Regulators on both sides of the border have made it a priority to try to police complex insider trading schemes. The aggressive approach by the Ontario Securities Commission, the Securities and Exchange Commission, and in particular the United States Attorney’s Office for the Southern District of New York has yielded stunning headlines over the last few years, but 2014 was marked by a series of setbacks in insider trading enforcement.
Notable insider trading defeats in 2014 included a defence verdict in the SEC’s 12-year pursuit of hedge-fund manager Nelson Obus, an acquittal of disgraced hedge-fund billionaire Raj Rajaratnam’s younger brother Rengan, and the dismissal of all charges against Jowdat Waheed and Bruce Walter related to the takeover of Baffinland Iron Mines Corp. by an independent panel of the OSC.
The most significant setback, however, was the Dec. 10 decision by the United States Court of Appeals for the Second Circuit in United States v. Todd Newman and Anthony Chiasson. If left to stand this decision jeopardizes the string of successful prosecutions and enforcement actions against “tippees” in the United States and makes Canadian law arguably more favourable to regulators in that regard.
Just a few days after the Second Circuit issued the Newman decision, the SEC also abandoned its revived use of in-house administrative proceedings to seek civil penalties for insider trading against downstream tippee Canadian Jordan Peixoto.
Although the SEC claimed its decision was based on the inability to procure critical witnesses for the hearing, Peixoto had requested additional time to incorporate the Newman decision in his request for summary dismissal and he had filed a civil action against the SEC seeking declaratory and injunctive relief to prevent the SEC from requiring him to submit to an alleged unconstitutional administrative proceeding.
U.S. and Canada insider trading regimes
In Canada, illegal insider trading is enforced civilly by provincial regulators pursuant to provincial securities laws — such as s. 76 of Ontario’s Securities Act — and criminally pursuant to s. 382.1 of the Criminal Code, which was added in 2004.
In contrast, there is no statutory crime or regulatory offence of “insider trading” in the United States. Rather, the unlawfulness of insider trading — both civil and criminal — is predicated on case law that considers certain behaviour to fall within the catch-all prohibition against securities fraud in s. 10(b) of the Securities Exchange Act of 1934.
None of these laws impose a general duty on everyone to forgo trades based on material, non-public information. Liability depends on the relationship between the individuals and companies involved.
Tipper and tippee liability
The law in both regimes has evolved to proscribe not just insider trading by the corporate insider, but also to proscribe the insider (a “tipper”) from passing on information to others (tippees) who trade on the information to make a profit or perhaps tip others further downstream.
The Newman case prosecuted hedge-fund managers three and four levels removed from the original tippers. Similarly, the ongoing OSC enforcement action against former Bay Street lawyer Mitchell Finkelstein and a network of downstream tippees seeks to hold accountable investment advisers one, two, three, and four levels removed from Finkelstein, the alleged tipper.
In Newman, the Second Circuit held Newman and Chiasson could only be convicted if the government proved (i) that the original tippers breached their fiduciary duties by exchanging confidential information for a personal benefit and (ii) that Newman and Chiasson knew that the original tippers passed on the information for personal gain.
In other words, passing on confidential information about your employer or client to a friend who trades in securities for a living might get you fired, but it is not fraudulent within the meaning of s. 10(b) of the exchange act and therefore not a crime unless your friend pays you something of value for the information.
Since tippee liability is derivative of tipper liability, traders who acquire and trade on material, non-public information from unpaid sources for which there is no quid pro quo are likewise not guilty of a crime. As the Second Circuit explained, “[a]lthough the Government might like the law to be different, nothing in the law requires a symmetry of information in the nation’s securities markets.”
Applying this standard to the facts, the Second Circuit vacated the convictions of Newman and Chiasson because the original tippers were an acquaintance and family friend of the first-level tippees and the evidence was too thin to suggest they received any personal benefit in exchange for their tips.
The court went on to hold that even assuming the evidence was enough to permit the inference of a personal benefit, there was no evidence showing that as remote tippees Newman and Chiasson knew (or consciously avoided learning) they were trading on information obtained from paid insiders as opposed to information predicted by analyst modeling or selectively disclosed by the companies themselves.
Not only does the secondary holding set a high bar for prosecuting downstream or remote tippees in the United States, but the primary holding sets a high bar even for prosecuting first level tippees.
In contrast to the liability standard enunciated in Newman, s. 76 of Ontario’s Securities Act does not impose a requirement that the tipper receive some sort of personal benefit to trigger liability. Instead, liability is predicated on the tipper or trader being in “a special relationship” with a reporting issuer. There is likewise no requirement that a tipper receive a financial benefit under s. 382.1 of the Criminal Code.
Downstream tippee liability under Ontario’s Securities Act is predicated on trading or sharing material, non-public information learned from someone else who was in a “special relationship” with a reporting issuer where the tippee “kn[ew] or ought reasonably to have known that the other person or company is a person or company in such a relationship.”
Whether liability under s. 76 can be imposed on downstream tippees equivalent to Newman and Chiasson in Finkelstein’s tipping chain remains to be seen. Even if it does not, the OSC has imposed sanctions for insider trading that does not meet the technical requirements of s. 76 pursuant to the OSC’s s. 127 power to sanction conduct that is nonetheless contrary to the public interest. The SEC has no similar power.
What’s coming in 2015?
Despite its high-profile defeat in the Baffinland case, the OSC vowed to continue “investigat[ing] suspected illegal insider trading schemes, no matter how complicated or challenging,” and to “continue to pursue cases when the evidence is compelling and when important matters of regulatory policy are involved.”
All eyes will be on the remaining allegations in the OSC’s closely watched case against Finkelstein and his alleged tipping chain as it proceeds in 2015.
The OSC is also consulting with federal and provincial police and the federal attorney general to have the insider trading and tipping criminal offences included on the list of offences for which wiretaps can be obtained under the Criminal Code. Wiretap recordings have been instrumental in many of the successful insider trading prosecutions in the United States in recent years.
In the U.S., prosecutors and regulators are just starting to come to grips with the fallout from the Newman decision. In the case itself, prosecutors have asked to have until Jan. 23, 2015 to decide whether or not to seek a panel rehearing and/or rehearing by the whole court. They also have 90 days to file a petition for a writ of certiorari with the United States Supreme Court.
Absent the decision being overturned, it is likely the co-operating co-defendants in Newman will seek to have their guilty pleas withdrawn. Beyond the Newman case, it remains to be seen how many criminal and SEC defendants will seek to have their guilty pleas withdrawn, convictions overturned, and civil settlements with the SEC undone as a result of the decision.
Next year will likely also bring renewed challenges to the SEC’s revived use of SEC administrative proceedings to adjudicate more insider trading cases.
Hilary Dudley is a Dalhousie Law School graduate and white-collar criminal defence attorney in the Boston office of Edwards Wildman Palmer LLP.