Monday, December 29, 2014

Insider Trading and Tippee Liability

In recent times, there has been a lot of discussion about how the regulators and the prosecution have been enormously successful in obtaining convictions in insider trading cases in the U.S. That momentum may have been somewhat restrained by a ruling of the United States Court of Appeals for the Second Circuit in United States v. Newman, et. al.

In that case, analysts at several hedge funds allegedly obtained material, nonpublic information from the employees of certain publicly traded companies which was not only shared amongst these analysts but also passed on to portfolio managers who traded in the securities of those companies. The persons who traded in the shares were “tippees” who were fed this information from “tippers” who were insiders of the companies. Crucially, the tippers and tippees were separated by several layers of intermediaries through whom the information passed before reaching the tippees. In an influential ruling, the Second Circuit Court of Appeals overturned the conviction of two portfolio managers Newman and Chiasson. The Court arrived at its conclusion after considering two significant decisions on insider trading issued by the U.S. Supreme Court, notably those in Dirks v. S.E.C., 463 U.S. 646 (1983) and Chiarella v. United States, 445 U.S. 222 (1980).

The Court’s ruling is important as it clearly circumscribed the situations in which tippee liability for insider trading arises. It observed:

In sum, we hold that to sustain an insider trading conviction against a tippee, the Government must prove each of the following elements beyond a reasonable doubt: that (1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.

The conditions for invocation of insider trading liability for tippees have been made quite stringent. Not only must the tippee be aware of the tipper’s breach of fiduciary duty due to disclosure of the information but also that the tippee knew that the tipper divulged it for personal benefit. This can often be difficult for the prosecution to demonstrate, particularly when the tipper and tippee have no direct relationship and are several layers removed.

Apart from circumscribing the legal principle as above, the Court’s ruling in Newman also has the effect of imposing more onerous requirements for discharging the burden of proof to establishing tippee liability for insider trading. Although the possibility of using circumstantial evidence to adduce proof insider trading was not disturbed, the Court refused to merely rely upon relationships between various persons as indicative of exchange of information for personal benefits. Hence, mere friendship or other social relationship would not indicate receipt of personal benefits, which must be specifically proven.

This ruling is important in as much as it narrows the scope of insider trading liability for tippees. At the same time, regard must be had to the fact that the ruling was delivered in the context of specific facts and circumstances that involved remote relationships (via intermediaries) between the tippers and the tippees. If a closer relationship exists, the outcome could be different.

Although the ruling in Newman has been delivered in the context of insider trading law as it applies in the U.S., the decision is likely to have a tangential impact on Indian insider trading law. Increasingly, orders of the Securities and Exchange Board of India (SEBI) and the Securities Appellate Tribunal (SAT) have been closely referring to and following the decisions of the U.S. courts as the jurisprudence in this area of the law has evolved substantially in that jurisdiction. While the proposed regulations on insider trading in India are likely to expand the scope of insider trading in the Indian context, the implementation of those regulations by the regulators and courts may be confronted by situations such as those presented in Newman.

1 comment:

Mangesh Patwardhan said...

In my view, the Newman case should not really have much impact in India. Unlike the insider trading (IT) prohibition in India which is very specific, the US prohibition is not to be found in statute, but has evolved thru judicial and administrative pronouncements. In fact, in Sameer Arora case, SAT acknowledged this. As against this, following US jurisprudence on manipulative and deceptive practices makes sense as SEBI Act provisions here closely track the language of Section 10(b) and Rule 10b-5 of the SEC Act and Rules respectively.
Tipee liability has been a tricky issue in the US because the US SC clearly rejected the equal access theory of IT prohibition in Chiarella. The prohibition there is based on classical (Chiarella, Dirks) and misappropriation (O’Hagan) theories. Both these are duty based theories. A person is prohibited from trading on MNPI only if such trading is in violation of her fiduciary duty or a similar duty of trust and confidence (to the issuer or the source of information respectively). Instead, if she discloses this information to another person (tipee), the tipee’s duty not to trade on it is only derivative of that of the tipper. Thus, the tipper must have breached her duty by disclosure and the tipee knew or should have known about such breach and still traded on such information.
The Dirks Court stated, “Thus, the test is whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty to stockholders. And absent a breach by the insider, there is no derivative breach.” Thus, the personal benefit requirement is a necessary condition to establish a breach of duty. These two are not distinct as you seem to imply. The Second Circuit has correctly read Dirks on this. Also, the Circuit Court is right in rejecting mere friendship or social relationship to infer a personal benefit. To quote Dirks again, “This requires courts to focus on objective criteria, i. e., whether the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings.” So at some point of time, the insider must benefit in pecuniary terms. Leaving aside the implications of this position in terms of policy rationale and enforcement issues, the Newman decision is faithful to Dirks and correctly states the US legal position in the context of tipee liability.
We don’t know the details of the coming IT Prohibition Regulations in India. But the Sodhi Committee Report clearly and explicitly premises the prohibition on the equal access theory. It characterizes IT as the wrong of trading in securities with the advantage of having asymmetrical access to unpublished information. Under the equal access theory, the tipee’s liability not to trade on UPSI is not derivative of that of the trader, but arises independently due to her superior access to information. Therefore, the definition of `insider’ in the proposed regulations covers anyone who is in possession of UPSI (the accompanying legislative notes further explain the rationale). While an innocent recipient of UPSI can raise a defence, she is required to exercise diligence to form a reasonable belief that the information was not UPSI or communication of such information did not violate any law or confidentiality obligation. In particular, no `personal benefit’ enquiry is implicated here. Should a Newman style case be brought under the proposed regulations, it would be hard to argue (under reasonable man standard) that the said information (quarterly earnings announcements as yet unpublished) was not UPSI, or its communication was not in violation of confidentiality obligation. Thus, Newman and Chiasson would be clearly liable under the framework proposed by the Sodhi Committee.