The Blindsided Insider: Insider Trading Liability for Supervising a Rogue Trader

Cleveland State University EngagedScholarship@CSU Cleveland State Law Review Law Journals 2013 The Blindsided Insider: Insider Trading Liability for Supervising a Rogue Trader Adam Felsenthal Follow this and additional works at: https://engagedscholarship.csuohio.edu/clevstlrev Part of the Securities Law Commons How does access to this work benefit you? Let us know! Recommended Citation Adam Felsenthal, The Blindsided Insider: Insider Trading Liability for Supervising a Rogue Trader , 61 Clev. St. L. Rev. 167 (2013) available at https://engagedscholarship.csuohio.edu/clevstlrev/vol61/iss1/7 This Article is brought to you for free and open access by the Law Journals at EngagedScholarship@CSU. It has been accepted for inclusion in Cleveland State Law Review by an authorized editor of EngagedScholarship@CSU. For more information, please contact . THE BLINDSIDED INSIDER: INSIDER TRADING LIABILITY FOR SUPERVISING A ROGUE TRADER ADAM FELSENTHAL* ABSTRACT In the past few years, federal prosecutors and the Securities and Exchange Commission (SEC) have engaged in the widest-ranging and most successful probe of insider trading ever, focusing in particular on investment professionals. However, the government has failed to charge anyone on the basis of supervisory liability, essentially an accusation of failing to notice and stop illicit trading done under one’s supervision. This Article discusses all of the potential ways in which prosecutors could bring such a charge, ranging from SEC administrative liability to civil and criminal charges. Through the lens of a theoretical situation in which an “innocent bystander” manager has failed to stop a “rogue trader” from trading on the basis of material non-public information, it proposes answers for some of the unanswered questions in this area of the law, and assesses the practical potential for the government bringing any of the above charges against such a manager. INTRODUCTION ................................................................................ 168 ANALYSIS ........................................................................................ 169 I. GLOBAL ISSUES IN CONTROL PERSON LIABILITY................. 169 A. Definition of “Control Person” ................................... 169 1. Statutory Definition and Regulatory Guidance ............................................................... 170 2. Case Law .............................................................. 170 3. Insider Trading Context........................................ 172 B. Delegation ................................................................... 172 II. SECTION 20(A) OF THE EXCHANGE ACT............................... 173 A. Statutory Background .................................................. 173 B. Requirement of “Culpable Participation” .................. 174 C. Case Law Analysis/Factual Basis for Liability ........... 176 D. Good Faith Defense ..................................................... 177 E. Application to “Innocent Bystander” Managers......... 179 III. THE INSIDER TRADING AND SECURITIES FRAUD ENFORCEMENT ACT (ITSFEA) OF 1988 ....................................................... 179 A. Statutory Background .................................................. 179 B. Case Law ..................................................................... 180 * J.D., New York University School of Law, 2010; B.S. Yeshiva University, 2004. The opinions expressed herein are solely those of the author. 167 Published by EngagedScholarship@CSU, 2013 1 168 CLEVELAND STATE LAW REVIEW [Vol. 61:167 C. Application to “Innocent Bystander” Managers......... 181 IV. SEC ADMINISTRATIVE LIABILITY ........................................ 181 A. Section 203(e) and (i) of the Investment Advisers Act ................................................................. 181 B. Cease and Desist Enforcement .................................... 184 1. Section 203(k) of the Investment Advisers Act ......................................................... 185 2. Exchange Act ....................................................... 185 3. Case Law .............................................................. 186 V. PRIMARY LIABILITY............................................................. 187 A. Conscious Avoidance ................................................... 187 B. Civil Aiding and Abetting Liability.............................. 188 C. Prior Law on “Substantial Assistance” Requirement ................................................................. 189 D. New Standard of Second Circuit ................................. 190 VI. CRIMINAL LIABILITY ........................................................... 191 A. Conspiracy ................................................................... 192 B. Criminal Aiding and Abetting Liability ....................... 192 C. Criminal Violation of Section 20(a) ............................ 193 CONCLUSION ................................................................................... 193 INTRODUCTION One of the greatest nightmares of any investment professional is of being accused of insider trading. Recently, this has become closer to reality. The Department of Justice, the Federal Bureau of Investigation (FBI), and the Securities and Exchange Commission (SEC) (collectively, the “government”) have been engaged in a broad investigation of insider trading over the past few years. Insider trading involves the trading of a public company’s stock on the basis of material non-public information. Public corporations must disclose material information to all investors or potential investors at the same time. This five-year investigation, dubbed “Perfect Hedge,” is primarily run by prosecutors in the U.S. Attorney’s office in the Southern District of New York, the FBI’s New York office, and the Securities and Exchange Commission. One theory of liability that has not yet been utilized in the insider trading probe is “control person” liability or liability arising from a manager’s supervision of an employee or firm that has violated the securities laws, even if the manager him or herself has not committed a crime. However, the government has indicated that it will step up this area of enforcement. Merri Jo Gillette, Director of the Chicago Regional Office of the Securities and Exchange Commission, recently stated that the SEC “is now bringing more secondary liability cases.”1 This Article analyzes the 1 Noam Noked, An “Entrepreneurial” and Restructured SEC Pledges Proactive Enforcement, HARV. L. SCH. FORUM ON CORPORATE GOVERNANCE & FIN. REGULATION, http://blogs.law.harvard.edu/corpgov/2012/04/05/an-entrepreneurial-and-restructured-secpledges-proactive-enforcement/ (last visited Jan. 26, 2013). https://engagedscholarship.csuohio.edu/clevstlrev/vol61/iss1/7 2 2013] THE BLINDSIDED INSIDER 169 potential civil and criminal “control person” or supervisory liability of a manager arising from violatio (...truncated)