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A recent opinion by New York State Supreme Court Judge Charles Ramos dismissing a civil suit against the New York Stock Exchange (NYSE) and its CEO rested upon the defendants’ successful assertion of the equitable in pari dilecto defense. Citing to both federal and state cases, civil and criminal holdings, as well as NYSE rules, that decision disclosed some novel interpretations of authorities governing federal insider trading law. This article posits that, given the deep difficulties presently facing the Securities and Exchange Commission (SEC) in proving insider trading cases, such new state court readings of the applicable precedents are not only inevitable, but outright desirable. The ‘Wey’ Decision The plaintiff in Wey v. NYSE owned an exchange seat from 2000 until March 21, 2005, during which time the company was a private, not-for-profit organization. On Feb. 10, 2005, the NYSE entered into a confidentiality agreement concerning merger discussions with the Archipelago Exchange, which owned the Pacific Stock Exchange. The plaintiff alleged that on Feb. 15, 2005, her husband attended a closed-door breakfast meeting for exchange “floor members,” at which he questioned then-NYSE CEO John Thain on whether the NYSE “was going public.” Mr. Thain allegedly responded in the negative, adding that “there are no plans for that to happen.” Conversely, Mr. Thain alleged that he had no specific recollection of Mr. Wey’s question or his response. The plaintiff subsequently sold her NYSE seat in March 2005 for $1.54 million. Approximately one month later, the NYSE announced its merger with Archipelago, as well as its intention for the merged entity to commence plans for an IPO. The price of individual exchange seats rose considerably, reaching a price of $2.41 million by mid-July 2005. That month, the plaintiff sued the NYSE and Mr. Thain on claims for fraudulent misrepresentation, negligent misrepresentation, and breach of fiduciary duty, alleging that she would have held onto her seat longer had she known of the NYSE’s imminent structural plans. In April 2007, Judge Ramos issued a preliminary decision holding the fraudulent misrepresentation and breach of fiduciary duty claims in abeyance pending brief and oral argument of the in pari dilecto/unclean hands defense. Certain staple issues, such as whether or not Mr. Thain was acting as a fiduciary when speaking to NYSE seat holders at the February breakfast meeting, were reserved for consideration by the jury. 1 In November 2007, Judge Ramos issued his final written decisionon the defendants’ summary judgment motion. The judge, although acknowledging that in pari dilecto defense “is used sparingly,” used it to dismiss the remaining claims against Mr. Thain and the NYSE, concluding that between Mr. Thain and the Weys, the latter were “substantially more at fault.” Countering the plaintiff’s assertion that an NYSE seat was not a “security,” the decision noted a seat’s value as an investment (relying on a Supreme Court case normally cited for the premise that goods of practical utility are not “securities” 2). Consequently, the securities laws applied, and Ms. Wey’s sale of her seat “using insider information” was in violation of both federal and state statutes because the information had been “misappropriated” from the NYSE. The judge added that Mr. Thain was ultimately not culpable because his remarks were “not motivated by personal gain,” and “reactive to the improper query posed by Mr. Wey.” 3 Federal Law On its face, Judge Ramos’ reasoning discounts, if not counters, a healthy variety of federal precedents governing insider trading claims. The federal violation, defined by the courts since 1997 as trading on material, nonpublic information in breach of a duty owed either to shareholders or the source of the information, remains wedded to the elements of the overarching SEC Rule 10b-5, which, among other things, require a purchase/sale and the presence of a fiduciary or similar duty. Thus, even accepting the existence of a duty between Mr. Thain and the Weys (who were not employed by the NYSE), Mr. Thain’s alleged statement was characterized as a lie. As such, it would be more readily classified as a misrepresentation than an inside “tip.” Accordingly, an insider trading analysis is irrelevant in that Mr. Wey left the breakfast meeting with, at best, misinformation. ‘Attempted Insider Trading’ Which may explain the decision’s reliance upon a finding of “attempted insider trading” by the Weys. An SEC creation in recent years, the violation has itself only been found in the presence of trades not succeeding in execution. The plaintiff here most clearly succeeded in her attempt to sell her NYSE seat. Alternatively, if the attempted insider trading charge is viewed as centering solely on Mr. Wey’s questioning of Mr. Thain (and not the ensuing sale or its attempt), then that act fails to state a violation because of a lack of a purchase/sale as traditionally required of all Rule 10b-5 actions. 4 Additionally, the specific duty of corporate insiders to disclose material premerger discussions has been established by the Supreme Court. 5Thus, any shifting of blame between the corporate “insider” to his inquisitor would seem intolerable under existing law; moreover, such a construction creates a duty to refrain from inquiry that federal courts have not even placed upon the professional, namely securities analysts. 6Finally, the exoneration of a tipper for lack of personal gain is simply not supportable. To the contrary, those disclosing material, nonpublic information have been consistently found liable for trading by their “tippees” in the complete absence of any tangible “benefit.” 7 Despite these incongruities, Judge Ramos’ decision does have appeal. It targets what many might feel was a “trapping” question while exhibiting a command of an evasive body of law. That appeal is magnified when one sums up the mixed results produced in the last few years by the SEC in its well-publicized attempts to punish its notion of the crime of insider trading. Problematic Law Born of an unprecedented 1961 administrative case emphasizing “fairness,” 8federal insider trading law grew to enlist the aid of judicial decision, sporadic legislative limitation (but concomitant refusal at definition), and piecemeal SEC rulemaking. Moreover, subsumed by the overarching tenets of SEC Rule 10b-5, the insider trading prohibition remains encumbered by such hurdles as a retroactive analysis of what constitutes a deception and grossly varying concepts of duty. The highest hurdle is still Rule 10b-5′s bifurcated application to insider and outsider. “Traditional” insider trading theory held the corporate insider liable to the shareholders, who are seen to be victimized when the insider uses company information to trade for personal gain. Bold applications of Traditional Theory to noninsiders in the 1970s prompted judicial hostility to the notion of material, nonpublic information as contraband. Subsequently, the SEC created, refined and had blessed a separate theory of liability for outsiders, the “misappropriation theory,” which, after several tries, gained Supreme Court approval in 1997. 9But the resulting hodgepodge has quite often been questioned and is not always accepted. For example, in 2006, the SEC’s case against an outsider who learned at a LendingTree.com board meeting of its intention to seek a merger resulted in summary judgment against the commission. There, the court held that the mortgage company’s failure to timely obtain a signed confidentiality agreement (and thus establish a fiduciary duty) precluded a finding of misappropriation. 10The same year, the SEC branded as insider trading the scheme of various day traders to access internal transmissions at other firms and “trade ahead” of their institutional customer orders (the popularized “squawk box” cases). After an ensuing criminal trial in the spring of 2007, six brokerage house employees, “outsiders” to the firm serving as the source of the information, were acquitted of all securities fraud charges by a federal jury in Brooklyn (while deadlocked on the seventh charge, conspiracy). 11 Later in 2007, a U.S. District Judge for the Southern District of New York granted a rare judgment notwithstanding the verdict in favor of a stock exchange specialist charged with “interpositioning” (i.e., acting as counterparty to profitable orders fillable by other customer orders). 12In that case, the judge found that the absence of any evidence that investors were misled made a jury verdict of guilt under Rule 10b-5 a legal impossibility. Months earlier, separate juries had acquitted two other specialists of Rule 10b-5 charges premised upon the comparable charge of “front running” customer orders. 13 Perhaps inspired by these losses, the SEC subsequently delayed further scrutiny of this “duty theory” in a number of cases initiated through the seeking of a temporary restraining order (TRO), thus employing the bold tactic of suing first and filling in the details on the requisite duty thereafter. The inevitable setback to this strategy came in January 2008, when a Southern District of New York judge refused a preliminary injunction against a foreign national accused of garnering profits by improperly accessing a company’s information services and trading prior to publication of material news. In SEC v. Dorozhko, Judge Naomi Reice Buchwald declared that the SEC “had not shown a likelihood of succeeding on the merits” on its Rule 10b-5 claim because Mr. Dorozhko’s actions, in the absence of a fiduciary duty, were not “manipulative” or “deceptive.” 14The judge addressed the ultimate question head on, stating that, “The barrier to issuing a preliminary injunction at this stage in the proceedings is that the alleged “hacking and trading,” while illegal under any number of federal and/or state criminal statutes, does not amount to a violation of �10(b) of the Exchange Act under existing case law,” reiterating the Supreme Court’s 2002 reminder that “theft by itself does not constitute securities fraud.” 15 More State Re-Interpretation It would thus seem likely that the SEC’s persisting courtroom difficulties argue for more state prosecutors and courts taking the lead in applying the insider trading prohibition to unsavory practices surrounding information asymmetries. One way in which state prosecutors have avoided the legal morass slowing the punishment of insider trading is to brand the activities in question a theft. Under this approach, a briefcase containing merger documents is tantamount to a new automobile for purposes of larceny. 16Such an approach can only grow with states increasingly attacking stolen data and other types of information conversion as garden variety theft; 17further, it comports with Judge Buchwald’s admonition that other laws can apply. If desiring to apply Rule 10b-5, states can always urge the interpretation of a broad state statute to include the federal prohibition, as New York has achieved with the Martin Act, 18or to implement a 10b-5 copycat statute, as was done in Massachusetts. The latter was utilized successfully by Secretary of State William Galvin in 2005 in punishing “market timing” by a major broker-dealer. 19 Under such a synergy, “traditional” insider trading could continue to be targeted by the commission, with the analysis of misappropriation/theft left for the local authorities. Indeed, a “tag-team” approach between federal and state law appears not only advisable but destined to be. The Securities Exchange Act of 1934 still contemplates referrals to and retention of jurisdiction by state regulators. In the past six years, the SEC has embraced local efforts in punishing unsavory research activities and hedge fund fraud. And in the historic 1997 O’Hagandecision itself, Justice Ruth Bader Ginsburg counseled that insider trading confessed to its source would still be reachable “under state law for breach of a duty of loyalty.” 20 Conclusion Cast against the opaque backdrop of insider trading law, Judge Ramos’ decision appears less anomalous than revolutionary. Given that it has been 20 years since Congress tackled (and left undefined) insider trading, and over 10 years since the Supreme Court directly addressed the related theories, practitioners may just see more state jurists reinterpreting (if not reinventing) the federal prohibition. The Weydecision ultimately proved the unwieldy Rule 10b-5 to be servant and not master, and the rationale for the insider trading regulation capable of return to its innate quest for fairness. Should the SEC continue to encounter difficulties in applying its evasive rule, this nascent federalism in the war on insider trading just might gain the federal government’s overt support. J. Scott Colesanti is a special professor at the Hofstra University School of Law, teaching securities regulation and broker-dealer regulation. Endnotes: 1. Wey v. New York Stock Exch. Inc,2007 NY Slip Op 50880 (April 10, 2007). 2. United Housing Found. Inc. v. Forman, 421 U.S. 837 (1975). 3. Wey v. New York Stock Exchange Inc.,No. 602510/05 (Nov. 7, 2007). 4. Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975). But see Merrill Lynch, Pierce, Fenner & Smith Inc. v. Dabit, 547 U.S. 71 (2006) (for purposes of removing state class action lawsuit to federal court, distinction between holders and purchasers/sellers of securities is not relevant). 5. Basic Inc. v. Levinson,485 U.S. 224 (1988). Basicspecifically denounced a bright line test for the disclosure of merger negotiations, and, for purposes of Rule 10b-5, held information not immaterial “merely because an agreement-in-principle as to price and structure” had not yet been reached. 6. See Elkind v. Liggett & Myers Inc. 635 F.2d 156, 165 (2d Cir. 1980) (explaining that the law should permit a “skilled analyst with knowledge of a company and the industry [to] piece seemingly inconsequential data together with public information into a mosaic which reveals material non-public information.”). 7. SEC v. Warde,151 F.3d 42 (2d Cir. 1998). 8. In the Matter of Cady, Roberts & Co.,40 SEC 907 (SEC 1961). 9. United States v. O’Hagan,521 U.S. 642 (1997). 10. SEC v. Talbot,430 F.Supp.2d 1029 (C.D. Cal. 2006). 11. Jenny Anderson, “6 Former Workers at a Day Trading Firm Are Acquitted,” The New York Times, May 11, 2007. A seventh defendant was convicted of witness tampering and making false statements. 12. United States v. Finnerty,474 F.Supp. 2d 530 (S.D.N.Y. 2007) (Honorable Denny Chin). “Interpositioning” has at times been charged interchangeably with “trading ahead” as a violation of Rule 10b-5, as both offenses are enabled by the stock exchange specialist’s advance knowledge of customer order flow. 13. See Chad Bray, “Volpe Is Acquitted in NYSE Case,” Wall St. J. , Sept. 19, 2006, at C3. 14. Dkt. No. 07 Civ. 9606 (NRB) (Jan. 8, 2008). Judge Buchwald did refuse to dismiss the SEC complaint with prejudice and concurrently encouraged discovery of facts that could later establish liability under the Traditional Theory – namely, that an insider had tipped Mr. Dorozhko. 15. SEC v. Zandford,535 U.S. 813 (2002). 16. See, for example, People v. Napolitano,282 AD2d 49 (1st Dept. 2001), appeal denied, 96 NY2d 866 (2001). 17. People v. Farrell,28 Cal. 4th 381 (Sup. Ct. of Ca., 2002) (“The crime of theft is not limited to unlawful taking of money; it may involve the theft of trade secrets.”) 18. The Martin Act was first upheld as a bar to insider trading in 1982. People v. Florentino,116 Misc. 692. It was held to include violations under a misappropriation theory analysis in People v. Napolitano, 282 AD2d 49 (A.D. 1st Dept. 2001). 19. Namely, Massachusetts Uniform Securities Act, M.G.L.c. 110A, �101. 20. 521 U.S. at 743.

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