Developments In Regulatory Investigations Into Insider Trading

Thursday, June 1, 2006 - 00:00

Regulatory investigations are often driven by the changing economic and political climate. What interests regulatory investigators today will be different from what interests them six months from now. It is imperative for those involved in the securities industry to recognize investigative trends sooner, rather than later. This is certainly true in the area of insider trading. Although the prohibition against insider trading is now well established under state and federal securities laws, investigative trends into insider trading schemes are ever changing. Although certain insider trading schemes will always garner regulator attention (see the Business Week example below), other schemes have only recently registered on regulators' radar screens.

Insider trading liability may arise in a wide variety of contexts, including criminal, civil or administrative proceedings. The U. S. Department of Justice has jurisdiction to pursue federal criminal actions. The Securities and Exchange Commission (SEC), self-regulatory agencies, and state securities enforcement agencies may initiate civil and administrative proceedings based on insider trading allegations. Private parties may also bring civil claims based on insider trading allegations.

Insider trading liability is ordinarily based on a violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, promulgated thereunder. Liability for trading on inside information is usually premised on Rule 10b-5's ban on fraudulent acts or practices. Rule 10b-5 is violated when a corporate-insider trades in that corporation's securities on the basis of material nonpublic information. Insider trading claims are frequently pursued against classic insiders - officers and directors of corporations who, in the regular course of their duties, have access to material nonpublic information. Professionals assisting those corporations, officers, and directors - lawyers, investment bankers and other advisors - frequently have access to this same information in the normal course of providing professional services. Indeed, it is not surprising that many insider trading claims are brought against these professionals, who are sometimes characterized as "temporary insiders" by virtue of their temporary access to inside information.

The Disclose Or Abstain Rule

Initially, the prohibition against insider trading was articulated as a "disclose or abstain" rule. This rule requires a corporate insider with a fiduciary duty to the corporation and its shareholders to either disclose material inside information or abstain from trading in the corporation's stock. A fiduciary relationship arises between a corporate insider and the corporation and its shareholders as a result of the insider's employment as an officer or director for the corporation. Under these circumstances, an insider with material non-public information has the obligation either to disclose the information, or abstain from trading in the corporation's securities.

At least initially, the scope of insider trading liability was fairly limited and only applicable in situations where the insider had a fiduciary duty to the party with whom the insider traded, the corporation or shareholders of the corporation whose securities were traded. That is, absent a fiduciary relationship, trading on material non-public information did not create insider trading liability.

The "disclose or abstain" rule was subsequently extended to third party "tippees" - individuals who trade based on tips from insiders. Professionals who obtain material non-public information from insiders in the regular course of their employment and tippees, with knowledge that the insider tipper has breached a fiduciary duty to the corporation by passing on inside information, have the same obligations as insiders under this rule.

The Misappropriation Theory

Because the "disclose or abstain" rule is somewhat limited, aggressive prosecutors and regulators have since sought to expand the scope of insider trading liability to situations where the trader obtains material non-public information by breaching a fiduciary duty other than a duty owed to the corporation whose securities are traded. This broader theory of insider trading liability, called the "misappropriation theory," bars trading by an insider even when the securities being traded are not those of the insider's employer. Under this theory, a person violates Rule 10b-5 by misappropriating someone else's information in breach of a fiduciary duty owed to the source of the information.

The misappropriation theory departs significantly from the narrow "disclose or abstain" rule. The misappropriation theory, by contrast, does not restrict itself to the fraud perpetrated on those who buy from or sell to the inside trader. Instead, it broadens the inquiry to determine whether the insider has obtained the material non-public information wrongfully - in breach of a duty owed to the source of the information.

An example of this broader theory of insider trading liability occurred in the early 1990s, when a psychiatrist tipped his broker some inside information he had received from a patient. The broker used that information to trade in his own account and in the accounts of several friends. The Second Circuit Court of Appeals rejected the broker's motion to dismiss, finding that the broker knew, or was reckless in not knowing, that the information had been misappropriated in breach of the psychiatrist's duty to his patient, and it was irrelevant for purposes of establishing insider trading liability that the patient was not herself a party to the securities transaction.

Tippees who receive misappropriated information may be liable for insider trading under the misappropriation theory even if the tipper - the provider of the misappropriated information - did not trade on that information. Tippee liability is imposed upon proof of a breach by the tipper of a duty owed to the owner of the material nonpublic information and the tippee's knowledge that the tipper had breached the duty.

The U.S. Supreme Court endorsed the misappropriation theory for the first time in United States v. O'Hagan, 521 U.S. 642 (1997). In that case, O'Hagan was an attorney whose firm was retained by Grand Metropolitan PLC in connection with a proposed acquisition of the Pillsbury Company. Before Grand Metropolitan publicly announced its tender offer for Pillsbury stock, O'Hagan purchased 2,500 Pillsbury call option contracts and approximately 5,000 shares of Pillsbury common stock. O'Hagan realized a profit of more than $4 million from these transactions. Since O'Hagan was not an "insider" of Pillsbury, the corporation in whose shares he traded, the government proceeded against O'Hagan under the misappropriation theory.

The government claimed that O'Hagan breached a fiduciary duty to his law firm and Grand Metropolitan when, through his employment at the law firm, he obtained material non-public information concerning Grand Metropolitan's interest in acquiring Pillsbury, and subsequently used that information as a basis for trading in Pillsbury securities. The Supreme Court agreed that the misappropriation theory is a permissible basis for imposing 10(b) liability.

Modern Insider Trading Liability

The SEC continues to investigate both time-tested, classic insider trading schemes and new ones. For example, just last month, the SEC issued charges against individuals involved in schemes of insider trading that yielded at least $6.7 million of allegedly illicit gains. As part of one of the alleged schemes, two former Goldman Sachs employees recruited an individual and helped him get a job at a printing plant that prints Business Week magazine, for the sole purpose of stealing copies of upcoming editions of the magazine. According to the complaint, the individual that was recruited used phony names as references on his application and listed cell-phone numbers belonging to the former Goldman Sachs employees. After getting a job at the printing plant, the individual allegedly began reading pre-publication copies of Business Week's "Inside Wall Street" column over the telephone to the former Goldman Sachs employees, who then used the information to make more than $345,000 in trading gains. According to the complaint, the scheme continued even after the printing plant fired the individual, because the individual continued entering the plant in his uniform to obtain pre-publication copies of the magazine.

Although, at first glance, the former Goldman Sachs employees' alleged scheme seems imaginative, it is actually a classic insider trading scheme that has been orchestrated and attempted many times before. By contrast, the SEC recently filed a complaint against a hedge fund in connection with a relatively new type of transaction, a Private Investment in Public Equity (PIPE) offering of stock. In a PIPE offering, a placement agent privately places restricted securities of a public company with accredited investors, who agree to purchase shares at a discounted price. The public company then agrees to register the stock so the purchasers can resell it at some specified future dates. Because a PIPE offering increases the supply of stock available in the market, it generally decreases the market share price of the issuing public company.

For each of the PIPE offerings that were the subject of the SEC's complaint, a placement agent allegedly advised the Director of Private Placements that the issuers were planning to conduct a PIPE offering. The director was further advised that such information was considered nonpublic, confidential information. In at least one case, the placement agent also sent a confirmation letter to the director cautioning him about his obligation under federal securities laws not to transact in the securities of the PIPE issuer while in possession of material nonpublic information.

Despite the advance warnings, the director allegedly began placing orders to sell short the issuers' stock on behalf of one of the hedge funds' investment funds. "Short selling" includes the practice of borrowing shares of stock from a broker and selling them without owning the shares, with the expectation that the share price will drop, enabling the seller to "cover the short" by delivering to the purchaser, shares the seller subsequently purchases at the lower price. According to the SEC's complaint, the director executed short sales before the issuers announced publicly their PIPE offerings, then reaped illegal trading gains after the announcements were made and the issuers' public stock price fell. Shortly after the SEC filed their complaint, the Hedge Fund agreed to pay $5.75 million to settle the SEC's charges.

Mark S. Enslin is a member of Lindquist & Vennum's Securities Litigation and Arbitration Practice Group, assisting clients in the areas of commercial and securities litigation, arbitration, antitrust and intellectual property. He can be reached at (612) 371-3944. More information about the cases referenced in this article, as well as other recent trends in the securities industry, can be found at Lindquist & Vennum's blog,

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