A Court Again Quashes 'Doctrinal Novelty' By Prosecutors

United States v. Newman and Chiasson

In that vein, in December 2014, the U.S. Court of Appeals for the Second Circuit reversed two insider trading convictions in the Southern District of New York and limited the scope of insider trading liability ' United States v. Newman and Chiasson, 773 F.3d 438 (2d Cir. 2014). Since there is no statute expressly prohibiting insider trading, prosecutors use the anti-fraud provision of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. Neither the Section nor the Rule define insider trading. They simply prohibit the use of a “deceptive device” in connection with the purchase or sale of a security. Under this broad definition, prosecutors increasingly broadened the class of persons and conduct they deemed to be criminal.

Newman draws a new line, limiting the application of these provisions to cases where there is a personal benefit, i.e., a quid pro quo. Now, the Government must prove that: 1) the insider received an actual personal benefit for sharing the inside information; and 2) the downstream tippee knew the tipper received that benefit.

The Sky Is Falling

While the doctrine is part of a trend ' albeit one that law enforcement has yet to discern ' the regulators nonetheless predict dire consequences. The DOJ petitioned the Second Circuit for rehearing en banc, because the opinion “threatens the effective enforcement of the securities laws,” and “will dramatically limit the Government's ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading.” The DOJ predicts that the opinion “will have serious consequences far beyond this case.” Joining the chorus, the SEC's amicus brief seeking a rehearing claims the decision will weaken its “ability to effectively police and deter insider trading,” and “could undermine investor confidence in the fairness and integrity of the securities markets.”

Mary Jo White, Chair of the SEC, expressed “concern” over the opinion's “overly narrow view of the insider trading law.” Preet Bharara, the U.S. Attorney for the Southern District of New York, was more measured, although somewhat defensive: “The decision affects only a subset of our recent cases, and in those cases ' as in all our criminal cases ' we investigated and prosecuted misconduct based on our good faith assessment and understanding of the facts and the law that existed at the time.”

Newman has, in fact, been cited by a dozen criminal defendants in the Southern District of New York, with the DOJ withdrawing charges against five defendants (U.S. v. Conradt). One judge asked DOJ to brief whether a guilty plea was valid (U.S. v. Riley), and some defendants are asking for their convictions to be overturned (U.S. v. Martoma, U.S. v. Goffer), though one such motion has already been rejected (Riley), and other proceedings have been put on hold (U.S. v. Steinberg, U.S. v. Kuo). Newman has also been cited by defendants in Massachusetts (S.E.C v. Parigian and McPhail), New Jersey (S.E.C. v. Holley), California (U.S. v. Decinces, S.E.C. v. Sabrdaran), North Carolina (S.E.C v. Musante), and Georgia (U.S. v. Melvin, U.S. v. Megalli).

The SEC has also had to confront Newman challenges in the Southern District of New York and in administrative proceedings. In Securities and Exchange Commission v. Jafar and Nabulsi' a federal judge agreed to reconsider an earlier decision, although the SEC voluntarily dismissed an administrative action involving illegal trading of Herbalife options (In the Matter of Peixoto). The agency's action against Steven A. Cohen remains on hold (In the Matter of Cohen , and an SEC administrative judge required the agency to show that an alleged tipper received a personal benefit beyond friendship (In the Matter of Bolan and Ruggieri).

How We Got Here

As with the mail fraud statute, absent more explicit statutory language, the law developed through prosecutors convincing the courts of two broad insider trading theories: “classical” and “misappropriation.” The classical theory prohibits a corporate insider from trading shares of that corporation based on inside information in breach of a duty of trust and confidence owed to shareholders, which is shown by personal gain. See S.E.C. v. Obus , 693 F.3d 277, 284 (2d Cir. 2012) (citing U.S. v. Chiarella, 445 U.S. 222, 228 (1980)); and S.E.C. v. Dirks, 463 U.S. 646, 662 (1983). Under the misappropriation theory of liability, a person external to the company to whom inside information has been “entrusted in confidence” commits insider trading by breaching a duty to the source of the information for personal gain. See id. (citing U.S. v. O'Hagan, 521 U.S. 642, 652 (1997)).

Over time, the personal-benefit requirement essentially evaporated as cases expanded to include many downstream unrelated traders. The absence of a personal gain element, advocated by DOJ, was derided by the Second Circuit for its “doctrinal novelty.” Instead, the court concluded that before a personal benefit may be inferred from the existence of a relationship between the tipper and tippee, the Government must prove “a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similar valuable nature. In other words, ' this requires evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latter.”

And, though the personal gain “need not be immediately pecuniary,” it “must be of the same consequence.” The court was clear that “the mere fact of friendship, particularly of a casual or social nature” is insufficient to prove receipt of a personal benefit.

What Next?

Query whether this is “clear and definite” enough to satisfy the Supreme Court or whether Congress will be required to be more explicit. At least one interested party, found often both courtside and in court as CEO of the Dallas Mavericks and as a defendant in a failed SEC insider trading action, Mark Cuban noted in an amicus brief: “[E]xpanding the reach of the insider trading laws is Congress's purview.” Either way, the pattern is the same. Congress passes a broad statute that is expansively and aggressively applied by prosecutors and regulators until a court finds it untenable and narrows the statute's scope to conduct that most would agree ought to be prohibited.

For example, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), 12 U.S.C. ' 1833a, has in recent years been creatively wielded by prosecutors, to dramatic effect. FIRREA allows the DOJ to impose civil penalties for certain predicate criminal violations, some of which criminalize conduct that “affect[s] a federally insured financial institution.” Of late, the DOJ has persuaded at least three judges in the Southern District of New York that a bank's conduct affecting itself satisfies the “affecting a federally insured financial institution” requirement. (U.S. v. Bank of N.Y. Mellon, U.S. v. Wells Fargo, and U.S. v. Countrywide Fin. Corp.). DOJ has successfully used FIRREA in this way to secure numerous multi-billion dollar penalties and settlements. Whether this is the correct application of the law is up for debate. For the time being, however, the courts have not reigned in FIRREA and so it continues to be a weapon in the government's arsenal.

And, while there may be a specific Congressional response to Newman ' a bill to amend Section 10 of the Securities Exchange Act explicitly removing the “personal benefit” requirement has already been introduced in Congress (H.R. 1173) ' such confrontations over the appropriate scope of broad statutes will, by and large, continue to be fought in the courts.

Accordingly, though Newman is obviously useful for those defending insider trading cases, it is also helpful in any challenge to the next example of a prosecutor's “doctrinal novelty.”

Joseph F. Savage, Jr. ([email protected]), a member of this newsletter's Board of Editors, is a partner in the Boston office of Goodwin Procter and a former federal prosecutor. Nomi Berenson ([email protected]), based in New York City, is an associate in the firm's Securities Litigation & White Collar Defense Group.

We've been down this road before: Congress enacts broad anti-fraud provisions and “creative” prosecutors, aided and abetted by compliant judges, invent crimes until told to stop. Stretching by prosecutors, and later contraction by some courts, has played out across a number of corruption related statutes, with courts ultimately requiring prosecutors to prove misconduct. For example, the U.S. Supreme Court decided in United States v. Sun-Diamond Growers of California (1999), that before the government may establish a violation of the federal bribery statute, it must prove a quid pro quo. Similarly, in United States v. McCormack (1991), the Court decided, contrary to the DOJ's view, that campaign contributions are only violations of the anti-fraud statute if there is a specific quid pro quo.

Again in McNally v. United States (1987), the Supreme Court struck down the expansive “honest services mail fraud doctrine.” Later, in Skilling v. United States (2010), it again limited the amorphous fraud provisions of the mail fraud statute to cases where the Government can prove a quid pro quo.

The effort to limit prosecution to clear misconduct ' rather than allowing prosecutors to condemn any behavior they find distasteful ' continued last month when the Supreme Court held that the anti-shredding provision of the Sarbanes-Oxley Act does not criminalize the throwing of fish overboard. The refrain is the same: “[I]t is appropriate, before we choose the harsher alternative [advocated by the DOJ], to require that Congress should have spoken in language that is clear and definite.” Yates v. United States (2015).

United States v. Newman and Chiasson

In that vein, in December 2014, the U.S. Court of Appeals for the Second Circuit reversed two insider trading convictions in the Southern District of New York and limited the scope of insider trading liability ' United States v. Newman and Chiasson , 773 F.3d 438 (2d Cir. 2014). Since there is no statute expressly prohibiting insider trading, prosecutors use the anti-fraud provision of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. Neither the Section nor the Rule define insider trading. They simply prohibit the use of a “deceptive device” in connection with the purchase or sale of a security. Under this broad definition, prosecutors increasingly broadened the class of persons and conduct they deemed to be criminal.

Newman draws a new line, limiting the application of these provisions to cases where there is a personal benefit, i.e., a quid pro quo. Now, the Government must prove that: 1) the insider received an actual personal benefit for sharing the inside information; and 2) the downstream tippee knew the tipper received that benefit.

The Sky Is Falling

While the doctrine is part of a trend ' albeit one that law enforcement has yet to discern ' the regulators nonetheless predict dire consequences. The DOJ petitioned the Second Circuit for rehearing en banc, because the opinion “threatens the effective enforcement of the securities laws,” and “will dramatically limit the Government's ability to prosecute some of the most common, culpable, and market-threatening forms of insider trading.” The DOJ predicts that the opinion “will have serious consequences far beyond this case.” Joining the chorus, the SEC's amicus brief seeking a rehearing claims the decision will weaken its “ability to effectively police and deter insider trading,” and “could undermine investor confidence in the fairness and integrity of the securities markets.”

Mary Jo White, Chair of the SEC, expressed “concern” over the opinion's “overly narrow view of the insider trading law.” Preet Bharara, the U.S. Attorney for the Southern District of New York, was more measured, although somewhat defensive: “The decision affects only a subset of our recent cases, and in those cases ' as in all our criminal cases ' we investigated and prosecuted misconduct based on our good faith assessment and understanding of the facts and the law that existed at the time.”

Newman has, in fact, been cited by a dozen criminal defendants in the Southern District of New York, with the DOJ withdrawing charges against five defendants (U.S. v. Conradt). One judge asked DOJ to brief whether a guilty plea was valid (U.S. v. Riley), and some defendants are asking for their convictions to be overturned (U.S. v. Martoma, U.S. v. Goffer), though one such motion has already been rejected (Riley), and other proceedings have been put on hold (U.S. v. Steinberg, U.S. v. Kuo). Newman has also been cited by defendants in Massachusetts (S.E.C v. Parigian and McPhail), New Jersey (S.E.C. v. Holley), California (U.S. v. Decinces, S.E.C. v. Sabrdaran), North Carolina (S.E.C v. Musante), and Georgia (U.S. v. Melvin, U.S. v. Megalli).

The SEC has also had to confront Newman challenges in the Southern District of New York and in administrative proceedings. In Securities and Exchange Commission v. Jafar and Nabulsi' a federal judge agreed to reconsider an earlier decision, although the SEC voluntarily dismissed an administrative action involving illegal trading of Herbalife options (In the Matter of Peixoto). The agency's action against Steven A. Cohen remains on hold (In the Matter of Cohen , and an SEC administrative judge required the agency to show that an alleged tipper received a personal benefit beyond friendship (In the Matter of Bolan and Ruggieri).

How We Got Here

As with the mail fraud statute, absent more explicit statutory language, the law developed through prosecutors convincing the courts of two broad insider trading theories: “classical” and “misappropriation.” The classical theory prohibits a corporate insider from trading shares of that corporation based on inside information in breach of a duty of trust and confidence owed to shareholders, which is shown by personal gain. See S.E.C. v. Obus , 693 F.3d 277, 284 (2d Cir. 2012) (citing U.S. v. Chiarella , 445 U.S. 222, 228 (1980)); and S.E.C. v. Dirks , 463 U.S. 646, 662 (1983). Under the misappropriation theory of liability, a person external to the company to whom inside information has been “entrusted in confidence” commits insider trading by breaching a duty to the source of the information for personal gain. See id . (citing U.S. v. O'Hagan , 521 U.S. 642, 652 (1997)).

Over time, the personal-benefit requirement essentially evaporated as cases expanded to include many downstream unrelated traders. The absence of a personal gain element, advocated by DOJ, was derided by the Second Circuit for its “doctrinal novelty.” Instead, the court concluded that before a personal benefit may be inferred from the existence of a relationship between the tipper and tippee, the Government must prove “a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similar valuable nature. In other words, ' this requires evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the latter.”

And, though the personal gain “need not be immediately pecuniary,” it “must be of the same consequence.” The court was clear that “the mere fact of friendship, particularly of a casual or social nature” is insufficient to prove receipt of a personal benefit.

What Next?

Query whether this is “clear and definite” enough to satisfy the Supreme Court or whether Congress will be required to be more explicit. At least one interested party, found often both courtside and in court as CEO of the Dallas Mavericks and as a defendant in a failed SEC insider trading action, Mark Cuban noted in an amicus brief: “[E]xpanding the reach of the insider trading laws is Congress's purview.” Either way, the pattern is the same. Congress passes a broad statute that is expansively and aggressively applied by prosecutors and regulators until a court finds it untenable and narrows the statute's scope to conduct that most would agree ought to be prohibited.

For example, the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), 12 U.S.C. ' 1833a, has in recent years been creatively wielded by prosecutors, to dramatic effect. FIRREA allows the DOJ to impose civil penalties for certain predicate criminal violations, some of which criminalize conduct that “affect[s] a federally insured financial institution.” Of late, the DOJ has persuaded at least three judges in the Southern District of New York that a bank's conduct affecting itself satisfies the “affecting a federally insured financial institution” requirement. (U.S. v. Bank of N.Y. Mellon, U.S. v. Wells Fargo, and U.S. v. Countrywide Fin. Corp.). DOJ has successfully used FIRREA in this way to secure numerous multi-billion dollar penalties and settlements. Whether this is the correct application of the law is up for debate. For the time being, however, the courts have not reigned in FIRREA and so it continues to be a weapon in the government's arsenal.

And, while there may be a specific Congressional response to Newman ' a bill to amend Section 10 of the Securities Exchange Act explicitly removing the “personal benefit” requirement has already been introduced in Congress (H.R. 1173) ' such confrontations over the appropriate scope of broad statutes will, by and large, continue to be fought in the courts.

Accordingly, though Newman is obviously useful for those defending insider trading cases, it is also helpful in any challenge to the next example of a prosecutor's “doctrinal novelty.”

Joseph F. Savage, Jr. ([email protected]), a member of this newsletter's Board of Editors, is a partner in the Boston office of Goodwin Procter and a former federal prosecutor. Nomi Berenson ([email protected]), based in New York City, is an associate in the firm's Securities Litigation & White Collar Defense Group.