Insider Trading

Political Philosophy
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Proverb, let me first say that you have started a big mess with this question. :slight_smile: But seriously, the securities laws are very difficult to understand. I’m going to try to work us through them. (I’m not saying “us” pejoratively. I mean to include myself because I don’t fully understand them.)

Our starting point is the Securities Exchange Act of 1934 (SEA). The full text of the SEA is available here:

http://www.sec.gov/about/laws/sea34.pdf

Section 10(b ) of the SEA states:

“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange-- . . . to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission [the SEC] may prescribe as necessary or appropriate in the public interest or for the protection of investors. . . .”

One of the applicable Rules prescribed by the SEC is Rule 10b5-1. As I understand it, this is the meat of the insider trading law because it defines “manipulative and deceptive device.” Let’s look at this definition. 10b5-1(a) states:

“The ‘manipulative and deceptive devices’ prohibited by Section 10(b ) of the Act [the SEA] . . . include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.”

There are, of course, terms within this definition that themselves need to be defined. For example, what does “on the basis of” mean? That’s answered in Rule 10b5-1(b ). Are there any affirmative defenses available? 10b5-1(b ) refers us to 10b5-1(c ). When is information “material”? I can’t remember the case offhand, but the Supreme Court has said information is material for purposes of Rule 10b5-1 if a reasonable investor would consider it important when considering whether to transact in the stock.

There are a whole host of other questions, and I do not purport to be able to answer any of them definitively, even the information I’ve given here. As time permits, I will explore further the legal questions you have raised and give everyone my findings. For now, I think it’s helpful for our understanding of what the law is to have some starting points.

(Btw, sorry all my b’s and c’s in parentheses have a space after them, but apparently a b in parentheses results in a sunglasses smiley, and a c in parentheses is a copyright.)

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There’re also short-swing trading rules under Section 16 of the SEA that forbid you from keeping profits on certain transactions within six months of each other.

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I guess I might have not been clear, but by ‘inside trading’ I mean:

I am a private shareholder that becomes privy to ‘inside’ information.

Does any scope of the information change how I am able to act on it?

This is my main question, however in reading your responces I am now interested in wether or not it is proper to have the shareprovider-shareholder be a matter of law.

Thank you Groovestien for the reference. And thanks for the considerations.

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. . . by ‘inside trading’ I mean:

I am a private shareholder that becomes privy to ‘inside’ information.

Does any scope of the information change how I am able to act on it?

This is my main question . . .

Again, from Rule 10b5-1(a):

“The ‘manipulative and deceptive devices’ prohibited by Section 10(b ) of the Act [the SEA] . . . include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.”

Notice that the Rule says nothing about the specific title or position of who’s doing it. It does, however, say that there must be a breach of duty of trust or confidence.

It sounds like you’re talking about what is called “tippee” liability. That is, are you liable if you receive a tip even though you owe no fiduciary duty? In Dirks v. SEC (1983), the Supreme Court said you are under certain circumstances. Tippees are liable if:

  1. the tipper breached a fiduciary duty, and

  2. the tippee knew or should have known of the breach.

In the context of tippee liability, the Court said that the tipper breaches a fiduciary duty where he gets a personal gain from divulging the information to the tippee.

Does this answer your question, or is there something else I’m missing?

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Here’s the Dirks opinion:

http://caselaw.lp.findlaw.com/scripts/getc…ol=463&page=646

There’s a nice little summary of the Court’s holdings towards the top that may also help answer some questions.

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…or should have known of the breach.

The above posts answers nearly all my questions.

One thing…

What objective standard defines when a tippee, “should have know.”

Thanks again.

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What objective standard defines when a tippee, “should have know.”

That’s a bit tricky, but there are these expressions like “reasonable man” and “ordinary diligence”. If a person is presented with evidence that has a certain level of credibility, which tells you that passing the information is a breach of fiduciary duty, then you “should have known”. For example if I knew that a certain neighbor was on the board of directors of Worthifood Corp. and he informed me “You really should invest as much as you can in Worthifood Corp. within the next 2 weeks, before October 1, 1999, and don’t tell anyone I said so”, then you should know that he is violating his fiduciary duty. This doesn’t mean that is how the “should have known” standard works legally (oh, crud, yet another mystery to unravel), but that is, at least, how it make some sense.

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What objective standard defines when a tippee, “should have know.”

This is too heavy a research task for me to do in the near future, but my guess is that, as David suggested, you’d find it being phrased as "whether a reasonable person in the tippee’s position would have known that . . . ".

These should have known, reasonable person issues tend to be decided by the “facts and circumstances of the particular case.” In other words, they’re very fact-dependent. (This is largely why it’d be a hefty research task for me right now.)

If you want to figure out whether a certain situation fits the bill, one of the first things you do is compare it to previous cases (and wear some earplugs to drown out Scalia’s shuddering at the thought).

If you’re lucky, you’ll find some hard-and-fast rules in those cases. For example, “We hold that where a tippee and tipper have a parent-child relationship, there is a rebuttable presumption that the tippee should have known for purposes of Dirks liability.” I made that up, but you might see a court somewhere finding that someone under a certain set of facts should have known as a matter of law.

If you want to find some summaries on the issue, hop over to UNLV’s law library and ask someone at the reference desk to help you. Start with something like American Jurisprudence 2d, find the book on Corporations, and look at the table of contents to find the sections you need.

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Anyone reading this, please remember that none of what I’ve said should be legal advice for you. There are so many other equally complicated rules that might apply to a particular transaction (e.g. Rule 14a-3 for tender offers), that not only do you need a lawyer to help you, you need a securities lawyer. This is not a field for the general practicioner.

Plus, what the hell are you doing relying on what a student says anyway? :slight_smile:

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One thing…

What objective standard defines when a tippee, “should have know.”

Speaking from personal experience, there is no objective standard to “should have known.” Hindsight is assumed to be 20/20 when you are dealing with the SEC.

Lou Holtz the Notre Dame coach got off of a charge saying that he overheard some people discussing a merger at a football game and therefore didn’t know that they were in breach of their fiduciary duty. He managed to win the case but barely from what I remember. As David points out, you may or many not even know if they are violating their fiduciary duty. The assumption again is like that of the IRS during an audit and you are effectively trying to prove why you are not guilty. And dealing with the SEC is very much like dealing with the IRS. They are equally pleasent.

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Lou Holtz the Notre Dame coach got off of a charge saying that he overheard some people discussing a merger at a football game . . .

What I’m about to say doesn’t address the “should have known” question, but is important to consider in these overhearing situations.

There may be a contractual arrangement that creats a duty to disclose. For example, between employer and employee whereby anything an employee overhears on the job must be disclosed to the employer. My teacher used the example of a first-class flight attendant overhearing passengers talking business.

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For example, between employer and employee whereby anything an employee overhears on the job must be disclosed to the employer.  My teacher used the example of a first-class flight attendant overhearing passengers talking business.

That’s hypothetical, right? Like, there does not exist an airline anywhere in the free world which has suich a requirement. Right? Except for a requirement to report a suspected crime, I would be utterly shocked if any employer had such a rule. Also appalled.

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That’s hypothetical, right?

I don’t remember. Ordinarily, I might give someone with as much experience as this professor the benefit of the doubt when it comes to devising a reasonable hypothetical. However, in my experience law professors do sometimes have whacked-out hypotheticals.

So, my memory is inconclusive, and in this context I think the safe default is to the hypothetical side.

However, I would not share your shock (surprise yes, but not shock) if this turned out to be true somewhere out there (not necessarily airlines). I’ve heard of some weird rules in loosely analagous circumstances.

For example, when I was doing my undergrad in Boston my friend told me that his friend from MIT said (double hearsay alert) that MIT owns anything you invent while you’re a student there.

This next one I know is true. Every law review article I’ve ever read says the copyright is in both the author and the law review, even if the author has no connection with the school that I can discern.

Why would the hypothetical airline policy appall you? I’m not appalled initially, but I’ll certainly consider your argument. It seems to me like the company has paid to put the employee where the employee is, and thus anything the employee gets as a benefit of that (like a stock tip) the company can contract a claim to. Keep in mind also, in this specific example, I believe the teacher only mentioned a duty to disclose to the company. As far as I can remember, the employee could still invest himself if he wished.

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Why would the hypothetical airline policy appall you?  I’m not appalled initially, but I’ll certainly consider your argument.  It seems to me like the company has paid to put the employee where the employee is, and thus anything the employee gets as a benefit of that (like a stock tip) the company can contract a claim to.  Keep in mind also, in this specific example, I believe the teacher only mentioned a duty to disclose to the company.  As far as I can remember, the employee could still invest himself if he wished.

My shock comes as a trusting customer. Supposing I were discussing secret business arrangements with a colleague and we are speaking of vital trade secrets. I would not speak of these matters out loud if I thought that someone else might hear; of course, I assume that the attendants are bound by professional ethics and company policy to not hear or act on secret information which they pick up on in the line of duty. I have an even stronger assumption along those lines when it comes to any email I might send (that my local sysadmin is not reading all of my mail and the ISP isn’t sniffing my info either); also I assume that the phone company isn’t listening in on my conversations to harvest marketable info. Of course this is just an assumption. I’d have to dig into those little 6-pt really long terms of service documents where they say things like “We promise not to sell your information or..”, to see whether they overtly say “if, in the course of normal business (of transporing you from place to place), we come into profitable information, we will feel free to use it and we will compell our employees to tell us of such information”. If so, that’s a good lesson in caveat emptor. At any rate, it’s about “normal assumptions”, and my take on society is that if an employee overhears information in the course of doing their job, they are obliged to not exploit that information. I wouldn’t say that the employer has paid to put the employee where they are: rather, they paid to get the employee to do thrir job (service me), and the employee needs to be in my vicinity to service me. Admittedly, I don’t actually hang out in a society where there is such a thing as secret information. But if I knew of such a practice by a company (and it mattered to me), I would take my business elsewhere, especially if such a policy were hidden from customers.

The copyright thing I know. I dunno about law reviews, but ling journals send you an agreement that you have to sign to turn over copyright, or permission to use, as the case may be. My journal licenses articles for 10-20 years, because we don’t claim that we wrote the articles.

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There are two issues in regard to the law and material non-public information

  1. Should the government have the right to protect individual investors from ignorance

  2. Should the insiders have the right to trade on insider information

Of course the answer to the first one is no, but the government believes it is their right to do that on the premise they are protecting the rights of the investor, an egalitarian principle. The second has nothing to do with the govt, but with the owners of the business and should be determined and chosen by each individual investor.

There is no question that some insider trading is decietful and fraudulent, which is already covered by law. But the ultimate question is similar to the the altruism issue because it is a destructive outcome of it. AR said something along the lines it is not a question of whether we should or should not give a bum a dime, but whether we have the right to exist if we don’t. So, it is not a question of whether insider trading is right or wrong, it is whether the government has the right to regulate it or not.

The company is the property of owners and therefore should be decided how to be used by the owners.

Furthermore, material non-public information is as such.

Material information - information that may affect the price of a security (uggh) including dividend declaration, M&As, gain or loss in contracts, offers that involve tender offers, earnings reports, or anything else you can think of

non-public - rule of thumb is the general investors must have time to react to it so this one completely escapes me because I am sure it would take some “general” investors days to respond (there are companies that specialize in disemminating this type of information like Business Wire which was just acquired by Warren Buffet)

Up to now I have been discussing “insider trading” as it applies to company execs and close entities. You can also become an inside trader if you use inside information that (and this applies more to the general money managers)

  1. breaches a fiduciary obligation

  2. is misappropriated (stolen, recieved fraudulently, etc)

  3. relates to a tender offer

  4. recieved in confidence

  5. an unreleased analyst recommendation

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There is a 5-minute video here from Fox News (scroll down to “Taking Stock”) discussing how Congress is not prohibited from insider trading. To any Congressmen reading this, let me say that there are not enough profanities in the English language to accurately describe what you are. You people can forcefully acquire information from businesses and then trade on it. Not even the biggest corporation in America could do that in the laissez-faire society you are so afraid of. You can also turn the business world upside-down with one bill. Judges have to recuse themselves from cases in which their impartiality might reasonably be questioned. They also have to keep tabs on their financials to make sure there’re no potential conflicts. Congressmen should have to do the same thing. In effect, that means Congressmen should be forbidden from owning stock. You don’t like it? Stay in the private sector where you don’t get to wield guns.

Every single one of you can go to hell.

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Thanks for the link to the video. I agree that, in today’s context, Congressmen should not own stocks directly. At most, stock should be held through some type of blind trust. Not trusting our current crop, I’d say that there should be restrictions even on such trusts.

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For example, when I was doing my undergrad in Boston my friend told me that his friend from MIT said (double hearsay alert) that MIT owns anything you invent while you’re a student there.

I worked as a computer programmer at a business where the CENTRAL point of the employment contract was that anything that I invented or authored during my employment OR FOR A YEAR THEREAFTER was the property of the company. I refused to sign until they removed the part about a year thereafter.

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Thanks for the link to the video. I agree that, in today’s context, Congressmen should not own stocks directly. At most, stock should be held through some type of blind trust. Not trusting our current crop, I’d say that there should be restrictions even on such trusts.

I disagree with that entirely. Stocks are generally just one facet of a persons wealth - we own homes, office buildings, rental properties, bonds, managed futures accounts etc. Why should someone in Congress be forced to delegate the decision making of his property, his wealth, to another through a blind trust. There have been many problems with blind trusts primarily because people can’t stand not having power over their own wealth. When Secretary of the Treasury Paulson sold $500 million of Goldman Sachs stock because it was a conflict of interest I was disgusted. How is the conflict of interest between a wealthy politician who could make decisions that would primarily benefit the wealthy any different from the conflict of interest between a poorer politician voting on issues that would increase government support to those in his position. As long as the conflict of interest is declared, then there is nothing wrong with the politician continuing to have control over his wealth and if his decisions benefit his position greatly then thats life - get over it because we all make decisions that are good for our own interest and someone like Paulson, if he advised Bush to further decrease taxes on the wealthy then the US economy would benefit along with him as the wealthy are those who have the largest stock of capital and if they can keep a larger portion of what they earn they’ll move it from tax free municipals and other investments primarily made because of distortions created by taxes and invest it, increasing the amount of capital goods in the economy and increasing production and the standard of living. Let them just disclose their holdings and be treated like individuals not slaves to conflict of interest rubbish.

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We have situation where politicians have more power than they ought. In our system, many of their decisions are necessarily arbitrary. That is what makes conflicts of interest an issue. Your argument basically reduces to this: since we cannot remove all conflicts of interest, we should remove none.