Written by Alan P. Gardner, Joseph N. Blinick and Douglas Fenton
A recent decision by the Ontario Court of Appeal has provided a powerful reminder to capital market participants to exercise caution before trading on a tip or discussing material non-public information—lest they run afoul of the prohibitions on insider trading and tipping in the Securities Act.
In Finkelstein v. Ontario Securities Commission, 2018 ONCA 61 [Finkelstein], the Ontario Court of Appeal considered the definition of a "person in a special relationship with an issuer," as it applies to an individual who learns of material non-public information from "successive tippees." In particular, the decision provides guidance as to when an individual who receives material non-public information will be found to be in a special relationship on the basis that they "ought reasonably to have known" that the source of that information was in a special relationship with the issuer.
Insider Trading and Tipping Under the Securities Act
The Securities Act prohibits any person in a "special relationship" with an issuer from trading in securities of the issuer while in possession of material non-public information ("insider trading") or from informing any other person of the material non-public information, except in the necessary course of business ("tipping").
Under the Securities Act, a "person in a special relationship" is defined to include insiders, directors, officers, and employees of the issuer. As a result, these persons are automatically captured by the insider trading and tipping prohibitions. The definition of a "person in a special relationship" also captures any person who learns of material non-public information from someone the individual "knows" or "ought reasonably to know" is in a special relationship with the issuer. Importantly, this can capture not only an individual who gets a tip directly from an insider, but also those who receive a tip from a successive tippee. The Court of Appeal's decision in Finkelstein provides important guidance as to whether a tippee "ought to have known" that the other person was in a special relationship with the issuer and clarifies the outer boundaries of liability for those down the "tipping chain".
In 2014, the Ontario Securities Commission (OSC) commenced proceedings against five individuals for alleged violations of the insider trading and tipping prohibitions in the Securities Act by recommending to family, friends and clients that they purchase shares of Masonite International Corporation, prior to the disclosure of a pending takeover bid. The OSC alleged that information about the proposed takeover bid (which was material non-public information) flowed through a chain of five people, beginning with a lawyer (Finkelstein) who was acting as Masonite's counsel with respect to the bid Finkelstein conveyed material facts about the takeover bid to an investment advisor friend (Azeff), who in turn informed an accountant (L.K), who passed the information on to another investment advisor (Miller), who conveyed the information to his associate (Cheng). Azeff also conveyed the material non-public information to another investment advisor (Bobrow). The OSC commenced proceedings against each individual, other than L.K, the accountant.
The OSC hearing panel found that each were in a special relationship with Masonite and had engaged in illegal insider trading and tipping. All five appealed to the Divisional Court, where only Cheng was successful. Since Cheng was the furthest removed from the source of the material non-public information (having received the information fourth-hand), the Divisional Court's decision suggested it may be more difficult to establish that a tippee was in a "special relationship" with an issuer the further they are down the "tipping chain." The OSC appealed the Divisional Court's decision to the Court of Appeal.
The Court of Appeal
The issue for the Court of Appeal was whether OSC had properly identified the circumstances in which an individual that learns of material non-public information "ought reasonably to have known" that the tipper was in a special relationship with the issuer.
The Court of Appeal expressly endorsed the framework applied by the OSC hearing panel for determining whether "a person standing in the shoes of the tippee would reasonably assume that the material non-public information passed on to him originated from a person" in a special relationship with the issuer. While not purporting to outline an exhaustive list of factors, the Court of Appeal found it relevant to consider:
- the relationship between the tipper and tippee;
- the professional qualification of the tipper (and, in particular, whether the tipper works in a setting where transactions and material non-public information are discussed);
- the professional qualifications of the tippee (and, in particular, whether the tippee's profession puts the tippee in a position to know that he/she cannot take advantage of confidential information);
- the nature and detail of the material non-public information;
- the time between the tippee receiving the material non-public information and trading;
- any intermediate steps taken by the tippee before trading to verify the material non-public information (with the absence of any steps to verify the information suggesting that the tippee believed the tipper to be in a special relationship);
- whether the tippee had ever owned the particular stock before; and
- whether the trade was significant, given the size of the tippee's portfolio.
In weighing these factors, the Court of Appeal indicated that the inference that the tippee "ought reasonably to have known" that the tipper was in a special relationship will be stronger where the tippee is a market registrant. In this regard, the Court of Appeal adopted the OSC's view that "a higher standard of vigilance and inquiry must be expected from a registrant than from someone who is a retail investor."
Applying these factors, the Court of Appeal determined the OSC hearing panel had properly found Cheng to be in a special relationship with Masonite at the time he traded in securities of the company. The Court of Appeal therefore overturned the Divisional Court, and restored the OSC hearing panel's decision.
In establishing a framework for when a tippee "ought reasonably to have known" that the tipper was in a special relationship with the issue, Finkelstein clarifies the outer boundaries of liability for insider trading and tipping down the "tipping chain." The decision also provides a powerful reminder that market participants must exercise caution before acting on a tip or discussing material non-public information. In particular, Finkelstein suggests that before trading on a tip, one should make reasonable inquires as to the source of the tip—with a view to identifying if the information is material non-public information and if the source of the tip is in a special relationship with the issuer. Simply being far removed from the original source of the material non-public information will not protect a market participant from liability for insider trading or tipping under the Securities Act.