Audit, Compliance and Risk Blog

Although the federal Securities Acts do not expressly outlaw stock trading that exploits preferential access to “insider” information, the Securities and Exchange Commission (SEC) and courts have applied general language in those Acts to cover these situations. A very recent decision by the federal Court of Appeals for the Second Circuit marks the latest such expansion, in a case holding the “tippee” of insider information liable for profits he helped third parties create by trading on that information (SEC v. Contorinis).

Established Insider Trading Prohibitions and Consequences

The 1934 Act’s Section 10(b) prohibits use of any “manipulative or deception device or contrivance” in violation of an SEC rule, in any transaction involving securities registered with SEC.

SEC’s Rule 10b-5 applies that prohibition generally to people who “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.” More specifically, SEC Rule 10b5-1 prohibits:

“the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, 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 material nonpublic information.”

Many insiders will owe a duty “directly” to the company, and this rule extends potential liability to “tippees” who receive information from insides, and thereby owe a duty “indirectly” to the company. Applications of Rule 10b5-1 focus on whether the tippee has material non-public information, gained through a breach of duty, trust, or confidence by the insider “tipper.”

Established case law confirms that tippers and tippees can be liable for violations of these rules, and thereby of Section 10(b) as well. Violations can trigger criminal charges, for conspiracy to violate the Securities Acts and/or to commit fraud. Violations can also be punished by civil penalties up to the greater of up to three times the profit from a trade, and/or debarment from acting as an officer or director of a public company. Finally, a court can order disgorgement of profits—courts order disgorgement as an equitable remedy intended to eliminate the violator’s unjust enrichment, independent of civil penalties.

The Contorinis Decision Expands Tippee Liability

Joseph Contorinis’ case extends potential liability for tippees, to explicitly include liability for profits made by the people they tip, passing along information originally received from an insider. Here’s a summary of the case:

Joseph Contorinis was one of two co-portfolio managesr of the Jeffries Paragon Fund (“Fund”), which invested in companies in the retail and personal products sectors. Cantorinis and his co-manager made investment decisions but did not control disbursements of profits. Sometime in 2000, he met and befriended Nicos Stephanou, who became an investment banker in the Mergers and Acquisitions (M&A) group at UBS in 2002. Thereafter, they spoke on the telephone often, sometimes as much as 75 times a month. Stephanou regularly provided confidential information to several friends, including Contorinis. Contorinis caused his Fund to purchase and sell securities based on these tips.

SEC subsequently prosecuted Stephanout and another M&A professional for insider trading, along with Contorinis and 4 other “tippees.” In the criminal case, Contorinis was convicted after trial of conspiracy to commit securities fraud and insider trading, and sentenced to six years imprisonment. The district court also ordered him to pay $12.65 million in criminal forfeiture penalties – which included profits made and losses avoided by the Fund, which Contorinis never pocketed himself. On appeal, the Second Circuit upheld the conviction, but after lengthy analysis of the legal theories behind criminal and civil forfeiture, noted that criminal forfeiture is a punitive act, found it inappropriate to penalize him criminally for profits made by others (U.S. v. Contorinis (2012)). On remand, the district judge reduced his forfeiture to $427,000 in linked compensation Contorinis received from the Fund as reward for those profits.

Separately, SEC also sought civil forfeiture for the Fund’s profits. The district court ordered him to “disgorge” $7.2 million in profits actually made by the Fund, plus $2.4 million in pre-judgment interest on those profits. On appeal, the Second Circuit Court noted this as the first case ever to reach a Court of Appeals seeking “disgorgement” of profits made by someone other than a defendant tippee. The Court again analyzed the theories behind forfeiture, as it had previously done in the criminal case. This time, the Court found that the theory behind “civil disgorgement” is not punitive, but equitable. Under equity principles, a court has more discretion to look more broadly at appropriate remedies. In this case, the majority of judges noted that “tippees” might have various ways to benefit from illicit insider information—the most obvious is to trade on it themselves and pocket the profits, but providing pass-along tips to business or personal associates might serve the initial tippees’ broader goals just as well. Here, Contorinis caused the Fund that employed him to make the profitable trades, generating some direct compensation for himself, and the broader benefits of being seen as a successfully portfolio manager. Accordingly, the majority ruled that he had benefited, directly and indirectly, from the trades, and that it would be inequitable not to require “disgorgement” of those profits. The judges also noted that a contrary decision would provide a legal incentive for “tippees” to pass on insider information to third parties, with plans to avoid personal liability but secure other indirect benefits. The judges noted, but rejected, his argument that it’s impossible to “disgorge” something one has not personally “swallowed,” and ordered him to forfeit the $9.6 million.

As noted, this decision is the first to address “tippee” liability for insider information they pass to third parties. If it stands up, it will establish a new benchmark for liability, allowing SEC to cast wider nets for suspicious trades, and to seek to trace back more convoluted chains of tipping.

Self-Assessment Checklist

Am I an “insider” with access to information that might be “material” to investment decisions in my organization’s securities (if it is publicly traded), or in securities of the organization’s clients or other business associates (if any of them are publicly traded), if made public (referred to as “material nonpublic information")?

• Am I an officer, director, or the beneficial owner of more than 10% of shares in a public company (if so, the Securities Acts define me as an insider)?

• In the course of my duties with the organization, am I privy to material non-public information?

Do I know when material non-public information has been disclosed publicly by the organization or some other party, so it ceases to be “non-public”?

Am I careful not to make trades in securities at times when I know material non-public information, except under circumstances SEC allows (such as under a pre-filed plan for periodic trading to rebalance investments)?

Am I careful not to provide material non-public information to parties outside the organization (so as not to become a “tipper”)?

If I do provide material non-public information to an outside party, am I careful to ensure that they recognize the information as such, and do not trade on it themselves or pass the information on to others?

If I receive information that may qualify as material non-public information, am I careful not to trade on it myself, or to disclose it to others?

Where Can I Go For More Information?

• SEC v. Contorinis decision (disgorgement decision 2/18/14; 2nd Circuit website) 

• US v. Contorinis (criminal case 8/17/12; 2nd Circuit website) 

Specialty Technical Publishers (STP) provides a variety of single-law and multi-law services, intended to facilitate clients’ understanding of and compliance with requirements. These include:

• Securities Law: A Guide to the 1933 and 1934 Acts and their Amendments, including Sarbanes-Oxley and Dodd-Frank

• SEC Disclosures Checklists Including Financial Statement, MD&A, and Sarbanes-Oxley Checklists

• Directors' and Officers' Liability

About the Author

Jon Elliott is President of Touchstone Environmental and has been a major contributor to STP’s product range for over 25 years. He was involved in developing 16 existing products,including The Complete Guide to Environmental Law and Securities Law.

photo credit: Hen3k Hen3k via photopin cc