Imagine the horror: a corporate executive confides in a family member, sharing information about her career (and, therefore, about her company), and the family member trades in the company‟s securities. Or a young professional shares a house with a friend, who pieces together what the professional is working on and trades. Government insider trading investigations ensue, the traders are charged, and lives are changed, all because of an inadvertent tip. And, because these cases are built on circumstantial evidence and credibility assessments, there is always the risk that the government could take the view that the tips were not inadvertent, and could charge the corporate executive or young professional with tipping, furthering the nightmare.
Ideally, of course, everyone could trust family members and friends to make good decisions and not act in a way that could put themselves and loved ones in danger. And ideally, the government would charge only people who actually violated the law. Unfortunately, the ideal is not always the reality: unless sensitive information is protected carefully, corporate insiders and service providers retained by companies to whom sensitive corporate information is entrusted risk government investigations that can wreak havoc on personal and professional lives. The current economy compounds this situation, increasing the temptation of “easy money” through insider trading. For those hit hardest economically, and with access to nonpublic information through a friend or family member, the lure may become especially hard to resist. Understanding the risk, and taking steps to protect against it, could save heartache – and worse – down the road.
How Liability is Determined. It is important to understand the contexts in which those who possess material nonpublic information risk liability for disclosing it. Any tipping case could be prosecuted by the criminal authorities if the level of proof is sufficient to establish guilt beyond reasonable doubt; the Securities and Exchange Commission faces a lower burden of proving its allegations by a preponderance of the evidence.1 Due to the heavy burden of proof required of criminal prosecutors and other high priority crimes they also must address, most tipping cases are brought by the SEC. Although some defendants litigate, many cannot afford the monetary and emotional cost of doing so, and most tipping cases brought by the SEC settle with the defendant neither admitting nor denying the SEC‟s allegations.2
The law provides that a tipper is jointly and severally liable with his or her tippees (both direct and indirect) for the ill-gotten gains (or the losses avoided) those tippees obtained as a result of the tip, plus interest.3 The tipper also may face a monetary penalty of up to three times the amount of those ill-gotten gains or losses avoided, although most cases settle for a one-time penalty equal to the disgorgement amount.4 Taken to an extreme, the tipper need not know anything about the trades themselves or have any voice in the dollar amounts at issue – the tipper can be liable for dollar amounts in the thousands, millions or even more for trading profits or losses avoided that he or she never received, shared, or even knew about.
The elements of a tipping charge are not statutory; they have evolved in case law interpretations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. To allege tipping, the government must prove that the tipper had material, nonpublic information; that he or she had a duty (as a company employee, or as a lawyer, accountant, banker, or other service provider retained by the company) to maintain the information as confidential; that the tipper communicated the information to someone who traded or tipped others to trade; and that the tipper intended to benefit personally by giving the tip.5
The crux of assessing potential tipping liability often centers on the “personal benefit” element. The SEC and various courts have construed the concept of a personal benefit very broadly. As a result, for such a significant allegation, the level of proof required in this “personal benefit” test is shockingly low. The United States Supreme Court has stated that, when the person who possesses the information passes it to a tippee, the SEC may prove intent to benefit through 1) receipt of pecuniary benefit (e.g. profits from the trading), 2) receipt of a “reputational” benefit, or 3) provision of the information as a “gift” to the tippee.6
Although some cases turn on whether profits were shared, such circumstances are not generally thought to be controversial as the sharing of trading profits can be a hallmark of an improper trading scheme. Thus, it is the second and third avenues that pose the biggest problems for those who possess inside information because those avenues are less susceptible to having precise definitions or clear criteria. Charging decisions can turn on subjective assessments of suspicious government attorneys. For example, the SEC has secured a settlement against a tipper under a reputational benefit theory when, for example, a CEO allegedly provided material nonpublic information to an investment analyst with the “hope” that the analyst would issue favorable reports about the CEO‟s company in the future.7 Under a “gift” theory, the Supreme Court has reasoned that information imparted to a friend or family member “resembles” insider trading by the officer or director him or herself with a subsequent gift of the proceeds to the tippee.8 As the gift doctrine has expanded, it has incorporated acts such as those intended “to effect a reconciliation with [a] friend and to maintain a useful networking contact.”9 These examples demonstrate that the personal benefit test is a malleable concept that, in the event of seemingly timely trades, risks having a relationship opened to thorough government scrutiny.
Unfortunately, determining the exact contours of the intent to benefit prong under an enhancement of reputation or bestowal of a gift theory is very difficult. Courts rarely find a lack of a gift where one is alleged, although this has occurred when a court concluded that an alleged tipper did not intend for the tippee to hear the information,10 and when there was no evidence of any personal relationship between the tipper and the tippee.11 Even casual acquaintances may be deemed friends by the government, and therefore the government may be suspicious of the motivations for sharing the information. If a person unintentionally discloses material nonpublic information that is ultimately traded on, it should be much easier for that person to convince the SEC that he or she had no intent to benefit.
Even where there is no basis for charging the insider or service provider with tipping, the government may still have potential theories it can pursue against the trader. In some cases, the SEC may not charge the corporate insider or service provider for having tipped, but instead may pursue the trader on a misappropriation theory only, meaning the trader obtained the material nonpublic information in a manner that did not give the insider or service provider any reason to believe that person would trade. This could occur if the insider or service provider did not intentionally or recklessly provide the information, or it could occur if the insider or service provider intentionally communicated the information for a different purpose and did not intend for the recipient to trade. Under a misappropriation theory,
a person commits fraud “in connection with” a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information…. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company‟s stock, the misappropriation theory premises liability on a fiduciary-turned-trader‟s deception of those who entrusted him with access to confidential information.12
Close family relationships carry with them a duty to the source of the information, and may therefore give rise to insider trading liability.13 While an SEC action against a trader under a misappropriation theory may spare the corporate insider or service provider from legal actions against him or her personally, it nevertheless can have significant collateral consequences in his or her life. The insider‟s or service provider‟s relationship with the trader will be, in many cases, irreparably damaged, and the insider‟s or service provider‟s relationship with his or her employer, in many cases, comes to an end.
Several recent cases have highlighted the dangers associated with friends and family trading on information directly or indirectly gleaned from a corporate insider. These cases serve as examples of the risks associated with holding material nonpublic information as well as important lessons on how best to prevent trades based on such information.
Apparently Inadvertent Disclosure. Although the category of friends and family insider trading cases has existed for as long as insider trading cases themselves, new lawsuits continually highlight the dangers that an insider‟s closest relationships can pose. The facts alleged in the June 2011 case of SEC v. Goetz, which Mr. Goetz settled without admitting or denying the allegations, is a recent example.14
According to the complaint, in December 2008, a young attorney working in the Los Angeles office of a large international law firm spent two weeks at her parents‟ home for the holidays.15 While visiting, she continued to work on a merger transaction between her firm‟s client, Advanced Medical Optics (“AMO”), and Abbott Laboratories, set to close in January 2009.16 She worked on aspects of the due diligence for the transaction in various locations around her parents‟ home, sometimes borrowing the office desk of her father, Dean A. Goetz, who was also an attorney.17 Some of the documents on which she worked included disclosure schedules which, unlike most of the merger documents, identified one of the parties by its actual name.18 Unbeknownst to his daughter, Mr. Goetz accumulated sufficient information from her documents, and, likely, from her announcement upon cutting her visit short that “[h]opefully we'll close soon,”19 to confirm the identity of one of the merging companies and the timing of the transaction.20
Mr. Goetz allegedly misappropriated this information and purchased shares in the merging company in the early afternoon of the day the merger was scheduled to be announced using a trading account he had not used in nearly a year.21 Once Mr. Goetz sold his shares after the merger announcement, his profits totaled $11,418.22 Although this was a relatively small sum compared to many other cases the SEC has brought, on June 3, 2011, the SEC charged Mr. Goetz and argued that he had misappropriated his daughter‟s material, nonpublic information by breaching his family duty of loyalty and confidentiality.23 Mr. Goetz‟s settlement included disgorgement of his profits, prejudgment interest, and a penalty equal to his profits, for a total of $23,761.65.24 The complaint named only Mr. Goetz,25 but we can be certain that the daughter was required to participate in the SEC‟s investigation in relation to the disclosure.26
Allegedly Intentional, Confidential Disclosure. A similar story played out in Connecticut, although in this case the insider allegedly intended to disclose facts to the family member, who in turn misappropriated the information by trading for himself and by tipping others who then also traded. According to the facts alleged in this June 2011 case, which Bruce Macdonald, Robert Maresca and Bruce Bohlander settled without either admitting or denying the allegations, Mr. Macdonald‟s wife was employed as the corporate secretary and vice president of human resources of Memry Corporation (“Memry”), a medical device company.27 While Mrs. Macdonald was serving in this capacity, Memry began seeking out suitors to buy the company, and negotiations evolved throughout 2007 and into the first half of 2008.28 Since Mrs. Macdonald was part of senior management, she was included in several important steps of the due diligence process,29 and she frequently updated her husband on the progress of the sale.30 In September 2006, the company instructed its employees that they were under a “blackout” from trading company shares for an indefinite period, and Memry recirculated the blackout notice the following year on September 30, 2007 and November 16, 2007.31 Mrs. Macdonald relayed such blackout restrictions to her husband because he was in charge of the family‟s trading accounts.32
The SEC alleged that, without telling his wife, Mr. Macdonald used the account of a small business that he owned and the account of a childhood friend, Mr. Bohlander, to purchase shares on numerous dates over a several-month period beginning on July 13, 2007, the day after the Board meeting concerning the process for hiring an investment bank, until April 4, 2008, over a month after on-site due diligence began.33 Memry did not announce the merger plan until June 24, 2008. Even though Mr. Macdonald ceased trading more than two months before the merger was announced, the SEC‟s allegations centered on several of Mr. Macdonald‟s trades, which coincided in date with important stages of the merger process.34 Mr. Macdonald also allegedly alerted three friends, co-defendant Mr. Maresca and two others who are not named or charged in the complaint.35 To Mr. Maresca, Mr. Macdonald said he should “[b]uy Memry stock. You don‟t want to know why.”36
As in Goetz, the SEC pursued a misappropriation theory, charging Mr. Macdonald and Mr. Maresca in February 2010 with insider trading, but not charging Mrs. Macdonald with tipping.37 Again, the profits were relatively slim: Mr. Macdonald‟s small business account earned a profit of $890, Mr. Bohlander‟s account earned $25,508,38 Mr. Maresca earned a total of $12,335, and the two other tippees received total profits of $7,307.50.39
Although five people allegedly profited, only Messrs. Macdonald and Maresca were charged with violating the law. The SEC named Mr. Bohlander as a relief defendant and required him to pay disgorgement of $25,508 and prejudgment interest of $1,748, but did not charge him with a violation, presumably since Mr. Macdonald had trading authority over his account. The two other traders were not named, and Mr. Macdonald was required to disgorge their profits himself, along with those in his business account. Mr. Macdonald‟s penalty covered his own trades, including the trades on Mr. Bohlander‟s account, but he was not penalized for the profits of the unnamed traders. Mr. Maresca disgorged his own profits, interest and a one-time penalty.40
Although she was not charged personally, Mr. Macdonald‟s wife must have been intimately involved in the investigation into her husband‟s conduct, and such investigations are an emotionally and financially draining experience, at a minimum.
Liability for Tipping Despite No Trading by Alleged Tippee. This 2010 case involved Kim Ann Deskovick and Brian S. Haig, who settled the SEC‟s charges without admitting or denying its allegations. According to the complaint, in early 2006, Ms. Deskovick was serving as the director of a regional bank in New Jersey.41 During this time, Ms. Deskovick hired an unnamed individual to perform services on her home and the two “developed a close personal relationship.”42 In mid-2006, the regional bank for which Ms. Deskovick served as a director decided that, in light of its decreasing revenues, it should search for a buyer.43 Ms. Deskovick‟s position at the bank not only made her aware of the bank‟s intent to find a buyer, but gave her access to confidential information about the progression of the deal.44 In March 2011, the SEC charged Ms. Deskovick with tipping inside information.45 Allegedly, Ms. Deskovick informed the unnamed individual about the impending sale and kept him informed as the deal moved forward.46 This unnamed individual allegedly tipped the inside information to his accountant, Mr. Haig, informing Mr. Haig that his friend “Kim” alerted him to the sale.47
The SEC‟s complaint stated that Ms. Deskovick telephoned the unnamed individual “in close proximity to several key events in the transaction,” after which the unnamed individual called Mr. Haig who then purchased stock.48 For example, the SEC alleged that Ms. Deskovick called the unnamed individual while he and Mr. Haig were having dinner with their spouses and told him that an agreement had been completed and an announcement was imminent, information that the unnamed individual conveyed to Mr. Haig.49 The following day, the acquisition was announced publicly, and Mr. Haig made a profit of $56,797 after selling his shares.50
The SEC‟s charges against Ms. Deskovick rested on a “gift” theory, alleging that Ms. Deskovick had knowledge that the unnamed individual had been in financial difficulty, she had helped him monetarily between March and July 2006, and she gave his wife gifts.51 The complaint does not allege that the unnamed individual ever traded on Ms. Deskovick‟s information, but the SEC apparently concluded that Ms. Deskovick‟s alleged intent to confer a gift provided the element necessary to pursue her for tipping.52 The SEC‟s allegations as far as Mr. Haig were concerned rested entirely on the timing of phone calls among Ms. Deskovick, the unnamed individual, and Mr. Haig, as well as the timing of Mr. Haig‟s trades.53 While Mr. Haig was ordered to pay disgorgement of $68,277, equal to his profits plus the profits of the deceased individual whom Mr. Haig had tipped, prejudgment interest of $18,007, and a civil penalty of $34,138, Ms. Deskovick also consented, without admitting or denying the allegations, to paying a civil penalty of $68,277 (an amount equal to Haig‟s and the deceased individual‟s profits).54 Ms. Deskovick was also barred from serving as an officer or director of a public company for five years.55
Instead of pursuing a misappropriation theory, the SEC in Deskovick alleged that the defendant herself had breached her fiduciary duty by passing information to the individual who ultimately tipped Mr. Haig. However, the SEC did not allege anything beyond circumstantial evidence that Ms. Deskovick intended to confer financial benefit on her friend, who did not ultimately trade in the stock. And, unlike in Goetz or Macdonald, the insider herself suffered direct, legal consequences as a result of conversations she had with a friend, to say nothing of any personal, non-legal consequences she may have suffered.
So what can be learned from these cases? Most people‟s natural tendencies make them inclined to believe the best about people, especially those with whom they are closest and who they trust the most. Ironically, because the showing of a close, personal relationship is frequently sufficient to show the intent to convey a benefit, it is precisely these individuals who pose the greatest potential risks to corporate insiders and service providers who confide confidential corporate information in them. An intentional betrayal or even a coincidental trade by a close friend or family member can not only damage or destroy a relationship, but also lead to a potential SEC investigation or even a criminal prosecution. Corporate insiders and the service providers who work with confidential information would be wise, therefore, to protect themselves and those around them by not discussing nonpublic company business at all.
As some of the above cases have shown, however, silence may not always be enough, and the current financial environment could increase the risk that people, even trusted family members and friends, may succumb to the temptation to try to analyze pieces of information shared with them and to take advantage of such information by trading upon it. This is a good time to remind corporate executives to provide information only to those who need to know it, and to renew efforts to protect information that might be accessible to family or friends who could be tempted to trade. They may also want to consider password protecting home computers, personal computing tablets, telephones and/or individual files that store the information, and keeping hard copies of documents either at work or locked in filing cabinets at home. These cases also serve as a good reminder to corporate counsel that insider trading policies should be clear and frequently circulated, that confidential documents should be marked as such and distributed only to those who need to know the information, and that clear warnings are issued to people when they receive material nonpublic information from their employer.
Family members and friends might be deterred by discussions of what could happen if they tread in these waters. But while those conversations are good to have, dishonest friends or family members can probably find a way to misappropriate material nonpublic information if they are truly determined.
Corporate insiders and service providers who frequently work with inside information do not want to undergo the extreme strain of an insider trading investigation or share that experience with loved ones. The emotional tax, financial burden, and significant time involved are all best avoided. The above examples serve as cautionary tales that even when a corporate insider believes that the risk of betrayal is small, it is still good practice to take extra precautions to reduce exposure.