"The only way to make money on Wall Street is through inside information. "
-- conventional wisdom

"We will come down on [insider traders] with hobnailed boots. "
-- former SEC Chairman John Shad

The stock market frenzy of the past decade has forever changed the landscape of investing in America. Terms like "short sales, " "swaps, " and "straddles" -- once the peculiar jargon of Wall Street -- have infiltrated the American lexicon. The airwaves today are filled with around-the-clock business reports and "real -time " stock quotes. Until the recent drop in technology stocks, plumbers in Silicon Valley were more interested in stock options than cash as payment for services rendered. Investing appears to have replaced baseball as the new American Pastime. In this brave new world of investing, information is power and power, to be sure, is money. Accordingly, those who possess reliable inside corporate information have a tremendous competitive advantage, and with this advantage comes the obligation to use the information wisely -- and lawfully. There are severe penalties for the misuse of corporate information and the line between a legitimate stock tip and a SEC insider trading prosecution is sometimes very narrow.

Insider Trading Basics

Insider trading has occupied a prominent position in the SEC 's enforcement arsenal since the celebrated scandals of the 1980s involving such Wall Street figures as Ivan Boesky, Michael Milkin and Dennis Levine. Each year the SEC brings between thirty and fifty insider trading cases, and many more are investigated. All told, insider trading cases represent almost 20% of the SEC 's enforcement caseload.

Insider trading is serious business. Fines can easily top the $1 million mark (depending on the size of the gain or loss avoided), 1 and offenders can also be jailed for up to ten years. 2 Former SEC Chairman Arthur Levitt called insider trading both a "chronic problem " and a "law enforcement priority. "3

There are two theoretical bases for insider trading. The first -- known as the "classical " theory -- applies to trading in a security by company insiders who possess material, nonpublic information. Company insiders include officers, directors and employees of the issuer, as well as "temporary insiders "such as lawyers, accountants, investment bankers and others who learn of confidential information in the course of serving the issuer. The second theory -- often referred to as the "misappropriation" theory -- applies to trading in a security based on confidential information that has been taken or "misappropriated" from someone -- not necessarily the issuer -- in breach of a duty of trust or confidence.

Evidence of insider trading can arise in many different ways. Both the SEC and NASD regularly monitor trading in exchange-listed securities in search of unusual trading patterns. Trading in advance of a merger announcement or just before the release of quarterly or annual earnings reports is particularly suspect. Another fertile source of insider trading investigations is anonymous tips from disgruntled employees, jilted lovers or envious competitors. Once a suspect is identified, the SEC will expand its investigation in search of others related to the suspect who also may have traded.

Despite the harshness of insider trading sanctions, there has never been clarity as to precisely what constitutes the offense of insider trading nor what viable defenses exist to the charge. For years the SEC resisted the call to define insider trading based on the fear that any definition would be too limiting. Typically, insider trading cases are prosecuted under the catchall fraud provisions of §10(b) of the Securities Exchange Act of 1934, and Rule 10b-5 thereunder. The law in this area is almost entirely judge-made and, not surprisingly, varies to some extent from circuit to circuit and sometimes from judge to judge. This has made the task of advising clients in this area particularly difficult.

Problems With Materiality

One of the most vexing questions confronting an insider is whether the nonpublic information is "material "as that term has been defined under the securities laws. As a general matter, information is material if "there is a substantial likelihood that a reasonable [investor ] w ould consider it important "in deciding whether to purchase or sell securities. 4 Because the materiality test is so ephemeral -- what information would an investor not consider important?-- counseling clients in this area has always been problematic.

In 1999 the SEC staff muddied the waters further when it issued an accounting bulletin purporting to clarify the concept of materiality in the context of financial reporting. 5 To many practitioners the staff bulletin created more problems than it resolved. Before the release, there was a general understanding that no item was material if it amounted to less than five percent of earnings. The bulletin purported to "clarify" that there is NO quantitative safe harbor if the information is qualitatively material.

In recent remarks, the SEC's Director of the Division of Enforcement, Richard H. Walker, indicated that seven types of information should "be reviewed carefully to determine whether they are material: earnings information, mergers and acquisitions, new products or developments regarding customers and suppliers; changes in control or management; change in auditors; a default or calling of securities; and bankruptcies. "6 In the context of his remarks, which purported to clarify what might constitute material information requiring disclosure under new Regulation FD, the most controversial item on the list was earnings information. Conventional wisdom had been that significant deviations between expectations and earnings might be material, but the SEC has made it clear that earnings information is presumptively material, regardless of the magnitude or the variance (or even no variance whatsoever) between expected and actual earnings. Once again, the "clarification" has generated confusion. Further, it is unclear whether the Commission's position on materiality will be generalized beyond FD to other contexts, including insider trading.

The SEC Responds

Over the past few years setbacks in the courts have left their mark on the SEC's insider trading program. Several courts have rejected in whole or in part various SEC theories of insider trading liability. In order to counteract these decisions, the Commission proposed two new insider trading rules -- among the first ever -- to address these setbacks. The new rules, which became effective October 23, 2000, are codified as Rules 10b5-1 and -2, 7 and were implemented pursuant to the rule-making authority granted to the SEC by Congress. The rules accompanied the adoption of the SEC's highly controversial initiative known as Regulation "FD" (for Fair Disclosure), which prohibits companies from selectively disclosing material information to company analysts and other favored sources.

New Rule 10b5-1

Rule 10b5-1 addresses the issue of whether the government must prove that an investor traded "on the basis of "material, non -public information, or simply "while in possession of " such information. For years the SEC had complained -- somewhat justifiably -- that it could never prove what information prompted a particular investor to trade, only what information was present in the investor's mind at the time the trade was executed. Conversely, many corporate insiders balked at the notion of liability for merely possessing information at the time of a trade when their sales or purchases had not been motivated by nonpublicly-disclosed information, or their decision to trade had been made before the insider learned of the nonpublic information. Pre-arranged stock purchase plans were thought to pass SEC muster, but participants could never be completely sure.

After the Ninth and Eleventh Circuits ruled that the government must prove more than mere possession of inside information in order to sustain a charge of insider trading, the SEC responded with Rule 10b5-1 in which it reaffirmed its position that a sale of a security will be deemed to be made "on the basis of " inside information if the investor "was aware of the material nonpublic information " at the time of the trade. It is questionable whether the SEC can overcome the judicial obstacles to the possession-vs. -use issue merely by implementing a new rule, however, and legal challenges to the rule will inevitably follow.

The SEC has included in the new rule two affirmative defenses to trading while in possession of inside information. The first applies to trades executed pursuant to a pre-existing contract, instruction or plan established by the investor. The second defense -- which applies only to organizations, not to individuals -- requires the organization to adopt a bona fide policy or procedure to isolate the persons responsible for trading decisions for the organization from material nonpublic information.

In order to invoke the first affirmative defense, the individual investor must be able to demonstrate that before becoming aware of the material nonpublic information the investor:

In addition, the contract, instruction or trading plan must have:

Finally, the purchase or sale at issue must have occurred "pursuant to the contract, instruction or plan, " meaning that the individual or entity that entered into the contract, instruction or plan did not alter or deviate from it, or enter into or alter a corresponding or hedging transaction with respect to the securities. A company insider may, however, modify a trading plan anytime the insider is not in possession of material nonpublic information. The availability of the Rule 10b5-1( c)(1) defense is contingent upon the good faith of the individual or entity in entering into the contract, instruction or plan. The rule specifically states it is not available where the trading plan was entered into "as part of a plan or scheme to evade" Rule 10b5-1.

New Rule 10b5-2

Rule 10b5-2 was implemented to address the government 's problem of establishing "a relationship of trust or confidence " between a tipper and tippee, a requirement in all cases prosecuted under the misappropriation theory. The new rule provides a non-exhaustive list of situations in which a position of trust or confidence between two individuals will be presumed. These include conversations between someone with inside information and their parent, spouse, child or sibling, as well as to conversations between two people who share a history of exchanging confidences, or where the recipient of the information agrees to keep it confidential.

Recent Trends

These new rules will not end the SEC 's problems in prosecuting insider tr ading for several reasons. First, insider trading cases are largely circumstantial and, therefore, time-consuming to prepare. Second, there are legal impediments to the adopted rules on "possession -vs. -use" and "positions of trust or confidence ". The gover nment cannot, at least not in criminal cases, shift the burden on any element of the offense to the defendant (as Rule 10b5-2 does), and the SEC 's rule -making authority does not, in my view, vitiate the concerns on the possession-vs. -use debate that have already been articulated by two circuit courts. Simply restating your litigation policy in an administrative rule does not, in and of itself, ensure judicial deference.

Finally, due to the lack of consensus in the mind of the American public as to whether insider trading should even be considered a crime, the impetus to assist prosecutors will remain quite low. Without cooperation, the SEC will encounter difficulty proving insider trading claims, which depend largely on circumstantial evidence. "Objective " d ata such as phone records and?trading tickets are a poor substitute for the persuasiveness of personal testimony when trying to convince a jury that someone betrayed his company and traded on inside information. An examination of recent cases highlights the problem. Over the course of the past year the SEC 's proof has been deemed inadequate in a number of insider trading cases. In SEC v. Truong, 8 for example, the court dismissed the majority of charges against a mid-level employee who allegedly traded on inside information because the SEC had failed to demonstrate how the employee had obtained the information in question. The court ruled that "[d]espite many years of investigation, including dozens of depositions, the SEC failed to garner direct or circumstantial evidence that [the defendant ] possessed material nonpublic information. "9 In SEC v. Hendrix, 10 the court dismissed the SEC 's entire complaint on the basis that it failed to state with enough specificity the origin and nature of the fiduciary duty that allegedly was breached by the ten defendants in the case.

Finally, in a case involving trading in connection with IBM 's 1995 takeover of Lotus Development Corp. , a federal jury recently acquitted three of the case 's eight defendants -- all three stock brokers -- who contended they purchased Lotus shares based on publicly-available information, not the inside information their clients purportedly possessed. 11 These cases are consistent with the general trend by courts to demand more specificity than "coincidence "before imposing insider trading liability.

Steps to Take Now

There are several things that companies and individuals can and should do now in order to benefit from the recent rules adopted for insider trading.

Companies should:

• review their insider trading policies to be sure they are up-to-date, particularly in light of the above-mentioned issues of possession-vs. -use and the presumptions regarding conversations with family and other confidants;



• review with employees the types of information that are presumptively material;12



• encourage employees to participate in company-approved stock purchase plans;



• work with company counsel and employees to develop plans that satisfy the differing interests of the company, the employee and the government;



• examine state laws to be sure that what is a safe harbor under the new SEC rules is not illegal under applicable state law; and



• ensure that policies and procedures are developed to keep employees responsible for trading in the company 's securities or the securiti es of others insulated from material nonpublic information.

Individuals should:

Conclusion

In view of investors ' current love affair with the public equity markets and their desire to sustain stratospheric returns on their investments, trading on the basis of inside information will continue to plague regulators and issuers alike. The SEC 's adoption of new rules in this area is a step in the right direction, although uncertainty in this field can never be entirely eliminated. Both companies and individua ls who desire to sell or purchase shares in their company 's stock -- or the stock of other companies for that matter -- are encouraged to develop trading plans and policies that mesh with the safe harbors created by the new rules.

NOTES:

1. 15 U. S. C. § 78u-1.

2. 15 U. S. C. § 78ff(a).

3. "A Question of Integrity: Promoting Investor Confidence by Fighting Insider Trading, " Remarks by Arthur Levitt before the Practicing Law Institute "SEC Speaks" Conference, February 27, 1998.

4. TSC Industries v. Northway, Inc. , 426 U. S. 438, 449 (1976).

5. SEC Staff Accounting Bulletin No. 99, "Materiality", August 12, 1999.

6. "Regulation FD-An Enforcement Perspective, " Speech by Richard H. Walker before the Compliance and Legal Division of the Securities Industry Association, November 1, 2000.

7. 17 C. F. R. § 240. 10b5-1 and -2.

8. SEC v. Truong, 98 F. Supp. 2d 1086 (N. D. Cal. 2000).

9. Id. At 1099.

10. SEC v. Hendrix, C-00-20655 JW (N. D. Cal. October 12, 2000). (See also SEC Litigation Release 16591 issued June 15, 2000).

11. "Jury in Lotus Insider-Trading Case Finds Four Liable, Absolves Three, " Wall Street Journal, December 8, 2000 at B8.

12. "Regulation FD-An Enforcement Perspective, " Speech by Richard H. Walker before the Compliance and Legal Division of the Securities Industry Association, November 1, 2000.

Copyright 2006. Richard A. Levan. All rights reserved