The Wall Street Journal recently reported on an SEC investigation of several hedge funds. The hedge funds traded on material nonpublic information concerning a change in Medicare reimbursement rates. Over a period of approximately one hour, an employee of the House Ways and Means Committee communicated information to a law firm lobbyist, who relayed the information to a political intelligence firm, who emailed the information to its clients including the hedge funds. The hedge funds bought shares in several large insurance firms before the close of trading. The stock of the insurance firms rose as much as 6% immediately prior to market close. These facts raise the question: Did any of these tippers or tippees violate the securities laws?
There is no specific federal law which prohibits trading while in possession of material nonpublic information. Prosecutors and civil plaintiffs use the antifraud provisions of the federal securities laws in such cases. Consequently, there is no liability unless the trading based on material nonpublic information amounts to fraud.
The leading Supreme Court case involved an employee of a printing firm who purchased shares based on information in the documents he was printing. The Supreme Court reversed a conviction and held that “liability is premised upon a duty to disclose arising from a relationship of trust and confidence between the parties to a transaction.” Since the printer had no such relationship with the shareholders of the public company, the printer did not commit criminal securities fraud.
What if the tipper does have such a duty. When does the tippee “inherit” such duty? The Supreme Court reviewed this issue in a case involving a consultant to a public company who told a broker that the public company may be committing fraud. The broker traded on the information. The Supreme Court stated that the antifraud provisions do not require equal information among all traders. A tippee inherits the tipper’s liability only when the tippee knows or should know that the tipper has breached a fiduciary duty to the shareholders of the affected company.
The question then becomes, what constitutes a breach by the tipper? The Supreme Court has also answered this question. A breach occurs if “the insider / tipper personally will benefit, directly or indirectly, from the disclosure; personal gain can be a pecuniary gain or a reputational benefit that will translate into future earnings.” The personal gain can also be the communication of confidential information to a relative or friend so that “the tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient.”
The bottom line is that a tipper and tippee do not violate the securities laws without the existence of fraud. Fraud arises from the tipper’s breach of a duty. That breach must involve the tipper acting for personal benefit. On the tippee’s side, a tippee is not liable for trading on material nonpublic information unless the tippee knew (or in some courts, should have known) that the tipper breached a duty in disclosing the information.
Based on the current state of the law, prosecutors and civil plaintiffs have a difficult burden of proof if the claim is against a third-tier or fourth-tier tippee with little knowledge of how the information passed down the chain. And depending on the relationship of the tipper to the company affected by the information, any such claims must prove that the tippee knew or had reason to know that the tipper disclosed the information for the personal benefit of the tipper.