U.S. v. Rajaratnam - No “Gain” Without Pain: Amending the Sentencing Guidelines for Insider Trading to Better Reflect the Rapidly Evolving Financial Industry

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295

U.S. v. Rajaratnam - No “Gain” Without

Pain: Amending the Sentencing Guidelines

for Insider Trading to Better Reflect the

Rapidly Evolving Financial Industry

Soo Ji Jung∗

ABSTRACT

The United States Sentencing Guidelines provide a range to place a crimi-

nal in a certain category and offense level that increases dependent upon

certain factors. For the crime of insider trading, one of the factors that in-

creases the offense level is “the gain resulting from the offense.” U.S.S.G.

§ 2B1.4. Only the Eighth and Tenth Circuit courts have interpreted “gain”

for sentencing purposes. The circuit courts’ interpretations of “gain” are

useful guideposts for sentencing purposes. However, a true representation

of the defendant’s crime is best calculated using the efficient capital market

hypothesis. In using such a method, a uniform calculation will better reflect

the goals of punishment and the sentencing guidelines.

I. INTRODUCTION

The United States Sentencing Guidelines (Guidelines) provide a range to place a defendant who is found guilty of trading on inside information in a certain category and offense level, which is dependent upon certain fac-tors.1 One of the factors that increases the offense level is “the gain result-ing from the offense.”2 Only the Eighth and Tenth Circuits have interpreted “gain” for sentencing purposes.3 Neither interpretation considers extrinsic

∗ University of Hawai′i at Mānoa, B.A. in Korean Language Flagship & Political Science,

B.B.A. in International Business & Management (2011); New England LawBoston, Can-

didate for J.D. (2014).

1. See U.S. SENTENCING GUIDELINES MANUAL ch.1, pt. A, §§ 1B1.1, 2B1.4, 4A1.1,

5A (2011).

2. Id. § 2B1.4.

3. See United States v. Mooney, 425 F.3d 1093 (8th Cir. 2005); United States v.

Nacchio, 573 F.3d 1062 (10th Cir. 2009).


296 CRIMINAL AND CIVIL CONFINEMENT [Vol. 40:295

factors, which affect the stock market and prices.4 The difference in the calculation may or may not seem like a detrimental amount, but the higher the calculated “gain,” the higher the proposed sentencing range.5 The cir-cuit courts’ interpretations of “gain” are useful guideposts for sentencing purposes. However, there is a need for a uniform calculation that is a true representation of the defendant’s crimes.

Consider the following hypothetical: Athos, Pathos, and Aramis share the same positive, material, non-public information about the future of their company, and each of them buys 1000 shares at five dollars a share.6 This information is made public four weeks later and is absorbed into the market by the fifth week so that the stock reflects that information by increasing to fifteen dollars a share.7 Athos sells his 1000 shares, making a gain of $10,000.8 Three months later, the stock price increases to fifty dollars a share, and Pathos sells his 1000 shares, making a gain of $45,000.9 Six months later, the stock price drops to two dollars a share, and Aramis takes a loss by selling his shares.10

Athos, Pathos, and Aramis have violated federal law by purchasing “a security of any issuer, on the basis of material non-public information about that security or issuer, in breach of a duty of trust or confidence.”11 Based on the Guidelines, all three of them would be sentenced to the same or different prison sentences, depending on the sentencing court’s interpre-tation of “the gain resulting from the offense.”12 Under the “market-absorption” approach adopted by the Tenth Circuit, Athos, Pathos, and Ar-amis would receive the same sentence of six to twelve months for the $10,000 gain made when the price of the stock was fifteen dollars a share.13 On the other hand, under the “net-gain” approach, adopted by the Eighth Circuit, Athos would receive a six to twelve month sentence for his $10,000 gain, Pathos would receive a fifteen to twenty-one month sentence for his $45,000 gain, and Aramis would receive a zero to six-month sen-

4. See Mooney, 425 F.3d at 1093; Nacchio, 573 F.3d at 1062.

5. See Nicholas P. Pellicani, No Pain, No Gain: The Criminal Absence of the Effi-

cient Capital Markets Theory From Insider Trading Sentencing, 84 ST. JOHN’S L. REV.

1057, 1057 (2010).

6. See Mooney, 425 F.3d at 1107 (Bright, J., dissenting).

7. See id.

8. See id.

9. See id.

10. See id.

11. 17 C.F.R. § 240.10b5-1(a) (2010); 15 U.S.C. § 78j(b) (2006).

12. U.S. SENTENCING GUIDELINES MANUAL §§ 2B1.1, 2B1.4 (2009).

13. See Mooney, 425 F.3d at 1107 (Bright, J., dissenting); §§ 2B1.1, 2B1.4, 5A (as-

suming these defendants are in Criminal History Category I).


2014] NO “GAIN” WITHOUT PAIN 297

tence for his $3,000 loss.14

The hypothetical above, although simplified, exhibits the differences be-tween the two approaches to interpreting the term “gain,” which have been adopted by the Eighth and Tenth Circuits.15 The different standards are a result of the difficulty in the calculation of gain and the lack of a single, vi-able, definitive definition of gain.16 According to the sentencing guidelines, when sentencing an offender for insider trading, the most important factor in determining a sentence is the amount “gained” by the offender.17 A uni-form calculation of gain is necessary in order for insider trading sentences to be predictable and equivalent to the culpability level of the defendant.

Part II of this Comment will examine the history and purpose of the Guidelines and insider trading. It is important to understand the underlying theories and purposes that drive the Guidelines. Part III will review the court’s decision in U.S. v. Rajaratnam.18 Part IV will explore the circuit split in the calculation of gain. Part V will propose a more flexible ap-proach to calculating gain that will better represent the offenders’ true cul-pability. This Comment concludes in Part VI, arguing that market-absorption and the net-gain approach do not adequately meet the practical and policy concerns of the guidelines. The United States Sentencing Com-mission (Commission), which is in charge of promulgating the Guidelines, should propose an amendment that can keep up with the rapidly changing financial industry and better serves the purposes of criminal punishment.

II. THE SENTENCING GUIDELINES & INSIDER TRADING

A. The Sentencing Guidelines

Effective November 1, 1987, the Commission promulgated guidelines that set the appropriate measure of sentences in relation to the crimes committed.19 The Commission is a permanent agency that monitors sen-tencing practices in the federal courts so that future amendments to the Guidelines will reflect the evolution of the justice system while balancing

14. See Mooney, 425 F.3d at 1107 (Bright, J., dissenting); §§ 2B1.1, 2B1.4, 5A.

15. See Mooney, 425 F.3d at 1107 (Bright, J., dissenting).

16. See Nicole Black, United States v. Nacchio and the Implications of an Emerging

Circuit Split: Practical and Policy Considerations of Amending Financial Gain as a Meas-

ure of Culpability, 87 DENV. U. L. REV. 633, 634 (2010).

17. See Danielle DeMasi Chattin, The More You Gain, the More You Lose: Sentenc-

ing Insider Trading Under the U.S. Sentencing Guidelines, 79 FORDHAM L. REV. 165, 168

(2010).

18. See generally United States v. Rajaratnam, No. 09 Cr. 1184(RJH), 2012 WL

362031 (S.D.N.Y. Jan. 31, 2012), aff’d, 719 F.3d 139 (2d Cir. 2013).

19. U.S. SENTENCING GUIDELINES MANUAL ch.1, pt. A.



the purposes of criminal punishment.20 By creating the Commission, Con-gress recognized the need for an agency to continuously review sentencing policies as there are changes in application, experience, statutes, and crimi-nal behavior.21

1. History & Purpose

The Sentencing Reform Act of 1984 was developed to further the goals of criminal punishment: deterrence, incapacitation, retribution, and rehabil-itation.22 The Commission prescribed guideline ranges that “specify an ap-propriate sentence for each class of convicted persons determined by coor-dinating the offense behavior categories with the offender characteristic categories.”23 The sentencing court must sentence the offender according to the appropriate range.24 If the court departs from the guidelines by sentenc-ing outside of the range, the court is obligated to specify its reasons.25 On appeal, the appellate court would review the reasonableness of the depar-ture.26 If sentenced within the range, the appellate court would review whether the Guidelines were applied correctly.27

In enacting the Sentencing Reform Act of 1984, Congress had three ob-

20. Id.

21. Id.

22. Id.

23. Id.

24. Id.; see United States v. Booker, 543 U.S. 220 (2005). The Court held that:

[T]he imposition of an enhanced sentence under the federal sentencing guidelines

based on the sentencing judge’s determination of a fact (other than a prior convic-

tion) that was not found by the jury or admitted by the defendant violated the

Sixth Amendment. The Court reasoned that an advisory guideline system, while

lacking the mandatory features that Congress enacted, retains other features that

help to further congressional objectives, including providing certainty and fairness

in meeting the purposes of sentencing, avoiding unwarranted sentencing dispari-

ties, and maintaining sufficient flexibility to permit individualized sentences when

warranted. The Court concluded that an advisory guideline system would continue

to move sentencing in Congress’ preferred direction, helping to avoid excessive

sentencing disparities while maintaining flexibility sufficient to individualize sen-

tences where necessary. An advisory guideline system continues to assure trans-

parency by requiring that sentences be based on articulated reasons stated in open

court that are subject to appellate review. An advisory guideline system also con-

tinues to promote certainty and predictability in sentencing, thereby enabling the

parties to better anticipate the likely sentence based on the individualized facts of

the case.

U.S. SENTENCING GUIDELINES MANUAL ch.1, pt. A.

25. U.S. SENTENCING GUIDELINES MANUAL ch.1, pt. A.

26. Id.

27. Id.



jectives in mind: (1) honest sentencing, (2) reasonable uniformity, and (3) proportionality.28 First, honest sentencing was an objective because before the Guidelines were put in place, the court imposed a sentence and the pa-role commission had discretion in determining how much of the sentence would be served.29 This led to obvious confusion and no uniformity in the length of sentences.30 Second, reasonable uniformity was an objective be-cause the disparity in sentences imposed on different offenders with similar crimes needed to be narrowed.31 Lastly, Congress wanted to put in place a system that would apply different sentences for crimes that were propor-tionate to the severity of the crimes committed.32

When amending the Guidelines, the Commission aims “to solve both the practical and philosophical problems of developing a coherent sentencing system.”33 The practical problems of sentencing include the organization of crimes into specific categories and provisions and the application of the technical terms of each provision.34 The philosophical problems include the need to meet the goals and purposes of sentencing determination.35 In order to amend the Guidelines in relation to insider trading, the Commission must: (1) look towards the category of economic crimes to provide context for the necessary changes, (2) consider the specific practical problems of using “gain,” and (3) ensure the amended change is consistent with the goals and purposes of the Guidelines and criminal punishment.36

B. Insider Trading

Insider trading in securities occurs when “a person in possession of ma-terial non-public information about a company trades in the company’s se-curities and makes a profit or avoids a loss.”37 It is punishable under the general anti-fraud provision of Rule 10b-5 of the Securities Exchange Act of 1934.38

28. Id.

29. Id.

30. Id.

31. Id.

32. Id.

33. Id. § 1A1.3.

34. Black, supra note 16, at 637.

35. Id.

36. Id. at 637-38.

37. MICHAEL V. SEITZINGER, THE SECURITIES AND EXCHANGE COMMISSION (SEC):

BACKGROUND, ISSUES, BIBLIOGRAPHY 17 (Brian J. Wilder ed., 1st ed. 2003).

38. 17 C.F.R. § 240.10b-5. “It shall be unlawful for any person, directly or indirect-

ly . . . [t]o employ any device, scheme, or artifice to defraud, . . . or [t]o engage in any act,

practice, or course of business which operates or would operate as a fraud or deceit upon

any person, in connection with the purchase or sale of any security.” Id.



The first requirement is a finding that the defendant is an “insider,” which is based on a duty not to trade on material, non-public information.39 Duty is premised on either classical or misappropriation schemes.40 Duty arises in a classical insider trading scheme when the corporate officer trades in his own corporation’s securities on the basis of material, non-public information.41 The corporate officer owes a fiduciary duty to the shareholders of the company not to trade on the non-public information.42 Duty arises under the misappropriation theory when a person takes “confi-dential information for securities trading purposes, in breach of a duty owed to the source of the information.”43

The second requirement is that the fraud must be “in connection with the purchase or sale of any securit[ies],”44 or when “capitalizing on such in-formation through securities transaction.”45 Thirdly, the trader must be aware that the information being used to purchase or sell the security is ma-terial and non-public.46 Lastly, the information must be “material,” which means information that “in reasonable and objective contemplation might affect the value of the corporation’s securities.”47

C. Sentencing for Insider Trading According to the Guidelines

The calculation for a sentence is based on a “point” calculation system.48 The points are calculated to a defendant’s total “Offense Level” (up to for-ty-three levels) and “Criminal History Category” (up to six categories).49 The offense level and criminal history category given to the defendant by the sentencing court are combined to give a range of months indicating the recommended sentence.50

The relevant provision to sentence an inside trader is section 2B1.4 of the Guidelines.51 The base offense level is eight and is increased in propor-tion to the gain resulting from the offense by using the table in section

39. Pellicani, supra note 5, at 1063.

40. Id.

41. Chiarella v. United States, 445 U.S. 222, 227-30 (1980).

42. Id. at 231-33.

43. United States v. O’Hagan, 521 U.S. 642, 652 (1997).

44. 15 U.S.C. § 78j (2010).

45. O’Hagan, 521 U.S. at 656.

46. 17 C.F.R. § 240.10b-5(b) (2010).

47. SEC v. Tex. Gulf Sulphur Co., 401 F.2d 833, 849 (2d Cir. 1968).

48. See generally U.S. SENTENCING GUIDELINES MANUAL §§ 2-5J (2011).

49. See id. §§ 1B1.1, 5A, 4A1.1.

50. Id. § 5A.

51. Id. ch.1, pt. A.



2B1.1.52 The central issue when sentencing for insider trading is the “gain resulting from the offense.”53 The court should consider that “the gain re-sulting from the deception stops when the deception stops, though there may be later gain (or loss) as the stock market gyrates along, unmolested by any deception.”54 Therefore, in order to ensure that the court sentences the defendant according to his or her harm committed by trading on materi-al, non-public information, it is crucial that the court conduct a thorough economic analysis to determine only the gain resulting from the decep-tion.55

III. EXAMINING UNITED STATES V. RAJARATNAM

A. Factual Background

Raj Rajaratnam was a billionaire investor and the head of Galleon Group, one of the world’s largest hedge funds.56 A federal jury convicted him of all fourteen counts of fraud and conspiracy on May 11, 2011 for in-sider trading.57 He was fined $10 million and sentenced to 132 months in prison, the longest ever prison sentence for insider trading.58 Rajaratnam and the government offered competing methods for calculating the “gain resulting from the offense.”59 After hearing arguments for the calculation of the defendant’s sentence, the sentencing court issued an opinion explain-ing their basis for the calculation.60

The United States District Court for the Southern District of New York agreed with the Government’s recommendation and calculated the applica-

52. See id. § 2B1.4(b)(1). The Guidelines refer to specific offense characteristics of

insider trading: “[i]f the gain resulting from the offense exceeded $5,000, increase by the

number of levels from the table in § 2B1.1 (Theft, Property Destruction, and Fraud) corre-

sponding to that amount.” Id.. For example, assuming that all other factors are equal and the

defendant is a first time criminal, the base level from a gain of $5,000 results in a sentencing

range of zero to six months, while a gain of $400 million would lead to a sentencing range

of 235 to 293 months. See id. §§ 2B1.1(b)(1)(A), (b)(1)(P), 2B1.4, 5A.

53. U.S. SENTENCING GUIDELINES MANUAL § 2B1.4 (2009).

54. United States v. Mooney, 425 F.3d 1093, 1106 (8th Cir. 2005) (en banc) (Bright,

J., dissenting).

55. See id. at 1108.

56. Michael Rothfeld, Susan Pulliam & Chad Bray, Fund Titan Found Guilty: Raja-

ratnam Convicted of Insider Trading; Jurors Cite Tapes: ‘Just a Lot of Evidence,’ WALL ST.

J. (May 12, 2011),

http://online.wsj.com/article/SB10001424052748703864204576317060246641834.html.

57. Id.

58. Id.

59. United States v. Rajaratnam, 09 Cr. 1184(RJH), 2012 WL 362031, at *1

(S.D.N.Y. Jan. 31, 2012).

60. Id.



ble Guideline ranges based off of a total offense level of thirty-eight and criminal history category of I to be between 235 and 293 months in pris-on.61 However, the Court significantly departed from the recommendation by sentencing him to 132 months in prison.62

B. The Court’s Reasoning

The government calculated the defendant’s gain “by taking the differ-ence 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.”63 This resulted in a total of $72,071,219 gained.64

On the other hand, Rajaratnam’s calculation relied on the premise that the phrase “gain resulting from the offense” meant “separating the gains attributable to the prohibited conduct (i.e., trading stock on the basis of ma-terial, non-public information) from gains attributable to factors unrelated to that conduct, such as gains caused by exogenous market movements or events unrelated to the material, non-public information.”65 Using an alter-native methodology calculated by an expert witness, the total “gained” was $36,358,313 (excluding losses avoided) and $41,710,839 (including losses avoided), which would mean a lower offense level than the government advocated.66

The Court concluded that the “gain resulting from the offense . . . [is] . . . the total increase in value realized through trading in securities by the de-

61. Id.

62. Courtney Comstock, Raj Rajaratnam Got a Lighter Sentence Because of the

Judge’s Sympathy, BUS. INSIDER (Oct. 13, 2011), http://www.businessinsider.com/raj-

rajaratnam-11-years-record-2011-10 (sentencing where Judge Howell factored in Raj’s

“progressive degenerative disease” and charitable donations and decreased the prosecution’s

recommended sentence of twenty-four years and probation’s recommended sentence of fif-

teen years to eleven years in jail and two years of probation); Peter Lattman, Raj Raja-

ratnam Assigned to Massachusetts Prison, N.Y. TIMES (Nov. 3, 2011),

http://dealbook.nytimes.com/2011/11/03/raj-rajartnam-assigned-to-massachusetts-prison/

(Raj Rajaratnam is serving his sentence at the Federal Medical Center Devens in Ayer,

MA); Rajaratnam, 2012 WL 362031, at *1.

63. Rajaratnam, 2012 WL 362031, at *4 (alteration in the original).

64. Id. at *2; Government’s Sentencing Memorandum at 37, Rajaratnam, 2012 WL

362031 (No. 1:09CR01184) ($63,812,164 from insider trading + $8,259,055 from the

Crossover fund = $72,071,219).

65. Rajaratnam, 2012 WL 362031, at *2.

66. Id.; Sentencing Memorandum on Behalf of Raj Rajaratnam at 26, U.S. v. Raja-

ratnam, 2011 WL 3473376 (S.D.N.Y. Aug. 9, 2011) (No. 1:09CR01184).



fendant.”67 The “offense” being when the offender executes or causes to be executed trades on inside information and “increase in value” meaning the difference between the purchase and sale price, the Court adopted the gov-ernment’s methodology.68

Therefore, the Court calculated Rajaratnam’s “gain” as:

[T]he sum of: (a) (the increase in the price of a company’s shares from

the time that Rajaratnam purchased them to the time that the public

learned the inside information) x (the number of shares that Rajaratnam

traded); and (b) (the decrease in value from the time that Rajaratnam

sold Intel,69 Google,70 and Goldman Sachs71 shares on the basis of tips

regarding those companies’ earnings to the time that the public learned

the earnings information) x (the number of Intel, Google, and Goldman

Sachs shares that Rajaratnam sold).

By any calculation, Rajaratnam’s gain falls between $50 and $100 mil-

lion, thereby warranting a 24 level increase to the base offense level of

eight (8).72

The Court included: (1) the “estimated actual gains based on the increase in price of a company’s shares from the date of defendant’s purchases to a time shortly after the public learned of the inside information”; (2) the “es-timated losses avoided in Intel and Google shares based on the decrease in price of the shares from the date defendant sold the shares to the time short-ly after the public learned of the inside information” and “losses avoided on Goldman Sachs’ stock were calculated based on the date certain analysts’ estimates of Goldman’s fourth-quarter loss in 2008 were publicized”; (3) “the defendant’s personal gains from insider trading” and “the much larger gains realized by Galleon investors” who benefited from the criminal activ-ity; and excluded (4) “any gains or losses avoided relating to the Galleon Crossover Fund” since there was “insufficient evidence to conclude that all these trades originated with the defendant.”73

67. Rajaratnam, 2012 WL 362031, at *8.

68. Id.

69. Id. at *11 (calculating that Rajaratnam avoided $882,915 in losses when he cov-

ered a short position in Intel stock on April 13 and April 16, 2007 using inside information

on Intel’s upcoming earnings announcement).

70. Id. at *12 (calculating that Rajaratnam avoided $5,312,250 in losses when he sold

135,000 shares in Google stock on July 13, 2007, using inside information on Google’s dis-

appointing earnings).

71. Id. (calculating that Rajaratnam avoided $3,800,565 in losses when he sold Gold-

man Sachs shares on October 24, 2007, using inside information on Goldman Sachs’ loss in

quarterly earnings).

72. Id. at *15.

73. Id. at *21.



IV. CIRCUIT SPLIT REGARDING THE INTERPRETATION OF “GAIN”

A. The “Net-Gain Approach”

1. The Facts of United States v. Mooney

The Eighth Circuit adopted the net-gain approach to interpreting gain in United States v. Mooney.74 Michael Alan Mooney was the former vice president of underwriting for United Health Care Corporation (United), one of the largest health care management service companies in the country.75 In early 1995, United approached the privately owned MetraHealth (Metra) and started negotiations for an acquisition.76 If United were to succeed in the acquisition, United would become the largest health care management service company in the country.77 During the negotiations, Mooney attend-ed confidential meetings and looked through “Metra’s financial records, membership projections, cost data, and confidential Book of Business.”78 United’s corporate counsel reminded all participants not to trade in stock and to keep the proceedings a secret.79

On May 17, 1995, Mooney contacted his stockbroker and instructed him to sell his 20,000 shares of United common stock.80 Mooney then used part of his $775,500 proceeds to purchase call options in United stock, amount-ing to $258,283.03.81 This gave him a right to buy 40,000 shares of United stock at $35 a share for the months of September, December, and Janu-ary.82 On June 22, 1995, the Wall Street Journal speculated that United would acquire Metra.83 On June 26, 1995, United publicly announced their decision to acquire Metra.84 On June 20, before the announcement, the stock traded at $40.125 per share; by July 15, the price was $44.50 per share; and by October 5, the price was over $49.00 per share.85 Mooney exercised his call options on July 14, October 4, and October 5, resulting in a return of $532,482.49.86

74. United States v. Mooney, 425 F.3d 1093 (8th Cir. 2005).

75. Id. at 1095.

76. Id.

77. Id.

78. Id. at 1096.

79. Id.

80. Id.

81. Id.

82. Id.

83. Id. at 1096-97.

84. Id. at 1097.

85. Id.

86. See generally id.



Mooney was charged with eight counts of mail fraud, four counts of se-curities fraud, and five counts of money laundering.87 He was found guilty on all counts and sentenced to forty-two months in prison and a $150,000 fine.88 Mooney appealed the decision, alleging that the district court erred in finding his gain as $274,199.96 and asserting that his gain was much less.89

2. Eighth Circuit’s Reasoning

The Court started its analysis with the plain language of the guideline.90 The “gain resulting from the offense” meant the defendant’s gain tied to the defendant’s offense.91 Furthermore, the commentary to § 2B1.4 defined gain resulting from insider trading as:

This guideline applies to certain violations of Rule 10b–5 that are com-

monly referred to as “insider trading.” Insider trading is treated essen-

tially as a sophisticated fraud. Because 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.92

The Court read this definition to mean that gain is the “total increase in value realized through trading in securities.”93 The commentary is an im-portant tool because it explains the guidelines, “provides concrete guidance as to how even unambiguous guidelines are to be applied in practice,” and is “an authoritative guide to the meaning.”94 The commentary helps with the interpretation and application of the Guidelines, which helps avoid sen-tencing disparities.95 Using the plain meaning and the commentary, the Court concluded that “gain is the total profit actually made from a defend-

87. Id. at 1097.

88. Id. at 1097-98.

89. Id. at 1098; Brief and Addendum of Appellant Michael Alan Mooney at 29, Unit-

ed States v. Mooney, 425 F.3d 1093 (8th Cir. 2005) (No. 02-3388) (noting that the court

calculated the “gain resulting from the offense” as the total sale price of options

($532,482.49) – total purchase price of options ($258,282.93) = $274,199.96), and Mooney

calculated his “gain resulting from the offense” as the value of calls on June 28 ($309,750) –

purchase price of calls ($258,282.53) = $50,467.47)).

90. Mooney, 425 F.3d at 1099.

91. Id.

92. U.S. SENTENCING GUIDELINES MANUAL § 2B1.4 cmt. background (2002).

93. Mooney, 425 F.3d at 1099.

94. Id. at 1100.

95. Id. at 1101.



ant’s illegal securities transactions.”96

Lastly, the Court decided that the Commission’s policy reasons behind this interpretation would reject Mooney’s approach.97 Using actual sales to calculate gain is a clear, accurate, and predictable bright-line rule that elim-inates the need to determine when the market has absorbed the material in-formation.98

Focusing on the increase in value “realized by the defendant’s trades provides a simple, accurate, and predictable rule for judges to apply and follows the congressional mandate that sentences reflect the seriousness of the offense.”99 Therefore, the Court held that the district court correctly in-terpreted and applied § 2B1.4 of the Guidelines.100

B. “Market-Absorption Approach”

1. Background of United States v. Nacchio

The Tenth Circuit illustrated the market-absorption approach in United

States v. Nacchio.101 Joseph Nacchio was the former CEO of Qwest Com-munications International, Inc. (Qwest).102 Qwest policy allowed officers to sell stock during short “trading windows” each quarter or according to an approved, fixed sales plan.103 In December 2000, Qwest executives in-formed Nacchio that a significant shift from indefeasible rights of use (IRUs) to monthly recurring revenue sales had to occur by April 2001 for the company to achieve their year-end public revenue target.104 Between April 26, 2001 and May 15, 2001, Nacchio exercised some of his options and sold 1,255,000 shares, which amounted to gross proceeds of $52,007,545.47.105 On July 4, 2001, Qwest issued a press release reporting its second-quarter financial results and hosted a conference call with inves-tors, announcing that their expected revenue would be near the low end.106 On August 14, 2001, Qwest “disclosed the magnitude of its 2000 and 2001 IRU sales in a filing with the Securities and Exchange Commission

96. Id. at 1100.

97. Id. at 1101.

98. Id.

99. Id.

100. Id.

101. United States v. Nacchio, 573 F.3d 1062 (10th Cir. 2009).

102. Id. at 1064.

103. Id. at 1065.

104. Id. at 1065-66.

105. Id. at 1065-68 (stating that the cost of exercising the options was $7,315,000; the

brokerage commissions and fees paid was $60,081.09; and the taxes paid were

$16,078,147.81).

106. Id. at 1066.



(SEC).”107 On September 10, 2001, Nacchio “issued a press release lower-ing Qwest’s public revenue targets for 2001 and 2002.”108

Nacchio was charged with forty-two counts of insider trading stemming from sales of Qwest stock using material, non-public information from January to May 2001.109 He was convicted of nineteen counts of insider trading, sentenced to seventy-months in prison for each count, two years of supervised release on each count, a $19 million fine, and a $52 million for-feiture.110 Nacchio appealed to the United States Court of Appeals for the Tenth Circuit, alleging that the district court had incorrectly calculated his “gain,” which led to an improper calculation of his sentence.111

2. The Tenth Circuit’s Reasoning

By rejecting the net-gain approach and adopting the market-absorption approach, the Court tried to create a more realistic and economic approach to the interpretation of “gain.”112 The Court determined that it is appropri-ate to look to the civil sphere, namely the civil disgorgement remedy, for guidance and that sentence should “reflect the individual criminal culpabil-ity of defendants and avoid unwarranted sentencing disparities.”113 This approach also was in accordance with the principles of federal sentencing policy since it “endeavors to hold the defendant accountable for the portion of the increased value of the stock that is related to his or her criminally culpable conduct.”114 Therefore, this method will not create sentencing disparities among similarly situated defendants.115

The Court determined that the district court should adopt a more realistic economic approach that (1) takes into account the “deception intertwined with the sales” due to the possession of insider information, and (2) com-putes “gain” for sentencing purposes based on the “gain resulting from that deception.”116 Therefore, the appeals court remanded the case with instruc-tions to the district court to calculate a figure that more closely approxi-

107. Id.

108. Id.

109. Id. at 1064.

110. Id. at 1066; Joseph P. Nacchio’s Sentencing Statement at 2, United States v.

Nacchio, 573 F.3d 1062 (10th Cir. 2009) (No. 105CR00545) (stating the Government’s

event study calculated “gain” to be between $24.1 million and $33.8 million, while

Nacchio’s event study calculated “gain” to be at most $1.8 million).

111. Nacchio, 573 F.3d at 1066.

112. Id. at 1072.

113. Id. at 1086.

114. Id. at 1080.

115. Id.

116. Id. at 1072.



mates the gain.117

V. EFFICIENT CAPITAL MARKET HYPOTHESIS

A. Purpose of Sentencing Guidelines & Punishment Objectives

The goals of criminal punishment are: rehabilitation, incapacitation, de-terrence, and retribution.118 Retribution seeks to punish an offender who chooses to commit a crime that is not in conformity with the values of the community.119 Thus, retribution is a theory of just deserts, that the “pun-ishment should be scaled to the offender’s culpability and the resulting harms.”120 Deterrence seeks to prevent future harm by deterring the com-munity as a whole from pursuing similar conduct and the offender through recidivism.121 The Sentencing Commission uses both retribution and deter-rence since there is no need to choose between the theories when the appli-cation of either theory would produce the same or similar results.122

B. Net-Gain v. Market-Absorption

The Eighth Circuit’s net-gain approach looks to the entire trade as a whole, which casts a broad definition of gain.123 The court in Mooney did not distinguish between the illegal transaction and the legal transaction.124 By adopting a broader definition, the Court emphasized the amount real-ized from the illegal transactions and did not limit its legal causation.125

On the other hand, the market-absorption approach adopted by the Tenth Circuit is a more narrow scope because the gain ends when the material, non-public information traded on becomes public information and the mar-ket absorbs the information.126 The Nacchio Court reasoned that the “un-derlying value of the share of stock, which is separable from the deceptive practice accompanying its purchase or sale, should not be attributed to an

117. Id. at 1087.


119. Id. at 657.

120. U.S. SENTENCING GUIDELINES MANUAL ch.1, pt. A (2011).


122. U.S. SENTENCING GUIDELINES MANUAL ch.1, pt. A (2011).


124. Id.

125. Id.; see United States v. Nacchio, 573 F.3d 1062, 1072 (10th Cir. 2009) (illustrat-

ing the flaws in assessing the culpability of trading on inside information, two traders have

options exercisable at $10: Trader 1 exercises and sells while the stock price is $35, making

a $25 profit; Trader 2 exercises and sells while the stock price is $10, making $0 profit;

when the inside information becomes public, the stock price drops to $5; under the net-gain

approach, only Trader 1 would be punished since Trader 2 did not earn a gain). See id.

126. Black, supra note 16, at 649-50.



inside trader.”127 Therefore, the Tenth Circuit limits the legal causation to “a reasonable time after” the material, non-public information is dissemi-nated.128

The net-gain approach looks to the time of sale to calculate gain.129 “The use of actual sales to calculate gain provides a clear and coherent bright-line rule, eliminating the need for extensive fact-finding to try and deter-mine when the market has absorbed non-public information.”130

In contrast, the market-absorption approach uses a “reasonable time after the dissemination of the material non-public information as the timeframe to calculate gain.”131 The reasoning behind this approach is that the “artifi-cially high value [attributable to the nondisclosure of material, non-public information]” should be used and not the stock’s inherent value and market price unrelated to inside information.132

In regards to the objectives of the Guidelines, the net-gain approach em-phasizes uniformity in sentencing but overlooks proportionality for the spe-cific offender by adopting a bright-line rule.133 The dissenting opinion in Mooney disliked this approach since it would result in unequal sentencing for equal crimes.134 However, the majority opinion stated that the market-absorption approach would be inappropriate in the criminal context.135

On the other hand, the market-absorption approach emphasizes propor-tionality by requiring extensive fact-finding but overlooks uniformity in sentencing.136 The Tenth Circuit emphasized proportionality of the crime and uniformity became a secondary purpose.137

As discussed in this section, the net-gain and market-absorption ap-proaches are lacking in certain important aspects of sentencing law. One is not necessarily a better method of calculating “gain” than the other because the Eighth and Tenth Circuit courts created these approaches to calculating “gain” without explicit approval from the Sentencing Commission. These competing approaches have led to differing standards in calculating “gain,” which could potentially lead to sentencing disparities in different courts for insider trading. An alternative method for calculating “gain” for sentencing

127. Nacchio, 573 F.3d at 1073 n.11.

128. Id. at 1078.


130. United States v. Mooney, 425 F.3d 1093, 1101 (8th Cir. 2005).

131. Black, supra note 16, at 652 (quoting Nacchio, 573 F.3d at 1078).

132. Nacchio, 573 F.3d at 1076-77.


134. Mooney, 425 F.3d at 1106-07 (Bright, J., dissenting).

135. Id. at 1101.


137. Nacchio, 573 F.3d at 1077.



purposes, which is a synthesis of the net-gain and market-absorption ap-proaches using the efficient capital market hypothesis, is proposed. Having one method for calculating “gain” will lead to uniformity in sentencing in-sider traders.

C. Applicability of the Efficient Capital Market Hypothesis (ECMH)

The efficient capital market hypothesis suggests that the prices in the stock market reflect all the material information available to the public and that the prices change rapidly as new information enters the marketplace.138 An efficient capital market is able to do this because it is efficient in pro-cessing information, so prices “fully reflect” all available information.139 This is based on the assumption that investors research such information and trade on that basis.140 Not all investors will have the same opinion of the value of stock but the efficient market approach results in stock prices that reflect all investors’ opinions of the stock price.141

The ECMH operates through a weak, strong, or semi-strong market re-sponse to information that represents the extent of the market’s efficiency based on the costs and availability of the information.142 A weak market is one where the “history of past prices does not lead to predictable valua-tions, minimizing exploitable trading opportunities.”143 A strong market is one where individuals “have monopolistic access to … information rele-vant [to] price.”144 A semi-strong market “assumes that all available public information is fully reflected in a security’s market price.”145 The price in a semi-strong market is the most realistic since it is a result of analysts at-tempting to interpret and process available information to purchase or sell shares.146

An efficient market is achieved by incorporating information into prices and providing liquidity in trading.147 Incorporating information into prices requires producing the information, verifying the information, processing the information, and analyzing the information.148 Providing liquidity in

138. Chattin, supra note 17, at 180.

139. EUGENE F. FAMA, FOUNDATIONS OF FINANCE: PORTFOLIO DECISIONS AND

SECURITIES PRICES 133 (1976).

140. Chattin, supra note 17, at 180.

141. Id.

142. Pellicani, supra note 5, at 1075.

143. Id.

144. Id.

145. Id.

146. Id. at 1075-76.

147. Id. at 1076.

148. Id.



trading requires a sufficient amount of competing participants seeking to achieve a predetermined risk level.149 Therefore, an efficient market re-quires information provided to all participants at a low cost and a large number of rational profit maximizers seeking to predict the future market values of individual securities.150

Once inside information becomes public, the information is reflected in the price of the stock and the insider is no longer misusing the information since the information is available to everyone.151 Therefore, liability for in-side trading should stop once the information becomes public and the price reflects the public information.152

The ECMH is better suited to defining “gain” for purposes of sentencing since the defendant should only be punished for the use of the undisclosed information; therefore, the price of the stock after disclosure is not an ade-quate measure. The ECMH is also better suited to meet the Guidelines’ pol-icies of (1) providing a clear standard of punishment; (2) avoiding sentenc-ing disparities; and (3) deterring future criminal conduct.153 The ECMH provides a clear standard of punishment by avoiding extensive fact-finding and only punishing according to the corrective disclosure period.154 In ad-dition, by accounting for profits unrelated to the curative disclosure, there will not be significant sentencing disparities.155 Lastly, the ECMH ap-proach results in a higher sentence when the stock price “bounces back” following a curative disclosure and having a definite period of confinement would effectively deter future criminal conduct.156

VI. CONCLUSION

As more individuals are being prosecuted for insider trading, the courts need a uniform interpretation of “gain” in order to impose the proper sen-tence on offenders. The Commission is in a position to promulgate new rules to facilitate the implementation of a uniform system. When proposing an amendment, the Commission should balance the practical and economic needs of a gain calculation to a dynamic and evolving financial market and the policy concerns of criminal punishment and federal sentencing goals.

Conflicting interpretations of the word “gain” leads to a sentencing dis-parity, which is the opposite of the Commission’s goals of uniform and

149. Id.

150. Id.

151. Id. at 1081.

152. Id. at 1082.

153. Id. at 1091.

154. Id. at 1091-92.

155. Id. at 1092-93.

156. Id. at 1093-94.



proportionate sentences. The net-gain approach and the market-absorption approach adopted by the Eighth Circuit and Tenth Circuit, respectively, do not adequately meet or further the goals of the Commission. The ECMH approach advocated in this Comment is a synthesis of the two approaches. It takes the need for a clear and coherent bright-line rule advocated by the Eighth Circuit and combines it with the culpability and duration advocated by the Tenth Circuit.

Insider trading is a crime because the government hopes to protect the operation of, and ensure confidence in, the securities markets. Section 2B1.4 of the Guidelines and defining “gain” for sentencing purposes should be amended to create uniformity in insider trading sentencing and further the purposes and goals of punishment and the Sentencing Commission. Such an amendment should create a hybrid-calculation methodology that includes the practical application needs of “gain” calculation and the policy objectives of criminal punishment and federal sentencing.

Documents

U.S. v. Rajaratnam - No “Gain” Without Pain: Amending the Sentencing Guidelines for Insider Trading to Better Reflect the Rapidly Evolving Financial Industry