Client Alert

Ninth Circuit Adopts More Stringent Insider Information Test

8/25/1998
The Ninth Circuit has issued its decision in a closely watched case involving a purloined voicemail message, internal corporate earnings projections, and allegations of criminal insider trading. United States v. Smith, 98 C.D.O.S. 6590 (9th Cir. Aug. 25, 1998). The Court rejected the Securities and Exchange Commission's "while in possession of non-public information" position in favor of a more stringent "use of non-public information" test. As a result, the government will have to prove that an investor actually used inside information as a "significant factor" in his or her investment decision in order to prevail on an insider-trading claim.

The case began when the Vice President for North American Sales of PDA Engineering, Inc. left a voicemail for a colleague. In the voicemail, the vice president stated that he had sold all of his stock, and was going to short more, "because I know it's going to go down a couple of points here in the next week as soon as Lou releases the information about next year's earnings." Unbeknownst to the vice president, another employee had improperly obtained the password of the message's recipient. This employee secretly made a tape of the message and then contacted the United States Attorney. The vice president was convicted on several counts of insider trading, and appealed.

Much of the Ninth Circuit's decision concerns the rules of evidence as applied to intercepted voicemail messages. This part of the decision will only be important to lawyers in criminal cases. In summary, the tape was excluded from evidence, but other evidence developed by the government, based on the initial tip and description of the tape, was admissible.

The last part of the decision, however, addresses an issue that has been a sore spot between the Securities and Exchange Commission and defense lawyers for many years. The Securities and Exchange Commission has maintained that insider trading occurs whenever a person trades "while in possession of material non-public information." Defense lawyers have countered that liability arises only when a trade is made "on the basis of" inside information. This has been called the "use" test.

The Ninth Circuit rejected the government's position, and adopted the more stringent "use" test. It held: "It is the insider's use [of non-public information], not his possession, that gives rise to an informational advantage and the requisite intent to defraud." The Ninth Circuit is now the second Court of Appeals to reach this conclusion. See Securities and Exchange Commission v. Adler, 137 F.3d 1325 (11th Cir. 1998).

The decision may have several practical consequences. Consider an example used by the Ninth Circuit in its opinion -- "an investor who has a preexisting plan to trade, and who carries through with that plan after coming into possession of material nonpublic information." Prior to this decision, that investor -- perhaps an executive with an established diversification strategy -- would have been at risk. But under this decision, the investor has not violated federal insider trading rules, because he "does not intend to defraud or deceive; he simply intends to implement his pre-possession financial strategy." Formal, well-documented diversification programs for executives will become even more important as a result of this decision.

One note of caution: the Ninth Circuit acknowledged the fine line between possessing non-public information and using it in making trading decisions. It noted that "any number of types of circumstantial evidence" might be used to satisfy the "use" test, including "unique trading patterns or unusually large trading quantities."

In a separate part of the opinion, the Ninth Circuit rejected the vice president's argument that internal quarterly revenue projections cannot be "material" for purposes of insider trading: "determining materiality requires a nuanced case-by-case approach." It affirmed the jury's decision on the materiality of the information used by the vice president, and affirmed his conviction on all counts.

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