Insider Trading

Overview to Insider Trading

In this course, we have previously encountered instances where civil and criminal liability may attach to corporate officers and directors who take information that is not publicly available, and use that information for their own benefit. Any such transaction is known as “trading on non-public information” – a.k.a. Insider Trading – and is illegal. A corporate employee who engages in any such activity may be forced to “disgorge” profits from the sale in addition to facing other civil and/or criminal penalties. 

The laws regarding insider trading are fairly complex, and there is a great deal of case law that is associated with how the courts will treat any such action. This section attempts to provide a rudimentary understanding of   insider trading by looking at the source of the laws for such actions and at the ramifications for officers who engage in such activity.

Rule 10b-5

Perhaps the single most important rule with regard to insider trading is Rule 10b-5 of the Securities and Exchange Act of 1934 (now codified as 17 CFR 240.10b-5). Rule 10b-5, reads in part: 

It shall be unlawful for any person… (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act…which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

EXAMPLE: Howard, one of the directors of XYZ Co. was prosecuted for violation of the insider trading laws when he sold all his interest in the firm shortly after discovering that the company had experienced a very bad quarter. In citing to a specific statute outlawing such activity, the courts cited section 10b-5(c) as the rule that Howard had violated.

See Securities and Exchange Commission v. Texas Gulf Sulphur Co., 401 F.2d 833 (2nd Cir. 1971).

While this is only a small percentage of the Rule itself, the purpose is clear. Count how many times the word “fraud,” or a synonym for fraud, is stated in the above definition, and you will have an understanding of what the rule seeks to outlaw. 

The purpose of Rule 10b-5, specifically section (c), is to act as the vehicle needed by the SEC to prosecute individuals who buy or sell securities based on information they have either gained illegally, or which is not known to the investing public at large. Corporate management is empowered with a great deal of responsibility and has access to a great deal of information that the public does not have. Given this position, it would be fundamentally unfair if investors were allowed to trade the company’s securities on the basis of information that they, and no others, have access to. See Diamond v. Oreamuno, 24 N.Y.2d 494 (N.Y. Ct. of App. 1969).

Rule 16(b)

An additional rule, though not as common in application as Rule 10b-5, that applies to insider activity, is Rule 16(b) of the ’34 Act. 16(b) is known as the “short-swing” profits rule. The rule dictates that if an insider trades and turns a profit on a transaction and there is a disclosure of information that creates a major price fluctuation within six months of the time of the transaction, the company can force the disgorgement of any profits made on that transaction. This is true whether or not the insider used, or even knew of, any insider information relevant to the transaction. See 17 CFR 240.16a-2.

While Rule 16(b) serves as a broad means of stopping insider trading, it is limited in its actual practice. The rule only applies to individuals who own greater than 10% of the company’s outstanding shares.

EXAMPLE: Carl is an insider of X Corp and owns about 12% of the company’s stock. He plans on trading some securities in the near future. However, he is aware of Rule 16(b) and is worried that if the company subsequently discloses any information that affects the stocks’ value, he may be forced to disgorge any profits that he gained as a result of the sale. As a result, Carl decides to confer with his attorney in order to make sure that he can properly sell the shares without facing penalties.

When Can Management Trade?

The question that arises in light of these rules is: when can management trade their shares in the company? The fact is that in many firms, managers own a large percentage of the company’s shares. Like any other investor, the managers may want to sell those shares to get some needed cash or they may be forced by financial circumstances to sell those shares at some point. The laws regarding the question of when and in what manner management may do so are extremely vague. 

In the end, the best advice that can be given to any manager who holds inside information is to wait for the inside information to be made public and for that information to be “digested by the market”. Essentially, what this means is that a manager must wait for the market to absorb the information and re-price the security on its own, prior to the manager trading his or her ownership stake. 

EXAMPLE: Victor is the President of Go Co. He has recently purchased a new home and furnished it with new furnishings. As such, he has determined that the best way for him to raise cash is to sell some of his shares. However, Victor is worried about the fact that the company, which makes new drugs for cancer treatment, is about to announce the fact that the drug that they had in FDA clinical trials has failed the trials. Victor knows that the company’s shares are likely to lose value once the information hits the market. To avoid liability under the SEC rules, he should wait until the information is disclosed by the company and until after the ensuing stock plunge before he sells his shares.