Combatting insider trading has been a high priority for the government since the 2008 financial crisis. From 2009 to 2012, the Securities and Exchange Commission (SEC) filed 168 civil insider trading actions, more than in any other three-year period in the agency’s history.1 In that same period, Manhattan U.S. Attorney Preet Bharara charged 72 people with counts of criminal insider trading, including some of the highest profile insider trading defendants in decades.2 Last year alone, the Financial Industry Regulatory Authority (FINRA) referred 347 insider trading cases to various enforcement agencies—a record year for the self-regulatory organization.3 This unprecedented wave of cases occasions a review of several key insider trading issues likely to be litigated in 2013 and beyond—some new and some longstanding. To that end, this article addresses: (i) the current scope of insider trading liability as to "non-insiders"; (ii) the government’s recent use of wiretap evidence in insider trading trials; and (iii) the status of the long-standing "use" vs. "possession" debate concerning the necessary standard to establish intent in insider trading cases.

Insider Trading Liability for ‘Non-Insiders’

Despite its moniker, liability for insider trading extends beyond corporate insiders in various situations, and the government continuously seeks to expand its scope. By way of background, the "classical theory" of insider trading prohibits a corporate insider from trading in the securities of his or her corporation on the basis of material, nonpublic information without disclosing that information to shareholders. Even under the classical theory, however, the government has successfully imposed liability on non-insiders. For example, courts have held that non-insiders may become "temporary insiders" by entering into certain confidential relationships with a company. "Temporary insider" status has been imposed on lawyers, consultants, accountants and various other agents who received confidential corporate information as part of their engagement with a company. Additionally, any individual who receives information from a corporate insider regardless of his or her relationship with the company may be subject to insider trading liability as a "tippee," if the individual knows or should have known the tip received was an improper disclosure.

In 1997, in United States v. O’Hagan, the U.S. Supreme Court recognized a new theory of insider trading—the misappropriation theory—which further expanded the scope of insider trading liability as to non-insiders. The misappropriation theory prohibits a non-insider from misappropriating "confidential information for securities trading purposes, in breach of a duty owed to the source of the information."4 Importantly, the court stated that this duty must be a fiduciary or fiduciary-like duty of trust and confidence. Thus, the court held that the defendant, a lawyer who had traded the securities of a company his client was targeting for a takeover, was liable for insider trading because he breached a duty of trust and confidence owed to his law firm and client. The court did not, however, define the full scope of a fiduciary or fiduciary-like duty of trust and confidence and that issue remains very much in dispute today.

In 2000, the SEC adopted Rule 10b5-2(b)(1) in an attempt to settle this issue. That rule states that a "’duty of trust or confidence’ exists" in various circumstances, including "[w]henever a person agrees to maintain information in confidence."5 Thus, according to the SEC, a confidentiality agreement between an insider and a non-insider is sufficient to establish a fiduciary or fiduciary-like duty for purposes of imposing insider trading liability. This rule, however, has been criticized by numerous commentators. Notably, Rule 10b5-2(b)(1) misquotes O’Hagan, by referencing a duty of "trust or confidence," as opposed to "trust and confidence."

In 2009, in SEC v. Cuban, involving Dallas Mavericks owner Mark Cuban, the Northern District of Texas expressly rejected Rule 10b5-2(b)(1) as an improper expansion of insider trading law beyond the SEC’s authority. The court held that an agreement not to disclose confidential information by itself was insufficient to establish insider trading liability, unless the agreement contained a promise by the non-insider "to refrain from trading" on the information.6 The district court dismissed the case, finding that the alleged confidentiality agreement between Cuban and the CEO of involved only a promise not to disclose the information but not a promise not to trade on it. The court explained that there was nothing "deceptive" about Cuban’s alleged conduct in selling his shares of after receiving confidential information because he had never promised not to do so. In 2010, however, this decision was vacated by the Fifth Circuit, which held that the complaint, read "in the light most favorable to the SEC," contained sufficient allegations that Cuban had agreed both not to disclose the information he was provided and not to trade on it, and remanded the case back to the district court for further proceedings, where the case is still pending. The Fifth Circuit did not, however, address whether Rule 10b5-2(b)(1) is valid, and its validity continues to be an open issue. The case is scheduled for trial in June.

Also, in 2009, in SEC v. Dorozhko, the Second Circuit established a new theory of insider trading liability as to non-insiders predicated on an affirmative misrepresentation, which does not require any showing of a fiduciary or fiduciary-like duty. In Dorozhko, the defendant allegedly hacked into a computer server to access the confidential quarterly earnings report of the company IMS Health, and immediately traded on the information to realize a profit of approximately $287,000 overnight. The Second Circuit held that the SEC did not need to establish either a fiduciary or fiduciary-like duty owed by the defendant to IMS Health because the defendant’s conduct involved an affirmative misrepresentation—hacking into a computer server—as opposed to "fraud qua silence," upon which the classical and misappropriation theories of insider trading are based.7 This decision has been heavily criticized by commentators as an improper departure from the long-standing precedent requiring a fiduciary or fiduciary-like duty, and has not yet been addressed by other circuits or the Supreme Court.

Wiretap Evidence at Insider Trading Trials

Historically, insider trading cases typically begin in one of two ways: (1) when FINRA (the successor to the regulatory arms of the NYSE and NASD) detects irregular trading, either in the form of a spike in the volume of trading or a significant change in market price of a public company’s stock; or (2) when a cooperator provides a prosecutor or the SEC with leads. When FINRA detects irregularities, it typically contacts the company involved and requests (1) a chronology of events leading up to the announcement or events that led to the change in trading, (2) a list of the persons and entities that knew about the information before it was released to the public, and (3) the company’s insider trading policy. Regulators or prosecutors are then notified and it is up to them to decide whether to conduct a further investigation. Once regulators or prosecutors are involved, they have authority to issue subpoenas, analyze trading records, phone records and company documents, and conduct interviews or depositions of key players.

As a result, at insider trading trials, the government has often relied heavily on circumstantial evidence, such as the timing of various trades and subsequent material public disclosures of information, and, where available, testimony from cooperating witnesses, to establish insider trading. Defense lawyers typically fight back by challenging the sufficiency and quality of the circumstantial evidence and attacking the credibility of the cooperating witnesses.8

Recently, however, the government has successfully added wiretap evidence to its arsenal for both investigating insider trading cases and proving them at trial. Such evidence—which captures in real time the actual words of cooperators and sometimes the defendant—has helped the government bolster its cases both by demonstrating the credibility of cooperating witnesses and by corroborating circumstantial evidence. While use of wiretaps has enabled the government to secure early guilty pleas and some of its most significant insider trading convictions in recent years, it has also garnered significant criticism. Commentators have expressed concern about the use of such an invasive investigatory tactic given that Congress originally authorized wiretaps to combat organized crime and drug crimes, not white-collar crimes.

The use of wiretap evidence is governed by Title III of the Omnibus Crime Control and Safe Streets Act of 1968. Title III limits the use of wiretaps in several critical ways, including that it may be used to investigate only certain enumerated "predicate" crimes, which do not include securities violations such as insider trading.9 In 2010, however, in United States v. Rajaratnam, the most publicized insider trading case in decades, the prosecutors were permitted to use wiretap evidence at trial. Judge Richard Holwell of the Southern District of New York ruled that the government’s wiretap evidence was admissible even though insider trading is not an enumerated "predicate" crime in Title III because the wiretap evidence was authorized as part of an investigation of wire fraud, which is an enumerated "predicate" crime. Rajaratnam has appealed his conviction, claiming among other things that the government misled the court about its investigation when it obtained authorization for the wiretaps under Title III. The appeal remains sub judice.

Wiretaps were also used last year in United States v. Gupta, the insider trading case against the former managing director of McKinsey & Company, who was an alleged coconspirator of Rajaratnam. Judge Jed S. Rakoff ruled that the wiretaps were admissible there as well, stating that the court agrees with Holwell’s decision in Rajaratnam. The media characterized these recorded phone calls as the government’s most powerful piece of evidence in the case. Gupta was found guilty in June. Like Rajaratnam, he too has appealed on various grounds, including that the wiretap evidence was improperly admitted. Oral argument has not yet been scheduled by the Second Circuit. Notably, Gupta has remained free on bail pending appeal, following the Second Circuit’s decision on Dec. 4, 2012 that his appeal raises substantial questions.10

Status of ‘Use’ vs. ‘Possession’ Debate

In the 1990s, a circuit split was created regarding the requisite knowledge necessary to impose insider trading liability. The Second Circuit held in 1993 in United States v. Teicher that "knowing possession" of inside information was sufficient to establish insider trading liability.11 Five years later, in United States v. Smith, however, the Ninth Circuit held that mere "possession" of inside information—without proof of its "use"—was insufficient to establish insider trading liability.12

In 2000, the SEC weighed in by establishing Rule 10b5-1, which states that an insider trading violation occurs where "the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale."13 Thus, according to the SEC, it need not prove that the defendant actually "used" the information when trading. While this apparently ended the debate in the civil enforcement context, it did not end the debate in the criminal context.

To establish a criminal violation of insider trading laws, the government still must prove in accordance with the Exchange Act that the defendant acted "willfully."14 As many commentators have explained, it would be difficult to satisfy the "willfulness" requirement if a defendant did not make actual use of the material, nonpublic information. And even in the Second Circuit, where Teicher was decided, the issue remains unclear. In 2008, in United States v. Royer, the Second Circuit again endorsed a "knowing possession" standard in a criminal prosecution for insider trading.15 But that decision is arguably dictum because the jury instructions at issue in Royer set forth a standard closer to "use" than "knowing possession,"16 thus leaving open the question of whether mere possession is ever sufficient in a criminal action.

Moreover, in three recent criminal insider trading cases in the Southern District of New York, the district courts used a "use" instruction as opposed to a "knowing possession" instruction. For example:

• In Rajaratnam, the jury charge stated: "The government must prove beyond a reasonable doubt that the defendant used material, nonpublic information in connection with the purchase or sale of the stock…."17 Going further, the judge defined "use" in the context of insider trading, stating "[a] person uses material, nonpublic information in connection with a stock purchase or sale if that information is a factor in his decision to buy or sell."18

• In United States v. Goffer, the jury charge stated that in order to convict, the jury must find "[t]hat the Defendant…used the material, nonpublic information he received to purchase the security you are considering."19

• In United States v. Jiau, the jury charge specified that the jury could convict only if it found that "Ms. Jiau…disclosed [the insider] information to [the tippees] in return for money and/or other things of value, anticipating that [the tipee's] hedge fund would trade on the basis of this inside information."20 Thus, knowing possession was not enough to establish liability; instead the government had to prove that the trade was made "on the basis" of the material, nonpublic information.21

For practical reasons, it seems unlikely that the Department of Justice would seek to convict criminal defendants who merely possessed, but did not use, inside information. Establishing liability under the more stringent "use" standard may help ensure that convictions are less susceptible to attack on appeal, and ultimately, acquittal. Moreover, in exercising its discretion to prosecute someone, the department may look at the defendant’s culpability much differently if the defendant did not actually use the information. Interestingly, the SEC itself has shown reluctance to impose a bright-line "possession" standard of Rule 10b5-1 in its civil enforcement cases. For example, in SEC v. Donovan, the SEC proposed and the court instructed that to find liability the jury had to conclude that the defendant’s inside information was a "factor" in the decision to trade.22

Consistent with the trend in recent years, the number of insider trading cases is likely to increase. As it does, courts and attorneys must contend with several unsettled legal issues, revisiting old debates and addressing new challenges—hopefully adding clarity to both.

Douglas Koff is a partner, and Joshua Bennett is an associate, at Paul Hastings in New York, where they work in the litigation department.


1., SEC Enforcement Actions: Insider Trading Cases,

2., "Insider Trading: Proactive Enforcement Paying Off,"; see also Fed. Bureau of Investigation, Financial Crimes Report to the Public: Fiscal Years 2010-2011 (2012), available at ("[T]he FBI has observed an increase in the number of insider trading cases").

3., 2012: FINRA Year in Review,

4. O’Hagan, 521 U.S. 642, 652 (1997)

5. 17 C.F.R. §240.10b5-2(b)(1).

6. SEC v. Cuban, 634 F. Supp. 2d 713, 725 (N.D. Tex. 2009), vacated, 620 F.3d 551 (5th Cir. 2010).

7. 574 F.3d 42 (2009).

8. See United States v. Larrabee, 240 F.3d 18, 21-22 (1st Cir. 2001) (sustaining an insider trading conviction based solely on circumstantial evidence); United States v. McDermott, 245 F.3d 133, 139 (2d Cir. 2001) (holding that "rational minds" could infer that insider trading had occurred despite the government’s failure to produce any direct evidence).

9. 18 U.S.C. §2510, et seq.

10. Rajaratnam’s younger brother, Rengan, was recently indicted on insider trading charges as well and the government is expected to seek to use wiretap evidence against him if and when he is tried.

11. 987 F.2d 112, 120-21, (2d Cir 1993).

12. 155 F.3d 1051 (9th Cir. 1998).

13. 17 C.F.R. §240.10b5-1(b) (emphasis added).

14. 15 U.S.C. §78ff(a).

15. United States v. Royer, 549 F.3d 886, 899 (2d Cir. 2008) ("We consequently adhere to the knowing possessions standard…").

16. Id. at 899 n.12 (providing the district court’s instructions, which read: "A purchase or sale of a security is ‘on the basis of’ material non-public information about the security if the person making the purchase or sale was aware of the material non-public information when the person made the purchase or sale, and the information in some way informed the investment decision").

17. Charge to the Jury at 49, United States v. Rajaratnam, No. 09- 1184 (S.D.N.Y 2011).

18. Id.

19. Jury Charge at 17, United States v. Goffer, No. 10-0056 (S.D.N.Y. 2011).

20. Transcript at 1584, United States v. Jiau, No. 11-0161 (S.D.N.Y. 2011).

21. Id.

22. No. 08-cv-10649 (D. Mass. Nov. 19, 2009).