The opinion of the court was delivered by: Richard J. Holwell, District Judge:
On May 11, 2011 a jury returned a verdict of guilty on all fourteen counts in an indictment charging defendant Raj Rajaratnam with conspiracies to commit and the commission of various insider-trading schemes.
On October 4, 2011 the Court heard argument on the calculation of defendant's guidelines sentence under the United States Sentencing Guidelines ("USSG" or the "Guidelines").
On October 13, 2011 the Court sentenced Rajaratnam to a total of 132 months in prison on all counts. Prior to imposing the sentence, the Court calculated the applicable Guideline range to be 235 to 293 months in prison based on a total offense level of 38 and a criminal history category of I. (Tr. of Hr'g, Oct. 13, 2011, at 32.) The Court indicated that it would issue an opinion setting forth the basis for that calculation. The following opinion does so and considers the three Guideline issues that were contested by the parties: (1) how to calculate Rajaratnam's "gain" pursuant to section 2B1.4(b) of the Guidelines; (2) whether section 3B1.1(a) of the Guidelines warrants an enhancement on the ground that Rajaratnam "was an organizer or leader of a criminal activity that involved five or more participants or was otherwise extensive"; and (3) whether section 3C1.1 of the Guidelines warrants an enhancement on the ground that Rajaratnam "willfully obstructed or impeded, or attempted to obstruct or impede, the administration of justice with respect to the investigation, prosecution, or sentencing of the instant offense of conviction."
A.Calculating the Defendant's "Gain"
The parties agree that defendant's base offense level is eight (8) pursuant to USSG sections 2X1.1 and 2B1.4(a). See U.S. Sentencing Guidelines Manual ("USSG") §§ 2X1.1, 2B1.4(a) (2010). Section 2B1.4(b) of the Guidelines provides, however, that "[i]f the gain resulting from the offense exceeded $5,000," the Court should "increase by the number of levels from the table in § 2B1.1 . . . corresponding to that amount." Id. § 2B1.4(b). Under this guideline, "[i]nsider trading is treated essentially as a sophisticated fraud." Id. cmt. background. Yet "[b]ecause the victims and their losses are difficult if not impossible to identify, the gain, i.e., the total increase in value realized through trading in securities by the defendant and persons acting in concert with the defendant or to whom the defendant provided inside information, is employed instead of the victims' losses." Id. Not unexpectedly, Rajaratnam and the government offer competing methods for calculating the "gain resulting from the offense."
1.The Parties' Gain Calculations
The government relies on calculations performed by Special Agent James Barnacle. According to the government, Special Agent Barncale calculated Rajaratnam's "profit by taking the difference between the price at which a security was purchased (or sold short) on the basis of inside information, and the price at which it was later sold (or covered) following the relevant public announcement, and then multiplying by the number of shares." (Gov't Mem. 32.) For example, if Rajaratnam purchased 100,000 shares of Intel stock at $10 per share on June 1, waited until the price rose to $15 per share when the price rose following the announcement of inside information on June 15, and then sold the shares on June 16 at that price, the government's calculation would result in a "gain" of $500,000 ($15-$10 = $5 x 100,000).
With respect to the stock of three companies-Intel, Google, and Goldman Sachs-the government alleged that Rajaratnam gained what he would have lost had he not sold his shares on the basis of negative inside information regarding those companies. "In these instances, the gain was calculated by taking the difference between the price at [which] Rajaratnam sold stock (or covered a short position) on the basis of inside information, and the price at which the security traded at the open of the market on the day following the public release of the relevant information, and then multiplying by the number of shares." (Gov't Mem. 32 n.8.) For example, if Rajaratnam sold 100,000 shares of Intel stock at $10 per share on June 1 and the price declined to $5 per share when the price rose following the announcement of inside information on June 15, the government's calculation would result in a loss avoided, or "gain," of $500,000 ($10-$5 = $5 x 100,000).
Using these methods, the government has calculated Rajaratnam's total "gain" as $72,071,219.*fn1
Rajaratnam challenges the government's method. The core of Rajaratnam's argument is the premise that the phrase "gain resulting from the offense" requires "separating the gains attributable to the prohibited conduct (i.e., trading stock on the basis of material, nonpublic information) from gains attributable to factors unrelated to that conduct, such as gains caused by exogenous market movements or events unrelated to the material, nonpublic information." (Rajaratnam Mem. 20.) Rajaratnam contends that including either of these factors in calculating his "gain" is improper "because the share price may fluctuate due to other market events, such as the launch of a new product or general market movement." (Id. at 21.)
Rajaratnam contends that his expert witness, Dr. Gregg Jarrell, avoided that result by using an alternative methodology. According to his sworn affidavit, Dr. Jarrell performed an event study-"a statistical regression analysis that examines the effect of an event on a dependent variable, such as a corporation's stock price," In re Vivendi Universal, S.A. Sec. Litig., 605 F. Supp. 2d 586, 599 n.10 (S.D.N.Y. 2009)-to isolate the price increase or decrease in a company's stock attributable to the public announcement of inside information regarding a company from the price increase or decrease attributable to events that happened to coincide with the announcement. (See Rajaratnam Mem. Ex. B, Aff. of Dr. G. Jarrell, July 11, 2011 ("Jarrell Aff.") ¶¶ 15-20.) Dr. Jarrell then multiplied the price increase or decrease attributable to the public announcement of the inside information by Special Agent Barnacle's estimate of the number of shares held by Galleon. (See id. ¶ 21.)
Using this method, Dr. Jarrell calculated Rajaratnam's gain as $41,710,839,*fn2 which would result in a lower increase in defendant's offense level calculation.
In Rajaratnam's view, "the government's methodology improperly includes: (1) all movements in the stock price that occurred after the shares were initially purchased but before the announcement of the alleged inside information; and (2) all movements in the stock price that occurred after the public reaction to the company's announcement of the alleged inside information until the date of sale, even if that date is days or weeks afterwards." (Id. ¶ 23.) To address this argument the Court considers three hypothetical scenarios.
1) Rajaratnam purchases 100,000 shares of Intel stock at $10 per share on June 1, waits until the price increases to $15 per share on June 15 following the announcement of positive inside information regarding its earnings, and sells the shares on June 16 at that price.
2) Rajaratnam purchases 100,000 shares of Intel stock at $10 per share on June 1. Over the next two weeks, the price of Intel stock increases to $15 per share on news that several major smartphone manufacturers have signed agreements to use Intel chips in millions of smartphones. On June 15, the price of Intel stock increases $5 per share to $20 per share following the positive earnings announcement, and Rajaratnam sells the shares on June 16 at that price.
3) Rajaratnam purchases 100,000 shares of Intel stock at $10 per share on June 1. Over the next two weeks, the price of Intel stock decreases to $5 per share on news that several major smartphone manufacturers who have abandoned previously announced plans to use Intel chips in millions of smartphones. On June 15, the price of Intel stock increases to $10 per share following the positive earnings announcement, and Rajaratnam sells the shares on June 16 at that price.
In the first scenario, the government's method yields a gain of $500,000 ($15-$10 = $5 x 100,000). In the second scenario, the government's method yields a gain of $1 million ($20-$10 = $10 x 100,000). And in the third scenario, the government's method yields a gain of $0 ($10- $10 = $0 x 100,000). In other words, the government's method yields three different gain calculations that have nothing to do with the conduct constituting the offense and everything to do with smartphone manufacturers.
A method that yields three different gain calculations for the same conduct constituting an offense seems to make little sense as a way to calculate the "gain resulting from the offense" of insider trading. The Tenth Circuit reached that conclusion in United States v. Nacchio, 573 F.3d 1062 (10th Cir. 2009).
In Naccio, the defendant, former Qwest CEO Joseph Nacchio, received stock options with an exercise cost of $5.50. See id. at 1065. Nacchio received the options between 1997 and 2001. See id. In 2001, while in possession of inside information regarding Qwest's accounting, Nacchio sold the options at a price ranging from $37 to $42 for profits of just over $52 million on the sales. See id. at 1065, 1067-68. Nacchio also incurred some $7.3 million in brokerage costs for the sales. See id. at 1067-68.
The government argued that the starting point for determining Nacchio's "gain" was his net profit, i.e., the amount Nacchio earned from the sales minus the cost of making them, or $44.6 million. See id. at 1068. Nacchio argued that "to include for sentencing purposes the total amount he made on the stock sales as gain is punishing him for the normal appreciation in Qwest's shares from 1997 to 2001, which had nothing to do with the charged offense." Id. at 1069. Instead, like Rajaratnam, Nacchio submitted an "event study" by an expert witness that "estimated the portion of [his] proceeds from the sale of Qwest stock during the insider trading period that was attributable to inside information concerning Qwest's financial guidance" and accounting. Id. at 1068. The district court disagreed and began from the $44.6 million figure.*fn3
The Tenth Circuit reversed. Drawing on Judge Bright's dissent in United States v. Mooney, 415 F.3d 1093 (8th Cir. 2005), the Tenth Circuit began from the premise that "[t]he essence of the offense of insider trading is not the trading itself-standing alone, a lawful act- but trading on the basis of inside information." Id. at 1072 (emphasis in original). From that premise, "it logically follows that any gain associated with lawful trading should not be considered gain as used to increase a prison sentence." Id. Rather, "[t]he plain language of § 2F1.2 [the identical predecessor to section 2B1.4(b)]*fn4 supports the notion that an insider trading defendant's 'gain' should not consist of the total amount that the defendant realized from his or her stock sales, but should be limited more specifically to the gain that resulted from trading with insider knowledge." Id.
The Nacchio court acknowledged that the Guideline commentary referred to "the total increase in value realized through trading in securities. . . ." Id. at 1073 (quoting USSG § 2B1.4(b) cmt. background). However, the court noted that the commentary referred to this "total increase" in value as a description of "the gain," which in the guideline itself was followed by the words "resulting from the offense." See id. at 1073. Accordingly, like Judge Bright, the Tenth Circuit concluded that "the insider trading guideline specifically limits the gain to that 'resulting from the offense' and that "the 'total increase in value' commentary language specifies how to calculate that gain." Id. at 1073 (emphasis in original). In other words, the commentary's "instruction is . . . applicable to the narrowly defined 'gain' that falls within the [Guideline] definition." Id. (emphasis in original).*fn5
The Tenth Circuit further reasoned that "[t]he language of the guideline commentary supports the view that a stock's inherent value-i.e., the market's assessment of the stock's value, reflecting primarily the value of the firm's net assets and operations and its potential earnings and growth prospects-should not be a component of the gain amount: rather than the 'total value realized,' the commentary describes gain as the total increase in value realized'- contemplating that there is a baseline stock value from which the gain (i.e. increase) is measured." Id. at 1075 (emphasis in original).
Put another way, the Nacchio court analogized calculating insider trading gains to calculating loss causation in a securities fraud case under Rule 10b-5. In such a case, a defendant's misrepresentation inflates the price of stock and investors lose money when the stock price declines in response to the defendant's revelation of the truth. In similar terms, the Tenth Circuit stated that "Nacchio's benefit stemmed from the illicit, though speculative, effect of the material inside information on the value of Qwest stock." Id. at 1076. Further,
[u]nder the government's prosecution theory, the market would have viewed the inside information in a negative light, and disclosure of that information would have detrimentally impacted the value of Qwest stock. Therefore, the nondisclosure of the information allowed the stock to maintain an artificially high value and allowed Mr. Nacchio to benefit from that value when he traded in the stock. It is that illicit, artificially high value that should be reflected in the gain calculation, not the underlying value of the stock.
Finally, employing examples similar to those discussed above which resulted in different gain calculations for defendants who committed the same crime, see id. at 1082-84, the Tenth Circuit stated that "the district court's approach would divorce the sentencing assessment of gain from the defendant's individual culpability." Id. at 1082-84; see also id. at 1081 ("However, if the impact of unrelated twists and turns of the market is ignored in the sentencing calculus then an insider trading defendant is likely to suffer a sentence that is detached from his or her individual conduct and circumstances.").
Notably, in that regard, the Nacchio court distinguished cases in which "two otherwise equally culpable bank robbers may face different sentences based solely on the different amounts of money that tellers happened to place in their bags; and two otherwise equally culpable drug trafficking mules may face different sentences based only on the different quantities of drugs that unbeknownst to them were given to them for transport." Id. at 1081 n.16. While the court acknowledged that "different circumstances that produce these disparate sentencing outcomes may not have been within the control of the defendants or even within their ken," it concluded that "those circumstances nonetheless stem from, and are closely tied to, their individual criminal activity and the resulting harm-that is, their acts of robbing a bank and demanding money from the teller, and their acts of taking delivery of and ferrying illegal drugs." Id. "In contrast, the act of trading in securities" and "a whole host of factors can contribute to the gains or losses that a defendant incurs from trading in stock that have nothing to do with the criminal dimensions of his or her activity-factors that relate simply to the ordinary economics and psychology of the marketplace." Id.
The Tenth Circuit's decision in Nacchio makes a compelling case that the government's method could punish a defendant for exogenous market events and lead to unequal sentences for equal crimes. However, while the Nacchio decision seems correct to point out that the Guidelines refer to the "gain resulting from the offense," it is far from clear that the method that decision endorsed-and which Rajaratnam advances here-accurately calculates that gain.
It is true that the offense in Section 10b-5 "is not the purchase of stock itself, but the use of a manipulative or deceptive contrivance in connection with the purchase." Mooney, 425 F.3d at 1106 (Bright, J., dissenting) (quoting 15 U.S.C. § 78j(b)) (emphasis in original). And for that reason there is some appeal to using the kind of event studies that courts use in fraudulent misrepresentation cases. Indeed, both fraudulent misrepresentation and insider trading cases involve measuring the value of information to the market. The former involve the value of the information that a company should have disclosed but did not; the latter involve the value of information that a company has lawfully chosen not to disclose but later will. And in both cases, the change in the company's stock price that cannot be explained by other market factors has become an accepted measure for the value of information.
However, for purposes of determining the defendant's "gain resulting from the offense," there is an important difference between fraudulent misrepresentation and insider trading cases: the inside trader does not cause the price of a company's stock to move. Of course, complicated financial models might show that the market reacts to the way that certain investors are trading. But in general, one who trades in a company's stock does not affect its price the way that the company's announcements (or omissions from those announcements) do.
Another way of saying that is that when a stock declines after a company announces the truth, the decline results from the defendant's offense, namely, fraud. That offense involves making a statement that inflates the price of stock above what its price would be if the market knew the truth. Hence the decline in the stock price attributable to the revelation of the truth measures the difference to investors between a world where the defendant lied and a world where the defendant told the truth.
Insider trading is different. When an insider trades on the basis of material, non-public information, the insider usually does not cause any price inflation or deflation. Indeed, the Tenth Circuit in Nacchio seemed to acknowledge as much in stating that "the non-disclosure of the information allowed the stock to maintain an artificially high value" rather than that Nacchio's trading gave the stock an artificially high value. Nacchio, 573 F.3d at 1076. Similarly, when a stock declines after a company announces worse than expected earnings or rises when a company announces better than expected earnings, the decline or rise itself does not result from the defendant's insider trading. Rather, as the Tenth Circuit acknowledged, the fact that Qwest had not disclosed the inside information merely "allowed Mr. Nacchio to benefit from that value when he traded in the stock." Id.
Where the rise or decline in the price of a stock in response to a public announcement does not result from any action of the defendant giving rise to the offense, it is hard to say that a defendant's gain from the rise or decline is a "gain resulting from the offense" of insider trading. Indeed, the change in stock price following the public announcement of information that an insider traded on in advance does not measure the difference between a world in which the defendant acted lawfully and a world in which the defendant acted unlawfully. An insider and a lawful investor who purchase stock at the same time will earn the same profit.*fn6 The difference between them is not how each has affected the stock but what each knows about the company issuing it. Measuring the change in stock price might measure the value of what an insider knows, but that is not how the Guidelines measure the "gain." The commentary refers to the "value realized through trading in securities" not the value of the information used to do the trading. And the plain language of the "value realized through trading in securities" is the increase in the price of stock from the time that the defendant purchased it to the time he sold it.
Of course, as the Tenth Circuit took pains to point out, the commentary is only an interpretation of the phrase "gain" and the Guideline itself refers to "gain resulting from the offense." But measuring insider trading gains based on the value of the inside information misinterprets "offense" because it rests on the false premise that insider trading has legal and illegal parts for purposes of that term.
The Nacchio court distinguished between trading vel non-"standing alone, a lawful act" and "trading on the basis of inside information." Nacchio, 573 F.3d at 1072 (emphasis in original). That position-that the "gain" "should be limited . . . to the gain that resulted from trading with insider knowledge," id. at 1072-assumes that a single trade can be divided into "trading with insider knowledge" and trading on the basis of public information.
The Second Circuit, however, appears to have rejected that proposition. "Unlike a loaded weapon which may stand ready but unused, material information cannot lay idle in the human brain." United States v. Teicher, 987 F.2d 112, 120 (2d Cir. 1993). Hence "[i]t does not follow, that when one such piece of information is revealed to be material, in and of itself, and the trader knows it to be material, the trader might somehow consider the information irrelevant to the whole." Id. at 121. Indeed, the Second Circuit has stated that "[i]t strains reason to argue that an arbitrageur, who traded while possessing information he knew to be fraudulently obtained, knew to be material, knew to be nonpublic-and who did not act in good faith in so doing-did not also trade on the basis of that information." Id.
Thus however logical it may be "that any gain associated with lawful trading should not be considered gain as used to increase a prison sentence," Nacchio, 573 F.3d at 1072, where a defendant has traded on the basis of inside information, the defendant has not engaged in any "lawful trading." Rather, the defendant has committed an "offense." The fact that the defendant later earns profits that he would have earned if he had, in fact, traded lawfully does not change the fact that he has traded unlawfully. And having made the decision to do so, it makes no more sense to insulate the insider trading defendant from the risk that he will earn more than he expects than to insulate the bank robber who robs a bank from the risk that the vault is full.
To be sure, there is a sense in which that result subjects an insider trading defendant to market mysteries that are far more elusive than whether the bank vault will have any money. But that is hardly objectionable as a measure of the punishment for an offense that enables a defendant to avoid (or least minimize) those very same risks.
Because an insider trading defendant knows what is going to happen, he has a one-way ratchet. Returning to the above example, suppose that Rajaratnam (a) knew that Intel was going to announce positive earnings results; (b) believes that Intel is about to renew its agreement with smartphone manufacturers to use Intel chips; but (c) fears the truth of rumors that the smartphone manufacturers will use AMD chips instead. In that case, Rajaratnam can purchase Intel stock knowing that if he is wrong about the smartphone manufacturers, his losses will likely be minimized by the positive earnings results, whereas if he is right about the smartphone manufacturers, he will earn even more profits.
In the event that Rajaratnam is right about the smartphone but is caught, including his gain from the smartphone news only punishes him for realizing the benefits of his advantage over an investor who might not have had the confidence to purchase when Rajaratnam did. It is that advantage that truly lies at the core of the "offense" of insider trading, which is complete at the time that the defendant causes a trade to be executed. And a punishment that subjects one who ...