Two years after the Second Circuit significantly limited the ability of the federal government to prosecute individuals for insider trading under the classic “tipper-tippee” liability theory in its Newman decision, the SEC is taking on one of Wall Street’s biggest hedge fund managers by relying on a relatively newer theory of insider trading liability, the so-called “misappropriation theory.” The SEC’s ongoing civil case against prominent hedge fund manager Leon Cooperman for making trades in Atlas Pipeline Partners in 2010 after receiving information from a company insider about an impending, beneficial transaction at the company will present the courts with an interesting question of what kind of evidence is necessary to prove liability under the misappropriation theory.
Why the SEC is Not Pursuing Tipper-Tippee Liability Against Cooperman
The SEC alleged in its complaint against Cooperman that he received information from an executive at Atlas Pipeline Partners that the company planned an asset sale that would improve its financial picture, and that Cooperman placed trades as a result which netted a handsome profit as the company’s stock rose 30%. Cooperman concedes that he did in fact receive information from someone at the company (and that talking to companies is in fact a regular part of his work), and that he traded as a result, but that he did not break insider trading laws.
In previous times, the SEC might have argued that Cooperman was in violation of Rule 10b5 (the federal prohibition on insider trading) under the theory that the company insider was a “tipper” who violated his or her duty to the company by providing insider information to Cooperman as the “tippee” in exchange for a “personal benefit,” and Cooperman as a tippee would be guilty. But in the 2014 case of United States v. Newman, the Second Circuit held that, for tipper-tippee liability to exist, the tippee must know that the tipper received a personal benefit and that this personal benefit must be “objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature.” Prior to Newman, any kind of potential career or friendship benefit might suffice, but Newman made it much harder for the government to show that a personal benefit to the tipper and known to the tippee existed.
The Newman case was a criminal prosecution for insider trading, and whether or not the Newman principles apply to civil cases is not quite resolved, but the SEC appears to believe it does as it chose to argue that Cooperman violated insider trading laws under a whole different theory of liability called the misappropriation theory.
The Haziness of the Misappropriation Theory
Because the federal security laws are quite vague with regards to how insider trading is defined, the courts have largely defined it as they go along. In 1997, the US Supreme Court found that insider trading charges could, in addition to tipper-tippee liability, be based on the so-called “misappropriation theory.” Instead of there being a tipper providing tips in exchange for a personal benefit, under this theory, an outsider creates an agreement with an insider to receive confidential information about the company and not to misappropriate it by trading on that information, and that such an agreement can be implicit where there is a “duty of confidentiality and trust.”
What constitutes grounds for the existence of a duty of confidentiality and trust is quite hazy, and in 2000 the SEC promulgated Rule 10b5-2 which stated that such a duty exists in one of two cases: (1) “Whenever a person agrees to maintain information in confidence;” or (2) “Whenever the person communicating the material non-public information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material non-public information expects that the recipient will maintain its confidentiality.”
Notably, the complaint against Cooperman includes few if any details about any such agreement between him and the insider at the company, nor does it provide any information suggesting there was a history, pattern, or practice of sharing confidences. In a previous case brought under the misappropriation theory, a court found there was insider trading where a man had a confidential relationship with a fellow member of Alcoholics Anonymous and used information the member gave him in their relationship.
But that type of intimate, confidential relationship appears to be different from the present case, where Cooperman appears to have regularly talked to company insiders as part of his work in managing investments in those companies, suggesting there was not a similarly confidential relationship. All in all, the civil case brought against Cooperman indicates that the SEC, in its attempts to find scapegoats in the hedge fund industry, is struggling to find reasonable legal theories on which to support its insider trading investigations.