§ 5.09 Trading

• Jurisdiction: United States
• Publication year: 2022

§ 5.09 Trading

[1]—Prevention of Insider Trading

[a]—Background

The SEC and federal prosecutors continue to focus insider trading within the hedge fund industry. All fund managers should be aware of the line between good research, including entirely lawful information-gathering, and impermissible insider trading.

The principal statutes governing insider trading are general anti-fraud statutes contained in the securities laws that do not explicitly prohibit insider trading. As a result the law of insider trading has developed principally as a result of a body of case law interpreting the securities laws.

Insider trading has three principal elements: trading while an individual (or the firm) is in possession of information that (i) is material, (ii) is non-public, and (iii) has been obtained in violation of a duty.

[b]—Material, Non-Public Information

Information is material where there is a substantial likelihood that a reasonable investor would consider that information important in making an investment decision. Generally, this includes any information the disclosure of which may have a substantial effect on the price of a company's securities.⁵⁴⁹ No simple test exists to determine when information is material; assessments of materiality involve a highly fact-specific inquiry. Material information often relates to a company's financial results and operations, including, for example, earnings results, significant merger or acquisition proposals or agreements, changes in previously released earnings estimates, liquidity problems, dividend changes, major litigation, and extraordinary management developments. Material information also may relate to the market for a company's securities. Information about a significant order to purchase or sell securities or the portfolio holdings of any fund may, in some contexts, be material. Pre-publication information regarding reports to be published in the financial press also may be material.

Determination of whether information is non-public is principally based on a determination of when it has been made "public." Information is "public" when it has been disseminated broadly to investors in the marketplace.⁵⁵⁰ For example, information is public after it has become available to the general public through a public filing with the SEC or some other government agency, a news reporting service or publication of general circulation, and after sufficient time has passed to allow the information to be disseminated widely.

[c]—Obtained in Violation of a Duty

U.S. law generally requires that a duty be violated in order to have an insider trading violation. This requires an analysis of the information obtained, the source of the information and what duties are owed (and these duties do not necessarily have to be owed to the source of the material, non-public information); for example, an officer can owe a variety of duties to a company by virtue of her position or an independent contractor can assume a duty of confidentiality by contract. An affirmative misrepresentation may be considered an equivalent of a breach of duty for insider trading purposes.

With respect to so-called "tipper-tippee" liability, a person (the "tippee") who receives material non-public information from another (the "tipper") will be deemed to have breached a duty when the tipper has disclosed the information in question in exchange for a personal benefit. Whether a personal benefit has been received is a fact-specific inquiry.⁵⁵¹ The U. S. Supreme Court has ruled that a personal benefit may be inferred where material non-public information is communicated to a close friend or relative.⁵⁵² However, no breach of duty needs to be shown to prove insider trading in the context of tender offers.⁵⁵³

[d]—Potential Changes to Personal Benefit Requirement

In May 2021, the U.S. House of Representatives passed the Insider Trading Prohibition Act ("ITPA").⁵⁵⁴ The ITPA has not yet been passed in the Senate or signed into law by the President. If passed, the ITPA would amend the Securities and Exchange Act of 1934 to prohibit the purchase or sale of securities by any person while such person is aware of material non-public information relating to such security, or if such person possesses any non-public information, from whatever source, that has, or would be reasonably expected to have, a material effect on the market price of any such security (so long as such person knows or recklessly disregards that the information has been obtained wrongfully or that such trading would constitute a wrongful use of the information). In addition, the ITPA would prohibit a person, whose own purchase or sale is made in violation of the ITPA, from communicating the non-public information to others to the extent that it is reasonably foreseeable that the recipient will (i) trade the relevant securities or (ii) communicate the information to another person who will trade the relevant securities. As a result, if signed into law as currently drafted, the ITPA would drastically curtail the "obtained in violation of a duty" element for insider trading liability and eliminate the "personal benefit" requirement for "tipper-tippee" liability.

In recent years, criminal prosecutors have been charging insider trading cases under the general securities fraud statute enacted as part of the 2002 Sarbanes-Oxley Act, 18 U.S.C. § 1348. As noted above, in cases brought under § 10(b), courts have long required the government to prove that a tipper received a "personal benefit" in exchange for providing material non-public information.

In 2019 the Second Circuit Court of Appeals decision in United States v. Blaszczak potentially made it easier for the Department of Justice to successfully bring criminal insider trading cases by eliminating the "personal benefit" requirement.⁵⁵⁵ In Blaszczak, the Second Circuit held that the Department of Justice did not have to prove a personal benefit in cases brought under Section 1348. The holding in Blaszczak is consistent with several District Court rulings; however, it is the first time a federal appeals court has held that the "personal benefit" requirement is not applicable in Section 1348 cases. In January 2021, the U.S. Supreme Court vacated the Second Circuit's decision and remanded the case for further consideration in light of the Supreme Court's decision in Kelly v. United States.⁵⁵⁶

[e]—Shadow Trading

On August 17, 2021, the SEC filed a complaint against a former corporate executive for "shadow trading," a form of insider trading where a person uses confidential information about one company to trade in the securities of an "economically linked" company, such as a competitor in the same industry.⁵⁵⁷ The SEC alleged that moments after learning his company was being acquired, a corporate executive purchased the securities of a competing company based on the belief that the competitor's stock price would rise following the public announcement of the merger.⁵⁵⁸ While the charges appear to be grounded in existing law, the SEC has never brought a case like this. The defendant is contesting the charges which should create an opportunity for a court to provide clarity as to whether awareness of MNPI about one company precludes trading in an unaffiliated company. In the interim, this enforcement action reveals a new way in which the SEC intends to apply insider trading concepts—one which likely will have significant implications for the entire investment community.

[f]—Consequences of Insider Trading

Violating the prohibitions on insider trading can have significant negative repercussions for the firm and any employees involved. In addition to the damage caused to a firm's reputation, state and federal governmental agencies can bring civil and criminal actions against the firm and any personnel. For instance, the SEC can bring formal and informal enforcement actions against those alleged to have engaged in insider trading and potentially impose a number of sanctions, including, among others, injunctions, disgorgement of illegal profits, and the payment of civil penalties for violations. The U.S. Department of Justice can also criminally prosecute alleged violators, and, if the violation is "willful," sanctions can include imprisonment. Additionally, Section 20A of the Exchange Act also gives investors a private right of action for violations of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder, and investors can demand, among other things, rescission of the transactions or damages resulting from the fraudulent conduct.

[g]—Adopting Insider Trading Policies

Section 204A of the Advisers Act requires registered investment advisers and exempt reporting advisers to establish and maintain insider trading policies reasonably designed to detect and to prevent the misuse of material, non-public information in violation of the Advisers Act, the Exchange Act, and the rules promulgated thereunder by registered fund sponsors and their associated persons. As with other aspects of drafting compliance policies and procedures, fund sponsors should tailor insider trading policies to address the particular insider trading risks faced by the business. Several key areas of focus and customization include:

• Director or Officer Positions. If the firm's employees serve as directors or officers of companies whose securities are held by its clients, the firm should establish policies and procedures to address and mitigate the risk that such employees will trade while the firm is in possession of material, non-public information and will not share such information with others.⁵⁵⁹
• Value Added Investors. If the fund sponsor has "value added investors" (i.e., investors that are corporate insiders, affiliated with other buy-side firms, or members of expert networks), the firm should adopt policies and procedures designed to identify such investors and restrict them from sharing information with firm employees.⁵⁶⁰

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