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Another insider-trading case hits financial world

Denver Business JournalOn the Money
From the  December 3, 2011 print edition

The FBI raided three large hedge funds in New York, Connecticut and Massachusetts on Nov. 22 as part of a three-year insider-trading investigation.

Already, 14 defendants have pleaded guilty.

“There’s a lot more patterns and serial insider trading than we previously thought had occurred,” said Scott Friestad, associate director in the Securities and Exchange Commission’s division of enforcement.

Authorities say the criminal and civil investigations could surpass the impact on the financial industry of any previous such probes. There may be more arrests, as investigators examine the role of consultants and analysts who provide hedge funds and mutual funds with detailed information about the businesses and industries in which they specialize.

To better understand what all this is about, let’s examine what federal law has to say about insider trading.

Financial gain often is dependent upon the ability to predict the future. (The back-dating options scandal showed that in the absence of predicting the future, some people will re-invent the past.) It follows, then, that the more knowledge one has about any given scenario, the power to predict will be higher.

Knowledge is power. However, sometimes that knowledge is unfair to the public and is a breach of fiduciary duty owed by the person who has the knowledge.

Insider trading wasn’t considered illegal at the beginning of the 20th century; in fact, a Supreme Court ruling once called it a “perk” of being an executive. After the excesses of the 1920s, the practice was banned, with serious penalties being imposed on those who engaged in insider trading.

To prevent insider trading, the Securities and Exchange Act of 1934 required that when an “insider” (defined as all officers, directors and 10 percent owners) buys the corporation’s stock and sells it within six months, all of the profits must go back to the company.

Insider trading becomes illegal when the purchases or sales violate a fiduciary duty or other relationship of trust and confidence. Other violations include “tipping” such information, securities trading by the person receiving the tip and securities trading by those who steal secret information.

In other words, trades by insiders in their own company’s stock, which are based upon “material non-public information,” are fraud. The insiders are violating the trust and duty they owe to all shareholders.

Corporate insiders have made a contract with all the shareholders to put the shareholders’ interests before their own. When the insider buys or sells based upon special, still-secret information, the contract is desecrated.

Insider trading also embraces the “misappropriation theory.” It states that anyone who misappropriates (steals) information from their employer and trades because of that information in any stock (not just the employer’s stock) is guilty of insider trading.

Common insider-trading activities scrutinized by the SEC are:

  • Corporate officers, directors and employees who traded the corporation’s securities after learning of significant, confidential corporate developments.
  • Friends, business associates, family members and other “tippers” of such officers, directors and employees.
  • Journalists learning about a takeover in the course of their work.
  • Employees of law, banking, brokerage and printing firms.
  • Government employees who received information because of their job.
  • Persons who stole or misappropriated, and took advantage of, confidential information.
  • And now, those with repeat access to insider information who often function as consultants, investment bankers, and hedge-fund and mutual-fund traders.

Illegal insider trading undermines investor confidence, and the fairness and integrity of the securities markets.

The final rules regarding selective disclosure and insider trading are contained in Title 17 Code of Federal Regulations (CFR) Parts 240, 243 and 249. They may be found on the web atwww.sec.gov/rules/final/33-7881.htm.

Two specific regulations regarding misappropriation are very important: SEC Rules 10b5-1 and 10b5-2. Rule 10b5-1 provides by definition that, “A person trades on the basis of material nonpublic information if a trader is ‘aware’ of the material nonpublic information when making the purchase or sale.” There are certain specified exceptions, such as pursuant to a pre-existing plan, contract or instruction that was made in good faith.

Rule 10b5-2 defines how a duty of trust or confidence arises, and thus could be subject to misappropriation. The circumstances fall into three categories.

1. Stated agreement – Whenever a person agrees to maintain information in confidence.

2. Expectation – When there is a history, pattern or practice of sharing confidences.

3. Family confidence – When the nonpublic information is from a spouse, parent, child or sibling.

Additional legislation aimed at insider trading includes The Insider Trading Sanctions Act of 1984 and the Insider Trading and Securities

Fraud Enforcement Act of 1988, which 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.

© C. Stephen Guyer for American City Business Journals Inc. All rights reserved.