by T. GormanPosted on Posted in SECActions

The courts have issued numerous opinions debating the elements an insider trading claim as well as the definitions of each While the elements sometimes vary, and the definitions can be debated, in the end the key question is always the evidence – what happened? In U.S. v Klein, Docket No. 17-3355 (2nd Cir. Jan. 10, 2019) the Court had little trouble concluding that the statement “it would be nice to be king-for-a-day” to a long-time friend and financial adviser by an attorney whose firm represented King Pharmaceutical, Inc. in a merger made was an illegal tip of inside information.

Background

Defendant Robert Schulman was a D.C. based partner at Hutton and William in the patent group. Tibor Klein was the principal of Klein Financial Services, a registered investment adviser based in Long Island, New York. Mr. Klein had served as the financial adviser to Attorney Schulman since 2000. The adviser had discretionary authority.

Over the years the attorney and adviser developed a routine of meeting about three times per year on a Friday afternoon to review the performance of the portfolio and advisory. Mr. Klein traveled to Washington, met with the attorney and his wife at their home in Virginia, and then stayed over-night following dinner.

The couple was generally pleased with Mr. Klein’s services although they had some concern that he had become to “bearish” in the wake of the great financial crisis. There had also been some concern in 2010 when the adviser purchased shares of Enzo Pharmaceuticals for the Schulman IRA account. Hutton represented Enzo at the time of the purchase.

In July 2010 the Shulmans met with the adviser. At the time Mr. Schulman knew firm client King Pharmaceutical was in merger discussions with Pfizer – the attorney learned about the deal while conducting patent litigation for the client. During the course of the evening Mr. Schulman stated that “boy, it would be nice to be king-for-a-day.” The attorney claimed the statement was a joke and that he never mentioned the merger or any discussions, according to the testimony he provided to the SEC. Essentially the same statement was made to the U.S. Attorney’s Office in a 2015 interview. Mrs. Schulman – the only person to testify at trial who was present at the time of the statement – did not remember anything being said about King.

The following morning – a Sunday – adviser Klein called long time friend and Ameriprise Financial adviser Shechtman but failed to reach him until Monday. During the Monday conversation Mr. Klein asked his friend what he would do if he had inside information – noting that “Pfizer’s buying King Pharmaceuticals.”

Mr. Shechtman subsequently spent $15,000 to acquire King options. Some were scheduled to expire in mid-September; others would expire in mid-October. He also invested $45,000 in King stock for himself and his wife. Mr. Klein spent $585,217 to acquire King stock in a number of his accounts as well as those of the Schulmans and forty-eight clients which included friends of the Schulmans and his parents.

The Pfizer-King deal was announced on October 12, 2010. Subsequently, all of the shares were sold. Mr. & Mrs. Schulman had profits of about $15,500 – about 50% in two months.

The SEC investigated and charged Mr. Shechtman. The adviser admitted liability, agreed to cooperate, and pleaded guilty in a parallel criminal case. Mr. Klien was also charged. The Schulmans fired him. Following trial, the jury deliberated for about one day. They returned a verdict of guilty on two counts – one based on conspiracy and a second for securities fraud. Following the denial of a Rule 29 motion for acquittal, the Court sentenced Mr. Schulman to serve three years of probation, pay a $50,000 fine, forfeit the trading profits and perform 2,000 hours of community service.

The Opinion

The key question on appeal was the sufficiency of the evidence. Mr. Schulman argued that the only evidence against him – the “king-for-a-day”– was insufficient to support his conviction on two criminal counts. In rejecting this claim the Second Circuit began by noting that an Appellant such as Mr. Schulman has a “heavy burden.” The reviewing court must “credit every inference that could have been drawn in the government’s favor.” If, from the reasonably drawn inferences, the “jury might fairy have concluded guilt beyond a reasonable doubt” the conviction must be affirmed.

In assessing the evidence, it is essential that it be viewed in its totality, not piecemeal or bits in isolation. The lynchpin to the Court’s conclusion is two statements by attorney Schulman, the inferences drawn from them and the trading. Initially, Mr. Schulman admits making the statement about being “a king-for-a-day,” although his wife did not recall it. Indeed, she testified that if she had heard it, the comment would have sounded silly.

Second, Mr. Schulman admitted that the “king-for-a-day” comment referred to King Pharmaceuticals, although there is no reference to the company in the statement. From these facts the Court inferred that “Klein apparently recognized that by ‘king’ Schulman meant ‘King.’” Further, “[c]ommon sense also would lead a rational juror to conclude that Schulman had to have communicated additional information to Klein for Klein to have promptly called Shechtman, cited ‘inside information’ about King and Pfizer . . and begun buying King stock. Indeed, this precise issue was argued to the jury . . .and was resolved by the jury against Schulman.”

Other evidence supports similar inferences – the record is “replete” with such evidence, according to the Court:

· A “reasonable jury could infer that Schulman intended Klein to trade from the evidence” because the trading followed immediately after the discussions of the two men;

· The immediacy of the stock purchases and their size supports the inference that the adviser was acting in accord with the directive of his client; and

· The fact that the adviser had once traded in the shares of a Hutton client – Enzo – supports the inference that he might again; while Mr. Schulman had been upset about the Enzo purchase as the adviser knew, that was because he believed the President of the firm was a “lunatic” but the context here of the “king-for-a-day” statement suggests approval.

When read in its totality, the evidence supports the determination of the jury, the Court concluded.

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by T. GormanPosted on Posted in SECActions

The Supreme Court may reshape SEC Enforcement by the end of this Term. The Court has already heard argument in Lorenzo v. SEC, No. 17-1077where the critical issue is the scope of primary liability under Exchange Act section 10(b). That case is discussed here and was analyzed at the Fifth Annual Federal Enforcement Forum here.

Argument later this year will be held in Emulex Corp. v. Varjabedian, No. 18-459. There the key question is whether Exchange Act section 14(e) provides a negligence-based cause of action for damages which echoes Securities Act sections 17(a)(2) and (3). The action is analyzed below.

Emulex

The issue for resolution centers on whether one component of section 14(e) imposes a negligence standard rather than scienter. The section provides in pertinent part that: “It shall be unlawful for any person to make any untrue statement of a material fact or omit to state any material fact . . . or to engage in any fraudulent, deceptive or manipulative act . . .” in connection with any tender offer.

Petitioner (defendant below) phrased the issue for resolution this way: “Whether the Ninth Circuit held, in express disagreement with five other courts of appeals, that Section 14(e). . . supports an inferred private right of action based on a negligent misstatement or omission made in connection with a tender offer.”

Respondent (plaintiff below) phased the issue for resolution differently: “”Section 14(e) . . . sets out two distinct forms of liability . . .” one for materially untrue statements and a second for manipulative or deceptive devices. “The question presented is: Whether an action premised solely on section 14(e)’s first clause, not its second, requires a pleaded of scienter to state a claim.” Neither party specifically presented the question of whether a cause of action for damages could be implied under the section.

Background

The action is based on the merger of two technology companies. One is Emulex, a producer of equipment for data centers. The other is Avago Technologies Wireless (USA), a leading designer and developer of analog semiconductor devices. The two firms jointly announced the merger on February 25, 2015. Under the terms of the deal $8 would be offered for each outstanding share of Emlex stock, a 26.1% premium to the stock closing price the day before the announcement.

The deal papers included the standard recommendations from the firm and a fairness opinion. A table compiled by Goldman Sachs, adviser to Emulex, was known as the Premium Analysis. According to Petitioner, that Table showed that “the 26.4% premium on the share price. . . was within the range of transaction premiums identified in these unrelated semiconductor transactions . . .” Respondents state that the “analysis revealed Emulex’s premium was decidedly below average . . .” Shareholders narrowly approved the transaction. This suit followed.

The district court dismissed the amended complaint with prejudice. The court rejected plaintiff’s claim that a negligence standard applied. The Ninth Circuit Court reversed. After noting that five circuit courts had adopted a scienter-based standard for section 14(e) private suits, the Court remanded the action to the district court for further consideration.

Petitioners

Petitioners’ (Defendants below) argument is built on three basic points: First, the Circuit Court’s decision contradicts the uniform judgment of every circuit which has considered the question. Second, the Circuit Court’s decision is wrong as a matter of law. Finally, the question presented here is of “exceptional importance.”

First, each Circuit Court which has considered the question agrees that section 14(e), like section 10(b), requires proof of scienter, not negligence. The first was the Second Circuit in Chris-Craft Industries, Inc. v. Piper Aircraft Corp., 480 F. 2d 341 (2nd Cir. 1973). There the Court noted the similarity of language between the two Exchange Act sections and concluded that negligence is not sufficient to contravene the provision. Subsequently, the Fifth, Sixth, Eight and Eleventh Circuit reached similar conclusions. Smallwood v. Pearl Brewing Co., 489 F. 2d 579, 606 (5th Circ. 1974); Adams v. Standard Knitting Mills, Inc., 623 F. 2d 422 431 (6th Cir. 1980); In re Digital Island Securities Litigation, 357 F. 3d 322 (3rd Cir. 2004); SEC v. Ginsburg, 362 F. 3d 1292, 1297 (11th Cir. 2002). While the Ninth Circuit recognized this fact, the Court concluded that the analysis of each Circuit was incorrect and not in accord with that of the Supreme Court’s decisions in Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) and Aaron v. SEC, 446 U.S. 680 (1980).

Second, the decision of the lower court is incorrect because it “upsets” the statutory scheme enacted by Congress. The 1933 and 1934 Acts “constitute interrelated components of the federal regulatory scheme governing transactions in securities,” according to Petitioner. When Congress created express causes of action imposing civil liability it added significant procedural restrictions such as a short statute of limitations and a bonding requirement for defendant’s costs and attorney’s fees.

The same should be true here if there was a negligence-based claim which there is not. When the Supreme Court acquiesced and accepted the implied cause of action under section 10(b), it focused on the overall thrust of the statute and statutory words such as “fraudulent,” “deceptive, and “manipulative” which connote scienter, not negligence. The Court also noted that where Congress enacted civil remedies based on negligence there were significant procedural restrictions. Here the statutory language suggests scienter and the procedural restrictions necessary for negligence are absent.

Finally, the question presented in this case is “undeniably important and one that warrants this Court’s review,” Petitioner told the High Court. The proper administration of the federal securities laws is critical to the effective functioning of the capital markets. Even before the decision in this case the Ninth Circuit was a “magnet” for securities litigation. That highlights the important of employing the correct standard in securities litigation. Indeed, Judge Friendly observed in SEC v. Texas Gulf Sulphur Co., 401 F. 2d 833 (2nd Cir. 1968) that the consequences of implying a cause of action based on negligent misstatements or omission in a securities filing are “frightening.” The decision to adopt such a standard in this case is thus seriously misguided and should be rejected.

Respondents

Respondents brief is the reverse mirror image of Petitioners’. It is built on three key points: First, there is no circuit split. Second, the decision below is correct. Third the petition does not warrant consideration by the Court.

First, there is no circuit split on the on the standard of conduct required to violate the first clause of section 14(e): “Contrary to petitioners’ contention, the Ninth Circuit did not create a genuine circuit conflict. Petitioners cannot identify a single circuit actually deciding the issue after analyzing Section 14(e)’s first clause, especially in a case post-dating this Court’s authoritative decisions.” (emphasis original). Respondents then dissect each case cited by Petitioners in an effort to demonstrate that none properly considered the language in the first part of the statute in view of Hochfelder and Aaron:

· Second Circuit in Chris-Craft Industries: The case predates the Supreme Court’s decisions in Hochfelder and Aaron;

· Fifth Circuit in Smallwood: This case also predates the key Supreme Court cases;

· Sixth Circuit in Standard Knitting Mills: This decision is based on sections 10(b) and 14(a) but not 14(e).

· Third Circuit in In re Digital Island: In this case the issue regarding the applicable standard for section 14(e) was conceded by both parties – not decided by the court; and

· Eleventh Circuit in SEC v. Ginsburg: This is an insider trading case – the critical issue is not presented here.

Second, the question regarding the applicable standard should be governed by the plain language of the first clause in the section. Virtually the identical language regarding misstatements and omissions was considered by the Court in Hochfelder and Aaron. In each case the Court concluded that the plain text of the provision – either rule 10b-5 or Securities Act section 17(a)(2) and (3) reflected a negligence standard. For section 10(b) the words of the statute however controlled the broader language of rule 10b-5, mandating a scienter standard. That was not true in the case of Securities Act section 17(a). Here the same should be true – the plain text of the statute should govern. That mandates a negligence standard for the first clause.

The claim by Petitioner that the statute must be read in its totality, rather than evaluated clause by clause should be rejected. There is simply no reason to ignore the first clause of the section.

Finally, the question presented here is clearly not of import. Not only is there no Circuit split, in view of the Court’s prior cases there is more than adequate guidance for the lower courts. This counsels permitting the issue to be considered and developed by those courts.

The effort by Petitioners to “obliquely suggest the Court should grant review on a question the Ninth Circuit did not decide: whether Section 14(e) provides a private right of action at all should be rejected.” That issue was not presented or considered by the lower courts. It has not been presented here.

Comment

In granting certiorari in Emulex the Supreme Court has set the stage for having a significant impact on enforcement actions by the SEC as well as in private securities litigation. The issues presented by Lorenzo and Emulex each turn on a question of statutory interpretation – the scope of primary liability for the former and the state of mind requirement for the latter. The question in each case centers on an issue that will impact the scope of a cause of action in an SEC enforcement action and a private damage action – in each type of case the cause of action turns on the language of the statute. Lorenzo and Emulex may thus rewrite securities litigation.

Nevertheless, the collective impact of these cases may be negligible by the end of the Term. At oral argument the High Court showed little appetite for rewriting the scope of primary liability under section 10(b). To the contrary, the Court seemed much more inclined to reaffirm its earlier decision in Central Bank of Denver v. First Interstate Bank of Denver, 511 U.S. 164 (1994) which held that the text of the statute governs the scope of a cause of action under the section. Such a holding could give the SEC its first supreme court win in some time and permit the agency to continue using the approach to section 10(b) it has employed for years.

Finally, Emulex could be resolved by finding that there is no implied cause of action under section 14(e). While this issue has not been specifically presented by either party, it is in fact subsumed within the claim both parties agree has been properly presented. Such a ruling would not only be consistent with the Court’s apparent disdain for implied causes of action but its growing conservative tilt. The end result of Lorenzo and Emulex, viewed in this context, may well be the status quo.

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