Chapter 25 Insider Trading

1. Chapter 25Insider Trading Insider trading basics What it is – classic / misappropriation Debate: pros and cons State law: ho-hum Majority rule: no fiduciary duty to shareholders “Special facts” rule Federal law: abstain or disclose Cady Roberts: fairness or equal access? Chiarella: duty of trust and confidence Dirks: (1) tipper breach + (2) tippee knows O’Hagan: misappropriator “defrauds source” Specific issues – SEC rules Rule 10b5-2: duty of “trust and confidence” defined Rule 10b5-1: “state of mind” defined / trading plans § 16: Disgorgement of short-swing trading profits Module VIII – Stock Trading Bar exam Corporate practice Law profession Citizen of world Chapter 25 Insider Trading

2. Insider trading primer (in 15 minutes) Chapter 25 Insider Trading

3. Misappropriation(Outsider Trading) Classic Insider Trading Company shareholders Outside shareholders Silence = fraud (duty of trust/confidence) Violates duty to source INSIDER • Insider-tipper violated duty * • Tippee knows / reason to know • * improper benefit • Rule 10b5-2 • Confidentiality agreement • Confidentiality practice • Family member – functional Tippee Tippee • Rule 10b5-1: state of mind when trading “on the basis” of material, nonpublic information • “aware” (“conscious knowledge”) • Pre-existing trading plans Chapter 25 Insider Trading

4. Insider trading Classic insider trading Outsider trading (misappropriation) Securities fraud Rule 10b-5: Misstatements ofmaterial fact • Dirks (US 1982) • Illegal tipping = • tip breaches duty* • know or reason to know • *for personal benefit O’Hagan (US 1996) Misappropriation = fraud on source (duty) icw securities trading Chiarella (US 1980) Silence = fraud in face of “duty of trust or confidence” Rule 10b5-1 Mind = awareness Pre-existing trading plan OK Rule 10b5-2 Duty: agree confidentiality / business practice / family Reg FD Tell one analyst: tell public! Chapter 25 Insider Trading

5. Insider trading hypos Chapter 25 Insider Trading

6. End Insider trading primer Chapter 25 Insider Trading

7. What is insider trading? Good news, bad news Outsider trading Chapter 25 Insider Trading

8. Insider trading Good news Stock market Buy from existing shareholders Insider • Buy “call options” • option to buy stock • at mkt (let’s say $25) • profit = new price (let’s • say $35) less exercise • price ($25) Corporation Non-public, material information Chapter 25 Insider Trading

9. Insider trading Bad news Stock market Sell to existing shareholders Insider • Buy “put options” • option to sell stock • at mkt (let’s say $25) • profit = exercise price • ($25) minus new price • (let’s say $15) Corporation Non-public, material information Chapter 25 Insider Trading

10. What is outsider trading … Chapter 25 Insider Trading

11. Outsider trading Good or bad news shareholders Investors / shareholders Insider Corporation Non-public, material information (such as takeover plans by Corp) Target Company Chapter 25 Insider Trading

12. Good Thing Not a Good Thing Chapter 25 Insider Trading

13. Chapter 25 Insider Trading

14. Pros Sends “soft information” to markets – thus protecting proprietary info Encourages insiders to own company stock Compensates insiders for developing “good news” Cons Unfair to those without information Discourages investors from entering market Adds to trading “spreads” in markets Constitutes theft of corporate intellectual property Distorts company disclosures as insiders manipulate company info Evaluate insider trading Chapter 25 Insider Trading

15. State law … Chapter 25 Insider Trading

16. Fraud (tort of deceit) Material misrepresentation Intentional (Def aware of truth) Reliance (Pl relies reasonably) Misrepresentation is cause of loss Damages Goodwin v. Agassiz (Mass 1933) Good news Stock market / Goodwin Buy from existing shareholder (impersonal market) Agassiz & McNaughton Corporation Secured options to land (geologist’s theory - leads to mineral strike) Chapter 25 Insider Trading

17. Goodwin v. Agassiz (Mass 1933) Good news Stock market / Goodwin • Fiduciary duty (to shareholders) • Majority rule – no duty in impersonal markets • “Special facts” –personal dealings on the basis of highly material facts • “Strict / Kansas” rule – face-to-face transaction, not necessarily special facts Buy from existing shareholder (impersonal market) Agassiz & McNaughton Corporation Secured options to land (geologist’s theory - leads to mineral strike) Chapter 25 Insider Trading

18.  "The contention that directors also occupy a position of trustee toward individual stockholders in the corporation is plainly contrary to repeated decisions of this court [and other courts]"  "Purchase and sales of stock dealt in on the stock exchange are commonly impersonal affairs.  An honest director would be in a difficult situation if he could neither buy nor sell on the stock exchange shares of stock in his corporation ..." Supreme Judicial Court of Massachusetts: Chapter 25 Insider Trading

19. Corporate recovery … Chapter 25 Insider Trading

20. “Bad news” Lower earnings Diamond v. Oreamuno (NY 1969) Investors / shareholders Sell to new investors Oreamuno / Gonzalez Corporation Non-public, material information (IBM puts squeeze on earnings) Chapter 25 Insider Trading

21. Arguments for: Distinguishes “good” companies from “bad” companies Agent can’t take from principal, even if principal not harmed Arguments against: Recovery screwy: Good news: Recovery goes to non-trading Shs who held stock, not those who sold stock Bad news: Recovery goes to all Shs, does not fully compensate Shs who bought Possible multiple liability (see Rule 10b-5) Corporate recovery Chapter 25 Insider Trading

22. Federal law of insider trading(duty to abstain or disclose) Theory under Rule 10b-5 Chiarella: duty of trust and confidence Dirks: tipper-tippee liability O’Hagan: misappropriation liability Chapter 25 Insider Trading

23. Section 10(b) / Rule 10b-5 Securities Exchange Act of 1934 Act § 10 It shall be unlawful for any person ... (b) To use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe • Fraud (tort of deceit) • Material misrepresentation • Intentional (defendant aware of truth) • Reliance (plaintiff relies reasonably) • Misrepresentation is cause of loss • Damages Chapter 25 Insider Trading

24. Is silence fraudulent? Conventional wisdom: • Must disclose latent, not patent, defects. • Fiduciaries (confidential relationship) must give full disclosure But: • Unequal access to information not significant factor • Courts over time less likely to require disclosure!! Krawiec (UNC-CH) & Zeiler (Georgetown) – 2004(466 contract cases / 200 years) Chapter 25 Insider Trading

25. Enter SEC … Chapter 25 Insider Trading

26. “Bad news” Cady Roberts (SEC 1961) Investors / shareholders Sell to new investors (sell short) Gintel (director) Curtiss-Wright Non-public, material information (directors vote to cut dividends) What is theory? Chapter 25 Insider Trading

27. Parity of information We hold that Gintel’s conduct violated clause (3) [of Rule 10b-5] as a practice which operated as a fraud or deceit on the purchasers If purchasers had available material information known by a selling insider, their investment judgment would be affected. Sales by an insider must await disclosure. Gintel has been fined $3000 by the NYSE .. And the protection of investors will be served if Gintel is suspended from the NYSE for 20 days. Chair WiIliam Cary (“race to bottom”) Chapter 25 Insider Trading

28. Enter Supreme Court … Chapter 25 Insider Trading

29. Chiarella v. US (US 1980) shareholders Pandick Press Chiarella Shareholders Insider Acquiror Inc Non-public, material info (takeover plans) Target Company Chapter 25 Insider Trading

30. Duty "... silence in connection with the purchase or sale of securities may operate as fraud actionable under § 10(b) ... But such liability is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.” .... duty to disclose ... guarantees that corporate insiders, who have an obligation to place the shareholder's welfare before their own, will not benefit personally through fraudulent use of material, nonpublic information. Justice Lewis Powell (corporate lawyer) Chapter 25 Insider Trading

31. Tipping … Chapter 25 Insider Trading

32. Dirks v. SEC (US 1983) Investors / shareholders Clients dump stock Secrist Equity Funding Non-public, material information (massive accounting fraud) Dirks Chapter 25 Insider Trading

33. Duty, again ... a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach. Whether the "tip" was a breach of the insider's fiduciary duty [depends on] whether ... the insider receives a direct or indirect personal benefit that will translate into future earnings. Justice Lewis Powell (very influential) Chapter 25 Insider Trading

34. Some hypos … Chapter 25 Insider Trading

35. Hypos Investors / shareholders #2 #1 Secrist Spouse Equity Funding Non-public, material information (massive accounting fraud) Chapter 25 Insider Trading

36. Chapter 25 Insider Trading

37. SEC v. Stewart (2003) Stock market #2 #1 #1 #1 Martha Stewart (at airport to Mx) Sam Wachtal (CEO) Imclone Non-public, material information (FDA likely to disapprove drug) Faneuil (broker’s asst) Chapter 25 Insider Trading

38. Outsider Trading (Misappropriation) “Fraud on source”? “in connection with” trading? Rule 10b5-2: Fiduciary relationship Rule 10b5-1: Insider awareness Chapter 25 Insider Trading

39. Section 10(b) / Rule 10b-5 Securities Exchange Act of 1934 Act § 10 It shall be unlawful for any person ... (b) To use or employ, in connection with the purchase or sale of any security ... any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe Chapter 25 Insider Trading

40. Attorney O’Hagan’s indiscretions … Chapter 25 Insider Trading

41. US v. O’Hagan (US 1997) Shareholders Option sellers Dorsey & Whitney O’Hagan Grand Met Non-public, material info (plan to make tender offer to Pillsbury shareholders) Shareholders Pillsbury Chapter 25 Insider Trading

42. Duty to source The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. See Brief for United States 14.  Justice Ruth Bader Ginsberg [civil rights lawyer] Chapter 25 Insider Trading

43. ICW trading [The "in connection with the purchase or sale of [a] security"] element is satisfied because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities. The securities transaction and the breach of duty thus coincide. Justice Ruth Bader Ginsberg [civil rights lawyer] Chapter 25 Insider Trading

44. What is insider trading? Chapter 25 Insider Trading

45. “Insider trading”(in the United States) • Classic insider trading: • Fraudulent silence under Section 10(b) • Duty of trust and confidence to “abstain or disclose” • Actionable silence in confidential relationships • Tipping: • Tippee knows or should know that • Tipper breached duty for direct/indirect personal benefit • Necessary to extend prohibition • Misappropriation (outsider trading): • Duty of trust and confidence to source • Fraud on source “in connection with” securities trading • Maintain integrity of securities markets Chapter 25 Insider Trading

46. SEC rules • Rule 10b5-1: state of mind when trading “on the basis” of material, nonpublic information • “aware” (“conscious knowledge”) • Pre-existing trading plans OK • Rule 10b5-2: duty to source in business/personal relations • Agree to maintain confidentiality • Practice of sharing known confidences • Spouse, parent, child, sibling – unless dysfunctional family • Regulation FD: no special access for stock analysts Chapter 25 Insider Trading

47. Q&A: The In's and Out's of Insider Trading The Wall Street Journal October 4, 2002 Chapter 25 Insider Trading

48. 1. You work as CFO in Up-N-Rising, a bakery franchiser, that is opening high-end bakery shops throughout the country. The numbers have been good, until this month when you notice an internal report showing a 25% fall in royalties from pastry sales. Question: You sell some of your stock. Insider trading? Yes. This is classic insider trading. Only question is whether drop in pastry sales is “material” State of mind – use versus knowledge – resolved by Rule 10b5-1 (“aware”) Insider trading quiz Chapter 25 Insider Trading

49. 2. You are outside counsel to Up-N-Rising. The CFO at Up-N-Rising calls you and tells you about this quarter’s 25% fall in pastry sales - resulting in a 15% drop in earnings . She asks whether the company should disclose this in a press release. Question: You sell Up-N-Rising short. Insider trading? Yes. You are temporary insider (see fn 14 - Dirks case) and owe a duty under 10b5-2. Drop in royalties is “material” Duty to source in business/ personal relation (Rule 10b5-2) Agree to maintain confidentiality Practice of sharing known confidences Insider trading quiz Chapter 25 Insider Trading

50. 3. You are a friend of Ralph, who you know is sales manager for Up-N-Rising. Ralph tells you that “something” is happening at the company and you might want to consider selling your Up-N-Rising holdings, if you have any. Ralph says no more. Question: You sell your Up-N-Rising stock? Insider trading? Probably. You received a tip (duty to inquire). If “something” is material, nonpublic Elements of illegal tipping Breach of duty by tipper (personal benefit) Tippee knows or reason to know of violation Insider trading quiz Chapter 25 Insider Trading