The recent reversal of convictions of hedge fund managers Todd Newman and Anthony Chiasson highlights the weakness of using a common law approach when interpreting Rule 10b-5 to reach remote tippees accused of insider trading. The decision reinforces the need for a statutory approach to bar insider trading. A statutory approach is not a novel idea. Most jurisdictions around the world, including the UK and the other member states of the EU, have made insider trading a statutory offense that captures a wider range of conduct than does the US regime in its reliance upon Rule 10b-5. However, the introduction of a statutory approach in the US should not necessarily mirror the EU regime, which is based on the rationale of parity of information as a requisite for a fair and orderly market. A regime based on parity of information risks interfering with and deterring independent analysis, which is important for generating new information that contributes to efficient markets. Thus, we suggest that a statutory approach in the US be a modified form of parity of information, in which the information must be shown to have directly or indirectly come from an inside source. However, it would not make a difference whether the insider were or were not authorized to disclose the information, which would reject the approach in an early insider trading case, the Dirks decision, on which the Newman decision was based. This distinction is important to the extent one wants to prohibit conduct by remote tippees, a difficult task if predicated on actual knowledge by the remote tippee of the relationship between or among often unrelated parties further up the line.
Newman and Chiasson are examples of remote tippees. The Court held that in insider trading cases against tippees in a classical misuse of information context, the Government must show that the benefit received by the tipper in return for his or her tip is “objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature” and that the remote tippee was aware of that benefit, even if he or she did not provide it.
The Government disagrees with the rationale of the Newman decision and has appealed. In a subsequent matter involving a request for approval of a settlement, the Durant case, the Government seeks to limit the approach in Newman, arguing that it should not apply when the case is based on the misappropriation theory, not the classical theory. In the classical case, some improper benefit is necessary because, as in the Dirks case, there may be legitimate reasons for an insider to disclose information—for example, to expose a fraud—and the tippee’s liability in a fraud based approach is derivative of the tipper’s liability. The Government argued in Durant that the “question of whether an insider has benefitted is part of the duty analysis in a classical case, not because a benefit per se is required, but because it evidences the improper motive necessary to give rise to liability for insider trading in this context.” In contrast, the misappropriation cases require simply proving a breach of duty owed to the source of the information, most frequently an employer, but sometimes other individuals or entities to which a duty of trust and confidence is owed. One does not have to show a personal benefit under the misappropriation theory where the misappropriator is not an insider. The principal is injured, and the agent acts disloyally, whenever information is misappropriated, as the principal has a property-like interest in the information and its confidentiality. The tippee is liable if he or she knew that confidential information was initially obtained and transmitted improperly (and thus through deception) and if the tippee intentionally traded while in knowing possession of that information. However, one US District Judge, Andrew Carter, has recently rejected this reasoning. He allowed guilty pleas to be retracted in a similar remote tippee situation based on the misappropriation theory involving IBM shares, stating the Newman decision “applies equally in misappropriation cases.” The distinction being urged by the Government in Durant is thus unlikely to be successful making it all the more important the Government is successful in having an en banc rehearing and reversal, as to which we are skeptical.
Focusing on such unpersuasive distinctions—a dividing line based solely on whether a case falls under the classical or misappropriation theory—is not necessarily in the public interest of a fair and orderly market and is challenging with respect to remote tippees. How does one establish what they knew about the source of the information? What obligations if any do they have to inquire, or can they turn a blind eye? The further removed the ultimate tippee is the more difficult it becomes to show the tippee had knowledge of the improper original source of the information. Perhaps this result is correct, in that knowledge of wrong doing is necessary for criminal behavior, and as you go further down the chain of tippees, this knowledge is understandably more and more open to question. However, that also provides an opportunity for abuse and loopholes unless one decides to accept some level of undisciplined insider trading in the system, at least at the criminal level.
An argument for continuation of the common law approach is that it retains flexibility to address unforeseen new developments. This, in fact, was the approach in SEC v. Dorozhko as we discuss in our article. But such an approach also leads to the government pushing the envelope, resulting, as in Newman, in the courts being concerned about criminal indictments based on novel theories of interpretation of what Rule 10b-5 covers that may violate fairness and due process notions. If one constructs on a case by case basis an offense based on an interpretation of a broad anti-fraud rule, to prosecute that offense criminally with the prospect of significant prison sentences means that there must be notice to the defendants and clarity with respect to the offense. The common law development is creating incentives for the Government to argue presumptions to satisfy the court developed tests, which in the case of criminal prosecutions raises issues of fairness and notice.
In essence, the Government in Newman is arguing a variation of the parity of information approach, an approach which was clearly rejected in the early case Chiarella. That is, the Government’s position in Newman and subsequently in Durant seems to be that it must simply show that the tippee knew that the information was material and non-public and was received from an unauthorized source without a showing of a breached duty. The desired outcome of the Governments position is that in the classical case, the remote tippee stands in the shoes of the initial tippee in terms of being able to trade, so while some benefit, which can be quite intangible under the Obus decision, must be shown, the Government need not show that the remote tippee had knowledge of the benefit, only that there was one. The Government’s intention to continue to go beyond Chiarella and Dirks and to tip the pendulum towards parity of information is reinforced by the decision to appeal the Newman decision. Instead of expending further resources to mold the common law into a new shape that is plagued with inconsistencies we should move to a statutory approach that addresses obvious loopholes in the common law but also defines the offense in a manner that avoids novel interpretations of a criminal violation with very serious criminal consequences.
The implications of the Newman decision may be similar with respect to trading based on criminal activities. Given the skepticism the court has with respect to using a common law approach in criminal prosecutions, one wonders whether the distinctions made by the court in the Dorozhko case and the novel construction of deception in connection with criminal hacking would be embraced by the Second Circuit after Newman.
Under the EU statutory approach, Newman and Chiasson would have been liable if they knew or should have known that the information was material non-public information (which itself was not a clear cut issue it seems for the court in Newman). Liability is not derivative in the EU. In addition, it is a separate offense for the tipper to communicate information, whether or not the tippee actually traded on the basis of the tip. See our discussion of the Hannam case in our prior article entitled “Duty-Free Insider Trading?”. We believe this separation of liability is effective as it prevents culpable tippees from escaping liability where the tipper may have been innocent but also discourages improper tipping since the act itself would be punishable regardless of the tippees culpability. The EU statutory approach would also resolve the use versus possession debate which continues in the US. And finally, it would remove any doubt about information obtained as a result of criminal activities since we no longer would need to show deception or breach of duty by one party. Many argue this stretches the bounds of potentially liable behavior too far. However, an important limitation existing in the EU statutory approach is that it requires information to be precise in order to reach the tippee. For example, it would not cover a tippee simply told to trade by his or her broker without more, though there has been discussion of criminalizing conduct by tippers that improperly “influence” trading decisions even where such influence does not amount to passing on insider information. The new Market Abuse Regulation in the EU seeks to extend the prohibition of insider dealing and other market abuse to “natural persons who take part in or [merely] influence the decision to carry out” the trade, presumably in circumstances in which the tippers themselves could not trade. We think that approach should be considered.
The EU approach is based on a parity of information concept, which, as explained above, is criticized for disincentivizing independent research that can generate efficient material non-public information that gives savvy investors an edge on the market. Such independent research is often triggered by putting together a “mosaic” of information based on statements by a company, its employees, suppliers or other agents. The UK has purported to address this criticism not by creating a statutory exception for this type of independent work product but by carefully construing definitions of terms in the statute. The regulator notes in the Code of Market Conduct that information is “general information”, and therefore deemed to be public, if it is obtained “by analysing or developing other information that is generally available” or is “obtained by observation by members of the public without infringing rights or obligations of privacy, property or confidentiality”. This statement by the UK is an indirect way of indicating that what is prohibited is material information from insider sources. However, the statute is silent and this is merely a gloss on words used in the statute itself, which is not binding on the courts.
We would limit the scope of liability more aggressively than the UK and suggest a parity of information standard based on the approach taken in Rule 14e-3 of the Exchange Act, which precludes trading in connection with a proposed tender offer if the information is specific and comes from designated insider sources. That is, we would focus on (i) whether the information is material and specific and (ii) whether the trader knew or should have known that the information was from (a) a source within the entity generating the information or from someone retained by it, (b) a source whose access to such information was based solely on his or her employment or (c) a source who obtains information by means of criminal activity. We would also have to address willful ignorance, which could be a potential problem especially in remote tippee situations. Rule 14e-3 uses possession as sufficient unless one can show that Chinese walls had been put into place. We would require use, or trading on the basis of, for liability in connection with trading, but that is something that could be subject to discussion.
An alternative approach could be to enact statutory language that generally prohibits trading on the basis of material non-public information but provide a statutory affirmative defense for those able to prove that they have used their own skill and work product to piece together pieces of information which in the aggregate would constitute material non-public information. This approach has developed in the US under the Rule 10b-5 common law approach and is known as the “mosaic theory”. What precisely fits under the umbrella of valid “work product” the use of which cannot be challenged will be a very important question that will need to be debated thoroughly and may prove to be too difficult to resolve effectively in practice.
In conclusion, we need a statutory approach, following a healthy debate as to its basis. If the modified approach we suggest is followed, it will require substantial thought about how one expresses the linkages necessary to avoid undermining independent research. We should move quickly. The Government’s position in Durant only goes to show that it will continue to aggressively apply the law by making distinctions that sometimes are hard to justify. Furthermore, the increased concerns about inexpensive and easy-to-perpetrate hacking and other cyber-crimes may make Congress more willing to ensure that laws relating to insider trading cover inappropriate behavior not necessarily involving breached fiduciary or related duties—possibly an unusual window of opportunity to consider developing a statutory approach.
This post comes to us from Edward F. Greene and Olivia A. Schmid. Mr. Greene is a Lecturer in Law at Columbia Law School and Senior Counsel at Cleary Gottlieb Steen & Hamilton. Ms. Schmid is an associate at Cleary Gottlieb Steen & Hamilton.