What constitutes insider trading?

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A reader raised the following topic: Many government contractors are publicly traded corporations. Sometimes, rumors of impending contract awards to these companies circulate. What are the limitations on using this information in private investment decisions? What constitutes improper insider trading?

In general, Section 10(b) of the Exchange Act, 15 U.S.C.

: 78j(b), proscribes the use of any "deceptive device" in connection with the purchase or sale of securities in contravention of the rules prescribed by the Securities and Exchange Commission. The pertinent rule, known as Rule 10b-5, similarly prohibits any device, scheme, artifice, act, practice or course of business to defraud or to deceive in connection with the purchase or sale of any security.

Under the traditional view of insider trading, Rule 10b-5 is violated when a corporate insider trades in the securities of a corporation on the basis of material, nonpublic information. Trading on such information constitutes a "deceptive device" under the Exchange Act because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation." [Chiarella v. United States, 445 U.S. 222, 228 (1980).] This relationship implies a duty on the insider to either disclose information or refrain from trading on that information so that no unfair advantage is taken of the uninformed stockholders. [Id. at 228-29.]

This view of insider trading extends to all officers, directors and other permanent insiders of the corporation. It also applies to consultants, accountants, attorneys and others whose fiduciary relationship with the corporation may be temporary. [See Dirks v. SEC, 463 U.S. 646, 655 n.14 (1983).]

Furthermore, in United States v. O'Hagan, 117 S.Ct. 2199 (1997), the U.S. Supreme Court found that any person who misappropriates confidential information for use in a securities transaction violates Rule 10b-5, even when the person is not an "insider." The decision resolved a conflict among the courts of appeals on this issue. According to the court, persons who use confidential information in a securities trade deceive those who have entrusted them with access to the information even if they owe no duty of loyalty to the corporation or its shareholders.

In the O'Hagan case, attorney James O'Hagan traded in the securities of a corporate takeover target based on information obtained through his law firm's work for the potential purchase. O'Hagan was not an insider of the target company and owed no fiduciary duty to it; therefore, his activities were outside the traditional view of the insider trading rule. But his activities breached the duties of trust and confidence he owed to his law firm and to its client. This was enough to fall within the misappropriation theory of Rule 10b-5.

In United States v. Cusimano, 123 F.3d 83 (2d Cir. 1997), the court upheld a finding that Robert Flanagan and his co-defendants had violated the misappropriation theory of insider trading liability by trading in the stocks of Digital Microwave Corp., NCR Corp. and Teradata Corp. on the basis of information wrongfully obtained from AT&T, which was in the process of acquiring those companies. The information at issue was "stolen" from AT&T by Charles Brumfield, then vice president of labor relations at the company, who passed the information to his friend and subordinate, Thomas Alger. Alger gave the information to Flanagan, who arranged for others to purchase securities on behalf of Alger, Brumfield and himself.

In SEC v. Mayhew, 121 F.3d 44 (2d Cir. 1997), a similar result was reached, notwithstanding arguments that the corporate insider had only confirmed to a friend certain things about which the press already had been speculating.

Insider trading may be punished by criminal and civil penalties. In addition, those who engage in insider trading can be forced to give up their illegal profits and may be sued directly by persons who are harmed by their activities. Moreover, such activities also may fall within other sections of the Exchange Act, including the "disclose or refrain from trading" requirements of Section 14(e), and various more general statutory prohibitions.

For many years the federal procurement rules have included an express provision governing the announcement of contract award decisions. For example, Federal Acquisition Regulation 5.303 states that contracting officers shall make information on significant contract award decisions available to agency headquarters in sufficient time for a public announcement by 5 p.m. Eastern time on the day of the award. In practice, most announcements of large contract awards are made immediately after the stock markets close for the day. Also, most announcements are made on Fridays. These practices help ensure that the information is disseminated as widely as practicable before the next trading day, to minimize the chances that someone could make unfair use of the information.

Peckinpaugh is a member of the government contracts section of the law firm of Winston & Strawn, Washington, D.C.