The Securities and Exchange Commission (“SEC”) charged Charles L. Hill Jr. with insider trading in connection with his purchase of shares of Radiant Systems stock the day before a merger was announced. Mr. Hill became aware of the material non-public information through a friend who obtained the information from his close friend, the Radiant COO. Mr. Hill had made no equity purchases in over four years before buying $2.2 million of Radiant stock before the announcement. The day after the merger was announced Mr. Hill sold his entire equity interest for a profit of approximately $744,000. In the eyes of the SEC, trading on material nonpublic information learned from a third party is no different from trading on information received directly from an insider.
By William M. Sullivan, Jr. and Jay B. Gould
Under the Second Circuit’s new ruling, prosecutors have two large hurdles they must clear to convict under securities laws. First, they must prove that a defendant knew that the source of inside information disclosed tips in exchange for a personal benefit. Second, the definition of “personal benefit” is tightened to something more akin to a quid pro quo exchange.
For years, insider trading cases have been slam dunks for federal prosecutors. The United States Attorney’s Office in the Southern District of New York had compiled a remarkable streak of more than eighty insider trading convictions over the past five years. But that record has evaporated thanks to the United States Court of Appeals for the Second Circuit’s ruling in United States v. Newman, in which the Second Circuit concluded that the district court’s jury instructions were improper and that the evidence was insufficient to sustain a conviction.
The Second Circuit relied upon a thirty year old Supreme Court opinion, Dirks v. SEC, 463 U.S. 646 (1983), and highlighted the “doctrinal novelty” of many of the government’s recent successful insider trading prosecutions in failing to follow Dirks. Accordingly, the Court overturned insider trading convictions for Todd Newman and Anthony Chiasson because the defendants did not know they were trading on confidential information received from insiders in violation of those insiders’ fiduciary duties. More broadly, however, the Court laid down two new standards in tipping liability cases, both likely to frustrate prosecutors for years to come.
Tougher Disclosure Requirements
Section 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission rules 10b-5 and 10b5-1 generally prohibit trading on the basis of material nonpublic information, more conventionally known as insider trading. In addition, federal law also prohibits an individual (the “tipper”) from disclosing private information to an outside person (the “tippee”), if the tippee then trades on the basis of this private information. This disclosure—a breach of one’s fiduciary duty—is known as tipping liability. As with most crimes, tipping liability requires scienter, a mental state that demonstrates intent to deceive, manipulate, or defraud. In these cases, the government must show that the defendant acted willfully—i.e., with the realization that what he was doing was a wrongful act under the securities laws.
Until last week, willfulness had been fairly easy to show, and that was one of the principal reasons for the government’s string of successes. Prosecutors only had to prove that the defendants traded on confidential information that they knew had been disclosed through a breach of confidentiality. In Newman, however, the Second Circuit rejected this position outright. The Court held that a tippee can only be convicted if the government can prove that he knew that the insider disclosed confidential information in exchange for a personal benefit, and one that is “consequential” and potentially pecuniary.
This distinction may seem minor, but its impact is enormous. The government now must prove—beyond a reasonable doubt, no less—that a defendant affirmatively knew about a personal benefit to the source of the confidential information. From the prosecution’s perspective, this is a massively challenging prospect.
Tightened “Personal Benefit” Standards
The Second Circuit also clarified the definition of “personal benefit” in the tipping liability context. Previously, the Court had embraced a very broad definition of the term—so broad, in fact, that the government argued that a tip in exchange for “mere friendship” or “career advice” could expose a trader to tipping liability.
The Court retreated from this position and narrowed its standard. Now, to constitute a personal benefit, the prosecution must show an exchange “that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” —in other words, something akin to a quid pro quo relationship. This, too, complicates a prosecution’s case significantly.
Implications of the Ruling
What effect will this ruling have moving forward? Of course, one effect is obvious from the start: prosecutors are going to have a much more difficult time proving tipping liability. But as with many new appellate cases, it may take some time to see how this rule shakes out on the ground in the trial courts. Here are a few things to keep in mind over the next few months and years.
- This ruling may cause some immediate fallout. For example, there are currently several similar cases in New York that are pending for trial or appeal, and these may now result in acquittals or vacated convictions. In fact, some defendants who previously took guilty pleas in cooperation with Newman and Chiasson’s case are considering withdrawing their pleas in light of this decision. Moving forward, look to see the SEC and potential defendants adjusting their behavior and strategies in light of this ruling. In fact, just this week, a New York Federal Judge expressed strong reservations about whether guilty pleas entered by four defendants in an insider trader case related to a $1.2 billion IBM Corp. acquisition in 2009 should remain in light of Newman.
- This is also welcome news for tippees who did not interact directly with the source of the inside information. Although the source of the leak may still be prosecuted as usual, this ruling may shield a more remote party from an indictment. As the Newman court noted, the government’s recent insider trading wins have been “increasingly targeted at remote tippees many levels removed from corporate insiders.” Now, without clear evidence that the insider received a quantifiable benefit and that the tippee was aware of such benefit for providing the information, cases against such “remote tippees” will be tremendously more difficult to prove.
- But, caution should still reign where tippees deal more directly with tippers. The tippees in this case were as many as three or four steps removed from the tippers. It is not difficult to imagine the Court coming out the other way if Newman and Chiasson had been dealing with the tippers themselves.
- One enormous question mark is to what extent the standards expressed in this case will affect the SEC’s civil enforcement suits. We will have to wait and see, but traders should still use caution. Because civil suits require a substantially lower burden of proof and lesser standard of intent compared to criminal cases, it is possible that these new rules may offer little protection from a civil suit. Additionally, SEC attorneys will probably emphasize this distinction to courts in an attempt to distinguish their enforcement suits from Newman and Chiasson’s criminal case, but whether this tactic is effective remains to be seen.
- Although the Court refined the meaning of a personal benefit, the definition is still purposefully flexible. This case tells us that abstract psychic benefits—friendship, business advice, church relationships—are not enough, but what about anything just short of exchanging money, favors, or goods? We don’t yet know, and for that reason clients should exercise care.
|If you have any questions about the content of this alert, please contact the Pillsbury attorney with whom you regularly work, or the authors below.|
|Jay B. Gould (bio)San Francisco
|William M. Sullivan (bio)Washington, DC
The authors wish to thank Robert Boyd for his valuable assistance with this client alert.
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The Securities and Exchange Commission (the “SEC”) charged Kevin McGrath, a partner at a New York investor relations firm with insider trading. According to the SEC complaint, McGrath allegedly received confidential information from clients in order to prepare press releases. The SEC discovered McGrath used non-public information from two different clients to buy or sell such clients’ securities for his personal benefit.
While high dollar insider trading cases are common news, this case involves profits of a mere $11,776. The financial penalties were similarly small and McGrath settled the case with a disgorgement of $11,776, interest of $1,492 and a penalty of $11,776, in addition to a prohibition on trading in any client security. Those with access to insider information should see this case as a reminder that no instance of insider trading will be ignored by the SEC.
The Securities and Exchange Commission (“SEC”), on March 31, 2014, announced insider trading charges against two men who allegedly traded on information they overheard from their respective wives. On April 3, 2014, the SEC announced charges against two friends who traded tips related to an impending acquisition deal. The spouse cases and friend cases differ with respect to the culpability of the tipper. In the friend cases, the tipper and the tippees were all aware that they were breaching their duties to maintain the information and not trade on it. In the spouse cases, the wives were unaware of their husbands’ intentions and actions and had previously informed their husbands of the prohibition on trading on any information gleaned from them.
The SEC has charged three friends who worked together to trade on nonpublic information related to the acquisition of The Shaw Group by Chicago Bridge & Iron Company. John W. Femenia was employed by a major investment bank from which he obtained the information about the impending acquisition. Femenia told his friend Walter D. Wagner the nonpublic information and Wagner passed that information along to Alexander J. Osborn. Osborn and Wagner proceeded to invest substantially all of their liquid assets based on the information from Femenia. When the public announcement was made, Wagner and Osborn profited approximately $1 million collectively.
Femenia was charged in December 2012 for knowingly being the source of nonpublic information to a whole insider trading ring.
Wagner settled with the SEC by disgorging all illicit profits and a parallel criminal action against him was announced on April 3rd. The SEC case against Osborn is ongoing.
The SEC charged two men with insider trading, in unrelated cases, for illegally trading on information they obtained from their wives. In each case, the husband overheard his wife on a business call in which market moving information was discussed. The SEC found that both men were aware of the prohibition on trading on the information obtained from their spouses and knowingly violated the duty and profited from the information.
Both men have settled their cases with the SEC and each has agreed to pay more than double the profits realized.
The lessons from these cases apply to any person who may obtain material nonpublic information about public entities that they have a duty to protect. Investment advisers and broker-dealers should be sure their insider trading training and policies address the friends and family issue directly. Employers should remind their employees to be cognizant of who can overhear their phone conversations or potentially see their written communication with clients or co-workers and take as many precautions as practicable to prevent the insider information from being used illegally.
Written by Cindy V. Schlaefer, Gabriella A. Lombardi and Laura C. Hurtado
Rule 10b5-1 trading plans are in the limelight due to investigations initiated by U.S. Attorney’s Offices and the SEC into possible abuses by corporate executives of such plans. Now, more than ever, companies and their boards of directors should review and strengthen their insider trading policies concerning Rule 10b5-1 trading plans.
Rule 10b5-1 trading plans are no stranger to controversy. First introduced in 2000 by the Securities and Exchange Commission (SEC), Rule 10b5-1 trading plans permit a corporate insider to adopt a plan of acquisition or disposition of his or her company’s stock when not in possession of material nonpublic information so that trades may be executed by a broker at predetermined times regardless of whether the insider then possesses material nonpublic information.
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