In a much anticipated decision released yesterday that carries implications for lawyers and other professional “gatekeepers,” a panel of the Ontario Securities Commission (OSC) found former Toronto lawyer Mitchell Finkelstein and four investment advisors to have engaged in insider tipping and trading in contravention of the Ontario Securities Act. The ruling in this high-profile case is significant given regulators’ well-publicized failures in recent years to prove insider trading and tipping allegations. As the panel itself acknowledged, tipping, in particular, is very difficult to establish since in most cases the only individuals with direct knowledge of the relevant communications are the wrongdoers themselves. Nevertheless, in a 52-page decision that may well serve as a roadmap for OSC Staff in their prosecution of future insider trading and tipping cases, the panel leaned heavily on vast amounts of circumstantial evidence and drew inferences that allowed them to conclude that it was more probable than not that the respondents breached securities laws in three of the six occasions at issue.

The Allegations

The allegations against the respondents centred on six takeover transactions between 2004 and 2007 involving Canadian public companies, and the respondents’ trades in the securities of those companies shortly before each of the transactions was made public. At the centre of the case was Finkelstein, a mergers and acquisitions lawyer at a prestigious Toronto-based firm. OSC Staff alleged that Finkelstein was in possession of material non-public information because he was aware of the impending transactions by virtue of being the lawyer directly involved in the deals or because he accessed deal documents on the firm’s file management system before the deals were made public. Staff alleged Finkelstein was in near-constant contact was Paul Azeff, an investment advisor with CIBC in Montréal, and long-time friend of Finkelstein. According to Staff’s allegations, during the relevant period, Finkelstein told Azeff that an imminent takeover transaction was to occur, and Azeff passed that material non-public information along to his partner Korin Bobrow. Azeff and Bobrow then used this information to place share purchases for themselves, friends and family members in amounts totalling several millions of dollars. They also conveyed the information to friends, who in turn tipped investment advisors Howard Miller and Man Kin Cheng, both of whom also made significant purchases of shares for themselves, family members and clients.

Significantly, each of Finkelstein, Azeff, Bobrow, Miller and Cheng were sophisticated professionals. In the panel’s words, they were “aware of the seriousness with which securities regulators view illegal tipping and illegal insider trading and the need for confidentiality of material non-public information.”

In support of its allegations, Staff pointed to extensive circumstantial evidence, including the dates on which Finkelstein was likely to have obtained the relevant information, the dates that Finkelstein was in contact with Azeff (and dates on which Azeff himself communicated with other “down-stream” tippees), and the timing of the purchases of securities that Azeff and others made relative to the dates that the transactions were announced. Staff collected extensive phone records, including from Finkelstein’s home, cell and office, and from Azeff’s office at CIBC. In addition, Staff demonstrated four instances when Finkelstein deposited between $6,000 and $25,000 in cash into his bank account shortly after the public announcements of the transactions and following meetings with Azeff in Toronto and Montréal. However, as the panel found, Finkelstein’s evidence of his habit of keeping large amounts of cash around his home satisfied the panel that these deposits, while “strange,” were merely coincidental.

The Ruling

In its lengthy but fairly clear reasons, the panel found that Finkelstein engaged in insider tipping in breach of section 76(2) of the Securities Act in respect of three of the six transactions at issue. In these instances, the panel found that Finkelstein was in a special relationship with the issuers by virtue of his role as a lawyer with the law firm engaged on the transaction, was in possession of material non-public information and informed Azeff of the information before the material facts were generally disclosed. In those instances in which Finkelstein was found not to have breached section 76(2), the reason was either that there was insufficient evidence that Finkelstein was in possession of material non-public information or that there was insufficient evidence that Finkelstein relayed any material non-public information to Azeff.

The panel found that all or some of the four investment advisors who received information down the chain from Finkelstein engaged in insider trading and tipping in breach of sections 76(1) and (2) of the Securities Act in respect of three of the six transactions. For the three “down-stream tippees” (i.e., the investment advisors who received information through Azeff and not directly from Finkelstein), the panel’s analysis was complicated by the requirement under section 76(5)(e) of the Securities Act that the individuals knew or ought reasonably to have known that the information originated with a person in a special relationship with the company. In other words, did the recipients of information who are two or three times removed from Finkelstein know, or should they have known, that the information they received was material non-public information that came from an insider? In three of the six transactions, the panel concluded that it had sufficient evidence to find that the respondents ought to have known, based on all of the circumstances, that the material non-public information derived from a knowledgeable person.

The Importance of Circumstantial Evidence and Inferences

In reaching its decision, the panel emphasized that in its role as an administrative tribunal (as opposed to a criminal court), circumstantial and other indirect evidence is not only admissible, but can sufficiently support inferences to establish the elements of the alleged improper acts. The panel acknowledged that it did not have the luxury of audio recordings or emails of Finkelstein relaying material non-public information to Azeff or others. This kind of direct evidence is rare in these cases and, as we have commented in a previous update and blog post, has made them difficult to prosecute successfully in both Canada and the United States. Instead, the panel relied heavily on circumstantial evidence to draw inferences that the respondents were aware of material information and used it to purchase securities during the relevant period.

The panel explained that the following types of circumstantial evidence, among others, can be indicia of insider trading or tipping: (i) unusual trading patterns (e.g., rapid accumulation of shares); (ii) a timely transaction in a stock shortly before a significant public announcement; (iii) a first time purchase of the stock (particularly where there is no evidence of market research); (iv) an abnormal concentration of trading by one brokerage firm or with one or a few brokers; (v) a trade that represents a very significant percentage of a particular portfolio.

The panel considered these kinds of circumstantial evidence with a view to the applicable standard of proof, which required the panel to determine whether the alleged events, based on clear, convincing and cogent evidence, were more likely than not to have occurred. In making its determination, the panel weighed Finkelstein’s evidence and made findings of credibility, including their observation that Finkelstein’s testimony “lacked spontaneity and was well rehearsed.” Considering all of the circumstances, the panel found that there was simply “no other reasonable explanation” for the timing of the trades than to believe Finkelstein had tipped Azeff and that Azeff had passed the information along to others.

Further Guidance on the “Special Relationship”

As the panel noted, section 76 is intended to prohibit insider trading by “an indefinite chain of indirect tippees.” But as information is passed from tipper to tippee and so on down the line, it becomes increasingly difficult to determine whether a distant tippee knew or ought to have known that the relationship came from a person in a “special relationship” with the issuer.

The panel clarified that there is a “dual test” that must be met in order to establish a special relationship under section 76: first, there must be an “information connection” to the issuer (i.e., there must be possession of inside information); second, there must be a “person connection.” The first aspect of the test is generally straightforward since it merely involves a comparison of the information the tippee has compared to the information that is publicly available.

The second part of the test, however, has proven much more difficult in tipping cases. It involves an enquiry into whether a person standing in the shoes of the tippee would reasonably assume that the material non-public information passed on to him originated with a knowledgeable person. The panel set out the following factors to consider in making this determination:

  • What is the relationship between the tipper and the tippee?
  • What is the professional qualification and standing of the tipper? Lawyers, businesspeople, bankers and other professionals are much more likely to possess material non-public information.
  • What is the professional qualification of the tippee? Significantly, a “higher standard of alertness is expected” of lawyers, accountants and other professional gatekeepers than of members of the general public.
  • How detailed and specific is the material non-public information?
  • How long after he receives the material non-public information does the tippee trade?
  • What intermediate steps before trading does the tippee take, if any, to verify the information received?
  • Has the tippee ever owned the particular stock before?
  • Was the trade a significant one given the size of his portfolio?

Motive Does Not Matter

Finkelstein argued that the amounts that Staff alleged he received for the tips he gave to Azeff – less than $50,000 – paled in comparison to Finkelstein’s household income, which approached $1 million in 2007. He was a young and well-regarded corporate lawyer at a top Bay Street firm. What possible motivation could he have had for passing material non-public information to Azeff?

The panel acknowledged that there was a “lack of motive” for Finkelstein to tip Azeff, but ultimately ruled that this consideration did not matter. While motive can be an important factor in concluding that tipping occurred, “[a]bsence of motive is not a determinative factor in favour of no tipping having occurred.” Based on all the facts, the panel concluded that Finkelstein relayed material non-public information to Azeff notwithstanding that there was no clear motive for him to have done so.

Implications for Future Insider Trading and Tipping Cases

The Finkelstein decision highlights the seriousness with which the Commission views insider trading and tipping offences. The panel emphasized that tipping and trading “erode confidence” in the capital markets when it is perceived that an insider has gained an advantage over other investors. However, given the stringent burden of proof in criminal cases, capital markets enforcement agencies and prosecutors have a poor record of obtaining criminal convictions for insider trading and tipping offences in Canada. Even in the United States, where insider trading is prosecuted aggressively in criminal courts and by the SEC, the recent Newman decision of U.S. Second Circuit Court of Appeals may have shifted the balance in favour of the accused. In that case, the appeals court reversed the decision of the district court on the basis that the government failed to prove beyond a reasonable doubt that the tippee knew that an insider disclosed confidential information and that he did so in exchange for a personal benefit.

Against this backdrop, it is clear that the OSC can and is willing to rely on its public interest powers to combat insider trading as an effective alternative to the criminal law process. The decision emphasizes the Commission’s willingness to apply an evidentiary standard which is lower than that required under criminal law through the use of circumstantial evidence and inferences. Given the recent pressure on the OSC to crack down on capital markets abuses, there can be little doubt that the Finkelstein decision will encourage Staff to push forward with a greater number of insider trading and tipping cases going forward. Enhanced investigation and prosecutorial tools and avenues, such as whistleblowing programs and the introduction of ‘wiretapping’ as an enforcement tool, should facilitate these more aggressive tactics in the criminal sphere. The Finkelstein case, unless overturned on appeal, provides OSC Staff another path through which to pursue what the panel described as “a cancer which erodes public confidence in the capital markets.”