Insider Trading- A Case Study
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include “tipping” such information, securities trading by the person “tipped,” and securities trading by those who misappropriate such information. Any and all persons that buy and sell stock may be subject to insider trading liability. This blog sets forth a particular hypothetical fact scenario and analyzes the associated insider trading implications.
Hypothetical Fact Pattern: Company X (the “Company”) sells shares to a group of 35 unaffiliated shareholders pursuant to an effective S-1 registration statement. These same 35 unaffiliated shareholders (the “Sellers”) sell their registered stock to a group of 35 unaffiliated purchasers (the Buyers”) in a private transaction (the “Transaction”). At or near the same time as the Transaction, the control block consisting of restricted shares of common stock is sold to a different purchaser (“Control Block Purchaser”) in a private transaction (collectively, the “Transactions”). The Transactions result in a complete change of control and shareholder base in the Company. The Buyers are known by the Control Block Purchaser and are introduced to the Transactions by the Control Block Purchaser. The Buyers and the Control Block Purchaser are aware of nonpublic information at the time of the Transactions. In particular, after the Transactions are completed, there will be either a reverse merger transaction with a previously identified operating business, or a complete change in direction of the Company’s current business. In addition, the Buyers are aware that a change of control transaction will occur contemporaneously with their Transaction. After the Transactions are complete, a reverse merger and/or complete change in direction of the Company’s business occurs, most likely resulting in an increase in value of the common stock of the Company.
Analysis and discussion:
Insider trading is prohibited by the general anti-fraud provisions and in particular Section 10(b) of the Securities Exchange Act of 1934, as amended and Rule 10b-5 thereunder. There are three main theories on which insider trading is based: (i) the classical theory; (ii) misappropriation theory; and (iii) tipper/tippee theory.
Section 10(b) of the Exchange Act makes it unlawful for any person to, directly or indirectly, “use or employ, in connection with the purchase or sale of any security… any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” Rule 10b-5, promulgated under Section 10(b), provides that “[I]t shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (a) To employ any device, scheme, or artifice to defraud, (b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or (c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.”
The elements of a Section 10(b) and Rule 10b-5 claim include:
(i) Misrepresentation or Omission of a Material Fact – the key point here being “material.” A fact is material if, in light of the totality of information, it is substantially likely it would impact a reasonable person’s investment decision. The test is based on a reasonable person’s perspective, not necessarily the investor making the claim.
(ii) Scienter/State of Mind – Rule 10b-5 requires that the defendant be aware of the fraud. Awareness can be established either by actual awareness (defendant states that they have 5 contracts when there are only 3) or by showing that the defendant should have been aware with reasonable inquiry and diligence (defendant knew that the Control Block Purchaser owned and operated a separate business that he intended to bring public, but never asked if he was purchasing this particular control block for that purpose).
(iii) Reliance – An investment decision must have been made in reliance on the misinformation or lack of information. In other words, there must be a link between the alleged fraud and the investment decision. It is presumed, when material information is withheld, that there is reliance. The presumption of reliance can be rebutted by showing that the claimant’s decision to purchase or sell shares was not influenced by the alleged fraud, or that the alleged fraud did not alter or change the stock price.
(iv) Causation – the plaintiff in a 10b-5 claim must show that the fraud caused damages. Damages are a calculation of the monetary loss of the claimant or monetary gain by the defendant, and such damages must be linked to the fraud.
(v) Damages – in addition to linking the damages to the fraud, actual damages must exist.
Rule description: Under the classical theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer. The “on the basis of” standard is met if the purchaser or seller is aware of the material nonpublic information at the time of the purchase or sale. Materiality is generally measured by whether there is a substantial likelihood that the material nonpublic information would have been viewed by a reasonable investor as having significantly altered the total mix of information currently available and influenced the investment decision. When forward-looking information is involved, including a potential reverse merger and/or future change in the direction of the Company’s business, a secondary layer of materiality is triggered, which is termed the probability-magnitude test. Under the probability-magnitude test, you must also weigh the likelihood that the future event will occur and the magnitude of the effect of the future event on the Company.
Nonpublic information is any information that is not generally disseminated to the investing public. A duty of trust or confidence arises when the person is a “corporate insider” or a “temporary insider.” A corporate insider is generally an officer, director, or employee of the Company. A temporary insider relationship arises when a special confidential relationship is established between the person and the Company in the conduct of business, and that person is given access to material nonpublic information solely for corporate purposes. A temporary insider is generally an accountant, attorney, underwriter, consultant, and directors or executives of another company that are engaged in merger talks with the Company. It is important to note that the insider trading rules under the classical theory require an insider to disclose or abstain from trading. This means that the insider must abstain from trading or disclose (disseminate) to the Company and the Company’s shareholders that the insider intends to trade on the material non-public information, and describe the information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the Company and the Company’s shareholders. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.
Analysis: Under the classical theory, the Buyers would not be considered a corporate or temporary insider, since they are not affiliated with the Company at all and a special confidential relationship has not been created between any of the Buyers and the Company. Thus, even if every other element was met, an insider trading case under the classical theory would not be brought against Buyers. Under the classical theory, the previously unaffiliated Control Block Purchaser would not be considered a corporate insider until after the purchase of the control block. However, the Control Block Purchaser could be deemed a temporary insider of the Company if the Control Block Purchaser was an officer or director of the target company that was engaged in reverse merger talks with the Company before the purchase of the control block. If it could be shown that the Control Block Purchaser was a temporary insider of the Company, then there could be liability under the classical theory unless the Control Block Purchaser disclosed their intention to trade on the information. However, in our fact scenario, the Control Block Purchaser purchases restricted stock that is not eligible to trade. In the event that the same Control Block Purchaser bought or sold stock in open market transactions, such Control Block Purchaser would be subject to insider trading liability under the classical theory.
Rule Description: Under the misappropriation theory, insider trading arises when there is a (1) purchase or sale of a security of an issuer, (2) on the basis of material nonpublic information about that security or issuer, (3) in breach of a duty of trust or confidence that is owed to any other person who is the source of the material nonpublic information. The previous description of “on the basis of,” materiality, and nonpublic information apply under the misappropriation theory as well. Under Rule 10b5-2(b), a duty of trust or confidence owed to the source of the information generally arises when (a) a recipient agrees with the source to maintain the information in confidence (and it is implied that the person will not trade), (b) the recipient and the source have a history, pattern, or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the source expects the recipient will maintain confidentiality, or (c) when the recipient is a close family member (spouse, parents, children, siblings) of the source. It is important to note that the insider trading rules under the misappropriation theory require the recipient to disclose or abstain from trading. This means that the recipient must abstain from trading or disclose to the source that the recipient intends to trade on the material non-public information. When such disclosure is made, the action is no longer considered deceptive under Section 10(b) and Rule 10b-5. In addition to the above elements, the remaining elements of 10(b) and/or 10b-5 must be established by the SEC and/or a private plaintiff as well. For example, it must be shown that the person acted with scienter, which means that the person knew or was reckless in not knowing that they were breaching their duty to the source. Factors showing scienter include manner of transmission of the information, personal benefit, and intent to deceive.
Analysis: Let us assume that before the Transaction, the Control Block Purchaser gave the Buyers information regarding an upcoming reverse merger and/or complete change in direction of the Company’s business, which we will also assume is material and non-public information. Under the misappropriation theory, the Buyers may have a duty of trust or confidence that is owed to the Control Block Purchaser. However, it is highly unlikely that the Buyers would have agreed to maintain the information in confidence or that the Buyers and the Control Block Purchaser had a history, pattern, or practice of sharing confidences and confidentiality was expected. However, the Control Block Purchaser was most likely informed by the Buyers that the Buyers intended to purchase the Company’s shares based on the material nonpublic information, which would eliminate any deception. The Buyers, however, would need to refrain from re-selling the shares while in possession of the material non-public information, as any subsequent purchaser could claim a deceit. As long as the Buyers refrained from any public trading in the shares while in possession of the material non-public information, an insider trading case under the misappropriation theory would most likely fail.
The Control Block Purchaser would also have exposure for insider trading liability under this theory. If the Control Block Purchaser knew of the merger talks (confidence with the target company) and engaged in public trading of the stock, the Control Block Purchaser would have violated its duty of confidence to such target company.
Tipper / Tippee Theory
Rule Description: This theory is utilized when a tipper gives material nonpublic information to a tippee (recipient) in breach of a duty of trust or confidence that is owed by the tipper. Under the tipper/tippee theory, the tippee assumes the duty to disclose their intent to trade on material nonpublic information to the Company, and/or the Company’s shareholders, and/or the original source of the information, which is derivative of the duty of a corporate insider, temporary insider, or a person who owes a duty to the original source of the information as detailed in Rule 10b5-2(b) under the misappropriation theory. It must be established that the tipper breached a duty of trust or confidence when the tipper disclosed the material nonpublic information to the tippee. Generally, that breach is established when the tipper directly or indirectly benefited personally from the disclosure of the nonpublic material information to the tippee (the tipper received money or reputational benefit, or if the tipper disclosed the information to repay a debt to a relative or friend). It also must be established that the tippee knew or should have known (reckless in not knowing) that the tipper had breached their duty. Furthermore, the other elements of Section 10(b) and/or Rule 10b-5 must be established as well.
Analysis: In this case, the Control Block Purchaser may be a tipper if the Control Block Purchaser buys the control block before the Transaction, and is deemed to be a corporate or temporary insider of the Company or to have a duty of trust or confidence with the potential reverse merger candidate. It would have to be established that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders by disclosing material nonpublic information (reverse merger and/or complete change in direction of the Company’s business) about the Company to the Buyers. In the alternative, it would have to be established that the Control Block Purchaser breached their duty of trust or confidence to the potential reverse merger candidate, by disclosing material nonpublic information about the upcoming reverse merger. Some personal benefit that the Control Block Purchaser received by disclosing the material nonpublic information would have to be established. The Buyers could be considered tippees, and it could be alleged that the Buyers knew or should have known that the Control Block Purchaser breached their duty to the Company and/or the Company’s shareholders.
The most common defenses to an insider trading claim are that the information is not material, the information is already publicly known or disseminated among the investing public, and/or that there is no intent to deceive because the requisite public disclosure was made before trading.
In a situation where the Control Block Purchaser obtains the control block in the Company before the Buyers purchase their shares, it is recommended that disclosure be made, such as the filing of a Form 8-K, which discloses the anticipated reverse merger and/or complete change in direction of the Company’s business. This would make the information publicly known, and generally eliminate any exposure for insider trading.
As a safe harbor from insider trading liability, Rule 10b5-1 provides that a purchase or sale of securities will not be deemed to be on the basis of material nonpublic information if it is pursuant to a contract, instruction or plan that (i) was entered into before the person became aware of the information; (ii) specifies the amounts, prices, and dates for transactions under the plan (or includes a formula for determining them); and (iii) does not later allow the person to influence how, when or whether transactions will occur.
Both the Control Block Purchaser and the Buyers have exposure for insider trading liability, and each should be aware and cautioned not to publicly trade in the stock of the Company until such information is made public. However, as long as all parties are aware of the material non-public information, there is likely no cause for insider trading from the Transactions themselves.
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