Alerts and Updates
Insider Trading: Its Perils and Penalties
November 1, 2006
Internal Controls Can Reduce a Company's Risk of Violations
A recent New York Times article highlighted the Securities & Exchange Commission's ("SEC") focus on potential insider trading violations by hedge funds. In March of this year, the publicly traded company Movie Gallery disclosed disastrous 2005 results during a confidential conference call with its lenders, most of which were hedge funds. In the following two days, Movie Gallery's shares plunged 25 percent in heavy trading.
A hedge fund typically trades in both equity and debt securities. Because lending agreements often require a company to disclose confidential financial information more frequently than the quarterly reports filed publicly, hedge funds trading in debt securities receive up-to-date financial information earlier than the public does. This information is confidential and cannot be used in the trade of securities. Since hedge funds are less regulated and smaller than traditional investment brokerage firms, the hedge fund employee trading in stocks and bonds may be sitting next to a person trading in debt who possesses the most up-to-date confidential financial information. In some cases, the person trading in stocks may be the same person trading in debt. The risk that confidential information may be misused in making securities trades multiplies.
Defining Insider Trading
While the challenges to preventing insider trading in the hedge fund industry may be unique to that industry, all companies that trade in securities, are publicly traded or provide professional services to publicly traded companies need to establish internal controls to avoid insider trading and its penalties. Insider trading is usually defined as the purchase or sale of securities, in violation of a fiduciary duty or other relationship of trust, while aware of material non-public information. One can also be guilty of insider trading by communicating the material non-public information to another for his or her trading benefit, also known as "tipping." Information is material if a reasonable investor would consider the information significant in determining whether to buy, hold or sell securities.
The penalties for insider trading can be severe. The SEC has the ability to enforce civil penalties and the Department of Justice has the ability to enforce criminal penalties. Civilly, a violator can be fined up to three times the profit gained or loss avoided. Criminally, an individual violator can be subject up to a $5 million fine and twenty years in prison for each violation, while a firm violator could face up to a $25 million fine. Employers may be additionally liable as "controlling persons" for violations by employees.
While directors and officers are certainly potential violators, employees, family members, friends and other business associates have also been prosecuted for insider trading. Insider status is not limited to corporate executives. Secretaries, mail room clerks and others at lower levels of the corporate hierarchy have access to inside information. They too are held responsible for maintaining the confidentially of their insider knowledge. Everyone having insider knowledge must understand the responsibility arising from that knowledge and the penalties to which that person can be subjected.
Internal Controls
Company awareness programs and rigorous corporate compliance must be used to minimize the risk of an insider trading violation. Such programs and policies are the best evidence of a corporation's good faith effort of compliance. More specifically, "controlling person" liability can be avoided where steps have been taken to prevent potential insider trading violations.
The internal controls that should be implemented will differ depending on the risk a company faces. Lawyers, accountants, brokers, investment bankers and other financial firms often require greater internal controls than other organizations. Directors, officers, managers or employees working on a specific project, such as a merger or acquisition, may need to follow additional policies than other employees. However, some general guidelines apply to all employees and all industries.
An effective insider trading policy must define insider trading and the severe penalties. The policy must prohibit both trading on non-public information and communicating that information to outsiders. Companies may want to impose blackout periods surrounding quarterly and annual reporting dates or require pre-clearance of trades. An individual should be designated to respond to employees' inquiries on potential trades. Some employers require their employees to sign a statement annually stating that they understand these policies and are complying with them.
Additionally, executives, officers, directors and 10-percent shareholders are subject to further requirements, such as regularly reporting their ownership of their company's securities to the SEC. Additional procedures and follow-up should be implemented to assure that these individuals submit reports timely and accurately and comply with the other requirements applicable to them.
For Further Information
For additional information on insider trading, the implementation of insider trading policy and corporate compliance, please contact one of the attorneys in our White-Collar Defense Group, one of the attorneys in our Corporate Practice Group, or the attorney in the firm with whom you regularly are in contact.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.
