Was Equitably Tolled, Until November 16, 2004

As with the SEC's other fraud claims under section 10(b), its claims for insider trading are precisely the types of claims to which the discovery rule -- rather than the doctrine of fraudulent concealment -- apply. However, the Court is again faced with the dilemma whether the SEC need merely assert that it did not discover the insider trading violation until some time after November 16, 2004 -- and could not have discovered it sooner with due diligence -- or whether it must plead all three prongs of fraudulent concealment. Once again, I find the pleadings adequate to support either basis for allowing the SEC's claims to proceed. In order to bring its insider trading claims against the Wylys and Schaufele, the SEC had to first "discover" the fact of the Wylys' control over the offshore entities that nominally entered into the security-based swap with Lehman Brothers. Without knowledge of that fact -- and the fact that Schaufele knew the Wylys controlled the offshore entities and were the real "insiders" behind the transaction -- it could not have stated the claim it now brings. And, as discussed earlier,*fn164 the SEC has alleged (1) that the Wylys engaged in dozens of acts of concealment to prevent the SEC's discovery of their control over the offshore trusts,*fn165 while Schaufele repeatedly misrepresented the independence of the offshore trusts to his employers; (2) that the SEC did not discover the Wylys' relationship to and control over the offshore trusts until November 16, 2004; (3) and both (a) that it could not with due diligence have discovered that information any earlier and (b) that it made at least one specific inquiry in 1999 about the Wylys' beneficial ownership of the offshore entities, an inquiry that was met with French's alleged lies. These allegations are sufficient to plead the application of both the discovery rule and fraudulent concealment, and accordingly defendants' argument that the SEC's claim for penalties under section 21A is time-barred fails.


A. Applicable Law

1. Exchange Act Section 10(b) and Rule 10b-5

Rule 10b-5, enacted pursuant to section 10(b), sets forth alternative bases for securities fraud liability. In addition to prohibiting (1) the "mak[ing] [of] any untrue statement[s],"*fn166 Rule 10b-5 also forbids (2) the use, "in connection with the purchase or sale of any security," of "any device, scheme, or artifice to defraud" or any other "act, practice, or course of business" that "operates . . . as a fraud or deceit."*fn167 confidential information by reason of their position with that corporation."*fn168

a. Insider Trading

i. Traditional or Classical Theory

"Under the 'traditional' or 'classical theory' of insider trading liability, [section] 10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information."*fn169 Trading on such information qualifies as a "deceptive device" under [section] 10(b) because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained

Thus, section 10(b) acts to "prohibi[t] an insider, who has a fiduciary duty to a corporate entity, from using material non-public information to the insider's advantage in order to make secret profits."*fn170

ii. Misappropriation Theory

Under the "misappropriation theory" of insider trading, an individual violates section 10(b) and Rule 10b-5 when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information. . . . The misappropriation theory is . . . designed to protec[t] the integrity of the securities markets against abuses by outsiders to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders.*fn171

To establish that a defendant is liable for insider trading under the misappropriation theory, the SEC must prove (1) that the information at issue was both material and nonpublic; (2) that the defendant breached a duty of confidentiality in sharing the information ("the cornerstone of a misappropriation liability case"*fn172 ); and (3) that the defendant acted with scienter.*fn173

iii. Materiality

Information is material if "'there is a substantial likelihood that a reasonable shareholder would consider it important' or, in other words, 'there [is] a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable shareholder as having significantly altered the total mix of information available.'"*fn174 Materiality "depends on the significance the reasonable investor would place on the withheld or misrepresented information."*fn175

"The determination [of materiality] requires delicate assessments of the inferences a 'reasonable shareholder' would draw from a given set of facts and the significance of those inferences to him, and these assessments are peculiarly ones for the trier of fact."*fn176

With respect to "contingent or speculative" information, materiality will depend at any given time upon a balancing of both indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity. . . . [I]n order to assess the probability that the event will occur, a factfinder will need to look to indicia of interest in the transaction at the highest corporate levels [such as] board resolutions, instructions to investment bankers, and actual negotiations between principals or their intermediaries . . . . To assess the magnitude of the transaction . . . , a factfinder will need to consider such facts as the size of the two corporate entities and of the potential premiums over market value. No particular event or factor short of closing the transaction need be either necessary or sufficient by itself to render merger discussions material.*fn177

"Furthermore, where there is a question of whether certain information is material, courts often look to the actions of those who were privy to the information in determining materiality."*fn178

B. Discussion

1. The Complaint Adequately Alleges the Wylys' and French's Liability for Fraud and French's and Schaufele's Liability for Aiding and Abetting the Wylys' Fraud

The SEC charges the Wylys and French with primary violations of section 10(b) of the Exchange Act and section 17(a) of the Securities Act, and alleges that French and Schaufele aided and abetted the Wylys' section 10(b) violation. For reasons that will be explained at a conference scheduled for April 14, 2011, at 5:00 p.m., the Wylys', French's, and Schaufele's motions to dismiss these claims are denied.*fn179

2. The Complaint Adequately Alleges Insider Trading Against the Wylys and Schaufele

The Complaint (Claim Two) alleges that the Wylys, in violation of their fiduciary duties as corporate directors of Sterling Software, used their offshore entities to execute a security-based swap agreement with Lehman in October 1999 while the Wylys were in possession of, and based on, material nonpublic information*fn180 -- namely, that they, as Chairman and Vice-Chairman of Sterling Software, had agreed and resolved that the sale of Sterling Software to an external buyer should be pursued.*fn181 It further alleges that Schaufele, in violation of numerous Lehman policies concerning insider trading, confidential information, conflicts of interest, and misappropriation of firm property, purchased Sterling Software stock through brokerage accounts in his wife's name while in possession of the material, nonpublic information that Sterling Software insiders -- the Wylys -- were about to execute a massive, bullish transaction.*fn182

The Wylys move to dismiss Claim Two as legally insufficient, arguing that they did not directly trade in "securities," as that term was then (and is now) defined by the Exchange Act and that the information on which they traded was not material as a matter of law.*fn183 Schaufele also moves to dismiss, arguing that the nonpublic information in his possession and on which he traded was not material and that he did not engage in "deception" in trading thereon. The defendants' arguments are without merit.

a. The Complaint States a Claim for Insider Trading Against the Wylys

i. The Security-Based Swap Agreement Was "in Connection With" the Purchase or Sale of Securities

The Wylys contend that the SEC has failed to allege a legally viable section 10(b) claim for insider trading because, when the conduct at issue here occurred, security-based swap agreements were not included within the Exchange Act's definition of a "security" and were not otherwise subject to section 10(b) or Rule 10b-5.*fn184 The Wylys' argument is based primarily on the fact that in December 2000 -- more than a year after the swap occurred -- Congress enacted the Commodity Futures Modernization Act of 2000 (the "CFMA"), which amended section 10(b) to explicitly cover security-based swap agreements.*fn185 Meanwhile, Congress simultaneously excluded security-based swaps from the definition of a "security" under the Exchange Act.*fn186 Thus, the Wylys argue, security-based swap agreements not only do not qualify as "securities" subject to the SEC's rule-making authority, but also were not subject to the antifraud provisions of section 10(b) before the CFMA "'extend[ed] the rules promulgated by the SEC under that section to prohibit fraud, manipulation, and insider trading, and judicial precedents decided under section 10(b), to [such instruments].'"*fn187

The Wylys' argument fails. Regardless of whether security-based swap agreements were included in -- or are now excluded from -- the statutory definition of a "security," section 10(b) and Rule 10b-5 have long applied to fraudulent devices undertaken "in connection with" the purchase or sale of securities. Although the classic instance of a misuse of corporate information "in connection with" a purchase or sale of securities occurs when the fiduciary in possession of confidential information herself purchases or sells securities, to satisfy the "in connection with" requirement, "[i]t is enough that the scheme to defraud and the sale of securities coincide."*fn188 Indeed, "[t]he 'coincide' requirement is broad in scope" and extends to conduct that merely "induce[s] securities transactions."*fn189 Moreover, the plain language of section 10(b) in no way restricts an insider trading claim to those situations in which the person breaching the fiduciary duty herself trades in the securities at issue; she need only breach the duty of confidentiality "in connection with" the purchase or sale of securities.

A swap agreement like this one -- which explicitly required the purchase of stock by Lehman and called for the Wylys' offshore entities to pay the transaction costs associated with those purchases -- clearly "touches on" and "coincides" with the purchase or sale of securities so as to satisfy the "in connection with" requirement, regardless of whether the Wylys themselves purchased or sold the securities. The Wylys "knew . . . that Lehman was hedging its side of the transaction by buying two million shares of Sterling Software common stock on the open market."*fn190 Indeed, "the transaction documents called for the Wyly offshore entities participating in the transaction to pay a fee of 6 cents per share . . . based on Lehman's hedging purchases of Sterling Software common stock,"*fn191 purchases that accounted for as much as eighty-three percent of the daily trading volume in Sterling Software shares at the time.*fn192 Moreover, as "the Wylys knew contemporaneously," the average execution price of Lehman's market purchases of the two million Sterling Software shares established the "notional price" for the swap agreement, which determined the amount of upfront collateral the Wylys would need to direct their Offshore System to pay Lehman for the two million shares.*fn193 Thus, this swap transaction not only touched, coincided with, and induced stock trading, but also required it.*fn194 Although the SEC was not explicitly authorized to prosecute insider trading involving "security-based swap agreements" prior to the CFMA, there is no evidence that the SEC lacked authority to do so before 2000 if such agreements were fraudulent devices used in connection with the purchase or sale of securities.*fn195 For these reasons, the Wylys' argument that security-based swaps are not "securities" is inapposite.*fn196

In their Reply, the Wylys argue that an essential element of insider trading under the "classical theory" is that a corporate insider "'trades in the securities of his corporation on the basis of material, nonpublic information,'"*fn197 noting that neither SEC v. Zandford nor Romano v. Kazacos involved claims for insider trading. However, the purpose of insider trading laws is to "'prevent[] a corporate insider from . . . tak[ing] unfair advantage of . . . uninformed . . . stockholders;'"*fn198 the crux of the violation is a "corporate insider['s] use[] []of undisclosed information for [his] own benefit."*fn199 The Wylys are alleged to have done just that: because they "benefitt[ed] personally through fraudulent use of material, nonpublic information" about Sterling Software's planned sale without "disclos[ing] [that information] prior to trading," they breached their "obligation to place [Sterling Software shareholders'] welfare before their own."*fn200 In particular, they placed their welfare ahead of the Sterling Software shareholders who sold on the opposite side of Lehman's hedging purchases, purchases that were a known requirement of the swap agreement that constituted their "trading." If this is a novel theory of insider trading, I hold that it is sufficiently "in connection with" the purchase or sale of securities to be a viable one.*fn201

ii. The "Information" on Which the Wylys Allegedly Traded Was Not Immaterial

The Wylys argue that, at the time of the swap, the Wylys' alleged decision that a sale of Sterling Software "should be pursued" was immaterial as a matter of law, because it had not "ripened into relevant corporate activity."*fn202 In particular, "[t]here had not been any decision by Sterling Software (such as a Board resolution), any corporate action by Sterling Software (such as the retention and instruction of investment bankers), or any actual merger negotiations between Sterling Software and a potential acquiror."*fn203 However, the absence of these factors, enumerated by the Supreme Court in Basic, is not dispositive of materiality, especially on a motion to dismiss.*fn204 Other allegations in the Complaint create the plausible inference that there was a high "indicated probability that the event [would] occur"*fn205 -- namely, that Sterling Software would be acquired. For example, the Wylys were not typical corporate insiders with generalized desires to sell a company and one or two seats on a board of directors; they founded Sterling Software in 1981, built it into one of the country's largest business software and services company, and spun off Sterling Commerce in 1996.*fn206 During the period of time leading up to the sale of Sterling Commerce and Sterling Software, the Wylys served as Chairman and Vice Chairman of the Board of Sterling Software, comprised two-thirds of its executive committee and, along with other family members and French, comprised half of its Board of Directors. In short, they could be confident that they could effectuate any planned sale, enhancing the probability that it would occur.

The fact that Sterling Commerce -- a company the Wylys spun off from Sterling Software and that was ultimately acquired the same month as Sterling Software -- had already retained Goldman Sachs as its advisor also strengthens the SEC's allegation that the Wylys intended to sell Sterling Software, thereby making its ultimate sale more "probable." This inference of probability is bolstered by the fact that, five days before Lehman completed its hedge to establish the notional price for the swap, Sterling Software amended its employment agreements to provide for enhanced payouts to the Wylys in the event of a change in control.*fn207 As for the "magnitude" of the transaction -- the sale of the company -- "a merger in which [a company] is bought out is the most important event that can occur in a small corporation's life, to wit, its death."*fn208 Thus, this Circuit has reasoned, "inside information, as regards a merger of this sort, can become material at an earlier stage than would be the case as regards lesser transactions -- and this even though the mortality rate of mergers in such formative stages is doubtless high."*fn209 In short, "a reasonable investor would almost certainly want to know information related to" the Wylys' planned sale of Sterling Software, rendering that information "plausibly material."*fn210

Moreover, the SEC's claim is for insider trading -- the Wylys themselves demonstrated the importance they attached to their own intentions to sell the company by acting on that nonpublic information in short order, engaging in a unique, "massive and bullish"*fn211 transaction in Sterling Software stock that replicated the purchase of two million shares of Sterling Software.*fn212 "Given the importance that the Wylys, as investors, attached to this information, it is hard for them now to protest at the motion to dismiss stage that no reasonable investor could have found it material."*fn213 Indeed, the very purpose of insider-transaction reporting requirements -- requirements the Wylys skillfully avoided by funneling their trades through offshore entities -- "is to give investors an idea of the purchases and sales by insiders which may in turn indicate their private opinion as to prospects of the company."*fn214 Thus, drawing all reasonable inferences in the SEC's favor and accepting its allegations as true, the Complaint's "allegations suffice to 'raise a reasonable expectation that discovery will reveal evidence' satisfying the materiality requirement, and to 'allo[w] the court to draw the reasonable inference that the defendant is liable.'"*fn215

b. The Complaint Alleges a Viable Insider Trading Claim Arising from Schaufele's Trading in Sterling Software Stock in His Wife's Brokerage Accounts

i. The Complaint Adequately Alleges that Schaufele Traded on Material Nonpublic Information

The material nonpublic information on which Schaufele allegedly traded was that the Wylys -- insiders at the very highest echelon of Sterling Software -- were engaging in a Sterling Software stock transaction that would be massive, bullish, and unique in the history of their trading, and that would be effected clandestinely through their Offshore System. Schaufele argues that the only information in his possession on October 1, 1999, when he purchased Sterling Software stock, "was that a customer had requested pricing information concerning one type of transaction and negotiations had begun about the possibility of doing a different potential long-term transaction" -- information that is "simply too remote and speculative to be the predicate of an insider trading claim" as a matter of law.*fn216 Moreover, because the terms of the swap were not agreed upon until October 6, 1999, "there was simply no way for Mr. Schaufele to know if a transaction would take place, much less what the terms of that transaction would be."*fn217

Schaufele's argument fails. The fact that Schaufele traded before the Wylys' transaction was finalized is immaterial where the Wylys allegedly asked for pricing on call options for four million Sterling Software shares at least three days before October 1st.*fn218 Thus, it may be reasonably inferred that the Wylys' bullish determination, as well as the highly material terms concerning the transaction's sizing and date parameters, were known to Schaufele when he traded. Although the Complaint alleges that the transaction under discussion had become an equity swap before October 1st,*fn219 it also alleges that the Wylys ultimately obtained a swap that was sized as largely as Lehman would allow -- and that they vigorously sought to size still larger.*fn220

As discussed earlier,*fn221 section 16 reporting obligations are rooted in the recognition that transactions in a company's securities by its own insiders can be material; thus, "information coming from an insider takes on special importance."*fn222 Here, it is entirely plausible that a reasonable shareholder knowing about the Wylys' planned bullish trade would conclude that a significant favorable corporate event or "shift in corporate control" was planned.*fn223 Moreover, Schaufele demonstrated the importance he placed on the information by acting immediately to buy the stock,*fn224 notwithstanding at least four prohibitions on such trading by his employer.*fn225 These allegations raise a plausible inference that the information on which Schaufele traded was material.

Schaufele also attempts to defeat the insider trading claim by arguing that the Wylys' transaction was "wholly consistent with [other] publicly-available information and add[ed] nothing material to that mix," pointing to other "bullish news" in the market, such as the company's five million share buy-back program and news that the stock was "vastly undervalued."*fn226 First, this argument invites precisely the type of factual weighing and analysis inappropriate for the Court to conduct on a motion to dismiss. Second, and more importantly, Schaufele's argument overlooks the crucial fact that the marketplace was wholly ignorant of the fact that it was the Wylys who were (secretly) increasing their stake in the company by engaging in a massive transaction through their offshore entities. It cannot be said that this information was "so obviously unimportant to a reasonable investor that reasonable minds could not differ on the question of [its] importance."*fn227

ii. The Complaint Alleges that Schaufele's Conduct was Deceptive

The SEC alleges that, at the time he purchased eighty thousand dollars worth of Sterling Software common stock through accounts in his wife's name, Schaufele "knew, or recklessly disregarded the fact, that his trading on the basis of such information was in violation of the duties he owned to his employer, Lehman Brothers."*fn228 In particular, the Complaint alleges that Schaufele violated several Lehman policies in place at the time of Schaufele's trading, including Lehman's (i) confidential information policy ("employees must never use the Firm's . . . proprietary information for their own or any other person's financial benefit"); (ii) its insider trading policy ("employees . . . are not permitted to buy or sell any security . . . if the employee is in possession of 'material' non-public information relating to the security, the issuer or the transaction"); and (iii) its conflicts of interest policy ("no employee may obtain any personal benefits from the Firm's dealings with others" unless approved by the Firm).*fn229

Schaufele argues that the SEC has failed to plead "deceptive conduct" because the Complaint "makes no allegation that Mr. Schaufele sought to conceal his trade from Lehman Brothers," pointing to other portions of the Lehman policies cited by the SEC's Complaint that "make clear that the trades by Mr. Schaufele in his wife's accounts . . . were subject to mandatory review to ensure that insider trading was not taking place."*fn230 Even assuming this Court can consider those other portions of the Lehman policies "for purposes of completeness"*fn231 on a motion to dismiss, and even assuming Schaufele expected the trades to be reviewed, the argument fails. This is because Lehman's knowledge that Schaufele traded in Sterling Software stock would not constitute "disclos[ure] to [Lehman] that [Schaufele] plan[ned] to trade on [] nonpublic information."*fn232 Put differently, any alleged "disclosure" that Schaufele traded in Sterling Software stock would not have revealed that the Wylys, who were Sterling Software insiders, originated the trade*fn233 or that the marketplace would remain in ignorance of the Wylys' trade because it was effectuated through the Offshore System, thereby evading reporting requirements.*fn234 In no way could Lehman's alleged "mandatory review" of the trades be deemed to cure the breach of his fiduciary duty to his employer "who entrusted him with access to confidential information."*fn235 Thus, the Complaint adequately alleges that Lehman was deceived regarding the relevant facts.*fn236


For the aforementioned reasons, and for reasons that will be explained at a conference scheduled for April 14, 2011, at 5:00 p.m., defendants' motions to dismiss the SEC's claims are denied in their entirety. The Clerk of Court is directed to close these motions (Docket Nos. 25, 28, and 29).


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