Illegal insider trading is a serious securities law violation which carries potential civil and criminal penalties. Civilly, the penalties can be as large as three times the gross profit on the trading. An insider trading investigation by the SEC requires experienced securities counsel, as the initial investigation often dictates the final outcome. If you have questions regarding an SEC subpoena or an investigation, call Mark Astarita, Esq. at 212-509-6544. Mark and his partners have decades of securities litigation experience as SEC Staff attorneys, and broker-dealer attorneys.
Insider trading laws have significant impact on the stock market, and the conduct of investors. I have been representing investors and financial professionals in insider trading investigations for over 30 years. In the mid-1980’s when my then-partner and I represented a financial printer in an SEC federal court proceeding.
Since that time, I have represented registered representatives and investors from all walks of life, in dozens of investigations. The insider trading laws and court decisions have changed dramatically over those decades, with the SEC and the courts expanding the scope of the theory of insider trading beyond all reasonable bounds. However, it is this concept that we need to deal with, and we have had a great deal of success in defending potential defendants – because the investigation gets closed before an case is filed.
Insider Trading Definition
“Insider trading” is a term that most investors have heard and usually associate with illegal conduct. Recent government actions, including the criminal case against Martha Stewart, have enforced that view. However, Martha Stewart was not convicted of insider trading, she was convicted for obstruction.
There is no statutory definition of “insider trading”. As defined by the courts, it refers to purchasing or selling a security while in possession of material, non-public information concerning that security, where the information is obtained from a breach of fiduciary duty, or a duty arising from a relationship of trust or confidence.
Obtaining the material information by way of a breach of duty or confidence is the key to an insider trading violation, but after decades of court rulings, it is almost impossible for a court to find that a duty was NOT breached in an insider trading case. Some duties are obvious – the CEO of the company, the CEO’s assistant, and every other employee owe a fiduciary duty to the company and if they use, or disclose, material non-public information, they are liable for insider trading, often even if they didn’t trade themselves.
Other examples are more of a stretch – the employee of the financial printer of the public company, or the truck driver for a financial publication have all been accused of insider trading, and most recently, an employee of a competitor was accused of insider trading. With the SEC demanding penalties of three times the profit (while ignoring losses from the same trading) the downside is significant.
Legal Insider Trading
However, the term “insider trading” also includes legal conduct. The legal version is when corporate insiders, officers, directors, employees and large shareholders, buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC. Many investors and traders use this information to identify companies with investment potential, the theory being, if the insiders are buying the stock, they must know more about their company than everyone else, so it is a good idea to buy the stock.
That may work well when the insider is buying stock, but it does not work as well when the insider is selling stock. Insiders sell stock for varied reasons – a new house purchase, a child going to college or if the insider simply feels that their holdings in their company are too concentrated.
Some insiders sell based on 10b-5 plans. These plans help insiders avoid a claim of insider trading. The plans are detailed, specific plans that are designed to let executives sell off shares at regular intervals, regardless of events inside the company at the time of the sales.
Reports of transactions by insiders are filed with the SEC on Forms 3, 4 and 5, and the SEC has an excellent overview of these forms and the requirements for filing of same. Most of the internet based financial quote sites have information for each particular security. Visit Yahoo Finance and select a security, then select the menu choice for Insider Transactions. Here is the insider trading page for Citigroup for an example.
Illegal Insider Trading
The insider trading definition that we are concerned about is the buying or selling of a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Over the last 10 years, the SEC and the courts have greatly expanded this definition, to include trading by individuals whose “relationship of trust” is so remote as to be non-existent, but that discussion is left for another day. While myself and most other securities attorneys believe that the concepts of insider trading have been expanded beyond all permissible bounds, the law today is that if material information about a company, or about the company’s stock, is obtained in violation of any duty to any person and used to trade, the trader is guilty of insider trading.
Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. Examples of insider trading cases that have been brought by the SEC are cases against:
- Corporate officers, directors, and employees who traded the corporation’s securities after learning of significant, confidential corporate developments;
- Friends, business associates, family members, and other “tippees” of such officers, directors, and employees, who traded the securities after receiving such information;
- Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
- Government employees who learned of such information because of their employment by the government;
- Employees of financial printers who learned of the information during the course of their employment; and
- Other persons who misappropriated, and took advantage of, confidential information from their employers.
In recent years, the SEC and the Courts have expanded this further, and insider trading can now include trading by the random man in the street if the SEC believes that he obtained the information from someone who should not have the information. See SECLaw Blog posts on insider trading for more information. In my opinion, this has all gone too far, and the SEC needs to be reigned in on the expansion of insider trading liability.
The theory behind the prohibition is that it undermines investor confidence in the fairness and integrity of the securities markets. The SEC claims that the detection and prosecution of insider trading violations as one of its enforcement priorities, and all investors must be aware of the potential danger in trading on a “tip” from someone who knows non-public information regarding a security.
Recent SEC Insider Trading Cases
Important Insider Trading Court Decisions
The laws relating to insider trading have come from the Courts, not Congress. As an overview of those cases (this is by no means a complete list of important insider trading cases):
SEC v. Texas Gulf Sulphur Co. (1970)The court stated that anyone in possession of inside information must either disclose the information or refrain from trading.
Dirks v. Securities and Exchange Commission. The Supreme Court held that those who receive inside information from an insider are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information.
SEC vs. Materia, is the case that first introduced the misappropriation theory of liability for insider trading. Materia, a financial printing firm proofreader, and clearly not an insider was found to have determined the identity of takeover targets based on proofreading tender offer documents in the course of his employment. After a two-week trial, the district court found him liable for insider trading, and the Second Circuit Court of Appeals affirmed holding that the theft of information from an employer, and the use of that information to purchase or sell securities in another entity, constituted a fraud in connection with the purchase or sale of security. This was the first use of the misappropriation theory of insider trading, expanded insider trading liability to corporate “outsiders” and was eventually adopted by the Supreme Court. New York Securities Lawyer Mark Astarita and his partner represented the defendant for the three week trial in the Southern District of New York, as well as on the appeal to the Second Circuit.
United States v. Carpenter (1986) found liability for a trader who received information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted, on the grounds that he had misappropriated information belonging to his employer, the Wall Street Journal. In that widely publicized case, Winans traded in advance of “Heard on the Street” columns appearing in the Journal.
The Court stated in Carpenter: “It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principal for any profits derived therefrom.”
United States v. O’Hagan the U.S. Supreme Court adopted the misappropriation theory of insider trading from SEC vs. Materia,521 U.S. 642, 655 (1997). O’Hagan was a an attorney whose law firm was representing a company who was considering a tender offer O’Hagan used this inside information by buying call options on the target’s stock.The Supreme Court 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 the information. When an employee or former employee engages in securities fraud while working at the company, the misappropriation theory may be used to hold the employer liable for the employee’s acts.
In 2000, the SEC enacted SEC Rule 10b5-1, which defined trading “on the basis of” inside information as any time a person trades while aware of material nonpublic information. It is no longer a defense for one to say that one would have made the trade anyway. The rule also created an affirmative defense for pre-planned trades.
United States v. Newman, the United States Court of Appeals for the Second Circuit cited the Supreme Court’s decision in Dirks, and ruled that for a “tippee” (a person who used information they received from an insider) to be guilty of insider trading, the tippee must have been aware not only that the information was insider information, but must also have been aware that the insider released the information for an improper purpose (such as a personal benefit). The Court concluded that the insider’s breach of a fiduciary duty not to release confidential information—in the absence of an improper purpose on the part of the insider—is not enough to impose criminal liability on either the insider or the tippee. 
The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is “aware” of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre-existing plan, contract, or instruction that was made in good faith.
Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.
Insider trading carries severe civil and criminal penalties. If you are contacted by a regulatory agency regarding trades that you made, you should contact a securities attorney before speaking to the regulators. For more information about the defense of insider trading allegations, contact Mark Astarita of Sallah Astarita & Cox, at email@example.com. For more general information regarding insider trading and the SEC’s views of it, read Insider Trading -A U.S. Perspective.
Mark J. Astarita, Esq. represents investors, financial professionals and firms in litigation, arbitration and regulatory matters across the country. He is a partner in the national securities law firm of Sallah Astarita & Cox, LLC and can be reached by email at firstname.lastname@example.org or by phone at 212-509-6544.
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