Insider Trading Outline

Insider Trading

1. In General

   1. Insider trading occurs when a person or entity trades in a security on the basis of material non-public information which has been obtained in breach of a duty of trust or confidence.

      1. Rule 10b5-1 defines trading "on the basis of" material nonpublic information simply in terms of whether the trader was "aware" of the information at the time of the trade.

         • The Rule provides for an affirmative defense if the trader can show that the rule was executed pursuant to a binding contract, specific instructions, or a written trading plan that was entered into before the trader became aware of the information.

           • A "Rule 10b5-1 Plan" must: (1) specify the amount of the securities to be traded and the price and date of the transaction; (2) include a written formula for determining amount, price, and date; or (3) not permit the insider to exercise any subsequent influence over how, when, or whether to effect the purchase or sales, so long as the broker or other who is granted that discretion is not aware of any material nonpublic information when making those decisions.

   2. "Insider" is not defined by securities laws but is construed by courts to be a person or entity that by virtue of a fiduciary relationship with an issuer has knowledge of, or access to, material nonpublic information.

   3. How is the prohibition against insider trading enforced?

      1. By the SEC under § 10(b) of the '34 Act and Rule 10b-5 or § 14(e) of the '34 Act.

         • § 14(e) proscribed trading after a "substantial step" has been taken towards a tender offer.

           • Scienter is required

      2. By the Department of Justice for "knowing or willful" violation

      3. Private right of action in favor of contemporaneous traders, or against corporation in a derivative action.

   4. The basic premise of early insider trading cases was a finding of fraud based upon the unfairness of allowing insiders to profit from their special access to sensitive information. See Cady, Roberts & Co.; SEC v. Texas Gulf Sulphur Co. (pg. 880)

      1. The court in SEC v. Texas Gulf Sulphur Co. noted that such unfairness frustrates "the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information." (pg. 880)

   5. Insider Trading is now applicable to members of congress. See The STOCK ACT

   6. Penalties

      1. Criminal penalties for "knowing or willful" violations

         • Up to 25 years and fines up to $5 million against persons and $25 million in cases of entities.

         • Mandatory Victims Restitution Act of 1996

           • Restitution for securities fraud victims.

           • Intent to make victims of crimes whole

           • Courts cannot take into account defendant's economic circumstances

      2. In Civil Suits by the SEC

         • Disgorgement of profits or losses avoided

         • Monetary penalties up to three times the windfall (treble damages)

         • Suspension or bar

         • Punitive damages

         • Insider Trading Sanctions Act of 1984

           • Monies go to the treasury

         • Insider Trading and Securities Fraud Enforcement Act of 1988

           • Enhances sanctions available to the SEC

      3. Private Right of Action

         • Insider Trading and Securities Fraud Enforcement Act of 1988 adds an express right of action for contemporaneous traders

         • Sanctions may not exceed three times the profits gained or losses avoided

         • § 20A of '34 Act allows recovery of pecuniary damages in the amount suffered by the contemporaneous trader, limited to the profits gained or losses avoided, less any disgorgement previously obtained by the SEC

   7. Policy

      1. Policies behind the prohibition of insider trading are fairness, market integrity, efficiency and social justice.

         • The basic premise of early insider trading cases was a finding of fraud based upon the unfairness of allowing insiders to profit from their special access to sensitive information. See Cady, Roberts & Co.; SEC v. Texas Gulf Sulphur Co. (pg. 880)

           • The court in SEC v. Texas Gulf Sulphur Co. noted that such unfairness frustrates "the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information." (pg. 880)

           • "Inequities based on unequal access to knowledge should not be shrugged off as inevitable in our way of life . . . ." SEC v. Texas Gulf Sulphur Co.

      2. O'Hagan made it clear that while some information disparity is inevitable, investors will hesitate to invest in a market where insider trading is unchecked.

      3. The laws also seek to eliminate quid pro quo arrangements where insider and noninsider trade valuable market information to the detriment of shareholders and others.

      4. Laws keep small investors from being disadvantaged by corporate insiders.

      5. Insider trading reduces investor confidence in the market.

         • Those who do not have inside information would be discouraged from tradin if they knew that those who had it were trading.

2. Duty to Abstain or Disclose - Traditional Theory

   1. "Abstain or disclose" means that the corporate insider must either abstain from personal trading (or "tipping" others) or ensure that the information is fully disclosed to the market before trading.

   2. "[N]ot every instance of financial unfairness constitutes fraudulent activity under § 10(b)." Chiarella v. United States (pg. 881)

   3. "[T]he element required to make silence fraudulent [is] a duty to disclose . . . ." Chiarella v. United States (pg. 882)

   4. "[T]he established doctrine [is] that duty arises from a specific relationship between two parties . . . ." Chiarella v. United States (pg. 882)

   5. "Section 10(b) is aptly described as a catchall provision, but what is catches must be fraud. When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak." Chiarella v. United States (pg. 882)

      1. The Court held in Chiarella that "a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information." Chiarella v. United States (pg. 882)

      2. The Court in this case did not address the misappropriation...

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