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Published: 2008-03-26

SEC Clarifies Insider Trading Rules



On August 10, 2000, the Securities and Exchange Commission (SEC) adopted Rules 10b5-1 and 10b5-2 that clarify certain principles of insider trading. In the same release, the SEC also announced the adoption of Regulation FD (Fair Disclosure), a new regulation that prohibits public companies from selectively disclosing material information to analysts and institutional investors before making the same disclosures to individual investors and the general public. Regulation FD is discussed in a separate Issue Update. Both of these initiatives are in response to SEC concerns that insider trading and selective disclosure result in a loss of investor confidence in the integrity of the capital markets.

The new rules regarding insider trading and selective disclosure will become effective on October 23, 2000.

Clarification of Insider Trading Rules

Standard for Enforcement of Insider Trading

Recent cases have resulted in a split among three appeals courts as to the causal connection that the SEC must show between a trader.s possession of insider information and the trading. Some courts have indicated that a trader may be liable for trading while in .knowing possession. of inside information, while other courts have required a showing that the trader .used. the information in the decision to trade. The SEC adopted Rule 10b5-1 to clarify that a person may be subject to insider trading liability arising out of transactions that occur when the trader is aware of material, nonpublic information when making a purchase or sale. The awareness standard reflects the SEC.s belief that a trader inevitably uses the inside information of which it is aware when making a decision to trade. The SEC.s rule is intended to clarify this standard without modifying any other aspect of insider trading case law.

Affirmative Defenses

The rule sets forth as affirmative defenses situations in which a person can show that the inside information was not a factor in the decision to trade. To establish the defense, the trader must demonstrate the following:

  • Before becoming aware of the information the trader entered into a binding contract, gave instructions to another person or adopted a written plan providing for the purchase or sale of the securities in good faith and not in an attempt to evade the new rules;
  • The contract, instructions or plan either: (a) expressly specifies the amount, price and date; (b) provides a written formula for determining amounts, prices and dates; or (c) does not permit the trader to exercise subsequent influence over how, when and whether to trade so long as the person with such influence is not aware of material nonpublic information when making such decisions; and
  • The purchase or sale that occurred was pursuant to the prior contract, instructions or plan (i.e., no alteration of or deviation from the contract, instructions or plan and no engagement in a corresponding or hedging transaction).

As long as the purchase or sale complies with these guidelines, the trade may occur even if the trader later becomes aware of material nonpublic information. In addition, if the trading party is an entity, the entity will not be liable if it can demonstrate that the person making the investment decision on the entity.s behalf was not aware of the information and the entity had implemented reasonable policies and procedures to prevent insider trading.

Misappropriation Theory Insider Trading Cases

The misappropriation theory insider trading cases hold that certain relationships necessarily give rise to a duty of trust or confidence such that trading or tipping information in violation of that duty would give rise to insider trading liability. The SEC has adopted Rule 10b5-2 listing three non-exclusive situations in which a person owes a duty of trust or confidence in non-business relationships and therefore can be liable under the misappropriation theory of insider trading. The rule indicates that a duty of trust or confidence exists when:

  • a person expressly agrees to maintain information in confidence;
  • the facts and circumstances of the relationship as a whole show a history, pattern or practice of mutual sharing of confidences; or
  • a person receives information from a spouse, parent, child or sibling, unless the person receiving the information can show that, under the facts and circumstances of the family relationship, no reasonable expectation of confidence existed.

The SEC noted that this bright-line list of family relationships in which a duty of trust or confidence exists does not include many non-traditional relationships (e.g., domestic partners) or extended family relationships, but indicated that many of those relationships will meet the facts and circumstances test to show that a history of shared confidences created a duty.

This update is intended solely to alert readers to the new rules adopted by the SEC clarifying certain principles of insider trading law and is not intended as legal advice. Further details may be necessary for a complete understanding of the information in this update and more information will be made available as the new rules shape business practices.

We would be pleased to provide you with additional information about the final rules or discuss with you the ramifications that these rules may have on your business. You can find the full text of the rules (Release Nos. 33-7881; 34-43154) on the SEC.s website at http://www.sec.gov/ or call 202/942-7111 for a paper copy. Click for information and contact details on Faegre & Benson.s Corporate Finance practice.