SEC Vacates 21(d)(3) Penalties for Insider Trading

In SEC v. Rosenthal, 10-1204-cv (L) (2d Cir. June 9, 2011), the court held that section 21(d)(3) of the Securities Exchange Act of 1934 does not provide for civil monetary penalties for insider trading. 

According to the allegations in the case, Amir Rosenthal, one of the defendants, learned from a friend working at Ernst & Young in April 2005 about a proposed acquisition of a public company by an Ernst & Young client. After obtaining this information, Amir sold put options of the target company.  In addition, Amir passed the information on to his supervisor at his law firm; Amir’s supervisor subsequently purchased call options for the target company. Ultimately, the transaction did not take place and Amir’s put options did not generate profits or avoid any losses. 

While working as an accountant at PricewaterhouseCoopers in May 2005, Ayal Rosenthal, Amir’s brother and another defendant in the case, also learned of a proposed merger and shared this information with Amir.  Once again, Amir sold put options and his supervisor bought call options.  Upon learning from Ayal that the merger would not take place, Amir liquidated the position without generating profits or avoiding losses. 

The Court of Appeals began its analysis of whether the defendants faced penalties pursuant to section 21(d)(3).  As the provision provides:

Whenever it shall appear to the Commission that any person has violated any provision of this chapter, [or] the rules or regulations thereunder, . . . other than by committing a violation subject to a penalty pursuant to section 78u-l of this title, the Commission may bring an action in a United States district court to seek, and the court shall have jurisdiction to impose, upon a proper showing, a civil penalty to be paid by the person who committed such violation.

Section 21A provides that penalties may be imposed for "purchasing or selling a security . . . while in possession of material, nonpublic information in, or . . . communicating such information in connection with, a transaction . . . ." 15 U.S.C. § 78u-1(a)(1).   Penalties were computed based upon the profits gained or the losses avoided.  Id. 

The SEC asserted that Section 21A was inapplicable because, while both brothers engaged in insider trading, neither earned any profits (or avoided any losses).  As a result, they could not be subjected to a penalty under the Section.

 After finding the statutory language ambiguous, the court concluded that the applicability of Section 21A did not depend upon whether the insider trading transaction resulted in profits but only whether insider trading had occurred.  The court held that “a defendant is ‘subject to’ a penalty under 21A as soon as he engages in insider trading, regardless of whether this activity ultimately ripens into profits or permits the avoidance of losses.” 

Based on this reading of 21A, the court found the defendants satisfied the requirements because they “purchased or sold securities ‘while in possession of material, nonpublic information’ or ‘communicat[ed] such information in connection with’ such transaction.”  One who violates insider trading laws is subject to a penalty directly proportional to the “profit gained or the loss avoided.” 

Because the defendants neither made money nor avoided losses, the court determined that the defendants were ineligible for a monetary penalty under Section 21A.  The applicability of Section 21A, however, took them outside of the penalties contemplated by 21(d)(3). 

Similarly, the court found support in the legislative history of Section 21(d)(3).  The provision was enacted with the intention of filling a gap to cover securities law violations other than section 21A and insider trading.  As a result, the court concluded the 21(d)(3) civil penalties imposed on the defendants must be vacated. 

The primary materials for this case may be found on the DU Corporate Governance website.