On January 12, 2015, the Department of Justice filed a brief in United States v. Durant, 12 Cr. 887 (ALC) (S.D.N.Y.), arguing that the guilty pleas previously entered in that case should be unaffected by the Second Circuit’s landmark ruling in United States v. Newman. A copy of the brief is available here: DOJ Brief in US v Durant. The argument comes down to a simple, and specious, contention that because the Durant prosecution is founded on the misappropriation theory of insider trading, and Newman involved a prosecution based on the “classical” theory of insider trading, they are apples and oranges, and, to mix metaphors, never the twain shall meet. Q.E.D. (at least, so says the DOJ). The arguments presented are formalistic. They fail to analyze the key issue in Newman, which was also the key issue in Chiarella v. United States and Dirks v. SEC: insider trading is a fraud theory, so it must be founded in conduct that is fraudulent. Amazingly, the DOJ brief never discusses why the conduct of the tipper in Durant was fraudulent, and why the tippee defendants knew or recklessly disregarded that fact when they bought options on shares of IBM takeover target SPSS.
Briefly, the facts are as follows. A law firm employee learned about the impending IBM acquisition of SPSS and improperly communicated that information to a friend, Trent Martin. There apparently is no evidence that the lawyer who leaked the information in the first place received any proceeds or benefits from doing so. Martin was a roommate and friend of defendant Thomas Conradt, and told Conradt about the SPSS deal. Conradt told other defendants about the deal. The defendants bought SPSS options and profited on them when the transaction was announced. Four defendants pleaded guilty to insider trading charges before Newman was decided, the fifth, Benjamin Durant, pleaded not guilty and is scheduled for trial on February 23. The four pleading defendants admitted in their plea allocutions that they committed insider trading and knew what they did was illegal. That, of course, was before Newman.
In Newman, the Second Circuit overturned jury verdicts for insider trading by hedge fund traders based on advance earnings information leaked by corporate insiders which eventually led to securities trades before the information became public. The decision is detailed; a lengthy discussion of the opinion can be found here: US v. Newman: 2d Circuit Hands Government Stunning, Decisive, and Far-Reaching Insider Trading Defeat. One key aspect of the decision was the ruling that tippees could have criminal liability for insider trading only if the original source of the information benefited from improperly sharing the information, and the defendants knew about that benefit. The decision turned on analysis of the Supreme Court’s decisions in Chiarella and Dirks, which emphasized the point that insider trading, as a violation of section 10(b) of the Securities Exchange Act of 1934, and SEC Rule 10b-5 thereunder, had to involve fraudulent conduct. Breaches of duty that do not rise to the level of fraud cannot form the basis for a violation of section 10(b) or Rule 10b-5.
The DOJ brief in Durant essentially ignores this core of the Newman opinion. Instead, it makes the simplistic argument that because Newman involved only “classical” insider trading — where the fraud emanates from improper use of inside information by an insider — and not insider trading violations founded on the “misappropriation theory” — where the fraud emanates from the improper use of information obtained from a fiduciary — Newman has no impact on the legal standards for insider trading in the Durant case. The DOJ brief then cites a number of pre-Newman Second Circuit and district court cases that make no mention of the need for evidence of a benefit obtained by a misappropriator to support insider trading violations by his or her tippees. The brief takes a stab at trying to explain why a benefit to the original source should be required for classical insider trading but not misappropriation insider trading, but this discussion is essentially circular: a misappropriation case supposedly turns only on the misuse of information that should be kept confidential because the object is to protect the owner of the information not to prohibit the improper use of the information, but true, classical inside information requires a benefit because . . . the Newman court just said it does.
It’s as if the DOJ lawyers donned blinders that refuse to allow them to see that the critical aspect of insider trading cases — the core element that must be proved to show a section 10(b) violation — is that the unlawful conduct was a fraud. Because under the law the tippees’ liability is an extension of the liability of the primary violator, that means the tipper’s conduct must be fraudulent. (See Dirks: “[t]he tippee’s duty to disclose or abstain is derivative from that of the insider’s duty,” 463 U.S. at 659.) That is why the disclosure of confidential information must be accompanied by a benefit, because frauds are designed to obtain property or benefits through deceit. Instead, the DOJ argues repeatedly in its brief that the only reason for requiring a benefit under the classical theory is “because it evidences the improper motive necessary to give rise to liability for insider trading in this context.” DOJ Brief at 7 (emphasis in original). That’s just wrong. “Improper motive” is an aspect of scienter, which is an element of fraud, but improper motive without improper benefit — the object of the fraud — leaves you with no fraud at all.
There are at least three fundamental flaws in the DOJ argument. First, the argument that a misappropriation alone triggers liability of the source of the information is just wrong. The originator of the information has no securities liability for disclosing it without benefiting from the disclosure. In United States v. O’Hagan, 521 U.S. 642 (1997), the Supreme Court ruled that a lawyer who used confidential client information to trade in securities violated section 10(b). That is because he owed a fiduciary duty to his client to use the information only for the client’s benefit and could not use it to benefit himself secretly, without client approval. His failure to disclose his improper use of the information was fraudulent because he owed his client a duty to disclose the use of that information for some purpose other than its intended use. Nothing about that theory suggests that the mere release of a fiduciary’s information with no more, would constitute fraud, as opposed to a mere breach of fiduciary duty.
Second, the theory proposed by the DOJ — that trading on misappropriated information requires no benefit to flow to the source of the improper disclosure — renders the classical theory of insider trading, and the Newman decision, superfluous. The misappropriation theory of insider trading, a bastardized offshoot of the classical theory, would now subsume the parent. That is because every communication to outsiders of confidential inside information is also a misappropriation of that information under the DOJ theory. Any time an insider breaches his or her duty of confidentiality to the employer or its shareholders by revealing confidential information, the recipient of the information would be in possession of material, nonpublic, misappropriated information. No tippee case would ever have to rely on the “classical” theory, and because that theory is — per the DOJ — more demanding than the misappropriation theory. The classical theory would become defunct. That makes no sense at all.
Third, consider the absurdity of the result the DOJ argues for. The DOJ argues that even though the lawyer who leaked the IBM/SPSS information received no benefit for doing so, the tippees have liability because the tipper was a misappropriator of the information and no benefit to the tipper is required under the misappropriation theory of insider trading. But if the tippees received the same information directly from an insider at IBM or SPSS who received no benefit from the improper disclosure, Newman prevents them from being prosecuted. So whether there is, or is not, liability turns on whether the source of the information was an insider who received no benefit (for which there is no liability) or an outsider working on the transaction who received no benefit (for which, DOJ argues, there is liability). It could be that “the law is a ass,” as Mr. Bumble puts it in Oliver Twist, but absurd new theories of liability that make it even moreso should not be proposed (or accepted).
The flaw throughout the DOJ brief is the complete failure to examine and argue the only point that should matter: why do the facts of Durant, unlike the facts of Newman, show that the source of the information — the lawyer — committed fraud when the information was shared with his friend, or perhaps that his friend committed fraud when the same information was shared by the friend with his defendant roommate? The DOJ does not engage on this issue because the facts seem to be bad. The lawyer probably breached a duty by revealing client confidences, but a mere breach of duty is not fraud. The friend may (or may not) have violated a confidential relationship with the lawyer when he passed the information on to his roommate, but that also is not fraud.
In reality, the DOJ’s flawed argument represents a desperate effort to allow prosecutions for insider trading to continue on the basis on non-fraudulent conduct, as long as the government uses the misappropriation theory. That simply ignores the law as laid down by the Supreme Court in Chiarella and Dirks, as most recently recognized by the Second Circuit in Newman. The district court judge should reject this approach, as should the Second Circuit when the same issue is eventually presented to it.
One final note. All of this does not mean that the defendants in this case could not have been prosecuted for their conduct. The factual discussion in the DOJ brief makes it pretty clear that the tippee traders could have been prosecuted for mail and/or wire fraud, because the brief describes fraudulent conduct by the tippees in the completion of their trading scheme (after-the-fact lying to open a new account, and to employers and investigators about the nature of the trading, being two examples). It is because the prosecutors are greedy for the notoriety that accompanies high-profile insider trading cases that they chose the flawed theory they are now trying to justify.
January 15, 2015
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