The Impact of Newman on SEC Enforcement: Part V

This is the fifth and concluding segment of a five part series discussing the impact of the Second Circuit’s ruling in Newman on SEC insider trading cases

Analysis

The impact of Newman on the SEC and the DOJ may be significant. If the decision is adopted and followed by other circuits it will clearly make pleading and prevailing in an illegal tipping case more difficult. Whether it will have the devastating impact projected by the Manhattan U.S. Attorney when trying to persuade the Second Circuit to revisit the decision is doubtful at best. Cases such as Kanodia, Zeringue and Gray suggest that in many instances the SEC will be able to plead facts regarding a quid pro quo of the type specified in Newman. While the benefit may not be as explicit as in those cases in each instance, no doubt enforcement officials will develop evidence demonstrating that there was a benefit to the person furnishing the inside information which was known to the recipient who traded. Indeed, it seems incongruous to suggest that a person would essentially steal material non-public information – breach a duty of trust and confidence and take information entrusted to them for a specific reason – risk a violation of the law and then just give it away. Viewed in this context the act of illegally tipping at least suggests there is some benefit, although it may be difficult to prove that the tippee knew about in some instances. Accordingly, there should be little doubt that enforcement officials will to continue bring illegal tipping cases.

The SEC may, however, take steps to avoid Newman. One approach is to try and differentiate between criminal and civil actions. While Payton suggests this approach, a more careful examination of the case, coupled with consideration of similar efforts in the past, suggests that this approach is flawed. In the initial paragraphs of the Payton decision where this distinction made, Judge Rakoff fails to cite any authority. That is consistent with the balance of the ruling which is little more than an effort to use the civil pleading rules which govern a motion to dismiss to draw every possible inference in favor of the plaintiff-SEC. In straining for every inference the Court may well have exceeded the limits of the plausibility test crafted by the Supreme Court in Ashcroft v. Iqbal, 129 S.Ct. 1937 (2009) and Bell Atlantic v. Twombly, 127 S.Ct. 1955 (2007) which governs basic pleading standards. Under those decisions – setting aside the more stringent Rule 9(b) fraud standards which apply here –the complaint must be plausible. Here that means that there must be plausible evidence of a personal benefit, quid pro quo. At best, that evidence in Payson is strained.

More fundamental is the proposition that Newman is based on a construction of Section 10(b). There is nothing in the language of that Section which supports a distinction of the type Payton attempts to create. To the contrary, prior efforts to evade similar constructions of Section 10(b) viewed as unfavorable by SEC enforcement officials have failed. See, e.g., Aaron v. SEC, 446 U.S. 680, 69 (1976)(rejecting SEC contention that scienter requirement imposed on private Section 10(b) actions in Ernst & Ernst v. Hochfleder, 425 U.S. 185 (1976) based on the language of the statute did not apply to a Section 10(b) SEC enforcement action); U.S. v. O’Hagan, 521 U.S. 642 (1997)(adopting misappropriation theory of insider trading in criminal case which also applies in SEC cases).

A second, would be to bring insider trading cases in an administrative forum. Following Newman, however, the SEC has not demonstrated an inclination to follow this path. While the agency did bring a series of those actions in that forum in the fourth quarter of 2014 as previously noted, that trend seems to have halted. Whether the SEC will return to that approach in view of the repeated law suits challenging its forum selection decisions and negative public comment is at best unclear.

Finally, since many of the SEC’s insider trading cases are not in the Second Circuit, the Commission may in cases outside that Circuit plead the Newman personal benefit test where it has the facts but challenge the ruling in other instances. Although the Second Circuit stated that its ruling is based squarely on the Supreme Court’s decision in Dirks, the SEC could to challenge that position, perhaps in a fashion suggested by the Manhattan U.S. Attorney’s Office in its petition for rehearing. There the Government argued, with the support of the SEC, that the requirement of a quid pro quo exceeds Dirks.This could eventually result in a Circuit split which might lead to a definitive definition by the Supreme Court.

For cases which can only be brought in the Second Circuit, the SEC may decide to bring the action as an administrative proceeding. By selecting that forum the SEC could plead the elements of tipping and the personal benefit test of Dirks in a fashion consistent with its interpretation of the law. This approach would be consistent with the SEC’s recently released memorandum on forum selection. There the agency gave notice that it may select an administrative forum for its cases where there are important questions regarding the securities laws to be resolved. While those cases would be subject to review by a Federal Court of Appeals, the Commission can be expected to argue on appeal that its determination is entitled to deference. Markowski v. SEC, 274 F. 3d 552 (D.C. Cir. 2001)(deferring to SEC interpretation of Exchange Act Section 10(b) in a market manipulation case). This approach could also eventually result in a Circuit split resulting in a determination by the Supreme Court.

Before choosing this approach, however, the SEC might be well advised to consider the results from the last time it selected this path. Dirks was initially brought as an SEC administrative proceeding. The D.C. Circuit upheld its determination that Ray Dirks engaged in illegal tipping. The Supreme Court, however, reversed in an opinion which first announced the personal benefit test – a ruling the Newman Court says is the predicate for its determination.

The Impact of Newman on SEC Enforcement: Part IV

The Impact of Newman on SEC Enforcement: Part IV

This is the fourth segment of a five part series discussing the impact of the Second Circuit’s ruling in Newman on SEC insider trading cases

Post Newman SEC Actions (continued)

2. Administrative proceedings

A second option for the SEC is to avoid the potential impact of the decision by filing its insider trading cases in an administrative forum. While the SEC traditionally brings insider trading cases in district court, in the four months prior to Newman the agency filed seven insider trading actions as administrative proceedings. All but one was settled at the time of filing (here). The remaining proceeding was later dismissed by the Enforcement Division after it was discovered that key witnesses had left the country.

The apparent trend toward a greater use of administrative proceedings spawned a number of suits against the agency, raising constitutional issues (here). To date only one the suit by Raji Gupta was successful, and it predated the late 2014 trend. Gupta v. SEC, 796 F. Supp. 2d 503 (S.D.N.Y. 2011). There the SEC initiated an administrative proceeding alleging insider trading, Mr. Gupta filed suit alleging a denial of equal protection because every other insider trading case stemming from the expert network investigations had been brought in district court. Judge Rakoff agreed and issed an injunction. The Commission dismissed the case and filed its traditional civil injunctive action. Later Mr. Gupta was convicted on criminal insider trading charges.

Since Newman the SEC has only brought one insider trading case as an administrative proceeding and that action avoided the question. In the Matter of Charles L. Hill, Jr., Adm. Proc. File No. 3-16383 (Feb. 11, 2015). The action centered on the tender offer by NCR Corporation for Radiant Systems, Inc., announced on July 11, 2011 after the close of the markets.

The deal began in early May 2011when NCR’s CEO called the CEO of Radiant and expressed an interest in a possible deal. Later that month Radiant’s board authorized discussions. Following discussions and due diligence the deal was structured as a tender offer in an agreement executed on July 11, 2011. Radiant’s COO, the brother of the CEO, learned about the deal in early May. Subsequently, he continued to discuss the matter with his brother. COO also negotiated his employment terms in the event that the deal was consummated.

COO had a Friend with whom he shared material, non-public information about the pending tender offer. COO had known Friend since childhood. They routinely shared confidential information. Friend also knew the position COO held at Radiant. Friend had a close personal relationship with Charles Hill. While the two frequently spoke, there is no allegation that they routinely exchanged confidential information. During the deal period the Order alleges that Friend furnished Mr. Hill with material, non-public information about the pending tender offer for Radiant. Mr. Hill “was aware of the relationship” between Friend and COO. Mr. Hill was also acquainted with COO.

Mr. Hill made a series of purchases of Radiant stock beginning on June 1, 2011. Eventually he acquired over 100,000 shares of a stock he had not purchased over the last four years. By July 8, 2011 the shares had a value of over $2.2 million. At the time of the purchases Mr. Hill knew, or had reason to know, that the information he obtained was material and non-public, according to the Order. He also had reason to know it came directly or indirectly from Radiant, or an officer, director or employee of the company. There is no allegation that Friend received any benefit for transmitting the information.

The SEC avoided the Newman issue, however, by only charging the case as a violation of Exchange Act Section 14(e), not 10(b). The Order thus alleges that each of the purchases was made after NCR had taken substantial steps to commence the tender offer, in accord with Section 14(e). Following the deal announcement the share price of Radiant increased over 30%. Mr. Hill had profits of about $744,000. The proceeding will be set for hearing.

Other SEC insider trading cases brought after Newman were filed in Federal district court. The reason the SEC halted what appeared to be a trend beginning in stemming from the fall of 2014 is unclear. The question of using the administrative forum in lieu of district court remains controversial however. Recently, at Senate hearings on the SEC budget, Chair White was questioned about the issue. Days later a paper titled “Division of Enforcement Approach to Forum Selection in Contested Actions” appeared on the Division’s website. While it enumerates factors considered by the Division when selecting a venue for its enforcement actions, it offers little real insight into the process (here).

3. Other post Newman cases

The Commission has filed at least three other post-Newman insider trading cases involving tips through May 1, 2015. Only one of those actions is in the Second Circuit were Newman is controlling precedent. These cases largely fail to head the teachings of Newman.

SEC v. Xia, Civil Action No. 23249 (S.D.N.Y. Filed April 29, 2015) is a “suspicious trading” case. As with most of these actions it is based on little more than trading and timing.

The action centers on the merger of two Chinese e-commerce companies, 58.com and ganji.com, announced on April 14, 2015. Prior to that date the two defendants, Dr. Xiaoyu Xia and Ms. Yanting Hu, residents of Beijing, China, purchased out-of-the-money call options in 58.com between the time of the agreement and the announcement. Each defendant is connected to the financial industry in China. There are no allegations regarding the source of the information or any quid pro quo type personal benefit. The complaint alleges violations of Exchange Act Section 10(b). Despite the paucity of the allegations the SEC did, as is typical in these actions, obtain an asset freeze over the U.S. brokerage accounts used. The Court also issued an order to show cause why a preliminary injunction should not issue. See Lit. Rel. No. 23249 (April 29, 2015).

A second pending case focuses on an insider trading ring where the allegations of the Commission’s complaint appear to at least partially satisfy Newman. SEC v. Gray, Civil Action No. 15-cv-00551 (N. D. Cal. Filed Feb. 5, 2015). Named as defendant are: John Gray, a one-time equity research analyst and representative at Barclays Capital; Christian Keller, a financial analyst first at Applied Materials and later a vice president of IR at Ravi; Kyle Martin, at one time employed at a car dealership; and Aaron Shepard, self- employed.

Beginning in 2009, and continuing for the next three years, Messrs. Gray and Keller led an insider trading ring The ring traded on information from Mr. Keller’s employer such as a potential acquisition and earnings announcements. Mr. Gray acted as the hub between the two men and was primarily responsible for placing the trades. The three men divided the profits from the trading. Disposable telephones were used as part of the efforts to conceal the ring.

Mr. Grey also tipped Aaron Shepard. While Mr. Shepard apparently knew that he was receiving inside information there is no allegation regarding his knowledge of a personal benefit. The complaint alleges violations of Exchange Act Sections 10(b) and 14(e) by Messrs. Gray, Keller and Martin. Mr. Sheppard was charged with violations of Exchange Act Section 10(b).

Messrs. Gray, Keller and Martin settled with the Commission. Each consented to the entry of a permanent injunction prohibiting future violations of the Sections cited in the complaint. Mr. Gray agreed to pay disgorgement of $287,487.55, prejudgment interest and a penalty of $448,876.02 and will be barred from the securities business and participating in any penny stock offering. Mr. Keller will pay disgorgement of $52,000, prejudgment interest and a penalty of $417,468.73 (total profits from transactions placed through Mr. Martin’s account) and will be barred from serving as an officer or director for 10 years. Mr. Martin will pay disgorgement of $243,276.10, plus prejudgment interest. No penalty was imposed based on his cooperation. Mr. Sheppard also settled, consenting to the entry of a permanent injunction based on Exchange Act Section 10(b). He will also pay disgorgement of $161,388.36 along with prejudgment interest. No penalty was assessed in view of his cooperation.

Finally, SEC v. Epstein, Civil Action No. 15-cv-0506 (E.D. Pa. Filed February 3, 2015) is an insider trading action based on the misappropriation theory. It unclear if the case is based on a tipping or a misappropriation of the information by the trader theory. If the former, the complaint fails to satisfy Newman. If the latter, the personal benefit analysis is inapplicable.

The case centers on the acquisition of Harleysville Group, Inc., an insurer of small and midsized businesses and individuals in Harleysville, Pennsylvania, by Nationwide Mutual Insurance Company. The deal was announced on September 29, 2011.

During the due diligence on the deal in August 2011 Girlfriend, a legal assistant working on the deal, told her live-in Boyfriend of 8 years about the transaction which had been causing her to work nights and weekends. The complaint alleges that the couple had a relationship of trust and confidence and that the information was shared with Boyfriend in that context.

Boyfriend in turn told his father, defendant Joel Epstein. The two men had a close personal relationship and worked at the Epstein tire store together. When the information was shared Mr. Epstein, an avid stock trader, he instructed his son not to mention the subject again. He also began purchasing shares. Mr. Epstein told four friends about the deal, instructing each to purchase 1,000 shares. Each did as instructed. After the deal announcement the share price rose, closing up 87% compare to the prior day’s close. Mr. Epstein had trading profits of $113,501. The four tippees had trading profits of $123,511.

The complaint notes that Boyfriend had a relationship of trust and confidence with his father, suggesting, but not stating, that the information would remain confidential. It also states, however, that father was an avid stock trader, suggesting, but not stating, that the transmission may have been an illegal tip. If the communication was the former, Newman would not apply – use of the information by Mr. Epstein would be a misappropriation. If the latter, the Newman would apply. The complaint alleges violations of Section 10(b).

To resolve the action Mr. Epstein consented to the entry of a final judgment of permanent injunction based on the Section cited in the complaint. In addition, he agreed to pay disgorgement of $237,014 which includes the profits of the four individuals he tipped, prejudgment interest and a civil penalty of $237,014. See Lit. Rel. No. 23187 (Feb. 3, 2015).