July | August 2014 Insider Trading Developments The implications of recent SEC actions affect fund managers SCHULTE ROTH & ZABEL LLP, INSIDER TRADING 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 hedge 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 hedge fund 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 stocks 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 stock, 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.