The Finkelstein Decision – The Ontario Securities Commission Allows the Admissibility of Circumstantial Evidence in a Tipping and Insider Trading Case

Background

On March 24, 2015, the Ontario Securities Commission (OSC) released its decision against a former mergers and acquisition lawyer, Mitchell Finkelstein (Finkelstein) and four investment advisors (together, the respondents) in a high profile tipping¹ and insider trading² decision. OSC staff alleged that Finkelstein tipped his long-time friend, Paul Azeff (Azeff), an investment advisor, about six impending takeover transactions between November 2004 to August 2007, and that Azeff and three other investment advisors engaged in tipping and insider trading for themselves, family members, and clients while in possession of material non-public information (MNPI), contrary to the Securities Act (Ontario) (the Act). Staff further alleged that these investment advisors acted contrary to the public interest by recommending the shares of target companies, about to be purchased, to their friends, families, and clients.

Finkelstein worked in Toronto for Davies Ward Phillips and Vineberg (Davies) whereas Azeff worked in Montreal as an investment advisor for CIBC. The pattern of conduct alleged was that Finkelstein contacted Azeff shortly before the public announcement of each takeover transaction. Azeff passed on the MNPI to his partner, Korin Bobrow (Bobrow) with whom he shared a trading code, DK4. They told friends about the imminent transactions, including LK. LK was Azeff’s accountant and his good friend. LK lived in Montreal. LK then telephoned his friend and senior investment adviser with TD in Toronto, Howard Miller (Miller). Miller then told his associate, Francis Cheng (Cheng).

The main legal issues that the OSC panel examined for each transaction were:

1. What were the undisclosed material facts?
2. Was there communication of the undisclosed material facts (tipping) by someone in a special relationship such as an officer, director or advisor engaged in some aspect of the transaction?³
3. Did the tippee or successive tippee know or ought he reasonably to have known that he was receiving undisclosed material facts from someone himself in a special relationship? ⁴

The OSC panel determined, on the balance of probabilities, that Finkelstein tipped Azeff, who then tipped Bobrow on three of the six takeover transactions, and that Azeff and Bobrow committed insider trading on such information in one of the three transactions; and they further acted contrary to the public interest by recommending shares of target companies to others. Miller and Cheng were held to have committed tipping and insider trading in one transaction and also acted contrary to the public interest by recommending shares to others in this instance.

This highly anticipated decision is particularly noteworthy because it highlights the OSC panel’s willingness to admit circumstantial evidence and other indirect evidence to draw inferences that the respondents breached the Act by engaging in tipping, insider trading or both. The panel found that in three transactions, there was no reasonable explanation for the sequence of events other than to conclude that Finkelstein had tipped Azeff who then passed the MNPI to others.

Circumstantial Evidence

The evidence to establish that the respondents committed the alleged wrongdoings, on a balance of probabilities, must be clear, convincing, and cogent. In cases of insider trading and tipping, the OSC panel indicated that circumstantial evidence is admissible and includes:

• unusual trading patterns;
• a timely transaction in a security shortly before a significant public announcement;
• a first time purchase of the security;
• an abnormal concentration of trading by one brokerage firm or with one or a few brokers; and
• a trade that represents a very significant percentage of the particular portfolio.

The panel noted that motive and intent can also be weighed as facts when drawing inferences about whether the alleged wrongdoing occurred. The panel found that Finkelstein lacked motive in tipping his friend, Azeff but ultimately held that this factor did not matter.⁵

Special Relationship with a Successive Tippee

Although it is not difficult to establish that a lawyer or investment advisor engaged in a professional activity with a reporting issuer is in a special relationship, the OSC panel explained that it becomes increasingly difficult to determine whether a successive tippee (such as Bobrow, Miller, and Cheng) knew or ought to have known that the MNPI came from someone in a special relationship. To satisfy this requirement for a successive tippee, the panel set out two tests that must be met. The first test is there must be an “information connection” to the issuer (i.e. possession of inside information). This test is not difficult to satisfy because it simply involves comparing what information the tippee had with the information that was publicly available at the relevant time.

The second test is there must be a “person connection”. This test is harder to satisfy. It is an objective test and requires asking: Should a person standing in the shoes of the tippee, reasonably assume that the MNPI passed on to him originated with a person whom the panel referred to as a “knowledgeable person”? A knowledgeable person is anyone acting for a party to a transaction and includes officers, directors, insiders, professional advisers, lawyers, bankers, and accountants.⁶

Put more simply, did the tippees who were two or three times removed from Finkelstein know or ought reasonably to have known that the information they received was MNPI that originated with an insider. The panel then set out the following list of factors to be considered:

• What is the relationship between the tipper and tippee? Are they close friends? Do they also have a professional relationship? Does the tippee know of the trading patterns, successes, and failures of the tipper?
• What is the professional qualification and standing of the tipper? Does the tipper have a profession (e.g. lawyer or investment advisor) putting him in a milieu where transactions are discussed?
• What is the professional qualification of the tippee? Does his profession put him in a position to know that he cannot take advantage of confidential information, which therefore imposes a higher standard of alertness on him than a member of the public?
• How detailed and specific is the MNPI? Does it include information that a takeover is occurring or information about its price, structure, and timing?
• How long after the tippee receives the MNPI does he trade?
• What intermediate steps before trading does the tippee take, if any, to verify the information received?
• Has the tippee ever owned the particular security before?
• Was the trade a significant one given the size of the tippee’s portfolio?

Contrary to the Public Interest

The OSC panel made it clear that “contrary to the public interest” is a discretionary concept that is not a substitute for a near miss of an essential element of a breach. Therefore, if a required element of an alleged breach of a specific section fails to be established, the allegation must be dismissed. However, if the conduct reviewed on its own is contrary to the objectives of the Act and harms investors or abuses confidence in the capital markets, the panel may make a finding that the conduct is not in the public interest.

Proving the Allegations of Tipping and Insider Trading with Circumstantial Evidence

OSC staff submitted substantial circumstantial evidence to show: when Finkelstein learned of the MNPI; when he communicated to Azeff; when Azeff and the other tippees communicated to friends, family members, and clients; the timing of purchases of shares among the tippees; and the trading volume. The OSC panel ultimately held that there was sufficient evidence to draw the inference that Finkelstein tipped Azeff in three of the six transactions, namely Masonite International Corporation (Masonite), Legacy Hotel REIT (Legacy), and Dynatec Corporation (Dynatec) and Azeff passed the MNPI to other tippees. The Masonite transaction was the only transaction where all of the respondents were held in breach of the Act. Finkelstein, Azeff, and Bobrow were held in breach in all three transactions. The following discussion will summarize some of the key evidence that the panel examined to arrive at its decision.

Finkelstein was the lawyer directly involved with the Masonite takeover of another company and Legacy’s takeover by an offeror consortium. He was not involved in Dynatec’s transaction but Davies was retained as counsel to advise a special committee established by Dynatec’s board. Before any public announcements of these transactions, OSC staff showed that Finkelstein knew of the MNPI.

A few months before the Masonite announcement, Finkelstein provided legal services such as reviewing the change of control provisions in the compensation agreements of senior officers and a standstill agreement. He assembled Masonite’s credit agreements for review by the potential target. He and other Davies’ lawyers attended a crucial meeting about five weeks before the announcement during which it became evident that Masonite intended to proceed with its takeover. He was also aware of the takeover price. Finkelstein was also the principal lawyer on the Legacy transaction. Before the Legacy announcement, he knew that the offeror consortium had submitted a bid to takeover Legacy, a deal which was likely to close. He also knew the date of the public announcement. As the lawyer for Masonite and Legacy, the OSC panel held that Finkelstein was in a special relationship with them.⁷

Although Finkelstein was not involved in the Dynatec transaction, he accessed transaction documents such as the voting agreement, the indicative timetable showing the timing of the public announcement, and the combination agreement. OSC staff was able to show the dates and times when Finkelstein accessed these documents, all of which occurred before the public announcement of the Dynatec transaction. The OSC panel held Finkelstein was in a special relationship with Dynatec.⁸

To show the relationship between the parties, OSC staff submitted significant phone records during the relevant times. Phone records included: home phone records that showed long distance calls between Finkelstein and Azeff; cell phone records of Finkelstein and Azeff; Davies’ phone records; and CIBC phone records showing calls from and to the extensions used by Azeff, Bobrow, and their assistant. Staff did not have any audio recordings or transcripts of the calls’ contents. The phone records were used to show the dates and frequency of calls and the timing of trades in relations to these calls. Staff did not have nor was there any email correspondence between Finkelstein and Azeff about any of the six transactions.

Relying considerably on the timing of phone calls between Finkelstein and Azeff and the sudden and voluminous purchasing by Azeff, Bobrow, their family members or clients, the OSC panel found that Finkelstein passed on the MNPI about Masonite, Legacy, and Dynatec to Azeff. The OSC panel held that Azeff was in a special relationship with these three companies because he knew or ought to have known that Finkelstein was in a special relationship with them.⁹

In further support of the OSC panel’s finding that Finkelstein passed on MNPI to Azeff, the panel made observations about Finkelstein’s demeanour at the hearing and stated, “Finkelstein’s manner of giving evidence lacked spontaneity and was well rehearsed. Often he would answer questions from his own counsel by indicating that they would be coming to that evidence later. He left the impression that his evidence was tightly controlled. The substance of his testimony ignored or touched lightly upon important elements that needed explanation.” In particular, the panel noted: Finkelstein spoke very little of his relationship with Azeff during the relevant timeframe of 2004 to 2007; Finkelstein did not explain why he spoke to Azeff dozens of times or why there were 190 calls between them in 2007; and Finkelstein made it clear that they were not talking about his small investment account with Azeff.¹⁰ As a result, the panel gave less weight to Finkelstein’s subjective testimony than to the objective facts.

The OSC panel inferred that Azeff informed Bobrow about the MNPI. Bobrow was Azeff’s long-time partner and they acknowledged in their testimony at the hearing that they shared clients and information. The timing of the phone calls between Finkelstein and Azeff corresponded with purchases that Azeff and Bobrow made for themselves, family members, and clients. Some of their purchases represented high volumes of trading. In the case of Masonite, for example, their purchases in one day through their DK4 trading code represented 48% of the volume traded on the TSX, 32.5% of the combined volume on the TSX and NYSE, and 97% of the CIBC purchases. In fact, Azeff and Bobrow purchased Masonite shares for more than 100 DK4 accounts before the public announcement of Masonite’s takeover transaction. OSC staff also pointed to emails and text messages between Bobrow and a very close friend and client, who purchased shares before the public announcements. The OSC panel held that Bobrow had all the same knowledge and information as Azeff and he was therefore in a special relationship with Masonite, Legacy, and Dynatec because he knew or ought to have known that Azeff was in a special relationship.¹¹

LK testified at the hearing that he learned of the MNPI about the transactions from Azeff. The timing of phone calls between Azeff and LK corresponded to LK’s subsequent purchases of shares.

Miller and Cheng did not testify at the hearing, so staff submitted their transcripts from their compelled interviews in which they made admissions about how they learned of the MNPI. This analysis will focus only on the Masonite transaction. Miller first became interested in Masonite after he received a phone call from LK. LK confirmed that he told Miller about Masonite and testified at the hearing that he spoke to Miller after his discussion with Azeff. OSC staff then pointed to emails from Miller to a client. In one email string, Miller told his client that he had “a tip” and responded that the issuer was Masonite when asked by his client. Another email string had details of the Masonite transaction, including the cash consideration, before the takeover was publicly announced.

Cheng admitted that he learned of the Masonite transaction from Miller in his compelled testimony and Miller also admitted sharing information about Masonite with Cheng. OSC staff pointed to an email from Cheng to a client in which Cheng stated that he was buying Masonite for clients because a 20% return was expected before Christmas.¹² The panel noted that this particular client had previously complained about Cheng. Miller and Cheng did not give any explanations for their own purchases of Masonite shares, which were their first purchases and the largest positions in each of their portfolios. Miller and Cheng recommended Masonite to family members and clients and purchased shares on their behalf. In fact, Cheng’s purchases of Masonite shares on his wife’s behalf represented 98% of her portfolio’s value.

The OSC panel stated that determining whether Miller and Cheng were in a special relationship was more difficult to assess. It had to be determined that LK, when he received the MNPI from Azeff, knew or ought reasonably to have known that Azeff was in a special relationship with Masonite, that is, that Azeff knew or ought to have known that the MNPI came from a knowledgeable person. It also required determining that Miller, when he received the MNPI from LK, knew or ought reasonably to have known that LK was in a special relationship with Masonite, that is, that LK knew or ought reasonably to have known that the MNPI came from a knowledgeable person.

The OSC panel found that Miller and Cheng did not know that the MNPI that Miller received from LK and that Cheng received from Miller came from a knowledgeable person. The panel then focused on whether Miller and Cheng ought reasonably to have known that the MNPI came from a knowledgeable person and reviewed the following factors:

• LK and Miller knew each other for a long time and re-established a friendship in 2002/2003 and often spoke by phone. Their conversations focused on their professional work in that LK asked Miller about the markets and Miller asked LK for tax and accounting advice. They had mutual respect for each other’s professions and expertise.
• Miller knew that LK who was a partner in a well-known Montreal accounting firm had business relationships with friends involved in transactions.
• Miller, as a senior investment adviser, knew or was deemed to know the prohibition on trading on MNPI, so a higher standard of alertness was expected of him than a member of the public.
• Miller received detailed and specific information about the Masonite takeover transaction from LK, but he did not ask how LK knew this information. Cheng similarly failed to ask Miller how Miller knew about the Masonite transaction. Neither Miller nor Cheng carried out any independent research.
• Miller and Cheng purchased a significant number of Masonite shares, which neither of them had previously owned.
• Cheng advised a client in an email to purchase Masonite shares. The OSC panel stated that Cheng would not have risked passing along speculative information, which may prove wrong, to a client who had previously complained about him.

The OSC panel held that Miller ought reasonably to have known that LK was in a special relationship with Masonite and the MNPI originated with a knowledgeable person, and similarly held that Cheng ought reasonably to have known that Miller was in a special relationship with Masonite and the MNPI originated with a knowledgeable person.¹³

In the Masonite transaction, the OSC panel held: Finkelstein, Azeff, Bobrow, Miller, and Cheng breached the tipping subsection of the Act; Azeff, Bobrow, Miller, Cheng breached the insider trading subsection of the Act; and they also acted contrary to the public interest by recommending, with the knowledge of MNPI, that clients purchase Masonite shares. In the Dynatec and Legacy transactions, the OSC panel held: Finkelstein, Azeff, and Bobrow breached the tipping subsection of the Act; and Azeff and Bobrow acted contrary to the public interest by recommending, with the knowledge of MNPI, that clients purchase Masonite and Legacy shares. Azeff and Bobrow were not held in breach of the insider trading subsection of the Act in the Dynatec and Legacy transactions because they did not purchase shares for themselves.

Tipping and Insider Trading Cases Going Forward

The OSC has made it abundantly clear that it is an administrative tribunal and not a criminal court. Accordingly, as a tribunal, it will allow the admissibility of circumstantial evidence to prove allegations of tipping and insider trading. There is no doubt that other commissions will follow the OSC’s lead in these types of cases.

In a Financial Post article dated March 26, 2015, Finkelstein’s lawyer, Gord Capern said that he expected to receive instructions to appeal this decision. It has yet to be seen whether an appeal has been filed by Finkelstein or the other respondents. This may prove difficult given the law is clearly laid out in this decision and the facts and evidence are carefully examined.¹⁴ The hearing on sanctions is currently scheduled for May 21, 2015.

This article contains general information only and is not intended to provide a legal opinion or advice. Please consult a lawyer or compliance advisor for matters related to your situation before relying on any of the statements made in this article.

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1. The definitions in section 76 of the Securities Act (Ontario) (the Act) during the relevant timeframe from 2004 to 2007 were different from the definitions as they appear today in the Act. Although there are similarities between the definitions, there are also noticeable differences. The definitions of section 76 in this article are from the relevant period. Tipping was defined in subsection 76(2) of the Act as follows:
   Tipping
   76(2) No reporting issuer and no person or company in a special relationship with a reporting issuer shall inform, other than in the necessary course of business, another person or company of a material fact or material change with respect to the reporting issuer before the material fact or material change has been generally disclosed.
2. Insider trading was defined in subsection 76(1) of the Act as follows:
   Trading where undisclosed change
   76(1) No person or company in a special relationship with a reporting issuer shall purchase or sell securities of the reporting issuer with the knowledge of a material fact or material change with respect to the reporting issuer that has not been generally disclosed.
3. Subsections 76(5)(a) to (d) were defined as follows:76(5) For the purposes of this section, “person or company in a special relationship with a reporting issuer” means,(a) a person or company that is an insider, affiliate or associate of,
   (i) the reporting issuer,
   (ii) a person or company that is proposing to make a take-over bid, as defined in Part XX, for the securities of the reporting issuer, or
   (iii) a person or company that is proposing to become a party to a reorganization, amalgamation, merger or arrangement or similar business combination with the reporting issuer or to acquire a substantial portion of its property,(b) a person or company that is engaging in or proposes to engage in any business or professional activity with or on behalf of the reporting issuer or with or on behalf of a person or company described in subclause (a) (ii) or (iii),(c) a person who is a director, officer or employee of the reporting issuer or of a person or company described in subclause (a) (ii) or (iii) or clause (b),(d) a person or company that learned of the material fact or material change with respect to the reporting issuer while the person or company was a person or company described in clause (a), (b) or (c).
4. Subsection 76(5)(e) of the Act had the following expanded definition of special relationship, which captured successive tippees:76(5)(e) a person or company that learns of a material fact or material change with respect to the issuer from any other person or company described in this subsection, including a person or company described in this clause, and knows or ought reasonably to have known that the other person or company is a person or company in such a relationship.
5. Finkelstein deposited cash totalling $36,750 in four instances after the public announcement of one of the six transactions. Finkelstein testified that it was his father’s practice to keep cash at home as a means of protecting his savings and the cash came from his own income or gifts from family and friends. Although the OSC panel thought his cash habits were strange, the panel accepted his explanation and noted that OSC staff did not ask any relevant questions of Finkelstein about the cash allegation in cross-examination.
6. The OSC panel stated that a knowledgeable person includes all those persons in section 76 of the Act.
7. The OSC panel held that Finkelstein was in a special relationship under subsection 76(5)(b) of the Act.
8. The OSC panel held that Finkelstein was in a special relationship under subsection 76(5)(c) as an employee of Davies or under the expanded definition of special relationship in subsection 76(5)(e) of the Act.
9. The OSC panel held that Azeff was in a special relationship under the expanded definition in subsection 76(5)(e) of the Act.
10. Finkelstein had a small investment account of approximately $90,000 with Azeff, but both testified at the hearing that Azeff never recommended or discussed the purchase of any shares with Finkelstein. The panel surmised that this may have been because Azeff knew Davies was the law firm involved with the transactions or none of the shares was suitable for Finkelstein’s account.
11. The OSC panel held that Bobrow was in a special relationship under the expanded definition in subsection 76(5)(e) of the Act.
12.  The Masonite takeover transaction was announced on December 22, 2004.
13. The OSC panel held that Miller and Cheng were in a special relationship under the expanded definition in subsection 76(5)(e) of the Act.
14. Alan J. Lenczner, QC of Lenczner Slaght wrote this decision and is recognized as one of Canada’s leading litigators.