Greater clarity on Prohibited Insider Trading in the United States?
Canadian securities legislation explicitly prohibits trading by insiders who possess material non-public information (MNPI). However, notwithstanding the significantly more effective enforcement efforts of American enforcement agencies relating to insider trading, prohibitions in the United States are principally grounded in judge-made law. Is that about to change?
The U.S. House of Representatives recently approved a bill titled the Insider Trading Prohibition Act (the Bill) by a vote of 410-13. The Bill, introduced by Connecticut Democrat Jim Himes, would prohibit a person from buying or selling securities “while in possession of material, nonpublic information [...] if such person knows, or recklessly disregards, that such information has been obtained wrongfully.”
A significant and potentially welcome development
As stated, there is currently no express statutory prohibition against insider trading under U.S. federal securities laws, forcing the U.S. Securities and Exchange Commission (the SEC) and Department of Justice to rely on more general anti-fraud statutes and decades of case law, subject to interpretation by individual judges. U.S. prosecutors generally seek insider trading convictions under SEC Rule 10b-5, an anti-fraud rule codified pursuant to the SEC’s authority granted under Section 10(b) of the Securities Exchange Act of 1934 (the Exchange Act). Generally speaking, Rule 10b-5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security. Despite making no reference to “insider trading”, American courts have construed Section 10(b) and Rule 10b-5 as prohibiting the trade of a security on the basis of MNPI about that security, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the MNPI.
However, the absence of any statute specifically prohibiting insider trading or defining the meaning of that term has led to inconsistent interpretation and application by regulators and courts, thus making it difficult for market participants to understand how to conform their conduct to the law. The Bill seeks to codify and clarify the overarching principles prohibiting insider trading that have been set forth by courts, while eliminating the ambiguities that have existed in the case-by-case evolution of the law in this area.
If passed by the Senate, the Bill would amend the Exchange Act by adding a new section which:
- makes it unlawful for a person to trade while aware of MNPI that has, or would reasonably be expected to have, a material effect on the market price of the security, if that person knows, or recklessly disregards, that the information was obtained wrongfully, or that making a trade would constitute a wrongful use of that MNPI; and
- prohibits those with wrongfully-obtained MNPI that has, or would reasonably be expected to have, a material effect on the market price of the security, from passing along that information to others, or “tipping” them, if it is reasonably foreseeable that the recipient of the MNPI will trade on that information or pass it along to others who will.
Key to the operation of these prohibitions is the basis for determining whether or not the MNPI was wrongfully obtained. The Bill provides that MNPI is wrongfully obtained only where it was obtained as a result of:
- theft, bribery, misrepresentation, or espionage;
- a violation of federal statutes protecting computer data;
- conversion, misappropriation, or other deceptive taking; or
- a breach of fiduciary duty, contract, code of conduct or ethics policy, or a breach of any other personal or other relationship of trust and confidence for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or a gift of confidential information to a trading relative or friend).
The Bill, if passed by the Senate and signed into law by the President, would offer U.S. courts and regulators significant assistance in prosecuting insider trading violations through its codification of an insider trading prohibition, and its significant reduction of the relevance of establishing a “personal benefit” resulting from a tip in the context of prosecuting tipping where other wrongful conduct can be established. U.S. courts have struggled in recent years with the question of whether a tipper must receive some personal benefit as a result of its communication of MNPI to a tippee to result in a violation of Rule 10b-5. The Second Circuit held in United States v. Newman (which we have previously discussed here and here) that where a tipper provides a tip but does not receive some personal benefit of a financial or similarly valuable nature in return from the tippee, the tipper has not engaged in conduct that violates the anti-fraud provisions of Rule 10b-5. While the decision in Newman initially frustrated U.S. prosecutors’ abilities to secure convictions in tipping offences, U.S. courts have since held that a personal benefit, though required, need not be financial or even tangible (see e.g., Gupta v. United States and Salman v. United States [PDF]). The Bill does not impose any requirement for a personal benefit of the tipper under the new tipping prohibition except in the limited context of establishing an alternative criteria to theft, breach of fiduciary duty and other wrongful conduct as a basis for establishing that MNPI has been wrongfully obtained. In doing so, the Bill more closely aligns with Canadian securities laws under which there is no personal benefit requirement for a finding of tipping.
Furthermore, in Newman, the Second Circuit held that in order to establish a violation of Rule 10b-5 prosecutors must prove that a person who trades on a tip “knew that an insider disclosed confidential information and that they did so in exchange for a personal benefit.” The Bill explicitly reverses this position and specifically provides that knowledge of a personal benefit is not required to prove a violation “so long as the person trading […] was aware, consciously avoided being aware, or recklessly disregarded that such information was wrongfully obtained”.
Further, the Bill does not require that the person trading on wrongful information, or making communication of wrongful information, knows the specific means by which the MNPI was obtained or communicated, so long as the person trading the securities in question, or tipping, was aware or “consciously avoided being aware” of the fact that the information was wrongfully obtained.
Comparison to the Canadian insider trading laws
Canadian securities laws create offenses for trading and tipping that are not based on whether the MNPI was wrongfully obtained. In provinces other than Quebec, the test that is applied is whether an alleged wrongdoer is in a “special relationship” with a reporting issuer. For example, the Ontario Securities Act prohibits persons or companies who are in a “special relationship” with an issuer and who have knowledge of MNPI related to the issuer, from trading (or encouraging others to trade) in securities of the issuer or disclosing that information to others except for disclosure made “in the necessary course of business”. The Ontario Securities Act further provides that a person or company is in a special relationship with the issuer if (i) that person or company learns MNPI from any other “special relationship” person (including directors, officers and employees of the issuer, as well as “tippees” who are in turn themselves considered “special relationship” persons), and (ii) the person or company knows or ought reasonably to have known that the source of the information was a special relationship person. In other words, while Canadian securities laws prohibit trading or tipping on the basis of MNPI, for an offense to occur the individual must know, or ought reasonably to have known, that the MNPI was coming from a “special relationship” person. In Quebec, the situation is somewhat different, in that a person in possession of “privileged information” that has not been disclosed to the public and could affect the decision of a reasonable investor is generally not permitted to trade or tip, no matter what the source of that information may be.
The Bill and its overwhelming support in the House signals that insider trading and tipping remain very much a focal point for regulators and prosecutors south of the border. The Bill would not resolve all of the uncertainty surrounding insider trading and tipping prosecutions in the United States, particularly as controversy is likely to continue over establishing the circumstances under which MNPI has been wrongfully obtained, especially in the context of an alleged breach of a “personal or other relationship of trust and confidence” for a “direct or indirect personal benefit”. However, any statutory codification of insider trading and tipping offenses under U.S. federal securities laws is likely to be a welcome development, lifting the United States out of its current position as the only major country in the world that does not expressly define its insider trading and tipping prohibitions by statute.
 A further distinction to be drawn is that Canadian securities laws do not require a tippee to have actually traded on the basis of MNPI in order for a violation of securities laws to be found; mere communication of the information is sufficient. In contrast, the Bill requires that a trade occurring as a result of a tip be “reasonably foreseeable”.