SEC Overreaching in Applying Penalty Act to Insider Trading, Contributed by Larry P. Ellsworth, Jenner & Block LLP

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By Larry P. Ellsworth, Jenner & Block LLP

The U.S. Court of Appeals for the Second Circuit recently held in SEC v. Rosenthal that it would be "absurd … to adopt the SEC's [Securities and Exchange Commission’s] interpretation" of the general civil penalties provision under Section 21(d)(3) of the Securities Exchange Act of 1934 (Exchange Act) as applying to insider trading.1 Instead, the Court held that Section 21A of the Exchange Act, a specific provision applicable only to insider trading violations, is the only basis for ordering civil penalties in insider trading cases brought in Federal court. While the Second Circuit had no cause to address the recent amendment contained in the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) to Section 21B of the Exchange Act, which contains civil penalty provisions applicable in administrative proceedings similar to those in Section 21(d)(3) for judicial proceedings, the SEC's overreaching in the Rosenthal case may portend a similar result in the SEC's recently filed Gupta case where the SEC seeks general civil penalties under Section 21B in another insider trading case.2

The Rosenthal Case

In the Rosenthal case, a family friend and Ayal Rosenthal, respectively, provided material, confidential information about two contemplated acquisitions to Amir Rosenthal who in each instance bought options in the target companies. In neither instance did the acquisition occur and Amir Rosenthal liquidated his positions without generating any profits or avoiding any losses.

Amir, Ayal, and the family friend each pled guilty to one count of conspiring to commit securities fraud. The SEC also sued under Section 10(b) of the Exchange Act and won summary judgment on the basis of the criminal pleas. Even though there were neither gains nor losses on the trades, the district court imposed civil penalties pursuant to Section 21(d)(3).

On appeal, the Second Circuit held that "civil monetary penalties for insider trading are not available under section 21(d)(3)." The Court first looked to the language of Section 21(d)(3), which provides for penalties "other than by committing a violation subject to a penalty pursuant to section 78u-1 of this title [Section 21A]." The SEC argued that the Rosenthals were not subject to a Section 21A penalty because that section provides for penalties of up to three times the gain or loss and in this instance there was no gain or loss; that is, three times zero is zero, so there would be no liability for civil penalties under Section 21A. But the Rosenthals, proceeding pro se, argued, and the Court agreed, that "section 21A clearly distinguishes between, on the one hand, the conduct that gives rise to the SEC's authorization to bring a civil action to impose a penalty for an insider trading violation and, on the other, the amount of the penalty that may be imposed for such a violation." Further, "subsection (a)(2) [of Section 21A] caps the amount of the penalty at a maximum of three times the profit or loss avoided . . . ."

However, "because the statutory language does not necessarily preclude the SEC's interpretation," the Court looked to the legislative history of Section 21(d)(3). That history repeatedly spoke in terms of enacting the general civil penalty provisions "for violations other than those described in section 21A," "[f]or cases other than those involving insider trading," and "to provide financial disincentives to securities law violations other than insider trading."

The Court ultimately concluded that "the text of section 21A clearly evinces congressional intent to make the amount of financial liability to which a violator of the insider trading laws may be exposed directly proportional to the amount of the profit gained or the loss avoided." Indeed, the Court explained, "it would be … absurd [to] … permit a violator who made no profit to face a penalty of up to $120,000 per violation [under Section 21(d)(3) on the facts of the Rosenthal case]. . . while a violator who profited by $1000 would be exposed to a penalty of no more than $3000 [under Section 21A]."

The Gupta Case

The SEC's overreaching in Rosenthal to apply the general civil penalty provision of Section 21(d)(3) to a judicial proceeding for insider trading simply because application of Section 21A would not result in a civil penalty also may doom its similar effort in Gupta to apply Section 21B to an insider trading case brought in an administrative forum where the insider trading penalty provision of Section 21A does not apply.

The SEC recently brought an administrative proceeding charging Rajat Gupta with illegally tipping material, confidential information to the founder of the Galleon Group, Raj Rajaratnam.3 This is the first insider trading case in which the SEC has sought a civil monetary penalty under the newly amended penalty provisions found in Section 929P of the Dodd-Frank Act.4 The SEC seeks a cease and desist order, disgorgement, and civil penalties pursuant to Section 21B of the Exchange Act. Section 21B contains civil penalties provisions for administrative proceedings similar to those of Section 21(d)(3) for judicial proceedings.

At least three prior insider trading cases have been brought by the SEC before an administrative law judge (ALJ), although each occurred before passage of Section 929P of the Dodd-Frank Act. In none of these cases has the SEC prevailed in obtaining civil penalties. However, in none did the ALJ decide the question of the Enforcement Division's authority to bring such an action, instead concluding that a civil penalty was not in the public interest or was time-barred.5 Nevertheless, in one of these cases, In re Lohmann, the ALJ noted concern that a civil penalty under the general penalty provisions of Section 21(d)(3) might be disproportionate to the three-times penalty model adopted under Section 21A.6 That ALJ also examined the legislative history surrounding Sections 21A and 21B of the Exchange Act and opined that "when Congress wanted to craft statutory language to deter insider trading violations by imposing civil penalties at more than triple the profit gained or loss avoided, it knew how to do so."

The question is whether Congress when it enacted Section 929P of the Dodd-Frank Act intended to authorize civil penalties in administrative insider trading proceedings at more than triple the profit gained or loss avoided to which the same case would be limited had it been brought in Federal court. If not, then no civil penalties can be awarded in administrative insider trading proceedings, since the treble penalties provision of Section 21A is available only in court proceedings. Prior to passage of Section 929P of the Dodd-Frank Act, the civil penalty provisions of Exchange Act Section 21B applied only to broker-dealers and other registered persons; they now apply to "any person." But nothing in the Dodd-Frank Act expressly changes anything else in the pre-existing statutory scheme for enforcing the insider trading laws. The Dodd-Frank Act did not amend Section 21A of the Exchange Act to authorize the SEC to seek insider trading penalties in administrative proceedings. Nor did Congress expressly grant that power when amending Section 21B of the Exchange Act.

On the other hand, the language in Section 21(d)(3) expressly stating that "civil monetary penalties for insider trading are not available under section 21(d)(3)" is not present in Section 21B, which may lead the courts to conclude that there is sufficient ambiguity to justify review of the legislative history. But the Dodd-Frank Act's legislative history does not address insider trading at all. Section 929P was initially part of H.R. 3817, the Investor Protection Act of 2009 (Investor Protection Act).7 This provision later became Section 929P of the Dodd Frank Act. The legislative history pertaining to both the proposed Investor Protection Act and the Dodd-Frank Act generally speaks of enhancing the power of the SEC in seeking civil penalties for violations of the federal securities laws. Neither bill, however, was described as altering the penalties for insider trading set out in Section 21A. In sum, no Dodd-Frank Act legislative history has been discovered that would demonstrate a congressional intent to authorize in administrative proceedings only imposition of civil penalties under Section 21B, which may exceed the treble civil penalty provisions set forth in Section 21A for insider trading cases that may be used only in judicial proceedings.

In these circumstances, courts are likely to rely on the canon of statutory construction that specific provisions of statutes should be favored over more general provisions.8 Here, Section 21A specifically addresses the appropriate civil penalties to be awarded in insider trading cases. Section 21B, like the similar Section 21(d)(3), addresses civil penalties more generally. Indeed, the later specifically says that it applies only when Section 21A does not. There is no specific evidence of congressional intent in Section 929P of the Dodd-Frank Act to make major alterations to the existing law governing insider trading. Therefore, the general penalty provisions in the Remedies and Dodd-Frank Acts should not be applied to allow civil penalties in administrative actions which would differ from, and may exceed, those awardable in judicial actions under the more specific provisions of Exchange Act Section 21A.

Larry P. Ellsworth is a partner in Jenner & Block's Litigation Department, and a member of its Securities Litigation and Class Action Practices. From 1993-2005, he served as Assistant Chief Litigation Counsel for the U.S. Securities and Exchange Commission's Trial Unit. He is co-author of BNA’s "Inside Information: Prevention of Abuse."


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