United States: Court Upholds SEC’s Insider-Trading Complaint And Questions Second Circuit’s Newman Decision

U.S. District Judge Jed Rakoff issued a decision in SEC v. Payton (S.D.N.Y. Apr. 6, 2015) denying the defendants' motion to dismiss a civil insider-trading suit filed by the SEC. The court held that the SEC's complaint had adequately alleged that the tipper of material nonpublic information had received a personal benefit for the disclosure and that the remote tippees had had sufficient knowledge of that benefit under the "recklessness" standard applicable to civil cases. In so ruling, however, Judge Rakoff observed that the Second Circuit's restrictive reading of the personal-benefit requirement in United States v. Newman "may not be obvious" in light of the Supreme Court's controlling decision in Dirks v. SEC.

The Payton case involved allegedly material nonpublic information about a potential corporate acquisition. The information came from one of the bidder's outside attorneys, who allegedly told a friend named Martin (the initial tipper) in circumstances where the two allegedly shared a duty of trust and confidence. Martin allegedly tipped his roommate, Conradt, who "shared a close, mutually-dependent financial relationship, and had a history of personal favors" with Martin. Conradt allegedly told another registered representative, who allegedly tipped the two defendants. Conradt also allegedly spoke to the two defendants about the information. The SEC brought these civil proceedings against the two defendants for their trading.

Judge Rakoff framed his analysis of the defendants' motion to dismiss by noting the need to distinguish criminal liability – which requires proof that the defendant "committed the offense 'willfully,' i.e., knowingly and purposely" – from civil liability, which requires only that the defendant "committed the offense recklessly, that is, in heedless disregard of the probable consequences." Based on that lower standard, the court denied the defendants' motion.

The court began with the Second Circuit's Newman decision, which held that a remote tippee cannot be liable unless the tipper received a personal benefit for disclosing material nonpublic information and the tippee knew about that benefit. (We previously blogged about Newman here.) The SEC argued that Newman applies only to "classical" insider-trading cases, where the tip came from a corporate insider, not to "misappropriation" cases, where (as here) the information originated from an outsider. The court noted that, "[w]hatever the abstract merits of this argument," the Second Circuit had foreclosed it by stating "unequivocally" that the elements of tipping liability are the same under both the classical and the misappropriation theories. This ruling is consistent with another Southern District of New York judge's decision in Conradt's case, about which we blogged here.

Judge Rakoff then turned to the personal-benefit requirement and compared the Supreme Court's enunciation of that test in Dirks with Newman's construction of Dirks. The Supreme Court had defined a personal benefit in Dirks as "a pecuniary gain or a reputational benefit that will translate into future earnings. . . . For example, there may be a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the particular recipient. The elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend." Judge Rakoff observed that, "in Newman, a criminal case, the Second Circuit held that, to the extent Dirks suggests that a benefit may be inferred from a personal relationship, 'such an inference is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.'"

Judge Rakoff appears to have questioned the Second Circuit's interpretation of Dirks: "Whether this is the required reading of Dirks may not be obvious, and it may not be so easy for a lower court, which is bound to follow both decisions, to reconcile the two." He added in a footnote that "the Dirks decision seems to distinguish a quid pro quo relationship from instances where an insider makes a 'gift' of confidential information to a relative or friend; whereas, the Newman decision suggests that the latter type of relationship (i.e. mere friendship) can lead to an inference of personal benefit only where there is evidence that is generally akin to a quid pro quo."

Nevertheless, Judge Rakoff held that, for purposes of a civil SEC enforcement action, the SEC's complaint met "any definition of 'benefit' set forth in either Dirks or Newman." The SEC alleged that Martin (the initial tipper) and Conradt (the initial tippee) "'shared a close mutually-dependent financial relationship, and had a history of personal favors,'" that "their expenses were 'intertwined,' that Conradt took the lead in organizing and initially paying their shared expenses, and that [Conradt] negotiated reductions in their utilities and rent payments." In addition, "Conradt assisted Martin with a criminal legal matter that threatened Martin's ability to remain legally in the United States, . . . and subsequently, 'Martin thanked Conradt for his prior assistance with the criminal legal matter and told Conradt he was happy that Conradt profited from the . . . trading because Conradt had helped him.'"

Judge Rakoff also ruled that the SEC had sufficiently pled, for civil-enforcement purposes, that the defendants had known of Martin's personal benefit. The defendants allegedly had known about Martin's and Conradt's friendship and about Martin's legal problems. The court also observed that, unlike in Newman, where the remote tippees "'knew next to nothing' about the tippers, were unaware of the circumstances of how the information was obtained, and 'did not know what the relationship between the [tipper] and the first-level tippee was,'" the defendants here allegedly "knew the basic circumstances surrounding the tip" and "recklessly avoided discovering additional details." In addition, the defendants allegedly had taken "multiple steps to conceal their own trading in [the target's] securities."

Judge Rakoff's decision, coming only several days after the Second Circuit denied panel and en banc rehearing in Newman, will likely add to the debate about whether Newman correctly construed Dirks's personal-benefit requirement. The Government is deciding whether to petition for certiorari in Newman, and three bills are pending in Congress to displace Newman (see our blog posts here and here). Indeed, Judge Rakoff observed that, "if unlawful insider trading is to be appropriately deterred, it must be adequately defined. The appropriate body to do so, one would think, is Congress . . . ."

The case also could illustrate the difference between civil and criminal standards of liability. Martin, Conradt, and Payton had pled guilty to insider trading before Newman, but a different Southern District judge (Judge Andrew Carter) vacated the pleas after Newman. However, Judge Rakoff sustained the SEC's complaint under civil-liability standards.

Court Upholds SEC's Insider-Trading Complaint And Questions Second Circuit's Newman Decision

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