Gordon Smith joins Larry Ribstein and James Joyner in wondering why Jeffrey Skilling was convicted on all the fraud and conspiracy but acquitted on all but one of the insider trading counts:
So the question remains: how could he have been engaged in fraud during 2000, but not been engaged in insider trading?
As I explain in my book Insider Trading, there is a long standing debate as to whether a defendant can be convicted for trading while merely in the possession of material nonpublic information or whether the defendant must have traded on the basis of such information. In this case, the jury instructions specifically required the jury to find beyond a reasonable doubt that Skilling traded not just while possessing but also on the basis of material nonpublic information. The jury instructions further explained that this meant that the government had to prove beyond a reasonable doubt that Skilling "used the material, nonpublic information in making his decision to sell Enron stock." My guess thus is that Skilling had a sufficiently plausible explanation for most of the trades (excepting the last trade, as to which there apparently was some sort of smoking gun), such as plan of regular trading or some personal reason for selling when he did.
In fact, according to the jury instructions, as to the set of trades challenged in Count 50 of the indictment, Skilling claimed he had a plan for regularly selling securities, which the court described as constituting a potential "complete defense" for the trades in question. In any case, because of the distinction between trading on the basis of material nonpublic information and trading while in possession of such information, there is no necessary inconsistency between the verdicts.
The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b-5’s scienter requirement. In United States v. Teicher, the Second Circuit agreed, albeit in a passage that appears to be dictum. An attorney tipped stock market speculators about transactions involving clients of his firm. On appeal, defendants objected to a jury instruction pursuant to which they could be found guilty of securities fraud based upon the mere possession of fraudulently obtained material nonpublic information without regard to whether that information was the actual cause of their transactions. The Second Circuit held that any error in the instruction was harmless, but went on to opine in favor of a knowing possession test. The court interpreted Chiarella as comporting with “the oft-quoted maxim that one with a fiduciary or similar duty to hold material nonpublic information in confidence must either ‘disclose or abstain’ with regard to trading.” The court also favored the possession standard because it “recognizes that one who trades while knowingly possessing material inside information has an informational advantage over other traders.”
The difficulties with the court’s reasoning should be apparent. In the first place, a mere possession test is inconsistent with Rule 10b-5’s scienter requirement, which requires fraudulent intent (or, at least, recklessness). In the second, contrary to the court’s view, Chiarella simply did not address the distinction between a knowing possession and a use standard. Finally, the court’s reliance on the trader’s informational advantage is inconsistent with Chiarella’s rejection of the equal access test.
In SEC v. Adler, the Eleventh Circuit rejected Teicher 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 choice between Adler and Teicher is difficult. On the one hand, in adopting the Insider Trading Sanctions Act of 1984, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information. In addition, a use standard significantly complicates the government’s burden in insider trading cases, because motivation is always harder to establish than possession, although the inference of use permitted by Adler substantially alleviates this concern.
On the other hand, a number of decisions have acknowledged that a pre-existing plan and/or prior trading pattern can be introduced as an affirmative defense in insider trading cases, as such evidence tends to disprove that defendant acted with the requisite scienter. Dictum in each of the Supreme Court’s insider trading opinions also appears to endorse the use standard. In light of the Circuit split that now exists between Teicher and Adler, the Supreme Court may eventually have to resolve the conflict.
In 2000, the SEC addressed 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, Rule 10b5-1 formally rejects the Adler position. In practice, however, the difference between Adler and Rule 10b5-1 may prove insignificant. On the one hand, Adler created a presumption of use when the insider was aware of material nonpublic information. Conversely, Rule 10b5-1 provides affirmative defenses for insiders who trade pursuant to a pre-existing plan, contract, or instructions. As a result, the two approaches should lead to comparable outcomes in most cases.
Rule 10b5-1 may not have applied to all the trades in which Skilling allegedly committed insider trading. Alternatively, the trial court may have been persuaded that SEC Rule 10b5-1 should not apply to criminal cases. Indeed, at least in the Ninth Circuit, not only is proof use, not mere possession, 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).
The Skilling trial court's pre-trial opinion denying Skilling's motion to dismiss the insider trading charges cited and discussed all the foregoing authorities, but did not attempt to resolve the discrepancies between them. Instead, the court simply held that it was "not persuaded that ¶ 120 fails to allege that he used material, nonpublic information when making the charged trades." At the very least, of course, this language does appear to adopt the use standard.
