Insider Trading Review: A Guide for CCOs.

A Guide for Compliance Officers:

Evolution of Insider Trading

Presenter Brandon Ortiz of Blue River Partners will provide an analysis of the key elements of insider trading, highlight important recent enforcement actions all CCO's should know, and share a discussion of best practices for CCO's in 2016 from how a solid compliance program can mitigate risks to how to spot telltale signs.

Brandon Ortiz

Mr. Ortiz is a Managing Director at Blue River Partners where he manages the implementation and administration of the firm’s compliance service offerings to alternative asset managers, which include fund launch, ongoing compliance program management and individual compliance project services.

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The Evolution of modern Insider Trading 

Let's get into the evolution of insider trading. A little bit more technical section here. We're going to go through certain cases. We're going to discuss how insider trading came to be in brief, and then we'll get into where we are today, circuit court split, and the Supreme Court decision.

We'll begin with Chiarella versus the United States. This was the case that explained the classical theory. Again, classical theory refers to traditional corporate insiders violating their fiduciary duty to shareholders, and improperly revealing MNPI or improperly acting on MNPI. One of the key quotes from that case is listed here, and it's "A duty to disclose or abstain does not arise from the mere possession of nonpublic market information. It arises rather from the existence of a fiduciary duty." Key to keep in mind.

United States versus O'Hagan ratified the misappropriation theory in 1997. These cases, both Chiarella and O'Hagan were Supreme Court decisions, and again in a misappropriation theory as a little bit different from the classical theory. The misappropriation theory covers individuals possessing insider information, court prohibited from trading on such information because they owe a due to a third party, but not the corporation whose securities are traded.

What is the Dirks benefit test?

Now we're going to get into the detail with respect to the current circuit split, which is the Dirks ... It's founded and based on the Dirks benefit test. Dirks versus the SEC is the seminal case in this context. It took place before the misappropriation theory was accepted, so they applied the classical theory.

In the context of Dirks, the elements and insider trading explained the importance of insider violating his fiduciary duty. The key here were three separate elements when determining insider trading. The tipper breached his fiduciary duty to shareholders by exposing information to the tippee, is the first key. The fiduciary duty to shareholders is always going to be the key aspect with respect to tippers. You have a fiduciary duty to those shareholders, you should know it and you shouldn't be getting any sort of material nonpublic information to a tippee. The tippee knew or should have known that there has been a breach, so there actually has to be knowledge of that, or you should know, or you should have knowledge of there being a breach. Then the tipper benefited, which is the real key to this point, is that the tipper benefited as a result of providing the information. For a duty to be breached, the test is whether the insider personally will benefit directly or indirectly from his disclosure.

Absent some personal gain, there has been no breach or duty to stock holders. An absent of breach by the insider, there is no derivative breach, is what the court said.

In moving onto Newman, which clarified the Dirks benefit test, and which was kind of the first step in many of the folks I described earlier, being let off in the context of their insider trading convictions, the Newman court looked at the benefit test and concluded that in order to sustain the conviction for insider trading, the government must prove beyond a reasonable doubt that the tippee knew that insider disclosed confidential information, and he did so in exchange for personal benefit. The personal benefit, again is the key here. Concluding there was a personal benefit is impermissible in the absence of proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of pecuniary or similar valuable nature.

"There has to be evidence of a relationship between the insider, and the recipient that suggest a quid pro quo from the latter, or an intention to benefit from the latter"

Again the differences, or the key points here are the benefits and the gain of pecuniary or similar value. There has to be evidence of a relationship between the insider, and the recipient that suggest a quid pro quo from the latter, or an intention to benefit from the latter. There had to have been some sort of knowledge and benefit actually received. Mere friendship is not enough in the context of Newman, to establish that something of value flowed from the tippee to the tipper. There had to have been a relationship there. There had to have been a benefit that was at least a potential gain of pecuniary or similar valuable nature.

Salman is where the Ninth Circuit court strayed from the decision in Newman. They actually looked at it in a totally different context. The benefit itself in their perspective related to the fiduciary duty and exploitation of nonpublic information as well as it did in Newman, but it also exists when an insider makes a gift of confidential information to a trading relative or friend. They took that language directly from Dirks. In Salman they rejected the argument that a pecuniary benefit or something similar of value was the only thing sufficient to establish tipping liability. Their criticism to the logic of Newman is that a corporate insider or other person persuaded to the Newman test, in possession of confidential or proprietary information would be free to disclose that information to his or her relatives, and they would be free to trade on it provided that she ask for no tangible compensation in return.

Again, Salman is talking about just the transfer of the information itself, the material nonpublic information itself, without the benefit, without the value. Without that value Salman thinks that there still should be a conviction on insider trading. They have refused to follow what the Newman court in the Second Circuit ... What they came to the agreement on.

Again, in terms of analysis of Newman and Salman, both circuits agree that the knowledge element including proving the tippee knew or should have known the tipper disclosed the confidential information in exchange for a personal benefit. What they disagree over is what constitutes the benefit. The tippee liability depends on whether the tippee knew or should have known the tipper breached a duty by disclosing the information.

Taking a step back, just in terms of the outcome, or what the results were of the Newman case. We probably all remember the Gupta Rajaratnam case, where Rajat Gupta, Mr. Gupta who worked at Goldman-Sachs, he worked at McKinsey and Company, he was on the board I should say, excuse me, of Goldman-Sachs, and he worked at McKinsey. He was the subject of a multi-year government investigation. There were wire taps involved, and they concluded that Gupta was tipping hedge fund manager, Mr. Rajaratnam, with insider information about Goldman-Sachs. He was convicted on three counts of securities fraud. He spent 19 months in prison. He was fined, I think 5 million dollars, and recently he requested a district court to overturn his conviction based on the Newman decision. Based that there was no benefit ... There was no value exchanged between he and Mr. Rajaratnam. That was actually denied by the District Court and the Appellate Court. However, in February, actually recently this month, the Second Circuit Court of Appeals in Manhattan agreed to revisit Gupta's appeal.

As you can see, the Newman case kind of opened up the door for those who have been convicted and fined in the context of insider trading to appeal their cases. Also as a result of the Newman case, Michael Steinberg of SAC Capital, his case ... The government dropped the insider trading case against him based on the Newman decision.

Then more recently, which was much more recent, and related to the SAC Capital that I just described, Level Global, which was involved in insider trading, or accused to be involved, and convicted and paid a large fine. I think it was 21.5 million dollars. They were actually granted ... One of the courts ordered the SEC to refund its settlement payment of approximately 21.5 million. As I described earlier, this company went out of business, Level Global, I think in 2011 as a result of a large insider trading investigation. After the fact they were able to get a portion, or a large portion of their settlement payment back from the SEC. At the end of the day the reputations that have been lost, and the business that have been lost, you can't get that back.

As I drove home earlier, the point I drove home earlier about the Newman case and the Salman case, and how that's going to end up, those things are the key facts to understand about those cases, and to understand how the courts and the SEC are viewing MNPI and insider trading is important, but at the end of the day if you get to the point of actually having to do that analysis as Level Global kind of shows, you're already potentially out of business and your reputation could be irreparably harmed.

Moving onto discussing the Supreme Court and where we are with the Supreme Court. Again, as I described earlier the Second Circuit and the Ninth Circuit, they have split in terms of their analysis of the Dirks benefit test. What is the Supreme Court going to be looking at? What is the issue at hand? What they're going to determine is whether the personal benefit to the insider that is necessary to establish insider trading under Dirks versus SEC, requires the proof that I described earlier in exchange that is objective, consequential, and represents at least potential gain of pecuniary or similarly valuable nature. Or as the Second Circuit held in the United States versus Newman, whether it is enough that the insider and the tippee shared a close family relationship as the Ninth Circuit held in the case. Again, it's all about the benefit and what you're receiving, or whether or not it's just the close family relationship and the fact that information was exchanged is enough.