Tag Archives: integrity of the securities markets

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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DOJ Petition for En Banc Review in Newman Case Comes Up Short

On January 23, 2015, the Department of Justice filed its petition for rehearing en banc in United States v. Newman.  A copy of that submission is available here: US v Newman Petition for En Banc Review.  Our previous discussion of the unanimous panel opinion can be read here: US v. Newman: 2d Circuit Hands Government Stunning, Decisive, and Far-Reaching Insider Trading Defeat.  The brief argues for review on several grounds.  Individually and together, they do not provide a basis for granting en banc review.  (On the standards for en banc review, see the linked article: Once More Unto The Breach — Rehearing In Newman?)

First, the DOJ argues that the 2d Circuit panel got it wrong because it misstated the appropriate standard for determining whether a tipper received a “benefit” in return for his or her tip:

The Panel’s holding on the definition of “personal benefit” in insider trading cases—specifically, that illegal insider trading has occurred only when an insider-tipper’s deliberate disclosure of material non-public information was for pecuniary gain or was  part 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”—cannot be squared with governing Supreme Court precedent, conflicts with prior holdings of other circuits and this Court, and defies practical application.

Petition at 10-11 (citation omitted).

The support for this argument is founded entirely in the contention that the panel misread the Supreme Court’s decision in Dirks v. SEC, 463 U.S. 646 (1983).  The brief points to statements in Dirks that the required personal benefit may be “direct or indirect,” that it need not be monetary, that “there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient,” and that it could be “a gift of confidential information to a trading relative or friend,” as “[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”  Petition at 11 (quoting from Dirks, 463 U.S. at 663-64).  The DOJ brief argues that although the panel decision acknowledges Dirks‘s language, “it added an unprecedented limitation” that effectively upended Dirks: “‘To the extent Dirks suggests that a personal benefit may be inferred from a personal relationship between the tipper and tippee,’ the Panel held, ‘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.'”  Petition at 12 (quoting Newman).  The DOJ calls this “flatly inconsistent with Dirks.”  Id. at 13.

But the DOJ brief then departs from the actual Dirks language to make the argument that “the mere fact of friendship” could be enough to satisfy the Dirks requirement: “The Opinion says that Dirks ‘does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship.’  But that is in fact precisely what Dirks says, see Dirks, 463 U.S. at 664 (benefit can be ‘a gift of confidential information to a trading relative or friend’).”  Petition at 13 (citation omitted).  The quote from Dirks does not support the view that a “mere fact of friendship” can satisfy the requirement —  the evidence of friendship must be accompanied by evidence that the transmittal of information was “a gift” to the tippee.  The difference between “mere facts of friendship” and evidence supporting a “gift” or “personal benefit” was critical to the Newman decision and, at least in this part of its discussion, the DOJ ignores it.

The DOJ argues in this section that the Newman court “nullifies” part of the Dirks  benefit test by “replacing it” “with a set of novel, confounding criteria for the type of ‘exchange’ that will now be required before an insider’s deliberate transmission of valuable inside information to a friend or relative could be punishable under the laws against insider trading.”  Petition at 14.  But the Newman opinion plainly does not “replace” the Dirks standard — it tries to explain how to apply the standard in the face of negligible evidence of either a “gift” or a “personal benefit.”  The Newman court’s statement that showing a benefit to the tipper requires 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” is made in the context of no other evidence of a benefit to the tipper or an intent to “gift” the information to the tippee.  In that context, the language is perfectly consistent with the statements in Dirks that “there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient,” and that the benefit requirement could be met by showing “a gift of confidential information to a trading relative or friend,” which would make the tip and trade “resemble trading by the insider himself followed by a gift of the profits.”

The DOJ petition does not address the key aspect of this portion of the Newman holding: that under Dirks, it was impermissible to allow a conviction for insider trading based on a “benefit” concept that is so broad and diffuse that it becomes no standard at all.  The court’s quoted language was an effort to make it clear that a real benefit must be shown, not just “the mere fact of friendship,” and that is plainly consistent with, and in furtherance of, the Dirks holding.  The DOJ’s brief paragraph on that issue essentially says nothing more than the DOJ’s view that it doesn’t think a broad and diffuse standard is a problem.  See Petition at 14-15No doubt that is so from the DOJ’s perspective, since the broader the standard, the more discretion the DOJ has to decide which conduct should be prosecuted and which should not.  But as a basis for imposing criminal sanctions — for imposing lengthy prison terms on purported violators — a broad standard that makes it difficult to determine what is lawful and what is not is no gift to society.

Second, the DOJ brief argues that the evidence against Newman and Chiasson was sufficient to show a true benefit to the respective tippers, as well as knowledge of that benefit by Newman and Chiasson.  This argues that the Second Circuit panel simply stated the evidence incorrectly by (i) failing to credit evidence showing benefits to the tippers, and (ii) failing to adopt a standard that allows a finding of knowledge of such benefits based on the mere fact that the information conveyed to the defendants by their subordinates was too accurate to have been obtained without giving a benefit to the original tipper.  See Petition at 15-22.  To begin, it seems highly unlikely that factual arguments that an undivided panel simply misread the record will be sufficient to induce the Second Circuit to grant en banc review.  But beyond this, the argument on knowledge seems particularly weak.  Although it appears to concede that proof of knowledge is, in fact, required (a concession not previously made in the district court or the court of appeals), it essentially asks that the Second Circuit rule that in this context the only evidence required to show such “knowledge” is that it is implausible that tippers give reliable tips without receiving some sort of benefit.  That is no more than a barely-veiled way to do away with the requirement altogether by conflating it with evidence that the tips were reliable (i.e., material).

Third, the DOJ makes a public policy argument that the Newman decision should not be permitted to stand because it uses a standard that would permit securities trading that would “threaten the integrity of the securities markets.”  See Petition at 22-25.  In the DOJ’s view, the Second Circuit should be deciding the breadth of section 10(b) by the DOJ’s (or the circuit court’s) view of what rule is most beneficial to the “securities markets.”  This is wrong in so many respects that it’s hard to know where to start.

First, it ignores the fact that the issue here involves two individuals’ criminal convictions.  Whether what they did was, or was not, criminal, should not be determined by what the DOJ or the courts may think is good or bad for the securities markets.  It must be determined by whether the statute in question bars the conduct proved, and does so with clarity, not what the DOJ or the courts think would be a desirable public policy to govern trading activity.

Second, the argument reflects a flawed core assumption by the DOJ about what section 10(b) is all about.  Strangely, in the entire DOJ brief, there is not a single discussion of the statute and why the panel decision misconstrues it.  The reason is clear: The Supreme Court has now held on multiple occasions that section 10(b) prohibits only fraudulent conduct in connection with securities trades.  It does not adopt any particular view about “fairness” of trading in the securities markets.  It certainly says nothing about whether securities markets are rendered “unfair” if some people trade with more information than others.  Indeed, as this blog previous made clear, section 10(b) was enacted at a time, and with an understanding, that it was not addressing the propriety of trading on nonpublic corporate information.  See The Myth of Insider Trading Enforcement (Part I).

Nevertheless, the DOJ argues that the panel decision should be rejected because it “significantly weakens protections against the abuse of inside information by market professionals with special access, and threatens to undermine enforcement efforts that are vital to fairness (and the perception thereof) in the securities markets.”  Petition at 23.  The short answer to this is that not all “abuses of inside information” are fraudulent, and therefore not all such “abuses” are prohibited by section 10(b).  See SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.  If the DOJ wants to criminalize all “abuses of inside information” — whatever that may mean — it should draft a statute doing so and get it enacted.  It should not ask the Second Circuit to define the boundaries of the law to achieve an end that the law never addresses.

Third, the DOJ argues (with no foundation) that somehow the issue of what is or is not a “personal benefit” to a tipper will impact “investor confidence”: “The consequences for investor confidence are plain: individuals will perceive that cozy relationships between  insiders and the most sophisticated traders allow exploitation of nonpublic information for personal gain.”  Petition at 24.  That argument makes the flawed assumption that is “plain” that “investors” are more interested in assuring that no one can “exploit” nonpublic information for personal gain than they are in assuring that to the extent possible, market prices for securities reflect the best available information, public or nonpublic.  The issue may be worthy of debate, but I seriously doubt that “investors” would prefer markets where better-informed people are barred from trading, with the result that securities are mispriced until information becomes “public.”  In any event, the securities laws contain no such requirement, and are founded instead on the paradigm of maximizing market efficiency, which is fundamentally different than the DOJ’s apparent concept of “fairness.”

Straight Arrow

January 26, 2015

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