                                                                             [PUBLISH]

                  IN THE UNITED STATES COURT OF APPEALS

                           FOR THE ELEVENTH CIRCUIT
                             ________________________

                                     No. 96-6084
                             ________________________
                            D. C. Docket No. 94-PT-2018-S

SECURITIES AND EXCHANGE COMMISSION,

                                                                 Plaintiff-Counter-
                                                                  Defendant-Appellant,

                                         versus

RICHARD F. ADLER,

                                                                     Defendant-Appellee,
PHILLIP L. CHOY, MAGATRONIC TRADING,
LIMITED, DOMER L. ISHLER,
                                                                     Defendants-Counter-
                                                                     Claimants-Appellees,
HARVEY L. PEGRAM,
                                                                     Defendant-Appellee.
                             ________________________

                      Appeal from the United States District Court
                         for the Northern District of Alabama
                            _________________________
                                  (March 27, 1998)

Before ANDERSON and COX, Circuit Judges, and ALARCON*, Senior Circuit Judge.

ANDERSON, Circuit Judge:

__________________
*Honorable Arthur L. Alarcon, Senior U.S. Circuit Judge for the Ninth Circuit, sitting by
designation.
      In this case, the appellant Securities and Exchange Commission (“SEC”) brought a

civil action against appellees Harvey L. Pegram, Richard F. Adler, Philip L. Choy,

Magatronic Trading Limited,1 and Domer L. Ishler, alleging violations of § 10(b) of the

Securities Exchange Act of 1934, 15 U.S.C. § 78j(b); SEC Rule 10b-5, 17 C.F.R. § 240.10b-

5; and § 17(a) of the Securities Act of 1933, 15 U.S.C. § 77q(a). The SEC seeks treble

damages for these alleged violations under the Insider Trading Sanctions Act of 1984, 15

U.S.C. § 78u-1. The SEC argues that Pegram engaged in illegal insider trading in September

1989. The SEC argues that not only Pegram, but also the other appellees engaged in illegal

insider trading in November 1992. We reverse and remand.



                      I. FACTS AND PROCEDURAL HISTORY

A. Pegram’s 1989 Transactions

      In 1984, Harvey Pegram, along with two business associates, founded Comptronix

Corporation (“Comptronix”), which provides contract manufacturing services to original

equipment manufacturers in the electronics industry. At that time, Pegram was made Vice

President of Purchasing and Material Management for Comptronix, and a member of its

Board of Directors. Pegram was also issued 869,897 shares of Comptronix Common


      1
     Magatronic Trading, Limited is a company owned by
Philip Choy and on behalf of which Choy traded his
Comptronix stock. A default judgment was entered
against Magatronic on November 30, 1995, in the amount
of $75,000. This default judgment has not been
appealed.
                                            2
Stock. In May 1989, Comptronix made an initial public offering of its stock. In the years

prior to the initial public offering, the relationship between the Comptronix founders

“disintegrated.” In July 1989, Pegram was removed from his position as Vice President of

Purchasing and Material Management and made Vice President of Marketing. On August

23, 1989, Pegram sued Comptronix and William Hebding, who was at that time the

Chairman and CEO of Comptronix, seeking a declaratory judgment and damages.2

Immediately after Pegram’s complaint was filed, Hebding asked Pegram to take an

indefinite leave of absence from Comptronix and to cease contact with Comptronix

customers. Pegram was eventually terminated in December 1989.

       During the early part of 1989, Comptronix began receiving decreased orders from

one of its largest customers, Conner Peripherals (“Conners”). On August 31, 1989,

Comptronix issued a press release stating that it had “received less than anticipated orders

from another major customer for disk drive products. As a result, management expects

that sales and earnings for the second half of 1989 will be lower than previously

anticipated, but still significantly higher than the levels of the previous year.” On

September 14, 1989, Pegram attended a meeting of the Comptronix Board of Directors.

Pegram contends that “nothing new of a material nature” was said regarding the Conners


       2
     In his complaint, Pegram alleged that Comptronix
had breached its employment contract with him, that
Hebding had misrepresented facts to Pegram concerning
the operation of Comptronix, and that Hebding had
tortiously interfered with Pegram’s employment
contract.
                                              3
account at this meeting, other than a statement reflected in the notes of Joe Ritch, the

secretary and general counsel of Comptronix, that “Conners shaky possibly all business

offshore.” The SEC contends, and the revised minutes of the Board meeting reflect,3 that

Comptronix’s CEO, William Hebding, reported to the Board that

       The Company was expecting either a complete termination or a substantial
       reduction in the orders from Conners, which is the largest customer of the
       Company due to Conner moving much of its manufacturing off-shore. Mr.
       Hebding stated that because Conners was the Company’s largest customer,
       when the information was disseminated the stock of the Company would
       likely drop substantially.

Therefore, during the September 14 Board meeting, the Board adopted a resolution

authorizing the company to purchase up to one million shares of its own stock in order to

support public confidence in the company.4

       On September 19 through September 26, 1989, Pegram sold 20,000 shares of

Comptronix stock. On October 6, 1989, Comptronix issued a press release stating that the

company “had received less than anticipated orders from a major customer for disk drive


       3
     Pegram alleges that the revised minutes of the
Board meeting were “doctored” by William Hebding in
order to make it appear that Pegram obtained material
nonpublic information at the Board meeting.
       4
     Pegram introduced evidence that at the September
14 Board meeting, Comptronix did not know with
certainty how many orders Comptronix would or would not
receive from Conners, and that after the September 14
Board meeting, Hebding met with Conners’ president who
reassured Hebding that Comptronix would still be able
to compete for Conners’ orders. However, Comptronix
soon learned that they would receive little or no
business from Conners.
                                              4
products,” the company “expect[ed] orders from this customer to decline even further in

the fourth quarter [of 1989],” and that “[a]s a result, Comptronix anticipates that sales and

earnings in the fourth quarter will be below the levels in the same period of 1988.”5 In

response to the Comptronix press release, the price of Comptronix stock dropped from

$3.63 to $2.63 over the next two trading days. The SEC maintains that by selling 20,000

shares of Comptronix stock before the October 6 press release, Pegram avoided $17,625 in

losses.

          Pegram contends that his September 1989 sales of Comptronix stock were not

made as a result of any alleged material nonpublic information, but were part of a

preexisting plan to sell Comptronix stock in order to buy an eighteen wheel truck for his

son’s business. First, Pegram emphasizes that he waited until September 19 to sell 20,000

shares of Comptronix stock because of a 120-day “lock-up” period following the initial

public offering of Comptronix stock on May 19.6 In an affidavit, Kenneth M. Sproul,

Pegram’s stockbroker, stated that on September 1, 1989, Pegram discussed his intention of



          5
     Pegram contends that an amended press release was
issued by Comptronix on that same day which stated that
1989 fourth quarter sales for Comptronix were expected
to be higher than 1988 fourth quarter sales. The SEC
alleges that no such amended release was issued and
Pegram did not produce any evidence of this purported
amended press release.
          6
     This lock-up agreement prevented Comptronix
officers and directors from selling any shares of
Comptronix stock until 120 days after the initial
public offering of Comptronix stock on May 19, 1992.
                                              5
selling 20,000 shares of Comptronix stock and that Sproul informed Pegram that the 120-

day lockup agreement with Comptronix’s underwriters would expire on September 14,

1989. Furthermore, as required by Comptronix company policy, Pegram obtained

approval for a sale from Joe Ritch, Comptronix’s general counsel on August 4, and

September 16, 1989.7 Finally, Pegram emphasizes that he sold only 20,000 of his 869,897

shares of Comptronix stock.

       The district court granted Pegram’s motion for summary judgment regarding the

1989 transactions in an unpublished order on May 2, 1995. After concluding that it was

“questionable” whether the information Pegram acquired at the September 14 Board

meeting was “material,” the district court found that Pegram “rebutted any reasonable

inference that he acted with scienter as is required under § 10(b), § 17(a), and Rule 10b-5”

because (1) Pegram did not sell a significant portion of his stock; (2) Pegram’s intention to

sell was known by the general counsel of Comptronix; and (3) Pegram sold the

Comptronix stock immediately after the lock-up period following Comptronix’s initial

public offering.

B. 1992 Transactions of Pegram, Choy, and Ishler



       7
     Joe Ritch was also a board member and the
corporate secretary of Comptronix. Ritch attended and
prepared the minutes of the September 14 Board meeting.
When asked why he interposed no objection when told of
Pegram’s proposed sale, and whether he believed Pegram
possessed material nonpublic information at the time,
Ritch stated that he “really did not think of it in
those terms.”
                                             6
       On November 15, 1992, the Comptronix Board of Directors held a special meeting

that was attended by Richard Adler, an outside director of Comptronix, by telephone from

Taiwan. None of the other appellees were present at this meeting. At the Board meeting,

the Comptronix directors were informed about potential fraud in which Comptronix CEO

and President William Hebding, President Allen Shifflet, and Treasurer Paul Medlin

allegedly made $4 million in false accounting entries in order to support certain

capitalized costs of the company. At this meeting, the Comptronix Board designated a

Special Committee, of which Adler was a member, to oversee an investigation into the

scheme.8 After a week of investigation, another meeting of the Board of Directors was

held on November 23, 1992, and the directors were informed that $16 million in false

accounting entries had actually been made, that there were not legitimate capitalizable

costs to offset these false entries, and that Comptronix’s sales records and earnings had

been misstated. Therefore, on November 25, 1992, Comptronix publicly announced that

Hebding, Shifflet, and Medlin were suspended from all decision-making responsibilities at

Comptronix and that the

       Board of Directors has formed a Special Committee to investigate certain
       matters relating to the Company’s financial statements. Based upon
       preliminary findings, the Special Committee believes that since 1989,
       certain members of the Company’s senior management have caused the
       Company to overstate gross profit by improperly recording certain assets on
       its balance sheet and either overstating current sales or understating current


       8
     The Comptronix directors were expressly advised
that they must keep the information they learned at the
Board meeting secret and confidential.
                                             7
       cost of sales on its income statement. There will likely be material
       adjustments to the Company’s historically audited financial statements.

This announcement resulted in a suspension of trading in Comptronix securities. When

trading resumed by the end of the day, Comptronix common stock had lost 72 percent of

its value, dropping from a closing price of $22 per share on November 24 to a closing

price of $6 1/8 per share on November 25.

       Richard Adler has maintained a social and business relationship with Harvey

Pegram for over thirty years. On November 16, 1992, the day after Adler first learned of

the potential fraud at Comptronix, Pegram, who was no longer an officer or director of

Comptronix, placed a call to Adler’s home in Taiwan at 7:53 a.m., Central Standard Time.

Phone records indicate that this call lasted 72 seconds.9 At 7:55 a.m., Pegram called his

wife, Margie Pegram, at home. Margie Pegram called the Pegrams’ stock broker at

approximately 8:07 a.m. and placed an order to sell 50,000 shares of Comptronix stock at

a limit price of $21 per share or better from a joint account she held with her husband.

Between November 16 and November 24, 1992, the Pegrams sold 150,000 shares of

Comptronix common stock. The SEC contends that Adler tipped Pegram in the early

morning call on November 16, 1992, and that the Pegrams avoided losses of $2,315,375.

       Harvey Pegram contends that the Pegrams’ sale of Comptronix stock in November

1992 was made pursuant to a preexisting plan to sell 150,000 shares of Comptronix after



       9
     Later that same day, Pegram placed a second call
to Adler at 4:26 p.m. that lasted 114 seconds.
                                             8
the November 3 presidential election. During the summer of 1992, the Pegrams decided

to sell 150,000 of their 400,000 shares of Comptronix stock based on their stockbroker’s

recommendation that they “diversify” their stock holdings.10 In August of 1992, the

Pegrams’ tax planner computed the taxes on selling 150,000 shares and advised them to

sell the shares in the fourth quarter of 1992. There is evidence that the Pegrams were

planning to sell the shares after the November 3 presidential election, but the illness and

death of Mrs. Pegram's father delayed the sale. Mrs. Pegram returned from her father’s

funeral on Friday, November 13, and she testified that November 16, the date of their first

sale of Comptronix stock, was the first opportunity she had to contact her stockbroker.

The Pegrams also emphasize that their 1992 sale of 150,000 shares of Comptronix stock

was “consistent” with their sale of 60,000 Comptronix shares in 1990 and 380,000

Comptronix shares in 1991.

       The Pegrams also testified that Mr. Pegram’s phone call to Mrs. Pegram on

November 16 was a “wake-up” call and that Mr. Pegram made no mention of a phone call

to Adler nor of any fraud at Comptronix.11 Pegram testified that between December 1991


       10
     Both Mr. and Mrs. Pegram testified that the
Pegrams debated about whether to sell 250,000 or
150,000 shares of Comptronix stock. Mrs. Pegram wanted
to sell 250,000 shares, but they eventually decided to
sell only 150,000 shares.
       11
     The Pegrams testified that their first knowledge
of any fraud at Comptronix came on November 25, 1992,
the date of Comptronix’s public announcement, and at
that time, they still owned approximately 250,000
shares of Comptronix stock. The value of the Pegrams’
                                              9
and December 1992, he frequently contacted Adler concerning requests for price quotes

on electronic parts and materials that Pegram needed for his business, BST

Manufacturing,12 and that his phone calls to Adler on November 16 related to these price

quotes.13 Therefore, Pegram argues that he did not possess material nonpublic information

about Comptronix when he and his wife sold 150,000 shares of Comptronix stock between

November 16 and November 24, 1992.

      The SEC also contends that Pegram tipped two business associates, Philip L. Choy

and Domer L. Ishler,14 who then traded on the information. On November 16, 1992, the

same day of the call from Pegram to Adler, Pegram made a call to Choy at Magatronic




remaining shares dropped approximately $4 million the
day of Comptronix’s public announcement.
      12
     After being discharged by Comptronix in December
1989, Pegram purchased BST Manufacturing, Inc., a small
company which assembled electronic control boards, in
December 1991.
      13
     On November 5, 1992, Adler sent a facsimile to
Pegram regarding an earlier facsimile from Pegram in
which Pegram sought price quotes on electronic parts.
Pegram testified that he did not have an opportunity to
review and respond to Adler’s facsimile until November
16 because of the death of his father-in-law. Pegram
testified that the electronic parts, which were scarce
and difficult to obtain, were ultimately purchased by
BST from a company which Adler worked with to obtain
and supply “difficult to locate” electronic parts.
      14
      Pegram, Adler, Ishler, and Choy, in addition to
being business associates, also saw each other socially
on occasion.
                                           10
Trading, Ltd. in Hong Kong at 8:02 p.m.15 At 9:39 p.m. that evening, Choy telefaxed the

brokerage firm for his company and directed its stockbroker to sell 5000 shares of

Comptronix stock at a price of “US$21/22" per share. This order was executed on

November 17 and 19, and the SEC contends that Choy and Magatronic avoided losses of

approximately $75,000 by selling Comptronix stock while in possession of material

nonpublic information. Choy and Pegram both testified that Pegram’s phone call to Choy

on the evening of November 16 was related to price quotes for Pegram’s business and that

Comptronix was not discussed by the parties. Pegram testified that he frequently

contacted Choy, a Hong Kong businessman, from December 1991 through January 1993

in order to obtain prices on electronic parts for BST Manufacturing.

       The SEC contends that Domer Ishler was tipped by either Pegram or Adler. On

November 15, 1992, Ishler called Adler while Adler, by telephone, was participating in

the special Comptronix Board meeting regarding the potential fraud at Comptronix. Adler

and Ishler both testified that Adler put the Board meeting on hold and told Ishler that he

could not talk with him and that Adler would call Ishler later. After a series of missed

connections, Ishler reached Adler on November 23 while Adler was in the U.S. for a

Comptronix board meeting. Ishler and Adler both testified that in this call Adler told

Ishler that he was in a meeting and that as soon as he knew his schedule, Adler would call

Ishler so they could “get together”. The SEC contends that Ishler was tipped about the



       15
         This call lasted 4 minutes and 42 seconds.
                                             11
fraud at Comptronix during one of his two phone calls with Adler or during a November

23, 1992, phone call with Pegram,16 and that on November 24, Ishler purchased 300 “put

options” in Comptronix stock based on this inside information.17 Ishler eventually

realized gains approximating $368,750 when he exercised the options after Comptronix’s

public announcement on November 25, 1992.


      16
     On November 23, 1992, one week after Pegram was
allegedly tipped by Adler, Ishler called Pegram at his
home at 11:23 p.m., and they had a conversation that
lasted approximately twenty-five minutes. The SEC
contends that Pegram revealed inside information about
the fraud at Comptronix during this call. Pegram and
Ishler both contend Ishler called Pegram in order to
determine the whereabouts of Adler.
      17
     Ishler purchased these put options for
approximately $21,000. The put options gave Ishler the
right to sell 30,000 shares of Comptronix stock at $20
a share and the options expired in three weeks. When
Ishler purchased the options, Comptronix was trading at
$22 ½ per share and thus unless the price of the stock
fell below $20 a share, Ishler would lose his $20,000
investment. Ishler testified that he went to the
stockbroker on November 24 in order to sell a thousand
shares of Comptronix “short” because he believed the
price of Comptronix stock would drop a few dollars a
share. Ishler and his broker both testified that they
discussed the stock of two other companies that were in
a similar line of business as Comptronix. After
writing out the ticket to sell Comptronix short, either
the broker or Ishler mentioned buying put options
because selling short would not have been nearly as
profitable as buying put options. Ishler had purchased
put options in 1990 with the same broker, and the
broker testified that Ishler had a history of buying
“highly speculative, high risk, leverage type” stocks
in industries similar to Comptronix.

                                           12
       In its May 2, 1995, order granting summary judgment to Pegram in regard to his

1989 transactions, the district court denied Pegram’s motion for summary judgment with

regard to the 1992 transactions because the timing of the telephone calls between the

appellees raised “a reasonable inference of materiality and scienter on the part of the

defendant [Pegram].” Therefore, the 1992 claims went to trial. However, after a seven

day jury trial, the jury was unable to reach a verdict and the district court declared a

mistrial. The appellees then filed renewed motions for judgment as a matter of law and

the district court granted the motions in an October 24, 1995, order.18 In granting

Pegram’s motion for judgment as a matter of law, the district court concluded that the

calls from Pegram to Adler, from Pegram to his wife, and from Pegram’s wife to her

stockbroker, raised a “possible reasonable inference” that Pegram received inside


       18
     In this order, the district court allowed Ishler
time to convince the court that he had timely filed an
initial motion for judgment as a matter of law and/or
to file a motion for summary judgment. In order for a
court to consider a renewed motion for judgment as a
matter of law, the moving party must have made a motion
for such a judgment under Rule 50(a) at the close of
all the evidence. Austin-Westshore Const. Co. v.
Federated Dept. Stores, Inc., 934 F.2d 1217, 1222 (11th
Cir. 1991); Fed. R. Civ. P. 50(b). Because the SEC
alleged that Ishler had not timely filed his initial
motion for judgment as a matter of law at the close of
evidence, Ishler filed a submission to establish that
his initial motion for judgment as a matter of law had
been timely filed. Ishler also filed a motion for
summary judgment. On December 6, 1995, the district
court entered an order granting Ishler’s motion for
summary judgment based on all the evidence introduced
at trial.
                                              13
information from Adler, but “any such inference” was rebutted by the evidence of

Pegram’s preexisting plan to sell 150,000 shares of Comptronix stock in November 1992.

The district court also granted judgment as a matter of law to Adler and Choy and

summary judgment to Ishler because the district court concluded that “the facts and

circumstances related to the other defendants [were] similar [to Pegram] and the principles

[were] the same.”19



                                      II. DISCUSSION

       We first discuss Pegram’s 1989 transactions, and then discuss the 1992 transactions

involving all four appellees.

A. Pegram’s 1989 Transactions

       A district court’s grant of summary judgment is reviewed de novo, applying the

same standards utilized by the district court. Konst v. Florida East Coast Ry. Co., 71 F.3d

850, 852 (11th Cir. 1996). Summary judgment should be granted only “if the pleadings,

depositions, answers to interrogatories, and admissions on file, together with the

affidavits, if any, show that there is no genuine issue as to any material fact.” Fed. R. Civ.

P. 56(c).


       19
     The district court noted that the revealed jury
split was 6-1 in favor of Ishler and that there was “no
need to discuss the evidence as to the other parties in
detail” because the SEC had “built its case on a domino
theory” and thus “[i]f the Adler-Pegram domino is not
significant, the others lose significant position.”
                                             14
       1. The SEC’s Legal Argument: The Knowing Possession Test

       The SEC argues that the district court erred as a matter of law in granting summary

judgment for Pegram in regard to his 1989 transactions in Comptronix stock because, in

concluding that Pegram’s preexisting plan to sell stock rebutted any reasonable inference

of scienter created by the suspicious timing of his sales, the district court improperly

considered whether Pegram used inside information in his trading. The SEC argues that

the district court incorrectly adopted a causal connection standard for insider trading

violations that allows a trader to avoid liability if the trader proves that he did not purchase

or sell securities because of the material nonpublic information that the trader knowingly

possessed. The SEC argues that it presented evidence that Pegram knowingly possessed

material nonpublic information, and thus Pegram, as a corporate director, violated the

prohibition against insider trading found in § 10(b), Rule 10b-5, and § 17(a) because,

“whether or not Pegram used the inside information,” Pegram traded in his company’s

stock while in possession of material nonpublic information.

       At the time of Pegram’s September 1989 sales, it is clear that Pegram possessed

nonpublic information. Pegram had attended the September 14, 1989, Comptronix Board

meeting at which nonpublic information was disclosed to Comptronix Board members.

There is a genuine issue of fact as to whether this nonpublic information was material. In

determining whether knowing possession of material nonpublic information, without

regard to whether this information was used or was an actual cause of the sale or purchase



                                              15
of securities,20 is sufficient to establish liability under § 10(b), Rule 10b-5, and § 17(a), we

must first consider the language of these provisions. See Ernst & Ernst v. Hochfelder, 425

U.S. 185, 197, 96 S. Ct. 1375, 1383 (1976) (quoting Blue Chip Stamps v. Manor Drug

Stores, 421 U.S. 723, 756, 95 S. Ct. 1917, 1935 (1975) (Powell, J., concurring)). Section

10(b) of the Securities Exchange Act of 1934 provides that

       It shall be unlawful for any person . . . [t]o use or employ, in connection
       with the purchase or sale of any security . . ., any manipulative or deceptive
       device or contrivance in contravention of such rules and regulations as the
       Commission may prescribe as necessary or appropriate in the public interest
       or for the protection of investors.

Pursuant to its rulemaking power under § 10(b), the SEC promulgated Rule 10b-5, which

provides that it is unlawful for any person

       (a) To employ any device, scheme, or artifice to defraud,
       (b) To make any untrue statement of a material fact or to omit to state a
       material fact necessary in order to make the statements made, in the light of
       the circumstances under which they were made, not misleading, or
       (c) To 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.

Section 17(a) of the Securities Act of 1933 provides that it shall be unlawful for any

person in the offer or sale of any securities:

       (1) to employ any device, scheme, or artifice to defraud, or
       (2) to obtain money or property by means of any untrue statement of a
       material fact or any omission to state a material fact necessary in order to


       20
     We refer to the two competing tests in the
following shorthand: the SEC’s position is “the knowing
possession” test, while the position advocated by
Pegram is the “use” or “causal connection” test.
                                                 16
       make the statements made, in the light of the circumstances under which
       they were made, not misleading, or
       (3) To engage in any act, practice, or course of business which operates or
       would operate as a fraud or deceit upon the purchaser.

Although § 10(b), Rule 10b-5, and § 17(a) do not explicitly address whether mere

possession of material nonpublic information at the time of trading is sufficient for

establishing liability of a corporate insider, the language suggests a focus on fraud,

deception, and manipulation.

       Several Supreme Court decisions are relevant to our discussion. In Chiarella v.

United States, 445 U.S. 222, 100 S. Ct. 1108 (1980), the Supreme Court repeated the

familiar maxim that under § 10(b) a corporate insider has a duty to disclose material

nonpublic information or to abstain from trading on the information. Id. at 1114 (quoting

In re Cady, Roberts & Co, 40 S.E.C. 907, 911 (1961)). This “disclose or abstain” rule

derives from the fiduciary duty that corporate insiders owe to the shareholders of the

corporation. The SEC argues that the “disclose or abstain” rule supports its position that

knowing possession of material nonpublic information while trading is sufficient to

establish liability under § 10(b). However, immediately after reciting the “disclose or

abstain” rule, the Chiarella court stated that an insider’s duty arises from “the unfairness of

allowing a corporate insider to take advantage of [inside] information by trading without

disclosure,” id. at 1114 (emphasis added) (citing In re Cady, Roberts & Co., 40 S.E.C. at

912, and n.15), and that “[t]he federal courts have found violations of § 10(b) where




                                              17
corporate insiders used undisclosed information for their own benefit.” Id. at 1115 (citing

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

       In Dirks v. SEC, 463 U.S. 646, 662, 103 S. Ct. 3255, 3265 (1983), the Court found

that a tippee's duty to disclose or abstain “is derivative from that of the insider's duty,” and

thus a tippee is only liable under § 10(b) or Rule 10b-5 for trading on the basis of material

nonpublic information if the inside tipper breached a fiduciary duty in disclosing to the

tippee. In determining whether the disclosure constituted such a breach of duty, the Court

considered whether the inside tipper personally benefitted directly or indirectly from the

disclosure to the tippee. Id. at 3264-65 (concluding that “[a]bsent some personal gain [to

the corporate insider], there has been no breach of duty to stockholders”).21 The Court

stated that “[n]ot only are insiders forbidden by their fiduciary relationship from

personally using undisclosed corporate information to their advantage, but they also may

not give such information to an outsider for the same improper purpose of exploiting the

information for their personal gain.” Id. at 3264 (emphasis added). This language and the

Dirks Court’s holding that an inside tipper must gain some personal advantage in order for

an outside tippee to be liable for trading on material nonpublic information, suggests that

knowing possession of material nonpublic information at the time of trading may not be

enough to establish liability for insider trading. Furthermore, the majority and the dissent

       21
     The Court also stated that “a purpose of the
securities laws was to eliminate ‘use of inside
information for personal advantage.’” Dirks, 463 U.S.
at 662, 103 S. Ct. at 3265 (quoting In re Cady, Roberts
& Co., 40 S.E.C. 907, 912 n.15 (1961)).
                                              18
in Dirks disagreed about whether motivation is relevant to proving scienter as an element

of an insider trading violation. Responding to the dissent's contention that “[t]he scienter

requirement addresses the intent necessary to support liability; it does not address the

motives behind the intent,” Dirks, 463 U.S. at 674 n.10, 103 S. Ct. at 3271 n.10

(Blackmun, J., dissenting), the Court stated that “contrary to the dissent’s suggestion . . .

motivation is not irrelevant to the issue of scienter. It is not enough that an insider’s

conduct results in harm to investors; rather a violation may be found only where there is

‘intentional or willful conduct designed to deceive or defraud investors.'” Dirks, 463 U.S.

at 663 n.23, 103 S. Ct. at 3266 n.23 (quoting Ernst & Ernst v. Hochfelder, 425 U.S. at 199,

96 S. Ct. at 1383). Finally, in United States v. O'Hagan, -- U.S. --, 117 S. Ct. 2199 (1997),

the Court stated that “[u]nder the 'traditional' or 'classical theory’ of insider trading

liability, § 10(b) and Rule 10b-5 are violated when a corporate insider trades in the

securities of his corporation on the basis of material, nonpublic information. Trading on

such information qualifies as a 'deceptive device' under § 10(b).” Id. at 2207 (emphasis

added).22 We acknowledge that the Supreme Court's language in Chiarella, Dirks, and

O’Hagan is dicta, because in those cases there was no question that the material nonpublic

information was actually used in trading.

       22
     In O’Hagan, the Court held that liability may be
based on the “misappropriation theory” because
“misappropriators . . . deal in deception. A fiduciary
who ‘[pretends] loyalty to the principal while secretly
converting the principal’s information for personal
gain’ . . . defrauds the principal.” O’Hagan, 117 S.
Ct. at 2208 (emphasis added).
                                               19
       Surprisingly, few courts have directly addressed whether §10(b), Rule 10b-5, and §

17(a) require a causal connection between the material nonpublic information and the

insider's trading or whether knowing possession of material nonpublic information while

trading is sufficient for liability.23 In United States v. Teicher, 987 F.2d 112, 119 (2d Cir.

1993), the two defendants, who were convicted by a jury of securities fraud, argued on

appeal that “the district court's jury charge erroneously instructed the jury that the

defendants could be found guilty of securities fraud based upon the mere possession of

fraudulently obtained material nonpublic information without regard to whether this

information was the actual cause of the sale or purchase of securities.” In discussing the


       23
     Although few courts have directly addressed the
issue, a number of commentators have expressed their
views on the use versus possession debate, with the
majority appearing to favor a causal connection/use
standard. See Allan Horwich, Possession Versus Use: Is
There A Causation Element in the Prohibition on Insider
Trading?, 52 Bus. Law. 1235, 1268 (1997) (ultimately
concluding, after a careful and thorough analysis of
the relevant case law, that the use test is “the better
rule”); 2 A. Bromberg & L. Lowenfels, Securities Fraud
& Commodities Fraud, § 7.4(600), at 7:159, 7:160.14
(1996) (ultimately concluding, after significant
analysis, that a corporate insider can introduce
evidence of nonuse of material nonpublic information as
an affirmative defense); 3 Arnold S. Jacobs, Litigation
and Practice Under Rule 10b-5, §66.02[c], at 3-657
(1981) (concluding that one of the “exceptions” to the
“general” disclose or abstain rule is that an
“insider's decision to buy or sell must be based on his
inside information”); but see 7 L. Loss & J. Seligman,
Securities Regulation 3504-3505 (3d ed. 1991)
(concluding, after brief analysis, that “[t]he very
difficulty of establishing actual use of inside
information points to possession as the test”).
                                              20
issue of whether a “causal connection” is a required element of a Rule 10b-5 violation, the

court listed several factors which tended to support the SEC’s position that a “causal

connection” is not required and that a violation is established merely upon proof that a

trade was conducted while the trader knowingly possessed material nonpublic

information.24 Although it is fair to say that the Teicher court appeared to look favorably

upon the SEC’s suggested test, the court’s discussion was clearly dicta. The court



       24
      The factors discussed included (1) the language of
§ 10(b) and Rule 10b-5 “require only that a deceptive
practice be conducted 'in connection with the purchase
or sale of a security'” and the “in connection with”
clause has been interpreted “flexibly”; (2) a “knowing
possession” test “comports” with the disclose or
abstain rule; (3) an inside trader “has an
informational advantage over other traders;” and (4)
the difficult task that the SEC would face in
attempting to prove that the inside information
actually impacted the insider's investment decision.
Teicher, 987 F.2d at 120-21. We find it difficult to
understand how the first factor is relevant to the
choice between a knowing possession and a use test. In
light of Chiarella and Dirks, we do not believe that
the third factor, an informational advantage, can be
considered a significant factor in establishing a Rule
10(b) violation. See Chiarella, 445 U.S. at 232-35,
100 S. Ct. at 1116-18 (rejecting the lower court’s
theory that the use by anyone of material nonpublic
information results in unequal access to information,
creates an unfair advantage, and thus is fraudulent;
the Court held that not every instance of financial
unfairness constitutes fraud under § 10(b)); Dirks, 463
U.S. at 656-57, 103 S. Ct. at 3262-63 (also rejecting
the equal access to information theory). We discuss
the second and fourth factors below and conclude that
they do not persuade us to adopt the knowing possession
test.
                                            21
expressly found that it was “unnecessary to determine whether proof of securities fraud

requires a causal connection.” Id. at 121.25

       In addition to the Supreme Court’s language in Chiarella, Dirks, and O’Hagan,

several cases arguably provide support for the proposition that there is no violation of §

10(b) and Rule 10b-5 in the absence of some causal connection between the material

nonpublic information and an insider’s trading. In a number of cases, courts have allowed

insiders to introduce evidence of preexisting plans or other “innocuous” reasons for sales

in order to rebut an inference of scienter. In In re Worlds of Wonder Securities Litigation,

35 F.3d 1407, 1427-28 (9th Cir. 1994), the court concluded that “[e]ven if the evidence

was sufficient to permit an inference that one or more of the defendants had access to

inside information, the defendants’ actual trading would conclusively rebut an inference of

scienter.” Furthermore, the court emphasized that some of the insiders “sold their shares

pursuant to a predetermined plan,” one insider sold “because it faced a pressing need to

service a huge debt incurred from overinvesting in real estate,” and another insider only



       25
     The court in Teicher obviously found the
defendants’ alleged motivations for trading to be
unpersuasive. The court stated, “It 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.” Teicher, 987 F.2d at
121. By considering the defendants’ alleged
motivations for trading, the Teicher court applied a
use/causal connection-type standard for insider trading
liability.
                                               22
sold a small percentage of his shares. Id.; see also Dura-Bilt Corp v. Chase Manhattan

Corp., 89 F.R.D. 87, 94-95 (S.D.N.Y. 1981) (In the context of a class certification and the

defendants’ argument that individual issues of fact predominated, the court indicated that a

relevant issue was whether the defendants “relied on inside information in making . . .

trading decisions.” The court stated that “[d]efendants’ reliance on inside information . . .

may be inferred from a showing of defendants’ possession of the information . . . [w]hile

defendants may introduce evidence to rebut this inference of use . . . .”).26




       26
     Pegram cites a number of other cases in support of
the proposition that a trader in possession of material
nonpublic information is able to rebut an inference of
use by producing evidence of a preexisting plan to sell
or another “innocuous” reason for trading. See, e.g.,
Searls v. Glasser, 64 F.3d 1061, 1068 (7th Cir. 1995);
Acito v. Imcera Group, Inc., 47 F.3d 47, 54 (2d Cir.
1995); Rubinstein v. Collins, 20 F.3d 160, 169 n.38
(5th Cir. 1994); In re Apple Computer Sec. Litig., 886
F.2d 1109, 1117 (9th Cir. 1989). The SEC argues that
these cases are not applicable to the use versus
possession debate because the cases were not actions
for inside trading violations, but instead involved
actions in which the insiders' trading was introduced
as evidence of the insiders' failure to make timely
public announcements of unfavorable corporate
information or as evidence that the insiders’
disclosure of positive information was a
misrepresentation. We agree with the SEC that these
cases cited by Pegram are not clearly applicable
because the relevant issues did not involve whether the
allegedly unfavorable inside information was the basis
or cause of the insider trading, but instead involved
whether the insiders actually possessed “negative”
material nonpublic information.
                                              23
       The SEC's position on whether knowing possession of material nonpublic

information while trading is sufficient to establish insider trading liability under § 10(b),

Rule 10b-5, and § 17(a) has undergone some fluctuation over time. In In re Investors

Management Company, Inc., [1970-71 Transfer Binder] Fed. Sec. L. Rep. (CCH), ¶

78,163, at 80,514 (SEC Ruling July 29, 1971), the SEC concluded that one of the elements

of an insider trading violation under §10(b) and Rule 10b-5 is that the material nonpublic

information “be a factor in [the insider's] decision to effect the transaction.” Id. at 80,519.

In evaluating this element, the SEC stated that when an insider engages in a sale just prior

to public dissemination of adverse inside information, then an inference arises that the

information was a factor in the investment decision, but “the recipient [of the inside

information] of course may seek to overcome such evidence by countervailing evidence.”

Id. at 80,522 n.28 (finding that the defendants' claims that they traded based on

“unconfirmed rumor” and “careful, painstaking analysis” of the corporation were not

sufficient to meet the defendants' “burden”).27 In Report of the Investigation in the Matter

of Sterling Drug, Inc., [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH), ¶ 81,570, at

80,295 (SEC Ruling April 18, 1978), the SEC, without mentioning its prior ruling and

without stating any rationale for its change of position, stated that “Rule 10b-5 does not


       27
         Commissioner Smith found that a corporate insider
would not be liable under § 10(b) and Rule 10b-5 “where a firm
decision to effect a transaction had been clearly made prior to the receipt of the
information and the information played no substantial role in the investment
decision.” Investors Management Co., Inc., ¶ 81,570 at 80,524 (Smith, concurring
in result).
                                              24
require a showing that an insider sold his securities for the purpose of taking advantage of

material non-public information.” Id. at 80,298 (rejecting evidence of an insider's

preexisting plan to sell because the SEC found that trading while in knowing possession of

material nonpublic information is sufficient for an insider trading violation).28

       We also must consider whether the provision allowing the SEC to seek treble

damages, the Insider Trading Sanctions Act of 1984 (“ISTA”), helps resolve whether

possession or use is the proper standard for an insider trading violation under § 10(b), Rule

10b-5, and § 17(a). See Aaron v. SEC, 446 U.S. 680, 700, 100 S. Ct. 1945, 1957 (1980).

In ISTA, Congress amended the Securities Exchange Act of 1934 to give the SEC

authority to seek a civil penalty of up to three times the amount of profit gained or loss



       28
         The SEC apparently has advocated a knowing possession standard for
insider trading liability since 1978. In testimony before Congress regarding the
Insider Trading Sanctions Act of 1984, the SEC General Counsel
asserted that the SEC's “consistent position has been
that possession of material inside information is the
test”, but the SEC Chairman noted that “in terms of
court decisions” the SEC has not “always won on that
ground.” Insider Trading Sanctions and SEC Enforcement
Legislation, Hearing on HR 559 Before Subcommittee on
Telecommunications, Consumer Protection and Finance of
the House Committee on Energy and Commerce, No. 98-33,
98th Cong., 1st Sess., 48-49 (1983). In a 1983
address, the SEC General Counsel stated that the SEC
“will continue to consider trading while in possession
of inside information as the test of liability, not the
more stringent [use] test,” but acknowledged that
“where the trader has a 'plausible argument that
complicates proof', the SEC will be 'cautious' about
bringing the case.” 15 Sec. Reg. & L. Rep. (BNA) 1820,
1821 (1983).
                                             25
avoided by a person who violates the federal securities laws “by purchasing or selling a

security while in possession of material, nonpublic information.” 15 U.S.C. § 78u-1(a)

(1997). Although Congress used the language “in possession” in ISTA, numerous

statements in the legislative history of ISTA disclaim any intent to modify the common

law definition of an insider trading violation. H.R. Rep. No. 98-355 (1984), reprinted in

1984 U.S.C.C.A.N. 2274 (report of House version of ISTA, H.R. 559);29 Insider Trading

Sanctions and SEC Enforcement Legislation, supra, at 49 (testimony of John M. Fedders,

SEC Director of Enforcement).30 We find that ISTA's “possession” language only sets a


       29
     The House Report stated that “[t]he legislation
does not change the underlying substantive case law of
insider trading as reflected in judicial and
administrative holdings. . . . The Committee believes
that the law with respect to insider trading is
sufficiently well-developed at this time to provide
adequate guidance. . . . the adoption of a statutory
definition could reduce flexibility; and . . . any new
definition which might be adopted would be likely to
create new ambiguities, thereby increasing rather than
limiting uncertainty.” H.R. Rep. No. 98-355 at 2286.
Congress resisted arguments from many members of the
bar to define insider trading and heard much
conflicting testimony regarding whether possession or
use was the correct standard for § 10(b) and Rule 10b-5
liability under the case law of that time. See
Bromberg & Lowenfels, supra, at 7:160.2-160.4.
       30
     Mr. Fedders testified before the House Committee,
which was considering the possession versus use issue,
that “[t]he proposed legislation in my view goes to a
remedy. It does not at the present time at all impact
the existing case law with regard to insider trading.
It is strictly a remedy saying that if a person engages
in this insider trading, however defined, that then the
amount of disgorgement can be three times the ill-
                                            26
condition for the SEC to seek a treble damages civil penalty that is discretionary with the

court and that is “implicitly dependent on the court finding a violation.” Bromberg &

Lowenfels, supra, at 7:160.3.31 Therefore, the “in possession” language of ISTA does not

resolve whether possession or use is the proper standard for an insider trading violation

under § 10(b), Rule 10b-5, and § 17(a).

       We view the choice between the SEC’s knowing possession test and the use test

advocated by Pegram as a difficult and close question of first impression. It is apparent

from the foregoing discussion that there is no definitive guidance on this issue from the

Supreme Court. However, we believe that Supreme Court dicta and the lower court

precedent suggest that the use test is the appropriate test. The strongest argument that has

been articulated in support of the knowing possession test is that a strict use test would

pose serious difficulties of proof for the SEC. It is true that it often would be difficult for

the SEC to have to prove that an insider used the inside information,32 i.e., that the inside




gained profit. And the proposed language that you have
before you, presented by the Commission, does not
impact the 'based on,' 'in possession of,' or a
'knowing' standard at all.”   Insider Trading Sanctions
and SEC Enforcement Legislation, supra, at 49.
       31
     Bromberg and              Lowenfels state that “Congress
clearly opted for              possession over use as a necessary
condition for the              civil penalty. Congress did not go
so far as to make              possession a sufficient condition for
the penalty, much              less for the violation.” Bromberg &
Lowenfels, supra,              at 7:160.4
       32
      We sometimes use “inside information” in this
discussion as shorthand for material nonpublic
information.
information has a causal connection to a particular trade. However, we believe that the

SEC’s problems in this regard are sufficiently alleviated by the inference of use that arises

from the fact that an insider traded while in possession of inside information.

       We believe that the use test best comports with precedent and Congressional intent,

and that mere knowing possession -- i.e., proof that an insider traded while in possession

of material nonpublic information -- is not a per se violation. However, when an insider

trades while in possession of material nonpublic information, a strong inference arises that

such information was used by the insider in trading. The insider can attempt to rebut the

inference by adducing evidence that there was no causal connection between the

information and the trade -- i.e., that the information was not used.33 The factfinder would

then weigh all of the evidence and make a finding of fact as to whether the inside

information was used.

       We adopt this test for the following reasons. First, of the several arguments in

support of the knowing possession test, the strongest is the fact that it often would be

difficult for the SEC to prove that an alleged violator actually used the material nonpublic

information; the motivations for the trader’s decision to trade are difficult to prove and




       33
          We note that if experience shows that this approach unduly frustrates the
SEC’s enforcement efforts, the SEC could promulgate a rule adopting the knowing
possession standard, as the SEC has done in the context of tender offers, see infra
note 36, or a rule adopting a presumption approach in which proof that an insider
traded while in possession of material nonpublic information would shift the
burden of persuasion on the use issue to the insider.
                                             28
peculiarly within the trader’s knowledge. However, we believe that the inference of use,

which arises from the fact that the insider traded while in

knowing possession of material nonpublic information, alleviates the SEC’s problem.34

The inference allows the SEC to make out its prima facie case without having to prove the

causal connection with more direct evidence.

       Second, we believe that our approach best comports with the language of § 10(b)

and Rule 10b-5, and with Supreme Court precedent. Section 10(b) of the 1934 Act

prohibits “any manipulative or deceptive device.” Rule 10b-5 and § 17(a) of the 1933 Act

prohibit “any device, scheme, artifice to defraud” and “any act, practice, or course of

business which operates or would operate as a fraud.” Similarly, the Supreme Court has

repeatedly emphasized this focus on fraud and deception. See O’Hagan, -- U.S. at --, 117

S. Ct. at 2209 (stating that “§ 10(b) is not an all-purpose breach of fiduciary duty ban;

rather it trains on conduct involving manipulation or deception”) (citing Santa Fe

Industries v. Green, 430 U.S. 462, 473-76, 97 S. Ct. 1292, 1300-02 (1977)); Dirks, 463

U.S. at 667 n.27, 103 S. Ct. at 3268 n.27 (concluding that “to constitute a violation of Rule

10b-5, there must be fraud”); Chiarella, 445 U.S. at 234-35, 100 S. Ct. at 1118 (stating that

“[s]ection 10(b) is aptly described as a catchall provision, but what it catches must be

fraud”); Ernst & Ernst v. Hochfelder, 425 U.S. 185, 199, 96 S. Ct. 1375, 1383-84 (1976)

(concluding that “manipulative,” “device,” and “contrivance” in § 10(b) “connot[e]

       34
      Thus, the fourth factor that Teicher listed as
supporting the knowing possession test is undermined.
See supra, note 24.
                                             29
intentional or willful conduct designed to deceive or defraud investors”). When an insider

trades on the basis of material nonpublic information, the insider is clearly breaching a

fiduciary duty to the shareholders and deriving personal gain from the use of the nonpublic

information. On the other hand, we do not believe that the SEC’s knowing possession test

would always and inevitably be limited to situations involving fraud. Indeed, O’Hagan, in

its discussion of the knowing possession test which has been adopted by the SEC in Rule

14e-3(a)35 for the tender offer context, recognized that the knowing possession test may

prohibit actions that are not themselves fraudulent. O’Hagan, -- U.S. at --, 117 S. Ct. at

2217 (holding that “under §14(e), the Commission may prohibit acts, not themselves

fraudulent under the common law or § 10(b), if the prohibition is ‘reasonably designed to

prevent ... acts and practices [that] are fraudulent’”).

       The SEC argues that the knowing possession test is supported by the familiar

maxim that an insider has a § 10(b) duty to disclose material nonpublic information or to

abstain from trading. However, a trade by an insider with such information does not


       35
     Rule 14e-3(a) provides that “[i]f any person has
taken a substantial step or steps to commence, or has
commenced, a tender offer . . ., it shall constitute a
fraudulent, deceptive or manipulative act or practice
within the meaning of section 14(e) of the ACT for any
other person who is in possession of material
information relating to such tender offer . . . to
purchase or sell or cause to be purchased or sold any
of such securities . . . unless within a reasonable
time prior to any purchase or sale such information and
its source are publicly disclosed by press release or
otherwise.” 17 C.F.R. § 240.14e-3(a) (1997) (emphasis
added).
                                               30
always and inevitably constitute a breach of the duty. Indeed, in the very case in which

the SEC articulated the “disclose or abstain” rule, In re Cady, Roberts & Co., 40 S.E.C.

907, 911 (1961), the SEC also acknowledged a preexisting plan to sell defense; the

defense was rejected for failure of proof, not as a matter of legal principle. Id. at 916

(finding that “we do not accept [the defendants’] contention that [one of the defendants]

was merely carrying out a program of liquidating the holdings in his discretionary

accounts-determined and embarked upon prior to his receipt of the [material nonpublic]

information. . . . The record does not support the contention that [one of the defendant’s]

sales were merely a continuance of his prior schedule of liquidation.”) We construe In re

Cady, Roberts & Co as an acknowledgment by the SEC that the analysis we embrace

today is not inconsistent with the “disclose or abstain” rule.36

       It is true that the SEC has stated its preference for the knowing possession test, both

in its brief to this court and in the Report of Investigation in the Matter of Sterling Drug,

Inc.. We decline to accord much deference to the SEC position for three reasons.37 First,

the SEC has not contended in this case that we should defer to its position. Second, as



       36
     Thus, the second factor listed by the court in
Teicher as supporting the knowing possession test is
undermined.
       37
         In Skidmore v. Swift & Company, 323 U.S. 134, 140, 65 S. Ct. 161, 164
(1944), the Court concluded “the weight of such a[n] [agency's] judgment in a
particular case will depend upon the thoroughness evident in its consideration, the
validity of its reasoning, its consistency with earlier and later pronouncements, and
all those factors which give it power to persuade.”
                                              31
noted above, the SEC position has not been consistent. In In re Investors Management,

the SEC initially utilized a test similar to the test we adopt today, and then in Sterling

Drug the SEC adopted a different position with no mention of its prior ruling and no

discussion of the rationale for the change.38 Third, the SEC has had ample opportunity to

adopt a rule or amend Rule 10b-5 so as to provide that a trade with knowing possession of

material nonpublic information triggers insider trading liability. However, although the

SEC has adopted such a rule in the context of tender offers,39 it has not formally adopted

the knowing possession test for insider trading. Rather, the SEC has articulated its

knowing possession test only in the context of a “report of investigation,” which provided

no reasoning and was not even binding on the parties to that matter. Report of

Investigation in the Matter of Sterling Drug, Inc., ¶ 81,570, at 80,295 (stating that “[t]he

investigation on which this Report is based was in no sense an adjudicatory proceeding . . .

[n]or is the report a determination of the rights or liabilities of any person”).

       In sum, we believe that the strong inference of use which arises from the fact that

an insider traded while in possession of material nonpublic information suffices to


       38
     Even now, the SEC apparently is “cautious” about
bringing cases where a trader has a plausible argument
that he did not use the inside information. See supra,
note 28.

       39
     In Rule 14e-3, the SEC adopted a knowing
possession test for trading on information related to
tender offers. See supra, note 35.


                                              32
alleviate the SEC’s difficulties in proving use. We believe that our approach best

comports with the statutory focus on fraud. See Chiarella, 445 U.S. at 243-35, 100 S. Ct.

1118 (“[s]ection 10(b) is . . . a catchall, but what it catches must be fraud”). Furthermore,

we do not believe our approach is inconsistent with the “disclose or abstain” doctrine, and

we do not believe deference to the SEC position in Sterling Drug is warranted.

       2. The SEC’s Factual Argument

       We turn now to the application of the test to the facts involved in Pegram’s 1989

transactions. On the dates of Pegram’s 1989 sales, it is clear that Pegram was in

possession of whatever information was dispensed at the September 14, 1989, Board

meeting. Although there is a genuine issue of fact as to the materiality of this information,

we agree with the district court that in the summary judgment posture of this case, we

must assume that the factfinder could find that Pegram possessed material nonpublic

information. Under the test we adopt today, the fact that Pegram traded while he

possessed material nonpublic information gives rise to a strong inference that such

information was used. Of course, the inference can be rebutted. Pegram has adduced

strong evidence that he had a plan to sell 20,000 shares of Comptronix stock and that the

plan predated his acquisition at the September 14, 1989, board meeting of the material

nonpublic information. However, after a careful review of this summary judgment record,

and in light of the strong inference that Pegram would have used that information in

finalizing his sale decision, we conclude that genuine issues of material fact remain for a

jury to decide (e.g., whether the information hastened the timing of Pegram’s decision to

                                             33
sell or affected the price at which he was willing to sell). Accordingly, the grant of

summary judgment in favor of Pegram as to the 1989 transactions is reversed.



B. 1992 Transactions of Pegram, Choy, and Ishler

       Unlike the action against Pegram regarding his 1989 transactions, the SEC’s action

against Pegram, Choy, Ishler, and Adler regarding their 1992 transactions in Comptronix

stock went to trial. After a seven day jury trial, the jury’s inability to reach a verdict, and

the district court’s declaration of a mistrial, the district court granted judgment as a matter

of law to Pegram, Choy, and Adler and summary judgment to Ishler.40

       We review a decision to grant a motion for judgment as a matter of law de novo,

applying the same standards utilized by the district court. Isenbergh v. Knight-Ridder

Newspaper Sales, Inc., 97 F.3d 436, 439 (11th Cir. 1996), cert. denied, 117 S. Ct. 2511

(1997). A judgment as a matter of law is warranted “[i]f during a trial by jury a party has

been fully heard on an issue and there is no legally sufficient evidentiary basis for a

reasonable jury to find for that party on that issue.” Fed. R. Civ. P. 50(a)(1). When

evaluating a motion for judgment as a matter of law, the court “must consider all of the

evidence and reasonable inferences arising therefrom in the light most favorable to the

nonmoving party” and “may not weigh the evidence or decide the credibility of

witnesses.” Isenbergh, 84 F.3d at 439. However, the nonmoving party “must provide


       40
         The district court granted Ishler’s motion for summary judgment based on
all the evidence introduced at trial, see supra, note 18.
                                              34
more than a mere scintilla of evidence to survive a motion for judgment as a matter of law;

‘there must be a substantial conflict in evidence to support a jury question.’” Id. (quoting

Carter v. City of Miami, 870 F.2d 578, 581 (11th Cir. 1989)).

       1. Pegram’s 1992 Transactions

       The SEC contends that during the 72 second telephone call from Pegram to Adler

on November 16, 1992, Adler tipped Pegram about the potential fraud that was disclosed

at Comptronix’s November 15 Board meeting. This telephone call is the primary alleged

source of material nonpublic information for Pegram. The issue before us is whether a

reasonable jury could find on this evidence that Adler tipped Pegram during that telephone

call. The SEC contends that the timing of the telephone calls between Pegram and Adler,

and Pegram and his wife, and his wife’s immediate sale of the stock, as well as the similar

scenario preceding Choy’s sale of Comptronix stock, combine to raise an inference that

Pegram possessed material nonpublic information. The SEC argues that a jury issue

remained notwithstanding Pegram’s preexisting plan to sell Comptronix stock in

November 1992.

       In order to establish liability under § 10(b), Rule 10b-5, and § 17(a)(1), the SEC

must prove that the inside trader acted with “scienter.” E.g., Aaron v. SEC, 446 U.S. 680,

695-696, 100 S. Ct. 1945, 1955 (1980). Scienter is defined as “a mental state embracing

intent to deceive, manipulate, or defraud.” Id. at 1950 n.5. Scienter necessarily requires

that the insider have possession of material nonpublic information at the time the insider

trades. See SEC v. MacDonald, 699 F.2d 47, 49 (1st Cir. 1983). Moreover, as we hold

                                             35
today in Part II.A.1, the SEC must also prove that the material nonpublic information was

used in the trade. However, proof of an insider’s possession of material nonpublic

information at the time of a trade gives rise to a strong inference of use. With respect to

the 1992 transactions, we discuss first the issue of Pegram’s possession of the information,

and then the use issue.

       Pursuant to well established law, the SEC raised a reasonable inference that Pegram

possessed nonpublic information by producing evidence of the suspicious timing of

Pegram’s 1992 sale of Comptronix stock and evidence of the phone calls between Adler,

Pegram, and Pegram’s wife. See, e.g., Freeman v. Decio, 584 F.2d 186, 197 n.44 (7th Cir.

1978); In re Apple Computer Sec. Litig., 886 F.2d 1109, 1117 (9th Cir. 1989) (“Insider

trading in suspicious amounts or at suspicious times is probative of bad faith and

scienter.”). This inference that Pegram possessed inside information also finds support in

the Pegram-Choy telephone call and the immediately following sale by Choy.

       However, it is also well established that this inference of possession is rebuttable.

In Freeman v. Decio, 584 F.2d 186 (7th Cir. 1978), a stockholder of a corporation brought

a derivative action against certain officers and directors of the corporation for allegedly

trading in the stock of the corporation on the basis of material inside information. After

concluding that the plaintiff could not maintain a derivative action for insider trading

under state law, the court considered the plaintiff’s argument that “the district erred in

considering evidence of the defendants’ past patterns of sales of [the corporation’s] stock



                                              36
and their motivations for making the sales in question.” Id. at 197. In rejecting the

plaintiff’s argument, the court concluded that

       When it is shown that an insider made a sudden sale of a significant portion
       of his holdings of his corporation’s stock and that subsequently, material
       adverse information became public concerning the corporation which led to
       a significant drop in the price of the stock, an inference arises that the
       insider was “bailing out” on the basis of material inside information.
       However, this inference can be nullified by a showing that sales in question
       were consistent in timing and amount with a past pattern of sales or that
       other circumstances might reasonably account for their occurrence. Hence,
       the district court was correct to consider these factors.

Id. at 197 n.44. See also In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1427-28 (9th

Cir. 1994) (concluding that where an inference of possession of material nonpublic

information and scienter arises from sales of stock prior to financial collapse, credible and

wholly innocent explanations for the sales--e.g., sales pursuant to a predetermined plan,

because of a pressing need to service a huge debt or sale of only a small fraction of

holdings--can rebut the inference of possession).41

       Thus, precedent and common sense indicate that where an inference of possession

of inside information arises from the suspicious timing of the sale, a credible and wholly

innocent explanation for said sale and timing tends to rebut the inference. In applying this

       41
           Although in Worlds of Wonder, the court affirmed the grant of summary
judgment in favor of the alleged inside trader, the different facts of the instant case
leave a jury issue. In Worlds of Wonder, the inference of possession was based
primarily on the fact that the insiders sold stock shortly before the public
announcement of unfavorable information; in the instant case, in addition to the
fact that the defendants sold stock shortly before the public announcement of
unfavorable information, the inference is supported by the phone calls from
Pegram to Adler, Pegram to his wife, and Pegram to Choy.
                                             37
legal principle, we have carefully reviewed the evidenced adduced at trial. Considering all

reasonable inferences in favor of the SEC, as we must in the posture of this motion by

Pegram for judgment as a matter of law, we conclude that a reasonable jury could find that

Adler tipped Pegram and thus that Pegram possessed material nonpublic information. The

SEC first emphasizes the evidence that Adler possessed material nonpublic at the time of

the November 16, 1992, telephone call with Pegram.42 Although the telephone call lasted

only 72 seconds, a jury could find that sufficient time existed for Adler to convey material

nonpublic information to Pegram. The following suspicious chronology raises a

reasonable inference that Pegram received such information from Adler:

              - the 7:53 a.m. telephone call between Pegram and Adler on November 16,

1992;

              - the 7:55 a.m. telephone call on the same day from Pegram to his wife;

              - the 8:07 a.m. telephone call on the same day from Mrs. Pegram to her

stockbroker placing the order to sell 50,000 shares of Comptronix stock;

              - the Pegrams’ sale of an additional 100,000 shares between November 18

and November 24, 1992.

This inference that Pegram possessed material nonpublic information is also supported by

the chronology of telephone calls relating to Choy and Choy’s stock sale:



         We conclude without need for further discussion that there is a jury issue
        42

as to whether the information that Adler learned during the November 15, 1992,
Comptronix Board meeting was material.
                                            38
              - Pegram’s telephone call to Choy at 8:02 p.m. on November 16, 1992, the

same day as the Pegram-Adler call;

              - Choy’s 9:39 p.m. fax on the same day to his stockbroker directing the sale

of Choy’s 5000 shares of Comptronix stock.

       Thus, based on this suspicious sequence of events, an inference arises that Pegram

received material nonpublic information from Adler. However, the inference can be

rebutted. Pegram has adduced strong evidence that he and his wife had a plan to sell

Comptronix stock, and that the plan predated the alleged tip on November 16, 1992. In

addition, Pegram has adduced evidence of innocent explanations for each of the relevant

telephone calls. Although Pegram’s evidence is strong, we cannot conclude that a

reasonable jury was required as a matter of law to believe every detail of the plan as

asserted by Pegram,43 nor was the jury required to believe the allegedly innocent

explanations for the telephone calls.

       Having concluded that a reasonable jury could find that Pegram received material

nonpublic information from Adler, we also conclude, for similar reasons, that a reasonable

jury could find that Pegram used the information in connection with his November 1992

sale of 150,000 shares of Comptronix stock (e.g., that there was a causal relationship

       43
     As noted above, the inference that Pegram
possessed the inside information arises not only from
the chronology surrounding the Pegrams’ sales, but also
from the chronology of the Pegram-Choy call and the
immediately following sale by Choy. The preexisting
plan to sell by the Pegrams does nothing to rebut the
latter inference.
                                             39
between the inside information and the time of Pegram’s sale or the price at which Pegram

was willing to sell).

       We conclude that these fact-intensive issues should be decided by a jury, which is

in the position to observe the demeanor of witnesses and make appropriate credibility

determinations. Accordingly, the judgment as a matter of law in favor of Pegram as to the

1992 transactions is reversed.

       2. Choy’s 1992 Sale of Comptronix stock

       As indicated above, at 8:02 p.m. on the evening of November 16, 1992, Pegram

called Phillip Choy. At 9:39 p.m. that same evening, Choy telefaxed the brokerage firm

for his company, Magatronic Trading Limited, and directed his stockbroker to sell 5000

shares of Comptronix stock. This order was executed on November 17 and 19. Choy

contends that he had a preexisting plan to sell his Comptronix stock in late 1992.44 Having

held that a reasonable jury could find that Pegram possessed and used material nonpublic


       44
          Choy introduced evidence indicating that in September 1992, Choy
contacted his stockbroker at Prudential Securities regarding the price of 5000
shares of Comptronix stock that Prudential held on behalf of Choy’s company,
Magatronic Trading Limited. Choy’s stockbroker replied that he had received
internal approval from Prudential for the sale of the Comptronix stock and that
Choy should contact him if he wanted to sell. Choy’s stockbroker also sent Rule
144 forms to Choy and informed Choy that he would have 90 days from the date of
submitting the forms to sell the Comptronix stock. Choy faxed his stockbroker and
stated that he would submit the Rule 144 forms when he wished to sell the shares.
In mid-October, Choy’s stockbroker informed Choy that Comptronix stock had
reached a new high. However, it was not until the evening of November 16, that
Choy placed his order to sell the 5000 shares and then submitted the Rule 144
forms on the next day.
                                            40
information in connection with his 1992 trading, we readily conclude that Choy’s

relatively weak evidence of a preexisting plan is not sufficient to rebut the inference that

he received material nonpublic information from Pegram and then used that information in

connection with his decision to sell 5000 shares of Comptronix stock. Therefore, the

district court’s grant of judgment as a matter of law in favor of Choy is reversed.

       3. Ishler’s 1992 Transaction; Adler’s Judgment as a Matter of Law

       The SEC alleged that Domer Ishler received material nonpublic information from

either Pegram or Adler, and that Ishler purchased 300 “put options” in Comptronix stock

on the basis of this inside information.45 In granting judgment as a matter of law to Ishler,

the district court relied on its rejection of the Pegram-Adler allegation. Because we have

found a jury issue in that regard, the district court’s reasoning has been undermined.

Ishler has proffered no evidence of a preexisting plan to buy Comptronix put options, and

argues only that his purchase of the put options was consistent with evidence of his prior

trading in options and other high-risk investments. This evidence is clearly not sufficient

to rebut the reasonable inference that Ishler possessed and traded on the basis of material

nonpublic information. This inference arises from the evidence of the multiple calls

between Ishler and Adler during mid-November 1992, the November 23, 1992, phone call

from Pegram to Adler, and the timing of Ishler’s purchase of Comptronix put options after

the telephone calls and immediately before the Comptronix press release that caused the


       45
            See supra note 17 for a discussion of Ishler’s purchase of Comptronix put
options.
                                             41
stock price to plummet dramatically.46 Therefore, we conclude that there is a genuine

issue of fact as to whether Ishler possessed and traded on material nonpublic information,

and we reverse the district court’s grant of summary judgment in favor Ishler.

       Finally, based on the above evidence and reasoning, we also conclude that the

district court erred in granting judgment as a matter of law to Adler. In other words, a

reasonable jury could find that Adler communicated material nonpublic information to

Pegram and/or to Ishler, who then traded upon it.47 Accordingly, we reverse the grant of

summary judgment to Ishler and reverse the grant of judgment as a matter of law to

Adler.48


       46
          We note that Ishler’s purchase of Comptronix put options was a bet that
the price of Comptronix would fall.
       47
     Ishler and Adler argue that the district court’s
grant of summary judgment to Ishler and judgment as a
matter of law to Adler should be affirmed because the
full extent of the fraud at Comptronix was not known at
the time of the November 15, 1992, Board meeting, and
thus the information learned by Adler at this meeting
was not material. We reject this argument as without
merit because there is a genuine issue of fact as to
the materiality of the nonpublic information learned by
Adler at the Board meeting. Furthermore, we also note
that the SEC produced evidence that Ishler and Adler
communicated on both November 15 and November 23 and
that by November 23, Adler had learned the full extent
of the fraud at Comptronix.

       48
     We also reject the appellees’ argument that the
SEC must prove any claims for treble damages under the
Insider Trading Sanctions Act of 1984 (“ISTA”) by clear
and convincing evidence. In Herman & MacLean v.
Huddleston, 459 U.S. 375, 388-91, 103 S. Ct. 683, 690-
                                            42
                     III. CONCLUSION


92 (1983), the Court established that plaintiffs in
civil actions under § 10(b) of the Securities Exchange
Act of 1934 need prove their cases only by a
preponderance of the evidence. The Court concluded
that clear and convincing evidence should be required
only in proceedings “where particularly important
individual interests or rights are at stake” and that
“imposition of even severe civil sanctions that do not
implicate such [individual] interests has been
permitted after proof by a preponderance of the
evidence.” Id. at 691. Although Huddleston was
decided before Congress passed ISTA, Congress expressed
approval for the preponderance standard in the
legislative history of ISTA:
        Some commentators expressed the view that,
    in light of the potential for a large penalty,
    the appropriate burden of proof in a civil
    penalty action brought by the Commission under
    the legislation should be more than the
    ‘preponderance of the evidence’ standard
    applicable to Commission injunctive actions.
    The Committee rejects this notion because a
    higher proof standard could hamper Commission
    penalty actions. The Supreme Court has
    expressly approved of the preponderance of the
    evidence standard in governmental civil penalty
    suits. The civil penalty proposed here is
    distinct in nature from those types of judicial
    action on which higher proof standards have
    been imposed.
        The Committee believes that, since the
    bill provides a new sanction, and makes no
    change to the underlying law, no additional
    language is required in the statute to express
    the intent of Congress that the preponderance
    of the evidence standard be applied to penalty
    actions brought under the legislation.
H.R. Rep. No. 98-376 (1984), reprinted in 1984
U.S.C.C.A.N. 2274, 2288-89 (citations omitted).
                           43
       For the foregoing reasons, we reverse the grant of summary judgment in favor of

Pegram with respect to the 1989 transactions; and with respect to the 1992 transactions,

we reverse the grant of judgment as a matter of law in favor of Pegram, Choy, and Adler,

and we reverse the grant of summary judgment in favor of Ishler.49 We remand for further

proceedings not inconsistent with this opinion.

       REVERSED AND REMANDED.




       49
      In light of our disposition of this case, we also
briefly address the SEC’s evidentiary arguments.
First, we conclude that the trial court did not abuse
its broad discretion under Fed. R. Evid. 403(b) by
excluding evidence relating to Pegram’s alleged insider
trading in 1989 from the trial regarding the 1992
transactions. Second, in regard to the other
evidentiary rulings challenged by the SEC on appeal, we
also conclude that the district court did not abuse its
broad discretion.
                                            44
