Insider Trading
(Federal Law)
• Classic insider trading
• Tipping liability
• Outsider trading
(misappropriation)
Last updated 27 Feb 12
Section 10(b)
Securities Exchange Act of 1934
Act § 10
It shall be unlawful for any person ...
(b) To use or employ, in
connection with the purchase or
sale of any security ... any
manipulative or deceptive device
or contrivance in contravention of
such rules and regulations as the
Commission may prescribe
Fraud Fraud
(tort of(tort
deceit)
of deceit)
• Material
misrepresentation
• Material
misrepresentation
• Intentional
(defendant
• Intentional
(defendant
aware
aware of truth)
of truth)
• Reliance
(plaintiff
• Reliance
(plaintiff
reliesrelies
reasonably)
reasonably)
• Misrepresentation is cause
• Misrepresentation
is cause of
of loss
loss
• Damages
• Damages
Misappropriation
(Outsider Trading)
Classic Insider Trading
Company
shareholders
Outside
shareholders
Silence = fraud
(duty of trust/confidence)
(1) Tip violates duty *
(2) Knows / reason to know
* improper benefit
Violates duty
to source
INSIDER
10b5-2
• Confidentiality agreement
• Confidentiality practice
• Family member – functional
Tippee
Rule 10b5-1: state of mind when trading “on the Tippee
basis” of material, nonpublic information
• “aware” (“conscious knowledge”)
• Pre-existing trading plans
Outsider Trading …
(Misappropriation)
US v. O’Hagan (US 1997)
“Misappropriation”
Shareholders
Option
sellers
Buy, buy, buy
Dorsey &
Whitney
O’Hagan
Insider
Shareholders
Pillsbury
Grand Met
Non-public, material info
(plan to make tender offer
To Pillsbury shareholders)
US v. O’Hagan (US 1997)
The "misappropriation theory" holds that a
person commits fraud "in connection
with" a securities transaction, and
thereby violates § 10(b) and Rule 10b-5,
when he misappropriates confidential
information for securities trading
purposes, in breach of a duty owed to
the source of the information. …
Under this theory, a fiduciary's undisclosed,
self- serving use of a principal's
information to purchase or sell
securities, in breach of a duty of loyalty
and confidentiality, defrauds the
principal of the exclusive use of that
information.
Justice Ruth Bader
Ginsberg
US v. O’Hagan (US 1997)
[The "in connection with the purchase
or sale of [a] security"] element is
satisfied because the fiduciary's
fraud is consummated, not when the
fiduciary gains the confidential
information, but when, without
disclosure to his principal, he uses
the information to purchase or sell
securities. … This is so even
though the person or entity
defrauded is not the other party to
the trade, but is, instead, the source
of the nonpublic information.
Justice Ruth Bader
Ginsberg
US “insider trading” primer
• Classic insider trading:
– Fraudulent silence under Section 10(b)
– duty of trust or confidence to “abstain or disclose”
• Tipping liability:
– know or should know that
– tipper has breached duty for improper personal
benefit
• Misappropriation liability:
– Fraud on source “in connection with” securities
trading
– Maintain integrity of securities markets
Effect of SEC rules
• Rule 10b5-1: state of mind when
trading “on the basis” of material,
nonpublic information
– “aware” (“conscious knowledge”)
– Pre-existing trading plans
• Rule 10b5-2: duty to source in
business/personal relations
– Agree to maintain confidentiality
– Practice of sharing known
confidences
– Spouse, parent, child, sibling – unless
no confidentiality
• Regulation FD: no special access
for analysts
Insider trading quiz
The Wall Street Journal
Friday, October 4, 2002
Q&A: The In's and Out's of Insider Trading
“So you get a hot stock tip on the golf course this weekend. Will
you get in trouble with the feds if you trade on it?”
Insider trading quiz
1. You work as CFO in UpN-Rising, a bakery
franchiser, that is opening
high-end bakery shops
throughout the country. The
numbers have been good,
until this month when you
notice an internal report
showing a 25% fall in
royalties from pastry sales.
Question: You sell some of
your stock. Insider trading?
1. Yes. This is classic
insider trading.
• Only question is
whether drop in
pastry sales is
“material”
• State of mind – use
versus knowledge –
resolved by Rule
10b5-1 (“aware”)
Insider trading quiz
2. You are outside counsel to
Up-N-Rising. The CFO at UpN-Rising calls you and tells
you about this quarter’s 25%
fall in pastry sales - resulting
in a 15% drop in earnings .
She asks whether the
company should disclose this
in a press release.
Question: You sell Up-NRising short. Insider trading?
2. Yes. You’re a
temporary insider (fn
14 - Dirks).
•
•
Drop in royalties is
“material”
Duty to source in
business/ personal
relation (Rule 10b52)
– Agree to maintain
confidentiality
– Practice of sharing
known
confidences
Insider trading quiz
3. You are a friend of Ralph,
who you know is sales
manager for Up-N-Rising.
Ralph tells you that
“something” is happening at
the company and you should
sell your Up-N-Rising
holdings, if you have any.
Ralph says no more.
Question: You sell your UpN-Rising stock? Insider
trading?
3. Yes. You received a
tip (duty to inquire).
•
•
If “something” is
material, nonpublic
Elements of illegal
tipping
1. Breach of duty by
tipper (personal
benefit)
2. Tippee knows or
reason to know of
violation
Insider trading quiz
4. You are a member of a
golf foursome. One of the
foursome says, “I think
something’s happening at
Up-N-Rising. You’d probably
do well to short it.” He says
no more.
4. No. Probably no duty
to inquire.
Question: You may no
further inquiries and buy UpN-Rising put options. Insider
trading?
•
•
•
What does
“something
happening” mean?
What are you aware
of?
What was the source
of information?
Insider trading quiz
Duty to inquire
•
WSJ: “If not from a company insider, you’re probably stupid
to just listen" and trade on it, says Jeffrey Haas, a professor of
securities law at New York Law School. “You don't have a
duty to find out where it came from.“
•
WSJ: Nancy Grunberg, former assistant director of SEC
enforcement, says, "The SEC would want to know -- unless it
was on a piece of paper that fell out of the sky -- whether you
asked about the source of the information before you acted on
it."
Insider trading quiz
5. New scenario. You are the
CFO of KK Donuts and have
been cogitating on what to do
with all the company’s extra
cash. You talk with the
company’s CEO and
investment banker, who agree
buying Up-N-Rising would be
a good move. You begin to
form a takeover team.
Question: You buy Up-NRising stock. Insider trading?
5. Yes – actually
“outsider trading.”
You cannot
misappropriate your
own company’s
info.
•
•
•
“Material”
Duty to source
“Awareness”
Insider trading quiz
6. You are the spouse of the
CFO of KK Donuts, who tells
you that she will be out of
town for the next few days.
“We’re looking at buying UpN-Rising.” You know that this
is only going to complicate
your life. You wish there were
a silver lining.
6. Yes. Either duty, or tip.
•
– WSJ: “Prosecutors have
found it fairly easy to satisfy
the requirement. Courts
have held sufficient to show
that the person's reputation
among colleagues would be
enhanced by having it
known that he was a good
tipper.”
•
Question: You buy Up-NRising stock. Insider trading?
Tipper violated duty –
personal benefit
Recipient had duty to
source
– Rule 10b5-2: “duty”
presumed in close family
relations, unless no
expectation of
confidentiality
Insider trading quiz
7. You are the head of strategic
planning at KK Donuts. You are
no fool. You figure that when KK
Donuts announces it is acquiring
Up-N-Rising, the stock prices of
competitors of Up-N-Rising will
likely fall. The Up-N-Rising
acquisition is moving apace.
Question: You sell short the
stock of Up-N-Rising’s
competitors. Insider trading?
7. No (maybe)
• No duty to outside
company
• No duty to source?
– Current academic
“state of art” issue
– Reach of insider
trading prohibition?
Insider trading quiz
8. You are an outside “public
relations” consultant to KK
Donuts. The company's CEO
calls and tells you KK Donuts
may be buying Up-N-Rising to
expand into the high-end French
bakery business. You are asked
if this would be good for public
relations. You have no
confidentiality agreement.
Question: You buy Up-N-Rising
stock. Insider trading?
8. Yes (probably)
Rule 10b5-2
• Defines duty to
source
• “Persons … have
history, pattern or
practice of sharing
confidential
information … so
recipient had
reason to know
communicator
expected
confidentiality.”
Insider trading quiz
9. You are the founder KK
Donuts. You hold about 40% of
the company’s stock and want to
diversify. Problem is if you sell,
during this volatile expansion
period, you will be accused of
insider trading. You tell your
broker to sell 1% every month
over the next two years – reducing
your KK position to 16%.
Question: You sell (under the
plan) when you are aware of the
Up-N-Rising deal. Insider trading?
9. No (if done right)
• Rule 10b5-1
(Martha Stewart defense)
– Pre-existing trading
plan negates
“awareness”
– Must show
• Binding contract,
instruct another,
written plan – when
“unaware”
• Strategy gives
specifics, formula, or
disables
Insider trading quiz
10. You are best friends with
Karl Konners, founder and
CEO of KK Donuts. You both
use the same broker. This
morning the broker called you
and blurted, “Karl is selling.
Karl is really selling.” You
knew that KK Donuts was
being investigated by the FDA
over its products’ fat content.
Question: You sell your KK
Donuts holdings. Insider
trading?
10. Yes (perhaps)
• Similar to facts of
Martha Stewart –
Imclone
– Insiders selling “material”
information?
– Breach of duty by
KK to “inform”
broker
– Sub-tippee knows or
should know
Martha Stewart
David M. Brodsky, co-head of securities litigation group
at Latham & Watkins in New York:
The mere fact that insiders are selling, even
heavily, isn't necessarily "material," or marketmoving information (though nonpublic). But if it
turns out that the sales truly are unique -- that the
founders had never sold shares before, for
example -- you may be courting trouble.
Insider trading quiz
11. You are in a taxi on a rainy
night in New York City. The driver
stops to pick up two wet
customers. “My gosh,” you think,
“It’s Karl Konners, the head of KK
Donuts.” Karl talks to his associate
in animated whispers about the
FDA dropping its fat-content
investigation. “Great news for KK
Donuts,” you tell yourself.
11. No.
•
•
No breach of duty
when KK talked
to associate
No duty of
eavesdropper to
source
–
–
Question: You buy KK Donuts
stock. Insider trading?
No
misappropriation
No tipping
Insider trading quiz
12. You are the head of investor
relations of KK Donuts. You
have been besieged by inquiries
about rumors of an Up-N-Rising
takeover. You talk to senior
management and decide on a
script: “KK Donuts is in
preliminary talks with Up-NRising management.” And so
on. You answer no questions.
Question: You call three leading
analysts of KK stock and read
the script. Insider trading?
12. Perhaps No
• Regulation FD (fair
disclosure)
– Addresses
systematic tipping
to analysts and
preferred analyst
back-scratching
– Treated as form of
insider trading
Regulation FD (fair disclosure)
•
“Advice” to market professionals of material
nonpublic information
–
–
–
•
Exceptions:
–
–
–
–
•
Intentional: simultaneous public disclosure
Unintentional: public disclosure within 24 hours
Applies to senior management, investor relations
Normal course of business (but not credit rating
agencies)
Government officials
Road shows when going public
Disclosure by foreign private issuers
Enforcement only by SEC (no private action)
Insider trading quiz
(answers)
1. Yes
2. Yes
3. Yes (inquire)
4. No (not inquire)
5. Yes
6. Yes
7. No (maybe)
8. Yes (probably)
9. No (if done right)
10. Yes (perhaps)
11. No
12. No
Classic insider trading …
Cady Roberts (SEC 1961)
“Classic”
Investors / shareholders
Sell to new investors
(sell short)
Gintel (director)
Curtiss-Wright
Non-public, material information
(board votes to cut dividends)
Duty to abstain or disclose …
Chiarella v. US (US 1980)
“Outsider”
shareholders
Pandick
Press
Chiarella
Shareholders
Insider
Acquiror Inc
Target
Company
Non-public, material info
(takeover plans)
Chiarella v. US (US 1980)
"... silence in connection with the
purchase or sale of securities may
operate as fraud actionable under §
10(b) ... But such liability is premised
upon a duty to disclose arising from a
relationship of trust and confidence
between parties to a transaction.”
Justice Lewis Powell
Tipping liability …
Dirks v. SEC (US 1983)
“Tipping”
Investors / shareholders
Clients dump stock
Secrist
Dirks
(analyst)
Equity Funding
Non-public, material information
(massive accounting fraud)
Dirks v. SEC (US 1983)
... a tippee assumes a fiduciary duty to the
shareholders of a corporation not to trade
on material nonpublic information only
when the insider has breached his fiduciary
duty to the shareholders by disclosing the
information to the tippee and the tippee
knows or should know that there has been
a breach.
Whether the "tip" was a breach of the insider's
fiduciary duty [depends on] whether ... the
insider receives a direct or indirect
personal benefit that will translate into
future earnings.
Justice Lewis Powell
Hypothetical
“Tipping”
Investors / shareholders
Sell Stock
Spouse
Secrest
Equity Funding
Non-public, material information
Massive accounting fraud)
Martha Stewart …
SEC v. Stewart (settled 2006)
“Tipping”
Stock market
Sells stock
Martha
Stewart
(at airport)
Sam
Wachtal
(CEO)
Imclone
Faneuil
(ass’t)
Non-public, material information
(FDA likely to disapprove drug)
The end