When You Ought to Have Known: Court of Appeal Upholds Liability Against Successive Tippees Who Lacked Actual Knowledge of the Source of the Inside Information

29 January 2018

By Khrystina McMillan
In a decision released last Thursday, January 25, 2018, the Ontario Court of Appeal considered for the first time the definition of a “person in a special relationship with an issuer” as it applies to successive tippees who possess inside information. In Finkelstein v Ontario Securities Commission, the Court of Appeal upheld findings of liability and significant sanctions against Howard Miller and Francis Cheng – the final two recipients in a five-person long chain of successive tippees – even though neither Miller nor Cheng knew that the source of the information was an insider. According to the Court of Appeal, however, they ought to have known that they were acting on inside information.

Background: The Finkelstein decision arises from the flow of material, non-public information about a reporting issuer – Masonite International Corporation (“Masonite”) – through a chain of five people. The information originated from a Bay street mergers and acquisitions lawyer, and was passed through two other individuals before it was received by Miller, who then passed it on to Cheng (both of whom were investment advisors at the same firm).

Subsections 76(1) and (2) of Ontario’s Securities Act contain prohibitions against the trading on, or the tipping of, undisclosed materials facts or changes concerning an issuer by persons or companies in a “special relationship” with the issuer. Subsection 76(5)(e) defines a “person or company in a special relationship with an issuer” to include a person or company who receives insider information and “knows or ought reasonably to have known that” the source of the insider information is a person or company in a special relationship with the issuer.

In a 2015 “Merits Decision” , an Ontario Securities Commission (“OSC”) panel found that all five individuals were in a special relationship with Masonite and had therefore breached the insider and tipping provisions and acted contrary to the public interest. The Divisional Court dismissed the appeals of all but Cheng, setting aside the findings of liability against Cheng because of errors in the OSC’s analysis of the evidence. The Court of Appeal granted leave to appeal to Miller and the OSC in respect of Cheng, but denied leave to the others.

The Court of Appeal Decision: At its heart, the appeal concerned the interpretation and application of section 76(5)(e) of the Securities Act and whether Miller and Cheng “ought reasonably to have known” that their respective tippers stood in a special relationship with Masonite: there was no dispute that Miller and Cheng received material, non-public information about Masonite, nor that neither of them had actual knowledge that the source of the information was a person in a special relationship with Masonite.

The Court of Appeal ultimately rejected Miller’s appeal and granted the OSC’s appeal in respect of Cheng, restoring the OSC panel’s decision. Under subsection 76(5)(e), the tippee does not necessarily need to know the identity of the initial tipper, and, on the facts of this case (including the application of the below factors), both Miller and Cheng ought to have known that their respective tippers were in a special relationship with Masonite.

When You Ought to Have Known: The statutory provision of “ought reasonably to have known” requires an objective test: should a person standing in the shoes of the tippee, reasonably assume that the information passed to her originated with an insider?

The bulk of the evidence in insider trading and tipping cases is usually comprised of circumstantial evidence of the tippee’s knowledge of the source of information. The Court of Appeal therefore held that it was reasonable for the OSC to identify certain factors to assist in drawing permissible inferences as to whether it was more likely that not that insider trading and tipping had occurred. The following factors, while not exhaustive, serve as a “reasonable guideline that can be applied in the vast majority of situations” when considered in light of totality of the evidence:
  1. What is the relationship between the tipper and tippee?
  2. What is the professional qualification and standing of the tipper? Does the tipper have a position which puts him in a milieu where transactions are discussed?
  3. What is the professional qualification of the tippee? Does her profession or position put her in a position to know she cannot take advantage of confidential information and therefore a higher standard of alertness is expected of her than from a member of the general public?
  4. How detailed and specific is the information? The more detailed and specific the information, the less likely it could result from a rumour.
  5. How long after he receives the information does he trade? A shorter period of time may give rise to the inference that the information is more likely to have originated from an insider.
  6. What intermediate steps before trading does the tippee take, if any, to verify the information received? The absence of any independent verification may suggest a belief on the part of the tippee that the information originated with a knowledgeable person?
  7. Has the tippee ever owned the particular stock before?
  8. Was the trade a significant one given the size of his portfolio?
The Takeaway: The Finkelstein decision is a stark reminder that you don’t need to actually know that you are acting on information received from a company insider to be liable for insider tipping or trading. Recipients of non-public information may face significant sanctions, even where the source of the information is unclear or unknown to the tippee: in Miller and Cheng’s cases, such sanctions include monetary penalties totalling about $525,000 and $225,000 respectively, as well as a ten-year ban on trading (with carve-outs), registration, and acting as directors or officers of a reporting issuer. Individuals who receive non-public information about a company should seek legal advice before trading on that information or sharing it with others.

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