Insider trading issues are again dominating the headlines. Insider trading violations occur when an individual in possession of material non-public information (a “tipper”) relays that information for personal gain (or in violation of a duty) to another person (a “tippee”), who trades on the basis of that information. One issue that frequently arises in such cases is whether an individual who receives such a tip has the requisite “scienter,” or state of mind, to have committed a violation.
Supreme Court cases discussing securities fraud and insider trading have appeared to use inconsistent, indeed conflicting, standards of scienter. In the case of Ernst & Ernst v. Hochfelder, the Supreme Court expressly stated that negligence could not satisfy the scienter standard. However, in the case of Dirks v. SEC, the court indicated that scienter could be satisfied by establishing not only what a tippee actually knew, but also what he or she should have known—a standard that sounds very close to the standard for negligence.
In SEC v. Obus, the 2nd Circuit clarified that the varying scienter standards used in the misappropriation theory of insider trading are not inconsistent. Rather, the different standards apply to different aspects of the communication.
In Obus, the alleged tipper worked for General Electric Capital Corp. and was performing due diligence in connection with Allied Capital Corp.’s planned acquisition of SunSource, Inc., which GE Capital was financing. The Securities and Exchange Commission (SEC) alleged that the tipper disclosed the potential acquisition to a friend (the “first level tippee”), an analyst at an investment fund that already held a large position in SunSource. The first level tippee then allegedly told the information to his boss, the second level tippee, who then purchased 287,000 additional shares of SunSource.
In considering whether the government could establish scienter, the 2nd Circuit drew distinctions between (1) the manner in which the tipper disclosed the material non-public information to the tippee and (2) the tippee’s scienter in connection with trading upon the information.
The 2nd Circuit held that the prohibition on negligence in Hochfelder applied to the manner in which the disclosure was made. By way of example, the 2nd Circuit commented that if someone who has gained access to insider information were to disclose the information negligently—such as by mentioning the information on a cell phone without taking care to ensure that others are not within earshot—the tipper would not be held liable for insider trading violations for trades made by those who overheard the information. Instead, the tipper would be held liable only if she made the disclosure intentionally or recklessly.
A lower standard of scienter, however, applies to a tippee’s knowledge that the tipper breached a duty, either to his corporation’s shareholders or to his principal, by relaying confidential information. Thus, in Obus, the 2nd Circuit held that the SEC’s evidence was sufficient to enable a fact-finder to conclude that the first level tippee knew or should have known (i.e., was negligent in not knowing) that the information was conveyed as a result of the tipper’s breach of duty. The appeals court reached this conclusion, in part, because the first level tippee was a “sophisticated financial analyst.” The court also concluded that the SEC had presented enough evidence to support a finding that the second level tippee had received the inside information and either knew or should have known that it was tipped as a result of the tipper’s breach of duty.
Impact of the 2nd Circuit’s decision
The 2nd Circuit’s application of the scienter requirements of both Hochfelder and Dirks has lowered the bar for tippee liability. A tippee need no longer have actual knowledge of (or be reckless with respect to) the existence of the tipper’s duty, the breach of that duty or the confidentiality of the information to be liable of insider trading. Rather, the government need only show that a tippee should have known of these things, allowing courts to impose liability for something closer to negligence. As a result, a potential tippee must be far more cautious when trading on a tip of non-public information. If the tippee is not fairly certain that the source of the tip did not breach a fiduciary duty in conveying the information, the tippee now faces a greater risk of a government prosecution for trading the stock in question.