T he Securities and Exchange Commission Securities Exchange Act of - - PDF document

Corporate Finance Alert

December 2000

SEC Casts Wider Net With New Insider Trading Rules

By Steven M. Hecht, Esq.

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he Securities and Exchange Commission adopted new rules on insider trading that became effective on October 23, 2000. The rules were designed to resolve ambiguities that had developed in the case law. After a period of public comment, the Commission adopted the rules with

• nly some minor changes. The purpose of this Alert

is to inform our clients and other friends as to the principal features of the rules as they were adopted by the SEC. The SEC has adopted two new rules intended to clarify insider trading liability under Rule 10b-5, which prohibits the employment of “deceptive devices” in the purchase or sale of securities. The rules expand the scope of prohibited conduct and thus help the SEC cast a wider net against insider trading activities. The SEC defends its expansive

“The rules expand the scope of prohibited conduct and thus help the SEC cast a wider net against insider trading activities.”

rules on the rationale that ambiguities in Rule 10b- 5 case law frustrate the SEC’s twin goals of protecting investors and preserving the integrity of the securities markets.

Rule 10b-5 Case Law

The new rules should be evaluated against the current legal landscape. The phrase “insider trading” is not defined by statute or rule. Instead, the law of insider trading developed primarily through judicial analysis of Section 10(b) of the Securities Exchange Act of 1934 and the SEC’s Rule 10b-5. In the Supreme Court’s landmark 1997 decision, United States v. O’Hagan, the court stated that unlawful insider trading occurs when securities are bought or sold “on the basis of” material non-public information. Historically, in determining whether an insider (someone who works within the company or is a third party who has a special relationship with the company, such as the company’s lawyer or other fiduciary) has traded securities of the company “on the basis of” material, non-public information, courts have grappled with

“The new rules should be evaluated against the current legal landscape.”

what is known as the “use/possession” distinction: under the “use” test, judges attempt to measure what, if any, causal connection exists between an insider’s possession of non-public information and his trading or possible use of that information. On the other hand, a stricter “possession” standard punishes any trade made by an insider who possesses significant non-public information, regardless of whether that insider actually used such information in executing his trade. Not surprisingly, for the past twenty years, the SEC has advocated the “possession” test, arguing that mere possession of inside information at the time of a trade is sufficient to establish a violation

• f the antifraud provisions. Courts have taken a

variety of positions on this issue, however. In a 1998 federal court of appeals ruling, SEC v. Adler, the court concluded that “mere knowing

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. 65 Livingston Avenue www.lowenstein.com

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possession” is not an inherent violation, but it also held that when an insider trades while in possession of material non-public information, a “strong inference” arises that the insider used such

• information. At that point, the suspected insider

trader must rebut the inference with proof that he did not use that information. Other rulings by federal courts, such as United States v. Smith, have reaffirmed the “use” test, and in doing so have placed the burden squarely on the government to prove causation between the insider’s possession and use of the non-public information. The various court decisions, taken together, failed to establish a uniform or definitive test: they range broadly from Adler’s near-possession standard to Smith’s more relaxed “use” analysis. Perhaps frustrated by the judiciary’s failure to adopt the “possession” test, the SEC is now attempting to use its rule-making power under Section 10(b) of the Securities Exchange Act to create a more precise test even stricter than the Adler court’s. Indeed, the Adler court invited the SEC to promulgate a rule that either adopted the knowing possession standard or that created a presumption that an insider who trades while in possession of material non-public information has used that information, thereby requiring the trader to prove that he or she did not in fact rely

• n such information.

Rule 10b5-1: An “Awareness” Test

Rule 10b5-1 first restates existing case law by declaring it illegal to trade a security “on the basis

• f material non-public information about that

security or issuer,” in breach of a duty to keep secret that information. Trading “on the basis of” non-public information is then defined to mean that the trader “was aware of” the information when he or she made the purchase or sale. The SEC does not, however, define the term “aware.” Nor is the term found in existing case law. Accordingly, despite its attempt at greater clarity, the SEC has instead left room for difficulties in applying the new rules. Will courts use a subjective test (focusing on what the trader was actually aware

• f) or an objective standard (drawing inferences

about what a trader should have been aware of based on objectively demonstrable facts or events)? Also, might an objective approach eliminate the scienter element (focusing on the trader’s intentions) from insider trading case law, despite the SEC’s statement that it did not intend to do so (and despite the fact that the SEC could not do so since it lacks authority to promulgate rules that are contrary to the requirements of Section 10(b) of the Exchange Act, from which the scienter element derives)? These questions will only be answered by the judiciary in applying the new rule. The rule states three safe harbor exceptions by which insiders may rebut the presumption that they traded on the basis of the inside information. These three exceptions involve situations in which a trader (i) enters into a binding contract to buy or sell a fixed amount of securities and then learns of material non-public information; (ii) provides instructions to his or her broker to execute a specified trade and then learns of material non- public information; or (iii) follows a written plan for buying or selling company securities. However, these three exceptions will protect an insider only where they have been pursued in good faith and not as part of a plan or scheme to evade the prohibitions of this rule. Certain commentators on Rule 10b5-1 suggested that the SEC should either redesignate the affirmative defenses as non- exclusive safe harbors or add a catch-all defense to allow a defendant to show that he or she did not use the information. However, the SEC rejected this suggestion in adopting the new rule because it believes that such an expansion of the available defenses would negate the “clarity and certainty” that the new rule, with its carefully delineated exclusive defenses, provides. Rule 10b5-1 focuses on the insider’s “awareness” of the inside information at the time that the insider makes a trade. In substance, this

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standard is comparable to the “knowing possession” test, but with one technical caveat: an insider would be excused from liability when the insider trades in his or her company’s stock and

• nly later comes into possession of inside

information before the trade is actually

• consummated. The SEC’s rationale for this

caveat is that such a trader plainly did not use or rely on the non-public information. By this one caveat, the SEC believes that it has thus avoided an overly mechanical approach that would categorically impose liability wherever an insider possesses knowledge but clearly does not use it. Significantly, in moving full-steam toward the “possession” standard, the SEC’s test shifts the burden of proof to the suspected insider trader to show that he meets one of the three enumerated exceptions in the rule. Thus, without phrasing it as such, the SEC continues to permit a “use” standard of scrutiny where an insider can show that it did not use the inside information it may have possessed, but only where the insider -- as

• pposed to the government -- satisfies the burden
• f proof.

The new rule also provides a special affirmative defense for trades made by or on behalf

• f institutions or other entities. The rule states

that for such traders, the individual making the investment decision on behalf of the institution must not be “aware” of material non-public information and the entity must have

“...institutional investors should consider adopting a formal written policy on trading by employees...”

implemented “reasonable policies and procedures” to avoid insider trading abuses. For example, the trading entity can take measures designed to ensure that the individual making the investment decision did not have access to material non-public information possessed by

• thers in the organization. Accordingly,

institutional investors should consider adopting a formal written policy on trading by employees if they have not already done so. Similarly, individual traders are likely to be most interested in the safe harbor for trades conducted pursuant to a written plan. Likewise, issuers considering open market repurchase programs should consider implementing a written plan for such repurchases, where possible, to fit within the available affirmative defenses. It should be noted that the rule as originally proposed included a requirement that the plan be “previously adhered to.” That requirement is omitted in the rule as adopted, which merely requires that the plan be adopted before the person becomes aware of material non-public information. Thus, the “previously adhered to” requirement was correctly

• mitted from the final rule as redundant, since the

rule’s requirement of good faith necessarily requires a trader to strictly adhere to any written plan that he or she might implement to avoid using insider

• information. In addition, the proposed rule’s

“previously adhered to” requirement would have resulted in uncertainty over the length of the previous adherence necessary to avoid liability, thus making the final rule as adopted more clear.

Rule 10b5-2: A More Expansive Misappropriation Theory

By its Rule 10b5-2, the SEC again shifts the law’s focus from the “use” to the “possession” test by expanding the misappropriation theory of insider

• liability. The new rule states the general

proposition that the antifraud provisions are violated when a trader misappropriates material non-public information in breach of a duty of “trust

• r confidence.” Such misappropriation may occur,

for example, when a father possessing inside information confides that information to his son on the expectation that the son will preserve the secret and not trade on the information, and yet the son in fact trades based on that information.

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(ii) where the history, pattern or practice of the relationship is such that the parties should recognize that the information is to be held in confidence (significantly, this factor departs from existing law by not requiring that the history, pattern or prior practice of sharing confidences involved the sharing

• f
• nly

“business confidences”); and (iii) where communications between spouses, parents and children, and siblings are made. In the third situation, the tippee accused of insider trading may attempt to avoid misappropriation liability by proving that despite the close familial relationship, no duty of trust or confidence in fact existed. Of course, winning the protection of this affirmative defense may not be easy because by default, the presumption is that the family relationship is indeed a trusting one, and the tippee’s task to prove a negative (i.e., that she is not close with her family) is always difficult. However, the SEC was right to carve out this defense in apparent recognition of well-known case law ruling that mere family relationships, without more, are not sufficient to create a duty of trust and confidence. Also notable is the rule’s enumeration of family relationships that give rise to a duty of trust or

• confidence. The rule arguably suffers from an

antiquated definition of a family relationship that does not include “non-traditional” relationships, such as domestic partners, step-parents or step- children, or even paramours. The SEC justified its refusal to expressly include such non-traditional relationships -- despite receiving several suggestions to expand its definition -- on the ground that most instances of insider trading between family members have in fact involved spouses, parents and children, or siblings. In any event, non-traditional relationships may still fall within the rule where the government proves that the relationship satisfies the fact-specific “history, pattern or practice” test by showing that a confidential relationship may be The SEC has now defined when that duty of trust or confidence is triggered. The new rule expands the existing definition by reaching a greater number

• f

family and personal relationships than those covered under existing law. The law in this area grows out of the Supreme Court’s ruling that liability for a violation of the insider trading rules must be predicated upon a breach of duty by a corporate insider or a person in whom sellers of the securities had placed their trust and confidence. The SEC has historically taken the position that in the latter context -- as well as in any situation in which a person comes into possession of confidential information -- the person who receives the information (the “tippee”) must either publicly disclose that information or refrain from trading upon it. The Supreme Court has rejected that view, deciding that there can be no duty to disclose where the person who traded on inside information was not a fiduciary of the company or was not someone in whom sellers of the securities had placed their trust and confidence. The courts have been reluctant to require a tippee to "inherit" the fiduciary obligations of the tipper, but have recognized a need to place some limitations on a tippee’s ability to trade on a tip. Accordingly, the balance struck was that a tippee cannot trade where he or she receives confidential information

“The new rule identifies three situations in which a duty of trust or confidence exists...”

pursuant to a relationship in which the tipper conveyed that information in “trust

• r

confidence.” The new rule identifies three situations in which a duty of trust or confidence exists: (i) where the parties have reached an agreement (which need not be in writing or expressly articulated orally as a confidentiality agreement);

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implied from past practice. In contrast, it is the spouses, parents and siblings (as opposed to the SEC) that will bear the burden of proving that no duty of trust or confidence existed in their respective family relationships. Thus, if someone traded on inside information

• btained from his wife, he will be found liable for insider

trading (which would also support criminal liability) unless he can show that that relationship did not involve a duty of trust or confidence. However, were he to trade on inside information given to him by his girlfriend, he would not be liable unless the SEC can prove that based on their history, pattern or prior practice, a duty of trust should be found to exist in that

• relationship. It will be left to the courts to avoid

applying these rules without creating inconsistent, arbitrary or unfair results, although the rule would seem to lend itself to such possibilities. The second aspect (a confidential relationship implied from past practice) deserves discussion. The rule as originally proposed focused only on whether the person providing the information reasonably expected that it would be held in confidence. However, the test adopted by the SEC requires both that the provider expects confidentiality and the recipient “knows or reasonably should know” of that expectation. This laudable change tends to prevent the tipper from imposing unilaterally a fiduciary duty on the tippee to hold the information in confidence, and instead imposes a burden on the tipper to make his intentions known to the tippee that she will be expected to maintain the information as confidential. The rule, at least in theory, thus encourages the parties to clarify at the outset whether their relationship is to be one of trust and confidence.

Section 16(b) Disgorgement For Short-Swing Profits Remains A Risk

We caution that nothing provided by the new insider trading rules changes in any way the existing law under Section 16(b), which requires corporate insiders to disgorge any “short-swing” profits from non-exempt transactions in the issuer’s securities. Thus, even if a trader is able to protect himself against insider trading liability by invoking the affirmative defenses provided by the new 10b5 rules, he may still face Section 16(b)

• exposure. The same precautions that are already being

taken (or that should be implemented) to comply with Section 16 must therefore still be followed irrespective

• f your compliance with the new insider trading rules.

For additional information on this or any other securities litigation matter, please contact Lawrence M. Rolnick, Chair of Lowenstein Sandler’s Securities Litigation and Enforcement Practice Group at 973-597-2468 or you can e-mail him at lrolnick@lowenstein.com. You can contact Steven M. Hecht at 973.597.2380 or you can e-mail him at shecht@lowenstein.com.

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