Much Ado About Little

The U.S. Supreme Court decided its big insider-trading case of the term on Tuesday, and it turns out you still can’t toss a friend or family member a tip to trade on. Who knew?

Here are the facts. The defendant’s brother-in-law was an investment banker who advised major healthcare companies on mergers and acquisitions. Over time, he shared inside information about these corporate deals with his biological brother, who shared them with the defendant. By the time of defendant’s trial, the brothers had both pleaded guilty, and they testified that defendant knew the tips came from insider trading.

Well, the jury convicted him, and on appeal, he relied on a recent case out of New York that we wrote about here.

Under that case, he argued, insider trading required proof that the insider benefited financially from the tipping. In his case, however, the insider (banker) had tipped off his brother freely as a gift. Therefore, none of it was insider trading.

The problem was that the New York case didn’t say that. While insider trading does require the insider to benefit personally from the tip, the law has long defined such personal benefit to include the benefit you get from making a gift of confidential information to a relative or friend. The New York case didn’t change that, though it did question who should count as a friend (or relative, for that matter) in a world full of loose connections.

Still, the New York case had caused a stir in the white-collar-defense world over whether the Supreme Court would use this case to reshape the law of insider trading.

But this case was different, and the Court did no such thing.

SEC Reports Enforcement Results for 2016

As we wind down the calendar year, the Securities and Exchange Commission has already reported its enforcement results for the fiscal year that ended September 30.

In case you missed it, here’s the press release. Naturally, there’s some self-patting on the back, but if the past predicts the future, the agency is looking to file cases. Its numbers have climbed steadily over the last dozen years, and it continues to ramp up its use of big-data analytics and the whistleblower program, which it launched in 2011.

Here are some highlights from 2016.

  • The agency filed a total of 868 cases, which was a new single-year high.
  • It filed a record number of cases involving investment companies or advisers and a record number under the Foreign Corrupt Practices Act.
  • It obtained over $4 billion in judgments and orders, which matched the haul from each of the last two years.
  • It awarded more money to whistleblowers ($57 million) than in all prior years combined.

The CFTC’s First Ever Case of Insider Trading

Two months ago, for the first time, the Commodity Futures Trading Commission flexed its new anti-fraud powers under the Dodd-Frank Act to punish insider trading in the futures markets.

How so? The agency filed and settled an enforcement action against an employee whose job was to trade energy futures for a large corporation. Allegedly, the employee used access to confidential information about the timing, volume, and prices of the company’s trades to profit his own personal accounts at his employer’s expense. He allegedly executed trades between the company’s account and his personal accounts, thus playing both sides of the deal, and he allegedly placed other personal orders just ahead of orders he placed for the company, thus benefiting from price movements caused by the company’s much larger trades. These actions violated the Commodity Exchange Act and its regulations.

Under the terms of the settlement, the employee did not admit or deny the agency’s findings and conclusions, but he agreed to pay restitution in the amount of $217,000, a monetary penalty of $100,000, and post-judgment interest on both. He also consented to a permanent bar from trading in commodities directly or indirectly.

For more details, here’s a copy of the Commission’s press release, and here’s a copy of the order itself. For more in-depth analyses on what this may mean for the agency’s enforcement efforts going forward, see here and here.

The SEC Dodd-Frank Whistleblower Program

Speaking of whistleblowers, the Securities and Exchange Commission just published its annual report to Congress on its own program that it launched in 2011.

And overall, it seems to be on the upswing.

The SEC’s program authorizes monetary awards for volunteering original information that results in a successful enforcement action, including sanctions that exceed $1 million. It doesn’t matter whether you help open a successful investigation or close an existing one more efficiently or favorably.

If you fit the bill, you get ten to thirty percent of whatever the agency collects, and the percentage will vary with the facts and circumstances of the case. Factors that can raise your percentage include the value of your information, the overall assistance you provide, the public interests at stake, and whether you tried to report the matter internally (and suffered retaliation for it) before going to the government. Factors that can lower your percentage include your own unclean hands, if any, whether you delayed unreasonably in reporting the matter, and whether you interfered with your company’s internal compliance program (if any).

According to the report, since 2011, the Commission has paid over $54 million to 22 whistleblowers, and in the last fiscal year alone, it paid over $37 million to eight of them. One received over $30 million and another received over $3 million.

Who are they? According to the agency, about half are current or former employees of the companies they blow the whistle on. Others include ticked-off investors, industry peers, or personal contacts of the person or company in question. They hail from all fifty states as well as other countries, but most come from California, New York, New Jersey, Florida, and Texas. Many submit their information anonymously through counsel.

What do they report on? It runs the gamut, but often, they report on misstated corporate disclosures and financials; fraud in connection with securities offerings; price manipulation; insider trading; unregistered offerings; or violations of the Foreign Corrupt Practices Act.

Yippee for Tippees

Earlier this month, in a pivotal decision on how far the government can go to prosecute insider trading, an influential federal court of appeals clarified that the recipient of a juicy corporate tip is not guilty of insider trading for acting on the tip unless he or she knew that it came from an insider who revealed it in return for a personal benefit.

The appeal was based on the convictions of two men who were three to four degrees of separation downstream the passing of tips from corporate insider to one person to another (and another). Although the men were indicted alongside other, fellow “tippees” who were upstream from them, none of the corporate insiders—that is, the “tippers”—were charged civilly, criminally, or administratively for insider trading or anything else.

One of the men was sentenced to 54 months and a $1 million fine. The other got 78 months and a $5 million fine.

On appeal, the U.S. Court of Appeals for the Second Circuit, which covers New York, Vermont, and Connecticut, reversed the convictions because the jury was not properly instructed on when a tippee could be convicted of insider trading. First, a corporate insider must actually have committed insider trading, meaning the insider not only breached a fiduciary duty by revealing the information but derived a personal benefit of some kind, directly or indirectly, by doing so. If the insider didn’t derive a personal benefit, it may still be something else, but it’s not insider trading. Next, to convict a tippee, the government must prove that he or she knew the tip was dirty and the insider derived a benefit from it. In other words, it’s not enough that a tippee traded on an inside tip; he or she must also have known that a corporate insider had traded the tip for a personal benefit.

In sum, the Court held that insider trading for tippees requires proof beyond a reasonable doubt of each of the following:

  1. A corporate insider was entrusted with a fiduciary duty;
  2. the insider breached his duty by disclosing confidential information in exchange for a personal benefit;
  3. the tippee knew that the information was confidential and divulged for personal benefit; and
  4. the tippee still used that information to trade in a security or tip someone else for personal benefit.

Against this standard, the government presented insufficient evidence to prove that any corporate insiders committed insider trading—and no evidence at all that the two men knew they were trading on the fruits of insider trading—so the Court reversed their convictions and sent the case back with instructions to dismiss the indictment with prejudice.

SEC Announces Its 2013 Enforcement Results in the Financial Markets

Here is a link to the Securities & Exchange Commission’s press release reporting its enforcement numbers for fiscal year 2013, which ran from October through September. Over that period last year, the agency filed 686 public lawsuits in the name of our capital markets, and it obtained a record $3.4 billion in monetary sanctions, like disgorgement of profits, including $3 billion from 169 people and entities associated with the financial crisis. Some of those results may have been the product of the agency’s tally in 2011, when it filed 735 enforcement actions, the most in its history. The people charged reportedly include 70 CEOs, CFOs, and other senior business executives.

Other highlights? The agency brought several novel actions against securities exchanges, including one that resulted in a largest-ever penalty of $10 million against NASDAQ for the bungled Facebook IPO. It rewrote its longstanding settlement policy to require admissions of wrongdoing in certain cases, and it settled the first cases in conformity with that. It continued to prosecute insider trading at full tilt, and it paid out more than $14 million to whistleblowers under its new program.

Coming attractions? At a higher level, two stand out. First, there is a pipeline of activity to come. The Enforcement Division opened 908 new investigations last year, and it obtained 574 formal orders of investigation on previously-opened files. The SEC issues formal orders when it finds it likely that a securities-law violation has occurred, and the formal order grants staff the ability to issue subpoenas and administer oaths. Second, the Commission is harnessing the power of Big Data. It’s reportedly upgraded its data-analytics capabilities significantly, which means it can review and analyze higher volumes of electronic documents as well as conduct better forensic analysis overall, detecting patterns of fraud or other malfeasance in the data.

Don’t Mess With Texas, (Mark) Cubans, or the SEC When It Comes to Insider Trading

As you may have heard, Texan billionaire Mark Cuban was acquitted a couple weeks ago in an insider-trading trial that accused him of selling his stake in a Canadian search-engine company after learning from its CEO that it was planning a stock sale that would dilute his stake. Cuban’s conversation with the CEO took place in 2004, just months after he had purchased his stake, and their conversation was by phone, so there was no recording of it. By selling his shares before the transaction was announced, Cuban avoided $750,000 in losses.

The Securities & Exchange Commission sued Cuban, alleging that his phone conversation included an agreement to keep the information confidential, which meant he was not allowed to trade on it. The SEC sued him for violations of §17(a) of the Securities Act of 1933, §10(b) of the Securities Exchange Act of 1934, and the SEC’s Rule 10b-5. These are some of the government’s most important tools for prosecuting insider trading and other forms of securities fraud. On October 16, after five years of litigation and an eight-day trial, the jury returned a defense verdict on all claims.

But there is some confusion about what insider trading means, or meant, in the Cuban case. The government wasn’t alleging so-called “classical” insider trading, which happens when a corporate insider—say, the CEO himself—trades on juicy information that the public doesn’t know about. There, liability is based on the notion that insiders bear a fiduciary duty to the company’s shareholders, including prospective shareholders looking to buy stock. As a result, the insiders must either not trade on the material, nonpublic information or disclose the information before they do.

In Cuban’s case, the government’s lawsuit was based on a “misappropriation” theory of insider trading, which reaches company outsiders (like shareholders) who come into possession of inside information under circumstances in which they owe a duty of confidentiality to its source. That’s why a company’s lawyers, for example, can’t trade on material, nonpublic information they gain by virtue of their representation. But who else owes such a duty? Well, in 2000, the SEC promulgated Rule 10b5-2, which identifies three, non-exclusive situations that create a duty of trust or confidence that, if breached, can support a misappropriation theory of insider trading:

  1. A person agrees to maintain the information in confidence;
  2. The person communicating the information has a history, pattern, or practice of sharing confidences with the recipient, such that the recipient knows or reasonably should know that there is an expectation of confidentiality; or
  3. The recipient obtains the information from a spouse, parent, child, or sibling, unless the recipient can prove that he or she neither knew nor reasonably should have known that there was an expectation of confidentiality because there was no agreement, understanding, history, pattern, or practice to that effect. (How’s that for a mouthful.)

Cuban’s case involved the first scenario. His defense was that there was no confidentiality agreement between him and the CEO, and absent that, he had no obligation to avoid trading on the information. He also presented evidence that the information was not confidential anyway because it had already been made public through an SEC filing that the company had made before their phone conversation.

Ultimately, the jury found that the government failed even to prove that Cuban received material, nonpublic information in the first place. It probably didn’t help that the government’s star witness—the company’s CEO at the time—testified by videotape rather than in court at trial. It turns out that the SEC couldn’t subpoena him because he lives in Canada, and apparently, he wasn’t willing or able to make the trip down south. His videotaped testimony, moreover, was from a deposition he gave in 2011, seven years after his conversation with Cuban.

The Cuban verdict, however, probably won’t affect the SEC’s priorities going forward. The agency has brought more insider-trading cases in the last three years than in any three-year period in its history, and for the most part, it’s been successful at trial, winning approximately 85% of the time.

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