This column will focus on two new and unrelated developments linked only by the fact that they both emanate from California: (1) the Ninth Circuit has handed down a significant decision on insider trading—United States v. Salman[1]—that disagrees (at least marginally) with the Second Circuit’s important (but controversial) decision in United States v. Newman[2]; and (2) the SEC’s Regional Office in California has issued Wells Notices to attorneys, taking the position that an attorney representing clients in immigration matters may be acting as a broker under the federal securities laws. The upshot is to place the SEC in what should be the uncomfortable position of using a sledgehammer to swat flies.

1. Rakoff’s Revenge?

Much attention has focused on the decision in United States v. Salman because it was written by an obscure Southern District judge, named Jed S. Rakoff, who was sitting by designation with the Ninth Circuit. Because Judge Rakoff has not always encountered a sympathetic reception on appeal in the Second Circuit (and because the press regards him as the rock star of the federal bench), the case has received possibly more attention than it deserves. [3] Some press reports view the case as one in which Judge Rakoff curbed the overreach of the Newman decision and thus evened his personal score with the Second Circuit. Frankly, that is a little silly. In my humble judgment, most (but possibly not all) Second Circuit panels would have reached the same outcome as did the Ninth Circuit in Salman, if the case had come up on appeal from a conviction in the Southern District. Conversely, most (but probably not all) Ninth Circuit panels would have reached the same outcome as the Second Circuit did in Newman (although they hopefully would not have overwritten their decision quite as much or attempted to lay down a detailed code of insider trading law covering all future cases).

As is usually the case in most areas of law (with the probable exception of constitutional law), the facts of the case count. Here, the facts of the two cases contrast glaringly. Both cases seemingly turned on whether the prosecution was required to show that the defendant knew that the tipper had provided the material nonpublic information to the tippee in exchange for a “personal benefit.” This requirement derives from the Supreme Court’s decision in Dirks v. S.E.C.,[4] which said that knowledge of “whether the insider personally will benefit, directly or indirectly, from his disclosure”[5] was a prerequisite to liability because those possessing such knowledge should realize that the information had been illegitimately obtained in breach of a fiduciary duty. In effect, the “personal benefit” requirement seeks to limit the reach of insider trading law to those who seem truly culpable on the premise that a subsequent tippee aware of the personal benefit knows from it—much like the classic “fence” who receives stolen property—that the information given him had been clearly misappropriated.

Important as this requirement is, the irony here is that there was no evidence of a personal benefit in either case. Even more ironically, this absence should not have been the grounds for the decision in either case. Let’s start with Newman, which was the paradigmatic “remote tippee” case. The two defendants—Newman and Chiasson—received material information pursuant to two elongated tipping chains.   In the case of the shorter chain involving information about Dell’s earnings, a corporate insider at Dell tipped information to an analyst, who told another analyst, who relayed the information to his manager, Newman, and others, with the information eventually also reaching Chiasson as well. At a minimum then, Newman heard the information third hand and Chiasson fifth hand. The Dell insider had gone to business school with his initial tippee, but the two were not “close” friends.[6] The only thing approaching a “personal benefit” was the fact that the tippee in the Dell chain had given the tipper some generalized professional advice about the qualifying exam required to become a securities analyst. Understandably, the Second Circuit found this professional courtesy to be insufficient to amount to the requisite “personal benefit.”

But there were even bigger problems with the Government’s case in Newman. According to the Second Circuit panel, “the Government presented absolutely no testimony or any other evidence that Newman and Chiasson knew that they were trading on information obtained from insiders, or that those insiders received any benefit in exchange for such disclosures, or even that Newman and Chiasson consciously avoided learning of such facts.”[7] This shortcoming dwarfs the legal question of whether a “personal benefit” needed to be paid to the tipper, because, even if it had been paid, defendants would still have been entitled to a reversal based on the apparent fact that they did not know that the information came from corporate insiders. The panel in Newman could have rested its decision on this point and not written a treatise on what constitutes a “personal benefit.” Put more simply, if the Government has not shown that the defendant knowingly received information from an insider, it has not gotten hallway to first base in terms of making a minimally adequate insider trading case.[8]

Why then did the Second Circuit panel focus so intensively on whether the alleged personal benefit was adequate on the facts of Newman. The answer may be that the panel was thinking about future cases and seeking to write clear rules that curbed the discretion of prosecutors and limited their ability to reach remote tippees. The real problem with Newman is not its outcome, but its attitude; it is an overwritten decision stuffed with dicta.

In the Ninth Circuit’s Salman case, there was also no personal benefit, and Judge Rakoff held (correctly in my view) that none was needed. Salman involved a much simpler trading chain. One brother, who worked at Citigroup’s healthcare investment banking group, regularly passed inside information about major transactions to his older brother, who in turn told their brother-in-law and close friend, defendant Salman, who traded through a disguised account with an associate. The furtive character of the trading strongly suggested scienter (in marked contrast to Newman, where the trading was done more openly and according to standard procedures).

Still, the tippee older brother paid no “personal benefit” to his tipper younger brother. Judge Rakoff turned to the well-known language in Dirks, which said that the elements of insider trading liability “also exist when an insider makes a gift of confidential information to a trading relative or friend,”[9] and essentially found this language to fit the facts of Salman like a glove. But defense counsel objected that Newman had re-interpreted Dirks’ “gift” language to require “an exchange that is objective, consequential and represents at least a potential gain of a pecuniary or similarly valuable nature.”[10] In effect, under this reading, even in the gift context, there needed to be some expectation of a future benefit by the tipper. It is far from clear that the Newman panel intended to say what defense counsel in Salman read into their words (namely, that the tipper making a gift of information must expect “at least a potential gain of a pecuniary or similarly valuable nature”[11] in return for its gift). Still, Judge Rakoff answered that it did not matter in the Ninth Circuit:

“To the extent that Newman can be read to go so far, we decline to follow it. Doing so would require us to depart from the clear holding of Dirks that the element of breach of fiduciary duty is met where an ‘insider makes a gift of confidential information to a trading partner or friend.’” [12]

The press has read this statement as a rebuff to the Second Circuit, but it is doubtful that Newman really intended to re-interpret Dirks to cut back on Dirks’ “gift” exception. Rather, Newman was only insisting that a “gift” could not be inferred, but needed to be substantiated by evidence of a “meaningfully close personal relationship.”[13] That relationship was present in Salman, but absent in Newman. Hence, the decisions are compatible, and no conflict between the Circuits therefore logically arises.

One mystery, however, does surround Salman. The exchange of information at its core was between brothers. Such an exchange is expressly described in Rule 10b5-2(b)(3) and made an automatic breach of duty for Rule 10b-5 purposes (along with certain other exchanges among family members).[14] Had it been invoked, this rule should have made the information exchange in Salman a violation of Rule 10b-5 without the need to show any intent to make a “gift” (and defendant Salman could have correspondingly convicted if the Government showed that Salman knew the information had been so exchanged between brothers (as he did know)). But Rule 10b5-2 was never discussed or referenced in the decision, apparently because it was never relied upon or cited by the prosecution. Did the prosecution just miss this? Or was there some reason that they feared using the rule in a criminal case (including Justice Scalia’s recent misgivings about the use of administrative rules in criminal cases)?[15] Still, if the same case arose tomorrow in the Second Circuit, Rule 10b5-2 should be invoked, and it would avoid the need to consider the intent of the gift-giving tipper.

For the immediate future, the current key issue is whether the U.S. Attorney for the Southern District should seek certiorari with respect to the Newman decision. Mr. Bharara has until August 1 to decide. In my humble judgment, and particularly in light of Salman, it would be sheer madness for the U.S. Attorney to take Newman to the Supreme Court. The Government’s case has many weaknesses, including the Second Circuit’s unusual findings about the insufficiency of the evidence. But beyond that, Justices Scalia and Thomas indicated last year in their concurring opinion on the denial of certiorari in United States v. Whitman[16] (another Rakoff decision) that they consider contemporary insider trading law to be excessively deferential to the prosecution. To bring Newman before them is to walk into an ambush with almost no chance of a victory.[17] Perhaps those two Justices could not convince a majority of the Court to overturn modern insider trading law, but the case is the best possible vehicle by which they could launch their attack.

In contrast, Salman is the perfect case to bring before the Court, even if the Court is intent on reconsidering insider trading law. The facts are simple; the culpability is palpable; and Judge Rakoff’s lucid and cogent decision is entirely faithful to Dirks. Also, the defendant in Salman is certain to appeal his conviction to the Court, asserting that there is now a conflict between two Circuits (which are the two principal Circuits for federal securities law purposes). In truth, the Court should not grant certiorari because (as earlier explained) there is no true split among the Circuits. Nonetheless, if the Court wants to rethink the substantive and clearly judge-made standards of insider trading law, Salman offers the safest vehicle for such a reconsideration.

For all his commendable zeal, the U.S. Attorney should recognize that discretion is sometimes the better part of valor and not appeal Newman. The “person benefit” rule may yet be eliminated by Congress (where legislation to do this is pending), but it will not be tossed out if Newman reaches the Court.

2. Are Immigration Attorneys “Brokers” When They Assist Clients to Obtain EB-5 Visas?

Can one imagine a less promising new litigation initiative from the SEC than this: the SEC’s Regional Office in Los Angeles has issued Wells Notices to immigration attorneys (including at least one in New York City) on the theory that, in assisting clients to obtain EB-5 visas, they acted as unregistered brokers in violation of Section 15(a) of the Securities Exchange Act of 1934. Fraud theories under Section 10(b) of the 1934 Act and Section 17(a) of the 1933 Act have also been asserted.

What is going on here? The EB-5 visa provides a method of obtaining a “green card” for foreign nationals who invest a defined amount of money in the U.S. To qualify, the foreign national must invest $1 million or, alternatively, at least $500,000 in a Targeted Employment Area with the effect of creating or preserving at least ten jobs.[18] As the program has developed, the investor can pay the minimum $500,000 investment to a “Regional Center” (which may be either a public or private body) that assumes the responsibility of creating the requisite number of jobs.

The program has been both controversial (because, to be blunt, it does sell visas for cash) and scandal-plagued (because foreign investors know little about these mysterious “Regional Centers”). Nonetheless, it has grown hyperbolically as thousands of newly wealthy Chinese investors are eager to purchase “green cards” (and the door to future citizenship) for $500,000. In 2014, Fortune Magazine published a detailed expose of “the dark, disturbing world of the visa-for-sale program.”[19] Much of the money so raised has gone into luxury hotels, such as ones in Hollywood and a pending Four Seasons Hotel in Tribeca (which are somehow located within poverty-stricken “Targeted Employment Areas”). Las Vegas casinos have been particularly successful in raising millions for expansion in this fashion, adding wings to their casinos to create new jobs.

Unsurprisingly, conflicts of interest are rampant. Chinese investors are solicited by various persons, including from offices in China established by American attorneys. These investors may not read English, have little knowledge about the thousands of Regional Centers that are now available (most established by an entrepreneur seeking funding), and probably defer to the party (attorney or developer) who solicited them. Attorneys for these clients typically also fail to disclose that they are receiving “contingent fees” from the developers for each $500,000 investment they bring in (a less elegant term for this payment might be “kickback”). But even if there are serious issues of legal ethics or even fraud in these practices,[20] why is that attorney deemed a “broker” and required to register under § 15(a) of the1934 Act?

Section 15(a) forbids any broker or dealer “to induce or attempt to induce the purchase or sale of any security… unless such broker or dealer is registered under Section 15(b).”[21] The term “broker” is broadly defined in Section 3(a)(4) of the 1934 Act, as one “engaged in the business of effecting transactions in securities for the account of others.”[22] Presumably, the SEC’s theory is that the attorney induced the sale and chose the Regional Center in which to invest for his client, probably choosing (or advising his client to choose) that “Regional Center” paying him an undisclosed commission.

But are the obligations so purchased truly “securities”? Here it should depend on whether the visa seeker thought that he was making a long-term investment for profit or whether he was simply buying a visa. Under United Housing Foundation, Inc. v Forman[23], an investor who buys shares in a housing cooperative does not buy a security if the investor’s primary motivation is to obtain housing. The typical EB-5 structure involves a capital contribution by the investor to a special purpose limited partnership or limited liability company that makes a construction loan to the developer (typically at an interest rate below what a bank would charge, which is why developers avidly seek such investments). To be sure, the line between an “investment” motivation and a “consumption” motivation is often not clear-cut, but the case law insists that the fact finder must look to the purchaser’s “primary motive.”[24] Here, profit is conceivable (but only if one believes in the tooth fairy).

Deeming the immigration attorney a “broker” has a range of consequences, most of which are costly and unnecessarily force the square peg into the round hole. For example, if the attorney must register as a broker, the attorney will also need to join FINRA and pass some form of FINRA examination. If attorneys retreat from this field, investors may lose the desirable screening and due diligence services that they can provide. From a cost/benefit perspective, the case for compelling immigration attorneys to comply with broker/dealer registration and FINRA compliance rules seems highly questionable.

Paradoxically, the burdens are less severe on the promoters and Regional Centers. Because these foreign investors are probably “accredited investors” in most cases, the issuer (and its controlling persons) can do a Rule 506 private placement, using, if desired, a general solicitation.[25] The real fraud in these cases seems more associated with the issuers than with the clients’ own attorneys. In a Rule 506 offering, disclosure does not need to be provided to accredited investors, except to the extent necessary to satisfy Rule 10b-5.[26]

What practical steps can the immigration attorney take to avoid being deemed a “broker”? The attorney could distance himself from the investment decision and find someone else (for example, a registered broker) to make the investment choice. This would certainly raise the costs to the client who would now have to pay both a broker and an attorney, and it would likely eliminate the chief source of revenue in these transactions to the attorney (namely, the contingent marketing fee paid to the attorney for each investor obtained). Alternatively, the attorney could move the investment transaction clearly offshore. Even if the developer’s bonds are securities, Rule 10b-5 cannot apply to the purchase or sale of a security in China under Morrison v. National Australia Bank Ltd.[27] Again, however, this might be costly.

On the policy level, the SEC once faced a similar dilemma when it deemed interests in resort and golf condominiums and cooperatives to constitute securities.  Suddenly, the SEC was faced with the prospect that thousands of real estate brokers would have to register under the 1934 Act as brokers. Rather than seek to force the registration of innumerable ski and beach resorts under the 1933 Act and real estate brokers under the 1934 Act, the SEC issued a guidelines release that set forth clearly demarcated standards as to what developers and real estate brokers could do or promise without being deemed to have sold a security.[28] A similar compromise would be sensible here also. Interfering in the relationship of attorneys and their clients is neither a wise nor cost-effective strategy for the SEC, and because it tends to frustrate the EB-5 program, it may produce more of a political pushback than the SEC’s staff has anticipated.  Once again, discretion should prove the better part of valor for the SEC as well.

ENDNOTES

[1] 2015 U.S. App. LEXIS 11555 (9^th Cir. July 6, 2015).

[2] United States v. Newman, 773 F. 3d 438 (2d Cir. 2014).

[3] For the redoubtable Rakoff, the Salman decision may not have even been his most interesting insider trading decision of the week. On July 2, 2015 (four days before Salman was released), Judge Rakoff also decided United States v. Gupta, 2015 U.S. Dist. LEXIS 86635 (S.D.N.Y. July 2, 2015), in which he decided that no personal benefit need be shown in the case of a prosecution of a tipper. In short, the “personal benefit” rule discussed in the text applies only to tippees. As usual, the decision is short, incisive, and well-reasoned.

[4] 463 U.S. 646 (1983).

[5] Id at 662.

[6] 773 F. 3d 438, at 452.

[7] Id at 453.

[8] In my judgment, this was the most likely reason the Second Circuit declined to rehear Newman en banc. One can dispute and disagree with some of the Newman panel’s statements about “personal benefit,” but there was no point in debating this if the conviction had to be dismissed anyway because of the general insufficiency of the evidence on other points.

[9] 463 U.S. at 664.

[10] 773 F. 3d at 452.

[11] Id.

[12] 2015 U.S. App. LEXIS 11555, at * 17.

[13] 773 F. 3d at 452.

[14] See 17 U.S.C. § 240.10b5-2. This rule provides that a “duty of trust or confidence” exists in certain circumstances, without the need to look to the underlying state law or common law. One such circumstance, specified in Subsection (b)(3) of the Rule, is a communication among certain family members, including siblings. An affirmative defense is also provided with the burden on the defendant to show that the relationship created no expectation of confidentiality.

[15] By its terms, Rule 10b5-2 applies in either civil or criminal cases. However, Justices Scalia and Thomas have argued that the Government is not entitled to deference in criminal cases. See Whitman v. United States, 135 S. Ct. 352, 353 (2014)(concurring opinion of Justice Scalia on denial of certiorari)(“legislatures, not executive officers, define crimes”). Only Justice Thomas joined in this opinion. Also problematic for the Government may be the special affirmative defense in Rule 10b5-2, which compels the defendant to prove that the relationship created no expectation of confidentiality. Although the legislature can place the burden of an affirmative defense on the defendant, it is less clear that the SEC can in a criminal case.

[16] See Whitman v. United States, 135 S. Ct. 352, 353 (2015)(“A court does not defer to a prosecutor’s interpretation of a criminal law.”).

[17] As noted earlier, because the Second Circuit panel also overturned the conviction based on the insufficiency of the evidence (because no showing was made that the defendants knew the information emanated from an inside source), the prosecution cannot reinstate the conviction, even if they convinced the Court to liberalize or eliminate the “personal benefit” rule. From this perspective, the case is not “cert-worthy.”

[18] The EB-5 visa program was created by the Immigration Act of 1990. See U.S. Citizenship and Immigration Services, “Green Card Through Investment” (http://www.uscis.gov/portal/site/ucis/menuitem/ebl).

[19] See Peter Elkind and Marty Jones, “The dark, disturbing world of the visa-for-sale program,” FORTUNE, July 24, 2014.

[20] The attorney who serves the client as an immigration counsel and various developers as a marketing agent has a severe conflict of interest. In some cases, a mail or wire fraud prosecution may be possible. Still, whether the undisclosed information about marketing fees is always material can be debated. See Golden Palm Investments Limited Partnership v. Azouri, 2015 U.S. Dist. LEXIS 75095 (D. Nev. June 18, 2015)(failure to disclose finder’s fee not material).

[21] See 15 U.S.C. § 78o

[22] See 15 U.S.C. § 78c(a)(4).

[23] 427 U.S. 837 (1975).

[24] See Rice v. Braniger Organization, Inc. 922 F. 2d 788 (11^th Cir. 1991). For a Second Circuit decision, see Grenader v. Spitz, 537 F. 2d 612 (2d Cir. 1976).

[25] When a general solicitation is used, sales may only be made to “accredited investors.” See Rule 506(c), 17 C.F.R. § 230.506(c).

[26] See Rule 502(b)(information need not be provided to accredited investors in order to satisfy Regulation D). However, material information must always be disclosed by a seller of securities under Rule 10b-5. But see Golden Palm Investments Limited Partnership v. Azouri, supra note 20.

[27] 561 U.S. 247 (2010).

[28] See Securities Act Release No. 5347 (January 4, 1973)(“Guidelines As to the Applicability of the Federal Securities Laws to Offers and Sales of Condominiums or Units In a Real Estate Development”). A corresponding release could give guidance as to what immigration attorneys could do and not do in connection with the EB-5 visa program. Disclosure of hidden fees might be required. At present, the SEC’s interpretation of “broker” is simply a trap for the unwary.

The preceding post comes to us from John C. Coffee, Jr., the Adolf A. Berle Professor of Law at Columbia University Law School and Director of its Center on Corporate Governance.