Cross Border Cut
Tipping as a Form of Insider Trading – Canadian and U.S. Courts Diverge Post-Newman
In addition to engendering numerous appeals of convictions for insider trading, the Second Circuit’s decision in United States v. Newman[1] illustrates some interesting differences in the legal frameworks proscribing insider trading in Canada and the United States.
In Canada’s financial epicenter, Ontario, trading securities on non-public material information obtained from a corporate insider, i.e., tipping, is explicitly barred under Section 76 of the Ontario Securities Act,[2] which reads, in relevant part: “No issuer and no person or company in a special relationship with an issuer shall inform, other than in the necessary course of business, another person or company of a material fact or material change with respect to the issuer before the material fact or material change has been generally disclosed.”
By contrast, there is no explicit statutory prohibition on “tipping” in the United States. Indeed, insider trading as a whole is not explicitly discussed in relevant U.S. statutes. Instead, case law in U.S. courts has established insider trading as a specific type of securities fraud, which is proscribed by the Securities Exchange Act of 1934.[3]
In the past, U.S. courts expanded insider trading to include certain circumstances in which a corporate insider (a tipper) does not personally trade on material, non-public information, but rather discloses it to an outsider (a tippee) who, in turn, uses it to trade.[4] In reversing the insider trading convictions of two investment professionals, Newman elaborated on specific aspects of the elements which must be proved in order for a tippee to be held liable. In doing so, the decision may make the prosecution of certain insider trading cases more difficult by explicitly requiring both proof that a corporate insider received a personal benefit of a pecuniary or similar nature, and—with respect to downstream recipients of confidential information—knowledge of the personal benefit received by the insider.
In particular, Newman held that a tippee’s conviction may be sustained only if the government proves that: (1) the tipper breached a fiduciary duty by disclosing confidential information in exchange for a personal benefit; and (2) the tippee knew of the tipper’s breach, including the fact that the tipper received a personal benefit.[5] The Second Circuit explained that Supreme Court precedent makes clear that an insider’s disclosure of confidential information constitutes a fiduciary breach only if it is done for personal gain.[6] Thus, while the “personal benefit” requirement of tipper liability may not always be expressly stated in a court’s definition of insider trading, it is nonetheless inherent in the fiduciary breach itself.[7] Emphasizing that tippee liability is derivative of tipper liability, the court reasoned that a tippee is therefore liable only if it is shown that the tipper disclosed confidential information in exchange for a personal gain.[8]
The evidence against the downstream investment professionals was insufficient in that it failed to establish both that (1) the tippers received a personal benefit in exchange for their disclosures, and (2), even assuming there was sufficient evidence of personal benefit, that the outsiders knew the information they were trading on was obtained from tippers in violation of their fiduciary duties.[9] The evidence of personal benefit deemed insufficient by the court included allegations that an insider sought career advice and assistance from an acquaintance, and that another insider disclosed confidential information to a family friend.[10] The court explained that language in previous decisions stating that a personal benefit need not necessarily be pecuniary in nature, “does not suggest that the Government may prove the receipt of a personal benefit by the mere fact of a friendship, particularly of a casual or social nature.”[11] Rather, the Second Circuit held that a personal benefit could be inferred from a personal relationship only where it is “meaningfully close” and “generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”[12] Moreover, the court held impermissible an inference that, as downstream tippees several levels removed from the tippers, defendants knew (or should have known) that the information originated with an insider.[13]
The full effects of Newman¸ which the U.S. Supreme Court declined to hear on appeal, remain to be seen. In late January 2016, the Supreme Court granted a cert petition regarding the Ninth Circuit’s decision in United States v. Salman[14] upholding an insider trading conviction where tripper did not provide the nonpublic information for potential pecuniary gain but as a gift to a relative. The Supreme Court will determine whether the concept of personal benefit requires proof of “an exchange that represents at least a potential gain of a pecuniary or similarly valuable nature” or whether a close family relationship between the tipper and tippee satisfies the personal benefit requirement. [15] During the pendency of Salman, numerous individuals in the U.S. have sought to have their insider trading convictions vacated in light of Newman. The success of such efforts, even assuming Newman remains good law, will largely depend on how squarely its holdings apply to the facts of each case.[16] Other things being equal, the further downstream a particular tippee is from an insider, the more difficult it may be to prove the tippee had knowledge of the insider’s fiduciary breach, including receipt of a personal benefit. Furthermore, where the prosecution has alleged a non-pecuniary personal benefit—or asserted that a non-immediate pecuniary benefit should be inferred from the nature of a relationship—it will likely be harder to establish liability for insider trading with respect to both tippers and tippees (remote or otherwise). It is also possible that Newman will result in a reduction in the number or scope of insider trading cases pursued. Indeed, the Second Circuit stated that “[t]he Government’s overreliance on our prior dicta merely highlights the doctrinal novelty of its recent insider trading prosecutions, which are increasingly targeted at remote tippees many levels removed from corporate insiders.”[17]
While Newman’s impacts are evolving, one conclusion is clear: U.S. and Canadian courts are motivated by divergent policy motivations. Under U.S. law, a downstream tippee’s trading on material, non-public information does not—absent proof of predicate tipper liability and knowledge by the tippee of the tipper’s fiduciary breach—constitute insider trading. Indeed, the Second Circuit has noted that “[a]lthough the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.”[18] The Second Circuit’s current approach differs markedly from the OSC’s.[19] In the OSC’s view: “Tipping of MNPI undercuts one of the foundational pillars of the [Ontario Securities] Act, namely confidence. It provides an informational advantage to some market participants at the expense of others.”[20] These policy differences will likely have profound regulatory and prosecutorial implications for the two jurisdictions.
Contributor: Daniel Madison
The contents of this article are provided for informational purposes only and do not constitute legal advice. All rights reserved. Attorney advertising. Prior results do not guarantee a similar outcome.
[1] United States v. Newman, 773 F.3d 438 (2d Cir. 2014) cert. denied, (U.S. Oct. 5, 2015).
[2] Securities Act (Ontario), R.S.O. 1990, c. S.5, as amended.
[3] Newman, 773 at 445. Securities fraud is prohibited by Section 10(b) of the Securities Exchange Act of 1934, as well as Rule 10b-5 promulgated thereunder.
[4] Newman, 773 F.3d at 446.
[5] Newman, 773 F.3d at 450.
[6] Newman, 773 F.3d at 446-48, 454. For example, liability for insider trading would be improper where a tipper divulges confidential information in order to expose fraud at his company, as opposed to in exchange for a personal benefit. See id. at 446.
[7] See Newman, 773 F.3d at 447-48.
[8] See id.
[9] Id. at 442.
[10] Id. at 451-52.
[11] Id. at 452; see also id. at 452-53. The Second Circuit further noted that if “the Government was allowed to meet its burden by proving that two individuals were alumni of the same school or attended the same church, the personal benefit requirement would be a nullity.” Id.
[12] Id. at 452. (“[T]his 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]”) (internal quotations omitted).
[13] Id. at 455. (“[I]in this case, where the financial information is of a nature regularly and accurately predicted by analyst modeling, and the tippees are several levels removed from the source, the inference that defendants knew, or should have known, that the information originated with a corporate insider is unwarranted.”).
[14] 792 F.3d 1087, 1092 (9th Cir. 2015) cert. granted in part, No. 15-628, 2016 WL 207256 (U.S. Jan. 19, 2016) and cert. granted in part, No. 15-628, 2016 WL 207256 (U.S. Jan. 19, 2016)
[15] Formally, the Supreme Court will answer the following question: “Does the personal benefit to the insider that is necessary to establish insider trading under Dirks v. SEC, 463 U.S. 636 (1983), require proof of an “exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the Second Circuit held in United States v. Newman, 773 F.3d 438 (2d Cir. 2014), cert. denied, No. 15-137 (U.S. Oct. 5, 2015), or is it enough that the insider and the tippee shared a close family relationship, as the Ninth Circuit held in this case?”
[16] For example, Raj Rajaratnam, convicted of multiple counts of insider trading after a jury trial in the S.D.N.Y., has filed a motion to vacate his convictions, which was fully briefed as of November 6, 2015.
[17] Newman, 773 F.3d at 448.
[18] Id. at 448-49.
[19] The Second Circuit, at least, seems to have previously shared the essence of the OSC’s view regarding the critical role securities law plays in ensuring equal access to information among market participants. See Newman at 449 (“[T]he Supreme Court rejected this Circuit’s 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.’”) (citing Chiarella v. United States, 445 U.S. 222 (1980)).
[20] In re Azeff, Bobrow, Finkelstein et al. (Sanctions Decision), OSC (Aug. 24, 2015). The OSC has also stated that “[t]ipping is considered as equally offensive as insider trading. Tipping provides an informational advantage unavailable, and hence unfair, to other investors. . . . Tipping and insider trading erode confidence when it is perceived that someone has gained an advantage, not through skill and the courting of risk, but because of an informational advantage unavailable to other investors.” In re Azeff, Bobrow, Finkelstein et al. (Merits Decision), OSC (March 24, 2015).