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Insider Trading Research Paper LEGL211 December 11, 2010 Abstract This paper will give a brief introduction to insider trading. It will attempt to define the aspects of insider trading both legal and illegal. The paper will give a synopsis of some of the laws that have been put in place to try and regulate insider trading. It will touch base on the penalties for illegal insider trading and list an overview of some of the more pertinent cases on insider trading. Table of Content Introduction 4 Definition 4 Legal Trading 5 Illegal Trading 6 Common Law 6 Misappropriation Theory 7 SEC Regulations 8 Court Decisions 8 Severe Penalties 10 Conclusion Bibliography Introduction If you read the news, work in an office, or talk with friends, you have heard of Insider Trading. Insider Trading has been all over the news over the last several years. First it was Enron and WorldCom. Then even the apparently squeaky clean Martha Stewart got pulled in with the ImClone insider trading scandal. So just what is Insider Trading' Despite all of the new coverage, you may still be unsure of what insider trading is and how it is punishable. Definition of Insider Trading Insider trading occurs if you know material confidential information about a public company and you are involved in trading of the company’s stock or other securities. Also if the trading was prompted by individuals with potential access to non-public information about the company. This trade was based on that information or a tip about the company before the information is released publicly. Material information is news that can affect a company's stock price, such as knowledge of a takeover or accounting problems, a dividend change, a new product, or earnings that are better or worse than expected. This type of trading may be legal if it is done in the proper manner (Insider, 2001). In the United States and several other jurisdictions, trading conducted by corporate officers, key employees, directors, or significant shareholders (in the U.S., defined as beneficial owners of ten percent or more of the firm's equity securities) must be reported to the regulator or publicly disclosed, usually within a few business days of the trade. Many investors follow the summaries of these insider trades in the hope that mimicking these trades will be profitable. While "legal" insider trading cannot be based on any information that would influence an investor's decision to buy or sell securities, some investors believe corporate insiders nonetheless may have better insights into the health of a corporation and that their trades otherwise convey important information. (Bhattacharya 2002) Legal insider trading When you hear about insider trading most people will automatically think of criminal actions where executives exchange stock market secrets. In theory, it is not illegal for insider trading to take place. Corporate officers, directors, and employees are permitted to buy and sell stock in their own companies. These trades are made public in the United States through the Securities and Exchange Commission (SEC) filings. Prior to 2001, US law restricted trading such that insiders mainly traded during windows when their inside information was public, such as soon after earnings releases (Stein, 2001). When trading stocks within your own company, you must report all your earnings from the trades to the Securities and Exchange Commission (SEC). The SEC is a government entity put in place to protect investors, and to maintain fair and orderly markets. According to the SEC, all investors, whether large institutions or individual traders, should have access to certain basic facts about an investment prior to buying it, and so long as they hold it. As a result, it is required by law that all public companies disclose meaningful financial information to the public. This is done to ensure that all investors have the ability to achieve the same of information about a company before deciding to invest their money into it (Insider, 2001). Illegal Insider Trading Illegal insider trading refers to buying or selling a stock while having the advantage of knowing information about the company that has not been made public. You may have a position within the business that has helped you acquire this information or you may have also been given tips by another party who has knowledge of non-public information. Either way, this information, gaining money, or avoiding a large loss, is considered illegal. The illegal kind of Insider Trading is the trading in a security, the buying or selling a stock, based on material information that is not available to the general public. (Coffee Jr) It is prohibited by the US Securities and Exchange Commission (SEC) because it is unfair and would destroy the securities markets by destroying investor confidence. While the stock market can be hard to navigate and understand, it is still subject to certain laws. Liability for insider trading violations cannot be avoided by passing on the information in an "I scratch your back, you scratch mine" or “quid pro quo” arrangement, as long as the person receiving the information knew or should have known that the information was company property (Bainbridge, 1999). Common Laws U.S. insider trading prohibitions are based on English and American common law prohibitions against fraud. In 1909, well before the Securities Exchange Act was passed, the United States Supreme Court ruled that a corporate director who bought that company’s stock when he knew it was about to jump up in price committed fraud by buying while not disclosing his inside information. Section 17 of the Securities Act of 1933 contained prohibitions of fraud in the sale of securities which were greatly strengthened by the Securities Exchange Act of 1934(Insider, 2001). Section 16(b) of the Securities Exchange Act of 1934 prohibits short-swing profits (from any purchases and sales within any six month period) made by corporate directors, officers, or stockholders owning more than 10% of a firm’s shares. Under Section 10(b) of the 1934 Act, SEC Rule 10b-5, prohibits fraud related to securities trading. In 2000, the SEC enacted Rule 10b5-1, which defined trading "on the basis of" inside information as any time a person trades while aware of material nonpublic information – so that it is no defense for one to say that she would have made the trade anyway. This rule also created an affirmative defense for pre-planned trades (Insider, 2001). The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of 1988 provide for penalties for illegal insider trading to be as high as three times the profit gained or the loss avoided from the illegal trading (Chatman Thomsen, 2006). Insider trading, or similar practices, are also regulated by the SEC under its rules on takeovers and tender offers under the Williams Act (Williams Act). Misappropriation Theory A newer view of insider trading, the "misappropriation theory" is now part of US law. It states that anyone who misappropriates (steals) information from their employer and trades on that information in any stock (not just the employer's stock) is guilty of insider trading. The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. Under this theory, a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information. The Court specifically recognized that a corporation’s information is its property: "A company's confidential information...qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty...constitutes fraud akin to embezzlement – the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another." (Quinn, 2003) SEC Regulations SEC regulation Fair Disclosure requires that if a company intentionally discloses material non-public information to one person, it must simultaneously disclose that information to the public at large. In the case of an unintentional disclosure of material non-public information to one person, the company must make a public disclosure "promptly (Final Rule). Court Decisions Much of the development of insider trading law has resulted from court decisions. In SEC v. Texas Gulf Sulphur Co. (1966), a federal circuit court stated that anyone in possession of inside information must either disclose the information or refrain from trading. In 1984, the Supreme Court of the United States ruled in the case of Dirks v. SEC that tippees (receivers of second-hand information) are liable if they had reason to believe that the tipper had breached a fiduciary duty in disclosing confidential information and the tipper received any personal benefit from the disclosure. Since Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in his case.) The Dirks case also defined the concept of "constructive insiders," who are lawyers, investment bankers and others who receive confidential information from a corporation while providing services to the corporation. Constructive insiders are also liable for insider trading violations if the corporation expects the information to remain confidential, since they acquire the fiduciary duties of the true insider. In United States v. Carpenter (1986) the U.S. Supreme Court cited an earlier ruling while unanimously upholding mail and wire fraud convictions for a defendant who received his information from a journalist rather than from the company itself. The journalist R. Foster Winans was also convicted, on the grounds that he had misappropriated information belonging to his employer, the Wall Street Journal. In that widely publicized case, Winans traded in advance of "Heard on the Street" columns appearing in the Journal. The court ruled in Carpenter: "It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived there from. In 1997 the U.S. Supreme Court adopted the misappropriation theory of insider trading in United States v. O'Hagan, 521 U.S. 642, 655 (1997). O'Hagan was a partner in a law firm representing Grand Metropolitan, while it was considering a tender offer for Pillsbury Co. O'Hagan used this inside information by buying call options on Pillsbury stock, resulting in profits of over $4 million. O'Hagan claimed that neither he nor his firm owed a fiduciary duty to Pillsbury, so that he did not commit fraud by purchasing Pillsbury options. The Court rejected O'Hagan's arguments and upheld his conviction. Severe Penalties Insider trading has a base offense level of 8, which puts it in Zone A under the U.S. Sentencing Guidelines. This means that first-time offenders are eligible to receive probation rather than incarceration. Anyone found liable in a civil case for trading on inside information may need to pay the government an amount equal to any profit made or any loss avoided and may also face a penalty of up to three times this amount. Persons found liable for tipping inside information, even if they did not trade themselves, may face a penalty of up to three times the amount of any profit gained or any loss avoided by everyone in the chain of tippees. Individuals can be barred from serving again as an executive or a director of a public company and can also face private lawsuits. These penalties are not the only consequence of an insider trading violation and investigation. Publicity and embarrassment also surround the investigation, even if it does not result in any formal charges, and damage is done to the company's business and image. Individuals who are convicted of criminal insider trading face prison terms, the Sarbanes-Oxley Act increased the maximum length of sentences and additional fines. In addition, violators are usually charged with mail and wire fraud and possibly with tax evasion and obstruction of justice. Corporations face additional penalties for failure to set up compliance programs and make reasonable efforts to prevent violations under the theory of "controlling person" liability. The SEC can also ask the court to impose a penalty of up to three times the profit the violators realized from their insider trading. In addition to the financial penalties, there are criminal penalties. Many now feel those penalties are not strong enough and are working to increase them substantially. A bill in the US Senate, for instance, seeks to make defrauding shareholders a felony punishable by up to 10 years in prison (8000). Bibliography 8000 - Miscellaneous Statutes and Regulations . (n.d.). In FDIC. Retrieved December 4, 2010, from http://www.fdic.gov/regulations/laws/rules/8000-6750.html Bainbridge, S. M. (1999). INSIDER TRADING. In ENCYCLOPEDIA OF LAW & ECONOMICS. Retrieved December 2, 2010, from http://encyclo.findlaw.com/5650book.pdf Bhattacharya, U., & Daouk, H. (2002, February). The World Price of Insider Trading. Retrieved December 2, 2010, from http://faculty.fuqua.duke.edu/~charvey/Teaching/BA453_2005/BD_The_world.pdf Chatman Thomsen, L. (2006, September 26). Testimony Concerning Insider Trading. In U.S. Securities and Exchange Commission . Retrieved December 4, 2010, from http://www.sec.gov/news/testimony/2006/ts092606lct.htm Coffee Jr, J. C. (2007, March). LAW AND THE MARKET:. Retrieved December 4, 2010, from http://cbe.anu.edu.au/capitalmarkets/papers/COFFEE-CAPITAL-MARKETS.pdf Final Rule: Selective Disclosure and Insider Trading. (n.d.). In U.S. Securities and Exchange Commission . Retrieved December 4, 2010, from http://www.sec.gov/rules/final/33-7881.htm Insider Trading (2001, April 19). In U.S. Securities and Exchange Commission. Retrieved December 3, 2010, from http://www.sec.gov/answers/insider.htm Newkirk, T. (1998, September 19). Speech by SEC Staff:. In U.S. Securities & Exchange Commission. Retrieved December 4, 2010, from http://www.sec.gov/news/speech/speecharchive/1998/spch221.htm Quinn, R. W. (2003). The misappropriation theory of insider trading in the Supreme Court: A (brief) response to the (many) critics of United States v. O'Hagan, . In Fordham Journal of Corporate & Financial Law. Retrieved December 4, 2010, from http://findarticles.com/p/articles/mi_qa4048/is_200301/ai_n9217300/pg_3/'tag=content;col1 Stein, S.  (2001, July). New standards for "legal" insider trading. Community Banker, 10(7), 44-45.  Retrieved December 8, 2010, from ABI/INFORM Global. (Document ID: 75282275). | Williams Act. (n.d.). In http://legal-dictionary.thefreedictionary.com. Retrieved December 3, 2010, from http://legal-dictionary.thefreedictionary.com/Williams+Act