Several commentators have speculated that Judge Rakoff’s denial of the defendants’ motion to dismiss in SEC v. Payton potentially stripped the Second Circuit’s U.S. v. Newman decision of significant impact in SEC insider trading enforcement proceedings. See, for example, Remote Tippees Beware: Even if the DOJ Can’t Reach You After Newman, The SEC Can, and Insider Trading: Does Payton Begin the Erosion of the Newman Tipping Test? Are they correct? The short answer from this writer’s perspective is “No.” I have two reasons for saying this. First, it is a decision on a motion to dismiss, and almost all of the positions taken in it flow from the extremely low bar set for sufficiency of complaints, especially when the plaintiff is the government. Second, the opinion is fundamentally flawed by the failure to perform the kind of analysis that Newman – and its doctrinal ancestors Chiarella v. United States and Dirks v. SEC – mandate. Judge Rakoff’s opinion is available here: Denial of Motion To Dismiss in SEC v. Payton.
This Was Only a Ruling on a Motion To Dismiss.
First, the opinion addressed a motion to dismiss. All such motions face steep obstacles, especially when the plaintiff is the government (I doubt if 0.1% of the motions to dismiss SEC actions are successful.) The SEC knew that its amended complaint had to make allegations to get past a motion, and it was designed to do so. Whether the evidence will support those allegations is another story entirely.
Judge Rakoff’s opinion is, as it must be, dependent on accepting all possible inferences that may be drawn from facts alleged in the complaint. So, after reciting the allegations, he writes: “drawing (as required) every reasonable inference in plaintiff’s favor,” he finds the allegations of the tippers “intent to benefit” sufficient. Slip op. at 13. He continues: “More generally, taking all the facts in the complaint as true and drawing all reasonable inferences in favor of the SEC, the amended Complaint more than sufficiently alleges that [the tipper and tippee] had a meaningfully close personal relationship and that [the tipper] disclosed the inside information for a personal benefit sufficient to satisfy the Newman standard.” Id. Likewise, his later discussion of allegations relating to the scienter of the downstream tippees who are the defendants in the action, Messrs. Payton and Durant, concludes: “Thus, taking these allegations as true and drawing all reasonable inferences in favor of the SEC, the Amended Complaint more than sufficiently alleges that defendants knew or recklessly disregarded that [the tipper] received a personal benefit in disclosing information to [the tippee], and that [the tipper] in doing so breached a duty of trust and confidence to the owner of the information.” Slip op. at 16.
The rubber meets the road with the introduction of evidence, and its consideration by the trier of fact. Judge Rakoff’s opinion says, and can say, little about that. Especially if the trier of fact is a jury, the jurors’ willingness to find the tippee’s “intent to benefit” the tipper, and the remote tippees’ intent to engage in a fraud, based on the relatively meager facts alleged is another thing entirely. Some people may think that Judge Rakoff’s willingness to draw those inferences from the allegations is powerful because he is a bright, outspoken, and well-regarded district court judge. But they should first consider his background as a former prosecutor, and then recall that his most notable recent decisions involving SEC cases criticize the SEC for (i) not prosecuting aggressively enough, and (ii) accepting settlements without sufficient justification in support of the agreed-upon terms. It is hardly surprising that his review of the complaint reflects a pro-prosecution frame of mind.
In the end, allegations about benefits allegedly flowing between tippers and tippees are bound up in the facts and circumstances of each case. That Judge Rakoff found those allegations sufficient here says little about what another judge will say about other facts elsewhere, or what anyone, even Judge Rakoff, would do when faced with evidence, not allegations. More important is the mindset that should be used to evaluate the sufficiency of such allegations. It is in that respect that Judge Rakoff’s decision misses the mark, and why it should not be accorded future deference.
The Opinion Misses the Mark Because It Fails To Focus on Whether Fraud Is Alleged
Judge Rakoff seems so interested in exploring how the SEC might satisfy the “intent to benefit” standard laid out in U.S. v. Newman that he ignores the more critical issue raised by the allegations, and focused upon in Chiarella and Dirks. He starts out on the wrong track, and never addresses the core, important issue. His statement of the driving factors behind insider trading violations is wrong, and he immerses himself in issues that, while perhaps interesting from a jurisprudential standpoint, make little difference to the claims asserted in the complaint. He fails to ask the most important question in these cases: accepting the allegations as stated, do they provide grounds for inferring that the defendants engaged in fraud in connection with their purchases or sales of securities. The entire discussion of the facts alleged never once seeks to answer that question.
The opinion reflects this flaw from the outset. Here is what Judge Rakoff says in his first paragraph:
As a general matter, there is nothing esoteric about insider trading. It is a form of cheating, of using purloined or embezzled information to gain an unfair trading advantage. The United States securities markets — the comparative honesty of which is one of our nation’s great business assets – cannot tolerate such cheating if those markets are to retain the confidence of investors and the public alike.
Slip op. at 1.
This may sound good, but it is wrong. Insider trading is not “a form of cheating”; it is a form of “fraud” in the context of securities transactions. Even if we give the judge the benefit of the doubt and assume that in his mind “cheating” and “fraud” are equivalents, the error of his statement is apparent in the remainder of that sentence, because insider trading certainly is not “using purloined or embezzled information to gain an unfair trading advantage.” That is wrong in two respects. The use of “purloined” information is not enough to support an insider trading violation because it lacks the aspect of deceit required to prove fraud. (“Purloined” is a fancy way of saying “stolen.”) And insider trading is not at all about having a “trading advantage,” fair or unfair.
In a “classical” insider trading case, one might argue that the transaction is “unfair” because the counter-party can theoretically expect an insider, under the law, to disclose material information before trading, but the real point is the breach of the disclosure duty (which constitutes fraud), not the fairness or unfairness of the transaction. In a “misappropriation” case, this description makes no sense at all, because in such cases, the victim of insider trading fraud is the owner of the information, who was deceived into sharing that information with someone who used it for an unauthorized purpose. The notion that the counter-party to the trade was a victim of an “unfair” transaction reflects acceptance of an equality of information standard in the marketplace, which plainly is not the law. The securities transaction itself need not be “unfair,” and it probably is not, because the counter-party is a willing participant getting the price he wants in a transaction with a stranger.
I focus on this only to show that from the very outset, Judge Rakoff is using language and a mindset that is inconsistent with the law, as laid out by the Supreme Court. As Judge Rakoff points out, there is no statute that prohibits insider trading, no less attempts to define it. Instead, insider trading violates section 10(b) of the Securities Exchange Act of 1934 if, and only if, the transaction is accomplished by means of fraud. This fundamental difference, between focusing on a concept of “fairness” rather than a concept of “fraud,” infects Judge Rakoff’s analysis.
Fraud, as we know, requires intentional deceit. Judge Rakoff says that because the Second Circuit’s opinion in Newman came in a criminal case, it may not control SEC civil cases because there may be instances where conduct that does not constitute criminal “insider trading” may still be considered “insider trading” in an SEC civil action. To be sure, the state of mind requirement for a criminal conviction – “willfulness” – does not apply to SEC civil cases. But even if one engages in a “reckless” fraud (if that concept makes sense, an issue not yet decided by the Supreme Court), it must nonetheless be a “fraud.”
To understand where Judge Rakoff’s opinion flies off the rails, we need to review the facts alleged in the complaint. Defendants Payton and Durant, are what is known as “remote tippees.” In this case, quite remote.
- The “owner” of the information. The information in question was a planned acquisition by IBM of another company, SPSS, Inc. The “insider,” and “owner” of that nonpublic information was IBM and SPSS. But no one at IBM or SPSS traded, or shared information with others for the purpose of trading.
- The original “tipper” and original “tippee” of the information. Instead, the information was learned by a lawyer at the Cravath law firm, Michael Dallas. Mr. Dallas obtained the information lawfully; there is no suggestion he did so deceitfully. Dallas had a close friend, Trent Martin. They engaged in many allegedly confidential conversations, although Dallas surely must have understood that he was not supposed to share client information with a third party, even a close friend. It is alleged that “Martin and Dallas had a history of sharing confidences such that a duty of trust and confidence existed between them. . . . They each understood that the information they shared about their jobs was nonpublic and both expected the other to maintain confidentiality.” Dallas allegedly shared specific information about the IBM/SPSS merger with Mr. Martin on several occasions. There is no allegation that the conduct of either Dallas or Martin relating solely to the sharing of this information between them was fraudulent. Since Dallas gained possession of the information as part of his work, he would not be a “tippee.” But there is no apparent authorization for communicating the information to Martin, so Martin should be considered a “tippee.” That would make Dallas the original “tipper,” and Martin the original “tippee.” Judge Rakoff calls Martin the “tipper”; that is right in the sense that he transferred the information to a second-level tippee, but Dallas plainly makes the first “tip,” although it was not alleged to be fraudulent, and Martin is not alleged to have traded SPSS securities.
- The second-level tippee. Martin shared housing with Thomas Conradt. It is alleged that “They shared a close, mutually-dependent financial relationship, and had a history of personal favors.” Focusing on pleading facts that will pass muster under Newman, the complaint describes several respects in which they assisted or did favors for each other. It also alleges that Martin, “in violation of his duty of trust and confidence to Dallas, tipped inside information about the SPSS acquisition to Conradt,” who bought SPSS securities. This makes Mr. Conradt a “second-level tippee.”
- The third-level tippee. Conradt worked at the same brokerage firm as a registered representative identified as “RR1.” Conradt allegedly told RR1 about the SPSS transaction. That makes RR1 a “third-level tippee.”
- The fourth-level tippees. Defendants Payton and Durant also worked at the same brokerage firm as Conradt and RR1. It is alleged that Conradt “learned that RRl had, in turn, shared the inside information with defendants Payton and Durant.” That makes the defendants “fourth-level tippees.” The complaint also alleges that after hearing about this, Conradt told Payton and Durant that he got the information about SPSS from his roommate, Martin. “On the basis of the inside information they learned from RRl and Conradt, defendants purchased SPSS securities.”
The SEC cause of action is against Payton and Durant. So the question to ask is: How do the allegations try to show that Payton and Durant committed acts of fraud in connection with their purchases of SPSS securities? Judge Rakoff says the following: (1) They knew that Martin was Conradt’s roommate, and that the information about SPSS went from Martin to Conradt to RR1; (2) Conradt told Payton that Martin had been arrested for assault; (3) they never asked Conradt why Martin had given him information about SPSS or how Martin had learned the information; (4) after the IBM/SPSS merger was disclosed to the public, they met with Conradt, RR1 and another Conradt tippee “to discuss what they should do if any of them were contacted by the SEC or other law enforcement,” and they “agreed not to discuss the trading with anyone and to contact a lawyer if questioned”; (5) Payton took steps to hide his transactions; and (6) after receiving an SEC subpoena, they lied to their employer about the origin of their interest in SPSS securities.
These alleged facts simply do not add up to adequate allegations of fraudulent conduct by defendants Payton and Durant, and certainly not under the strict pleading requirements for stating fraud claims under Fed. R. Civ. P. 9(b), which applies to this claim.
Why not? To put it simply, there is no allegation of any deceptive act by the defendants leading up to, and consummating, their purchases of SPSS securities. The bulk of Judge Rakoff’s opinion focuses on the relationships and reasons for communications between Dallas, Martin, and Conradt. Dallas and Martin allegedly had a close confidential relationship, and Martin and Conradt allegedly had “a close, mutually-dependent financial relationship” and “a history of personal favors.” But Conradt is not alleged to have had any special relationship with RR1 or the defendants, and RR1 is not alleged to have had any special relationship with the defendants. Nor are there any allegations that the defendants (Payton and Durant) knew about the existence of the source of the information, Dallas, or anything about nature of the relationship between Dallas and Martin, or Martin and Conradt, other than that Martin and Conradt were roommates and Martin had been arrested for assault.
Nothing about any of these facts suggests Payton and Durant defrauded anyone up to, and including, the consummation of their SPSS security purchases. No facts suggest they owed a duty to disclose anything about what they knew (or, more accurately, were willing to bet on) about a possible IBM/SPSS merger before trading SPSS securities. They were not insiders, and, as alleged, had no knowledge that the information they learned originated with an insider. As a result, there is no basis for finding a duty of disclosure from them to SPSS shareholders. And they had no knowledge that the information they learned had been “misappropriated” from its owner – the only possible owner they knew about was Martin (they are not alleged to have known anything about the relationship of Dallas and Martin), and they had no reason to believe that Conradt misappropriated information from Martin. In fact, the SEC complaint makes it clear that Mr. Conradt did not misappropriate the information from Mr. Martin, since it alleges that Martin intentionally “tipped inside information about the SPSS acquisition to Conradt.”
Judge Rakoff dwells on the alleged fact that neither Payton nor Durant asked Conradt about why Martin gave information to Conradt and how Martin got the information in the first place. But no fact alleged suggests they were under any duty to ask such questions. To be sure, the “willful blindness” doctrine might preclude them from arguing lack of that knowledge in defending the scienter element, although willful blindness seems a stretch here, but Judge Rakoff provides no reason why they had any legal duty to ask such questions before trading on the information they learned from RR1 and Conradt.
So where is fraud alleged against Payton and Durant? Whether an insider trading violation is viewed under the classical or misappropriation theory, it must be founded in deceiving someone by failing to disclose material nonpublic information in advance of trading, when such disclosure is required. That is the fraud. Under the classical theory, a prior disclosure of the information to the counter-party cures any claim of fraud because the disclosure duty is satisfied, eliminating any insider trading liability (the so-called “disclose or refrain from trading” requirement). Under the misappropriation theory, a prior disclosure to the owner of the information of the intent to trade on the basis of the information eliminates the fraud, which is the undisclosed use of the information to trade (assuming the relationship with the owner created a duty to disclose). In each instance, the insider trading liability flows from the deceptive breach of the duty of disclosure.
But no allegation in the complaint identifies any person to whom Payton and Durant owed a duty of disclosure. There is no disclosure they could have made to allow them to go forward with the trades (to satisfy the “disclose or refrain” mandate) because there is no disclosure they were required to make to anyone, based on the allegations in the complaint. Not to Dallas, whom they didn’t know existed; not to Martin, with whom they had no relationship, and to whom even Conradt owed no disclosure duty because he had been given the information without any promise of confidentiality; not to RR1 or Conradt, neither of whom is alleged to have had a special relationship with the defendants, and both of whom knew about their trading anyway; and not to any shareholder of SPSS, because the defendants were not insiders, or even “constructive” insiders by virtue of knowing their information was confidential and originated with insiders.
What about all the alleged post-trading conduct that supposedly evidences “guilty knowledge” or the like? I would argue those allegations could be equally explainable by the defendants’ fear that the authorities or their employer would be concerned about, and would certainly investigate, the trades, even if they were not unlawful. Does Judge Rakoff really believe that running away from the police is evidence of having committed a crime? Even a former prosecutor should be wary about making that connection. In any event, no amount of allegedly incriminating post-trading conduct can turn a lawful trade into an unlawful one. Such conduct would have a bearing on the issue of scienter, but all the scienter in the world doesn’t create a violation where there was none. “Guilty knowledge” doesn’t count for much if the person is, based on the alleged facts, not guilty.
Judge Rakoff discusses none of this, and that is why the opinion is fundamentally flawed. One gets the sense that his overall objective is to try to make sure that people who he believes “cheated” would be held accountable because, as he says it: “The United States securities markets . . . cannot tolerate such cheating if those markets are to retain the confidence of investors and the public alike.” But that is a legislative thought, not a judicial one. He is bound to adjudicate within the strictures of section 10(b), which he does not do. He is so focused on trying to show that the allegations could support an inference satisfying the Newman intent to benefit standard that he ignores the core meaning and analytical framework of Newman, and of Chiarella v. United States, and Dirks v. SEC as well: that fraud is what section 10(b) is all about, not supposedly unfair informational advantages or even sketchy opportunism by traders. The whole point of Newman’s intent to benefit requirement is to assure that nonpublic information known to a trader is the result of fraudulent conduct, not something else, before that person can be found liable under section 10(b), criminally or civilly. A tipper’s unauthorized and undisclosed transmission of information to a tippee simply is not fraudulent unless it is done to obtain some form of tangible benefit that was the object of fraud.
Judge Rakoff’s opinion does nothing to explain how these fourth-level tippees could have section 10(b) liability under the facts alleged. Because the allegations in the complaint in SEC v. Payton fail to provide plausible inferences that their securities trades were founded on fraudulent conduct, not to mention particularized allegations of the fraud (which at least would require identifying the persons defrauded and how), the complaint fails to state a claim under section 10(b), and should have been dismissed.
April 22, 2015
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