Illegal insider trading refers to buying or selling a stock, in breach of a duty of trust and confidence while in possession of “material, non-public information” about the stock. This can also apply if the person possessing the information (the “tipper”) passes along the information to a “tippee,” who then trades the stock.
Steve is Treasurer of XYZ Corp., which is in talks to be acquired by ABC Corp. at a 50 percent premium to XYZ’s current price. It is illegal for Steve to buy XYZ. Similarly, if he passes along the information to his brother Bill, who then buys XYZ, that is a violation by both the tipper (Steve) and tippee (Bill).
Unfortunately, there’s no statutory definition of what constitutes illegal insider trading, so the law has been developed on a piecemeal basis by the courts, with the definition of illegal activity alternately expanding and contracting.
A significant contraction occurred in December 2014, when the U.S. Court of Appeals reversed the conviction of Todd Newman. The court raised the hurdle for proving illegality, mandating 1) the tipper had to have received a “personal benefit” for providing the confidential information and 2) the tippee had to know the tipper was receiving that personal benefit.
You might have read recently about the lawsuit the Securities and Exchange Commission filed May 19 naming former Dean Foods Chairman Thomas Davis and Las Vegas-based sports bettor William “Billy” Walters as defendants and three-time Masters champion Phil Mickelson as a “relief” defendant. (See a 2011 "60 Minutes" profile of Walters here).
According to the SEC's complaint, Davis was a director of Dean who tipped Walters with highly confidential information concerning Dean from 2008 through 2012, including “sneak previews” of at least six of Dean’s quarterly earnings announcements and advance notice of the spin-off of Dean’s subsidiary WhiteWave (using a prepaid “burner” cell phone provided by Walters and “Dallas Cowboys” as the code word for Dean). Walters, in turn, tipped Mickelson on WhiteWave.
The SEC charged Walters’ trades in Dean stock netted illicit profits of at least $40 million. Davis pleaded guilty in a related criminal case filed by U.S. Attorney Preet Bharara and is cooperating. Mickelson was not accused of wrongdoing, but the SEC argued he was “unjustly enriched” and must disgorge “ill-gotten gains” plus interest totaling just over $1 million, to which he readily agreed.
On June 18, 2008, Davis told Walters that Dean was performing ahead of expectations, according to the SEC. Over the next three days, Walters bought a whopping $73.5 million of Dean’s stock. When Dean publicly announced its good news on June 25, Walters’ profit was a cool $6 million.
Davis owed gambling debts to Walters. In addition, starting in 2010, Walters provided Davis with almost $1 million in “loans,” including $100,000 to repay funds wrongly taken from a domestic abuse charity he managed to pay a gambling debt owed to a Las Vegas casino. This constituted the “personal benefit” received by Davis.
Mickelson also owed gambling debts to Walters. On July 27, 2012, Walters called Mickelson, who bought $2.4 million of Dean’s stock, the SEC said. When Dean announced the spin-off on Aug. 7, the stock popped 40 percent. “Lefty” sold all his shares the next day for a profit of $931,000, using some of the proceeds to repay Walters.
The SEC did not allege Mickelson knew the information furnished to him by Walters came from a breach of a duty of trust by Davis for a personal benefit (i.e. the “Newman” hurdle). Because he was not charged, Mickelson’s lawyer said, “Phil feels vindicated.”
When asked why Mickelson wasn’t charged, Bharara’s indirect response was, “Conduct we think is nefarious, and undermines faith in the market and fairness of the markets, will not be able to be prosecuted because of the Newman decision.”
Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC. He can be reached at (812) 376-9444 or firstname.lastname@example.org.