A View of Insider Trading Trials

By Michael A. Collora

Published:  October 16, 2009, course material for ABA Fourth Annual National Institute on Securities Fraud

Insider trading trials, either civil and criminal, are not common given the number of allegations and investigations conducted by the SEC, and the number of civil cases and indeed even criminal filing brought by the authorities. One reason of course is that both the SEC and the Department of Justice rarely bring a case where they think the evidence is doubtful (even though eventually an element may be disputed). Thus their preliminary investigation rules out many weak cases before an actual claim is brought. In addition, often the defendant is offered a deal he or she cannot refuse, such as lesser jail time, or a minimum financial civil penalty. Thus the case settles, either civilly, criminally or both. 

The occasional case of course does go to trial. To show the complexity of these often daunting cases, we review one recent criminal case, and one recent civil case, to show what the issues can be, how they are resolved, and the consequences. 

A Criminal Trial

A criminal case of note which is still ongoing and worth analyzing, is that brought by the United States against Joseph Nacchio, the former CEO of Quest Communications. The indictment was originally filed in late 2005, alleging that Nacchio traded company stock for his profit during a time when the information he possessed was not available to the public. See United States v. Nacchio, CR 1:05-00545 (D.Col.) (hereafter “Docket # __”).

The case has been expensive to prosecute for both sides and is not yet over as of this writing. Nacchio was convicted by a jury in April 2007 when it found Nacchio criminally liable on the first 23 Counts, and not guilty on Counts 24-42. The Court sentenced Nacchio to imprisonment for 72 months and a fine of $19 million. He appealed, won, lost and the Supreme Court now has the case.

Pretrial Proceedings

There were over 280 docket entries in the case, pre-trial. Among them Nacchio filed a motion to dismiss based partly upon prosecutorial misconduct (Docket # 57), general discovery motions (Docket # 65) including requesting expert summaries (Docket # 69) (and later a motion to change venue due to excessive publicity (Docket # 113))

The Court in U.S. v. Nacchio,  2006 WL 2475282 (D.Col.) (8/25/06) (Docket # 147) summarized the Indictment and denied the motion to dismiss; it did grant some relief by requiring further answers to a Bill of Particulars. All other motions were basically denied that date as well. See Docket # 151. Later that year, defendant sought and was denied the Government’s instruction to the Grand Jury. See U.S. v. Nacchio, 2006 WL 3292818 (D.Col., 11/3/06).

Nearing trial, defendant in early 2007 sought to exclude the Government’s proposed expert regarding backdating of a pre-set trading plan designed by Nacchio to periodically sell Quest stock. The plan permitted some of the sales at issue to be sold when ordinarily insiders could not sell. While conceding relevance, defendant argued disclosure of this expert was late. The court agreed with defendant as to the late disclosure, noting it failed to comply with Cr.Rule 16(a)(1)(G). Rather than continue the trial date, it excluded the evidence although noting that expert might still be used in rebuttal. Id. See U.S. v. Nacchio, 2007 WL 4688422 (D.Col., 3/22/07). Since timing was in issue, it permitted the Government to open with what evidence it had as to backdating but for the expert. See Order, 3/16/07 (Docket # 283). 

Timing of expert disclosures later became a major issue. It is ironic in light of Nacchio’s motion that defendant then did not disclose his expert until March 16, 2007. Trial began March 19, 2007 and took 16 days. Nacchio expert was excluded during trial from giving certain opinions both on the basis of late disclosure, and also Daubert. 

The import of a pre-filed plan to sell options was at the heart of the trial and ultimately the government prevailed. Nacchio had launched a substantial battle to convince the jury he could sell when he did and he made a major effort to exclude certain types of 404(b) evidence. See Nacchio Trial Brief, Docket # 364 (dated 3/9/07). Ultimately he was unsuccessful.

Defendant was convicted; he was not only sentenced to serve six (6) years but fined $19 million and ordered to forfeit $52 million.

Post-Trial Proceedings

After sentencing, itself quite contested, the case then went through a tortured history on appeal.  Nacchio was initially successful before a panel of the Tenth Circuit, in obtaining a reversal based the lower court’s improper exclusion of his expert on Daubert grounds. See United States v. Nacchio, 519 F.3d 1140 (10^th Circuit, 2008). In a split decision, that panel did find the evidence was sufficient over arguments that the undisclosed information was not material. There was also an extended and useful discussion of the jury instructions. The case was remanded so he could be retried.  

On reapplication by the United States, the 10^th Circuit en banc in a split decision ruled that the District Court properly excluded the expert proffered by the defendant. See United States v. Nacchio, 555 F.3d 1234 (10^th Circuit 2009) petition for cert. granted (08-1172). The previous dissenting judge, now in the majority, wrote that in a lengthy opinion that the expert’s proffered opinions were properly excluded under Daubert. The conviction was affirmed, and the case was returned to the panel which decided the original matter, which then had to decide sentencing issues because there were challenges by Mr. Nacchio to the determination by the District Court as to his gain, which affected the term and fine, and forfeiture

As to the gain, Mr. Nacchio had exercised certain options and then sold the underlying stock during the period in question.  According to the Government, Mr. Nacchio’s gain was approximately $44 million. On the other hand, Nacchio’s expert indicated that the maximum made from simply the non-disclosure of the information at issue resulted in profit of only $1.8 million. At sentencing the District Court had reached the sum of $28 million for sentencing purposes, deducting taxes on the gain asserted by the government. Nacchio was then fined $19 million but also been ordered to forfeit $52 million. 

In its new opinion, the 10^th Circuit panel pointed out that normally in an insider trading case the loss if any is difficult to compute but that usually the gain i.e. the total increase in value realized by the improper trading, is to be used as the standard for sentencing purposes. See U.S. v. Nacchio, 2009 WL 2343716 (10^th Cir., 2009). The panel decided to adopt the plain language of § 2F 1.2 (2000) of the Sentencing Guidelines and limited the definition of “gain” for an insider trading defendant to that “gain” resulting from the offense, i.e. the use of the insider trading information. It relied upon the dissent in U.S. v. Mooney, 425 F.3d 1093 (8^th Cir., 2005) (en banc) to the same effect. It stated non-disclosure of the information held by Nacchio likely maintained the Quest stock at an artificial level and that must be the basis upon which the District Court should sentence; it remanded the case to the District Court for re-sentencing.

In the meantime, while Mr. Nacchio awaits re-sentencing, his case on the merits is now with the Supreme Court, which may accept the case this Fall. He is in jail. See U.S. v. Nacchio, 608 F. Supp. 1237 (Col., 2009) (denial of bail and a new trial). 

A Civil Trial

Matching some of the difficulty and complexity surrounding the trial of Mr. Nacchio, was a civil case recently decided, Securities and Exchange Commission v. Steven Nothern, Civil l:05-10983 (D. Mass.) There, the civil jury reached a verdict for the SEC

The case began when one Peter Davis, a Washington, D.C.-based consultant, attended a Treasury Department quarterly refunding conference on October 31, 2001. At the time he learned that the Treasury Department intended to cease issuance of the 30-year so-called “long bond”. Apparently a diminished amount of such bonds would increase the value of the outstanding ones and thus it was valuable to know such information ahead of time. According to the SEC and later by Davis’ acknowledgement in both civil and criminal cases, he broke his agreement with Treasury to not reveal this information during a time when it was embargoed and called several of his clients. Davis was sued civilly and settled with the SEC, disgorging his consulting fees and a penalty of $120,000. He was also prosecuted criminally and received a probationary sentence. See U.S. v. Davis, 1:03-cr-01054 (S.D.N.Y.).

The first client Davis called shortly after the conference was one John M. Youngdahl at Goldman Sachs & Co. Youngdahl, realizing the value of the information, advised traders at Goldman’s U.S. Treasury desk and they bought, apparently generating a profit of $1.5 million. Youngdahl was sued by the SEC and settled; he paid a civil penalty of $240,000 and was barred from the industry. See SEC Lit. Rel. 18453 (11/12/03). In addition, he was prosecuted criminally and sentenced to 33 months. See United States v. Youngdahl, 1:03-00991 (S.D.N.Y.). Goldman Sachs also paid, disgorging the trading profits and a penalty of $5 million. 

However, Youngdahl was not the only individual called. Davis also called Stephen Nothern then a senior vice president and manager at Massachusetts Financial Services Company. Apparently acting on this information, Nothern told his managers to buy $65 million worth of long bonds generating an ultimate profit of $3.1 million. Nothern was not criminal prosecuted and refused to settle.

Pre-trial Motions

The civil case against Nothern was initially filed in the Southern District of New York in 2003 where jurisdiction of him was disputed; the complaint was re-filed in Massachusetts in 2005 and went to trial in 2009. The Docket reflects approximately 255 entries prior to trial. See SEC v. Nothern, 05-10983 (D. Mass.). 

The complaint alleged Nothern’s use of material non-public information received from Davis and claimed Nothern was allegedly aware of Davis’ obligation to maintain the confidentiality of the information. It went on to say this trading was a violation of Section 10(b) and Rule 10(b)5 of the 1934 Act. The SEC sought an injunction, disgorgement of profits, interest and monetary penalties. 

In Nothern’s answer he disputed the use of insider information and asserted a defense (among others) of estoppel. In his estoppel argument Nothern had argued that Treasury impermissibly allowed Nothern’s consultant access to the material information and failed to enforce the embargo. 

Ruling promptly, the Court denied an estoppel defense. See SEC v. Nothern, 400 F. Supp. 2d 362 (D. Mass. 2005). According to the Court’s summary of the complaint and evidence proffered during the argument, Nothern had traded prior to 9:43 a.m. on 10/31/01, after which time the public was notified of the suspension of the long-term bond; Nothern himself made a $1.4 million purchase for the portfolios he managed. Normally said the Court, estoppel does not apply against the federal government except in the most extreme circumstances, citing Dantram, Inc. v. United States Department of Labor, 171 F.3^rd 58 (1^st Circuit 1999). In any event, the court pointed out that Nothern wasn’t at the press conference so he could not have relied to his detriment on any misrepresentation of fact by Treasury. Further he has not been able to show any affirmative misconduct by the government. Consequently that defense was overruled. 

Discovery then ensued. Nothern sought production of documents from Treasury and from the Department of Justice, which they resisted and he also sought to take depositions of certain Treasury officials which Treasury opposed, citing United States ex rel v. Touhy, 340 U.S. 462 (1951).  In opposition, the SEC took the position that it was an independent legal entity and thus did not possess nor control the documents or people at issue. The Magistrate/Judge, persuaded that the agency was independent, said it could not be forced to obtain the requested documents from Treasury. It therefore denied the motion to compel and motion for show cause. See docket Securities and Exchange Commission v. Nothern, # 63. (1/24/07) (hereafter “Docket # ___).

In another discovery dispute, Nothern sought interview memoranda for five individuals jointly conducted by DOJ and the SEC. The SEC claimed that these were work product and the subject of the “common interest” agreement with the DOJ and deserving of work product protection. See SEC opposition, Docket # 69. The Magistrate/Judge held that the interview notes were prepared in anticipation of litigation by the DOJ and the SEC and there was no waiver given the common interest in the litigation by both agencies. See Ruling dated 5/31/07, Docket #s. 82 and 83. 

Following factual discovery, there was the expected dispute about purported expert witnesses. Unusual for most insider trading, was the issue of the exact timing of the disclosure, as apparently if Nothern had acted several minutes later, the information he had obtained from Peter Davis would have been public at that point and he would be off the hook. Thus when he received the information and when he acted upon it was important.  Several experts were deposed to testify about the timing of the disclosure, its availability, etc. Nothern sought to exclude the government’s expert on this topic. See Docket ## 124 and 125. 

In turn the SEC moved to exclude the purported expert testimony of one Bentley who was prepared to testify about news embargos, their ineffectiveness, non-bindingness, etc.; the SEC argued these opinions were irrelevant. See SEC motion dated 11/14/08, Docket #s 133 and 134. 

The Court, in a short order dated 5/22/09 overruled Nothern’s motions, denied the SEC’s motion in limine re: Bentley, then forced the SEC to limit offering portions of Nothern’s depositions since he would be available for testimony and finally limited testimony at trial to 20 hours for each party including cross-examination. See Docket # 225.

Just prior to trial, the court ruled on Nothern’s motion for summary judgment. In that motion Nothern attempted to argue it was undisputed that Nothern had traded on already public information, or that the embargo was unenforceable under the First Amendment, or Davis owed no fiduciary duty to Treasury, or that Nothern was unaware of Davis’ duty, if he had one. 

The Court overruled this motion and ordered the matter to trial. See SEC v. Nothern, 598 F. Supp. 2d 167 (D. Mass., 2009). According to the Court, the SEC had offered enough evidence that the key trade (which apparently occurred at approximately 9:42 a.m.) was based on non-public information since the information regarding the termination of the long bond, was solely in a computer staging server and not actually available to the public. In addition the SEC was able to show that attendance at the press conference announcing the termination of the long bond was limited and everyone was requested to obey an embargo, which embargo the court held was constitutional. Further said the Court, Davis had an obligation of confidentiality which was passed on to the tippee. At issue was SEC Rule 10(b)5-2(b) which the SEC had enacted to further define under what circumstances information may be considered confidential. The SEC had evidence that Davis through his own testimony had agreed to keep the information confidential.  The Court said that new SEC rule did not expand liability under Section 10(b) of the 1934 Exchange Act and upheld the Rule. Thus the matter was ready for trial. 

Both parties submitted proposed jury verdicts. The SEC’s submittal was rather brief, see Exhibit A attached hereto. The defendant’s however was quite elaborate, asking the jury to respond to a number of questions. See Exhibit B attached hereto. The Court adopted the SEC’s version, and the jury after a ten day trial, entered a verdict for the plaintiff SEC in the form requested. See Exhibit C. 

Prior to the end of trial the defendant had filed a motion for judgment along with a legal memorandum dated June 19, 2009. See Docket Nos. 253 and 254. The SEC of course filed an opposition. See Opposition dated 6/21/09 Docket # 255. The motion filed by the defendant tracked its motion for summary judgment, claiming Peter Davis did not owe Treasury a fiduciary duty and consequently Nothern did not derivatively owe Treasury a fiduciary duty. The Court overruled that motion and permitted the matter to go to the jury. 

Conclusion

I hope the above summaries of the dockets and rulings may be of use to those of you with insider trading cases. Both the criminal and the civil defendant fought the government’s allegations with vigor, and did so in an almost exhaustive manner. Perhaps nothing less will do. However, few defendants can afford such a defense, which at least as of this date has not yet been successful for either of them.