Tag Archives: Rule 10b-5

First Circuit Rebuffs SEC in Flannery and Hopkins Case and Vacates SEC Order

The SEC suffered a stunning loss in the First Circuit in a December 8, 2015 decision ruling that the SEC’s findings of securities law violations by two executives in connection with the operation of a State Street Bank bond fund lacked substantial supporting evidence.  The Commission had, by a 3-2 divided vote, overturned a decision by one of its administrative law judges that no violations had occurred, and in doing so wrote a highly controversial opinion in which it staked out aggressive positions on a variety of securities law issues.  See SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5; New, Thorough Academic Analysis of In re Flannery Shows Many Flaws in the Far-Reaching SEC Majority Opinion; and SEC not entitled to deference in State Street fraud appeal – law prof.

The First Circuit panel found, however, that the underlying evidence simply failed to support the finding of any violation on any  theory, even the aggressive interpretations set forth by the Commission in its opinion.  As a result, the First Circuit never ruled on the validity or invalidity of several important legal issues raised by the Commission in its overreaching opinion.  Therefore, the key issue whether the SEC’s attempt at aggressive revisions of the scope of the law are entitled to deference or acceptance was not reached.  The end result, however, which vacates the SEC Order, leaves no SEC precedent in place to support those aggressive opinions.

The First Circuit’s opinion is available here: 1st Circuit Decision in Flannery v. SEC.  The now-vacated SEC opinion is available here: In re Flannery Majority Opinion.

Perhaps the most stunning aspect of the First Circuit opinion is the way in which the court schooled the SEC — the supposed experts on securities —  by explaining why the evidence the SEC found compelling (despite a contrary ruling by its ALJ) was in fact deeply flawed.  Where the Commission majority found evidence of material intentional and negligent misrepresentations, the appellate court found no substance whatever.  What does this say about the competence of the SEC and its staff to consider such issues?  If you read the opinion, you will see that the SEC’s willingness to stretch minimal evidence into supposed violations of law, and to disregard the lack of real evidence of materiality and state of mind proffered during the trial, seems a lot like the strained efforts of plaintiffs’ lawyers to find securities fraud everywhere.  And that is the reality faced by those being investigated and prosecuted by the SEC: the investigation and prosecution proceeds on the basis of a distorted view of what constitutes important information, and intentional or negligent behavior, that puts almost every decision in the SEC’s cross-hairs based largely on backward-looking, “fraud by hindsight” reasoning.

 The First Circuit opinion is based on an analysis of the specific evidence in the record, and therefore is not easily summarized.  The case turned on two sets of events.

The case against Mr. Hopkins turned on a short presentation to investors in which he participated, and, indeed, a single power-point slide in that presentation.  That slide set forth various parameters of the bond fund at issue (State Street’s Limited Duration Bond Fund, hereafter “the Fund”) under the heading “Typical Portfolio Exposures and Characteristics.”  It never purported to lay out the exact characteristics of the Fund at the time of the presentation, although Mr. Hopkins had that information available if any investor asked about them.  The SEC charged Mr. Hopkins with fraud for discussing this power-point slide without providing the exact information about the Fund at that time, which in some respects differed from the “typical” slide, and in others did not.  In particular, the percentage of holdings of different types of asset-backed securities — ABS (asset-backed securities, included residential mortgage-backed securities), CBS (commercial-backed securities), MBS (mortgage-backed securities), and other designations — at the time varied from the “typical” slide by having heavier ABS holdings.

The case against Mr. Flannery focused on two letters sent by State Street to investors regarding the impact of the 2007 financial crisis on the Fund and steps being taken to respond to that.  Mr. Flannery signed one of those letters, but not the other.  Many State Street officials participated in the drafting of these letters, including its General Counsel.  The SEC contended that Mr. Flannery negligently participated in a “course of business” that “operated as a fraud” in his role in connection with these letters.  The alleged misrepresentations in the letters related to whether steps taken to divest the Fund of certain bonds were properly described as lessening its exposure to risk.

As you can see, these are “in the weeds” issues to which the SEC should be able to bring sophistication and expertise.  Instead, they pursued a blunderbuss case that ignored the context of the disclosures, the realities of these types of communications (what they are intended to communicate and what not), and the actual language used.  The SEC essentially waved its hands around and said “this is bad; this is bad” and “look how badly the funds did when the mortgage-backed securities market tanked.”  But it failed to present evidence that what was said was wrong, or that the aspect that it contended was wrong was even important to investors, and ignored substantial evidence to the contrary.

Here is some of what the court said with respect to the case against Mr. Hopkins:

Questions of materiality and scienter are connected. . . .  “If it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact.” . . .

Here, assuming the Typical Portfolio Slide was misleading, evidence supporting the Commission’s finding of materiality was marginal.  The Commission’s opinion states that “reasonable investors would have viewed disclosure of the fact that, during the relevant period, [the Fund’s] exposure to ABS was substantially higher than was stated in the slide as having significantly altered the total mix of information available to them.”  Yet the Commission identifies only one witness other than Hopkins relevant to this conclusion. . . .

[T]he slide was clearly labeled “Typical.”  [The witness and his firm] never asked … for a breakdown of the [Fund’s] actual investment….  Further, the Commission has not identified any evidence in the record that the credit risks posed by ABS, CMBS, or MBS were materially different from each other, arguing instead that the percent of investment in ABS and diversification as such are important to investors.  Context makes a difference.  According to a report [the witness] authored the day after the meeting, the meeting’s purpose was to explain why the [Fund] had underperformed in the first quarter of 2007 and to discuss its investment in a specific index that had contributed to the underperformance.  The Typical Portfolio Slide was one slide of a presentation of at least twenty. Perhaps unsurprisingly, the slide was not mentioned in [the witness’s] report.

Hopkins presented expert testimony . . . that “[p]re-prepared documents such as . . . presentations . . . are not intended to present a complete picture of the fund,” but rather serve as “starting points,” after which due diligence is performed.  [The expert] explained that “a typical investor in an unregistered fund would understand that it could specifically request additional information regarding the fund.”  And not only were clients given specific information upon request, information about the [Fund’s] actual percent of sector investment was available through the fact sheets and annual audited financial statements.  The … fact sheet … six weeks prior to the … presentation [said] the [Fund] was 100% invested in ABS.  The [fact sheet one-month after the presentation said] the [Fund] was 81.3% invested in ABS. These facts weigh against any conclusion that the Typical Portfolio Slide had “significantly altered the ‘total mix’ of information made available.” …

This thin materiality showing cannot support a finding of scienter here….  Hopkins testified that in his experience investors did not focus on sector breakdown when making their investment decisions and that [Fund] investors did not focus on how much of the [Fund] investment was in ABS versus MBS….  He did not update the Typical Portfolio Slide’s sector breakdowns because he did not think the typical sector breakdowns were important to investors.  To the extent that an investor would want to know the actual sector breakdowns, Hopkins would bring notes with “the accurate information” so that he could answer any questions that arose.  We cannot say that these handwritten notes provide substantial evidence of recklessness, much less intentionality to mislead — particularly in light of Hopkins’s belief that this information was not important to investors….

We conclude that the Commission abused its discretion in holding Hopkins liable under Section 17(a)(1), Section 10(b), and Rule 10b-5.

Slip op. at 21-24 (footnotes omitted).

The court said in a footnote: “… We do not suggest that the mere availability of accurate information negates an inaccurate statement.  Rather, when a slide is labeled ‘typical,’ and where a reasonable investor would not rely on one slide but instead would conduct due diligence when making an investment decision, the availability of actual and accurate information is relevant.”  Slip op. at 22 n.8.

And here is some of the discussion about the case against Mr. Flannery:

… At the very least, the August 2 letter was not misleading — even when considered with the August 14 letter — and so there was not substantial evidence to support the Commission’s finding that Flannery was “liable for having engaged in a ‘course of business’ that operated as a fraud on [Fund] investors.”

The Commission’s primary reason for finding the August 2 letter misleading was its view that the “[The Fund’s] sale of the AAA-rated securities did not reduce risk in the fund.  Rather, the sale ultimately increased both the fund’s credit risk and its liquidity risk because the securities that remained in the fund had a lower credit rating and were less liquid than those that were sold.” At the outset, we note that neither of the Commission’s assertions — that the sale increased the fund’s credit risk and increased its liquidity risk — are supported by substantial evidence.

First, although credit rating alone does not necessarily measure a portfolio’s risk, the Commission does not dispute the truth of the letter’s statement that the [Fund] maintained an average AA-credit quality. Second, expert testimony presented at the proceeding explained that the July 26 AAA-rated bond sale reduced risk because these bonds “entailed credit and market risk that were substantially greater than those of cash positions. In addition, a portion of the sale proceeds was used to pay down [repurchase agreement] loans and reduce the portfolio leverage.”

Further, testimony throughout the proceeding indicated that the [Fund’s] bond sales in July and August reduced risk by decreasing exposure to the subprime residential market, by reducing leverage, and by increasing liquidity, part of which was used to repay loans.

To be sure, the Commission maintained that the bond sale’s potentially beneficial effects on the fund’s liquidity risk were immediately undermined by the “massive outflows of the sale proceeds . . . to early redeemers.”  But this reasoning falters for two reasons. First, the Commission acknowledged that between $175 and $195 million of the cash proceeds remained in the LDBF as of the time the letter was sent; it offered no reason, however, why this level of cash holdings provided an insufficient liquidity cushion.  Second and more fundamentally, even if the Commission was correct that the liquidity risk in the [Fund] was higher following the sale than it was prior to the sale, it does not follow that the sale failed to reduce risk.  Rather, to treat as misleading the statement in the August 2 letter that State Street had “reduced risk,” the Commission would need to demonstrate that the liquidity risk in the LDBF following the sale was higher than it would have been in the counterfactual world in which the financial crisis had continued to roil — and in which large numbers of investors likely would have sought redemption — and the [Fund] had not sold its AAA holdings. But the Commission has not done this.

Independently, the Commission has misread the letter. The August 2 letter did not claim to have reduced risk in the [Fund].  The letter states that “the downdraft in valuations has had a significant impact on the risk profile of our portfolios, prompting us to take steps to seek to reduce risk across the affected portfolios” (emphasis added).  Indeed, at oral argument, the Commission acknowledged that there was no particular sentence in the letter that was inaccurate. It contends that the statement, “[t]he actions we have taken to date in the [Fund] simultaneously reduced risk in other [State Street] active fixed income and active derivative-based strategies,” misled investors into thinking [State Street] reduced the [Fund’s] risk profile.  This argument ignores the word “other.”  The letter was sent to clients in at least twenty-one other funds, and, if anything, speaks to having reduced risk in funds other than the [Fund].

Even beyond that, there is not substantial evidence that [State Street] did not “seek to reduce risk across the affected portfolios.”  As one expert testified, there are different types of risk associated with a fund like the [Fund], including market risk, liquidity risk, and credit or default risk.  The [Fund] was facing a liquidity problem, and … the Director of Active North American Fixed Income, explained that “[i]t’s hard to predict if the market will hold on or if there will be a large number of withdrawals by clients.  We need to have liquidity should the clients decide to withdraw.” Flannery noted that “if [they didn’t] raise liquidity [they] face[d] a greater unknown.”  … [The Fund’s] lead portfolio manager, noted that selling only AAA-rated bonds would affect the [Fund’s] risk profile.  After discussion of both of these concerns, the Investment Committee ultimately decided to increase liquidity, sell a pro-rata share to warrant withdrawals, and reduce AA exposure. And that is what it did.…  The August 2 letter does not try to hide the sale of the AAA-rated bonds; it candidly acknowledges it. At the proceeding, Flannery testified that selling AAA-rated bonds itself reduces risk, and here, in combination with the pro-rata sale, was intended to maintain a consistent risk profile for the [Fund].  [Another witness] testified that the goal of the pro-rata sale was to treat all shareholders — both those who exited the fund and those who remained — as equally as possible and maintain the risk-characteristics of the portfolio to the extent possible.  These actions are not inconsistent with trying to reduce the risk profile across the portfolios.

Finally, we note that the Commission has failed to identify a single witness that supports a finding of materiality….  We do not think the letter was misleading, and we find no substantial evidence supporting a conclusion otherwise. 

We need not reach the August 14 letter…. Even were we to assume that the August 14 letter was misleading, in light of the SEC’s interpretation of Section 17(a)(3) and our conclusion about the August 2 letter, we find there is not substantial evidence to support the Commission’s finding that Flannery engaged in a fraudulent “practice” or “course of business.”

Slip op. at 25-30 (footnotes omitted).

As noted above, it is obvious that the court’s decision turned on a close examination of the evidence, and an understanding of what the statements made by Hopkins and Flannery really meant, within their context.  The generalized power-point slide used by Mr. Hopkins, in the context of a broader presentation, and the availability of specific information on request, was so close to immaterial that Mr. Hopkins’ understanding that investors would not place significant weight on the “typical” data could not be reckless.  And the State Street letters to investors in which Mr. Flannery participated were not inaccurate because the SEC did not understand that the transaction described was, in fact, a means of reducing risk exposure.  That last point is a killer: the SEC could not even understand how to evaluate the risk exposures of these types of portfolios!  How good does that make you feel about the Commissioners that are responsible for understanding and protecting our capital markets?

This is a huge loss for the Commission because so much effort was made to make this case a showpiece for enforcement against individuals for supposed securities violations in the sale of the mortgage-backed securities that were devastated in the financial crisis.  The SEC was loaded for bear to hold some individuals responsible, regardless of the evidence.  Thank goodness a court was ultimately available to return us to the true rule of law.

Straight Arrow

December 9, 2015

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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

Contact Straight Arrow privately here, or leave a public comment below:

Supreme Court Filings in U.S. v. Newman and Chiasson Leave Serious Doubts on Grant of Certiorari

With all of the publicity, hubbub, and hype surrounding the Second Circuit’s decision in United States v. Newman and Chiasson, a grant of writ of certiorari at the Government’s request is a foregone conclusion, right?  In a word, “no.”  The filings on the Government’s motion seeking certiorari make it pretty clear that if you remove the publicity, hubbub, and hype – and consider what the Newman opinion says, and not just what the Government portrays it as saying – the Supreme Court’s normal standards for hearing a case simply are not satisfied.  Let me explain.

(The filings on the petition for certiorari can be read here: Petition for Writ of Certiorari in US v. Newman; Newman Opposition to Cert. Petition; Chiasson Opposition to Cert. Petition.

The Government’s entire push for Supreme Court review turns on two arguments: (1) the Second Circuit amended the Supreme Court’s decision in Dirks v. SEC by mandating that a tippee exchange tangible value for tipped material nonpublic information from the tipper, when Dirks says that “gifts” of such information by the tipper to the tippee can be sufficient to create liability; and (2) the Second Circuit’s revision threatens the integrity of the securities markets by undermining investors’ belief in the fairness of those markets.  The briefing on certiorari, however, leaves little doubt that the Government cannot (or at least does not) provide support for either of these arguments.  Instead, these arguments are based on (i) a reading of the opinion that ignores what the court said, and is not how the courts have treated the Newman opinion since it was issued; and (ii) ipse dixit assertions by the Government about the terrible consequences of Newman on markets and law enforcement, which lack any substantiation.

But beyond this, the briefing makes it clear that Newman simply is not the kind of case that the Supreme Court normally would review, for three reasons: (1) the ruling the Government asks for would not, in fact, change the result – Messrs. Newman and Chiasson will be not be prosecutable in any event because the Government does not seek review of determinative aspects of the Second Circuit opinion that prevent any conviction; (2) the aspect of the Newman decision that the Government does challenge is an evidentiary issue – not an important issue of law – that is limited in its impact, other than in support of the view that the actual evidence presented in a case matters, which the Supreme Court is unlikely to countermand; and (3) the ruling the Government asks for would make it difficult for investors and their advisers to gather and use information in ways the Dirks court sought to protect as critical to the functioning of an efficient marketplace.

The Supreme Court Usually Doesn’t Review Cases To Provide an Advisory Opinion

Let’s start with what should be the most important issue for a cert. petition: will Supreme Court review actually make a difference in the case.  The answer here plainly is that it would not.  Why? Well, the Government presents for review only a single question: “whether the court of appeals erroneously departed from this Court’s decision in Dirks by holding that liability under a gifting theory requires ‘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.’”  Cert. Pet. at (I).  But the Second Circuit reversed the convictions of Messrs. Newman and Chiasson for another, totally independent reason: that because this is a criminal case, a conviction required proof that the defendants knew that the information they used to trade securities was obtained through a breach of duty by an insider, and there was no evidence from which a reasonable juror could make such a finding.  Because of this, even if the Supreme Court were to agree with the Government on its question presented, the defendants’ convictions would still be overturned.  The Supreme Court typically does not accept cases in which its opinion, in effect, becomes an advisory opinion on the law and does not impact the determination of the case before it.

Here is how the Newman cert. opposition discusses this point:

The central legal holding in the court below was that insider trading liability requires a tippee to know that the tipper received a personal benefit.  While the government opposed such a requirement in the trial court and on appeal, it does not challenge that ruling now. Instead, the Petition seeks review of a single, fact-based sufficiency determination regarding whether there was a personal benefit in the first place.  Notably, the government’s articulation of the question presented addresses only the type of evidence required to prove a personal benefit; it does not implicate the court of appeals’ independent holding that Newman committed no crime because he did not know of the benefit.  Accordingly, even if this Court were to agree with the government that the Second Circuit misstated the type of evidence required to support an inference of a benefit, the decision dismissing the indictment on the independent ground that Newman did not know of any benefit would stand.

The government understands, of course, that the Supreme Court does not grant review to issue advisory opinions.  To overcome that obstacle, the government proposes that this Court “correct” the Second Circuit’s analysis of what evidence may be used to prove a personal benefit and then remand to the Second Circuit for reconsideration of both the sufficiency of whether there was a benefit and whether Newman knew of the benefit.  Pet. 29-31.  This attempted sleight of hand is unconvincing.  The Second Circuit determined that, “[e]ven assuming that the scant evidence . . . was sufficient to permit the inference of a personal benefit,” the proof was insufficient to establish knowledge of any benefit because the defendants “knew next to nothing” about the insiders or the circumstances of their disclosures, and the government “presented absolutely no testimony or any other evidence that Newman and Chiasson knew . . . that those insiders received any benefit in exchange for such disclosures . . .” . . . .  This conclusion was not based on a nuanced view of how personal benefit should be defined; it was based on the utter lack of evidence that the defendants knew of any benefit, however defined, or even the basic circumstances under which the disclosures were made.  No decision by this Court on the narrow issue presented for review would change the ultimate disposition of this case.

Newman Cert. Opp. at 1-3.

The Second Circuit Decision Is Inaccurately Portrayed by the Government

Let’s turn now to the guts of the Government argument, and show why it fails because it is founded on a reading on the Newman opinion that is inaccurate and misleading.

The Government’s core argument is that the Second Circuit broke from Dirks by refusing to allow a “gift” from the tipper to the tippee to be considered a basis for the required breach of duty to support an insider trading violation:

The court of appeals’ decision is irreconcilable with Dirks.  In the guise of interpreting this Court’s opinion, the court of appeals crafted a new, stricter personal-benefit test, stating that “[t]o 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,’ *** 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.” . . .

That new “exchange” formulation erases a form of personal benefit that this Court has specifically identified.  Under Dirks, an inference of a personal benefit to the insider arises in two situations: when the insider expects something in return for the disclosure of the confidential information, or when the insider freely gives a gift of information to a trading friend or relative without any expectation of receiving money or valuables as a result. . . .  The Second Circuit purported to recognize that second form of personal benefit . . . but then rewrote the concept of a “gift” so as to eliminate it.  The court held that an insider cannot be liable on a gift theory unless he receives something from the recipient of information “that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” . . .  But such an “exchange” is, by definition, not the same thing as a “gift”; rather, it is a quid pro quo, “something for something.”

Cert. Pet. at 18-19.

This argument should fail because the Supreme Court Justices – and their clerks – should easily see that the Second Circuit decision does not say what the Government argument describes.  The Government accepts that the entire discussion of “personal benefit” occurred as the Second Circuit “considered the sufficiency of the evidence that the . . . insiders personally benefitted from disclosing confidential corporate information,” and that in doing so, the court of appeals “acknowledged that in [Dirks, the Supreme] Court stated that ‘personal benefit’ includes reputational benefit and ‘the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.’”  Cert. Pet. at 11 (emphasis added).

The problem was that the Government introduced no evidence showing that in either of the two instances of alleged tipping (involving communications between insiders at Dell and NVIDIA with industry analysts they knew), the tipper either (a) received a tangible benefit in return, or (b) provided the information as a “gift.”  Instead, the Government relied on the mere circumstances of the relationship between the alleged tippers and the alleged tippees to provide a sufficient inference of a “gift” to satisfy the breach of duty requirement laid out in Dirks.  The Second Circuit rejected this effort because a review of the evidence showed no meaningful relationships between these people that would suggest that the insiders transferred information as an intended “gift” to the analysts.

The actual evidence showed that the relationship between the Dell insider and the analyst he spoke to was no more than that they knew each other at business school, spoke on limited occasions when they both worked at Dell, and that the analyst gave career advice to the insider that was not terribly meaningful.  The evidence also showed that the communications between them were consistent with the insider’s job responsibilities to develop relationships with financial firms that could be a source for possible investors, and the insider was never told anyone was trading on information he provided.  The NVIDIA insider attended the same church as the analyst he spoke to and sometimes had lunch with him.  While the analyst said he sometimes traded NVIDIA stock, he never said he would use information they discussed to trade.

Based on this evidence, the Second Circuit proceeded to try to implement the Dirks duty standard, not revise that standard.  As the Newman cert. opposition says: “the Second Circuit’s refusal to accept the mere fact of friendship as per se evidence that a tipper intended to bestow a gift on a tippee is consistent with, and indeed compelled by, Dirks.”  Newman Cert. Opp. at 20.

Dirks said that “there may be a relationship between the insider and the recipient that suggests a quid pro quo . . . or an intention to benefit the particular recipient,” but said no more about the parameters of such a relationship.  See Dirks, 463 U.S. at 663.  The Dirks Court also said that an inference of personal gain to the tipper that would evidence the required breach of duty could flow “when an insider makes a gift of confidential information to a trading relative or friend” (id.), but said nothing about how to determine if such an inference is reasonable, except that such a circumstance could “resemble trading by the insider himself followed by a gift of profits to the recipient.”  Id.  The Dirks Court left it to lower courts to figure out how best to implement these principles.  See id.  The Second Circuit plainly was trying to work out when it might be reasonable to conclude that a communication of information is intended as a “gift” based solely on the nature of the parties’ relationship.

The Government’s argument turns on the appellate court’s use of the term “exchange”:

The court reinterpreted this Court’s holding that an insider personally benefits when he “makes a gift of confidential information to a trading relative or friend,” . . . to require “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.” . . .  That holding cannot be reconciled with Dirks, which did not require an “exchange” to find liability for a gift of inside information and did not impose amorphous standards for the relationships that can support liability.

. . . .

Under Dirks, an inference of a personal benefit to the insider arises in two situations: when the insider expects something in return for the disclosure of the confidential information, or when the insider freely gives a gift of information to a trading friend or relative without any expectation of receiving money or valuables as a result. . . .

The Second Circuit purported to recognize that second form of personal benefit . . . but then rewrote the concept of a “gift” so as to eliminate it.  The court held that an insider cannot be liable on a gift theory unless he receives something from the recipient of information “that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” . . . .  But such an “exchange” is, by definition, not the same thing as a “gift”; rather, it is a quid pro quo, “something for something.” . . .  If the personal-benefit test cannot be met by a gift-giver unless an “exchange” takes place, then Dirks’s two categories of personal benefit are collapsed into one—and the entire “gift” discussion in Dirks becomes superfluous.

Cert. Pet. at 14.

This argument intentionally ignores the gist, and the actual language, of the Newman opinion.  It begins by ignoring the paragraphs leading up to the quoted passage, which emphasize that the intent to gift confidential information to another person can be sufficient, but there needs to be evidence proving it.  If that evidence is nothing more than the nature of the relationship between the parties, then that relationship has to be strong enough to warrant a reasonable inference that the information exchange was intended as a gift.  Here is what the court said:

The circumstantial evidence in this case was simply too thin to warrant the inference that the corporate insiders received any personal benefit in exchange for their tips.  As to the Dell tips, the Government established that Goyal and Ray were not “close” friends. . . .  The evidence also established that Lim and Choi were “family friends” that had met through church and occasionally socialized together.  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.

We have observed that “[p]ersonal benefit is broadly defined to include not only pecuniary gain, but also, inter alia, any reputational benefit that will translate into future earnings and the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.” . . .  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.  In other words . . . this requires evidence of “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].”. . .

United States v. Newman, slip op. at 21-22 (emphasis added and some cites omitted).

This quote makes it apparent that to justify its argument, the Government badly, and misleadingly, truncates the Second Circuit discussion on this issue.  The Government’s argument ignores language that makes it clear that the Second Circuit did not limit the “gift” concept to a tangible “exchange.”  Instead, in the very paragraph the Government quotes, the court twice says that evidence showing a tipper’s intent to gift information to a tippee would be sufficient to satisfy the Dirks personal benefit standard — (i) including “the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend” as sufficient to show a personal benefit, and (ii) using the disjunctive “or” in describing the need for evidence of “a relationship . . . that suggests a quid pro quo . . . or an intention to benefit the [tippee].”

This makes it plain that the court was not excluding from the range of potentially sufficient evidence an “exchange” in which the tipper’s value received was consummating an “intention to benefit” the tippee.  But there still needs to be evidence of that intention to benefit, and if that evidence is solely the relationship between the parties, proof of a “meaningfully close relationship” is important because relying solely on evidence of a “friendship . . . of a casual or social nature” would undermine the Dirks “personal benefit requirement” by making it an effective “nullity.”

(By the way, this explains why the Second Circuit reached a different result in Newman than the Ninth Circuit did in U.S. v. Salman.  In Salman, there was direct evidence that the transfer of information was made with an intent to benefit the tippee, and even beyond this, the tipper and tippee where brothers, which is well beyond the kind of “casual” friendships at issue in Newman.  In truth, Salman is not even a close case under the Newman standard.  See In U.S. v. Salman, Judge Rakoff Distinguishes Newman in 9th Circuit Opinion Affirming Insider Trading ConvictionThe Government’s argument that this represents a split in the Circuits is, with respect, laughable.)

This is how the Newman cert. opposition addressed this key point:

Dirks recognized that “[d]etermining whether an insider personally benefits from a particular disclosure, a question of fact, will not always be easy for courts.” 463 U.S. at 664.  By characterizing the inquiry as “a question of fact” the Court appreciated that lower courts would need to formulate rules for weighing the evidence in the particular circumstances before them.  That is exactly what the Second Circuit did here.  The court of appeals’ assessment of what kind of proof would support a factual inference is the type of evidence-based analysis that Dirks recognized would be within the province of the lower courts to develop.

Dirks also recognized that a personal benefit in the form of a gift is not simply a matter of whether a tipper gives inside information to a friend or relative.  The Court repeatedly emphasized that it is the purpose of the disclosure that is determinative.  E.g., 463 U.S. at 662 “Whether disclosure is a breach of duty therefore depends in large part on the purpose of the disclosure.”). . . .  The Court’s focus on the purpose of a disclosure would be undermined if a jury were permitted to infer a personal benefit from the bare fact that two people knew each other.  That is because it is not reasonable to presume that the purpose of communicating financial information between casual acquaintances is to provide a gift.  Casual acquaintances typically do not give each other the kind of gifts contemplated by Dirks, i.e. the equivalent of the insider trading stock and gifting the proceeds to someone else.  On the other hand gifts, especially of money, are much more likely among people who take a deep personal interest in each other’s lives, such as close friends or relatives.  The Second Circuit’s evidentiary formulation is thus consistent with the gift theory as articulated in Dirks because it limits the inference of an intentional gift of trading proceeds to circumstances that reasonably support that conclusion.

Newman Cert. Opp. at 20-21.

So, what the Government cert. petition comes down to is a request that the Supreme Court re-examine the evidentiary record to determine whether the agreed-upon Dirks standard was satisfied in this case, even though that issue is not even case-determinative.  That’s not the resolution of an important securities law issue, it is an effort to get the High Court to relieve the Justice Department of the embarrassment of being shot down for an overly-aggressive prosecution fueled more by ambition than evidence.  That’s not cert.-worthy in my book.

There Is No Basis To Expect Harmful Market Consequences from the Newman Decision

The Government’s last argument in support of certiorari – that absent Supreme Court reversal the securities markets and securities law enforcement will be devastated by the purportedly “new,” limited scope of the insider trading prohibition adopted in Newman – fails for multiple reasons.

First, as discussed above, The Newman court did not limit the scope of the law as stated by Dirks.  It tried its best to articulate an evidentiary standard for satisfying the Dirks “personal benefit” standard in the narrow circumstances where there was no quid pro quo from tippee to tipper, and there was no evidence of an intended “gift” from the tipper to the tippee apart from the nature of their relationship.

Second, the Government cited no empirical data even suggesting that requiring evidence of a “meaningfully close relationship” between tipper and tippee to prove insider trading fraud in such cases would harm investor confidence or undermine the overall integrity or efficiency of the securities markets.  Both the Newman and Chiasson cert. oppositions lay out the facts showing that since the Newman decision, Government insider trading cases have not failed because of Newman.  See Newman Cert. Opp. at 27-30; Chiasson Cert. Opp. at 30-33.  Such unsupported “sky is falling” predictions are hardly the grounds for granting certiorari.  In fact, Dirks itself undermines this Government argument, because the Dirks opinion warned against low standards for proving insider trading fraud based on communications with securities analysts, whose purpose is to ferret out information and incorporate it into the market:

Imposing a duty to disclose or abstain solely because a person knowingly receives material nonpublic information from an insider and trades on it could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market.  It is commonplace for analysts to ‘ferret out and analyze information,’ . . . and this often is done by meeting with and questioning corporate officers and others who are insiders.  And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation’s securities.  The analyst’s judgment in this respect is made available in market letters or otherwise to clients of the firm.  It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation’s stockholders or the public generally.

Dirks, 463 U.S. at 658-59 (footnotes and cites omitted).  Dirks makes it clear that “objective facts and circumstances” must provide evidence of misconduct, especially when we are dealing with communications of information between businesses and analysts.  The Newman opinion is a step in the direction Dirks espoused, made with due regard for the fact that communications of the nature involved in Newman provide the foundation for efficient securities markets.

In Contrast, the Government’s Proposed Rule Would Undermine the Securities Markets

As we have written before, it has long been the Government’s view that the securities laws should be interpreted to mandate equal access of information to all investors, even though that concept is inconsistent with market efficiency, and even market fairness.  (Market efficiency depends on dissemination of information.  Market fairness is undermined when preventing the dissemination of information causes securities transactions to be completed on the basis of incomplete information, and the consequential mispricing of the securities traded.)  See The Myth of Insider Trading Enforcement (Part I), and SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.  The Government’s cert. petition continues to reflect this bias, notwithstanding the fact that the Supreme Court has rejected this view repeatedly, including this quote from Dirks itself:

Here, the SEC maintains that anyone who knowingly receives nonpublic material information from an insider has a fiduciary duty to disclose before trading.  In effect, the SEC’s theory of tippee liability in both cases appears rooted in the idea that the antifraud provisions require equal information among all traders.  This conflicts with the principle set forth in Chiarella that only some persons, under some circumstances, will be barred from trading while in possession of material nonpublic information.  Judge Wright correctly read our opinion in Chiarella as repudiating any notion that all traders must enjoy equal information before trading: ‘[T]he ‘information’ theory is rejected. Because the disclose-or-refrain duty is extraordinary, it attaches only when a party has legal obligations other than a mere duty to comply with the general antifraud proscriptions in the federal securities laws.’ . . .  We reaffirm today that “[a] duty [to disclose] arises from the relationship between parties . . . , and not merely from one’s ability to acquire information because of his position in the market.”

Dirks, 463 U.S. at 656-58 (footnotes and cites omitted).

This bias is reflected in the Government’s revisionist view that Dirks was consistent with the view that communications between what the Second Circuit called “casual” friends should be sufficient to satisfy the “breach of duty” requirement, and suggesting that in such cases, the burden should shift to the accused to show that “selective disclosures” had “a valid business purpose” or were a “mistake.”  That view, if accepted, would greatly impact the nature of communications between and among securities analysts, and would undermine market efficiency and fairness by presuming every communication of information between acquaintances is unlawful absent their ability to prove otherwise.  This is what the Government says:

Dirks recognizes that not all selective disclosures of confidential information trigger the disclose-or-abstain-from-trading rule. . . .  It explains that if an insider has a valid business purpose for selective disclosure (for instance, supplying data to another company in the course of merger talks), or mistakenly believes that information is not material or is already in the public domain, disclosure does not violate the insider’s fiduciary duties. . . .  The fact that analysts (or others) may be friends with company insiders does not automatically preclude such a legitimate business reason for disclosure.”

Cert. Pet, at 21.

In fact, Dirks makes it crystal clear that the burden falls on the Government to prove that even communications between friends or acquaintances rise to the level of a breach of duty that could support an insider trading fraud finding.  The Chiasson cert. opposition addresses this attempted Government sleight-of-hand:

Finally, at the close of its discussion of Dirks, the Government tips its hand. The Government’s problem is not really with the decision below; it is with Dirks itself.  The Government asserts (at 21) that an insider violates his fiduciary duty by disclosing information unless the insider “has a valid business purpose for selective disclosure” or “mistakenly believes that information is not material or is already in the public domain.” But that turns Dirks on its head. Dirks does not require the insider to prove some “legitimate” reason for his disclosure to avoid liability. . . .  To the contrary, under Dirks, an insider is not liable unless the Government proves that “the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders.” . . .  And the circumstances under which an insider may disclose information without receiving a personal benefit are hardly limited to the two scenarios the Government acknowledges. The Court in Dirks made clear that mistaken disclosures were only an “example” of the type of disclosure that would not constitute a breach. . . .  Even disclosures that violate company policy or confidentiality obligations are not necessarily made for the insider’s personal benefit. . . .  The Government may wish to pursue prosecutions that go beyond what Dirks contemplated, but that is no reason to revisit precedent that has been on the books since the Burger Court.

Chiasson Cert. Opp. at 19-20.

It seems especially strange that the Government is pursuing this argument in the context of a case with facts that seem so close to the kind of communications that Dirks wanted to protect.  The evidence here is that securities analysts were discussing company performance with company officials.  That’s what analysts are supposed to do.  The evidence is also that for at least one of these companies — Dell — the insider’s job was to stay in touch with, and develop relationships with, market analysts who could ultimately be a source of investors.  The communications were not known to be for the purpose of trading.  This strikes me as precisely the kind of communications between company insiders and outside analysts that Dirks wanted to enshrine, not attack.  It truly seems like it is the Government that is trying to alter Dirks, not the Second Circuit.

*                      *                      *

The flaws in the Government’s argument in support of granting the writ of certiorari are manifold and serious.  One normally expects the Justices and their clerks to recognize this, even when the proponent of the writ is the Government.  Yet, it remains possible that all of the brouhaha over the Newman decision – much of which can be traced to the Government’s own hissy fit over losing these cases (which are certainly marginal at best) – will drive the Court towards granting cert.  This person’s view is that if this happens, the Government will regret the decision to elevate this case.  There is much more potential for downside for the Government than upside, because when the Court further specifies the elements of insider trading fraud under section 10(b) and Rule 10b-5, the Government’s discretion to pursue its favored “equality of information” policies is likely to become more, rather than less, constrained.

Straight Arrow

September 3, 2015

Contact Straight Arrow privately here, or leave a public comment below:

New, Thorough Academic Analysis of In re Flannery Shows Many Flaws in the Far-Reaching SEC Majority Opinion

One of the most important actions by the SEC over the past year was the far-reaching majority opinion of three commissioners in In the Matter of Flannery and Hopkins, SEC Release No. 3981, 2014 WL 7145625 (Dec. 15, 2014). That opinion can be read here: In re Flannery Majority Opinion.

Soon after Flannery was decided, we discussed the extraordinary nature of this opinion in an administrative enforcement action, in which the majority sought to create new, precedential legal standards for the critical antifraud provisions of the Securities Act of 1933 (section 17(a)) and the Securities Exchange Act of 1934 (section 10(b)).  In many respects, the standards they espoused departed significantly from judicial precedent, including Supreme Court and Courts of Appeals decisions.  The majority specifically invoked the doctrine of deference under Chevron U.S.A. Inc. v. Natural Resource Defense Council, Inc., 467 U.S. 837 (1984), as a means of pressing for the courts to defer to these expressed views instead of continuing to develop the parameters of these statutes through judicial standards of statutory analysis.  See SEC Majority Argues for Negating Janus Decision with Broad Interpretation of Rule 10b-5.

Since that time, some commentators have addressed aspects of the Flannery decision.  See, for example, ‘‘We Intend to Resolve the Ambiguities’’: The SEC Issues Some Surprising Guidance on Fraud Liability in the Wake of JanusThe decision is currently being briefed on appeal in the First Circuit under the caption Flannery v. SEC, No. 15-1080 (1st Cir.).  You can read the appellant’s brief here: Flannery Opening Appeal Brief in Flannery v. SEC, and the SEC’s opposition brief here: SEC Opposition Brief in Flannery v. SEC.  An amicus brief filed on behalf of the Chamber of Commerce can be read here: Chamber of Commerce Amicus Brief in Flannery v. SEC.

For an opinion this far-reaching, and attempting to make such extraordinary changes in the interpretation and application of two key statutes, there has been sparse commentary and analysis overall.  Perhaps this is because the majority opinion was so expansive in what it addressed (often unnecessarily, purely in order to lay down the SEC’s marker) that it was difficult to analyze comprehensively.  Fortunately, this is about to change.  The first sophisticated and in-depth analysis of key aspects of the Flannery opinion is in the final stages, written by Andrew Vollmer, a highly- experienced former SEC Deputy General Counsel, former private securities enforcement lawyer, and current Professor of Law at the University of Virginia Law School and Director of its Law & Business Program.  Professor Vollmer released a current version of an article (still being revised) on SSRN.  It is worth reading in its entirety, and is available here: SEC Revanchism and the Expansion of Primary Liability Under Section 17(a) and Rule 10(b)(5).

Professor Vollmer had the wisdom to realize that the best in enemy of the good, and limited the scope of his article to analysis of the majority opinion’s effort to expand primary liability under section 17(a) and section 10(b) and its claimed entitlement to Chevron deference.  Other provocative aspects of the opinion are left for hoped-for future analysis (by Professor Vollmer or others).  But the important issues of the majority’s attempt to alter the trajectory of judicial legal developments governing section 17(a) and section 10(b) liability, and the majority’s assertion that its views on these issues are worthy of Chevron deference by the courts, are examined with a depth and sophistication lacking in any other publication to date known to us, and well beyond the level of analysis given to these issues by the Commission majority itself.

For those who want a flavor of Professor Vollmer’s views without delving into the entire 60-page comment, I will quote at some length portions of his useful executive summary:

An exceedingly important question for those facing the possibility of fraud charges in an enforcement case brought by the Securities and Exchange Commission is the scope of primary liability under the two main anti-fraud provisions, Section 17(a) of the Securities Act and Rule 10b-5 of the Securities Exchange Act.  That subject has received close attention from the Supreme Court and lower courts, and recently the SEC weighed in with a survey of each of the subparts of Section 17(a) and Rule 10b-5 in a decision in an administrative adjudication of enforcement charges.

In the Flannery decision, a bare majority of Commissioners staked out broad positions on primary liability under Rule 10b-5(a) and (c) and Section 17(a)(1), (2), and (3) . . . .  The Commission not only advanced expansive legal conclusions, but it also insisted that the courts accept the agency’s legal interpretations as controlling.

The SEC’s decision in Flannery raises thought-provoking issues about the role of administrative agencies in the development, enforcement, and adjudication of federal law. The purpose of this article is to discuss two of those issues.

The first concerns the consistency of Flannery with the Supreme Court and lower court decisions defining the scope of primary liability under Rule 10b-5 and Section 17(a).  This article explains that much about Flannery is not consistent with, and is antagonistic to, a series of prominent Supreme Court decisions that imposed meaningful boundaries around aspects of primary liability under Rule 10b-5.  Those decisions are Central Bank of Denver, NA v. First Interstate Bank of Denver, NA, Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc., and Janus Capital Group, Inc. v. First Derivative Traders.

The Commission in Flannery sought to confine and distinguish those precedents, but Part II.A below questions the SEC’s reading of the cases and explores the reasoning and analysis in Stoneridge and Janus to determine whether the opinions were, as the Commission said, limited solely to the reliance element in private cases or to subpart (b) of Rule 10b-5.  That review reveals that the effort of the Supreme Court in the cases was to draw a crisper line between primary liability and aiding and abetting and to define a primary violator as the separate and independent person with final control and authority over the content and use of a communication to the investing public.  The Court’s rationales ran to both Rule10b-5 and Section 17(a).

Part II.B then compares the reasoning and analysis in the Supreme Court cases plus a selection of court of appeals decisions with the Commission’s approach in Flannery.  One point of comparison is that the Commission used a loose and unprincipled policy of interpreting the laws flexibly to achieve their remedial purpose.  The Supreme Court long ago discredited and refused to apply that policy, but Flannery wielded it repeatedly to reach outcomes that grossly exceed the boundaries the Court appeared to be setting in Stoneridge and Janus.

For example, the Commission would extend primary liability to a person who orchestrated a sham transaction designed to give the false appearance of business operations even if a material misstatement by another person creates the nexus between the scheme and the securities market.  According to the Commission, Section 17(a)(1) goes further and covers a person who entered into a legitimate, non-deceptive transaction with a reporting company but who knew that the public company planned to misstate the revenue. These constructions disregarded the lesson of Stoneridge.  A person entering into a transaction with a public company, even a deceptive transaction, that resulted in the public company’s disclosure of false financial statements did not have primary liability when the public company was independent and had final say about its disclosures.  The Commission would extend primary liability to a person who drafted, approved, or did not change a disclosure made by another, but Janus held that a person working on a public disclosure was not the primary actor when another independent person issued and had final say about the disclosure.

A reading of the Flannery decision leaves the definite impression that a majority of SEC Commissioners aimed to use the case as a vehicle to recover much of the territory lost in the enforcement area from the Supreme Court decisions and the lower federal courts that have been following the Supreme Court’s lead.  It was an effort to supersede the court judgments by re-interpreting and extending the prohibitions in Rule 10b-5 and Section 17(a).  If these concerns have merit, the actions of the SEC, an administrative agency within the Executive Branch, are unsettling.  They take the stare out of stare decisis, rattle the stability of legal rules, upset traditional expectations about the role of the courts in the development of the law, and head toward a society ruled by bureaucratic fiat rather than ordered by laws.

 The second issue discussed in this article is whether the courts must or should treat the SEC’s legal conclusions in an adjudication as controlling under Chevron U.S.A. Inc. v. Natural Resources Defense Council, IncFlannery included an overt claim to Chevron deference.  Part III evaluates this bid for Chevron deference and concludes that the courts would have doctrinal and precedential grounds for refusing to accept the Flannery positions as controlling.  Part III.C goes through these reasons, starting with the text of the provision of the Administrative Procedure Act governing judicial review of agency actions and looking closely at the actual practice of the Supreme Court and courts of appeals when they review a legal conclusion in an agency adjudication.  Part III.E discusses particular features about Flannery that would justify a reviewing court in not giving controlling weight to the interpretations of Rule 10b-5 and Section 17(a).

The precedents identify good reasons for not granting Chevron deference to Flannery or similar agency adjudications in enforcement cases.  Giving controlling effect to the SEC’s decision in Flannery would allow the agency both to avoid the teachings of leading Supreme Court authorities and to trump the Supreme Court and other federal courts on significant matters of statutory interpretation.  It would empower the SEC to cut short and silence the normal process in the federal courts for testing and establishing the limits of liability provisions, and it would enable the SEC to tip the scales in enforcement cases by converting its litigating positions into non-reviewable legal interpretations.  The cumulative effect of an agency’s decision to roll back Supreme Court precedent and to consolidate for itself ultimate decision-making power over questions of law traditionally left to the courts would seriously alter a balance between agencies and courts long recognized in our system of government.

These two issues are not the only topics of interest in Flannery.  The Commission opinion raises many more.  Chief among them are the proper interpretations and coverage of each of the sub-parts of Section 17(a) and Rule 10b-5.  That was the main subject of Flannery, and it deserves careful study and analysis by courts, practitioners, and scholars.  The purpose of this article is not to propose conclusions on that important set of questions, although the discussion in Part II below will suggest some considerations and limitations that should bear on an appropriate construction of the statute and Rule.

Flannery touches on other points that are beyond the scope of this article. For example, the Commission majority suggested that the SEC does not need to prove either negligence or scienter for a violation of Section 17(a)(2) or (3).  Strict liability might exist, even though courts of appeals require the Commission to prove negligence.  Another example is the Commission’s position that Section 17(a)(3) prohibits pure omissions without a corresponding duty to disclose.  A third issue that deserves more attention is the Commission’s view that it could use a section of the Dodd-Frank Act to impose a monetary penalty in an administrative proceeding for conduct occurring before the enactment of the Dodd-Frank Act.  All in all, Flannery provides much fodder for rumination by the bench, bar, and academy.

Thanks to Professor Vollmer for picking up the gauntlet thrown down by three SEC commissioners in the Flannery opinion.  This is an important — a critical — battleground on which the scope of future liability for alleged securities fraud is now being fought.  Much of the commissioners’ expansive treatment of primary section 10(b) liability matters little to the SEC itself, because the SEC always has at its disposal allegations of aiding and abetting liability in its enforcement actions.  The crucial impact of the expanded scope of primary section 10(b) liability would be in private securities class actions.  The careful limits on securities class action strike suits against alleged secondary violators in the Supreme Court’s decisions in Central Bank, Stoneridge, and Janus would fall by the wayside under the majority’s expanded view of primary section 10(b) liability.  In no small respect, the three commissioners who penned the Flannery opinion are laying the foundation for the future wealth of the private securities plaintiffs’ bar more than they are creating meaningful enforcement precedent for the SEC itself.  Only the staunch, rigorous analysis of those like Professor Vollmer may stand in the way of that questionable redistribution of wealth.

Straight Arrow

July 9, 2015

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In U.S. v. Salman, Judge Rakoff Distinguishes Newman in 9th Circuit Opinion Affirming Insider Trading Conviction

In an opinion issued July 6, 2015, a Ninth Circuit panel affirmed the insider trading conviction of Bessam Salman in the case captioned United States v. Salman, No. 14-10204 (9th Cir.).  The opinion is relatively straightforward, but is noteworthy for two reasons.  First, it is written by Southern District of New York Judge Jed Rakoff, who seems to attracting insider trading cases of late, and has written several opinions interpreting and applying the Second Circuit U.S. v. Newman decision.  Second, the defendant-appellant argued that the Newman opinion supported reversal of the conviction, which gave Judge Rakoff another chance to state his views on Newman.  The opinion can be read here: U.S. v. Salman.

The opinion does little to advance the interpretive analysis of the Newman decision because it is governed directly by the Supreme Court holding in Dirks v. SEC, 463 U.S. 646 (1983).  In fact, Judge Rakoff says so in no uncertain terms: “Dirks governs this case.”  Slip op. at 10.  The only real comment Judge Rakoff makes on Newman is that if Newman held that a personal gift of material inside information from a tipper breaching a fiduciary duty of confidentiality to a tippee with whom he has a close relationship, for the specific purpose of enriching the tippee, was insufficient to support a conviction, then “we decline to follow it.”  Slip op. at 13.  Since Newman never suggested such a result – which would be plainly contrary to the Dirks opinion – there is no distance between the Salman and Newman opinions.

As Judge Rakoff notes, the facts in Salman and Newman are very different.  In particular, in Newman, the evidence showed no intention by the original sources of the inside information to confer a benefit on a close friend or relative by improperly communicating the inside information.  In Salman, however, the evidence in the record was exactly the opposite.  The tipping brother testified “that he gave [his brother] the inside information in order to ‘benefit him’ and to ‘fulfill[] whatever needs he had.’”  Slip op. at 5.

The Dirks opinion plainly included this in its description of unlawful tipping, as quoted by Judge Rakoff: “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.”  Slip op. at 10, quoting Dirks, 463 U.S. at 664.

Some may contend that Salman rejects the concept of a “personal benefit” to the source in the nature of a “quid pro quo” as a prerequisite for tippee liability, referred to in Newman.  See, for example, Ninth Circuit Disagrees with Second Circuit on Personal-Benefit Requirement for Insider Trading.  That is not how I read either Salman or NewmanNewman never questioned that the required benefit to the tipper could be a non-monetary one — like the benefit of directing wealth to a close friend or relative you want to benefit from being more wealthy — it just found the evidence of such a benefit insufficient in that case because the mere fact of providing information, with no evidence that it was to fulfill the tipper’s desire to transfer wealth, was “too thin” to support finding a benefit to the tipper.  And Salman plainly finds, and emphasizes, the strong evidence in the case of a benefit to the tipper in the form of intentionally directing wealth to a beloved relative.

There can be no doubt that the Newman court never rejected that holding in Dirks.  Instead, it tried to apply the Dirks holding to the evidence presented in Newman, which the court found insufficient to show any personal benefit derived by the sources from their “tips” because “the mere fact of a friendship, particularly of a casual or social nature” was not enough to prove a intent to benefit the tippee.  Slip op. at 12-13, quoting Newman, 773 F.3d at 452.  The Newman court found the “circumstantial evidence” in that case “too thin to warrant the inference that the corporate insiders received any personal; benefit in exchange for their tips.”  Slip op. at 13, quoting Newman, 773 F.3d at 451-52.  That obviously does not describe the evidence of benefit presented in Salman, which was neither circumstantial nor thin because the source himself described the pleasure he took in giving the gift of information to his brother.  See slip op. at 11 (testimony from the source and his tippee, who were brothers, showed that the tipping brother “intended to ‘benefit’ his [tippee] brother and to ‘fulfill[] whatever needs he had’”).

If Salman stands for anything meaningful, it is that it shows that Newman was not a meaningful departure from existing insider trading law, but rather a ruling that there are limits to how far the Government can stretch mere casual friendships or acquaintances to prove a transfer of information was intended as the “gift of confidential information” described in Dirks.  In short, the sky did not start falling when the Newman opinion was adopted.  See DOJ Petition for En Banc Review in Newman Case Comes Up Short.

Judge Rakoff’s Salman opinion concludes: “If Salman’s theory were accepted and this evidence found to be insufficient, then a corporate insider or other person in possession of confidential and proprietary information would be free to disclose that information to her relatives, and they would be free to trade on it, provided only that she asked for no tangible compensation in return.  Proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the breach of fiduciary duty element of insider trading.”  Slip op. at 14.  Newman never suggests any different result.

Straight Arrow

July 6. 2015

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SEC Gambit To Avoid Judge May in Timbervest Case Seems To Have Failed

We previously wrote about the SEC’s desperate effort to avoid the assignment of Timbervest, LLC v. SEC, Civil Action No. 1:15-CV-2106 (N.D. Ga.), to District Judge Leigh Martin May.  See SEC, Desperate To Avoid Judge May, Challenges Related Case Designation in Timbervest Action and SEC Argues Common “Facts” Are Not Common “Issues of Fact” — I Kid You Not.  You recall that Judge May ruled in Hill v. SEC that the appointment of SEC ALJ James Grimes violated the appointments clause of Article II of the Constitution — see Court Issues Preliminary Injunction Halting Likely Unconstitutional SEC Proceeding.

Well, it appears that the SEC’s motion challenging the “related case” assignment of the Timbervest action to Judge May failed.  There is no order in the docket denying the motion, but a recent scheduling order issued by Judge May suggests she will continue to preside over the case.  See Timbervest v. SEC Scheduling Order.  In the Order, Judge May states that the SEC must respond to plaintiffs’ Motion for a Temporary Restraining Order and/or Preliminary Injunction by June 29, plaintiffs must file a reply brief by July 16, and “the parties will attend a hearing in this matter a hearing” on July 21, in Courtroom 2107.  Courtroom 2107 is listed in the N.D. Georgia directory as Judge May’s courtroom.

In the meantime, in the SEC administrative case brought against Gray Financial Group, In the Matter of Gray Financial Group, Inc. et al., File No. 3-16554, SEC ALJ Cameron Elliot declined to issue a stay of proceedings in response to an unopposed motion founded on the pending federal action for injunctive relief by Gray Financial in the same Georgia federal court, which was also assigned to Judge May.  He said: “Commission Rule of Practice 161 instructs that I ‘should adhere to a policy of strongly disfavoring’ stay requests unless ‘the requesting party makes a strong showing that the denial of the request or motion would substantially prejudice their case.’  17 C.F.R. § 201.161(b)(1).  Respondents have not made such a showing.  I will abide by an injunction if it is issued; however, as of now I have been instructed to resolve this proceeding within 300 days of service of the OIP.”  See Order Denying Unopposed Motion To Stay Administrative Proceeding Against Gray Financial Group.

So, chaos still reigns, and apparently the SEC is unsure about how best to bring it under control.  See SEC Rejects Easy Answers To Admin Court Challenges.  In that article, Law 360’s Stephanie Russell-Kraft reported on a discussion between Judge Richard Berman and a DOJ lawyer representing the SEC.  Judge Berman asked whether, in light of comments by Judge May that it might be easy to cure the appointments clause violation, the similar claims brought before him by Barbara Duka (in Duka v. SEC) could be resolved simply by having the Commission reappoint its current ALJs.  The DOJ lawyer declined to address whether that could be done, leading to the following colloquy:

“Is the commission opposed to an easy fix?” Judge Berman asked.

“The Department of Justice is very actively considering the best litigation approach to address this issue,” Lin answered.

“I’m asking you if [appointing the judges] would solve this issue,” Judge Berman pressed, pointing out that the case pending before him had nothing to do with the SEC’s litigation strategy.

“It’s not like if we pursue one of these options this case or other cases will go away,” Lin answered, adding that changing the way it appoints its judges is not a “meaningful way” to address Judge May’s decisions or a “practical way” for it to approach its long-standing administrative court scheme.

“The commission has to consider all the cases it has,” she said later, to which Judge Berman replied, “I don’t.”

Meanwhile, the SEC’s administrative proceeding against Laurie Bebo continues to be tried, even while the appeal of Ms. Bebo’s injunctive action moves forward in the Seventh Circuit.

The ship is plainly adrift.

Straight Arrow

June 23, 2015

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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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