Earlier this month, the U.S. Court of Appeals for the Second
Circuit, arguably the most influential court in the country for
federal securities law matters, issued an important decision
regarding the scope of insider trading liability. The decision
addresses a number of issues relevant to both corporate management
and large investors, including (i) the circumstances in which a
shareholder can, for purposes of the prohibitions on insider
trading, be deemed a corporate "insider" potentially
subject to those restrictions and (ii) what types of relationships
can trigger a legal obligation not to trade while in possession of
non-public information
Background
The decision, In re Archegos 20A Litigation, arose out of the March 2021 collapse of Archegos Capital Management, a New York-based investment fund. Archegos had acquired controlling, non-public positions in seven public companies (the "Issuers") via "total-return swap" ("TRS") agreements with certain banks (the "Banks"). Under the TRS contracts, the Banks agreed to purchase stock in the Issuers and to pay Archegos any appreciation or dividends generated by the stock in exchange for a certain amount of fees. If, however, the value of an Issuer's stock declined, the Banks could issue a margin call requiring Archegos to compensate them for that decline. If Archegos failed to meet the margin calls, the Banks could sell the stock. To hedge against the risk of having to make payments to Archegos if the Issuers' stock increased in value, the Banks also purchased their own shares of the Issuers' stock.
In March 2021, several of the Issuers' stock declined precipitously. Per the terms of the TRS agreements, the Banks issued margin calls. Archegos told the Banks that it would be unable to meet these calls, the Banks declared Archegos in default, and Archegos' financial condition deteriorated rapidly. The Plaintiffs, shareholders in the Issuers, alleged that, before news of Archegos' rapidly deteriorating condition became public, the Banks sold the vast majority of their own shares in the Issuers, which, according to the Plaintiffs, helped the Banks avoid billions of dollars in losses while harming other investors who were "unaware of Archegos' impending collapse."
The Plaintiffs later filed actions in the Southern District of New York, alleging that, by selling their shares in the Issuers before knowledge of Archegos' collapse became public, the Banks committed insider trading in violation of Section 10(b) of the Securities Exchange Act of 1934 and SEC Rule 10b-5. The Plaintiffs also brought claims under Section 20A of the Exchange Act, which provides a private right of action for "contemporaneous traders" against persons who committed a predicate insider trading violation. The trial court dismissed the Plaintiffs' claims in their entirety, and the Plaintiffs appealed to the Second Circuit.
The Second Circuit Decision
The Second Circuit's September 16 decision held the trial court correctly dismissed the case. The court began by noting that liability for insider trading "largely turns on the relationship between the parties," in particular the existence of fiduciary duties or confidentiality obligations.
The court reviewed the two existing theories of insider-trading liability. First, under the "classical theory" of insider trading, a corporate insider is prohibited from trading in the shares of the corporation based on material, non-public information ("MNPI") because the insider has duties of trust and confidence to the corporation's shareholders. Second, under the "misappropriation theory," a person entrusted with MNPI, who does not need to be a corporate insider, can be liable for insider trading if they breach a duty of trust and confidence to the source of the information by trading the securities at issue. As the Second Circuit noted, under either theory, a person who owes a duty of trust and confidence can be liable for "tipping" others about the MNPI. Similarly, those who receive such tips—"tippees"—can be liable for insider trading if they know of the tipper's breach and nonetheless use that information to trade or to tip another individual for personal benefit.
The Court found the Plaintiffs could not state a claim against the Banks under either the classical or misappropriation theories.
First, as to the classical theory, the Plaintiffs had alleged that, by virtue of its holdings in the Issuers, Archegos itself qualified as a "constructive insider" with duties of trust and confidence to the Issuers' shareholders and that the Banks became "tippees" of Archegos when Archegos told them of its impending collapse. The Court rejected this theory because, it held, Archegos was not actually a corporate insider of any of Issuer. The Court noted that, given the terms of the TRS agreements, the Banks, not Archegos, actually owned the Issuers' stock. Moreover, there was no allegation that Archegos had access to any Issuer's internal corporate information or had any power or influence over the Issuer's "day-to-day or long-term operations." Citing Supreme Court precedent, the Court also stated that "an entity does not become a corporate insider based solely on its beneficial ownership of stock."
Second as to the misappropriation theory, the Plaintiffs alleged that the Banks, having received MNPI from Archegos about its impending collapse violated their duty to Archegos by (i) trading the Issuers' stock based on that information and (ii) tipping preferred clients so they could trade on that information.
As to (i), the Court held that the Banks did not owe any fiduciary duty to Archegos, given there was no evidence of an agreement by the Banks to act in Archegos' best interests or to otherwise serve as fiduciary. Indeed, the Court reasoned that the TRS agreements, including the Banks' ability to sell the underlying stock if Archegos could not meet margin calls, were characteristic of an arms-length, commercial relationship, not a fiduciary-like relationship of trust and confidence. As to (ii), the Court held that Plaintiffs had "fail[ed] to plead sufficient facts to imply the content and circumstances of such tips."
Takeaways
- The decision is an important reminder that, as the Second Circuit said, insider trading liability turns "on the relationship between the parties"—in particular whether the parties have confidentiality obligations or owe fiduciary duties to one another—not merely whether a party is in possession of material, non-public information. That said, parties considering engaging in trading while in possession of potentially material, non-public information should carefully, and with the assistance of counsel, identify any confidentiality obligations they may be under before trading.
- The decision's analysis of when, for purposes of insider-trading liability, one becomes a "corporate insider" is also important for major shareholders or those potentially acquiring a controlling stake in a corporation. The Court was clear that "an entity does not become a corporate insider based solely on its beneficial ownership of stock." Instead, the Court indicated that one becomes a corporate insider for insider trading purposes when it has access to confidential information, and/or can influence corporate decisions, akin to the role played by an officer or director.
- Although not central to the Second Circuit's decision, it is worth noting that the Plaintiffs' theory of MNPI in this case was more attenuated than in traditional insider trading cases. Here, although Plaintiffs were shareholders in the Issuers, they did not allege that Archegos or the Banks possessed MNPI about the Issuers themselves, such as, for example, not-yet public information about a pending major corporate transaction by the Issuers or about an earnings announcement by the Issuers. Instead, Archegos and the Banks allegedly possessed MNPI about how their own trading would likely impact the Issuers' stock price. In this way, the Plaintiffs' theory resembled the "shadow" insider trading theory approved by a federal trial court in California in 2024 in SEC v. Pamuwat. In that case, the SEC alleged, and a jury agreed, that the defendant violated the securities laws by—while in possession of MNPI about his own company which was likely to affect the stock price of similarly sized companies in the same industry—trading in the stock of a similarly situated company. The appeal from Pamuwat is currently being briefed in the Ninth Circuit. If the Ninth Circuit affirms, Archegos may help defendants ring fence more attenuated insider trading theories given the somewhat analogous circumstances to Pamuwat.
- Finally, it also bears noting that the Second Circuit's decision deals only with certain (albeit important) issues of insider trading liability. It does not impact, for example, when a corporate insider may be liable for short swing sales under Section 16, the rules governing "black out" periods, or the rules governing 10b5-1 trading plans. Nor does it analyze the potential liability of downstream "tippees" who received material non-public information from other sources.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
