 The sequel to Wall Street having been released, it appears appropriate to reflect that insider trading scandals are not only a vestige of the 1980’s but are as active as ever. Gordon Gecko may be wavering on if “greed is good,” but the SEC certainly continues to fight the Martha Stewarts of this world. Through their positions of trust, corporate lawyers are not immune to the siren song of greed. On occasion they find themselves in situations that present a lucrative yet illicit investment opportunity. Such opportunities place the attorney at a crossroads as a guardian of insider information versus liability for breach of an ethical duty. Federal regulation, common law, and corporate policies are all mechanisms to combat the increasing amount of insider trading by attorneys, including a probe at the SEC in 2009 of its own attorneys.1 Attorney liability for insider trading may result in imprisonment, a permanent injunction against future violations of securities laws, disgorgement of profits or losses avoided, a permanent ban against serving as an officer or director of a public company, and/or revocation of a professional license.2 |
| Two Theories of Liability Under Section 10b of the Securities and Exchange Act of 1934, 15 U.S.C. § 78a et seq., fraud in connection with the purchase or sale of a security is illegal. Under SEC Rule 10b-5, 17 C.F.R. § 240.10b-5,3 the SEC or the plaintiff in a private action must establish the elements of materiality and scienter.4 Nonpublic information is deemed material if there is “a substantial likelihood that a reasonable shareholder would consider it important.”5 To prove scienter under Rule 10b-5, the defendant must have acted with the intent to deceive. There are two primary theories of insider trading liability: the classical theory and the misappropriation theory. |
| The classical theory is based on liability for corporate insiders – officers, directors and owners of at least 10% of a company’s equity securities – who knowingly trade company stock based on material nonpublic information or tip others to trade on such confidential information. In SEC v. Texas Gulf Sulphur, 401 F.2d 833, 848 (2d Cir. 1968), the Second Circuit interpreted Rule 10b-5 to require that anyone in possession of material nonpublic information either: (1) disclose such information to the investing public; or (2) abstain from trading or recommending the securities while such inside information remains undisclosed. The duty to disclose or abstain flows naturally from Rule 10b-5 since it maintains the spirit of the Rule that all investors act on an equal playing field. |
| The misappropriation theory invokes insider trading liability to individuals who are not corporate insiders. This liability is based on a duty owed to the source of information not to trade on confidential information. Unless the corporate attorney is an insider or an insider as defined by the SEC as a 10% owner of the company, attorneys generally come into conflict with insider trading under the misappropriation theory. In the leading case, United States v. James O’Hagan, 521 U.S. 642 (1997), the defendant was a partner at the law firm of Dorsey and Whitney LLC, which represented Grand Metropolitan PLC (“Grand Met”). O’Hagan never worked on the representation of Grand Met, yet discovered that the firm’s client intended to purchase Pillsbury Corporation. O’Hagan purchased Pillsbury stock and call options. Following Grand Met’s public announcement of its tender offer, O’Hagan sold his shares for a four million-dollar profit. O’Hagan was convicted of securities fraud in violation of Rule 10b and Rule 10b-5, fraudulent trading in connection with a tender offer in violation of Section 14(3)3-a, and violations of the federal mail fraud and mail laundering statutes. The Eighth Circuit overturned O’Hagan’s convictions on the grounds that Rule 10b and Rule 10b-5 violations cannot be based on the misappropriation theory. The Supreme Court reversed the Circuit Court’s decision, however, and affirmed O’Hagan’s Rule 10b-5 convictions by adopting the misappropriation theory. |
| Following the O’Hagan decision, the SEC adopted Rule 10b5-2 to create a non-exclusive definition of outsider liability under the misappropriation theory. Under Rule 10b5-2 a duty of trust is owed to the source of information when: (1) the persons involved in the communication have agreed to keep the information confidential; (2) the persons involved have a history, pattern, or practice of sharing confidences that resulted in reasonable expectation of confidentiality; and (3) the person who provided the information was a spouse, parent, child, or sibling of the person who received the information. The defendant may then try to prove that based on the facts and circumstances, there was no reasonable expectation of confidentiality. Although Rule 10b5-2 establishes a bright-line rule of liability, it does not prevent a future finding of outsider liability under different circumstances. |
| Not all courts have unequivocally endorsed Rule 10b-2. The Eleventh Circuit in SEC v. Yun, 327 F.3d 1263, 1271-1274 (11th Circ. 2003) rejected the Rule 10b5-2 presumption that a marriage creates a duty of confidentiality under Rule 10b5-2. Furthermore, the United States v. Kim, 184 F. Supp. 2d 1006 (N.D. Cal. 2002), the court questioned whether Rule 10b5-2 exceeded its limitation by establishing a duty based on a mutual expectation of confidentiality without a binding agreement. |
| Despite the repercussions, attorneys have continuously been found liable for insider trading. In SEC v. Guttenberg, Lit. Rel. No. 20022 (March 1, 2007), the SEC brought an insider trading action against former executives and traders from UBS and a former inhouse attorney with Morgan Stanley. This case reveals an example of both the misappropriation and classical theory. Counsel and her husband, also an attorney, pleaded guilty to criminal charges after the counsel illegally tipped to her husband material nonpublic information regarding pending acquisitions and shared in illegitimate trading profits. In SEC v. Aragon Capital Management LLC, Lit. Rel. No. 19995A (February 13, 2007), an attorney pleaded guilty to conspiracy in an insider trading operation. He was sentenced up to five years in jail, paid a substantial fine, and was permanently barred from participation with an investment adviser. |
| In SEC v. David Schwinger, Lit. Rel. No. 20152 (June 13, 2007), the SEC brought securities fraud charges against a former managing partner of Katten Muchin Rosenman LLP after he allegedly misappropriated information discovered while interviewing a former corporation’s chief counsel for a position the firm. The attorney settled with the SEC by consenting to a permanent injunction from violating Rule 10(b) and Rule 10b-5, disgorgement of profits ($13,027), and payment of damages equal to twice the profits. Although not mentioned in the settlement, it has been suggested that the penalty was higher than usual because the defendant was an attorney. |
| Strategies to Prevent Insider and Outsider Trading Corporations have enacted policies that warn employees about the implications of trading or revealing material nonpublic information. Counsel should advise corporate clients of the need for such corporate policies. |
| To prevent insider trading, corporations may offer classes to educate employees on the dangers of insider trading. The SEC has required blackout periods, trading plans, or limited trading windows for directors, officers, or employees. These policies have thwarted illicit trading by controlling when insiders are permitted to trade company stock. |
| A blackout period is a mechanism to safeguard against insider trading during a time when employees may possess material nonpublic information. During a blackout period officers, directors, and other employees are prohibited from buying or selling corporate stock. These blackout periods are usually instituted prior to the release of financial reports. This restriction on trading helps maintain confidence in the stock price as well as prevent corporate insiders from gaining an unfair trading advantage. |
| A written plan for trading securities under Rule 10b5-1, 17 C.F.R. 240.10b5-1, allows corporate insiders to buy or sell company stock under specified conditions. Those who agree to such a plan are not ordinarily restricted to the rules of a blackout period. Under such a plan, corporations are able to monitor insider trading. Additionally, a trading plan offers transparency to other traders and the SEC about insider involvement. However, 10b5-1 trading plans have certain limitations. The plan must be agreed upon before the insider has material nonpublic information, and the insider cannot influence the person or entity responsible for executing the plan.6 |
| Corporations may allow insiders to openly trade company stock during what is called a trading window. Following the public announcement of its financial reports, insiders are permitted to trade company stock for a short time. Such trading by insiders is allowed because there is a presumption that all relevant material information is publicly available.7 The purpose of a trading window is to limit any trading advantage to insiders. |
| Conclusion Federal security laws, case law development, and corporate policies all work to prevent corporate insiders and outsiders, including attorneys, from acting in breach of their fiduciary duties of confidentiality. Insider trading liability can stem from an outsider misappropriating information that has not been disclosed to the public, or from an insider trading on material nonpublic information. The penalties for such a violation are severe, both criminal in scope and civil suits that are enough to terminate one’s legal career. Counsel must be cautious when advising public clients in trading companies’ securities since they may find themselves a suspect in an insider trading probe and subject to harsh penalties. As the cases illustrate, attorneys liable for insider trading may be held to a higher standard, may have more to lose than others, and may receive a more stringent punishment for such illegal actions. |
| Stanley H. Fischer is a founding member of the firm of Fischer and Burstein, PC and has been admitted to practice law in the State of New York since 1968. He represents numerous corporate entities and serves as general counsel to a publically traded company. He may be reached by e-mail at: sfischer@fischerandburstein.com.
David S. Fischer is an attorney admitted to practice law in the states of New York (2006) and New Jersey (2005). He has previously clerked for the Honorable Micha Lindenstrauss (current comptroller of the State of Israel) while Mr. Lindenstrauss was the chief judge of the Haifa (Israel) District Court. Gaddi Goren is a third year law student at Brooklyn Law School. |
| 1. Laura Strickler, Armen Keteyian, “SEC Attorneys Probed For Insider Trading” http://www.cbsnews.com/stories/2009/05/14/cbsnews_investigates/main5014672.shtml May 14, 2009 2. See Carney, John J. and Fokas, Jimmy. “Insider Trading: Why More Attorneys are Being Charged and What Companies Should do to Prevent It” New Jersey Law Journal, August 1, 2007. 3. See Hazen, Thomas Lee. “Identifying the Duty Prohibiting Outsider Trading on Material Nonpublic Information.” Hastings Law Journal, Vol. 61:888, p. 889. March, 2010. 4. SEC v. McDonald, 699 F.2d 47, 50 (1st Cir. 1983). 5. TSC Indus., Inc. v. Northway, Inc. 426 U.S. 438, 449 (1976). 6. Whitepaper. ComputerShare. “SEC Rule 10b5-1 Insider Trading Plans – Establishing a Program That Works.” 2009 7. Id. |
