With all the rhetoric surrounding recent insider trading enforcement actions, it is easy to forget that not all trades on the basis of material, nonpublic information are inherently wrongful, much less illegal.
In fact, some regulators and much of the general public appear to have a common but misguided understanding that an investor's use of nonpublic information is, or at least should be, unlawful because it is somehow unfair to other market participants. This misapprehension is understandable given that insider trading law has evolved into what has been aptly described as a “jerry-rigged and confusing system of common law duty rules, twisted fraud doctrines, and unprincipled exceptions.”1 Nonetheless, this view is questionable as a matter of economic policy, conflicts with the legitimate research and due diligence activities of sophisticated investors, and is plainly inconsistent with the law.
Notably, the Securities and Exchange Commission's explanatory webpage begins by stating that, although insider trading is a term that most investors associate with illegal conduct, that “term actually includes both legal and illegal conduct.”2 This is true, in part, because there is no universal duty among all market participants to forgo trading based on nonpublic information. Distinguishing between lawful and unlawful trading, however, has become increasingly difficult, particularly with respect to indirect recipients of inside information, or “remote tippees.” This difficulty has profound implications for the use of expert networks, and the collection and use of information by investors more generally.
Under the classical theory of insider trading, a corporate insider may be criminally liable for trading on the basis of inside information when such trading is done in breach of the insider's duty to the shareholders of the corporation, not some vague duty to the entire marketplace. Moreover, to protect lawful dissemination of information from prosecution, courts have further required that an insider personally benefit from a disclosure before imposing liability.3 This second requirement is particularly relevant to the question of tippee liability.
A tippee's duty to disclose or abstain derives from that of the insider. Accordingly, under the classical theory, a tippee may become exposed to criminal liability only where he knows or should have known that the inside information was disclosed in breach of the insider's duties and in exchange for personal benefit. Thus, as at least one court has explicitly recognized, “an improperly motivated tipper may pass information to a tippee who lacks knowledge of the tipper's personal benefit and who may therefore trade on inside information without liability.”4 In other words, unless the tippee has knowledge sufficient to put him in a position where he is a participant—after the fact—in the insider's breach of duty, imposition of criminal liability on the tippee may be inconsistent with the current state of the law.
Recent enforcement actions have targeted not only direct tippees but also individuals who are separated from the tipper's initial disclosure by as much as four or five degrees. Cases against these remote tippees can be challenging because the more remote a tippee is from the initial disclosure, the more likely it is that the tippee lacks knowledge of any breach of duty, much less any personal benefit given to the tipper in exchange for the original disclosure. While a direct tippee may readily be shown to have knowledge that a tipper breached his duty for personal gain, problems of proof often arise in establishing that a remote tippee knows that the original tip was the result of a breach by an insider motivated by personal benefit.
These problems of proof do not reflect some unfortunate shortcoming in the reach of the criminal prohibitions on certain forms of insider trading. Rather, they speak to the importance of preventing the prosecution of lawful activity that the U.S. Supreme Court has described as laudable and deserving of protection. As recognized in Dirks, efforts by investors to “ferret out and analyze information” by meeting with and questioning corporate insiders are both routine and “necessary to the preservation of a healthy market.”5 In addition, there is no shortage of regulations and doctrines that prevent or at least deter “selective disclosure” and other perceived wrongs or acts of unfairness on the part of corporate insiders. When the government prosecutes a remote tippee in the absence of clear evidence showing that tippee knew about a personal benefit given to the insider, the government risks chilling beneficial activity because it creates a threat of liability based on the good-faith receipt of information.
This risk is made all the more real by the fact that the courts have accepted scant circumstantial evidence as sufficient to support an inference of personal benefit to the insider. For example, the mere existence of business contacts, friendships, or familial ties between the insider and the initial tippee have been held sufficient to support an inference that the insider revealed inside information in exchange for some amorphous “reputational” benefit. The ease with which the government can meet its burden on the element of personal benefit thus leaves lawful recipients of information vulnerable to prosecution on the basis of vague inferences drawn from limited evidentiary showings.
Moreover, in several recent trials involving tippees, including the proceedings in United States v. Goffer6 and United States v. Contorinis,7 courts have instructed the jury to determine whether the tipper “personally benefited in some way” without advising the jury of any requirement that the tippee knew of that benefit. The language used in these cases may have been fomented, at least in part, by the relevant model jury instructions, which also appear not to require tippee knowledge of the tipper's personal benefit.8 Whatever the origin, inadequate instructions may increase the risk that a tippee will be held criminally liable for receiving information even though he or she was not aware of facts establishing an underlying breach by an insider in exchange for personal benefit.
In contrast, jury instructions in other recent trials involving alleged tippees, including the trials in United States v. Rajaratnam9 and United States v. Whitman,10 have explicitly recognized that “the second prerequisite to tippee liability—tippee knowledge of tipper breach—necessitates tippee knowledge of each element, including the personal benefit, of the tipper's breach.”11 In these cases, the jurors were advised that the tippee defendants could be found guilty of insider trading only if they knew that the information had been obtained from an insider in exchange for, or in anticipation of, a personal benefit. This distinction is essential to distinguishing the good-faith gathering of information about publicly traded companies from illegal trading by knowing participants in an underlying breach, and it should not be overlooked.
Again, it is not unlawful for insiders to provide information to analysts. In some instances, corporate insiders may be acting at the direction of (and for the benefit of) the issuer when making such disclosures. Moreover, there are a wide range of circumstances in which an insider may inadvertently or even improperly disclose inside information without having acted in a way that is a breach of any duty the insider may owe to shareholders. Those circumstances should not create a risk of criminal prosecution for supposed tippees, whether remote or direct, who go on to make trades on the basis of such disclosures. Strict enforcement of knowledge requirements, particularly with respect to the element of personal benefit, is necessary to ensure that lawful conduct is not criminalized and that insider trading liability does not restrain the incentives of investors to gather and use market information profitably. Unless or until brighter lines are drawn by regulators or the courts, it will be critically important to ensure that compliance policies and practices effectively address the origins of information used in making investment decisions.
Investors who use an expert network firm or similar research enterprises should examine the compliance policy of that firm and obtain at least a basic understanding of how the firm has implemented and enforced that policy. If the firm collects information from experts who are current or former insiders, the investor should—at a minimum—take steps to confirm that the information was provided without violating any current or ongoing obligations of confidentiality. It may not be enough to assume that a reputable firm has resolved these potential issues prior to retention, and conducting basic, documented due diligence with respect to each engagement is essential.
Investors need to be aware of the risks posed by information indirectly acquired from current and former corporate insiders and, as the SEC has repeatedly emphasized, build appropriate controls around how information is obtained by and from these sources. Recent enforcement actions and commentary by enforcement agencies have reaffirmed that these controls need to go beyond formalist proscriptions and incorporate realistic business solutions that anticipate regulatory concerns.
A shareholder at Stradling Yocca Carlson & Rauth PC, Jason de Bretteville is a complex business and securities litigator who represents companies, financial institutions, and senior executives in major criminal and civil enforcement proceedings brought by the Securities and Exchange Commission, the Department of Justice, the Commodity Futures Trading Commission, the Office of the Comptroller of the Currency, and the Office of Foreign Assets Control.
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