By Andrew H. Yong, J.D. Candidate
You’re a Fortune 100 sales executive. You earn a $120,000 salary, which provides for a comfortable life in the Midwest. However, after paying your mortgage, car payment, and your children’s college bills, your monthly bank statements are hardly flush. On top of that, your 401(k) was decimated in the downturn, erasing decades of savings. You are dissatisfied with your career as a middle manager.
Suddenly the phone rings.
“How would you like to make a $1,000 an hour on your lunch break? All you have to do is take a phone call and answer some questions about your company with some New York investment folks.”
This is all too good to be true, you think to yourself. But why not? The caller, a salesman at a research firm assures you that you won’t have to do anything illegal; and besides, wouldn’t a shiny new Porsche look great in your driveway?
And thus, an expert paid consultant is born.
A slew of guilty verdicts in recent enforcement actions stemming from sweeping government investigations into insider trading at hedge funds bucks the apparent lax criminal enforcement of post-financial crisis Wall Street, and raises novel definitional issues of insider trading.
James Fleishmann, a former Silicon Valley sales manager at Primary Global Research, was recently found guilty by a Manhattan federal jury of one charge each of conspiracy to commit securities fraud and conspiracy to commit wire fraud. Mr. Fleishmann once operated as the caller in the above hypothetical, arranging discussions between technology executives and investors. The government alleges illegal stock tips were swapped during these meetings about Apple, Dell, and other technology companies.
Experts, of course, are not limited to sales executives. They can be customers (who may place large purchase orders), clients, or even physicians engaged in clinical trials for the latest potential biotech or pharmaceutical blockbuster. Indeed, there are many legitimate and valuable reasons for investors to speak with industry experts that have nothing to do with the expert’s employer, let alone material non-public information. Such legitimate examples include offering explanations of how particular industries operate, interpretation of jargon, and discussion general trends.
In recent years, hedge funds have grown dramatically in scale and influence; the industry now manages a record $2 trillion in assets. In explaining the rise of the expert-network industry and their push against permissive boundaries, observers commonly cite the previously unregulated nature of hedge funds, coupled with the fierce competitiveness of often rapid-fire trading, and the promise for outsized compensation for traders. Yet the actual reasons for the expert-network industry’s concomitant rise are more nuanced. The sell-side research scandals of a decade ago, which made Jack Grubman and Henry Blodget household names (or at least staple MBA case-studies), and Regulation FD in 2000, which effectively severed the direct lines between Wall Street and company management, operate just as much to create an environment which allows expert-network firms to flourish, in essence, playing an advanced game of telephone to circumvent regulation.
The extension of insider trading to expert-network is the latest development in insider trading law, whose primary regulatory vehicle is §10(b) of the Securities Exchange Act and §10b-5 of the rules promulgated by the Securities and Exchange Commission in 1942. Since enactment, courts have gradually expanded the scope of §10(b) and §10b-5 in cases such as Texas Gulf Sulphur, which expansively spoke with any person with material, non-public information being subject to the “disclose or abstain” proscription, and U.S. v. O’Hagan,where the Supreme Court validated the “misappropriation theory,” extending securities fraud liability to “outsiders,” thus viewed as a high-water mark for finding insider trading liability.
Factually, Mr. Fleishman’s case can be seen as a cross of O’Hagan and Dirks v. SEC, where the Court found liability for a tippee who had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received personal benefit. Mr. Fleishman’s case is unique in that he was, technically speaking, neither a tipper (paid consultant or industry insider) nor a tippee (trader). Thus, the Dirkstheory of tippee fiduciary duty is not directly on point as Fleishman may very well have no personal knowledge of material nonpublic information. While Fleishman did not benefit directly through securities transactions, as O’Hagan did, the jury correctly found liability by application of §10(b)’s “in connection with the purchase or sale of any security” requirement to reach the critical middle-man activity linking insiders with traders.
Federal prosecutors in Manhattan have, over the past two years, obtained 50 guilty pleas or convictions among the 54 individuals charged with insider trading crimes. Mr. Fleishman was the sixth person to take a case to trial, and all have been found guilty. These government enforcement wins rightfully serve as a deterrent to investors seeking to profit by obtaining an informational advantage in circumvention of disclosure rules. This is a primary purpose of the Securities and Exchange Act to “insure [sic] honest securities markets and thereby promote investor confidence.” With continuing domestic economic malaise and a seemingly unrepentant Wall Street, these convictions served as an important signal to Main Street and Wall Street that bad behavior will not be tolerated. The challenge, of course, remains how securities jurisprudence will evolve to keep up with Wall Street practices without unduly stifling necessary innovation.