Tag Archives: Ruggieri

SEC ALJ Jason Patil Stings Enforcement Division with Dismissal in Ruggieri Case

SEC Administrative Law Judge Jason Patil’s September 14, 2105 Initial Decision in In the Matter of Bolan and Ruggieri, File No. 3-16178, represents a milestone is SEC administrative jurisprudence in several respects.  The decision is available here: Initial Decision in In the Matter of Bolan and Ruggieri.

First, coming as it did in the midst of controversy over questionable fairness, and allegations of bias, in the SEC’s administrative enforcement process, ALJ Patil’s opinion, which rules against the SEC Division of Enforcement in a publicized insider trading case, shows that SEC ALJs are capable of giving serious scrutiny to the Division’s often overblown charges and questionable evidentiary support in support them.  ALJ Patil, a recent arrival at the SEC, has already shown a judicial temperament and backbone that is needed to assure a more level playing field in these cases.  We previously noted some high quality work by Mr. Patil.  See Some SEC Administrative Law Judges Are Thoughtful and Even Judicious.

Second, ALJ Patil’s decision itself was solid and thoughtful.  His analysis was mostly independent and well-reasoned.  The main exception was a not-very-thoughtful rejection of several constitutional challenges, which was presented in brief paragraphs that showed little of the painstaking analysis he gave to the evidence and the law in the remainder of his opinion.  He devoted fewer than two pages to dismiss five distinct constitutional arguments.  See Initial Decision at 2-4.  I chalk this up to a recognition that the constitutional issues were pretty much beyond his pay-grade, a point he even used in response to one of them (“I do not have authority to adjudicate this claim” (referring to a delegation doctrine argument)).  Id. at 3.  The treatment of the Appointments Clause issue now before several courts completely deferred to the SEC’s decision in In the Matter of Raymond J. Lucia Cos. (id.), and on the related issue of the double layer of ALJ tenure protection, he speciously argued that the Supreme Court footnote in its decision regarding the PCAOB in Free Enterprise Fund v. PCAOB meant that it “did not support” applying the same analysis to SEC ALJs.  Id.  That, of course, evades the argument, it does not address to it.  And the one sentence on the Seventh Amendment jury trial issue fails to consider the key point – whether a process that allows solely the SEC to require a jury trial (by choosing the forum) but deprives a respondent of any comparable right could be consistent with the Seventh Amendment. Id. at 6.

ALJ Patil was wrong to give these issues scant treatment because they were a side show.  If he didn’t want to take them seriously, he should have declined to address them because they were, as it turned out, unnecessary to consider in light of his decision on the merits.  Knowing his decision on the merits made this discussion superfluous, the correct approach was simply to decline to rule on those constitutional issues.

But in the overall picture, this may be just a quibble.  When it came to doing the hard work of evaluating the evidence and applying the law to the evidence, ALJ Patil did excellent work.  There were some flaws in his description of insider trading law, but he eventually got to the right place.

Third, ALJ Patil took on some key aspects of the implementation of insider trading law pursuant to Dirks v. SEC and United States v. Newman, and showed the fortitude to adopt positions – which I believe to be correct – that conflict with current SEC and Government arguments being made in Newman itself and in other insider trading cases.  That takes some cojones, and ALJ Patil should be commended for taking an independent view.

In particular, ALJ Patil rejected the argument now being made by the Government in the Newman cert. petition that the Newman decision breaks with Supreme Court precedent in Dirks v. SEC: “In its petition for a writ of certiorari, the government contends that Newman conflicts with Dirks and erroneously heightened the burden of proof.  See Pet. Writ Certiorari, United States v. Newman, No. 15-137 (July 30, 2015); 17 C.F.R. § 201.323 (official notice).  I do not, however, read Newman as conflicting with Dirks, but rather as clarifying the standard where proof of a personal benefit is based on a personal relationship or friendship.  See 773 F.3d at 452.”  Initial Decision at 35.  He also rejected the Division’s concerted argument that the “personal benefit” requirement for tipper liability adopted in Dirks, and further developed in Newman, has no place in insider trading violations based on the “misappropriation” theory, rather than a “classical” insider trading violation.  We will discuss his analysis on this point below, but his bottom line was that the personal benefit requirement plays the same important role in misappropriation cases as it does in classical cases.  See id. at 28-32.  Finally, he rejected multiple arguments by the Division that the personal benefit requirement was satisfied by the evidence when it was plain that the evidence did not support any such inference.  See id. at 33-49.

The Facts

Unlike many recent tippee cases, including the Newman/Chiasson case, the facts here are relatively straightforward.  Bolan and Ruggieri both worked for Wells Fargo.  Bolan was a researcher and analyst covering healthcare companies; Ruggieri was a senior trader of healthcare stocks who traded for Wells Fargo clients and also in a Wells Fargo proprietary account.  Unpublished Wells Fargo research and ratings analysis was proprietary and confidential company information.  Wells Fargo mandated that analysts not share ratings changes with traders before they were made public. Ruggieri knew that he was prohibited from trading based on nonpublic information from a forthcoming research report.

The SEC alleged that Bolan tipped Ruggieri to imminent Wells Fargo ratings changes he was about to make for specific stocks, and that Ruggieri took advantage of that knowledge on six occasions to trade in advance of publication and profit when the stock prices moved after the ratings change was announced.

Bolan settled the SEC’s case against him.  Ruggieri did not.  He was charged with violations of section 17(a) of the 1933 Act and section 10(b) of the 1934 Act and Rule 10b-5 thereunder.

The Findings

Much of the opinion addresses the evidence surrounding Ruggieri’s trades involving six stocks.  There apparently was little dispute that Bolan provided Ruggieri advance information about his views on these six companies.  But the evidentiary issues were complicated because Ruggieri argued that his decisions in all of these cases were based on his own knowledge of these companies and the market for their stocks, not on Bolan’s incipient ratings changes.  After all, much of the data available to Bolan was also available to Ruggieri, and in addition to that, Ruggieri had independent sources of information through the institutional investors he serviced for Wells Fargo, who often were the source of information about investor views about these companies.

After reviewing the extensive record, ALJ Patil concluded that the Division did not satisfy its burden of proving that Ruggieri’s trades in two of the six stocks were founded on tips from Bolan, but that he did rely on Bolan’s tips on four of the trades.

ALJ Patil’s Overview of Insider Trading Law Was Not Quite Right

ALJ Patil’s decision includes extensive discussion of his understanding of unlawful insider trading.  His Overview of the law (Initial Decision at 8-9) is mostly correct, but reflects some errors that, while not determinative in this case, suggest a less than complete understanding of the law.

ALJ Patil starts out with a summary statement about the law that is half right and half almost-right: He says that section 17(a) and section 10(b) “do not require equal information among market participants; the mere act of trading on insider information is not fraud. . . .  Rather, insider trading constitutes fraud within the meaning of these provisions when it involves a market participant’s breach of a fiduciary duty owed to a principal for a personal benefit.”  Id. at 8.  The first part is right – the Supreme Court has repeatedly rejected the theory that trading on material nonpublic information is itself unlawful.  The second part is half-right because it omits an important element – insider trading is “fraud within the meaning of these provisions when it involves a market participant’s breach of a fiduciary duty owed to a principal for a personal benefit” if, and only if, that breach of duty is undisclosed.  Trading on information that breaches a fiduciary duty to a principal is not “fraud” under these provisions if it is disclosed.  The importance of the fiduciary duty is that it creates a duty to disclose the breach to the principal, and the failure to do so in the context of a fiduciary relationship constitutes fraud.  That is why it is always said that the trader has the choice to “disclose or abstain from trading” to avoid violating the law.

ALJ Patil goes on to describe that this case involves the “misappropriation” theory of insider trading, since the critical information was not confidential information owned by the issuer of the traded stock, but confidential analytic information about various issuers owned by Wells Fargo: “The Division alleges that Bolan tipped Ruggieri with confidential information . . . in breach of a duty to Wells Fargo for a personal benefit and Ruggieri traded based on such tips.”  Id.  In such cases, the duty is owed to the owner of the information – here, Wells Fargo – and a fraud occurs if “[a] fiduciary who pretends loyalty to the principal while secretly converting the principal’s information for personal gain.”  United States v. O’Hagan, 521 U.S. 642, 653-54 (1997) (emphasis added).  As discussed above, what makes this conduct fraudulent is the failure to disclose the misuse of information stolen from the principal (“secretly converting”).

ALJ Patil notes that under Dirks, Ruggieri’s liability as a tippee “is derivative of Bolan’s alleged breach.”  Initial Decision at 8.  He states: “To establish Ruggieri’s liability, the Division must therefore show that: 1) Bolan tipped material non-public information to Ruggieri in breach of a fiduciary duty owed to Wells Fargo for a personal benefit to himself; 2) Ruggieri knew or had reason to know of Bolan’s breach, that is, he knew the information was confidential and divulged for a personal benefit; and 3) Ruggieri still used that information by trading or by tipping for his own benefit.”  Id. Actually, as discussed above, there is a fourth requirement, which is that Ruggieri knew that the breach of duty remained undisclosed to the principal at the time he traded.

ALJ Patil’s discussion of “materiality” is also not quite right, although his error seems of no consequence here.  He says there is no dispute that Bolan’s ratings were material because “ratings changes typically moved stock prices,” and Bolan’s ratings changes “had a statistically significant impact on the stock prices of the securities being rated.”  Id. at 9.  That would be correct if the disclosure duty at issue here were a duty to company shareholders, as in a case based on the classical insider trading theory.  But, as discussed above, the fraud in a misappropriation case is on the owner of the information, not any investor.  The correct materiality analysis must look for materiality to the owner – not investors.  If the owner of the information could care less whether the information was used or not – i.e., did not treat the confidentiality of the information as important – then even if it were highly material to certain investors there would be no fraud by the employee’s failure to disclose the use of it for his own benefit.  In this case, the information Bolan gave to Ruggieri was material because Wells Fargo made it plain in its internal policies that it was important to keep this information confidential from investors and from other employees outside of the research department.  That would be true even if it was not clear whether disclosing the information would or wouldn’t impact the stock price of the companies researched.  Because the secret ratings information was material to Wells Fargo, ALJ Patil’s finding of materiality was correct, albeit for the wrong reason.

Fortunately, these analytic shortcomings in ALJ Patil’s overall statement of the law did not prevent him from getting to the right decision based on the theory pursued by the Division and the evidence placed before him.

ALJ Patil’s Analysis of Dirks and Newman Was Spot On

ALJ Patil’s best work in this opinion is his discussion of the Dirks “personal benefit” requirement, as further developed by the Second Circuit in Newman.  In pages 28 to 32, he explains why the personal benefit requirement must apply to a misappropriation case, and in pages 33 to 50, he rejects every Division argument that the evidence presented adequately showed that Bolan obtained a personal benefit as part of his communication of impending ratings changes to Ruggieri.  Because there was no such benefit proved, Bolan’s tip was not fraudulent and Ruggieri could not have tippee liability derived from a fraud by Bolan.

ALJ Patil first addressed whether the Division was required to prove a personal benefit. Dirks “rejected the premise that all disclosures of confidential information are inconsistent with the fiduciary duty that insiders owe to shareholders.”  Initial Decision at 29.  He noted that the key element of a violation is “manipulation or deception”: “As Dirks instructs, mere disclosure of or trading based on confidential information is insufficient to constitute a breach of duty for insider trading liability.  Not every breach of duty, and not every trade based on confidential information, violates the antifraud provisions of the federal securities laws.  Rather, such conduct must involve manipulation, deception, or fraud against the principal such as shareholders or source of the information.”  He quoted both O’Hagan (521 U.S. at 655) (section 10(b) “is not an all-purpose breach of fiduciary duty ban; rather, it trains on conduct involving manipulation or deception”) and Dirks (463 U.S. at 654) (“Not all breaches of fiduciary duty in connection with a securities transaction, however, come within the ambit of Rule 10b-5.  There must also be manipulation or deception.”).  Id.  This led to the conclusion: “the Court identified the personal benefit element as crucial to the determination whether there has been a fraudulent breach.”  Id. at 30.  This is how Dirks separated communications not designed to deceive shareholders from those with an element of deception.  Otherwise, “If courts were to impose liability merely because confidential information was disclosed to a non-principal, this would potentially expose a person to insider trading liability ‘where not even the slightest intent to trade on securities existed when he disclosed the information.’”  Id. (quoting SEC v. Yun, 327 F.3d 1263, 1278 (11th Cir. 2003).

He then expressly rejected the Division’s contention that the Dirks personal benefit requirement did not carry over to misappropriation cases by pointing out that O’Hagan, which first accepted the misappropriation theory, equally focused on the need for deceptive conduct:

Contrary to the Division’s position, the alleged breach committed by a misappropriator is not any more “inherent” than the alleged breach committed by an insider in a classical case.  In both scenarios, confidential information was leaked and/or used to trade in securities.  The harm to the principal—the source of the information in a misappropriation case or the shareholders in a classical case—is the same, if “not more . . . egregious” in a classical case. Yun, 327 F.3d at 1277.  “[I]t . . . makes ‘scant sense’ to impose liability more readily on a tipping outsider who breaches a duty to a source of information than on a tipping insider who breaches a duty to corporate shareholders.”  Id.

It is true that Dirks was decided in the context where an insider leaked confidential information to expose corporate fraud, which put the Court in the unenviable position of either finding insider trading liability when there was no objective evidence of an ill-conceived purpose, or crafting a standard to ensure that the securities laws were of no greater reach than intended.  The Division contends that Dirks required a benefit in classical cases to differentiate between an insider’s improper and proper use of confidential information.  The Division asserts that “use of confidential information to benefit the corporation (or for some other benevolent purpose consistent with the employee’s duties to his employer) cannot logically breach a fiduciary duty to the corporation’s shareholders.”  Div. Opp. to Motion for Summary Disposition at 21.  But the same rationale applies in an alleged misappropriation case.  An outsider might just as well divulge information for purposes that he believes might be in the best interest of the source to which a fiduciary duty is owed.

Courts cannot simply assume that a breach is for personal benefit.  See Newman, 773 F.3d at 454 (“[T]he Supreme Court affirmatively rejected the premise that a tipper who discloses confidential information necessarily does so to receive a personal benefit.”).  And the breach in a misappropriation case has not been defined by the Supreme Court as inherent, but as connected to personal benefit.  The misappropriation theory “holds that a person commits fraud ‘in connection with’ a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”  O’Hagan, 521 U.S. at 652.  “Under this theory, a fiduciary’s undisclosed, self-serving use of a principal’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.”  Id. (emphasis added).  In contrast to a classical case premised “on a fiduciary relationship between company insider and purchaser or seller of the company’s stock, the misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.”  Id.

It is with this view that the Supreme Court “agree[d] with the Government that misappropriation, as just defined, satisfies § 10(b)’s requirement that chargeable conduct involve a ‘deceptive device or contrivance’ used ‘in connection with’ the purchase or sale of securities.”  O’Hagan, 521 U.S. at 653.  The Court “observe[d] . . . that misappropriators, as the Government describes them, deal in deception.  A fiduciary who pretends loyalty to the principal while secretly converting the principal’s information for personal gain . . . dupes or defrauds the principal.” Id. at 653-54 (emphasis added). . . .  The Court analogized misappropriation to the scenario where “an employee’s undertaking not to reveal his employer’s confidential information ‘became a sham’ when the employee provided the information to his co-conspirators in a scheme to obtain trading profits,” which constituted “fraud akin to embezzlement—‘the fraudulent appropriation to one’s own use of the money or goods entrusted to one’s care by another.’” Id. at 654. . . .  Thus, the O’Hagan Court accepted the government’s misappropriation theory on the premise that the breach was committed secretly for self-gain, not on the assumption that this element is inherent.

Initial Decision at 30-31 (footnotes and some cites omitted).

ALJ Patil then rejected the Division’s reliance on other cases in support of its argument, finding that though they may have used loose language, they did not need or intend to address the personal benefit issue in this context.  He concluded:

Neither the Supreme Court nor any federal court of appeals has drawn the curtain between classical and misappropriation cases that the Division urges.  Rather, courts have emphasized that the two theories are complementary, not mutually exclusive. . . .  In fact, “nearly all violations under the classical theory of insider trading can be alternatively characterized as misappropriations.”  Yun, 327 F.3d at 1279; see id. at 1276 n.27.  By requiring personal benefit to be proved in a misappropriation case, respondents are judged under similar standards.  Liability should not vary according to the theory under which the case is prosecuted.

At bottom, the Division’s position here, as the one advanced in Dirks, would have “no limiting principle.”. . .  The proposition that an alleged misappropriator violates his duty to a source, in violation of the antifraud provisions, by the mere disclosure of confidential information would improperly revive the notion that the antifraud provisions require equal information in the market, which has been rejected by the Supreme Court. . . .  [Dirks, 463] at 666 n.27 (rejecting similar arguments that “would achieve the same result as the SEC’s theory below, i.e., mere possession of inside information while trading would be viewed as a Rule 10b-5 violation” and reemphasizing that “there is no general duty to forgo market transactions based on material, nonpublic information.” . . .  I therefore adhere to my ruling that the Division must prove personal benefit.

Id. at 31-32.

ALJ Patil then turned to examining the evidence of the alleged personal benefits Bolan received from his tips.  I will not go through the details of the analysis of this evidence, which goes on for 14 pages.  The Division presented multiple claims of “personal benfit,” but the evidence showed that all of them were not in fact benefits related to providing tips but the internal operations of Wells Fargo in the normal course.  Purported “personal benefits” from the tips included “career mentorship” (found to be the norm at Wells Fargo); “positive feedback” (found to be no different for Bolan and others except as his performance justified); “friendship” with Ruggieri (found not be especially strong); a good “working relationship” (again found to be consistent with the Wells Fargo norm); and an intended gift by Bolan (found unproved – the Division did not even call Bolan as a witness).  As a nail in the coffin, ALJ Patil found that the evidence suggested Bolan simply accorded little weight to Wells Fargo’s policies, as reflected in recidivist violations of Wells Fargo confidentiality rules with others as well as Ruggieri (for which he was fired by Wells Fargo).

Why Did the Division of Enforcement Try Ruggieri as a Tippee?

This review of the facts and law of the case leaves a strange question.  What was the point of charging Ruggieri as a tippee rather than for his direct misappropriation of confidential Wells Fargo information?  He received Bolan’s information as a Wells Fargo employee and was obligated to keep that information confidential.  If he knowingly used that information improperly (in violation of his duties to Wells Fargo), in order to gain a benefit for himself (the Division contended the successful trades increased his compensation), and failed to disclose this to Wells Fargo, he violated section 10(b) regardless of whether Bolan did as well.  The Division would not have been stymied by a personal benefit requirement because the lack of a benefit to Bolan wouldn’t matter – the alleged increased compensation to Ruggieri would be sufficient to support a fraud claim.

I’m guessing the Division voluntarily made its case against Ruggieri harder because it wanted to stick it to both Bolan and Ruggieri.  Bolan, who agreed to a settlement (and had already been fired by Wells Fargo), could not be charged with fraud if he were not alleged to be a tipper, and the SEC staff always wants to charge fraud.  So, the ultimate irony of the case may be that in a case centered on greed, it may have been the Division’s own greed for multiple fraud judgments that pushed it to charge a case it lacked sufficient evidence to prove.  It would not be the first time the Division lost a case because, like Johnny Rocco (Edward G. Robinson) in Key Largo, it was motivated simply by wanting “more.”

Johnny Rocco

Johnny Rocco (Key Largo)

(“There’s only one Johnny Rocco.”

“How do you account for it?”

“He knows what he wants.  Don’t you, Rocco?”

“Sure.”

“What’s that?”

“Tell him, Rocco.”

“Well, I want uh …”

“He wants more, don’t you, Rocco?”

“Yeah. That’s it. More. That’s right! I want more!”

“Will you ever get enough?”

“Will you, Rocco?”

“Well, I never have. No, I guess I won’t.”)

Like Johnny Rocco, the SEC staff almost always wants “more.”

Straight Arrow

September 15, 2015

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Some SEC Administrative Law Judges Are Thoughtful and Even Judicious

We have now on several occasions bemoaned the fate of Laurie Bebo, former CEO of Assisted Living Concepts, Inc., to be forced to litigate her professional future before SEC Administrative Law Judge Cameron Elliot, whom we believe to be, shall we say, not the brightest star in the firmament.  See SEC ALJ Cameron Elliot Shows Why In re Bebo Should Be in Federal Court; Bebo Case Continues To Show Why SEC Administrative Proceeding Home Advantage Is Unfair; and SEC ALJ in Bebo Case Refuses To Consider Constitutional Challenge and Denies More Time To Prepare Defense.  And we have argued that the SEC’s home administrative law court is not a fair forum for the resolution of career-threatening enforcement actions against non-regulated defendants, notwithstanding that the Dodd Frank Act permits such cases to go forward.  See Challenges to the Constitutionality of SEC Administrative Proceedings in Peixoto and Stilwell May Have Merit; Ceresney Presents Unconvincing Defense of Increased SEC Administrative Prosecutions; and Opposition Growing to SEC’s New “Star Chamber” Administrative Prosecutions.  That might make a reader think we believe that all SEC ALJs lack the ability or temperament to preside over and decide important cases.  So, to set that record straight, allow us to say that, like almost almost any other place, the SEC administrative law courts are administered by appointees with a range of abilities and demeanors.  It is not the lack of judicial ability that makes the SEC’s administrative courts a poor forum for such cases, it is that the forum is bereft of procedural protections that enhance the chance that a respondent will get a fair shake even when the presiding ALJ is one of poor judicial timber.

In federal court, there are also good judges, bad judges, and a range in between.  But the scales of justice have calibrating factors other than the judge.  In a federal court, equal access to potential evidence through liberal discovery; equal opportunity to develop familiarity with the record over a reasonable period of time; evidentiary rules designed to assure that unreliable evidence, and excessively prejudicial evidence, is excluded; and, of course, the fact that a jury sits to consider the evidence, and use their combined common sense to find facts, all combine to make it possible for a defendant to overcome poor judging.  There is a vacuum of such protections in the administrative law court.  That makes the quality, or questionable quality, of the judge/trier of fact, much more important.  When the judge fails to understand, or care, that he or she is essentially the only factor between a fair proceeding and one tilted in favor of the prosecutor, justice suffers.

So, in celebration of the new baseball season, I’d like to throw a change-up today and discuss an SEC administrative law judge who, although appointed only recently, is showing great potential to be worthy of his position.  I’ve not seen SEC ALJ Jason Patil in the courtroom, but I’ve been very impressed with his approach in some recent cases.  He’s shown he can act with independence, thoroughness, attention to detail, and a strong dose of common sense.  So this blog post is to give credit where credit is due.

All the more credit is due because Jason Patil is the proverbial “new kid on the block.”  He was appointed to the SEC’s ALJ bench on September 22, 2014, after receiving a Stanford degree in political science in 1995, a law degree from from the University of Chicago Law School in 1998, and an L.L.M, from Georgetown University Law Center in 2009.  He served at the Department of Justice for 14 years.

Fewer than 3 months after ALJ Patil started at the SEC, the Second Circuit rocked the boat of the DOJ and the SEC with its insider trading decision in United States v. Newman.  ALJ Patil had to consider the impact of that decision in a case before him: In the Matter of Bolan and Ruggieri.  The SEC’s enforcement lawyers made every effort to obtain an early, post-Newman ruling from ALJ Patil in that case that would limit the scope of the Newman opinion through the adoption of a standard that would not apply Newman‘s holding to insider trading cases based on the misappropriation theory, rather than the so-called “classical” insider trading theory on which the Newman and Chiasson prosecution was founded.  ALJ Patil resisted the SEC’s full-court press to make him an early adopter of an approach that essentially ignored key language in the Second Circuit opinion.  He rejected that effort, ruling that, as the Newman court said, the standard for liability was the same under either the classical or misappropriation insider trading theory.  See SEC ALJ in Bolan and Ruggieri Proceeding Rules Misappropriation Theory Mandates Proof of Benefit to Tipper.

That showed intelligence, independence, and, to be frank, guts, for a newly-appointed ALJ.  But it was a later decision that showed me that ALJ Patil seems to have the stuff of a good judge.  In the Matter of Delaney and Yancey, File No. 3-15873, was not a high profile insider trading case, but it was apparent from the Initial Decision he wrote that he was able and willing to evaluate cases fairly and decisively.  His decision in that case is available here: ALJ Initial Decision in the Matter of Delaney and Yancey.  In that case, he wrote a careful opinion, weighing the evidence, distinguishing between the roles and conduct of the respondents, weighing expert testimony, considering (and often rejecting) varying SEC legal theories, and applying a strong dose of common sense.

The case was a technical one, involving charges against two individuals, the President and CEO of a broker-dealer that was a major clearing firm for stock trades (Mr. Yancey), and that firm’s Chief Compliance Officer (Mr. Delaney).  The SEC alleged many violations by the firm of SEC regulations governing the settlement of trades.  Mr. Delaney was charged with aiding and abetting, and causing, numerous violations of SEC regulations by virtue of his conduct as the Chief Compliance Officer.  Mr. Yancey was charged with failing adequately to supervise Mr. Delaney and another firm employee, allowing the violations to occur.  ALJ Patil exhaustively reviewed the evidence to reach reasoned decisions, with cogent explanations supporting his views.  In doing so, he was not shy about chiding the SEC for fanciful theories and woefully unsupported proposed inferences.

The opinion is long, detailed, and more in the weeds than many of us like to get.  The aiding and abetting charge against Mr. Delaney required proof that he assisted the violations through either knowing or extremely reckless conduct (i.e., scienter).  The SEC enforcement staff is quick to accuse people of knowing or reckless misconduct, and is often willing to draw that inference with little in the way of supporting evidence.  ALJ Patil’s review of the evidence presented in support of the scienter element was precise and thorough.  He dissected the evidence piece-by-piece, in impressive detail.  Here is some of what he said:

The Division has failed to show that Delaney acted with the requisite scienter, and
therefore its aiding and abetting claim against Delaney fails.  As an initial matter, I note that the Division is unable to articulate or substantiate a plausible theory as to why Delaney would want to aid and abet [his firm’s violations].  While the Division correctly argues that motive is not a mandatory element of an aiding and abetting claim, numerous courts have noted its absence when finding that scienter has not been proven. . . .    The Division also failed to establish that Delaney had anything to gain from the alleged misconduct.  The Division’s original theory was a wildly exaggerated belief that [the] . . . violations resulted in millions of dollars of additional profits. . . .  The Division was forced to abandon that theory, and in the end agreed that the “only specifically quantified benefit” to [the firm] . . . was a meager $59,000.  I do not find that sum would have given Delaney any motive to aid and abet the . . . violation. . . .  Although the Division also argues that there would have been “substantial costs to [the firm] . . . that . . . could expose the firm to significant losses,” the Division produced no evidence to quantify the costs or losses, and the testimony to which the Division points is general and speculative. . . .  As the Division did not provide any evidence quantifying the purported costs or losses, I am unable to determine whether there were any.

One of the SEC’s major points was the contention that Mr. Delaney’s knowing misconduct was apparent because he was shown to be a liar by misstatements in the Wells Submission submitted to the SEC on his behalf by his lawyers.  ALJ Patil forcefully torpedoed this theory:

I disagree with the Division’s conclusion that “Delaney has not been honest or
truthful” and “[i]nstead . . . has been evasive and inconsistent.”. . .  The Division’s
primary evidence for this alleged dishonesty are statements made in Delaney’s Wells
submission.  The Division argues, “either the statements Delaney approved about his knowledge and actions were lies to the Commission in his Wells submission or his repudiation of those statements are lies to the Court now.”. . .  Based on my careful review of that document, I conclude that it is primarily comprised of argument by counsel and grounded in incomplete information. . . .  It is based not just on Delaney’s understanding at that time, but on his counsel’s characterization of other evidence selectively provided to Delaney by the Division. . . . .  In contrast to that argumentative submission, Delaney testified five times under oath, including at the hearing. . . .  I find that Delaney’s testimony was overwhelmingly consistent, and the handful of inconsistencies alleged by the Division in such testimony either do not exist or are easily explained by the circumstances. . . .  In this case, where Delaney testified multiple times under oath at the Division’s request, as did other witnesses, I have decided to base my decision on that testimony and other documents in the record, which I find more probative than past characterizations made by Delaney’s counsel. . . .  I do not accept the Division’s insistence that everything in the [Wells Submission], particularly the statements in the legal argument section, should be taken, in essence, as testimony of Delaney.

Perhaps most telling was ALJ Patil’s careful review of supposed inconsistencies in testimony by Mr. Delaney.  His evaluation of that testimony reflected thoughtful consideration of the facts and circumstances both when the events at issue occurred, and when the testimony was given.  The decision took the SEC lawyers to task for arguing that testimony was inconsistent when the supposed inconsistencies were more plausibly explained by poor questioning by the SEC staff during their numerous examinations of him:

To the extent that Delaney’s testimony could be at all be characterized as “evasive” or
“inconsistent” . . . , it may be because he lacks a completely clear recollection of what
took place years ago regarding his alleged conduct.  Delaney credibly and convincingly
explained that his initial testimony was given with virtually no preparation or opportunity to
review documents, thus preventing him from having a full and fair recollection of the events he was asked about. . . .  While his conduct with respect to [the Rule at issue] is especially
important in the present action, at the time of such conduct, Delaney was in the business of
putting out “fires,” . . . and [the Rule], though undeniably important, was most assuredly not the top priority for the compliance department. . . .  [T]he Division argues that “Delaney quibbled about whether he had seen the release [for the Rule] in the same exact format as that in the exhibit used at the hearing and during his testimony.” . . .  Several exhibits copy or link to the text of the releases . . . with the appearance and formatting of each differing dramatically from the way the text of such releases is ultimately arranged in the printed version of the Federal Register, the document Delaney was shown at the hearing. . . .  When someone is testifying about a document that may not look anything like the version he had read, it is not “quibbling” to explain that one has never seen something that looks like the exhibit.  I in fact thought that the Federal Register version of the releases looked considerably different from the other copies and would have been hesitant to say I had read the exhibit without first looking it over. . . .  Despite his exasperation at the Division’s repeated insinuations that he was lying, I found Delaney a credible and convincing witness. My perception, that his hours of testimony were sincere and truthful, is consistent with the attestation of all the hearing witnesses regarding Delaney’s honesty and integrity.

Finally, the Division asserts that Delaney contradicted himself because, on the one hand,
in August 2012 he did not recall being concerned about the contents of [a FINRA letter] and, on the other hand, in July 2013 he testified that a disclosure in that letter would be a big deal for [his firm]. . . .  However, because Delaney was asked somewhat different questions on the two different occasions (as opposed to being asked the same question on both occasions), his answers were consistent.  In August 2012, Delaney was asked whether he was concerned about the letter, not the conduct at issue. . . .  When asked about the purported contradiction at the hearing, Delaney reasonably explained that he was not concerned about the letter disclosing the conduct, which was accurate as he understood it, but at the same time was concerned about the underlying rule violations. . . .  It is telling that the Division, who has had Delaney testify so often, seizes on such minor supposed contradictions.  I find all of the purported inconsistencies identified by the Division are
either immaterial or have been adequately explained by Delaney.  I found, on the whole,
Delaney’s testimony to be credible, with the exception, noted previously, that he may not recall comparatively minor events and discussions that took place up to six years before the hearing.

Having found no evidence of knowledge, ALJ Patil went on to reject the SEC staff’s suggestions that Mr. Delaney’s conduct was nevertheless “reckless.”  He carefully distinguished between evidence of negligence and “extreme recklessness.”  He then dissected individual emails presented by the staff as “red flags” to show, one-by-one, that they were no such thing.

ALJ Patil nevertheless found Mr. Delaney liable for “causing” some of the firm’s violations, based on his conclusion that Mr. Delaney acted negligently.  He found violations “because the evidence supports that Delaney contributed to [the firm’s] violations and should have known he was doing so.”  He did so on the basis of testimony “that according to SEC guidance, in situations ‘where
misconduct may have occurred’– as opposed to ‘conduct that raises red flags’ – compliance
officers should follow up to facilitate a proper response.”  He provided a lengthy and lucid explanation of why he reached the conclusion that Mr. Delaney faced such a situation and failed to act prudently.

The case against Mr. Yancey failed entirely.  ALJ Patil found that Mr. Yancey, as CEO, was Mr. Delaney’s supervisor, but the evidence did not show intentional conduct by Mr. Delaney, and a supervisory violation can occur only when “[t]he supervised person must have ‘willfully aided, abetted, counseled, commanded, induced, or procured’ the securities law violation.”  But even if Mr. Delaney had willfully aided an abetted the firm’s rules violations, “the Division has failed to show that Yancey did not reasonably supervise Delaney . . . because “[a] firm’s president is not automatically at fault when other individuals in the firm engage in misconduct of which he has no reason to be aware.”  He concluded: “Yancey had no reason to believe that any ‘red flags’ or ‘irregularities’ were occurring at [the firm] that were not already the subject of prompt remediation.  Given the absence of such evidence, I find that the Division did not prove that Yancey failed reasonably to supervise Delaney, even were such a claim viable here.”

As for the supervisory charge regarding the second firm employee, who was a registered representative who did act willfully, Yancey “persuasively dispute[d]” that the employee was not subject to the CEO’s “direct supervision.”  “[A]s an initial matter, a president of a firm ‘is responsible for the firm’s compliance with all applicable requirements unless and until he or she reasonably delegates a particular function to another person in the firm, and neither knows nor has reason to know that such person is not properly performing his or her duties.’ . . .   I find that Yancey is not liable for [the employee’s] intentional misconduct because the record supports that Yancey reasonably delegated supervisory responsibility over [him] . . . and then followed up reasonably.”  ALJ Patil rejected several theories of the SEC staff why Mr. Yancey should nevertheless be considered a supervisor.  He ultimately found no liability for Mr. Yancey.

On the issue of sanctions, ALJ Patil did not rubber stamp SEC staff requests.  He gave a reasoned explanation for issuing a cease and desist order against Mr. Delaney, found he could not issue a bar order against him because he did not act willfully, and imposed what seem to be reasonable civil penalties, totaling $20,000, for the conduct involved.  His order on the SEC’s disgorgement request was, perhaps unintentionally, amusingly tongue-in-cheek: “I have opted not to order disgorgement in this case, because the amount at issue is negligible. The Division contends, in effect, that Delaney must pay back the portion of his $40,000 in bonuses during the relevant time period that arose from the Rule 204T/204 violations.  The quantified benefit of the violations, $59,000, is approximately 0.008 percent of [the firm’s] revenue during that period. . . .  Even if all of Delaney’s bonuses were based on [the firm’s] performance (which, they are not, since the parties seem to be in general agreement that such performance was only one of three factors in bonuses), based on the preceding figures, the percentage of Delaney’s bonuses tied directly to the quantifiable benefit . . . is three dollars and twenty cents.  Even accounting for prejudgment interest, a disgorgement order is unwarranted.”

Kudos to ALJ Patil for what appears to be a fine job of adjudicating a tiresome case.  In a careful ruling, he handed the SEC a substantial defeat and a partial victory.  If he keeps this up in his tenure as an SEC ALJ, we should see some high-quality, thoughtful, and independent decisions penned by him.

Straight Arrow

April 14, 2015

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SEC ALJ in Bolan and Ruggieri Proceeding Rules Misappropriation Theory Mandates Proof of Benefit to Tipper

On February 12, 2015, SEC Administrative Law Judge Jason Patil rejected the SEC’s argument in the insider trading case In the Matter of Bolan and Ruggieri that the misappropriation theory did not require proof of a benefit flowing to the original tipper.  The respondents had moved for summary disposition of the case under the legal standard stated by the Second Circuit in United States v. Newman (see their Reply Brief on Impact of Newman Decision in In the Matter of Bolan and Ruggieri).  The SEC argued that Newman’s analysis applied only to the “classical theory” of insider trading.  ALJ Patil disagreed, in a brief ruling that can be read here: ALJ Ruling in In re Bolan and Ruggieri.

The ALJ stated the issue as follows: “whether, in an insider trading case brought under a misappropriation theory, the Division must establish that the tipper received a personal benefit for allegedly tipping material, non-public information.”  Slip op. at 1.  The ALJ rejected the SEC’s argument that the Newman court’s discussion of the personal benefit requirement was dicta.  He noted that the Second Circuit previously ruled in SEC v. Obus, 693 F.3d 276, 284 (2d Cir. 2012), that although the “tipping liability doctrine” stated by the Supreme Court in Dirks v. SEC involved a case under the classical theory, “the same analysis governs in a misappropriation case.”  As a result, when the Second Circuit “reconfirmed this principle” in Newman, “it was not mere dicta, but citing established law.”  Slip op. at 2.  He added: “Although the Division points to dicta from cases indicating that the personal benefit requirement is either not firmly established in misappropriation case-law or that it does not apply, no controlling authority has held as such.  Moreover, such a proposition would conflict with controlling authority—Dirks and Obus.”  Id.

On the issue of how the SEC could prove the required “personal benefit,” the ALJ said that proof of a close friendship between tipper and tippee “may be enough for a fact-finder to infer a personal benefit” (citing Obus, 693 F.3d at 291), but “such evidence, without more does not necessarily establish that the personal benefit element has been met.”  Slip op. at 2 (emphasis added).  His quote from the Newman opinion on the issue concluded with the Second Circuit’s focus on the need for proof of a personal benefit to establish “a fraudulent breach” by the tipper: “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 3 (quoting Newman, 773 F.3d 438, 452 (2d Cir. 2014) (emphasis in original).

ALJ Patil ordered that the SEC make a factual proffer stating in “sufficient detail” “the allegations on which it intends to base its personal benefit theory,” and “the evidence it has or expects to establish at a hearing on the personal benefit element,” and suggested that he might hold “an evidentiary hearing on the issue of personal benefit.”

Straight Arrow

February 14, 2015

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