Corporate Insiders: When Can You Legally Trade??

While corporate insiders are prohibited from trading on nonpublic material information (MNPI), they are generally permitted to own and trade their company’s securities. Lawful insider trades remain subject to applicable disclosure requirements and the provisions of the insiders’ company policy, however. So, just because a corporate insider trades during an “open trading window” does not necessarily mean their trade is lawful.

When the SEC alleges that an insider trade was illegal, the SEC generally must show a corresponding violation of a duty of confidentiality. This means that in order for the insider’s trade (or failure to trade) to be illegal, the insider must have allegedly traded (or failed to trade) in order to reap a profit from the secret use of nonpublic material information.

Any form of “security” can support allegations of insider trading. Along with company stocks, securities used to facilitate insider trading allegations include bonds, convertible debentures, preferred stock, warrants, options, and all other forms of securities.

Section 10(b) of the Securities Exchange Act of 1934 is the law that generally prohibits “the use of any manipulative or deceptive device” in connection with the purchase or sale of securities. The SEC adopted its Rule 10b-5 in 1942 to give broader definition to the prohibitions contained in Section 10(b) of the Exchange Act.

Corporate insiders, board members, directors, consultants, attorneys, accountants, and others breach their duties when they secretly exploit nonpublic shareholder information to make undisclosed private profit. Their alleged duty to uphold the integrity of the American securities market is what makes their actions illegal.

At Spodek Law Group, we have handled insider trading cases against the SEC, DOJ, and other agencies on a nationwide basis. We can defend individuals and corporate entities that are accused of insider trading, and we can defend others who are accused of illegally “tipping” (or receiving) nonpublic material information about the securities market.

How can I tell whether I may trade today?

Possessing Confidential Information is Not Enough to Establish Insider-Trading Liability

Possessing confidential information about your company (or another company) does not, on its own, necessarily establish grounds for insider-trading liability. For an insider trade (or failure to trade) to be illegal, the information in the insider’s possession must be both material and nonpublic. The securities law definition of materiality is information that a reasonable investor would consider significant, or information that would matter, when making an informed decision about whether to buy or sell a particular security. Information is considered nonpublic when it is not yet widely available to the general investing public through a broad dissemination of the information to investors.

Corporate Trading Policies and Preclearance

Corporate insiders must ensure that their trades are consistent with their companies’ corporate trading policies in order to avoid liability for violating those policies as well as federal securities laws. Federal securities laws generally do not require the adoption of corporate trading policies, but, where applicable, corporate trading policies may impose restrictions that are more stringent than federal insider-trading law.

Additionally, although company preclearance procedures have been implemented by some companies, preclearance does not create a federal insider-trading safe harbor. Preclearing an insider trade helps ensure compliance with the applicable corporate trading policy, but the preclearing insider can still face scrutiny for exploiting confidential information.

Waiting After Public Disclosure

Although MNPI must be public information before it can be used to trade, there is no universal waiting period after disclosure, and an insider cannot assume that disclosure through any specific medium is sufficient for trading purposes. The timing of disclosure is an issue of considerable uncertainty. While investors must be given a reasonable opportunity to absorb the newly disclosed information, there is no time-bound standard that clearly dictates when this requirement is satisfied, and insiders may be subject to scrutiny for trading too soon after disclosure.

Examples of Material Information

The types of information that can trigger insider-trading liability are virtually endless. Examples of potentially material information include (but are not limited to):

• Earnings reports (actual, estimated, and projected)
• Pending mergers and acquisitions
• Contract awards or terminations
• Product developments or releases
• Leadership changes
• Ongoing or pending litigation
• Changes in the corporate structure
• Government investigations
• Strategic initiatives
• Financial adjustments
• Market share changes
• Share buybacks
• Dividend announcements
• Stock splits
• Environmental or safety audits
• Intellectual property matters
• Regulatory approval developments
• Major client losses or gains
• Changes in analyst recommendations
• Cybersecurity breaches or vulnerabilities
• Labor disputes or union negotiations
• Changes in accounting methods
• Lease terminations or expansions
• Pending loan or credit applications
• Significant corporate assets purchases or sales
• Executive compensation adjustments
• New product specifications or feature updates
• Pending patent approvals or rejections
• Updates to insider trading policies or trading windows
• Changes in relationship with a major supplier or distributor

What should I do after accidentally receiving confidential information?

Misappropriation Liability

Misappropriation liability is a concept that applies to third parties who trade based on misappropriated MNPI. In traditional insider-trading cases, the insider trades in the securities of the company with which they have a fiduciary relationship. With misappropriation liability, the trades may involve the securities of a completely different company. The focus of these cases is not on the securities that were traded, but rather on the duty the trading individual owed to the source of the information.

While most misappropriation cases involve trading in the securities of the company whose MNPI was misappropriated, this is not always the case. In SEC v. Panuwat, the SEC asserted that misappropriation liability extends to “shadow trading”, using misappropriated MNPI about one company to trade in the securities of a related company. The court endorsed this application of the misappropriation theory, though it remains a subject of significant legal debate.

Reporting, Recusal, and Other Internal Corporate Procedures

If you have accidentally received confidential information, you must first determine what your company’s internal policies and procedures require you to do. Federal securities laws do not impose a universal internal procedure for handling accidentally received MNPI, but some corporate insiders’ companies will require employees to report any MNPI that comes to light and recuse themselves from participating in business decisions that involve the information.

Overhearing, Finding, and Other Methods of Receiving MNPI

The securities law prohibits use of MNPI regardless of how the information was obtained. This means that trade based on information that is overheard or accidentally discovered can be unlawful if deception or the violation of a duty of confidentiality is at play. As a result, lawyers, accountants, consultants, and others can face misappropriation liability when they are accused of trading on information that they acquired by virtue of a confidential relationship. Hackers who steal MNPI from company servers and then trade on that MNPI can face charges for securities fraud under the misappropriation theory as well.

What makes a Rule 10b5-1 trading plan valid?

Rule 10b5-1 Plan Protection Is Not Blanket Immunity

It is important to remember that Rule 10b5-1 protection is affirmative in nature. While it can be a complete defense to insider-trading liability, this is only true if the Rule 10b5-1 plan qualifies as a valid affirmative defense. If it is not, then the insider can still be held liable for insider trading (and potentially other violations) and any other relevant protections may apply.

Rule 10b5-1 Plan Requirements for Corporate Insiders and Others

To qualify for affirmative defense protection, Rule 10b5-1 plans must satisfy a variety of substantive and procedural requirements. These requirements were greatly strengthened in 2022. The main ones are discussed below:

Adoption Without MNPI

The insider’s trading plan must be adopted while the insider is not in possession of MNPI. Any insider who adopts an invalid Rule 10b5-1 plan can face substantial financial liability if a securities enforcement agency targets them for an insider-trading investigation.

Continued Good-Faith Operation

Rule 10b5-1 protection is also contingent on the insider’s continued good-faith operation of the plan. Any evidence that an insider improperly influenced the plan’s operation (or the results of the plan’s operation) can disqualify the insider from affirmative defense protection.

Rule 10b5-1 Cooling-Off Period

In 2022, the SEC adopted a new Rule 10b5-1 cooling-off period. This means that insiders cannot immediately execute a trade upon adopting a Rule 10b5-1 trading plan; instead, the adoption of the trading plan must be followed by a mandatory “cooling-off period.” For directors and Section 16 officers of publicly traded companies, the Rule 10b5-1 cooling-off period runs until the later of 90 days after the plan’s adoption or two business days after the issuer discloses its financial results for the fiscal quarter in which the plan was adopted, subject to a 120-day cap.

While others can also use Rule 10b5-1 plans, they are generally subject to a 30-day cooling-off period instead. The SEC created this Rule 10b5-1 cooling-off period to allow more time for MNPI to be disclosed before the insider can trade on the basis of the nonpublic information.

Attestation of Compliance

For directors and Section 16 officers of publicly traded companies, Rule 10b5-1 plans also must include an attestation of compliance. Directors and Section 16 officers must sign the Rule 10b5-1 plan and certify that they are adopting the plan in good faith and without the possession of any MNPI. Insiders who certify false attestations of compliance can face criminal charges for making false statements in their certification.

Spodek Law Group, led by managing partner Todd Spodek, defends clients in federal criminal and white collar matters.

What can invalidate a Rule 10b5-1 plan after adoption?

Overlapping Trading Plans

Under Rule 10b5-1, corporate insiders and others are generally prohibited from maintaining simultaneous overlapping open-market trading plans. However, Rule 10b5-1 generally permits an insider or other trader to use a single-trade plan during any 12-month period. While Rule 10b5-1 generally prohibits multiple overlapping open-market trading plans, a limited exception allows for overlapping plans that are used for “qualifying sell-to-cover tax transactions,” as defined by Rule 10b5-1.

Trading on Form 4 or Form 5

While Rules 16a-1(a)(4) and 16a-1(a)(7) of the Exchange Act govern disclosures on Form 4 and Form 5, these rules specifically identify Form 4 and Form 5 transactions that are intended to qualify for affirmative defense protection under Rule 10b5-1.

Material Changes to a Rule 10b5-1 Trading Plan

While a Rule 10b5-1 plan is intended to be a good-faith commitment to execute certain trades without the insider’s day-to-day influence or involvement, Rule 10b5-1 also allows for plan modification in certain circumstances. However, as discussed below, modifications can lead to issues with Rule 10b5-1’s requirements and affirmative defense protections.

Specifically, material modifications to a Rule 10b5-1 plan (e.g., material changes to the planned trade amount, price, or timing) will trigger a new requirement to satisfy Rule 10b5-1’s substantive and procedural requirements. This means that the modified Rule 10b5-1 plan must meet the Rule 10b5-1 cooling-off period and other Rule 10b5-1 requirements before the modified plan becomes effective.

Trades Outside of a Rule 10b5-1 Plan

Trades that are made outside of a Rule 10b5-1 plan cannot claim the plan’s affirmative defense protection. While the Rule 10b5-1 plan may help establish the insider’s intent to trade in good faith (and may satisfy a corporate trading policy), the trades in question must themselves qualify for Rule 10b5-1 protection.

Post-Adoption Influence Over Trade Execution

Trading plan protection is contingent on the plan’s good-faith operation following its adoption. If the insider improperly influences the plan’s operation or the results of the plan’s execution (e.g. by changing the value of the company’s shares so a trade executes when it does), this can disqualify the insider’s trade from Rule 10b5-1 protection.

Voluntary Termination of a Rule 10b5-1 Trading Plan

Voluntarily terminating a Rule 10b5-1 trading plan may raise questions regarding whether the insider’s subsequent conduct is in good faith. If, however, a Rule 10b5-1 trading plan was properly adopted, the insider’s voluntary termination of that plan does not necessarily defeat the insider’s affirmative defense protection for any trades executed under the plan before its termination.

What must Section 16 insiders report after trading?

Form 4 Reporting Requirements

For the majority of corporate insiders that fall under Section 16 of the Exchange Act, trades must be disclosed to the SEC via Form 4. Generally, the transaction must be reported to the SEC within two business days of the trade’s execution. As with other types of insider trading, disclosures must generally be filed through the SEC’s electronically filing system. Section 16 of the Exchange Act generally applies to directors and officers (known as “insiders” in Section 16 disclosures), as well as companies and individuals that own more than 10 percent of the issuer’s beneficial stock.

Section 16(b) Short-Swing Profits Liability

Along with Section 16’s reporting requirements, the securities laws establish liability for Section 16 “insiders” who realize matched purchase-and-sale profits during a six-month period. This is referred to as Section 16(b) short-swing profits liability. Generally, Section 16(b) liability does not require MNPI or any evidence of wrongful intent. Shareholders of publicly traded companies can enforce Section 16(b) on behalf of the company, and this means that shareholders can seek to recover short-swing profits from corporate insiders and other insiders directly through private civil litigation.

Rule 10b5-1 Plan Compliance and Section 16 Reporting Obligations

Rule 10b5-1 compliance does not eliminate an insider’s Section 16 reporting obligation, nor does it eliminate the risk of Section 16(b) short-swing profits liability. It can potentially eliminate insider-trading liability under Rule 10b5-1’s affirmative defense provision.

Bona Fide Gifts by Section 16 Insiders

Although corporate insiders may not always receive a financial benefit from making a bona fide gift of their company’s securities, bona fide gifts are still transactions subject to reporting under Section 16. With this in mind, corporate insiders must typically file Form 4 disclosures with the SEC when making a gift of their company’s securities.

Option Exercises by Section 16 Insiders

As with bonus or award stocks, option exercises by corporate insiders also trigger Form 4 disclosures under Section 16 of the Exchange Act. Corporate insiders must typically file disclosures with the SEC within two business days of executing an option or receiving bonus stocks or award stocks.

Exception for Qualifying Issuer-to-Insider Equity Awards

Rule 16b-3 provides an exception to Section 16(b) short-swing profits liability when a public company grants equity award securities to its directors or officers. For an equity award to qualify for the Rule 16b-3 exemption, it must be approved in advance by the issuer’s board of directors, by a committee of two or more non-employee directors, or by the issuer’s shareholders, or the insider must hold the securities acquired for six months following the grant. Along with these two requirements, the equity award must be granted under a valid plan that was adopted without insider influence (unless the voting shareholders of the company otherwise approved the grant or modification).

How do SEC and DOJ insider-trading cases differ?

SEC Investigations

The SEC will typically examine brokerage records, communications, and the relationships between suspected parties to uncover evidence in insider-trading cases. The SEC may also examine the timing of trades, media reports, and other sources of material information to identify potential violations of Rule 10b-5.

SEC’s Enforcement Capabilities

The SEC will typically pursue civil and administrative enforcement actions against suspected insider traders. This means that the SEC will seek to impose civil penalties and to recover the profits gained or losses avoided through an allegedly illegal insider trade. The SEC does not prosecute criminal insider-trading cases. Those cases are prosecuted by the Justice Department.

DOJ Prosecutions

The Justice Department (or DOJ) investigates and prosecutes criminal insider-trading cases in federal court. These cases may involve either civil and criminal charges or criminal charges alone.

SEC and DOJ Insider-Trading Proceedings

The SEC and DOJ can both initiate proceedings against an insider suspected of insider trading. These proceedings can run concurrently, meaning that an insider who faces an SEC enforcement action or investigation can simultaneously face an insider-trading investigation or criminal charges from the DOJ.

Section 10(b) and Rule 10b-5 Insider-Trading Liability

The SEC must generally prove scienter in order to prevail in an insider-trading case involving allegations of a Rule 10b-5 violation. Scienter is generally defined as “a mental state embracing intent to deceive, manipulate, or defraud,” but an insider who acts with a reckless disregard for the truth can be found liable as well. Negligence alone is not enough to establish Rule 10b-5 liability, though.

Insider-Trading Liability under 15 U.S.C. § 78ff

Under 15 U.S.C. § 78ff, the DOJ pursues criminal charges based on allegations of insider trading. Along with pleading insider trading under the Exchange Act, Rule 10b-5, or Rule 10b5-1, the DOJ’s charges must satisfy Section 78ff’s requirement that the alleged suspect acted with “willfulness.” The Supreme Court has held that evidence of willfulness is not required to establish Rule 10b-5 liability, but it is required for criminal liability under the Exchange Act.

Insider-Trading Charges Under 18 U.S.C. § 1348

The DOJ’s criminal insider-trading charges under 18 U.S.C. § 1348 do not depend on proving a Rule 10b-5 violation. Instead, in order to seek criminal penalties under Section 1348, the DOJ needs to prove that the accused insider “knowingly executed” or “knowingly attempted to execute” a fraudulent scheme to “obtain, by means of false or fraudulent pretenses, representations, or promises, any securities.”

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.