LAW-Use vs. Possession in Insider Trading Cases

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Use vs. Possession in Insider Trading Cases

Steven R. Glaser and Raymond Bilderbeck

New York Law Journal

07-09-2012


More than 10 years ago, the Securities and Exchange Commission (SEC) enacted Rule 10b5-1 as an attempt to resolve questions about the requisite knowledge necessary to impose liability for insider trading offenses. Yet, rather than providing clarity in insider trading cases, the precise role of "knowledge" in these cases has remained obscure, for although the SEC rule purported to create a relatively simple formula for imposing liability on defendants—under which anyone "aware" of material non-public information can be found guilty of trading on the basis of that information, regardless of whether any evidence exists that their possession of this information was the motivation for those trades—commentators have long argued that the SEC exceeded its rulemaking authority by enacting it.

Furthermore, in recent cases, courts in both civil and criminal actions have proved hesitant to impose liability so broadly. Thus, there remains significant room for defense counsel in insider trading cases to continue to advocate against the application of Rule 10b5-1's knowledge standard, and require the SEC and the Department of Justice (DOJ) to prove that the material non-public information in question was actually used.

This article will proceed in three stages. First, it will provide a brief overview of Rule 10b5-1 and the problems that it was intended to address. Second, it will discuss subsequent academic and jurisprudential commentary of the rule, including arguments suggesting that the SEC exceeded its authority in enacting the regulation. The third section will then discuss more recent developments in the debate, including distinctions that have been drawn between civil and criminal enforcement actions, and the reluctance of courts to embrace the full scope of Rule 10b5-1.

Early Cases

Prior to the enactment of Rule 10b5-1, courts had frequently struggled with the question of the requisite state of mind for insider trading violations. Courts had typically construed trading on the basis of material non-public information as "manipulative and deceptive devices" that therefore constitute violations of Securities Exchange Act §10(b), as well as SEC Rule 10b-5.1 However, neither §10(b) nor Rule 10b-5 explicitly address insider trading, and therefore they provide little statutory guidance on the state of mind and the conduct required to create liability for such offenses. It is in this context that disputes surrounding the connection between knowledge of material non-public information and trades allegedly made "on the basis" of that information arose.2 The central problem can be summarized as follows: Is it sufficient for the SEC or the DOJ to prove that a defendant was merely aware of material non-public information, or must they also demonstrate that the defendant actively used this information when making the securities trades in question?

A number of circuit court cases from the 1990s demonstrate the problem. In the criminal context, the Ninth and Second circuits came to contradictory conclusions on the issue, with the Ninth Circuit in United States v. Smith holding that mere "possession" of non-public information—without proof of its use—was insufficient to show the intent necessary for a criminal conviction,3 while the Second Circuit in United States v. Teicher suggested that "knowing possession" would be sufficient for an insider trading conviction.4 Meanwhile, in the civil context, the Eleventh Circuit split the difference between Smith and Teicher, holding in SEC v. Adler that in a civil enforcement action the SEC could benefit from a presumption of use, but that this presumption could be rebutted by a defendant.5 Notably, the court in Adler expressly declined to opine about whether such a presumption would be appropriate in the criminal context, as the Second Circuit had held in Teicher. The situation was ripe for legislative or regulatory clarification.

Rule 10b5-1

Thus in 2000, the SEC enacted Rule 10b5-1 in an attempt to provide guidance. For the first time, the SEC codified insider trading as a violation of §10(b), and clarified that, in its view, this prohibition would cover securities trades where "the person making the purchase or sale was aware of [] material non-public information when the person made the purchase or sale."6 According to the SEC, 10b5-1 was not supposed to "modify or address any other aspect of insider trading law [such as scienter standards], which has been established by case law."7 However, the bar was quick to note that the rule expanded liability for insider trading in a way that appeared to conflict with the scienter requirements that the Supreme Court had established for securities fraud generally, including securities fraud in the civil context,8 and for criminal insider trading violations in particular. Regarding the latter, the court has held that:

[Section] 10(b) and Rule 10b–5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, non-public information.…[and the] fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities.9

This language exists in tension with the "possession" standard of Rule 10b5-1. Notwithstanding the fact that the SEC superficially endorsed this precedent when enacting the rule—by prohibiting trades made "on the basis of" material non-public information—it ensured that no one would mistake this for an endorsement of a "use" standard by providing an expansive definition of trading "on the basis of" non-public information:

[A] purchase or sale of a security of an issuer is "on the basis of" material non-public information…if the person making the purchase or sale was aware of the material non-public information when the person made the purchase or sale.10

Needless to say, many commentators and defense lawyers at the time were not convinced of the propriety of what they saw as the SEC's efforts to expand liability under the statute.11 Notably, the rule did not address a number of the concerns raised by the court in Adler, such as whether any heightened standard would apply in the criminal context, or whether a defendant would have the opportunity to avoid liability by providing evidence that he or she had not used the material non-public information when making the trades in questions.

Instead, the rule appeared to offer an unequivocal endorsement of the Teicher decision, which applied the "possession" standard in the criminal context. Furthermore, the rule offered a defendant a limited and statutorily prescribed list of "non-use" defenses, based on pre-existing trading plans.12 The remainder of this article will examine recent developments in this ongoing dispute, focusing in particular on evidence that courts have remained wary of the new rule in both criminal and civil cases.

Recent Case Law

Notwithstanding the continued skepticism of many practitioners and academics regarding the validity of Rule 10b5-1, in the few cases where the rule has been directly challenged by defendants, courts have tended to side with the government, and have accepted that a "knowing possession" standard satisfies the scienter requirements of securities fraud violations in both the civil and criminal contexts. For example, the Second Circuit, following its own precedent in Teicher, embraced the validity of the "knowing possession" standard in a criminal insider trading case in United States v. Royer.13

However, outside the Second Circuit, a number of courts have expressed discomfort with the new standard, suggesting that it remains susceptible to attack on the grounds that the rule exceeds the administrative authority of the SEC by turning a scienter-based offense into a potentially strict liability one. Unfortunately, many of these cases have had unusual procedural postures, such that there are few cases in which a lower court has explicitly rejected the SEC rule and subsequently been upheld on appeal. Thus, for example, in United States v. Heron, the district court favored a standard that required the prosecution to show that the material, non-public information at issue was a "substantial factor," rejecting the government's request for an instruction requiring that the information be "a factor, however small" in the decision to trade, and opining that this reduced standard would constitute an inappropriate presumption against a criminal defendant.14 On the basis of this holding, the district court found that no reasonable jury could have found the requisite scienter to convict.

In reversing the decision, the Third Circuit held that the facts were sufficient to support an inference of scienter, but did not comment on the validity of the district court's jury instruction.15 Similarly ambiguous cases exist in other jurisdictions, in which courts have demonstrated their apprehensions about the new rule, but have not definitively declared it invalid.16

These cases suggest that the validity of the rule has not yet been conclusively determined, and that counsel should continue to test the limits of the rule in cases where the "use" of material non-public information by a defendant is unclear. This conclusion is buttressed by the jury instructions that have been given in recent insider trading cases in both the criminal and civil context.

In two criminal trials in the U.S. District Court for the Southern District of New York arising from the Galleon hedge fund investigation, different judges both adopted "use" standards. In the prosecution of Zvi Goffer, the Judge Richard Sullivan unequivocally stated that the jury had to find that Goffer actually used material non-public information in order to support an insider trading conviction:

In order to find that the Defendant you are considering engaged in insider trading, you must also find that he purchased or sold stock using material, non-public information…. [T]he law requires [] that the information be a substantial factor in the decision to buy or sell.17

Similarly, in the Raj Rajaratnam trial, Judge Richard Holwell instructed the jury that in order to convict on the insider trading charges, it was necessary for the jury to find "that material, non-public information given to the defendant was a factor, however small, in the defendant's decision to purchase or sell stock."18 Although Rajaratnam's counsel sought a "substantial factor" instruction similar to that received by Goffer, the government did not appear to oppose the "use" standard more generally. Other courts have also given instructions that conflict with the "knowing possession" standard of 10b5-1.19

It might be argued that in light of the heightened scienter standards that apply under §32(a) of the Securities Exchange Act of 1934 for criminal prosecutions, which only permits convictions for "willful" violations of the securities laws, both the DOJ and the courts have recognized the tension, and possible peril, in using a "knowing possession" standard; ordinarily the willfulness requirement is met by a defendant's improper use of the information. It could also be argued that it is difficult to imagine the DOJ exercising its discretion to bring an insider trading case where the defendant did not actually use the information at issue. For these reasons one might assume that the criminal cases are somewhat sui generis.

Interestingly, however, courts have been equally reticent about instructing juries under a "knowing possession" charge in civil actions brought by the SEC. Although there are cases in which courts have given juries "knowing possession" instructions in civil insider trading cases,20 in general they appear to have favored some variation of a "use" standard. For example, in SEC v. Donovan, the court instructed the jury that:

The SEC doesn't have to prove that [the defendant] bought the stock solely on the basis of the non-public information. It's enough if it shows that that was a substantial factor in his decision to buy.21

Significantly, even the SEC's own proposed instructions in that case would have only imposed liability if the jury found that the non-public information was "a factor" in the decision to make the relevant trades. In SEC v. Gowrish, the SEC agreed to a "use" instruction that would have permitted the jury to draw an inference of "use" from the possession of non-public information, but would also have allowed the defendant to rebut this inference without necessarily using the safe harbors provided by Rule 10b5-1.22 Thus, even in the civil context, it appears that the government is not eager to seek the jury instructions that Rule 10b5-1 would technically permit.

Conclusion

More than 10 years after it was established, SEC Rule 10b5-1 has not ended the debate on whether the government must show a causal connection between the material non-public information and the specific trades at issue in insider trading cases. The reluctance of courts in both criminal prosecutions and civil enforcement actions to endorse the rule's watered-down knowledge standard—and the government's frequent reluctance to advocate for the relaxed standard—indicates that this area of the law remains unsettled, and will be ripe for counsel to continue to contest it in the future.

Steven R. Glaser, a partner in Skadden, Arps, Slate, Meagher & Flom's white-collar crime practice, served as an assistant U.S. Attorney for the Southern District of New York prior to joining the firm. Raymond Bilderbeck is an associate at the firm.

Endnotes:

1. See, e.g., SEC v. Texas Gulf Sulfur, 401 F.2d 833 (2d Cir. 1968).

2. See United States v. O'Hagan, 521 U.S. 642, 656 (1997).

3. 155 F.3d. 1051 (9th Cir. 1998).

4. 987 F.2d 112 (2d Cir. 1993).

5. 137 F.3d 1325 (11th Cir. 1998).

6. Id.

7. SEC Final Rule: Selective Disclosure and Insider Trading, available at http://www.sec.gov/rules/final/33-7881.htm.

8. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).

9. United States v. O'Hagan, 521 U.S. 642, 652, 656 (1997) (emphasis added); see also Chiarella v. United States, 445 U.S. 222 (1980); Dirks v. SEC, 463 U.S. 646 (1983).

10. 17 C.F.R. §240.10b5-1(b) (emphasis added).

11. See, e.g. Jennifer L. Neumann, "Insider Trading: Does 'Aware' Really Resolve the 'Possession' Versus 'Use' Debate?," 7 Wash. U.J.L. & Policy 189 (2001).

12. 17 C.F.R. §240.10b5-1(c).

13. 549 F.3d 886 (2d Cir. 2008).

14. United States v. Heron, 525 F. Supp. 2d 729, 748-50 (E.D. Pa. 2007).

15. United States v. Heron, 323 F. App'x 150 (3d Cir. 2009).

16. See United States v. Causey, 2005 WL 3560632 at *3-4 (S.D. Tex. Dec. 29, 2005); United States v. Nacchio, 519 F.3d 1140, 1167-68 (10th Cir. 2008) (commenting that the district court's "use" instruction may have been too favorable to the defendant, but declining to reach the issue); SEC v. Lipson, 278 F.3d 656 (7th Cir. 2001).

17. Jury Instructions, United States v. Goffer, No. 10-cr-0056 (S.D.N.Y. June 2, 2011).

18. Jury Instructions, United States v. Rajaratnam, No. 09-cr-1184 (S.D.N.Y. April 25, 2011).

19. See, e.g., Jury Instructions, United States v. Skilling, No. 04-cr-0025 (S.D. Tex. May 15, 2006) ("the government must prove beyond a reasonable doubt that [defendant] used the material, non-public information in making his decision to sell…stock"); Jury Instructions, United States v. Contorinis, No. 09-CR-1083 (S.D.N.Y Oct. 4, 2010); Jury Instructions, United States v. Cioffi, No. 08-cr-0415 (E.D.N.Y. Nov. 9, 2011).

20. See, e.g., Jury Instructions, SEC v. Gunn, No. 08-cv-1013 (N.D. Tex. Nov. 5, 2009). However, in this case defense counsel's own proposed instructions included an "awareness" standard, and therefore did not raise this issue with the court.

21. No. 08-cv-10649 (D. Mass. Nov. 19, 2009).

22 No. 09-cv-5883 (N.D. Cal. Jan. 12, 2011).


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