In United States v. Chow, the Second Circuit (Kearse, Carney, Bianco), affirmed the defendant’s 2018 conviction for insider trading (among other offenses). The case arose out of a failed 2016 merger spearheaded by Defendant Benjamin Chow, who passed along key details regarding merger negotiations to a business associate, who then traded based on this information. The Court reiterated its rule, recently expressed in its 2020 Kosinski decision, that corporate outsiders assume a fiduciary duty to a corporation when they sign a confidentiality agreement.
Background
Defendant Benjamin Chow was the managing director of China Reform, an investment firm owned by the Chinese government. In April of 2016, Chow contacted the bankers representing a Portland-based semiconductor company to explore a potential acquisition. The company, Lattice Semiconductor Corporation, is listed on the NASDAQ.
Chow led negotiations with Lattice’s CEO. As talks ramped up in late April, Chow and the CEO signed a non-disclosure agreement on behalf of their respective firms.[1] Each party agreed not to disclose or use any proprietary information except for purposes of evaluating a potential transaction. Critically, the very existence of the negotiations and potential sale was deemed confidential and subject to the restrictions of the NDA.
Negotiations continued, and during the summer of 2016 China Reform submitted multiple non-binding offers. Following its second offer, China Reform was granted a period of “exclusivity” through August 21, during which Lattice agreed not to consider any other offers. At the conclusion of the exclusivity period, China Reform submitted a third non-binding offer which was rejected by Lattice’s board of directors.
The next day, Chow informed Lattice that he was leaving China Reform and starting a new fund named Canyon Bridge. This new fund, he explained, would submit a proposal to buy Lattice. Lattice’s CEO initially believed that Canyon Bridge would be based in the United States and backed by private funds. He soon discovered, however, that the new fund was in fact a subsidiary of China Reform and funded in large part by that state-owned entity.
Nevertheless, on September 9, Chow (now on behalf of Canyon Bridge) signed an NDA with Lattice’s CEO. The terms were identical to those of the NDA between Lattice and China Reform. Negotiations moved quickly, and Canyon Bridge was granted a period of exclusivity. The period was extended twice. Finally, on November 3, 2016, Lattice announced that it would be acquired by Canyon Bridge. Immediately after this announcement, Lattice’s stock price rose 18%.
The transaction, however, was never consummated. The Committee on Foreign Investment in the United States (“CFIUS”), blocked the proposed acquisition to prevent semiconductor technology from falling into the hands of the Chinese government, which was ultimately behind Canyon Bridge.
Shortly after the announcement of the transaction, FINRA became aware of unusual trading activity in Lattice stock and commenced an investigation. The investigation ultimately led to an individual named Shaohua (Michael) Yin, who controlled five brokerage accounts that had held Lattice stock, none of which were listed under his own name. It further emerged that Yin had known Chow since at least 2011, and that the two communicated frequently during the pendency of negotiations to purchase Lattice.
More importantly, and damningly for Chow, Yin’s purchases of Lattice stock aligned with key dates in the merger process. For example:
- Two days prior to submitting China Reform’s first offer, Chow contacted Yin and arranged to meet at a Starbucks in Beijing. Shortly after this meeting, one of the accounts controlled by Yin purchased almost 250,000 shares of Lattice.
- Approximately two weeks prior to submitting China Reform’s second offer, Yin emailed investment bankers at Jefferies, asking them to introduce Chow to an analyst focused on the semiconductor industry. That same day, the men spoke over the phone, and Yin offered to put Chow in touch with a CFIUS lawyer. They agreed to meet the following day, and over the course of the next 10 days, Yin’s accounts purchased more than 250,000 shares of Lattice.
- The day before Canyon Bridge submitted the first draft of a merger agreement, Chow and Yin agreed to meet in Beijing. Over the next few days, Yin bought over 1 million shares of Lattice.
- The day before Canyon Bridge’s initial exclusivity period was set to end, Chow and Yin met again in Beijing. Over the next several days, Yin purchased almost 2 million shares of Lattice. Following this, Yin wrote Chow congratulating him on the successful launch of his new fund and asking where he should send several bottles of wine he had ordered.
Lattice announced on November 3, 2016 that it had signed an agreement to be acquired by Canyon Bridge. When the NASDAQ opened for trading later that day, Yin sold more than 3.73 million shares for more than $5 million in profit.
The government brought a variety of charges against Chow, including 12 total counts of insider trading (each count corresponding to Yin’s purchases on a specific day or period of days). The jury found him guilty of conspiracy to commit securities fraud (Section 371), securities fraud (Section 1348), and six counts of insider trading (Section 10(b) of the Exchange Act). The jury found him not guilty as to the other six counts of insider trading. Chow was sentenced to concurrent three-month terms of imprisonment for each count, to be followed by two years' supervised release.
The Second Circuit’s Decision
Chow raised three principal arguments on appeal: (1) that the government failed to prove various elements of insider trading; (2) that the government did not prove violations of Section 371 (general conspiracy) and Section 1348 (securities fraud); and (3) that the government failed to carry its burden of establishing that venue was proper in the Southern District of New York. In a unanimous opinion authored by Judge Kearse, the Second Circuit affirmed the jury’s verdict on all three issues.
1. Sufficiency of the Evidence: Insider Trading
Chow also argued on multiple levels that insufficient evidence supported the jury’s verdict. In rejecting these arguments, the panel emphasized the demanding legal standard for plaintiffs who make such a challenge: that the jury was entitled to look at the evidence as a whole, rather than piecemeal, and that the Court of Appeals must draw all inferences in support of the verdict.
Was there sufficient legal evidence that Chow owed a legal duty?
Before getting into the details of fiduciary duties, the Court outlined the statutory basis for insider trading. There is no single, express statutory prohibition of all insider trading. Instead, it is ordinarily prosecuted under the general anti-fraud provisions of federal securities law. The Securities Exchange Act of 1934 makes it unlawful to use or employ any “manipulative or deceptive device” in connection with the purchase or sale of any security. 15 U.S.C. § 78j(b). SEC Rule 10b-5 expands on that statute by outlawing any act which operates “as a fraud or deceit upon any person” in connection with the purchase or sale of any security. 17 C.F.R. § 240.10b-5.
The Court then summarized the two theories of insider trading liability: the “classical theory” and the “misappropriation theory.” The “classical” or “traditional” theory is generally applied to corporate insiders, such as employees or officers, while the “misappropriation theory” reins in corporate “outsiders” who nevertheless owe a duty of trust to another.
The classical theory focuses on employees or officers who trade (or tip someone such that they trade) on material, nonpublic information. Such a trade qualifies as a “deceptive device” because it breaches the trust that exists between shareholders of a corporation and its officers and employees. Dirks v. SEC, 463 U.S. 646, 655, n. 14 (1983).
The misappropriation theory, by contrast, focuses on a corporate outsider. This individual has access to confidential information, but does not owe a fiduciary duty to that corporation’s shareholders. Still, the outsider engages in “deception” by trading on information entrusted to her by another. She “dupes” the principal by pretending to be loyal yet secretly converting this information for personal gain. United States v. O’Hagan, 521 U.S. 642, 653-654 (1997).
The Second Circuit applied the misappropriation theory of liability in light of Chow’s status as a corporate outsider vis-a-vis Lattice. Chow, however, maintained that the misappropriation theory cannot be applied to those who deal at arm’s-length with a corporation. The Court rejected this contention, citing various cases in which signing a confidentiality agreement converts outsiders into “temporary insiders.” See, e.g., United States v. Kosinski, 976 F.3d 135, 144 (2d Cir. 2020).
The panel illustrated this principle by summarizing its recent ruling in Kosinski. In that case, the president of a clinical research firm signed two confidentiality agreements with a pharmaceutical company. The agreements required him to keep confidential any information he was provided in support of his services. Undeterred, he purchased stock in the company, and sold it after receiving an email alerting him that patients in the clinical trial had suffered allergic reactions. The Court upheld his conviction, noting that his “explicit acceptance of a duty of confidentiality” was itself sufficient to establish a fiduciary duty subjecting him to penalties for insider trading. Id. at 146 (quoting United States v. Falcone, 257 F.3d 226, 234 (2d Cir. 2001)). Moreover, the Court expressly rejected the notion that Kosinski could not have been a fiduciary because he had dealt with the company at arm’s-length. Id. at 148.
With this legal background, the sufficiency of the government’s evidence was apparent, as there was little dispute that Chow entered into NDAs with Lattice. In passing, the Court also rejected Chow’s argument that the District Court erred when it told the jury that the NDAs created a legal duty of nondisclosure. The Court pointed to Rule 10b5-2, which states that a duty of trust or confidence exists whenever a person agrees to maintain information in confidence.” 17 C.F.R. § 240.10b5-2(b)(1).
Was there sufficient evidence that Chow disclosed material, nonpublic information?
The Court held that the jury was justified in concluding that Chow actually breached the fiduciary duty he owed to Lattice by disclosing confidential information. Specifically, the jury reasonably found that Chow revealed the details of actual merger negotiations to acquire Lattice, as opposed to his thoughts on the industry generally. The Court focused on the evidence presented at trial, which did not, in the Court’s view, require significant leaps of imagination. In September of 2016, Yin sent a text message to an associate stating that a “friend of [his] recently said that Lattice Semiconductor’s project is moving forward. If quick, there would be intentions by mid October.” Yin also left a voicemail for Chow saying he had heard from a banker that there might be CFIUS concerns. Chow replied that he should be signing the contract soon.
In particular, the Court held that the jury was entitled to consider the suspicious confluence of Yin’s discussions with Chow and his trades and to draw inferences from those facts. Yin made large purchases shortly after meetings or conversations with Chow, and those conversations coincided with critical steps in the merger process. This, combined with Chow’s education and experience level, was a solid basis from which the jury could conclude that Chow intentionally disclosed confidential information in breach of his duty to Lattice.
Did Chow receive a personal benefit for providing the information?
The panel also analyzed another requirement for insider trading liability—that the tipper receive a benefit for disclosing the information. This principle was discussed at length in the Second Circuit’s Martoma case, which outlined a broad interpretation of “personal benefit” that need not include tangible benefits. United States v. Martoma, 894 F. 3d 64, 76 (2d Cir. 2017). Mere access to future business opportunities is sufficient, even if that benefit is only hypothetical or hoped-for.
The Court pointed to the extensive business connections between the two men. Yin helped Chow on a number of occasions and in a fashion that could be viewed as providing Chow with a personal benefit. For example, Yin provided Chow with pertinent business information on semiconductors and connected Chow with Jefferies investment bankers who could help Chow with future transactions. He also “benefitted” Chow the old-fashioned way by sending wine and cigars to him. That evidence, consisting of both intangible “networking” help and some tangible objects of value, was sufficient to meet the personal benefit test.
2. Sufficiency of the Evidence: Securities Fraud and Conspiracy
The Court also briefly rejected Chow’s argument that he was wrongly convicted of securities fraud and conspiracy. The same evidence that supported a finding of insider trading supported the verdict on the other counts of conviction brought under Section 371 and Section 1348.
3. Venue
Lastly, the Court reiterated that the Southern District of New York has the authority to charge crimes related to trading on the New York-based stock exchanges. The government needed to prove by a preponderance of the evidence that the crime was committed, at least in part, in Manhattan. The panel pointed to evidence presented at trial that the NASDAQ was based in the Southern District, and that was where Yin purchased Lattice shares on NASDAQ. Further, the Court noted that the jury could reasonably have inferred that Chow, a highly educated businessman, was aware of the fact that Lattice shares were traded in Manhattan.
Commentary
Judge Kearse’s detailed and careful opinion merits a close read, especially for those who handle insider trading cases. As we have seen in the past decade, the Circuit has issued several notable decisions addressing the reach of insider trading. In particular, the personal benefit test has been the subject of notable decisions in Newman and Martoma (the latter of which resulted in multiple opinions from the Court). The Circuit did not use this appeal as an opportunity to wade further into those turbulent waters of insider trading liability. This case did not involve a long chain of tippees as in Newman, nor was the personal benefit difficult to identify or conceptualize. The question of whether or when a non-disclosure agreement also carries an implicit prohibition on trading or tipping is one addressed recently in Kosinski and that decision more or less led to the outcome in this appeal (which was decided 15 months after argument). The Court’s sufficiency analysis relied on a common-sense approach in deferring to the jury’s factual findings. Chow, an educated and experienced businessman, could not rely on a lack of smoking-gun evidence to set aside his convictions. In addition, since the panel found that there was evidence of a personal benefit, the Court did not have to address the question of whether a defendant could be guilty for violating Section 1348 in the absence of a personal benefit, an argument considered and rejected in United States v. Blasczak.
[1] The term “non-disclosure agreement” is often shortened to “NDA” and used interchangeably with “confidentiality agreement” or “confi.”
