Explain how insider trading in Abbott Laboratories acquisition led to serious charges.
My name is Steve Hart, and I am a contributing journalist for Compliance Mitigation. I am a Partner at Conformity 360, a compliance consulting firm, serving as the resident subject matter-expert in buy-side Compliance. Prior to joining Conformity360, I was Chief Compliance Officer (“CCO”) for the prestigious firm Allen & Company, and prior to that, served as the Global Chief Administrative Officer for Compliance at BlackRock, the world’s largest asset management company. I hold an Investment Adviser Core Certification, an M.S. in Banking and Financial Services from Boston University and a B.A. in Political Science from the University of Pennsylvania.
Having worked as the CCO for Registered Investment Advisers (“RIAs”), I have been through numerous regulatory audits and examinations. Experience gives me insight into how the SEC conducts investigations and attempts to obtain enforcement actions.
After completing this case study, the participants will be able to:
- Define insider trading.
- Define fiduciary duty.
- Explain why insider trading breaches a RIA’s fiduciary duty standard.
- Understand what prompts the Securities Exchange Commission (“SEC”) to bring enforcement actions against RIAs concerning insider trading.
- Identify market manipulation.
Insider Trading, Fiduciary Duty, Material Non-Public Information, Market Manipulation, Tipping
Some financial services see no problem getting a little edge by engaging in insider trading. Most, however, deem it unethical. Regardless, getting caught engaging in it can lead to serious legal consequences. Insider trading decreases market efficiencies in the long term through market manipulation. “Unfairness offends human sensibilities and people may either punish those who treat them unfairly, or opt out of the game.” Investors then may stay out of the market if they see rampant insider trading. If enough investors stay out of the market and make other investments instead, such as “buy government bonds only, market efficiency will be harmed.”
In recent years, the SEC has brought insider trading cases against hundreds of entities and individuals, including financial professionals, hedge fund managers, corporate insiders, attorneys, and others whose “illegal tipping or trading has undermined the level playing field that is fundamental to the integrity and fair functioning of the capital markets.”
The Securities and Exchange Commission (“SEC”) charged two business associates in Chile with insider trading on nonpublic information that one of them learns while serving on the board of directors of a pharmaceutical company. The SEC alleges that Juan Cruz Bilbao Hormaeche exploits highly confidential information from CFR Pharmaceuticals S.A. board meetings at which parties discuss Abbott Laboratories’ tender offer. The SEC obtains a court order to freeze assets in the U.S. brokerage accounts used to conduct the trading.
Enforcement of insider trading cases will increase as technology makes it easier for the government to follow the inevitable electronic trail. Household names like Martha Stewart have been found guilty of insider trading. Martha Stewart maintains she did not know she traded on insider information. The SEC going forward will not take into consideration whether a party consciously knows if it is engaging in insider trading. Brokerage and trading firms must have reasonably designed policies and procedures to prevent the abuse of material, non-public information that can, and will, lead to insider trading.
Illegal insider trading generally occurs when a security is bought or sold in breach of a fiduciary duty or other relationship of trust and confidence while in possession of material, nonpublic information. Insider trading violations can include the “tipping” of such information to others who trade on the information. Insider trading continues to be a high priority area for the SEC’s enforcement program and the Department of Justice. It will undoubtedly remain a high priority for the foreseeable future.
In a U.S. brokerage account of which he is the beneficiary, Bilbao purchases millions of dollars’ worth of American Depositary Shares (“ADS”) of CFR Pharmaceuticals on the basis of nonpublic information about progressing negotiations between the two companies. Bilbao uses Tomás Andrés Hurtado Rourke to place the trades in the brokerage account, and Hurtado also purchases several hundred thousand dollars’ worth of ADS in his own U.S. brokerage account.
After Abbott Laboratories publicly announces a definitive agreement to acquire CFR Pharmaceuticals and commences the tender offer, Bilbao and Hurtado tender the ADS they purchase. They gain approximately $10.6 million in illicit profits. Bilbao abused his position on a company’s board as he stockpiled ADS on the basis of inside information that “a major payday was coming soon on those shares.”
The SEC’s complaint filed in U.S. District Court for the Southern District of New York alleges that Bilbao violates “Sections 10(b) and 14(e) of the Securities Exchange Act of 1934 and Rules 10b-5 and 14e-3.” The complaint also alleges Hurtado violates “Sections 14(e) and 20(e) of the Exchange Act and Rule 14e-3.” The complaint seeks disgorgement of “ill-gotten gains” plus prejudgment interest and financial penalties in addition to permanent injunctions against further violations of these provisions of the securities laws.
In June 2020, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) issues a Risk Alert highlighting several problem areas it identified in examinations of Investment Advisers, both registered and exempt. Many of the items raised in this Risk Alert have been the subject of recent SEC enforcement actions against insider trading. The Risk Alert focuses on policies and procedures regarding employees’ access to material non-public information.
Insider trading is an unethical practice. It is unfair and illegal. Insiders have access to information that is not given to the public. Unequal possession of information is an advantage that cannot be competed away because this advantage depends on a lawful privilege to which an outsider cannot acquire access.
RIAs have a fiduciary duty to their clients. A fiduciary duty exists when a person or entity places trust, confidence, and reliance on another to exercise discretion or expertise in acting on behalf of the client. The fiduciary must knowingly accept that trust and confidence. In the U.S. legal system, a fiduciary duty describes a relationship between two parties that obligates one to act solely in the interest of the other. The party designated as the fiduciary owes a legal duty to a principal, and strict care must be taken to ensure that no conflict of interest arises between the fiduciary and the principal.
Many insider trading cases occur due to deficiencies falling under “Section 206 of the Investment Advisers Act of 1940,” which applies equally to RIAs (as well as those required to be registered) and to “exempt reporting advisers” (e.g., advisers with less than $150 million of assets under management in the United States and advisers solely to venture capital funds). Consequently, exempt reporting advisers should be mindful of any such deficiencies in their compliance programs. The OCIE announced plans to begin examining both RIAs and exempt reporting advisers as part of its routine examination program. The Justice Department is also constantly lurking in the background on these types of cases, occasionally cherry-picking ones ripe for criminal action as well.
Regulations obligate Financial Services Firms to maintain and enforce policies and procedures reasonably designed to prevent the misuse of material non-public information. In response to this requirement, RIAs must adopt rigid insider trading policies as part of their codes of ethics. The OCIE Staff observes that RIAs often fail to establish or enforce insider trading policies, including the monitoring and preclearance of personal trading of securities by employees.