A review of insider trading law, with emphasis on its application to recent cases involving hedge funds. Reviews Preet Bharara’s scorecard, the Galleon case, materiality and the “Mosaic Theory," and tipping chains.
4. Securities Exchange Act of 1934
Section 10(b)
Rule 10b-5
Disclose or
Abstain Theory
Misappropriation
Theory
Section 14(e)
Rule 14e-3
Overview of USA Insider Trading Laws
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5. Criminal
Up to 20 years imprisonment
(per instance)
Up to $5,000,000 fine (per
instance)
Civil
Disgorgement of profits (or
amount of loss avoided)
Civil fine of up to 3x profits (or
amount of loss avoided)
Bans from securities industry
for professionals
Ban from serving as director or
officer of public corporations.
Penalties for Insider Trading
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6. Market surveillance techniques:
• The SEC and all of the major markets have software systems to
monitor trading activity for suspicious patterns.
• FINRA: An ―artificial intelligence‖ surveillance application -- the
Securities Observation, News Analysis and Regulation (SONAR)
system -- to detect suspicious patterns. Regardless, insider trading
enforcement remains difficult.
The SEC receives roughly 700,000 tips per year from
informants:
• The SEC can pay bounties to informants.
US Attorneys can get wiretaps, confidential informants, and other
criminal investigation techniques.
Detecting Insider Trading
10. Securities Exchange Act § 10(b) SEC Rule 10b-5
It shall be unlawful for any person, directly
or indirectly, by the use of any means or
instrumentality of interstate commerce or of
the mails, or of any facility of any national
securities exchange—
(b) To use or employ, in connection with
the purchase or sale of any security
registered on a national securities
exchange or any security not so
registered, or any securities-based swap
agreement any manipulative or deceptive
device or contrivance in contravention of
such rules and regulations as the
Commission may prescribe as necessary
or appropriate in the public interest or for
the protection of investors.
It shall be unlawful for any person,
directly or indirectly, by the use of any
means or instrumentality of interstate
commerce, or of the mails or of any
facility of any national securities
exchange,
(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.
The Key Prohibition
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11. United States v. O’Hagan, 521 U.S. 642 (1997)
Under the ―traditional‖ or ―classical theory‖ of insider trading liability, 10(b) and Rule
10b-5 are violated when a corporate insider trades in the securities of his corporation
on the basis of material, nonpublic information.
Trading on such information qualifies as a ―deceptive device‖ under 10(b), we have
affirmed, because ―a relationship of trust and confidence [exists] between the
shareholders of a corporation and those insiders who have obtained confidential
information by reason of their position with that corporation.‖ Chiarella v. United
States, 445 U.S. 222, 228 (1980).
That relationship, we recognized, ―gives rise to a duty to disclose [or to abstain from
trading] because of the ‗necessity of preventing a corporate insider from ... taking
unfair advantage of ... uninformed ... stockholders.‘ ― Id., at 228-229 (citation omitted).
The classical theory applies not only to officers, directors, and other permanent
insiders of a corporation, but also to attorneys, accountants, consultants, and others
who temporarily become fiduciaries of a corporation.
Rule 10b-5: Disclose or Abstain Theory of Liability
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12. United States v. O’Hagan, 521 U.S. 642 (1997)
The ―misappropriation theory‖ holds that a person commits fraud ―in connection
with‖ a securities transaction, and thereby violates 10(b) and Rule 10b-5, when
he misappropriates confidential information for securities trading purposes, in
breach of a duty owed to the source of the information.
Under this theory, a fiduciary‘s undisclosed, self-serving use of a principal‘s
information to purchase or sell securities, in breach of a duty of loyalty and
confidentiality, defrauds the principal of the exclusive use of that information.
In lieu of premising liability on a fiduciary relationship between company insider
and purchaser or seller of the company‘s stock, the misappropriation theory
premises liability on a fiduciary-turned-trader‘s deception of those who entrusted
him with access to confidential information.
Rule 10b-5: Misappropriation Theory of Liability
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13. United States v. O’Hagan, 521 U.S. 642 (1997)
The two theories are complementary, each addressing efforts to capitalize on
nonpublic information through the purchase or sale of securities.
The classical theory targets a corporate insider‘s breach of duty to shareholders
with whom the insider transacts; the misappropriation theory outlaws trading on
the basis of nonpublic information by a corporate ―outsider‖ in breach of a duty
owed not to a trading party, but to the source of the information.
The misappropriation theory is thus designed to ―protect the integrity of the
securities markets against abuses by ‗outsiders‘ to a corporation who have
access to confidential information that will affect the corporation‘s security price
when revealed, but who owe no fiduciary or other duty to that corporation‘s
shareholders.‖
Rule 10b-5: Relationship
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14. Tipping
If a corporate insider or
misappropriator (the tipper)
1. Discloses material non public
information (tips)
2. To another person (the tippee)
3. And receives a personal benefit
for doing so
The tipper can be held liable for
breaching Rule 10b-5
The tippee‘s liability is derivative
of that of the tipper.
• The tippee must know both:
1. That the tipper had provided
him or her with material non-
public information in breach
of a duty and
2. That the tipper received or
anticipated receiving a
personal benefit.
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15. Application to typical recent hedge fund case
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Shareholders
Issuing
Corporation
Insider
Expert
Networking
Firm
Hedge Fund
Trader
17. Application to typical recent hedge fund case
Was the information material?
• Mosaic Theory (below)
Misappropriation/Tipping
• Insider tips hedge fund manager
1. Insider has fiduciary duty to issuer.
Failure to disclose plan to tip is a
breach of that duty = Misappropriation.
2. Insider gets personal benefit ($) for
doing so = Tipper liability.
• Trader (tippee) knows both:
1. That the tipper had provided him or
her with material non-public
information in breach of a duty and
2. That the tipper received or anticipated
receiving a personal benefit.
Hedge fund would have control person
liability
• Also possible tippee liability
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18. Definition Examples
Information is material if
there is a substantial
likelihood that a
reasonable shareholder
would consider the fact
important in deciding how
to trade
An issuer will show above-expected
delinquencies in the pool of mortgages
backing its bonds
An issuer is about to release financial
projections
An issuer is about to make a PIPE offering
An issuer is about to receive a tender offer
An issuer will soon announce a change in
management
An issuer will soon announce a rating
change
An issuer will soon announce a merger or
asset sale
An issuer will soon announce earnings
An issuer will soon disclose a valuable
mineral discovery or R&D development
An issuer will soon receive an upcoming
buy recommendation from a financial
analyst
An issuer will be featured in a financial
news column
Materiality and the ―Mosaic Theory‖
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19. Mosaic Theory Application in Raj Rajaratnam’s (Galleon) case
Professional investors make
trading decisions based on the
amalgamation of myriad pieces of
information and data obtained
from various sources and
resources.
No single piece of information
and data is material to the
professional.
It is the review and analysis of the
whole – the finished mosaic –
that determines how the investor
will proceed.
Defense claim: Traders patched
together data from equity analysts'
reports, company announcements and
newspaper articles.
Judge rejected argument that there is a
different definition of materiality of
investment professionals.
Jury rejected defense on facts of case.
• Much of Rajaratnam‘s ―mosaic‖
consisted of independently material
information.
Probable legal rule in tipping cases:
• If tipper knows immaterial information
will enable tippee to complete a material
mosaic, information becomes material
and liability follows.
Materiality and the ―Mosaic Theory‖
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20. Tipping chain liability:
Can government prove
Newman knew
information came from
a corporate insider who
received a personal
benefit for making the
tip?
Must the government?
See SEC v. Obus, 693
F.3d 276 (2d Cir.
2012).
Application to typical tipping chain case
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21. The tippee must know that the
tipper received or expected to
receive a personal benefit.
The law ―does not require that
[tippee] had knowledge that the
insider obtained a personal
benefit‖ but only that the tip was
unauthorized.
―Tippee liability requires that (1) the tipper breached a duty by tipping confidential
information; (2) the tippee knew or had reason to know that … the information
was obtained through the tipper’s breach; and (3) the tippee, while in knowing
possession of the material non-public information, used the information by trading
or by tipping for his own benefit.‖
Second Circuit Decision
United States v. Whitman (S.D.N.Y. 2012) United States v. Newman (S.D.N.Y. 2013)
SEC v. Obus
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22. For more information
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Insider Trading Law and Policy (Foundation
Press Concepts and Insights Series)
• Stephen M. Bainbridge
