The Second Circuit recently affirmed the 2018 insider trading conviction of Benjamin Chow, a corporate outsider who was found guilty of tipping off his former colleague about a potential acquisition of a US publicly traded company. The case, United States v Chow, involved allegations that Chow, a managing partner of one of the potential acquirors and a founder of a second potential acquiror, had breached non-disclosure agreements (NDAs) with the potential target company and provided his former colleague with non-public information about the acquisition.(1) For the second time within a year, the Second Circuit has addressed the issue of whether the breach of a duty of confidentiality created by an NDA can form the basis for insider trading liability. Relying on its September 2020 decision in United States v Kosinski,(2) the Second Circuit affirmed Chow's conviction, once again ruling that a breach of an NDA can lead to insider trading liability.
As set out in the Second Circuit's opinion, Chow's prosecution stemmed from a Financial Industry Regulatory Authority (FINRA) investigation into trading in the stock of Lattice Semiconductor Corporation in connection with the announcement that Lattice had entered into an agreement to be acquired. FINRA flagged the trading of Michael Yin, who had acquired more than 7 million shares of Lattice through accounts that he controlled in the names of others, including two in the names of his parents, in the four months prior to the acquisition announcement. Yin had then sold approximately half of those shares after the public announcement, realising a profit of more than $5 million.
During the course of the investigation, FINRA learned that Chow and Yin were former business colleagues and social acquaintances. Chow was a managing director at a Chinese state-owned private equity firm that had expressed an interest in acquiring Lattice.
Chow led negotiations and met and corresponded with Lattice's CEO several times regarding the potential acquisition. Chow and Lattice's CEO entered into an NDA on behalf of their respective companies which required the parties not to disclose or use any proprietary information of the other party and the negotiations to remain confidential. The parties took several other precautions to maintain the confidentiality of the potential acquisition and negotiations, such as:
- using code names for each other;
- meeting in hotel conference rooms rather than at Lattice's offices; and
- including reminders of the NDA and other legends prohibiting disclosure within their written and presentation materials.
Lattice's board eventually rejected Chow's firm's offer. The next day, Chow informed Lattice that he would be submitting another proposal to acquire Lattice through Canyon Bridge Capital Partners, a US-based fund that Chow was purportedly starting. Chow subsequently entered into a second NDA with Lattice on behalf of Canyon Bridge.
During the course of Chow's negotiations with Lattice, he communicated with Yin numerous times, including:
- meeting in person;
- exchanging emails, text messages and WeChat messages; and
- speaking by phone.
These communications occurred close to significant events during the course of the negotiations between Lattice and both the Chinese state-owned private equity firm and Canyon Bridge. Shortly after the communications, Yin acquired shares of Lattice through one of the accounts that he controlled. On one occasion, in response to a WeChat message from Yin asking about Chow's return to Beijing, Chow responded that he was "making a deal" and "can't come back". Following this exchange, when NASDAQ next opened, Yin purchased 120,000 shares of Lattice. On another occasion, Yin and Chow agreed to meet in person. Later that same day, Yin bought over 100,000 shares of Lattice. During the days that followed, the accounts that Yin controlled purchased an additional 1,005,111 Lattice shares. Following the last purchase, Yin sent a text message to an associate stating: "[A] friend of mine recently said that Lattice Semiconductor's project is moving forward. If quick, there would be intentions by mid October."
Over the course of a few months, Yin amassed more than 7 million shares of Lattice. On 3 November 2016 Lattice announced that it had entered an agreement to be acquired by Canyon Bridge. Later that day, Yin sold over half of his shares of Lattice and realised a profit of more than $5 million.
Chow was indicted on various charges, including 12 counts of insider trading based on allegations that he had provided material non-public information about the potential acquisition to Yin, which had led to Yin acquiring large positions in Lattice shares. Following a nine-day jury trial, Chow was convicted of numerous charges, including six of the 12 counts of insider trading. Chow appealed his conviction, primarily contending that the execution of NDAs with Lattice was insufficient to subject him to prohibitions against insider trading and that even if he had been under a duty of non-disclosure, the evidence was not sufficient to show that he had breached or profited from such duty.
Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder prohibit insider trading under two theories of liability – a traditional theory and a misappropriation theory. Under the traditional theory of insider trading liability, federal securities laws are violated when corporate insiders trade in the securities of their company on the basis of material, non-public information. On the other hand, the misappropriation theory holds that a person commits fraud in connection with a securities transaction in violation of the securities laws when they misappropriate confidential information for the purpose of securities trading in breach of a fiduciary duty owed to the source of the information.(3) Rule 10b5-2, promulgated in 2000, provides that "[f]or purposes of [§ 10(b)], a 'duty of trust or confidence' exists", among other times, "[w]henever a person agrees to maintain information in confidence".(4)
In its September 2020 decision in United States v Kosinski,(5) the Second Circuit affirmed the insider trading conviction of a principal investigator for a clinical trial of a drug developed by a publicly traded biopharmaceutical company. The court found that Kosinski owed a duty of trust and confidence to the biopharmaceutical company because he had signed agreements with confidentiality provisions, including his express agreement to keep company information confidential, which was sufficient to form the basis for insider trading liability. In Kosinski, the Second Circuit characterised individuals who entered into NDAs, under which they were provided access to company information that they agreed not to disclose, as "temporary insiders" bound by a duty not to trade. On that basis, the Second Circuit upheld Kosinski's insider trading conviction.(6)
Corporate insiders and individuals with a fiduciary duty to a corporation are further prohibited from tipping insider information to others for the purposes of trading. Tipping occurs when a tipper provides material, non-public information to a tippee and the tippee then trades on that information. The Supreme Court has held that a tippee is liable for insider trading where the tipper has breached their fiduciary duty by disclosing information to the tippee and the tipper receives a personal benefit from the disclosure. For instance, the court in Dirks(7) reasoned that absent a personal gain to the tipper, there is no breach of duty to stockholders, and that absent such a breach, there is no breach by and thus no liability for the tippee.(8) Decades later, the Supreme Court clarified that liability does not require evidence that the tipper received pecuniary gain. In Salman v United States, the court held that "when a tipper gives inside information to 'a trading relative or friend,' the jury can infer that the tipper meant to provide the equivalent of a cash gift".(9) The Second Circuit further explored the personal benefit requirement in United States v Martoma and held that the personal benefit element is satisfied where there is evidence that the tipper intended to benefit the recipient.(10)
On 6 April 2021 the Second Circuit, relying on Kosinski, affirmed Chow's conviction. The court held that the NDAs which Chow had signed imposed a legal duty of confidentiality on him that was sufficient to establish a fiduciary duty of trust and confidence. The court concluded that Chow had breached this duty by disclosing information to Yin, the tippee, and that this breach of duty created liability under the misappropriation theory.
With respect to the requirement that a tipper personally benefit in order to be held liable for insider trading, the Second Circuit reiterated its decision in United States v Martoma that the government need not show that the tipper expected or received a specific or tangible benefit in exchange for the tip and that the personal benefit element is satisfied by the tipper's intent to benefit the tippee.(11) Nevertheless, the court noted several benefits that Chow had received from Yin, such as:
- analyst reports on the semiconductor industry;
- recommendations for partners in Chow's business venture; and
- wine and cigars.
The court added that the evidence was sufficient to infer that Chow had knowingly and intentionally breached his duty of confidentiality by disclosing material, non-public information concerning the merger between Lattice and Chow's fund with the intention of the tippee making trades based on that information. This indicated that the personal benefit element was satisfied by the tippee benefiting.
Unlike other aspects of securities fraud and insider trading in which the law has been in some flux in recent years, the issues decided by the Second Circuit in Chow represent a confirmation and degree of continuity. This is a cautionary tale for corporate outsiders of the potential liability that they could face, at least under circumstances similar to those seen in Kosinski and Chow.
Endnotes
(2) 976 F3d 135 (2d Cir 2020).
(3) See United States v O'Hagan, 521 US 642, 651-52 (1997).
(4) 17 CFR Section 240.10b5-2(b)(1).
(5) 976 F3d 135, 144 (2d Cir 2020).
(7) Dirks v SEC, 463 US 646 (1983).
(9) 137 S Ct 420, 427-28 (2016).
