Tuesday, 9 February 2016
Last updated 6 hours ago
Nov 13 2009 | 11:42am ET
“How do men act on a sinking ship? Do they hold each other? Do they pass around whiskey? Do they cry?” -- The Perfect Storm by Sebastian Junger (1997)
By Lawrence Cohen, Esq., Director, Gibbons P.C. -- Last month, the SEC brought criminal charges against the founder of Galleon Management L.P., Raj Rajaratnam, and five other individuals for alleged insider trading violations. The Galleon fund capsized within days.
The breadth of the network of parties that were allegedly involved in the Galleon affair was unprecedented and the impact of the scandal triggered rapid investor redemption demands and shattered careers. The waves of insider-trading accusations that sank Galleon have rocked other funds. Quadrum Capital, a hedge fund in business for less than two years, was implicated in the scandal and abruptly shut down its operations. Three weeks after the initial charges against Galleon, nine more people were arrested and fourteen more have been charged. Among those arrested were four people associated with the hedge fund Incremental Capital.
Galleon provides an important cautionary tale for hedge funds as well as the funds of funds and other investors that invest their capital and faith in underlying fund managers. Both hedge funds and their investors should be on high alert and prepared to recognize and prevent illegal insider trading. That every fund manager should act with the highest level of propriety is stating the obvious. But every organization should immediately take measure of its own situation and ensure that its house is in order, starting with its supervisory and compliance systems. In order to successfully guard against illegal insider trading, a fund’s management must first understand how it is defined. This article offers a general overview of the law of illegal insider trading, which is evolving and often beset with inconsistent interpretations by the courts, regulators and legal commentators. It also outlines certain protective measures that a prudent fund manager should adopt.
The Legal Context
It is important to understand that insider trading is not inherently illegal. The term “insider trading” has been used by Wall Street and the press as shorthand for certain acts that constitute illegal securities trading. However, company insiders buy and sell securities every day under perfectly legitimate circumstances. To be clear, only when an insider trades securities in violation of such individual’s fiduciary duties under the law can civil and/or criminal charges ensue.
At its core, illegal insider trading is a fraudulent act. On that basis alone, the party committing that transgression may be subject to traditional state law anti-fraud claims. The federal insider trading prohibitions that are in place today are derived from historical English and American common law developments dealing with fraud. For example, in a 1909 classic insider trading case, Strong v. Repide, the U.S. Supreme Court upheld the conviction for fraud of a director who bought his company’s stock when he knew it was about to increase in price, but failed to disclose his inside information.
The first federal securities laws were enacted during the New Deal. Section 17(a) of the Securities Act of 1933 made it unlawful to engage in fraud in the offer or sale of securities, but the enforcement tools under the Securities Exchange Act of 1934, which primarily regulates transactions of securities in the secondary markets, proved to be more effective for policing insider trading.
The Exchange Act includes a section specifically designed to discourage individuals within a public corporation from taking advantage of their inside information in the trading of the corporation’s securities. Section 16 imposes sanctions on insiders who use material nonpublic information to enter into short-swing profits. Every such person must file a report with the SEC at the time of the registration of the security on a national securities exchange or by the effective date of a filed registration statement or within ten days after he becomes a 10% beneficial owner, director, or officer and within ten days after the close of each calendar month if there has been a change in the ownership or if the person has purchased or sold a security-based swap agreement.
Another Exchange Act provision, Section 10(b), granted the SEC rulemaking authority to proscribe “manipulative or deceptive” conduct. It took until 1942 for the SEC to adopt Rule 10b-5, which makes it
“. . . unlawful for any person, directly or indirectly, . . . (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.”
While neither Section 10(b) or Rule 10b-5 actually refers to insider trading, they are the key federal provisions used to prosecute illegal insider trading cases.
In the 1980s, Congress sought to expand the sanctions that can be imposed for insider trading violations. The Insider Trading Sanctions Act of 1984 was, according to the U.S. House of Representatives’ Report, enacted because of the belief that
“[i]nsider trading threatens...markets by undermining the public’s expectations of honest and fair securities markets where all participants play by the same rules. This legislation provides increased sanctions against insider trading in order to increase deterrence of violations.”
The principal purpose of this act was to create a civil penalty in addition to the criminal remedies already available to the SEC. If the SEC believes that any person has bought or sold a security while in possession of material nonpublic information, it may bring an action in US District Court to seek up to three times the profit gained or loss avoided.
The Insider Trading and Securities Fraud Enforcement Act of 1988 enlarged the scope of civil penalties by applying them to control persons who fail to take adequate steps to prevent insider trading. It doubled the maximum jail terms for criminal securities law violations from five to ten years, with maximum criminal fines for individuals increased from $100,000 to $1,000,000 and for entities from $500,000 to $2,500,000. A bounty program was initiated, giving the SEC discretion to reward informants who provide assistance to the agency. Finally, it required broker/dealers and investment advisers to establish and enforce written policies reasonably designed to prevent the misuse of inside information.
In addition to the securities fraud provisions of Section 10(b) and Rule 10b-5, the SEC can bring an enforcement action if the transaction involves a violation of the Exchange Act’s Tender Offer provisions under Section 14(e) and Rule 14e-3, which prohibits trading while in possession of material nonpublic information (discussed below) concerning a tender offer. Unlike Rule 10b-5, Rule 14e-3 does not require that the trading take place in breach of a fiduciary duty in order to impose liability. This may have significant effect, in practice. SEC v. Ahlstrom was a 1998 SEC complaint that was filed against a man whose wife heard about a take-over of a company from her neighbor. He made a small profit by trading before news of the tender offer was publicly released. Although he was not a “fiduciary” in any way associated with the company, the SEC still considered him to be subject to Rule 14e-3. A settlement was reached with the target, so no court had the occasion to review the legal basis for the complaint.
Who Is An “Insider”?
For purposes of Exchange Act Section 16, discussed above, an insider is defined as any “person who is directly or indirectly the beneficial owner of more than 10 per centum of any class of any equity security...which is registered...or who is a director or an officer of the issuer.” As a general axiom, simply by accepting employment, an individual agrees to put the interests of the employer’s security holders’ before his or her own in all matters relating to the company.
However, insiders are not necessarily limited to officers and owners. Illegal insider trading may be “imputed” to non-insiders if they are imbued with the status of a fiduciary to the issuer based on a special relationship to the “company insider” or the issuer itself. These constructive insiders include lawyers, investment bankers and others who receive confidential information from a company while providing services to it. A duty of trust may be imputed to any individual, even unrelated to the issuer, who trades based on material non-public information. Thus, as Galleon shows, where a company insider gives a tip to a friend involving non-public information that likely to have an effect on the company’s share price, the fiduciary duty that the company insider owes the company will be imputed to the tippee, who will violate that duty of loyalty to the company and its shareholders if he or she trades on the basis of this information.
Material and Nonpublic Information
How do insiders cross the line from legal to illegal trading? Generally, an illegal insider trade is based on material and nonpublic information obtained during the performance of the insider’s duties at the corporation, or otherwise in breach of a fiduciary duty or other relationship of trust and confidence, or where the nonpublic information was misappropriated from the company.
“Material” Not Defined
There is no statutory definition of material information. Information is generally considered to be material if it is relevant to the decision of a prospective investor who is considering the purchase of securities or a current owner of securities who is considering their sale.
In determining whether the information relied upon in a purchase or sale is material, judges have looked to the information’s “market price impact.” There is little doubt that information is material if it significantly impacts a stock’s actual value or the market’s perception of its value. For example, if the announcement of a dividend cut causes a company’s shares to fall by 10% it is clearly a material event. On the other hand, if a company reports that it will open a new factory and, following the announcement, its stock still performs in line with the movement of the market as a whole, the event is highly unlikely to be considered material and an insider with prior knowledge of the event would not likely be held criminally liable if he/she purchased stock prior to the public announcement.
In analyzing whether information is material, the source as well as the nature of the purportedly material information should be considered. If an investor places a short trade after her investment banker-friend tells her that an influential analyst at his firm is preparing to issue a report that downgrades the stock from “Buy” to “Sell,” that transaction is very likely based on material information and an illegal insider trade. The investor should wait for public disclosure of the change in the opinion. Another investor who makes the same short trade based solely on his golf-instructor’s remarks questioning the prospects of the issuer clearly would not be considered to be based on material information.
The second element of illegal insider trading is whether there is public disclosure of the information. Public companies are bound by specific reporting requirements and procedures designed to make certain that information is truly public and to ensure a system of fairness in which all market participants are given a chance to act on the information. Issuers whose securities are registered with the SEC typically must file reports on Forms 10-K, 10-Q, and 8-K. Regulation FD (for “Full Disclosure”) provides that if a company intentionally discloses material nonpublic information to one person, it must simultaneously disclose that information to the public at large. If a company makes an unintentional disclosure of material nonpublic information to one person, it must make a public disclosure “promptly.” Whether information is nonpublic has an important quantitative element that is difficult to define. Even when information is disclosed, but done selectively (e.g., to a small group of investment analysts; on a conference call with a limited number of participants; in an e-mail to only a handful of parties), the information may still be regarded as “nonpublic” and may form the basis for an illegal insider trading action.
Duty to Disclose or Abstain
The SEC has consistently taken the position that trading in the open market by company insiders on the basis of material, nonpublic information is a “deceptive” device in violation of Section 10(b) and Rule 10b-5. In a 1961 administrative decision (In Re Cady, Roberts & Co.), the SEC articulated the “disclose or abstain” rule, under which a company insider must disclose all material nonpublic information known to him before trading or, if disclosure is improper or impracticable, abstain from trading. Eight years later, the Supreme Court held that anyone who possesses inside information of a consequential nature must either disclose it to all of the investing public or abstain from trading until that information is public (SEC v. Texas Gulf Sulphur).
In a 1980 case, Chiarella v. U.S., the Supreme Court noted that Rule 10b-5 cannot be violated for a person’s failure to disclose “absent a duty to speak.” The Supreme Court reversed the conviction of an employee of a financial printer (not an employee of an issuer) who traded on material, nonpublic information that came into his possession, and stated that the duty to disclose or abstain does not arise from the mere possession of nonpublic information, but from a relationship of trust and confidence between the alleged insider trader and the other party to the transaction. The court did not believe that the employee of the printer had a relationship of trust and confidence with the companies whose financial information came across his desk.
Tipper and Tippee
About four years after the Chiarella decision, the Supreme Court further refined the duties of persons who are not company employees, but are “imputed” insiders. Dirks v. SEC (1984) involved an officer of Equity Funding Life, Ronald Secrist, who was encouraged by his employer to create false insurance policies. Secrist was laid off and, bitter over his firing, tipped off a securities analyst, Ray Dirks, to the scheme. Secrist did this to exact revenge for his termination, and was not motivated by personal financial gain.
Dirks informed his institutional clients and many promptly sold their Equity Funding stock. He also reported the information to the Wall St. Journal’s Los Angeles editor. The editor informed the SEC and, as the saying goes, “no good deed goes unpunished” - the SEC investigated Dirks’ role in the exposure of the fraud and censured him. The SEC’s position was that Dirks, as a ‘tippee’ - regardless of his motivation or occupation - came into possession of material information that he knew was confidential and knew or should have known came from a corporate insider. Thus, he must either publicly disclose the information or refrain from trading (in this case, enable his clients to trade). Dirks, however, believed his actions were proper. He appealed the censure to the Court of Appeals, which upheld it. Dirks took his case to the Supreme Court, which reversed the Court of Appeals. Justice Powell noted in his opinion that a tippee is not liable under Rule 10b-5 for trading on information received from an insider or anyone else holding information in trust unless (a) the insider/tipper, by disclosing the information to the tippee, breached a fiduciary duty of loyalty to refrain from profiting on the information entrusted to him, and (b) the tippee knows or has reason to know of the breach of duty. Because Secrist, the tipper, did not commit such a breach of loyalty or trust (he had no economic benefit, and in fact exposed a fraud by his employer), Dirks, as a tippee, could not commit a “derivative” breach.
Misappropriation Theory - Deception and Disclosure
The concept of “imputed” or “constructive insiders” continued to evolve, as courts adopted the misappropriation of information as an alternative basis for illegal insider trading liability.
In a 1997 decision, US v. O’Hagan, the Supreme Court upheld the conviction of an attorney who profited from material nonpublic information acquired in a deal that he worked on. O’Hagan’s law firm represented Grand Metropolitan, which was considering a tender offer for Pillsbury Company’s common stock. O’Hagan bought call options on Pillsbury and netted over $4 million in profits. Indicted by the SEC, O’Hagan claimed that because neither he nor his firm owed any fiduciary duty to Pillsbury, he did not commit fraud. The Supreme Court rejected this argument and upheld his conviction, deciding that a person commits fraud in violation of Rule 10b-5 “in connection with” a securities transaction (not necessarily in a direct offer or sale) when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.
Under the misappropriation theory applied in O’Hagan, a trader is deemed to be an imputed insider because he owes a fiduciary duty not to the other trading party or the issuer of the securities, but to the source of the material nonpublic information.
O’Hagan was considered to be a fiduciary, and his undisclosed, self-serving use of material nonpublic information to trade in options was in breach of his duty of loyalty and confidentiality to his firm and his client, whom he defrauded of the exclusive use of the information. The Supreme Court specifically recognized that “a company’s confidential information...qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty...constitutes fraud akin to embezzlement – the fraudulent appropriation to one’s own use of the money or goods entrusted to one’s care by another.”
Applying this analysis, liability is based on the trader’s deception of those who entrusted him with access to confidential information. Accordingly, disclosure cures the deceptive nature of the conduct that is prohibited by Rule 10b-5. It would have been perfectly legal for O’Hagan to trade on his inside information had he disclosed to his client, Grand Met, and his law firm what he intended to do, notwithstanding the overall “unfairness” to other market participants.
The latest case with national exposure that addressed the issues of misappropriation, confidentiality, and deception was SEC v. Cuban. In its 2009 decision, the U.S. District Court (Northern Texas) held that Mark Cuban, owner of the Dallas Mavericks, was not guilty of illegal insider trading even though he entered into a transaction after receiving confidential information on the issuer. The court concluded that, since Cuban’s alleged oral agreement to maintain the confidentiality of the information provided to him did not go so far as to have him agree “not to trade on or otherwise use it,” there was no misappropriation because, “absent a duty not to use the information for personal benefit, there is no deception in doing so.” In October, the SEC filed to appeal the District Court’s decision.
Steps to Protect Against Illegal Insider Trading
There is constant temptation in the investment world to either profit from (or avoid loss through) knowledge of material nonpublic information. That is why hedge funds and other investment companies must have an effective compliance program in place. It should do more than simply create a superficial awareness of illegal insider trading and the applicable fines and jail sentences. Fund management should make every effort to reduce, as much as reasonably possible, the potentially fatal risks to the enterprise and the careers of its employees that can result from insider trading violations. Moreover, funds of funds and other investors in hedge funds should thoroughly investigate the compliance programs of their underlying investments to ensure that their investments are not in jeopardy.
Control of the trading environment is the most significant aspect of a system to avoid illegal insider trading. If material nonpublic information comes into the possession of fund personnel, management should have systems in place to prevent it from being widely shared and traded upon, and thus remove the source of the temptation to make illegal profits.
The minimum elements of an effective insider trading compliance program should include: (a) segregation of personnel (i.e., the firewall); (c) confinement of material nonpublic information (only select personnel should have access to such information and only on a “need-to-know” basis); (c) oversight of internal communications (the compliance/legal staff might serve as a clearing house through which all interdepartmental memos are sent); and (d) strict monitoring of employee trades (those with sensitive jobs might be required to receive advance permission to trade).
As applied to insider trading compliance, certain departments (e.g. research) may have access to material nonpublic information that could be misused by other departments (e.g., trading). An information “firewall” should be instituted to prevent sensitive material from being disseminated between certain departments of a firm - only a select few individuals need to know sensitive information.
As part of an effective program, a “restricted list” of certain issuers (those that are the focus of researchers or investment banking personnel) is often maintained, as needed, to limit employee trading. If a restricted list is “too public,” a firm can adopt the use of a more discrete “watch list.” The Chief Compliance Officer (CCO) or another high-level executive typically monitors the companies on such lists, perhaps making inquiries of an employee based on such employee’s trading activities, but maintaining the confidentiality needed for a particular circumstance.
Fund managers may come into contact with material nonpublic information in a variety of ways. When it occurs, however, the recipient must be trained and understand his/her obligation to inform his/her supervisor or CCO and not disclose any additional information to co-workers. If a fund relies on internal research analysts, this may raise what is often referred to as the “mosaic” theory of gathering information which, depending on the context, may serve as a defense to a charge of illegal insider trading.
Research analysts regularly gather nonpublic information from a variety of sources (e.g., interviews with company insiders). Each segment may not be material in and of itself, but the “mosaic” as a whole can be interpreted to reveal material nonpublic information. The recommendation that is made for trading (or not trading) on the basis of the fragmented, but pieced-together, information may or may not constitute a breach of a fiduciary duty. It all depends on the context of the ultimate information gleaned from disparate data and whether the result should be obvious, to a reasonable investor, that it was material nonpublic information. The decision resulting from the information gathered may, in practice, conflict with the duty of the manager as a fiduciary to its fund and the fund’s investors, which requires that it act in their best interest.
In a research analyst’s practice, careful records of the research process, with a viable rationale for each investment decision, should be maintained. This can help protect an analyst who relied on the mosaic theory and actually relied on several items of nonmaterial, nonpublic information to form an investment opinion.
Personal securities trades by fund employees should be carefully monitored and, where the executives of a fund manager are conducting personal trades, a procedure to monitor their transactions by a high level officer, like the CCO, should be imposed. The trades of the CCO should be monitored by another senior officer so that the foxes are not guarding the hen-house. Every organization must have “buy-in” by its leaders to avoid intimidation and pressure to look the other way, which may occur when an individual is monitoring the trades of an officer senior to him or her.
Finally, an effective training and continuing education program should be instituted to ensure that all personnel are fully educated about and informed of the dangers triggered by insider trading violations. For such a program to be successful, it should be administered at least annually by an independent professional. Where there are new developments, such as the recent legislation proposed in Congress to require the registration of hedge fund managers, written updates and interim training meetings should be instituted.
Lawrence Cohen is a director in the corporate department at law firm Gibbons P.C. As a former legal officer and compliance director of mutual fund groups, he brings practical experience to the regulation and registration of public investment companies and the formation and operation of private investment companies.
*This article should not be construed or relied upon as legal advice or legal opinion on any specific facts or circumstances.