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.
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.
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 (Key Largo)
(“There’s only one Johnny Rocco.”
“How do you account for it?”
“He knows what he wants. Don’t you, Rocco?”
“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.”
September 15, 2015
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