The Second Circuit: Jury Instructions and Insider Trading

Regulatory 27 Aug 2012

A recent decision by the U.S. Court of Appeals for the Second Circuit may have marginally expanded the working definition of “nonpublic information” with which securities lawyers in that circuit will have to work hereafter, making life a bit more dangerous for any asset managers whose pursuit of alpha leads them to make aggressive use of rumors within their  ‘mosaic’ of sources.

Nicos Stephanou seems not to have been a very discreet fellow. He talked a lot starting in 2002 about goings on at UBS, where he worked. Among his confidants was one Joseph Contorinis, to whom he spoke (as the circuit court’s opinion puts it) “sometimes as much as 75 times a month.” Contorinis was a portfolio manager at the Jefferies Group, co-managing the Paragon Fund.

Zigzags on Road to a Deal

In September 2005, a grocery store chain, Albertson’s, announced that it was considering selling itself. Eventually it would be acquired by a consortium that included Supervalu, CVS Corp., and investment funds, including Cerberus. But there was a lot of to-and-fro on the way to that happy ending.

On November 22, 2005, Stephanou learned through his UBS position that it was more likely than not that Albertson’s would be acquired. He was at this point on a UBS team advising Cerberus. He conveyed what he had learned to his various friends.

Also on November 22, Contorinis purchased 250,000 shares of Albertson’s on behalf of the portfolio he managed.

On December 6, Stephanou learned that deal negotiations had suffered a setback. On December 7, Contorinis’ fund closed out its long position, and in fact briefly went short on Alb3ertson’s.

On December 9, Stephanou heard that the deal was back on. On December 11, he spoke with Contorinis, whose fund soon thereafter purchased another large bloc of Albertson’s stock.  There were a couple of more such ups and downs, which it might be tiresome to relate in further detail here. The specific trades on which Contorinis was tried occurred on December 22 and then again on January 11, 2006. The guiding principle was clear. Contorinis wanted to close out his position, or even to go short, whenever he heard that the deal was about to fall apart, and wanted to renew his long position whenever he heard that it was back on.

Mosaic Theory

At trial, Contorinis’ defense was that he had available to him a lot of other sources bearing on the value of Albertson’s stock, quite independent of what his friend Stephanou was telling him, and that indeed Stephanou was not making a material addition to what he was learning from those other sources.

This is known as the mosaic theory. As one academic study has put it, the theory is that “insider trading violations should not result when a perceptive analyst reaches a conclusion about a corporate action or event through an analysis of public information and items of nonmaterial nonpublic information [as a result of] good analytical skills.”

In this case, it availed naught. Contorinis was found guilty, in October 2010, of seven counts of securities fraud and one count of conspiracy. He was sentenced to six years in prison and the forfeiture of $12.65 million.

He appealed on the basis of the judge’s instruction to the jury, which said in pertinent part that information is nonpublic

if it was not available to the public through such sources as press releases, Securities and Exchange Commission filings, trade publications, analysts’ reports, newspapers, magazines, rumors, word of mouth or other sources…. [If] UBS policy was to give out certain information to people who ask for it, that information is public information. Whether information is nonpublic is an issue of fact for you to decide.

On the other hand, the confirmation by an insider of unconfirmed facts or rumors – even if reported in a newspaper – may itself be inside information.

The defendant’s attorneys had asked for a rather different instruction. They wanted the jury told:

[An] insider’s confirmation of published information may itself constitute material nonpublic information if it discloses significant details that are not apparent from what is public, such as the certainty that a rumored event in fact will occur. However, if an insider simply repeats what has appeared in the public press, the repetition of that information is not material nonpublic information…. It is a fact issue for you to decide whether Mr. Stephanou [provided information] sufficiently different from the information that was available in the marketplace to be material.

The appellate court found that the instructions actually given “adequately conveyed the applicable standards” as to the material and non-public character of the contested information.  The suggested charges, as the appellate court read them, sought to exclude from the jury’s consideration the reliability of particular sources, and the increase of reliability that a “tip” may provide even to information that is already public. In that respect, defense counsel misstated the law, and the judge got it right, says the Second Circuit.


It wasn’t all a loss for the defendant/appellant, though. He had also appealed the amount of the forfeiture order of the sentencing court. On that ground, he was successful. The 2d Circuit found that the district court erred in ordering the forfeiture of $12.65 million, which was “the total amount of profits made, and losses avoided” by the trades found to have been illegal. The defendant wasn’t the one making that profit, or threatened with those losses, he was himself an employee of the fund.

Since the defendant did have some equity in his employer, and since his salaries, bonuses and such could have been enhanced by the criminal actions, there may well be a proper forfeiture component to this sentence, but it isn’t $12.65 million. The court remanded the matter to the district court for further proceedings on that issue.

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