Psst, I Got a Tip On a Hot Stock
Over the last several years, there has been a big push by the DOJ (particularly in New York) and the SEC to prosecute C-Suite executives, and those who work with them, for insider trading violations. In fact, the U.S. Attorney in Manhattan, Preet Bharara, has staked out his reputation on pursuing these prosecutions. Until a very recent set back, he has had incredible success in winning convictions. These cases have often resulted in long jail terms and ruined reputations. Even where criminal cases have not been brought, lives have been destroyed for those living under the cloud of suspicion or the threat of indictment.
For the C-Suite, insider trading issues present a significant and real life risk, The risk stems, in large part, from the uncertainty of defining insider trader. Unlike other areas of the criminal law, there is no statutory definition of insider trading. The law in this area is almost entirely judge-made, cobbled together over the years without any clear direction. Federal criminal law prohibits “manipulative or deceptive practices,” and the courts have allowed prosecutors to put people in jail for trading on certain information within this very broad framework. But when does trading on information become a “deceptive” practice? The answer to that question is far from clear.
Most companies have insider trading policies that seek to fill in the gaps. For example, there is no doubt that corporate insiders cannot trade on the basis of confidential information learned in the course of carrying out their corporate responsibilities. Obviously, the CEO of a company about to be bought out cannot run to her broker and purchase shares of her company’s stock in the expectation that the price will rise once the acquisition becomes public. This is classic insider trading – where an insider breaches a special relationship of trust and confidence with shareholders by profiting from a securities transaction driven by inside information. Under these circumstances, a corporate insider has a duty to restrain from trading on information that is unavailable to other shareholders of the company. Similarly, a corporate insider is going to get into a lot of trouble for leaking confidential information about her company to third parties that later profit from securities transactions. All of that makes perfect sense.
But what if a C-Suite executive acts upon a tip about the stock of another company from someone who may or may not have a relationship with that company? Now things get dicey and more uncertain. The executive is not trading on information about her company, but rather about another company. For example, a golfing buddy says he has a hot tip on a stock, and you (commonly called the “tippee”) purchase stock based on the tip. Could this be insider trading? Unfortunately, the answer to that question is not very satisfactory: it depends.
Recently, this very issue came up in a federal court case prosecuted by Preet Bharara’s office in New York. Portfolio managers for hedge funds were prosecuted for insider trading based on information they received from analysts who, in turn, had obtained information from corporate insiders. In the legal jargon used in the case, these managers were “remote tippees” – they had obtained information far down the chain of information, but they clearly knew they were getting an inside scoop.
So the prosecutors brought a case (commonly called “Newman”), and the managers were convicted and sentenced to long terms of imprisonment. They appealed, and the Court of Appeals saved their lives. The court ruled that a tippee is not liable for insider trading unless she knows that the person disclosing the information (the “tipper”) is breaching a fiduciary duty and also knows that the tipper is receiving some sort of personal benefit from the disclosure. Seems somewhat clear? Maybe.
One big question is how does the recipient of a tip know whether or not the person disclosing information is breaching a fiduciary duty by getting some sort of benefit out of the deal? All of this is mushy and unclear. To make matters more confusing, the tipper’s “personal gain” does not have to be money or goods, but may be something as amorphous as “reputational benefit” (whatever that means) or the expectation that the gift of information may one day down the road lead to future earnings or benefits. Not much clarity here. The Newman case, although a huge setback to Bharara’s prosecution team, raises more questions than it answers.
And the example of the golfing buddies getting a hot tip? Well, that comes right from an SEC prosecution in Massachusetts, where a C-Suite executive passed along some information to friends at a country club—friends who later profited from the sales of stock in the executive’s company. As far as the Newman case goes, the Government may appeal the decision to the U.S. Supreme Court, so the last word on the issue may not have been written.
Where does this leave C-Suite executives (and those who work with them) who are thinking about trading on “information” that may not be generally known to the public? Well, the short answer is: call your lawyer and get sound advice. Otherwise, be prepared for many sleepless nights.
Remember, be careful out there.