July | August 2014

Insider Trading Developments The implications of recent SEC actions affect fund managers SCHULTE ROTH & ZABEL LLP, NEWSLETTER 2014

he US Securities and Exchange • Trading based on non-public information 2013 conviction of Michael Steinberg, a Commission and Department of from governmental sources is under former portfolio manager at SAC Capital T Justice are continuing to investigate investigators’ scrutiny. Advisors, whom the government likewise has and prosecute insider trading cases at a rate prosecuted under the theory that it need not not seen in a generation or more, and even Though such developments are the focus prove the defendant knew the insider received the New York State Attorney General has of this article, that should not be taken to a personal benefit in exchange for disclosing become involved in the area. The popular suggest that the more widely discussed topics the inside information.1 and legal press have focused attention on mentioned above are in any way trivial. The the prominence of some of the targets, the government’s wide-ranging, aggressive and Unregistered securities and Cayman increasingly disparate success rates of the largely successful prosecutions of well-known companies Manhattan US Attorney’s Office and the fund complexes, including Galleon Earlier this year, the Second Circuit ruled that SEC, and the anticipated ruling from the US Management personnel and associates, the duties that make insider trading illegal Court of Appeals for the Second Circuit on the demonstrate that the government is willing under US law apply to trading in unregistered question of what must be proven regarding and able to take on some of the most securities, including securities of companies the knowledge of a remote tippee. But several prominent and well-heeled members of the organized in the Cayman Islands or other other developments may carry greater practical financial community, much as it did in the jurisdictions that do not expressly require significance for most managers days of Drexel Burnham & Lambert and Ivan disclosure of the information relevant to the and other members of the financial services Boesky more than 25 years ago. The SEC’s alleged insider trading. The court explained industry. Those developments highlight the spate of recent trial defeats (see, e.g., SEC v. that the United States’ federal common law, potential for insider trading prohibitions and Cuban; SEC v. Moshayedi; SEC v. Obus; SEC v. rather than the law of the country where the remedies to extend beyond where one might Schvacho) and partial defeats (see, e.g., SEC securities’ issuer is organized, determines normally expect, which, in turn, could affect v. Jacobs (jury rejected Rule 10b-5 charges whether such trading is illegal. portfolio managers, investment management but found against defendants on Rule 14e- compliance officers and other industry 3 (tender offer fraud) charges); SEC v. Life In Steginsky v. Xcelera Inc., 741 F.3d 365 (2d personnel in ways not necessarily anticipated. Partners Holdings (jury rejected insider trading Cir. Jan. 27, 2014), the plaintiff sold her shares charges but found against defendants on in Xcelera Inc. pursuant to a tender offer In particular, recent insider trading-related accounting fraud charges); SEC v. Siming Yang made by an acquisition vehicle controlled by rulings, prosecutions and regulatory initiatives (jury rejected insider trading charges but found Xcelera’s officers several years after the SEC have clarified that: against defendant on related front-running and had revoked the registration of the Cayman Schedule 13(d) charges)) shows that one need Islands company’s securities for its failure • Insider trading laws apply to unregistered not roll over when the SEC threatens to bring to make its required periodic filings. No securities and Cayman Islands companies a claim. But the Southern District of New York information regarding the company’s financial under federal common law; US Attorney’s Office’s reported 81-1 record in condition was disclosed in connection with • Portfolio managers can be held responsible prosecuting insider trading cases since 2009 the tender offer. The plaintiff later sued the for allegedly illicit profits that they personally should prevent any illusions about a criminal buyers for insider trading under Section 10(b) did not receive or directly cause; defendant’s odds of beating insider trading of the Securities Exchange Act of 1934 and • Accounts may be frozen based on mere charges (Rengan Rajaratnam’s recent streak- SEC Rule 10b-5. The district court dismissed suspicions of insider trading arising from breaking victory notwithstanding). the complaint, ruling that the defendants had transactions that closely preceded public no duty to disclose any information before announcements; Finally, the Second Circuit’s forthcoming purchasing the plaintiff’s securities because, • Lawfully using one’s diligence or wherewithal decision on the appeal of the convictions the court said, the duty to disclose did not to obtain non-confidential information upon of Todd Newman and Anthony Chiasson is apply to unregistered securities and was which to make time-sensitive trades may no expected to answer the question of whether defined by Cayman Islands law, which, the longer be acceptable in some circumstances; the government must prove that a criminal court said, imposed no such duty. The Second • Lawfully disclosed information can lead to tippee defendant knew the initial tipper Circuit reversed. The court held, first, that insider trading prosecutions against the stood to gain a benefit from disclosing the “unregistered securities are not immune from recipient if there is any room for dispute material non-public information on which the duty to disclose.” The court then held that about whether the information was obtained the defendant ultimately traded. That federal common law, rather than Cayman under an agreement not to trade; and decision could also impact the December Islands law, determined the disclosure duty.

1 July | August 2014

That federal common law, the appeals court The manager, Joseph Contorinis, was found the public announcement of a proposed explained, requires that any insider possessing to have used inside information he learned acquisition of H.J. Heinz Company, based material non-public information must either from an employee of an investment bank on the fact that call options had been disclose such information or abstain from regarding a pending merger to place trades purchased in the account the day before the trading (or recommending) the securities so on behalf of a hedge fund for which Contorinis announcement (SEC v. Certain Unknown long as the information remains undisclosed. was a co-manager. The fund realized profits Traders in the Securities of H.J. Heinz Co., No. of $7,304,738 as a result of the trades. He 13-cv-1080 (S.D.N.Y.)); The ruling serves as an important reminder was ultimately convicted of insider trading • $38 million-worth of Hong Kong and that all firms’ insider trading policies should and sentenced to six years in prison, and the Singapore-based trading accounts of a extend beyond just the paradigmatic situation SEC then obtained a civil judgment against Hong Kong company and initially unknown involving publicly traded and options, him as well. Though the Second Circuit had persons and entities less than four days after and it is especially relevant to venture capital, earlier ruled that his criminal sentence could the public announcement of a proposed private equity and activist funds and managers not require him to forfeit the amount of the acquisition of Nexen Inc., based in part on the who often have access to inside information hedge fund’s profit, this past February the fact that Nexen shares had been purchased regarding their portfolio companies by virtue court held that Contorinis could be ordered to in the accounts during the week before the of board seats, management positions or pay disgorgement of that amount in the SEC’s announcement (SEC v. Well Advantage Ltd., otherwise. When selling their stakes (or civil case. The majority reasoned that because No. 12-cv-05786 (S.D.N.Y.)); and portions thereof) in private companies, such prior cases had established that a tipper could • A $6 million US-based trading account of a funds and managers must be careful to ensure be ordered to disgorge insider trading profits Thai national less than a week after the public that they disclose all material non-public earned by a tippee, the same should be true for announcement of a proposed acquisition of information in their possession, or risk later a defendant who, instead of passing the inside Smithfield Foods, based largely on the fact being sued by the buyer for insider trading information on to a third-party tippee, places that Smithfield , options and futures had (though the court did not address to what the trade directly in the third party’s (e.g., the been purchased in the account during the extent the parties to a private transaction hedge fund’s) account. week before the announcement (SEC v. Badin can contract out of (such as via “big boy” Rungruangnavarat, Case No. 13-cv-04172 (E.D. provisions) the disclosure duty imposed The case demonstrates that the government Ill.)). by federal common law). The ruling also can hold portfolio managers liable for millions highlights that, regardless of how permissive of dollars of insider trading profits that the In each of those cases, the SEC has gone on to other countries’ laws or customs may be with portfolio managers never received personally. obtain multi-million-dollar consent judgments respect to the sharing and use of material The result is similar to last year’s ruling by a for disgorgement and civil penalties against non-public information, the United States’ unanimous panel of the Third Circuit, which the account holders (who could not access prohibitions will apply to any trading that held that, when determining a convicted the assets in their accounts while the cases touches it. insider trading tipper’s sentencing range remained pending). Further, insofar as those under the US Sentencing Guidelines, courts cases all involve foreign accounts and/or Disgorging insider trading profits are to consider the combined illicit gains of all traders, they demonstrate that the SEC is In SEC v. Contorinis, 743 F.3d 296 (2d Cir. Feb. the traders to whom the defendant provided taking a broad view of its jurisdictional reach 18, 2014), a divided Second Circuit panel held material non-public information. US v. Kluger, (in addition to an aggressive view of its right to that a hedge fund manager could be held 722 F.3d 549 (3d Cir. July 9, 2013). provisional remedies). liable for disgorgement of the illicit profits earned by the fund for which he placed SEC freezing suspected accounts The SEC’s willingness and ability to seek and illegal insider trades even if the manager did Information regarding trading patterns gleaned obtain preliminary asset freezes extends not make any trades for his own account or through automated reviews of trading data even to cases where the ultimate outcome otherwise directly profit from the trading. (The has led to an increasing tendency of the SEC on the merits is far from certain. In one case, manager in the case did receive $427,875 of essentially to “shoot first and ask questions in fact, a court ruled (four months after the linked compensation from the trades, which he later” by seeking and obtaining court-ordered asset freeze, involving what the SEC alleged previously had been ordered to forfeit as part asset freezes of accounts — wherever located were Canary Islands and Lebanon traders or of his criminal conviction and was not a subject — of individuals and entities believed to have accounts, was put in place) that the SEC’s of the appeal.) The court further held that the engaged in insider trading. For example, during complaint failed to satisfy basic pleading manager could be ordered to pay prejudgment the past two years, the SEC has sought and standards. Specifically, in SEC v. One or More interest on the disgorgement amount even obtained court orders freezing: Unknown Traders in the Securities of Onyx though he did not actually have use of the ill- Pharmaceuticals, Inc., No. 13 Civ. 4645 (S.D.N.Y. gotten gains during the prejudgment period (or • A multi-million-dollar Swiss-based trading Nov. 21, 2013), the court dismissed the SEC’s any period). account of a Brazilian national the day after complaint, reasoning that trading history alone

2 July | August 2014

was insufficient to support an insider trading pressure for holders of frozen accounts to everyone understood that one of the main claim in the absence of evidence of a breach of consent to judgments. In any case, the SEC’s purposes of the information was to inform fiduciary duty, tipping of material non-public practice of seeking asset freezes serves as a trading decisions. By proceeding under authority information, a tipper or a tippee. Even that caution flag for the consequences that can conferred by New York’s Martin Act, however, court, however, maintained the asset freeze it potentially (and immediately) flow from the Attorney General appears to be seeking to had earlier imposed (albeit in a more limited trading in advance of merger announcements, push the law toward eliminating trading based form) while the SEC considered whether to whether or not such trading was well informed on unequal access to information rather than amend the complaint, and while the parties or merely coincidental, and regardless of the just trading on information disclosed in breach litigated the defendants’ motion to dismiss locales in which the trading proceeds are held of a fiduciary or contractual duty. that amended complaint. (A ruling on that and the traders and issuers are located. motion is pending.) Thus, based on the new policies, anyone ‘Insider Trading 2.0’ expanding obtaining and trading on selective, early or, Meanwhile, another court granted summary definitions potentially, otherwise unequal information judgment to several defendants a year and Perhaps the most interesting set of insider going forward would run the risk of an insider a half after having frozen their assets in trading-related developments in the past year trading prosecution, both because of the New response to a request the SEC had made less or so do not actually involve insider trading, York prosecutor’s expanded view of the law and than a month after the public announcement as defined by federal law, at all. Largely in because any disclosure (or early disclosure) or use of a merger involving a Chinese company response to a push by the New York State of information subject to one of the agreements whose stock the defendants (all of whom Attorney General dubbed “Insider Trading 2.0,” with the Attorney General would now potentially were Chinese persons or entities) had financial media organizations and others who constitute misappropriation of the information. purchased in US accounts just days before the often have information or opinions capable of Put another way, violating an agreement with, announcement (SEC v. All Know Holdings Ltd., swaying securities prices have been agreeing say, PR Newswire to not engage in high-frequency No. 11-cv-08605 (N.D. Ill. June 11, 2013)). The to cease providing selective or staggered trading with information from its data feed would court found that the SEC could not sustain its disclosure of such information and views. not necessarily be just a breach of contract; it allegations in the absence of evidence of any could potentially be a crime. tipper. (The SEC reached settlements with three Last July, Thomson Reuters agreed to stop other defendants.) selling to priority subscribers early access to the Lawful disclosures can lead to University of Michigan’s consumer confidence prosecutions Similarly, in another case (which involved survey. On 25 February of this year, the Attorney The SEC is making clear that it does not view trading in the stock of a Chinese company General announced that he had reached insider trading as limited to situations involving by Chinese nationals and a BVI entity in US agreements under which 18 of the country’s surreptitious tips from rogue employees or accounts), the SEC obtained an asset freeze in largest broker-dealers promised to no longer agents. To the contrary, it has brought a number April 2012, but stipulated in August 2012 to the respond to certain surveys from buy-side firms of cases under a misappropriation theory dismissal with prejudice of three defendants seeking analyst sentiment. And on April 29 of this against persons who were openly and properly and suffered an adverse verdict in January 2014 year, PR Newswire followed the earlier leads of given material non-public information by fully on insider trading charges against two other Business Wire and Marketwired by agreeing with authorized personnel who were soliciting defendants (though it did secure a favourable the Attorney General to require its subscribers investments from the recipients, but under verdict on front-running and reporting charges to certify that they would not engage in high- agreements — or alleged agreements — to against one of those defendants). SEC v. Siming frequency trading with information they receive keep the information confidential and not to Yang, No. 12-cv-02473 (N.D. Ill.). (The SEC via that outlet’s direct data feed. Meanwhile, the trade on it. reached a December 2013 settlement with Attorney General has said he is also investigating another defendant.) the traders who obtain and use such selective or For example, in SEC v. Massoud, No. 13-cv- early information. 01691 (D. Conn.), the SEC charged the managing It remains to be seen whether the Onyx, member of an investment group with insider All Know Holdings, and/or Yang results will None of the information that is the subject of trading based on information the investment stem the SEC’s burgeoning tactic in this area those agreements, or any trading based on it, group allegedly learned under a confidentiality (either by causing the SEC to use it more would appear to have been covered by existing agreement that it had entered into upon joining judiciously or by causing courts to view it federal insider trading law, as the disclosure of the bidding process for the issuer. He settled more skeptically), or whether the SEC (and the the information did not breach any duties to the charges by paying nearly $1.5 million in courts) will instead view occasional setbacks securities issuers, or anyone else, and neither disgorgement and penalties. Likewise, in SEC v. as a small price to pay for the benefits of the disclosure nor the use of the information Langston, No. 13-cv-24360 (S.D. Fla.), the SEC securing potential illicit profits before they are was prohibited by the original (or intermediate) charged an investor with insider trading ahead dissipated and of creating greater economic sources of the information. To the contrary, of the public announcement of a secondary

3 July | August 2014

offering based on information he learned reportedly informed a lobbyist of a change from a placement agent for the offering after in Medicare reimbursement rates before allegedly agreeing to keep the information the official announcement of the change. “Based on the new confidential and not trade on it. He agreed The lobbyist then reportedly emailed the to pay nearly $400,000 to resolve the charges information to a brokerage firm, which then policies, anyone (which alleged that he had made just under issued an alert to clients, and the share prices $200,000 on the trading). of companies that were positively obtaining and trading affected by the change promptly rose. By on selective, early or, Of course, the most prominent insider trading early May of this year, the staff director and case involving undisputedly lawfully disclosed the committee itself had each received SEC potentially, otherwise information was the SEC’s recent prosecution subpoenas regarding the matter, and the of Dallas Mavericks owner, Mark Cuban. He staff director had also received a grand jury unequal information sold shares he held in Mamma.com after subpoena. The committee and staff director having been told by its CEO that it would objected to the SEC subpoenas, and in June the going forward would be making a PIPE offering. The CEO and SEC SEC sued to compel responses. Regardless of run the risk of an insider claimed that Cuban had agreed to keep the how that particular dispute turns out, it is clear information confidential and not trade on it, that the government is monitoring trading in trading prosecution.” but Cuban denied having so agreed. Though advance of not only corporate announcements last fall’s well-publicized jury verdict in Cuban’s but also government announcements, and favour exonerated him with respect to that that portfolio managers and traders need to dispute, the case is nevertheless a cautionary be mindful of whether information relevant to tale of the dangers of trading even on lawfully their trading decisions may have been provided, disclosed material non-public information: directly or indirectly, in breach of a government Cuban spent five years and millions of dollars employee’s duty to the government or its litigating with the SEC over a trade on which citizens. THFJ he allegedly avoided losses of just $750,000. Thus, the case is a reminder that the SEC is not shy about pursuing non-classic insider trading FOOTNOTES cases under a misappropriation theory, or about doing so even where the evidence of any 1. Schulte Roth & Zabel’s representations confidentiality agreement or agreement not to include, in some cases, matters discussed trade is disputed. in Insider Trading Developments or other firm publications. The information discussed The government is investigating herein is limited to material contained in the disclosure and use of political the public record, and nothing herein is intelligence intended to constitute an endorsement of Although no charges have been brought yet the positions taken by any court, agency or under the Stop Trading on Congressional legislator, or other public or private person Knowledge (STOCK) Act during the two-plus or entity, or to suggest that any pleading or years since it became law, both the SEC and opinion accurately reflects the facts or the the DOJ are actively pursuing at least one correct state of the law. investigation into potential violations of its provisions, which specify that lawmakers and other federal employees have “a duty arising from a relationship of trust and confidence” ABOUT THE ARTICLE to Congress, the federal government, and US citizens, and expressly prohibit congressional members, staffers and other federal employees This is a publication of SRZ’s Litigation Group. To from using information gained from their view their complete summary of recent insider positions for personal benefit. That investigation trading actions by the SEC, DOJ and others, visit: stems from an incident in April 2013 in which tinyurl.com/Recent-Insider-Trading-Actions the staff director of the House Ways and Means Committee’s Subcommittee on Health

4