Protect Yourself from Insider Trading Accusations
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UPDATED: Feb 21, 2016
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Although some federal courts have limited the reach of prosecutors who charge individuals with insider trading, anyone who profits from a stock sale or purchase that is based on confidential information may be at risk of prosecution. A recent example of that risk involves an attorney at a law firm who was convicted of insider trading after he based stock trades on confidential information concerning a client of the firm.
As a general rule, corporate insiders, including corporate officers and directors, can legally sell their stock in their own company. They may run afoul of the law, however, when they base stock trades on their knowledge of confidential information that is unavailable to the general public.
According to the Securities and Exchange Commission, insider trading means “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.” The SEC explains that insider trading laws may also be violated by giving a stock tip to someone else, or by acting in reliance on a tip, if the tip is based on confidential information.
The U.S. Court of Appeals for the Second Circuit narrowed the latter definition when it held that someone who receives confidential information is guilty of insider trading only if the recipient knew that it came from an insider who benefitted from its disclosure and, despite that knowledge, used the information while trading in securities. The Second Circuit’s definition of insider trading has been criticized by prosecutors as unduly limiting and lauded by others as reigning in prosecutorial overreaching.
Disagreeing with the Second Circuit, the Court of Appeals for the Ninth Circuit concluded that insider trading can occur when a recipient of confidential information knowingly trades on that information even if the person who provided the tip obtained no benefit from the disclosure. The Ninth Circuit discerned no difference between a tipster who benefits himself and a tipster who benefits a friend or relative. The United States Supreme Court recently agreed to resolve the conflicting interpretations of insider trading.
Lawyer Convicted of Insider Trading
Regardless of how the Supreme Court ultimately defines insider trading with regard to investors who receive tips, it is clear that a person who has a duty to keep corporate information confidential cannot use that information to make stock trades to his or her own benefit. Herbert Sudfeld worked as a real estate attorney with the firm of Fox Rothschild in Philadelphia. Fox Rothschild was handling the merger of two insurance companies, Nationwide and Harleysville, during 2011. Federal prosecutors charged Sudfeld with buying Harleysville stock when he knew that the merger was imminent. Sudfeld bought the stock one day before the merger was announced, then sold it the next day at a profit of $75,500.
Prosecutors based their case on Sudfeld’s access to confidential information about the merger. They argued that Sudfeld learned about the merger from a conversation between an attorney who was working on it and their shared legal assistant. Prosecutors also introduced evidence that Sudfeld browsed the firm’s intranet for information about the transaction. The firm itself was not accused of assisting Sudfeld or of knowing about his stock transactions.
Sudfeld’s attorney argued that the merger had been rumored for days and that the rumor had been reported in a Philadelphia newspaper. The jury evidently rejected those alternative sources of information upon which Sudfeld might have based his lucrative stock trade. After four hours of deliberations, the jury found Sudfeld guilty of insider trading.
The jury also found Sudfeld guilty of lying to the FBI during its investigation. Martha Stewart was famously convicted of that crime after the government decided that evidence of insider trading was too shaky to justify charging her with anything other than making false statements to government investigators.
Avoiding a Criminal Prosecution
Until the Supreme Court resolves the definition of insider trading as it applies to tips received from insiders, anyone who obtains a stock tip based on confidential information might be taking a serious risk by trading in that company’s stock. An insider who has a duty to keep information confidential and uses it to his or her own benefit always takes a huge risk. Prudence dictates that investors should wait until the information enters the public arena, when basing stock trades on that information becomes fair game.
To avoid being charged with making false statements to the government, the best plan is to make no statements at all. If an FBI agent or SEC investigator (or any other government employee) want to question you about potential wrongdoing, saying “I need to have my lawyer present before I answer any questions” is your best protection against an eventual criminal prosecution. Martha Stewart would probably have dodged a prison sentence if she had followed that advice.