As Insider Trading Reaches A Tipping Point, How Do You Comply?

Let’s get personal

Do you think that you can assume a personal benefit was received based solely relationship status? Spouse, yes, brother, maybe, friend, really?

For purposes of proving a personal benefit, in the context of an insider trading case, where the defendant traded on information supplied by a tipper, the law requires the prosecution to show more than mere friendship — well according to the December 2014 Newman decision at least. The Newman standard requires a real, objective, almost pecuniary benefit to the tipper — that individual who passed on the inside information — in order for the receiver (tippee) who traded on that information to be guilty of insider trading. (Full Decision Here).

Game Changer

Newman is a sea change in the insider trading law in every case where an insider tips a friend without a quid pro quo. This has become the deal breaker — if the prosecutors can’t demonstrate a real, non-ephemeral benefit, basically a pecuniary benefit, then there is no case. The issue whether the tippee should have known the tipper was violating a duty is still present, but secondary to the quid pro quo of the Newman personal benefit. (Read here on how Newman changed insider trading law).

In the wake of Newman, fourteen of the 96 people criminally charged in the Second Circuit since 2009 have had their cases dropped or overturned. (More on that here — a 2013 conviction of an SAC employee overturned.) One the most high profile convictions: Rajat Gupta, former Goldman Sachs director and McKinsey executive is under appeal (see here). The SEC also settled its wide ranging investigation of SAC capital (more on that capitulation here and and SAC’s second act here).

Supreme Court Review

Newman created a split on Supreme Court language and the court has agreed to review. However it will not review Newman, but another case decided after Newman that did not apply the Newman standard — Salman, which is from the Ninth Circuit. (Full Details on Salman here). In Salman the tippee trader was the brother of an insider. There are facts that the insider brother passed on information to help his brother, so the prosecution offered evidence besides a mere relationship. (See here for why Salman is the case the court would rather hear than Newman).

Newman may not have given a new interpretation to a 31 year-old case by reading the language of Dirks as requiring a real, objective benefit, but instead raised the prosecutorial burden in response to an increasingly looser use of the case law by prosecutors: “[t]he Government’s overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders” — US v Newman.

All Law is Case Law

Absent a clear statute on the topic, insider trading law, when the liability of non-insiders is involved, has always been murky. At one point, anyone who traded while in possession of material nonpublic information violated the anti-fraud provisions of the federal securities laws — at least from the Government’s perspective. During that time the government was focused on policing the information and not the insider, until a duo of cases, Chiarrella and Dirks, changed the focus to policing the insider.

In Chiarrella and Dirks, the Supreme Court held that the appropriate test focuses on whether an insider benefited — either by trading or by tipping in exchange for a benefit from the person to whom he tipped. This shift in focus was based on the common law understanding of fraud which was drawn from the manipulative device language in Section 10-b5 of the Exchange Act. (See here for more on 10-b5) .

What about Dirks?

Raymond Dirks was an equity analyst who received whistle-blower information about a fraud in a public company. Since the whistle-blower told him. In trying to resolve that fraud, there was no personal benefit. Some of Dirks customers traded on the information he passed on — that there was a fraud in the company. The Court in Dirks, relying on the general corporate law view of fraud, found that Chiarellla required a breach of a specific fiduciary duty, and Dirks’ sources violated no duty.

Dirks has stood to limit tippee insider trading to situations that resembled traditional fraud actions in corporate law. By focusing on policing the insider and not the information, the court required an examination of the insider’s motive in passing on that information. (More on how Dirks changed Insider Trading here). Dirks defines a breach of fiduciary duty as a breach of the duty of confidentiality in exchange for a personal benefit and it also requires that the trader knew of that breach. Newman makes clear that the reception of a personal benefit is inherent in the breach of duty — no benefit, no breach, no case for the tipper or tippee.

Although the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets — U.S. v Newman

No change in SEC approach

In the past six years the SEC has brought insider trading actions against more than 650 defendants. Just last week at the 2016 SEC Speaks Series, Deputy Director Stepahine Avakian, stated that 1) there is no change in the way the SEC brings insider trading cases, 2) it will continue to bring strong new cases, and 3) it has not seen other courts apply Newman. This speech effectively made insider trading a 2016 enforcement priority. (Read more: SEC approach remains the same).

This Monday, the SEC won its civil case against two New York brokers, who had their criminal charges dropped due to Newman (see here). The civil court did not apply the Newman standard. Currently, the SEC is appealing an administrative law judge’s dismal based on the Newman standard (see here). It does appears that Newman may only apply to criminal cases brought in the in the Second Circuit — for now.

Compliance rules remain

For compliance officers at investment advisers and investment companies, rules 204A-1 and 17-J remain the same. These rules will not catch most of the recent tippee insider trading cases. Nor will they capture hedge fund managers who receive tips from sell side analysts or through ‘investment clubs' and the trade in the firm’s accounts. (That type of insider trading still exists).

The rules’ design is more simplified — to prevent financial industry employees from trading in their household accounts on information that they may come across as part of their employment. The full requirements for 204A-1 are best read in the adopting release and 17-J is a similar rule. The rules are best complied through an automated system that meets all the necessary elements of a sound personal trading policy.

Actionable Advice

These are the elements of a sound personal trading policy:

• Reporting: all employees should report all accounts in which they hold beneficial ownership of securities.
• Certification: all employees should attest to:

Policy: reading and complying with the personal trading policy

Accounts: name, number, and title of all reportable accounts

Holdings: all beneficial ownership of all reportable securities

Trades: all transactions in those reportable securities

• Preclearance: preclearance policies should reflect the firm’s business — a traditional private equity shop will be restricted list driven based on NDAs, while a trading shop will be more focused on front running. Preclearing volitional transactions in all reportable securities is best practice.
• Trade Review: all trades in reportable securities should be reviewed for compliance with preclearance rules.
• Forensic Testing: periodically, additional tests that seek to find patterns in employee trading outside of the on-going trade review should be conducted. It is possible that an employee is following the letter of the policy, but violating the spirit and it’s also possible that your policy doesn’t cover every situation.
• Employee Training: a cornerstone of sound compliance program, which needs to be buttressed by a strong culture of compliance. (See my last post on employee training here).

A few areas of concern:

• Access Persons: Everyone is an access person. In general apply the same rules to all employees, but realize that there may be employees who because your business and their role require extra scrutiny. No employee should require less.
• Managed Accounts: all managed accounts need to be reported, reviewed, certified and tested forensically. (Read the SEC IM Guidance).
• Reportable Securities, Beneficial Ownership: are defined in rule 204A-1. Your personal trading policy should include those definitions.

Newman is a response to increasingly wider net cast by zealous prosecutors and like Dirks returns to the basics of anti-fraud and fiduciary duty. The basics of a sound personal trading policy are also worth returning to, whether the Supreme Court tips in favor a real objective benefit test or buys the “doctrinal novelty” of recent insider trading cases.

Thanks for Reading! Your welcome to join me for my next webinar: Compliance in Volitile Markets