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Analysis: New approach to “insider” gains


A major dispute over how severely to punish a corporate “insider” who makes gains from trading in the company’s stock with information other investors don’t have seemed a likely bet for Supreme Court review.  But that won’t happen now: the Justice Department has decided not to test the question further, after losing on it recently in the Tenth Circuit Court.

In a direct conflict with the Eighth Circuit Court, the Tenth Circuit on July 31 adopted a new theory on stock market activity that can have the effect of sharply reducing the amount of money an executive made on “insider” transactions, leading to a required lowering of the criminal sentence for conviction of that crime.  The Tenth Circuit ruled in the case of a former telecom tycoon, Qwest’s former CEO, Joseph P. Nacchio. ( The ruling can be found here; thanks to Howard Bashman of How Appealing blog for the alert.)

Nacchio was convicted of 19 counts of “insider” trading, based on sales of Qwest stock between April 26, 2001, and May 29, 2001, using inside information about the risks that the company might not make its projected revenue targets for that year.  He was sentenced to six years in prison, fined $19 million, and ordered to forfeit about $52 million.  (Nacchio has appealed to the Supreme Court to challenge his conviction, in Nacchio v. U.S., docket 08-1172.  The documents in that proceeding — not involving the sentencing issue — can be found under the docket number in this list of cases.  That case had been ready for the Justices to act last Term, but the Court then called for the lower court record; the petition will be considered in the new Term.)

After the Tenth Circuit had upheld his conviction, Nacchio pursued a separate challenge to his sentence, contending that the trial judge misapplied the federal Sentencing Guidelines. He won on his key legal point in the Circuit Court’s July 31 ruling.

In general, the  Circuit panel adopted a variation of the so-called “market absorption theory,” as applied directly to “insider” trading.  Simply put, this theory suggests that, if an “insider” trades on private information about the company, the gain made from the transactions will be reduced if there is evidence that — once all investors had access to that information — the market absorbed it, so that any gain beyond that point for the “insider” would be due to market activity, not the continuing effect of the illegal trading.

Only two federal appeals courts have ruled on that theory. The Eighth Circuit rejected it in its 2005 divided en banc decision in U.S. v. Mooney.  Embracing the views of the Eighth Circuit dissenters, and creating a direct conflict, the Tenth Circuit embraced the theory.  That conflict increased the prospect that the Supreme Court could take up the issue.  But, the Justice Department will not test it in the Nacchio case, either by seeking Circuit en banc review or by filing a Supreme Court petition.  “We will not be seeking further review,” a Department spokesperson, Beverley Lumpkin, said on Tuesday in response to a query.

Joseph Nacchio made a total gain on his Qwest trading, selling 1,255,000 shares, in the spring of 2001 that added up to $52.007,545. That included $7,315,000 as costs of exercising stock options, brokerage fees of $60,081 and taxes of ‘$16,078.147.   Before sentencing, prosecutors argued that his prison sentence should be calculated based on gains resulting from his crime, totaling $44.6 million — the total gain less the cost of exercising the options.  Nacchio’s counsel, however, argued that, using a market absorption theory, the net gain that could be traced to his use of inside information was only about $1.8 million.  The difference is not only significant in dollar amounts, but in their effect on sentencing: the government approach would mean a federal Guidelines sentence ranging from 70 to 87 months, while Nacchio’s approach would mean a range of 41 to 51 months.

The trial judge rejected both sides’ arguments, followed the Eighth Circuit majority view, and found the gain attributable to Nacchio’s illegal trading at $28 million.  That was based on a calculated net gain after costs of  $44.7 million, less $16.1 million in taxes.  The $28 million, the judge concluded, was “the total increase in value realized through” illegal trading.  That produced a Guidelines range of 63 to 78 months; the judge chose 72 months.

The Circuit Court rejected the District Court analysis, concluding that Nacchio’s gain “should be calculated in a manner that is more narrowly focused on producing a figure that reflects, in at least approximate terms, the proceeds related to his criminally culpable conduct.”  It did not go ahead and make a new calculation, instead sending the sentencing issue back to District Court with guidance on the analysis it should use.

The dispute centers on a phrase in the Sentencing Guidelines, basing sentencing of “;insiders” on the “gain resulting from the offense.”  A Guidelines commentary says further that gain here means “the total increase in value realized throught rading in securities” by the insider.

The Eighth Circuit said that wording means the total profit actually made from illegal trading.  The Tenth Circuit, however, interpreted the Guideline wording (but not the commentary language) to mean that gain is only the amount that can be traced to the illegal conduct itself — that is, to the executive’s use of deception in trading company stock.  If the private information becomes public, and the market then absorbs that information, according to the Tenth Circuit, the deception has ended; the market in the company’s shares then goes on, “unmolested by any deception.”  Since it is not illegal for an “insider” to trade in company stock unless he or she does so with the device of private information, only the deception’s effect should be punished, the panel concluded.

The market’s adjustment to the released information, according to the theory, may result thereafter in fluctuation but those are the result of other factors, and the effect of the deception no longer accounts for further gains in the stock’s value.  In Nacchio’s case, the private information he had possessed when he made his spring 2001 deals came out in public later in 2001.

The Tenth Circuit, in fashioning its version of the absorption theory, turned in part to the contours of a “disgorgement remedy” that the Securities and Exchange Commission uses in the civil, not the criminal, context.  In doing so, it borrowed ideas from the Supreme Court’s 2005 decision in Dura Pharmaceuticals v. Broudo, cautioning in a civil fraud context against focusing solely on the price of  stock on a single day in calculating the loss suffered by the fraud victim.  The Guidelines, the Tenth Circuit said, should not peg other investors’ loss from deception to a simple calculation of total gain realized by the “insider.”

Nacchio’s appeal, besides challenging his 72-month prison sentence, appealed the District Court’s order that he forfeit all of the $52 million found to have been gained.  However, his counsel did not argue against a high forfeiture figure well beyond the $1.8 million gain that he insisted was the whole of his gain.   The Circuit Court ordered the trial judge to use a different legal framework for calculating the forfeiture amount.

The Circuit Court did not decide another claim by Nacchio: that the $19 million fine was excessive under the Eigthh Amendment’s “cruel and unusual punishment” clause, leaving that issue to the District Court after it figures a new forfeiture amount, and compares that to the fine.