Background
As set forth in the Second Circuit’s opinion, defendant Benjamin Chow’s prosecution stemmed from a FINRA investigation into trading in the stock of Lattice Semiconductor Corporation (Lattice) in connection with the announcement that Lattice had entered into an agreement to be acquired. FINRA flagged the trading of Michael Yin, who acquired more than seven million shares of Lattice through accounts he controlled in the names of others, including two in the names of his parents, in the four months prior to the acquisition announcement—then sold approximately half of those shares after the public announcement, realizing a profit of more than US$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 interest in acquiring Lattice. Chow led negotiations, and met and corresponded with Lattice’s CEO several times regarding the potential acquisition. Chow and the CEO of Lattice entered into an NDA on behalf of their respective companies, which required that the parties not disclose or use any proprietary information of the other party and that the negotiations were 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 U.S.-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, and shortly after the communications Yin acquired shares of Lattice through one of the accounts 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 the 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 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 over seven million shares of Lattice. On November 3, 2016, Lattice announced that it entered an agreement to be acquired by Canyon Bridge. Later that day, Yin sold over half of his shares of Lattice and realized a profit of more than US$5 million.
Chow was indicted on a variety of charges, including 12 counts of insider trading, based on allegations that Chow provided material non-public information about the potential acquisition to Yin, which 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 was under a duty of nondisclosure, the evidence was not sufficient to show he breached the duty or profited from it.
Insider trading liability
Section 10(b) of the Securities Exchange Act of 1934 (Exchange Act) and SEC Rule 10b-5 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 on material, non-public information. The misappropriation theory, on the other hand, holds that a person commits fraud in connection with a securities transaction in violation of the securities laws when he/she misappropriates confidential information for purposes of securities trading in breach of a fiduciary duty owed to the source of the information. See United States v. O’Hagan, 521 U.S. 642, 651-52 (1997). 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.” 17 C.F.R. § 240.10b5-2(b)(1).
In its September 2020 decision in United States v. Kosinski, 976 F.3d 135, 144 (2d Cir. 2020), 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, finding that Kosinski had a duty of trust and confidence to the biopharmaceutical company because Kosinski 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 characterized individuals who entered into non-disclosure agreements, under which they were provided access to company information that they agree not to disclose, as “temporary insiders” bound by a duty to not trade and, on that basis, upheld Kosinski’s insider trading conviction. 976 F.3d 135.
Corporate insiders and individuals with a fiduciary duty to a corporation are further prohibited from tipping insider information to others—tippees—for purposes of trading. Tipping occurs when a tipper provides material nonpublic 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 his fiduciary duty by disclosing information to the tippee, and the tipper receives a personal benefit from the disclosure. Dirks v. SEC, 463 U.S. 646 (1983). The Dirks Court reasoned that absent personal gain to the tipper, there is no breach of duty to stockholders; absent such a breach, there is no breach by the tippee, and thus no liability for the tippee. Id. at 662. Decades later, the Supreme Court clarified that liability did 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.” 137 S. Ct. 420, 427-28 (2016). 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. 894 F.3d 64, 74 (2d Cir. 2017).
Second Circuit decision and implications
On April 6, 2021, the Second Circuit affirmed Chow’s conviction, relying on Kosinski. The Court held that the NDAs Chow signed imposed a legal duty of confidentiality on him that was sufficient to establish a fiduciary duty of trust and confidence. Chow breached the duty, the Court concluded, by disclosing information to Yin, the tippee, and this breach of duty created liability under the misappropriation theory.
With respect to the requirement that a tipper personally benefit to be held liable for insider trading, the Second Circuit reiterated its decision in United States v. Martoma that the government is not required to 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. 894 F.3d 64, 74 (2d Cir. 2018). Nevertheless, the Court noted several benefits Chow received from Yin, the tippee, 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 knowingly and intentionally breached his duty of confidentiality by disclosing material nonpublic information as to the merger between Lattice and Chow’s fund, intending for the tippee to make trades based on that information, indicating that the personal benefit element was satisfied by the tippee benefitting.
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—and, for corporate outsiders, a cautionary tale of the potential liability they could face, at least under circumstances similar to those seen in Kosinski and Chow.
Authored by Ann Kim, James McGovern, Matthew Sullivan, and Rupinder Garcha
