Risky Business: Trafficking In Insider Information About Customers

The Department of Justice and the Securities and Exchange Commission have been jointly cracking down on the use of "expert" consulting networks that they say paid company employees to provide funds with material inside information about their employers. The Department of Justice has brought well publicized actions charging criminal violations of federal insider trading laws and the SEC has followed suit, alleging civil violations of the same laws.1 These cases, however, also bring to light an important variation on the theme. In several instances, the government alleges that employee "experts" were paid for providing material information about their employer's customers. This article examines the federal insider trading law as it relates to tipping information about suppliers and customers. It suggests that investment advisers inform their employees that the government is treating material nonpublic information about a company's customers obtained from a company employee as encompassed within federal insider trading prohibitions, especially when the disclosure violates the policies of the employer.

Key excerpts from the SEC Amended Complaint in SEC v. Longoria are attached.

In SEC v. Longoria et al.,2 the SEC charged "expert" consultants engaged by Primary Global Research LLC ("PGR") with illegally tipping material nonpublic information about their employers to certain of PGR's hedge fund clients. But the charges go further. They also charged two of the employees with tipping material information about companies their firms did business with, including Apple Inc., Research in Motion Ltd. ("RIM") and Omnivision Technologies, Inc.

The complaint alleges that a Dell, Inc. employee, in violation of Dell's policy, disclosed information about Dell as well as information about two of Dell's suppliers whose contracts with Dell were significant to the suppliers and, therefore, material to the financial prospects of the suppliers. The complaint similarly asserts that a Flextronics International Ltd. employee disclosed material information about orders placed by RIM, Apple and Omnivision with Flextronics in contravention of Flextronics's policy prohibiting disclosure of confidential information about Flextronics or its customers, suppliers, or other business partners.3

It is significant that the two "experts" charged with providing material nonpublic information about their employers' business partners did so in violation of articulated employer policies. The SEC complaint, in this respect therefore did not have to rely on an assertion that employees should have understood that their employers expect that they will not disclose nonpublic information about customers or suppliers to third parties.

However, the notion that an employee must not appropriate information obtained from his employer, including information about suppliers and customers, for his benefit may well be viewed by the government and private litigants, among others, as an emerging norm. Increasingly, customers demand that their business with a company be treated as confidential and increasingly companies are adopting policies, such as those adopted by Dell and Flextronics.

The Supreme Court's recognition of the misappropriation theory of insider trading in U.S. v. O'Hagan4 provides a basis for the Department of Justice and the SEC to treat tipping by an employee of material nonpublic information about an employer's business partners as a violation of federal insider trading law.

In O'Hagan, the government brought a criminal insider trading charge against a partner in a law firm who came to know from his status as a partner in the firm that the firm was engaged to represent a takeover bidder. Acting on that information, he traded in options on the target company's shares counting on those options to be in the money when the tender offer became public. The Supreme Court majority held that although the partner owed no duty to the target company, he owed a duty to his firm and its client, which were the sources of the information, and therefore could be held liable under Rule 10b-5 for fraud in connection with a securities transaction for "misappropriating" confidential information in breach of this duty.

O'Hagan and its misappropriation theory lie at the heart of the SEC's complaint in the Longoria case as it relates to tipping material nonpublic information about Apple, RIM and other publicly traded companies by employees of firms that did business with these companies.

The conduct condemned by O'Hagan falls squarely within Rule 10b5-2 adopted by the SEC in 2000. The preliminary note to the Rule states that it provides "a non-exclusive definition of circumstances in which a person has a duty of trust or confidence for purposes of the 'misappropriation' theory of insider trading under" Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5. The preliminary note to the Rule makes clear that the law of insider trading can also be established by judicial opinions, permitting courts to expand the scope of the requisite duty of trust or confidence beyond the Rule. However, Rule 10b5-2 states that the misappropriation of material nonpublic information in breach of a duty of trust or confidence includes circumstances in which "a person agrees to maintain information in confidence." The Dell and Flextronics policies provide a basis for the government to argue that the accused employees so agreed.

Moreover, a second formulation of a duty of trust or confidence found in Rule 10b5-2 covers circumstances where the person communicating the "material nonpublic information and the person to whom it is communicated have a history, pattern or practice of sharing confidences such that the recipient of this information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain confidentiality." This language in and of itself, as elaborated...