Insider Trading Sanctions: an Update
| Publication year | 1985 |
| Pages | 959 |
1985, June, Pg. 959. Insider Trading Sanctions: An Update
Nancy Luria-Cohen, Denver, is an associate with the firm of Cogswell and Wehrle.
On August 10, 1984, the Insider Trading Sanctions Act ("ITSA") was signed into law.(fn1) The purpose of the statute is to increase sanctions against, and enhance the deterrence of, insider trading. ITSA also strengthens the Securities and Exchange Commission's ("Commission") enforcement remedies in other areas. However, in adopting ITSA, Congress neither defined "insider trading" nor used the term in the body of the act. Congress chose instead to leave the issue open to continuing analysis by the courts, the Commission and the legal community.
In the past four years, the Commission has made prosecution of insider trading one of its priorities. Recent cases have found law firms and their employees, along with financial printers and traditional corporate insiders, liable for insider trading violations. The combination of the pressure to bring insider trading into the forefront and the increased sanctions for a violation of insider trading makes it even more important for persons who might be deemed "insiders" or "tippers" to understand the development of the law in this area. This article reviews the new penalties against insider trading under ITSA and recent case law developments in the area.
"Insider trading" has been described in the legislative history of ITSA to involve trading in the securities markets while in possession of material information about the issuer of the security or about the trading market for the issuer's security which is not available to the investing public.(fn2) The term "insider trading" is a misnomer, however, as it encompasses persons who are not insiders of a company whose securities are traded, persons who do not trade, and trading or tipping on "market information," not "inside information."
During consideration of the Securities Exchange Act of 1934 ("Exchange Act"), insider trading was one of the areas Congress sought to address. At that time, the Senate Banking and Currency Committee stated:
Among the most vicious practices unearthed at the hearings before the Subcommittee was the flagrant betrayal of their fiduciary's duties by directors and officers of corporations who use their positions of trust and the confidential information which came to them in such positions, to aid them in their market activities. Closely allied to this type of abuse was the unscrupulous employment of inside information by large stockholders who, while not directors and officers, exercised sufficient control over the destinies of their companies to enable them to acquire and profit by information not available to others.(fn3)
Section 16(b) of the Exchange Act was adopted specifically to curb a limited range of insider trading activities. This provision states that profits earned by corporate officers, directors and 10 percent shareholders as a result of purchasing and selling, or selling and purchasing, securities of the issuer within a six-month period shall be recoverable by the issuer. The purpose of § 16(b) is to prevent the unfair use of information by specified persons because of their relationship to the issuer. Significantly, it requires no showing of actual unfair use for recovery. A cause of action can be maintained by an issuer under § 16(b), regardless of the intention on the part of the individual in entering or making the transaction.
The six-month test required for a violation of § 16(b) was developed on the theory that "improper use of inside information by corporate insiders is most likely to occur in short-term in-and-out trading." The insider who holds the security for more than six months does not become liable under § 16(b), no matter how strong the proof of use of nonpublic information. The intent of Congress was to minimize misuse of confidential information without unduly discouraging bona fide long-term investment.(fn4) Section 16(b) does not correct all insider trading violations. In fact, the six-month limitation is so limiting that an insider waiting an extra day over the six-month period would be beyond the scope of the statute.(fn5)
Because of the narrowly defined time frame of a violation and of the persons falling within the ambit of § 16(b), there were a limited number of abuses sought to be remedied by Congress. As noted, § 16(b) is limited to a six-month period and only specific insiders are liable (directors, officers and 10 percent shareholders). The statute does not require trading on inside information for a cause of action---any officer, director or 10 percent shareholder who profits within a six-month period is liable. Moreover, the company itself has a cause of action to recover profits, and,
subject to certain requirements, any shareholder may initiate an action on behalf of the company to make such recovery.
Congress also included a general antifraud provision, § 10(b), in the Exchange Act. This provision prohibits use of nonpublic information by an insider that constitutes a fraud. The Colorado fraud statute found in CRS § 11-51-123 of the Colorado Securities Act is virtually identical to § 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder.(fn6) However, the Colorado Securities Act has not been the subject of a single reported decision by the Colorado courts relating to the issue of insider trading.(fn7) Thus, due to the similarity of state and federal statutes and the fact that no cases have been brought under the general antifraud provisions of the Colorado statute regarding insider trading, this article focuses on federal case law.
Securities markets have grown dramatically in size and complexity while Commission enforcement resources have decreased 11 percent since 1979.(fn8) In information sent to public shareholders, there are increasing incidences of companies inflating profits, overstating inventory, issuing false financial statements in documents and making false and misleading statements with respect to financial conditions.(fn9) The potential for immense profits from insider trading has become a powerful lure to illegal activities. For example, in one instance, an individual purchased $3,000 in call options of a company which was the subject of a takeover and forty-eight hours later realized a profit of $430,000.(fn10)
Despite the decline in enforcement resources, the Commission has made the prosecution of insider trading a priority and has brought more insider trading cases in the past four years under the Exchange Act than in all of the previous years combined. While the Commission's enforcement program had raised the awareness level of the problem, there remained a public perception that the risk of detection was slight, in part because existing remedies consistently failed to deter violations.(fn11) ITSA was enacted to increase sanctions so that penalties might better deter insider trading.
The legislative history of ITSA emphatically suggested that capital formation and economic growth and stability in the United States depend on investor confidence in the fairness and integrity of capital markets.(fn12) Congress believed that the prices of the majority of actively traded securities reflect available information about companies and the economy. Insider trading, by undermining expectations of fairness and integrity, threatens these securities markets. Thus, public investors would be less inclined to invest in the securities markets if they feared that a person in possession of confidential information would take unfair advantage. Moreover, courts have long held that insider trading is against sound public policy and a breach of fiduciary duties owed to the shareholder.(fn13)
The abuse of informational advantage that other investors cannot hope to overcome through their own efforts is unfair and inconsistent with the investing public's legitimate expectation of honest and fair securities markets where all participants play by the same rules.(fn14)
Readers should be aware of another viewpoint. It has been contended that speculative trading by insiders may be beneficial in an economic sense and, therefore, that regulation of insider trading has a detrimental effect on the economy.
The exploitation and sale of valuable information are necessary as a method of compensating entrepreneurs, so as to guarantee the uninterrupted flow of entrepreneurial abilities into American business enterprise;... no one is really hurt when insiders market valuable information....[F]ar from there having been any economic demonstration of the evils of insider trading, it is a good thing.(fn15)
The basis of liability under the insider trading violations is that market investors may be injured and become disillusioned when insiders are allowed to trade on material nonpublic information. The reasoning suggests that, after learning the facts, investors may regret such a transaction. Thus, an insider would be trading and profiting on information which the investors, had they known, might not have traded.
To continue reading
Request your trial