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Key16 Inside information: the law on juicy tidbits

Federal securities laws consider all directors to be insiders, meaning that they have access to information about their companies that is not generally available to the market. Under Section 10(b) of the 1934 Securities Exchange Act, directors cannot trade on inside information. For example, a director will know long before the information becomes public that a merger of his company with another company is in the works. Generally the announcement that a company is about to be acquired sends the stock price higher. But insiders are not permitted to profit from that information by buying stock in advance of the announcement. Trading on insider makes trading on such information will be turned over to the SEC and/or the persons from whom those profits were made.

When the regulation of insider trading was first promulgated, some people thought that perhaps they could avoid insider trading sanctions by simply passing the information along to others and allowing these non-insiders to trade. Such persons, while not insiders, are still subject to 10(b) because they got their information from insiders. For example, Mervyn Cooper, a psychotherapist, happened to be treating a Lockheed executive in a troubled marriage while the executive was working on the Lockheed merger with Martin Marietta. In fact, the pressure the executive felt with the work on the merger came up during the counseling session. Dr. Cooper passed the information along to a friend, Kenneth Rottenberg, who then proceeded to buy options on Lockheed stock for the two of them. Mr. Rottenberg, warned by his broker about the risks of call options, assured the broker that a major announcement was coming, disclosing that he had inside information. Both Dr. Cooper and Mr. Rottenberg were charged by the SEC with violations of 10(b) and paid back their profits of nearly $200,000 along with a fine equivalent to those profits.

While the statute is clear that insiders and so-called “tippees” are covered under the insider trading sanctions, the definitions remain a bit muddled. A live-in boyfriend tipped by his lover that her company has just landed a big government contract cannot trade on her company’s stock prior to the public announcement. But a patron in a theater lobby who overhears a discussion between that same couple out celebrating her success in landing the contract could go ahead and trade on the stock.

But while the definition of who is an insider may be muddled, one thing remains consistently clear: directors are always insiders and cannot profit in advance from their company’s plans. Directors must wait until information becomes public to trade in their company’s stock. In fact, most companies have hard and fast rules on insider trading by directors and officers. During so-called “blackout” periods, directors and officers are not permitted to do any trading in the company’s stock. These periods tend to be those just prior to the release of monthly or quarterly financial statements. During window periods, there is a safe harbor for trading and these periods tend to follow immediately the company’s public announcements or release of earnings. Even during window periods, many companies require directors to check with that company’s legal counsel before trading in the stock.

One final aspect of insider trading rules is the obligation of the officers and directors to be forthcoming about the company’s status and any changes. Information released to the public should be neither overly pessimistic. For example, in one of the landmark cases on information and corporate disclosure, SEC v. Texas Gulf Sulphur, the company released overly pessimistic information about a mineral find. While the market digested that negative information, directors and officers traded on the company’s stock and then announced that, indeed, the mineral find was the largest in its history. The directors and officers had violated 10(b)in their release of misleading information and then further violated it by trading on that misleading information’s effect on the price of their company’s stock in the market.

The penalties for insider trading include civil and criminal penalties. The criminal charges carry up to five years in prison. The public disgrace can last a lot longer.