Prevention of Insider Trading Through Disclosure

1. Prevention of Insider Trading Through Disclosure Insider Trading (IT) Theory Classifying IT IT Prevention under Reg.FD

2. What is a “Security?” • Jurisdictional Boundary of Securities Law • S.E.C. v. Howey “Investment Contract” • Producing citrus land sale w/ cultivation (K) • Investment of Money • Common Enterprise • Expectation of Profits • Derived from Efforts of Others • Court Interpretations: • Ltd. (P); some franchises; variable annuities, universal life

3. “Disclose or Abstain” Rule • Dilemma for Insiders & Fiduciaries • Usually a Hobson's choice • Disclose Inside Info to Avoid Liability • Disclosure may breach fiduciary duty to maintain confidentiality • FD requires certain disclosures • Abstain from Trading to Avoid Liability • Abstention also avoids confidentiality breach

4. IT as a Form of Fraud • Misrepresentation • Commissions • Omissions • Half-Truths • Material Fact • Justifiable Reliance • Damages

5. SEC Rule 10b5 It shall be unlawful for any person, directly or directly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of a national securities exchange, • to employ any device, scheme, or artifice to defraud, • 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 • 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.

6. Recurring IT ?’s: Who? What? When? Where? Why? How? • Who is an Insider? • What is Inside Information? • Acquisition, Permitted Uses, Transfer, Who Captures its Benefits? • When: Is the Insider’s Trading Restricted when in Possesion of Insider Information? • Where: Jurisdiction, Trading? • Why: Duties owed by whom? To whom? Derived from what source? • How are Insider Trading Rules Reconciled with Practice & Incentives?

7. Who is an “Insider?” • Common IT misconceptions: • Only issuer's employees trading restricted • Confidential, non-public information comes only from within issuer who's shares traded • In re Cady Roberts: 1. Relationship gives access to information, 2. Intended only for a corporate purpose, & 3. Unfairly used for the insider's personal benefit. • Emp’es at Any Level w/ Access to Confidential, Non-Public Info • Outsiders & during takeover activities

8. Arguments for Prohibiting IT • Breaches Fiduciary Duty • Undermines Investor Confidence • Cannot Overcome Insider’s Informational Advantage w/ Skill or Diligence • Unfairness • Its Illegal under SecReg, Fiduciary Law

9. Arguments against Prohibiting IT • IT Permits reduced Official Compensation • Victimless Crime • Entrepreneurial Mgrs need IT Incentive • Investors Trade Only on Fundamentals • Irrelevant to pre-determined trading decision • Enforcement is Too Costly for Ltd. Societal Benefits • Should be Left to Private Contracting • Most firms have chosen not to restrict IT • IT Externality Ltd to Firm Traded, not Mkt. • Insiders Greater Right to Info. • They personally produced info. • IT Enhances Mkt Efficiency thru Signaling

10. Reconciling the IT Controversy • Victimless Crime Argument • Unlikely premise investors mere "price-takers" • Limited Externality Argument • Presumes no IT affect on other prices or integrity of mkt. • Private Contracting Argument • Presumes no work rules prohibit IT • Most firms now prohibit IT & misappropriation of information, IP & other intangible assets

11. Reconciling the IT Controversy • Emolument Theory Presumes: • Empe’s have personal rights to corp. info • Only productive entrepreneurs will trade on inside info. • No info manipulation likely • Optimal Imbedding Inside Info into Price? • Inferred indirectly from trading patterns, volume & price • Flow directly thru disclosure to all

12. Insider Trading Theories • Traditional Theory • Tipping Theory • Temporary Insiders • Misappropriation Theory • Tender Offer IT

13. Insider Trading: Traditional Theory ISSUER INSIDER SHARE- HOLDER stock sold money paid

14. SEC v. Texas Gulf Sulphur Facts: TGS substantial mineral discovery kept confidential to acquire surrounding mineral leases more cheaply. TGS falsely denied rumors, numerous TGS employees purchased TGS stock before public disclosure. Issue: Is it securities fraud to misrepresent corporate events while insiders are trading? YES Rationale: TGS owed no disclosure duty to surrounding landowners, but TGS employees' fiduciary duty required voluntary disclosure before trading stock. False denial of rumors also violated Rule 10b-5 as disclosure fraud.

15. Insider Trading: Tipping ISSUER INSIDER TIPPEE SHARE- HOLDER money paid stock sold

16. Tipping Inside Information • Tipping-Confidential Nonpublic info tip made to tippee • Tippee Knows or Has Reason to Know Insider’s Tip Breached Fiduciary Duty • Tip has Improper Purpose: • EX: tipper expects personal benefit, payment, return favor, private personal relationship

17. Insider Trading: Temporary Insider ISSUER CONSULTANT SHARE HOLDER INSIDER stock sold money paid

18. Temporary Insiders • Temporary Insiders: Disclose or Abstain • Exposed to confidences while consulting for issuer or takeover bidder • Dirks14 Legit Info Tsfr in Outsourcing: • Underwriter, accountant, lawyer, consultant • Such outsiders have fiduciary duty due to: • special confidential relationship • giving access to secret info • intended solely for corporate purposes

19. Temporary Insiders • Temp Insiders are Tippers, Not Tippees • Duty Arises if: • Corp expects outsider to keep disclosed non-public information confidential & relationship implies confidentiality • Consultant Emp’es Owe Fiduciary Duty Directly to Their Own Emp’r • Emp’r Expressly/Impliedly Pledges Con-fidentiality in Consulting Engagement

20. Misappropriation Theory of Insider Trading ISSUER BIDDER CONSULTANT SHARE HOLDER INSIDER stock sold money paid

21. Misappropriation Theory Misappropriation Elements: i. Confidential source of info ii. Source has superior rights over info iii.Source has intent to keep information confidential iv.Source makes confidentiality efforts

22. Misappropriation Examples • Financial Printer • Financial Analyst @ Investment Bank • Law Firm Emp’e • Financial Journalist/Emp’e • Takeover Bidder Emp’e/Consultant • Judge’s Clerk/Regulatory Emp’e • Physician’s Confidant • Reports: Weather (NOAA), Crop (USDA)

23. U.S. v. O’Hagan (’97) Facts: O’Hagan was non-participating law partner whose firm represented Grand Met in takeover attempt of Pillsbury. Before any public announcement, O’Hagan learned of the plan & purchased Pillsbury options & stock. Issue: Is O’Hagan guilty of IT & criminal misappropriation under 10b-5, mail fraud, 14e-3 (also money laundering)? YES Rationale: • Rule 10b-5 permits both traditional-classical theory & misappropriation theory IT actions.

24. U.S. v. O’Hagan Rationale • Deception occurs with non-disclosure of the outsider-misappropriator’s personal purpose: to trade securities in another firm using info from a confidential source, even if no fiduciary or client relationship exists between empr & co. traded. • Deception damages empr’s reputation; outsider trading undermines investor confidence in mkt’s fairness; “in connection with” requirement satisfied by outsider’s deceptive personal misuse of empr’s confidences by capitalizing in securities transactions.

25. Tender Offer Insider Trading ISSUER BIDDER SHARE HOLDER INSIDER stock sold money paid

26. Insider Trading Prevention & Detection • SEC Regulation FD • Chinese Walls • Social Network Analysis • Stock Prices Change Abruptly Just Before Major Events • Whistleblowers • CyberForensics of Electronically Stored Information (ESI)

27. SEC Rule FD “Fair Disclosure” • Basic general Rule FD: “ . . . When an issuer, or person acting on its behalf, [makes selective disclosure of] material nonpublic info to . . . It must make public disclosure of that info [contemporaneously-if the disclosure was intentional or w/in a reasonably short time-if non-intentional].

28. Rationale for Mandatory Fair Disclosure • Voluntary disclosure outside the mandatory & periodic disclosure regime is generally a good thing for securities market integrity! • However, there is substantial evidence that issuers often disclose material nonpublic info to select groups (e.g., analysts) before any public release concerning important events, conditions or performance: • Earnings forecasts • Major corporate events

29. Rationale for Mandatory Fair Disclosure • Selective disclosure erodes investor confidence that securities markets are fair game “level playing field” • Selective disclosure closely resembles tipping but the tipping law is not clearly applicable • Market integrity further eroded if selective disclosure made to secure favorable analyst reviews: analysts risk losing preferred access • Electronic communications remove many costly impediments to timely public disclosures

30. Mechanics of SEC Rule FD • No issuer or person acting on behalf of an issuer may selectively disclose material nonpublic information • Disclosure TO whom is covered by FD? • Broker Dealer or an associate • Investment advisor, institutional investment mgr. or an associate • Investment Co. (mutual fund) or an associate • Issuer’s security holder if their trade thereon is reasonably foreseeable

31. Intentional vs. Non-Intentional • Impacts timing of required FD cure • Intentional selective disclosure is made to select group knowing the info is material & nonpublic • Public discl MUST be made contemporaneously • Nonintentional selective disclosure is made inadvertently, in respond to surprise question, not prepared or rehearsed • Public discl MUST be made “promptly” • W/in 24 hrs or start of next NYSE trading session

32. FD Compliance Processes • Review of all public statements, press releases, website by FD competent (securities counsel, PR or investor relations using FD method) • Assess materiality & nonpublic character • FD training for all units regularly interacting w/ outsiders & before units go “online” w/ material discl to outsiders

33. FD Compliance Processes • Contemporaneous or prompt public release of the selective disclosure • “File” (liab. risks) or “furnish” (reduced liab. risk) Form 8K to SEC • Method or combination of methods • Reasonably calculated for broad/effective receipt by the public: press release, past discl. practices • Posting on Co’s website, e-mail to existing SH, or other Internet delivery probably not yet a sufficient, sole method

34. SEC’s Suggested FD Method: • Press release thru regular channels • Press release &/or web posting of time, date &access method if conference call is scheduled about topic • Conference calls should be open, allow investor listening access • No requirement yet on asking questions • Taped replay availability thereafter

35. Netflix • 7.3.12 Reed Hastings, CEO, posted to Facebook • Netflix streamed 1 billion hours of content in June • Never alerted Netflix SH of Facebook posts • Post NOT accompanied with Netflix Website post nor press release nor Form 8K • Arguably constituted selective disclosure violating FD • “One set of shareholders should not be able to get a jump on other shareholders just because the company is selectively disclosing important information,”

36. FD Compliant Social Media • Every case is unique, analysis ad hoc • SH must be given advance notice of particular SN site • Facebook less likely compliant • Well-Known Twitter more likely compliant “Most social media are perfectly suitable methods for communicating with investors, but not if the access is restricted or if investors don’t know that’s where they need to turn to get the latest news.”

37. Using Information Barriers to Prevent Insider Trading • Various Relationships & Screening Procedures • Control Transfer or Attribution of Non-Public Information • Chinese Walls • The Great Wall of China • Purpose: Defense vs. Isolation • Effectiveness • Persistence of its’ Symbolism • Appropriateness of Metaphorical Use

38. What is a Chinese Wall? • Engender Awareness of Sensitivities to the term “Chinese Wall” – consider synonyms: • Ethical Wall • Information Barriers • Segmentation of business units • Firewall • Internal Control Policies & Procedures • Nevertheless persistent, durable symbolism, metaphorical & colloquial usages • Berlin, US-Mexican border

39. What is a Chinese Wall? • Control procedures to isolate non-public information & prevent tipping or trading • Restrict Communication of Information • Restrict Influence • Policies & procedures employed by broker-dealers to segment the flow of sensitive info • Prevent transmission of insider information within multi-service firms in securities, investment banking industries • Controls over conflicts of interest towards investment banking client confidences & brokerage customer best interests • Administrative & Physical Controls, Training, Monitoring, Surveillance, Testing, Revisions

40. Analogies from Other Professions & Industries • Big 4 Audit/Attest migrating away from previous mgt consulting arms • Law Firms, regulators, judges • MDPs • Realtors • Trade Secrecy: • Confidentiality, NDAs, Workrules • “Information IS property”

41. Arguments about Chinese Walls • Pro: • Limits insider trading • Preserves fiduciary duties • Promotes fair game for investors • Con: • Costly to maintain • Limits fiduciary duties • Communications Imbeds non-public info into prices through signaling

42. Implements Supervision Duty • Duty of securities firms to oversee activities of broker/dealers & other units • Emp’e knowledge/compliance w/ securities laws, SEC & SRO rules, Workrules, “shingle duty” • ITSFEA: Minimize opportunity for IT & tipping • Monitor & review subordinates’ activities • Firm & emp’e subject to censure, debarment

43. Breaching the Wall