57 RI Bar J., No. 4, Pg 23. Insider Trading and Tippee Liability - An Update.

• Author: Willis H. Riccio, Esq. Partner of Adler Pollock & Sheehan P.C. and Chair of its Securities Section. Minette Loula, Esq. works in the Legal Department of Hasbro.

Rhode Island Bar Journal

Volume 57.

57 RI Bar J., No. 4, Pg 23.

Insider Trading and Tippee Liability - An Update

Rhode Island Bar Journal57 RI Bar J., No. 4, Pg .23January/February 2009 Insider Trading and Tippee Liability - An UpdateWillis H. Riccio, Esq. Partner of Adler Pollock & Sheehan P.C. and Chair of its Securities Section. Minette Loula, Esq. works in the Legal Department of Hasbro.In an interview late last year, a Securities and Exchange Commission (S.E.C.) official stated that ". . . for the foreseeable future insider trading and hedge funds will continue to be enforcement priorities."(fn1)

It is not clear when so-called insider trading became an S.E.C. priority, for through the years a small number of cases were brought involving such activity but without the insider trading label. Formal prioritization more than likely was developed at a Regional Administrator's Conference held in Gettysburg, Pennsylvania in 1979.

The concept, propelled by the fairly standard argument of preserving the integrity of the marketplace really accelerated with high profile actions brought against such well known financial individuals such as Ivan Boesky and Michael Milliken, among others. As usual, the notoriety attending these actions attracted the attention of the media, followed by the politicians, at which point insider trading as a priority became a self-fulfilling prophecy with a life of its own.

It is lost in the bosom of history as to when the term insider trading first enjoyed popular usage, but generally, at first, it was most frequently associated with Section 16 of the Securities Exchange Act of 1934(fn2) - where the term was accurate. However, that provision relates to a particular group type and essentially is a liability without fault provision. In contrast what is currently understood about so-called insider trading involves a general anti-fraud violation, applicable to anyone and requiring proof of scienter.(fn3)

The landscape became somewhat confused in terms of tippee liability for insider trading and remained so until the Supreme Court clarified the issue with its Dirks opinion.(fn4) Today, what is inaccurately called insider trading really is trading on the basis of material non-public information. While courts throughout the United States have addressed tippee liability, the federal courts in the Southern District of New York seemed to have most frequently encountered it.

Thus, this paper focuses on those Second Circuit opinions - to a large degree - in presenting the status of current law with respect to insider trading and tippee liability.

1. General Legal Standard

   Section 10(b) of the Securities Exchange Act of 1934 is violated when (1) "any manipulative or deceptive device" is used; (2) "in connection with the purchase or sale of any security." 15 U.S.C. § 78j(b); see also United States v. Falcone, 257 F.3d 226, 228 (2d Cir. 2001). Under this Section, the Securities and Exchange Commission adopted Rule 10b-5, which provides, in pertinent part:

   It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,

   (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or omit to state facts necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

   17 C.F.R. § 240.10b-5.To establish that an individual violated Section 10(b) and Rule 10b-5, the S.E.C. must show: (1) a misrepresentation, an omission, or other fraudulent device; (2) the device was used in connection with the purchase or sale of any security; (3) scienter by the person who has made the misrepresentation or omission; and (4) the misrepresentation or omission was material. S.E.C. v. Falbo, 14 F.Supp.2d 508, 518 (S.D.N.Y. 1998) (citing S.E.C. v. Tome, 638 F.Supp. 596, 620 (S.D.N.Y. 1986)). The S.E.C. need not prove that the individual actually decided to trade based on that material, non-public information. S.E.C. v. Thrasher, 152 F.Supp.2d 291, 302 (S.D.N.Y. 2001). Proof of this connection is not required because a trader who possesses inside information is presumed to have an advantage over less-informed traders in the market whether he consciously uses the material, non-public information or not. Id. at 302 (citing United States v. Teicher, 987 F.2d 112, 120 (2d Cir. 1993)).

2. The Traditional Theory Of Insider Trading Involves A "Corporate Insider."

   There are two general theories of liability under Section 10(b) and Rule 10b-5: the "traditional" theory and the "misappropriation" theory. United States v. Cassese, 272 F.Supp.2d 481, 485 (S.D.N.Y. 2003) (citing United States v. O'Hagan, 521 U.S. 642, 651-52 (1997)). Under the traditional theory of insider trading, a corporate insider buys or sells securities of his corporation's stock on the basis of material, non-public information. Id. This type of trading constitutes deception under Section 10(b) of the Act because: a relationship of trust and confidence exists between the shareholders of a corporation and those insiders who have obtained...