Insider Trading Law Explained
Neither Section 10(b) of the Securities Exchange Act of 1934 nor Rule 10b-5 of the Securities and Exchange Commission (SEC) expressly forbids insider trading. Nevertheless, insider trading is considered a type of securities fraud which is prohibited by the Act and the Rule. The classical theory holds a corporate insider (such as an officer or director) violates Section 10(b) and Rule 10b-5 by trading in the corporation’s securities on the basis of material, nonpublic information about the company. Such trading would constitute a breach of the fiduciary duty owed shareholders of the corporation. The case-law on insider trading is both exhaustive and exhausting. Recently, the U.S. Court of Appeals for the Second Circuit had occasion to clarify the law in a widely-discussed case, U.S. v. Newman, Nos. 13-1837, 13-1917.
In May of 2013, Todd Newman and Anthony Chiasson were convicted in Federal District Court for the Southern District of New York (with jurisdiction over Wall Street) of conspiracy to commit insider trading and insider trading. The U.S. Court of Appeals for the Second Circuit reversed the convictions in December 2014 and denied the petition for rehearing by the government in April of 2015. The Supreme Court denied certiorari on October 5, 2015. The government had alleged a group of analysts at various hedge funds and investment firms had obtained material, nonpublic information from employees of publicly traded companies, shared it among each other, and subsequently passed the information to portfolio managers at their respective companies.
The facts are simple. Newman was a portfolio manager at Diamondback Capital Management and Chiasson at Level Global Investors. Newman earned $4 million and Chiasson $68 million in trades of Dell and NVIDIA stock. Newman and Chiasson had obtained information as tippees in a tipping chain which started with insiders at each of the two companies.
With respect to the Dell tipping chain, Rob Ray of Dell’s investor relations department tipped information relating to the company’s earnings to Sandy Goyal, an analyst at Neuberger Berman. Goyal gave the information to Diamondback analyst Jesse Tortora. Tortora relayed the information to his manager Newman as well as to other analysts including Level Global analyst Spyridon Adondakis. Adondakis passed the information to Chiasson, making Newman and Chiasson three and four levels removed from the inside tipper, respectively.
With respect to the NVIDIA tipping chain, Chris Choi of NVIDIA’s finance unit tipped inside information to Hyung Lim, a former executive at Broadcom Corp. and Altera Corp., whom Choi knew from church. Lim passed the information to co-defendant Danny Kuo, an analyst at Whittier Trust. Kuo circulated the information to a group of analyst friends, including Tortora and Adondakis, who in turn gave the information to Newman and Chiasson, making Newman and Chiasson four levels removed from the inside tippers.
The Court of Appeals held that to sustain an insider trading conviction the government must prove the tippee knew an insider disclosed confidential information,the tipper disclosed the information in exchange for a personal benefit, and the tippee knew the information had been disclosed in exchange for a personal benefit. The Court found there was no evidence of any personal benefit received by the insiders and, in any case, there was no evidence Newman and Chiasson knew they were trading on information obtained from insiders in violation of those insiders’ fiduciary duties. Moreover, Newman and Chiasson were several steps removed from the corporate insiders.
The government argued Newman and Chiasson, as sophisticated traders, must have known the information obtained was disclosed by insiders in breach of a fiduciary duty and not for any legitimate corporate purpose. Newman and Chiasson argued that in order to establish tipper liability, case-law requires proof corporate insiders provided inside information in exchange for a personal benefit. Because a tippee’s liability derives from a tipper’s liability, Newman and Chiasson argued they could not be found guilty of insider trading. Furthermore, they argued, even if the corporate insiders had received a personal benefit in exchange for the inside information, there was no evidence they knew about such benefit. Absent such knowledge, they were not aware of or participants in the tippers’ presumed fraudulent breaches of fiduciary duties to Dell and NVIDIA.
The Court of Appeals presented an extensive review of the law of insider trading concluding the Supreme Court had explicitly rejected the notion of a “general duty between all participants in market transactions to forgo actions based on material, nonpublic information.” As to the tipper-tippee fact situation, the Supreme Court has held tippers may not give inside information to tippees for the purpose of exploiting the information for personal gain. The test for determining whether the corporate insider tipper has breached his fiduciary duty “is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty.”
The Supreme Court has rejected the SEC’s theory a tippee must refrain from trading whenever “he receives inside information” from a tipper. Instead, the Court has held the tippee’s duty is derivative from the tipper’s duty. Because the tipper’s breach requires personal benefit, a tippee may not be held liable in the absence of such benefit to the insider-tipper. Furthermore, a tippee may be found liable only when the “tippee knows or [should have known] there has been a breach”. For example, in a case where the tipper provided confidential information to expose a fraud and not for personal benefit, the tipper had not breached his duty to the company’s shareholders and thus the tippee could not be held liable.
The Court of Appeals carefully examined the evidence as to whether the insider-tippers received personal benefits in exchange for their tips by narrating the personal and business friendships among the tippers and tippees in soporific detail. The government may not prove the receipt of a personal benefit by the mere act of friendship, particularly of a casual or social nature. The exchange between tipper and tippee must be “objective, consequential, and [represent] at least a potential gain of a pecuniary or similarly valuable nature”. There must be evidence of a quid pro quo or an intention by the tippee to benefit the tipper.
Even worse for the government’s case, there was no evidence Newman and Chiasson knew they were trading on information obtained from insiders or those insiders had received any benefit in exchange for such disclosures or Newman and Chiasson had “consciously avoided learning of these facts”. In order for the government to have prevailed it would have had to prove beyond a reasonable doubt Newman and Chiasson knew the insiders received a personal benefit.
Nevertheless, the government argued that, given the detailed nature and accuracy of the updates received by defendants, they must have known or deliberately avoided knowing, the information originated with corporate insiders and those insiders disclosed information for personal benefit. The Court held such an inference would have been unwarranted given the tippees were several levels removed from the source. Moreover, even if the detail and specificity of the information could support an inference the information came from an insider, it did not necessarily support an inference the insider had received a benefit in exchange for the disclosure.
The Second Circuit got this case right. No one should be convicted of insider trading based on suppositions predicated on assumptions rooted on suspicions. As it is, the law of insider trading is quite confusing. Financial analysts are caught in a dilemma. To serve their clients well they must find out as much as possible about the companies they follow. At the same time, they have to steer clear of trading on material, nonpublic information improperly obtained. In fact, in the case discussed it is a wonder the traders made any money. The portfolio managers could just as easily have lost $4 million or $68 million given they had received information third or fourth hand and we all know how unreliable such information usually is. No one should go to jail for being lucky.
In a future article, we will be discussing Supreme Court insider-trading case law.
Author: Néstor Enrique Cruz
Attorney and Counsellor, Dunlap, Bennett & Ludwig
Posted in: Business Law