Criminal Justice Insider

Over the past decade, federal courts around the country have been defining and redefining the contours of insider trading liability. The crime of insider trading is loosely delineated in a single paragraph of the Securities Exchange Act of 1934 as the use of manipulative device in contravention of the rules and regulation of the Securities and Exchange Commission. See 15 U.S.C. Sec. 78j(b). It has been left to the courts to fill in the gaps to protect markets from manipulation through the use of non-public information.

The courts have demonstrated little compunction with regard to filling in the blanks by adding numerous requirements and theories of liability found nowhere in the statute. The latest shot across the proverbial bow came in the Second Circuit’s decision in United States v. Chow, 19-0325 (April 6, 2021) which expands insider trading liability to outsiders who enter into non-disclosure agreements with a company.

In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court decided that in order to sustain an insider trading conviction, the Government had to prove that the insider breached a fiduciary duty in disclosing or utilizing the private information. The classic case of insider trading involves a person in a company who obtains non-public information through his or her work and then trades on that information. Such trading is breach of the fiduciary duty between shareholders and corporate insiders thus giving rise to insider trading liability.

The Supreme Court has also permitted a “misappropriation theory” of insider trading. See U.S. v. O’Hagen,521 U.S. 642 (1997). Under a misappropriation theory, a person commits insider trading when he or she misappropriates confidential information in breach of a duty owed to the source of that information. For example, an accountant who steals information from a corporate client’s financial records and trades on that information would have insider trading liability under a misappropriation theory. The company entrusted the accountant with secret information and expected that the accountant would keep such information confidential. The Supreme Court was quite clear that in order to sustain a conviction on a misappropriation theory the defendant must have had a special confidential relationship with the company the breach of which would be a violation of a fiduciary duty. See Dirks, 463 at 655.

In the recently decided Chow, the Second Circuit extended the breadth of such a special and confidential relationship to a non-disclosure agreement. In Chow, the defendant was a managing director of an investment firm that was seeking to acquire a technology company. During the course of the negotiations, Chow moved firms and signed several non-disclosure agreements. Chow ultimately organized the acquisition through his own firm. Following the acquisition, FINRA discovered that Chow communicated frequently with an individual who purchased shares of the acquired company shortly before the acquisition and sold slightly after for a profit of $5,000,000. Chow was subsequently arraigned and convicted of six counts of insider trading.

On appeal, the Second Circuit affirmed Chow’s conviction. In doing so, the Court found that by signing a non-disclosure agreement, Chow had assumed an express duty of confidentiality. It found that such agreements can render signatories as “temporary insiders” that assume a duty akin to a fiduciary duty to a company. See United States v. Kozinksi, 976 F.3d 135 (2d. Cir. 2020); United States v. Afriyie, 929 F.3d 63 (2d Cir. 2019). Although Chow was not, in fact, an insider, and was negotiating with the acquired company at arm’s length, the non-disclosure agreement placed him within the confines of a special relationship such that insider trading liability ensued. This holding marks a notable expansion of insider trading liability to contractual relationships.

Given the vague boundaries of the statute, the federal courts continue to expand, redefine and reconfigure insider trading liability. Under Chow that liability can now result of a contractual relationship. How much further the courts will go remains to be seen.

For more information on the topic discussed, contact:

• Adam M. Felsenstein  |  felsenstein@thsh.com  |  212-508-7533