Tag Archives: 2d Circuit

Second Circuit Denies Petition for Rehearing En Banc in U.S. v. Newman

The Court of Appeals for the Second Circuit today denied the petition of the Department of Justice for reconsideration of the panel decision, or rehearing en banc, in United States v. Newman.  This is as we had predicted.  See DOJ Petition for En Banc Review in Newman Case Comes Up Short and SEC’s Amicus Brief in U.S. v. Newman Fails To Improve on DOJ’s Effort.

Will the Supreme Court grant a petition for writ of certiorari?

Here is the Order:

Newman Order on Petition for Rehearing En Banc

Newman Order on Petition for Rehearing En Banc

Straight Arrow

April 3, 2015

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Tilton v. SEC: Lynn Tilton Files Latest Challenge to SEC Administrative Proceeding

On April 1, 2015, Lynn Tilton and the private equity funds she runs filed a complaint against the SEC seeking declaratory and injunctive relief against the SEC’s pursuit of an enforcement action against them in the SEC’s captive administrative law court.  The complaint is available here: Tilton v. SEC Complaint.  The complaint follows the general formula of other actions of this nature filed recently.  Perhaps even moreso than usual, since her lawyers, Skadden Arps, were the architects of the action filed by Joseph Stilwell when he was the target of an SEC administrative enforcement action (Stilwell v. SEC).  The Stilwell action was never decided; the SEC case against Stilwell was settled (In the Matter of Joseph Stilwell and Stilwell Value LLC).  Rumor has it that the SEC was especially eager to do so to rid itself of Stilwell’s legal action in the SDNY, but we can’t attest to that.  We previously wrote that the constitutional challenges to the SEC’s administrative law court are far from frivolous in light of existing Supreme Court precedent: Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit.

The Tilton complaint does have some new tweaks, however.  It still presents the theory that the SEC ALJs do not comply with Article II of the Constitution because they are “officers” that have “double insulation” against removal by the President — they cannot be removed from office by the SEC Commissioners other than for cause, and the SEC Commissioners cannot be removed other than for cause by the President.  This is precisely what was found unconstitutional by the Supreme Court in Free Enterprise Fund v. Pub. Co. Accounting Oversight Bd., 561 U.S. 477 (2010).  The only dispute can be whether the SEC ALJs are “officers” within the meaning of Article II.  But the Tilton complaint adds a second theory: that “SEC ALJs have not been appointed by the SEC Commissioners, as the Constitution requires.”  That theory is based on the argument that the SEC is “a “Department” of the United States,” that “the Commissioners collectively function as the ‘Head’ of the Department with authority to appoint such ‘officers,’ but that the SEC ALJs are not, in fact, appointed by the Commissioners.  The complaint alleges that: “The Commissioners have not appointed ALJs, as constitutionally required. SEC ALJs are hired by the SEC’s Office of Administrative Law Judges, with input from the Chief Administrative Law Judge, human resource functions and the Office of Personnel Management.  In some cases, ALJs have been simply transferred to the Commission from FERC and other federal agencies.  The Commissioners themselves are not involved in the appointment of ALJs.”

The Tilton complaint is also supplemented with new allegations based on events after the Stilwell and Peixoto complaints were filed.  These include the call by Commissioner Piwowar for the adoption of standards for determining the forum to be used in SEC enforcement actions, and the inability of Enforcement Director Ceresney to identify in Congressional testimony any such standards.  And, unlike the Stilwell case, Ms. Tilton and her private equity funds are not subject to statutorily-mandated SEC regulatory control.

The actions that have been filed against the SEC to enjoin an administrative proceeding have so far run into a roadblock because federal judges have concluded that even if the complaints had merit, the requirements for injunctive relief are not satisfied because the plaintiffs can eventually get their constitutional challenges heard if they lose their administrative case and pursue an appeal to a federal court of appeals.  See SEC Wins First Skirmish on Constitutional Challenge to Chau Administrative Proceeding.  One of the judges even dismissed the claim despite finding that the “claims are compelling and meritorious.”  See Court Dismisses “Compelling and Meritorious” Bebo Constitutional Claims Solely on Jurisdictional Grounds.  These courts say that the SEC’s targets will not suffer “irreparable harm” from being forced to use the administrative process to adjudicate their constitutional challenges. That’s lawyer-speak for telling folks that they have to suffer through years of a potentially unlawful proceeding, and the expense of that proceeding, in order to get a court to decide whether it was lawful in the first place.  Not exactly a shining moment for the American judiciary, but judges are lawyers, and lawyers have, in the words of a former colleague of mine, “an instinct for the capillary.”

Ms. Tilton tries to overcome this obstacle by alleging in her complaint that there are special reasons in her case why that kind of delay would be debilitating, and therefore her case does satisfy the irreparable harm requirement.  She alleges:

The SEC’s administrative machinery does not provide a reasonable mechanism for raising or pursuing Plaintiffs’ claims.  The SEC’s Rules of Practice do not permit counterclaims against the SEC, nor do they allow the kind of discovery of the SEC personnel necessary to elicit admissible evidence of such claims, such as interrogatories and demands for admissions.  Meaningful judicial review cannot await an appeal to the U.S. Court of Appeals following a final Commission decision. The curtailed ALJ proceeding is unlikely to create a full record on Plaintiffs’ claims adequate for review in the Court of Appeals. As described in greater detail below, Plaintiffs perform a sensitive role managing investment funds and deeply distressed companies that employ tens of thousands of people.  If they are forced to undergo an unconstitutional administrative proceeding, and are found liable, it may well be too late to salvage important value for the funds.  The OIP allegations do not take issue with Ms. Tilton’s and Patriarch’s performance of their vital function in executing the investment strategy of turning around distressed businesses, and an unconstitutional administrative proceeding should not be permitted to interfere with such performance and put American jobs at risk.  The SEC ALJ is in no position to rule that he or she has been unconstitutionally appointed and has no legal authority whatsoever. And the Commission, having ordered the administrative proceeding and directed action by the SEC ALJ, is in no position to take a fresh look at the constitutional infirmities of its own ALJ program.

*          *          *

Without injunctive relief from this Court, Plaintiffs will be required to submit to an unconstitutional proceeding. This violation of a constitutional right, standing alone, constitutes an irreparable injury. The lack of traditional procedural safeguards in SEC
administrative proceedings further exacerbates that harm.

Allowing the SEC to pursue an administrative proceeding while the instant complaint is pending would require the expenditure of substantial legal fees defending against an unconstitutional action.  Moreover, plaintiffs cannot assert counterclaims or seek declaratory relief in an administrative proceeding, foreclosing any possibility of review until an appeal to a federal circuit court of appeals.  The burdens incurred during an administrative proceeding would be for naught, because such administrative proceeding is unconstitutional and the SEC likely would try to reprise its case in a lawful setting, such as federal district court.  However, forcing Plaintiffs to litigate twice would compound costs, lost time, and reputational risk….

The availability of an appeal after an administrative proceeding to a federal circuit court of appeals cannot avoid it, because the administratively-imposed sanction already may take effect – and the damage therefore already substantially and harmfully done – by the time the appellate court made a ruling.

Likewise, the harm cannot be remedied after the fact by money damages.  Various immunity doctrines substantially constrain Plaintiffs’ ability to seek damages from the SEC.  Furthermore, even if damages were procedurally available, the reputational harm to Ms. Tilton and Patriarch – possibly permanent and devastating to Ms. Tilton’s business – should the SEC impose administrative sanctions would be impossible to monetize.  And because Ms. Tilton’s business model involves debt and equity positions in private distressed companies, which positions are illiquid, accurately calculating the value of the lost ownership opportunities that would result from an unfavorable ruling in an unconstitutional administrative proceeding would be well-nigh impossible.

We will see whether this effort is successful, or perhaps whether the judge hearing the case, Judge Ronnie Abrams, has a more realistic sense of what constitutes irreparable harm in an action in which the very forum that is used to adjudicate the SEC’s claims is the subject of a constitutionality challenge, and the financial entities involved may well be defunct before judicial consideration is possible.

Straight Arrow

April 2, 2015

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SEC Wages Desperate Battle To Limit Newman in SEC v. Payton and Durant

In addition to joining the DOJ in the effort to get the panel decision in United States v. Newman reconsidered en banc, the SEC continues to pursue arguments in lower courts to emasculate the substance of the Newman decision.  The latest example of that is in SEC v. Payton and Durant, No. 14-cv-4644 (S.D.N.Y.), which is the SEC civil enforcement action that parallels DOJ criminal actions in U.S. v. Durant and U.S. v. Conradt.

These cases all involve the same factual circumstances – trading by alleged tippees in possession of inside information about a future IBM acquisition of SPSS, a software company.  A law firm employee allegedly learned about the impending IBM acquisition of SPSS and improperly communicated that information to a friend.  The friend told his roommate and friend about the SPSS deal, who then allegedly told Durant and Payton about the deal.  We discussed the criminal cases against Durant and Conradt in earlier posts about the impact of the Newman decision here (U.S. v. Durant: DOJ Argument that Newman Reasoning Does Not Apply to Misappropriation Theory Misses the Mark) and here (First Post-Newman Shoe Drops: Insider Trading Guilty Pleas Vacated in U.S. v. Conradt).

The SEC’s civil action was originally filed against Payton and Durant in June 2014, well before the Second Circuit’s December 2014 Newman decision.  The allegations were essentially as follows. Michael Dallas, a lawyer at the Cravath firm, learned about the IBM transaction from his work at the firm and discussed the impending IBM transaction with his close friend, Trent Martin.  Dallas and Martin supposedly had a close confidential relationship, and Martin supposedly knew the information was to be kept confidential. Martin nevertheless traded securities based on that nonpublic information, which the SEC alleges was a “misappropriation” of the information.  Martin also conveyed the information to his roommate, Thomas Conradt, but there was no allegation that Martin received anything for the information, told Conradt how he obtained the information, or intended it as a gift to Conradt.  Conradt traded on the information and also shared the information with co-workers Payton and Durant.  There was no allegation that Conradt told Payton or Durant how Martin learned the information.  The original complaint can be found here: Original Complaint SEC v. Payton.

In short, defendants Payton and Durant are alleged to be tippees several times removed from the original source, Dallas, the Cravath lawyer.  The SEC pleads Martin’s communication of the information as a “misappropriation,” but it was effectively an unauthorized transfer of information from Dallas.  In any event, Payton and Durant were alleged to have no involvement in, or knowledge of, the circumstances of the Dallas to Martin information transfer, or the Martin to Conradt information transfer.

The allegations about the transfer of information from Conradt to Payton and Durant were slim, indeed.  They all were alleged to be co-workers and friends, and then the complaint alleges:

  1. On or prior to July 20, 2009, Conradt disclosed to both Durant and Payton the Inside Information, including the names of the parties to the impending transaction, the price, and that the deal would occur soon.
  2. At the time Conradt disclosed this information to Durant and Payton, he also  informed them that his friend and roommate had disclosed the information to him.

In other words, all that was alleged was that Conradt disclosed the information to Payton and Durant, and that he learned the information from his friend and roommate.  There can be little doubt that this falls short of the Newman requirement that tippees must have specific grounds to believe that the original information transfer was fraudulent.

Thus, it seems pretty plain that the original complaint failed to support an insider trading claim under the Newman standards.  But after Newman was decided, the SEC chose not to amend its complaint.  On February 23, 2015, the defendants moved to dismiss the complaint, laying out the reasons why the allegations did not support a claim of insider trading fraud against either Payton or Durant.  The memorandum in support of that motion is here: Motion To Dismiss in SEC v. Payton.

The SEC did not bother to defend the original complaint.  After the motion to dismiss was filed, it amended the complaint.  (See here: Amended Complaint SEC v. Payton.)  This is not unusual.  Like many plaintiffs, the SEC often files relatively minimalist complaints, hoping it can get by with only minimal factual allegations.  That causes the defendants to incur costs on a motion to dismiss, and allows the plaintiff to learn from the motion papers, and respond by filing an amended complaint, without even trying to oppose the motion.  (Other plaintiffs have the excuse that they often lack access to key information needed to draft a more complete complaint. But the SEC has no such excuse – it fully investigates the facts with subpoena power before a case gets filed.)  Here, the legal insufficiency of the original complaint should have been obvious after Newman was decided.  The SEC lawyers should not have caused the defendants the substantial expense of preparing motion papers on the original allegations if they knew – as they must have – that they would amend the complaint if a motion were filed.  In a fair world, the costs of preparing that motion would be charged to the SEC.

In its amended complaint, the SEC expanded its discussion of the nature of the interactions between Martin and Conradt, including alleging that Conradt helped Martin with some legal problems, and Martin was grateful for the help.  However, not much was added in the amended complaint about how much Payton and Durant knew about the Martin-Conradt interactions, or about how Martin came by the information.  Here is what the amended complaint says on that issue:

  1. Both defendants Payton and Durant had experience in the securities industry prior to their employment at the Broker. Accordingly, Payton and Durant often assisted Conradt in his duties at the Broker. Among other things, Payton and Durant gave Conradt advice on good Broker-approved stocks for clients, helped him with work problems, and provided him leads for new clients. For example, in mid-June 2009 an issue arose regarding commissions Conradt felt he was owed by Broker. Conradt turned to Payton and Durant for their advice and Payton interceded with Conradt’s supervisor. Conradt thanked Payton and Durant for their help and wrote to Payton, “I owe you one.”
  1. Prior to July 20, 2009, Conradt had discussed both his apartment and his roommates with defendants Payton and Durant. Both Payton and Durant knew that Martin was Conradt’s roommate and friend, and that Martin worked at a securities firm. Additionally, Conradt told Payton about Martin’s assault arrest near Grand Central Station.
  2. On or before June 24, 2009, Conradt told RR1 the Inside Information. On June 25, 2009, RR1 purchased 20 July SPSS call options with a strike price of $35.
  3. On or before July 1, 2009, Conradt learned that RR1 had told defendant Durant the Inside Information that Conradt had previously told RR1. Conradt then personally told defendants Payton and Durant that his roommate Martin had told him that SPSS was likely going to be acquired. Knowing that Conradt was Martin’s roommate, Payton and Durant did not ask Conradt why Martin told Conradt the Inside Information and did not ask Conradt how Martin learned this information.

In other words, there is no allegation that Payton or Durant were told anything about the nature, propriety, or impropriety, of the transfer of information from Dallas to Martin, or the reason why the information was transferred by Martin to Conradt.  The best the SEC could do on those points was alleged that they “did not ask why Martin told Conradt the Inside Information and did not ask Conradt how Martin learned this information.”

This would appear to fall well short of the Newman requirement that distant tippees have a factual basis to believe the earlier information transfers were fraudulent.  Payton and Durant are alleged to have known nothing about those transfers – for all they knew, Martin’s knowledge and transfer of the information was not unlawful, nor was Conradt’s. The complaint tries to turn that lack of knowledge into an asset, on the apparent theory that Payton and Durant had a duty to learn the answer to those questions before trading on the information.  If this theory of liability were accepted, Newman would be effectively nullified.  Even without knowledge, distant tippees would become liable for not inquiring into the basis for information communicated to them.  Here is the SEC’s memorandum arguing that the amended complaint is sufficient: Opposition to Motion To Dismiss in SEC v. Payton.

Judge Jed Rakoff, who is presiding over the case, had a hearing with counsel after the SEC amended its complaint.  Presumably, at that hearing the court adopted a schedule for defendants to file a new motion to dismiss the amended complaint and supporting memorandum that addresses the new allegations in the amended complaint.  I look forward to seeing how defense counsel treat the SEC’s latest legerdemain on stating insider trading fraud claims under section 10(b).

Straight Arrow

March 11, 2015

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Let’s Get Real: When SEC “Disgorgement” Remedy Is Used as Punishment It Should Be Treated that Way

Virtually every SEC enforcement proceeding includes a request for so-called “disgorgement” relief.  Once upon a time, “disgorgement” meant that a wrongdoer should be denied benefits he or she gained from misconduct.  As a matter of justice or fairness, that seemed hard to argue about.  There seems no good reason why someone found liable for misconduct should be entitled to retain the benefits of that misconduct.  And there would seem to be good reasons why that shouldn’t happen: otherwise one could argue we leave in place an economic incentive to commit wrongdoing, if the proceeds of misconduct exceed penalties imposed once liability is found (plus other costs of the proceeding).

But where the rubber meets the road, things get more complex.  How exactly should we figure out what the “ill-gotten gains” really are?  How do we take into account potential ongoing civil liabilities for that conduct?  Is it really “disgorgement” of ill-gotten gains if victims of the misconduct can recover those amounts in civil actions, perhaps benefited by application of collateral estoppel against the wrongdoer on the issue of liability?  Is it “disgorgement” to cause multiple liabilities for the same “ill gotten gains”?  What about other possible governmental liability for the “ill-gotten gains”?  If another governmental entity has a claim to recover some or all of those amounts, how many times should the government get to recover the gains, plus impose “penalties”?  What if there are parallel criminal and civil government enforcement actions?  Is it “piling on” to impose a “disgorgement” on top of a  criminal fine, possible criminal forfeiture, and civil penalties, which together are much larger than any possible “ill-gotten gains”?

It gets even more complex.  What rights does an accused have when he faces government actions for “disgorgement,” on top of civil penalties and other possible forms of relief?  An accused has a right to a jury trial in any criminal action, but also has a Seventh Amendment right to a jury in many civil actions.  As a relic of history, there is no Seventh Amendment right to a jury in a civil action that would, in former days, have been tried in courts of “equity.”  Should disgorgement be treated as an “equitable” remedy for which there is no right to jury trial?  Does that seem right (might one say “equitable”?) if the “disgorgement” calculation proposed by the government could result in a liability that vastly exceeds any possible civil penalty that is permitted by statute?  Indeed, does it ever really make sense to allow a “disgorgement” theory that results in findings of liability that dwarf the statutory limits on penalties that can be awarded in a case?  And what about time limits on seeking disgorgement relief?  There are statutes of limitation for criminal and civil actions, but, again as a vestige of judicial history, those statutory time limits don’t apply to actions for so-called “equitable relief.”  If actions for civil penalties are time-barred, should it really be possible to pursue stale liability claims solely for “disgorgement”?  How about if the stale claims for “disgorgement” seek amounts that vastly exceed the possible penalties that are time-barred?

These are complicated and nuanced questions, which have multiple layers of issues of fairness and public policy.  Unfortunately, the SEC has little patience for any such considerations.  It not only takes a knee-jerk position that what it calls “disgorgement” should be pursued in every case, but it opposes any meaningful restriction on how it should calculate such “disgorgement,” and opposes allowing an accused procedural rights to fight disgorgement like other civil liabilities.  Not only that, the SEC has also decided that “disgorgement” doesn’t really mean that a wrongdoer must give up his or her ill-gotten gains; to the SEC, it means that the wrongdoer must also pay amounts gained and retained by other persons as a result of the misconduct.  (As an example, just look at the SEC’s most recent effort in SEC v. McGee to get an insider trader to be responsible for “disgorgement” that includes not only the $292,000 he earned in alleged illegal profits, but also more than $1 million in alleged profits earned not by him, but by the “downstream” tippees who traded.)  And as to the calculation of “ill-gotten gains,” let’s just say that the only principle the SEC accepts in doing such calculations is that “more is better.”

Unfortunately, courts have been much too willing to accept aggressive SEC theories of “disgorgement,” which naturally has led to increasingly more outrageous SEC disgorgement calculations on the “more is always better” theory of law enforcement public policy.  The law in this area is now so prolix it is impossible to follow.  Somehow, we have reached the stage where, contrary to every sense of fairness and due process, a defendant is required by some courts to bear the burden of proving that a proposed SEC disgorgement calculation is incorrect, as long as the SEC proposal is deemed by the court to be plausible.  This judicial recognition of the concept “close enough for government work” as the rule of law in an enforcement proceeding is a mockery of due process, especially when what is at issue often may be amounts of supposed “disgorgement” that make the defendant bankrupt or destitute.  And, in a bizarre rejection of jurisprudence on the issue of causation, although the courts agree that for disgorgement not to be a form of punishment, it must be “causally connected” to the wrongdoing, some courts now accept that the proceeds of misconduct can be determined by mere “but for” causation, notwithstanding what may be, at best, strained proximity between the wrongdoing and the ultimate proceeds.  These are not just district court decisions, but influential appellate decisions in the Second and Third Circuits as well.  See SEC v. Contorinis, 743 F.3d 296 (2d Cir. 2014); SEC v. Teo, 746 F.3d 90 (3d Cir. 2014).  The SEC often takes the position that a company employee who commits or assists in a violation should “disgorge” all or portions of his or her salary, apparently on the bizarre (and, of course, unproven) theory that they were paid for the violations and not to perform actual duties as employees.  Some courts actually accept this nonsense.

In short, a combination of SEC over-exuberance, to be kind, and judicial acceptance, has resulted in bringing the securities “disgorgement” remedy far from its origins as a means of divesting a wrongdoer of his or her ill-gotten gains.  This departure raises serious questions about whether what is now labeled a “disgorgement” remedy is, in fact, a traditional form of equitable relief.  See The Equity Façade of SEC Disgorgement, and Thinking about SEC Disgorgement.  There is no doubt that Supreme Court consideration will ultimately be required.

The issue of disgorgement relief is so significant and complex, it is impossible to address in a single blog post.  On several previous occasions, we have discussed the issue in specific enforcement contexts.  The SEC v. Wyly enforcement action provided several opportunities to examine the issue.  In that case, Judge Scheindlin issued one decision describing the current state of the law of disgorgement in the Second Circuit, and then refusing to follow it because the result was so plainly inequitable.  See SEC v. Wyly: New Scheindlin Disgorgement Opinion Shows How SEC Remedy Has Gone Awry.  Judge Scheindlin also rejected some of the SEC’s more far-fetched theories of unlawful proceeds — including the notion that all of the increased value of stock the Wylys over a 13-year period should be disgorged when the only violation found was that they failed to disclose those holdings in section 13(d) disclosure filings, which certainly did not drive the increasing value of the stock.  See SEC v. Wyly III: SEC’s Overreach on Disgorgement Remedy Shot Down.  On the other hand, Judge Scheindlin ultimately awarded as a “disgorgement” for securities law violations a supposed unlawful tax avoidance that, if it truly was an unlawful tax avoidance, could be recovered by the IRS — and was actively being investigated by the IRS.  As a result, the defendants will be required to “disgorge” as supposed tax benefits either amounts the IRS do not allow them to retain (meaning there are no real “ill-gotten gains” to disgorge), or amounts the tax authorities determine were not, in fact and law, unlawful tax avoidances, in which case there also is no ill-gotten gain.  (Judge Scheindlin’s disgorgement order tried to address this issue by allowing disgorged amounts to be “credited towards any subsequent tax liability determined in an IRS civil proceeding as a matter of equity,” but the effect of that determination is far from clear, since the IRS is not a party to the SEC case.  She also tried to account for the possibility that tax was not really avoided by allowing a motion to vacate the judgment if another court rules that no taxes were owed — but not if the IRS itself determines not to assert any unlawful tax avoidance — which on its face is a half-baked approach to the issue, since much tax policy is determined without a court determination.)  This is “Alice in Wonderland” jurisprudence.  See Wyly Brothers Hit with More than $300 Million Securities Law Disgorgement Order for Unpaid Taxes.  As a result of the huge “disgorgement” imposed by Judge Scheindlin, Sam Wyly, once one of the wealthiest men in America as a result of growing a huge retail and securities empire with his now-deceased brother, is in bankruptcy.

Another example of disgorgement without bounds discussed in earlier posts is the SEC’s outrageous calculation of a $2 billion disgorgement in SEC v. Life Partners Holdings, Inc., which we discussed here: SEC Again Runs Amok, Seeking $2 Billion in Texas Case.  Fortunately, the district court rejected this absurd contention: see SEC Gets Reasonable Relief in Life Partners Case — but only 2.5% of $2 Billion Request.  The combined penalties and disgorgement issued in that case still forced the company into bankruptcy.  One wonders how “equitable” that felt to the company’s shareholders, whom the SEC presumably was trying to protect.

Which brings us to the disgorgement dispute du jour: whether the SEC’s effort to obtain “disgorgement” in SEC v. Graham should be permitted because, unlike the civil remedies found time-barred in that case, the five year statutory statute of limitations under 28 U.S.C. § 2462 does not apply to the portion of an enforcement action seeking disgorgement.  Section 2462 bars government civil claims for fines, penalties, or forfeitures, “pecuniary or otherwise” if they are not commenced “within five years from the date when the claim first accrued.”  For years, the SEC argued for a restrictive reading of section 2462 which would allow it to pursue claims for five years after they were “discovered,” rather than five years from when they accrued.  That position was finally put to rest by the Supreme Court in Gabelli v. SEC, 133 S. Ct. 1216 (2013).  Since then, the SEC has been searching for other ways to pursue enforcement actions after the five-year period expires.

In Graham, the SEC alleged a classic Ponzi scheme, in which the alleged perpetrators promised wealth-creating returns to purchasers of condominium units that were to be renovated and rolled into a large, nationwide resort.  As alleged, the returns paid to investors were funded by later purchases of new investors.  Because the last condominium sale occurred in 2007, however, and the SEC didn’t commence any action until 2013, the district court held that section 2462’s five-year statute of limitations barred all of the SEC’s claims.  District Judge King rejected the SEC’s argument that its claims should continue for the requested relief of disgorgement and an injunction because those were equitable claims and therefore not subject to any statute of limitations.  On the issue of disgorgement, Judge King wrote: the “disgorgement of ill-gotten gains . . . can truly be regarded as nothing other than a forfeiture (both pecuniary and otherwise),” which is expressly covered by section 2462.  “To hold otherwise would be to open the door to Government plaintiffs’ ingenuity in creating new terms for the precise forms of relief expressly covered by the statute in order to avoid its application.”  See his opinion here: SEC v. Graham.

In our discussion of this case at the time (see SEC v. Graham: SEC’s Delay in Filing Causes Ponzi Scheme Claims To Be Dismissed) we said: “This last ruling is dagger for the SEC.  Its litigation position is always that the non-penalty relief involves equities, not penalties, which relieves the SEC of unpleasant litigation burdens (including taking those issues away from a jury).  To be fair, most courts have historically agreed with that view, although the analysis is typically thin.  But in recent years the courts have tended to take a much more critical view of the relief the SEC always seeks because it often is highly punitive, even though the SEC portrays it as otherwise.  But that is an issue for another day.”  That other day has now arrived.  The SEC’s appeal is now before the Court of Appeals for the Eleventh Circuit in SEC v. Graham, No. 14-13562-E.

Will the Eleventh Circuit look past SEC’s label of “disgorgement” and recognize that so-called “disgorgement” relief has, in reality, become a harsher form of penalty than the civil “penalties” the SEC is permitted to obtain by statute?  Will the court accept the SEC argument that the “disgorgement” remedy is no more than long-standing ancillary equitable relief forcing divestiture of ill-gotten gains, and therefore not a penalty or forfeiture and not covered by section 2462?  Or will the court take note of the myriad ways that the SEC has caused the disgorgement concept to mutate in one the most severe forms of punishment in its arsenal of punitive weapons?

The Securities Industry and Financial Markets Association (SIFMA) is hoping it can convince the Eleventh Circuit court to see things as they are, not as they are labeled.  It filed an amicus brief in support of affirming the decision below, which seeks to explain why the SEC’s actions for these so-called “equitable” remedies are government enforcement actions that are, and should be, within section 2462’s actions for “civil fine, penalty, or forfeiture, pecuniary or otherwise.”  SIFMA’s brief is available here: SIFMA Amicus Brief in SEC v. Graham.

Whichever way the Eleventh Circuit goes on this, the many disgorgement issues mentioned above will remain, and will have to be resolved over time.  Let’s hope the courts will more consistently look at “disgorgement” on a case-by-case basis, and treat it in all respects for what it really is in each case, rather than allowing the SEC to label punishment as “disgorgement,” like a wolf in sheep’s clothing.

Straight Arrow

March 3, 2015

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Law Professors Argue that Newman Panel Decision Enhances Market Integrity

Professors Stephen Bainbridge (UCLA Law School), M. Todd Henderson (Chicago Law School), and Jonathan Macey (Yale Law School) jointly filed an amicus brief in opposition to the DOJ’s petition for rehearing en banc of the panel decision in United States v. Newman. The sole point of the professors’ submission was to contest the contention of the DOJ and the SEC that the Newman decision threatened the integrity of the United States securities markets.  The professors argued that, to the contrary, the panel’s application of the “personal benefit” standard stated by the Supreme Court in Dirks v. SEC enhanced the integrity of the securities markets by reducing the “chilling effect” on lawful disclosures of a vague rule favoring government flexibility in determining when disclosures are unlawful.  The amicus brief is available here: Amicus Brief of Professors Bainbridge, Henderson and Macey in U.S. v. Newman.

As they summarized at the outset of the brief: “Far from endangering the integrity of the markets, the Newman opinion correctly applies the Supreme Court’s personal benefit test—a test founded in the Supreme Court’s explicit determination that the market must be protected from the chilling effects of standardless liability for insider trading.  The threat to market integrity comes not from Newman’s correct application of the personal benefit test, but from the government’s and the SEC’s campaign to make Dirks’s ‘personal benefit requirement . . . a nullity.’  Newman op. at 22.”  Professors’ Brief at 3.

The professors argued that the Supreme Court’s adoption of the “personal benefit” requirement in Dirks was specifically aimed at finding a way to differentiate between lawful and unlawful disclosures of nonpublic information in order to assure that lawful disclosures, which enhance marketplace efficiency and integrity, are not “chilled” by creating an uncertain prospect of liability for such disclosures under a less than clear standard.  The Dirks Court drew the line with the “personal benefit” standard: “The distinction between fraudulent disclosure, in breach of that duty, and permissible disclosure, turns on the purpose for which disclosure is made.  [Citing Dirks v. SEC, 463 U.S. 646, 662 (1983).]  The ‘personal benefit’ test is the litmus test used to gauge the underlying purpose that motivates the insider to disclose information.  Unless the insider ‘personally benefits’ from the disclosure, there is no breach of duty, and so no derivative liability if the recipient of the information trades.”  Professors’ Brief at 4.

The Dirks standard was founded on precedent and the language of the statute, but also “on an explicit policy determination to protect the market from the threat of prosecutorial over-reaching.”  Id.  The “SEC advocated for a far broader liability rule than the Supreme Court was willing to countenance.”  The Dirks Court rejected the SEC’s broader standard of illegality “on the explicit policy ground that the SEC’s rule would impair ‘the preservation of a healthy market.’”  Id., quoting Dirks, 463 U.S. at 658.  The Dirks court was explicitly protecting the ability of market analysts to “ferret out” information from insiders, which “enables more accurate pricing in capital markets and helps to assure that capital will ultimately be allocated to the highest value users.”  Professors’ Br. at 5-6, citing Dirks, 463 U.S. at 658-59.  Accordingly, “Broad prohibitions against trading based on material, non-public information—such as the SEC’s proposed interpretation of Section 10(b) in Dirks—ultimately damage the overall health of the market, because they limit the incentives of market participants to seek out information on which to trade.”  Id. at 6.

 The Professors note that the “personal benefit” test was the Supreme Court’s means of proving a “limiting principle” for investors and analysts using “objective criteria.”  Id. at 8.  In the professors’ view: “To effectively protect the socially beneficial activities of market participants operating under the eye of the SEC, requires definite and objective limits on the scope of insider trading liability.”  As the Dirks Court said, relying “on the reasonableness of the SEC’s litigation strategy” as the only assurance that activities will not be prosecuted “can be hazardous.”  Id. at 8, quoting Dirks, 463 U.S. at 664 n.24.

The professors argue that the Newman panel drew the right line.  “The Newman panel correctly recognize[ed] that the government would make ‘a nullity’ of the personal benefit rule.”  Professors’ Brief at 12.  “Newman protects the integrity of the market by placing a meaningful and objective limit on the scope of insider trading liability, allowing investors[,] analysts and insiders to function with reasonable certainty and security about whether their conduct violates the law.  In contrast, the government’s version of the personal benefit test fails to supply a standard to which market participants can reasonably conform their conduct.”  Id.

Straight Arrow

Feb. 26, 2015

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Chiasson Opts for Mocking Tone in U.S. v. Newman Brief

Counsel for defendant Anthony Chiasson used a rhetorical mocking tone in the appellate brief filed on his behalf in response to the DOJ’s petition for rehearing en banc in United States v. Newman.  The brief opens by likening the DOJ to “Chicken Little” screaming “the sky is falling,” arguing that the Government’s rehearing petition “echoes Chicken Little’s complaint.”  It then declares that the DOJ’s “tone is less that of a frightened hen and more that of a petulant rooster whose dominion has been disturbed.”  The brief later takes a rhetorical shot at the SEC: “The SEC, like “Turkey Lurkey” in the “Chicken Little” folk tale, joins in the lament that the regulatory “sky is falling.”  (Dropping a footnote to explain who Turkey Lurkey is seems more than a little self-indulgent.)  A copy of the Chiasson brief can be found here: Brief of Anthony Chiasson in opposition to DOJ Petition for Rehearing en banc in U.S. v. Newman and Chiasson.

An appellate brief is not a blog post (where we have in the past taken the Government for “sky is falling” arguments: see SEC’s Amicus Brief in U.S. v. Newman Fails To Improve on DOJ’s Effort).  Rhetoric rarely is the winning play in an appellate brief, and ridicule is a dangerous way to play the upper hand in an appellate dispute with the Government.  That is especially so when a “just the facts ma’m” approach seems well-tailored to win the day.

Fortunately, the Chiasson brief does come back down to earth to present compelling arguments in favor of denying the rehearing petition.  The brief does point out in its first section that “contrary to the government’s argument, the Opinion leaves intact the rule that the government can prevail if it shows that the tipper made a gift of material nonpublic information to a friend, anticipating and intending that the friend would trade on the information and earn trading profits. . . .  However, the mere existence of a friendship, and the disclosure of information to a friend, is not enough.  There must be either the expectation of a quid pro quo or the intention that the recipient trade on the information and reap profits.  This analysis is faithful to Dirks and its progeny.”  Chiasson Brief at 6-7.  And it also captures the key flaw in the DOJ’s approach to the “personal benefit” requirement: “In its Petition, as in its prior briefing, the government ignores the central point of Dirks, which identifies the tipper’s exploitation of confidential information for personal benefit as the gravamen of culpable insider trading.  Rather than accepting this rule of law, which has been stated more than once by the Supreme Court, the government apparently wishes to water down the meaning of ‘personal benefit’ so that, as a practical matter, it can bring insider trading charges whenever someone trades on material nonpublic information that is disclosed without authorization by a company insider.”  Id. at 7-8.

Most importantly, the brief emphasizes that an insider trading section 10(b) violation must be anchored in fraud, noting that conduct that “may violate corporate policy or the SEC’s Regulation FD” but still not be “fraudulent self-dealing under Dirks and its progeny, and does not open the door to prosecution for insider trading.”  Id. at 8.  They might have added that the “personal benefit” requirement is what converts the conduct to fraud, which requires deceit to obtain property or its equivalent.

All of this harkens back to the decision in Dirks v. SEC itself.  The DOJ and SEC arguments in Newman effectively seek a Second Circuit imprimatur that they may elide the Dirks opinion.  The Dirks Court noted that the requirement was critical to assure there were limits on the breadth of insider trading enforcement actions, which the DOJ and SEC are now trying desperately to avoid: “Determining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts.  But it is essential, we think, to have a guiding principle for those whose daily activities must be limited and instructed by the SEC’s inside trading rules, and we believe that there must be a breach of the insider’s fiduciary duty before the tippee inherits the duty to disclose or abstain.  In contrast, the rule adopted by the SEC in this case would have no limiting principle.”  Dirks v. SEC, 463 U.S. 646, 664 (1983).  Lest this not be perfectly clear, the Dirks Court added by footnote: “Without legal limitations, market participants are forced to rely on the reasonableness of the SEC’s litigation strategy, but that can be hazardous, as the facts of this case make plain.”  Id. n.24.  Chiasson or Newman might well add: “as the facts of this case make plain as well.”

The Chiasson brief goes on to explain why the DOJ provides no valid reason for a rehearing to reconsider the analysis of the evidence of personal benefit in the panel decision.  This is especially so as to the lack of any evidence of knowledge by Messrs. Newman or Chiasson of any possible personal benefit that may have flowed to the original tippers.  As the brief points out: “The government now explicitly declines to challenge” the key holding “that a tippee must know that an insider has disclosed material nonpublic information in exchange for personal benefit in order to commit insider trading.”  Id. at 2.

Finally, the brief does a good job of laying waste to the Government’s contention that the Newman decision “threatens the integrity of the securities markets” (albeit with unnecessary recurring references to Chicken Little).  The brief points out that virtually all of the DOJ’s and SEC’s traditional insider trading cases are unaffected by the Newman decision.  It goes on: “It is only recently that the government has decided to push the doctrinal envelope, and bring cases in which tippers have not been charged with criminal acts and the defendants are remote tippees who are ignorant of the circumstances attending the tippers’ disclosure of material nonpublic information.  To the extent that convictions are jeopardized because the government cannot prove that the tippees knew that the tippers were receiving a personal benefit . . . the government is not in a position to complain.  The Court has determined that such knowledge is required, and the government has explicitly decided not to contest this holding on rehearing.”  Id. at 19.

In the finale, Chaisson argues that “there is no indication” that the Government intends to abide by the law as stated by the Supreme Court.  It chastises the DOJ for taking conflicting positions in its insider trading cases, which “reflects either its confusion about insider trading doctrine or, worse, its inclination to take whatever legal position serves its immediate interest in a particular case.  At best, it illustrates that the government’s legal analysis about the subtleties of insider trading jurisprudence should be taken with a considerable grain of salt. The law as depicted in the brief that the government filed in this case—on a point with which this Court agreed—is now portrayed as something that is not the law and never was the law!” (Violating the sound practice that one never, never uses an exclamation point in an appellate brief.)

The conclusion is as it should be, pointing out that any “confusion” in the law could and should easily be handled by the SEC in its rulemaking capacity: “[T]o the extent that the government and the SEC do sincerely believe that their enforcement agendas are threatened by the decision in this case, the SEC can promulgate a regulation either implementing a different formulation of the ‘personal benefit’ requirement or defining what constitutes fraudulent insider trading.  Having failed for more than 50 years to issue a regulation that defines insider trading, it is remarkable that the agency now comes before this Court to complain about ‘confusion’ in insider trading jurisprudence.  If there is any ‘confusion,’ it results mainly from the SEC’s refusal to use its authority to promulgate an appropriate regulation.  It has been content instead to leave the job of defining insider trading to the courts, basking in the freedom to bring cases on a ‘we know fraud when we see it’ basis.  Having left to the courts the job of articulating the meaning of insider trading, the SEC should not now be heard to complain about ‘confusion’ when it gets a result that it does not like.”

One hopes and expects that the Second Circuit judges will look past the questionable rhetorical flourishes and focus on the strong substantive arguments laid out in the Chiasson brief.

Straight Arrow

February 22, 2015

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SEC’s Amicus Brief in U.S. v. Newman Fails To Improve on DOJ’s Effort

Earlier this week, the SEC filed an amicus brief in support of the DOJ’s petition for rehearing en banc of the panel decision overturning two insider trading convictions in United States v. Newman.  The Newman decision is discussed here: US v. Newman: 2d Circuit Hands Government Stunning, Decisive, and Far-Reaching Insider Trading DefeatThe DOJ’s petition for en banc review is discussed here: DOJ Petition for En Banc Review in Newman Case Comes Up Short.  The SEC’s amicus filing did little to show why the Second Circuit should take the extraordinary step of reviewing en banc the unanimous panel decision.  The SEC’s brief can be found here: SEC Amicus Brief in US v Newman.

The SEC started from the same flawed foundation as the DOJ, contending that existing law mandated that an insider “engages in prohibited insider trading” merely by “disclosing information to a friend who then trades.”  SEC Brief at 1.  That supposedly is “because that is equivalent to the insider himself profitably trading on the information and then giving the trading profits to the fried.”  Id.  This makes me want to scream out loud: Just because you say something over and over again does not make it true!  This proposition leaves out the key requirement in the law, flowing directly from the language of the Supreme Court in Dirks v. SEC, that a tipper-insider must “personally … benefit … from his disclosure” (463 U.S. at 662), and that this benefit could arise out of “a gift of confidential information to a trading relative or friend”  463 U.S. at 664 (emphasis added).  The DOJ and SEC continue to pretend that every disclosure of confidential information to a friend is of necessity, a “gift,” and therefore no further evidence is required to show that a “gift” was intended.  In other words, the required “personal benefit” flowing to the tipper is conclusively presumed whenever the tippee is a “friend.”  No aspect of Dirks suggests such a result.

The holding of the Newman court was not an extraordinary extension or expansion of the “personal benefit” requirement.  The court did no more than examine the evidence – or actually, lack of evidence – of any real benefit flowing to the tippers in the case, and insist that there actually be such evidence before there is tippee liability, because, as Dirks made clear, there can be no tippee liability if there is no tipper liability.

This passage from Dirks makes that clear: “Determining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts.  But it is essential, we think, to have a guiding principle for those whose daily activities must be limited and instructed by the SEC’s inside trading rules, and we believe that there must be a breach of the insider’s fiduciary duty before the tippee inherits the duty to disclose or abstain.  In contrast, the rule adopted by the SEC in this case would have no limiting principle.”  Dirks v. SEC, 463 U.S. 646, 664 (1983).  As for the wisdom of allowing law enforcement authorities decide the lines to be drawn for enforcement actions, the Dirks Court wrote: “Without legal limitations, market participants are forced to rely on the reasonableness of the SEC’s litigation strategy, but that can be hazardous, as the facts of this case make plain.”  Id. n.24.

True to this Supreme Court insight, ever since Dirks was decided, the SEC and DOJ have been trying to water down the “personal benefit” element of tipper liability to the point that they now argue that this element has no substance at all – mere proof of “friendship” – which, by the way, is itself an extraordinarily stretched concept, in the SEC and DOJ view – is all you need to show “beyond a reasonable doubt” that a tipper personally benefited from a disclosure.  The law enforcement authorities have tried over many years to negate Dirks (and its predecessor decision Chiarella v. United States, which provided the foundation for Dirks) by stretching “personal benefit” to the point of near infinite elasticity if a “friend” is involved, and stretching the concept of “friend” to be the equivalent of “acquaintance.”  The Newman panel simply said, in no uncertain terms, they’d had enough of this.

In this context, it is more than a little “rich” for the SEC to argue that the “panel decision also creates uncertainty about the precise type of benefit … an insider who tips confidential information must receive to be liable.”  SEC Brief at 2.  For years, the SEC has tried, mostly successfully, to make the standards of insider trading liability as amorphous as possible, and has resisted efforts to develop precise definitions.  Its explanation for this is that if you give a precise definition, you allow someone to evade liability with sharp practices that fall outside of the definition.  In the SEC’s view, the Commission and the Division of Enforcement should decide which trading practices should be unlawful, almost always in after-the-fact enforcement actions.  They view themselves as “keepers of the faith,” who, of course, will always act in the public interest, and therefore do not need precise legal standards to govern their enforcement actions.  Suffice it to say that many of us who have represented clients on the other side of SEC investigations do not have quite this level of confidence in the SEC staff’s determination of the “public interest.”  That is in part because the Division of Enforcement is a huge aggregation of weakly-managed lawyers whose judgments on these issues are usually deferred to, but many of whom exercise questionable judgment, and give more weight to their personal views of the world than the actual evidence in the case.  See, e.g., SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law, and SEC Enforcement Takes Another Blow in SEC v. Obus.

Hence, the SEC believes that an argument for rehearing the Newman decision is that the SEC has brought many enforcement actions “where the only personal benefit to the tipper apparent from the decisions was providing inside information to a friend” and Newman’s insistence on evidence of “personal benefit” to the tipper beyond this would “impede enforcement actions.”  SEC Brief at 12.  But what if those prosecutions were overly aggressive under the law, as laid out in Dirks?  The SEC is always trying to stretch the law so that it has increased discretion to determine what to prosecute “in the public interest” (and to get added leverage in efforts to force settlements of enforcement actions with questionable factual support).  One example of this is the recent extraordinary effort of the Commission in In re Flannery and Hopkins to expand the scope of Rule 10b-5 by edict (not by rulemaking), and thereby negate the impact of the Supreme Court’s decision in Janus Capital Group v. First Derivative Traders, as discussed here: SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5.)  The attempt to negate the “personal benefit” requirement, and expand the Dirks reference to “a trading relative or friend” beyond reasonable recognition, are part and parcel of that “we know it when we see it” approach to the law.  But, especially in criminal cases, there is no place for allowing prosecutors such discretion and providing citizens no reasonable notice of the parameters of the law.

U.S. v. Newman does not represent a significant limit on the ability of the DOJ or SEC to bring meritorious insider trading claims.  It merely requires that before tippees are held criminally liable, or subjected to severe civil penalties and employment bars, law enforcement authorities present evidence sufficient to support a finding that a tipper-insider actually benefitted from the tip, and that the defendants had the requisite scienter.  If, as the SEC argues, friendship and “gifting” are almost inevitably synonymous, this is not a high burden, especially in SEC enforcement actions, which need only satisfy a “preponderance of the evidence” standard of proof.

Straight Arrow

January 29, 2015

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