This week's news that Phil Mickelson, a professional golfer, was caught up in an insider trading crackdown and had to disgorge nearly $1M in profits from stock sales (but was not prosecuted by the SEC) gave me pause. I wasn't actually surprised by this seeming paradox - and maybe it's because I've been sporadically blogging about insider trading for a while now. The question of how you can be obligated to return profits obtained from trading stock on inside information, without actually being prosecuted is a good one, and I'm guessing the muddled answer may elude some. An article in the New York Times this week summed up the matter of Mickelson's insider trading quite handily: "How to Get Away with Insider Trading." In today's blog I'm not going to focus on how to get away with insider trading, but rather on how muddled the definition of insider trading has become in recent years.
The Short Story
You may have caught wind of this story already, so I'll keep my summary of it short. The former chairman of Dean Foods admitted to passing on inside information to a well-known professional sports bettor in Las Vegas. According to the NY Times, "The sports bettor made an estimated $43 million over five years from this information, according to federal prosecutors. A second beneficiary of stock tips was the professional golfer Phil Mickelson, who had gambling debts of his own." Mickelson received the tip to sell stock, sold stock and paid off his gambling debts. So why was Mickelson not charged if he did indeed trade on inside information? Well, he was not named a "defendant" in the civil lawsuit, but rather a "relief defendant." What is a relief defendant? A Fortune article on the topic described the term as "someone who is not accused of wrongdoing but has received ill-gotten gains as a result of others’ illegal acts." The key here is that Mickelson may not have been aware that the tip he got, though inside information, was obtained illegally. Mickelson did agree to disgorge $931,000 in profits from the sale and pay $105,000 in prejudgment interest.
Did you follow all that? I had to sort through it myself. So just how do we define what is considered legal or illegal when trading on non-public information? I've decided to create a short quiz to help sort through the matter.
Test Your Insider Trading Know-All
I've come up with a few questions to help test your know-how, and also sort through the answers. Fun and educational all in one.
Okay, so the quiz doesn't come with a prize. Otherwise I'd have to work harder to hide the answers a little farther away from the questions. But at least you can learn something from our Q&A game.
True or False? Federal law defines "insider trading" as any trade that is made on the basis of material, non-public information: False. There is no federal law that defines insider trading. This is particularly problematic in prosecuting insider trading cases. The New York Times reported that "First, neither Congress nor the S.E.C. has ever defined “insider trading” in a comprehensive way. So our laws are largely made by judges who, bound by precedent, rarely update law to fit new circumstances." In a previous NASPP Blog titled "Insider Trading Isn't Illegal?) (April 2, 2015), I explained that "...although the SEC has been successful in pursuing these cases, they have had to use loopholes to do so – relying on general antitrust laws and decades of case law (and, I’m not a lawyer, but I’m told that case law is subject to interpretation by individual judges, so the application of that could vary widely). The bottom line is there isn’t a statute that specifically addresses insider trading, which leads to potential ambiguity and inconsistencies in the courts."
True or False? One is not likely to be charged with insider trading if they trade on a stock tip but remained unaware of any benefit the provider of the tip obtained for that information (e.g. friend says "buy this stock" with no further details as to how they got the information.): True (likely). The answer to question 3 is a bit muddled, but thanks to the appeals court case of United States v. Newman, which overturned the convictions of two hedge fund managers for insider trading because the government failed to prove they had known about any benefit provided to the sources of the information, it's not likely the SEC will be bringing formal charges against those innocents embroiled in insider trading cases who lacked understanding of the benefit the tipper may have received for that information (which is seemingly how things played out in the Mickelson case.) The Supreme Court has agreed to hear the appeal of the securities fraud conviction in Salman v. United States. According to the New York Times, "The court will consider what evidence the government must introduce to prove a benefit passed between a source of confidential information and the recipient who trades on it, called the 'tippee.'" That won't happen until 2017. For more details, view the full New York Times article "The Rocky Road of Insider Trading Law." (April 2016)
True or False? In order to be required to disgorge trading profits to the SEC, you must be found guilty of charges of civil or criminal wrongdoing related to insider trading: False. As we have seen with the Mickelson case, the SEC has means to prompt those involved in insider trading (even if they did not engage in wrongdoing themselves) to return the profits they obtained from the related trades. In the Mickelson case, naming him as a relief defendant in the civil case allowed the SEC to pursue disgorgement of the profits.
Clearly a lot still needs to be settled when it comes to clearly defining insider trading. What seems clear is that those involved in trading stock should do their absolute best to ensure the trade is not based on any material, non-public information. Even if prosecution isn't imminent, profits would still likely need to be repaid in an SEC investigation that finds insider trading somewhere in the chain of events. As stock plan professionals we're likely well aware of insider trading policies and practices designed to prevent trading on inside information. Education of our employees in this area should address the recent publicity around insider trading that has likely created more questions than provided answers. At minimum, employees should be taught to scrutinize information they receive about trading stocks, and be very careful about sharing their own company's information with others. That's pretty consistent age old advice that still applies in modern times, even with all the ambiguity around what really is truly illegal when it comes to trading on inside information.