SEC Whittles Big Boy Letters Down to Size

The Securities and Exchange Commission is warning Corporate America that anyone who thinks so-called “big boy” letters can protect him or her from the agency’s latest crackdown on insider trading should think again.

In the last two months of 2007, two top SEC officials said either in panel discussions or speeches that, regardless of the letters’ usefulness as a defense in private securities litigation, big boy letters carry no weight in the face of an SEC enforcement action, according to a recent client letter fired off by Cleary Gottlieb.

Greenberg

“It gets your attention,” says Joel Greenberg, a corporate lawyer with the firm Kaye Scholer.

Big boy letters are generally used by two investors who consider themselves fully aware of the risks in a transaction; hence the “big boy” moniker. The letters waive any claims one party may have against the other, if the other knows material, non-public information about the deal but does not disclose it. Essentially, it’s a private pact between two parties who agreed not to sue each other if a deal sours.

Such letters have been around for years. Most lawyers contend that if two institutions are parties to a “big boy” letter, a subsequent claim is unlikely to survive in court. The claim must establish that the buyer relied on the seller not having adverse information that the seller failed to disclose, Greenberg explains. “Private cases are very tough,” he says. “They typically involve sophisticated investment banks and hedge funds.”

One lawsuit over a big boy letter is currently winding its way through the court system. R2 Investments, a hedge fund, claims it was hurt by a big boy letter dating back to 2001 that it had with investment bank Salomon Smith Barney (now simply called Smith Barney). Smith Barney allegedly learned of some material, non-public information about a telecommunications company called World Access.

Smith Barney subsequently sold its position to the Jefferies Group using a big boy letter. Jefferies then sold the securities to Fimat Group without one of the letters, which then sold the bonds to R2 without a letter. Two days after Smith Barney’s sale, World Access publicly disclosed it had no more cash, and the value of R2’s investment plummeted. R2 then sued Smith Barney, alleging that the big boy letter did not exempt the bank from insider-trading liability.

The matter is still pending, according to the law firm Bracewell & Guiliani.

Enter the SEC

The SEC finally weighed in last year with its own case, asserting that “big boy” letters are no defense to SEC enforcement action. The case involved Barclays Bank, which last May agreed to pay $10.9 million to settle insider-trading charges. Steven Landzberg, the bank’s former head trader of distressed debt, also paid $750,000 stemming from allegations that he illegally traded millions of dollars of bond securities over a period of 18 months while aware of material non-public information received through six creditor committees. Landzberg had served as Barclays’ representative on the committees and as its proprietary trader.

BIG BOY COMPLAINTS

Below are three of the complaints filed by the SEC in the United States Securities and Exchange Commission v. Barclays Bank PLC and Steven J. Landzberg.

Defendant Landzberg simultaneously served as Barclays’ representative on the

creditors committees and as Barclays’ proprietary trader of distressed securities. Over a period of eighteen months, the Defendants purchased and sold millions of dollars of securities while aware of material nonpublic information received through six creditors committees—all in breach of fiduciary and similar duties of trust or confidence.

Defendants failed to disclose their illicit trading activities to the sources of

material nonpublic information (the creditors committees and issuers), or to the U.S. Trustee or federal bankruptcy courts. Defendants also failed to disclose the material nonpublic information to trading counterparties.

In connection with three official unsecured creditors committees, Barclays and

Landzberg owed fiduciary duties to all of the bondholders. In a few instances, Landzberg used purported “big boy letters” to advise his bond trading counterparties that Barclays may have possessed material nonpublic information. However, in no instance did Defendants disclose the material nonpublic information they received through official creditors committees to their bond

trading counterparties.

Source

U.S. Southern District Court of New York.

According to the SEC, Landzberg used big boy letters several times to advise his bond trading counterparties that Barclays may have possessed material non-public information. The SEC said that in no instance did Barclays or Landzberg disclose the material non-public information received from creditors committees to their bond-trading counterparties.

The Commission also said that Barclays’ use of a big boy letter did not protect the firm or the trader. Rather, Landzberg and the bank took unfair advantage of this information disparity to reap ill-gotten gains of nearly $4 million.

In a legal bulletin at the time, Cleary Gottlieb said a big boy letter “would seem to provide some legal comfort to the insider in the event that private litigation later ensues where the aggrieved counterparty alleges fraud.” But in cases where the second party has signed a waiver for all legal claims, that waiver might be deemed invalid under Section 29(a) of the Securities Exchange Act of 1934. That clause says that any “condition, stipulation, or provision binding any person to waive compliance with any provision of [the Exchange Act] or of any rule or regulation thereunder … shall be void.”

Becker

“In private litigation on a fraud basis, you must prove you relied on someone’s misstatement,” explains David Becker, a partner with Cleary Gottlieb. “The SEC doesn’t have to prove that. They just have to prove an intentional false statement of material fact or omission.” This is easier to prove, he says.

Now as the SEC continues its crackdown on insider trading, it is warning anyone engaging in such transactions and using “big boy” letters that they will not be immune from enforcement. “They have stirred up the hornet’s nest,” Becker says. “That’s one of the things they want to do when they give a speech. They want to put people on notice.”

Goldsmith

Attorneys now are bracing for the SEC to bring another case so it can address the issue more directly, a tactic the Commission has used routinely in the past. And what are lawyers advising their clients? Barry Goldsmith, a partner with Gibson Dunn, says he would recommend they carefully consider whether they want to use a big boy letter at all.

If a client insists, Goldsmith advises that institutional buyers and sellers use more than boilerplate language. “Make disclosures as specific as you can,” he says.

Greenberg says if it is clear the buyer intends to hold the securities and not resell them quickly, he would argue that the risk of using a big boy letter is low. If it is not clear the buyer will simply hold on to the securities, that party should seriously consider waiting until the SEC’s position is more clear, he says.

The upshot: Greenberg believes there will be a general decrease in the use of these letters. And “that's exactly what the staff had intended” when it recently started speaking out on the issue, he adds.