March 22 (Westlaw Business) A counterpunching Rajat Gupta has come out swinging in the latest round of Gupta v. SEC. This bout offers more than just sensational headlines: an immensely powerful new Dodd-Frank tool, the civil cease-and-desist proceeding, looms large in the center of the ring. Whether the SEC can employ the device retroactively remains to be seen, but at a minimum, the landscape of insider trading prosecutions could be in for a dramatic and controversial shift.
Filing a complaint in federal district court in Manhattan, Gupta has sought declaratory and injunctive relief in an urgent bid to stave off a civil cease-and-desist proceeding brought by the SEC under the aegis of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Gary P. Naftalis of Kramer, Levin, Naftalis & Frankel1 signed the complaint on Gupta’s behalf, with Lawrence F. Robbins of Robbins, Russell, Englert, Orseck, Untereiner & Sauber appearing as of counsel.
With the clock running out on his time to answer the SEC’s allegations In the Matter of Rajat K. Gupta, Gupta filed his own collateral action arguing among other things, that: (1) §929P of Dodd-Frank has been improperly applied retroactively; (2) Gupta himself has been unfairly and unconstitutionally singled out by the SEC; (3) the SEC cannot establish a prima facie case of insider trading against him, as notwithstanding other defects, the Commission cannot prove scienter or that Gupta personally profited from the allegedly illegal trades of Galleon’s Raj Rajatnaram; and (4) the SEC’s administrative proceeding will compromise Gupta’s due process rights.
Although sensational elements of the SEC’s case at this stage have been publicized (see, e.g., Westlaw Business Currents article SEC’s Boardroom Bombshell: Ripped From the Headlines, Directors Can be Costly), many of the legal questions within the action have only begun to percolate. At a threshold level, these include whether the SEC’s move works an unconstitutional ex post facto penalty on Gupta.
Even the shortest answer remains subject to the lawyer’s nuance. First, Gupta only complains of the procedure’s retroactivity; the complaint does not invoke the Constitution’s Ex Post Facto Clause. The prohibition against ex post facto punishment applies only to criminal penalties, not civil.
The Supreme Court has said that, “If the intention of the legislature was to impose punishment, that ends the inquiry. If, however, the intention was to enact a regulatory scheme that is civil and nonpunitive, we must further examine whether the statutory scheme is so punitive either in purpose or effect as to negate [the State's] intention to deem it civil.” Smith v. Doe, 538 U.S. 84, 92 (2003) (internal citations omitted). “The court normally defers to Congress's stated intent, and therefore only the clearest proof will suffice to override legislative intent and transform what has been denominated a civil remedy into a criminal penalty.” U.S. v. Lawrance, 548 F.3d 1329,1333 (10th Cir. 2008) (internal quotations omitted).
Gupta alleges that Dodd-Frank has driven this action, and that §4 of the Statute provides, “Except as otherwise specifically provided in this Act or the amendments made by this Act, this Act and such amendments shall take effect 1 day after the date of enactment of this Act.”
Without question, Gupta’s conduct from 2008 to 2009 as alleged in the SEC’s order predates Dodd-Frank. The Statute itself contains no express provision relating to retroactive application of §929P’s levy of civil fines in connection with administrative cease-and-desist proceedings. On the other hand, the language in the Statute declares without ambiguity the civil nature of any such fines. A court may say the civil fines may not be applied retroactively, but such a judgment should fall short of meeting the standard for ex post facto law violation.
As to whether Gupta himself has been unfairly singled out, this seems a weaker fallback position. Gupta’s complaint notes that the Commission has charged 27 Galleon defendants in federal court; only Gupta has been graced with the administrative proceeding. Gupta also cites the timing of his own Wells notice submission as suggesting the Commission had already determined its course of action. “The only plausible inference,” says Gupta, “is that the Commission is proceeding how and where it is against Mr. Gupta for the bad faith purpose of shoring up a meritless case by disarming its adversary.”
The SEC should be able to come up with counterarguments distinguishing Gupta’s case from those of other Galleon defendants. At a minimum, Gupta’s singular profile as a director at both Goldman Sachs and Procter & Gamble puts him in very select company among other would-be respondents. If not unconstitutional, the Commission should be able to argue that no less an authority than Dodd-Frank supports the public policy behind such an action.
The contention that the SEC cannot prove Gupta profited from alleged illegal trading may appear stronger than it really is. The benchmark for proving insider trading remains the Supreme Court’s decision in Dirks v. SEC: “[A]n insider will be liable under Rule 10b-5 for inside trading only where he fails to disclose material nonpublic information before trading on it and thus makes ‘secret profits.’” 2
Gupta’s complaint sets great store by this element of an insider trading charge:
The Commission could not carry its burden of proving to a jury either (i) that Mr. Gupta provided material nonpublic information to Mr. Rajaratnam, or (ii) that he acted with the requisite scienter or stood to obtain (or in fact obtained) any benefit from the alleged disclosures -- both essential elements of an insider trading charge. The order does not -- and cannot -- allege that Mr. Gupta himself traded on or in any way profited from insider information as part of a quid pro quo for supplying such information. Nor does the order identify any direct evidence that Mr. Gupta conveyed material, nonpublic information about Goldman Sachs or Procter & Gamble. The Commission's case thus rests on (i) the occurrence of certain phone calls between Mr. Gupta and Mr. Rajaratnam (without direct evidence of the content of those calls, and without consideration of the entire course of dealing between the two men) and subsequent trading by Mr. Rajaratnam....3
But how well-founded is this reliance? In spite of the eminent distinctions between Dirks’s facts and Gupta’s, consider the limitation of this doctrine imposed by the United States District Court for the Southern District of New York — the very forum in which Gupta has sought refuge. In S.E.C. v. Sekhri,4 an unpublished opinion from 2002, the court both distinguished and refined the concept of personal benefit as an element of insider trading:
The first part of Sehgal's argument fails because it is based on an overly narrow interpretation of the rule stated in Dirks. While Sehgal is correct in arguing that the evidence must show that Sekhri sought some personal benefit from disclosing the nonpublic information to Sehgal in order to have breached his fiduciary duty, he ignores the remainder of the Court's statement.… While noting that the insider must seek to benefit from disclosing inside information, the Supreme Court noted that “[t]here are objective facts and circumstances that often justify [the] inference” that the insider benefitted from the disclosure…. For example, “[t]he elements of fiduciary duty and exploitation of nonpublic information also exist when an insider makes a gift of confidential information to a trading relative or friend.” …. (emphasis added (by Court)). Thus, when Sekhri disclosed insider information to his father-in-law, Sehgal, it may be inferred that Sekhri received some personal benefit from the gift of information. Likewise, the burden of proof shifts from the SEC to Sehgal, and Sehgal must prove that his son-in-law derived no benefit from the disclosure in order to negate the inference that Sekhri benefitted from the transaction. (emphasis added by Eds.) (internal citations omitted)
The above passage could have dramatic import for Gupta. Gupta says the SEC can’t show Gupta himself profited, ergo, no case. Sekhri, however, says that “objective facts” can “justify [an] inference” — an inference that shifts the burden of proof. This could be a huge problem for Gupta. Consider the following from the SEC’s order: “Gupta is a Founding Partner and the Chairman of New Silk Route Partners LLC, an investment firm that was originally called Taj Capital Partners and was founded by Gupta, Rajaratnam, and others in 2006.”5 In addition, alleges the SEC,
[d]uring the relevant period, Gupta had a variety of business dealings with Rajaratnam and stood to benefit from his relationship with Rajaratnam. In addition, Gupta was an investor in, and a director of, Galleon’s GB Voyager Multi-Strategy Fund SPC, Ltd., a master fund with assets that were invested in numerous Galleon hedge funds, including those that traded based on Gupta’s illegal tips.6
If such an inference is permitted, Gupta will be forced to prove a negative, i.e., that he derived no benefit from any alleged tips provided to Rajatnaram. This burden-shifting dovetails with another of Gupta’s arguments: Due process.
Gupta urges — correctly — that the administrative proceeding has fewer procedural evidentiary safeguards than afforded by a plenary court trial. This may not evoke a great deal of judicial sympathy, as an overwhelming portion of adjudications at the federal level take place within administrative proceedings.
More importantly, what the cease-and-desist proceeding does is give the government an extra bite at the apple. By the order signed on March 1, Gupta has 20 days to answer the allegations or he “may be deemed in default and the proceedings may be determined against him upon consideration of this Order, the allegations of which may be deemed to be true.” Should Gupta default, he stands to forfeit not only any civil monetary penalties, but he could also box himself into an estoppel argument in other proceedings. He can, of course, invoke a Fifth Amendment privilege in the civil proceeding, but circumstantial evidence thus far alleged won’t simply go away.
It can’t yet be known precisely why the Commission has taken this tack, or what specific result it hopes to achieve, viz., whether the civil proceeding is merely a test case or part of a larger, overarching strategy. Even if a court (including the Second Circuit or the Supreme Court) were to find the retroactive application of Dodd-Frank impermissible, even prospectively, the device of the civil cease-and-desist proceeding could be an enormous advantage for the SEC in prosecuting insider trading. The SEC could recover civil penalties from cornered respondents, while still holding out the prospect of a criminal trial made easier with evidence obtained in the civil proceeding.
On the other hand, a sympathetic court could see through the two-bite gambit and view the playing field as hopelessly slanted against defendants. In any event, Gupta’s latest counterpunch won’t be the last word on the SEC’s use of the administrative cease-and-desist proceeding.
1Other Kramer, Levin, Naftalis & Frankel attorneys appearing as counsel of record include: Michael S. Oberman, Alan R. Friedman, David S. Frankel and Robin M. Wilcox.
2Dirks v. SEC, 463 U.S. 646, 654 (1983).
3Gupta v. SEC, Complaint at ¶10.
42002 WL 31654969, (S.D.N.Y. November 22, 2002).
5Matter of Rajat K. Gupta, at ¶6.
6Id. at summary ¶4.