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Ignorance Is Not Bliss: Market Registrants Beware

Market registrants beware!

A market registrant’s lack of actual knowledge of the source of tip or their tipper’s relationship to an issuer will not protect them from liability under the Securities Act, according to the Ontario Court of Appeal in its recent decision in Finkelstein v. Ontario Securities Commission. The appeal court upheld findings of liability against investment advisers Howard Miller and Francis Cheng on the basis that both ought reasonably to have known that their respective tippers stood in a special relationship with the issuer.


This case arose out of the OSC’s administrative proceedings against five individuals, including Miller and Cheng. It was alleged that each of the five individuals in the tipping chain breached the insider trading and insider tipping provisions of the Securities Act and acted contrary to the public interest when they recommended to family and friends the purchase of shares in a reporting issuer, Masonite International Corporation. The OSC alleged that Miller and Cheng stood in a special relationship with Masonite and informed another person of a material fact about Masonite before it was publicly disclosed.

The tip, or material, non-public information (“MNPI”) about Masonite originated from Mitchell Finkelstein, a Toronto mergers and acquisitions lawyer, who was working on a takeover bid involving Masonite. Finkelstein informed his friend, Paul Azeff, a Montreal based investment adviser of material facts about the bid. Azeff informed an accountant, LK, who passed the information along to Miller. Miller conveyed the information to Cheng, a colleague at the same firm, whom he had taken under his wing.

After receiving the tip from LK, Miller immediately began to buy Masonite shares for himself and his clients.  In a few days, Masonite became the largest equity position in Miller’s own portfolio. After Cheng received the tip from Miller, he started buying Masonite shares for his wife, then other family members and clients. Cheng also passed the specifics of the tip along to a client who had been complaining of losses in their account. Cheng purchased approximately $450,000 in Masonite shares in the accounts of family members and clients.

OSC Hearing

The OSC brought proceedings against Finkelstein, Azeff, Miller and Cheng, but not LK. The OSC Panel found that Finkelstein and all the tippees in the chain had a special relationship with Masonite and had informed others of material facts about Masonite before they were publicly disclosed.

In relation to Miller, the OSC Panel found:

From these established facts, we conclude that Miller ought to have known that the MNPI LK gave him derived from a knowledgeable person.  The relationship between the tipper and tippee, the essential details of the [Masonite] takeover bid, the precipitous, anomalous, significant trading by Miller, the registrant, make it more probable than not that he ought reasonably to have known that LK was in a special relationship with [Masonite] and the [Masonite MNPI] originated from a person in a special relationship.

In relation to Cheng, the OSC Panel found:

Cheng, too, relied on the same factual basis tipped to him by Miller, his mentor and supervisor.  Cheng’s email to SK underscores his reliance on the reliability of the MNPI that Miller gave him.  He would not have risked passing speculative information, which may prove wrong, to an already complaining client.  Cheng, too, as a registrant, failed to inquire of Miller the source of Miller’s information. Cheng, too, did no due diligence on [Masonite] and undertook no research.  He relied entirely on the MNPI given to him by Miller and precipitously bought a large position for … family members of [Masonite], a stock neither he nor they had owned previously.  On the basis of all the facts regarding Cheng, we conclude, on a balance of probabilities that he ought reasonably to have known that Miller was in a special relationship with [Masonite] and the [Masonite MNPI] originated from a knowledgeable person.

Administrative sanctions were imposed on each of these registrants.

All five appealed the OSC Panel’s decision. The Divisional Court dismissed all but Cheng’s appeal. Miller obtained leave to appeal the Divisional Court’s decision. The OSC also obtained leave to appeal in respect of Cheng.

Ontario Court of Appeal

This case marked the first time the Court of Appeal considered the interpretation and application of s. 76(5)(e) of the Securities Act. Specifically, the court was tasked with determining whether Miller or Cheng were people “in a special relationship with an issuer”.

Section 76(5) of the Securities Act creates two categories of “person in a special relationship with an issuer.” The first, found in ss. 76(5)(a)-(d), includes those who are part of, or very closely connected to, the issuer – insiders, directors or officers of the issuer, or a person engaged in business or professional activity with the issuer, such as a lawyer or investment banker. The second category, established by s. 76(5)(e), encompasses those who are further removed from the issuer but receive MNPI in certain circumstances. It is this section that catches tippees who convey the information they have received to others.

Section 76(5)(e) defines a “person or company in a special relationship with an issuer” as:

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 is in such a relationship.

It was agreed that s. 76(5)(e) contains two requirements to establish liability – an information connection and a person connection. To establish the information connection, a comparison of the information the tippee received to that which was publicly available was sufficient. There was no dispute that both Miller and Cheng received MNPI about Masonite.

In respect of the person connection, it was agreed that neither Miller nor Cheng had actual knowledge that their sources of the information stood in a special relationship with Masonite or another person in a special relationship with Masonite. The question to be determined was whether, on an objective basis, Miller and Cheng “ought reasonably to have known” that their respective tippers stood in a special relationship with Masonite.

To assist in determining what the tippee ought to have known, the OSC Panel considered the following factors:

  • the relationship between the tipper and the tippee
  • the professional qualification and standing of the tipper
  • the professional qualification of the tippee
  • how detailed and specific the MNPI was
  • how long after receiving the MNPI did the tippee trade
  • any intermediate steps taken by the tippee to verify the information received before trading
  • whether the tippee has ever owned the particular stock before
  • the significance of the trade given the size of the portfolio

Miller and Cheng argued that the factors relied on by the OSC to draw inferences about the “person connection” were an unreasonable interpretation of the plain language of the statute by focussing on the type of information received by the tippee and not the their knowledge of what happened above them in the tipping chain.

The Court of Appeal agreed with the OSC Panel’s characterization of the factors as “a reasonable guideline that can be applied in the vast majority of situations”. It further agreed that the factors were not “exhaustive and that the evidence must be considered in its totality and assessed applying the objective test of “ought reasonably to have known.” It found no basis on which to find the OSC Panel’s decision to be unreasonable.

Practical application

In its practical application, this decision is a warning to market registrants about trading on tips or rumours. If a market registrant receives a tip, they would be well advised to make inquiries of the tipper about the source of the information and to conduct their own due diligence on the issuer. If there is any doubt as to the source, the information should neither be traded on nor passed on. The mere fact that a market registrant is far removed from the original source of the information will not protect them from liability.

Meredith Hayward
Affleck Greene McMurtry LLP

Meredith Hayward

Meredith has earned an impressive reputation for her skill and abilities in Commercial Litigation and Administrative Law, appearing at all levels of court in Ontario, before the British Columbia Court of Appeal, and before the Supreme Court of Canada.

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