The Lessons of 'Lyon' on Insider Trading Liability

The Securities and Exchange Commission (SEC) has a long history of aggressively pushing the boundaries of insider trading liability. One such campaign gave rise to what has become known as the “misappropriation theory,” a now well-established doctrine that expanded the net of the insider trading laws to capture individuals who are not traditional “corporate insiders.”¹ The misappropriation theory and its expansive application by the SEC create many pitfalls for professional trading firms such as hedge funds that simultaneously pursue both public and private investments in the same issuer. U.S. District Court for the Southern District of New York Judge Sidney H. Stein’s recent opinion in SEC v. Lyon² illustrates the dangers to professional investors who engage in such parallel trading strategies without a clear understanding of this complex and sometimes counterintuitive area of the securities laws.

‘SEC v. Lyon’

In Lyon, the SEC relied on the misappropriation theory to bring insider trading charges against hedge fund Gryphon Partners and its chief investment officer (collectively, Gryphon) for allegedly short-selling the shares of several public companies while in possession of inside information about the fact that the companies were going to issue new shares through Private Investment in Public Equity (PIPE) offerings. A PIPE is a capital-raising technique that involves a public company issuing additional shares through a private offering, often at a discount to the prevailing market price. An announcement of a PIPE can cause the company’s public share price to decrease because, among other things, such offerings result in shareholder dilution and are often seen by the market as a sign that the issuer is facing financial difficulties.³ The SEC alleged that Gryphon profited on the inside information about the impending PIPEs by covering its short positions after the deals were announced and the market prices of the issuers’ securities declined as a result. The issuers provided Gryphon with the non-public information about the PIPEs in an effort to solicit it to invest in those offerings.