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[5](1): Inside Information in Markets

[5](1): Inside Information in Markets. Seller offers to sell his shares of a corporation, but for what reason? Cash for consumption, paying off debts, or reinvesting in other assets Or knows that the corporation’s earnings will decline

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[5](1): Inside Information in Markets

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  1. [5](1): Inside Information in Markets • Seller offers to sell his shares of a corporation, but for what reason? • Cash for consumption, paying off debts, or reinvesting in other assets • Or knows that the corporation’s earnings will decline • Buyer should adjust his offer to buy downward to take account of the latter • Buyer offers to purchase shares of a corporation, but for what reason? • Investing excess cash • Or knows that the corporation earnings will increase • Seller should adjust his offer to sell upward to take account of the latter • Inefficient Market - mutually beneficial transactions will not occur • Some buyers would be willing to buy at a higher price • Some sellers would be willing to sell at a lower price • Thus, some transactions will not occur

  2. [5](2): Lessons for Securities Markets • Markets are less efficient at determining prices • Wider bid-ask spreads • Investors without confidential information will exit the markets • Fewer small investors will participate directly in the markets • Savings of small investors will be channeled to professional investors • Market price will be determined the bids and asks of professional investors with non-public information • Only investors who believe they have better non-public information will trade • Participating investors will focus on obtaining better non-public information • Investors will focus less effort on generating new information or assessing public information

  3. [5](3): Laws Governing Insider Trading • Insider Trading means trading on “material non-public information” • Three main securities laws govern insider trading • Section 16(b) of SEC Act (1934) • Regulates short-swing purchases and sales by corporate insiders • SEC Rule 14e-3(a): • Civil liability for trading on non-public information about tender offers • SEC Rule 10b-5, Sections (1) or (3): • Civil liability for fraudulent practices, which includes insider trading • Applies to corporate insiders, quasi insiders, and their tippees • Applies to outsiders with a duty of confidentiality and their tippees

  4. [5](4): Section 16(b) of SEC Act (1934) • Obligations of directors, officers, and owners of more that 10% of shares in any corporation: • Must report all trades in the stock of their corporation • Must refund any profits on “short-swing” trades to the corporation • A short-swing trade is a purchase and subsequent sale within 6 months • Section 16(b) allows corporate insiders to trade in their stocks, but prevents them from profiting on non-public information • Stock is an important dimension of compensation and incentives • But studies show that managers out-perform other investors in trading the stock of their own corporation • Securities analysts watch reported trades of insiders • Sarbanes-Oxley (2002) requires reports to be filed within two business days

  5. [5](5): Insider Trading Under Rule 14e-3(a) • Williams Act (1968) amended the SEC Act (1934) and allows the SEC to regulate tender offers • Section 14(e) governs fraudulent practices, just as Rule 10b-5(1) and (3) • Rule 14e-3(a) prohibits purchase or sale of securities on the basis of material non-public information about a tender offer • If trader knows or has reason to know that the information was non-public and was acquired directly or indirectly from the directors, managers, employees, advisors, or representatives of either corporation • Adopted after US v. Chiarella (1980) in which a printer of tender offer solicitations identified the parties and traded in the target stock • Rule 14e-3(d)(1) also prohibits the communication of material non-public information by insiders when it is reasonably foreseeable that the communication will result in a violation of Rule 14e-3(a)

  6. [5](6): Insider Trading Under Rule 10b-5 • (1) purchase or sale of securities (or related benefit) • (2) on the basis of material non-public information • (3) that was obtained by either a • (a) breach of a fiduciary duty, or • (b) breach of a duty of confidentiality • (4) with knowledge of both (2) and (3) • What does “knowledge” mean? • Known or should have known that the • Information was material and non-public • Information was obtained by a breach of a duty • No defense for conscious ignorance of the source of the information

  7. [5](7): Rule 10b5-1 • Rule 10b5-1 allows directors and officers to diversify by selling their stock holdings without violating Rule 10b-5. • Rule 10b5-1(b): “On the basis of” means that the trader was aware of the non-public information when trading • Rule 10b5-1(c)(1): Affirmative Defenses • (A) Before becoming aware of the non-public information, the person • (1) Entered into a binding contract to purchase or sell, OR • (2) Instructed an agent (broker or trustee) to purchase or sell, OR • (3) Adopted a written plan for purchasing or selling • (B) The contract, instruction, or plan • (1) Specified the number of shares, price, and date, OR • (2) Included a written formula or computer program for same, OR • (3) Allowed no influence by the person on the agent

  8. [5](8): Civil Penalties for Insider Trading • Traditional penalty = disgorgement of profits from the trading • Loss avoided = sale price - market price after information becomes public • Profit gained = market price after information becomes pubic - purchase price • Payment to Treasury, or compensate investors (Sarbanes-Oxley (2002)) • Disgorgement has NO deterrence effect (aside from criminal penalties) • Insider Trading and Securities Fraud Enforcement Act (1988) • New penalty: Treble (3X) the profit gained or loss avoided • New penalties for “Controlling Persons” such as employers • Corporation and its advisors such as investment banks, law firms, accounting firms • If knew or recklessly disregarded that employees were violating Rule 10b-5 and failed to take appropriate steps to prevent the violations • If knowingly or recklessly failed to enforce a policy to prevent violations • penalty up to $1 million OR treble the profit gained or loss avoided of employer • Bounty for informers up to 10% of the penalty imposed

  9. [5](9): Civil Liability for Insider Trading • Traditional Remedy = rescission of transactions • damages = true stock value at time of sale - transaction price • Or the profit of the trader with the non-public information, if larger • traditional problems for plaintiff: identifying whether the other trader had non-public information and then proving reliance on the public information • Insider Trading and Securities Fraud Enforcement Act (1988) • Affirmed the private right to sue for damages • Defined class of “contemporaneous traders” • No need to prove that each plaintiff traded (purchased or sold) with a person having material non-public information • No need to prove that each individual relied on public information if stock traded on a public exchange • Damages of class limited to the profit gained or loss avoided by traders with non-public information

  10. [5](10): Questions Addressed in Cases • What is “Material” Information? • Basic v. Levinson (1988) • What is “Non-Public” Information? • SEC v. Texas Gulf Sulfer (1968) • What is a “Related Benefit”? • Dirks v. SEC (1983) • What is a Breach of Fiduciary Duty? • Dirks v. SEC (1983) • What is a Breach of Duty of Confidentiality • US v. O’Hagan (1997)

  11. [5](11): SEC v. Texas Gulf Sulfer - Facts • Texas Gulf discovers large copper deposit in Ontario, and schedules a press release on April 16, 1964 • 9:40 AM: Canadian press release • 10:00 AM: U.S. press release begins • 10:15 AM: U.S. press release is completed • 10:29 AM: News hits Merrill Lynch internal private wire • 10:54 AM: News hits Dow Jones ticker tape • Trading by Directors of Texas Gulf • 8:30 AM: Crawford places buy order on Midwest Stock Exchange • 10:20 AM: Coates places buy order with his broker son-in-law • Stock price rises from $16-18 in November 1963; to $29 on April 15 1964; to $37 on April 16 (day of the press release); and then to $58 on May 15.

  12. [5](12): SEC v. Texas Gulf Sulfer - Decision • Did the information become public at 10:15? • NO: because not adequately disseminated yet • Did the information become public at 10:30? • Probably Not: because not adequately disseminated yet • Did Crawford and Coates violate Rule 10b-5? • Yes, insiders cannot place orders to be executed after the press release • Did the information become public at 11:00? • Because it was announced on the Dow Jones ticker? • NO: information must be effectively disclosed to markets • Press release is just the first step in disclosure to the markets • Investors require some time to read in business media • Investors may also require time to evaluate the implications for the corporation

  13. [5](13): SEC v. Texas Gulf Sulfer - Questions • Did the other defendant insiders violate Rule 10b-5? • YES, they were buying stock and receiving stock options from the initial drilling • Classic examples of insider trading • Is the April 12 press release false or misleading? • “The work done to date has not been sufficient to reach definite conclusions and any statement as to size and grade of ore would be premature and possibly misleading” • In a shareholder lawsuit claiming that the April 12 statement was false or misleading, what is the legal relevance of the reaction of the business press to the press release? • Material Fact because the business press discussed it? • Reliance because the business press disseminated it? • Would the interview with Northern Minor violate Regulation FD?

  14. [5](14): Breach of Duty Under Rule 10b-5 • Which Insiders have a Fiduciary Duty? • Corporate Insiders: directors, officers, and employees • Quasi-Insiders have a contractual fiduciary duty • Investment bankers, attorneys, accountants, consultants • Which Outsiders have a Duty of Confidentiality? • Outsiders who have access to the non-public information from their employment • Outsiders have a duty of confidentiality to their employer • Employer has a contractual duty to the corporation • Employees of firms providing services to the corporation • Duty of Confidentiality derives from the Misappropriation Theory • Rule 10b5-2(b): Duty arises when there is an confidentiality agreement or a history and practice of maintaining confidences • See U.S. v. O’Hagan (1997)

  15. [5](15): Tippers and Tippees • Who is a Tipper? • Person with non-public information who conveys the information to a Tippee • Tipper may be an insider or outsider, but can also be a Tippee • Who is a Tippee? • Person who receives non-public information from a Tipper • Tippee will typically have no relationship to the corporation or its advisors • Liability for Tippees of Insiders • know or should have know that the information was obtained by a breach of a fiduciary duty • Liability for Tippees of Outsiders • know or should have know that the information was obtained by a breach of a duty of confidentiality

  16. [5](16): Related Benefit • Do Tippers violate Rule 10b-5 if they do not trade? • YES, as long as they receive benefits in some other way • Tipper could receive cash by the Tippee (e.g. Ivan Boesky) • Tipper could receive commissions on other transactions by Tippees • Tipper could receive raises or bonuses from his employer with Tippees as clients • Tipper could benefit personally from helping family or friends • Assuming the Tipper knows that the family member or friend will trade • Do Tippees violate Rule 10b-5 if their Tipper did not benefit? • No clear decisions, but don’t count on it!!! • Tippers can benefit in many ways other than trading • If an earlier Tipper in the chain benefited, that may be sufficient for a violation by the current Tippee

  17. [5](17): Knowledge of Tippees • Do Tippees violate Rule 10b-5 if they do not actually know that the information is non-public? • Suppose the tip came from a friend or relative? • Assume that the friend or relative could not have access to non-public information • Suppose the tip came from your broker? Martha Stewart • Assume that they would not tip non-public information • What does it mean that Tippees “should have known”? • One should be suspicious if the tip comes from an insider • One case suggests that a Tippee has an obligation to ask the Tipper when the circumstances are suspicious • Do Tippees violate Rule 10b-5 if they do not actually know of the breach of duty? • No clear decisions, but don’t count on it!!!

  18. [5](18): SEC v. Dirks (1983) • Was Dirks a corporate or quasi insider of Equity Funding? • NO, Dirks was an investment analyst at a brokerage firm • Was Dirks a Tippee from a corporate or quasi insider? • YES, Secrist, the Tipper, was a former officer of Equity Funding • Did Secrist trade the stock of Equity Funding? • NO, Secrist was primarily interested in exposing the fraud • Did Secrist benefit is some other way? Maybe • Did Dirks trade the stock of Equity Funding? • NO, Dirks pursued the fraud • Did Dirks benefit in some other way? Maybe

  19. [5](19): SEC v. Dirks (1983) • Did Dirks tip this information to others? • YES, to clients of the brokerage firm who dumped Equity Funding • So what is the SEC position that Dirks violated Rule 10b-5? • (1) Tippee from an insider Secrist • (2) Dirks benefited as a Tipper to the clients of the brokerage firm • His compensation from his brokerage firm was higher - conflicting evidence • Why does the Supreme Court reject this SEC position? • Secrist did not breach a fiduciary duty to the shareholders of Equity Funding because he did not benefit from trading or any other way • Dirks had no independent duty to the shareholders of Equity Funding • So Dirks had no duty to disclose or abstain from trading

  20. [5](20): SEC v. Dirks (1983) - Questions • Suppose that Secrist had sold shares of Equity Funding • Would Secrist violate Rule 10b-5? • Yes, he was a corporate insider and traded on it • Would Dirks then violate Rule 10b-5? • Yes, if he received higher bonuses from tipping clients of his firm • Dirks would be a Tippee who inherited the breach of duty by Secrist • Would Dirks’ Brokerage Firm then violate Rule 10b-5? • Yes, the firm benefits from helping clients and their future business • Firm would be a Tipper and knows that its clients will trade and benefit • Firm would be presumed to know that Dirks obtained non-public information • Would the Clients of the Brokerage Firm violate Rule 10b-5? • No, they would not be expected to know that the information was non-public

  21. [5](21): U.S. v. O’Hagan (1997) • Was O’Hagan a corporate insider? NO • Was O’Hagan a quasi-insider? • No, he was a partner for the law firm who had represented Grand Met • BUT he was not assigned to work on the acquisition of Pillsbury • Where did O’Hagan obtain the non-public information? • From another partner assigned to work on the acquisition of Pillsbury • This other partner was a quasi-insider who had represented Grand Met • Did the other partner breach his fiduciary duty to the law firm? • No, he did not trade on the information • No, he had no reason to know that O’Hagan would trade • Was O’Hagan a tippee from a quasi-insider? • No, he was an Outsider with a duty of confidentiality to the law firm

  22. [5](22): U.S. v. O’Hagan (1997) • Did O’Hagan violate Rule 10b-5? • Yes, because he breached a duty of confidentially to his employer • Yes, because he misappropriated the non-public information • Yes, because he traded on the information • Supreme Court adopts the “misappropriation theory” • Would a Tippee of O’Hagan violate Rule 10b-5? • Yes, if Tippee traded and knew or should have known of the breach • Does Rule 14e-3(a) require a breach of duty when trading on non-public information about a tender offer? • No, anybody who trades is liable (probably breaching a duty) • Court upholds this Rule in order to protect the tender offer process

  23. [5](23): Regulation FD (2000) • Policy Concern: “selective disclosure” of information to securities professionals • non-public information is then passed to their clients for trading • Rule 100: Whenever an issuer, or person acting on its behalf, • discloses material non-public information • to securities market professionals (or to shareholders who may trade) • the issuer must make a public disclosure of the information • simultaneously (for intentional disclosures) • promptly (for non-intentional disclosures) • Applies only to senior officers and public relations officers • Violation if officers knew or should have known that the information was both material and non-public • Not a violation of Rule 10b-5 and thus no private lawsuits

  24. [5](24): Litton v. Lehman Brothers (2d Cir. 1992) • Litton seeking acquisitions in defense technology in 1982 • hires Lehman Bros. as investment banker • Lehman suggests Itek Corp. (electronic warfare) • Lehman employees use inside information to buy Itek stock • drove the market price of Itek stock from $26 to $33 • Litton must offer a higher tender offer price • planned to offer $42.50, but increased offer to $48 (January 1983) • Litton discovers the facts in 1986, sues Lehman for fraud • District Court rejects fraud claim, but 2d Circuit reverses • Lehman fails to inform Litton why the market price is increasing • Market price determines the tender offer and takeover price • affects the Itek Board’s recommendation and Itek shareholder decisions

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