Transcript FD - Pennsylvania State University

Prevention of Insider
Trading Through
Disclosure
Insider Trading (IT) Theory
Classifying IT
IT Prevention under Reg.FD
What is a “Security?”
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Jurisdictional Boundary of Securities Law
S.E.C. v. Howey “Investment Contract”
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Producing citrus land sale w/ cultivation (K)
Investment of Money
Common Enterprise
Expectation of Profits
Derived from Efforts of Others
Court Interpretations:
– Ltd. (P); some franchises; variable annuities,
universal life
“Disclose or Abstain” Rule
• Dilemma for Insiders & Fiduciaries
– Usually a Hobson's choice
• Disclose Inside Info to Avoid Liability
– Disclosure may breach fiduciary duty to maintain
confidentiality
– FD requires certain disclosures
• Abstain from Trading to Avoid Liability
– Abstention also avoids confidentiality breach
IT as a Form of Fraud
• Misrepresentation
– Commissions
– Omissions
– Half-Truths
• Material Fact
• Justifiable Reliance
• Damages
SEC Rule 10b5
It shall be unlawful for any person, directly or directly,
by the use of any means or instrumentality of
interstate commerce, or of the mails, or of any
facility of a national securities exchange,
(1) to employ any device, scheme, or artifice to defraud,
(2) to make any untrue statement of a material fact or to omit to
state a material fact necessary in order to make the statements
made, in the light of the circumstances under which they were
made, not misleading, or
(3) to engage in any act, practice or course of business which
operates or would operate as a fraud or deceit upon any
person, in connection with the purchase or sale of any security.
Recurring IT ?’s: Who? What?
When? Where? Why? How?
• Who is an Insider?
• What is Inside Information?
– Acquisition, Permitted Uses, Transfer, Who Captures its
Benefits?
• When: Is the Insider’s Trading Restricted when in
Possesion of Insider Information?
• Where: Jurisdiction, Trading?
• Why: Duties owed by whom? To whom? Derived
from what source?
• How are Insider Trading Rules Reconciled with
Practice & Incentives?
Who is an “Insider?”
• Common IT misconceptions:
– Only issuer's employees trading restricted
– Confidential, non-public information comes only from
within issuer who's shares traded
• In re Cady Roberts:
1. Relationship gives access to information,
2. Intended only for a corporate purpose, &
3. Unfairly used for the insider's personal benefit.
• Emp’es at Any Level w/ Access to Confidential, NonPublic Info
• Outsiders & during takeover activities
Arguments for Prohibiting IT
• Breaches Fiduciary Duty
• Undermines Investor Confidence
• Cannot Overcome Insider’s Informational
Advantage w/ Skill or Diligence
• Unfairness
• Its Illegal under SecReg, Fiduciary Law
Arguments against Prohibiting IT
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IT Permits reduced Official Compensation
Victimless Crime
Entrepreneurial Mgrs need IT Incentive
Investors Trade Only on Fundamentals
– Irrelevant to pre-determined trading decision
• Enforcement is Too Costly for Ltd. Societal Benefits
• Should be Left to Private Contracting
– Most firms have chosen not to restrict IT
• IT Externality Ltd to Firm Traded, not Mkt.
• Insiders Greater Right to Info.
– They personally produced info.
• IT Enhances Mkt Efficiency thru Signaling
Reconciling the IT
Controversy
• Victimless Crime Argument
– Unlikely premise investors mere "price-takers"
• Limited Externality Argument
– Presumes no IT affect on other prices or integrity of
mkt.
• Private Contracting Argument
– Presumes no work rules prohibit IT
– Most firms now prohibit IT & misappropriation of
information, IP & other intangible assets
Reconciling the IT
Controversy
• Emolument Theory Presumes:
– Empe’s have personal rights to corp. info
– Only productive entrepreneurs will trade on inside info.
– No info manipulation likely
• Optimal Imbedding Inside Info into Price?
– Inferred indirectly from trading patterns, volume &
price
– Flow directly thru disclosure to all
Insider Trading Theories
• Traditional Theory
• Tipping Theory
• Temporary Insiders
• Misappropriation Theory
• Tender Offer IT
Insider Trading: Traditional Theory
ISSUER
INSIDER
stock sold
money paid
SHAREHOLDER
SEC v. Texas Gulf Sulphur
Facts: TGS substantial mineral discovery kept
confidential to acquire surrounding mineral leases
more cheaply. TGS falsely denied rumors,
numerous TGS employees purchased TGS stock
before public disclosure.
Issue: Is it securities fraud to misrepresent
corporate events while insiders are trading? YES
Rationale: TGS owed no disclosure duty to
surrounding landowners, but TGS employees'
fiduciary duty required voluntary disclosure before
trading stock. False denial of rumors also violated
Rule 10b-5 as disclosure fraud.
Insider Trading: Tipping
ISSUER
INSIDER
TIPPEE
money paid
stock sold
SHAREHOLDER
Tipping Inside Information
• Tipping-Confidential Nonpublic info tip
made to tippee
• Tippee Knows or Has Reason to Know
Insider’s Tip Breached Fiduciary Duty
• Tip has Improper Purpose:
– EX: tipper expects personal benefit, payment,
return favor, private personal relationship
Insider Trading: Temporary Insider
ISSUER
SHARE
HOLDER
CONSULTANT
stock sold
INSIDER
money paid
Temporary Insiders
• Temporary Insiders: Disclose or Abstain
– Exposed to confidences while consulting for
issuer or takeover bidder
• Dirks14 Legit Info Tsfr in Outsourcing:
– Underwriter, accountant, lawyer, consultant
– Such outsiders have fiduciary duty due to:
• special confidential relationship
• giving access to secret info
• intended solely for corporate purposes
Temporary Insiders
• Temp Insiders are Tippers, Not Tippees
• Duty Arises if:
– Corp expects outsider to keep disclosed nonpublic information confidential & relationship
implies confidentiality
• Consultant Emp’es Owe Fiduciary Duty
Directly to Their Own Emp’r
• Emp’r Expressly/Impliedly Pledges Confidentiality in Consulting Engagement
Misappropriation Theory
of Insider Trading
ISSUER
SHARE
HOLDER
BIDDER
CONSULTANT
stock sold
INSIDER
money paid
Misappropriation Theory
Misappropriation Elements:
i. Confidential source of info
ii. Source has superior rights over info
iii.Source has intent to keep information
confidential
iv.Source makes confidentiality efforts
Misappropriation Examples
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Financial Printer
Financial Analyst @ Investment Bank
Law Firm Emp’e
Financial Journalist/Emp’e
Takeover Bidder Emp’e/Consultant
Judge’s Clerk/Regulatory Emp’e
Physician’s Confidant
Reports: Weather (NOAA), Crop (USDA)
U.S. v. O’Hagan (’97)
Facts: O’Hagan was non-participating law partner
whose firm represented Grand Met in takeover
attempt of Pillsbury. Before any public
announcement, O’Hagan learned of the plan &
purchased Pillsbury options & stock.
Issue: Is O’Hagan guilty of IT & criminal
misappropriation under 10b-5, mail fraud, 14e-3
(also money laundering)? YES
Rationale:
• Rule 10b-5 permits both traditional-classical
theory & misappropriation theory IT actions.
U.S. v. O’Hagan Rationale
• Deception occurs with non-disclosure of the outsidermisappropriator’s personal purpose: to trade
securities in another firm using info from a
confidential source, even if no fiduciary or client
relationship exists between empr & co. traded.
• Deception damages empr’s reputation; outsider
trading undermines investor confidence in mkt’s
fairness; “in connection with” requirement satisfied
by outsider’s deceptive personal misuse of empr’s
confidences by capitalizing in securities transactions.
Tender Offer Insider Trading
ISSUER
SHARE
HOLDER
BIDDER
stock sold
INSIDER
money paid
Insider Trading Prevention &
Detection
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SEC Regulation FD
Chinese Walls
Social Network Analysis
Stock Prices Change Abruptly Just Before
Major Events
• Whistleblowers
• CyberForensics of Electronically Stored
Information (ESI)
SEC Rule FD “Fair Disclosure”
• Basic general Rule FD:
“ . . . When an issuer, or person acting on its
behalf, [makes selective disclosure of]
material nonpublic info to . . . It must make
public disclosure of that info
[contemporaneously-if the disclosure was
intentional or w/in a reasonably short timeif non-intentional].
Rationale for Mandatory Fair
Disclosure
• Voluntary disclosure outside the mandatory &
periodic disclosure regime is generally a good
thing for securities market integrity!
• However, there is substantial evidence that
issuers often disclose material nonpublic info to
select groups (e.g., analysts) before any public
release concerning important events, conditions
or performance:
– Earnings forecasts
– Major corporate events
Rationale for Mandatory Fair
Disclosure
• Selective disclosure erodes investor confidence
that securities markets are fair game “level
playing field”
• Selective disclosure closely resembles tipping
but the tipping law is not clearly applicable
• Market integrity further eroded if selective
disclosure made to secure favorable analyst
reviews: analysts risk losing preferred access
• Electronic communications remove many costly
impediments to timely public disclosures
Mechanics of SEC Rule FD
• No issuer or person acting on behalf of an issuer
may selectively disclose material nonpublic
information
• Disclosure TO whom is covered by FD?
– Broker Dealer or an associate
– Investment advisor, institutional investment
mgr. or an associate
– Investment Co. (mutual fund) or an associate
– Issuer’s security holder if their trade thereon is
reasonably foreseeable
Intentional vs. NonIntentional
• Impacts timing of required FD cure
• Intentional selective disclosure is made to select
group knowing the info is material & nonpublic
– Public discl MUST be made contemporaneously
• Nonintentional selective disclosure is made
inadvertently, in respond to surprise question, not
prepared or rehearsed
– Public discl MUST be made “promptly”
– W/in 24 hrs or start of next NYSE trading session
FD Compliance Processes
• Review of all public statements, press
releases, website by FD competent
(securities counsel, PR or investor
relations using FD method)
• Assess materiality & nonpublic
character
• FD training for all units regularly
interacting w/ outsiders & before units
go “online” w/ material discl to outsiders
FD Compliance Processes
• Contemporaneous or prompt public release of
the selective disclosure
• “File” (liab. risks) or “furnish” (reduced liab. risk)
Form 8K to SEC
• Method or combination of methods
– Reasonably calculated for broad/effective receipt by
the public: press release, past discl. practices
– Posting on Co’s website, e-mail to existing SH, or
other Internet delivery probably not yet a sufficient,
sole method
SEC’s Suggested FD Method:
• Press release thru regular channels
• Press release &/or web posting of time,
date &access method if conference call is
scheduled about topic
• Conference calls should be open, allow
investor listening access
– No requirement yet on asking questions
– Taped replay availability thereafter
Netflix
• 7.3.12 Reed Hastings, CEO, posted to Facebook
– Netflix streamed 1 billion hours of content in June
– Never alerted Netflix SH of Facebook posts
– Post NOT accompanied with Netflix Website post nor
press release nor Form 8K
– Arguably constituted selective disclosure violating FD
– “One set of shareholders should not be able to get a
jump on other shareholders just because the company
is selectively disclosing important information,”
FD Compliant Social Media
• Every case is unique, analysis ad hoc
• SH must be given advance notice of
particular SN site
– Facebook less likely compliant
– Well-Known Twitter more likely compliant
“Most social media are perfectly suitable methods for
communicating with investors, but not if the access
is restricted or if investors don’t know that’s where
they need to turn to get the latest news.”
Using Information Barriers to
Prevent Insider Trading
• Various Relationships &
Screening Procedures
• Control Transfer or
Attribution of Non-Public
Information
• Chinese Walls
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The Great Wall of China
Purpose: Defense vs. Isolation
Effectiveness
Persistence of its’ Symbolism
Appropriateness of
Metaphorical Use
What is a Chinese Wall?
• Engender Awareness of Sensitivities to the
term “Chinese Wall” – consider synonyms:
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Ethical Wall
Information Barriers
Segmentation of business units
Firewall
Internal Control Policies & Procedures
• Nevertheless persistent, durable symbolism,
metaphorical & colloquial usages
– Berlin, US-Mexican border
What is a Chinese Wall?
• Control procedures to isolate non-public information
& prevent tipping or trading
– Restrict Communication of Information
– Restrict Influence
• Policies & procedures employed by broker-dealers to
segment the flow of sensitive info
– Prevent transmission of insider information within multiservice firms in securities, investment banking industries
• Controls over conflicts of interest towards investment
banking client confidences & brokerage customer
best interests
• Administrative & Physical Controls, Training,
Monitoring, Surveillance, Testing, Revisions
Analogies from Other
Professions & Industries
• Big 4 Audit/Attest migrating away from previous
mgt consulting arms
• Law Firms, regulators, judges
• MDPs
• Realtors
• Trade Secrecy:
– Confidentiality, NDAs, Workrules
– “Information IS property”
Arguments about Chinese
Walls
• Pro:
– Limits insider trading
– Preserves fiduciary duties
– Promotes fair game for investors
• Con:
– Costly to maintain
– Limits fiduciary duties
– Communications Imbeds non-public info into prices
through signaling
Implements Supervision
Duty
• Duty of securities firms to oversee
activities of broker/dealers & other units
• Emp’e knowledge/compliance w/
securities laws, SEC & SRO rules,
Workrules, “shingle duty”
• ITSFEA: Minimize opportunity for IT &
tipping
• Monitor & review subordinates’ activities
• Firm & emp’e subject to censure,
debarment
Breaching the Wall