Insider trading is an ever-present danger in the corporate world. As the SEC points out, the term describes both legal and illegal conduct. After all, corporate insiders can trade stock in their own companies under certain conditions and within certain windows. However, it can become illegal when it involves insider information or breaches a duty.
Because the focus is on an individual's conduct rather than his or her financial gain, a person can be liable for insider training even where no money was gained and could face penalties of up to $5 million or 20 years in prison. Case law has highlighted some important distinctions and circuit splits regarding insider trading law, many of which revolve around statutory interpretation. To protect your corporate clients, it's important to understand the laws in their jurisdiction and what measures they can take to minimize their liability.
In the past, insider trading laws applied specifically to insiders associated with the issuing corporation. Section 16(a)(1) of the Securities and Exchange Act of 1934, for example, defines an insider as anyone "who is directly or indirectly the beneficial owner of more than 10 percent of any class of any equity security [...] or who is a director or an officer of the issuer of such security [. . . ]." For those individuals deemed insiders, Section 10(b) prohibits the use of "any manipulative or deceptive device [...] in connection with the purchase or sale of any security [...]."
However, the pool of insiders dramatically expanded with the holding in U.S. v. O'Hagan. That case created liability for individuals with no relationship to the company whose stock they are trading under the "misappropriation theory." This theory, also addressed in SEC regulations, attaches liability whenever people trade on the basis of non-public information entrusted to them. It focuses on relationships to the source of insider information and recognizes duties to that source to protect the information and to disclose any intention to trade. The Supreme Court determined that access to such information can constitute deception "in connection with" a security transaction, using the language contained in Section 10(b). With this ruling, the Supreme Court allowed the SEC and Justice Department to cast a much wider net when enforcing insider trading laws.
Possession or Use?
While the Supreme Court clarified the scope of federal laws against insider trading, it left open the question of whether the possession of inside information alone is sufficient or whether liability also requires use of that information. After O'Hagan, the Eleventh Circuit addressed this issue directly in SEC v. Adler. In that case, the Court rejected the "knowing possession test" favored by the SEC and instead held that the SEC must demonstrate that the insider actually used the information. The Court was mindful of the SEC's concern that a "use test" would present evidentiary issues as the true motivations for a trade are often hard to prove. Because of this, the Court recognized "a strong inference" that information possessed is also used in a trade, although this is rebuttable. This inference would allow the SEC to make out a prima facie case and permit the fact-finder to determine the true reason for the trade.
However, while Adler set forth the law in the Eleventh Circuit, a conflicting view has taken hold in the Second Circuit with the case of U.S. v. Teicher (1993). In that case, the Court adopted the "knowing possession test" because, among other things, the "in connection with" language in Section 10(b) can be satisfied even with a "very tenuous" relationship between possession of the information and the actual trading.
Given this split and its impact on insider trading cases, it's clear that the Supreme Court may eventually need to step in. In the meantime, it's important for your clients to know the laws in their jurisdiction to better protect themselves.
In possession test jurisdictions, your clients should ensure that they have clear policies in place to protect corporate information and those with access to it. One approach is to have all insider trades approved by the company General Counsel, who should carefully police each trade to ensure that the trader doesn't have insider information. For cases not involving intra-corporation trading, your clients should document all information they receive about a trade and its source and, for questionable cases, should meet with their counsel before trading.
For clients in use test jurisdictions, possession alone may be insufficient, but they may still need to overcome the presumption that information possessed was actually used in a trade. Among other things, your clients should ensure that:
- Their trades occurred in the company's pre-approved trading windows;
- The record clearly documents the decision to trade securities at that given time (if unrelated to insider information);
- Individuals document their intention to trade securities as early as possible to show that it was unrelated to any inside information that might come after the decision but before the trade.
For more information on these and other topics, see FindLaw's Corporate Counsel section which provides you with free access to information and resources for representation of corporate clients.