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.