Chapter 25 Insider Trading

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Chapter 25 Insider 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? - PowerPoint PPT Presentation

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<ul><li><p>Corporations:A Contemporary ApproachChapter 16Public Shareholder Activism</p><p>Slide *of 65 Fortune Magazine (Cover), The Gray Art of Insider Trading (Aug 13, 2013)</p><p>Chapter 16Public Shareholder Activism</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Chapter 25Insider TradingInsider trading basicsWhat it is classic / misappropriationDebate: pros and consState law: ho-humMajority rule: no fiduciary duty to shareholdersSpecial facts rule Federal law: abstain or discloseCady Roberts: fairness or equal access?Chiarella: duty of trust and confidenceDirks: (1) tipper breach + (2) tippee knowsOHagan: misappropriator defrauds sourceSpecific issues SEC rulesRule 10b5-2: duty of trust and confidence definedRule 10b5-1: state of mind defined / trading plans 16: Disgorgement of short-swing trading profitsModule VIII Stock TradingCitizen of worldLaw professionCorporate practiceBar exam</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Insider trading primer(in 30 minutes)</p><p>Chapter 25Insider Trading</p></li><li><p>US Insider TradingStory of Raja RajaratnamCurriculum vitaeCrimePunishment</p><p>US law of insider trading Duty to source of informationBreach of duty Federal enforcement</p><p>Comparison to EU regulationDefinition: inside informationCategories of personsProhibition against useCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Story of Raj RajaratnamCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Raj Rajaratnam</p><p>PersonalBorn: June 15, 1957 (Sri Lanka)Married: Asha Pabla (3 children)EducationU Sussex / EngineeringMBA - Wharton / U Penn (1983)Work experienceLoan officer: Chase ManhattanAnalyst --&gt; President: Needham &amp; Co.Founder &amp; CEO, Galleon GroupDirector, Goldman SachsInvestmentsPersonal net worth $1.8 BOwns50% of Sri Lankan stock marketCharity$5 MM for 2004 Tsunami fund$3.5 MM Tamils Rehabilitation (frozen)Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Guilty14 counts of insider trading (conspiracy)Age: 53 (married; children 14-19)11 years in prison (until July 2021)$60 million in trading gains$150 million in civil /criminal fines</p><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Some questions:</p><p>What is a hedge fund?</p><p>What was Rajs crime?</p><p>How was he caught? </p><p>Why case brought as conspiracy?</p><p>PortfolioFund investorsHedge fund[Galleon]Public companyPublic companyIBMIntelPublic companyPublic companyPublic companyMcKinsey &amp; CoCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>US insider trading lawTrading on basis of material, non-public informationCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Classic Insider TradingINSIDERCompany shareholdersMisappropriation (Outsider Trading)TippeeTippeeTrading violates duty of trust/confidence(Silence = fraud)Trading on tip is illegal when -- Insider-tipper violates duty*Tippee knows / reason to know</p><p>* improper benefitOutside shareholdersTrading violates duty to sourceRule 10b5-2: Trading illegal when --Confidentiality agreementConfidentiality practice Family member (functional)</p><p>Rule 10b5-1: specifies illegal state of mind when person trades on the basis of material, nonpublic informationPerson aware (conscious knowledge)Not part of pre-existing trading planCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Insider tradingClassic insider tradingOutsider trading(misappropriation)Chiarella (US 1980)</p><p>Silence = fraud in face of duty of trust or confidenceDirks (US 1982)</p><p>Illegal tipping = tip breaches duty*know or reason to know*for personal benefitOHagan (US 1996)</p><p>Misappropriation = fraud on source (duty)icw securities tradingRule 10b5-2</p><p>Duty: agree confidentiality /business practice / familyReg FD</p><p>Tell one analyst: tell public!Securities fraudRule 10b-5:</p><p>Misstatements of material factRule 10b5-1</p><p>Mind = awarenessPre-existing trading plan OKCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Purposes for Insider Trading RegulationProvidefairness Assure mktintegrity</p><p>Reduce cost of capital</p><p>ProtectpropertyCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Insider trading corrodes investor confidence. It undermines the integrity of the markets by tilting, unacceptably, the playing field in favor ofthose whose greed drives them to betray the duties and confidences they owe others. Robert Khuzami SEC enforcement directorCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Sanctions for insider tradingPrivate enforcementOwner of information / tradersTrading gains /avoided lossesPrivate actions rarely brought</p><p>SEC enforcementInvestigation (with NYSE)Disgorgement of profits Civil penalties (3X losses)</p><p>Criminal enforcementDepartment of JusticeCriminal fines (up to $5 MM)Imprisonment (up to 20 years)Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>SEC Insider Trading Enforcement ActionsCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>EU insider trading law[Specified persons] prohibited from using inside information [precise + when revealed significant price effect]Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Use of inside infoPERSONSecurities of issuerUse of inside infoTippeeTippeeArt 2: Possesses inside infoby virtue mgmt or capital(or criminal activities)Art 4: Prohibition of Art 2 and 3applies to others who knowinside informationSecurities of other issuerArt 2: Possesses inside infoby virtue of employ, prof, duties Art 4: Prohibition of Art 2 and 3applies to others who knowinside informationArt 2: prohibits use of inside info by acquiring Financial info to which inside info relatesArt 3: Tipping prohibitedArt 3: Tipping prohibitedCorporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Insider trading hypos</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19End </p><p>Insider trading primer</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19What is insider trading?Good news, bad newsOutsider trading</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Insider trading</p><p>Corporation</p><p>Non-public, material informationStock market InsiderBuy from existing shareholdersBuy call options option to buy stock at mkt (lets say $25) profit = new price (lets say $35) less exercise price ($25)Good news</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Insider trading</p><p>Corporation</p><p>Non-public, material informationStock market InsiderSell to existing shareholdersBuy put options option to sell stock at mkt (lets say $25) profit = exercise price ($25) minus new price (lets say $15)Bad news</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19What is outsider trading </p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Outsider trading</p><p>Corporation</p><p>Non-public, material information(such as takeover plans by Corp)</p><p>Investors / shareholdersshareholdersTarget CompanyGood or bad newsInsider</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Good Thing Not a Good Thing</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Evaluate insider tradingPros</p><p>Sends soft information to markets thus protecting proprietary infoEncourages insiders to own company stock Compensates insiders for developing good newsCons</p><p>Unfair to those without informationDiscourages investors from entering marketAdds to trading spreads in marketsConstitutes theft of corporate intellectual propertyDistorts company disclosures as insiders manipulate company info</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19State law </p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Goodwin v. Agassiz (Mass 1933)</p><p>Corporation</p><p>Secured options to land (geologists theory - leads to mineral strike)Stock market / GoodwinAgassiz &amp; McNaughtonBuy from existing shareholder (impersonal market)Good newsFraud (tort of deceit)Material misrepresentationIntentional (Def aware of truth)Reliance (Pl relies reasonably)Misrepresentation is cause of lossDamages</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Goodwin v. Agassiz (Mass 1933)</p><p>Corporation</p><p>Secured options to land (geologists theory - leads to mineral strike)Stock market / GoodwinAgassiz &amp; McNaughtonBuy from existing shareholder (impersonal market)Good newsFiduciary duty (to shareholders)Majority rule no duty in impersonal marketsSpecial facts personal dealings on the basis of highly material factsStrict / Kansas rule face-to-face transaction, not necessarily special facts</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19 "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]" </p><p>"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:</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Corporate recovery </p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Diamond v. Oreamuno (NY 1969)Bad newsLower earnings</p><p>Investors / shareholdersSell to new investorsCorporation</p><p>Non-public, material information(IBM puts squeeze on earnings)Oreamuno / Gonzalez</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Corporate recoveryArguments for:</p><p>Distinguishes good companies from bad companiesAgent cant take from principal, even if principal not harmed</p><p>Arguments against:</p><p>Recovery screwy:Good news: Recovery goes to non-trading Shs who held stock, not those who sold stockBad news: Recovery goes to all Shs, does not fully compensate Shs who boughtPossible multiple liability (see Rule 10b-5)</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Federal law of insider trading(duty to abstain or disclose)Theory under Rule 10b-5Chiarella: duty of trust and confidenceDirks: tipper-tippee liabilityOHagan: misappropriation liability</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Section 10(b) / Rule 10b-5Securities Exchange Act of 1934 Act 10 </p><p>It shall be unlawful for any person ... </p><p>(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 prescribeFraud (tort of deceit)Material misrepresentationIntentional (defendant aware of truth)Reliance (plaintiff relies reasonably)Misrepresentation is cause of lossDamages</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Is silence fraudulent?Conventional wisdom:Must disclose latent, not patent, defects. Fiduciaries (confidential relationship) must give full disclosure </p><p>But:Unequal access to information not significant factor Courts over time less likely to require disclosure!!</p><p>Krawiec (UNC-CH) &amp; Zeiler (Georgetown) 2004 (466 contract cases / 200 years)</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Enter SEC </p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Cady Roberts (SEC 1961)Bad news</p><p>Curtiss-Wright</p><p>Non-public, material information(directors vote to cut dividends)</p><p>Investors / shareholdersGintel (director)Sell to new investors(sell short)What is theory?</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Parity of information</p><p>We hold that Gintels conduct violated clause (3) [of Rule 10b-5] as a practice which operated as a fraud or deceit on the purchasers</p><p>If purchasers had available material information known by a selling insider, their investment judgment would be affected. Sales by an insider must await disclosure.</p><p>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)</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Enter Supreme Court </p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Chiarella v. US (US 1980)</p><p>Acquiror Inc</p><p>Non-public, material info(takeover plans)</p><p>ShareholdersshareholdersTarget CompanyPandick Press</p><p>ChiarellaInsider</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Duty</p><p>"... 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.</p><p>.... 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)</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Tipping </p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Dirks v. SEC (US 1983)</p><p>Equity Funding</p><p>Non-public, material information(massive accounting fraud)Investors / shareholdersDirks SecristClients dump stock</p><p>Chapter 25Insider Trading</p></li><li><p>Corporations:A Contemporary ApproachChapter 25Insider TradingSlide *of 19Duty, again</p><p>... a tippee assumes a f...</p></li></ul>