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“Loose Lips Sink Ships” - Insider Trading and The Lessons of Galleon
By Lawrence Cohen, Esq., Director, Gibbons P.C.
November 10, 2009
[AUTHOR’S UPDATE: Raj Rajaratnam was convicted in May 2011 of directing the one
of the largest insider-trading rings. His 11 year prison sentence was the longest ever handed
down for such a crime. A three- judge panel rejected his last-minute plea to remain free while he
appealed his conviction. In addition to his prison sentence, Rajaratnam was ordered to pay a
$10 million fine and forfeit $53.8 million, as well as pay $92.8 million in a civil case filed by the
Securities and Exchange Commission, the biggest fine assessed against an individual in an
insider-trading case. As part of the fall-out from Rajaratnam’s prosecution, Rajat K. Gupta, a
former director of Goldman Sachs, Inc., was charged in October 2011 with insider trading in
connection with Raj Rajaratnam’s offenses and his case is expected to go to trial in April or May
2012].
“How do men act on a sinking ship? Do they hold each other? Do they pass around whiskey? Do
they cry?”
The Perfect Storm by Sebastian Junger (1997)
Last month, the SEC brought criminal charges against the founder of Galleon
Management L.P., Raj Rajaratnam, and five other individuals for alleged insider trading
violations. The Galleon fund capsized within days.
The breadth of the network of parties that were allegedly involved in the Galleon affair.
was unprecedented and the impact of the scandal triggered rapid investor redemption demands
and shattered careers. The waves of insider-trading accusations that sank Galleon have rocked
other funds. Quadrum Capital, a hedge fund in business for less than two years, was implicated
in the scandal and abruptly shut down its operations. Three weeks after the initial charges
against Galleon, nine more people were arrested and fourteen more have been charged. Among
those arrested were four people associated with the hedge fund Incremental Capital.
Galleon provides an important cautionary tale for hedge funds as well as the funds of
funds and other investors that invest their capital and faith in underlying fund managers. Both
hedge funds and their investors should be on high alert and prepared to recognize and prevent
illegal insider trading. That every fund manager should act with the highest level of propriety is
stating the obvious. But every organization should immediately take measure of its own
situation and ensure that its house is in order, starting with its supervisory and compliance
systems. In order to successfully guard against illegal insider trading, a fund’s management must
first understand how it is defined. This article offers a general overview of the law of illegal
insider trading, which is evolving and often beset with inconsistent interpretations by the courts,
regulators and legal commentators. It also outlines certain protective measures that a prudent
fund manager should adopt.
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The Legal Context
It is important to understand that insider trading is not inherently illegal. The term
“insider trading” has been used by Wall Street and the press as shorthand for certain acts that
constitute illegal securities trading. However, company insiders buy and sell securities every day
under perfectly legitimate circumstances. To be clear, only when an insider trades securities in
violation of such individual’s fiduciary duties under the law can civil and/or criminal charges
ensue.
At its core, illegal insider trading is a fraudulent act. On that basis alone, the party
committing that transgression may be subject to traditional state law anti-fraud claims. The
federal insider trading prohibitions that are in place today are derived from historical English and
American common law developments dealing with fraud. For example, in a 1909 classic insider
trading case, Strong v. Repide, the U.S. Supreme Court upheld the conviction for fraud of a
director who bought his company’s stock when he knew it was about to increase in price, but
failed to disclose his inside information.
The first federal securities laws were enacted during the New Deal. Section 17(a) of the
Securities Act of 1933 made it unlawful to engage in fraud in the offer or sale of securities, but
the enforcement tools under the Securities Exchange Act of 1934, which primarily regulates
transactions of securities in the secondary markets, proved to be more effective for policing
insider trading.
The Exchange Act includes a section specifically designed to discourage individuals
within a public corporation from taking advantage of their inside information in the trading of
the corporation’s securities. Section 16 imposes sanctions on insiders who use material
nonpublic information to enter into short-swing profits. Every such person must file a report
with the SEC at the time of the registration of the security on a national securities exchange or by
the effective date of a filed registration statement or within ten days after he becomes a 10%
beneficial owner, director, or officer and within ten days after the close of each calendar month if
there has been a change in the ownership or if the person has purchased or sold a security-based
swap agreement.
Another Exchange Act provision, Section 10(b), granted the SEC rulemaking authority to
proscribe “manipulative or deceptive” conduct. It took until 1942 for the SEC to adopt Rule
10b-5, which makes it
“. . . unlawful for any person, directly or indirectly, . . . (a) To
employ any device, scheme, or artifice to defraud, (b) To make any
untrue statement of a material fact or to omit to state a material fact
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.”
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While neither Section 10(b) or Rule 10b-5 actually refers to insider trading, they are the key
federal provisions used to prosecute illegal insider trading cases.
In the 1980s, Congress sought to expand the sanctions that can be imposed for insider
trading violations. The Insider Trading Sanctions Act of 1984 was, according to the U.S. House
of Representatives’ Report, enacted because of the belief that
“[i]nsider trading threatens...markets by undermining the public’s
expectations of honest and fair securities markets where all
participants play by the same rules. This legislation provides
increased sanctions against insider trading in order to increase
deterrence of violations.”
The principal purpose of this act was to create a civil penalty in addition to the criminal remedies
already available to the SEC. If the SEC believes that any person has bought or sold a security
while in possession of material nonpublic information, it may bring an action in US District
Court to seek up to three times the profit gained or loss avoided.
The Insider Trading and Securities Fraud Enforcement Act of 1988 enlarged the scope of
civil penalties by applying them to control persons who fail to take adequate steps to prevent
insider trading. It doubled the maximum jail terms for criminal securities law violations from
five to ten years, with maximum criminal fines for individuals increased from $100,000 to
$1,000,000 and for entities from $500,000 to $2,500,000. A bounty program was initiated,
giving the SEC discretion to reward informants who provide assistance to the agency. Finally, it
required broker/dealers and investment advisers to establish and enforce written policies
reasonably designed to prevent the misuse of inside information.
In addition to the securities fraud provisions of Section 10(b) and Rule 10b-5, the SEC
can bring an enforcement action if the transaction involves a violation of the Exchange Act’s
Tender Offer provisions under Section 14(e) and Rule 14e-3, which prohibits trading while in
possession of material nonpublic information (discussed below) concerning a tender offer.
Unlike Rule 10b-5, Rule 14e-3 does not require that the trading take place in breach of a
fiduciary duty in order to impose liability. This may have significant effect, in practice. SEC v.
Ahlstrom was a 1998 SEC complaint that was filed against a man whose wife heard about a takeover of a company from her neighbor. He made a small profit by trading before news of the
tender offer was publicly released. Although he was not a “fiduciary” in any way associated
with the company, the SEC still considered him to be subject to Rule 14e-3. A settlement was
reached with the target, so no court had the occasion to review the legal basis for the complaint.
Who Is An “Insider”?
For purposes of Exchange Act Section 16, discussed above, an insider is defined as any
“person who is directly or indirectly the beneficial owner of more than 10 per centum of any
class of any equity security...which is registered...or who is a director or an officer of the issuer.”
As a general axiom, simply by accepting employment, an individual agrees to put the interests of
the employer’s security holders’ before his or her own in all matters relating to the company.
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However, insiders are not necessarily limited to officers and owners. Illegal insider
trading may be “imputed” to non-insiders if they are imbued with the status of a fiduciary to the
issuer based on a special relationship to the “company insider” or the issuer itself. These
constructive insiders include lawyers, investment bankers and others who receive confidential
information from a company while providing services to it. A duty of trust may be imputed to
any individual, even unrelated to the issuer, who trades based on material non-public
information. Thus, as Galleon shows, where a company insider gives a tip to a friend involving
non-public information that likely to have an effect on the company’s share price, the fiduciary
duty that the company insider owes the company will be imputed to the tippee, who will violate
that duty of loyalty to the company and its shareholders if he or she trades on the basis of this
information.
Material and Nonpublic Information
How do insiders cross the line from legal to illegal trading? Generally, an illegal insider
trade is based on material and nonpublic information obtained during the performance of the
insider’s duties at the corporation, or otherwise in breach of a fiduciary duty or other relationship
of trust and confidence, or where the nonpublic information was misappropriated from the
company.
“Material” Not Defined
There is no statutory definition of material information. Information is generally
considered to be material if it is relevant to the decision of a prospective investor who is
considering the purchase of securities or a current owner of securities who is considering their
sale.
In determining whether the information relied upon in a purchase or sale is material,
judges have looked to the information’s “market price impact.” There is little doubt that
information is material if it significantly impacts a stock’s actual value or the market’s
perception of its value. For example, if the announcement of a dividend cut causes a company’s
shares to fall by 10% it is clearly a material event. On the other hand, if a company reports that
it will open a new factory and, following the announcement, its stock still performs in line with
the movement of the market as a whole, the event is highly unlikely to be considered material
and an insider with prior knowledge of the event would not likely be held criminally liable if
he/she purchased stock prior to the public announcement.
In analyzing whether information is material, the source as well as the nature of the
purportedly material information should be considered. If an investor places a short trade after
her investment banker-friend tells her that an influential analyst at his firm is preparing to issue a
report that downgrades the stock from “Buy” to “Sell,” that transaction is very likely based on
material information and an illegal insider trade. The investor should wait for public disclosure
of the change in the opinion. Another investor who makes the same short trade based solely on
his golf-instructor’s remarks questioning the prospects of the issuer clearly would not be
considered to be based on material information.
“Nonpublic Information”
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The second element of illegal insider trading is whether there is public disclosure of the
information. Public companies are bound by specific reporting requirements and procedures
designed to make certain that information is truly public and to ensure a system of fairness in
which all market participants are given a chance to act on the information. Issuers whose
securities are registered with the SEC typically must file reports on Forms 10-K, 10-Q, and 8-K.
Regulation FD (for “Full Disclosure”) provides that if a company intentionally discloses material
nonpublic information to one person, it must simultaneously disclose that information to the
public at large. If a company makes an unintentional disclosure of material nonpublic
information to one person, it must make a public disclosure “promptly.” Whether information is
nonpublic has an important quantitative element that is difficult to define. Even when
information is disclosed, but done selectively (e.g., to a small group of investment analysts; on a
conference call with a limited number of participants; in an e-mail to only a handful of parties),
the information may still be regarded as “nonpublic” and may form the basis for an illegal insider
trading action.
Duty to Disclose or Abstain
The SEC has consistently taken the position that trading in the open market by company
insiders on the basis of material, nonpublic information is a “deceptive” device in violation of
Section 10(b) and Rule 10b-5. In a 1961 administrative decision (In Re Cady, Roberts & Co.),
the SEC articulated the “disclose or abstain” rule, under which a company insider must disclose
all material nonpublic information known to him before trading or, if disclosure is improper or
impracticable, abstain from trading. Eight years later, the Supreme Court held that anyone who
possesses inside information of a consequential nature must either disclose it to all of the
investing public or abstain from trading until that information is public (SEC v. Texas Gulf
Sulphur) .
In a 1980 case, Chiarella v. U.S., the Supreme Court noted that Rule 10b-5 cannot be
violated for a person’s failure to disclose “absent a duty to speak.” The Supreme Court reversed
the conviction of an employee of a financial printer (not an employee of an issuer) who traded on
material, nonpublic information that came into his possession, and stated that the duty to disclose
or abstain does not arise from the mere possession of nonpublic information, but from a
relationship of trust and confidence between the alleged insider trader and the other party to the
transaction. The court did not believe that the employee of the printer had a relationship of trust
and confidence with the companies whose financial information came across his desk.
Tipper and Tippee
About four years after the Chiarella decision, the Supreme Court further refined the
duties of persons who are not company employees, but are “imputed” insiders. Dirks v. SEC
(1984) involved an officer of Equity Funding Life, Ronald Secrist, who was encouraged by his
employer to create false insurance policies. Secrist was laid off and, bitter over his firing, tipped
off a securities analyst, Ray Dirks, to the scheme. Secrist did this to exact revenge for his
termination, and was not motivated by personal financial gain.
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Dirks informed his institutional clients and many promptly sold their Equity Funding
stock. He also reported the information to the Wall St. Journal’s Los Angeles editor. The editor
informed the SEC and, as the saying goes, “no good deed goes unpunished” - the SEC
investigated Dirks’ role in the exposure of the fraud and censured him. The SEC’s position was
that Dirks, as a ‘tippee’ - regardless of his motivation or occupation - came into possession of
material information that he knew was confidential and knew or should have known came from a
corporate insider. Thus, he must either publicly disclose the information or refrain from trading
(in this case, enable his clients to trade). Dirks, however, believed his actions were proper. He
appealed the censure to the Court of Appeals, which upheld it. Dirks took his case to the
Supreme Court, which reversed the Court of Appeals. Justice Powell noted in his opinion that a
tippee is not liable under Rule 10b-5 for trading on information received from an insider or
anyone else holding information in trust unless (a) the insider/tipper, by disclosing the
information to the tippee, breached a fiduciary duty of loyalty to refrain from profiting on the
information entrusted to him, and (b) the tippee knows or has reason to know of the breach of
duty. Because Secrist, the tipper, did not commit such a breach of loyalty or trust (he had no
economic benefit, and in fact exposed a fraud by his employer), Dirks, as a tippee, could not
commit a “derivative” breach.
Misappropriation Theory - Deception and Disclosure
The concept of “imputed” or “constructive insiders” continued to evolve, as courts
adopted the misappropriation of information as an alternative basis for illegal insider trading
liability.
In a 1997 decision, US v. O’Hagan, the Supreme Court upheld the conviction of an
attorney who profited from material nonpublic information acquired in a deal that he worked on.
O’Hagan’s law firm represented Grand Metropolitan, which was considering a tender offer for
Pillsbury Company’s common stock. O’Hagan bought call options on Pillsbury and netted over
$4 million in profits. Indicted by the SEC, O’Hagan claimed that because neither he nor his firm
owed any fiduciary duty to Pillsbury, he did not commit fraud. The Supreme Court rejected this
argument and upheld his conviction, deciding that a person commits fraud in violation of Rule
10b-5 “in connection with” a securities transaction (not necessarily in a direct offer or sale) when
he misappropriates confidential information for securities trading purposes, in breach of a duty
owed to the source of the information.
Under the misappropriation theory applied in O’Hagan, a trader is deemed to be an
imputed insider because he owes a fiduciary duty not to the other trading party or the issuer of
the securities, but to the source of the material nonpublic information.
O’Hagan was considered to be a fiduciary, and his undisclosed, self-serving use of
material nonpublic information to trade in options was in breach of his duty of loyalty and
confidentiality to his firm and his client, whom he defrauded of the exclusive use of the
information. The Supreme Court specifically recognized that “a company’s confidential
information...qualifies as property to which the company has a right of exclusive use. The
undisclosed misappropriation of such information in violation of a fiduciary duty...constitutes
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fraud akin to embezzlement – the fraudulent appropriation to one’s own use of the money or
goods entrusted to one’s care by another.”
Applying this analysis, liability is based on the trader’s deception of those who entrusted
him with access to confidential information. Accordingly, disclosure cures the deceptive nature
of the conduct that is prohibited by Rule 10b-5. It would have been perfectly legal for O’Hagan
to trade on his inside information had he disclosed to his client, Grand Met, and his law firm
what he intended to do, notwithstanding the overall “unfairness” to other market participants.
The latest case with national exposure that addressed the issues of misappropriation,
confidentiality, and deception was SEC v. Cuban. In its 2009 decision, the U.S. District Court
(Northern Texas) held that Mark Cuban, owner of the Dallas Mavericks, was not guilty of illegal
insider trading even though he entered into a transaction after receiving confidential information
on the issuer. The court concluded that, since Cuban’s alleged oral agreement to maintain the
confidentiality of the information provided to him did not go so far as to have him agree “not to
trade on or otherwise use it,” there was no misappropriation because, “absent a duty not to use
the information for personal benefit, there is no deception in doing so.” In October, the SEC
filed to appeal the District Court’s decision.
Steps to Protect Against Illegal Insider Trading
There is constant temptation in the investment world to either profit from (or avoid loss
through) knowledge of material nonpublic information. That is why hedge funds and other
investment companies must have an effective compliance program in place. It should do more
than simply create a superficial awareness of illegal insider trading and the applicable fines and
jail sentences. Fund management should make every effort to reduce, as much as reasonably
possible, the potentially fatal risks to the enterprise and the careers of its employees that can
result from insider trading violations. Moreover, funds of funds and other investors in hedge
funds should thoroughly investigate the compliance programs of their underlying investments to
ensure that their investments are not in jeopardy.
Control of the trading environment is the most significant aspect of a system to avoid
illegal insider trading. If material nonpublic information comes into the possession of fund
personnel, management should have systems in place to prevent it from being widely shared and
traded upon, and thus remove the source of the temptation to make illegal profits.
The minimum elements of an effective insider trading compliance program should
include: (a) segregation of personnel (i.e., the firewall); (c) confinement of material nonpublic
information (only select personnel should have access to such information and only on a “needto-know” basis); (c) oversight of internal communications (the compliance/legal staff might
serve as a clearing house through which all interdepartmental memos are sent); and (d) strict
monitoring of employee trades (those with sensitive jobs might be required to receive advance
permission to trade).
As applied to insider trading compliance, certain departments (e.g. research) may have
access to material nonpublic information that could be misused by other departments (e.g.,
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trading). An information “firewall” should be instituted to prevent sensitive material from being
disseminated between certain departments of a firm - only a select few individuals need to know
sensitive information.
As part of an effective program, a “restricted list” of certain issuers (those that are the
focus of researchers or investment banking personnel) is often maintained, as needed, to limit
employee trading. If a restricted list is “too public,” a firm can adopt the use of a more discrete
“watch list.” The Chief Compliance Officer (CCO) or another high-level executive typically
monitors the companies on such lists, perhaps making inquiries of an employee based on such
employee’s trading activities, but maintaining the confidentiality needed for a particular
circumstance.
Fund managers may come into contact with material nonpublic information in a variety
of ways. When it occurs, however, the recipient must be trained and understand his/her
obligation to inform his/her supervisor or CCO and not disclose any additional information to coworkers. If a fund relies on internal research analysts, this may raise what is often referred to as
the “mosaic” theory of gathering information which, depending on the context, may serve as a
defense to a charge of illegal insider trading.
Research analysts regularly gather nonpublic information from a variety of sources (e.g.,
interviews with company insiders). Each segment may not be material in and of itself, but the
“mosaic” as a whole can be interpreted to reveal material nonpublic information. The
recommendation that is made for trading (or not trading) on the basis of the fragmented, but
pieced-together, information may or may not constitute a breach of a fiduciary duty. It all
depends on the context of the ultimate information gleaned from disparate data and whether the
result should be obvious, to a reasonable investor, that it was material nonpublic information.
The decision resulting from the information gathered may, in practice, conflict with the duty of
the manager as a fiduciary to its fund and the fund’s investors, which requires that it act in their
best interest.
In a research analyst’s practice, careful records of the research process, with a viable
rationale for each investment decision, should be maintained. This can help protect an analyst
who relied on the mosaic theory and actually relied on several items of nonmaterial, nonpublic
information to form an investment opinion.
Personal securities trades by fund employees should be carefully monitored and, where
the executives of a fund manager are conducting personal trades, a procedure to monitor their
transactions by a high level officer, like the CCO, should be imposed. The trades of the CCO
should be monitored by another senior officer so that the foxes are not guarding the hen-house.
Every organization must have “buy-in” by its leaders to avoid intimidation and pressure to look
the other way, which may occur when an individual is monitoring the trades of an officer senior
to him or her.
Finally, an effective training and continuing education program should be instituted to
ensure that all personnel are fully educated about and informed of the dangers triggered by
insider trading violations. For such a program to be successful, it should be administered at least
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annually by an independent professional. Where there are new developments, such as the recent
legislation proposed in Congress to require the registration of hedge fund managers, written
updates and interim training meetings should be instituted.
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