One of the questions left open after the Supreme Court's decision in U.S. v. O'Hagan was whether Section 10(b) and Rule 10b-5 "require a causal connection between the material nonpublic information and the insider's trading or whether knowing possession of material nonpublic information is sufficient for liability." SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998). The Eleventh Circuit, in Adler, rejected the "knowing possession" standard urged by the SEC and, in a carefully reasoned opinion, adopted instead a test requiring the SEC to show that the defendant used the material nonpublic information when trading. To satisfy concerns about the problems of proving a causal connection between the inside information and a particular trade, the Eleventh Circuit also held that trading while in possession of material nonpublic information creates "a strong inference" that the information was used in trading. The defendant has the burden of rebutting the inference by showing that the information was not used.
The Eleventh Circuit faced this issue in the context of the district court's rulings in favor of Harvey Pegram and other defendants charged by the SEC with illegal insider trading. Pegram was a founder, director and officer of Comptronix Corporation. In 1989, after allegedly learning in a board meeting that Comptronix's largest customer was likely to substantially reduce or completely terminate its business with Comptronix, Pegram sold some of his Comptronix stock. In 1992, after Pegram was no longer an officer or director of the company, he again sold shares. Pegram's 1992 sales were made within ten minutes of a brief conversation with his friend Richard Adler who was a current Comptronix director. At a Comptronix board meeting held on the day prior to the conversation with Pegram, Adler had learned about potentially fraudulent accounting within Comptronix.
Initial Defense Victory
After the SEC sued, the district court granted summary judgment in favor of Pegram on the 1989 trades, finding that Pegram had rebutted any inference that he had acted with scienter because:
- he only sold a small portion of his stock holdings,
- his plan to sell the stock predated his receipt of the material nonpublic information,
- he obtained approval for the sale from the general counsel of Comptronix, and
- he sold the stock immediately after the expiration of the lock-up period that followed Comptronix's initial public offering.
Pegram also defeated the SEC's charges relating to his 1992 trades when the court ruled in his favor after a seven-day trial left a jury deadlocked. Again, the district court found that Pegram had rebutted any inference that he traded illegally through evidence that he had a preexisting plan to sell the Comptronix stock. The district court ruled in favor of the other defendants who had traded in 1992 for similar reasons.
The SEC appealed, arguing that Pegram's knowing possession of inside information at the time of his trades was sufficient to impose liability for insider trading under Rule 10b-5. The Eleventh Circuit rejected that standard but nonetheless reversed the district court.
Reversal on Appeal
In resolving what it viewed as a "difficult and close question," the court carefully examined relevant cases. It focused primarily on three Supreme Court cases, Chiarella v. United States, Dirks v. SEC and United States v. O'Hagan, noting that dicta in each case suggested that a causal connection between the information and the trading was required. For example, the Chiarella Court had acknowledged that federal courts found securities laws violations when corporate insiders "used" material nonpublic information for their own benefit. The Dirks Court stated that an insider violated the law only when he engaged in "intentional or willful conduct designed to deceive or defraud investors." Similarly, the O'Hagan Court stated that a violation occurred when an insider trades "on the basis" of material nonpublic information. Such language, the Eleventh Circuit reasoned, supported adoption of a liability standard requiring that the defendant have used the information in his or her trading.
In light of such language, the Eleventh Circuit rejected as unpersuasive the Second Circuit's analysis of the issue in United States v. Teicher, in which the Second Circuit had supported the "knowing possession" test. It also noted that the Second Circuit's analysis was dicta since the Second Circuit had "expressly found that it was `unnecessary to determine whether proof of securities fraud requires a causal connection.'" Instead, the Eleventh Circuit relied on cases such as In Re Worlds of Wonder Securities Litigation, where the Ninth Circuit had allowed defendants to introduce evidence of innocent reasons for their trading to rebut an inference of scienter.
Further, the Eleventh Circuit declined to defer to the SEC's interpretation of Rule 10b-5 since the agency's position on whether knowing possession of inside information while trading sufficed to establish insider trading liability had "undergone some fluctuation over time." The court highlighted the SEC's 1971 decision in In Re Investors Management Company, Inc., in which the agency had applied a standard very similar to the one that the court ultimately adopted. While the court recognized that, since 1978, the SEC had taken the position that trading while in "knowing possession" of material nonpublic information violated Section 10(b) and Rule 10b-5, the court found that the SEC had changed its prior position as set forth in Investors Management Co. "without mentioning its prior ruling and without stating any rationale for its change of position." The court also pointed out that the SEC had had "ample opportunity" to adopt the "knowing possession" test in a rule or through amendment of Rule 10b-5 yet had not done so despite the agency's express adoption of such a test in the context of Rule 14e-3 which, among other things, bans trading by insiders in knowing possession of material nonpublic information about tender offers.
Rebuttable Presumption/Disclose or Abstain
The court concluded that its rebuttable-presumption approach satisfied concerns articulated in Teicher regarding the difficulty for the SEC of proving whether a defendant actually used inside information when trading. The court also concluded that its approach comported with the "disclose or abstain" rule, another basis for the Second Circuit's support of the "knowing possession" test in Teicher. The disclose or abstain rule requires that a corporate insider such as Pegram either disclose material nonpublic information or abstain from trading on the information.
The Eleventh Circuit pointed out that in the case where the SEC first announced the "disclose or abstain" rule, In re Cady Roberts & Co., the SEC had recognized the possibility of a defense to insider trading charges based on a preexisting plan to trade. The Eleventh Circuit found that Cady Roberts was "an acknowledgment by the SEC" that the rebuttable-presumption approach was not inconsistent with the "disclose or abstain" rule.
Analyzing Pegram's 1989 trades, the Eleventh Circuit reversed the district court's grant of summary judgment, finding that "the strong inference that Pegram would have used the [material nonpublic] information in finalizing" his decision to sell the stock raised genuine issues of material fact for a jury to decide. The court also reversed the ruling in favor of Pegram on his 1992 trades, finding that, although Pegram's evidence rebutting the inference that he used material nonpublic information when trading was strong, "these fact-intensive issues should be decided by a jury . . . ." Finally, the Eleventh Circuit applied the same analysis to reverse the summary judgments granted in favor of the other defendants in the case. The entire case was remanded for trial, even though the court stated that certain defendants had failed to introduce sufficient evidence to rebut the inference.
In reaching its decision, the Eleventh Circuit emphasized that the SEC has the burden of showing that the defendant used the material nonpublic information he or she possessed at the time of the allegedly illegal trades. In assessing whether the agency had met its burden, the court recognized the validity of the types of circumstantial evidence the SEC often uses to prove insider trading — proof of contact with an insider and suspicious timing of trades. Finding that the SEC had presented such proof in Adler, the court inferred that the defendants possessed material nonpublic information and used it in their trades.
Since the SEC had met its initial burden, the court then shifted the burden of proof to the defendants. "[A] credible and wholly innocent explanation for [suspicious] sales and timing tends to rebut the inference." Adler suggested strongly that a plan to make the trades prior to any possible tip and innocent explanations for contacts with alleged tippers are persuasive evidence tending to rebut the inference. On the other hand, evidence that the trades are consistent with prior trading "is clearly not sufficient to rebut the reasonable inference" established by suspiciously timed contacts and trades.
Other courts are likely to follow Adler. The rebuttable-presumption approach adopted by the Eleventh Circuit is well reasoned, fair to both the SEC and defendants, and not a radical departure from past cases. Its ultimate impact may be an increase in the likelihood that juries, rather than courts ruling on summary judgment motions, will decide the issues in insider trading cases. The Eleventh Circuit required even Pegram, the defendant who had introduced strong evidence that his trading was innocent, to face a trial. Likewise, the SEC was required to go to trial against other defendants whom the Eleventh Circuit found had not introduced sufficient evidence to rebut the inference that they had obtained and used material nonpublic information in their trading.