Former New York Congressman Chris Collins’ recent guilty plea to insider trading charges was straightforward: he passed material nonpublic information (MNPI) to his son who traded on that information and avoided hundreds of thousands of dollars in losses. However, the less straightforward the facts or attenuated the connection between tipper and tippee, the more insider trading law looks like the muddy waters of the Mississippi.
Nevertheless, the proposed Insider Trading Prohibition Act (H.R. 2534) (Act) could clarify the legal haziness that financial institutions, corporate executives, and casual investors regularly wrestle, and at the same time raise new legal issues.
As one of a few bills receiving bipartisan support in such a charged political environment, it appears that some version of the Act has a chance to land on the president’s desk. With a potential revamping of insider trading law within reach, industry participants are on notice that the Department of Justice, Securities and Exchange Commission, and the Commodity Futures Trading Commission will have a new weapon to punish alleged misconduct on Wall Street and beyond.
Decades of Piecemeal Case Law
It’s a shock to most people that no U.S. law expressly forbids or defines insider trading. Insider trading is largely a federal common law construct derived from Section 10(b) of the Securities Exchange Act.
Decades of piecemeal case law has attempted to articulate what constitutes insider trading, but the resulting uncertainty has created an unpredictable enforcement environment, particularly in tipper-tippee cases, with increasing uncertainty the further you get from the MNPI’s source.
Looking to clarify the scope of insider trading, in 1983 the U.S. Supreme Court delivered its seminal opinion addressing tipper-tippee liability. Dirks v. SEC set out the personal benefit requirement: There is no breach of a duty—and therefore no insider trading violation—when a tipper discloses MNPI to an outsider absent some personal gain to the tipper, even if the tipper knew or should have known that information was obtained in breach of a fiduciary duty.
The Dirks court found the defendant not guilty because he tipped MNPI to expose a fraud and not for his personal benefit.
The Dirks test has survived for decades, in large part because courts consistently applied a low threshold for evidence needed to show a personal benefit. But in 2014, the Second Circuit narrowed tipper-tippee liability.
United States v. Newman held that to demonstrate a personal benefit sufficient for insider trading liability in cases where there is not a direct benefit to the tipper, the government needed to prove a “meaningfully close personal relationship” between the tipper and tippee, and at least the “potential gain of [something] pecuniary or similarly valuable nature.”
Two years later in Salman v. United States, the Supreme Court rejected the pecuniary requirement of Newman as inconsistent with Dirks. However, Salman did not expressly address the close personal relationship requirement of Newman, instead holding that disclosing MNPI to a “trading relative or friend” inherently confers a personal benefit to the tipper. Doing so was “the same thing as trading by the tipper followed by a gift of the proceeds.”
In 2017, the Second Circuit looked to Salman in addressing the types of relationships giving rise to a personal benefit. Martoma I overturned Newman’s close personal relationship requirement and held that tippees may be convicted for trading on MNPI conveyed to the tippee as a gift, even if the tipper and tippee did not share a “meaningfully close relationship.”
The next year, the Second Circuit, sitting en banc, re-visited Martoma I and walked back its decision to overturn Newman. In Martoma II, the Second Circuit explained that “there are many ways to establish a personal benefit,” including showing the tipper and tippee had a “quid pro quo” relationship, or that the tipper had an “intent to benefit” the tippee, both of which have been long-recognized by Second Circuit case law.
Muddy Waters Lead to Legislation
Clear as mud, right? That’s partly why, in May, Rep. Jim Hines (D-Conn.) introduced the bipartisan Act to clarify insider trading law. Under the Act, the DOJ and SEC may bring charges against anyone who “was aware, consciously avoided being aware, or recklessly disregarded” that MNPI was “wrongfully obtained or communicated.”
Importantly, the Act eliminates the personal benefit test articulated in over 30 years of case law. Because the Act does not require that defendants actually know how the information was obtained, it could lead to an increase in insider trading prosecutions.
The new standard extends the reach of insider trading liability because it narrows prosecutions to: Did you communicate or trade on inside information? If yes, did you know or should you have known that information was obtained illegally?
Liability Questions for C-Suite
But proponents of the Act should expect resistance. While it provides some clarity, it also throws new mud in the water and raises liability questions in the C-Suite and for companies.
The Act exempts from liability any employer or person (e.g., high-ranking executive) so long as that “controlling person or employer did not participate in, profit from, or directly or indirectly induce” the illegal act. But, is a company that unknowingly receives proceeds of insider trades liable? Is a hedge fund manager that bases traders’ compensation on commissions at risk? What types of information will be viewed as red flags, suggesting that someone should have expected nefarious conduct?
Similarly, the Act prohibits trading and tipping MNPI relating to securities or “the market for” securities. But what kind of information falls into this category and how specific does the information or market need to be? Those are just a few of the many questions the industry will face.
Bracing for Impact
As Congress deliberates, industry participants must brace for impact. Companies should consider re-evaluating policies and procedures to account for novel ways that information can be obtained wrongfully.
Additionally, financial institutions, large and small, should consider rolling out new training programs so its “street level” employees can identify red flags. At the same time, companies must implement enhanced vigilance and monitoring programs that identify, capture, and quash potential misconduct. Moreover, companies will need to stay up-to-date on when and how the DOJ and SEC brings and prioritizes cases.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Kyle DeYoung is a partner in Cadwalader’s White Collar Defense and Investigations Practice as well as the firm’s Corporate and Financial Services Litigation and Regulation Practice. Based in the firm’s Washington, D.C., office, he focuses on representing corporations, investment funds, and individuals in regulatory investigations and providing clients with strategic counseling when facing corporate crises, potential enforcement action and other complex regulatory issues.
Lex Urban is a special counsel in Cadwalader’s White Collar Defense and Investigations Practice and is based in the firm’s Washington, D.C., office. His practice focuses on representing companies and financial institutions, as well as their directors and officers in criminal and civil investigations.
Stephen Weiss is an associate in Cadwalader’s White Collar Defense and Investigations Practice and is based in the firm’s Washington, D.C., office. His practice concentrates on advising U.S. and international clients in connection with internal and government investigations and enforcement proceedings.