United States: Insider Trading: Focus On Subtle And Complex Issues

Many hedge funds routinely face insider trading concerns as they trade equity or debt. Sometimes these issues are fairly obvious, such as where the fund has learned material, non-public information, or MNPI, directly from the company. Perhaps the company solicited the fund as an investor in a new equity offering and brought the fund "over the wall," meaning that the information is embargoed until the offering is public. However, in many cases, insider trading issues are more subtle and complex. Assume, for example, that a fund learns from one of its consultants that companies that produce solar panels are having a down quarter due to developments and trends that logically should impact sales of other renewable energy products. Can the fund short the common stock of a portfolio company that produces the blades for wind mills that generate electricity?

In this chapter, we summarize the law that applies to insider-trading issues, including the practical impact, if any, of the relatively recent and widely-publicized Supreme Court and Second Circuit decisions. We then trace through a factual scenario to focus on more complex issues, including:

• Third-Party Sourcing: When a fund learns information from a source other than the issuer of the equity or debt in question, such as from a supplier, as noted in the example above;
• Big Data (a derivative of third-party sourcing): When fund managers gather information from sources rather than directly from a public company to gain insight; to inform their investment, using vendors or generated/analyzed internally.
  
  For example, "web scraping" or "spidering" refers to the practice of gathering data from websites using software. Big data also includes information from credit and debit card receipts, information from IoT, satellite imagery, and information from app developers for cell phones;
• Mosaic Theory: When a fund gathers a piece of immaterial information that, when combined with other public information, completes a mosaic that provides material trading insight. For example, assume that one of your employees took a photo of the CEO of a public company walking to his car in the evening and wearing an Abu Dhabi baseball cap, thereby perhaps providing some confirmation of market rumor that the company is doing a deal with an oil company in that country;
• Handling non-public information that you possess but don't want to have;
• "Almost" Public Information: Material information that is theoretically accessible by the public, but is not obvious, such as where an issuer posts the information in an unexpected website location. An example is when, several years ago, the CEO of Netflix posted new growth in monthly online viewing data on his personal Facebook account without having given notice that the market could find this information in that place; and
• "Big Boy" Letters: Where the buyer acknowledges that the seller may have MNPI and purports to waive its right to such information.

TODAY'S INSIDER TRADING LAWS: QUICK PRIMER

Before we get to more current, complex issues, here is a brief synopsis of the insider trading laws as they stand today.

Bases for Insider Trading Liability

In the United States, with a few exceptions, trading on the basis of material, non-public information does not – without more – violate the law. This distinguishes the United States from other countries, such as the UK, where the laws effectively require that buyer and seller have parity of information. In the U.S., there must be fraud, deceit or some other breach of duty in order for a violation of the federal securities laws to occur. For example, the information must have been obtained in breach of a fiduciary duty or a duty of trust and confidence owed to shareholders or the company (where the breach is by an insider of the company), or owed to the source of the information even if the source is not an insider (for example, the duty of confidentiality that an employee owes to his or her employer).

Classical Theory

The classical theory of insider trading involves a breach of fiduciary duty to the issuer and its shareholders. This situation occurs when a company insider provides material, non-public information to an investor without authorization to do so. For example, assume that a vice president for investor relations meets with a personal friend and hints at a down quarter before quarterly earnings have been released, expecting or suspecting that the friend will trade on the information. The friend then trades. The officer clearly breached his fiduciary duty to his company's shareholders by tipping his friend.

Misappropriation Theory

The "misappropriation" theory is an alternative basis for insider trading claims. It is usually applied where the information came from a source other than the company. In other words, no breach of fiduciary duty to the company or its shareholders is involved, because the person who traded on the information did not receive the information directly or indirectly from a company insider. One well-known case involved, R. Foster Winans, a Wall Street Journal columnist responsible for the "Heard on the Street" column. As it does today, the column discusses individual public companies, and its contents can impact the price of a stock positively or negatively. Mr. Winans leaked information about his articles to a stockbroker and to his roommate prior to publication, and they traded profitably on the news. Mr. Winans' defense to insider trading charges was that he may have violated conflict-of-interest policies at The Wall Street Journal, but he had not committed a crime because he had not obtained MNPI from a corporate insider. The Court of Appeals for the Second Circuit upheld his conviction on grounds that he had "misappropriated" information belonging to his employer and that the misappropriation was a sufficient basis for his conviction. (The court speculated, however, that misappropriation might not have occurred if the Journal itself had traded on the information, because the information belonged to the Journal – although the court observed that no self-respecting news organization would do such a thing.)

What About All the Fuss in the Press About Insider Trading and Frustrated Prosecutors?

For insider trading prosecutions in the Second Circuit, which includes New York, it temporarily became significantly more difficult for the government to prevail in a criminal insider trading case under the federal securities laws. That is because the Circuit, in its 2014 "Newman" decision, held that, in proving a breach of duty by a tipper providing the information to a tippee, the government had to prove that the tipper received a tangible personal benefit "of some consequence," such as something of economic or "pecuniary" value – and the tippee could not be held liable for trading on the tip unless he or she knew of the tipper's breach of duty, including the tipper's receipt of the personal benefit. The required "nature" of the personal benefit went to the Supreme Court in 2016 in the "Salman" case, and the Supreme Court rejected the "Newman" decision "to the extent [it] held that the tipper must also receive something of a 'pecuniary or similarly valuable nature' in exchange for a gift to family or friends." The Salman case thus undermined one aspect of the Newman decision. A subsequent Second Circuit decision in 2018 in the "Martoma" case undermined another aspect of Newman, which had held that, where the personal benefit to the tipper is inferred from the nature of the relationship between the tipper and tippee (as, for example, in a gift-giving situation), "a meaningfully close personal relationship" is required. Martoma held that the requisite relationship between the tipper and the tippee can be established through proof "either that the tipper and tippee shared a relationship suggesting a quid pro quo or that the tipper gifted confidential information with the intention to benefit the tippee."

The combination of Salman and Martoma has probably eased the burden of proof in criminal insider trading cases against tippers and their direct tippees. But neither Salman nor Martoma undercut what the Martoma court called "the central question in Newman": A tippee must have known (or at least been reckless in not knowing) that there was a breach of fiduciary duty in providing MNPI in exchange for a personal benefit. While this burden might not create a big hurdle in cases involving direct tippees, it could prove insurmountable in cases involving remote tippees. Tippees at the end of a long chain might have no idea of what happened at the top of that chain between the tipper and the direct tippee. If the government cannot prove the remote tippees' knowledge (or their conscious avoidance of knowledge), the prosecution will fail – as it did on appeal in Newman.

More Stringent Laws Might Apply

The Sarbanes-Oxley Act added a new criminal insider trading provision that has been applied by a few lower courts to criminal prosecutions without the government having to prove some of the elements in a traditional insider trading case, such as knowledge of a personal benefit to the tipper. In one recent case in New York, the defendants were acquitted of the traditional insider trading charges, but convicted under the new law. The new law is modeled after the mail and wire fraud statutes, and subjects to criminal prosecution:

It remains to be seen whether the appellate court will agree with the lower court judges' interpretations, and whether prosecutors will use the new law more frequently to try to avoid some of the doctrinal constraints under traditional insider trading law.

There is one other exception in the U.S. where the law does essentially require parity of information between the buyer and seller, and that is in the context of a tender offer. The SEC's Rule 14e-3 provides that, if any person has taken "a substantial step or steps" to commence a tender offer (or has already commenced a tender offer), Section 14 of the Exchange Act prohibits any other person who has material, non-public information relating to that tender offer to buy or sell the potential target's securities if such person knows or has reason to know that the information is non-public and has acquired it directly or indirectly from someone associated with either the potential offeror or the potential target. Assume, for example, that a fund has learned indirectly about a potential merger. Assume also that a potential merger partner had begun discussions with banks about financing a tender offer and had hired an attorney, who put together deal scenarios that included a friendly tender offer. The fund may have liability under Rule 14e-3 after trading on the information, or at least the SEC may take such a position, even if the fund traded on the information without any breach of duty.

Further, certain state laws could also create liability (at least in enforcement actions, rather than private damages suits) for trading based on MNPI even without a breach of duty. Some state Attorneys General have used state laws (such as the Martin Act in New York) to threaten enforcement actions based on general principles of unfairness where parity of information did not exist.

Laws Outside the U.S.

Beware if your transaction has contacts with jurisdictions outside the United States. The insider trading laws of other countries differ from ours, and, as noted above, some of them more simply proscribe trading on MNPI, without regard to whether a breach of duty has occurred. The European Union's Market Abuse Regulation (the "MAR"), for example, prohibits trading on material, non-public information as long as the trader knows or has reason to know that the information is non-public. The MAR applies not only to trading within the EU, but also to any securities that are listed for trading on an EU market. Thus, for example, if a stock is cross-listed in the United States and the EU, the MAR applies even to transactions on the U.S. exchange. While the MAR does not yet appear to have been enforced as to U.S. trading of a cross-listed security, you do not want to be the poster child for a first-ever enforcement action.

What Is "Material"?

One of the most difficult problems faced by funds is determining whether information is material. At the far end of the spectrum the analysis is easy. Learning the company's dress code is immaterial. Getting advance information on quarterly earnings is material. For some reason, the information in question is nearly always somewhere in between.

Analysis of materiality is confusing in part because there are multiple approaches, all of which should be considered. The first approach is to consider the rather open-ended language contained in the opinions of federal courts. The Supreme Court has stated that materiality depends on whether there is a substantial likelihood that a reasonable shareholder would consider the information important in deciding whether to buy, sell or hold the securities. The information need not be dispositive – i.e., the investment decision need not turn on it. But it needs to be something a reasonable investor would consider significant. An alternative formulation is whether the reasonable investor would have viewed the information as having significantly altered the "total mix" of information made available. These are thoughtful and logical formulations, but often unhelpful in solving difficult problems. And the Supreme Court has repeatedly refused to draw bright lines, because it considers materiality to be fact-specific.

Second, there is a balancing test for uncertain future events. The Supreme Court has held that materiality depends on a balance of the indicated probability that the event will occur and the anticipated magnitude of the event for the issuer if the event does occur. In other words, the less likely the occurrence, the less likely the materiality. But if the contingent event would be enormously significant to the issuer (for example, a merger), materiality might exist even at a lower level of probability than would be the case for a less-significant event.

Third, there is the quantitative test, expressed as a percentage of assets or revenues. In some respects, the SEC has sanctioned the use of quantitative tests, at least in certain circumstances. For example, the requirement to disclose civil litigation in periodic reports is qualified by an exception where the "amount involved" does not exceed 10% of current assets. Where available, quantitative measures are important factors in many analyses of materiality, often the most important. However, the SEC has made clear that quantitative measures cannot, alone, determine materiality. For example, assume that a retailer's revenues have dropped 1% for the quarter, in a period where sales should have been strong given the overall economic environment. The drop occurred because the company was having inventory problems resulting from its adoption of new inventory software that is dysfunctional. While the 1% drop may not be material to the company in isolation, two related, intangible facts likely are material. First, the fact that sales are declining when they should be increasing. Second, the fact that the company is experiencing inventory problems that may continue into the future. The SEC thus applies qualitative as well as quantitative considerations; it does not necessarily view quantitative results in isolation. Courts also reject quantitative bright lines. For example, the Third Circuit recently held that a jury could rationally view information about only 2% of an issuer's revenues as material for purposes of an insider trading conviction.

Finally, another factor is the anticipated impact on stock price. If the event is anticipated to impact the stock price, that factor suggests materiality. Because markets are not perfect, nor always rational, stock price should not always be a significant factor. We have all heard the warning that materiality is judged in hindsight, meaning that a material change in stock price could create a strong presumption of materiality. Indeed, the SEC enforcement cases focusing on compliance with Regulation FD some years ago did pay a lot of attention to stock price movements.

Because materiality is so fact-specific and is viewed in hindsight, after the trading has produced a profit or avoided a loss, we often counsel our clients to avoid making trading decisions based on the conclusion that specific nonpublic information is not material. In some cases, the information might objectively be viewed as immaterial, but an objective interpretation is not always possible. And we frequently cannot help but feel that, if our clients are so interested in the information that they are asking us about it, then they themselves might consider the information to be material.

The "Mosaic Theory" – When Immaterial Facts Complete a Puzzle

The "mosaic" theory is the view that collecting individual pieces of immaterial non-public information cannot violate the laws against insider trading, even if those pieces of information effectively add up to material insight into trading decisions. Indeed, by definition, if the information in question is not material, then there can be no insider trading liability. The problem in implementing this theory is being certain that the information in question is not material.

The "mosaic theory" has some logic, but the SEC has not endorsed it in the context of insider trading. It has adopted it in a related area of the law: Regulation FD. Regulation FD prohibits public companies from selectively disclosing MNPI to analysts and investors. In adopting Regulation FD, the SEC stated that "an issuer is not prohibited from disclosing a non-material piece of information to an analyst, even if, unbeknownst to the issuer, that piece helps the analyst complete a 'mosaic' of information that, taken together, is material."

Let's consider an example that illustrates the "mosaic theory," as well as how issues of materiality can be intertwined with the other elements of insider trading, such as whether the information is non-public. Assume that it is public knowledge that significant tariffs will be imposed on the importation of specialized rubber that is not currently available in the United States. A fund has invested equity in a public company that manufactures Zamboni machines that groom the ice at skating rinks. It is public knowledge that the specialized rubber in question is often used in Zamboni tires, as it results in superior performance. A fund principal calls an acquaintance who works as a salesman at the public company, and learns that the company in fact uses the rubber to manufacture its tires. The fund shorts the common stock of the company, anticipating a price drop when the increased price of the rubber causes an increase in manufacturing costs, and a decrease in revenue and profit. If the shorts prove profitable, did the fund violate the federal insider trading laws?

Is confirmation that the company uses the rubber in question "non-public," given that it is known that some manufacturers use the rubber in their tires because it improves performance? Assume also that the company in question is only one of four manufacturers of ice clearing machines in the world, and that it produces the most high-end, and most expensive, models. The probability that the company uses the rubber is therefore high. On the other hand, the company's oral confirmation to the fund removes any uncertainty, and changes the information from speculative to certain. Thus, the only non-public information is the final confirmation from the company. A conclusion that the information is already "public" would appear to be clearer if the manufacturer provides the information on the tire ingredients to anybody who calls its customer service number.

Even if the information were non-public, is it material? The nature of the material that the company uses to make its tires is arguably immaterial in isolation. The information provided trading insight only when coupled with the high probability that the company uses the rubber in question, and the already public news about the proposed tariffs. On the other hand, though, one could argue that the oral confirmation about the composition of that particular company's tires became material in light of the news about anticipated tariffs.

While it is not the focus on this sub-section, there may also be arguments that there was no breach of duty or misappropriation when the company employee confirmed the identity of the rubber to the fund, depending on the facts and circumstances. Indeed, as noted above, Regulation FD provides for a company to disclose immaterial information even if, unbeknownst to the employee, it completes a "mosaic" that provides material trading insight.

We advise clients not to rely on the mosaic theory except where non-materiality is clear-cut. The SEC has not formally endorsed the theory in the context of insider trading, and it relies on determinations of "materiality" that are subject to after-the-fact second-guessing. Some of the "expert network" firms have purported to rely on this approach by collecting non-material information that could, in the aggregate, provide useful investment guidance. The SEC has focused on a handful of these firms in the course of insider trading investigations.

Is the Information "Public"?

The analysis of whether information is "public" or "non-public" in some cases determines whether a fund can trade on material information. For example, assume that a technology company, perhaps accidentally, makes available select elements of a new product in background materials prepared for an industry conference. The information is included in the conference materials that are provided to participants to review later; it is not part of the actual presentation at the conference. An institutional investor that specializes in this area of technology discovers the information in the background materials, but doubts that many other investors have noticed it. The information is clearly in the public domain, but is it really "public" for purposes of the federal insider trading laws?

Just as there is no absolute rule requiring parity of information between buyer and seller, there is no rule requiring that the dissemination of material information have actually reached both buyer and seller at the time of a trade. The focus instead is the degree or manner to which the information has become available to the trading market and the amount of time the market has had to absorb it.

In the context of Regulation FD, the SEC has identified two prongs to the analysis of this question, mainly focusing on what information is "non-public." Of course, what is "public" for purposes of insider trading is not necessarily "public" for Regulation FD purposes, and vice versa. For purposes of the insider trading laws, the information need only be sufficiently publicly available to avoid being considered "non-public," while under Regulation FD the information must be publicly disclosed "in a manner reasonably designed to provide broad, non-exclusionary distribution of the information to the public." Further, under Regulation FD, the bar should be a higher one, because the company is in control of the manner in which it releases the information, and the policy objective is to ensure that every investor has a fair opportunity to access the information.

Nonetheless, as a benchmark, it is useful to understand what is "public" for purposes of Regulation FD. If information is sufficiently available for these purposes, it should normally also be for insider trading purposes. For Regulation FD purposes, a filing on a Form 8-K is always enough, normally coupled with a press release. If a conference is webcast with open access, a statement made at the conference should be "public" if there was adequate advance notice of the conference. Unconfirmed market rumors are not enough, because rumors are not the same as confirmed information. Nor are social media posts sufficient, unless investors have a reasonable expectation and practice of finding material information in the location where the posts are made. For example, the SEC has stated that a company's posting of financial information on Facebook should suffice if the company has provided notice that it will post such information in that location, and investors actually expect to find it there, and in practice do find it there.

Depending on the manner of dissemination, the SEC might also focus on whether the information has had time to reach the marketplace.

We now return to the example summarized above, where new product information was included in the background materials for the conference. The information arguably is "public." However, a plaintiff or regulator may contend that the unexpected inclusion of the product information among the conference materials does not render the information immediately "public," absent the passage of time. Such conference materials are often viewed only later by conference participants, to learn more about a specific subject. On the other hand, some participants, like the fund in our example, will be motivated to review the materials expeditiously. Moreover, the materials may be available only to the conference attendees rather than the public at large (unless the company later posts them on its website), and the conference site is not an official governmental site nor a site that necessarily sees a lot of "traffic". With the passage of time, however, the information should become more clearly "public."

Extinguishing MNPI

Sometimes funds obtain information that they don't want to have. For example, it is not as unusual as one would think for a fund to obtain information by receiving an accidental email from a public company or statement by a company officer. Or the company may have deliberately communicated to the fund information about a potential equity offering, hoping the investor will participate. We are often asked how to "cleanse" the information, meaning how to reverse the fact that the fund has the information.

If a fund obtains MNPI, it is frozen from trading. There are two ways to cleanse the information: (1) the company can publicly disclose the information, and/or (2) the information could become stale. If the issuer discloses the information (or the portion of the information that it views as material), then the fund's knowledge might be cleansed (although the fund itself needs to be comfortable that the issuer has disclosed all MNPI, regardless of what the issuer thinks). Information can become stale because the company disclosed it in the ordinary course or because sufficient time has elapsed to make the information out of date (although factual questions could arise about whether old information is or is not still material). For example, if the fund received a preview of quarterly earnings before the quarterly earnings conference, the information is cleansed once the company holds its quarterly earnings conference.

"Big Boy" Letters

If a trade occurs privately with an identified buyer rather than on the public markets, there is an opportunity to enter into a "big boy" letter. That is a letter signed by the buyer in which the buyer acknowledges that the seller may have material, non-public information that it is not sharing with the buyer, and the buyer waives any right to pursue a claim based on it, as well as any assertion of detrimental reliance on the non-disclosure. These letters can be helpful as a practical matter, as they reduce the likelihood that a buyer will decide to bring a lawsuit or complain to regulators. However, waivers of rights under the federal securities laws are not enforceable as a matter of law, so the general waiver of claims may not be available for use as a defense in court or in a regulatory or criminal action. Section 29(a) of the Exchange Act states that "[a]ny condition, stipulation, or provision binding any person to waive compliance with any provision of the [Exchange Act] or of any rule or regulation thereunder. . . shall be void." Moreover, the government is not a party to a "big boy" letter, so it would not be contractually bound by the letter in any event.

Elements of the letter, however, might provide a defense to a traditional insider trading fraud claim, because "deception" and "reliance" are both elements of such a claim. The disclosure of the possibility of having material, non-public information can undermine a claim of "deception," and the non-reliance language would tend to undermine "reliance." The strength of these arguments is less than clear, depending on the circumstances, and some state laws might have exceptions for situations where one party has "peculiar knowledge" unavailable to the other party.

Nevertheless, a "Big Boy" letter, where it is possible to obtain one, can be helpful even if it does not eliminate risk. As a practical matter, we believe that it is more likely to be helpful in the context of civil litigation than it is in a regulatory or criminal matter.

To read this Chapter in full, please click here.

Insider Trading: Focus On Subtle And Complex Issues

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.