Family Members and Insider Trading Liability.

The phrase “insider trading” does not appear in the Exchange Act itself. Instead, federal insider trading law is primarily a matter of interpretation of Section 10(b) of the Exchange Act, Rule 10b-5, and judicial precedent.

While “insider trading” refers generally to the illegal purchase or sale of securities based on nonpublic information, the government must prove specific requirements to establish liability. To establish insider trading liability, the government must prove:

• The information in question was nonpublic and material;
• The insider owed a duty of trust or confidence to the source of the information;
• The insider breached this duty by buying or selling securities based on the information, or by passing it on to a “tippee” who then bought or sold securities; and
• The insider received a personal benefit.

The definition of a corporate insider is key to establishing insider trading liability. While a common misconception is that anyone who has confidential information about a corporation constitutes a corporate insider, mere possession of confidential information about a corporation is generally not sufficient to make someone subject to a duty of trust and confidence under the Exchange Act’s Section 10(b). Similarly, just because someone is a family member of a corporate insider does not necessarily make them subject to liability for insider trading.

Under Rule 10b-5, information is considered “material” when “there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision.” Even if information is material, it is only considered “nonpublic” if it has not been disclosed to the general public in a manner “reasonably calculated to disseminate to investors.”

Corporate insiders may also lawfully trade securities in companies in which they hold a position of trust and confidence, provided that they are not aware of material nonpublic information at the time they trade. Additionally, corporate insiders may trade securities of companies to which they owe no duty, provided the information they hold was not obtained in breach of a duty of trust or confidence owed to its source.

What Confidentiality Duties Exist Between Family Members?

Rule 10b5-2(b)(3) provides a presumption of a duty of trust and confidence when the following family members receive information from the source in confidence:

• Spouse
• Parent
• Child
• Sibling

If your relationship to the source of the information is one of the above, the presumption of a duty of trust and confidence applies. Importantly, however, Rule 10b5-2(b)(3) also expressly provides the ability to rebut the presumption of a duty of trust and confidence. The rule states:

“the presumption can be rebutted by showing that it is ‘inconsistent’ with ‘the relationship between the parties.’”

Other circumstances that may give rise to a duty of trust and confidence include those that fall under other provisions of Rule 10b5-2. These include:

• Express confidentiality agreements: Rule 10b5-2(b)(1) provides a duty of trust and confidence “when the recipient received the information from the source pursuant to: ‘any agreement between the parties that expressly requires the recipient to keep information confidential;’” and,
• A pattern or practice of sharing confidential information: Rule 10b5-2(b)(2) provides a duty of trust and confidence “when the recipient received the information from the source pursuant to: ‘any other relationship or circumstances involving a “history, pattern, or practice of sharing or protecting confidential information between the parties,” or “the sharing or protecting of confidential information” on an occasion that the recipient should have known was intended to be confidential.’”

It should be noted that aunts, uncles, cousins, and in-laws are not specifically listed under Rule 10b5-2(b)(3). However, listed and non-listed family members alike can still owe a duty of trust and confidence under Rule 10b5-2 if any of the following apply:

• The family member received the information pursuant to a contractual confidentiality agreement;
• There is a history, pattern, or practice of sharing or protecting confidential information between the family members;
• On the occasion in question, the family member received or shared the information in confidence; or,
• Otherwise, the family member should have known that the information was intended to be confidential.

The government has the authority to designate other individuals as temporary insiders as well. In Dirks, the U.S. Supreme Court explains that “lawyers, accountants, consultants, underwriters, and others can become temporary insiders when they engage in a special confidential relationship with the source of the information.” According to the Court, temporary-insider status also requires that the individual perform “a service for the corporation, in furtherance of its interests.”

Can I Be Liable for Receiving a Family Tip?

Tippees can face insider-trading liability in some circumstances, but usually this depends on the tipper’s violation of the rules. In Dirks v. SEC, the Supreme Court explains:

“Tippees are not liable unless they know or should know that the information they possess was obtained through a breach of a duty of trust and confidence.”

To breach a duty of trust and confidence, the tipper must do more than just disclose material nonpublic information. In most cases, the government must show that the tipper received a direct or indirect “personal benefit” in exchange for disclosing the confidential information. In Dirks, the Court notes:

“This is because the communication of the information by the insider must be both a breach of the insider’s duty and in exchange for a personal benefit.”

The Court later clarified the “personal benefit” requirement in Salman v. United States. In a series of statements that have had a major impact on federal insider trading cases, the Court says:

“A disclosure by an insider to a relative for the relative’s use in trading does not have to be conditional on the insider’s receiving a cash payment in order to qualify as a personal benefit to the insider. We, and indeed the vast majority of the courts below, have recognized that ‘a gift of confidential information to a family member’ can constitute a personal benefit to the insider. When, as here, the tipper gave the confidential information to a relative so that the relative could trade on it, the tipper received a personal benefit. Rule 10b-5’s ‘personal benefit’ requirement is satisfied when an insider knowingly discloses material non-public information to a relative who subsequently trades. In short, the rule in Dirks is that a tipper who discloses confidential information to a tippee for the purpose of which the tippee subsequently trades is receiving a benefit. A gift of information to a family member for his personal use, which is what the insider did here, is essentially same as a cash payment. The recipient uses it for the same purpose, and the gift of it achieves the same result as the cash gift.”

However, accidental disclosures are different. In United States v. Newman, the Court notes:

“The accident of disclosure is not the same as a ‘gift.’”

Under the Rule in Salman, tippers can face liability without personally executing a trade based on the information they disclosed. The Court notes:

“The tipper, too, may face liability even though he never executed a single securities transaction. ‘A tipper who discloses material nonpublic information may be liable for insider trading even if he does not trade himself.’”

The fact that the relative later violated the rule is not necessarily sufficient to trigger liability for the tipper:

“A tipper may also be liable without trading if he discloses information in breach of a fiduciary duty for a personal benefit. But, even if he did trade, the fact that the relative violated the insider trading law does not, of itself, give rise to tippee liability.”

Importantly, the Supreme Court’s ruling in Dirks affirmed the exoneration of Ray Dirks, but not from a criminal conviction:

The Supreme Court reversed the censure that the Securities and Exchange Commission had imposed on Ray Dirks. That case did not involve a criminal conviction, and the decision does not provide a general defense against civil tippee liability.

Can a Relative Be Liable Without Being a Tippee?

While classical insider trading cases typically involve corporate insiders’ fiduciary duties to the issuer’s shareholders, cases involving misappropriation liability instead focus on deception of the party that is the source of the material nonpublic information. While the misappropriation theory of insider trading was once the subject of debate, the U.S. Supreme Court approved the theory in United States v. O’Hagan (1997).

When a family member receives confidential information about a corporation from a corporate insider, liability for the family member can arise in one of two ways. The first is that the family member is found to be a “tippee” who violated the rules by trading on the insider’s breach of duty. The second is that the family member is found to be independently liable for “misappropriating” the information, i.e., betraying the confidential source of the information.

The analysis for downstream recipients is similar to that for the family member who received the information, although it requires a separate analysis of the downstream recipient’s knowledge, duties, and trading conduct. Proving insider trading liability in cases involving downstream recipients is famously difficult. This is because the chain of information transfer complicates the government’s need to prove knowledge, duty, and breach, as well as a personal benefit.

When defending against accusations of insider trading, family members, downstream recipients, and corporate insiders can often rely on the fact that the information they possess is either (i) immaterial, (ii) not nonpublic, or (iii) obtained in lawful manner. As the U.S. Supreme Court explained in Chiarella v. United States (1980), possessing nonpublic market information is not per se illegal:

“Neither . .. can we see that the . .. Exchange Act . .. contains any such provision. We cannot, therefore, find the authority in the . .. Exchange Act to impose liability in cases like this.”

Todd Spodek and the attorneys at Spodek Law Group handle federal cases of this kind from New York, Brooklyn, Queens and Los Angeles.

How Do Investigators Determine Who Placed the Family Trade?

If you are aware that the SEC is actively reviewing all trades in companies that are the target of mergers or acquisitions, you can infer that this is the SEC’s standard investigative approach. This approach is common in other investigations involving market-moving corporate announcements, as well. When the SEC identifies suspicious securities trading by a retail investor and a corporate insider who are related, the SEC will typically use all of the resources at its disposal to examine the investigation target’s records. If the SEC is unable to pinpoint which of the two individuals placed the order, the SEC may rely on circumstantial evidence of an insider’s intention to tip in exchange for a personal benefit.

• Securities Trading Records: The SEC may review trading records for suspicious activities, including a relative’s prior securities transactions.
• Trading Record of Corporate Insider: The SEC may review securities transaction records for the corporate insider as well.
• Email and Call Logs: The SEC will look to emails, call logs, and potentially other forms of communication that could suggest the family members discussed information about the corporation.
• Testimony and Interviews: The SEC may interview witnesses to establish whether and when the family member received confidential information.

Once the SEC has a general idea of the time frame and the participants in a suspected insider trading violation, it may review broker-dealer transaction records to identify who placed the trade. While the order to execute the securities transaction may have come from a joint account, this may or may not establish which of the account holders placed the order. The SEC may review records of individual brokerage accounts, as well as:

• Order tickets: Order tickets can show who placed an order (and whether they placed it over the phone, in person, or via the internet).
• Access logs: In cases where the broker accessed a client’s account, the broker’s access logs can also help establish who placed the order.
• Communications with broker: The SEC will also look for communications with the broker and other brokerage records that may help establish whether the corporate insider discussed the trade with the broker.

Once the SEC identifies who executed a family trade, the SEC will then attempt to establish whether the corporate insider obtained the material nonpublic information before it was traded. The SEC will review communications, securities transaction records, and other brokerage records to pinpoint the approximate time of disclosure.

Finally, it is imperative to remember that U.S.C. § 1519 makes it a federal crime to destroy or alter documents if “there is a reasonable anticipation of a federal investigation,” and this restriction applies specifically to “destruction, alteration, or falsification of records, documents, or tangible objects.”

Do Tender Offers Follow Different Insider Trading Rules?

While Rule 10b-5 and Section 10(b) apply to most securities transactions, Rule 14e-3 applies to tender offers. Along with being subject to different timing requirements, Rule 14e-3 contains a different substantive standard for liability. For example, unlike Rule 10b-5, Rule 14e-3 does not require a “personal benefit” showing under Dirks. Rule 14e-3 instead prohibits any purchase or sale of securities on the basis of nonpublic information concerning a tender offer that came from the offeror or the target company (or from someone acting on their behalf). This applies regardless of whether the person who obtained the information did so in breach of a duty of trust or confidence.

Under Rule 10b5-1, a person who is aware of material nonpublic information when trading is treated as having traded “on the basis of” that information, although liability still requires a breach of a duty of trust or confidence. This is similar to the standard under Rule 14e-3.

When Does Rule 14e-3 Apply to Tender Offers?

Rule 14e-3 applies “after substantial steps have been taken to commence a tender offer.” After this point, any purchase or sale of the target’s securities based on nonpublic information about the tender offer violates the rules, as long as the person who obtained the information is aware that the information came from (i) the offeror, (ii) the target company, or (iii) someone acting on the offeror’s or target company’s behalf.

Tipping and Tender Offers

When does Rule 14e-3 apply to the act of tipping? The SEC explains:

“Rule 14e-3(d) prohibits sharing material nonpublic information about a tender offer with another person if the person sharing the information ‘knows or recklessly disregards’ that the recipient will trade on the information. While this is a slightly different standard than the one in Rule 10b-5, it is a similar standard. Essentially, Rule 14e-3(d) prohibits sharing information with others if the trade is ‘reasonably foreseeable’ in the circumstances.”

Example of a Rule 14e-3 Violation

One notable case involving Rule 14e-3 is United States v. O’Hagan. In this case, O’Hagan earned approximately $4.3 million by purchasing Pillsbury securities and securities options based on nonpublic information that an unrelated corporation was planning to make a tender offer for Pillsbury. The fact that O’Hagan had a fiduciary duty to his firm (and not to Pillsbury) did not shield him from liability. The Supreme Court explained that O’Hagan owed a fiduciary duty to his firm, and that he had misappropriated confidential information from that firm.

Can a Rule 10b5-1 Plan Protect a Family Trade?

If you have an established Rule 10b5-1 plan that meets all of the requirements imposed by Rule 10b5-1, then the Rule 10b5-1 plan may potentially protect a securities transaction that was planned in advance. Rule 10b5-1 trading plans are affirmative defenses. In addition to having the potential to protect you from insider trading liability, this also means that you must meet all applicable regulatory conditions for Rule 10b5-1 to apply. These regulatory conditions include:

• The “cooling-off period” requirement: Under Rule 10b5-1, directors and Section 16 officers are subject to a cooling-off period running until the later of 90 days after adoption or two business days after the issuer discloses its financial results for the quarter in which the plan was adopted, capped at 120 days. Persons other than directors, officers, and the issuer are subject to a 30-day cooling-off period, and issuers themselves have no cooling-off period.
• The Rule 10b5-1 requirement against changing the trade’s amount, price, or timing: This requirement is similar to the rule requiring compliance with a cooling-off period. While changing the amount, price, or timing of a trade will not necessarily violate the insider trading rules, this could trigger a requirement to satisfy the applicable cooling-off period again.
• Rule 10b5-1’s good-faith requirement: The good-faith requirement under Rule 10b5-1 applies not only when establishing the plan, but throughout the duration of the plan.
• Rule 10b5-1’s prohibition against overlapping trading plans: Rule 10b5-1 generally prohibits overlapping open-market trading plans, subject to specified exceptions. Overlapping plans do not currently enjoy the protection of Rule 10b5-1.
• Rule 10b5-1’s requirement for officer-director trading plans to include certifications regarding material nonpublic information: Rule 10b5-1 requires that trading plans for officers and directors of publicly-traded companies include certifications of the plan-maker’s knowledge (or lack thereof) regarding material nonpublic information.
• The requirement to comply with other securities laws: Compliance with Rule 10b5-1 does not necessarily mean that the transaction is otherwise lawful. Specifically, the insider trading rules apply in conjunction with the “material nonpublic information” rules that apply specifically to the issuance, purchase, sale, or redemption of a company’s securities.
• No cooling-off period for issuer trading plans: Finally, Rule 10b5-1 imposes no cooling-off period for trading plans established by corporate issuers.

What Penalties and Proof Standards Apply in Insider Trading Cases Involving Family Members?

Proof Standards

Insider trading cases are investigated by both the Department of Justice (DOJ) and the Securities and Exchange Commission (SEC). If the DOJ decides to pursue criminal enforcement action, the prosecution must meet the “beyond a reasonable doubt” standard for proving insider trading violations. If the SEC decides to pursue civil enforcement action, the SEC must meet the “preponderance of the evidence” standard. While the preponderance-of-the-evidence standard is easier to meet than the beyond a reasonable doubt standard, it still requires that the evidence shows that the insider violated the rules more likely than not.

If the DOJ brings criminal charges, the investigation and prosecution will follow the federal criminal procedure outlined in the Federal Rules of Criminal Procedure. If the SEC brings civil charges, the investigation and prosecution will follow the federal civil procedure outlined in the Federal Rules of Civil Procedure.

Penalties

The penalties for insider trading liability under the Exchange Act include:

• Imprisonment: Under Section 32(a) of the Exchange Act, any individual who knowingly and willfully violates the Act can face imprisonment for up to 20 years.
• Fines: Under U.S.C. § 3571(d), any individual who willfully violates the securities laws can face a fine of up to twice the gross gain of the defendant or twice the gross loss to the victims.
• Civil penalties: Under Section 21A of the Exchange Act, any individual or entity who commits insider trading can face a civil penalty of up to three times the gross gain or the gross loss avoided as a result of the transaction.

Along with civil penalties, these penalties can also include disgorgement of the unlawful proceeds and civil fines up to approximately $200,000 for individuals and entities.

Scienter and Willfulness

The burden of proving intent is different for federal insider trading charges than it is for most other federal criminal charges. In order to prove a willful violation of the securities laws, the government must prove that the defendant acted with scienter. This is defined as “intent to deceive, manipulate or defraud.” Scienter is generally a subjective standard, and evidence of a defendant’s knowledge (or lack thereof) and the circumstances surrounding the defendant’s trading are generally considered relevant to determining whether the defendant had the requisite intent to violate the rules.

While criminal securities law violations require a showing of scienter, they also require a showing of willfulness. Willfulness in this context means that the defendant must have acted with a culpable state of mind and known that his conduct was wrongful. When the SEC brings a civil Rule 10b-5 case, the government must prove the defendant had scienter, but not necessarily criminal willfulness. Thus, criminal liability for insider trading generally requires a higher level of culpable intent than civil liability does.

Speak With a Federal Defense Lawyer

If you are dealing with any part of what this article describes, the next step is a conversation with a lawyer who handles these cases. Spodek Law Group is a second generation criminal defense firm practicing since 1976, representing clients nationwide from offices in New York, Brooklyn, Queens and Los Angeles. Call 212-300-5196 to speak with our team.