New York, NY – As the insider trading investigation has progressed over the past few months, numerous market participants have held extensive discussions about how best to limit the legal risk of potentially receiving material nonpublic information as a result of their analysts’ or portfolio managers’ use of expert networks. Many expert network providers, and the asset managers that use these services, have come to rely on two contractual agreements between the experts and the networks they work for to limit their liability, including “Terms and Conditions” and an “Employer’s Consent”. Today’s blog discusses the value of an employer’s consent.
Definition of Insider Trading
Over the years, the Supreme Court has embraced two complementary theories of insider trading interpreting section 10(b) of the Securities Exchange Act of 1934. The “classical theory” defined in Chiarella v. United States, says that corporate insiders are forbidden to trade on material nonpublic information in violation of a fiduciary duty to their company’s shareholders. In this case, the court emphasized that an actor must have a fiduciary duty to the shareholders of his or her company to be considered a corporate insider. Later, in Dirks v. SEC, the Court reaffirmed that interpretation and reiterated that insider-trading liability was dependent on the existence of a fiduciary relationship.
The second theory of insider trading, known as the misappropriation theory, was recognized by the Supreme Court in United States v. O’Hagan and extended insider-trading liability to individuals who are not “insiders”. This includes actors who misappropriate, and then trade on, material nonpublic information in violation of a duty of trust or confidence owed to the source of the information. Thus, the Supreme Court decided that a law-firm partner who is aware of a regulated client’s still-private plans to acquire stock in another company may not trade on that information.
In the past few years, most expert networks have provided clients with the ability to obtain an agreement from an expert’s employer that they have approved of their employee speaking with an expert network user. This agreement is traditionally called an “employer’s consent”.
The reason that many expert network users have required this type of consent is the view that by signing such an agreement, a company is effectively waiving any “duty of trust or confidence” that the employee had with the firm. Consequently, the belief is that if an expert network user receives material nonpublic information from an employee that has an employer’s consent, the recipient of this information cannot be held liable for insider trading under the misappropriation theory.
The Benefits of Employer’s Consent
Upon first glance, it would appear that an institutional investor that receives an employer’s consent to speak with their employees appears to be better positioned legally than if they did not receive the employer’s consent. How can a hedge fund manager be faulted if he asked and received permission from the employer to speak with their employees?
However, discussions with compliance officials at existing expert networks, former SEC staffers, and private practice attorneys have all suggested that an employer’s consent might not reduce an investor’s risk under a variety of circumstances.
The Shortfalls of Employer’s Consent
Although an employer’s consent might lower the legal risk of an expert network user, there are still a number of issues that must be addressed before an investor can reasonably rely on employer consent.
First, the language of the consent must be broad enough that it covers all of the types of information the employee talks about. If the employer consent limits the topics or scope of the employee’s ability to speak, then the employee may quickly breach the consent agreement, thereby breaching a clear duty to his/her employer. Most expert networks admit that the employer consent agreements that their experts typically have signed are narrow and specific, prohibiting employees from discussing certain confidential topics. Consequently, these employees are still have a “duty of trust” regarding certain topics – particularly topics where material nonpublic information is involved.
Secondly, an employee must obtain meaningful consent from a principal in the company who has the authority to give that consent. In other words, if the employee obtains consent from the Human Resources department, this is arguably not meaningful consent because HR employees do not understand the legal issues and risks. The employee needs to obtain official consent from someone within the company who knows the issues and who understands the risks – – the general counsel, for instance. If the consent is signed by a low level employee in the company, then most prosecutors and/or regulators will argue that it is not reasonable for anyone to rely upon it – particularly sophisticated investors like hedge fund or mutual fund professionals.
Lastly, a regulator is likely to argue that it is unreasonable for anyone to rely upon an employee’s representation that they have received consent from their employer. If the SEC comes knocking alleging insider trading, anyone who thinks they can rely on an employee’s representation that their employer consented to them acting as an expert may be surprised to learn than the SEC will argue this reliance was unreasonable.
Thus, an institutional investors’ risk of being investigated for insider trading might be reduced if they obtain a written consent agreement from an authorized company official that is broad enough to cover all of the types of information that they want to learn about from the employee AND the employee they speak to does not exceed the terms of the consent agreement. However, the type of consents that are signed by most employers are generally not comprehensive enough to eliminate the “duty of trust” that an employee has to the firm if they provide material nonpublic information to an investor — consequently, these agreements don’t typically eliminate the risk that an investor who receives this type of information won’t be prosecuted for insider trading.