Lewis Tse Pui Lung/Shutterstock.com. February/March 2016 Practical Law Thomson Reuters. All rights reserved.

Transcription

1 Lewis Tse Pui Lung/Shutterstock.com 34 February/March 2016 Practical Law

2 Prosecutors and regulators increasingly use modern investigative techniques and aggressive enforcement tactics to pursue insider trading cases. However, well-prepared counsel can take advantage of various substantive defenses to build a successful defense strategy. MIKE PIAZZA PARTNER DLA PIPER LLP (US) Mike focuses his practice on securities and white collar litigation, business litigation, and complex commercial litigation. Previously, he was the Regional Trial Counsel for the Pacific Regional Office of the SEC. JONATHAN W. HARAY PARTNER DLA PIPER LLP (US) Jon represents corporations and individuals in white collar litigation, government investigations, and securities enforcement matters, including insider trading cases. He is a former federal prosecutor and SEC litigation counsel, and has tried more than three dozen jury trials. KATIE RUFFING ASSOCIATE DLA PIPER LLP (US) Katie dedicates her practice to securities and professional liability litigation. She has extensive involvement in numerous investigations involving the Public Company Accounting Oversight Board and the SEC, and has worked on complex litigation and class action suits. The Journal Litigation February/March

3 No corporate legal issue captures public attention quite like insider trading. These cases epitomize the worst stereotypes of Wall Street and often involve high-profile individuals. Government prosecutors and securities regulators also are drawn to insider trading cases, and pursue them vigorously. The US Attorney s Office in Manhattan alone obtained 85 consecutive insider trading convictions, through trials and guilty pleas, until eventually being dealt an acquittal in Both the Securities and Exchange Commission (SEC) and Department of Justice (DOJ) have publicly identified insider trading as an enforcement priority, and the US Supreme Court is currently poised to weigh in on disputed issues in this area. This article provides an overview of insider trading law and looks at current issues and trends in the context of government investigations, criminal prosecutions, and civil enforcement proceedings. It identifies: The laws governing insider trading violations. The primary regulatory agencies pursuing insider trading investigations and enforcement. The elements of an insider trading claim. The investigative techniques used by regulators. The sanctions and penalties available to regulators. The most common substantive defenses to insider trading claims. The key strategies for counsel in defending against insider trading claims. SECTION 10(b) AND THE LEGAL FRAMEWORK Insider trading refers to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material nonpublic information about the security. Violations also might involve securities trading by individuals who misappropriate material nonpublic information. Insider trading claims most commonly are based on alleged violations of Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and its implementing regulation, Rule 10b-5. Section 10(b) is a catch-all anti-fraud provision that prohibits manipulative and deceptive devices in connection with the purchase or sale of securities. (15 U.S.C. 78j.) Search Liability Provisions: Securities Offerings for more on Section 10(b) and Rule 10b-5. Insider trading is merely one type of device, scheme, or artifice to defraud enforced under Section 10(b). The law has emerged from the founding principle that violating the relationship of trust and confidence that exists between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation amounts to fraud. (United States v. O Hagan, 521 U.S. 642, (1997) (internal quotations omitted).) These types of claims also can be pursued under other Exchange Act provisions and laws, including: Rule 14e-3 under the Exchange Act. This rule prohibits insider trading in connection with tender offers. (17 C.F.R e-3a.) Section 20(a) of the Exchange Act. This provision creates secondary control person liability over any entity that has control over another person engaged in insider trading, unless the controlling person acted in good faith and did not directly or indirectly induce the acts constituting the violation or cause of action. (15 U.S.C. 78t(a).) The Sarbanes-Oxley Act of This statute prohibits any director or executive officer of an issuer of any equity security from, directly or indirectly, purchasing, selling or otherwise acquiring or transferring any equity security of the issuer during a pension plan blackout period. (15 U.S.C (Section 306(a)).) Regulation Fair Disclosure (Regulation FD). This issuer disclosure rule prevents selective disclosure, that is, disclosing important nonpublic information to securities analysts or institutional investors before making full disclosures to the general public. (17 C.F.R ) The SEC has likened selective disclosure to tipping or insider trading because a privileged few gain an informational edge (Selective Disclosure and Insider Trading, Release Nos , (Aug. 15, 2000), available at sec.gov). The Stop Trading on Congressional Knowledge (STOCK) Act. This statute prohibits members of Congress and other government employees from trading based on nonpublic information obtained in the course of their duties. (Pub. L. No , 2038, 126 Stat. 291 (2012).) ENFORCEMENT AUTHORITIES Defending against insider trading allegations often involves dealing with several investigative entities. These include: The SEC, which has principal authority for enforcing the nation s securities laws, and can seek civil penalties, disgorgement, and the imposition of suspensions and bars from engaging in certain activities. The DOJ, including the US Attorney s Offices in each judicial district, which enforces criminal securities laws and can initiate grand jury investigations and criminal prosecutions that can result in imprisonment, fines, and criminal forfeiture based on insider trading violations. The Financial Industry Regulatory Authority (FINRA), a notfor-profit organization authorized by Congress to regulate the securities industry. Other agencies, including state regulatory and criminal authorities. Search Federal Securities Regulators: Overview for more on the government agencies responsible for regulating and enforcing federal securities laws. These authorities often work together, sharing information and pursuing common enforcement goals. For example: FINRA may conduct an inquiry into trading activity in connection with a merger announcement, requesting information from a public company and its officers concerning suspicious trading, and then share the results with the SEC if it believes there is evidence of a possible securities offense. 36 February/March 2016 Practical Law

4 The SEC may advance the investigation by issuing administrative subpoenas and taking investigative testimony. If the SEC identifies evidence sufficient in nature and quality to sustain the higher burden of a criminal prosecution (including evidence of fraudulent intent rising to the beyond a reasonable doubt standard), a referral to the DOJ might follow. If the DOJ opens a criminal investigation, it may issue grand jury subpoenas for documents and testimony, and use additional investigative resources and techniques involving federal law enforcement agents. If authorities pursue criminal charges, the result could be a criminal indictment on federal securities charges. When facing an inquiry related to possible insider trading allegations, counsel must assume that information provided to civil or regulatory authorities will be passed along to others with enforcement authority, even federal prosecutors in the most serious instances. Before responding to an inquiry, producing documents to regulators, or testifying before the SEC, counsel must consider and advise their client of: The dangers of making admissions in an insider trading investigation. The potential for criminal charges if the client waives his Fifth Amendment right against self-incrimination and cooperates with authorities (see below Cooperation). ELEMENTS OF A CLAIM There is no statute defining unlawful insider trading or the elements of an insider trading violation. Rather, insider trading is a type of securities fraud, and its legal contours are largely the result of judicial opinions and enforcement actions arising under certain securities statutes and rules. A securities fraud charge under Section 10(b) of the Exchange Act requires proof of: A breach of a fiduciary duty or other relationship of trust and confidence. The use or possession of material nonpublic information in connection with the purchase or sale of securities. Scienter. A personal benefit, for cases where corporate insiders (tippers) pass or tip material nonpublic information to outsiders (tippees) who trade based on that information. An aider and abettor is liable to the same extent as a principal in criminal cases. In a civil enforcement action, the government must prove every element of its case by a preponderance of the evidence. In criminal cases, the DOJ must prove its case beyond a reasonable doubt. (See 15 U.S.C. 78j(b); 17 C.F.R b-5; see also United States v. Gansman, 657 F.3d 85, 91 n.7 (2d Cir. 2011).) FIDUCIARY DUTY An insider trading claim requires the existence of a fiduciary duty. There are two broad, sometimes overlapping, theories defining the types of duty that, when breached, can lead to insider trading violations: Classical theory. Misappropriation theory. In a limited number of cases, the SEC has asserted insider trading allegations in the absence of a fiduciary duty, where a defendant has obtained material nonpublic information by fraudulent means (such as computer hacking), based on an affirmative misrepresentation theory. Unlike the traditional theories of insider trading, liability under this theory does not depend on a breach of a duty. (See, for example, SEC v. Dorozhko, 574 F.3d 42, (2d Cir. 2009) (holding that an affirmative misrepresentation can constitute actionable fraud despite the absence of a fiduciary duty, and distinguishing affirmative misrepresentations from remaining silent where there is a duty to disclose).) Classical Theory Under the classical theory of insider trading, liability arises for corporate officers or insiders who owe a fiduciary duty to the company and its shareholders. A duty arises where: A relationship of trust and confidence exists between the insiders and shareholders of a company. The insiders have obtained confidential information due to their position with the company. If a duty exists, the insiders who possess material information must either: Refrain from trading on the information. Publicly disclose the information before trading. (See Chiarella v. United States, 445 U.S. 222, (1980).) The classical theory also can extend to temporary insiders, such as underwriters, accountants, lawyers, or consultants, who have both: Entered into a special confidential relationship in the conduct of the business of the company. Access to information solely for corporate purposes. (See Dirks v. SEC, 463 U.S. 646, 655 n.14 (1983).) The Supreme Court articulated in Chiarella the two key principles underlying an insider s or a temporary insider s duty: The insider has access to information intended to be available only for a corporate purpose and not for anyone s personal benefit. The unfairness inherent in trading on information that is inaccessible to those with whom one is dealing. (445 U.S. at ) Misappropriation Theory In misappropriation cases, no fiduciary duty exists between the person trading securities and the shareholders of the issuing company. Instead, the misappropriation theory rests on a duty of trust and confidence that the person making the trade owes to the source of the confidential information. Rule 10b5-2 under the Exchange Act includes a non-exhaustive list of circumstances giving rise to a duty of trust and confidence that, if breached, can form the basis of a misappropriation insider trading violation. A duty exists where: A person has agreed to keep information confidential. Information is shared between people with a history or pattern of sharing confidences, where it should be reasonably The Journal Litigation February/March

5 understood that the information being discussed is to be kept confidential. Information is shared between relatives, such as spouses, siblings, or a parent and child, unless the relationship is such that the parties should not have expected the information to be kept confidential. (17 C.F.R b5-2(b).) USE OR POSSESSION OF MATERIAL NONPUBLIC INFORMATION An insider trading violation must include the use or possession of material nonpublic information in connection with the purchase or sale of a security, including purchases and sales of options and warrants on securities and short sales. This does not mean that the SEC must prove that a trade would not have happened but for the use of inside information. In many cases (including those brought in the Second Circuit), the SEC merely must show that a defendant had knowing possession of the information when making a trade. Although some circuit courts have rejected this position, the use requirement imposes a relatively low threshold in practice. (See below Lack of Use.) Material information can include anything that a reasonable investor would consider significant when deciding whether to buy or sell stock. Common examples of material information include: News of a possible corporate merger or acquisition. An anticipated earnings announcement that might cause a company s stock to rise or fall. Materiality is often shown by a fluctuation in stock prices once the information is publicly released. It is not required, however, that an investor would buy or sell stock based solely on the information at issue, if the information is significant enough to alter the total mix of available information. Search Securities Litigation: Pleading and Proving Materiality for more on materiality. Nonpublic information is information that is unavailable through news media or other publicly available sources. Information can be nonpublic even where it is known to a limited group of outside individuals. By contrast, where information has been effectively disseminated to the investing public, the information generally is reflected in the existing price of a company s stock. (See Basic Inc. v. Levinson, 485 U.S. 224, (1988).) SCIENTER In a civil case, proof of scienter, meaning either knowing or reckless conduct, is enough to establish an insider trading violation. Scienter must be established by a preponderance of the evidence. (See SEC v. Johnson, 174 F. App x 111, 115 (3d Cir. 2006).) Search Securities Litigation: Pleading and Proving Scienter for more on scienter. In a criminal case, proof of the defendant s intent to defraud is required and must be established beyond a reasonable doubt (see Gansman, 657 F.3d at 91 n.7). PERSONAL BENEFIT IN TIPPER-TIPPEE CHAINS Where an insider, or someone who misappropriated inside information, gives a third party a tip about material nonpublic information and the third party trades on the information, then both the tipper and the tippee can be liable for insider trading. All of the elements of insider trading apply equally in tippertippee cases. Additionally, the government must establish that: The tipper knew (or reasonably should have known) that the tippee would trade on the information. The tipper personally benefitted from giving the tip. The tippee must have known (or recklessly disregarded) that the information was obtained in breach of a duty and for personal benefit. (See Dirks, 463 U.S. at 660, 662; United States v. Newman, 773 F.3d 438, 446 (2d Cir. 2014).) This process can have many layers, with tippees becoming tippers by passing information along to others later in the chain of events. The farther the information gets from its source, the more difficult the case is for government attorneys to prove. What constitutes a personal benefit in a tipping chain case is perhaps the most significant current legal issue in insider trading law. Historically, the personal benefit requirement had a relatively low threshold, but lately it has been the subject of much scrutiny. The test is whether the insider personally will benefit, directly or indirectly, from his disclosure (Dirks, 463 U.S. at 662). This might consist of: A direct financial gain. Intangible benefits, such as gaining a reputational advantage, currying favor with a boss, or merely intending the information as a gift to the recipient. What constitutes a personal benefit in a tipping chain case is perhaps the most significant current legal issue in insider trading law. Historically, the personal benefit requirement had a relatively low threshold, but lately it has been the subject of much scrutiny. 38 February/March 2016 Practical Law

6 However, circuit courts are grappling with the extent to which an inference of personal benefit can be drawn in the absence of evidence of direct financial gain. For example, the US Court of Appeals for the Second Circuit requires evidence of a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter]. Inferring a personal benefit based on the existence of a friendship is impermissible absent proof of a meaningfully close personal relationship that generates an exchange that: Is objective. Is consequential. Represents at least a potential gain of a pecuniary interest or another valuable interest. (Newman, 773 F.3d at 452.) After Newman was decided, the US Court of Appeals for the Ninth Circuit held that proof that the insider disclosed material nonpublic information with the intent to benefit a trading relative or friend is sufficient to establish the personal benefit element of an insider trading claim (United States v. Salman, 792 F.3d 1087, 1094 (9th Cir. 2015)). There is some confusion in the courts on whether, under Dirks, the personal benefit to the insider requires proof of an objective, consequential, and pecuniary gain, as required under Newman, or instead can rest simply on a close family relationship between the tipper and tippee. Having granted certiorari in the Salman case, the Supreme Court is poised to weigh in on this issue (see Salman v. United States, No , 2016 WL (U.S. Jan. 19, 2016)). INVESTIGATIVE TECHNIQUES The manner in which the government investigates allegations of insider trading has changed over time. Making a successful case once depended on a painstaking process of manually reviewing trade information (referred to as blue sheets ) supplied by brokers and clearinghouses, and there was little likelihood of capturing a defendant s real-time communications with co-actors. Today, technological advances and the aggressive use of law enforcement tactics have changed the nature of insider trading investigations in both civil and criminal actions. CIVIL PROCEEDINGS The SEC has ramped up its insider trading enforcement through three significant developments: Cooperation program. In the past five years, the SEC s Enforcement Division has developed and implemented a cooperation program like those traditionally used by prosecutors offices. The SEC will enter into cooperation agreements with admitted wrongdoers and grant leniency in exchange for testifying against others. The SEC has touted the effectiveness of its cooperation program in insider trading investigations, where regulators often are eager to obtain testimonial evidence to fill in evidentiary gaps. (See, for example, Press Release, SEC Charges Six Individuals With Insider Trading in Stock of E-Commerce Company Prior to Acquisition by ebay (Apr. 25, 2014), available at sec.gov.) Whistleblower incentives. The SEC aggressively courts tipsters and whistleblowers, particularly since establishing its The Impact of New Investigative Techniques Advances in investigative techniques provide various benefits to the government in its efforts to combat insider trading. For example, by exploiting the use of big data, the SEC can identify trading patterns and relationships that would have been undetectable in the past. Data analytics can reveal parallel trading among several participants whose associations with each other is unknown, or whether an individual trader buys or sells securities in patterns. As an enforcement tool, this information can lead to witnesses, documents, and trading transactions that give SEC staff attorneys greater knowledge of the facts and more evidence of an alleged insider trading scheme. Further, aggressive enforcement tactics, including the use of cooperators and an increased emphasis on obtaining electronic communications, are designed to help the SEC and DOJ get a more complete picture of the trading transactions and a look into the minds of the people executing them. Eyewitness testimony from cooperators and real-time electronic communications, such as s and text messages, can provide incriminating details about whether participants are trading on unlawful inside information. In some circumstances, defendants can take advantage of these enhanced capabilities by raising expectations with judges and juries. Given all of the resources at the government s disposal for investigating insider trading cases, juries might come to expect (or even require) the government to produce recorded conversations and many layers of corroborative evidence, and defendants can argue forcefully that any gaps in evidence should be held against the government. whistleblower program following the passage of the Dodd- Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act). Offering large rewards in exchange for information (up to 30% of any penalty of $1 million or more that resulted from a whistleblower s tip) provides a tremendous incentive for individuals, including company outsiders, to report allegations of misconduct to authorities. (See 2015 Annual Report to Congress on the Dodd-Frank Whistleblower Program, available at sec.gov; Press Release, SEC Awards Whistleblower More Than $700,000 for Detailed Analysis (Jan. 15, 2016), available at sec.gov; see generally SEC Office of the Whistleblower, available at sec.gov.) The Journal Litigation February/March

7 Technological advances. Perhaps most importantly, advances in technology have given authorities the ability to examine vast amounts of data to detect, investigate, and pursue insider trading charges against suspected violators. The SEC s market surveillance now allows regulators to: zpinpoint suspicious trading across multiple securities; and zidentify possible relationships among traders. (See Andrew Ceresney, Director of the SEC Division of Enforcement, Keynote Address at Compliance Week 2014 (May 20, 2014), available at sec.gov.) CRIMINAL PROCEEDINGS In criminal investigations, federal prosecutors, aided by law enforcement agents from the FBI and elsewhere, have demonstrated their increasing willingness to use techniques traditionally reserved for violent criminal enterprises to pursue those suspected of insider trading and other white-collar offenses. Investigators have vast data resources and are using a variety of tools to uncover trading patterns and communications revealing possible evidence of insider trading, including: Judicially approved wiretaps. Undercover surveillance. Cooperating witnesses. Search warrants. Given that agencies often collaborate in these investigations, witnesses providing off-the-record statements or administrative testimony to the SEC should consider the possibility that the SEC staff is coordinating with criminal authorities and has access to investigative work product that incriminates the witness (see, for example, James B. Stewart, A Dragnet at Dewey & LeBoeuf Snares a Minnow, N.Y. Times, Mar. 14, 2004 (describing the participation of prosecutors and law enforcement during an SEC interview of a former Dewey & LeBoeuf employee)). While some attorneys might view it as sandbagging a witness, regulators and prosecutors often do not reveal to a witness that they possess incriminating communications until after the witness has made what the government perceives to be a false statement. In that scenario, counsel for the witness should consider whether to: Stop the interview to fully analyze the implications of providing information. Advise the witness to assert his Fifth Amendment right against self-incrimination. SANCTIONS AND PENALTIES The possible sanctions for insider trading depend on the type of case. If convicted criminally, an insider can face: Imprisonment for up to 20 years. Fines of up to: z$5 million for an individual; or z$25 million for a corporate entity. Criminal forfeiture. (15 U.S.C. 78ff.) Criminal prosecution for insider trading also can result in attendant charges of aiding and abetting, conspiracy, and obstruction of justice, among others. If found civilly liable for insider trading, a defendant or respondent can be subject to disgorgement and monetary penalties of up to three times the profit gained or the loss avoided (15 U.S.C. 78u-1; see also Dodd-Frank Act, Pub. L. No , 929P(a), 12 U.S.C. 5565). DEFENSES In addition to attacking the sufficiency of the evidence supporting each of the substantive elements of an insider trading claim, defense counsel also should consider the viability of a defense based on: The mosaic theory. An operative trading plan created in accordance with Rule 10b5-1 under the Exchange Act. The defendant s reliance on the advice of counsel. The defendant s lack of knowledge that certain information was confidential. The defendant s failure to use the material nonpublic information at issue. The issuer s public disclosure of the information at issue. The defendant s reporting of its insider trades. Search Defending Against Insider Trading Claims Checklist for a quick guide on the substantive defenses to insider trading claims. MOSAIC THEORY Under the mosaic theory defense, the defendant argues that a person can legally obtain bits and pieces of nonpublic information that, when pieced together with public information, including rumors, can lead to the discovery of material nonpublic information. To assert this defense, the defendant must demonstrate that each piece of the mosaic is, in and of itself, immaterial information. This defense historically has been used in cases involving securities analysts. (See Dirks, 463 U.S. at (noting that it is commonplace for analysts to ferret out and analyze information that forms the basis for judgments on the market worth of a company s stock) (internal quotations omitted).) However, more aggressive interpretation and enforcement of the materiality standard by the SEC and, to a lesser extent, the DOJ appear to be eroding the mosaic theory defense. In particular, this defense is now more vulnerable due to: The SEC s adoption of Regulation FD. The SEC has stated that, while an issuer is not prohibited from disclosing an immaterial piece of information to an analyst, Regulation FD prohibits issuers from attempting to render material information immaterial simply by breaking it into ostensibly non-material pieces (Selective Disclosure and Insider Trading, Release Nos , ). The regulators new evidence-gathering methods. Regulators have access to technology that allows them to 40 February/March 2016 Practical Law

8 track and analyze trades virtually in real-time. Together with tactics previously reserved for organized crime investigations, such as aggressive use of wiretaps, cases now brought to court have substantial, concrete evidence to back them. This is a significant change from older insider trading cases that were based on conjecture and circumstantial evidence. Courts and juries have followed the SEC s lead and increasingly are rejecting the mosaic theory defense. For example, billionaire hedge fund founder Raj Rajaratnam contended that he based trading decisions on immaterial bits of information he pieced together, but the jury rejected the defense in light of overwhelming contradictory evidence contained in recorded conversations (United States v. Rajaratnam, 802 F. Supp. 2d 491, (S.D.N.Y. 2011)). General Affirmative Defense To assert an affirmative defense under Rule 10b5-1, the defendant bears the burden of establishing that: The person for whom the plan is being implemented was not in possession of material nonpublic information at the time the plan was adopted. No trading under the plan occurred until after a reasonable period of time had passed after adoption of the plan. The insider had only one plan at a time, with minimal terminations or amendments to the plan. (See, for example, Press Release, SEC Charges Former Countrywide Executives with Fraud (June 4, 2009), available at sec.gov (charging a CEO with insider trading where he set Regulators have access to technology that allows them to track and analyze trades virtually in real-time. Together with tactics previously reserved for organized crime investigations, such as aggressive use of wiretaps, cases now brought to court have substantial, concrete evidence to back them. RULE 10b5-1 TRADING PLANS Rule 10b5-1 allows individuals, including executives, officers, and directors, to adopt trading plans that implement periodic, scheduled trades, even if the plan holder is in possession of material nonpublic information at the time of the trading. The rule provides: A general affirmative defense, which is available to both individuals and entities. An alternative affirmative defense, which is available only to entities. Search Rule 10b5-1 Trading Plans and Rule 10b5-1 Plans: Best Practices Checklist for more on establishing a plan and the affirmative defenses under Rule 10b5-1. A defense under Rule 10b5-1 can be vulnerable to dismissal if there is concern that the plan gave an insider an unfair trading advantage (see Linda Chatman Thomsen, Director of the SEC Division of Enforcement, Remarks at the 2007 Corporate Counsel Institute (Mar. 8, 2007), available at sec.gov). While no enforcement action has yet called into question a Rule 10b5-1 plan, the continued public and regulatory scrutiny of officers and directors and their compensation virtually guarantees that a regulator or prosecutor will at some point test the limits of Rule 10b5-1 protection. up four 10b5-1 trading plans within a three-month period while in possession of material nonpublic information, and started trading under the plans shortly after the plans establishment).) The trading plan must do at least one of the following: Set the date, price, and amount of any trades. Specify an algorithm, formula, or program that will determine the trades. Delegate the ability to determine the date, price, and amount of any trades to a third party who does not possess material nonpublic information at the time of the trades. (17 C.F.R b5-1(c)(1).) Alternative Entity Affirmative Defense An additional affirmative defense is available only to entities, such as issuers or investment banks. An entity can avoid liability if it can demonstrate that: The individual making an investment decision on the entity s behalf was not aware of any material nonpublic information. The entity had implemented reasonable policies and procedures to prevent insider trading, such as the use of robust informational barriers to stem the flow of knowledge between different divisions or units within the issuer and its affiliated broker-dealers. (17 C.F.R b5-1(c)(2).) The Journal Litigation February/March

9 This alternative affirmative defense is particularly useful for a broker-dealer affiliated with a company that often facilitates trades in the company s securities, however, it has not yet been tested in court. Search Sample Corporate Policy on Insider Trading for a sample corporate policy prohibiting any form of insider trading and imposing special trading restrictions on directors and officers, with explanatory notes and drafting tips. RELIANCE ON COUNSEL A defendant may refute an insider trading claim based on his reliance on counsel s advice. Reliance on counsel is not an absolute defense, but it serves to rebut any allegation of the defendant s intent to violate the securities laws. To assert this defense, the defendant must establish that he: Disclosed all relevant facts and circumstances to counsel. Requested advice from counsel about the contemplated trading. Received advice from counsel that the contemplated trading was legal. Relied in good faith on counsel s advice. (See SEC v. Goldfield Deep Mines Co. of Nev., 758 F.2d 459, 467 (9th Cir. 1985).) Defense counsel should bear in mind that asserting the reliance on counsel defense requires waiver of the attorney-client privilege, which could open the door to disclosures that are better kept privileged and confidential. Search Attorney-Client Privilege: Waiving the Privilege for more on the scope of a privilege waiver when asserting the reliance on counsel defense. NO KNOWLEDGE OF CONFIDENTIALITY A defendant may resist an insider trading claim by challenging his awareness of a breach of duty in cases brought under: The tipper-tippee theory. The misappropriation theory. Claims Based on Tipper-Tippee Theory Under the tipper-tippee theory, liability for the tippee rests on whether he knew or was aware of the tipper s breach of fiduciary duty (see above Fiduciary Duty). The standard is the same regardless of whether the tipper s duty stems from the classical or misappropriation theory. Before the use of wiretaps and evidence, prosecutors often showed this awareness through circumstantial evidence. Even with the new evidence-gathering techniques available to law enforcement, circumstantial evidence still plays an important role in proving a tippee s liability. Courts tend to focus on whether the tippee knew the source of the material nonpublic information. If that source is a corporate insider, knowledge and awareness generally are established. For defense counsel representing a tippee, challenging awareness of a breach of duty is an important defense strategy. In cases involving multiple trades, tips, tippers, and tippees, counsel should analyze any distinctions among the individual tippees, such as how they learned of the material nonpublic information and their relationship (if any) with the tipper. The defendant must establish at least one of the following: The tippee did not know, and had no reason to know, that the tipper breached a duty of trust or confidence. The tipper received no direct or indirect personal benefit. (See Newman, 773 F.3d at 446.) Claims Based on Misappropriation Theory Under the misappropriation theory, a person might be liable if he breaches either a clear fiduciary duty or a relationship of trust and confidence, such as a spousal or other familial relationship, or a business partner, employee, or consultant. There are other ways a duty of trust and confidence can arise, and the analysis is highly fact-specific. Rule 10b5-2 lists several circumstances and factors indicative of a relationship of trust and confidence (see above Misappropriation Theory). This can be a fruitful area for defense counsel to attack the government s case. (See, for example, SEC v. Payton, 2015 WL , at *2-3 (S.D.N.Y. Dec. 28, 2015) (genuine issues of material fact existed on whether an equities salesman who received confidential information owed a duty of trust and confidence to his close friend and attorney for purposes of determining insider trading liability under a misappropriation theory).) In September 2015, the DOJ issued new guidance to prosecutors, directing them to focus on the accountability of individuals in their investigations of corporate wrongdoing, and requiring companies to disclose to prosecutors all relevant facts about the individuals involved in corporate misconduct to be eligible for any cooperation credit. 42 February/March 2016 Practical Law

10 Federal Securities Litigation and Enforcement Toolkit The Federal Securities Litigation and Enforcement Toolkit available on Practical Law offers a collection of resources to assist counsel with the procedural and substantive aspects of federal securities litigation and enforcement matters. It features a range of continuously maintained resources, including: Criminal and Civil Liability for Corporations, Officers, and Directors Internal Investigations: US Privilege and Work Product Protection Securities Enforcement: A Roadmap of the SEC s Investigation and Enforcement Process Securities Enforcement: Settling Securities Cases with Regulators Securities Litigation: Answer Securities Litigation: Defending a Private Securities Fraud Lawsuit Checklist Trends in Federal White Collar Prosecutions LACK OF USE Some jurisdictions allow defendants to assert a lack of use defense in insider trading cases. Before Rule 10b5-1 was enacted, the circuit courts were divided on whether possession of material nonpublic information alone was sufficient for insider trading liability or whether an actual causal connection was a necessary element. For example: Knowing possession of material nonpublic information at the time of the trade was sufficient in the Second Circuit (see, for example, United States v. Teicher, 987 F.2d 112, 119 (2d Cir. 1993)). Actual use of the material nonpublic information was required in the Eleventh Circuit, which could be inferred from the fact that an insider traded while in possession of inside information (see, for example, SEC v. Adler, 137 F.3d 1325, 1337 (11th Cir. 1998)). The government was required to show actual use of the material nonpublic information by the trader in the Ninth Circuit (see, for example, United States v. Smith, 155 F.3d 1051, (9th Cir. 1998) (distinguishing this criminal prosecution from Adler, a civil enforcement proceeding, and finding that the court is not at liberty, as was the Adler court, to establish an evidentiary presumption that gives rise to an inference of use, and instead requiring actual evidence of use)). When Rule 10b5-1 was enacted, the SEC adopted an awareness standard identical to the knowing possession standard followed by the Second Circuit. To the SEC, the affirmative defenses in Rule 10b5-1 are the exclusive defenses available to defendants accused of insider trading. (See Selective Disclosure and Insider Trading, Release Nos , ) However, several courts have reverted to a non-use analysis (see, for example, SEC v. Talbot, 430 F. Supp. 2d 1029, 1045 (C.D. Cal. 2006), rev d on other grounds, 530 F.3d 1085 (9th Cir. 2008)). PUBLIC DISCLOSURE OF INFORMATION Under Regulation FD, when a securities issuer selectively discloses material nonpublic information to a party such as a broker-dealer or an investment adviser, the issuer also must effect a broad, non-exclusionary distribution of the information to the public to avoid liability. Disclosure may be made through a Form 8-K or another method of mass information distribution. Where the selective disclosure was made intentionally, the public disclosure must be made simultaneously. If it was made unintentionally, the shared information must be made to the public promptly, meaning that it is effected by the later of 24 hours or the beginning of the next trading day on the New York Stock Exchange. In either case, public disclosure must be made after a senior official of the issuer learns of the selective disclosure and knows, or should know, that the disclosed information was material and nonpublic. (17 C.F.R ) Search Complying with Regulation FD (Fair Disclosure) for more on the requirements of Regulation FD. REPORTING OF INSIDER TRADES A company insider may trade in the company s securities if he reports the trades to the SEC by filing the appropriate disclosure form under Section 16 of the Exchange Act (15 U.S.C. 78p). To be lawful, the trades cannot be based on material information that is not in the public domain. STRATEGIC CONSIDERATIONS There are important strategic considerations for both individuals and companies under investigation or prosecution for insider trading. These include evaluating and continually reassessing which individuals or entities are the subjects of the investigation and whether they are in jeopardy of criminal prosecution. To make informed decisions, counsel should: Conduct an internal review. Take appropriate steps to preserve information. Assess whether (and to what degree) the client should cooperate with the authorities. Consider possible legal challenges to raise in an administrative proceeding. These considerations can differ greatly for individuals and companies, particularly since companies have no Fifth Amendment right against compelled self-incrimination. Significantly, in September 2015, the DOJ issued new guidance The Journal Litigation February/March

11 to prosecutors, directing them to focus on the accountability of individuals in their investigations of corporate wrongdoing, and requiring companies to disclose to prosecutors all relevant facts about the individuals involved in corporate misconduct to be eligible for any cooperation credit. Search I Want You! DOJ s New Policy on Corporate Investigations Focuses on Individuals for more on the DOJ s new guidance. INTERNAL INVESTIGATIONS As soon as the government launches an investigation, counsel must make every effort to help an individual or entity client get ahead of that investigation. The way to do so is through an effective internal investigation, comprised of: Litigation holds. Document collection and review. Witness interviews. Legal research. Counsel must not risk making uninformed decisions, which can be costly for their client both in terms of monetary sanctions and reputational harm. The goal of an internal investigation is to learn as much about the evidence as possible before beginning to meet with the government, tendering documents, offering witnesses for testimony, and engaging in settlement negotiations. Every effort should be made to preserve the attorney-client privilege during the course of the investigation. Search Conducting Internal Investigations Toolkit for a collection of resources to assist counsel in preparing for an internal investigation and protecting privilege during the course of the investigation. LITIGATION HOLDS Once law enforcement begins an investigation, the subject company should promptly issue a litigation hold. The hold should explicitly include all forms of potentially responsive information. Data like text messages and instant messaging communications sometimes contain key evidence, and can remain in existence long after the actual communication took place. Before issuing a litigation hold, counsel and their client must determine its scope, including: The time period covered by the hold. The subject matter of the data to be retained. The persons and departments subject to the hold. Additionally, counsel must make immediate efforts to determine whether backup tapes, disks, files, cloud storage, and similar materials exist and secure them for possible review. To the extent an investigation focuses on potentially ongoing conduct, the litigation hold must provide for the preservation of newly created documents and communications that also might be relevant to the investigation. Custodians subject to the hold must be told to: Not delete or otherwise destroy any potentially responsive material, to prevent a later claim of evidence spoliation, or worse, obstruction of justice. Further identify and retain other or data files from personal or home accounts that might be responsive. Counsel should periodically reassess the parameters of the hold (particularly for identification of additional custodians and subject areas), as investigations tend to evolve, and periodically remind recipients that the hold remains in place. Search Litigation Hold Toolkit for a collection of resources to assist counsel with properly preserving documents and implementing a litigation hold. COOPERATION To help a client decide whether to cooperate in an insider trading case, counsel must have extensive knowledge of the facts and circumstances, state of the law, and strength of the government s evidence. Cooperation also could have significant privilege implications. The decision cannot, and should not, be made in a vacuum. Because companies have no Fifth Amendment right against self-incrimination, they have limited avenues to challenge government subpoenas requiring the production of documents. Further, a company responding to a government investigation might benefit from cooperating with authorities should it face allegations of wrongful conduct, because prosecutors and regulators tend to want (or need) the company s cooperation to effectively target individuals in later civil or criminal proceedings. In these circumstances, a company might avoid a criminal prosecution or obtain a more favorable resolution, subject to the DOJ s all-or-nothing approach to cooperation credit. Under the DOJ s approach, companies must provide all facts to prosecutors about individual misconduct to receive any cooperation credit. Search Securities Enforcement: Responding to Regulator s Request for Information and Documents for more on strategic considerations for a company communicating with a regulator. The cooperation calculus for an individual is different. If the individual is a potential whistleblower, he can avoid liability and even obtain a monetary recovery under the SEC s whistleblower program. If an individual is a potential target of an investigation, he has critical decisions to make about cooperation and representation. The individual should consider whether to: Assert his Fifth Amendment right against self-incrimination and further refuse to cooperate with any internal investigation. Seek separate counsel early in the process. Search Handling a Government Investigation of a Senior Executive Checklist for more on strategic considerations for an individual facing a government investigation. ADMINISTRATIVE PROCEEDINGS Since the Dodd-Frank Act greatly expanded the SEC s ability to bring its cases in administrative proceedings, the SEC s Enforcement Division has moved aggressively to bring all types of cases in that venue, from accounting fraud to insider trading cases. Traditionally, insider trading civil cases brought by the 44 February/March 2016 Practical Law

12 SEC were filed only in federal court, however, this is no longer the case. The SEC now may bring administrative proceedings against all alleged insider traders, including unregulated individuals, and may seek monetary penalties in addition to disgorgement. After an administrative law judge (ALJ) renders a decision, the first level of appellate review is by the five SEC Commissioners. A federal court may review the case only after that review by the panel. Seeking injunctive relief in federal court. Defense counsel may move for injunctive relief on the ground that the administrative proceeding is unconstitutional, which stays any administrative proceedings. Although these motions are rarely successful, a few have been granted and are currently working their way through the federal appellate process (see, for example, Duka v. SEC, 2015 WL , at *1 (S.D.N.Y. Aug. 12, 2015)). Counsel involved in an SEC administrative proceeding should be aware of procedural differences from court proceedings, including: The timing of administrative decisions, which must be issued within 300 days after the case is first filed. The unavailability of traditional document discovery. Instead, the SEC turns over its investigative case file, including its witness statements and exculpatory records, under Brady v. Maryland (a benefit over civil litigation, where Brady does not apply) (373 U.S. 83 (1963)). The parties inability to take depositions except under unusual circumstances. The defendant s limited power to subpoena third parties for records or testimony. Counsel should prioritize hearing preparations, because the cases move quickly. Generally, a contested administrative hearing, which is equivalent to a federal court trial, begins four months after the initial conference of all parties. Counsel also should learn the preferences and priorities of the ALJ as early as possible, because no right to a jury exists in an administrative proceeding. The SEC has taken notice of the rising tide of criticism aimed at its administrative process. In late 2015, the SEC proposed changes to the administrative proceeding rules that would allow for some deposition discovery, up to eight months before the trial begins (as compared to the current four months), and a few other minor adjustments. This is a rapidly evolving area of the law. Counsel should anticipate divergent opinions from different courts until there is either a legislative fix or a Supreme Court opinion that addresses directly the constitutionality of current SEC administrative proceedings. Given these procedural challenges, defense counsel should consider: Moving to dismiss on the ground that the administrative proceeding is unconstitutional. Some courts have questioned the constitutionality of the SEC s appointment of ALJs. The SEC appoints all of the ALJs who hear its administrative cases, but their appointment is not done by the SEC Commissioners, in potential violation of Article II of the US Constitution (see U.S. Const. art. II, 2, cl. 2). Courts have questioned the constitutionality of a government agency suing an otherwise unregulated person in the agency s home court (see, for example, Hill v. SEC, 2015 WL , at *19 (N.D. Ga. June 8, 2015)). Use of Practical Law websites and services is subject to the Terms of Use ( and Privacy Policy ( The Journal Litigation February/March