US v. Nacchio: The SEC Wins One

One thing is for certain about the decision in US v. Nacchio, the SEC came out a winner. In reviewing the sufficiency of the evidence, the main issue was the materiality of the non-public information known to Nacchio at the time he traded. undisclosed information, an amount equal to 4.2% of the company's revenue. The court not only found the amount material, but blessed Staff Accounting Bulletin No. 99. SAB 99 is a document that reflects the views of the staff and contains an expansive interpretation of materiality. It is now persuasive authority in the 10th Circuit.

The court also made clear (consisting with SAB 99) that determining the percentage threshold was only the "beginning of an analysis of materiality." As the opinion noted:

• 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 statements 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.

In other words, putative defendants arguing that information was not material will not be able to rest on the percentage alone. This has long been the position of the Commission and is now the law in the 10th Circuit. Moreover, in finding the 4.2% of revenue material, the court relied on a "skittish" market. As the opinion noted:

• The government argued that the shortfall had particular salience given the state of the economy and the industry. Mr. Nacchio himself had said in January that the “skittish market” was so “mercurial” that even a $50 million shortfall could create a 15–20% drop in stock price.

In other words, the court did not rely on evidence that the numbers were necessary to meet analyst forecasts or suggested that Qwest was avoiding problems befalling others in the industry, both factors likely to not be present in most other cases. Instead, it was enough that the market was "skittish."

Finally, the court noted that the jury instruction for insider trading may have been incorrect because it was too favorable to the defendant.  The instruction essentially required that the inside information be the basis (or at least a substantial factor in the reason for) the trade.  The Commission in Rule 10b5-1 adopted a different standard, that required merely that the insider trade while in possession of the inside information.  As the court noted:

• This instruction was arguably incorrect because it was too favorable to Mr. Nacchio. Since 2000, Rule 10b5-1 has provided that an insider trades “on the basis of” information so long as he is “aware” of it, 17 C.F.R. §240.10b5-1(b), unless he falls into one of the rule’s safe-harbors—the creation of an automatic trading plan or some other binding contract or election to sell stock in advance of acquiring the information. Id. § 240.10b5-1(c). This would make Mr. Nacchio liable even if he could prove that he had unrelated reasons for his sales (such as the need to dispose of options before their expiration date) and thus that he did not trade “on the basis of” the information.

This case, therefore, benefits the particular defendant but will, in the long-term, provided the greatest benefit to the SEC, providing the agency with very favorable law on materiality and the standard for establishing insider trading.