Statement on In the Matter of Lloyd D. Reed

The Commission’s Order finds that Lloyd D. Reed violated Exchange Act Section 10(b) and its accompanying Rule 10b-5 “by trading on material, non-public information [of Torotel, Inc.] in breach of his duty of trust and confidence owed to his business partner (“Business Partner”), who was also a Torotel director and family member.”[1] In other words, the case is based on the misappropriation theory of insider trading: Reed’s Business Partner shared with him material, non-public information about Torotel with the expectation that Reed would keep that information confidential, and Reed misappropriated that information by trading on it in breach of his duty to his Business Partner to keep the information confidential. The Order’s next line, however, states: “Reed purchased Torotel stock in July and August 2019 based on information Business Partner gave him about Torotel’s plans to seek a business combination and after observing Business Partner’s increased activities with Torotel.” (emphasis added). Undoubtedly, that a company is considering a business combination generally would constitute material, non-public information about that company. But when and how one’s observations of what someone else is doing for a company constitute material, non-public information about the company is considerably less clear.

The Order explicitly identifies two instances when Reed’s Business Partner passed Torotel’s material, non-public information to him. First, in February 2015, his Business Partner, who at that time had been hired by Torotel to analyze its business, gave Reed a copy of the resulting thirteen-page report and recommendations. In the Order’s telling, the 2015 Report included an “analysis . . . [of] additional investments to prepare the company for sale in the future” and “recommendations about preparation for a possible sale of Torotel.” Second, “on August 5, 2019, Business Partner sent Reed an email . . . about a potential Torotel merger [which] referenced the internal pseudonym for Torotel’s search for bidders and identified a document summarizing the bids Torotel had received.” A gap of four years and six months separated the date his Business Partner shared a report that recommended, among a number of other options, the possibility of a merger from the date his Business Partner sent him an e-mail that indicated Torotel was in fact pursuing a merger.

Granted, the Order recites many other facts that likely are material, nonpublic information related to Torotel’s plans. For example, it notes that in December 2018, Torotel’s board decided to pursue a strategic transaction, and in April 2019 set up an ad-hoc committee—later converted to a formal Special Committee—to oversee the process. The Order also states that Torotel in July 2019 started discussions in earnest with “potential strategic partners and financial sponsors,” and that it had “financial offers to purchase Torotel” by August 1, 2019. The Order does not state that his Business Partner—or anyone else—shared any of these specific facts with Reed.

Reed was aware of his Business Partner’s involvement with Torotel. Reed knew that his Business Partner joined Torotel’s board in February 2018, that he performed work for Torotel after joining the board, and that his compensation from Torotel “was ultimately payable” to an entity that he and Reed co-owned[2]. Additionally, “Reed knew that Business Partner focused his business activities on potential growth and other strategic transactions.” His Business Partner’s appointment to the board in February 2018 and that his consulting work focused, among other things, on mergers and acquisitions were not material, non-public pieces of information because Torotel filed a Form 8-K in February 2018 disclosing both these facts. Specifically, the Form 8-K stated that his Business Partner was the “founder and principal of [an entity] which provides strategic planning and implementation, operational execution, and M&A support.”[3] The remaining fact—that Reed knew his “Business Partner had become unusually busy on Torotel-related matters” in June 2019—appears to be the key “observation” that bridges the temporal chasm between the February 2015 report and Reed’s purchases of Torotel stock in July 2019.

This bridge is a rickety structure at best, and one that we should not hazard to cross. That Reed knew that his Business Partner was unavailable “to meet or discuss shared business interests” is significant only inasmuch as Reed also knew the reason for the unavailability—that his Business Partner was “unusually busy on Torotel-related matters.” The crux of the case is this question: What material, non-public information informed Reed in July 2019 that his Business Partner’s unavailability was due to his work on a strategic transaction for Torotel? Recall that the Order cites no evidence that Reed knew in July 2019 that Torotel had decided in December 2018 to pursue such a transaction, had set up a Special Committee to oversee the efforts, had started discussions with potential partners in July 2019, or had received offers. Also recall that Torotel’s Form 8-K disclosed both his Business Partner’s appointment to the board and that he did work in mergers and acquisitions. The only piece of material, non-public information available to Reed in July 2019 was the February 2015 report. Even if one were to view his Business Partner’s June-July 2019 Torotel workload through the lens of February 2015 report, it does not follow that the Business Partner must have been working to complete a strategic transaction. His Business Partner’s “analysis of a potential sale” was but one of the “recommendations” in the four-year old report. That Torotel was actively pursuing a strategic transaction, while a possible inference from his Business Partner’s busy schedule during the summer of 2019, was not the only possible inference. Moreover, the materiality of an analyst’s recommendations from February 2015 to an assessment of the probability of Torotel’s business decisions in July 2019 is dubious at best.

An August 5, 2019 email from his Business Partner revealed material, non-public information that a business combination was underway. Accordingly, while I do not support the charge that Reed engaged in unlawful insider trading when he purchased Torotel shares before receiving the August 5 e-mail, I support the charge that he engaged in unlawful insider trading when he purchased 6,800 Torotel shares after receiving the e-mail and before Torotel announced its acquisition.

The Order gives me pause. First, the Order appears to assess whether particular information is material and non-public information about a company based on the relationship between the individuals sharing it. Assume, for example, that the Business Partner was a volunteer Little League coach, and told the assistant coach that he was unavailable for games in June and July because of his Torotel workload. Surely, we would not contend that the Business Partner thereby passed material, non-public information about Torotel to the assistant coach. Why do we make that contention with respect to Reed, who knew precisely the same fact, but for a different reason—his Business Partner’s unavailability to discuss matters related to their co-owned businesses and their familial relationship? Whether a fact is material and non-public information about a company is determined by the nature of the fact itself, not by the nature of the relationship in which it is conveyed. At bottom, as I read it, the Order conflates distinct aspects of the misappropriation theory—the requirement for material, non-public information about a company and the requirement that the tipper and tippee have a relationship of trust and confidence—by presuming that the existence of a relationship of trust and confidence somehow transmogrifies non-material, public information into material, non-public information. Reed’s trading on public information should not be illegal simply because Reed had a different relationship with his Business Partner.

This leads to my second concern: that a reasonable inference drawn from pieces of information that are either non-material, public, or both can itself be material, non-public information. The kind of securities analysis that is central to making markets work—gathering pieces of information (none of which are both material and non-public) and putting these pieces together to make reasonable assumptions about a company’s prospects—will be at risk. Will an investor who makes money based on the inferences she draws from information she has worked hard to assemble face insider trading charges if those inferences prove to be accurate?

If this Order forms the basis of a new tenet of our insider-trading canon, it will undermine the efficiency of our markets. For these reasons, I respectfully dissent.