Next Article: Defenses to Rule 10(b)(5) Actions
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What is “insider trading” under Rule 10(b)(5)?
Insider trading is the sale or purchase of securities by individuals privy to non-public, material information of a firm based upon her special relationship with the firm. Generally, anyone who has material, non-public information must either disclose that information prior to trading the securities or abstain from trading in the effected or related security. Normally, insiders include officers, directors, and professionals in fiduciary relationships with the firm. The negative aspect of insider trading is that it provides individuals an advantage over others in the sale or purchase of securities and undermines the integrity of the market and the confidence of those investing in securities. Section 10 of the ’34 Act has been broadly interpreted to prohibit the practice of trading securities based on material, non-public information received as an insider or from an insider of a company.
• Note: Trading securities on non-public information is most commonly addressed in 10(b)(5) actions. The SEC is charged with bringing civil actions under Rule 10(b)(5), while the Department of Justice is charged with bringing criminal actions against violators.
Elements of a 10(b)(5) Action
The insider or an individual receiving information from an insider is liable for trading securities based on the information. A “tippee” is a person who learns of nonpublic information from an insider. Upon receipt, this person is considered to be a legal, temporary insider. As a temporary insider, the tipee is subject to the prohibitions of Section 10(b) prohibiting the insider from trading securities based upon the inside information. The elements of a 10(b)(5) action are the same for criminal and civil actions and are as follows:
• Information – The insider must have material, non-public information.
⁃ Note: This type of information is generally the result of detailed knowledge of business performance or long-term plans that will affect the corporation’s value in the market if it were publicly known.
⁃ Example: I am a director on the board of ABC Corp. I receive a report that demonstrates that the corporation’s cost of production is going to drop dramatically in the near future due to a drop in materials cost. This information is not public and it will certain increase corporate profits.
• Fiduciary Duty – A core element of a 10(b)(5) action is the breach of a fiduciary duty. Insiders and third parties may have a fiduciary with regard to the material, non-public information.
⁃ Insiders – Corporate insiders have a fiduciary duty to the company.
⁃ Example: Corporate insiders who have a fiduciary duty include: board members, major shareholders, employees, and so-called temporary insiders, such as lawyers and investment bankers who are doing deals for the company.
⁃ Third Parties – A fiduciary duty exists for third parties in a personal relationship with an insider if:
⁃ the third party receives information and promises to keep the information secret;
⁃ the insider has a reasonable expectation that the recipient will not tell; or
⁃ the recipient has obtained the information from her spouse, parent, child or sibling.
• Trading and/or Misappropriation – Either the insider or third party may breach a fiduciary duty by trading on (i.e., using the information to make stock trades) or misappropriating the information.
⁃ Insiders (Tippers) – The insider breaches a fiduciary duty by trading on the information. Further, an insider misappropriates and breaches his fiduciary duty by transmitting information if:
⁃ he knows the information was confidential, and
⁃ he expected some personal gain.
⁃ Third Parties (Tippees) – Third parties misappropriate information obtained through a professional or personal relationship from an insider. Therefore, a third party violates a fiduciary duty to the rightful owner of the information by trading on the information if she knows:
⁃ the information is confidential,
⁃ that it was transmitted in breach of a fiduciary duty, and
⁃ the insider expected a personal gain from transmitting the information.
The idea of holding a third-party, recipient of material, non-public information liable for trading on that information is based on theory that the information is misappropriated from the rightful owners (shareholders). The third party has no duty to reveal the nonpublic information to the public, since she was not in a fiduciary position with respect to company. Trading on that information, however, is effectively breaching a duty owed to those shareholders to either disclose that information or refrain from trading. In summary, anyone who has material, non-public information must either disclose the information prior to trading the securities or abstain from trading in the effected or related security.
Examples of Insider Trading
ImClone case of 2001 – Martha Stewart sold around 4000 shares of a biopharmaceutical company, ImClone systems, after she received information from a broker at Merrill Lynch, whose name was Peter Bacanovic. The information was shared by the broker to Martha when the company was awaiting FDA’s decision on Erbitux, an anti-cancer. The information was that ImClone system’s CEO, Samuel Waksal, was selling all his shares of the company.
Shortly after selling of the shares by Martha, FDA rejected the drug application and the company’s shares fell by 16% in a day. Since Martha sold her shares earlier, she was saved from a loss of more than $45,000. Since the sale was made on a tip of the CEO selling his shared which was not public at that time, it was considered as insider trading and Martha was changed by SAE with obstruction of justice and securities fraud and insider trading in 2003.
Directors of companies are not the only people who have the potential to be convicted of insider trading. In 2003, Martha Stewart was charged by the SEC with obstruction of justice and securities fraud – including insider trading – for her part in the 2001 ImClone case. After a case in 2004, Martha’s charges were reduced to crime of obstruction of a proceeding, conspiracy and making false statements to federal investigators. She served five months as punishment in a federal corrections facilty.
Amazon Insider Trading Case – In September 2017, former Amazon.com Inc’s one of the financial analyst Brett Kennedy was charged with insider trading. Kennedy was believed to have provided information regarding the quarterly sales to Maziar Rezakhani before they were released to the public. Rezakhani made a profit of $115,977 as per SEC, by trading Amazon shared based on this information and paid $10,000 to Kennedy in return for the information.
• Discussion: How do you feel about holding a tippee of insider information liable under Section 10(b)? Is it fair to consider a tippee to be a temporary insider? Why or why not? Do you think the knowledge requirement for third parties is fair? Why or why not?
• Practice Question: Arnold is a director of ABC Corp. He is specifically involved in a committee that evaluates potential mergers and acquisitions. He becomes aware that a group of managers are considering a manager buyout that would allow the managers to purchase all corporate shares and make the company private (i.e., no longer publicly traded). This would ease the regulatory burdens of reporting to the SEC. Also, the buy-out will drive up the price of shares temporarily. What Arnold face liability if he purchased a large block of ABC shares based upon this knowledge? What if he provided this information to his brother-in-law who subsequently purchased a large block of shares?