Justice Deferred Justice Denied

OfficeMeetingThe government files insider trading charges with much fanfare, declaring that the traders will be brought to justice and investors protected. But it is often years before the cases ever reach a courtroom, and a change in the law in December 2014 is making it more difficult for the Securities and Exchange Commission to prove violations in two cases that will start in the New Year.

In the first case, filed in 2013, the S.E.C. brought an administrative charge against Steven A. Cohen over his failure to supervise two employees accused of engaging in insider trading at his hedge fund firm, SAC Capital Advisors. This came after the firm settled criminal charges by paying a $1.2 billion penalty and withdrawing from the management of outside money, leading to its change to a family office operating under the name Point72 Asset Management. The S.E.C. wants to bar Mr. Cohen from acting as an investment adviser for failing to properly supervise Mathew Martoma and Michael Steinberg, portfolio managers at SAC who were indicted on charges of trading on nonpublic information on behalf of the firm. Juries convicted both men in separate trials, with Mr. Martoma’s case involving what the government asserted was the largest amount ever involved in insider trading, totaling nearly $275 million in gains and losses avoided. The administrative proceeding was postponed until the criminal cases were wrapped up. The second case, filed in 2014, involved civil insider trading charges against Daryl M. Payton and Benjamin Durant III, who received information about I.B.M.’s plan to acquire SPSS indirectly from one of the lawyers working on the deal. That case was also halted until resolution of a parallel criminal case in which four defendants, including Mr. Payton, had originally pleaded guilty while Mr. Durant planned to go to trial on the charges.

Both cases looked like near-certain victories for the S.E.C. until the United States Court of Appeals for the Second Circuit in Manhattan overturned the insider trading convictions of two hedge fund managers in United States v. Newman. That December 2014 decision made it harder to prove a case involving tipping inside information between friends because the government must meet a higher standard to establish the requisite relationship between the source and the recipient, called the tippee. No longer will mere friendship suffice to show that a benefit flowed from passing the information. The appeals court held that the government must offer proof of “a meaningfully close personal relationship that generates an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature” between the tipper and tippee. The Supreme Court turned down the Justice Department’s request to review the lower court’s decision, leading prosecutors to dismiss charges against a number of defendants, including Mr. Steinberg. The S.E.C. also dismissed its civil insider trading case against Mr. Steinberg, undercutting one of the pillars on which it built its case against Mr. Cohen because the conduct could no longer be considered illegal. The S.E.C. plans to amend its charge against Mr. Cohen on Monday to eliminate the references to this trading, limiting the failure-to-supervise claim to Mr. Martoma’s transactions. Yet the agency still wants to use Mr. Steinberg’s trading to prove its charge. In a filing with the administrative judge shortly before Christmas, the S.E.C. said it still intended to offer evidence of Mr. Cohen’s supervision of Mr. Steinberg to show his “liability for failing to supervise Martoma and the need for appropriate relief,” which Mr. Cohen’s lawyer are sure to oppose.

The S.E.C.’s Rules of Practice require that irrelevant evidence be excluded from the administrative proceeding. Conduct that is not illegal would seem to be extraneous to proving a supervisor fell short in his oversight responsibilities. The agency may argue that even if Mr. Steinberg’s trading was not illegal, it was still a “red flag” when he used confidential information in placing profitable trades, something that Mr. Cohen should have monitored more carefully. That is a bit of a stretch because it would allow evidence of any questionable transaction to be used to show Mr. Cohen’s negligence in not supervising employees, even if the behavior was not illegal. Without evidence of Mr. Steinberg’s purchases, it may be difficult for the S.E.C. to establish that Mr. Cohen ignored indications of impropriety at SAC Capital when the only instance of insider trading is by Mr. Martoma – one red flag may not be enough to prove a failure to supervise. Unless there is a negotiated settlement of the charge, one avenue open to Mr. Cohen is to file a constitutional challenge to the appointment of the S.E.C.’s in-house judges. A number of defendants in other cases have filed such challenges, and district court judges in Atlanta and Manhattan halted administrative proceedings because the judges were not properly appointed. So the S.E.C. faces the prospect that its case against Mr. Cohen could be delayed even further if he chooses to pursue this option. The civil case against Mr. Payton and Mr. Durant is likely to be the first one in which the full impact of the decision in the Newman case will be tested in court. Shortly after that opinion came out, a district court judge dismissed criminal charges against the defendants who traded and tipped on the SPSS acquisition, including those who pleaded guilty. But the S.E.C. persisted in pursuing the lawsuit, unlike its decision to dismiss the civil case against Mr. Steinberg. Judge Jed S. Rakoff of the Federal District Court for the Southern District in Manhattan, who is presiding over the S.E.C. case that is set to start on Feb. 16, issued an opinion last week explaining that a jury had to decide whether the relationship between the tipper and the initial tippee, who were roommates in Manhattan, was close enough to find a benefit was conferred in exchange for the information. The roommates previously settled with the S.E.C., but their relationship is the key to proving whether Mr. Payton and Mr. Durant should have known a benefit was passed to the tipper in exchange for the information about I.B.M.’s plan to acquire SPSS that they eventually traded on. The evidence the jury will consider about their relationship includes “that they together ate dinner, drank beers, played video games, watched TV, used drugs and discussed their respective days, current events and personal details of their lives.” It will be interesting to see whether the daily life of young Manhattan professionals will be sufficient to prove a “meaningfully close personal relationship.”

Because this is a civil case, the losing side is almost certain to appeal, unlike a criminal prosecution in which a “not guilty” verdict would bring the case to a close. Judge Rakoff’s instructions on the elements of a violation and the strength of the S.E.C.’s evidence are sure to be crucial issues on any appeal, giving the appeals court a chance to explore further what kind of relationship is sufficient to prove a violation for tipping inside information. For the S.E.C., the cases provide a test for how much of an impact the decision in the Newman case has for proving insider trading. What started with great promise may turn out to be much more troublesome.