On March 31, 2014, the Securities and Exchange Commission brought insider trading charges against Ching Hwa Chen, the husband of a corporate insider, alleging that he misappropriated financial information from his wife and then shorted her employer’s stock, netting $138,000 in ill gotten gains. SEC v. Chen, No. 5:14-cv-01467 (N.D. Cal). The SEC’s allegations (taken from its complaint) are as follows: Chen’s wife was the Senior Tax Director of Informatica, a data integration company. In late June 2012, Informatica learned it would miss its revenue guidance for the first time in 31 consecutive quarters. That miss caused the defendant’s wife to work more than usual as the company scrambled to close its books and prepare for a potential pre-release of its quarterly revenues. Over the next several days, the defendant overheard his wife’s phone calls addressing the revenue miss, including on a four-hour drive to Reno, Nevada where his wife fielded calls from the passenger seat as he drove. Early the next week, convinced that Informatica’s stock would lose value, Chen bet heavily against the company, shorting its stock, buying put options, and selling call options. In early July, after announcing the miss, Informatica’s stock price fell 27% from $43 to $31. Chen closed out all of his positions that same day.
The Commission’s complaint alleges that Chen “misappropriated” information from his wife in violation of Section 10(b) and Rule 10b-5. There are three basic theories of liability for insider trading under the federal securities laws. The first, or classical theory, generally occurs when a corporate insider, usually an employee, learns of material nonpublic information about her own employer and then trades on that information without disclosing it to the stockholder on the other side of the trade. Here, the law sees the employee’s breach of fiduciary duty to the trading stockholder as a fraudulent act in violation of Rule 10b-5. See generally Chiarella v. United States, 445 U.S. 222 (1980).
The second theory is tipper-tippee liability, where a corporate insider discloses material nonpublic information to an outsider who then trades on that information. If (i) the insider breached a fiduciary duty to his employer by disclosing the information and did so for personal benefit, and (ii) the tippee either knew or had reason to know of the breach, the tippee is liable under the securities laws. See generally Dirks v. SEC, 463 U.S. 646 (1983). (The tipper would also be liable under this scenario, as seen in the Rajat Gupta case.)
The third and final theory—used by the SEC here—is the misappropriation theory. There, a corporate outsider learns of material nonpublic information from a corporate insider who may have provided it for legitimate business reasons or believed that the information would be kept confidential. The outsider then essentially “steals” that information for his or her own personal benefit. Rather than being founded on an insider’s breach of fiduciary duty for personal benefit, the misappropriation theory developed out of criminal mail and wire fraud law and is premised on the theft of information. That theft is considered the fraudulent act “in connection with” the purchase or sale of a security under Rule 10b-5. See generally United States v. O’Hagan, 521 U.S. 642 (1997).
In recent history, the SEC has brought a number of cases against the spouses of corporate insiders (or other fiduciaries) who are alleged to have misappropriated information and then traded on it. See, e.g., SEC v. Hawk, No. 5:14-cv-01466 (N.D. Cal. Mar. 31, 2014); SEC v. Balchan, No. 4:13-cv-00298 (S.D. Tex. Feb. 6, 2013); SEC v. Hanold, No. 11-cv-07148 (N.D. Ill. Oct. 11, 2011); SEC v. Marovitz, No. 1:11-cv-05259 (N.D. Ill. Aug. 3, 2011). In most cases, the corporate insider has unwittingly trusted his or her spouse and, as was alleged here, openly discussed the confidential information in his or her presence. In other cases, the spouse may have gone to great lengths to maintain the confidentiality of the information only for the spouse to have figured it out. In both instances, the SEC has charged under the misappropriation theory.