A person who has been ‘tipped off’ and trades in securities with confidential information may escape insider trading liability in the United States. This follows a recent[1] decision by the US Supreme Court which confirmed the ruling last December by the Second US Circuit Court of Appeals in New York[2] (Newman Decision) that is seen as narrowing the scope of insider trading laws involving tipping.
The Newman Decision means that for a person to be guilty of insider trading when they have been provided with a ‘tip’, it must be shown that the insider providing the tip (the Tipper) received a tangible benefit and that the person receiving the tip (the Tippee) knew that the Tipper was receiving a benefit in exchange for the confidential information. The court also narrowly defined what constituted a ‘benefit’ to the Tipper by saying it had to be of ‘some consequence’, more than the ‘ephemeral benefit of the value of friendship’.
The Newman Decision overturned convictions of hedge fund managers Todd Newman and Anthony Chiasson for trading on inside information about Dell and Nvidia Corporation. It also paved the way for Australian stockbroker Trent Martin to walk free after his original guilty plea for insider trading in New York in 2012 was reversed by a judge because of the legal precedent that was created by the Newman Decision.[3]
In effect, the Newman Decision means that in the United States it is not necessarily illegal to buy or sell shares using inside information. In Australia, this is not the case. The reason for the stark contrast in insider trading liability stems from the fact that there is a fundamental difference between Australia and the US in the basis for insider trading offences.
In this alert, we discuss the Newman Decision and the basis for, and differences between, insider trading in the United States and Australia.
The Newman Case
The Newman Decision concerned a case involving the prosecution for insider trading offences[4] by two hedge fund managers, Todd Newman[5] and Anthony Chiasson[6], who traded on non-public information about Dell and Nvidia Corporation. The inside information was provided by analysts at their respective hedge funds who had in turn received the information from employees of the publicly traded technology companies. Newman and Chiasson were initially convicted in 2012 and sentenced to 4.5 years and 6.5 years in prison, respectively.
The Newman Decision reversed their convictions because the Court held that it could not be shown that the insiders received the requisite benefit for divulging the inside information, and even if they had, Newman and Chiasson had no actual or constructive knowledge that they had received any benefit, given their levels of removal from the insider.
Insider trading laws: Australia v United States
Australia
In Australia the Corporations Act 2001 (Cth) explicitly makes it an offence for any person who has ‘inside information’[7] to trade financial products[8] (such as shares) with, procure trading with or communicate for the purpose of a person trading with, that inside information.
The Australian insider trading laws are founded on ideals of market integrity for which information symmetry between market participants is considered critical. Trading must be on the basis of information that is available to the entire market.
Consequently, both ‘tipping’ another person to trade with inside information, and trading as an insider or tippee are explicitly made offences.
Critically, it does not matter whether the person (tipper or trader) makes a profit or gains a benefit from trading (or tipping another person who trades); the very possibility of trading occurring in Australia’s financial markets if participants may be taking advantage of informational asymmetries is considered to undermine the integrity and efficiency of the market, and therefore is prohibited and policed with vigilance.
United States
The United States position is different to Australia. There is no explicit criminalisation of insider trading per se. Rather, insider trading offences are based on the securities fraud laws; there must be ‘fraudulent activity’ and certain persons or insiders are taken to have engaged in ‘fraud or deception’ if there is an improper use of confidential company information, generally because of their position as a fiduciary.
The United States courts have affirmatively established that insider trading liability is essentially based on breaches of fiduciary duty and not on informational asymmetries.
The United States courts have expressly stated that nothing in the law requires a symmetry of information in the nation’s securities markets and rejected the conclusion that the federal securities laws have created a system providing equal access to information necessary for reasoned and intelligent investment decisions because material non-public information gives certain buyers or sellers an unfair advantage over less informed buyers and sellers.
“The policy rationale [for prohibiting insider trading] stops well short of prohibiting all trading on material non-public information. Efficient capital markets depend on the protection of property rights in information. However, they also require that persons who acquire and act on information about companies be able to profit from the information they generate…”[9]
The relevant legislation in the US prohibits the use “in connection with the purchase or sale of any security…[of] any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe…” (Section 10(b)). Insider trading is not expressly prohibited; rather, the unlawfulness of insider trading is predicated on the notion that insider trading is a type of securities fraud proscribed by Section 10(b).
This application of Section 10(b) is based on ‘classical’ and ‘misappropriation’ theories of insider trading.
Under the ‘classical theory’, a corporate insider (for example, a director) violates Section 10(b) by trading in the corporation’s securities on the basis of material non-public information because there is a special relationship of trust and confidence (fiduciary relationship) between the shareholders and the insiders who have obtained confidential information by reason of their position, and because of that relationship the corporate insider has a duty to disclose (or to abstain from trading) to prevent the corporate insider from taking unfair advantage of uninformed shareholders. Importantly, a corporate insider will not have committed a breach of fiduciary duty unless they receive a personal benefit. The implication of this theory is effectively that only corporate insiders with a fiduciary duty could be guilty of ‘insider trading’ under Section 10(b).
Under the ‘misappropriation theory’, liability extends to an outsider (someone who doesn’t have a fiduciary relationship with shareholders) where the outsider is using information to trade in breach of a duty owed to the owner of the information. The conduct violates Section 10(b) because the misappropriator engages in deception by pretending loyalty to the principal while secretly converting the principal’s information for personal gain.
Therefore, because of the limited scope of Section 10(b) to ‘insider trading’, a tipee’s liability derives only from the tipper’s liability for breach of a (fiduciary) duty, not simply from trading on material, non-public information.
Consequently, it is well accepted that for a tipping offence in the United States the elements of criminal liability, which must be proven beyond a reasonable doubt, are that:
- the corporate insider was entrusted with a fiduciary duty (to protect confidential information);
- the corporate insider breached his fiduciary duty by:
- disclosing confidential information to a tipee;
- in exchange for a personal benefit;
- the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and
- the tippee still used that information to trade in a security or tip another individual for personal benefit.
Critically, the court held in the Newman Decision that without establishing that the tippee knows of the personal benefit received by the insider in exchange for the disclosure, the prosecution cannot meet its burden of showing that the tippee knew of a breach.
Conclusion
The US Solicitor General Donald Verrilli has criticised the Newman Decision, saying it would ’hurt market participants, disadvantage scrupulous market analysts, and impair the government’s ability to protect the fairness and integrity of the securities markets.
Arguably it is the fundamental laws in the United States which, unlike Australia, provide no general prohibition on market participants trading on material, non-public information, rather than the Newman Decision that narrows the scope of the insider trading laws and limits their reach of those who have been tipped off.
For more information or discussion, please contact HopgoodGanim Lawyers' Corporate Advisory and Governance team.
[1] 5 October 2015.
[2] US v Newman, 773 F.3d 438 – Court of Appeals, 2nd Circuit 2014 (New York).
[3] Mr Martin and four American stockbrokers allegedly made combined profits of more than $US1 million from suspect trades. In 2009 they allegedly bought securities in Chicago software company SPSS after they received confidential information that IBM was preparing to launch a $US1.2 billion takeover offer for the technology firm. Mr Martin was allegedly told about the deal by a friend who was a lawyer working on the deal. The SPSS share price surged 41% when the bid was announced. Mr Martin allegedly shared the tip with his stockbroker roommate who passed the tip onto 3 colleagues. Mr Martin pleaded guilty to conspiracy to commit securities fraud in September 2013 and was facing up to 5 years’ jail when he was due to be sentenced in April 2015. The case was dismissed because of the need to prove that a person receiving an inside tip knew that the tipper received a personal benefit in return, established by the Newman Decision.
[4] Securities fraud in violation of sections 10(b) and 32 of the Securities Exchange Act of 1934 (1934 Act), 48 Stat. 891, 904 (codified as amended at 15 USC SS78j(b), 78ff), Securities and Exchange Commission (SEC) Rules 10b-5 and 10b5-2 (codified at 17 CFR SS 240 10b-5, 240.10b5-2) and 18 USC S 2 and conspiracy to commit securities fraud in violation of 18 U.S.C. S371.
[5] A former Diamondback Capital Management portfolio manager.
[6] Co-founder of Level Global Investors.
[7] Inside information is essentially information which is not generally available which, if generally available, would reasonably be expected to have a material effect on the price or value of securities.
[8] Refers to a “Division 3 financial product”, as defined in section 1042A of the Corporations Act.
[9]United States v Chestman, 947 F.2d 551, 578 (2d Cir.1991) (Winter J concurring).