“Insiders” of an issuer, such as officers, directors, attorneys
and other special classes of persons, are never permitted to trade on
material non-public information concerning the issuer. Persons who are
not “insiders”, such as fund managers, investors, analysts,
investment advisers, etc., are prohibited from trading in an issuer’s
securities while in possession of material non-public information about
the issuer when such non-insiders obtain the information through the breach
of a duty either by the person who transmitted the information or by the
recipient of the information who is seeking to trade on the basis of it.
Thus, for a non-insider to be liable for trading on the basis of inside
information, the information must be “material”, and “non-public”,
and the non-insider must know or have reason to know that the information
was disclosed through the breach of a “duty”. We will discuss
these concepts below.
This article will focus on the laws, regulations and cases pertaining to
insider trading by fund managers and other members of the financial community.
DISCUSSION
- Is the Information Non-Public?
In determining whether you are in possession of Inside Information you
should first ask yourself whether the information is public. If information
is public, you are permitted to trade on the basis of it and you need
not consider whether it is also “material” or whether the
information was disclosed or obtained through a breach of a duty. For
information to be deemed “public,” it must be disseminated
in a manner making it generally available to the investing public.[1] Obviously, if the information has been published in the financial press
or is disclosed in the issuer’s filings with the Securities and
Exchange Commission (“SEC”), it is public. Information furnished
by an issuer in a webcast or conference call which is publicly announced
in advance and made available to analysts, investment managers and the
general investing public also would be deemed public.[2] On the other hand, information provided by an officer of the issuer in
a one-on-one private conversation with an analyst, fund manager, etc.
would generally not be deemed public information.[3]
Rumors
Rumors do not necessarily constitute public information. You must be very
careful when you are in possession of a rumor concerning the issuer. If
the so-called “rumor” is reported as a rumor in the financial
press, then you can consider it public. However, if it is not reported
in the financial press or in an SEC filing, you run the risk that the
information is non-public and, if it is both material and was disclosed,
directly or indirectly, through the breach of a duty, you may be prohibited
from trading on the basis of it. One way to determine whether a “rumor”
is publicly available would be to call the issuer’s public relations
officer and ask him or her if the company has publicly confirmed or denied
the rumor. You should
not contact any officer or employee of the issuer to determine the
accuracy of a rumor because a confirmation or a denial of the rumor could, in itself,
be non-public information.
- Is the Information Material?
In order to be subject to the prohibition against trading on the basis
of Inside Information, the information must not only be non-public, but
it must also be “material.” Determining what constitutes “material”
information is not an easy task. In the seminal case of
TSC Industries, Inc. v. Northway, Inc., the U.S. Supreme Court set forth a standard of materiality. Information
is material if “there [is] a substantial likelihood that the disclosure
of an omitted fact would have been viewed by the reasonable investor as
having significantly altered the total mix of information made available.”[4] Accordingly, information is material if it would “significantly
alter the total mix of information currently available regarding the security.”[5] Subsequent to the
TSC ruling, the Association for Investment Management and Research (“AIMR”)
came out with what may be considered a clearer definition of materiality
which expands upon the Supreme Court’s statements: “information
is material if its disclosure would be likely to have an impact on the
price of a security or if reasonable investors would want to know the
information before making an investment decision.”[6] The issue of materiality may be characterized as a mixed question of law
and fact involving application of a legal standard to a particular set of facts,[7] and, as such, there is no bright line test from a legal perspective to
assist in determining what is material. As a general rule of thumb, if
you consider the information to be important, it is probably “material.”
The SEC has stated that one kind of information -- earnings guidance --
is virtually always material:
One common situation that raises special concerns about selective disclosure
has been the practice of securities analysts seeking “guidance”
from issuers regarding earning forecasts. When an issuer official engages
in a private discussion with an analyst who is seeking guidance about
earnings estimates, he or she takes on a high degree of risk under Regulation
FD [17 C.F.R. §240.100][8]. If the issuer official communicates selectively to the analyst nonpublic
information that the company's anticipated earnings will be higher
than, lower than, or even the same as what analysts have been forecasting,
the issuer likely will have violated Regulation FD. This is true whether
the information about earnings is communicated expressly or through indirect
“guidance,” the meaning of which is apparent though implied.
Similarly, an issuer cannot render material information immaterial simply
by breaking it into ostensibly non-material pieces.[9]
The bottom line is that analysts and fund managers should no longer seek
confirmation of their own projections about the issuer from the issuer.
The SEC has enumerated other types of information and events, in addition
to earnings information, which are likely to be considered material, including
the following:
- Mergers, acquisitions, tender offers, joint ventures, or changes in assets;
- New products or discoveries;
- Developments regarding customers or suppliers (e.g., acquisition or loss
of a contract);
- Changes in control or in management;
- Changes in auditors, or auditor notification that issuer may no longer
rely on the audit report; and
-
Events regarding the issuer’s securities:
- Defaults
- Redemptions
- Splits
- Changes in dividends
- Changes in rights of holders
- Sales of securities
-
Bankruptcies/receiverships.[10]
The Mosaic Theory
In 2000, the SEC adopted Regulation FD[11] to prevent the practice of selective disclosure by issuers to market professionals,
including analysts and investment managers. While Regulation FD governs
the activities of issuers who release information, and not the analysts
and investment managers who receive it, the Release issued by the SEC
in connection with the promulgation of Regulation FD provides helpful
guidance to such analysts, investment managers and other market professionals.
The SEC explains in its Release that, under the so-called “mosaic”
theory, an analyst or investment manager is permitted to “put together
pieces of public information and non-material, non-public information
to create a mosaic from which a material, non-public conclusion may be
drawn.”[12] For example, you may be aware from an issuer’s SEC filings that
it is highly dependent upon the supply of cashmere wool from India, and
you may have learned of an earthquake in Kashmir which has severely disrupted
production of cashmere, all of which is public information. Based upon
that information, you may draw the conclusion that the issuer’s
earnings for the next quarter or year are likely to fall dramatically
which may be a forecast that the issuer has not publicly disseminated
and is not widely shared in the financial markets. Under this example,
you would be permitted to trade on the basis of your conclusion.
You must be careful to differentiate between non-public conclusions
which you may have drawn and obtaining
confirmation from the issuer of such conclusions. If, in the above example, you called the issuer’s
Chief Financial Officer to confirm your projection of the effect of the
earthquake in Kashmir on the issuer's future earnings, and you received
a confirmation or a denial from that officer, such confirmation or denial
may, in itself, constitute material, non-public information which would
prevent you from trading in the issuer’s stock.
The case of
SEC v. Monarch Fund[13], which involved a claim against an investment advisor for trading on inside
information, contains language which further supports the mosaic theory
and also evinces a certain deference accorded to analysts who gather information
concerning public companies. In that case, the U.S. Court of Appeals for
the Second Circuit reversed a finding of liability against an investment
manager. In the course of its decision, the court stated the following:
All reasonable investors seek to obtain as much information as they can
before purchasing or selling a security. Investors will usually consult
a broker, having confidence that such a professional keeps abreast of
the market, including the information circulated regarding specific securities,
and will rely upon the information given to them by their broker. Therefore,
investment advisors seek to obtain as much information including rumors
regarding a security as they can so that they may properly advise their clients.
Since [the defendant] was the investment adviser for his family investment
companies, it was his duty to trade in securities that he thought had
attractive investment potential. It was for this reason that he made inquiries
in the investment community to get information that he thought would be
helpful in determining the efficacy of investments to be made for the
clients he represented[14].
In holding that the defendant investment adviser was not liable for trading
on the information he had learned, the Court also noted that the investment
adviser had "testified that no one had told him that the rumors circulating
in the market place…constituted corporate inside information. Indeed,
the evidence indicated that rumors of [the alleged inside information]
were circulating throughout the over-the-counter-community."[15]
The Court in the
Monarch Fund case also noted that the adviser's liability depends upon whether
the information involved "is of a specific or general nature."[16] "This determination is important," stated the court, "because
it directly bears upon the level of risk taken by an investor. Certainly
the ability of a court to find a violation of the securities laws diminishes
in proportion to the extent that the disclosed information is so general
that the recipient thereof is still 'undertaking a substantial economic
risk that his tempting target will prove to be a "white elephant."[17]
The SEC, in its release adopting Regulation FD, specifically acknowledged
the validity of the “mosaic” process and stated that the staff
was not attempting to prevent an astute analyst from reaching material
conclusions about a company.[18] The United States Supreme Court also has recognized the legitimate role
played by investment analysts in contacting company officials to obtain
information necessary to investment decisions.[19] The SEC stated in its Release that Regulation FD is designed to prohibit
officers of an issuer from selectively disclosing information and is not
intended to focus on “whether an analyst, through some combination
of persistence, knowledge, and insight, regards as material information
whose significance is not apparent to the reasonable investor.”[20] On the other hand, analysts and fund managers must be careful not to "cajole
a corporate spokesman into selectively disclosing material information.”[21] In this regard, it would be beneficial to have a written insider trading
policy containing procedures for addressing the receipt of material, non-public
information. Such policies are required to be maintained by registered
investment advisers.
- Was the Information Obtained Through the Breach of a Duty?
If you are in possession of material, non-public information, the question
of whether or not you may still trade on the basis of such information
depends upon how you received it. As a general rule, if you received the
information, directly or indirectly, through a person who was under a
duty not to disclose it and you knew or should have known that the disclosure
was made in breach of the duty, you would not be permitted to trade on
the basis of that information.[22]
- Breaches by Insiders
The traditional prohibition against insider trading prohibits trading in
the securities of a public company, i.e., an “issuer,” while
in possession of information about the issuer which is received, directly
or indirectly, from an "insider" of the issuer who discloses
that information through a breach of a duty. The concept of an “insider”
is broad. It includes officers, directors, members, and employees of the
issuer. In addition, a person can be a “temporary insider”
if he or she enters into a special confidential relationship in the course
of performing services for the issuer and, as a result, is given access
to information solely for the issuer’s purposes. A temporary insider
can include, among others, a company’s attorneys, accountants, consultants,
bank lending officers, and the employees of such organizations.
There are various contexts in which a person breaches a duty by transmitting
material, non-public information. An officer of an issuer violates his
duty if he intentionally transmits material, non-public information concerning
the company without any justifiable business purpose and the officer knows
or should know that the recipient of the information will trade in the
issuer’s securities after receiving such information.[23] A secretary of a law firm working on a merger breaches her duty to the
law firm and the client by revealing information about the issuer which
is the subject of the merger.
It is not always easy to determine whether an insider has breached a duty
by disclosing material, non-public information. In a leading case decided
by the U.S. Supreme Court several years ago,
SEC v. Dirks, the Court held that a former officer of an issuer who disclosed non-public
information to an analyst concerning a fraud involving the issuer did
not breach a fiduciary duty because the officer did not benefit from the
disclosure.[24] Since the former officer did not breach a duty in disclosing the information,
the Court held that the analyst did not violate the insider trading laws
by conveying the information to his clients who sold the stock based on
the information.[25]
Based upon the
Dirks case, the SEC has made some very novel arguments to attempt to demonstrate
that the disclosing party benefited from the disclosure and therefore
breached his or her duty. For example, in the case of
SEC v. Stevens, the SEC argued that the Chief Executive Officer (“CEO”) of
an issuer had violated the insider trading laws by tipping analysts concerning
an upcoming quarterly earnings drop. The SEC argued that the CEO’s
benefit for tipping the information was to avoid an unpleasant earnings
surprise which would be injurious to the CEO’s professional reputation
among financial analysts.[26]
There are situations in which a fund manager has a relationship with an
Issuer or an officer or employee of an Issuer which imposes a duty of
trust or confidence on the part of the manager. If the fund manager receives
material non-public information about the Issuer as result of that relationship,
the fund manager is prohibited from trading in the Issuer’s securities.
For example, if a fund manager sits on a creditors’ committee of
an Issuer that is in bankruptcy and learns material non-public information
about the Issuer in the course of that role, the fund manager would not
be permitted to purchase or sell that Issuer’s securities. Similarly,
if an Investment Fund is approached to make a loan to an Issuer or to
make a large investment in the Issuer (sometimes referred to as a private
investment in public entity or a “PIPE”) the Investment Fund
may be prohibited from trading in the securities of the Issuer until the
loan or the PIPE transaction is disclosed to the general investing public.[27] The SEC has promulgated a rule which specifies certain relationships which
create a “duty of trust or confidence” for the purposes of
restricting the use or disclosure of information obtained in the course
of such relationships.[28]
- Misappropriated Information
There may be circumstances in which information about an issuer is obtained
from persons who are not employed by, or owe a duty of confidentiality
to, the issuer and, therefore, are not deemed to be insiders or temporary
insiders. Such non-insiders may be persons who have, or are employed with
companies who have, arms-length dealings with the issuer, such as vendors
and suppliers.
If the information obtained from a non-insider is disclosed by the non-insider
under circumstances in which the non-insider breaches a fiduciary duty
or otherwise commits a fraud, trading on the basis of that information
may also constitute a violation of the securities laws. This is the so-called
“misappropriation” theory of insider trading liability. That
is, the information, which may be material to the stock of an issuer,
is “misappropriated” and used to trade. Examples of such misappropriated
cases are the “printer” cases, in which an employee of a printing
company learns through the information being printed that a company plans
to acquire a public company and the employee uses the information to purchase
or sell securities of the public company that is to be acquired. Since
the printer was hired by the acquiring company, and not the public company,
the employee of the printer is not an “insider” or “temporary
insider.” But the employee has nevertheless defrauded his employer
(the printing company) as well as the company that hired the printing
company, by using such information to trade. The “misappropriation”
of such information is a breach of fiduciary duty and a fraud and is therefore
considered a violation of the anti-fraud provisions of the securities laws.[29]
Keep in mind that if the employer, or some other person or entity from
whom the information is appropriated, has no objection to the use or disclosure
of the information, then there would be no breach of fiduciary duty or
fraud in such use or disclosure for the purpose of trading in securities.[30]
- Knowledge of Breach of Fiduciary Duty
In order to be liable for trading on inside information, the person conveying
the information must do so in breach of a fiduciary duty or otherwise
as part of a fraud, and the recipient of the information must know or
have reason to know that the information was conveyed to him in breach
of a fiduciary duty or otherwise through a fraud. This rule applies when
the person conveying the information is an insider of the company whose
stock is traded or is an outsider who owes no fiduciary duty to the company
whose stock is being traded but misappropriates information concerning
the company and conveys it as part of a breach of fiduciary duty or other fraud.[31]
If the source of the information (i.e., the tippee) has breached a duty in disclosing it, the recipient (i.e., the tippee) need not have also breached a fiduciary duty in using or
further disclosing the information in order for the tippee to be liable
for such use or disclosure. If the tippee uses or discloses information
which he knows or should have known has been obtained through a breach,
the tippee is deemed to be a participant with the person who breached
the fiduciary duty “in a ‘co-venture’ to breach a duty
[and is] held responsible for all the consequences flowing therefrom”
as if the tippee was a fiduciary himself.[32]
On the other hand, if the tipper has not breached a duty in disclosing
the information, the tippee will not be liable for using the information
to trade in securities unless the tippee’s use of the information
itself constitutes a breach of some duty. So, if a corporate executive
discloses information to an analyst in a context in which the disclosure
does not violate company policy, then the analyst does not commit a violation
in using the information. But the analyst must be cautious here because,
if the corporate executive disclosed material non-public information in
a one-on-one conversation with an analyst, there is a strong risk that
a regulator or a court will find some way to conclude that the executive
breached a duty in doing so, and that, therefore, the analyst participated
in the breach by using that information. As one commentator has put it,
“[a]bsent facts that would suggest that the insider believed that
immediate dissemination of the information was essential and saw the analyst
as the only practicable means of publicizing the information – a
rare circumstance . . . – the analyst should be on notice that the
insider (personally or on the corporation’s behalf) is purposely
breaching a fiduciary duty by so favoring him.”[33]
There are other contexts, aside from disclosures by corporate executives,
in which material non-public information is disclosed appropriately. For
example, a person might make the disclosure to his or her spouse concerning
something he or she learned on the job, and the disclosing party assumed
that the spouse would keep the information confidential. The spouse who
receives such innocently disclosed information has a duty not to use or
disclose it, and the breach of such duty would create liability. So, if
the initial disclosure is innocent or otherwise permissible, the recipient
will be liable for using it if the recipient engages in a breach of duty
by doing so.
Recent Cases Clarifying the Element of Knowledge
-
The
Obus Case
On September 6, 2012, the Second Circuit Court of Appeals issued a decision
that clarified the requirements of scienter, as they pertain to tipper
and tippee liability in a civil case brought by the SEC. In the case of
SEC v. Obus,[34] the Second Circuit considered an appeal of a dismissal of insider trading
claims following a grant of summary judgment by the U.S. District Court.
In reversing the dismissal, the Second Circuit had to reconcile two apparently
inconsistent definitions of scienter, both articulated by the U.S. Supreme Court.
In the case of
Ernst & Ernst v. Hochfelder, the Supreme Court defined scienter as “a mental state embracing
intent to deceive, manipulate, or defraud.”[35] However, in the case of
Dirks v. SEC, the Supreme Court indicated that scienter could be satisfied by establishing
not only what a tippee actually knew, but also what he “should have known.”[36] The Second Circuit reconciled these two holdings in
Obus in deciding whether to uphold the grant of summary judgment in favor of
three individual defendants: an insider who, the SEC alleged, gave the
initial tip (the “Tipper”); a former college friend of the
Tipper who, the SEC alleged, was the first to receive the inside information
(the “First Level Tippee”); and the First Level Tippee’s
boss who, the SEC alleged, received the inside information from the First
Level Tippee (the “Second Level Tippee” and, along with the
Tipper and First Level Tippee, the “Defendants”).
The Tipper worked for General Electric Capital Corporation (“GE Capital”)
and, in that capacity, was performing due diligence on behalf of Allied
Capital Corporation (“Allied”) for its planned acquisition
of SunSource, Inc. (“SunSource”). The SEC alleged that the
Tipper later told the First Level Tippee of the planned acquisition. The
SEC further alleged that the First Level Tippee subsequently communicated
word of the potential acquisition to the Second Level Tippee, who, the
SEC alleged, then purchased 287,000 shares of SunSource. When Alliance
did in fact acquire SunSource several weeks later, the value of the shares
nearly doubled. In granting summary judgment in favor of the Defendants,
the U.S. District Court determined that the SEC had failed to establish
a genuine issue of fact as to whether the Tipper breached his duty to
GE Capital and, thus, held that there was no duty for either the First
or Second Level Tippee to inherit. “The district court based this
finding on GE Capital’s internal investigation, which concluded
that [the Tipper] had not breached a duty to his employer, and on the
fact that SunSource was not placed on GE Capital’s Transaction Restricted
List until after the SunSource acquisition was publicly announced…The
district court further held that the SEC failed to establish facts sufficient
for a jury to find that [the Tipper’s] conduct was deceptive…and
that [even if the Tipper had breached a fiduciary duty to GE capital]
the SEC failed to present sufficient evidence [that the Second Level Tippee]
‘subjectively believed that the information he received was obtained
in breach of a fiduciary duty.’”[37] The Second Circuit reversed and vacated the District Court’s ruling.
According to the Second Circuit in
Obus, for a tipper to be liable, first, “the tipper must tip deliberately
or recklessly, not through negligence.”[38] The Court explained how this “scienter’ requirement differs
from mere negligence by offering an example:
Assume two scenarios with similar facts. In the first, a commuter on a
train calls an associate on his cellphone, and, speaking too loudly for
the close quarters, discusses confidential information and is overheard
by an eavesdropping passenger who then trades on the information. In the
second, the commuter’s conversation is conducted knowingly within
earshot of a passenger who is the commuter’s friend and whom he
also knows to be a day trader, and the friend then trades on the information.
In the first scenario, it is difficult to discern more than negligence
and even more difficult to ascertain that the tipper could expect a personal
benefit from the inadvertent disclosure. In the second, however, there
would seem to be at least a factual question of whether the tipper knew
his friend could make use of material non-public information and was reckless
in discussing it in front of him.[39]
In order for the tipper to be liable, it also must be shown that the tipper
knew, or was reckless in not knowing, that the information is non-public
and material. Also, “the tipper must know (or be reckless in not
knowing) that to disseminate the information would violate a fiduciary
duty.”[40] In other words, scienter requires a showing of what the tipper actually
knew or recklessly disregarded, not what he
should have known. Thus, the Court held in
Obus that the
Hochfelder scienter standard applies to all elements of tipper liability.
While the SEC initially alleged that the defendants violated Section 10(b)
and Rule 10b-5 on the basis of the classical and misappropriation theories
of insider trading liability, it only appealed that portion of the District
Court’s decision which dismissed the claim based on the theory that
the defendants misappropriated the information from GE Capital. The Second
Circuit also stated in
Obus that the “abstain or disclose” rule, as it applies to the misappropriation
theory, requires disclosure to the person from whom the information was
appropriated, not to the investing public. “Under either theory,
if disclosure is impracticable or prohibited by business consideration
or by law, the duty is to abstain from trading.”[41] The Second Circuit also ruled that the District Court erred in requiring
the SEC to prove “‘deception’ beyond the tip itself.
. . . If the jury accepts that a tip of material non-public information
occurred and that [the Tipper] acted intentionally or recklessly, [the
Tipper] knowingly deceived and defrauded GE Capital. That is all the deception
that section 10(b) requires.”
However, when determining the liability of a tippee, the court held that
“the
Dirks knows or should know standard pertains to a tippee’s knowledge that
the tipper breached a duty, either to his corporation’s shareholders
(under the classical theory) or to his principal (under the misappropriation
theory), by relaying confidential information.”[42] “Hochfelder’s requirement of intentional or reckless conduct pertains to the tippee’s
eventual use of the tip by either trading or further dissemination of
the information.”[43] In short, the Second Circuit in
Obus bifurcated the scienter requirement of tippee liability and set a lower
bar of liability for tippees than for tippers.
Applying the above principles, the Second Circuit held, first, that the
SEC had presented a material issue of fact with respect to the Tipper’s
potential liability. The Court noted that the SEC alleged facts to support
a finding that the Tipper knew he was under “an obligation to keep
information about the SunSource/Allied deal confidential” and that
there was sufficient circumstantial evidence to support an inference that
the Tipper disclosed the potential deal to the First Level Tippee.[44] (The Tipper and the First Level Tippee denied that the Tipper disclosed
the proposed deal[45] but the SEC argued that there was sufficient circumstantial evidence to
support a finding that the proposed deal was disclosed.) The Second Circuit
also concluded that the SEC’s allegations were sufficient to present
a question of fact as to whether the Tipper acted knowingly or recklessly
with respect to the First Level Tippee’s ability to use the information
to trade in securities.[46] Specifically, the Second Circuit noted that the SEC alleged that because
the Tipper knew that the First Level Tippee worked for a company that
was already a large holder of Sunsource stock, the First Level Tippee
was likely either to purchase additional shares based upon the inside
information or relay the information to one of his superiors, as he allegedly did.[47]
With regard to the First and Second Level Tippees, the Court concluded
that there were sufficient allegations to support a finding that the First
Level Tippee knew or
should have known that the Tipper breached his fiduciary duty to GE Capital when he informed
the First Level Tippee of the SunSource/Allied deal.[48] Among the allegations cited by the Second Circuit were that the First
Level Tippee “knew [the Tipper] was involved in developing financing
packages for other companies and performing due diligence; and that information
about a non-public acquisition would be material inside information that
would preclude someone from buying stock.”[49] The Second Circuit held that this was “sufficient for a jury to
conclude that [the First Level Tippee] knew or had reason to know that
any tip from the [Tipper] on SunSource’s acquisition would breach
[the Tipper’s] fiduciary duty to GE Capital.”[50] The First Level Tippee therefore inherited the Tipper’s duty, which
the Tippee allegedly breached when he allegedly relayed the tip to the
Second Level Tippee.[51] The Second Circuit reached this conclusion, in part, because the First
Level Tippee was a “sophisticated financial analyst,” which
is the sort of fact made relevant by the
Dirks “knows or should know” standard.[52] The Second Circuit also held that the SEC must prove that the tippee derived
some personal benefit. Here, it held that the jury could find that the
First Level Tippee hoped to curry some favor with his boss by passing
along the information.[53]
As with the First Level Tippee, the Second Circuit concluded that the SEC
had presented a material question of fact with respect to the liability
of the Second Level Tippee, in light of certain alleged comments and phone
calls made to the CEO of SunSource indicating that he knew of the impending takeover.[54]
On May 30, 2014, following trial, a unanimous jury rendered a verdict in
favor of the defendants, finding that they did not trade on inside information.[55]
In all, the Second Circuit’s application of the scienter requirements of both
Hochfelder and
Dirks clarifies that a tippee need not have actual knowledge of (or be reckless
with respect to) the existence of the tipper’s duty, the breach
of that duty or the confidentiality of the information. Rather, the SEC
now need only show that a tippee knew or should have known of these things,
allowing courts to impose liability for something closer to negligence.
However, as discussed in the next section, the level of knowledge by the
tippee for liability in a
criminal case is higher.
-
The
Newman Case
Since the Supreme Court’s 1983 decision in the case of
Dirks v. SEC., courts and commentators alike have noted the considerable uncertainty
surrounding two key issues concerning tippee liability for insider trading:
- First, what kind of “personal benefit” must the initial tipper
receive in order to establish the tipper’s breath of duty when he
makes the tip; and
-
Second, what level of knowledge (if any) must the tippee have of the personal
benefit received by the tipper in order to be held derivatively liable
for the alleged breach.
[56]
In its December 10, 2014 decision in the case of
U.S. v. Newman,[57] the Second Circuit clarified the requirements for tippee criminal liability.
While there are still several questions that remain unanswered, securities
traders (and the regulators) now know, based on the
Newman decision, that a personal benefit to the tipper is a required element
before imposing tippee criminal liability and that the tippee must have
had some knowledge, or have deliberately avoided knowledge, of the tipper’s
receipt of such a benefit. The Court also went on to describe the type
of benefit which would support a finding of criminal liability, rejecting
the argument that the mere existence of a personal relationship between
the tipper and tippee allowed for an inference of some intangible benefit.[58] The Second Circuit instead held that there must be “an exchange
that is objective, consequential, and represents at least a potential
gain of a pecuniary or similarly valuable nature.”
[59] Finally, the Second Circuit held that a tippee must have actual knowledge
of the benefit (or purposefully avoid such knowledge) to be held criminally
liable for insider trading.
Newman involved the transfer of confidential earnings-related information from
two corporate insiders to several different layers of tippees.[60] The two defendants in the case, Todd Newman and Anthony Chiasson,[61] were portfolio managers at two different hedge funds and were several
layers removed from the initial tippers.[62] The Defendants traded on the confidential information initially disclosed
by the insiders and were subsequently convicted by a jury of several counts
of insider trading.[63] They appealed their conviction on the ground that the jury instructions
provided by the trial court misstated the legal requirements for tippee
liability by not requiring the jury to find that the Defendants had knowledge
of the personal benefit received by the tipper in order to be held criminally liable.[64] The Second Circuit agreed and reversed the conviction.
Citing the Supreme Court’s decision in
Dirks, the Second Circuit confirmed that the tipper’s receipt of a personal
benefit was an essential element of the tipper’s breach of his or
her fiduciary duty.[65] In the absence of the receipt of a personal benefit, the tipper’s
disclosure of insider information is a mere breach of confidentiality,
but not his or her fiduciary duties to the company or its shareholders.[66] Because a tippee’s criminal liability for insider trading is derivative
of the tipper’s breach of fiduciary duty, a tippee cannot be held
criminally liable unless the government can show that the tipper received
either a “pecuniary gain” or a “reputational benefit
that will translate into future earnings.”[67] In finding that no such benefit existed in this case, the Second Circuit in
Newman found that “the circumstantial evidence…was simply too thin
to warrant the inference that the corporate insiders received any personal
benefit in exchange for their tips.”[68] The tippers had casual personal relationships with the first-level tippees,
however the Second Circuit concluded that if that alone were sufficient
to establish an inference of a personal benefit, “practically anything
would qualify.”[69] Instead, the Second Circuit defined personal benefit in such a way as
to require an actual or potential pecuniary gain or something similarly
valuable in nature.[70]
With respect to the tippee’s knowledge of the existence of the personal
benefit received by the tipper, the Second Circuit again sided with the
Defendants, concluding that “well-settled principles of substantive
criminal law . . . require[ ] that the defendant know the facts that make
his conduct illegal” and that such knowledge “is a necessary
element in every crime.”
[71] In finding that the government had failed to make such a showing in this
case, the Court in
Newman held that “the Government presented absolutely no testimony or any
other evidence that Newman and Chiasson knew that they were trading on
information obtained from insiders, or that those insiders received any
benefit in exchange for such disclosures, or even that Newman and Chiasson
consciously avoided learning of these facts.”[72] Rather, the evidence showed that the Defendants “knew next to nothing
about the insiders and nothing about what, if any, personal benefit had
been provided to them.”[73] In short, even if the tipper in
Newman had received a personal benefit in exchange for the disclosure of confidential
information, the Defendants could not be held criminally liable as tippees
unless they had
actual knowledge (or purposefully avoided knowledge) of the breach and the corresponding benefit received. This holding clarifies
an area of law that had previously been open to interpretation and should
serve to alleviate the concerns of many in the securities industry that
mere negligence on the part of the tippee could support a finding of criminal
insider trading liability.
Keep in mind that
Newman is a criminal case. Despite clarifying several key questions pertaining
to the imposition of tippee criminal liability, the Court in
Newman did leave open the question of whether its holdings extend to cases involving
civil liability. Because it was a criminal case, the Second Circuit did
not need to address these same issues within the context of a civil insider
trading enforcement action by the Securities and Exchange Commission.
In fact, the Court’s analysis appears to suggest that its holdings
are limited to the criminal context. For example, the Court’s conclusions
with respect to the required showing of knowledge on the part of the tippee
are set against the backdrop of its discussion of “mens rea,” a distinct concept of criminal law.[74] At no point does the Court preclude the application of its rationale in
Newman to the civil context, but it has left the door open for the government
to argue that the high legal and evidentiary bars set in
Newman do not pertain to the civil context. In short, the Securities and Exchange
Commission and other law enforcement agencies could conceivably argue that
Newman is limited to the criminal context and that more lenient standards should
be applied in civil enforcement actions. As noted in the discussion of the
Obus case, supra at pp. 16-18, the SEC need only prove that a tippee knew or
should have known that the tipper breached his fiduciary duty and received a personal benefit.
In sum, the Second Circuit has now held that the Government must show the
following in order to establish criminal tippee liability for insider trading:
- the corporate insider was entrusted with a fiduciary duty;
- the corporate insider breached this duty by disclosing confidential information
to a tippee in exchange for a personal benefit;
- the tippee knew that the tipper engaged in a breach of fiduciary and that
the tippee received a personal benefit for disclosing the information,
and that the informatoin was confidential; and
-
the tippee used that information to trade in a security or tipped another
individual for his or her own personal benefit.[75] (This element will be discussed further in the section below, entitled
“The Personal Benefit Requirement.”
The government filed a petition with the Second Circuit for rehearing and
rehearing
en banc, but its petition was denied on April 3, 2015. The government also petitioned
for certiorari to the U.S. Supreme Court and the petition was denied on
October 5, 2015.[76]
-
The
Whitman Case
U.S. v Whitman[77] is another case in which the court clarified the level of knowledge required
to establish liability for insider trading. Doug Whitman, a trader at
a hedge fund, was charged with criminally violating Section 10(b) and
Rule 10b-5 for allegedly trading on inside information he received from
tippees who had, in turn, obtained information from inside employees at
three publicly-held companies. Mr. Whitman was convicted. After the trial,
the judge who presided in the case issued an opinion discussing the following
three legal issues which he ruled upon in the course of issuing his instructions
to the jury:
- Whether in a criminal prosecution under the federal securities laws, the
scope of an employee’s duty to keep material non-public information
confidential is defined by state or federal law?
- Whether a person who receives such information from someone outside the
company must, to be criminally liable for trading on such information,
know that the information was originally obtained from an insider who
not only breached a duty of confidentiality in disclosing such information
but also did so in exchange for some personal benefit?
-
Whether even a secondary tippee like Mr. Whitman must, in order to be criminally
liable, have a specific intent to defraud the company from which the information
emanates of the confidentiality of that information?[78]
Citing
Dirks v. SEC, the court stated that “a tippee assumes a fiduciary duty to shareholders
of a public company not to trade on material nonpublic information if
(a) the tipper has breached his fiduciary duty to the company and its
shareholders by disclosing such information to the tippee in return for
some personal benefit and (b) the tippee knows or should have known of
the breach.”
Id. at 366.
Press reports about the trial stated that Mr. Whitman testified that he
never thought his sources of information possessed secret information
about the stocks that he traded. (http://dealbook.nytimes.com/2012/08/20/hedge-fund-manager-whitman-is-found-guilty/.) According to the complaint filed by the SEC in a related civil case,
the defendant’s primary source was Roomy Khan, described as an individual
investor who was a friend and neighbor of the defendant. The SEC alleged
that Khan’s sources were an employee of one of the companies about
which the alleged inside information pertained and an employee of a public
relations firm which provided services to one of the other companies.
The defendant argued that under the law of California the fiduciary duty
of confidentiality only applies to upper level employees and that the
original tippers in this case did not fall within that category. While
the government disputed Mr. Whitman’s interpretation of California
law, it also argued that federal law and not state law controlled whether
or not a duty of confidentiality is imposed, and the court ultimately
agreed with the government’s position and so instructed the jury.
Discussing the level of knowledge required by a tippee, the judge (in a
decision issued prior to the Second Circuit’s decision in
Newman) posed the issue as follows: “what did a secondary tippee, like
Mr. Whitman, who obtained his information from the direct tippees, have
to know about the tipper’s breach of duty to be criminally liable?
The Government argued that it needed only to show that the defendant knew
(or recklessly disregarded) that the information was conveyed as a result
of an unauthorized disclosure by some inside tipper but not that he also
knew of any benefit provided to the tipper…”
Id. at 370.
The court held that, since an element of the violation of “classic”
insider trading includes showing that the tipper anticipated something
in return for the unauthorized disclosure, “the tippee must have
knowledge that such self-dealing occurred, for, without such a knowledge
requirement, the tippee does not know if there has been a ‘improper’
disclosure of inside information.”
Id. at 371. “On the other hand,” the court stated, “there
is no reason to require that the tippee know the details of the benefit
provided; it is sufficient if he understands that some benefit, however
modest, is being provided in return for the information.”
Id. Thus, the court instructed the jury that in order to convict Mr. Whitman,
it must find that he traded in the securities of a particular company
on the basis of material nonpublic information about the company, knowing
that the information had been obtained from an insider for the company
who had provided the information in violation of that insider’s
duty of trust and confidence and in exchange for, or in anticipation of
a personal benefit.
* * *
As to the defendant’s knowledge that the insider has breached the
insider’s duty of trust and confidentiality in return for some actual
or anticipated benefit, it is not necessary that Mr. Whitman know the
specific confidentiality rules of a given company or the specific benefit
given or anticipated by the insider in return for disclosure of inside
information; rather, it is sufficient that the defendant had a general
understanding that the insider was improperly disclosing inside information
for personal benefit. Id. at 371.
The court recognized that “one can imagine cases where a remote tippee’s
knowledge that the tipper was receiving some sort of benefit might be
difficult to prove.”
Id. at 372. (While this might give some comfort to a research analyst or trader
who hears a “tip,” it also presents the significant risk that
the government would attempt to prove, based upon the facts and circumstances,
that the recipient had a “general understanding” that the
information was initially revealed through a breach of duty by a person
who received some kind of benefit.) On appeal from the conviction in
Whitman, the Second Circuit held that these instructions were not erroneous and
affirmed the conviction.[79]
The court then discussed whether the government is required to prove specific
intent to defraud and not just that the defendant intended to commit the
act which was fraudulent. The court concluded that Rule 10b-5 is a “specific
intent” statute for the purposes of criminal liability, and then
addressed the question of “what ‘specific intent to defraud’
means in the context of [an insider trading] case.”
Whitman, 904 F.Supp.2d at 374. The court held that “the heart of the fraud
is the breach of the duty of confidentiality owed to both the company
and its shareholders, and accordingly the specific intent to defraud must
mean, in this context, an intent to deprive the company and its shareholders
of the confidentiality of its material nonpublic information.”
Id. at 375. (It is important to note that a criminal violation of Rule 10b-5
requires “willfulness” which is what caused the court to deem
the statute to be a “specific intent offense.” Consequently,
the specific intent requirement would not apply to a claim filed by the
Securities and Exchange Commission.)
The court concluded by summarizing his holdings as follows:
- The scope of an employee’s duty to keep material non-public information
confidential is defined by federal common law, which imposes a uniform
duty on all insiders to maintain the confidentiality of material nonpublic
information entrusted to them as part of a relationship of trust and confidence
and not to exploit it for personal benefit.
- To be held criminally liable, a tippee like Mr. Whitman must have a general
understanding that the inside information was obtained from an insider
who breached a duty of confidentiality in exchange for some personal benefit,
although the tippee need not know the details of the breach or the specific
benefit the insider received or anticipated receiving.
-
To be held criminally liable in a Dirks-like case, a tippee like Mr. Whitman
must have a specific intent to defraud the company to which the information
relates (and, indirectly, its shareholders) of the confidentiality of
that information.
Whitman, 904 F.Supp.2d at 374.
Based upon the foregoing decisions, in a civil action brought by the SEC,
the SEC need only prove that the tippee
should have known that the information he received was tipped in breach of a fiduciary duty
and that the tipper received some kind of personal benefit, whereas in
a criminal case, the government must prove that the tippee
knew that the information was tipped in breach of a fiduciary duty and that
the tipper received some form of personal benefit, but the tippee’s
knowledge of the breach need only be a “general understanding”
that a breach had occurred (rather than an understanding of the specific
nature of the breach), and the government is not required to prove that
the tippee knew the specific nature of the personal benefit received by
the tipper.
The Personal Benefit Requirement
On December 6, 2016, the U.S. Supreme Court issued a unanimous decision,
in the case of U.S. v. Salman,[80] in which it clarified a key element which the government must prove to
establish a charge of insider trading. The Court held that the “personal
benefit,” which a tipper must receive from the tippee in order to
establish liability, may be in the form of a gift to a trading relative
or friend.
The case Salman case involved the transfer of confidential information from one brother
(the tipper) to another brother (the tippee) which was then passed on
to a third person, the defendant Salman, who traded on the information.
The tipper-brother did not receive anything of pecuniary value from his
tippee-brother; rather, the tipper testified that he tipped the information
to his brother because he loved his brother and wanted to “benefit
him” and “fulfill [] whatever need he had.” The Supreme
Court held that, due to the close personal relationship between the tipper
and the tippee, the desire of the tipper to make a gift to the tippee
was a sufficient “benefit,” and it was not necessary for the
benefit to have some pecuniary value to the tipper. Relying on an earlier
Supreme Court decision,
Dirks v. SEC,[81] the Court ruled that “when an insider makes a gift of confidential
information to a trading relative or friend . . . [t]he tip and trade
resemble trading by the insider himself followed by a gift of the profits
to the recipient.” The Court further held that, in such situations,
it is not necessary for the government to show that the tipper received
something of a “pecuniary or similarly valuable nature.”
The defendant in the
Salman case argued that, in order to satisfy the “personal benefit”
requirement, the government was required to prove that the original tipper
received “’a pecuniary or similarly valuable nature’
in exchange – [and] that [the defendant] knew of such benefit,”
citing language from the Second Circuit’s decision in the
Newman case in which the court stated that, in exchange for the information being
conveyed by the tipper, the tipper must receive “at least a potential
gain of a pecuniary or similarly valuable nature . . . .”[82] This language suggested that the tipper’s intention merely to make
a “gift’ of the information to the tippee would not be sufficient
to satisfy the requirement that the tipper receive a personal benefit.
The Supreme Court laid this question to rest in
Salman and held that the tipper’s intention to make a gift would be sufficient
to satisfy the personal benefit requirement.
While the ruling in
Salman eases somewhat the government’s burden of proving insider trading
cases, there are still some significant hurdles which the government must
overcome in such cases. Apart from showing that the tipper received a
benefit or intended to make a gift, the government also must prove that
the tippee who traded on the inside information knew or had reason to
know that the tipper received the benefit or intended to make a gift,
and that the disclosure was made in breach of a duty. Those elements were
not in dispute in
Salman because the person who actually traded (i.e., the tippee of the tippee-brother) was fully aware of the relationship
between the two brothers. Also, the Supreme Court itself recognized in
its decision that “in some factual circumstances assessing liability
for gift-giving will be difficult.” Indeed, a significant open question,
in light of this decision, is: when does the relationship between the
tipper and tippee rise to the level of a “friendship,” which
would render the tip a “gift” and thereby satisfy the “personal
benefit” requirement?
The
Salman decision does not, therefore, remove the significant obstacles which the
government faces when bringing cases against tippees who are far removed
from the source of the original tip. But for the original tippers –
and for tippees who are close to the source of the tip -- the government’s
burden was made somewhat easier as a result of the
Salman decision.
Some Practical Observations
Whether you receive material, non-public information directly from the
person committing the disclosure breach or whether you receive it three
steps removed, you are always running the risk that the SEC or another
litigant will contend that you knew or should have known that the information
you received was obtained or disclosed through the breach of a fiduciary
duty. As a practical matter, it is going to be very difficult to determine
with any kind of certainty whether a party who disclosed material, non-public
information “benefited” from such disclosure and thereby breached
his or her duty. Consequently, you should always know the source of material,
non-public information concerning an issuer before you trade while in
possession of such information. If you have any reason to believe that
the information which you received was improperly disclosed, you should
not trade and you also should not disclose such information to any other
party until it becomes public. This may impose a significant burden, as
one commentator has pointed out:
In an environment where rumors are rampant, any attempt to investigate
the source seems impracticable, and would probably be fruitless. Is the
only safe course, then, not to trade? For members of the public, this
may be possible, but it is hardly a means of encouraging investment. And
for investment professionals like arbitrageurs, analysts and stockbrokers…avoiding
all trading and recommendations with respect to all stocks about which
they hear some suspicious information is hardly feasible.[83]
While the burden of either abstaining from trading or investigating whether
the source of the information is significant, the risks of not doing so
are equally severe. If the recipient trades on the information, and there
is a subsequent significant movement in the stock, a regulatory investigation
will most likely ensue, and the cost, in terms of time and money, in responding
to the investigation could be substantial, regardless of the innocence
of the party who traded on the information. Because of the prospect of
such expense, it may be warranted to refrain from trading when the recipient
knows or has reason to know that the information which he or she has received
is material and non-public, regardless of whether it is known whether
or not the information has been disclosed improperly.
- Field Research and Use of Outside Research Firms
Many hedge fund analysts obtain information about companies in which they
are investing by going out into the field and gathering information from
retail outlets of the companies they are investing in or speaking with
the vendors or suppliers of such companies or other parties whose business
may have an impact on the companies’ business. With respect to contacting
retail outlets of the companies, the issue is whether an analyst is obtaining
inside information about the companies. For example, if the analyst’s
fund is investing in MacDonald’s and the analyst walks into a MacDonald’s
franchise and asks the manager how sales are going, the analyst must realize
that he is talking to a company employee who could be deemed an insider.
It is probably permissible for the analyst to ask a store manager general
questions about the business; but it is probably not permissible to ask
the store manager to show him spreadsheets reflecting actual sales figures.
In the first situation, the analyst is doing his job in researching the
company in which his fund is investing, and it is likely that the information
he obtains is not in itself material but, rather, is “mosaic”
information which he is entitled to gather and use; in the latter situation,
there is a greater likelihood that the analyst is receiving material non-public
information which the store manager should not be disclosing. It is also
more likely that, in the latter situation, the store manager is breaching
a duty of confidentiality in disclosing such information.
Another scenario is where the analyst approaches persons who are not employees
of the company whose stock is being traded, for example, vendors or suppliers
of the company his fund is investing in, or some other party which has
a relationship with that company. Such persons are not insiders or temporary
or quasi-insiders (such as the company’s attorneys, accountants
or investment bankers) because they do not owe a fiduciary duty to the
company whose stock is the subject of the investment. Ordinarily, these
outsiders are “fair game” and the information obtained from
them may be used by the analyst to trade in the company’s stock.
There is, however, one significant caveat: if the outsider is breaching
a fiduciary duty to his own employer by divulging the information to the
analyst, the analyst may be prohibited from trading on the basis of such
information. In such a case, the defrauded party is not the shareholder
of the company whose stock the fund is purchasing or selling on the basis
of such information; rather, based on the misappropriation theory discussed
above, the defrauded party is the employer of the person who is divulging
the information to the analyst, but the use of such information may still
constitute a securities fraud because the information is being used in
connection with the purchase or sale of securities. The key to whether
or not a fraud has occurred in the “misappropriation” context
is whether the employee is, in fact, violating a policy of the employer
by divulging the information.
There have been several criminal prosecutions involving a hedge fund’s
use of outside research firms to provide information about public companies.[84] Such research firms typically pay individuals at various companies to
provide information that may be useful to hedge funds in making investment
decisions. The risk of using such research firms is that the people whom
the research firms are paying to provide the information may be violating
the disclosure policies of the companies where they work. If they are,
the breach of the disclosure policies may constitute a fraud, and if that
breach is made for the purpose of conveying information that is passed
on to others who are using it to trade in securities, the practice may
involve a violation of the securities laws. This may be a problem not
only for the employees conveying the information and the research firm
which is paying them for the information; it also may be a problem for
the hedge funds which retain the research firms to obtain the information.
Keep in mind that the prohibition on using misappropriated information
applies regardless of the level of the employee (i.e., president, secretary, paralegal, janitor, etc.) who engages in a misappropriation.[85]
Even if the pieces of information that a research firm is gathering are
not in themselves material, there may still be liability for using the
information if it is disclosed in breach of a fiduciary duty. Materiality
is an essential element to establish liability for trading on inside information
because, when inside information is used, the defrauded party is the investor
with whom the person in possession of the information trades, and that
investor is only defrauded if the undisclosed information would have been
material to his investment decision. But, under the misappropriation theory,
the defrauded party is the person or entity from whom the information
was misappropriated, and that party is defrauded regardless of whether
the information that was misappropriated is material to an investment
decision concerning the stock which is purchased on the basis of such
information. Nevertheless, two Courts which have addressed the issue of
materiality in the context of misappropriated information have held that
the standard for materiality is whether the information would affect the
market price of the stock.[86]
One other item to keep in mind about field research is that the person
seeking the information should not use fraud or deception to obtain it.[87] One form of fraud, discussed above, is where an employee breaches a duty
of loyalty to his employer by disclosing information that his employer
does not want disclosed. Another potential fraudulent practice would arise
if the person seeking to obtain the information from an employee uses
deceptive means to obtaining it, such as misrepresenting one’s identity
or the purpose for which the information is being sought in order to induce
the person into disclosing the information. An analyst need not disclose
his affiliation or his purposes when he seeks information, but he should
not make affirmative false representations about his affiliation or purpose.
- Investor-Affiliates of Companies in Which Funds Are Invested
Hedge Funds should avoid having investors in the funds who are affiliated
with the companies they are investing in. While such investors are usually
passive and not involved in investment decisions, there is a greater risk
of being the subject of an insider trading regulatory investigation if
a fund has traded in stock shortly before a significant movement in the
price of the stock and one or more of the investors in the fund is affiliated
with the company. At a minimum, the fund will have the burden of convincing
the regulator that the investor-affiliate did not convey material non-public
information to the fund manager.
- “Possession” verses “Use” of Information
You should also be aware that the SEC takes the position that a party who is in
possession of improperly obtained material, non-public information concerning an
issuer may not trade in the issuer’s securities regardless of whether
the trade was
based upon the information. In Rule 10b5-1 promulgated by the SEC under Section 10(b)
of the Exchange Act, the states that insider trading liability requires
that the person trade “on the basis of” improperly obtained
material nonpublic information. However, the Rule defines “on the
basis of” as “aware[ness] of the material nonpublic information
when the person made the purchase or sale.”.[88] Thus, according to the SEC, mere possession of the information while trading
is sufficient to establish liability. The SEC Rule permits a person to
establish an affirmative defense to the element of trading “on the
basis of” the information if the person demonstrate that, before
making the purchase or sale, the person: “i. Entered into a binding
contract to purchase or sell the security, ii. instructed another person
to purchase or sell the security for the instructing person’s account;
or iii. adopted a written plan for trading securities.”[89] The Courts which have addressed this issue, however, have taken a different
view from the SEC, as reflected in the excerpt below from the Second Circuit’s
Summary Order in the
Whitman case:
[T]he district court instructed the jury that inside information must be
“at least a factor” in Whitman’s trading decision. Whitman
does not dispute that under the law of this Circuit, he was entitled to
no more favorable instruction, but argues that we should adopt the law
of the Ninth Circuit, which dictates that a defendant is only liable if
inside information was a “significant factor” in an investment
choice. United States v. Smith, 155 F.3d 1051, 1066 (9th Cir. 1998). As
Whitman acknowledges, his proposed change in circuit law could be adopted
only by the Court sitting en banc. Absent such review, we are bound by
controlling circuit precedent just as the district court was. We therefore
find no error in the instruction.[90]
- Special Rule Governing Information About Tender Offers
There is a special, stricter insider trading rule[91] which pertains to non-public information about impending tender offers.
In order for a person in possession of non-public information concerning
an impending tender offer to be held liable for trading on the basis of
such information, it is not necessary to demonstrate that the recipient
knew or had reason to know that the information was transmitted in breach
of a duty. Rather, it need only be established that the recipient knew
or had reason to know that the information he received was non-public
and was acquired, directly or indirectly, from the company which is the
subject of the proposed tender offer or from the company planning to make
the tender offer.
- Penalties
Penalties for communicating or trading on the basis of Inside Information
are severe. Violators may be subject to criminal penalties[92] as well as civil penalties (i.e., the person who committed the violation, can be sued for up to three times
the profit gained or loss avoided as a result of such unlawful purchase,
sale or communication; while the person or entity that directly or indirectly
controlled the person who committed the violation[93] can be sued for the greater of $1,000,000 or three times the amount of
the profit gained or loss avoided as a result of such controlling person’s
liability)[94]. Moreover, there may be other penalties that flow from being found guilty
from insider trading in the event the violator is also a member of a self-regulatory
organization, such as the Financial Industry Regulatory Authority or the
National Futures Association.
Conclusion
Trading on the basis of Inside Information can have significant consequences.
Unfortunately, it is not always clear what constitutes Inside Information.
While the SEC has provided some guidance and has clarified certain aspects
concerning insider trading, it has not developed bright line tests which
apply to each circumstance. As such, if there is any doubt as to the appropriateness
of trading on any given information, it must be reviewed carefully and
a determination should be made on a case-by-case basis.
For more information on the topic discussed, contact
Ralph A. Siciliano at
siciliano@thsh.com.
Ralph A. Siciliano is a member of the law firm of Tannenbaum Helpern Syracuse & Hirschtritt
LLP whose offices are located at 900 Third Avenue, New York, New York.
Mr. Siciliano heads the firm’s Regulatory Investigations Practice
and advises investment advisers, investment funds and securities broker-dealers
on regulatory issues concerning the federal securities laws and state
securities matters. Prior to joining the firm, Mr. Siciliano held senior
administrative posts in the New York Regional Office of the United States
Securities and Exchange Commission and was lead trial counsel in several
major securities cases. Further information concerning Mr. Siciliano and
his firm can be found at
www.thsh.com. This article, which may constitute attorney advertising, is for educational
purposes and should not be construed as legal advice in any jurisdiction.
[1]
In the Matter of Certain Trading In the Common Stock of Faberge, 45 S.E.C. 249 (May 25, 1973).
[2] Securities Act of 1933, Release No. 33-7881, dated August 15, 2000 ("SEC
Release"), p. 11.
[4]
TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 96 S.Ct. 2126 (1976).
[6]
See
Association for Investment Management and Research (7th Edition, 1996).
[8] Regulation FD prohibits the selective disclosure of information by an
issuer and certain of its officers (see p.5,
infra).
[10] SEC Release, pp. 10-11.
[11] 17 C.F.R. § 240.100.
[12]
Standards of Practice for Investor Relations, National Investor Relations Institute (2d Edition, January 2001), p. 51.
[13] 608F 2d 938 (2d Cir. 1979)
[16] 608 F 2d at 942. (citing United States v. Chiarella, 588 F. 2d 1358, 1366-67 [(2d Cir.)],
cert. granted, 441 U.S. 942, 99 S. Ct. 2158, 60 L.ED.2d 1043 [1979].
[19]
SEC v. Dirks, 463 U.S. 646, 658-659 (1983).
[21] “The Twilight Zone Of Disclosure: A Prospective on the SEC’s
Selective Disclosure Rules,” Groskaufmanis, K. and Anixt, D., p. 15.
[22]
SEC v. Dirks, 463 U.S. at 660.
[23]
Sec v. Dirks, 463 U.S. at 659.
[26] 91 Civ. 1869, SEC Litig. Rel. No. 12813 (March 19, 1990).
[27] In
SEC v. Cuban, 620 F.3d 551 (2010), the United States Court of Appeals for the Fifth
Circuit reinstated the SEC’s complaint in an enforcement action
which alleged insider trading based on information concerning a PIPE.
[28] Rule 10b-5-2 promulgated under the Securities Exchange Act of 1934, as
amended, 17 C.F.R. §240.10b5-2.
[29]
See, e.g., S.E.C. v. Materia, Fed. Sec. L. Rep. (CCH) ¶99583, 1983 WL 1396 (S.D.N.Y.).
[30] Langevoort, pp. 6-31 – 6-33.
[31] Langevoort, p. 4-4, citing
United States v. Chiarella.
[32] Langevoort, p. 6-35.
[34] 693 F.3d 276 (2d Cir. 2012).
[35] 425 U.S. 185, 193 & n. 12 (1976) (emphasis added). The Second Circuit
has since expanded the definition of scienter to include “reckless
disregard for the truth.”
SEC v. McNulty, 137 F.3d 732, 741 (2d Cir. 1998).
[36] 463 U.S. at 660. The articulation of scienter in
Dirks sounds very close to negligence, which requires a determination not necessarily
of what the defendant did actually know, but rather what a reasonable
individual in those same circumstances should have known. Yet, the Supreme Court in
Hochfelder expressly stated that negligence could not satisfy the scienter standard.
[38]
Obus, 693 F.3d at 286.
[45] The First Level Tippee claimed that the Tipper had only asked questions
about SunSource’s management and that those questions led the First
Level Tippee to suspect that SunSource was considering a transaction that
would dilute existing shareholders.
[52]
Id. The First Level Tippee’s professional experience and expertise made
him more qualified to conclude that the Tipper’s relaying of the
SunSource/Allied deal constituted a breach of the Tipper’s fiduciary
duty to GE Capital. As a result, according to the Second Circuit, there
was a material question of fact as to whether the First Level Tippee “should
have known” of the breach.
[55]
SEC v. Obus, et al, 06-cv-03150 (dkt. entry no. 163) U.S.D.C., S.D.N.Y., June 2, 2014.
[56]
See U.S. v. Newman, 773 F. 3d 438 (2014),
cert. denied 136 S.Ct. 242 (2015) (noting that the court has been accused of being “somewhat
Delphic in [its] discussion of what is required to demonstrate tippee
liability”).
[61] Collectively, the “Defendants.”
[62]
Id. at *443. In fact the chain was four levels: Choi (of the company’s
finance unit) tipped Lim (a former executive a technology company that
Choi knew from church), who then tipped Kuo (an analyst ) who then tipped
friends, Tortora and Adonakis, who then turned the information over to
Newman (the defendant in this case.)
[76]
United States v. Newman, 136 S.Ct. 242 (2015).
[77] 904 F.Supp.2d 363 (S.D.N.Y. 2012).
[78] 904 F.Supp.2d at 365.
[79]
U.S. v. Whitman, 555 Fed.Appx. 98 (2d Cir. 2014).
[80]
U.S. v. Salman, 137 S.Ct. 420 (2016)
[81] 463 U.S. 646 (1983).
[83] Langevoort, p. 4-30.
[84] Chad Bray and Jenny Strasburg,
Suspect is Exception: She’s Still Locked Up,
The Wall Street Journal, March 30, 2011 at 1.
[85] Langevoort, p. 6-18 – 6-18.1.
[86]
United States v. Mylett, 97 F.3d 663, 667 (2d Cir. 1996);
United States v. Libera, 989 F.2d 596, 600 (2d Cir. 1993).
[87] Langevoort, pp. 6-40 – 6-41.
[88] Rule 10b5-1(b), 17 C.F.R. §240.10b5-1(b).
[89] Rule 10b5-1(c)(A), 17 C.F.R. §240.10b5-1(c)(A).
[90] Summary Order in
Whitman, p. 15.
[91] Rule 14e-3(a), 17C.F.R.§240. 14e-3(a).
[92] Section 32 of the Securities Exchange Act of 1934, as amended, 15 U.S.C.
§78ff.
[93] The SEC must establish the controlling person knew or recklessly disregarded
the fact that a controlled person was likely to engage in the act constituting
the violation and failed to take appropriate steps to prevent such act.
[94] Sections 21A(a)(2) and (3) of the Securities Exchange Act of 1934, as
amended, 15 U.S.C. §§78u-1(a)(2) and (a)(3).
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