Tag Archives: Chiarella

Why Judge Rakoff’s Decision in SEC v. Payton Should Not Have a Lasting Impact

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.

Straight Arrow

April 22, 2015

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Mark Cuban Amicus Brief Puts U.S. v. Newman Insider Trading Prosecution in Proper Context

Mark Cuban recently filed an amicus brief in the Second Circuit, addressing the DOJ petition for rehearing en banc, which provides helpful context amid the flurry of arguments made by the DOJ and SEC about the United States v. Newman panel decision.  The Cuban brief dismantles the prosecutors’ notion that the Supreme Court’s decision in Dirks v. SEC made every transfer of material inside information from one “friend” to another a sufficient basis for convicting the recipient for violating section 10(b) of the Securities Act of 1934 if there is a trade made in possession of that information.  We previously discussed the flaws in the DOJ and SEC contentions here: DOJ Petition for En Banc Review in Newman Case Comes Up Short, and here: SEC’s Amicus Brief in U.S. v. Newman Fails To Improve on DOJ’s Effort.  The Cuban brief is available here: Mark Cuban Amicus Brief in US v. Newman.

One very helpful aspect of the Cuban brief is to put insider trading law into its proper historical context.  We began to do this in one of our early posts: The Myth of Insider Trading Enforcement (Part I),  That post described how a statute that never barred insider trading was converted by SEC and judicial fiat into one that prohibited trading that the SEC thought was inequitable.  Regrettably, that discussion ends just before the critical Supreme Court decision in Chiarella v. United States, which represented the Supreme Court’s first effort to bring high-flying theories of insider trading liability endorsed by the SEC and the Second Circuit back to earth.  In particular, the long-standing effort of the SEC to found insider trading fraud on the concept of equal access to information, rather than conduct that constitutes fraud, was — or should have been — halted by the Chiarella decision.  The Cuban brief goes into some of this history, explaining how the SEC and DOJ have consistently tried to expand the scope of what is unlawful based on theories of equity among investors, rather than what section 10(b) actually does, which is to prohibit fraud in connection with securities trades.

In many respects, the Cuban brief follows and expands on our “Myth of Insider Trading” analysis (which perhaps explains why we like it):

While Congress was aware of concerns regarding insider trading at the time the Securities Exchange Act of 1934 was enacted, see, e.g., Donald Cook & Myer Feldman, Insider Trading under the Securities Exchange Act, 66 Harv. L. Rev. 385, 386 (Jan. 1953), the Act addresses only a narrow subspecies of insider trading – namely, where a director, beneficial owner, or officer personally achieves shortswing profits by using nonpublic information to make both a purchase and a sale of company stock within six months of each other.  Securities Exchange Act of 1934,404, tit. 1, § 16(b) (codified as amended at 15 U.S.C. § 74p(b)).  And even in that situation, only the company (or a shareholder acting derivatively on behalf of the company) may sue for disgorgement; there is no criminal liability, and the SEC may not bring an action to enforce the prohibition.  Id.

Despite the lack of Congressional proscription (or even intent) regarding insider trading beyond the limited context of section 16(b), the SEC has not hesitated to argue that section 10(b)’s fraud provision and Rule 10b-5 broadly proscribe “insider trading.”  Addressing the issue in In the Matter of Cady, Roberts & Co., 40 S.E.C. 907 (1961), the SEC held that a trader committed a fraud – and thus violated Rule 10b-5 – whenever he or she traded while knowing material nonpublic information that the counterparty did not.  In effect, the SEC demanded a parity of information between traders: A trader either had to disclose his informational asymmetry or abstain from trading. See Chiarella v. United States, 445 U.S. 222, 227 (1980).

This expansive view of insider trading had little basis in the Exchange Act – indeed, it went well beyond Congress’s narrow proscription in section 16(b) against short-swing trades by a limited group of insiders.  The SEC nevertheless managed to convince lower courts – including this one – to adopt its “disclose or abstain” rule, and many successful (but baseless) insider trading actions were brought accordingly.  See, e.g., SEC v. Tex. Gulf Sulfur Co., 401 F.2d 833 (2d Cir. 1968).

The SEC pressed its flawed parity-of-information rule for nearly two decades. It jettisoned the rule only when the Supreme Court reversed a decision of this Court to hold that information parity is “inconsistent with the careful plan that Congress has enacted for regulation of the securities markets.”  Chiarella, 445 U.S. at 235.  The Chiarella Court explained that Congress did not outlaw all forms of insider trading but only those that constitute fraud.  IdTrading on nonpublic information is fraudulent only when the investor has an independent duty under the common law to disclose that information or abstain from trading. Id. By contrast, the SEC’s parity-of-information rule had created a “general duty between all participants in market transactions to forego actions based on material, nonpublic information” and thus “depart[ed] radically” from both the Exchange Act and established fraud doctrine.  Id. at 233.

Despite the setback in Chiarella, the SEC continued to press for expanded insider trading proscriptions.  Three years after Chiarella, the Supreme Court again took up the issue in Dirks v. SEC, 463 U.S. 646 (1983).  There, the SEC had charged an analyst with insider trading after he had received and passed on to traders information from insiders concerning corruption at a financial firm.  Id. at 648-49.  The SEC’s position was that the analyst automatically inherited the insiders’ common law duty not to trade on confidential information by virtue of having received information from those insiders . Id. at 655-56. In other words, the SEC believed that every tippee is subject to the parity-of-information rule. Id.

Once again, the Supreme Court rejected the SEC’s view of insider trading as overly expansive. After repeating Chiarella’s holding that there can be no liability for insider trading unless there is a fraud, id. at 666 n.27, the Court held that a tippee does not per se acquire a duty to disclose or abstain whenever he acquires insider information, id. at 659. To the contrary, a tippee “assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.”  Id. at 660 (emphasis added); see also Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 313 (1985) (explaining that Chiarella and Dirks make clear that “a tippee’s use of material nonpublic information does not violate § 10(b) and Rule 10b-5 unless the tippee owes a corresponding duty to disclose the information”).

History thus demonstrates that the SEC and DOJ will relentlessly push to expand the outer limits of what constitutes insider trading until they are reined in. But expanding the reach of the insider trading laws is Congress’s purview. . . .  And time and again, Congress has declined to define insider trading.

Cuban Brief at 5-9 (footnotes and some citations omitted).

The Cuban brief also provides some history about the failure of Congress to provide any definition of what falls inside, and outside, of an insider trading prohibition.  Despite continuing uncertainty about what is and is not lawful conduct, no clarification of the law has ever occurred, although numerous unsuccessful efforts were made.  See the Cuban Brief at 9-12.  Of course, the SEC has always had it within its power to use the rulemaking process to create more clear parameters of what is and is not prohibited.  It has never done so, in no small part because the SEC has no desire to have a clear standard that would limit the ability of law enforcement authorities to exercise wide discretion effectively to legislate the scope of what is prohibited through enforcement actions.  See our post: SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.

The Cuban brief sums up well where this leaves the state of insider trading law:

[T]he ambitious stance of the Department of Justice (egged on by the SEC in its own cases) [is] to take every opportunity to seek an expansion of the parameters of prohibited insider trading by bringing claims based on novel theories for which there is no precedent.  Without definitive guidance as to what is a violation and what is not, well-meaning innocent individuals are left in the untenable position of having to worry that what is (and should be) a lawful transaction today will suddenly be alleged by the Government to violate the federal securities laws tomorrow.

The Government, in its ever-broadening campaign against insider trading, seems to have lost sight that its underlying goal should be to assure that the markets are fair and equitable so that companies and investors are able to participate with confidence, thus encouraging capital formation. Companies need capital to grow, and investors need to know that the companies in which they invest, and the markets in which they transact, will treat them fairly. Pursuing individuals under novel theories does nothing to improve the fairness of the markets.

Cuban Brief at 2-3 (footnote omitted).

Our previous posts on Newman explain that the panel decision did not open the floodgates for insider trading or impose any new great burden on the DOJ or SEC to prove violations of section 10(b).  But even if the DOJ’s and SEC’s “sky is falling” prediction in their rehearing filings with the Second Circuit were right, reconsidering the Newman decision is not the solution to that problem.  The solution is a studied effort to define what is and is not unlawful and provide certainty in this area of the law that prevents fraud but allows trading markets to function fairly and efficiently.

Straight Arrow

February 20, 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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U.S. v. Durant: DOJ Argument that Newman Reasoning Does Not Apply to Misappropriation Theory Misses the Mark

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.

Straight Arrow

January 15, 2015

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US v. Newman: 2d Circuit Hands Government Stunning, Decisive, and Far-Reaching Insider Trading Defeat

Today (December 10, 2014), the Second Circuit court of appeals delivered a stunning rejection of Government insider trading theories in United States v. Newman and Chiasson, Nos. 13-1837, 13-1917 (“Newman”).  Coming from an appellate court traditionally receptive to government efforts to extend the scope of insider trading liability, this decision may have a major impact on insider trading enforcement, criminal and civil.

The court not only rejected the theory of violation reflected in government-proposed jury instructions accepted by district court judge Richard Sullivan, it took the highly unusual step of determining that no evidence could support a conviction of Newman and Chiasson, and vacated the indictment with prejudice.  In doing so, the court gave the government insider trading law enforcement entities – the Department of Justice and Securities and Exchange Commission – an impetus to reconsider their entire mindset on insider trading.  You can read a copy of the opinion here: U.S. v. Newman and Chiasson.

The case involved the use by hedge funds of analysts who are hired to scour all sources of business information to generate non-public sources of expected company performance, and feed that information to stock traders who invest in portfolios for their hedge funds.  Todd Newman was a portfolio manager for Diamondback Capital Management, and Anthony Chiasson was one for Level Global Investors.  Both funds are now defunct – they were forced to close because of the impact of the government’s insider trading investigation and charges (which now prove unfounded).

Todd Newman and Anthony Chiasson (Courtesy NY Times)

Todd Newman and Anthony Chiasson

The indictment charged that a group of these analysts from several hedge funds communicated with each other and shared tips.  Among the information they shared were earnings predictions emanating from tech companies Dell and Nvidia.  The analysts did not know what motivated the insiders at those companies to provide this information.  Neither of the insiders ultimately identified by the government as the sources of this information were prosecuted, criminally or civilly.  The government went after the analysts and gave them deals as government witnesses to assist in the prosecution of the portfolio managers to whom they passed on these tips.

The government’s prosecution was driven by the same overall theory it has pursued in many criminal and civil cases for many years – that people who trade stock in possession of material non-public information, and who have strong grounds to know they have material non-public information, commit insider trading offenses in violation of section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5 issued thereunder.  The Supreme Court rejected this concept twice, in Chiarella v. United States, 445 U.S. 222 (1980), and then again in Dirks v. SEC, 463 U.S. 646 (1983).  But government lawyers persisted in the view that the rulings handed down in Chiarella and Dirks left enough leeway to allow them to stretch the scope of insider trading violations beyond the limits apparently imposed by those decisions.  See our earlier post entitled: “SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.”

In the past, the Second Circuit’s loose language in some cases suggested it was willing to accept extensions of the law beyond the strict language of Chiarella and Dirks.  But in Newman, the Second Circuit obliterates that view of their cases.  The panel provided an exceptionally clear statement of its holding and rejection of attempts to find support for the government case in earlier Second Circuit decisions.  Even more important, it explained that the government’s preferred approach – to bar trading by persons with material non-public information as part of an overall concept of parity of information for all stock traders – had been rejected by Chiarella and Dirks and was inconsistent with how the financial markets are supposed to work.

The Court’s Description of Current Law

The court briefly explained the current status of insider trading law as set forth in what are known as the “classical” and “misappropriation” theories.  “The classical theory holds that a corporate insider (such as an officer or director) violates Section 10(b) and Rule 10b‐5 by trading in the corporation’s securities on the basis of material, nonpublic information about the corporation.”  That is because “there is a special ‘relationship of trust and confidence between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position within that corporation.’”  This relationship means insiders have “‘a duty to disclose [or to abstain from trading] because of the ‘necessity of preventing a corporate insider from . . . tak[ing] unfair advantage of . . . uninformed . . . stockholders.’”  Slip op. at 9-10 (quoting Chiarella).

The court emphasized, however, that “the Supreme Court explicitly rejected the notion of ‘a general duty between all participants in market transactions to forgo actions based on material, nonpublic information,’” and instead “limited the scope of insider trading liability to situations where the insider had ‘a duty to disclose arising from a relationship of trust and confidence between parties to a transaction,’ such as that between corporate officers and shareholders.”  Id. at 10 (quoting Chiarella).

The “misappropriation theory” of insider trading liability “expands the scope of insider trading liability to certain other ‘outsiders,’ who do not have any fiduciary or other relationship to a corporation or its shareholders.  Liability may attach where an ‘outsider’ possesses material non‐public information about a corporation and another person uses that information to trade in breach of a duty owed to the owner. . . .  In other words, such conduct violates Section 10(b) because the misappropriator engages in deception by pretending ‘loyalty to the principal while secretly converting the principal’s information for personal gain.’” Id. (quoting and citing United States v. O’Hagan, 521 U.S. 642 (1997), and SEC v. Obus, 693 F.2d 276, 285-86 (2d Cir. 2012)).

Finally, the court explained that the liability of “tippees,” who obtain information from others is governed by the same elements, regardless of whether the “tipper’s” duty arises from the classical or misappropriation theory.  The key case on this is Dirks, under which, the Newman court noted: “The test for determining whether the corporate insider has breached his fiduciary duty ‘is whether the insider personally will benefit, directly or indirectly, from his disclosure.  Absent some personal gain, there has been no breach of duty. . . .” Slip op. at 11 (quoting Dirks, 463 U.S. at 662, with added emphasis).  Moreover, the Dirks Court “rejected the SEC’s theory that a recipient of confidential information (i.e. the ‘tippee’) must refrain from trading ‘whenever he receives inside information from an insider.’”  Id. (quoting Dirks, 463 U.S. at 655).  Instead, the Dirks Court held “that ‘[t]he tippee’s duty to disclose or abstain is derivative from that of the insider’s duty.’”  Id. at 11-12 (quoting Dirks, 463 U.S. at 659).  “Because the tipper’s breach of fiduciary duty requires that he ‘personally will benefit, directly or indirectly, from his disclosure,’. . . a tippee may not be held liable in the absence of such benefit.”  Id. at 12 (quoting Dirks, 463 U.S. at 662).

The Court Takes the Government To Task for Ignoring Key Language in Dirks

The Newman court then went about explaining why the government’s case against Newman and Chiasson failed to satisfy the key requirements in Dirks.  It acknowledged that the Second Circuit had been “accused of being ‘somewhat Delphic’ in our discussion of what is required to demonstrate tippee liability,” but nevertheless, “the Supreme Court was quite clear in Dirks.”  Slip op. at 13.  In particular, tippee liability “derives only from the tipper’s breach of a fiduciary duty, not from trading on material, non-public information”  Id.  (This is critical, because the government’s refusal to accept this aspect of Chiarella and Dirks underlies many of the improper extensions of insider trading liability the DOJ and SEC pursue.)  And there is no insider breach of fiduciary duty “unless he receives a personal benefit in exchange for the disclosure.”  Id. at 13-14.  Finally, “even in the presence of a tipper’s breach, a tippee is liable only if he knows or should have known of the breach.”  Id.

The court then pounded this point again: “Dirks counsels us that the exchange of confidential information for personal benefit is not separate from an insider’s fiduciary breach; it is the fiduciary breach that triggers liability for securities fraud under Rule 10b‐5.  For purposes of insider trading liability, the insider’s disclosure of confidential information, standing alone, is not a breach.  Thus, without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the Government cannot meet its burden of showing that the tippee knew of a breach.”  Id.  Then, in an unusual aside, the court noted that the government’s failure to accept this led to excessively “novel” insider trading prosecutions: “The Government’s overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.”  Id.

Perhaps the most telling portion of the opinion is the court’s explanation that the government’s “novel” insider trading prosecutions not only ignore Dirks, but they ignore the very foundation of financial markets.  Because this is where the court puts the barrel of the bat on the ball, we quote the entire paragraph here:

In light of Dirks, we find no support for the Government’s contention that knowledge of a breach of the duty of confidentiality without knowledge of the personal benefit is sufficient to impose criminal liability.  Although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.  The Supreme Court explicitly repudiated this premise not only in Dirks, but in a predecessor case, Chiarella v. United States.    In Chiarella, the Supreme Court rejected this Circuit’s conclusion that “the federal securities laws have created a system providing equal access to information necessary for reasoned and intelligent investment decisions . . . . because [material non‐public] information gives certain buyers or sellers an unfair advantage over less informed buyers and sellers.”  445 U.S. at 232.  The Supreme Court emphasized that “[t]his reasoning suffers from [a] defect. . . . [because] not every instance of financial unfairness constitutes fraudulent activity under § 10(b).”  IdSee also United States v. Chestman, 947 F.2d 551, 578 (2d Cir. 1991) (Winter, J., concurring) (“[The policy rationale [for prohibiting insider trading] stops well short of prohibiting all trading on material nonpublic information.  Efficient capital markets depend on the protection of property rights in information.  However, they also require that persons who acquire and act on information about companies be able to profit from the information they generate . . . .”).  Thus, in both Chiarella and Dirks, the Supreme Court affirmatively established that insider trading liability is based on breaches of fiduciary duty, not on informational asymmetries  This is a critical limitation on insider trading liability that protects a corporation’s interests in confidentiality while promoting efficiency in the nation’s securities markets.

Slip op. at 15-16 (emphasis added).

The court did not go on to explain why the Supreme Court made a breach of fiduciary duty the basis for insider trading liability, but that is apparent in the Chiarella and Dirks opinions.  Insider trading is a violation of federal law only to the extent it is prohibited by section 10(b) of the 1934 Act.  Because section 10(b) only prohibits fraudulent conduct, the mere trading with asymmetric information is not a violation because the trade is based on neither a misrepresentation to the counter-party, or an omission to disclose required information to the counter-party.  Only the existence and breach of a fiduciary duty between parties in connection with that trade establishes a fraud.  The fiduciary duty creates a duty of disclosure to the fiduciary that does not otherwise exist, and the breach of that duty constitutes fraud.  Justice White’s pithy comment way back in the Chiarella opinion applies no less now than it did then: “Section l0(b) is aptly described as a catch all provision, but what it catches must be fraud.  When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak. We hold that a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.”  Chiarella, 445 U.S. at 235 (emphasis added).  In short, the government (DOJ and SEC) has been fighting that admonition since 1980.  It is time to accept it and apply the law as decided by the Supreme Court.  (For more on these underlying insider trading issues, see our post: The Myth of Insider Trading Enforcement (Part I).)

The Coup de Gras: The Newman Court Rules There Is Insufficient Evidence To Convict

Appellate courts rarely decide on the appeal of a criminal conviction that a jury could not convict the defendant on the basis of the evidence presented.  As the Newman court acknowledged: “As a general matter, a defendant challenging the sufficiency of the evidence bears a heavy burden, as the standard of review is exceedingly deferential.”  Slip op. at 20.  But the evidence presented by the government that either the insiders leaking corporate information breached a fiduciary duty, or that the defendants knew that such a breach of duty occurred, was so meager that the court dismissed the entire case on the merits.  This is a huge and stunning blow, because it not only says the government got the law wrong, but that its entire view of what satisfies the required element of a “benefit” to the tipper in return for the tip is unacceptably distorted.

The government will argue almost anything satisfies the “benefit” requirement.  Nowadays, the government argues that almost any form of positive interaction between the tipper and the tippee satisfies the benefit requirement.  The Newman court rejects that view handily.  It notes that the government has taken permissive language finding a benefit may be more than just a pecuniary gain to an absurd logical conclusion: “This standard, although permissive, does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature.  If that were true, and the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity. To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee, where the tippee’s trades ‘resemble trading by the insider himself followed by a gift of the profits to the recipient,’ see 643 U.S. at 664, we hold that such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature. . . .  While our case law at times emphasizes language from Dirks indicating that the tipper’s gain need not be immediately pecuniary, it does not erode the fundamental insight that, in order to form the basis for a fraudulent breach, the personal benefit received in exchange for confidential information must be of some consequence. ”  Slip op. at 21-22.

In one instance, the government contended that by receiving career advice from the tippee, the tipper satisfied the benefit requirement.  In the other, the government argued that the required benefit was shown because the tipper and tippee were “family friends” that met through church and socialized occasionally.  The court concluded with some apparent irony: “The Government argues that these facts were sufficient to prove that the tippers derived some benefit from the tip.  We disagree.  If this was a ‘benefit,’ practically anything would qualify.”  Slip op. at 21.

The court later reiterated: “The Government now invites us to conclude that the jury could have found that the appellants knew the insiders disclosed the information “for some personal reason rather than for no reason at all.”  Gov’t Br. 65.  But the Supreme Court affirmatively rejected the premise that a tipper who discloses confidential information necessarily does so to receive a personal benefit.”  Slip op. at 25.

This is a potentially far-reaching development.  The government, and in particular the SEC, commonly treats the “benefit” requirement as de minimis in tippee cases.  For example, in the recently filed case SEC v. Peixoto, in which the respondent Peixoto is alleged to be a second-level tippee (having allegedly obtained information from a tippee who was the roommate of a hedge fund analyst who had mentioned some non-public hedge fund activities), the only allegation bearing on “benefit” to the alleged tipper was that he and the tippee “were very close friends who had grown up together in Poland.  From 2008 to April 2013, they shared an apartment as roommates in New York, New York.”  The supposed benefit flowing to the roommate from Peixoto was that he “received a personal benefit by gifting confidential information to his friend, Peixoto.”  That is precisely the sort of “benefit” rejected as insufficient in Newman.

                                                           *                      *                      *

In short, the Newman decision strikes a major blow against government attempts to pursue attenuated insider trading theories.  Insider trading must involve fraud in the traditional, common law sense.  Coming from the influential Second Circuit, the impact of this decision could be huge.  Unfortunately, it comes too late to save the Diamondback and Level Global hedge funds, who were effectively put out of business for doing nothing wrong, or their hundreds of employees.

Straight Arrow

December 10, 2014

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