Insider Trading: Law, Trust, and Prevention
Bahram Seyedin-Noor and Hollis O'Brien
Judging from the budget submitted by the Obama administration in February, addressing financial fraud is a major goal of the administration. The president requests an 11 percent boost for the Securities and Exchange Commission, primarily for staff units that are investigating fraud. This month there was news about reorganization within the SEC; there are now divisions that are somewhat more specialized. One of those five divisions is focused on securities market issues.
This comes on top of the SEC announcement in January that the commission will use techniques that have, in the past, typically been associated with criminal investigations to encourage individuals and companies to cooperate in its enforcement investigations.
What Is Insider Trading?
These remarks are by Bahram Seyedin-Noor:
It's important to be clear about the definition of illegal insider trading. A crude way of understanding the issue is the "abstain or disclose" rule: You have material non-public information that others don't have. You either disclose it to the counter-party, or you just don't trade. That's actually not really the law; the law is much more nuanced than that. But it's a healthy attitude to have from an ethics perspective.
There are various forms of insider trading. Most of us are familiar with what's referred to by the courts as the classical insider trading scenario, which is when an insider with fiduciary duties to shareholders is in possession of material non-public information and trades on that information. Then, you've got the tipper/tipee scenario, where the insider passes that information to someone who's one level removed, who then trades. Finally, the misappropriation theory is a less well-understood species of insider trading, but one which got a lot of press this year. It holds that an individual may be guilty of insider trading if they violate a promise or duty not to trade on inside information, which they owed to the source of the information.
Insider Trading Cases
Here are several scenarios that illustrate what is and what is not insider trading:
- You accidentally overhear two business people at the next table discussing the fact that a company in which you hold stock is going to miss quarterly earnings. You then sell your stock.
Commentary: This activity is actually not illegal. It is not illegal if you just happen to overhear someone say something. It may be considered unethical. And some view it as corrupting the securities markets because some traders have "unfair" advantages over others-which is a policy pillar of the federal insider trading laws. Nonetheless, the law doesn't yet encompass this situation. It probably never will.
- Now, let's say, you don't just overhear someone reveal insider information; you get on a computer and hack into a company's financial database and find they won't make their quarterly earnings. And you sell!
Commentary: Hacking into a computer becomes illegal insider trading because you're engaging in deceptive practices. The statutes are very focused on fraud and deception. That's where you kind of come within the ambit of those statutes. In the first case, you just happened to be in the right place at the right time-or the wrong place at the right time. But in this hypothetical, you obtain the information through deception.
- You have a meeting with a banker, and the banker invites you to take part in a private investment in a public entity-the company is trying to raise capital. The banker sits you down, hands you an NDA [non-disclosure agreement]. The NDA says you will keep this information private. You sign it, and promise to keep it confidential. The banker then tells you about this offering the company needs, tells you about what's going on at the company. The meeting ends and you say you have no interest in taking part in this offering. A minute later you call your broker and liquidate your stock in the company. Two weeks later, the offering is announced, and the company's stock tanks.
Commentary: This fact pattern comes under the ambit of what's called the misappropriation theory. One issue with respect to misappropriation is whether you're in possession of information that you know someone is giving to you in certain confidence.
So the misappropriation theory says that if someone gives you information, and if they give you that information with the agreement that you're not going to trade on it, then you shouldn't be trading. Sometimes that comes in the context of a fiduciary relationship between you and the source of the information. Sometimes it comes in familial relationships, which are specifically addressed by statute. In this case, one view is that if you had no explicit understanding with the banker that you would not trade on the information then you arguably are not guilty of insider trading under current case law. That said, there are some jurists who would disagree and a case with similar facts is being appealed by the SEC.
The Ethics of Insider Trading
That a trade is legal does not necessarily make it ethical. The ethical principle is easy to understand because the principle tenet of our securities market is that no trader should have an unfair advantage when trading. When a trader has material non-public inside information, and he or she trades with someone who doesn't, it seems to many to be unfair on its face. That's one of the guiding principles. But the courts, and Congress, have been reluctant to declare that a blanket rule-that is to say you can never trade with material, non-public information-it may be unethical, but it is not necessarily illegal.
How Is Insider Trading Monitored?
There are numerous bodies monitoring trades. In-house counsels routinely get requests asking the company to disclose information around particular events; usually it's because there's some suspicious trading activity, and those regulatory bodies want to know who knew what when. Typically, they'll ask you where everyone at the company who had the material information lives. They want to see if people who trade are living in the same neighborhood, or if an insider lives next to someone who traded large quantities of stock.
These days, the SEC and other regulatory bodies may refocus to look beyond geography, at social networking sites. That's one area where we may see more analysis and rigor on the part of the regulatory bodies, because you can learn a lot about someone, their network, just by looking at their presence online, in the virtual world.
So, what's the regulatory focus? The SEC is on a crusade -- insider trading is a real focus. The leadership of the enforcement division is now a former federal prosecutor. He's using some of the same tools that were being used in the criminal end in the civil end at the SEC, including different agreements such as cooperation agreements. Another tool, which has been in the SEC's arsenal for a long while, is the payment of a bounty to informants, and the SEC may make greater use of that avenue to obtain information.
Another key development is you're seeing more tools, more cooperation between the SEC and criminal authorities. This gives each a whole new tool bag, including wiretaps, which can be very effective in successfully prosecuting cases.
There's also been an internal reorganization at the SEC, focusing attorneys into more specific groups, one of which focuses on trading activity. You end up with situations like we saw last year: dozens of subpoenas going out to some of the most respected and powerful people in the economy, people at private equity firms now under scrutiny, some discovering they'd been wire-tapped for the last year. And it's not surprising, given what happened with the financial meltdown in 2008. The SEC has been very aggressive; and this is probably just the beginning of prosecutions we're going to see in 2010.
What Businesses Can Do
There are various ways of limiting and discouraging insider trading. Obviously, some level of training is always a necessity; this needs to be refreshed in people's minds. The lessons we think are obvious are often not. And a lot of these ethical breaches begin with small slips that evolve into something bigger.
These training programs could also require certifications that employees are not engaging in that sort of practice, that they're aware of the laws and so on. If you're afraid of being in a situation that some of these private equity firms are in now, that's one way of addressing it.
There are also 10b5-1trading plans, which are specifically detailed plans that limit liability because trades have been pre-planned well in advance of any news or event. A lot can be said about the efficacy of 10b5-1 plans. They're generally a good idea. But they are also subject to abuse. If you're amending your 10b5-1 plan five days in advance of any material news or event that changes the trading pattern for any reason, that's not going to be ignored. The same rules apply concerning material non-public information at the time you're trading, or designing a plan to trade. The friction arrives when individuals use this as a cloak to mask otherwise improper trades.
The following comments on what businesses can do come from Hollis O'Brien:
We live in a completely different business environment, where people don't work in their offices, where they work in Starbucks, hallways, etc. The opportunity to share information is probably greater now than it has ever been. From a company's perspective, you don't want people sharing information unnecessarily. If you're a technology company, you want people being very cautious about what they say, even in a restaurant. We have this desire that markets trade freely, and trade fairly, but we have to lay that on top of this environment where there's simply information everywhere. So what do we do from an in-house perspective to try to limit our exposures?
My list starts with 10b5-1 plans. You can put specific parameters around them-for example, that there are certain windows within which you can enter into a plan, and certain requirements related to the duration of the plan, which cannot be modified. Even the brokers require a certain duration for the plan - no shorter than 1 year, for example.
I consider a pre-clearance procedure important. An employee, even though the window is open, would have to check with the CFO or the general counsel, and get an approval before he or she trades. But even those procedures are not always foolproof. At one point I instructed an executive that he could not trade, and he traded anyway. His problem wasn't actually an insider-trading issue; it was a Section 16 issue, which is even worse. He had absolute liability; we had the trade reversed and the individual disciplined.
One other approach is to require all executives to use one brokerage firm. This is usually unpopular, because often executives have their own brokers, but this helps to make sure that you, as the in-house "controller," are acquainted with their brokers. If you can establish a relationship with the broker or consolidate trading via one broker, that's very helpful. I had an interesting experience with an executive who had a bad broker. He was in a 10b5-1 plan, but his broker continued to execute other trades outside the approved windows. If you don't have a good broker, you can have trouble like this.
I would also caution folks that when your window is not open, you still have to monitor internal communications. CEOs like to share information with employees, make them feel like they're in the loop. I've had examples where CEOs have sent out quarterly earnings to large groups of employees before they were made public. Of course, these came with disclaimers saying the information can't leave the company. We ended up calling the broker we had for most of our employees to shut down trading because the CEO had, in effect, pre-announced earnings.
Also, on the front end of the process, it's important to have solid equity grants and procedures. Most companies do now, after the whole scandal of options backdating. You want to protect your executives from any implication that they had anything to do with the strike price of their equity. That's a good way to start: protect them at the front; protect them at the back.
But how do limit leaking, and tipping? Quite frankly, most companies' problems relate to leaking, not tipping-the sharing of information with people who shouldn't have it. Companies leak, in my view, all the time. They leak from almost every possible level in the organization. Leaks can exist for any number of reasons; they can exist because people don't know that the information they have is confidential. They don't think they're a big shot, that it's just their little, insignificant project: it can't possibly be a problem. So they start blogging about it. Crazy things happen nowadays. At the other end of the spectrum, you have the people who are just evil, deliberately gaming the system and trying to make money from it.
What we've done is to set a really serious tone at the top. Your executives have to mandate confidentiality, realizing that information is the lifeblood of the company, and keep everything confidential. Start with the board. There's a bit of a push lately for board confidentiality policies. I think it stemmed more from shareholder activism and constituency directorships, folks on the board that aren't regular board members. The confidentiality policies need to be very broad, and apply not just to material, non-public information, but also include board discussions. There are a lot of questions about how enforceable these policies are; but the true value is that they give you a baseline from which you can function; they give you a tool to train people with; they give you an opportunity to sit down and talk about confidentiality.
Training is very important; you have to have periodic training, A.K.A. reminder training. With senior executives you don't always have to just train them on the window policy, or just on insider trading; you can add training about regulation FD, which also relates to the disclosure of non-public information. You can include training about when not to talk to analysts before an earnings announcement. But you do have to do periodic training. You can do it online or in-person training; just keep it in front of them, and keep it fresh.
A training opportunity that can be overlooked can effectively take place in new-employee orientation. You've got to train everybody when they come in. There's an ongoing human resource flow at every company; employees come in long enough to learn your confidential information, and then they're gone. If you don't get them up front, you won't train them at all.
Another action would be to restrict, within the company, access to sensitive information. This flies in the face of people who want to communicate-everybody wants to be in the know, but if you have a project that could affect the trading of your stock, you have to restrict access. What I suggest is to frequently remind the people who are working on the project that they cannot talk to anybody not working on the project team. Basically, they sign an internal non-disclosure agreement, a paper accepting the basic tenet of not sharing information.
February 3, 2010
Ethics Center announces faculty Hackworth grantees
The Ethics Center is please to announce its Hackworth Grant Faculty recipients, awarded to selected Santa Clara University staff who will focus on ethics-related projects.
Young Park New Global Jesuit Network Scholar
Professor Young Park from Sogang University in Seoul, Korea has been named Global Jesuit Network Visiting Scholar at the Ethics Center, thanks to a generous gift from Chuck and Nan Geschke.