CCOs struggle to keep up with evolving insider-trading legal standards

Nearly one year after the U.S. Supreme Court declined to hear the government’s appeal in the 2nd Circuit’s landmark insider-trading case, U.S. v. Newman, federal prosecutors this month scored their first post-Newman legal victory.

In U.S. v. Stewart, a New York federal court jury on Aug. 17 found Sean Stewart guilty of insider trading following allegations that he illegally tipped off his father, Robert Stewart, on at least five occasions over a four-year period concerning future mergers and acquisitions he learned about while working as an investment banker at Perella Weinberg and JPMorgan Chase.

According to the complaint, Robert Stewart then cashed in on these tips by placing and directing highly profitable securities trades ahead of the public announcement of these corporate transactions, generating more than $1 million in illicit proceeds, of which Robert Stewart personally received about $150,000. “Time and time again, Sean Stewart took his clients’ most sensitive corporate secrets and fed them to his father on a silver platter for quick and illegal profits,” Manhattan U.S. Attorney Preet Bharara said in a statement.

The criminal charges brought against Sean Stewart by the U.S. Attorney’s Office for the Southern District of New York were based on similar conduct underlying insider-trading charges brought by the Securities and Exchange Commission in May 2015. He is scheduled to be sentenced on Feb. 17, 2017.

What’s novel about the case is that it marks the first insider-trading conviction since the 2nd Circuit’s ruling in U.S. v. Newman, which effectively made it more difficult for prosecutors in that Circuit to prevail on a “tippee” theory of insider-trading liability.

The Newman case arose out of insider-trading and conspiracy charges brought by the U.S. Attorney’s Office for the Southern District of New York against Todd Newman and Anthony Chiasson, portfolio managers at two hedge funds, Diamondback Capital Management and Level Global Investors, respectively.

“One of the key developments rising out of the Newman case is the recognition that compliance needs to take a very active role in forensic testing and modeling with respect to potential insider trading.”
Marc Elovitz, Chair, Investment Management Regulatory & Compliance Group, Schulte Roth & Zabel

The government alleged that financial analysts at Diamondback and Level Global received non-public earnings information from insiders at two publicly traded technology companies and passed that inside information to their portfolio managers, including Newman and Chiasson. As a result, the government charged Newman and Chiasson with “willfully participating in this insider-trading scheme by trading in securities based on inside information illicitly obtained by this group of analysts,” according to the opinion.

Ultimately, the 2nd Circuit vacated Newman and Chiasson’s convictions, finding that a tippee cannot be convicted unless the tippee “knows of the personal benefit received by the insider in exchange for the disclosure.” In addition, Newman held that the “personal benefit” received by the tipper “must be of some consequence” and must be a true quid pro quo, rejecting the government’s notion that mere friendship and association could meet this requirement.

According to the court, Newman and Chiasson were “several steps removed from the corporate insiders, and there was no evidence that either was aware of the source of the inside information,” the court said. This lack of evidence made it difficult to also prove that either knew of any personal benefits the tippers might have received, the court said. In October 2015, the U.S. Supreme Court declined to hear the federal government’s appeal.

Since Newman, federal prosecutors have had to adjust their legal strategies by seeking out evidence to meet the Newman standard before bringing an insider-trading case. In the Stewart case, for example, prosecutors argued that Robert Stewart used some of his ill-gotten gains to pay $10,000 toward his son’s wedding expenses, thus providing a “personal benefit,” a stark example of just how far prosecutors are stretching to meet the Newman standard.

It’s not likely Newman will result in fewer prosecutions, “but rather the government will be more careful in the evidence it gathers and how it presents the cases,” says Marc Elovitz, chair of the investment management regulatory and compliance group at law firm Schulte Roth & Zabel.

Compliance lessons

Of course, not all insider-trading cases can be prevented, but the evolving insider-trading enforcement landscape provides important lessons for corporate compliance and legal counsel, nonetheless. “One of the key developments rising out the Newman case is the recognition that compliance needs to take a very active role in forensic testing and modeling with respect to potential insider trading,” Elovitz says.

SEC v. STEWART

Below is a summary of the allegations by the SEC in the case SEC v. Stewart.
This matter involves an unlawful, serial insider-trading scheme orchestrated by three financial industry professionals, in which S. Stewart tipped material, non-public information to his father, R. Stewart, in breach of a duty he owed to his investment bank employers and/or the shareholders of the companies these banks advised. In an effort to conceal his trading, R. Stewart partnered with a friend (identified here as Trader I) to exploit this information by placing highly profitable securities trades. As an investment banker at two prominent investment banks, S. Stewart learned non-public information about future mergers and acquisitions involving clients of these investment banks. From 2010 to 2014, on at least six occasions, S. Stewart tipped his father, R. Stewart, about imminent mergers and acquisitions so that his father could benefit from this valuable information. R. Stewart used this valuable information to place trades in his own account and in accounts owned by Trader I to generate approximately $1.1 million in illicit proceeds over a four-year period.
Both S. Stewart and R. Stewart took steps to avoid detection. In 2011, in response to a regulatory investigation into potential insider trading, S. Stewart lied to his investment bank employer. And R. Stewart knew that because of his undeniable relationship with his son, he needed to recruit a partner who would trade in his stead to conceal his trading activity. To this end, R. Stewart approached Trader l and the two men agreed that Trader l would trade in his account and then split the illicit profits with R. Stewart.
Additionally, R. Stewart and Trader 1 attempted to conceal their illegal trading and evade detection by: (a) primarily meeting in-person to discuss the scheme; (b) using coded email messages to discuss the scheme; (c) spreading trades over numerous stock options series in an attempt to avoid regulatory scrutiny; (d) buying stock options during periods when the securities were more heavily traded in order to blend into the daily volume; (e) refraining from options trading too close to the expected announcement date of a merger or acquisition; and (f) in most instances, sharing the illicit profits through cash payments.
Source: SEC v. Stewart

Compliance teams at some large companies, for example, are turning to data analytics to help them proactively identify potential insider-trading activity. Hewlett Packard Enterprises (HPE), for example, released new software this year that leverages HPE’s archiving, compliance, and machine-learning capabilities to automatically detect patterns and anomalies in structured and unstructured data, enabling companies—such as financial institutions—to stop illegal behavior in its tracks.

“What it does is it allows you to look at not just employee communications, but other actions that are taking place in the market to foresee risk events and take action on them before they happen,” explains Joe Garber, global vice president of marketing at HPE.

Another way for compliance to reduce the risk of their company getting caught in an insider-trading scandal may be to embed compliance officers in high-risk areas of the business, such as trading, portfolio management, and M&A departments. 

It’s not enough from a compliance perspective to say the company has a policy that prohibits employees from trading on material, non-public information. Most companies have written policies in place prohibiting insider trading, “but you have to make the employee understand why that policy is so important,” says Carrie Cohen, former assistant U.S. Attorney in the Southern District of New York and now a partner with Morrison Foerster.

Training is a key component of reinforcing insider-trading policies and protocols. Most people are motivated by the fear of personal liability. Thus, an effective approach for compliance officers may be to show how insider trading can affect the employee personally, citing real-life examples.

For people who focus on compliance issues, one of the best things they can do is pay attention to these stories and circulate them internally to remind everybody how careful they need to be,” says Dixie Johnson, a partner at law firm King & Spalding and co-leader of the firm’s securities enforcement and regulation practice.

As with most other compliance procedures, too, recordkeeping is another important component of minimizing corporate insider-trading liability. The company should keep copies, for example, on the training agenda employees received on insider trading, the materials that were handed out, and written certifications from employees that they’ve received and signed the company’s insider-trading policy. 

Furthermore, at the outset of any meeting in which material, non-public information is going to be discussed, senior executives should “think about who needs that information and whether everybody in the meeting actually needs it,” Johnson says. Those meetings are another opportunity to remind employees about the risk of sharing material, non-public information, particularly information that may be accessible to family or friends who could be tempted to trade, she says.

Remind employees to keep sensitive documents secure both inside and outside the office, Johnson advises. For example, they may want to consider password protecting home computers, personal computing tablets, and individual files that store that sensitive information and keep hard copies of documents either at work or locked in filing cabinets at home, she says.

In recent years, both the SEC and Department of Justice have substantially increased their scrutiny of alleged insider trading, and enforcement will only heat up as the implications of Newman rage on.

In October, the Supreme Court will be hearing arguments in the case Salman v. United States, which will address the question of whether the personal benefit necessary to establish insider trading requires proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the 2nd Circuit held in Newman, or is it enough that the insider and the tippee shared a close family relationship, as the 9th Circuit has held?

No matter which way the U.S. Supreme Court finds in Salman, corporate insider trading is a risk that should continue to be on the radar of corporate compliance and legal counsel. Insider-trading policies should be clear and frequently circulated, employee training on the risks conducted regularly, and confidential documents should be marked as such and distributed only on a need-to-know basis.