Tag: Rule 10b-5

Do Section 10(b) and Rule 10b-5 Apply Outside of the U.S.?

Spoiler Alert: No, and this applies to civil and criminal matters, according to the Second Circuit.

Link:  U.S. v. Vilar 

Amid a selection of evidentiary and litigation-y claims, the recent 2nd Circuit case of U.S. v. Vilar did have some interesting nuggets for securities professionals.  Looking at an open issue following the U.S. Supreme Court case of Morrison v. National Australia Bank Ltd., the court looked at whether criminal liability under the Securities Exchange Act of 1934 extended to conduct outside the U.S.

Morrison was a civil case that limited Exchange Act Section 10(b) and Rule 10b-5 to domestic transactions in securities.

Background

The defendants were investment managers and advisers managing up to $9 billion before the tech bubble burst.  They offered select clients the opportunity to invest in securities that paid a high, fixed rate of interest, which were backed primarily by high quality, short-term deposits.  However a portion was invested in publicly traded emerging growth stocks.  See where this is going?

The bubble burst and the defendants were not able to meet the interest payments.  They created another investment vehicle and sold it to an investor, using the proceeds to settle a portion of the previous securities and for various personal expenses.  This investor complained to the SEC after demands to return her funds were met with questionable responses.

The defendants were convicted on a variety of securities, mail and wire fraud counts.

The Argument

Relying on Morrison, he defendants argued that their convictions should be reversed since their conduct was extraterritorial, or outside the U.S.

The court agreed and quoted Morrison for the proposition that when a statute gives no clear indication of an extraterritorial application, it has none.  Although Section 10(b) clearly forbids a variety of fraud, its purpose is to prohibit crimes against private individuals or their property, which is the sort of statutory provision for which the presumption against extraterritoriality applies (responding to the government’s examples of cases broadly applying statutes extraterritorially where the victims were government actors).  A statute either applies exterritorially or it does not, and once it is determined that  a statute does not apply extraterritorially, the only relevant question is whether the conduct occurred in the territory of a foreign sovereign.  In such a case, the court’s test is:

A securities transaction is domestic when the parties incur irrevocable liability to carry out the transaction within the United States or when title is passed within the United States.  More specifically, a domestic transaction has occurred when the purchaser has incurred irrevocable liability within the United States to take and pay for a security, or the seller has incurred irrevocable liability within the United States to deliver a security.

The Upshot

The conviction stands.  The conduct at issue was conducted in the United States, with ties to New York and Puerto Rico, which counts for the court’s purposes.

The defendants claimed that they structured the transaction carefully to avoid U.S. jurisdiction.  However, the court declined to “rescue fraudsters when they complain that their perfect scheme to avoid getting caught has failed.”

The Takeaway

The court summarized its conclusion on the relevant (to us) point as follows:

  • Section 10(b) and Rule 10b-5 do not apply to extraterritorial conduct, regardless of whether liability is sought criminally or civilly.
  • A defendant may be convicted of securities fraud under Section 10(b) and Rule 10b-5 only if he has engaged in fraud in connection with:
    1. a securities listed on a U.S. exchange; or
    2. a security purchased or sold in the United States.

Insider Trading – How Much Of A Factor Must The Material Non-Public Information Play In The Investment Decision?

Spoiler alert: Not much.

Link: United States v. Raj Rajaratnam

Raj Rajaratnam, former billionaire hedge fund manager, appealed his notorious insider trading conviction.  If you recall, he was the founder of the Galleon Group hedge funds who received insider information from contacts at McKinsey, Intel, Goldman Sachs and other hedge funds.

Among the issues raised at trial was whether the fraud counts should be vacated because the court told the jury that it could convict Rajaratnam if the “material non-public information given to the defendant was a factor, however, small, in the defendant’s decision to purchase or sell stock.  He claimed that this allowed to jury to convict without a causal connection between the inside information and the trade.

The court noted that under the misappropriation theory of insider trading, a person commits fraud “in connection with” a securities transaction in violation of Rule 10b-5 when he misappropriates confidential information for securities trading purposes in breach of a duty owed to the source of the information.  The Supreme Court in the O’Hagan case enshrined/created this theory to “protect the integrity of the securities markets against abuses by ‘outsiders’ to a corporation” who have access to confidential information that will affect the corporation’s security price but otherwise owe no duty to the corporation’s shareholders.

The court in this case endorsed the “knowing possession” standard* that is consistent with the cardinal rule of insider trading:

If you have a fiduciary or other duty to the company and hold material non-public information, disclose or abstain.

On this basis, the appeals court said that the district court’s instruction was more favorable to Rajaratnam than the legal standard.  Rather than merely be in possession of the information, the jury had to find that he used it in some manner to find him guilty of insider trading.  As a result, the jury instruction satisfied the “knowing possession” standard.

*The knowing possession standard became the law in the 2nd Circuit in United States v. Teicher and United States v. Royer.