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Insider Trading: A Brief Primer

There's a problem with insider trading: no statute defines exactly what it is. You can't read a statute and easily understand what you can and can't do. You have to be able to interpret case law — or get a good lawyer to explain it to you.

"Is this activity considered insider trading? If it is, a lot of people seemed to be unaware of that fact—which is why the Street is so concerned." -Trader Talk, Bob Pisani

Unfortunately, the government seems to be constantly seeking to expand the concept of insider trading, and may be helped by companies who do not like people gathering information on them that is not contained in their own press releases. So even reading case law makes it difficult to understand what can and can't be done.

Why is Wall Street so freaked out by this? Because the government may be trying to criminalize what many thought was perfectly legal. When a CFO provides earnings numbers or sales numbers ahead of a quarterly report to a trader who then trades on that information, that is insider trading, and everyone knows it — including everyone on Wall Street.

(More: Why the FBI and SEC Insider Trading Investigation is so Theatrical)

But the real world is less black and white. A giant apparatus exists on Wall Street to do research. This research can include many approaches:

1) counting cars or railcars or shipments;

2) interviewing suppliers;

3) interviewing low-level employees on how business is doing.

Is this activity considered insider trading? If it is, a lot of people seemed to be unaware of that fact, which is why the Street is so concerned. And this ultimately may be a defense should the government decide to stretch the boundaries, since due process does require knowledge that the act was wrong.

The origin of insider trading laws go back to the Securities Exchange Act of 1933. Section 10 makes it unlawful:

"To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors."

The key phrase is it is unlawful to use "any manipulative or deceptive device" to purchase or sell securities.

The Classic Definition

Separate rules enacted pursuant to this provision made unlawful "the purchase or sale of a security by one who is in possession of material information relating to [a] tender offer which information he knows or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly."

Here is the two important requirements: they must have "material information" and it must be "nonpublic." This is the classic definition of insider trading used by the courts.

The Sarbanes-Oxley Act also made it criminal to defaud any person in connection with securities, or falsely or fraudulently obtain money or property in connection with the sale or purchase of any security.

Misappropriation. The Supreme Court significantly expanded the concept of insider trading in United States v. O'Hagan in 1997. Here the Court created a "misappropriation theory" that held that a person commits a crime when he "misappropriates" confidential information for the purpose of trading securities. This could be a potentially important case in the current climate, since it implies that if there is a duty owed to the source of the information, a crime may have been committed. So "breach of duty" is often employed in insider trading cases.

But in SEC v. Dorzhko, a 2009 Second Circuit Decision, the court held that a breach of duty is not necessary to prove insider trading. This, according to attorney Robert Anello, "significantly expands the type of activity that may constitute insider trading..."

Let's go back and ask about those three circumstances:

1) counting cars or railcars or shipments: insider trading or no? This would be tough to claim, since it does not appear anyone is using "any manipulative or deceptive device" nor is anyone misappropriating information.

2) interviewing suppliers: insider trading or no? Under the misappropriation theory, if there is a clear expectation of confidentiality between the supplier and the company, it could be argued that it is.

3) interviewing low-level employees on how business is doing: insider trading or no? Again, under misappropriation, if the government argues that even low-level employees have confidential obligations to their employers, it could be argued that it is.

I will have attorney Robert Anello of Morvillo, Abramowitz, Grand, Iason, Anello & Bohrer on to discuss these issues at 3:20pm ET. Mr. Arnello has been involved in many insider trading cases. He is the author of an article on Insider Trading in the New York Law Journal, Aug. 3, 2010.

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