The News Corp-Dow Jones Insider Trading Case: A Significant Settlement

Yesterday, the SEC settled one of the high profile insider trading cases it brought last year: the New Corp-Dow Jones case, SEC v. Kan King Wong, Civil Action No. 07 Civ. 3628 (S.D.N.Y. Filed May 8, 2007) (the SEC’s Press Release is here). The case centers on trading in advance of the May 1 public announcement of New Corp’s bid for Dow Jones. The Commission’s initial complaint, filed just seven days after the announcement of the bid, was long on allegations and short on facts. The initial complaint named Kan King Wong and wife Charlotte Ka On Wong Leug, both residents of Hong Kong, as defendants. It alleged that the couple purchased 415,000 shares through a Merrill Lynch Hong Kong account between from April 13 to April 30. Funds for a portion of the purchase were wired in from another account. By May 4, when the husband ordered the sale, the account had an $8.1 million profit from the share price increase that followed the public announcement of the takeover bid.

The SEC’s quick action permitted it to freeze the defendants’ account and keep the trading profits from perhaps disappearing. At the same time, that swift action deprived the SEC of one of its best weapons – a through and complete investigation. Careful examination of the initial complaint suggests that at the time of filing, the SEC had little more than the information which was available from Merrill Lynch: the account statements and the account opening documents which would show the trades, cash flows in and out of account and the identity of those who owned and controlled the account. The complaint did not specify how the defendants received any inside information or even suggest a possible source of such information. Indeed, it is likely that the allegations of insider trading in the complaint were little more than inferences drawn from the trading.

Yesterday, however the SEC amended its complaint. The First Amended Complaint identifies the source of the information and lays out in detail how the insider trading scheme took place: News Corp board member David Li, a well respected business man in Hong Kong, told his close friend and business associate Michael Leung, who in turn told his daughter and son-in-law: the defendants in the initial complaint. The amended complaint adds David Li and Michael Leung as defendants and details how Mr. Leung traded through the account of his daughter and son-in-law with their assistance.

Simultaneous with the filing of the amended complaint, each defendant consented to the entry of an order enjoining them from future violations of Section 10(b) and Rule 10b-5. In addition, David Li was ordered to pay an $8.1 million civil penalty, Michael Leung to pay $8.1 million in disgorgement plus pre-judgment interest and an $8.1 million penalty and K. K. Wong to pay $40,000 in disgorgement plus prejudgment interest and a $40,000 civil penalty. This is a significant result for the Commission and the staff in a major insider trading case.

Stoneridge: The Supreme Court’s Ruling and Its Impact – Part 3: The Circuits Struggle to Define Primary Liability

Following Central Bank and the passage of the PSLRA, the Circuit Courts struggled to draw the line between primary and secondary liability. At the same time, the District Courts struggled to apply the tests crafted by the circuits. While Central Bank cautioned that anyone could be held liable under Section 10(b) and Rule 10b-5 where each of the elements of a private damage is satisfied, much of the debate focused on defining what type of conduct and thus who would be held liable.

The Circuit Courts evolved two basic approaches to defining primary liability, the “substantial participation” test and the “bright line” test. Each of these became a precursor to “scheme liability” and the Supreme Court’s decision in Stoneridge.

The Ninth Circuit created the “substantial participation” test immediately following the decision in Central Bank. In re Software Toolworks, Inc., 50 F.3d 615 (9th Cir. 1995). There, the question was whether auditors who had helped prepare offering documents that were fraudulent and who had made false representations to the SEC during the review process could be held liable in a private Section 10(b) action. The court concluded that the auditors could be held liable as primary violators in view of their substantial participation. There was virtually no discussion of reliance or whether the investors knew or should have known about the actions of the auditors.

Five years later, the Ninth Circuit reaffirmed the “substantial participation” test in Howard v. Everex Systems, Inc., 228 F.3d 1057 (9th Circ. 2000). Again, there was virtually no discussion of the reliance element.

Other circuits, such as the Tenth and the Second, rejected the “substantial participation” test as inconsistent with Central Bank. Those circuits adopted what became known as the “bright line” test. The Second Circuit’s decision Shapiro v. Cantor, 123 F.3d 717 (2nd Cir. 1997) is one of the early and leading cases utilizing this theory of primary liability. There, the court held that a claim against an auditor was insufficient based on allegations that the defendant had assisted in the development of business plans and had participated in internal communications despite allegations that the company had defrauded its shareholders. To hold the auditor liable the court held, there had to be facts demonstrating that the auditors not only participated in a misrepresentation, but also that they knew or should have known that it would reach the investors.

The Second Circuit’s ruling echoed and built on a Tenth Circuit decision handed down the year before Shapiro. Anixter v. Home-State Production Co., 77 F.3d 1215 (10th Cir. 1996). There, in considering the sufficiency of a claim against an auditor in a case based on a ponzi swindle, the court concluded that a key element of primary liability is a misrepresentation that the auditor knew or should have known would be relied on by the investors.

Subsequently, the Eleventh Circuit adopted an even more restrictive version of the bright line test in Ziemba v. Cascade Int., Inc., 256 F.3d 1194 (11th Cir. 2001). The Ziemba court added to the bright line test by requiring that the statement alleged to be false be publicly attributed to the defendant.

Other courts adopted variations of the bright line test which were less restrictive than the version employed by the Eleventh Circuit. For example, in In re Lemout & Hauspise Sec. Litig., 230 F. Supp. 2d 152, 166-67 (D. Mass. 2002), the court held that it was sufficient to establish liability if it could be inferred from available facts that the statement claimed to be false had been made by the auditor defendant.

As the courts debated over how to define primary liability under Section 10(b) and whether the bright line or substantial participation test was the appropriate standard, the SEC crafted a theory of Section 10(b) primary liability it called “scheme liability.” That test was later rolled out in amicus briefs in huge fraud cases such as Enron and Homestore. Ultimately, a version of the test was adopted by the Ninth Circuit and argued by the Stoneridge plaintiff. The debate over that theory and its potential ultimately set the stage for what many commentators thought would be the “securities law decision of the century.”

Next: The SEC’s scheme liability theory.