Friend And Family Perils: When The SEC Alleges Tipping

Imagine the horror: a corporate executive confides in a family member, sharing information about her career (and, therefore, about her company), and the family member trades in the company's securities. Or a young professional shares a house with a friend, who pieces together what the professional is working on and trades. Government insider trading investigations ensue, the traders are charged, and lives are changed, all because of an inadvertent tip. And, because these cases are built on circumstantial evidence and credibility assessments, there is always the risk that the government could take the view that the tips were not inadvertent, and could charge the corporate executive or young professional with tipping, furthering the nightmare.

Ideally, of course, everyone could trust family members and friends to make good decisions and not act in a way that could put themselves and loved ones in danger. And ideally, the government would charge only people who actually violated the law. Unfortunately, the ideal is not always the reality: unless sensitive information is protected carefully, corporate insiders and service providers retained by companies to whom sensitive corporate information is entrusted risk government investigations that can wreak havoc on personal and professional lives. The current economy compounds this situation, increasing the temptation of "easy money" through insider trading. For those hit hardest economically, and with access to nonpublic information through a friend or family member, the lure may become especially hard to resist. Understanding the risk, and taking steps to protect against it, could save heartache – and worse – down the road.

How Liability is Determined. It is important to understand the contexts in which those who possess material nonpublic information risk liability for disclosing it. Any tipping case could be prosecuted by the criminal authorities if the level of proof is sufficient to establish guilt beyond reasonable doubt; the Securities and Exchange Commission faces a lower burden of proving its allegations by a preponderance of the evidence.1 Due to the heavy burden of proof required of criminal prosecutors and other high priority crimes they also must address, most tipping cases are brought by the SEC. Although some defendants litigate, many cannot afford the monetary and emotional cost of doing so, and most tipping cases brought by the SEC settle with the defendant neither admitting nor denying the SEC's allegations.2

The law provides that a tipper is jointly and severally liable with his or her tippees (both direct and indirect) for the ill-gotten gains (or the losses avoided) those tippees obtained as a result of the tip, plus interest.3 The tipper also may face a monetary penalty of up to three times the amount of those ill-gotten gains or losses avoided, although most cases settle for a one-time penalty equal to the disgorgement amount.4 Taken to an extreme, the tipper need not know anything about the trades themselves or have any voice in the dollar amounts at issue – the tipper can be liable for dollar amounts in the thousands, millions or even more for trading profits or losses avoided that he or she never received, shared, or even knew about.

The elements of a tipping charge are not statutory; they have evolved in case law interpretations of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. To allege tipping, the government must prove that the tipper had material, nonpublic information; that he or she had a duty (as a company employee, or as a lawyer, accountant, banker, or other service provider retained by the company) to maintain the information as confidential; that the tipper communicated the information to someone who traded or tipped others to trade; and that the tipper intended to benefit personally by giving the tip.5

The crux of assessing potential tipping liability often centers on the "personal benefit" element. The SEC and various courts have construed the concept of a personal benefit very broadly. As a result, for such a significant allegation, the level of proof required in this "personal benefit" test is shockingly low. The United States Supreme Court has stated that, when the person who possesses the information passes it to a tippee, the SEC may prove intent to benefit through 1) receipt of pecuniary benefit (e.g. profits from the trading), 2) receipt of a "reputational" benefit, or 3) provision of the information as a "gift" to the tippee.6

Although some cases turn on whether profits were shared, such circumstances are not generally thought to be controversial as the sharing of trading profits can be a hallmark of an improper trading scheme. Thus, it is the second and third avenues that pose the biggest problems for those who possess inside information because those avenues are less susceptible to having precise definitions or clear criteria. Charging decisions can turn on subjective assessments of suspicious government attorneys. For example, the SEC has secured a settlement against a tipper under a reputational benefit theory when, for example, a CEO allegedly provided material nonpublic information to an investment analyst with the "hope" that the analyst would issue favorable reports about the CEO's company in the future.7 Under a "gift" theory, the Supreme Court has reasoned that information imparted to a friend or family member "resembles" insider trading by the officer or director him or herself with a subsequent gift of the proceeds to the tippee.8 As the gift doctrine has expanded, it has...