In 1998, the Ninth Circuit, in United States v. Smith 1 significantly increased the government's burden in prosecuting insider trading actions. It followed the Eleventh Circuit's adoption in SEC v. Adler 2 of the so called "use test," holding that in order to succeed in an insider trading case against a corporate insider, the SEC must demonstrate not only that the insider traded while in possession of material non-public information, but that the information was actually used in the trading. The Ninth Circuit then went even further, holding that in a criminal prosecution, the government would not be able to take advantage of any inference that an insider who possessed inside information actually used the information3.
In late 1999, the SEC proposed Rule 10b5-1, to codify its position that any corporate insider who trades while in possession of material nonpublic information is liable for insider trading without any finding, whether by direct evidence or with the benefit of an inference, that he actually used the information. On August 10, 2000, the SEC unanimously adopted the Rule4.
In light of Rule 10b5-1, the primary focus in most insider trading cases involving corporate insiders will be on whether the defendant was in possession of material nonpublic information at the time of the trading. Earlier this year, the Northern District of California, in SEC v. Truong, dealt the SEC a serious blow by making it substantially more difficult for the SEC to establish that the corporate insider is in possession of inside information. In Truong5, the court was presented with suspicious trading activity shortly before the company announced poor quarterly results that caused the stock price to drop by 38 per cent. Since there was no direct proof that Truong possessed the adverse information at the time of his trades, the SEC would have had to ask the jury to infer possession based on circumstantial evidence. The Court dismissed the charges based on insufficient evidence.
The Facts
Truong was the manager of a software group in the engineering department of Molecular Dynamics, Inc. (MDI). He was not privy to confidential sales and financial information in the normal course of his duties. On March 22, 1994, Truong attended an engineering staff meeting at which he learned that senior staff had frozen headcount and had ordered an expense control program because the outlook for the quarter ending the following week was behind plan. Within the four days prior to the meeting, Truong had sold all of his MDI shares and his brothers had sold a substantial amount of MDI shares. Although there was evidence that Truong could have learned of the adverse information before the March 22 meeting (and before the sales), there was no concrete evidence that he did. In granting summary judgment dismissing the insider trading charges, the court held that, despite the suspicious timing of the trades, without any concrete evidence that Truong was actually in possession of the adverse information at the time of the trades, there was insufficient evidence to permit the case to go to a jury.
The decision is noteworthy because, while there was no concrete evidence that Truong was in possession of adverse material non-public information, there was a wealth of evidence that such information existed and that Truong could have had access to it. That evidence included the following:
1. Truong attended a supervisors' meeting on February 16 at which there was a general discussion concerning order shortfalls (the court considered the information immaterial because it would have been too early in the quarter to have been able to project that the quarter would turn out to be poor and MDI had publicly disclosed that market conditions were weak and a moderation in growth was expected);
2. Truong could have walked through MDI's sales department at any time and discerned a decrease in sales activity (the court found no evidence that Truong actually did walk through the department or that what he would have seen would have been sufficiently specific as to be material);
3. MDI's senior managers were told to cut expenses and eliminate all discretionary spending (the court found no evidence that Truong was privy to this information before March 22);
4. Truong was slated to add a new software engineer to his team but human resources held up the paperwork (the court found that Truong was unaware of the holdup until March 22);
5. MDI employees generally were aware of order shortfalls and a lack of shipments (the court found this to be too vague to be material, particularly in light of MDI's publicly expressed worries concerning its revenue potential);
6. A confidential January 1994 financial report distributed on February 24 reported low sales across all product lines, combined with below normal margins, generating a loss in January, and a confidential February 1994 financial report showing a large sales shortfall and a large operating loss (the court found no evidence that Truong was privy to these reports);
7. MDI weekly Flash Reports showed shipments consistently behind plan, in a memorandum dated March 14 the CFO expressed concern about the low orders for the month of March, and a March 16 memorandum addressed to seven senior staff members indicated that actual sales trailed behind forecasted sales (the court found no evidence that Truong was privy to any of these Flash reports or memoranda); and
8. On March 15 and 16, MDI personnel and its outside counsel were working on SEC filings that contained financial information (the court rejected, as pure speculation, the fact that Truong could have overheard conversations or seen drafts because MDI finance personnel worked in open cubicles near Truong
The SEC argued that the suspicious timing of the trades and access to information was, at the very least, circumstantial evidence that Truong possessed the adverse information such that this question should go to a jury. The court disagreed, holding that without any concrete evidence that Truong was in possession of any of this material non-public information at the time of his trades, it would not permit a jury to infer that Truong possessed the information based on the suspicious timing of his trades.
However, with respect to one of Truong's brother's trades after March 22, when there was concrete evidence that Truong possessed the adverse non-public information but no direct evidence that his brother possessed the information, the court had no hesitation in letting a jury decide whether to infer that Truong tipped his brother. The post March 22 trades involved short sales of 15,000 MDI shares that were allegedly financed with the proceeds from Truong's pre March 22 sales. Truong could not make these trades directly because the trading window was closed and, as an MDI employee, he was prohibited from selling short MDI shares. The value of the trades approximated Truong's brother's annual income and half his net worth. The court apparently concluded that these facts, in conjunction with the suspicious timing of the trades, constituted enough circumstantial evidence from which a jury could reasonably infer that Truong's brother had received from Truong material non-public information concerning MDI and used it.
The Burden of Proof
The Court appears to have made an interesting distinction with respect to when an inference of possession of non-public information can go to a jury. If the suspicious trading is done by a corporate insider with possible access to adverse information, the case will not go to a jury unless there is evidence of actual knowledge of the adverse information. In contrast, if the trader is not an insider, the case may proceed to trial if the SEC can demonstrate that there exists someone with possession of confidential non-public information who may have tipped the outsider.
With respect to the hurdle imposed in Truong in terms of proving possession, it is unclear whether the court was simply responding to "Silicon Valley" concerns that an open space working environment makes it too easy for the SEC to assert that a defendant possessed adverse information, or whether the court intended to raise to new levels the quality of proof required in any insider trading case to get the issue of knowledge before the jury. In either case, the SEC is certain to attack the holding at its next opportunity.
Robert A. Horowitz and Karen Y. Bitar are shareholders in the New York Office of Greenberg Traurig and are members of the firm's Securities Litigation Practice Group. They regularly defend corporations and individuals in securities actions nationally.
1. 155 F.3d 1051 (9th Cir. 1998)
2. 137 F.3d 1325 (11th Cir. 1998)
5. SEC v. Truong, Civil No. 98-21137 SW (EAI) (N.D. Cal. April 12, 2000)