While the most high-profile insider trading allegations have historically been made against individuals, more recently, the focus has shifted.
Insider trading has been making big headlines lately. Since 2010 168 actions have been filed against nearly 400 individuals and entities.
Illegal insider trading is defined as trading in a corporation’s securities while in possession of material non-public information, which is in breach of a fiduciary duty or other relationship of trust and confidence to either the corporation or the source of the information. Some trading activity by insiders is not considered to be “illegal insider trading” if it occurs under Rule 10b5-1, as discussed below.
The financial, reputational, and criminal penalties for illegal insider trading can be severe for individuals and companies. Violators can face civil penalties such as being disgorged of profits gained or losses avoided, paying three times that amount in fines, and being barred from serving as a director or officer of a public company. Criminal penalties include fines up to $5 million and up to 20 years in prison. Employers may face potential civil and criminal exposure; either vicariously liable for the actions of their employees, or for recklessly failing to prevent employees from engaging in illegal trading. There’s also the potential for negative publicity that can impact a company’s reputation.
While the most high-profile insider trading allegations have historically been made against individuals, more recently, the focus has shifted. The SEC and US Department of Justice (DOJ) are now investigating hedge funds, expert networks, 10b5-1 plans—and even directors.
Some observers say recent SEC and DOJ actions foreshadow continued interest in the activities of hedge funds and expert networks. Expert networks are research consulting firms that provide data and analysis to the investment community. They connect experts to traders, analysts, and others who are looking for information on the experts’ topics of expertise. Expert networks charge fees for their services and are frequently used by some hedge funds.
Expert network firms evolved after Regulation Fair Disclosure (Reg FD) was adopted in 2000. Reg FD bans public companies from disclosing “material non-public information to certain individuals or entities” without simultaneously disclosing it to the public. That regulation made it illegal for corporate executives to share information only with certain parties, which prompted some investors to look for new sources of research.
The SEC and DOJ recently started looking into expert networks to see whether they were providing insider information to the financial services industry and hedge funds. Since then, dozens of people associated with expert networks have been charged with insider trading.
Enacted in 2000, Rule 10b5-1 allows companies to maintain trading plans for insiders to sell a predetermined number of shares at a predetermined time, despite those insiders having visibility into material non-public information. These plans allow insiders—most commonly executives and even directors—to liquidate their holdings in a stable, legal manner. A 10b5-1 plan typically takes the form of a contract between the insider and his or her broker. These plans can provide corporate insiders with an affirmative defense to illegal insider trading—if they were established in good faith, adopted when the insider was unaware of material non-public information, and the insider did not exercise subsequent influence over the trades.
A well-designed and properly executed plan can provide insiders with a valuable diversification tool. But some have criticized them because they don’t have to be filed or publicly disclosed. Some insiders choose to disclose that they have such plans, but many do not disclose their details. Critics are concerned that these plans could be misused.
The Council of Institutional Investors (CII) recently sent a letter to the SEC expressing concerns about the plans. It requested that the SEC consider implementing amendments to Rule 10b5-1, including limiting the time period for the adoption of Rule 10b5-1 trading plans to the issuer’s open trading window; prohibiting the adoption of multiple, overlapping trading plans; requiring a mandatory three-month or longer delay between the adoption of the plan and the first trade; and limiting the frequency of modifications and cancellations of trading plans. They also requested that boards explicitly be responsible for oversight of 10b5-1 plans.
Non-executive directors’ use of 10b5-1 plans increased 55% since 2008, according to an analysis of regulatory filings done by The Wall Street Journal. Since 2006, more than 2,200 independent directors have disclosed using 10b5-1 plans, according to the newspaper. Directors’ use of the plans has come into the spotlight, in particular those of directors who run investment or hedge funds. Some investigations have ensued.
Recently, a federal judge tentatively approved a record $600 million insider trading settlement with a hedge fund.
Broker-dealers and investment advisors have an affirmative obligation to adopt, maintain, and enforce policies and procedures aimed at preventing illegal insider trading. They can be liable if they knowingly or recklessly fail to enforce or establish those policies and procedures. Other corporations can be held civilly liable for insider trading by employees, including directors, if they knew or recklessly disregarded the fact that someone was likely to engage in illegal insider trading and did not take appropriate steps to prevent that trading.
Directors should understand if a company has an adequate systematic internal control environment and a strong ethics policy in place. They should understand if a company conducts assessments of the possible sources of material non-public information across the organization. Directors should ensure they are updated on any developments on insider trading. They should also examine risk management processes.
Company policies about employee use of, or participation in, expert networks may be of interest. Directors should understand what the company’s policies are regarding expert networks. They should also know whether a company allows 10b5-1 plans. There is increased pressure for directors to better oversee these plans and any trades made under them.