X

Thank you for sharing!

Your article was successfully shared with the contacts you provided.
In insider trading cases, like other white-collar criminal cases, the war between the prosecution and the defense is usually over intent. However, that fight can be impacted by the existence of a rule promulgated in October 2000 by the Securities and Exchange Commission that attempted to reduce the government’s burden in proving insider trading. That rule, Rule 10b5-1, creates a presumption that trading occurred “on the basis of material nonpublic information” if the person making the purchase or sale was “aware” of the information at the time of the transaction. In adopting the rule, the commission was trying to cut off the defense that the alleged insider trader had not actually used the material nonpublic information, but instead had traded on the basis of other information, such as market rumors. When Rule 10b5-1 was adopted six years ago, commentators expressed concern that the rule effectively made insider trading a “strict liability” offense. 1Specifically, the expressed concern was that Rule 10b5-1 would preclude the putative defendant from establishing a defense of good faith and lack of intent by showing an alternative explanation for the trade in question. However, since the adoption of Rule 10b5-1 in 2000, three reported decisions-each from the Southern District of Texas in matters relating to the Enron debacle-have considered the “use versus possession” issue. Two of the cases suggest that, in the criminal context, Rule 10b5-1 will have no impact. In U.S. v. Causey, 2005 U.S. Dist. LEXIS 39619 (S.D. Tex. 2005), criminal enforcement authorities experimented with drafting mere possession language in the indictment and then avoided putting the rule to the test. More recently, in U.S. v. Yeager, 2006 U.S. Dist. LEXIS 63274 (S.D. Tex. 2006) the government initially sought a mere possession instruction but later backed off, accepting that the Court should charge that the use of material nonpublic information must be established. A third Enron-related case in the civil context, In Re Enron Corp. Securities, Derivatives & ERISA Litigation, 258 F. Supp. 2d 576 (S.D. Tex. 2003), illustrates that, notwithstanding Rule 10b5-1′s presumption, scienter must still be shown as an element of civil claim. This article will review the background that led to the adoption of Rule 10b5-1, the commission’s pronouncements at the time of the adoption of the rule, the cases decided since adoption of the rule, and points for defense counsel to have in mind when defending an insider trading case. 1. The ‘Use vs. Possession’ Debate Prior to the adoption of Rule 10b5-1, federal circuit courts had been split on the issue of whether actual use of material nonpublic information must be proven in an insider trading case-whether a criminal case or an SEC enforcement action. In U.S. v. Teicher, 987 F.2d 112 (2d Cir. 1993), the Second Circuit decided in the criminal context that “knowing possession” of material nonpublic information was sufficient to support a criminal conviction, and that actual use need not be proven. The Teicherdefendants had challenged a jury instruction that “the government need not prove a causal relationship between the misappropriated material nonpublic information and the defendants’ trading.” 2The defendants complained that this instruction precluded them from arguing that they had not, in fact, traded upon material nonpublic information. The Second Circuit, noting that the defendants sought to establish that they “lacked the requisite scienter to have committed securities fraud,” rejected the challenge, stating that: 3“It strains reason to argue that an arbitrageur, who traded while possessing information he knew to be material, knew to be nonpublic -and who did not act in good faith in so doing-did not also trade on the basis of that information.” 4The court contended that: “Unlike a loaded weapon which may stand ready but unused, material information cannot lie idle in the human brain.” 5 Five years later, the Eleventh Circuit took a different approach in an SEC civil enforcement case, Securities and Exchange commission v. Adler, 137 F.3d 1325 (9th Cir. 1998). The court required the SEC to prove a causal connection between material nonpublic information and the trading in question. 6The court also held that where a person trades while in possession of material nonpublic information, “a strong inference arises that such information was used by the insider in trading.” 7While allowing for that inference, the Court also allowed that defendants could seek to rebut such an inference. 8 In the same year as Adler, the Ninth Circuit considered the issue in a criminal matter, U.S. v. Smith, 155 F.3d 1051 (9th Cir. 1998), and disagreed head on with the Second Circuit’s decision in Teicher. Dismissing the Second Circuit’s “knowing possession” standard in Teicheras dicta, the Ninth Circuit stated that the Supreme Court had “consistently suggested, albeit in dictum, that rule 10b-5 requires that the government prove causation in insider trading prosecutions.” 9The Smithcourt declined to permit any presumption to arise from the mere possession of material nonpublic information, noting that given the criminal context of the matter, “we are therefore not at liberty, as was the Adlercourt, to establish an evidentiary presumption that gives rise to an inference of use.” 10In this regard, the court cited Sandstrom v. Montana, 442 U.S. 510 (1979), which voided on Fourteenth Amendment grounds an evidentiary presumption that shifted the burden of proof to a criminal defendant. 2. Rule 10b5-1 In the wake of Smith, the SEC sought a rule that would create a presumption that mere possession of material nonpublic information gives rise to an inference that the trading had been done on the basis of that information. 11To that effect, Rule 10b5-1 provides that, subject to certain very limited affirmative defenses set forth in the rule, “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.” 12In promulgating the rule, the SEC stated that this “awareness standard reflects the common sense notion that a trader who is aware of inside information when making a trading decision inevitably makes use of the information.” 13 Rule 10b5-1 sets forth several very narrow affirmative defenses that can be employed to rebut a finding of insider trading where a person is aware of material nonpublic information. Under the rule, liability can be avoided where, before becoming aware of the information, the person had either (a) entered into a binding contract to purchase or sell the security, (b) instructed another person to purchase or sell the security for the instructing person’s account, or (c) adopted a written plan under which the securities were traded without any action or influence by the person in possession of the information. Significantly, the enumerated affirmative defenses are the only ones permitted under the rule; in other words, the rule does not permit the putative defendant to establish, in any other way, that he or she did not trade “on the basis” of material nonpublic information in their possession. Commentators at the time of the rule’s adoption protested that the rule would effectively eliminate the scienter requirement found in Section 10(b) of the Exchange Act. Cases prior to the rule’s adoption had permitted a variety of explanations beyond those recognized as affirmative defenses under the rule, such as prior trading patterns, a sudden need for cash, or a broker’s recommendation. The concern, as expressed at the time in these pages, was that Rule 10b5-1 would work to deprive litigants of legitimate defenses to insider trading liability. 14However, in the Adopting Release, the SEC dismissed those objections out of hand: Some commentators stated that an awareness standard might eliminate the element of scienter from insider trading cases, contrary to the requirements of Section 10(b) of the Exchange Act, and that we therefore lack the authority to promulgate the rule. These comments misconstrue the intent and effect of the rule. . . . Scienter remains a necessary element for liability under Section 10(b) of the Exchange Act and rule 10b-5 thereunder, and Rule 10b5-1 does not change this. 15 3. Recent Developments Since the adoption of Rule 10b5-1 six years ago, three reported decisions, each from the Southern District of Texas, have considered “use vs. possession” in light of Rule 10b5-1. In the one civil case, the court applied Rule 10b5-1′s “knowing possession” standard, but made clear that scienter must still be established. Where the issue arose in two criminal decisions, the prosecution’s efforts to make use of Rule 10b5-1 were thwarted or rejected. 16 a. ‘In Re Enron Corp. Securities, Derivatives & ERISA Litigation’ In In Re Enron Corp. Securities, Derivatives & ERISA Litigation, 258 F. Supp. 2d 576 (S.D. Tex. 2003), purchasers of Enron securities between 1998 and 2001 brought a class action against Enron directors, alleging, among other things, insider trading. The outside directors filed a motion to dismiss the complaint for failure to meet pleading requirements. In assessing the insider trading allegations, the court took note of Rule 10b5-1 and accepted its “awareness” standard. 17At the same time, the court cited the SEC adopting release statement that Rule 10b5-1 does not eliminate the scienter requirement under Section 10(b), and went on to examine whether plaintiffs’ complaint made sufficient allegations of scienter to survive the motion to dismiss. With regard to outside directors who had sold stock during the period in question, the court dismissed the insider trading claims after reviewing evidence as to the directors’ trading patterns. The court found that those patterns failed to give rise to a strong inference of scienter, since the evidence suggested that they had not known of various frauds at Enron or traded to take advantage of that knowledge. 18The court dismissed the plaintiffs’ complaint with regard to the Enron outside directors, finding that it failed to sufficiently plead scienter. 19The decision illustrates that at least one court has continued to require a showing of scienter without regard to the “knowing possession” standard of Rule 10b5-1. b. ‘U.S. v. Causey’ In U.S. v. Causey, 2005 U.S. Dist. LEXIS 39619 (S.D. Tex. 2005), the Enron Task Force drafted the indictment against Jeffrey Skilling to include a charge “that while in possession of material nonpublic information, Skilling sold shares of Enron stock . . . .” 20Skilling moved to dismiss arguing that the allegation was insufficient in that it charged “possession” rather than “use” of material nonpublic information. Skilling made use of the Ninth Circuit’s decision in U.S. v. Smithto argue that “use” of the material nonpublic information, not mere possession, was necessary to establish a crime. Rather than defend its indictment as written, the government backed off and took the position that “read practically and not technically, the language of the Indictment is sufficient to show use as well as knowing possession.” 21Attempting to moot the issue, the government told the court that “the discussion in defendant’s motion on the “use vs. possession” debate is largely academic and raises an issue the Court need not address.” 22 In disposing of Skilling’s motion, the District Court followed the government’s lead, and rejected Skilling’s arguments that the indictment “fails to allege that he used material nonpublic information when making the charged trades.” 23The court explained that Skilling’s sale of Enron stock while in possession of material nonpublic information could have been fraudulent only if that information had been a factor in his decision to make the trades, since only then would there have been a violation of his fiduciary duty to Enron shareholders. 24The court thereby accepted the government’s implicit concession that it would have to prove “use” rather than mere possession of material nonpublic information to sustain its charge against Skilling of insider trading. Thus, both the government and the court avoided reaching the issue of the application of Rule 10b5-1 to a criminal insider trading charge. c. U.S. v. Yeager Finally, a decision issued in August 2006 reveals another instance in which prosecutors considered using Rule 10b5-1 in a criminal insider trading case but eventually backed down. In 2003, seven former executives of Enron Broadband Services were indicted on charges alleging insider trading, securities fraud and wire fraud. After a four-month trial, several of the defendants were acquitted, including Scott Yeager. The jury found Yeager not guilty of securities fraud and wire fraud, as well as related conspiracy charges. The jury deadlocked on the insider trading charges against Yeager. Yeager was reindicted on insider trading charges in 2005. Yeager challenged that indictment on collateral estoppel grounds, claiming that the elements of the securities fraud charges, of which he had been acquitted, were the same as those underlying the subsequent insider trading charges. The court framed the issue as whether the jury in the first trial could have acquitted Yeager of securities and wire fraud charges without finding that he did not use material nonpublic information in his sale of Enron stock. 25 The court stated that, in accepting Yeager’s defenses on the securities and wire fraud charges, the jury had merely determined that Yeager had not knowingly or willfully participated in a scheme to defraud-but had not necessarily rejected the government’s contention that Yeager had possessed and used material nonpublic information in trades of Enron stock. 26The jury instructions in Yeager’s original trial had required the jury to find that Yeager had “in fact used” material nonpublic information in his purchase or sale of Enron stock. 27No verdict was reached on that issue in the original trial, and thus Yeager was free to be tried again on insider trading charges. Notably, in Yeager’s original trial, the government had initially sought jury instructions to the effect that mere possession of material nonpublic information was sufficient to establish insider trading. The government later, “in order to streamline the contested issues,” proposed instructions requiring that use be established beyond a reasonable doubt. 28According to the government’s brief, its proposed jury instructions requiring a “use” standard had been adapted from two recent criminal cases from the Southern District of New York, U.S. v. Ballesteros, No. 01-cr-00258 (S.D.N.Y. 2002) and U.S. v. Robles, No 00-cr-00169 (S.D.N.Y. 2002). 29Thus again, the government, after an initial flirtation with the mere possession standard of Rule 10b5-1, decided to avoid putting Rule 10b5-1′s standard to the test. Practice Points After all the worry about the impact of Rule 10b5-1, six years after its adoption, the rule has been at issue in only a few cases. Courts have yet to grapple fully with the implications of having a presumption of use under an SEC rule that appears inherently incompatible with the element of criminal intent and with the scienter requirement in SEC enforcement cases and civil claims. Nonetheless, the indicators so far are that the traditional imperatives of criminal law requirements of intent and civil law requirements of scienter are trumping Rule 10b5-1 and limiting its usefulness to the government or to the plaintiff’s class action bar. In defending insider trading cases, counsel should remain alert to efforts by the government to use the rule itself or the “mere possession” language of the rule. Practitioners should challenge such language or the government’s invocation of the rule as inconsistent with the requirements of criminal intent or civil scienter. Counsel also should not be content to accept the rule’s enumerated affirmative defenses as exclusive. Where the facts suggest that material nonpublic information was not actually relied upon or used in connection with a trade, that exculpatory evidence should be advanced even though it falls outside what the rule purports to allow. Audrey Strauss is a partner of Fried, Frank, Harris, Shriver & Jacobson. The assistance of her partner, Matt T. Morley, in preparing this article is gratefully acknowledged. Endnotes: 1 See generally James Q. Walker, Insider-Trading rule Approaches Strict Liability, N.Y.L.J. (Apr. 26, 2000). 2 987 F.2d at 119. 3 Id. at 121. 4 Id. 5 Id. at 120. 6 137 F.3d at 1337. 7 Id. 8 Id. 9 155 F.3d at 1067, citing U.S. v. O’Hagan, 521 U.S. 642 (1997), holding that under rule 10b-5, “the fiduciary’s fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities.” 521 U.S. at 656. 10 155 F.3d at 1069. 11 In the Adopting and Proposing Releases for Rule 10b5-1, the SEC acknowledged the decision in U.S. v. Smith, but did not address whether, in the commission’s view, Rule 10b5-1 would apply in a criminal case. 12 Rule 10b5-1(b), 17 C.F.R. 240.10b5-1. 13 Selective Disclosure and Insider Trading, Exchange Act Release No. 43,154, 2000 SEC LEXIS 1672 at *79 (Aug. 15, 2000) (the “Adopting Release”). 14 Walker, supra note 2. 15 Adopting Release at *77 – 78. 16 Two other court decisions following adoption of Rule 10b5-1 have considered use vs. possession issues, but only tangentially because the conduct at issue occurred prior to the adoption of the rule in October 2000. In SEC v. Lipson, 278 F.3d 656 (7th Cir. 2002), the court upheld jury instructions along the lines of the Adlercase, permitting an inference of use to be made from the possession of material nonpublic information, but also allowing for rebuttal by evidence that the information was not used in trading. In Johnson v. Aljian, 394 F. Supp. 2d 1184 (C.D. Cal. 2004), the court applied the “presumptions” of the Adler case, while noting that “application of the ‘actual use’ standard in a criminal case may be necessary to protect the constitutional rights of the accused . . . .” Id. 17 258 F. Supp. at 592 – 93. 18 Id. at 612 – 17; 627 – 28; 633 – 37. 19 Id. at 627 – 28; 633 – 37. 20 2005 U.S. Dist. LEXIS 39619, at *16-17. 21 Id. at *11 – 12. 22 Id. at *12. 23 Id. at *16. 24 Id. at *17. 25 2006 U.S. Dist. LEXIS 63274 (S.D. Tex. 2006), at *27. 26 Id. at *39 – 40. 27 Id. at *25. 28 Government’s Supplemental Brief on Jury Instructions Regarding Defendants’ Use of Inside Information at 2, U.S. v. Hirko, Cr. No. H-03-93-04, (S.D. Tex. May 10, 2005). 29 Id. Similar jury instructions were issued with regard to at least two of the other Enron Broadband defendants. See U.S. v. Hirko, 2006 U.S. Dist LEXIS 64731 (S.D. Tex. 2006) and U.S. v. Shelby,2006 U.S. Dist. LEXIS 66402 (S.D. Tex. 2006).

This content has been archived. It is available through our partners, LexisNexis® and Bloomberg Law.

To view this content, please continue to their sites.

Not a Lexis Advance® Subscriber?
Subscribe Now

Not a Bloomberg Law Subscriber?
Subscribe Now

Why am I seeing this?

LexisNexis® and Bloomberg Law are third party online distributors of the broad collection of current and archived versions of ALM's legal news publications. LexisNexis® and Bloomberg Law customers are able to access and use ALM's content, including content from the National Law Journal, The American Lawyer, Legaltech News, The New York Law Journal, and Corporate Counsel, as well as other sources of legal information.

For questions call 1-877-256-2472 or contact us at [email protected]

 
 

ALM Legal Publication Newsletters

Sign Up Today and Never Miss Another Story.

As part of your digital membership, you can sign up for an unlimited number of a wide range of complimentary newsletters. Visit your My Account page to make your selections. Get the timely legal news and critical analysis you cannot afford to miss. Tailored just for you. In your inbox. Every day.

Copyright © 2021 ALM Media Properties, LLC. All Rights Reserved.