Recent high-profile Securities and Exchange Commission cases against hedge fund managers revive the most universal question associated with insider trading regulation. For almost every “buy-side” investor, a persistent concern centers on determining when fundamental investment research touches the gray areas of insider trading law. A renewed SEC focus on “Wall Street” defendants heightens the importance of understanding when research activity that can be viewed as appropriate nonetheless may become the source of regulatory scrutiny.

This is not a new concern. Since its inception, insider trading regulation has focused on distinguishing between legitimate research on the one hand and fraudulent conduct on the other. In its 1981 opinion relating to securities analyst Raymond Dirks, the SEC recognized that, with respect to research analysts, “[t]he value to the entire market of these efforts cannot be gainsaid; market efficiency in pricing is significantly enhanced by such initiatives to ferret out and analyze information… .”1 Two years later, in rejecting the SEC‟s case against Dirks, the Supreme Court stressed that the position taken by the Commission in that enforcement action “could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market.”2

The great majority of investment analysts and portfolio managers are not trading tips on disposable cellular telephones, nor are they providing envelopes of cash for market information. Almost every buy-side investor evaluates information with the goal of reaching a conclusion that the rest of the market does not yet appreciate. The research process involves a myriad of methods and sources – meetings with public company management, models of forecasted income, assessment of macroeconomic trends and walks through the aisles of retail stores to assess shopping trends. This work exposes investors to nonpublic information, and some of that information will be significant to the analyst involved.

The SEC‟s recent enforcement docket reflects a belief that certain buy-side investors‟ investment activities were rife with insider trading violations, and that there are more to be found. Recent insider trading enforcement actions have targeted multiple hedge fund advisers and their employees; SEC v. Galleon names a total of seventeen individual defendants, many previously associated with blue-chip companies.3 Beyond that, the SEC‟s Enforcement Division has been reorganized to focus on, among other things, cases against buy-side defendants. Specifically, the Enforcement Division has formed specialized units to focus on, among other topics, investment management and market abuse. It is inevitable that these groups will spend at least some of their time combing evidence in a search for big-ticket insider trading cases.

While the focus of many recent high-profile enforcement actions has been on hedge fund advisers and their personnel, the concern is more widely applicable because it carries over to all asset managers – mutual fund advisers, insurance companies, pension funds and others. With uncertain legal standards and emboldened civil and criminal enforcement, the universal question is what direction to give investment staff handling the nuts and bolts of fundamental research to avoid insider trading risks. Five guidelines should be highlighted.

First, investment staff must be required to flag when they receive material, nonpublic information about a portfolio company or potential portfolio company. In the normal course, analysts and portfolio managers will follow multiple avenues to ferret out information about an investment opportunity. If, in the course of these efforts, they become aware of nonpublic information that they consider to be material, they should be required to bring this information to the attention of, as applicable, a compliance officer, internal counsel or a principal of the investment adviser. The significant risk of government investigations and potential liability make it important that an institutional judgment be made before acting on the information.

This risk attaches to material information. Materiality is a test of significance; it is information that a reasonable investor would consider significant in deciding whether to purchase or sell a company‟s securities.4 A buy-side investor routinely weighs multiple sources of nonpublic information that are not material. While some investors take concentrated positions and receive information through representation on the company‟s board of directors, most do not. For most investment analysts and portfolio managers, the receipt of material, nonpublic information is an exceptional event.

This should be a rare event because SEC Regulation Fair Disclosure (“Reg. FD”) prohibits issuers and their primary spokespersons from disclosing material, nonpublic information selectively to the buy side – persons associated with investment advisers, investment managers, broker-dealers or a holder of the company‟s securities “under circumstances in which it is reasonably foreseeable that the person will purchase or sell the issuer‟s securities on the basis of the information.”5 Reg. FD creates a legal requirement that the individuals with the most direct access to a company‟s material information take steps to safeguard that information.

Investment staff should flag the receipt of material, nonpublic information because the law of insider trading is imprecise. Despite a half century of insider trading enforcement, the U.S. remains a relatively rare jurisdiction in that it has no statutory definition of the violation.6 Instead, this body of law has been developed through court decisions and SEC proceedings generally applying the antifraud prescription in Section 10(b) of the Securities Exchange Act. If an analyst highlights the receipt of material, nonpublic information, two judgments can be made before anyone acts on the information.

One judgment assesses whether it would be illegal to use the information to trade securities. This involves an analysis of whether the principal theories of insider trading liability, discussed below, could be used to sanction the trading. In the most general terms, this requires an assessment of whether a breach of some duty or obligation would be implicated by trading on the information.

The other judgment assesses whether acting on the information is likely to expose the buy-side investor to the distraction and expense of government investigation (even in the absence of any legal liability). For example, a 2003 SEC enforcement action alleged that Schering-Plough Corporation‟s Chief Executive Officer selectively disclosed material, nonpublic information about the just-completed third quarter of 2002 in a series of meetings with institutional investors.7 The Commission stated that the investors sold millions of Schering-Plough shares before the material information was disclosed by the company. Presented with these facts, the SEC named the company and its CEO as defendants in a proceeding alleging violations of Reg. FD. While none of the investors was a defendant in the case, the Commission‟s complaint made it clear that each had supplied information over the course of the SEC‟s inquiry.

The analysis in each instance is highly dependent on facts and circumstances. A buy-side investor can only make an advance assessment of the risk of liability or regulatory scrutiny if the investment analyst has highlighted the receipt of material, nonpublic information before acting on this information.

Second, insider trading risks for investors are heightened when they receive material, nonpublic information subject to a confidentiality agreement. The misappropriation theory is one of the principal tools to assert insider trading claims against “outsiders” like buy-side investors. The malleability of this theory makes it critical that investment staff appreciate the risks associated with utilizing information that is the subject of any type of confidentiality agreement.

Under the misappropriation theory, an investor violates Section 10(b) “when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information.”8 That duty can be derived from the relationship between two parties (e.g., attorney/client) or through a contractual commitment between two parties to keep the information confidential. Validated by the Supreme Court‟s 1997 O’Hagan decision, the misappropriation theory has been a principal tool for proceedings involving outsiders, including buy-side investors.

The precursor to the current round of insider trading cases against hedge funds involved a series of investigations that routinely focused on hedge fund trading prior to the announcement of private investment in public equity (“PIPE”) transactions. These investigations resulted in both civil and criminal actions. The relevant PIPE transactions often were marketed to hedge funds; the investigations focused on short selling that preceded the announcement of the PIPE (often leading to a decline in the issuer‟s stock price). A common thread to the cases that were prosecuted by the SEC and federal prosecutors involves allegations that the hedge fund personnel had received the information about the PIPEs after entering into confidentiality commitments with the issuers.9

There are a number of contexts in which a public company‟s management might seek to enter into a confidentiality agreement with an institutional investor. Reg. FD expressly recognizes that issuers can selectively share material, nonpublic information with an investor if the investor has entered into a confidentiality agreement with the issuer. In the context of a restructuring, offering or significant transaction, a company might want to limit dissemination of the information through a confidentiality agreement.

Whatever the context, many institutional investors require that any confidentiality agreement – written or oral – must be reviewed by internal counsel. The viability of the misappropriation theory makes it important for such investors to add the issuer to a Restricted List for at least as long as the relevant information remains material and nonpublic.

Third, investment staff must assess whether a person who is a source of information is breaching a duty in communicating the information to them. The standard for tipper/tippee liability is particularly important for buy-side investors. This standard segregates legitimate research contacts from improper communications of sensitive corporate information.

The Dirks standard for tipper/tippee liability was set in an SEC proceeding targeting a securities analyst. The Supreme Court‟s Dirks decision mandated that in a tipping case, the government must demonstrate that: (a) the tipper “has breached his fiduciary duty to the shareholders by disclosing the information to the tippee;” (b) the tippee “knows or should know that there has been a breach;” and (c) some benefit inured to the tipper.10 The Dirks test was consciously calibrated to capture fraudulent communications without chilling legitimate research.

The allegations in Galleon detail a web of alleged improper communications from corporate insiders and advisors to public companies. The government has proceeded with other tipper/tippee cases involving fact patterns that have allowed the SEC to allege that the buy-side investor was on notice that the information was being communicated in breach of a clear duty. Examples include transactional information disclosed by junior law firm attorneys,11 takeover-related information from a former co-worker tasked with due diligence in the transaction12 and a corporate insider who tipped his brother, a mutual fund adviser, about adverse results in a Food and Drug Administration review of a key corporate product.13  

Using the Dirks standard as a lodestar, analysts should be alert to avoid contact with research sources who are not authorized to share information with investors. For example, communications with bankers, lawyers, accountants and other advisors in contexts in which it is clear that the communications were not directed by their clients are potentially problematic. Contacts with designated spokespersons are less so. Since many questions fall between these poles, it underscores the importance of addressing this question, in particular, when there is any concern that the investment staff has received material, nonpublic information.

Fourth, buy-side investors need to communicate these risks to all staff who have access to market-sensitive information. In the normal course, it is typical for an institutional investor to focus its compliance efforts on investment staff. This limitation understates the universe of individuals who have access to (and the opportunity to misuse) material, nonpublic information.

The SEC‟s insider trading action against Chen Tang underscores that administrative staff can share in these risks.14 The SEC alleged that Tang directed trading and tipped off others as to information he garnered as Chief Financial Officer of a private equity fund (in addition to tips provided by his brother-in-law, himself the CFO of a venture fund). Through these sources, the SEC alleged that Tang and his tippees earned over $7 million in illegal profits. Tang resolved a parallel criminal investigation by agreeing to enter a guilty plea.15

There are many precedents for the case against Tang in the public company space. Indeed, the government recently announced proceedings against a Disney Corporation employee who contacted multiple hedge funds offering to sell nonpublic Disney earnings information.16 In the end, the conspirators succeeded only in supplying that information to undercover federal agents.

For institutional investors, these risks are most pronounced for investors (like the private equity fund that employed Tang) that routinely receive material information about portfolio companies. While the individuals pay most directly for reckless decisions, they invite regulatory and press attention that no institutional investor needs.

Finally, investors should anticipate that the SEC will continue to export insider trading principles to new markets. Earlier this year, significant attention was paid to the SEC‟s loss on the merits in SEC v. Rorech,17 its first case alleging insider trading in credit default swaps (“CDSs”). Significantly less attention was paid to the longer term implications of the court‟s ruling that the SEC had the jurisdictional authority to bring this case.

A CDS is a contract that allocates risk. Typically, a CDS buyer agrees to make fixed periodic payments to the CDS seller; the CDS seller promises to make a fixed payment (the notional amount) if a specified event occurs with respect to specified securities (e.g., an issuer files for bankruptcy). In Rorech, the SEC alleged that a broker-dealer‟s salesman tipped material information about a pending VNU N.V. bond offering to a hedge fund portfolio manager. The trading involved CDSs referencing VNU debt. In a detailed opinion after a trial on the merits, the court dismissed the SEC‟s complaint, concluding that the record surrounding these transactions demonstrated that the tipper neither breached a duty nor was aware of material information at the pivotal times highlighted in the SEC‟s complaint.18

One threshold defense advanced by the defendants in Rorech was that the SEC lacked jurisdiction to bring a case alleging insider trading in these CDS contracts. In the 2000 Commodity Futures Modernization Act, Congress amended Section 10(b) of the Exchange Act to extend its restrictions to the purchase or sale of any “securities-based swap agreement.” The defendants argued that “because the price of the CDSs [was] stated in basis points and does not explicitly refer to the price or value of any security,” the court should conclude that the CDSs were not based on any particular security.19

The Rorech court rejected that argument. The court concluded that “the fact that Congress extended section 10(b) and Rule 10b-5‟s anti-fraud rules to „security-based swap agreement[s]‟ and not other „swap agreement[s]‟ that clearly are not based on securities, appears to bring CDSs like those in this case into the heartland of the swap agreements Congress intended to govern under section 10(b) and Rule 10b-5.”20 Viewing the evidence in this case, the court ruled that the material terms of the VNU CDS contracts were based on the price, yield, value or volatility of VNU‟s securities.21 These were, the court ruled, securities-based swap agreements subject to the SEC‟s jurisdiction.

For other institutional investors, the ruling on this technical point may be as important as the court‟s evaluation of the merits of the SEC‟s case. While the vast majority of SEC and criminal insider trading cases focus on trading in equity securities, the government has extended these principles to the market for corporate bonds and government debt.22 Rorech establishes the Commission‟s authority to pursue insider trading claims in trading involving comparable CDS contracts. These actions pose a particular challenge because they are rare; investment staffs may not be lulled into underestimating the insider trading risks associated with these markets.

In 2000, the SEC‟s release adopting Reg. FD emphasized that the rule‟s adoption had been calibrated to foster and protect fundamental investment research. The Commission stressed that “[a]nalysts can provide a valuable service in sifting through and extracting information that would not be significant to the ordinary investor to reach material conclusions.”23 The new rules “will not be implicated where an issuer discloses immaterial information whose significance is discerned by the analyst.”24

The current spate of buy-side insider trading cases, and the Commission‟s direction of resources to develop comparable cases in the future, should not have the effect of limiting fundamental research. At the same time, however, these developments heighten the probability that investors who have engaged in legitimate research nonetheless may have their trading scrutinized because it coincides with a material event involving a portfolio company. These trends make it likely that investors will continue to confront the most universal question of insider trading regulation – how to foster and benefit from good research while minimizing the risk of scrutiny or liability for insider trading violations.