• Does Martha Have a Defense?
  • May 5, 2003 | Author: John W. Lundquist
  • Law Firm: Fredrikson & Byron, P.A. - Minneapolis Office
  • If there is one extraculinary achievement Martha Stewart can take credit for, it is the fact that virtually every person over age 16 in the United States now knows what "insider trading" means. Or do they?

    Liability for insider trading under Section 10(b) of the Securities Exchange Act of 1934 (and Rule 10b-5 promulgated by the SEC) generally arises when an insider or tipee trades stock on the basis of material, nonpublic information. The policy underlying the rule is that the insider ought not to be permitted to take advantage of information that is not available to those with whom he is dealing. One who exploits material, nonpublic information may end up in the crosshairs of a civil enforcement proceeding brought by the SEC, a criminal prosecution initiated by the Department of Justice (if willful), or both.

    Implicit in the concept of insider trading is the notion that the rule forbids trades made "on the basis," or directly because, of the inside information. But consider the following hypothetical. Jill, an officer of a public company, orders her broker late on a Friday afternoon to sell 1,000 shares of company stock when the market opens the following Monday. Things are going well at the company and Jill wants to cash in on her success. Alas, Jill is called into the office Saturday to discuss an emergency. It seems that the company will need to restate its earnings as soon as possible to eliminate a significant amount of income that had been erroneously accrued during the preceding quarter. An announcement will be made after the market closes on Monday. Jill breathes a deep sigh of relief, knowing that she will have sold a good chunk of her stock before the announcement will cause it to go south.

    Imagine Jill's surprise when she discovers three months later that the SEC is investigating her trade.

    Does Jill have a defense to the charge of insider trading?

    The short answer is "maybe."

    The SEC has said that the mere possession of material, non-public information is sufficient to make a case for insider trading, regardless of whether the trade was motivated by the inside information. An insider must abort a trade if she learns of inside information. An exception would be trading plans authorized under SEC Rule 10b5-1. This rule, however, is quite narrow and covers only written plans that meet its fairly rigorous criteria.

    Even though insiders may be targeted as a result of totally fortuitous circumstances, the SEC must still establish the element of scienter, which means that it must prove that the individual conducting the inside trade acted intentionally. This normally requires proof that the defendant acted to exploit material nonpublic information. It will be a strong defense for Jill that she planned the trade before she possessed any material non-public information.

    And so, too, for Martha. If she can show that she had a pre-existing trading plan to sell her Imclone stock if the price dipped below a specified level, it will be difficult for the SEC to establish scienter even if she received a tip prior to her stock transaction being executed. Unfortunately for Ms. Stewart, it appears that the government will call at least one witness who will testify that there was no such plan.

    The moral of the story in these days of skepticism about corporate America might be as follows:

    Insiders should avoid even the appearance of trading at a time when non-public, material information is known or perceived to be known.

    Companies should establish policy that permits insiders only to trade within narrow "trading windows."

    Consideration should be given to aborting trades that, after the fact, are found to have occurred coincidentally with the development of material information.