The United States Supreme Court’s decision last year in U.S. v. O’Hagan dramatically affirmed the Securities and Exchange Commission’s powers to enforce the federal insider trading laws and, as expected, has shown that the SEC continues to place a high priority on eliminating insider trading. These developments should put securities professionals, public companies and investors on notice that trading on inside information could have unexpected and dire consequences.
The “classical theory” of insider trading applies to corporate insiders, such as directors, officers, employees and major shareholders of the corporation, those who are in a position to take advantage of inside information. By trading on this information, the insider breaches his or her fiduciary duty to the company and becomes liable for an insider trading violation.
If a non-insider trades on information which is not obtained directly from an insider, the classical theory of insider trading could not be used as a basis for enforcement. Thus, the financial printer who traded on information he learned from takeover documents his company was printing, or the investment analyst who obtained inside information from a former employee of a public company and passed this information on to his clients, who then traded the shares of the company, were not liable under the insider trading laws because no fiduciary duty was owed.
As a result of these losses-the SEC developed what came to be known as the “misappropriation theory.” The essence of the misappropriation theory is that a party in possession of nonpublic information who has acquired it from a source to whom a duty of confidentiality is owed, and then converts this information to his or her personal advantage, is guilty of insider trading.
In the O’Hagan case, a lawyer for a firm who represented a takeover target traded in the stock of the bidder. Under the classical theory, no violation would have occurred because the lawyer did not owe a fiduciary duty to the bidder (the client was the takeover target), but under the misappropriation theory, because he breached his duty of confidentiality to the client whom his firm represented by, essentially, stealing his client’s information without disclosing it to the client, an insider trading violation was found.
0 ‘Hagan provides the SEC with a legal basis to bring enforcement actions against securities professionals in the area of “selective disclosure,” whic
h occurs when companies disclose material, nonpublic information to a limited group of people who then may use this information to trade in an otherwise uninformed market. This poses a particular problem for the securities industry, where it is commonplace for companies to enjoy good relationships with analysts tracking their stock and, perhaps inadvertently, to share information with securities professionals which is not known to the general market.
At a recent speech, the SEC’s chairman, Arthur Levitt, sounded a warning against this type of practice when he noted that “[companies] should not selectively disclose information to certain influential analysts in order to curry favor with them and reap a tangible benefit, such as a positive press spin.”
When a company has big news to report, typically the company goes through the usual steps: it drafts a press release and arranges a conference call with a large group of analysts and institutional investors which occurs before the press release goes out. To no one’s surprise, there is an unusual amount of trading in the stock before the news is released publicly.
Mr. Levitt note that it “doesn’t take Oliver Stone to imagine how that might come about. Any investor looking at this situation would think it’s wrong for those who have received this information to trade before the public announcement or to tip off their friends, or their family members, or their colleagues in their firms.”
To combat selective disclosure, securities firms should have strong impediments (such as Chinese Walls, restricted lists, code names, educational programs and the like), which prevent the spread of this information from the analysts to the trading desks. The fact is, however, that these programs may not be working. The SEC’s general counsel, Richard Walker, recently noted one particular egregious case in which an analyst engaged in trading while an analysts’ conference call was still in progress.
The SEC seems increasingly willing to bring insider trading charges under these circumstances. Brian Lane, the director of the SEC’s Division of Corporation Finance, noted that the SEC’s position as articulated by its Chairman, Mr. Levitt, is a “shot across the bow to alert the world about this concern.”
In light of the SEC’s warnings, securities firms should place renewed emphasis on the containment and isolation of inside information to prevent trading before the information becomes public.
