The fall-out from the Second Circuit’s decision in U.S. v. Newman continued last week in SEC v. Payton, when Southern District of New York Judge Jed S. Rakoff denied a motion to dismiss an SEC civil enforcement action against two former brokers, Daryl Payton and Benjamin Durant, one of whom (Payton) had just had his criminal plea for the same conduct reversed in light of Newman. Although the United States may be unable to make criminal charges stick against some alleged insider traders under a standard of “willfulness,” Judge Rakoff found that the SEC had sufficiently alleged that related conduct of the two brokers at the end of the tip line was “reckless,” satisfying the SEC’s lower civil standard.
In Newman, the Second Circuit held that prosecutors in insider trading cases must show that the tipper received a personal benefit in exchange for the tip, and that the tippee knew the tipper received that benefit. The Newman court further held that the personal benefit must be “of consequence.” Following Newman, the DOJ and SEC expressed concern that the Second Circuit had limited their ability to penalize individuals who trade on leaked inside information. Also, after Newman was decided, SDNY Judge Andrew Carter indicated that, based on Newman, he planned to vacate guilty pleas of four defendants involved with the alleged trading of SPSS securities. The criminal setbacks to insider trading enforcement will not save two brokers from facing civil claims arising out of the same transaction, however.
Despite the Newman fall-out in the criminal case involving SPSS, the SEC continued its enforcement action against Payton and Durant based on a misappropriation theory of insider trading. Under misappropriation theory, the tipper is not a corporate insider, but an outsider who learns material, nonpublic information, and discloses the information in breach of a duty of trust or confidence to the source of the information. The SEC alleged that the misappropriation tipping stream in Payton began when former Cravath, Swaine & Moore associate Michael Dallas told his friend Trent Martin about the pending IBM acquisition of SPSS. Martin later allegedly shared the information with his roommate, Thomas Conradt, who allegedly shared the information with a colleague, who then passed the information to Payton and Durant. Conradt later allegedly told Payton and Durant that Martin had passed the tip to him, and they began trading in SPSS securities. Payton and Durant were thus several steps removed – or downstream – from the inside tipper, Dallas.
The SEC argued that Newman should not apply to insider trading actions based on misappropriation and that a tippee’s knowledge that inside information emanates from corporate outsiders, standing alone, should be sufficient for remote tippee liability because it is equivalent to knowledge that the recipient of the information has stolen property. Rejecting the government’s argument, Judge Rakoff found that Newman unequivocally held that the elements of insider trading apply equally to classic and misappropriation insider trading theories. Importantly, Judge Rakoff also found that he must consider the distinction between the criminal and civil standards for insider trading. Individuals in criminal cases such as Newman must have committed the offense “willfully,” while defendants can be civilly liable for mere “recklessness,” a lower standard.
Judge Rakoff’s decision and recognition that the SEC’s civil burden for insider trading is lighter than the criminal standard undoubtedly gave the SEC a sigh of relief. The SEC is now likely to rely on Payton to inform how it frames claims against remote or downstream tippers – at least at the motion to dismiss stage where the court must accept all well-pled facts as true and draw inferences in the agency’s favor. What remains to be seen is how Payton and Newman will affect the agency’s enforcement actions against remote tippees at later stages of litigation – when it is required to make evidentiary showings.