As you would expect, corporate executives tend to own some of their corporation’s stock and may be receiving it as a form of compensation, especially at public companies. When you consider that these shares may be sold at some point, this raises the potential for some interesting issues, related to insider knowledge.
Legal vs. Illegal Insider Trading
Corporate insiders — including officers, directors, and employees — can buy and sell stock in their own companies, legally. Or, it can happen illegally when the insider is trading based on material, non-public information, and is a breach of their fiduciary duty. The trick is telling the difference between the two.
The way the SEC puts it:
Illegal insider trading refers generally to buying or selling 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. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.
New Rules of Play
Importantly, the SEC recently adopted new rules to resolve two insider trading issues where the courts have disagreed.
Rule 10b5-1 defines when a purchase or sale constitutes trading “on the basis of” material nonpublic information in insider trading cases. It clarifies that an individual illegally trades on the basis of material nonpublic information if the trader is “aware” of the material nonpublic information when making the purchase or sale. Importantly, it includes several affirmative defenses to liability. It allows individuals 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.
Duty of Trust or Confidence
New Rule 10b5-2 clarifies how the misappropriation theory applies to certain non-business relationships where individuals receiving material, non-public information would owe a duty of trust or confidence (so they could be liable for illegal insider trading if they bought or sold stock based on this information).
The SEC clarified that a “duty of trust or confidence” exists:
- Whenever a person agrees to maintain information in confidence;
- Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; or
- Whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling; provided, however, that the person receiving or obtaining the information may demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties’ history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information.
Avoiding the Red Card with a Specified Trading Plan
It has been accepted even prior to this that an executive could avoid the whole problem by entering in advance into a specified trading plan. So-called “10b5-1 plans” date back to 2000, as a way to allow executives to trade for legitimate reasons without worrying about exploiting the confidential information they often possess.
This would be true because one of the affirmative defenses against illegal insider trading is that:
(A) Before becoming aware of the information, the person had:
…( 3 ) Adopted a written plan for trading securities;
Such a plan would:
- Specified 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;
- Included a written 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; or
- Did not permit the person to exercise any subsequent influence over how, when, or whether to effect purchases or sales; provided, in addition, that any other person who, pursuant to the contract, instruction, or plan, did exercise such influence must not have been aware of the material nonpublic information when doing so.
This protection would only be applicable when the plan to purchase or sell securities was given or entered into in good faith and not as part of a plan or scheme to evade the prohibitions of this section.
…Or Being Thrown from the Game
The penalty for illegal insider trading varies depends on the fact in each case. An individual may be fined, required to disgorge any profit or savings, banned from sitting on the board of directors of a public company and possibly jailed. Corporations involved in insider trading can face penalties of up to $25 million.
A well-known example is Martha Stewart. She wasn’t an executive or employee of ImClone Systems, but was convicted of insider trading for lying to investigators about selling some shares of the company’s stock back in 2001. Ms. Stewart had allegedly been tipped with insider information from her stock broker which had come from a senior company executive, and she then sold her shares to avoid a loss. She was convicted, went to prison and paid a $30,000 fine. At the time she also suffered a significant hit to her reputation and to that of her firm.
So it pays to be cautious and to consider that, just because a prearranged trading plan that permits executives to trade their own companies’ stock by scheduling trades for particular times or prices exists doesn’t mean that the executives would necessarily be shielded from all enforcement actions. Rather, while such a plan can be a basis for a strong affirmative defense against allegations that the trading was illegal, it may not act as a complete defense.
While the number of SEC enforcement actions involving alleged illegal insider trading may not strike you as significant, it continues to be a high priority area for the SEC’s enforcement program. The 58 insider trading actions brought in FY 2012, involved actions against 131 individuals and entities. During the last three years, the SEC has filed more insider trading actions (168 total) than in any three-year period in their history – and this involved roughly 400 individuals and entities and illicit profits (or losses avoided) of approximately $600 million. It may also be important to note that with every case the SEC has brought after 1984, it has handed over to the Justice Department to prosecute.
This is all in addition to concerns the Wall Street Journal announced that it “found profitable and well-timed trades by more than 1,400 executives” in an investigation that it conducted on insider trading.
All of this means that it may be time to review one’s 10b5-1 plans.
1. Legal trades by insiders must be reported to the SEC. Most online financial sites then display this information on Insider Transactions at the click of a button.
2. Rules 10b5-1 and 10b5-2. By “disagreed,” we mean that the SEC lost several insider trading cases because while it could prove that an executive had been in possession of inside information at the time of the trade, it could not prove that he or she made the trade because of the inside information. So the SEC did what any enforcement body that gets to write the rules that it enforces would do: it changed the rules.