T he Securities and Exchange Commission Securities Exchange Act of - PDF document

G Corporate Finance Alert December 2000 SEC Casts Wider Net With New Insider Trading Rules By Steven M. Hecht, Esq. T he Securities and Exchange Commission Securities Exchange Act of 1934 and the SEC’s adopted new rules on insider trading that Rule 10b-5. In the Supreme Court’s landmark became effective on October 23, 2000. The 1997 decision, United States v. O’Hagan , the court rules were designed to resolve ambiguities that had stated that unlawful insider trading occurs when developed in the case law. After a period of public securities are bought or sold “on the basis of” comment, the Commission adopted the rules with material non-public information. Historically, in only some minor changes. The purpose of this Alert determining whether an insider (someone who is to inform our clients and other friends as to the works within the company or is a third party who principal features of the rules as they were adopted has a special relationship with the company, such as by the SEC. the company’s lawyer or other fiduciary) has traded securities of the company “on the basis of” material, The SEC has adopted two new rules intended to clarify insider trading liability under Rule 10b-5, non-public information, courts have grappled with “The new rules should be evaluated against the which prohibits the employment of “deceptive devices” in the purchase or sale of securities. The current legal landscape.” rules expand the scope of prohibited conduct and thus help the SEC cast a wider net against insider what is known as the “use/possession” distinction: under the “use” test, judges attempt to measure trading activities. The SEC defends its expansive what, if any, causal connection exists between an “The rules expand the scope of prohibited insider’s possession of non-public information and his trading or possible use of that information. On conduct and thus help the SEC cast a wider net the other hand, a stricter “possession” standard punishes any trade made by an insider who against insider trading activities.” possesses significant non-public information, rules on the rationale that ambiguities in Rule 10b- regardless of whether that insider actually used 5 case law frustrate the SEC’s twin goals of such information in executing his trade. protecting investors and preserving the integrity of the securities markets. Not surprisingly, for the past twenty years, the SEC has advocated the “possession” test, arguing Rule 10b-5 Case Law that mere possession of inside information at the The new rules should be evaluated against the time of a trade is sufficient to establish a violation current legal landscape. The phrase “insider of the antifraud provisions. Courts have taken a trading” is not defined by statute or rule. Instead, variety of positions on this issue, however. In a the law of insider trading developed primarily 1998 federal court of appeals ruling, SEC v. Adler , through judicial analysis of Section 10(b) of the the court concluded that “mere knowing This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. L Roseland, New Jersey Telephone 973.597.2500 65 Livingston Avenue www.lowenstein.com 07068-1791 Fax 973.597.2400

G possession” is not an inherent violation, but it also applying the new rules. Will courts use a subjective held that when an insider trades while in test (focusing on what the trader was actually aware possession of material non-public information, a of) or an objective standard (drawing inferences “strong inference” arises that the insider used such about what a trader should have been aware of information. At that point, the suspected insider based on objectively demonstrable facts or events)? trader must rebut the inference with proof that he Also, might an objective approach eliminate the did not use that information. Other rulings by scienter element (focusing on the trader’s federal courts, such as United States v. Smith , have intentions) from insider trading case law, despite reaffirmed the “use” test, and in doing so have the SEC’s statement that it did not intend to do so placed the burden squarely on the government to (and despite the fact that the SEC could not do so prove causation between the insider’s possession since it lacks authority to promulgate rules that are and use of the non-public information. The contrary to the requirements of Section 10(b) of various court decisions, taken together, failed to the Exchange Act, from which the scienter element establish a uniform or definitive test: they range derives)? These questions will only be answered by broadly from Adler’s near-possession standard to the judiciary in applying the new rule. Smith’s more relaxed “use” analysis. The rule states three safe harbor exceptions by Perhaps frustrated by the judiciary’s failure to which insiders may rebut the presumption that they adopt the “possession” test, the SEC is now traded on the basis of the inside information. attempting to use its rule-making power under These three exceptions involve situations in which Section 10(b) of the Securities Exchange Act to a trader (i) enters into a binding contract to buy or create a more precise test even stricter than the sell a fixed amount of securities and then learns of Adler court’s. Indeed, the Adler court invited the material non-public information; (ii) provides SEC to promulgate a rule that either adopted the instructions to his or her broker to execute a knowing possession standard or that created a specified trade and then learns of material non- presumption that an insider who trades while in public information; or (iii) follows a written plan for possession of material non-public information has buying or selling company securities. However, used that information, thereby requiring the these three exceptions will protect an insider only trader to prove that he or she did not in fact rely where they have been pursued in good faith and on such information. not as part of a plan or scheme to evade the prohibitions of this rule. Certain commentators on Rule 10b5-1: An “Awareness” Test Rule 10b5-1 suggested that the SEC should either redesignate the affirmative defenses as non- Rule 10b5-1 first restates existing case law by exclusive safe harbors or add a catch-all defense to declaring it illegal to trade a security “on the basis allow a defendant to show that he or she did not of material non-public information about that use the information. However, the SEC rejected security or issuer,” in breach of a duty to keep this suggestion in adopting the new rule because it secret that information. Trading “on the basis of” believes that such an expansion of the available non-public information is then defined to mean defenses would negate the “clarity and certainty” that the trader “was aware of” the information that the new rule, with its carefully delineated when he or she made the purchase or sale. The exclusive defenses, provides. SEC does not, however, define the term “aware.” Nor is the term found in existing case law. Rule 10b5-1 focuses on the insider’s Accordingly, despite its attempt at greater clarity, “awareness” of the inside information at the time the SEC has instead left room for difficulties in that the insider makes a trade. In substance, this