Defending Against Insider Trading Allegations.

• Often (and not always), civil SEC proceedings and criminal DOJ proceedings will investigate the same trading.
• While some regulators believe awareness of Rule 10b5-1 eliminates an insider’s need to address the other elements of Rule 10b-5, this view is mistaken.
• Even insiders may lawfully trade without violating their fiduciary duties.
• In federal securities law, “confidential” information is not necessarily “material.”
• Lawful, diligent research may involve combining otherwise immaterial nonpublic information with publicly available data.
• There is no statute, federal regulation, or agency designation identifying the most feared law firm.
• Law-firm directories and rankings tend to use disparate methodologies; categories tend to overlap with substantial variation; and there is often a correlation between rankings and firm size.

Which insider trading theory is the government using?

What are the principal insider trading liability theories?

Insider trading cases generally take one of two forms.

The classical theory of liability is an insiders’ (corporate insiders, for example) liability for deceiving their company’s shareholders. This is a theory of fraud and breach of fiduciary duty.

The misappropriation theory of liability is an insider’s (or a non-corporate insider’s) liability for deceiving a source of confidential information. This is also a theory of fraud and breach of fiduciary duty. United States v. O’Hagan, 521 U.S. 642, 652 (1997), is the seminal case for this theory.

Other forms of insider trading cases include tipper/tippee cases, cases involving violations of Rule 14e-3, and other cases involving federal securities law.

What constitutes insider trading under a tipper/tippee theory?

Generally, a tipper has breached a fiduciary duty when they disclose, or advise someone else to trade upon, material nonpublic information in exchange for, or in expectation of, a personal benefit.

Generally, a tippee has violated Rule 10b-5 when they (i) are aware of the tipper’s breach of a fiduciary duty, (ii) trade securities on the basis of material nonpublic information disclosed in breach of that fiduciary duty, and, (iii) have scienter.

Lawful investment research and lawful trading are based on inferences and conclusions derived from piecing together publicly available (but not necessarily obvious) information and other seemingly immaterial non-public information.

Is there any difference between classical and misappropriation liability?

Both are theories of fraud under federal securities laws. They differ only in who is supposedly defrauded. A corporate insider who trades on material non-public information defrauds shareholders. A corporate insider who tips material non-public information to an outside confidant in exchange for a personal benefit also defrauds shareholders. Outside recipients of non-public information can be guilty of securities fraud under Rule 14e-3 if they trade upon information they received in connection with a tender offer, even if the source of the information was not an insider.

What is a tender offer?

A tender offer is a publicly disclosed (or secret) bid by an acquirer to buy some or all of the outstanding shares of a target company directly from the target company’s shareholders at a fixed price.

Under Rule 14e-3, in cases involving tender offers, plaintiffs and prosecutors do not need to prove:

• Breach of a fiduciary duty
• Intent to defraud
• Possession of material non-public information
• Personal benefit from disclosure

These reduced elements make insider trading liability easier to establish than under Exchange Act Section 10(b) and Rule 10b-5.

How difficult is insider trading for the government to prove?

In practice, proving each element of Rule 10b-5 insider trading liability may be difficult.

• Materiality. Generally, information is material if it would significantly alter the “informational mix” for a “reasonable investor.” Many insider trading cases involve information that does not meet the definition of material (e.g., general knowledge of a pending contract or merger) or information that is not nonpublic (e.g., information available through public sources).
• Breach. Again, “breach” can be difficult to establish if it is not clear what fiduciary duties exist.
• Rule 10b5-1 ( Trading on the Basis of Information ). Under Rule 10b5-1, an individual who is aware of material non-public information (MNPI) but sells or buys securities despite that awareness is treated as having traded “on the basis of” that information.

A trading plan executed under a Rule 10b5-1 afirmative defense, however, has no presumption of liability. In such cases, the government must establish that the insider actually traded on the basis of the material non-public information. In other words, the government must establish that the information was “at the inside trader’s state of mind” at the time of trading.

Does an alternative trading motive shield an insider from Rule 10b5-1 liability?

Not automatically. While an alternative trading motive can be relevant, such motives are not necessarily sufficient to defeat Rule 10b5-1 liability.

What does it take to establish Rule 10b-5 scienter?

The third element of Rule 10b-5 insider trading liability is the trading actor’s scienter. Establishing scienter is a burden that the government will need to meet. If an insider trading case is civil, the government will need to establish that the defendant acted “intentionally, knowingly, or with recklessness.” If the case is criminal, the prosecution must establish that the defendant “willfully” violated federal law.

When challenging a pending insider trading case, we pay extremely close attention to the government’s (supposed) evidence of scienter. The government may try to establish scienter by asserting that there is evidence of a personal benefit, or, even if not directly applicable, may still be relevant in other cases. However, just because the government thinks it has a “personal benefit” theory does not mean it is entitled to rely on this evidence to establish scienter.

How do insider trading liability cases proceed?

In these cases, the government will typically seek to demonstrate an insider’s Rule 10b-5 scienter by circumstantial evidence. In other words, the government will try to demonstrate that:

• An insider knew of the existence of MNPI
• An insider had access to MNPI
• An insider trades on the MNPI (even if MNPI was not the insider’s sole motivation)
• The timing of the trades and communications are suggestive

While these circumstances may be evidence of insider trading, they are not conclusive. They can explain lawful trading, lawful research, and otherwise lawful (albeit possibly coincidental) communications, and the government may not be able to establish the necessary scienter.

If any of this describes your situation, it is worth talking it through with counsel. Spodek Law Group can be reached at 212-300-5196.

Should I give SEC testimony during a Wells inquiry?

In a Wells inquiry, the SEC is seeking to obtain (or confirm) evidence against an individual. This can lead to civil enforcement action and may present evidence that will eventually appear in a DOJ investigation. Thus, decisions regarding testimony should take into account not only the risks of providing testimony in a Wells inquiry, but also potential subsequent prosecution.

If you (or your company) are being investigated, you should seek an experienced white-collar criminal defense attorney immediately. In this case, your defense attorney can determine whether you should give testimony.

An attorney may advise against giving testimony during a Wells inquiry based on, for example, the fact that you have been subpoenaed (or subpoenaed by mail), the fact that you have been charged, or the fact that you have an issue with the government’s jurisdiction.

Do I have a Wells submission right?

A “Wells notice” is an SEC notification that the SEC staff thinks an insider trading violation is on the table. A Wells notice is a formal step in the SEC’s procedures, not a finding of guilt.

A “Wells submission” is an informal (but important) opportunity to present arguments in response to a Wells notice. It can play a role in influencing the SEC’s decision. It is important to seek an experienced white-collar criminal defense attorney who can use the opportunity effectively.

Can the Fifth Amendment apply in a Wells inquiry?

Generally, the Fifth Amendment does not protect someone being compelled to testify in a Wells inquiry. However, in some cases the Fifth Amendment may apply in a Wells inquiry.

Does my company’s counsel represent me?

Generally, no. Your company’s counsel generally represents your company, not you. If you have been subpoenaed, this may mean that you are not being accused, but the SEC or DOJ wants to question you. If you are not being accused, your company’s counsel may be able to assist you. However, in some cases, company counsel may be able to represent you.

How can I keep my attorney-client privilege from being voided?

You can potentially avoid accidentally voiding your attorney-client privilege. If you work at a large corporation and the corporation is under investigation for insider trading, you must understand the limitations of the company’s representation of you. If you find that you are not being represented, then you must engage a new attorney.

In other words, avoid unnecessary third-party disclosure and avoid unnecessary public disclosure.

Can I delete evidence if an investigation is underway?

Deleting evidence can potentially be considered obstruction of justice.

If you are under investigation (or have been subpoenaed), you should seek an experienced white-collar criminal defense attorney immediately. Your attorney can provide advice regarding when it is necessary to keep documents and other records in order to avoid potential obstruction exposure.

If you are under investigation, then it is also important to avoid making any false statements. If you are under investigation, then it is important to work with an experienced white-collar criminal defense attorney to assess your liability risks for other potential offenses under 18 U.S.C. § 1001.

How much can insider trading penalties and remedies total?

What are the statutory penalties and remedies under Section 21A?

Under Section 21A, the SEC can impose civil penalties if it proves you traded based on MNPI.

Statutory insider-trading penalties under Section 21A are a civil disgorgement (the amount of illicit gains or losses avoided) plus an additional penalty that can reach three times the amount of those gains or losses. While the total civil insider-trading penalty could reach four times illicit trading gains, in practice the SEC seeks three times the gains or losses.

Section 21A civil insider-trading penalties also generally carry a five-year statute of limitations.

Can the SEC seek disgorgement under another federal statute?

In addition to seeking Section 21A civil insider-trading penalties, the SEC can also seek “equitable disgorgement” under Section 21. If a defendant is found liable for insider trading, the SEC can seek both disgorgement and Section 21A penalties. This can create liability exposure in excess of three times an insider’s illicit gains.

Furthermore, disgorgement under Section 21 can carry a ten-year statute of limitations for scienter-based claims.

Can I be sued for more than disgorgement under the SEC v. Liu case?

Generally, no. In Liu v. SEC, 591 U.S. 71, 140 S. Ct. 1936 (2020), the United States Supreme Court limited the SEC’s ability to seek disgorgement to “wrongdoers’ net profits.” If an individual is found to have committed insider trading, then the SEC may recover disgorgement limited to the net profits the insider obtained from the unlawful trading.

What other remedies can the SEC seek in cases involving insider trading?

The SEC can pursue injunctions, officer-director bars, industry restrictions, and other forms of liability. Many of these remedies require the SEC to prove scienter.

Under Section 21A, the SEC can seek civil penalties, bars, and suspensions for those who assist in a violation of securities fraud laws.

Because insider trading is a scienter-based violation, the SEC must show that the defendant acted knowingly or recklessly in order to obtain civil insider-trading penalties.

Can the SEC seek imprisonment, a criminal forfeiture, or any other criminal penalty?

No. Only the DOJ can seek imprisonment, criminal forfeiture, and other criminal penalties.

Can the SEC bar me from acting as an officer or director of a company?

Yes, the SEC can seek officer-director bars in securities-fraud cases involving scienter. Officer-director bars can carry five years, ten years, or lifetime bans.

The SEC can seek officer or director bans and suspensions in other cases as well, but these bars and suspensions must generally either (i) involve scienter and “substantial unfitness” to continue serving in an officer or director capacity, or (ii) be the result of some other violation.

Can the SEC ban me from investing and from advising other investors?

Yes, the SEC can seek to bar or suspend individuals who engage in insider trading. The SEC can seek similar bans and suspensions in cases involving broker-dealers and investment advisers.

Can a Rule 10b5-1 plan defeat insider trading allegations?

Yes, a compliant Rule 10b5-1 plan can provide an affirmative defense for insiders and executives accused of securities fraud.

If you (or the company you represent) has a Rule 10b5-1 plan and is facing a Rule 10b-5 insider trading investigation, you should consult your white-collar criminal defense lawyer immediately.

It can be difficult to determine whether a Rule 10b5-1 plan is validly executed and whether you are entitled to rely on the rule’s safe harbor protections.

What are the implications for Rule 10b5-1 cooling-off periods?

While Rule 10b5-1 plans protect insiders and executives from insider trading liability, they also impose requirements to adopt a plan, and they also impose restrictions on how long an insider can wait after adopting a plan before they can trade.

For company directors and officers, the mandatory cooling-off period is 90 days (or two business days after the company’s next 10-Q or 10-K filing date, but not more than 120 days).

For all other individuals who have a Rule 10b5-1 plan, the mandatory cooling-off period is 30 days.

The cooling-off period is based on the individual’s Rule 10b5-1 plan adoption date, not on the individual’s status as an insider.

What makes a Rule 10b5-1 plan non-compliant?

A Rule 10b5-1 trading plan is non-compliant if it is not adopted in good faith, or if a trading insider manipulates it. To avoid loss of safe harbor protection and establish bad faith, trading insiders can’t engage in deceptive or manipulative practices, or seek to circumvent requirements of Rule 10b5-1. In addition, once a Rule 10b5-1 plan is established, trading insiders cannot intervene with the plan’s operation, including by engaging in insider trading or by canceling the plan due to material non-public information (MNPI).

For example, if a trading insider abandons or cancels the plan because of material non-public information, then this can create a risk of a violation of Rule 10b-5.

Talk to Spodek Law Group

Every case turns on its own facts, and general information is no substitute for advice about yours. Todd Spodek, managing partner of Spodek Law Group, and the firm's attorneys defend federal criminal and white collar matters nationwide. Reach the firm at 212-300-5196.