Recent high-profile insider trading cases brought by the SEC and the DOJ have resulted in hefty prison sentences, fines and settlements. The SEC has made it clear that insider trading continues to be a high enforcement priority and that it will pursue criminal trading aggressively. In particular, the SEC says it will continue to scrutinize trading around significant corporate transactions, such as a merger.
Studies have shown that illegal insider trading increases as perception of the likelihood of getting caught decreases. In light of the sophisticated means that the SEC, DOJ and FBI use to monitor suspicious trading and pursue illegal activity, however, belief that there is a low risk of discovery and prosecution is unwarranted.
In this enforcement environment, public companies need to understand the issues and ensure that they have the right policies and programs in place to stay out of trouble. The following Q&A summarizes the issues and recommends action items.
What constitutes insider trading?
Insider trading is not defined in the federal securities laws, but key components have emerged over time. Illegal insider trading refers to buying or selling a security, in breach of a fiduciary duty or other relationship of trust, while in possession of material nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information.
These recent insider trading cases reflect the range of illegal activity:
- September 21 – The SEC announced charges against Tibor Klein, a Long Island financial adviser, relating to pharmaceutical giant Pfizer, Inc.’s planned acquisition of King Pharmaceuticals, Inc., alleging that Klein bought securities for himself and more than 40 clients. The SEC alleges that he also passed the information to his friend Michael Shechtman, a stockbroker who lives in Lake Worth, Fla. While Klein netted only $8,824 in profits from the transaction, his clients made $319,550 and Shechtman and his wife made $109,041, the complaint said.
- August 12 – The SEC announced charges against Chad McGinnis and his friend Sergey Pugach for insider trading in advance of Green Mountain Coffee’s quarterly earnings announcements and garnering $7 million in illicit profits.
- July 30 – The SEC announced charges against Sandeep Aggarwal, a sell-side analyst who tipped Richard Lee, who was also charged, in advance of a July 2009 public announcement about an Internet search engine partnership between Microsoft and Yahoo. Richard Lee purchased large amounts of Yahoo stock in the S.A.C. Capital hedge fund that he managed, as well as in his personal trading account on the basis of the inside information. Aggarwal allegedly learned of the information from a friend who worked at Microsoft.
- April 11 – The DOJ charged Scott London, a former KPMG auditor, with criminal insider trading for passing nonpublic information about Herbalife Ltd. and Skechers USA Inc. to a friend.
- April 8 – The SEC charged a former employee at a California-based medical device manufacturer with illegally tipping confidential financial data to her brother, who illegally traded in the company’s stock and enabled his hedge fund clients to do the same.
- March 29 – The SEC charged Michael Steinberg, a portfolio manager at New York-based hedge fund advisory firm SAC Capital Advisors, with trading on inside information ahead of quarterly earnings announcements by Dell and Nvidia Corporation.
- March 21 – The SEC charged Rajarengan “Rengan” Rajaratnam for his role in the massive insider trading scheme, spearheaded by his older brother Raj Rajaratnam and hedge fund advisor Galleon Management, to cultivate highly placed sources and extract confidential information for an unfair advantage over other traders.
What is material nonpublic information?
Information is material if it is deemed relevant to an investor who is considering buying or selling the security. There is no strict definition, and materiality is often determined based on hindsight. Assessing materiality often turns on this question: Does adding this new information significantly alter the perception of the company’s stock?
Information is nonpublic if it has yet to be disclosed to the general marketplace. Generally, information that has been selectively disclosed to a few remains nonpublic.
Material nonpublic information is not just financial information. Depending on the circumstances, material nonpublic information may include: information about the status of significant commercial contracts and strategic partnerships, developments in material litigation, events related to R&D and technology, regulatory communications, order backlogs and inventory levels, and personnel changes.
How can companies deter illegal insider trading?
Most public companies already have insider trading policies in place. These policies prohibit directors, officers and employees from disclosing material nonpublic information about the company and permit them to trade in company securities only in accordance with special procedures, such as pre-clearance or pre-notification requirements and black-out periods. While no written policy alone can stop misconduct by someone who is resolved to do wrong, a well-developed and clearly articulated company policy can reduce the risk that an employee’s carelessness or ignorance will result in unnecessary embarrassment and legal trouble.
Another important deterrent to insider trading involves imposing tight controls on company information. Limiting access to key financial and other material company information to personnel on a strict “need to know” basis can reduce the ability (and thus the temptation) to tip or trade illegally to a very few.
What should public companies do now?
KPMG is now reviewing its internal safeguards in the fallout from the Scott London insider trading charges. According to the Wall Street Journal, a KPMG spokesman stated “our internal controls are always subject to assessment and continuous improvement, and we will certainly review all our processes as a result of this incident.”
All companies should review, re-evaluate and update their policies as necessary on a regular basis and should not wait for a scandal to do so. In particular, companies should consider these action items:
- Understanding what constitutes illegal conduct, coupled with a perception of the high risk of getting caught, appears to be the best deterrent. As a result, companies should conduct regular training programs for their employees on the scope and dangers of insider trading.
- Remind employees that material nonpublic information can include any positive or negative information that investors in company securities would consider important or that could have a substantial effect on the market price of the securities, regardless of how “important” they deem that information to be.
- Tightly control material information regarding the company and disclose sensitive non-public information regarding significant corporate transactions and financial results only on a “need to know” basis. Questions regarding the company from brokers, securities analysts and the media should be directed to the company’s CEO (media) or CFO (brokers and securities analysts).
- Revise company policy to explicitly prohibit employees’ misuse of nonpublic information about customers, suppliers and business partners (i.e., companies other than their employer). Misuse should include trading in the securities of the company’s business partners while in possession of material nonpublic information or otherwise using this information for personal gain, such as disclosing information to third parties in exchange for a consulting fee.
- Help officers, directors and employees legally buy and sell company stock by offering clear policies and SEC reporting assistance. Encourage best practices in any Rule 10b5-1 trading plans adopted by insiders, including:
- entering into trading plans only during the company’s open trading windows;
- avoiding frequent modifications or cancellations of trading plans; and
- waiting a period of time before trading begins under a plan.
Insider trading continues to be a high priority area for the SEC’s enforcement program. Over the last three years, the SEC has filed more insider trading actions (168 total) than in any three-year period in its history. The SEC has published this review of its insider trading enforcement actions, noting that the illegal activity is “undermining the level playing field that is fundamental to the integrity and fair functioning of the capital markets.”
Companies should have in place comprehensive insider trading policies that cover both the company’s nonpublic information and securities as well as nonpublic information and securities of the company’s business partners. Such a policy will help create a compliance culture that deters employee misconduct and avoids the criminal, civil and reputational risks that arise from an insider trading scandal.