The SEC and Insider Trading

I always tell my clients that when initials are after you (like the SEC, IRS, DEA, or FBI), you are in big trouble and that you should sprint – not walk – to the office of an experienced criminal defense attorney.  And here is why.

Several years ago, I was retained to represent a Columbus, Ohio businessman who had been indicted in federal court for insider trading and other security and fraud-related crimes.  Besides my client, a number of other individuals were charged, including a local attorney and a well-known Ohio State University professor.  During the six week jury trial in Columbus, Ohio, I observed first-hand the power of the federal government and the resolve of the SEC in prosecuting those who it believes are or have engaged in insider trading, thereby violating federal securities laws.

Since the time of that trial, the SEC has only continued to expand its prosecution.  A recent examination of  the SEC’s website reflects that the agency continues to make its enforcement program a high priority and has particularly narrowed its focus to allegations of insider trading.  For example, in 2011, the SEC brought fifty-seven (57) insider trading actions against one-hundred twenty-four individuals and entities; almost an eight percent (8%) increase from the previous fiscal year.  Many of these actions involved financial professionals, hedge fund managers, corporate insiders, and attorneys who unlawfully traded or conspired with others who traded on material non-public information, undermining the level playing field that is fundamental to the integrity and fair-functioning of the capital marketplace.

Recent well-publicized actions illustrate the SEC’s continued resolve to enforce its regulations.  Last year, Raj Rajaratnam, a billionaire investor and manager of the Galleon Group (one of the world’s largest hedge funds) was convicted in federal court of fraud and conspiracy.  The SEC-related action alleged that Rajaratnam conspired with others in an insider trading scheme that also led to the indictment and conviction in June of this year of Rajat K. Gupta, a former director of Goldman-Sachs and Proctor & Gamble.  Mr. Rajaratnam was sentenced in October of 2011 to eleven (11) years in prison and fined ten million dollars.

Even more recently, in July of 2012, the SEC obtained an emergency court order to freeze the assets of Well Advantage, a company controlled by Chinese billionaire Zhang Zhirong.  The order was obtained because the SEC believed the company had profited from insider trading.

Based upon these increased enforcement actions by the SEC, I think it is important to have a basic understanding of the law of insider trading.

“Insider trading” is not defined in the federal securities laws, but insider trading laws have developed through SEC and court interpretations of Section 10(b) of the Securities Exchange Act of 1934, as amended, prohibiting use of a “deceptive device” and the anti-fraud provisions of Rule 10b-5 promulgated thereunder. Insider trading is considered a “deceptive device” and generally includes using material non-public information to trade in securities either personally or on behalf of another (whether or not one is an “insider”) or communicating material non-public information to others. The laws pertaining to insider trading encompass (a) trading by an insider while in possession of material non-public information; (b) trading by a non-insider while in possession of material non-public information, where the information either was disclosed to the non-insider in violation of an insider’s duty to keep it confidential or was misappropriated; and (c) communicating material non-public information to others.

The concept of an “insider” is broad and includes officers, directors and employees of an issuer. In addition, a person can be a “temporary insider” if he or she enters into a special confidential relationship with the issuer and, as a result, is given access to confidential infor­mation. A temporary insider can include an issuer’s attorneys, accountants or consultants.

Trading on inside information is not a basis for liability unless the information is material. “Material information” generally is defined as information for which there is a substantial likelihood that a reasonable investor would consider it important in making his or her investment decisions, or information that is reasonably certain to have a substantial effect on the price of an issuer’s securities. Material information can be positive or negative and can relate to virtually any aspect of a company’s business or to a type of security.

Material information does not have to relate to an issuer’s business. For example, in Carpenter v. U.S., 484 U.S. 19 (1987), the Supreme Court considered material certain information about the contents of a forthcoming newspaper column that was expected to affect the market price of a security. In that case, a Wall Street Journal reporter was found criminally liable for disclosing to others the dates that reports on various companies would appear in the Journal and whether those reports would be favorable or not.

Information is non-public until it has been effectively communicated to the marketplace. One must be able to point to some fact to show that the information is generally public. For example, information found in a report filed with the SEC or appearing in The Wall Street Journal or other publications of general circulation, or on a quotation service such as Bloomberg, would be considered public. General release of the information over a computer-based news service, in a corporate communication to shareholders or in a widely distributed prospectus, followed by the passage of adequate time for the investing public to absorb such informa­tion, normally constitutes adequate disclosure. The circulation of rumors, however, even if they turn out to be accurate, does not constitute sufficient public disclosure. Information is not adequately disclosed to the public merely because a finite number of persons in the investment community may be aware of it.

Material information that is communicated under circumstances indicating that it has not been widely disseminated or where the recipient knows or suspects that it has been provided by an inside source should be treated as non-public information.

Generally speaking, there are two theories of liability for trading on material non-public information:

1. Fiduciary Duty or “Classical” Theory

Under the fiduciary or “classical” theory, liability arises when a corporate insider trades in the securities of his or her corpora­tion on the basis of material non-public information. There is no general duty to disclose before trading on material non-public information, but such a duty arises only where there is a fiduciary relationship. That is, there must be a relationship between the parties to the transaction such that one party has a right to expect that the other party will disclose any material non-public infor­mation or refrain from trading. Chiarella v. U.S., 445 U.S. 222 (1980).

In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court discussed alternative theories under which non-insiders can acquire the fiduciary duties of insiders: (i) non-insiders can enter into a confidential relationship with the issuer through which they gain information (e.g., attorneys, advisers or accountants); or (ii) non-insiders can acquire a fiduciary duty to the issuer’s shareholders as “tippees” if they are aware or should have been aware that they have been given confidential information by an insider who has violated his or her fiduciary duty to the issuer’s shareholders.

A “tippee’s” liability for insider trading is no different from that of an insider. Tippees can obtain material non-public information by receiving overt tips from others or through, among other things, conversations at social, business or other gatherings.

2. Misappropriation Theory

Another basis for insider trading liability is the “misappropriation” theory, first recognized by the Supreme Court in United States v. O’Hagan, 521 U.S. 642 (1997). Under the misappropriation theory, liability arises when trading occurs on material non-public information that was stolen or misappropriated from any other person in breach of a duty owed to the source of the information. The misappropriation theory premises liability on a trader’s deception of the person who entrusted him or her with access to con­fidential information. It should be noted that the misappropriation theory can be used to reach a variety of individuals not previ­ously included under the fiduciary duty theory.

As to penalties, civil attorneys like to talk about fines, license issues, and civil trials.  The reality is, however, that if you are convicted of a criminal violation of federal security laws that involve insider trading, you will go to prison.

The conviction of Raj Rajaratnam is a stark example of this reality.  Mr. Rajaratnam was sentenced to eleven years in federal prison despite his age, poor health, and billions of dollars.  In federal prison, eleven years means eleven years.  There is no such thing as early parole like there is in state prison systems.

In conclusion, I offer the following advice:  if you are contacted by the SEC then you need to immediately contact a criminal attorney who has experience in the defense of white collar cases.  All too often, individuals make the mistake of contacting a civil attorney or a local DUI attorney whose name they recognize.  Hiring the wrong attorney can result in long-term, far-reaching consequences at best.  Even worse, hiring an inexperienced attorney can even result in additional charges.  Therefore, when hiring an attorney for these type or charges, be sure to ask your attorney about his/her experience and whether he or she has ever tried a securities action in state or federal court.

Remember, in Ohio, a lawyer can advertise that he or she is a “white-collar criminal attorney” without ever having tried a case in this very specialized area.  As such, people facing these charges must verify their attorney’s experience to ensure they retain the right person.