Insider Trading – 2022 In Review
With the start of a new year, it’s a good time to look back at 2022’s developments in insider trading.
The SEC’s 2022 Numbers. The federal government’s fiscal year runs from October 1 to September 30 of the following year, so the SEC’s FY 2022 numbers don’t perfectly align with calendar 2022 – but close enough. The FY 2022 Annual Report from the SEC’s Division of Enforcement (link here) shows the number of both enforcement cases generally and insider trading cases increased in 2022 from the year before. In 2022 the SEC brought 462 stand alone enforcement cases compared to 434 in 2021, and 43 insider trading cases compared to 28 in 2021. The 43 insider trading cases, against 93 individuals, represented 9% of the enforcement cases brought in 2022, which is in-line with the historic average of insider trading cases comprising between 8% and 10% of the SEC’s cases. Although up, the number of insider trading cases brought in 2022 is still below the wave of insider trading cases from a decade or so ago – for example, in 2012 the SEC brought 58 insider trading cases against almost 200 individuals.
The alleged profits in the FY 2022 insider trading cases ranged from $4,995 to $49 million. Seven of the 43 cases were brought as administrative proceedings and the other 36 were brought in federal District Court. Some of the settled cases imposed a civil penalty of twice the amount of the trading profits, reflecting the recent legal issues with disgorgement, while others continued with the old practice of ordering disgorgement of profits plus a civil penalty equal to the profits (both paths thus lead to similar economic outcomes – except that prejudgment interest is imposed on disgorgement but not civil penalties). The vast majority of cases involved profiting from information that caused the price of the company’s stock to increase, but as always there were a few cases were traders sold their positions before bad news was disclosed and thereby avoided losses. An informal count shows that about 40% of the SEC cases involved a parallel criminal case brought by the Department of Justice. As for the information in the cases, approximately 48% involved mergers and acquisitions, 24% involved earnings announcements, 11% involved drug trial results, and the remainder were a smattering of other material information such as significant contracts, listing of crypto assets, a data breach, and negative developments with a significant customer.
Relevant to institutional investors, two of the cases involved investors who entered into nondisclosure/no-trading agreements in order to learn about an investment opportunity, and then traded anyway. In one case, a family office had executed a nondisclosure agreement in connection with possibly participating in a transaction to take Dunn & Bradstreet private. However, two individuals at the family office – alleged to be aware of the restrictions in the nondisclosure agreement – bought options and stock in Dunn & Bradstreet and one tipped the information to a cousin (link to SEC release here). In the other case, an investor in a public company was “wall crossed” by a public company to learn about an opportunity to participate in a secondary offering the company was planning. Contrary to the agreement to refrain from trading after learning about the offering, the investor sold shares of the company and avoided losses of about $180,000 when the company’s stock fell 50% upon the public announcement of the dilutive offering (link to SEC release here). NDAs and wall crossings are common for institutional investors and these cases are a reminder that an NDA or wall crossing means the company in question goes on the restricted list. The Holzer (Dunn & Bradstreet) case is also a reminder that if the firm is restricted because of the receipt of MNPI, employees of the firm are also restricted from trading in their personal accounts or tipping the information to others (although it’s unlikely that anyone really needed that reminder).
10b5-1 Plans. In September the SEC brought a case involving two executives who improperly sold stock pursuant to a 10b5-1 plan. While a properly implemented 10b5-1 plan is a defense to an insider trading claim, in this case the SEC alleged that the executives possessed negative material, nonpublic information when they entered into the plans (which invalidates the defense – a 10b5-1 plan can be properly adopted only when one has no MNPI). The plans then executed sales of the executive’s stock prior to the MNPI being publicly disclosed, which caused the stock price to drop. The executives thus avoided losses by selling their shares before the bad news was disclosed, but the 10b5-1 plans provided them no defense since they adopted the plans when they already knew the bad news (link to SEC release here). To my knowledge this is the first case to make an insider trading allegation in connection with the use of a 10b5-1 plan, but as alleged by the SEC the conduct is clearly illegal.
The other 10b5-1 case that comes to mind was an unusual case brought in October of 2020 against a public company for having entered into a 10b5-1 plan to repurchase shares while in possession of material, nonpublic information. However, that case was charged as a failure to have sufficient internal controls and not as an insider trading case (it’s not clear why). 10b5-1 plans have recently come under scrutiny for potential abuses, although they also did back in 2006 following an academic study suggesting they were being abused and again in 2013 following a Wall Street Journal article raising the same concerns. However, this time around the SEC proposed and adopted amendments to Rule 10b5-1 meant to curb potentially abusive behavior and require greater disclosure of plans (SEC’s adopting release here). There are now more rules to follow but the good news is that most public companies have well-developed internal groups to guide 10b5-1 plan users through the rules and disclosures. As far as 10b5-1 plans being a new area of growth for insider trading cases, that is unlikely.
Use of Data Analytics in Investigations. Insider trading is an area where the SEC’s efforts to use data analytics have really paid off. Over a decade ago the SEC’s Division of Enforcement formed the Analysis and Detection Center within the Division’s Market Abuse Unit’s to use data analysis software to detect suspicious trading patterns. To highlight the group’s work, on July 25, 2022, the SEC brought three insider trading cases that had been originated through the Center’s data analytics work (link here). In addition to the three cases highlighted in the release, dozens of other cases involving insider trading rings, disparate and seemingly unconnected traders, and traders repeatedly trading in front of market moving information have been uncovered by the group’s work over the years. No one knows how much insider trading is really occurring, but the government’s ability to find seemingly hidden suspicious trading should worry anyone trying to get away with it.
Investment Adviser MNPI Compliance Risk Alert. In April the SEC’s Division of Examinations issued a Risk Alert highlighting deficiencies identified by the examination Staff with investment advisers’ required insider trading policies (link here). Specifically, the examiners found that advisers were not adopting policies tailored to address (i) the possible receipt of MNPI through “alternative data” providers, (ii) risks related to “value-add investors” – investors more likely to possess MNPI, such as public company officers or investment bankers, and (iii) expert networks. While these areas merit special attention since identified by the SEC, it is helpful for advisors to keep in mind that they should consider all research avenues they use and what policies tailored to each of those different avenues are reasonable and necessary.
First Digital Asset Insider Trading Cases. In June, the Department of Justice brought a criminal case alleging an “insider trading scheme” involving nonfungible tokens (release here). Nathaniel Chastain, an employee of Open Sea, the leading NFT marketplace, was alleged to have purchased dozens of NFTs based on his knowledge of which NFTs were going to be featured on Open Sea’s homepage – which typically caused the NFTs to substantially increase in value. Once featured on the site’s homepage and the market price of the NFTs increased, Chastain sold the NFTs for a profit. Although labeled an insider trading scheme, the charges brought were actually wire fraud and money laundering. That is not surprising since it’s not at all clear that NFTs are securities, which is a prerequisite for bringing a case under the traditional securities laws provisions used in insider trading cases.
In July the SEC brought its first crypto insider trading case against an employee of Coinbase and two people he tipped (release here). The SEC’s case alleged that Ishan Wahi, through his employment at Coinbase, knew when certain crypto assets were going to be made available to trade on Coinbase. The crypto assets typically increased in value after they were listed. Wahi tipped this information to his brother and a friend, who made about $1.1 million by purchasing the crypto assets before they were listed. The SEC alleged that the defendants traded 25 crypto assets in this way and that 9 of those assets were securities (hence giving the SEC jurisdiction to bring a case as to those 9 assets).
The takeaway from these cases is that the government is looking for insider trading in digital assets (and other abusive trading). Moreover, the Department of Justice at least has latitude to bring digital asset cases even where it is not clear that the assets are securities or commodities (the Dodd Frank Act of 2010 added a statute to the Commodity Exchange Act that allows insider trading cases to be brought by the CFTC or DOJ in connection with commodities trading). Of course, the attention and resources the government devotes to digital asset trading issues will depend on whether those markets continue to attract meaningful investment.
The Use of Other Federal Criminal Statutes to Prosecute Insider Trading. Criminal insider trading cases are generally brought under the same securities fraud statutes that the SEC relies on in its civil insider trading cases (primarily Section 10(b) of the Exchange Act and SEC Rule 10b-5). In recent years criminal prosecutors have also brought insider trading claims under the securities fraud provision in the 2002 Sarbanes Oxley Act (18 U.S.C. § 1348 – which was modeled on the wire and mail fraud statutes). The Sarbanes fraud statute is only a criminal statute and it is therefore only used by the Department of Justice (the SEC brings civil insider trading cases under the federal securities laws). The reason prosecutors sometimes use the Sarbanes statute goes back to the tangled and confusing issue of the nature of the “personal benefit” that a tipper must be shown to receive in tipper-tippee cases brought under the federal securities laws (exploring that issue is well beyond the scope of this post). In short, some courts have held that under the Sarbanes fraud statute there is no requirement that the government show a personal benefit to the tipper and it is thus easier for the government to prove an insider trading case under that law in some situations. There have been a dozen or so criminal insider trading cases brought under the Sarbanes statute.
At the end of December, the Second Circuit Court of Appeals issued an opinion in US v. Blaszczak that touches upon the use of the Sarbanes statute in insider trading cases. Blaszczak may be a name familiar to those who follow insider trading cases. Mr. Blaszczak was a political intelligence consultant who was a former employee of the Centers for Medicare and Medicaid Services (CMS). Blaszczak was alleged to have received confidential information from a CMS employee about the timing and substance of proposed changes to the reimbursement rates for certain types of medical care. Blaszczak passed that information on to his hedge fund clients, who profitably sold short the stock of companies that would be negatively impacted by the reimbursement rate reductions. Blaszczak and three others were sued by the SEC in a civil insider trading case and the Department of Justice brought a criminal case. The criminal case alleged a violation of the traditional statutory basis for insider trading claims (Section 10(b) of the Exchange Act) as well as several other charges, including wire fraud and the Sarbanes fraud statute. At the criminal trial, Blaszczak and the others were acquitted of the “traditional” insider trading claims but he and two others were convicted under the Sarbanes securities fraud statute. The convictions were upheld on appeal, which was significant because in so doing the Second Circuit held that proof of a personal benefit was not required under the Sarbanes fraud statute and thus endorsed an arguably easier way for the government to prove criminal insider trading in tipper-tippee cases (the first appellate decision is referred to as Blaszczak I).
But that was not the end of the story. Blaszczak and the other defendants appealed to the Supreme Court and while the appeal was pending the Supreme Court issued an opinion in the “bridgegate” case (Kelly v. US) that was relevant to the Blaszczak appeal (for those who don’t remember, the bridgegate case involved the prosecution of officials in the then governor Chris Christie’s administration for closing lanes on the Washington bridge to create a traffic jam at Fort Lee, NJ, in retaliation for the refusal of the mayor of Fort Lee to endorse governor Christie’s bid for reelection). The specific details are beyond the scope of this post, but the Supreme Court’s opinion in reversing the convictions in Allen held that governmental decision-making did not constitute “property” under the wire fraud statute. That was relevant to Blaszczak because the Sarbanes securities fraud statute, like the wire fraud statute at issue in Allen, applies to a fraudulent schemes to obtain “money or property”. If government decisions, such as CMS’s reimbursement rate changes, are not “property” then a necessary element of the Sarbanes fraud convictions could be missing. The Blaszczak I opinion was vacated and the case was sent back to the Second Circuit for consideration in light of Allen. The Second Circuit issued an opinion concluding that the CMS information was not property and therefore vacated the convictions (Blaszczak II).
So government information cannot be a basis for insider trading? No, and no one should interpret the Blaszczak II opinion as a green light to trade on confidential government information. For one, the Second Circuit’s reasoning that the confidential information in Blaszczak is not property or a “thing of value” is not overwhelmingly convincing and the dissent makes a good argument for the opposite conclusion – so this issue probably isn’t entirely settled. More importantly, the property concept has no application to a “regular” insider trading case brought by the SEC or the DOJ under the securities laws and so the Blaszczak II opinion should not change any practices when it comes to government information.
Separately, the question of whether the “personal benefit” test was required under the Sarbanes statute was not before the court in Blaszczak II and was not addressed by the majority opinion. However, one of the three judges on the panel issued a concurring opinion that leveled a blistering criticism on Blaszczak I’s exclusion of the personal benefit requirement under the Sarbanes fraud statute. The concurring judge argued that it offended “traditional notions of fair play” to allow a criminal prosecution for insider trading on a lower standard than applies to the SEC’s civil insider trading cases (since the SEC’s civil tipping cases do require proof of a personal benefit to the tipper). The judge went on to ask the Second Circuit, the Supreme Court, and Congress to address this “glaring anomaly” in the law. The concurring opinion was joined by the author of the majority opinion, meaning that two of the three judges on the Blaszczak II panel believed that Blaszczak I was wrongly decided on this issue.
It is hard to disagree with the concurring opinion on this point. Decades of judicial decisions in civil and criminal insider trading cases have wrestled with trying to articulate the legally required elements to prove an insider trading case. There is no reason to think that in enacting the Sarbanes securities fraud statute that Congress meant to eliminate any of those established elements in criminal insider trading cases and create a lesser standard for criminal insider trading cases. In fact, it seems more likely that Congress had no intent to address insider trading with the Sarbanes statute since Congress has never defined what insider trading is – leaving it up to the courts to fashion the definition through case law.
As a practical matter, market participants should not alter their conduct in light of the questions around the personal benefit test. Several other courts have held that the Sarbanes fraud statute does not require the showing of a personal benefit so it is safest to assume that it need not be proven. Moreover, even if a personal benefit is required to be shown, that is not a particularly difficult hurdle in many cases and the standard for what constitutes a personal benefit varies across the judicial Circuits (for example, the threshold is relatively low out here in the Ninth Circuit). From a compliance perspective, it is far better to focus on the duty issue – ensuring that sources of information are not breaching any duty in sharing information. With no breach of duty, there is no regular insider trading, there is no Sarbanes securities fraud, and there is no wire fraud.
Finally on Blaszczak II – it is also hard to disagree with the chorus of voices asking for a legislative clarification of the law of insider trading. A more clear and simplified definition – like proposed in legislation several years ago – would eliminate much confusion in this area of law, clarify boundaries for traders, public company officers, and prosecutors, and promote some incremental market efficiency (including lower legal bills).
Shadow Trading. The Panuwat case remains the only “shadow trading” case the SEC has brought, and yes, that was in 2021. However, in January of 2022 the court hearing Mr. Panuwat’s case denied his motion to dismiss and upheld the SEC’s shadow trading theory of insider trading (so there is a 2022 connection). More broadly, the concept is worth highlighting again since for compliance professionals and market participants it remains the most significant insider trading development in the past few years. If you are interested in the background and particulars of the case, please see these prior blog posts on the subject (here and here). From a compliance perspective, consideration needs to be given to policies and procedures to address situations where MNPI “about” one company is material to another public company. And difficult question do remain such as how to assess materiality of information about one company to other companies. For now, market participants are probably best off consulting with their legal and compliance service providers when confronted with potential shadow trading situations.