Last Friday, the Tenth Circuit Court of Appeals decided U.S. v. Nacchio, a white collar criminal case involving insider trading by the former CEO of Quest Communications. The Court held that, in calculating Mr. Nacchio’s gain for purposes of sentencing, the district court must determine the proceeds related to his insider information, rather than simply calculating total net profit. The Eighth Circuit Court of Appeals held the opposite in U.S. v. Mooney in 2005. The Eleventh Circuit, which hears appeals in federal cases here in Atlanta, Georgia, has never addressed this issue.
Mr. Nacchio began earning stock options through his position as CEO of Quest in 1997. By early 2001, he held over 4.4 million vested options. Between April and May 2001, he sold more than 1.3 million of his shares. That July, the company announced to investors that its expected revenue for 2001 would be near the lower end of previously announced ranges. In August, Quest disclosed the magnitude of its prior use of nonrecurring sources of revenue, such that it was at substantial risk of not meeting its year-end guidance.
Alleging that Mr. Nacchio was aware of material, nonpublic information when he sold his shares of Quest stock, the federal government charged him with forty-two counts of insider trading in 2003. He was convicted on nineteen counts covering the trades he made in April in May. The district court sentenced him to 72 months imprisonment, 2 years of supervised release, a $19 million fine, and forfeiture of $52 million. The Tenth Circuit reversed the sentencing order and remanded to the district court for resentencing.
The problem with the district court’s original sentencing calculation involves Section 2F1.2 of the 2000 Sentencing Guidelines, which is in the current Guidelines at Section 2B1.4, and applies specifically to insider trading. The Sentencing Guidelines prescribe progressively greater penalties based on the relevant amount of losses to victims. For insider trading, however, because victims and their losses would be so difficult to identify, the courts must look to the defendant’s gains.
The dispute in this case was over how to calculate those gains. Rather than agreeing with the district court’s use of the net proceeds from the sale, the Tenth Circuit decided that the method used for figuring disgorgement in civil insider cases was an appropriate analogue to the sentencing calculation. Disgorgement seeks to strip wrongdoers of ill-gotten gains and deter improper conduct, while taking into account that stocks have inherent value and some purported gain amounts may actually be the product of the ordinary influences of the market.
Basically, the district court’s approach ignored that some profits from the sale of Mr. Nacchio’s stock could have been (and probably were) due to normal appreciation in market prices during the period from 1997 to 2001 that he owned it. The Tenth Circuit’s disgorgement approach takes normal market forces into account and holds defendants culpable for only those gains attributable to the information based upon with they improperly traded.
The Tenth Circuit’s opinion is available here.