1. Insider Trading When is “tipping” illegal? When are outsiders “insiders”? (last updated 9 Oct 06)

2. Rule 10b-5 Securities Exchange Act of 1934 Act § 10 It shall be unlawful for any person... (b) To 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 Fraud (tort of deceit) Material misrepresentation Intentional (defendant aware of truth) Reliance (plaintiff relies reasonably) Misrepresentation is cause of loss Damages

3. Rule 10b-5 Securities Exchange Act of 1934 Act § 10 It shall be unlawful for any person... (b) To 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 Fraud (tort of deceit) Material misrepresentation Intentional (defendant aware of truth) Reliance (plaintiff relies reasonably) Misrepresentation is cause of loss Damages

4. Justice Lewis Powell "... silence in connection with the purchase or sale of securities may operate as fraud actionable under § 10(b)... But such liability is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.” Chiarella v. US (US 1980)

5. What about tips? Equity Funding execs who prepared company financials -- hamming it up (all went to prison)

6. Dirks v. SEC (US 1983) “Tipping” Equity Funding Non-public, material information (massive accounting fraud) Investors / shareholders Dirks (analyst) Secrist Clients dump stock Did Dirks do something wrong?

7. ... a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach. Whether the "tip" was a breach of the insider's fiduciary duty [depends on] whether... the insider receives a direct or indirect personal benefit that will translate into future earnings. Dirks v. SEC (US 1983) Justice Lewis Powell

8. 1.Secrest decides, “To heck with altruism. I’m going to save myself.” He sells his Equity Funding holdings. 2.Sam, an outside attorney for Equity Funding, consults on the company’s financial reporting. Realizing how bad things are, Sam sells his EF holdings. 3.Secrest tells his brother-in-law, “Bob, there are some bad things happening at Equity Funding. You’d make a ton by selling short.” Bob does. 4.Secrest calls Dirks today and blurts it all. Has Secrest violated Reg FD? Does this mean he violated 10b-5? Hypotheticals

10. SEC v. Stewart (filed 2003) “Tipping” Imclone Non-public, material information (FDA likely to disapprove drug) Stock market Martha Stewart (at airport) Sam Wachtal (CEO) Faneuil (broker ass’t) Sells stock

11. Effect of SEC rules Rule 10b5-1: state of mind when trading “on the basis” of material, nonpublic information –“aware” (“conscious knowledge”) –Safe harbor for pre-existing trading plans

12. Outsider Trading (Misappropriation)

13. US v. O’Hagan (US 1997) “Misappropriation Grand Met Non-public, material info (plan to make tender offer To Pillsbury shareholders) Shareholders Pillsbury O’Hagan Option sellers Insider Dorsey & Whitney Buy, buy, buy

14. The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. … Under this theory, a fiduciary's undisclosed, self- serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information. Justice Ruth Bader Ginsberg US v. O’Hagan (US 1997)

15. [The "in connection with the purchase or sale of [a] security"] element is satisfied because the fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities. … This is so even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information. US v. O’Hagan (US 1997) Justice Ruth Bader Ginsberg

16. 1.O’Hagan learns about Grand Met’s plans to acquire Pillsbury. He figures that the deal will drive down the stock of the competitors of Pillsbury. He buys put options on the competitors. 2.Dorsey & Whitney attorneys suspected that O’Hagan was trading on inside information, particularly when he began driving a chauffeur-driven Rolls-Royce to work. Is the firm liable? 3.You are a consultant to the D&W law firm. Are you an insider? 4.You brazenly write an email to the firm and client Grand Met. Hypotheticals Hey guys – Thanks for the info, I’m trading on Pillsbury.” ARP

17. Effect of SEC rules Rule 10b5-2: duty to source in business/personal relations –Agree to maintain confidentiality –Practice of sharing known confidences –Spouse, parent, child, sibling – unless no confidentiality

18. A final review …

19. “Insider trading” –Classic insider trading: Fraudulent silence under Section 10(b) duty of trust or confidence to “abstain or disclose” –Tipping liability: know or should know that tipper has breached duty for improper personal benefit –Misappropriation liability: Fraud on source “in connection with” securities trading Maintain integrity of securities markets

20. “Insider trading” –Classic insider trading: Fraudulent silence under Section 10(b) duty of trust or confidence to “abstain or disclose” –Tipping liability: know or should know that tipper has breached duty for improper personal benefit –Misappropriation liability: Fraud on source “in connection with” securities trading Maintain integrity of securities markets

21. “Insider trading” –Classic insider trading: Fraudulent silence under Section 10(b) duty of trust or confidence to “abstain or disclose” –Tipping liability: know or should know that tipper has breached duty for improper personal benefit –Misappropriation liability: Fraud on source “in connection with” securities trading Maintain integrity of securities markets