So Much for Relying on Valleywag

Just minutes after writing this post, which relied on Valleywag’s recounting of a paywalled WSJ story, I came across a link to the actual case.

The actual case says (at page 12): “There was no error in excluding the classified information.” Valleywag’s version: “The appeals court agreed that classified documents related to those negotiations were improperly excluded.” (For you non-lawyers, that is the opposite.)

But the circuit court’s analysis is awfully interesting, and I think it’s wrong. I’ll copy the whole thing because it’s so brief and then run it past some analysis of insider trading law:

Mr. Nacchio also argues that the district court was wrong to prevent him from presenting certain classified information as evidence at trial. He claims that the evidence would have shown that he personally had reason to believe that Qwest’s economic prospects were much better than others realized. Thus, he says, this evidence should have been permitted both to show that he did not have material information and to negate scienter. We affirm the district court’s decision, because even if the classified information were presented and established what he said it would, it could not exonerate Mr. Nacchio as he claims.

Essentially, Mr. Nacchio argues that undisclosed positive information can be used as a defense to a charge of trading on undisclosed negative information. We disagree. If an insider has material information that he cannot disclose because it is confidential or proprietary, then he must abstain from trading. That is the lesson of In re Cady, Roberts & Co., Exchange Act Release No. 6,668, 40 S.E.C. 907, 911 (1961), later applied in SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848, 850 n.12 (2d Cir. 1968), and Chiarella v. United States, 445 U.S. 222, 226–29 (1980). It is black-letter law that insiders must disclose their material information or else abstain. It is true that in cases like Texas Gulf Sulphur, insiders were trading in bullish positions ahead of the disclosure of the company’s proprietary discovery, and thus their trading correlated with the inside information, while here Mr. Nacchio argues that his possession of classified information neutralizes his possession of other inside information. However, the general rule applies. If an insider trades on the basis of his perception of the net effect of two bits of material undisclosed information, he has violated the law in two respects, not none.

The court treats insider trading as a strict liability offense: You had inside information. You traded. You’re guilty. An executive who sold stock knowing the price would soon go up – say, because he was so wealthy that he wanted to reward shareholders instead of enjoying the gains himself – would be guilty of insider trading. But what the court calls “black letter law” on this is not nearly so black. (The following analysis is cribbed liberally from this Memorandum Opinion and Order in U.S. v. Skilling and Lay)

Section 10(b) of the Exchange Act, 15 U.S.C. § 78j(b), provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange—
. . .
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

15 U.S.C. § 78j(b).

Pursuant to this section, the SEC promulgated Rule 10b-5, which provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

17 C.F.R. § 240.10b-5.

Although § 10(b) does not use the term “insider trading,” a violation of § 10(b) and Rule 10b-5 occurs “when a corporate insider trades in the securities of his corporation on the basis of material nonpublic information.” United States v. O’Hagan, 117 S.Ct. 2199, 2207 (1997). Insider trading constitutes a “deceptive device” under § 10(b) because “a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position in the corporation.” Id. (quoting Chiarella v. United States, 100 S.Ct. 1108, 1114 (1980)). The relationship between corporate insiders and shareholders “gives rise to a duty to disclose [or to abstain from trading] because of the necessity of preventing a corporate insider from . . . tak[ing] unfair advantage of . . . uninformed . . . stockholders.” Id. (quoting Chiarella, 100 S.Ct. at 1115).

The Supreme Court’s determination that § 10(b) and Rule 10b-5 are violated “when a corporate insider trades in the securities of his corporation on the basis of material nonpublic information,” O’Hagan, 117 S.Ct. at 2207, has raised the question of whether the phrase “on the basis of material nonpublic information” requires a showing that an insider actually used material, nonpublic information obtained through his position in deciding to make the securities trade at issue, or whether a showing that the insider merely possessed material, nonpublic information when the securities trade occurred is sufficient to establish liability. See In re Enron Corp. Securities, Derivatives & “ERISA Litig.”, 258 F.Supp.2d 576, 591-593 (S.D. Tex. 2003). Considering the issue in the context of a criminal case, the Ninth Circuit held that a conviction could not be had absent proof that the defendant not only possessed material, non-public information, but that the defendant also used that information in deciding to make the securities trade at issue. See Smith, 155 F.3d at 1066-1069.

Thus, in the Ninth Circuit a criminal conviction for insider trading cannot be had without proof that a causal connection exists between the material, nonpublic information and the trade at issue. Id. Considering the issue in a civil enforcement action, the Eleventh Circuit held that the insider defendant’s “knowing possession” of material, nonpublic information raises a “strong inference” that the defendant used that information in trading, sufficient to make a prima facie showing of liability that the defendant could rebut with evidence showing that the material, nonpublic information was not a factor in the decision to trade. SEC v. Adler, 137 F.3d 1325, 1337-1339 (11th Cir. 1998). But see United States v. Teicher, 987 F.2d 112, 120-121 (2d Cir.), cert. denied, 114 S.Ct. 467 (1993) (suggesting that “knowing possession” is sufficient due to the difficulty of establishing actual “use,” but finding resolution of the issue unnecessary under the facts of the case). See also Smith, 155 F.3d at 1069 & n.27 (declining to apply Adler presumption in a criminal case but expressing no view as to its applicability in a civil enforcement proceeding).

In answer to the question of “what, if any, causal connection must be shown between the trader’s possession of inside information and his or her trading,” the SEC promulgated Rule 10b5-1, which in pertinent part provides:

(b) . . . [A] purchase or sale of a security of an issuer is “on the basis of” material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.

17 C.F.R. § 240.10b5-1(b).

Rule 10b5-1 supports the Tenth Circuit’s opinion ratifying the trial court’s exclusion of evidence about NSA contracts Nacchio thought were going to Qwest, and it appears that the Ninth, Tenth, and Eleventh Circuit each have a different standard for insider trading liability. (I’d have to research that more to see if it’s really true.)

But what’s really interesting is that it completes the conversion of an anti-fraud statute into a strict liability regulatory crime. Have you ever heard of a fraud that was committed by mistake? That didn’t have a state-of-mind requirement? There is no such thing. You have to mean to defraud someone to defraud someone.

I also think that this interpretation exceeds the power given the SEC by the statute. The SEC can promulgate any rule it wants subject to the limitation that a violation must involve the use of a “manipulative or deceptive device or contrivance.” If the SEC rule were to outlaw talking on the phone – assume that was rationally related to preventing securities fraud – it would only be a violation to talk on the phone if one was talking on the phone and using a “manipulative or deceptive device or contrivance.” The SEC can’t just outlaw talking on the phone, and it can’t just outlaw trading with inside knowledge in the absence of manipulation, deception, contrivance, and such.

Will the split in the circuits or the SEC’s overreach allow Nacchio a hearing in the Supreme Court? Will my wholesale copying and rusty legal skills expose me as a worthless lawyer any more? I’d put my money on the latter. But I think the court should have allowed Nacchio to put the canceled government contracts into evidence.

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