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 (tort of deceit) Material misrepresentation Intentional (defendant aware of truth) Reliance (plaintiff relies reasonably) Misrepresentation is cause of loss Damages Fraud (tort of deceit) Material misrepresentation Intentional (defendant aware of truth) Reliance (plaintiff relies reasonably) Misrepresentation is cause of loss Damages

Classic Insider Trading INSIDER Company shareholders Misappropriation (Outsider Trading) Tippee Silence = fraud (duty of trust/confidence) (1)Tip violates duty * (2)Knows / reason to know * improper benefit Outside shareholders Violates duty to source 10b5-2 Confidentiality agreement Confidentiality practice Family member – functional Rule 10b5-1: state of mind when trading “on the basis” of material, nonpublic information “aware” (“conscious knowledge”) Pre-existing trading plans

Outsider Trading … (Misappropriation)

US v. O’Hagan (US 1997) “Misappropriation” Buy, buy, buy Insider Grand Met Non-public, material info (plan to make tender offer To Pillsbury shareholders) Shareholders Pillsbury Dorsey & Whitney O’Hagan Option sellers

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. US v. O’Hagan (US 1997) 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 Up- N-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 Up- N-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-N- Rising 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 10b5- 2) –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 Up- N-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. Question: You may no further inquiries and buy Up- N-Rising put options. Insider trading? 4.No. Probably no duty to inquire. 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-N- Rising 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 Up- N-Rising.” You know that this is only going to complicate your life. You wish there were a silver lining. Question: You buy Up-N- Rising stock. Insider trading? 6.Yes. Either duty, or tip. Tipper violated duty – personal benefit –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.” 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 market- moving 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. Question: You buy KK Donuts stock. Insider trading? 11. No. No breach of duty when KK talked to associate No duty of eavesdropper to source –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-N- Rising 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 –Intentional: simultaneous public disclosure –Unintentional: public disclosure within 24 hours –Applies to senior management, investor relations Exceptions: –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” Curtiss-Wright Non-public, material information (board votes to cut dividends) Investors / shareholders Gintel (director) Sell to new investors (sell short)

Duty to abstain or disclose …

Chiarella v. US (US 1980) “Outsider” Acquiror Inc Non-public, material info (takeover plans) Shareholders shareholders Target Company Pandick Press Chiarella Insider

Justice Lewis Powell "... 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.” Chiarella v. US (US 1980)

Tipping liability …

Dirks v. SEC (US 1983) “Tipping” Equity Funding Non-public, material information (massive accounting fraud) Investors / shareholders Dirks (analyst) Secrist Clients dump stock

... 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. Dirks v. SEC (US 1983) Justice Lewis Powell

Hypothetical “Tipping” Equity Funding Non-public, material information Massive accounting fraud) Investors / shareholders Secrest Spouse Sell Stock

Martha Stewart …

SEC v. Stewart (settled 2006) “Tipping” Sells stock Imclone Non-public, material information (FDA likely to disapprove drug) Stock market Martha Stewart (at airport) Sam Wachtal (CEO) Faneuil (ass’t)

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