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US v. Newman and the Rewriting of the Law of Insider Trading (Part 16)

How will this case come out? 

First, the court has to decide whether to take the case en banc.  Second, assuming it does, the court has to decide whether to revise the analysis of the Newman panel. 

With respect to the decision on rehearing en banc, the case warrants rehearing.  Predicting the outcome of these things is inherently uncertain.  Nonetheless, the case involves important legal issues that arguably (clearly?) conflict with a Supreme Court decision that will have a significant effect on the ability to trade on material inside information.  On that basis, the court should rehear the case en banc.

If the issue is considered in political terms, the court should also grant rehearing.  The panel in Newman consisted of three judges appointed by Republican presidents.  The panel included judges Winter (appointed by President Reagan), Parker (appointed by the second President Bush), and Hall (appointed by the second President Bush).  The list of judges in the Second Circuit and their date of appointment is here.   

The full Second Circuit that will consider the petition for rehearing en banc currently has a majority of judges appointed by Democratic presidents.  There are 13 active judges.  Eight were appointed by Democratic presidents (5 by President Obama; 3 by President Clinton) and five by Republican presidents (1 by President Bush Sr. and four by the second President Bush).  This change is relatively recent; in 2008, for example, the court was divided equally between appointees of Republican and Democratic presidents (with one vacancy).  

The rules of the Second Circuit provide that only active judges can vote on whether to hear a matter en banc where democratic appointees have a decisive advantage.  See IOP Rule 35.1(b) ("Only an active judge may vote to determine whether a case should be heard or reheard en banc.").  On that issue, therefore, the appointees of Democratic presidents have an 8-5 advantage.  Moreover, two of the judges on the Newman panel, Judges Winter and Parker, cannot participate in the poll since both have taken senior status.  A vote that breaks along party lines will, therefore, result in the court agreeing to rehear the case en banc. 

In political terms, the decision on the merits is much closer.  The rules of the Second Circuit provide that decisions en banc are to be made by active judges.  In addition, however, the rules allow the senior judges on the relevant panel to participate.  See IOP 35.1(d) ("Only an active judge or a senior judge who either sat on the three-judge panel or took senior status after a case was heard or reheard en banc may participate in the en banc decision.").  

Judges Winter and Parker, having taken senior status, cannot, therefore, participate in the decision to rehear en banc but can participate in the actual decision by the full court.  If they do, the political balance in the decision making phase shifts from 8-5 in favor of appointees of Democratic presidents to 8-7, still an advantage but a much closer one.  This does not, of course, take into account other factors that may change the make-up of the full court such as recusals. 

Of course, what would be best would be a decision that does not break along party lines but instead results in a clear and unequivocal reversal of the analysis in Newman.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here. 


US v. Newman and the Rewriting of the Law of Insider Trading (Part 15)

Perhaps the most interesting foray into the case was an amicus brief filed by three law professors arguing that the case was correctly decided. The brief correctly noted the policy goal of Dirks.

  • As the analyst-insider communication, a liability standard that is overly broad or unclear will deter market participants from seeking quality information on which to trade and thereby damage the healthy functioning of capital markets. The Supreme Court fashioned the personal benefit test accordingly, to draw a clear line between permissible and impermissible information gathering, so that analysts and investors would know when trading was permissible and not be needlessly deterred from seeking the best information available to them. 

Likewise, the brief rightfully noted that a test based upon friendship did not depend upon the purpose of the tip.  Professor's Amicus Brief ("Unlike the personal benefit test, the fact that an analyst can be characterized as a social “friend” of the insider who discloses information, does nothing to illuminate the purpose for which the disclosure was actually made.").  But of course, neither did the pecuniary benefit test.  An insider benefiting from the disclosure of material non-public information could still be acting in the best interest of the corporation and shareholders.

The brief concluded from this that the government's position would undermine the purposes set out in Dirks.  

  • the rule advocated by the government and the SEC would undermine in a fundamental way the policy purpose for which the Supreme Court adopted the personal benefit test. If mere evidence of “friendship” is presumptive evidence of personal benefit, then virtually all disclosures are potentially subject to prosecution, because insiders are far more likely to be involved in discussion of their companies with people they know than with strangers. As such, analysts and insiders who are engaged in industry activity that the Supreme Court correctly understands to be normal, socially beneficial, and important to the integrity of capital markets, and that it explicitly seeks to protect, would operate at peril of prosecution for securities fraud simply because they talk regularly, have common friends with whom they socialize, or have some other point of social interaction that could lead to their characterization as “friends.” Based only on such arbitrary and amorphous facts, the disclosure of material information in good faith, or for a permissible purpose under Rule 10b, presumptively criminal. That rule would have the same predictable chilling effect on analyst-insider communications that the Supreme Court set out to avoid in Dirks. It cannot possibly be what the Supreme Court intended.

The analysis is flawed.  It conflicts with an approach in Dirks that treated tips to friends and relatives differently than tips to market professionals.  It is Dirks that indicated that the nature of the relationship rather than the purpose of the disclosure was what mattered. 

To the extent that there is some concern that the friendship standard can interfere with corporate communications (the two alleged tippees in this case were in fact market participants), the solution is to narrow the definition of friendship.  The approach taken in Newman is to instead require some kind of pecuniary/objective gain in all cases.  Such a test would apply not just where the friend was an analyst or other market participant but also to tips by parents to children, wives to husbands, etc.  In those circumstances, there is no need to immunize the communications in order to protect the market disclosure process (which is what Dirks intended) yet the test in Newman would do exactly that.   

We will include one more post that will provide a possible basis for predicting the outcome of any en banc hearing. With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.    


US v. Newman and the Rewriting of the Law of Insider Trading (Part 14)

The Justice Department has rightfully sought rehearing en banch.  The government challenged the panel's interpretation of personal benefit, particularly with respect to gifts. 

  • First, seizing on an issue raised briefly by only one defendant, the Opinion redefines a critical element of insider trading liability—the requirement that the insider-tipper have acted for a “personal benefit”—in a manner that: (i) runs contrary to Dirks v. SEC, 463 U.S. 646 (1983), the decision that first established the personal benefit requirement; (ii) conflicts with decisions of other circuits, and, indeed, prior decisions of this Court; and (iii) conflicts with the definition accepted by all parties and relied upon by the District Court below. Even on its own terms, the new definition is deeply confounding and, contrary to the Panel’s express intention of supplying clarity, is certain to engender confusion among market participants, parties, judges, and juries.

The government also challenged the need for tippees to "know" that the tipper received a benefit and the decision in this case that there was inadequate evidence to make this showing. 

  • Second, applying this new and incorrect definition of personal benefit, and holding for the first time that a culpable tippee must know that the insider-tipper who supplied the inside information acted for such a benefit (a requirement the Government argued against, but does not challenge herein), the Panel erroneously ordered dismissal of the charges against the tippee-defendants in this case. Specifically, the Panel held that the Government’s evidence was insufficient to prove that the defendants knew the insidertippers had acted for a personal benefit, and, indeed, insufficient even to prove that the insider-tippers had acted for a personal benefit at all. These unfounded conclusions led the Panel to deny the Government the opportunity to retry its case in light of the newly announced knowledge requirement.

The SEC likewise filed an amicus brief supporting the request for rehearing en banc.  The SEC did not take issue with the need of the tippee to know of the benefit but did take issue with the panel's interpretation of benefit in the context of the gift analysis.

  • In particular, the panel decision states that evidence of friendship between an insider who tips and his tippee is insufficient to support an inference that the insider derived a personal benefit from the tipping—a requirement for liability. That ruling is directly at odds with Supreme Court and prior Second Circuit decisions holding that an insider derives a personal benefit—and thus engages in prohibited insider trading—by disclosing inside information to a friend who then trades, because that is equivalent to the insider himself profitably trading on the information and then giving the trading profits to the friend, which is obviously illegal.

The SEC asserted that rehearing was necessary given the uncertainty resulting from the opinion.  See SEC Amicus Brief ("The panel decision also creates uncertainty about the precise type of benefit that the panel believes an insider who tips confidential information must receive to be liable. Some passages in the decision suggest that certain non-pecuniary benefit to the insider is a sufficient predicate for liability, but others could be read to require some form of a pecuniary gain in exchange for disclosing the information."). 

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 13)

Newman did one other thing.  Until that decision, lower courts had allowed for the imposition of liability on tippees (and remote tippees) when the circumstances surrounding the receipt of the information suggested that it was improperly disclosed.  The courts did not specifically require that the tippees and sub-tippees actually know the benefit received by the insider.

The panel in Newmansought to change that approach.  Knowledge of the actual benefit was required.  The impact of the approach is to allow any tippee or sub-tippee to trade with abandon as long as they are not informed of the actual benefit, despite awareness that the information was improperly disclosed.  This of course is the norm.  To the extent, for example, that the tippee benefits from tipping the information to sub-tippees (for example by sharing trading profits), there will be no insider trading so long as both are kept in the dark about the actual benefit obtained by the insider. 

As a practical matter, therefore, insider trading for tippees will be limited to those circumstances where the tippee actually provides the benefit (by for example sharing trading profits).  Unless the tippee is particularly loquacious, sub-tippees will never be liable, even when aware that inside information was wrongfully disclosed.     

The approach is not quite wrong; there is a certain logic in concluding that the awareness of the breach of fiduciary duty requires awareness of the benefit. It is, however, excessively narrow and unrealistic.  Moreover, there are many readings of Dirks that, while "logical" are inconsistent with any reasonable interpretation of the prohibition on insider trading.  

Take for example the fact that defendants in Newman were almost certainly not fiduciaries (one was in the finance department; another in investor relations).  The panel could also have read Dirks as exonerating these individuals because of the absence of this duty.  Yet no court has ever adopted this approach, something that would allow most employees to trade on (and tip) material non-public information.       

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 12)

The panel's view of benefit was not, however, consistent with Dirks.

Dirks contained two approaches to benefit.  One dealt with disclosure to market participants.  This required some kind of objective benefit.  The second dealt with disclosure to friends and relatives.  This required only the showing of the requisite relationship.  The panel of the Second Circuit found that evidence of a close relationship was not, standing alone, sufficient.  Instead, the tip had to hold the promise of some type of pecuniary or similar gain.  

In doing so, the panel essentially replaced the two standards with a single test based upon pecuniary/objective gain. Indeed, given the need for a pecuniary or similar gain, it is difficult to see the relevance of friendship or family to the analysis.  Moreover, the analysis ignored the difference between disclosure to market participants and to friends/relatives.  The Supreme Court in Dirks sought to protect one but not the other.  Indeed, by using the term "gift", the Court intended to capture disclosures given, as one dictionary put it, "voluntarily without payment in return".

There may have been room to argue for a narrow interepretation of the friendship standard, particularly when applicable to market participants.  But assuming the requisite friendship, Dirks did not leave room for the requirement that the information provide a pecuniary/objective benefit to the tipper.  Such an approach would essentially allow unlimited disclosure of material non-public information among family and friends without triggering the prohibition on insider trading, at least where the tipper received no pecuniary gain/benefit.  This is exactly what Dirks wanted to prevent by articulating the gift standard.   

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 11)

The main issue in the case was the court’s view of benefit.  The case did not, apparently, turn on allegations that the tippers received a pecuniary gain from disclosing the inforomation.  Instead, the government argued that there was sufficient evidence of friendship.  The court found the evidence of friendship to be inadequate.

  • 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, but had known each other for years, having both attended business school and worked at Dell together. Further, Ray, who wanted to become a Wall Street analyst like Goyal, sought career advice and assistance from Goyal. The evidence further showed that Goyal advised Ray on a range of topics, from discussing the qualifying examination in order to become a financial analyst to editing Ray’s résumé and sending it to a Wall Street recruiter, and that some of this assistance began before Ray began to provide tips about Dell’s earnings.   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.   

To the extent that this evidence was sufficient, the court reasoned, “practically anything would qualify.” 

In addition, however, the court reasoned that evidence of friendship, standing alone, was not enough. In addition to friendship, there had to be an inference that the tip of non-public information provided "at least a potential gain of a pecuniary or similarly valuable nature.” 

  • 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 , 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. 

Moreover, the “benefits” that were alleged to have occurred were deemed not to be significant.  “Career advice” was characterized as “little more than the encouragement one would generally expect of a fellow alumnus or casual acquaintance.”  Id.  (“Crucially, Goyal testified that he would have given Ray advice without receiving information because he routinely did so for industry colleagues.”).  As for inferring that the inside information was provided in return for the career advice, the Second Circuit panel found that the insider “disavowed that any such quid pro quo existed” and that the evidence showed that the career advice had begun before insider information had been provided.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 10)

With all of that background, lets jump ahead to US v. Newman, 773 F.3d 438 (2nd Cir. 2014). 

In that case, the government  brought criminal actions against Todd Newman and Anthony Chiasson for insider trading.  Both were convicted in a six week trial.   Under the alleged facts, the government asserted that a number of analysts at hedge funds obtained material non-public information (advanced knowledge of earnings) from employees at public companies (Dell and NVIDIA). In one case, the employee was the head of investor relations.  In another, the employee was someone in the "finance unit."  Neither appear to have been officers.

The non-public information was then alleged to have passed on to portfolio managers.  The government asserted that Newman and Chiasson received and used this information, earning profits of $4 million and $68 million for their funds. Both were ultimately convicted by a jury of trading on material nonpublic information. 

The panel of the Second Circuit reversed.  In setting out the test for insider trading, the held that:

  • the Government must prove each of the following elements beyond a reasonable doubt: that (1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit. 

The court found that there was insufficient evidence to demonstrate that the tippers had benefited from the tip.  As a result, all tippees were exonerated.  In addition, to the extent that there was a benefit, the court found that there was insufficient evidence to demonstrate that Newman and Chiasson were aware that it existed. 

As the court put it, both Newman and Chiasson were “several steps removed from the corporate insiders” and as a result were unaware of “the source of the inside information.”   Indeed, with respect to Dell, both Newman and Chiasson were  “three and four levels removed from the inside tipper”.  See Id. (“a tippee's knowledge of the insider's breach necessarily requires knowledge that the insider disclosed confidential information in exchange for personal benefit.”). 

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 9)

So, in summary, Dirks successfully protected the relationship between insiders and market participants.  The analysis, however, had numerous gaps that subsequent courts for the most part just ignored them.  Fiduciary duties for purposes of insider trading extended to all employees, not just officers and directors.  Fiduciary duties applied to sales, even where the buyers were not shareholders and a fiduciary duty did not actually exist. 

At the same time, Dirks did not protect the relationship between insiders and their family members or friends.  The decision treated disclosure to these persons as a breach of an insider’s fiduciary duty.  The case, therefore, encouraged communications between insiders and market participants and discouraged communications between friends and family.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 8)

With respect to tippee analysis, Dirks made clear that insider trading was predicated upon a breach of a duty by the insider.  In other words, the tippee’s duty was derivative.  The trading activities of the tippee were, therefore, largely irrelevant.  Instead, the tippee was guilty of insider trading if the insider was guilty (which meant having a benefit) and the tippee knew about the breach.  As the Court reasoned: 

  • Thus, some tippees must assume an insider's duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly.  And for Rule 10b-5 purposes, the insider's disclosure is improper only where it would violate his Cady, Roberts duty. Thus, a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.  . . . Tipping thus properly is viewed only as a means of indirectly violating the Cady, Roberts disclose-or-abstain rule.  

The emphasis, therefore, was on the awareness of the tippee that the information had been disclosed improperly.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 7)

The need for a breach of fiduciary duty, for all of its problems, did not accomplish the goal of the Supreme Court.  Secrist was still open to a claim that he violated those duties by tipping information to Dirks that harmed the company (albeit while helping the market).  The Court addressed the continuing uncertainty by defining breach in a narrow manner, unconnected to state law. 

Breach occurred when the fiduciary obtained a benefit.  Moreover, benefit had to be something pecuniary or objective.  See Dirks, at 663 (“This requires courts to focus on objective criteria, i. e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.”).  Reputational benefit, for example, left open the possibility that the Secrists of the world could still be subject to uncertainty to the extent the government could claim that the tip was in return for something ephemeral such as improved reputation. 

The analysis had little connection to state law fiduciary duty principles.  For the most part, fiduciary duties looked to the interests of shareholders.  The Court, however, ignored the impact on shareholders and instead focused entirely on the benefits (or lack thereof) to the insider.  The approach was both under and over inclusive.  Insiders routinely benefit from the corporation without violating their fiduciary obligations (getting paid compensation for example).  Likewise the absence of benefit does not mean they were acting in the best interests of shareholders. 

The made up nature of the standard had some intended advantages.  Much of the uncertainty was gone.  The “slip of the tongue” cases where material nonpublic information was accidentally disclosed in a manner that did not benefit the corporation (and even caused harm) were no longer actionable.  Moreover, the practical reality was that insiders rarely gave away information in circumstances detrimental to the company unless they somehow benefited. 

The test, therefore, largely protected the flow of information from insiders to market participants.  The Court, however, understood that relationships between fiduciaries and family/friends raised different concerns.  In those circumstances, there was no presumptive benefit to the company and no need to protect the flow of information between insiders and friends/family. 

As a result, the Court recognized that in these circumstances, there was no need for an overinclusive rule that would protect the two way flow of communications.  As a result, a pecuniary benefit was not required. See Dirks, at 664 (“The 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. The tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”).  The analysis turned not on the nature of the benefit but on the nature of the relationship.    

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 6)

Of course, the most noticeable gap in the Court’s requirement of a fiduciary relationship concerned the application to officers aware of material nonpublic information about other companies.  During the takeover waive of the 1980s, the Court’s analysis threatened to give a pass to any insider of a bidder who became aware of an impending offer for the shares of a target company. The officer of the bidder had no fiduciary obligation to the shareholders of the target company and could, at least to the extent that Dirks required a fiduciary relationship, trade without triggering the prohibitions on insider trading. 

Ultimately, this gap in the analysis was filled with the invention of the doctrine of misappropriation.  Misappropriation allowed authorities to treat as insider trading instances where persons (not just fiduciaries) traded on material nonpublic information in violation not of a fiduciary duty but of a duty of trust and confidence.  Freed of the need for a fiduciary duty, an insider of a bidder who traded in the shares of a target could be guilty of insider trading. 

Of course, even this fix contained analytical holes and silly evidentiary requirements.  Insider trading suddenly depended upon whether husbands and wives, parents and children, psychiatrists and patients, had obligations of trust and confidence. Decisions turned on the closeness of buddies on the golf course.  

Insider trading cases, therefore, required an exploration of the marital relationship, the closeness of family members, and the strength of friendships.  Moreover, the tipper always had an incentive to argue that a relationship of trust and confidence existed (so that tipper was not really a tipper since the “tip” was conveyed within a relationship of trust and confidence) and the tippee always had an incentive to argue that the relationship did not exist (so that the tippee was not really a tipper since he/she did not violate a duty of trust and confidence). These cases where, therefore, invariably a she said, he said, raising considerable uncertainty and litigation risk. 

The Supreme Court eventually affirmed the misappropriation theory.  See US v. O’Hagan, 521 U.S. 642 (1997).  Today, O’Hagan and approval of the misappropriation theory has an air of inevitability.  That, however, was not true. 

First, O’Haganstill drew a dissent from three Justices (Scalia, Thomas and Rehnquist).  More importantly, the doctrine had, apparently, come close to rejection by the Supreme Court only a decade earlier.  In 1987, the Supreme Court had divided 4-4 on a case raising the misappropriation theory.  See Carpenter v. United States, 484 U.S. 19 (1987) (“The Court is evenly divided with respect to the convictions under the securities laws and for that reason affirms the judgment below on those counts. For the reasons that follow, we also affirm the judgment with respect to the mail and wire fraud convictions.”). 

What happened between Dirks and O’Hagan?  Most noticeably, the Court experienced a significant turnover. The majority in Dirksconsisted of Justices Powell (the author of the opinion), Berger, Stevens, White, O’Connor, and Rehnquist.  Justice Blackmun wrote a dissent, joined by Justices Brennan and Marshall.  In Carpenter, the lineup was the same except that Justice Kennedy had replaced Powell.  By 1997, however, Chief Justice Burger was gone.  So were Justices Brennan, Blackmun and Marshall.  Instead, the Court included Breyer, Thomas, Souter, Ginsburg and Scalia.  From the original decision in Dirks, only Rehnquist, Stevens and O’Connor remained. 

In other words, approval of the misappropriation theory by the Supreme Court took 14 years from the Dirks decision and only occurred where the Court experienced significant turnover and consisted mostly of justices with no direct attachment to the decision in Dirks.  Only in these circumstances was the misappropriation theory affirmed.   

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 5)

First was the problem of coverage.  To the extent limiting the analysis to fiduciaries, the Court promised to leave the prohibitions on insider trading inapplicable to most insiders or their advisors. 

To address the problem of accountants and lawyers, the Court invented what has become known as the “temporary insider” doctrine.  Persons hired by the company could assume a fiduciary duty.  See Id.  (“Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer, or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders. The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes. “). 

While fiduciary duty concepts were probably fluid enough under state law to allow its extension to untraditional classes of persons (beyond officers, directors and key employees), the Court adopted an interpretation that more or less always imposed temporary fiduciary obligations on these advisers.  The Court cited no state law cases for this interpretation.  The idea that investment banks or lawyers could be sued for breach of fiduciary duty to shareholders as a general course (as opposed to aiding and abetting a breach) was inconsistent with state law.  Nonetheless, the Court needed to plug a gap created by its own analysis, otherwise Dirks would not be able to legally tip information but lawyers and accountants could.

With respect to ordinary employees or officers selling rather than buying shares, the opinion remained silent.  Lower courts (and the SEC) for the most part ignored the discontinuity between the need for a fiduciary duty and its application to these groups of individuals.  Insider trading applied to ordinary employees and to officers who sold even though under state law, it almost certainly did not. 

With respect to the latter group, the SEC could rely on In re Cady Roberts, an administrative decision that did extend the prohibition on insider trading to non-shareholders.  See In re Cady Roberts, 40 SEC 907 (admin proc. Nov. 8, 1961).  Indeed, in Dirks, the Court often referred to the “Cady Roberts duty.”  Cady Roberts, however, found that insiders had a duty to purchasers not because of a fiduciary relationship but  because of the obvious unfairness to the investing public.  See Id. (“We cannot accept respondents’ contention that an insider’s responsibility is limited to existing stockholders and that he has no special duties when sales of securities are made to non-stockholders. This approach is too narrow. It ignores the plight of the buying public-- wholly unprotected from the misuse of special information.”). 

Officers and directors of corporations, however, do not have fiduciary obligations to the investing public.  The case does not, therefore, provide any meaningful support for applying fiduciary principles to purchasers of shares from insiders (at least purchasers who are not already shareholders).  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 4)

So what exactly did the Court hold? 

The majority in Dirks determined that insider trading occurred when an insider disclosed material non-public information in breach of a fiduciary duty. The Court, however, used the phrase without any reference to state law.  This was presumably intentional.  State law would not have supported the analysis.  This could be seen in a number of ways.

First, Dirks involved a tip by an officer (or former officer).  Under state law, officers had a fiduciary relationship that ran to shareholders.  Limiting insider trading to fiduciaries, however, left out more than it included. 

Corporate advisers such as accountants and lawyers were not typically fiduciaries.  Nor were the persons inside the company delivering the mail or moving boxes at the loading dock.  Fiduciary duties extended to officers, directors, and key employees but not everyone working for the corporation.  Limiting insider trading to those with a traditional fiduciary obligation would, therefore, exclude large swathes of persons with access to material non-public information from the prohibitions imposed by Rule 10b-5. 

Even with respect to officers, problems existed.  Fiduciary duties ran to shareholders.  Yet insider trading often occurred when officers sold shares aware of impending negative developments.  Unless selling to existing shareholders, the insider had no fiduciary obligation to those purchasing the shares until after they became shareholders. 

Second, limiting insider trading to instances where the tipper had a fiduciary obligation did not fully accomplish the Court’s goal.  Under traditional state law concepts, a fiduciary could violate his or her duties when not acting in the best interests of shareholders.  This left officers interacting with market professionals open to claims that they improperly “tipped” information anytime they did so in a context that did not appear to benefit the corporation.  

The Court addressed some of these problems and left others unattended.  We will look at the analysis in the next post.  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 3)

The Supreme Court confronted the facts in Dirks with a clear goal.  The majority intended to make certain that the law of insider trading did not unnecessarily impede communications between the company and market participants.  In doing so, the Court opted for an overbroad test that unquestionably sanctioned behavior that, in any common sense world, would constitute insider trading.  Better to let off some individuals who engaged in insider trading than to leave in place a test that chilled legitimate communications with market participants. 

The Court did so by using a vocabulary familiar to any corporate lawyer.  Insider trading was keyed to fiduciary duties and a breach of those duties.  Yet the Court then departed from conventional law by interpreting those terms in a manner largely unrecognizable to those practicing in the area.  In part as a result, the Court had to invent an approach and lexicon that filled gaps created by its own analysis.  We will explore this in a bit more detail in the next post.

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 2)

Lets start at the beginning, with Dirks.  

Dirks involved allegations that an insider (actually a former insider) tipped information to Dirks, an analyst.  The information related to possible fraud at an insurance company.  Dirks attempted to expose the fraud by going to media outlets (the WSJ) but to no avail.  Ultimately, he informed five investment advisers of the information.  The advisers liquidated their positions in the relevant company and ultimately avoided the rout that occurred in share prices once the fraud was exposed. 

It was not a very sympathetic set of facts for an insider trading claim against Dirks but the SEC brought it nonetheless (in the form of an administrative proceeding).   See In re Dirks, Exchange Act Release No. 17480 (admin proc Jan. 22, 1981) (“On the basis of the Commission's opinion issued this day, it is ORDERED that Raymond L. Dirks be, and he hereby is, censured.”).  The Commission’s opinion acknowledged the concern that the action would interfere with disclosure that was important to investors and actually reduced the sanction imposed by the administrative law judge.  As the Commission noted:  

  • We fully appreciate the importance of the analyst's work in providing public investors with an accurate and complete factual basis upon which to make their investment decisions. Accordingly, we do not seek in any way to chill the investigation of rumors concerning a particular company. Nonetheless, the analyst's role, like that of any other person, is constrained by the well-established proscriptions of the antifraud provisions of the federal securities laws, and we cannot condone the unfairness inherent in the selective dissemination of material, inside information prior to its public disclosure. Neither the analysis set forth above, nor the sanction we impose, should hamper legitimate, investigative securities analysis. 

21 S.E.C. Docket 1401 (1981).  For the SEC, however, it was enough to show that the tippee provided information from an insider knowing that the recipient would trade on the information.  Id.  (“Such a tippee breaches the fiduciary duty which he assumes from the insider when the tippee knowingly transmits the information to someone who will probably trade on the basis thereof.”). 

Light though the sanction was, the SEC nonetheless penalized an analyst who had tried to get the information to news outlets and ultimately contributed to the exposure of a major fraud.  Under the logic of the decision, future analysts in the same position would have an incentive to remain silent out of fear of liability, depriving the market of important information. 

Even broader, any analyst who received nonpublic information as a result of doing his or her job (meeting with management for example) would be open to claims of insider trading if taking advantage of the information.  Moreover, given the uncertainty of any materiality analysts, analysts receiving nonpublic information could rationally conclude that it was better not to use the information even if likely immaterial.  Thus, a standard that allowed insider trading claims to be brought whenever insiders “tipped” information that would then be used to make trading decisions had the potential to “chill” the flow of information to the market.  See SEC v. Dirks, 463 US 636 (1983) (“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”).  

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  The amicus filed by a small group of law professors that supports the decision is here.  


US v. Newman and the Rewriting of the Law of Insider Trading (Part 1)

In US v. Newman, a panel of the Second Circuit dismissed a conviction for insider trading against two defendants.  The Government has sought rehearing en banc and the Commission has filed an amicus brief supporting the efforts.  A small group of law professors (Professors Bainbridge, Macey and Henderson) have filed an amicus brief arguing that the decision is correct.  

The case is worthy of consideration for a number of reasons.  First, it reflects a substantial rewriting of the law of insider trading.  The decision essentially eliminated the gift analysis from Dirks and removed from the prohibition on insider trading tips of information to family and friends absent the presence of an exchange "that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature."  Given that many "tips" to friends and family will not be motivated by the potential for pecuniary gain, the court has essentially eliminated from the prohibition on insider trading the exchange of information by family members.   

Second, the panel in Newman consisted of three judges appointed by Republican presidents, two of them senior judges (Winter and Parker) and one active (Hall).  The en banc court, however, includes 13 full time judges, with eight appointed by Democratic presidents.  To the extent that the case goes en banc and is decided along party lines (based upon the political party of the appointing president), the decision will be reversed.      

Finally, the opinion is of interest because of other areas where the Second Circuit seems to be rewriting the law under Rule 10b-5.  In ParkCentral v. Porsche, for example, a panel of the Second Circuit essentially reinstated an “affects test” for determining the extraterritorial application of Rule 10b-5 in a manner that can only be used to deny, rather than grant, jurisdiction.   

In contending that the Second Circuit was incorrect (in both Newman and Porsche), the conclusion is based upon the law as it is.  Given, however, a desire by some on the Supreme Court to narrow the application of Rule 10b-5 (see Janus, Morrison and Stoneridge), the Second Circuit’s rewriting of the law may well be approved if it makes it to the Supreme Court.    

With respect to Newman, the decision and the request for rehearing en banc is posted, along with the SEC’s amicus brief, at the DU Corporate Governance web site.  


Robert Bach, et al v. Amedisys: District Court’s Dismissal Reversed and Remanded

In Bach v. Amedisys Inc., No. 13-30580, 2014 BL 291495 (5th Cir. May 20, 2014), the United States Court of Appeals for the Fifth Circuit reversed and vacated the district court’s decision granting the defendant’s motion to dismiss and, accordingly, remanded the case for further proceedings.

Amedisys is a home health company and, as provided by federal law, receives Medicare reimbursement only when providing patients with medically necessary services. From 2005 – 2009, Medicare reimbursements accounted for approximately 90% of the company’s total reimbursements for services rendered.

The Public Employee’s Retirement System of Mississippi and Puerto Rico Teacher’s Retirement System (together, “Plaintiffs”) filed suit against Amedisys, Inc. (“Amedisys”) and seven prior and current board members (collectively, “Defendants) for violating sections 10(b) and 20(a) the Securities Exchange Act of 1934 alleging Defendants defrauded investors by concealing a Medicare fraud scheme.  Plaintiffs alleged that Amedisys engaged in fraud when it (1) pressured employees to perform unnecessary service visits in order to maximize Medicare reimbursements, and (2) released materially false or misleading statements causing Amedisys’s stock to be traded at an inflated price. Plaintiffs further alleged that when information regarding potential fraud became publicly available, Amedisys’ stock values dropped, causing significant financial loss to shareholders.  The district court dismissed the claim, finding that plaintiffs had not sufficiently alleged loss causation. 

To bring an action under Section 10(b) and Rule 10b-5, plaintiff must allege that the  “misrepresentations (or omissions) proximately caused Plaintiff’s economic loss.” To demonstrate proximate cause, a plaintiff must allege that when a “relevant truth” regarding fraud became public, it caused stock prices to fall, thereby proximately causing the economic harm. The court emphasized the “test for ‘relevant truth’ simply means the truth disclosed must make the existence of actionable fraud more probable than it would be without that alleged fact, taken as true.”

In applying the standard, the court found that plaintiffs had sufficiently alleged the requisite causation. 

  • The Complaint consists of over 200 pages of allegations regarding, among other things, Defendants’ fraudulent Medicare billing practices. Where the Complaint sets forth specific allegations of a series of partial corrective disclosures, joined with the subsequent fall in Amedisys stock value, and in the absence of any other contravening negative event, the plaintiffs have complied with Dura’s analysis of loss causation. 

In so holding, the court asserted that it was evident “the whole is greater than the sum of its parts.”

Accordingly, the United States Court of Appeals for the Fifth Circuit reversed and vacated the district court’s decision granting Defendant’s motion to dismiss, and remanded the case for further proceedings.

The primary material for this case may be found on the DU Corporate Governance website.


Special Projects Segment: Comment Letters in Favor of the Proposed Crowdfunding Rules

We are discussing possible Rulemaking Regarding Crowdfunding under the JOBS Act.

On October 23, 2013, the Securities and Exchange Commission (“SEC”) issued its proposed Crowdfunding rules (“Proposed Rules”) in response to Title III of the Jumpstart Our Business Startups Act of 2012 (“JOBS Act”). The rules are designed to permit general solicitations to non-accredited investors through brokers or over crowdfunding platforms. The rules seek to protect investors against fraudulent offerings while facilitating capital raising. The public comment period closed on February 3, 2014, and the SEC has not issued final rules. 

The SEC received over 500 public comment letters. Some remarks supported the Proposed Rules. Many, however, expressed concern the regulations would stifle startup companies.

The Rules would require audited financial statements for issuers offering more than $500,000 in securities through a crowdfunding offering.  Moreover, the new rules state that financial statements must be reviewed by a Certified Public Accountant (“CPA”) for offerings between $100,000 and $500,000.  CPAs generally endorsed the mandatory reporting requirements imposed on companies using the exemption.

Many CPAs, however, echoed the reservations expressed in Ernst & Young’s comment letter that urged the SEC to reconsider requiring startup companies to report two years of U.S. GAAP-based financials because the requirement was onerous and expensive. As an alternative, Ernst & Young recommended, and the American Institute of Certified Public Accountants (“AICPA”) mainly concurred, that startup companies should be permitted to report their financials by using an Other Comprehensive Basis of Accounting (“OCBOA”). The AICPA comment letter specifically noted the “crowdfunding provisions of the JOBS Act were designed to help make raising capital through securities offerings less costly for startups and small businesses” and asserted that the use of an OCBOA would help advance that goal.

The North American Securities Administrators Association, Inc. (“NASAA”) also submitted a comment letter, which noted the importance of a “balanced regulatory approach that minimizes unnecessary costs and burdens on small businesses while providing meaningful investor protection from fraud and abuse.” NASAA supported the efforts to protect investor privacy, grant investors the ability to cancel investment transactions, require job creation reporting, provide for transparent, independently audited financial statements, and bar bad-actors from crowdfunding. NASAA nevertheless warned the Proposed Rules created unnecessary statutory ambiguity. NASAA posited the JOBS Act clearly required funding from all sources to be limited to a $1 million ceiling. The SEC’s proposal, however, provided for a $1 million cap that looked only to other crowdfunding offerings during the prior 12 months. NASAA feared this interpretation could potentially allow for abuse by large companies and distort congressional intent.   

Comments in support of the Proposed Rules shared some commonality in their concerns. Ernst & Young, the AICPA, and NASAA urged the SEC to consider underlying congressional objectives. They stressed, as did many other commenters, that overregulation could make equity based crowdfunding too onerous and expensive for startup companies. They also warned this provision should be cautiously tailored to prevent abusive practices by larger companies.

Despite the importance of investor protections, many proponents of the new regulations feared that the costs of compliance with the Proposed Rules would outweigh the benefits.  As a result, small businesses and startups would be unable to use the exemption as a source of capital raising.


SEC v. Shavers: Over $40 Million Disgorged in Bitcoin Fraud Case

In SEC v. Shavers, No. 4:13-CV-416, (E.D. Tex. Sept. 18, 2014), the United States District Court for the Eastern District of Texas entered final judgment against Trendon T. Shavers and Bitcoin Savings and Trust (“BTCST”) and ordered them to pay more than $40 million in disgorged profits and prejudgment interest. The court further required each defendant to pay an additional civil penalty of $150,000. 

According to the SEC’s allegations, Shavers established BTCST, an unincorporated online entity, in February 2011, in order to obtain investments that would provide returns in the form of bitcoins. Shavers used online chat rooms to solicit BTCST investors with false promises of earning interest of up to 7% every week. According to the court, “[t]he uncontested summary judgment evidence establishes that Shavers knowingly and intentionally operated BTCST as a sham and a Ponzi scheme, repeatedly making misrepresentations to BTCST investors and potential investors concerning the use of their bitcoins; how he would generate the promised returns; and the safety of the investments.”   

The SEC alleged Shavers violated Section 10(b) of the Exchange Act and Rule 10b-5, as well as Section 17(a) of the Securities Act. Section 10(b) and Rule 10b-5 prohibit (1) the use of any “device, scheme, or artifice to defraud”; (2) “an untrue statement of a material fact” or omission; or (3) “any act, practice, or course of business which operates . . . as a fraud or deceit upon any person.” Additionally, to establish liability, the SEC had to prove Shavers acted with scienter or “an extreme departure of the standard of ordinary care . . . and a danger of misleading [investors] . . . so obvious the defendant must have been aware of it.” To establish Section 17(a) Security Act liability, the SEC had to prove the same elements, but without the scienter requirement. The SEC also alleged that Shavers violated Section 5 of the Securities Act of 1933 by failing to register the investments in BTCST. 

In pretrial motions, the court addressed whether the interests in BTCST were investment contracts under the federal securities law. Because investors paid for the interest in bitcoins, Shavers argued that bitcoins were not currency and the interests did not involve an investment of money. The SEC argued that the use of bitcoins constituted an investment of money. In an August 6, 2013 ruling, the court agreed and held that the investments in BTCST were in fact securities. 

In the September 2014 ruling, the court addressed the claims under Section 10(b) of the Exchange Act and Sections 5 and 17(a) of the 1933 Act.  As the court found:  

  • From February 2011 through August 2012, contrary to representations Shavers made to BTCST investors, the risk of the BTCST investments was not "very limited" or "almost 0"; Shavers did not receive "cash in hand" before moving any BTCST investors' bitcoins; and Shavers was not, as he promised investors, in a position to cover any losses personally.
  • From February 2011 through August 2012, contrary to representations Shavers made to BTCST investors, BTCST was a sham and a Ponzi scheme, whereby Shavers used new bitcoins received from BTCST investors to make payments on outstanding BTCST investments and diverted BTCST investors' bitcoins for his personal use.

It also found Shavers acted with “a high degree” of scienter. See Id. (“Shavers made blatant misrepresentations to BTCST investors concerning the use of their bitcoins and the safety of their investments, while running BTCST as a sham and a Ponzi scheme, and diverting BTCST investors' funds for his personal use, including rent, car-related expenses, utilities, retail purchases, visits to casinos, and meals. Defendants' conduct was not an isolated occurrence.”). 

The court also determined Shavers violated Sections 5(a) and 5(c) of the Securities Act. In order to violate Sections 5(a) and 5(c) a defendant must (1) offer or sell a security; (2) without filing a registration statement with the SEC; and (3) make use interstate communication in connection with the offer or sale. The court held the investments were previously determined to be a security, there was no evidence a BTCST registration statement had been filed. Id. (“Here, Defendants violated Sections 5(a) and 5(c) because there was no registration statement filed or in effect as to the BCTST securities offered and sold over the Internet.”). 

Accordingly, the court ordered disgorgement of over $38 million in profits, payment of prejudgment interest totaling $1.8 million, a civil penalty against each Defendant of $150,000, and permanently enjoined Shavers and BTCST from future violations of Sections 5 and 17(a) of the 1933  Act, as well as Section 10(b) of the Exchange Act and Rule 10b-5.

The primary materials for this case may be found on the DU Corporate Governance website.


Developments and Visions of the SEC for the Future

In alignment with the vision of Alan B. Levenson, co-founder of the Securities Regulation Institute, members of the “private bar and SEC staff” gathered together earlier this year in an effort to strengthen communications between the private and public players in the capital markets. SEC Chair Mary Jo White gave the keynote address, focusing her speech on the evolution of market technology, financial products, and the response to the SEC’s 2014 rulemaking initiatives. Moving forward, the SEC can be expected to maintain a similar agenda in these areas, as was discussed by White. A full transcript of the speech can be found here.

Over the course of its 80-year history, the SEC has maintained initiatives geared toward protecting investors, allowing companies of all sizes to raise funds, and ensuring the fair and efficient functioning of the markets. Constant technological advances, however, have forced the SEC to adapt to such technology and harness its accompanying benefits in order to further various objectives that remain in line with the SEC’s mission. The SEC utilizes these advances by creating new software and database systems. For example, the SEC developed the National Exam Analytics Tool (“NEAT”), an instrument that allows examiners to quickly and efficiently analyze huge amounts of transactional data. The NEAT system makes it easier for the SEC to monitor and, in turn, investigate suspicious behavior in the industry. Similarly, the new Market Information Data Analysis System (“MIDAS”) collects, records, and analyzes trading data ultimately helping the SEC and other regulatory bodies develop a better understanding of trending behaviors occurring in the market. The SEC has also emphasized the more effective utilization of existing technology to address vulnerabilities in market infrastructures. In the near future, this may include the adoption of Regulation SCI (Systems Compliance and Integrity), which would impose stricter requirements for the use of technology in the securities industry.

The financial products market is another area that has experienced huge changes in recent history and has been the subject of SEC reformation. First, the SEC has recommended, under the direction of the Dodd-Frank Act, creating greater transparency for security-based swaps and similar derivative transactions. Second, in response to concerns about the instability of money market funds, the SEC is considering two proposals formulated to work concurrently with amendments made in 2010 to “reduce interest rate, credit, and liquidity risks.” One such proposal would implement a “floating Net Asset Value (“NAV”) for prime institutional money market funds,” and the other would “impose a liquidity fee and permit . . . redemption gates.”  The SEC expects these reforms to be completed in 2014. Lastly, the SEC is looking to finalize new disclosure rules for asset-backed securities, spurred by the enactment of the Dodd-Frank Act.

These new ideas have inspired new ways of thinking amongst investors, regulators, and companies seeking investors. This has caused the SEC to “reconsider how companies can seek capital and communicate with potential investors.” Accordingly, the SEC has adopted rules to amend the requirements for general solicitation as part of a plan to implement the JOBS Act. Companies have been utilizing this new rule, with the amount of capital raised in private offerings surpassing that of public offerings in the last few years. Additional rules related to Crowdfunding and Regulation A have also been proposed by the SEC, and along with past developments, should allow for “companies of all sizes . . . to raise capital.” The SEC does not, however, intend for these new rules to change their goal of reforming disclosure requirements for public companies.

As a last area of focus for 2014, the SEC intends to continue its pursuit of vigorous enforcement.  The first step in addressing this goal is to allow the SEC to require “admissions of guilt [in settlements] where parallel criminal or other regulatory cases were brought with admissions.”  This change would force companies to have greater accountability for their actions, a goal also in line with the Financial Reporting and Audit Task Force.  Furthermore, the exchanges and alternative trading systems have been the target of recent SEC enforcement, with rules enacted to ensure that they are operated fairly and in accordance with applicable standards. 

Although these items are only part of the SEC’s agenda for the coming year, these examples indicate the potential issues the SEC may focus on in the upcoming months.  As Chairwoman White stated, “it is a constant, but always exciting, challenge to keep pace and indeed to accurately see around the next corner for the newest market developments or another innovative variant of, or new venue for, fraud.”  By keeping up with developments in market technology, financial products, and the vulnerabilities that they create in the market, the SEC boasts a plan that should help it remain true to its longstanding 3-prong mission.

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