Hedge Fund Managers Didn't Know They Were Paying For Their Inside Information

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You're only guilty of criminal insider trading, in America,1 if:

  • you trade on information that is material and nonpublic, and
  • some other stuff.

The other stuff is mostly stuff that only a lawyer could love, but man do they love it. It consists most importantly of the rule that the person who gives you the material nonpublic information needs to have done so in breach of some duty to keep the information secret and in order to get some personal benefit for himself. If a stranger just wanders up to you and says "I'm the CEO of Smerbafife and it's a giant fraud, gotta go," and you trade on that: you're probably good.

This doesn't help very often, though, since the personal benefit for the tipper doesn't have to be an explicit bribe, or an explicit anything; just a desire to spice up your friendship with some material nonpublic information can qualify.2 (Also: usually there are bribes. You start with casual venting of frustrations and the next thing you know you're accepting bags of cash in parking lots.)

It might help Anthony Chiasson and Todd Newman though:

Level Global Investors LP co-founder Anthony Chiasson and former Diamondback Capital Management LLC portfolio manager Todd Newman, sentenced to prison for insider trading, can remain free while they fight their convictions, an appeals court ruled. ... Lawyers for both men today told a federal appeals court in New York that their clients should remain free because there is a “substantial question” of law to be decided in the case. Both fund managers said U.S. District Judge Richard Sullivan, who presided over their case, issued a ruling during the trial that made it easier for the government to prove culpability for insider trading.

The defense lawyers argued that two other federal judges in Manhattan have ruled differently than Sullivan in securities fraud cases, concluding that the recipient of a tip isn’t liable for insider trading unless he knew the person who provided the illegal information did so for a personal benefit.

The fact that the appeals court granted bail from the bench suggests that they take this argument pretty seriously. If they ultimately agree when they hear the appeal, then the jury in the Chiasson and Newman trial were instructed incorrectly about what the government needed to prove, which probably means that Chiasson and Newman would get a new trial, and a chance to prove that while they knew they were trading on inside information, they didn't know that the people who got them the inside information had paid the tippers for it. Or, like, had a friendship with the tipper that the tipper wanted to maintain, or whatever:

Their lawyers maintain that to be convicted of insider trading, Mr. Chiasson and Mr. Newman were required to know that the insiders — an employee at Dell and an employee at Nvidia — leaked the confidential information in exchange for a personal benefit. And because both were so far removed from the information, neither had any knowledge of whether the tippers provided the secret data to benefit themselves, they argued.

Well that would be helpful wouldn't it? We've talked before about the lengthy path that the inside information traveled in the Dell/Nvidia/Diamondback/Level Global/Fight Club/etc. insider trading investigation, and about how best practices for hedge fund managers who want to insider trade might involve setting up an impenetrable wall to keep out whatever inside information their analysts get. But best practices might actually be more like a semi-porous wall:

Imagine the comfort of knowing that you're trading on material nonpublic information, without the criminal liability of knowing that it was obtained in exchange for a personal benefit to the tipper! And this sort of semi-porous wall is much easier to set up than the impenetrable wall: instead of your analyst coming to you and saying "boss, I got a good feeling about Nvidia, don't ask me why," and you having to trust him, your analyst can come to you and say "I have material nonpublic information about Nvidia that I obtained from a company insider." All he has to do is not go on to say "also I bribed him." Pretty good, huh?

That's not quite right. Even the judges who agree with Chiasson and Newman's lawyers probably wouldn't endorse the semi-porous wall theory of insider trading in so many words:

In instructing the jury in United States v. Whitman, the Honorable Jed S. Rakoff concluded that the Government must prove that a tippee knew the company insider received some personal benefit in exchange for disclosing confidential information. But, Judge Rakoff clarified, the tippee need not know exactly what that benefit was, and the Government can satisfy its burden of proving knowledge of a personal benefit by showing that the tippee purposefully blinded himself to obtaining actual knowledge about this benefit.

So, a semi-porous wall would be problematic if it took the form of, like, a sign in the hedge fund manager's office saying "In Here We Don't Talk About What We've Done For Our Sources Of Inside Information." Still. If you were, say, running a hedge fund in which many independent analysts and portfolio managers did their own research, and you traded on it without keeping a close eye on exactly what they were doing, and what they were doing included a lot of insider trading, you might take yesterday's ruling as pretty good news.

Chiasson, Newman to Remain Free During Appeal, Court Says [Bloomberg]
Chiasson and Newman to Remain Free During Appeal, Court Rules [DealBook]

1.But not in England! Also not legal advice etc.

2.Here's a law firm memo on the topic. Relevant:

Under Dirks, the mere disclosure of material, nonpublic information by itself is insufficient to constitute a breach of an insider’s fiduciary duties. The purpose of the disclosure is determinative as to whether a breach has occurred. Because the policy underlying insider trading laws is rooted in stopping the use of inside information for personal gain, an insider does not run afoul of those laws or fiduciary duties to shareholders unless the insider receives a personal benefit. ...

“Personal benefit” has been defined expansively, requiring only minimal proof by the government. Proof that the tipper made a gift of information to a trading relative or friend has been found a sufficient benefit to the tipper. In Yun, evidence that the tipper and tippee were friends, worked together as realtors and split commissions on sales was sufficient for a jury reasonably to conclude that the tipper expected to benefit through maintaining a good relationship with the tippee. Similarly, in SEC v. Maio, the court accepted an inference of a personal benefit based solely on the close friendship between the tipper and the tippee, and the “hypothetical benefits” that may have been derived from it.

Related

Members Of Insider Trading "Club" Were Good At Obtaining Material Non-Public Information, Not So Good At Playing It Cool On Conversations Recorded By The Feds

Later this week, Anthony Chiasson, a Level Global co-founder, and Todd Newman, a former Diamondback portfolio manager, will go to trial in Federal Court for allegedly making $67 million in ill-gotten gains, based on inside information they obtained about Nvidia Corp and Dell Inc. According to U.S. Attorney Preet Bharara, Chiasson and Newman, who've both pleaded not guilty, were able to rack up all their profits by teaming up with a bunch of friends and forming an insider trading club, which is a lot like a book club or fight club in that they took roll, traded canapé duties, and drank Pinot Grigio, but different in that instead of discussing The Art Of Fielding or punching each other in the face, they spent every Monday night from 7 to 9 sharing material non-public information with each other. “This case describes a tight-knit circle of greed on the part of professionals willing to traffic in confidential information,” Bharara said when the charges were announced in January. “It was a circle of friends who essentially formed a criminal club, whose purpose was profit and whose members regularly bartered inside information.” In the beginning, when the club was first formed, there was a spirit of camaraderie, as the club members happily traded tips for everyone's mutual benefit. Unfortunately, things started to break down when some people agreed to cooperate with the government by recording their friends admitting wrongdoing, in exchange for leniency. Former Diamondback analyst Jesse Tortora, for instance, gave fellow club member Danny Kuo a call at the direction of the FBI on December 1, 2010, a conversation that Chiasson and Newman's lawyers are trying to use as evidence that Tortora, who will be testifying against them, lacks credibility, based on the fact that when asked by Kuo if his phone was being tapped, Tortora didn't say "Yup! Helping the Feds build a case against you, actually." “What’s happening, man?” Tortora asked during the call, according to a transcript prosecutors submitted to the court. “Dude, is your phone tapped?” Kuo replied. “Wait, is the phone tapped?” Tortora asked, adding, “Why do you ask that?” Despite losing major points for repeating the question-- you never repeat the question!-- and the extremely unconvincing "Oh, why do you ask" attempt to act natural and not like he was working for the government, Tortora ultimately recovered. After Kuo and Tortora discussed defense strategy to explain their trades were made after legitimate research, Kuo concluded the call with a final warning to Tortora about making future calls from a personal telephone, according to the transcript. “I would seriously invest in some quarters, and start calling from 7-Elevens,” Kuo said. Hedge Fund Founder Faces Jury as FBI Raids Yield Trial [Bloomberg]

After The STOCK Act It Will Still Be Legal To Trade On Congressional Inside Information*

Here's a sort of touching monologue from David Einhorn's call with Punch: If you’ve done the analysis, and come to the conclusion that on it’s own, the company is not going to make it, it makes all of the sense in the world to raise equity at whatever the price is, so that you can know that the company, you know, is – is going to make it. Now, what that brings to my mind though is, you know, obviously we haven’t done your analysis, we haven’t done -- signed an NDA; I don’t know that we’re going to sign an NDA, because we prefer to just remain investors, but from my perspective, and I’ll be just straight up with you, is that gives a lot of signalling value. And the signalling value that comes from figuring out the company has figured out that it’s not going to make it on it’s own is that we’ve just grossly misassessed the -- you know what’s going on here. And -- and that, that will cause us to have to just reconsider what we’re doing, which is not the end of the world to you. You will continue on even if we don’t continue on with you. You could sort of see why the FSA read that to mean that he was insider trading. Like ... (1) You have told me something with signalling value. Sorry - "a lot of signalling value." (2) I will now act on that signal. (3) Don't be mad. "Signalling value" sure sounds like it means "material nonpublic information," doesn't it? Now as we've discussed before, trading on that information would not be enough to make Einhorn guilty of insider trading in the US, though maybe it wouldn't be exactly a great idea here either. Why? Because in our weird but sort of sensible insider trading laws, it's just not illegal to trade on material nonpublic information. It's only illegal to trade based on material nonpublic information that was obtained in violation of some sort of duty of confidence. Since Einhorn didn't sign an NDA, he had no duty of confidence. And since the Punch CEO and bankers weren't tipping him for nefarious purposes, but were instead sounding him out on the company's behalf as a shareholder and potential investor in a new capital raise, they weren't breaching their duty of confidence. You could quibble with the details of that but it's basically the law here. In England not so much. That also seems to be the law for our friends in Congress, who recently passed a law making it illegal for them to insider trade, which is worrying some people who make their living from trading on Congressional inside information: