Minimizing the Risk of Insider Trading Liability
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The Misappropriation Theory Becomes The Law Of The Land
In O'Hagan, the Supreme Court adopted the so-called "misappropriation theory" that had been adopted in some circuits and rejected in others. Under that theory, liability attaches when one trades on the basis of material non-public information entrusted to him in confidence even if neither the purchaser nor seller have a relationship to the company whose stock they are trading. In light of the fact that prior to O'Hagan, 40% of the SEC's insider trading enforcement actions were predicated on the misappropriation theory, (See Footnote 1) the O'Hagan decision was a critical victory for the SEC.
However, while the SEC proclaimed a major victory in O'Hagan, defense counsel quickly seized upon the following language in the Supreme Court opinion: "[u]nder the 'traditional' or 'classical theory' of insider trading liability, §10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, non-public information." 117 S. Ct. at 2207 (emphasis added). Defense counsel, relying on the phrase "on the basis of," contend that an insider who trades while in possession of material non-public information but who did not use the information could not be guilty of insider trading. The issue was squarely presented to the Eleventh Circuit in Adler.
In what the Eleventh Circuit described as a "difficult and close question of first impression," id. at 10, the Court expressly rejected the SEC's so-called "knowing possession test," holding that in order to succeed in an insider trading case against a corporate insider, the SEC must demonstrate not only that the insider traded while in the possession of material non-public information but that the information was actually used in the trading. The so-called "use test" adopted by the Eleventh Circuit makes it easier for corporate insiders to dispose of company stock without facing liability for insider trading.
In Adler, Harvey Pegram, a founder of Comptronix Corporation, faced criminal liability for insider trading in connection with trades in 1989 and 1992, respectively. In connection with the 1989 trade, Pegram avoided losses of $20,000 by selling Comptronix stock shortly before a company announcement that orders from a major customer were less than expected. Pegram argued that this sale was predicated on a pre-existing plan to sell and not tied to the adverse information that he had learned at a Board meeting shortly before his sales. The District Court granted Pegram's motion for summary judgment on this trade, even though Pegram was indisputably in possession of insider information, because Pegram offered evidence that he did not use the information.
The SEC argued that any corporate insider who trades while in the possession of material non-public information is liable for insider trading even if the insider did not use the information. The SEC relied on Chiarella v. United States, 445 U.S. 222, 100 S. Ct. 1108 (1980), in which the Supreme Court repeated the familiar "disclose or abstain rule" which provides that a corporate insider has a duty to disclose material non-public information or to abstain from trading. Based on this language, the SEC argued that mere possession of insider information alone would support a finding of insider trading.
However, the Eleventh Circuit found support for the "use test" in dicta in several Supreme Court cases, including Chiarella. The Adler court noted that the SEC's position is inconsistent with the fact that in Chiarella, the Court found that the insider's duty to disclose or abstain arises from "the unfairness of allowing a corporate insider to take advantage of inside information by trading without disclosure" and its statement that "[t]he federal courts have found violations of §10(b) where corporate insiders used undisclosed information for their own benefit." Id. at 8. The Adler court also reviewed Dirks v. SEC, 463 U.S. 646, 1103 S. Ct. 3255 (1983), in which the Supreme Court held that a tippee's duty to disclose or abstain is dependant on whether the tipper, in disclosing the material non-public information, breached his fiduciary duty. The court noted that the mere fact that the tippee traded while in possession of inside information was not alone sufficient to support an insider trading violation. Finally, the Eleventh Circuit considered the O'Hagan dicta that an insider violates §10(b) and Rule 10b-5 when he trades "on the basis of" material non-public information.
The Eleventh Circuit further pointed out that the SEC's position in Adler was not fully supported even by its own precedent. In an administrative proceeding, Investors Management Company Inc. [1970-1971 Transfer Binder] Fed. Sec. L. Rep. (CCH), 78,163, at 80514 (SEC Ruling July 29, 1971), the SEC concluded that one of the requirements of a §10b-5 insider violation is that the material non-public information "be a factor [in the insider's] decision to effect the transaction". Id. at 80,519. In that proceeding, the SEC expressly adopted the "use test":
[W]hen an insider engages in a sale just prior to public dissemination of adverse inside information, then an inference arises that the information was a factor in the investment decision, but "the recipient [of the inside information] of course may seek to overcome such evidence by countervailing evidence." Id. at 80,522 n.28.
Seven years later, in another administrative proceeding, Sterling Drug, Inc. [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) 81,570 at 80.295 (SEC Ruling April 18, 1978), the SEC, without any reference to its earlier stance, and without any rationale for its change of position, embraced the "mere possession test."
In analyzing these and other precedents, the Adler Court stated its belief that the use test "best comports with precedent" and that "proof that an insider traded while in possession of confidential nonpublic information is not a per se violation" Id. at *10. Mindful of the SEC's concern that a "use test" would pose serious difficulties of proof for the SEC as the true motivations for a trade are often difficult to prove and exclusively within the trader's knowledge, the Adler court held that "a strong inference arises that [inside] information was used by the insider in trading." (See Footnote 2.) The inference allows the SEC to make out a prima facie case without having to prove causation with more direct evidence, and then permits the fact-finder to weigh all the evidence so as to make a finding of fact as to the true reason for the trade. Id. at *10.
In originally granting Pegram's motion for summary judgment based on his failure to have used the inside information, the District Court relied on the fact that Pegram did not sell a significant portion of his stock, Comptronix's general counsel was aware of the sale, and the sale was immediately after the lock-up period following Comptronix's initial public offering. Although the Eleventh Circuit held that the District Court should not have disposed of the case on summary judgment, its holding makes clear that on remand, the factfinder could find that these facts rebutted the inference that Pegram used the inside information in connection with his sale.
The Supreme Court may ultimately have to decide whether mere possession of material nonpublic information is enough to support a finding of insider trading liability because in U.S. v Teicher, 987 F.2d 112, 119 (2d Cir. 1993), cert. denied, Teicher v. U.S. 510 U.S. 976, 114 S. Ct. 467 (1993), post conviction relief denied, U.S. v. Teicher, No. 88 CR 796 (CSH), 1994 WL 141979 (S.D.N.Y. Apr. 20, 1994), the Second Circuit indicated in dicta that it would probably adopt the "knowing possession test." (See Footnote 3.) In Teicher, the Second Circuit considered whether a "causal connection" between the misappropriated information and trading was necessary for a 10b-5 violation. The Court cited several factors supporting the "knowing possession test." The first was the fact that Rule 10b-5 requires only that a deceptive practice be conducted "in connection with the purchase or sale of the security," a clause which the Court held must be "construed ...flexibly to include deceptive practices 'touching' the sale of securities...a relationship defined as 'very tenuous indeed"'(citations omitted), id at *119. The Court also cited the Chiarella duty to "disclose or abstain" rule, and commented favorably upon the sheer "simplicity" of the "knowing possession test." Id. at 119.
In light of Teicher, there exists a substantial likelihood that there will be a split of authority between the Second and Eleventh Circuits, making the question ripe for Supreme Court review.
Coincidence As An Explanation For Alleged Insider Trading
Defendants charged with insider trading can argue that the suspicious timing of their trades is simply coincidence and offer an alternative explanation for their trades. This argument can be offered to establish either that the defendant did not possess material non-public information, SEC v. Moran, 922 F. Supp.867 (S.D.N.Y. 1996) or, if the Adler decision becomes the law of the land, that the defendant, though in possession of material non-public information, did not use the information.
Moran was a money manager and broker dealer against whom the SEC filed civil charges arising out of his purchase of cable television stocks shortly before Bell Atlantic's 1993 announcement that it was acquiring Telecommunications, Inc.("TCI") and Liberty Media Corporation in the largest cable television deal ever. Mr. Moran's son, the senior cable television analyst at Salomon Brothers, Bell Atlantic's investment banker, began working on the deal a week before the father's purchases. The SEC had documented telephone records that the father and son had spoken that week. After being an outspoken bear on cable television stocks for nearly two years, Moran purchased $35 million of cable television stocks for his personal, client and firm accounts just two days before the deal was announced.
At trial, Moran testified that he had no information concerning the Bell Atlantic acquisition when he purchased the cable television stocks. He offered a cogent and logical explanation for the purchases based un publicly available information, demonstrating that the timing of the trades, based on what appeared to be material inside information, was mere coincidence. After a three week trial in the Southern District of New York, the Court agreed, and dismissed the insider trading charges.
In Adler, the trial court on remand will have to determine whether Pegrams 1992 trade in advance of adverse news was merely coincidental. Pegram, who by 1992 was no longer associated with the Comptronix, avoided losses of $2.3 million by selling a significant portion of his Comptronix stock shortly before the Company announced that it would be restating its financial results as far back as 1989 (when Pegram was a Director), resulting in a 72% decrease in price of Comptronix stock. Richard Adler, Pegram's old friend and a director of the Company, placed a phone call to Pegram shortly after the Board met to discuss the restatement but before it was announced publicly. Both Adler and Pegram denied that Adler tipped Pegram. Pegram claimed that such sales were made pursuant to a preexisting plan to sell after the 1992 presidential election and based on his stockbroker's recommendation that he diversify his portfolio and that a call to his wife and his wife to their broker instructing the broker to sell the stock only one half hour after the call from Adler were mere coincidences. The jury was unable to reach a verdict (it was deadlocked at six to one in favor of an acquittal) and the District Court granted a mistrial. The Court then granted Pegram's motion for judgment as a matter of law, holding that the reasonable inference that Pegram received inside information from Adler was rebutted by evidence of Pegram's preexisting plan to sell the stock.
The Eleventh Circuit agreed with the District Court that there was an inference of insider trading and that the inference could be rebutted by evidence of a preexisting plan to sell. However, the Eleventh Circuit reversed and remanded, holding that under these facts, a reasonable jury was not required as a matter of law to find in Pegram's favor. On remand, defendant Pegram will now be able to argue with respect to his 1992 trades that, like Moran, he did not possess inside information or, alternatively, that if he did in fact possess material non-public information, he did not use it.
While Adler provides a possible defense to individuals accused of insider trading, any defendant accused of insider trading who cannot demonstrate that he was not in possession of material non-public information will have a very difficult burden to overcome in light of the strong presumption that the inside information was used in connection with the trading.
To overcome the presumption, the inside trader should be able to demonstrate that:
- The trades occurred in the company's pre-approved trading windows;
- The trades were approved by the company General Counsel who should carefully police each trade to ensure that the trader does not have material non-public information. (See Footnote 4.)
- As soon as the inside trader decides to sell, he should document his decision to show that it was unrelated to any material
non-public information that might come to his attention after his decision but before the actual trades.
The reasons for the trade should be supported by documentary proof.
These steps may prove invaluable to rebut the strong inference that the defendant engaged in illegal insider trading.
1/ As per William McLucas, then SEC Director of Enforcement. Federal News Digest, Vol. 29, No. 32, p.1098. return
2/ The Court also noted the SEC has had ample opportunity to adopt a rule, amend Rule 10b-5 or urge Congress to amend the Insider Trading Sanctions Act of 1984 ("ITSA") to provide for a knowing possession test for insider trading liability. return
3/ The Court's analysis was mere dicta because the theory of the defense did not turn on whether the defendants used the information, but rather on the claim that the defendants did not know that the information they received was confidential or wrongly acquired. Id. at 120. return
4/ This advice, rendered by the authors in a prior article, takes on a new significance in light of a seller's need to rebut the inference that the trades were based on use of confidential non-public information. See "Corporations Need to Police Trading by Insiders Now More Than Ever" as printed in the Metropolitan Corporate Counsel, vol. 4 no. 11, Nov. 1996. return
© 1998 Paul, Hastings, Janofsky & Walker LLP