US and UK insider trading regulators diverge

Courts have reined in the SEC's crusade against insider trading, while the FCA criticises investors' bad practices

When it comes to prosecuting insider trading, there is a clear gulf between the US and the UK: while US regulators are zealous in bringing down miscreant hedge fund traders, the UK’s Financial Conduct Authority (FCA) is rarely successful in its prosecutions.

That may be about to change. New York’s federal appeals court has reined in the Securities and Exchange Commission (SEC) over its insider trading prosecutions, causing a number of Wall Street individuals guilty of insider trading to come forward asking federal courts to throw out their convictions.

Lawyers say that the US government “pushed the boundaries” over insider trading and now the courts have pushed back.

At the same time, the FCA has published a review into asset managers’ inside information controls, finding examples of poor practice among City firms and calling on the companies examined to set up a “comprehensive” system of safeguards.

Over the past six years, hedge funds have not been in the FCA’s sights for this type of offence. Since 2009 the watchdog has prosecuted 25 individuals for insider trading, only two of whom were hedge fund traders.

Anjam Ahmad of Ako Capital and the once-feted Julian Rifat of Moore Capital Management were found guilty in 2010 and 2014, respectively. None of the FCA’s eight ongoing investigations concern hedge fund managers.

By contrast the SEC has taken scalps at SAC Capital and Galleon Group, among other major Wall Street firms. Manhattan court prosecutors have charged 93 people with insider trading since October 2009, of whom 88 were convicted. A large number of these were hedge fund traders.

Many of those convicted have now appealed to the Second Circuit court of appeals in Manhattan to overturn their jail sentences and multimillion dollar fines, while the SEC in response has asked the appeals court to reconsider its verdict.

However, Tim Selby, head of law firm Alston & Bird’s New York-based investment management practice, says he would not advise US compliance officers to change their insider trading precautions. The main changes ought to come in the UK as the FCA says it expects asset managers to improve their safeguards.

Extra scrutiny in London

A main finding of the FCA’s probe was that only two of the 19 firms examined “effectively highlighted and properly investigated potentially suspicious trades”.

The watchdog found a number of firms lacked awareness of front-office research activity and often had no records of external meetings. These firms could not easily flag up suspicious trades, say after an analyst had met a fund manager.

The best asset managers’ systems could flag up large trades directly before key corporate announcements and could spot patterns such as an oddly high number of trades from the same person.

But while firms had policies to limit the sharing of inside information, “only a minority of firms monitored the effectiveness of this policy”.

One company notified all traders when it had received market-sensitive non-public information in order to prevent trading until a system block was in place. However, traders were not only told the company name, but also details of the corporate action. The FCA called this “unnecessary dissemination” of information.

The watchdog did, however, find overall adequate levels of training and awareness and all but two firms in the probe used a warning prompt to prevent trading due to the company’s possession of inside information.

Legal flux in New York

The Second Circuit appeals court in Manhattan has put the US law on insider trading in flux. Its ruling holds that the government must prove the corporate insider tipped off the defendant “in exchange for a personal benefit”, and that the defendant knew this, in order to find the defendant guilty.

The court states: “Personal benefit is broadly defined to include not only pecuniary gain, but also, inter alia, any reputational benefit that will translate into future earnings and the benefit one would obtain from simply making a gift of confidential information to a trading relative or friend.”

Significantly, the appeals court argues that proof of a friendship, particularly of a “casual or social nature”, is insufficient to show an expectation of personal benefit.

Selby of Alston & Bird reckons that US prosecutors will be reluctant to bring insider trading actions unless and until the appeals court ruling is overturned.

“The law is now more ambiguous and hence less predictable so now building an insider trading case will be challenging,” he says.

Indeed, the US Department of Justice has already asked the Manhattan federal district court to dismiss charges against five stockbrokers accused of trading on confidential information about IBM.

In response to the ruling, the SEC states in a brief to the court: “The panel’s narrowed definition of personal benefit and lack of clarity about the evidence required for establishing such benefit could negatively affect the SEC’s ability to bring insider trading actions.”

The US regulator argues that the gift of inside information to a friend is sufficient to show an indirect personal benefit, due to a relationship that suggests a quid pro quo.

The Department of Justice is similarly robust in its protests to the Second Circuit court. “The… decision dramatically (and, in our view, wrongly) departs from 30 years of controlling Supreme Court authority and, in so doing, legalises manipulative and deceptive conduct that no court has ever sanctioned,” it writes in a brief.

The arguments over the definition of insider trading have a long history, say Wall Street lawyers, who think the US government has “pushed the boundaries” in its prosecution cases.

“The [appeals] court thought it was pushing the boundaries on what ‘personal benefit’ meant,” says Jack Yoskowitz, New York-based commercial litigation lawyer at Seward & Kissel. “This is a full stop by the Second Circuit court, which is saying enough is enough, you’ve gone too far.”

Two traders, many steps removed

The critical appeals court case concerns the convictions of Todd Newman and Anthony Chiasson, two portfolio managers at Diamondback Capital Management and Level Global Investors respectively.

The pair were found guilty of insider trading in December 2012, and given fines of $1 million and $5 million, respectively. The former was sentenced to four-and-a-half years in jail; the latter was handed a six-and-a-half-year sentence.

Newman and Chiasson were at the end of a long chain of information being sent from insiders at Dell on to their contacts and their contacts’ contacts. In fact, the pair was three and four steps removed from the source, Rob Ray, on Dell’s investor relations team.

In its judgement, the Second Circuit court states: “It is largely uncontroverted that Chiasson and Newman, and even their analysts… knew next to nothing about the insiders and nothing about what, if any, personal benefit had been provided to them.”

As to Ray’s relationship with Sandy Goyal, analyst at Neuberger Berman, the court states that the US government admitted Ray and Goyal were not close, but “had known each other for years, having both attended business school and worked at Dell together”. Moreover, Goyal gave Ray career advice.

The court says: “If this was a ‘benefit’, practically anything would qualify.” Proving a benefit could simply mean showing two people went to the same church or the same school, rendering the personal benefit requirement a “nullity”, the court says.

In response, the SEC says it makes a distinction between classic cases where the original tipster is an insider and so-called misappropriation cases where the original tipster is not a company employee.

In misappropriation cases, the SEC argues that a proof of benefit is not necessary, because the original tipster is an outsider who owes no duty to the shareholders of the company whose securities were traded as a result of the tip. The SEC argues the tipster in a misappropriation case owes a duty of trust only to the source of the information.

In classical cases an insider’s disclosure of non-public information may not be improper, so the tipster’s duty – in this case to shareholders – may not have been violated. The SEC concedes that proof of a personal benefit here is evidence of an improper motive.

John Carney, partner at Baker Hostetler, thinks that prosecutorial guidelines on insider trading should be clearer, adding there is a “real danger” that the lack of consistency in the law could turn compliance into a guessing game.

“The law of insider trading is something that has developed over many years through case law, rather than explicitly laid out in statute by Congress or in regulation by the SEC,” he says.

Carney – formerly senior counsel at the SEC – believes the entire market would benefit if the Commission would lay out clearly in which circumstances it would prosecute firms and individuals for insider trading and when they would not. “The government can draw a clear line if it wants to,” he says.