Many of the most public and celebrated securities cases have been cases involving insider trading. The public’s appetite for such cases is as endless as the cases themselves. Martha Stewart’s case is notable only because it is recent–the past forty years have brought forth cases involving not only corporate insiders, but also attorneys, psychiatrists, football coaches, athletes, newspaper columnists, printers, golfing partners, and even professional escorts. The SEC repeatedly announces the elimination of insider trading to be one of its top enforcement priorities. Unfortunately, the law of insider trading is highly interpretive and it is difficult to distill a steadfast rule.
Readers are cautioned that the penalties for insider trading are extremely onerous, and one should rely upon this summary only as an informational starting point, and not as a definitive guideline for making trades.
The Source of the Prohibition
“Insider Trading” violations can be traced to Rule 10b-5, which prohibits any device, scheme, artifice, act, practice or course of business to defraud or to deceive in connection with the purchase or sale of any security.
Under the traditional view of insider trading, Rule 10b-5 is violated when a corporate insider trades in the securities of a corporation on the basis of material, nonpublic information. Trading on such information constitutes a “manipulative and deceptive device” under the Exchange Act because “a relationship of trust and confidence exists between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.” This relationship implies a duty on the insider to either disclose information or refrain from trading on that information so that no unfair advantage is taken of the uninformed stockholders–familiarly called the “disclose or abstain” rule. In practice, disclosure is hardly practical, which leaves the “informed” insider with only one option: to abstain from trading.
What Is “Material” Information?
The U.S. Supreme Court has broadly stated that a fact is material if it “would have taken on actual significance in an investor’s deliberations.” By way of example, the following nonpublic information has been found to be material when in the possession of insiders:
- A company that was soon to receive a tender offer to be purchased.
- A company that was soon to announce a merger.
- A favorable earnings announcement.
- A soon to be disclosed valuable mineral find.
- A soon to be announced dividend payment.
- An upcoming buy recommendation by a financial analyst.
- An upcoming appearance in a financial news column.
An Expanded Definition of “Insiders”
In general terms, with respect to insider trading, corporate insiders may be defined as persons who, by virtue of their relationships with the issuer, are aware of material information about the entity that is not available to the public at large. Corporate Insiders would include all persons included in the Section 16 definition of “Insiders” (see Volume 5 of our newsletter), but would also include members of the immediate families of directors, officers and controlling persons. Also, underwriters, accountants, lawyers, and consultants – “even if outside the Corporation” – can be deemed insiders under some circumstances.
The Tipper/Tippee Problem; When Nonpublic Information is Passed
One of the most complex, fluid, and opaque topics in insider trading law is the problem of whether liability attaches to tippees–non-insiders who learn of nonpublic material information from insiders and then trade on that information. Recall that a condition of insider trading liability is the “breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer–or the shareholders–or to any other person who is the source of the material nonpublic information.” So, when is a tippee in a position of derivative trust or confidence? The Supreme Court has offered several pronouncements that help to answer this question.
- For subsequent tippees to be liable, the insider (tipper) must breach his or her duty of trust or confidence to the issuer’s shareholders.
- In order for a tippee to be held liable, there must have been some benefit to the tipper in making the tip. The tipper’s benefit need not be tangible, a gift of information to a friend or relative is sufficient.
- The tipper need not be a “true” insider such as a director, officer, or lawyer. Liability can be extended to “temporary insiders” such as financial printers.
- The tipper need not have a belief that the tippee (or subsequent tippee) will trade, wrongfulness is presumed merely from the divulgence of confidential information.
- In most cases, for liability to attach to the tippee, the tippee must know that the information received is tainted in breach of a duty of trust or confidence.
- Subsequent tippees can create a “chain” of liability, if the breach of trust and confidence is passed down the line. One example of liability involved the passing of information from husband to wife, then from the wife to a third party.
- There is a recent trend in the case law narrowing the breadth of tippee liability.
The Timing of Insider Trades
At what point after public disclosure of material information may insiders trade in their company’s securities depends on how quickly the information makes its way through newswire services and on the nature of the information. In an important case, a court ruled that an insider should not have placed an order to purchase securities until the information could reasonably have been expected to appear over the news service with the widest circulation. The SEC typically has adopted a sterner position, requiring that in addition to dissemination through recognized channels of distribution, public investors must be afforded a reasonable waiting period to react to the information. The American Exchange recommends that insiders wait from 24 to 48 hours after general publication of information.
The SEC Likes Tattle-Tales
In order to increase the likelihood of discovering insider violations, the Commission is permitted to make bounty awards from the civil penalties that are actually recovered from violators. With minor exceptions, any person who provides information leading to the imposition of a civil penalty upon an insider may be paid a bounty.
Insider Trading Penalties and Punishment The penalties, both civil and criminal, for insider trading are severe. First, there are private civil remedies, as found in Section 20A of the Exchange Act of 1934. Persons who are harmed by insider trading can bring actions in most circumstances to recover the illegal profits (or avoided losses) enjoyed by wrongful traders in contemporaneous trading.
Furthermore, the SEC has the authority to impose criminal penalties, civil penalties, and punitive civil awards against wrongful traders. Congress passed the Insider Trading Sanctions Act in 1984 to toughen penalties for illegal traders. The civil penalty in such a suit can include disgorgement of profits and a penalty of up to three times the ill-gotten profits. The 1984 law also increased the criminal penalty from $10,000 to $100,000.
And, in 1988 Congress went even farther by passing the Insider Trading and Securities Fraud Enforcement Act in 1988. ITSFEA impacts an issuer’s controlling persons. ITSFEA made clear that tippers and tippees are both primary violators and are thus jointly and severally liable. Under ITSFEA, a court can impose sanctions equaling up to three times the illegal profits made by inside traders. These recent laws have led the SEC to adopt a very aggressive enforcement posture and have yielded tremendously large settlements.
The Good News: Protecting Legitimate Insider Transactions The term “insider trading” is a misnomer; not all insider trades are unlawful. Executives may in good faith make purchases of their company’s stock. Rule 10b-2 of the Exchange Act outlines a compliance program that can protect insider transactions. 10b-2 dictates that a purchase or sale is deemed not made on the basis of material nonpublic information if the trader adopts a regular, periodic and written plan for the acquisition or sale of securities. The written plan can be a “formula or algorithm, or computer program, for determining the amount of securities to be purchased or sold and the price at which and the date on which the securities were to be purchased or sold.” The development (and faithful observance) of such a plan can be a powerful device in defeating a charge of insider trading.
Where To Go for More Information
Professor Stephen Bainbridge of UCLA has authored a thorough and definitive summary of insider trading law entitled Securities Law: Insider Trading , available in paperback for about $15 through Amazon.com.