United States: Insider Trading: New SEC Rules And An Important New Case

On August 10, 2000, the SEC adopted Rule 10b5-1 to codify its position that any corporate insider who trades while in possession of material nonpublic information is liable for insider trading without any finding, whether by direct evidence or with the benefit of an inference, that he actually used the information. The SEC proposed the Rule in response to a split of authority amongst the Circuits as to whether insider trading liability requires that the insider "use," rather than merely "possess," any confidential non-public information. While providing in the new rule that mere possession of confidential non-public information generally will be enough to incur insider trading liability, the SEC included in the proposed rule several exceptions in the form of affirmative defenses.

Courts have defined insider trading as trading "on the basis of" material nonpublic information. In Rule 10b5-1, the SEC has defined "on the basis of" as "while aware of," thus expressly adopting its "knowing possession" test. However, the new rule further provides that an individual who trades while "aware of" material nonpublic information will not be liable for insider trading if he can establish any one of the following affirmative defenses:

1. if, before becoming aware of the material nonpublic information, the trader entered into a binding contract to trade in the amount, at the price, and on the date at which the trade was ultimately made;
2. if, before becoming aware of the material nonpublic information, the trader had provided instructions to another person to execute the trade in the amount, at the price, and on the date at which the trade was ultimately made;
3. if, before becoming aware of the material nonpublic information, the trader had adopted and had previously adhered to a written plan specifying purchases or sales of the security in the amounts, and at the prices, and on the dates at which the person purchased or sold the security; or
4. the purchases or sales result from a written formula, algorithm or computer program for trading securities.

The Rule also requires that the person trading pursuant to a contract, instruction or plan did not exercise any subsequent influence on how, when, or whether to effect purchases or sales, did not deviate from the plan in any manner, and did not create a corresponding hedging position with respect to those securities. In addition, any other person who, pursuant to the contract, instruction, or plan, did exercise such influence with respect to those purchases or sales must not themselves have been aware of confidential non-public information when doing so.

The Rule creates a separate affirmative defense for entities that trade. It requires that the entity demonstrate that the individuals making the decision on behalf of the entity were not aware of the inside information, and that the entity had implemented reasonable policies and procedures, such as information barriers and restricted lists, to prevent insider trading.

Finally, the affirmative defenses will only apply where the contract, instruction, or plan was given or entered into in good faith and not part of a plan or scheme to evade insider trading prohibitions.

The SEC proposed the Rule following two cases that had seriously hampered its insider trading enforcement efforts. In early 1998, in SEC v. Adler,² the Eleventh Circuit adopted the "use test," holding that in order to succeed in an insider trading case against a corporate insider, the SEC must demonstrate not only that the insider traded while in possession of material non-public information, but that the information was actually used in the trading. At the same time, however, the Eleventh Circuit eased the burden by holding that the government would have the benefit of an instruction that the jury could infer that anyone who traded while in possession of material nonpublic information also used that information. Later that year, in United States v. Smith,³ the Ninth Circuit further increased the government’s burden by holding that, in a criminal prosecution for insider trading, the government would not be able to take advantage of any inference that an insider who possessed inside information actually used the information. ⁴

In light of these opinions, the SEC was required to prove, either through direct or circumstantial evidence, that the defendant traded because he had material non-public information. Recognizing that this could seriously hamper the SEC’s enforcement efforts, the Smith court noted that the SEC could promulgate a rule rejecting the "use test" in favor of its "knowing possession test," whereby the SEC would only have to demonstrate that a defendant possessed confidential information and traded. The SEC took the cue and, in late 1999, proposed Rule 10b5-1.

In adopting the affirmative defenses defined in Rule 10b5-1, the SEC appears to have acknowledged that so long as the material non-public information is not the "basis for the trade," liability should not attach. However, in drafting the affirmative defenses so narrowly, and not including a catch-all defense based on any other proof that the defendant did not use the material non-public information, the SEC appears to be far more concerned with easing its burden of proof than with adhering to the concept that an insider whose trades are completely unrelated to any material non-public information should not be liable for insider trading.

Further, by adopting its "knowing possession" test, the SEC has now switched to the defendant the burden of proving non-use, even under the narrowly defined circumstances described in the affirmative defenses. Thus, under the Rule, the SEC now will only have to demonstrate that the defendant traded "while aware" of material non-public information. The defendant will then have the burden to demonstrate that, although he had the information, he falls within the specific circumstances described in the affirmative defenses that excuse the trading.

In light of Rule 10b5-1, there now may well be an even greater focus than before on the evidence required to establish that the insider was in possession of material non-public information at the time of the trading. In April 2000, the Northern District of California, in SEC v. Truong,⁵ dealt the SEC serious blow in this regard by making it substantially more difficult for the SEC to establish that the corporate insider is in possession of inside information.

In Truong the court was presented with suspicious trading activity shortly before the company announced poor quarterly results that caused the stock price to drop by 38%. The SEC argued that the timing of Truong’s trades, combined with the evidence suggesting that Truong, had access to material non-public information was, at the very least, strong circumstantial evidence that Truong possessed the adverse information, such that the issue of possession should go to the jury. Despite the fact that the SEC offered fairly compelling evidence that Truong, the manager of a software group, could have had access to adverse non-public material information, including his attendance at a supervisor meeting, his review of sales department flash report activity, his mere presence in an open office which was suffering from a general business downturn, and his possible access to soon to be filed financial information, the Court did not permit the issue to go to the jury. The court held that without any actual evidence that Truong was in possession of any of this material non-public information at the time of his trades, it would not permit a jury to infer that Truong possessed the information.

It is unclear whether the Truong court was simply responding to "Silicon Valley" concerns that an open space working environment makes it too easy for the SEC to assert that a defendant possessed adverse information, or whether the court intended to raise to new levels the quality of proof required in any insider trading case to get the issue of knowledge before the jury. In either case, in light of Rule 10b5-1 and the fact that only realistic defense available to the inside trader may be that he was unaware of the material non-public information when he traded, the SEC is certain to turn its attention to this issue and attack the Truong holding at its next opportunity.