Intent to Reconcile: Sec V. Obus, the Second Circuit's Edification of the Tippee Scienter Standard

INTRODUCTIONOn September 6, 2012, the U.S. Court of Appeals for the Second Circuit resurrected a $1.3 million enforcement action initiated by the U.S. Securities Exchange Commission (SEC) against, among others, Wynnefield Capital, Inc. founder Nelson Obus.1 Finding that the SEC provided sufficient evidence to create genuine issues of material fact as to whether Obus and the other defendants engaged in conduct amounting to insider trading in violation of the Securities Exchange Act of 19342 and Rule 10b-53 promulgated thereunder, the Second Circuit vacated the district court's decision to grant summary judgment in favor of the defendants.4 However, the significance of the Second Circuit's decision is not limited to its revival of the SEC's complaint. Perhaps more importantly, the opinion offered a longawaited resolution to the question of the degree of knowledge a tippee5 must have in order to satisfy insider trading's scienter element.6 The Second Circuit opined that sufficient scienter exists when the "tippee knew or had reason to know that confidential information was initially obtained and transmitted improperly" and "the tippee intentionally or recklessly traded while in knowing possession of that information."7This Note argues that by adopting both a negligence and actual knowledge standard in SEC v. Obus,8 the Second Circuit failed to provide a practical resolution to the apparent tippee scienter conflict. Part I provides a brief overview of the seminal Supreme Court cases that define the ambits of insider trading regulation and outlines the theoretical inconsistency in the Supreme Court's approach to tippee scienter. Part II sets forth the facts and procedural history of Obus and provides the details of the Second Circuit's decision. Part III contends that by adopting the conflicting language without offering a workable application mechanism, the Second Circuit merely solidified the incongruity surrounding tippee scienter rather than providing for a remedy. Part III further argues that the Second Circuit undermined the connection between insider trading and fraud by adopting a negligence standard.I. BACKGROUNDA. Liability for Insider Trading: An Overview of the Supreme Court's Interpretation of Section 10(b) and Rule 10b-5Prohibition of insider trading-the "unlawful trading in securities based on material non-public information"9-is well vested in the American legal system.10 However, the statutory footing on which the prohibition stands-section 10(b) of the Exchange Act with companion Rule 10b-5-is notably devoid of any express proscription.11 Instead, section 10(b) and Rule 10b-5 state merely that it is unlawful for individuals to perpetrate a fraud or deceit upon any person in connection with the purchase or sale of securities.12 Thus, in the absence of more specific direction from Congress or the SEC, courts have been leftto define the contours of the law against insider trading.13Generally, the Supreme Court has interpreted "deceptive device"14 in section 10(b) to include the use of inside information, i.e., material nonpublic information about an issuing company or the market, in connection with the buying and selling of securities.15 However, the Court has stopped short of classifying all securities trading on the basis of inside information as a form of deception contemplated by the Act and accompanying Rule.16 Instead, the Court has built its insider trading jurisprudence on the notion that only certain individuals have a duty to either disclose inside information or abstain from trading on it.17 In Chiarella v. United States,18 the Supreme Court articulated that the duty to disclose or abstain arises from the existence of a fiduciary relationship between a corporate insider and the corporation's shareholders.19 The Chiarella Court explained that it is this duty that implicates section 10(b) and Rule 10b-5's antifraud provisions, because consistent with misrepresentation in the common law, "one who fails to disclose material information . …