The Netherworld of Insider Trading Law

Article excerpt

As a recent case against Citigroup shows, advanced disclosure of research may be prohibited by brokerage firm policies but it is not insider trading.

Identifying insider trading sometimes seems like a game of three- card monte: first you see it, then you don't.

A recent settlement by Citigroup with a Massachusetts regulator over leaking internal research to clients raises question about when such disclosure crosses the line into insider trading.

Citigroup agreed to a consent order entered by the Massachusetts Securities Division requiring it to pay a $30 million penalty after it failed to have proper procedures in place to protect against the early release of research by the firm's analysts.

One of the analysts, Kevin Chang, gave information to a few institutional investors, most notably SAC Capital Advisors, about a decrease in orders for iPhones that would affect Apple and one of its main suppliers, the Hon Hai Precision Industry Company.

The consent order shows how SAC and other institutional investment firms badgered Mr. Chang for his analysis when a competing investment bank issued a research report calling into question optimistic views about the number of iPhones that would be shipped. After revising his estimates substantially downward, he e- mailed those figures to SAC and other large institutional clients on Dec. 13, a day before Citigroup released his revised research report on Hon Hai. Apple shares dropped about 5 percent on Dec. 14.

Those actions appear to be a classic insider trading case: leaking material nonpublic information that will affect the price of companies to a few favored investors who can trade ahead of the market. Throw in the fact that SAC, which has been indicted on charges of insider trading violations, was a recipient, and it seems like a slam dunk.

One of the largest trades by SAC in its criminal case involves tips from a doctor to a portfolio manager at the firm about disappointing results from a drug trial that allowed SAC to avoid losses and make short sales. So why isn't this case exactly the same?

The difference is that insider trading based on tipping requires the source of the information to violate a fiduciary duty when giving it out. In Dirks v. S.E.C., the Supreme Court said that "the test is whether the insider personally will benefit, directly or indirectly, from his disclosure." Mr. Chang was not a tipper because he made the disclosure in connection with his job as an analyst. He did not receive anything from the firms that received his information.

Citigroup prohibits its employees from giving out previews of research. But violation of an internal policy does not turn this case into an insider trading issue, unless there was a special benefit provided by the recipients to get him to release the information.

That explains why this is a case against Citigroup and not Mr. Chang and SAC. The Massachusetts regulator asserts that the firm failed to properly supervise its analyst to prevent advance disclosure of its research, which means the analyst was acting on behalf of the firm when he selectively disclosed his conclusions about iPhone shipments.

This case is similar to a 2012 administrative proceeding brought by the U.S. Securities and Exchange Commission against Goldman Sachs, after the firm's research was selectively disclosed before publication. …