beth i.z. boland and jonathan n. halpern · overview of insider trading law underpinnings of newman...

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©2015 Foley & Lardner LLP • Attorney Advertising • Prior results do not guarantee a similar outcome • Models used are not clients but may be representative of clients • 321 N. Clark Street, Suite 2800, Chicago, IL 60654 • 312.832.45001

Beth I. Z. Boland

Jonathan N. HalpernBeth I.Z. Boland

and Jonathan N. Halpern

May 28, 2015

©2015 Foley & Lardner LLP

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Before We Begin, A Few “Housekeeping” Items:

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Today’s Presenters

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Beth I.Z. BolandNational Chair, Securities Enforcement & Litigation Practice

Jonathan N. HalpernPartnerLeads Government Enforcement, Compliance & White Collar Defense Practice, New York Office


■ Overview of insider trading law

■ Underpinnings of Newman (Dirks v. SEC, 463 U.S. 646 (1983))

■ Newman -- the evidence, rulings, and standards for tippee liability (knowledge and personal benefit)

■ Newman -- securities market considerations

■ Implications, limitations, and the aftermath of Newman

■ SEC Use of Administrative Proceedings

■ Examples of DOJ/SEC Actions Post-Newman4

Summary of Presentation

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■ Basic Definition:– Buying or selling a security, – In breach of a fiduciary duty or other relationship of trust and confidence, – While in possession of material, nonpublic information (MNPI) about the

security– Engaging in manipulation and deception (failure to disclose MNPI before

trading on it and thus making “secret profits”)

■ Liability may extend to those who: – Tip such information– Trade with such tipped information

■ Criminal Liability: Requires “Willful” ConductA knowing and purposeful commission of the offense “[A] realization on the defendant’s part that he was doing a wrongful act under the securities laws”

■ Civil Liability: Requires “Reckless” Conduct“[H]eedless disregard of probable consequences”

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Insider Trading Overview


■ The “Classical” Theory– Corporate insider

– Owes fiduciary duty to his company or its shareholders to disclose or abstain from trading

– Breaches the duty By trading based on company’s MNPI or

By tipping outsider in exchange for personal benefit

Without publicly disclosing (and thereby makes secret profits)

– Acts with requisite knowledge

– Consequence: Defrauds company and shareholders

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Insider Trading: The “Classical” Theory

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■ Corporate outsider

■ Entrusted with MNPI in confidence

■ Breaches a duty to employer or other source of confidential information

■ Trades on MNPI to profit in the securities market or

■ Provides MNPI to tippee in exchange for a personal benefit

Example: Non-insider attorney traded in stock of target, based on MNPI learned confidentially from his law firm, which represented tender offerer.

Conviction upheld for misappropriating confidential information in breach of fiduciary duty to law firm

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Insider Trading: The “Misappropriation” Theory


■ SEC Rule 10b5-2: guidance on when duty of trust or confidence arises for outsider liability – Recipient agrees to hold MNPI in confidence

– Relationship reflects history of honoring confidentiality

– Recipient is spouse, parent, child, or sibling Except in civil case: recipient proves she neither knew nor

reasonably should have known that source expected family member to keep information confidential

17 C.F.R. Section 240.10b5-2

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More On The “Misappropriation” Theory

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■ Differences In The Theories As To How The Duties Arise: – Classical: corporate insider owes fiduciary duty to

corporation and shareholders

– Misappropriation: outsider owes duty of confidentiality to source of information (e.g., employer, confidant, etc.)

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Tipping Liability Under Both The “Classical” and “Misappropriation” Theories


■ Tipping Liability – The same for both theories of insider trading, based on

the tippee’s knowledge that there was a breach of duty (Newman)

■ Requirements for Tippee Liability– Personal benefit to tipper – insider or misappropriator -- in exchange

for disclosure of MNPI

– Tippee’s knowledge of the personal benefit to tipper -- insider or misappropriator

■ Tippee Conduct – Tippee uses MNPI to trade in a security or to tip another

individual for a personal benefit10

Tipping Liability Under Both The “Classical” and “Misappropriation” Theories

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■ Tippee Knowledge– The insider held a fiduciary duty

– The insider breached his fiduciary duty by disclosing MNPIto a tippee in exchange for a personal benefit

– Tippee knows or should have known of the tipper’s breach. Dirks v. SEC, 463 U.S. 646 (1983) Knowledge that insider knew information was confidential

Knowledge that insider disclosed in exchange for a personal benefit United States v. Newman, 773 F.3d 438 (2d Cir. 2014)

■ Tippee Conduct – Tippee uses MNPI to trade in a security or to tip another

individual for a personal benefit11

More On The “Classical” Theory: More On Tippee Liability


■ Supreme Court:– Rejected theory that recipient must refrain from trading “whenever he

receives inside information from an insider.” – Held no breach of duty unless insider received personal benefit in

exchange for disclosure. – When disclosure is not for personal benefit, such as to expose fraud,

there is no breach of duty and no tipper/tippee liability– The SEC itself recognizes that “the value to the entire market of

[analysts’] efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by [their] initiatives to ferret out and analyze the information, and thus the analyst’s work redounds to the benefit of all investors.” Dirks, 463 U.S. at 659 n.17 (quoting Investors Mgmt. Co., 44 S.E.C. 633, 646 (1971))

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Pre-Newman Limitations On Tippee Liability (Dirks v. SEC, 463 U.S. 646 (1983))

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■ No breach of duty unless the personal benefit is received in exchange for disclosure. A breach of duty occurs if “the insider will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty.” Dirks, 463 U.S. at 662.

■ Duty “arises from the relationship between parties . . . , not merely from one’s ability to acquire information because of position in market.”

■ Court focuses on – Whether the insider “receives a pecuniary gain or a reputational benefit that

will translate into future earnings,” or

– Whether there is a relationship between the insider and the recipient that suggests a quid pro quo from the latter,” or “a gift of confidential information to a trading relative or friend.” Dirks, 463 U.S. at 664.

– Since Dirks insider had disclosed to expose fraud, not for personal benefit, no breach of duty and no tippee liability

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Underpinnings of Newman: The Supreme Court’s Opinion In Dirks v. SEC, 463 U.S. 646 (1983)


■ After Dirks and before Newman, courts upheld broad definition of “personal benefit” with low threshold– Invitation to join investment club held sufficient as benefit (even though no tips were

received in exchange for MNPI). United States v. Jiau, 734 F.3d 147, 153 (2d Cir. 2013)

– Close friendship held suggestive of tipper’s intent to benefit recipient, satisfying benefit element. SEC v. Warde, 151 F.3d 42 (2d Cir. 1998)

– Where gift of MNPI has been made to a trading relative or friend, such as father-in-law, a benefit to insider tipper is inferred. SEC v. Sekhri, 2002 U.S. Dist. LEXIS 22677 (S.D.N.Y. 2002)

– However, client-barber relationship without more held insufficient. SEC v. Maxwell, 341 F. Supp. 2d 941 (S.D. OH 2004).

■ Little attention to tippee knowledge of personal benefit as explicit element of breach of duty– SEC must prove that (i) “outsider” tipper breached duty by passing MNPI for personal

benefit; (ii) tippee knew or had reason to know information improperly obtained; (iii) tippee used the information to trade. SEC v. Obus, 693 F.3d 276 (2d Cir. 2012).

– No mention of requirement that tippee needed to know of tipper’s personal benefit.

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“Personal Benefit” In The Wake of Dirks

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■ Issue of First Impression for Second Circuit – Whether tippee’s knowledge of a tipper’s breach of

fiduciary duty requires knowledge of the tipper’s personal benefit

– Ruling flows from Dirks: “[E]xchange of confidential information for personal benefit

is not separate from an insider’s breach; it is the fiduciary breach that triggers liability for securities fraud” (emphasis added)

By itself, insider’s disclosure of confidential information is not a breach

Without proving that tippee knows of personal benefit insider received in exchange for the MNPI, government cannot prove that tippee knew of a breachNewman, 773 F3d 447-48 (2d Cir. 2014)

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Newman: The Second Circuit Weighs In On Tippee Knowledge


■ Insiders at Dell and NVIDIA disclosed to financial analysts company earnings numbers before publicly released

■ Analysts passed the MNPI to their portfolio managers (including indicted defendants Newman and Chiasson)– Newman traded ($4 MM in profits)– Chiasson traded ( ($68 MM in profits)

■ Newman and Chiasson three and four levels removed from insider tipper, respectively (for Dell), and each four levels removed (for NVIDIA)

■ No evidence that either knew the source of the MNPI■ Government’s theory: Defendants were sophisticated

traders and must have known MNPI was disclosed by insiders in breach of a fiduciary duty and not for a legitimate corporate purpose

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Newman: Summary Of The Facts

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■ Defendants’ Rule 29 Motion:– No evidence that insiders exchanged MNPI for a personal

benefit per Dirks– Because tippee liability derives from tipper’s, the traders

cannot be liable– Even if insiders had received a personal benefit in

exchange, there was no evidence of traders’ knowledge– Absent knowledge, traders could not be participants in

insiders’ fraudulent breaches of fiduciary duties and could not be convicted of insider trading under Dirks

■ Defendants’ Request for Jury Instruction:– In order to convict, jury must find that defendants knew

insiders had disclosed MNPI for a personal benefit 17

Newman: At Close Of The Evidence


■The Trial Court’s Rulings:– Rule 29 Motion: Reserved decision and then denied motions post-

conviction

– Judge’s Jury Instructions On Defendants’ Knowledge (Over Defendants’ Objection): Mere receipt of MNPI, even if traded on, is insufficient;

the government must prove that the defendant “must have known that [the MNPI] was originally disclosed by the insider in violation of a duty of confidentiality”

No instruction given as to defendants’ knowledge of personal benefit

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Newman: At The Close Of The Evidence

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■ Jury instruction incorrectly permitted jury to find defendant guilty if it found he knew that an insider had disclosed confidential information– But breach of duty of confidentiality not fraudulent

unless MNPI was exchanged for a personal benefit

– Ruling comports with mens rea requirement that defendant know the facts that make his conduct illegal

– Crime requires “willful” conduct by statute Intentional, purposeful and voluntary, not accidental or

negligent

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Newman: The Second Circuit Narrows Standard For Tippee Knowledge


■ Jury required to find that tippees knew the insider disclosed for personal benefit

■ No evidence that defendants knew information they were trading on was from insiders or any insider benefit, or that they consciously avoided learning facts

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Newman: The Standard For Tippee Knowledge

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■ Broadly defined, not limited to “pecuniary gain”■ Merely casual or social-based friendship insufficient

– E.g., school alumni, members of the same church (“nullity”)

■ For personal benefit from personal relationship, evidence must prove it to be “meaningfully close” yielding exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature”– Quid pro quo from recipient or an intention to benefit the recipient

■ More than “the ephemeral value” of friendship– “[S]cant evidence” insufficient to establish a personal benefit

Dell: Career advice from analyst (Goyal) to investor relations staffer (Ray) –encouragement of fellow alum or casual acquaintance – began a year before disclosures started and routinely provided to industry colleagues unaffected by tip

NVIDIA: Choi and Lim merely casual acquaintances, and Lim testified that Choi did not know Lim was trading stock

■ More than career advice needed– In Dell, advice first tendered a year before disclosure 21

After Newman, What Is A Personal Benefit?


■ The Second Circuit Newman test:– Insider held a fiduciary duty;

– Insider breached his fiduciary duty by disclosing MNPI to a tippee

in exchange for a personal benefit

– Tippee knew of the tipper’s breach – i.e., that the insider knew the information was confidential and disclosed in exchange for a personal benefit; and

– Tippee used the MNPI to trade in a security or to tip another individual for a personal benefit

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Newman: What The Government Must Prove To Convict Tippees Of Insider Trading

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■ Insider trading prosecutions, especially of downstream tippees, expected to drop– 2d Circuit makes note of the “doctrinal novelty” of increasing

number of insider trading prosecutions that “target[] . . . remote tippees many levels removed from corporate insiders.”

■ Heavier evidentiary burden imposed in criminal prosecutions with knowledge element restored– Increasingly difficult to prosecute remote tippees (at least three

and four levels removed from insider)– Tippees cannot be prosecuted for merely trading on inside

information when unaware of personal benefit to insider– Newman principles also apply in civil context, but use of

recklessness versus willfulness standard may limit Newman’s effect in SEC enforcement actions. See SEC v. Payton, 2015 U.S. Dist. LEXIS 44732 (S.D.N.Y. Apr. 6, 2015)

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Aftermath of Newman (At Least In The Second Circuit)


■ Trial evidence supports Court’s views: ■ Evidence that “investor relations departments routinely

assisted analysts with developing their models”■ Analysts run their models by investor relations

departments and ask whether assumptions are “too high or too low” or in “the ballpark”– Inference: analysts routinely update numbers in advance of the

earnings announcements– Leaked earnings data by investor relationship personnel

To establish relationships with financial firms who might be in a position to buy Dell stock

Corporate insiders regularly engage with analysts and routinely selectively disclose same type of information

– (so no deliberate avoidance of defendants’ learning the facts)

– The financial information is of a nature regularly and accurately predicted by analyst modeling

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Newman: Recognition Of Practical Realities Of Securities Market Operations

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■ “Imposing a duty to disclose or abstain solely because a person knowingly receives MNPI from an insider and trades on it could have an inhibiting influence on the role of market analysts….” Dirks, 463 U.S. at 658.

■ Newman may reduce inhibiting influence on role of market analysts– SEC recognizes “the role of market analysts “ as “necessary to the

preservation of a healthy market.” Id. E.g., whistleblower disclosing a fraud (Dirks, Payton)

– What’s the purpose of the disclosure? Answer helps determine if there’s been a breach (Dirks, Newman)

■ Where tippees (analyst)/tippers meet with corporate insiders to learn and report information (without personal benefit), there is no breach or violation – “Meeting with and questioning corporate officers and others who are insiders”

– To “ferret out and analyze information”

– Analysts’ reports of investment views

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Additional Implications/Ramifications Of Newman For Remote Tippees


■ The Court recognizes real-world, non-criminal realities of securities markets

■ Recognizes important role that analysts in general can play in revealing information that corporations may want to withhold from the public

■ Recognizes appropriate difficulty in establishing tippees’ illegal knowledge (breach of duty) even with receipt of detailed, accurate data

– Evidence that analysts routinely estimate revenue, margins, earnings through “legitimate financial modeling with publicly available information and educated assumptions about industry and company trends.”

■ Appreciates that liberal discourse among analysts, corporate insiders and the public can promote and protect securities markets and does not constitute wrongdoing

■ Asserts that SEC rule on tippee insider trading is imprecise -- where does the line get drawn

– There is no “general duty between all participants in market transactions to forgo actions based on [MNPI]”

– “All disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders.” Newman, 773 F.3d at 454, citing Dirks, 463 U.S. at 661-62.

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Newman: Recognition Of Practical Realities Of Securities Markets And Implications For Tippees

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■ Pieces of non-material, non-public information amassed to create larger, more meaningful “mosaic” from which conclusions drawn– Sales data/channel checking

– Production data

– Information on new products

■ SEC’s prior view -- is it changing?:– “Regulation FD will not be implicated where an issuer discloses immaterial

information whose significance is discerned by the analyst. Analysts can provide a valuable service in sifting through and extracting information that would not be significant to the ordinary investor to reach material conclusions. We do not intend, by Regulation FD, to discourage this sort of activity.” SEC Exchange Act Rel. No. 43154 (2000)

■ Materiality judged by hindsight

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“Mosaic” Theory Of Materiality


■ Limited to prosecutions and SEC claims within the Second Circuit (though may be deemed persuasive elsewhere)

■ Courts outside of the Second Circuit may distinguish or not adopt standard– E.g., U.S. v. Musante (4th Circuit, May 2015) - denial of motion for stay pending appeal– E.g., U.S. v. Riley (SDNY, Mar. 2015) personal benefit: tip given to “maintain[] or further a friendship”

held circumstantial evidence of quid pro quo relationship

■ Prosecutions and SEC lawyers may turn to alternate jurisdictions outside of the Second Circuit

■ Prosecutors and SEC to focus on developing evidence of personal benefit and tippee knowledge

■ Notwithstanding the court’s explicit assertion, application to “misappropriation” cases may technically be viewed as dicta

■ SEC to look increasingly to AP as more favorable forum■ Petition to Supreme Court may still follow■ Determinations of knowledge and personal benefit are extremely fact-dependent■ SEC claims may survive in light of reckless standard ■ Enormous personal, financial, career and reputational toll merely to defend

against investigation even if ultimately vindicated 28

Limitations In Applying Newman

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■ Ongoing multiple Newman challenges to tippee insider trading convictions and charges– Approximately 20 current challenges in district and appellate courts

– Various claims: legal error; insufficiency of evidence; fact-based inquiry; failure of being properly advised

E.g. insufficient evidence that defendants knew tipper received personal benefit (United States v. Conradt, 12 Cr. 887 (SDNY) (AJC) (four guilty pleas vacated)

– Several courts have rejected arguments on grounds that Newman represents only a potential change of law that did not bind the court. SEC v. Somers, 2015 WL 2165460 (W.D. Ky. Mar. 16, 2015)

■ Serious issue whether pre-Newman “mere friendship” cases would survive tightened standard requiring a close personal relationship that “generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.”

■ SEC Chair Mary Jo White: Newman ruling is an “overly narrow view of the insider trading law, and that is a concern”

■ Judicial recognition of “legitimate reasons” for an insider to disclose inside information to an outsider:– Whistleblower disclosing a fraud

– Insider carrying out company policy of “priming the market” by disclosing to analysts before a public announcement

SEC v. Payton, 2015 U.S. Dist. LEXIS 44732 (S.D.N.Y. Apr. 6, 2015) (J. Rakoff)

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The Aftermath Of Newman


■ Absent Supreme Court petition for review, DOJ may enlist Congress to enact insider trading statute

■ Continuing prosecutions and SEC claims involving tangible and direct personal benefit:– E.g., alleged kickback payment to tipper of approx. $220,000 of $1.1 million of ill-gotten

profits by tippee who traded. United Sates v. Kanodia et al. (D. Mass, Apr. 2, 2015)

■ Investigations seek to develop and demonstrate evidence of – (i) consequential personal benefit; and

– (ii) tippee’s knowledge of it

E.g.: United States v. Stewart et al.; SEC v. Stewart et al. (SDNY, May 14, 2015)

Criminal Complaint Alleges:

C/W asked R. Stewart (tippee) if son (tipper) tipped “out of the goodness and kindness of his heart”

Evidence of R. Stewart’s check for $10,055 payable to photographer for son’s wedding

Payments of at least $15,000 to S. Stewart

SEC v. Sabrdaran, 14 – cv – 04825 (N.D. Cal. Mar. 2, 2015) (Newman does not affect requirement that tipper disgorge tippee’s profits)

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Examples Of DOJ’s/SEC’s Adapting To Newman Ruling

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■ 2010 Dodd-Frank overhaul expands SEC authority to bring APs

■ Recent trend of defendants challenging constitutionality to SEC’s administrative charges have not been successful. – See, e.g., Chau v. SEC, 2014 WL 6984236 (S.D.N.Y. Dec. 11, 2014);

Bebo v. SEC, 2015 WL 905349 (E.D. Wis. Mar. 3, 2015); Duka v. SEC, 15 Civ. 357 (S.D.N.Y. Apr. 15, 2015)

■ Newman may strengthen the SEC’s resolve to use APs for insider trading enforcement as alternative to federal court

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SEC’s Pursuit Of Alternative Forum To District Court: Administrative Proceedings (AP)


■Differences from district court trials:– Shorter timeline for trial ruling– Limited discovery (essentially precluding depositions,

except to preserve evidence)– Federal Rules of Evidence inapplicable– No right to jury trial– Initial fact finder (ALJ) is SEC employee– Review of ALJ’s decision by SEC commissioners who

originally voted to bring enforcement action – Appeal from administrative proceedings directly to

federal court of appeals

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SEC’s Administrative Proceedings (APs)

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■ SEC’s “home court advantage” means SEC is more likely to bring enforcement actions in first instance– SEC has significantly greater win rate in APs– Recent federal district court decisions upholding AP proceedings – AP structure allows SEC greater latitude in interpreting and applying

its own laws and regulations, subject only to eventual correction by court of appeals

■ Without hearsay rules and depositions, APs arguably less directed to zealously pursue truth–seeking mission of trials

■ AP timeline allows significantly less time and ability to prepare for trial (identifying witnesses, selecting experts, etc.)

■ Evidentiary and risk assessment should factor in liberal admission of all forms of evidence, even hearsay

■ Appeals are routine– SEC reliably assumes aggressive position regarding its interpretation

of federal securities laws in APs

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Practical Implications Of Trend Toward SEC Administrative Proceedings


■ SEC v. Payton and Durant (SDNY, J. Rakoff) (14 Civ. 4644, April 6, 2015)– Motion to dismiss SEC complaint denied notwithstanding

dismissal of criminal charges (by J. Carter, SDNY, Jan. 20, 2015)

– Recognition of lower civil standard (recklessness, not willfulness)

– SEC met pleading standard, with inferences favoring SEC– Allegations of personal benefit to tipper sufficiently pled “close mutually-dependent financial relationship” “history of personal favors” – tippee took lead in handling shared

expenses Tippee assisted tipper with a criminal legal matter Tipper thanked tippee for prior assistance and expressed

happiness over tippee’s profits from trading because of prior help

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Examples Of Recent SEC/DOJ Actions

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■ U.S. v. McPhail et al. (D. Mass.)– Credits Newman as persuasive, but denies motion to dismiss insider

trading indictment on “misappropriation” theory– Source of MNPI is an unwitting executive and participant in the chain

of information to tipper that was betrayed by misappropriator– Personal benefit need not be alleged or proved to inure to the benefit

of unwitting participant– Indictment alleged that tipper received a benefit and/or that tippee

knew tipper would receive or expect to receive benefit– Requisite relationship of trust or confidence is sufficient if it

generates understanding that confidences would not be disclosed Establishing pattern and practice of sharing confidences

– Reliance on O’Hagan Fiduciary or business relationship between corporate source and

misappropriator not necessary; personal relationship suffices

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Examples Of Recent SEC/DOJ Actions


■ Newman (At Least in The Second Circuit)– Tightens standards for tippee liability – narrower in its

application for prosecutions than in SEC cases– Requires criminal knowledge of both components of the breach

of duty element of insider trading Duty of confidentiality Knowledge of consequential personal benefit to tipper for tip

– Provides clearer notice of what conduct constitutes actionable insider trading

– Significantly increases evidentiary burden to convict downstream tippees and such prosecutions should decrease significantly

– Makes clear that prosecutions of remote tippees may be misdirected and insensitive to common and innocent discourse between corporate insiders and analysts

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Conclusion

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Thank You

beth i.z. boland and jonathan n. halpern · overview of insider trading law underpinnings of newman...

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