New England Biz Law Update
It is not unlikely that one of your periodic roles as inside counsel for a publicly traded company will be to handle inquiries from a federal agency as to potential insider trading.
Such an inquiry can become difficult as it may implicate upper level officials or major stockholders. It can also be embarrassing if there was a leak of corporate news to outsiders ahead of a major event. It also can take much of your time.
Handling an SEC investigation of trading in your company’s stock can be time consuming and exhausting. Care must be taken at the outset to clarify your role, and permit you (or outside counsel) to exercise independent judgment. The investigation itself can cause discord among higher ups at the company, a difficulty you should anticipate if the investigation lengthens.
This article reviews some of the likely issues to arise if you are involved in such an inquiry.
Insider trading is prohibited by Rule 10b-5 of the 1934 Exchange Act adopted by the SEC in the 1940s, and also by Rule 14(e) pertaining to mergers, adopted by the SEC in 1980. The U.S. Supreme Court has upheld these rules. U.S. v. O’Hagan, 521 U.S. 642 (1997).
Violations carry both civil fines and disgorgement of profits, SEC v. Sargent, 329 F.3d 34 (1st Cir. 2003), and criminal penalties, U.S. v. Larrabee, 240 F.3d 18 (1st Cir. 2000). Most prosecutions involve a breach of confidentiality by a corporate insider, but outsiders, who gain access to inside information, by breaching a duty of confidentiality, can also be prosecuted. See United States v. Youngdahl, Cr. 03-00991 (S.D.N.Y.); Sec. Litig. Release 18322, 09/04/03) (government alleges bond trader learned of plans to cease issuing 30-year bonds through breach of confidential government plans).
The SEC has been active in New England with respect to insider trading. Officials of local companies, who traded ahead of impending financial news, have faced SEC civil prosecutions, many reaching stipulated judgments with disgorgement orders and fines.
These have included a director of Microtouch Systems, Inc. (involving a merger), a division chairman of Waters Corp. (poor earnings), a director of Metro West Bank (merger), a director of Galileo Corp. (production difficulties) and a senior financial analyst at IDX Systems (poor financials).
There have also been criminal insider trading prosecutions, including one recently of a lawyer at Vertex, a biotech company in Cambridge, Mass. He has been accused and recently pleaded guilty of trading ahead of the news release of adverse clinical data, netting $476,785. See U.S. v. Marks, No. Cr. 03-10297 (District of Massachusetts).
Precautionary Measures
Certain precautions taken ahead of time will limit exposure of your company and its officers to an inquiry. For example, it is standard procedure for listed companies to require all high ranking officials to sign agreements binding them to ethical standards, including not trading company stock without notice or when in possession of material inside information, and maintaining company confidentiality on major business events.
As well, all publicly held companies impose black-out periods where company employees may not trade their company stock — usually shortly before and after disclosure of quarterly and yearly financials, and other major events. If circumstances require, such restrictions could be imposed selectively on certain officials, or for all employees (for other, short periods of time), but these may be difficult to administer.
Obviously, disclosure of major corporate events should likewise be limited to persons who must have knowledge of the event and who have agreed to insider trading policies to prevent an accidental slip of information.
Potentially, restrictions on share certificates, or requiring pre-clearance of sales of senior executives by enlisting the aid of the brokerage house selected to handle option trading of the company’s stock can act as an additional brake on trading by a corporate insider.
A failure to have good policies in place can hurt. Even an experienced trading company like the brokerage house Goldman Sachs & Co. can get into trouble when one of its employees crosses the line. One of its bond traders allegedly used a breach of confidential information to gain a profit for Goldman Sachs customers. Goldman Sachs was censored by the SEC, paid a substantial financial penalty and was forced to adopt new remedial policies to remedy its noncompliance. See In the Matter of Goldman Sachs & Co., SEC Adm. Proc. Release No. 34-48436 (9/4/03).
As inside counsel, while trying to prevent breaches of the rules, you can suggest alternatives for insider selling. For example, while Rule 10b-5 penalizes trading of stock by insiders ahead of major impending news, amendments to that Rule in 2000 permit inside counsel to design a written plan for officers and directors or other “insiders” permitting them to engage in pre-scheduled regular purchases, sales, or gifts of company stock without regard to the possession of “inside” information, absent fraud on their part. See Rule 10b-5-1.
This can permit orderly, disclosed sales (or even purchases) of stock without incurring liability.
Initial Stages Of Inquiry
An announcement by a company of a major event, such as a merger, successful clinical trial or decreased earnings will likely affect the value of its stock dramatically. If there was extensive trading prior to the announcement that creates a dramatic change in stock value, the self regulatory agency where the stock is listed (NASDAQ, NYSE or ASE) through its market regulatory department will often find out who traded and then send an inquiry to the company listing recent buyers or sellers and asking the company if those persons have links to persons within the company and what these links were.
Inside counsel will have to coordinate this inquiry. First, the initial inquiries must be circulated, collected and returned to the stock exchange, which may have follow up questions. All of this will take time. And, trading by employees may be revealed — violating internal “blackout” or “pre-clearance” rules if nothing else.
If this has occurred, counsel, together with upper management, must decide the penalty for a violation of internal trading rules. These could include suspension, firing, or limits on discretionary payments (of course, wages must still be paid).
SEC Inquiry
The initial inquiry could be followed by an SEC inquiry, possibly with subpoenas, which would focus on the unusual purchases (or sales) and try to determine if these traders had access to inside information
Again, inside counsel will have to coordinate production of company material, which could include executives phone records and business calendars, sensitive e-mails and financial material. The SEC would likely try to interview market traders and company personnel, initially by phone, later in person — trying to determine if insider information got leaked, by whom and for whose benefit.
While inside counsel represents only the corporation and should make that clear to employees, often counsel will participate in these initial interviews. Careful notes should be kept. It pays for counsel to advise company witnesses to be candid with the government interviewers, or not talk at all. The SEC will use obstructive actions to bolster their case, and it could encourage a criminal referral.
Hiring Of Outside Counsel
Inside counsel, if experienced in working with an investigative agency, can likely handle the initial inquiries, although care must be taken to track documents carefully, by source, and make it clear to witnesses that counsel represents only the company.
Inside counsel may wish to hire outside counsel, particularly if the initial inquiry mushrooms and the document product and witness inquiry becomes onerous. For example, it may be much easier to have outside counsel deal with the board of directors, or special committee if the focus falls on a director or top officer. Inside counsel can stay active, of course, handling document production and similar tasks thereby reducing costs.
In this respect, care must also be taken in advising corporate officers of their rights and obligations if the focus turns on one of them. In such cases, suggesting independent counsel for them at an early stage may limit obstructive activity since the insider may be more candid with his own counsel than with you.
It also helps if the corporation pays for this referral. Delaware law permits indemnification of counsel fees by the corporation contemporaneously with the inquiry if the individual signs an indemnification letter. See Del. Code Ann. Title 8, §415 (2002).
Liability
Liability for insiders leaking confidential information used by someone else depends on their state of mind. If an insider made an accidental disclosure, or one during which they thought confidentiality was assured (say to a family member) then they would likely not be prosecuted, even if someone else traded on the information.
This is because the statute commonly used, §10b of the 1934 Securities Exchange Act, and its famous progeny Rule 10b-5, require a mental state of intent to defraud, which is difficult to prove when the person giving out the information does not intend to profit by it.
In one local case involving a 1994 merger, the SEC chose not to prosecute an outside director who disclosed information about a merger but decided to sue his financial partner who did not trade but shared that information with friends. See SEC v. Sargent, 329 F.3d 34 (1st Cir. 2003) (due to relationship with traders, the partner was liable for disgorgement of profits even though he himself did not trade).
The degree of involvement needed by the tipper to be implicated in a trade by the tippee is often disputed. See SEC v. Yun, 327 F.2d 1263 (11th Cir. 2003) (holding tipper must receive some benefit to be liable).
On the other hand, insiders who act on information and then actively conceal some aspect of the trade can be liable both civilly and criminally. In another local case of note, a Sepracor middle manager advised his father of impending bad financial news at the company. The father traded put options and upon inquiry the father then lied to the SEC. Both men were prosecuted civilly and criminally. See SEC v. Potter, C.A. 30-32M (D.N.H.). Sec. Lit. Rel. 18145 (5/19/03).
Formation Of Special Committee
If there was extensive trading by one or more insiders prior to an event, there may be a demand by shareholders requesting that the corporation sue to recover these profits, (or “avoided losses”).
It is unclear in Massachusetts whether insider trading can justify a derivative claim. The Delaware courts and some others permit such a claim, holding a director may not profit from misuse of confidential information. See Brophy v. Cities Serv. Co., 70 A.2d 5 (Del. Ch. 1949). Other courts have disagreed. See Freeman v. Decio, 584 F.2d 186 (7th Cir. 1978).
If the initial motion to dismiss the derivative claim by the individuals on this basis is unsuccessful, inside counsel may have to devise a plan for an independent portion of the board to review the facts of the trade and determine if it wishes to pursue the suit itself, or move to dismiss again, after investigation, and independent of the original motion.
The procedure for setting up such a committee is discussed in Houle v. Low, 407 Mass. 810 (1990). The court noted the requirement of an independent committee to review a stockholder demand, but went on to say that the trial court itself must determine de novo, whether the decision not to go forward was reasonable and principled.
The independence of that committee’s decision not to sue can be challenged by the plaintiffs and discovery of the committee’s process can occur. Sometimes that committee’s decision or its very independence can be rejected. See In Re Oracle Corp. Derivative Litigation, 824 A.2d 917 (Del. Ch. 2003).
Michael A. Collora is a partner at Dwyer & Collora in Boston, and is a former assistant U.S. attorney with significant experience in white-collar criminal investigations, trials and appeals.
