Here’s what constitutes insider-trading practices

On the Money
From the April 6, 2007 print edition

[In 1952, CBS Television aired a popular game-show called “I’ve Got a Secret.” The contest was basically a guessing game where the panel tried to determine a contestant’s “secret.” Today, we are witnessing another incarnation of “I’ve Got a Secret” in the form of the insider-trading trial of Joseph Nacchio.

Nacchio, the former CEO of Denver-based Qwest Communications, is charged with improperly (as in using secret or insider information), taking for himself $101 million through the sale of Qwest stock.

Prosecutors claim Nacchio, sold his stock while knowing the company had severe financial problems. Shares of Qwest plummeted from more than $60 a share in 2000 to just $2 a share in 2002. Its near-collapse left thousands of investors and pensioners in financial ruin. If the DJIA fell that much it would stand at 413.46.

Regardless of what intuition may tell you about this series of events, the question before the court is, were these sales against the law?]

The current trial of Joe Nacchio, former CEO of Qwest Communications International Inc., puts the spotlight on the practice of insider trading.

Nacchio is charged with 42 counts of insider trading for allegedly exercising stock with the knowledge that the Denver-based telecommunications company would not meet its fiscal goals for 2001. He earned $101 million from the stock sales.

Were these sales against the law? What do our federal laws have to say about illegal insider trading?

Financial gain often depends upon the ability to predict the future. (The options scandal showed that in the absence of predicting the future, some people will reinvent 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 represents 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 it.

To prevent illegal 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 infringement may 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, that are based upon “material non-public information,” are fraudulent. 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.

For example, this would apply to journalists learning about a takeover in the course of their work.

Common insider-trading activities and targets scrutinized by the SEC include:

• 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.
• Employees of law, banking, brokerage and printing firms.
• Government employees who received information because of their employment.
• People who stole or misappropriated, and took advantage of, confidential information.

The SEC treats the detection and prosecution of insider-trading violations as an enforcement priority. Such violations undermine 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 at www.sec.gov/rules/final/33-7881.htm.

Two regulations describing misappropriation are very important: SEC Rules 10b5-1 and 10b5-2. Rule 10b5-1 says one definition of misappropriation is when “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 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. If someone uses information gleaned in one of these three manners, it’s considered misappropriation:

• Stated agreement — Whenever a person agrees to maintain information in confidence.
• Expectation — When there is a history, pattern, or practice of sharing confidences.
• Family confidence — When the nonpublic information is from a spouse, parent, child or sibling.

[You may or may not “have a secret.” But if you do, think twice before trying to make money off it.]

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