The Impact of Newman on SEC Enforcement: Part II
This is the second segment of a five part series discussing the impact of the Second Circuit’s ruling in Newman on SEC insider trading cases
The Immediate Impact of Newman
The most immediate impact of Newman is on pending criminal and civil cases. This is illustrated by the decisions in U.S. v. Conradt, 12 cr. 887 (S.D.N.Y.) and SEC v. Payton, Civil Action No. 14 civ 4644 (S.D.N.Y.), two parallel enforcement actions. Both cases center on the acquisition by I.B.M. of SPSS. Both alleged illegal tipping in violation of Exchange Act Section 10(b). Both are based on the same facts. Yet there are opposite results – the criminal charges were dismissed. The SEC charges survived a motion to dismiss and the case is in litigation.
The illegal tip traces to attorney Michael Dallas, an associate in a New York law firm assigned to work on the deal. Mr. Dallas was close friends with broker Trent Martin. The two men had a history of sharing confidential information. Beginning in the spring of 2009 Mr. Dallas told his friend about the SPSS deal. Over time he provided updates. Both men understood that the information they shared regarding their work was non-public and confidential. Both expected that confidentiality would be maintained.
Mr. Martin was roommates with Thomas Conradt, an attorney employed at another New York brokerage firm. They had a close, mutually dependent financial relationship with a history of personal favors. Mr. Martin told his roommate about the SSPS deal. Mr. Conradt purchased shares of SPSS prior to the deal announcement on July 28, 2009.
Messrs. Payton and Durant were co-works of Mr. Conradt. The three men had discussions about Mr. Conradt’s roommate – Trent Martin. Each knew that Mr. Martin worked at a brokerage firm. Mr. Conradt told his co-workers that he learned about the SPSS acquisition from his roommate. Messrs. Payton and Durant did not ask more about the roommate. They did purchase shares of SPSS just prior to the public announcement of the deal. In addition, Mr. Conradt is alleged to have tipped David Weishaus and three others who worked at the same brokerage firm. Each tippee traded.
2. The criminal cases
Messrs. Conradt, Weishaus, Martin and Payton were each charged with insider trading. Each pleaded guilty prior to the decision in Newman. Following the Second Circuit’s decision in Newman, Judge Carter vacated the guilty pleas and dismissed the criminal charges. U.S. v. Conradt, 12 – 887 (S.D.N.Y. Order Dated January 22, 2005). Under Rule 11(b)(3) of the Federal Rules of Criminal Procedure the district court has an “obligation up through the entry of judgment to vacate a previously-accepted guilty plea and enter a plea of not guilty on behalf of a defendant if it becomes clear that there no longer is a sufficient factual basis for the plea,” Judge Carter held. This is in accord with established Second Circuit decisions such as U.S. v. Calderon, 343 F. 3d 587, 589-90 (2nd Cir. 2001) which require the court to determine if there is a factual basis for the plea by matching the facts in the record with the legal elements of the crime.
Here Newman is the controlling case, defining the elements of tipping liability under either the classic or misappropriation theory of insider trading, according to the Court’s order. While the Government contended that this statement in Newman need not be followed because it is dicta, the Court rejected the contention noting that “Newman’s unequivocal statement on the point is part of a meticulous and conscientious effort by the Second Circuit to clarify the state of insider-trading law in this Circuit. Accordingly, even assuming arguendo that the Government is correct that the cited language in Newman [that the personal benefit test applies to both theories of insider trading] is dicta, it is not just any dicta, but emphatic dicta which must be given the utmost consideration.” Accordingly, the guilty pleas were vacated. In a subsequent order, dated February 3, 2015, the Court dismissed the indictments without prejudice. Other defendants in criminal cases are either seeking to vacate their guilty pleas or have their conviction reversed on appeal based on Newman. See, e.g., SAC Manager’s Tipper Says Newman Voids Plea, Sentence, Law 360 (May 5, 2015), available at www.law360.com/articles/651882/print?section=securities
3. The SEC case
Since Newman is based on a construction of Exchange Act Section 10(b) its teachings should apply with equal force in either a criminal or civil action. See, e.g., U.S. v. O’Hagan, 521 U.S. 642 (1997)(adopting misappropriation theory of insider trading in criminal case which applies also to civil cases); see also Aaron v. SEC, 446 U.S. 680, 691 (1980)(rejecting SEC contention that scienter applies to civil damage actions based on Section 10(b) but not SEC enforcement actions). Nevertheless, in the SEC’s civil enforcement action which parallels Conradt, Judge Rakoff appears to have drawn a line between civil and criminal insider trading actions is refusing to dismiss the action based on Newman. SEC v. Payton, Civil Action No. 14 civ 4644 (S.D.N.Y. Opinion issued April 6, 2015). See also SEC v Conradt, Civil Action No. 12-cv-08676 (S.D.N.Y.).
In Payton Judge Rakoff began by stating that there is a difference between criminal and civil cases. In the former the “court is obliged to define unlawful insider trading narrowly, so as to provide the fair notice that due process requires . . .” In the latter, typically brought by the SEC, “the court is inclined to define unlawful insider trading broadly, so as to effectuate the remedial purposes behind the prohibition of such trading.” The Court did not cite any authority for these propositions. Judge Rakoff did, nevertheless, state that to properly plead tippee liability the SEC must set forth facts in its complaint which are sufficient to meet the Newman test. Those facts must be construed in favor of the SEC.
Under Newman the first question is whether the SEC has sufficiently alleged that Mr. Martin, the tipper, received a personal benefit when furnishing the inside information to his friend, Mr. Conradt. That requirement has been met, Judge Rakoff found, because the SEC alleged that Mr. Conradt had a mutually dependent financial relationship with his friend, a history of personal favors and their expenses were “intertwined.” Mr. Conradt “took the lead” in organizing and initially paying for shared expenses. He also assisted his friend with a criminal charge. Later the two men had a conversation in which, according to the complaint, “Martin thanked Conradt for his prior assistance with the criminal legal matter and told Conradt he was happy that Conradt profited from the SPSS trading because Conradt had helped him.” These allegations support an inference of a quid pro quo relationship, the Court found.
The second critical question is whether the defendants knew of the benefit. Here again, the allegations of the complaint are sufficient, the Court concluded, when all inferences are drawn in favor of the SEC. Those allegations demonstrate that the defendants knew Messrs. Conradt and Martin were friends and roommates and that Mr. Conradt assisted with the criminal matter. “This is enough to raise the reasonable inference that the defendants knew that Martin’s relationship with Conradt involved reciprocal benefits,” according to Judge Rakoff. This inference is bolstered by the fact that Mr. Durant repeatedly asked Mr. Conradt if additional information could be obtained from his roommate – and it was secured.
Finally, the two defendants took steps to conceal their trading activity while avoiding any discovery of the circumstances surrounding the tip between Messrs. Martin and Conradt. The latter is evidence of “conscious avoidance of details about the source of the inside information and nature of the initial disclosure,” according to the Court. Collectively, these allegations are sufficient to survive a motion to dismiss based on Newman.