On the flight back from my spring break ski trip, I had a chance to read the recent Tenth Circuit opinion reversing the insider trading conviction of former Qwest CEO, Joseph Nacchio. Mr. Nacchio had been convicted of 19 counts of insider trading, sentenced to six years in prison (plus two years’ supervised release), fined $19 million, and ordered to disgorge $52 million more. In a 2-1 decision authored by Judge McConnell, the Tenth Circuit reversed Nacchio’s conviction because of the district court’s exclusion of expert testimony by Dan Fischel (my corporations prof). The court also concluded that retrial will not constitute double jeopardy because a properly instructed jury could have found Nacchio guilty of insider trading. To reach that conclusion, the court had to delve extensively into the law of insider trading and the evidence presented at trial.
Here are a few thoughts on the decision.
Fischel’s Expert Testimony
The court was right to insist that Nacchio be allowed to present Prof. Fischel’s expert testimony. The government’s basic claim against Nacchio was that he sold Qwest stock after he learned that the company’s revenues were largely comprised of non-recurring sources, implying that the company would have a hard time meeting projected earnings. Nacchio maintained that he sold the stock not because he was trying to avail himself of an inflated stock price but because he wanted to diversify after he exercised soon-to-expire stock options. He also contended that the specific information to which he was privy (i.e., that much of Qwest’s revenue was non-recurring) was not “material” non-public information because the market didn’t react when the information was publicly disclosed.
Prof. Fischel was to testify (1) that Nacchio’s trading pattern was more consistent with a diversification strategy than with an attempt to profit from inside information and (2) that the stock price effect of the disclosure concerning Qwest’s non-recurring revenue suggested that the information wasn’t material. The district court ruled that Prof. Fischel wasn’t properly disclosed as an expert witness and that, in any event, his testimony wouldn’t “assist the trier of fact.”
I don’t want to get into the expert disclosure rules (where the district court apparently ignored distinctions between the criminal and civil contexts), but it seems clear to me that the district court was just wrong on the question of whether Fischel’s testimony would help a jury. Having taught Business Organizations a few times, I’ve seen that many smart, educated people are not aware of (1) why diversification is so important (and thus why sophisticated investors always diversify) and (2) how stock prices immediately incorporate material information. Fischel’s testimony would undoubtedly help jurors understand Nacchio’s defense. (More on this aspect of the decision from Jay Brown.)
Two Wrongs Don’t Make a Right (…as I said earlier)
One of Nacchio’s arguments was that his knowledge of pending deals with the government — deals that would have boosted Qwest’s revenue — immunized him from insider trading liability. This undisclosed “good news,” he argued, negated the materiality of the undisclosed fact that much of Qwest’s revenue was non-recurring. Moreover, he contended, the fact that he knew this information shows that he did not act with scienter (an intent to deceive).
I previously expressed skepticism about Nacchio’s defense. In a post titled Nacchio’s Puzzling (Innovative?) Defense, I wrote the following:
Is Nacchio claiming that it was OK for him to sell while in possession of material non-public bad news regarding company prospects because he also possessed material non-public good news? Is this a “two wrongs make a right” theory?…
Nacchio’s defense (or this part of it, at least) is that two “wrongs” do make a right because the second piece of non-public information to which Nacchio was privy when he traded (i.e., the likelihood of the lucrative defense contracts) would make the first piece (i.e., various bits of bad news at the company) immaterial. In other words, the theory seems to be that the totality of non-public information of which Nacchio was aware would not be something a rational investor would consider important in deciding how to invest (and thus would not be material), for Nacchio’s private negative information was counterbalanced by private positive information.
…I’m not optimistic for Nacchio.
It seems my skepticism was warranted. Upholding the district court’s decision to prohibit Nacchio from presenting classified information about the alleged government contracts, the Tenth Circuit quickly disposed of the “two wrongs” theory:
[E]ven if the classified information were presented and established what he said it would, it could not exonerate Mr. Nacchio as he claims. Essentially, Mr. Nacchio argued that undisclosed positive information can be used as a defense to a charge of trading on undisclosed negative information. We disagree. … If an insider trades on the basis of his perception of the net effect of two bits of material undisclosed information, he has violated the law in two respects, not none.
An Opening to Challenge Rule 10b5-1
Nacchio claimed that his sales were not illegal insider trading because he did not make them “on the basis of” material non-public information. Even if he possessed such information when he sold his stock, the information, he insists, did not cause the sales; he would have made them anyway in order to exercise his options and achieve diversification. Thus, the sales were not “on the basis” of material non-public information.
If one were to look only to the securities regulations, Nacchio’s position would seem doomed. The SEC’s Rule 10b5-1 states that any securities trade made while “aware” of material non-public information is made “on the basis” of such information, unless the trade was made pursuant to some securities trading plan executed before the trader became aware of the information. Thus, if you possess material non-public information, and you trade, and your trade wasn’t pursuant to some previously executed contract or instruction or “written plan for trading securities,” you’re in trouble.
But that rule would seem to read the “scienter” element out of an insider trading claim. The law prohibiting insider trading, Section 10(b) of the Securities Exchange Act, prohibits only “manipulative or deceptive device[s] or contrivance[s]” that contravene SEC rules. This language would seem to require some intent to deceive (or at least recklessness), and the Supreme Court has interpreted it accordingly. In a prominent insider trading case, Dirks v. SEC, the Court was careful to emphasize that “[t]here must also be ‘manipulation or deception’ in an insider trading case,” and it said the following about the required scienter element:
Scienter — “a mental state embracing intent to deceive, manipulate, or defraud” — is an independent element of a Rule 10b-5 violation. Contrary to the dissent’s suggestion, motivation is not irrelevant to the issue of scienter. It is not enough that an insider’s conduct results in harm to investors; rather, a violation may be found only where there is “intentional or willful conduct designed to deceive or defraud investors by controlling or artificially affecting the price of securities.”
(Note 23, citations omitted.)
Thus, it would seem that proof of “intent to deceive, manipulate, or defraud” is required to establish illegal insider trading. Rule 10b5-1 would impose liability without such proof, but that rule, promulgated by the SEC, can’t go further than the authorizing statute, Section 10(b). The rule, then, may be invalid. (For more on this, check out this from Prof. Bainbridge.)
On remand, Nacchio is almost certain to challenge the validity of Rule 10b5-1. Judge McConnell’s opinion invites him to do so. It notes that “[s]ome commentators maintain that [Rule 10b5-1] (the authority of which has not been resolved by any circuit) is unlawful because it effectively eliminates fraud from the liability standard.” Watch for Nacchio’s lawyers to seize on this argument when fighting over jury instructions on remand.
A Lenient Materiality Standard
Finally, the Tenth Circuit’s decision is notable for adopting a very lenient standard for the “materiality” of non-public information. The non-public information at issue in this case suggested that earnings targets were overstated. Nacchio argued that this information was not material because the degree of overstatement was so slight. He contended that the degree of overstatement was 1.4% of total revenues; the government maintained that it was 4.2%. In either event, Nacchio’s argument would seem to be fairly strong. The Tenth Circuit noted that “[c]ourts regularly look to the magnitude of a potential loss in determining whether knowledge of it is material,” and it cited an unpublished Ninth Circuit decision concluding that “[revenue] projections which are missed by 10% or less are not generally actionable.” (In re Apple Computer, Inc., 127 F. App’x 296, 204 (9th Cir. 2005).) It also quoted from an SEC accounting bulletin in which the accounting staff assessed the “common ‘rule of thumb’ among accountants ‘that the misstatement or omission of an item that falls under a 5% threshold is not material in the absence of particularly egregious circumstances.'” In that bulletin, the accounting staff stated:
The use of a percentage as a numerical threshold, such as 5%, may provide the basis for a preliminary assumption that–without considering all relevant circumstances–a deviation of less than the specified percentage with respect to a particular item on the registrant’s financial statement is unlikely to be material. The staff has no objection to such a “rule of thumb” as an initial step in assessing materiality. But quantifying, in percentage terms, the magnitude of a misstatement is only the beginning of an analysis of materiality; it cannot appropriately be used as a substitute for a full analysis of all relevant considerations.
Given the accounting staff’s unwillingness to create a real safe harbor for revenue deviations of less than 5% of projections, the Tenth Circuit was unwilling to conclude that Nacchio’s non-public information about a likely revenue shortfall (which the court measured at 4.2% of projections) was immaterial. So much for the rule of lenity.
(More on the materiality ruling here.)
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So what’s going to happen on remand? Jay Brown thinks Nacchio’s prospects are pretty grim. I’d perhaps offer a brighter prognosis. If Nacchio can get the court to reject Rule 10b5-1’s “awareness” standard, so that the government must prove that the material non-public information caused the sales at issue AND if Fischel sets forth a convincing case for why the stock trades must have been accomplished as part of a diversification strategy, not as an attempt to profit from inside information, then he has a shot.
Of course, those are some big ifs. Nacchio’s best approach might be a plea bargain. I, of course, hope he doesn’t do so so that a court can directly confront Rule 10b5-1’s overbreadth.