Insider Trading and Hedge Funds

A couple of weeks ago the US Court of Appeals for the Second Circuit reversed insider trading convictions in which the US government had prosecuted portfolio managers (PMs) at hedge funds (Diamondback Capital Management and Level Global Investors) and investment firms for trading on confidential information they had received from their analysts. The court tightened the standard for prosecution and held that the government must prove beyond a reasonable doubt that (1) the corporate insider (a “tipper”) was entrusted with a fiduciary duty; (2) the tipper breached his fiduciary duty by (a) disclosing confidential information to a “tippee” (that is to say, a recipient of confidential information) (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 case is significant because it has focused attention on how insider trading cases in the US have created different standards of liability in different parts of the country (and on the need for clarity from either Congress or the US Supreme Court). The decision may also provide relief, for the time being, to hedge funds in their use of expert networks. The Second Circuit was concerned that prosecutors had lost the plot, and that insider trading cases have been increasingly targeted at remote tippees many levels removed from corporate insiders who were the source of the confidential information and who improperly disclosed it. The Second Circuit stated its view that the Supreme Court’s decisions have established that insider trading liability is based on breaches of fiduciary duty, not on unequal access to information.

It so happens that neither the Securities Exchange Act of 1934 (the Exchange Act) nor the regulations issued pursuant to it, including Rule 10b-5 (the anti-fraud rule), expressly prohibit insider trading. Rather, the unlawfulness in the US of insider trading is predicated on the notion developed in court cases that insider trading is a type of “securities fraud” proscribed by Section 10(b) of the Exchange Act and Rule 10b-5. (Incidentally, the same is not true in Europe, where the Market Abuse Directive defines and prohibits insider trading.)

The prosecution in the Second Circuit’s recent case alleged that analysts at investment firms received information from insiders at Dell and NVIDIA disclosing those companies’ earnings numbers before they were publicly released in Dell’s and NVIDIA’s respective earnings announcements. These tippees passed along the confidential information to analysts at hedge funds, who then passed the inside information to their PMs, who, in turn, executed trades in Dell and NVIDIA stock. The defendants were thus three or four levels removed from the “tipper”, and the confidential information flowed through other investment firms before reaching the PMs at the hedge funds. The PMs contended that they had no knowledge of any breach of fiduciary duty by the tippers, nor whether the tippers stood to derive any “personal benefit” in any way from disclosure of confidential information. Crucially, the court of appeal noted that members of both Dell’s and Nvidia’s investor relations teams engaged so frequently in “selective disclosure” of confidential information to people in the financial services industry, that it was unlikely the PMs would be aware that any particular piece of confidential information was disclosed in breach of fiduciary duty and for a personal benefit to the insider. Law students are cautioned that cases turn on the facts, and bad facts make bad law, two maxims that are proved in the present case. Essentially these corporations’ investor relations departments leaked like a sieve in order to manage earnings expectations at securities houses, and the Second Circuit refused to punish the PMs.

Note that this is not, however, a free pass for PMs to engage in what the law metaphorically calls “wilful blindness” (that is, consciously avoiding learning the facts), for example by allowing their analysts to engage in “info laundering” by passing confidential information along a chain of gossips until, at some number of levels removed, it is magically no longer confidential information. Under US securities law, liability for securities fraud requires proof that the defendant acted with “scienter”, a word that is not found in most English dictionaries, and is primarily used by lawyers and judges to “not let daylight in upon magic” of the legal process, supply an aura of gravitas (accented by a furrowed brow), and which really just means “a mental state embracing intent to deceive, manipulate or defraud” (passing over, for the moment, the circularity of the definition). A defendant’s intent may be inferred from the defendant’s conduct. As a defence, artifice will not suffice.

And what does it mean that the tipper must have violated a “fiduciary duty”? In 1980, in a case called Chiarella v United States, the Supreme Court described two theories of insider trading liability, the classical theory and the misappropriation theory. The classical theory holds that a corporate insider (such as an officer or director) violates Section 10(b) of the Exchange Act and Rule 10b-5 by trading in the corporation’s securities on the basis of confidential information about the corporation. Under this theory, there is a fiduciary relationship between a corporation and its insiders, that is, a “relationship of trust and confidence between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position within that corporation”, and a duty on the part of the insider to not take unfair advantage of uninformed shareholders (for example, by “selling” (exchanging) that confidential information to someone else for a personal benefit).

The basic idea is that confidential information “belongs” to the corporation, and “fiduciary duty” usually would mean the insiders have a duty to use that information only for the benefit of the corporation, and not for their own benefit. In accepting this theory of insider trading, the Supreme Court explicitly rejected the notion of “a general duty between all participants in market transactions to forgo actions based on material, nonpublic information.” The easy bit is that insiders should never trade on confidential information. Less widely understood is that it is not necessarily forbidden to others to trade on material, non-public information – this is where the fog creeps in.

However the classical theory’s focus on “insiders” had a shortcoming that became apparent when a financial printer surreptitiously obtained confidential information about a corporate customer and used the confidential information to trade in the customer’s shares – the printer was not an “insider”. The “misappropriation” theory expanded the scope of insider trading liability to certain other “outsiders,” who do not have any fiduciary or other relationship to a corporation or its shareholders. Liability may occur where an “outsider” possesses material, non-public information and another person uses that information to trade in breach of a duty owed to the owner. In other words, such conduct violates Section 10(b) of the Exchange Act because the person who misappropriates the confidential information engages in deception by pretending “loyalty to the principal while secretly converting the principal’s information for personal gain.” If the matter seems difficult to follow, it can reduced to “don’t trick or deceive people into giving you confidential information, and don’t take it by stealth, to trade on”.

It is the fiduciary breach, not the unequal access to information, that triggers liability for securities fraud under Rule 10b-5. According to the Second Circuit, a breach of the duty of confidentiality is not fraudulent unless the tipper acts for personal benefit, that is to say, there is no breach unless the tipper “is in effect selling the information to its recipient for cash, reciprocal information, or other things of value for himself”. Feeling generous, and inclined to freely bestow some confidential corporate information to the natural objects of one’s bounty? It is not only monetary gain that is meant by this, but also the benefit one would obtain from simply making a gift of confidential information to a relative or friend who might trade on it. This requires evidence of “a relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].”

It will not be smooth sailing for all PMs who would like to hit the trading desks in January armed with all the inside information they gleaned at parties in December, mindful that they were wholly unaware of any “personal benefit” to whomever tipped them off – it was, after all, a season of goodwill gestures. In the US court system, cases begin in a district court and are appealed to a court of appeal. Different courts of appeal (there are 12 of them relevant to these cases, covering different geographic regions of the US) can reach different conclusions based on what their own binding precedent cases have held, so that lines of cases in different courts of appeal can create different binding precedent for different courts under them. The Second Circuit (NY, CT and VT) case is not binding in other courts of appeal, which may continue down the line of reasoning that the prosecution had alleged in this case. Trading desks in Boston, Philadelphia, Chicago and San Francisco are forewarned. At some point, the Supreme Court may hear a case to resolve conflicting case law from the different courts of appeal, or Congress may decide to codify exactly what “insider trading” is. The leading academic authorities on this matter suggest further clarity is needed.

The case was United States v Newman, et al. (2d Cir.).