Securities Snapshot
March 26, 2019

Second Circuit Upholds $92.8 Million Civil Penalty for Insider Trading

Second Circuit upholds $92.8 million civil penalty for insider trading; Second Circuit affirms dismissal of shareholder suit against mutual fund investment adviser; Second Circuit affirms dismissal of “creative attempt to recast corporate mismanagement as securities fraud”; stock drop suit based on alleged misrepresentations and omissions relating to Lexmark’s inventory glut to proceed.

On March 5, 2019, a Second Circuit panel upheld a nearly $93 million civil penalty imposed on Raj Rajaratnam for insider trading. Rajaratnam appealed the decision of U.S. District Court Judge Jed S. Rakoff on two grounds. He argued that the lower court committed legal error by interpreting Section 21A of the Securities Exchange Act to allow civil penalties based on trades from which he did not personally profit. He also argued that the lower court abused its discretion by at once improperly considering his personal wealth while failing to consider the criminal penalties that had already been imposed on him.

In affirming Judge Rakoff’s decision, the Second Circuit held that under subsection 2(a) of Section 21A, a civil penalty may be based on the total profit resulting from a violation, not just the defendant’s personal profit. Under de novo review, the Second Circuit reasoned that if Congress had wanted to base the civil penalty solely on the profit earned by the defendant, it would have done so, as it had in other sections of the federal securities statutes, by expressly limiting a penalty’s amount to the “gross amount of pecuniary gain to such defendant as a result of the violation.” The Second Circuit also noted that basing civil penalties solely on the defendant’s personal trading profits would prevent courts from imposing civil penalties on tippers.  

After concluding that the basis for civil penalties under Section 21A is not limited to a defendant’s personal profit, the Second Circuit also held that Judge Rakoff did not abuse his discretion in considering Rajaratnam’s wealth when assessing the civil penalty. The Second Circuit noted that Judge Rakoff was not limited by the factors listed in SEC v. Haligiannis, which are not exclusive and had never been considered “talismanic.” Furthermore, the Second Circuit reasoned that consideration of a defendant’s wealth is critical to avoiding a penalty being perceived as just a “cost of doing business.” The Second Circuit also held that Judge Rakoff did not abuse his discretion because he explicitly considered Rajaratnam’s criminal penalties and fines and because the statute provides latitude to the courts in coming to such determinations.

The decision is notable because it establishes that the basis for civil penalties in insider trading cases is not limited by a defendant’s personal profit and may take into account the defendant’s wealth.


On March 18, 2019, a Second Circuit panel affirmed the dismissal of a shareholder suit accusing a mutual fund adviser of breaching its fiduciary duty under Section 36(b) of the Investment Company Act by charging excessive fees to manage one of its affiliated mutual funds. On appeal, plaintiff argued that the Southern District of New York erred by considering each of the six Gartenberg factors separately and by applying each of them incorrectly. 

Reviewing the lower court’s decision de novo, the Second Circuit held that any error in considering the Gartenberg factors individually was moot because its own independent evaluation determined that the complaint failed to state a claim.  Specifically, the complaint failed to raise an inference that the investment adviser charged excessive fees with regard to three of six of the Gartenberg factors. The Second Circuit rejected as “weak” the central allegations of the complaint—that the fees charged by the investment adviser were excessive because the investment adviser charged another affiliated mutual fund lower advisory fees, charged lower subadvisory fees to an unaffiliated mutual fund, and charged fees higher than those paid by other “large-cap U.S. equity blend” funds (as categorized by Bloomberg Financial). It also held that the complaint’s allegations regarding the nature and quality of services and profitability “wanting” because the complaint alleged that the fund’s performance was in the top 20% of similar funds and failed to allege any facts suggesting that the investment adviser’s profits for managing the fund were excessive. Although the Second Circuit held that the complaint did allege the existence of some fall-out benefits, some unshared economies of scale, and that the mutual fund’s board could have implemented a better process for evaluating the fees charged by the investment adviser, it ultimately concluded that those allegations did not support the inference that the fees charged were excessive. District Court Judge Edward R. Korman, who sat on the panel, filed a concurrence contending that an earlier Second Circuit decision in a different case brought under Section 36(b)—Amron v. Morgan Stanley Investment Advisors Inc.—bound him to the same result reached by the rest of the panel but imposes an “impossible pleading burden” by applying the Gartenberg factors before the close of discovery.

The decision is notable for being the first appellate decision to address whether the fee an investment adviser charges its own mutual funds is excessive because the investment adviser charges a lower fee to provide investment advisory services to third-party mutual funds as a subadviser. It is also one of the few decisions in the last 10 years to affirm dismissal of a Section 36(b) complaint before discovery. 


On March 5, 2019, a Second Circuit panel affirmed the dismissal of a putative class action brought on behalf of a purported class of individuals who acquired securities of Cigna Corporation from February 27, 2014 to August 2, 2016. The plaintiff claimed that statements made by Cigna and some of its officers regarding its regulatory compliance were materially misleading, constituting fraud under Sections 10(b) and 20(a) of the Securities Exchange Act and Rule 10b‐5 promulgated thereunder. The allegedly materially misleading statements included statements in the company’s 2013 and 2014 Form 10-Ks and Cigna’s code of ethics that Cigna has “established policies and procedures to comply with applicable requirements,” and that “it’s so important for every employee . . . to handle, maintain, and report on [Cigna’s financial] information in compliance with all laws and regulations. . . .” The plaintiff alleged that these statements, among others, coincided with a series of compliance failures by Cigna’s Medicare operations. Specifically, the Centers for Medicare and Medicaid Services sent Cigna more than seventy-five notices relating to compliance infractions from April 2014 through December 2015, and conducted an extensive audit of Cigna’s Medicare operations, concluding on January 21, 2016 that “Cigna substantially failed to comply with CMS requirements.” Cigna disclosed the audit result in a Form 8-K filed the next day, and Cigna’s stock price fell from $140.13 to $135.85 over the next four days. Following an announcement on July 29, 2016 that Cigna had spent nearly $30 million to remedy the compliance violations, Cigna’s stock price fell to $124.13.     

The Second Circuit concluded that a reasonable investor would not rely on the challenged statements as representations of regulatory compliance, distinguishing from those at issue in Meyer v. Jinkosolar, in which “the company described its compliance mechanisms in confident detail, including references to 24‐hour monitoring teams, specific compliance equipment, and its clean compliance record.” In contrast, statements about Cigna’s regulatory compliance were “simple and generic” and “framed by acknowledgements of the complexity and numerosity of applicable regulations.” Thus, the Second Circuit held that the statements were not materially misleading.

The case establishes that, without more, generic statements regarding a corporation’s compliance program cannot form the basis for a securities fraud class action.


On March 19, 2019, the Southern District of New York refused to dismiss a putative securities fraud class action naming as defendants Lexmark International, Inc. and certain of its senior executives. The suit is purportedly brought on behalf of investors who acquired Lexmark stock between August 1, 2014 and July 20, 2015. The plaintiff claims that the defendants made various materially misleading statements and omissions about Lexmark’s channel inventory levels and their impact on Lexmark’s financial health in SEC filings, press releases, earnings calls, and investor conferences. Lexmark’s accounting practices recognized revenue when Lexmark sold printer supplies into the channel to distributors, and not when distributors resold the inventory out of the channel to end users.  While Lexmark used models to estimate channel inventory levels, it did not publicly report its estimated channel inventory levels during the putative class period. Between mid-2014 and 2015, a confluence of factors, including Lexmark raising its prices and decreasing demand among end users, resulted in Lexmark’s distributors reaching a saturation point that prevented Lexmark from selling into the channel, thereby impairing its revenue.  While the individual defendants allegedly participated in monthly “CEO calls” that included details about a steadily increasing excess of channel inventory, the defendants refrained from disclosing or, alternatively, made materially misleading statements regarding Lexmark’s financial health to investors until a July 21, 2015 earnings call. Lexmark then stated that its dismal 2Q15 performance “was attributable to a decline in printer supplies revenue stemming from the need to reduce elevated channel inventory . . . .” Following the call, Lexmark’s stock fell 20% from $47.32 per share on July 20, 2015 to $37.75 per share on July 21.

While the defendants argued that the alleged misstatements were accurate and/or nonactionable opinions, the court ultimately sided with the plaintiff. Specifically, the court held that the alleged misstatements were materially misleading because they failed to mention the importance of channel inventory levels to Lexmark’s financial health and that channel inventory had swollen to unusual levels. The court similarly concluded that the plaintiff adequately alleged omissions based on the sufficiency of the allegations relating to the defendants’ misstatements as well as on the basis of a violation of Item 303. 

The defendants also argued that the complaint failed to allege scienter because it contains no allegations that the individual defendants had the motive to commit fraud. The court again sided with the plaintiff, holding that despite the absence of any allegations based on information from confidential witnesses, the inference of fraudulent intent was at least as compelling as non-fraudulent intent because the individual defendants were reckless in ignoring information about spiraling inventory levels that was provided during the monthly CEO calls. The court also held that the inference of fraudulent intent was supported by the “core operations” doctrine because inventory levels were critical to Lexmark’s prospects.

The opinion is an important reminder to companies of Item 303’s requirement to disclose known trends and uncertainties, even when they involve metrics not previously disclosed by the company.