New York, NY – To win an insider trading case, the prosecution needs to prove that the person who passed along the material non-public information breached a “duty of trust and confidence” to maintain the confidentiality of that information. This topic has recently received increased attention due to a new insider trading case regarding tips obtained from a friendship formed at Alcoholics Anonymous. In addition, the proposed STOCK Act attempts to clarify that members of congress have such a duty when it comes to information they obtain as a part of their jobs in Washington.
The Duty of Trust Established
In 1997 the U.S. Supreme Court established the misappropriation theory of insider trading in United States v. O’Hagan, 521 U.S. 642, 655 (1997). O’Hagan was a partner in a law firm representing Grand Metropolitan, while it was considering a tender offer for Pillsbury Co. O’Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O’Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options. The Supreme Court rejected O’Hagan’s arguments and upheld his conviction.
The court ruled that under the misappropriation theory of insider trading, an individual commits securities fraud and violates Section 10(b) and Rule 10b-5 if he misappropriates or steals confidential information used to trade securities in breach of a duty owed to the source of the information to keep the information confidential and not to use it for his personal benefit. This is the “duty of trust and confidence.”
Over the years, additional court cases have clarified the duty of trust and confidence. A few of these circumstances include:
- Whenever a person agrees to maintain information in confidence;
- Whenever the person communicating the material non-public information and the person who receives the information have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows, or reasonably should know, that the person communicating the material non-public information expects that the recipient will maintain its confidentiality; or
- Whenever a person receives or obtains material non-public information from his or her spouse, parent, child, or sibling; except when the person receiving or obtaining the information can demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties’ history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information.
Alcoholics Anonymous Case
Last week, the SEC recently brought civil charges against Timothy J. McGee, a former investment adviser at Ameriprise Financial Services, who allegedly obtained insider information from an unnamed executive at Philadelphia Consolidated Holding Corp. (PHLY). The PHLY executive allegedly confided in McGee about its impending sale to Tokio Marine Holdings while both were members of Alcoholics Anonymous (AA). Mr. McGee is accused of trading on the information and realizing profits of almost $300,000. In addition, McGee purportedly tipped others, who allegedly made a total of $1.2 mln in profit by buying stock and options. Four others were named in this case.
The SEC complaint asserts that the confidentiality inherent in the operation of AA is sufficient to establish a “duty of trust and confidence”. According to the complaint, “individuals who participate in AA and share information at meetings or in private discussion with other AA members are asked to abide by a policy of anonymity, which is the “Twelfth Tradition” of AA.” The SEC further emphasized the confidentiality of information shared at AA meetings. According to the compliant, McGee assured his source that he would keep the information they shared confidential.
This case is surprising because the SEC is charging that a “duty of trust and confidence” can be established based on the confidentiality practiced by a private organization like AA rather than the more typical legal relationships seen in insider trading cases, like those between an employee and employer or the fiduciary duty of a lawyer or investment adviser.
Click here for more information in this case.
The 2012 STOCK Act
In early February, 2012 the U.S. House of Representatives passed the “Stop Trading on Congressional Knowledge Act of 2012” (the STOCK Act) by a vote of 417 to 2. A similar bill, which bans insider trading by members of Congress and the administration, was passed previously by the Senate. The Senate must now determine how to address the differences in the two versions of the bill.
Many journalists have focused on the fact that the recent House bill which was passed does not include a requirement that firms which provide “Political Intelligence” services be required to register in the same way that lobbyists must register under the Lobby Disclosure Act (LDA). However, we think that clearly establishing a “duty of trust and confidence” will be helpful to the SEC if they ever want to prosecute a member of Congress on insider trading.
The following is a direct quote from the House version of the STOCK Act which clarifies this issue.
“For purposes of the insider trading prohibitions arising under the securities laws, including section 10(b) and Rule 10b–5 thereunder, each Member of Congress or employee of Congress owes a duty arising from a relationship of trust and confidence to the Congress, the United States Government, and the citizens of the United States with respect to material, nonpublic information derived from such person’s position as a Member of Congress or employee of Congress or gained from the performance of such person’s official responsibilities.”
Click here for the complete text of the House version of the STOCK Act.
Last month, at a breakfast hosted by the Christian Science Monitor, Securities and Exchange Commission (SEC) Chairwoman Mary Schapiro expressed her support for this aspect of the STOCK Act. “I think the STOCK Act can be helpful to us in this regard, the clarity that there is in fact a duty that members of Congress owe to the Congress, to the government, to the American people is very useful,” she said. “Because we need to show violation of the duty when we bring an insider trading case.”
It is important to understand that this “duty of trust and confidence” doesn’t only impact employees of the legislative or executive branch of government who are covered under the STOCK Act. It also increases the risk for asset managers and other investors who engage lobbyists, law firms, and other providers of political intelligence services to gather information from political insiders about developments in Washington DC.
In the past, many U.S. institutional investors felt they could legally invest on material non-public information obtained from members of Congress, their staffers, or other government policy-makers because they did not breach a duty owed to the source of the information to keep the information confidential and not to use it for their personal benefit. The explicit duty in the proposed STOCK Act will change all this.
The new SEC case against Timothy McGee could have a significant impact on the “duty of trust and confidence” if the Commission is successful in broadening this duty to the misappropriation of information derived from personal relationships versus contractual or fiduciary relationships.
Clarifying that members of Congress and their staff have a “duty of trust and confidence” in the STOCK Act could have an even more profound impact. We don’t believe that U.S. investors will be prohibited from gathering and using information about Washington political, regulatory, and policy developments in their investment process. However, we do think investors will need to conduct the same type of analysis when it obtains information from political insiders that it currently adopts with potential MNPI from corporate insiders. We suspect this will also mean that asset managers will want to ensure that political intelligence firms and other policy research providers have implemented similar types of compliance controls that they have come to expect from best of breed expert networks, channel checks providers, and traditional fundamental equity research firms.