Insider trading bill passes milestone

The House of Representatives on Dec. 5 did something remarkable (at least for securities lawyers): It passed a bipartisan bill that for the first time expressly prohibits illegal insider trading. More importantly, the Insider Trading Prohibition Act ( the "ITPA"), which passed by 410-13, both clarifies and expands the scope of illegal insider trading.

The public likely assumes that federal law expressly bars insider trading. But insider trading actions by the Securities and Exchange Commission and U.S. attorneys are brought under Section 10(b) of the Securities Exchange Act of 1934, the general antifraud provision of the securities laws. Criminal actions also are brought under wire fraud, mail fraud and other criminal law provisions. Ironically, the Exchange Act provides remedies and punishment for illegal insider trading without expressly prohibiting or defining it. The SEC traditionally opposed congressional enactment of a definition that might limit the agency's flexibility in bringing insider trading actions. But Congress acted in the face of mounting criticism that judicially constructed standards for insider trading are extremely muddled and cry out for statutory clarification. In particular, well-known federal judge Jed S. Rakoff, who has authored several insider trading opinions, has urged Congress to write an insider trading law.

Definition of Insider Trading

The ITPA creates a new Section 16A of the Exchange Act that makes it unlawful for any person, directly or indirectly, to purchase, sell, or enter into, or cause the purchase or sale of, or entry into, any security, security-based swap or security-based swap agreement, "while aware of material, nonpublic information relating to" such security, security-based swap or security-based swap agreement, "or any nonpublic information from any source, that has, or would reasonably be expected to have, a material effect on the market price ... if such person, knows, or recklessly disregards, that such information has been obtained wrongfully, or that such purchase or sale would constitute a wrongful use of such information."

This provision makes a subtle modification in the usual definition of illegal insider trading, as trading "while in possession" of material nonpublic information. The 9th U.S. Circuit Court of Appeals has held that the government must show that a defendant traded "on the basis of" material nonpublic information. U.S. v. Smith, 155 F.3d 1051 (9th Cir. 1998) (insider trading liability requires use, not just possession, of material nonpublic information). See also SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998) (insider may rebut inference of use by showing no causal connection between trade and use). However, SEC Rule 10b-5(1)(b) defines "on the basis" as trading when the person was "aware" of the nonpublic information when the trade occurred. The ITPA appears to adopt Rule 10b-5(1)(b), meaning that although the "possession" standard has been discarded, a person still could be liable even if the confidential information was not the basis of the trade.

Wrongful Use of Information

Insider trading liability currently requires proof of a breach of a fiduciary duty or another relationship of trust or confidence. The classical theory of insider trading -- so-named because it was the original basis -- is predicated on a breach of a fiduciary duty owed by a corporate insider to the company's stockholders that required the insider to disclose any material nonpublic information or abstain from trading. Chiarella v. U.S., 445 U.S. 222 (1980). The Supreme Court has recognized that individuals such as lawyers, bankers and accountants, who have a confidential relationship with a company, also assume a fiduciary duty to the company's stockholders to disclose or abstain. Dirks v. SEC, 463 U.S. 646, 655 n.14 (1983).

The alternative basis is the misappropriation theory, in which liability arises from a breach of a duty of trust and confidence owed to the source of the material nonpublic information. U.S. v. O'Hagan, 521 U.S. 642 (1997). SEC Rule 10b5-2 provides the rebuttable presumption that some relationships -- spouses, parent-child and siblings -- definitionally entail a duty of trust and confidence. Whether such a duty exists in other relationships depends on whether the parties have a history, pattern or practice of sharing confidences, such that the recipient of information knew or reasonably should have known that the information should be kept confidential, or whether a person agreed to maintain information in confidence. The misappropriation theory has been broadly applied to encompass employer-employee and physician-patient relationships; friendships; a contractor who overheard conversations at a workplace; a person who acquired information while visiting his sister's office; and lawyers, accountants and bankers who purchased stock in a client's acquisition target.

But Section 16A(c)(1) of ITPA broadens insider trading liability to include information obtained by theft, bribery, misrepresentation or espionage; a violation of any federal law protecting computer data or the intellectual property or privacy of computer users; conversion, misappropriation, or other unauthorized and deceptive taking of information; and the breach of contract or a code of conduct or ethics policy. The ITPA would end any doubt over whether it is illegal to trade on stolen information. See SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009) (trading on information obtained by computer hacking not necessarily "deceptive" under Section 10(b)). The bill reflects Judge Rakoff's view that insider trading should be based on the embezzlement of corporate information. Rather than painstaking, abstruse examinations of whether a fiduciary relationship existed between two parties, the focus would center on whether one party "wrongfully" obtained confidential information from the other.

Tipper-Tippee Liability

The ITPA also clarifies a particularly convoluted aspect of insider trading: when does a corporate insider -- the "tipper" -- have liability for conveying material nonpublic information to another person -- the "tippee" -- who trades on the information and/or conveys the information to someone else. The Supreme Court in Dirks held that a tippee's liability derives from that of the tipper and therefore the tippee breaches his or her fiduciary duty to stockholders only when the insider conveyed the information for an improper purpose. The insider must have received a personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that would translate into future earnings. But the court added that an illegal exploitation of nonpublic information also occurs when an insider "makes a gift of confidential information to a trading relative or friend." 463 U.S. at 663-64.

The "personal benefit" requirement was typically satisfied merely by alleging that the tipper sought to enhance his reputation. However, in U.S. v. Newman, 773 F.3d 438 (2d Cir. 2014), the 2nd U.S. Circuit Court of Appeals held that, to the extent that a personal benefit might be inferred from a tipper-tippee relationship, there must be proof of a "meaningfully 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." Moreover, the tippee must be aware of the benefit obtained by the tipper.

But the Supreme Court rejected Newman's personal benefit test in Salman v. U.S., 137 S. Ct. 420, 427-28 (2016), which, in holding that Dirks squarely applied to the disclosure of confidential information by an investment banker to his brother, stated that to the extent that Newman mandated that a tipper receive something of a pecuniary or similarly valuable nature for a gift to family or friends, the requirement was inconsistent with Dirks. But the court did not accept the government's contention that any disclosure for a noncorporate purpose satisfied Dirks (presumably because there was no need to address the issue), leaving uncertainty over whether there is liability for tipping a non-friend or relative where the tipper did not receive a financial benefit.

The 2nd Circuit also hedged on whether Salman undermined Newman's "meaningfully close personal relationship" test for determining whether there was a gift of confidential information; the required relationship could be established by a quid pro quo; or the tipper's intent to benefit the tippee. U.S. v. Martoma, 894 F.3d 64 (2d Cir. 2018), amending and superseding U.S. v. Martoma, 869 F.3d 58 (2d Cir. 2017). Also left intact is Newman's requirement that a tippee must know the personal benefit received by the initial source of the confidential information, increasing the difficulty of prosecuting "remote" tippees.

The ITPA eliminates the confusion surrounding the personal benefit requirement. There still is liability for trading on or communicating material nonpublic information in breach of a personal or other relationship of trust or confidence, including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend. But it appears that a personal benefit is no longer a prerequisite for tipper-tippee liability. Instead, it would be unlawful to communicate information that is wrongfully obtained as defined in Section 16A(c)(1) when it is "reasonably foreseeable" that the recipient would trade while aware of the information, as opposed to requiring that the tipper intended the tippee to trade. There is no reference to any need to prove the tipper's personal benefit. Further, ITPA provides that it "shall not be necessary" that someone trading on or communicating material nonpublic information know the specific means by which the information was obtained or communicated, "or whether any personal benefit was paid or promised by or to any person in the chain of communication, so long as the person ... was aware, consciously avoided being aware, or recklessly disregarded that such information was wrongfully obtained, improperly used or wrongfully communicated." Thus liability depends on the tippee's awareness of whether information was wrongfully obtained, used or communicated rather than knowledge of the tipper's personal benefit.

Even if the ITPA fails to become law, it will serve as a template for future legislation. In summary, it appears that liability for insider trading will be both clarified and expanded. 