The SEC's civil suit against former Enron CEO Ken Lay charges Lay with insider trading; alleging that:
Lay took advances on a non-collateralized $4 million line of credit with Enron in the total amount of $77,525,000. Thereafter, in twenty separate transactions, Lay repaid the credit line by selling $70,104,762 worth of Enron stock back to the company, at prices he knew did not accurately reflect Enron's true financial condition.
In contrast, the Justice Department's criminal indictment of Lay does not allege insider trading. Why not?
Lay has defended the transactions in question by arguing that he needed to raise cash to satisfy margin calls on stock:
Lay insisted that his sales of Enron stock were made to meet margin calls, which are demands to pay back loans made to buy the stock, that kicked in as Enron's stock price dropped in late 2001. Lay noted that he tried to do everything he could to hold onto his Enron shares, including using a $10 million company bonus, instead of stock, to pay down debt.
Lay's defense raises a technical, but highly important issue in the law of insider trading; namely, can one be held liable for insider trading where the government merely shows that one possessed material nonpublic information at the time of the trade in question or must the government show that one used that information (i.e., that one traded on the basis of that information)? [The following discussion is excerpted from my book Securities Law: Insider Trading.]
The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b-5, the regulatory provision governing most insider trading (including that of Ken Lay). The difficulties with the SEC’s position, however, are readily apparent to any securities lawyer. Most importantly, a mere possession test is inconsistent with Rule 10b-5's scienter requirement, which requires a showing that the defendant had intent to defraud (or, at least, acted recklessly).
In SEC v. Adler, 137 F.3d 1325 (11th Cir.1998), the Eleventh Circuit rejected the SEC’s position in favor of a use standard. Under Adler, "when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade—i.e., that the information was not used." Although defendant Pegram apparently possessed material nonpublic information at the time he traded, he introduced strong evidence that he had a plan to sell company stock and that that plan predated his acquisition of the information in question. If proven at trial, evidence of such a pre existing plan would rebut the inference of use and justify an acquittal on grounds that he lacked the requisite scienter.
The Ninth Circuit subsequently agreed with Adler that proof of use, not mere possession, is required. The Ninth Circuit further held that in criminal cases no presumption of use should be drawn from the fact of possession—the government must affirmatively prove use of nonpublic information. United States v. Smith, 155 F.3d 1051 (9th Cir.1998).
In 2000, the SEC tried to resolve this issue by adopting Rule 10b5-1, which states that Rule 10b-5's prohibition of insider trading is violated whenever someone trades "on the basis of" material nonpublic information. Because one is deemed, subject to certain narrow exceptions, to have traded "on the basis of" material nonpublic information if one was aware of such information at the time of the trade, however, Rule 10b5-1 rejects the Adler/Smith position. In its effect, if not in its precise language, Rule 10b5-1 tries to resurrect the mere possession test.
Did the SEC have authority to adopt Rule 10b5-1 in the face of contrary judicial holdings? The SEC cannot adopt rules that go beyond the scope of the statutes authorizing them. Admittedly, there is some evidence that supports the SEC’s position. In adopting the Insider Trading Sanctions Act of 1984, for example, Congress imposed treble money civil fines on those who illegally trade "while in possession" of material nonpublic information.
The bulk of the evidence, however, raises serious doubts as to the validity of Rule 10b5-1. The Supreme Court has consistently held that Section 10(b) of the Securities Exchange Act, which provides the authority under which Rule 10b-5 was adopted, prohibits only fraud and manipulation. In turn, as we have seen, fraud requires proof that the defendant intended to deceive (i.e., scienter). Indeed, the Supreme Court explained in Dirks that "[i]t is not enough that an insider's conduct results in harm to investors; rather a violation [of Rule 10b-5] may be found only where there is 'intentional or willful conduct designed to deceive or defraud investors.' " Dirks v. SEC, 463 U.S. at 646, 663 n. 23, (1983). Yet, as the Ninth Circuit pointed out in Smith, “a knowing-possession standard would … go a long way toward making insider trading a strict liability crime.” Second, as the Ninth Circuit also noted, “the Supreme Court has consistently suggested, albeit in dictum, that Rule 10b-5 requires that the government prove causation in insider trading prosecutions.” In other words, the government must prove that the defendant used the inside information in making the relevant trading decisions.
Bottom line? I’m guessing that the Justice Department is loath to rely on Rule 10b5-1. Instead, the Justice Department seems to assume that Smith is the law of the land. If Ken Lay had a plausible argument that his trades were intended to satisfy margin calls, the government would have a very difficult time proving beyond a reasonable doubt that he used inside information in connection with the trades. Lay would be in the position of a forced seller, who would have traded anyway. In contrast, the SEC’s complaint makes clear that it is relying on Rule 10b5-1 and going forward on a mere possession basis. If Lay defends himself as vigorously as he claims, perhaps the Lay case will finally give us a definitive ruling as to the validity of the Rule.
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