Insider trading has been a focus of the Justice Department and the Securities and Exchange Commission. But it is not defined in any federal statute, and two recent cases filed by the S.E.C. show how malleable the term “insider trading†can be.
Most insider trading cases are pursued as a violation of Rule 10b-5, which prohibits making misstatements or omitting material facts, or employing “any device, scheme, or artifice to defraud†investors. As a type of fraud, insider trading requires showing the defendant violated a duty of trust and confidence by taking confidential information and using it for personal gain.
In one case, the S.E.C. sued Ladislav Schvacho over trades generating more than $500,000 in profits in Comsys IT Partners stock shortly before the announcement that it would be acquired, causing a 31 percent jump in its shares. He is accused of learning about the transaction from Larry L. Enterline, a close friend who was the chief executive of Comsys.
To prove insider trading, the S.E.C. will have to show not only that Mr. Schvacho possessed the information, but that he violated a fiduciary duty to Mr. Enterline based on their long friendship. Mr. Schvacho did not have any other connection to Comsys, and so did not have the typical duty owed by an employee or agent of a corporation.
The Supreme Court established the fiduciary duty requirement in Chiarella v. United States, holding that insider trading “is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.†In most cases, the person obtains the information as part of their job, or as an outside consultant, like a lawyer or investment banker in a transaction.
In United States v. Chestman, the United States Court of Appeals for the Second Circuit rejected a marital relationship as sufficient for insider trading liability when a husband learned of an impending deal from his wife. Whether the personal friendship between Mr. Schvacho and Mr. Enterline is enough for an insider trading violation is certainly questionable, although the case was filed in Georgia (which is in the 11th Circuit), so the Chestman decision is not directly controlling.
If the S.E.C. is right that a friendship can be enough to show the requisite fiduciary duty for insider trading, then it will expand the potential for pursuing cases based only on personal relationships even if the trader did not have any formal connection to the source of the confidential information.
Even if the commission cannot show insider trading under Rule 10b-5, it may still be able to win its case because it also accused Mr. Schvacho of violating Rule 14e-3, which prohibits insider trading on information about a tender offer. Unlike the usual case, this violation does not require proving a breach of a fiduciary duty, only that the person knew the information was confidential. It was mo re a matter of luck for the S.E.C. that the Comsys transaction was made through a tender offer rather than another means for an acquisition, like a merger or asset sale.
In a second case, the S.E.C. sued Manouchehr Moshayedi, the chief executive and chairman of STEC, for selling shares for over $133 million without disclosing negative information about the company's sales. Although the S.E.C. may be able to show the trading involved fraudulent conduct, it is not clear how it constitutes insider trading.
Mr. Moshayedi sold his shares in a secondary offering â€" at a nearly 10 percent discount to the market price â€" when STEC announced its quarterly earnings in August 2009. The company's announcement hailed increased revenue and profit, including sales of its leading flash memory product to EMC.
The S.E.C. claims that Mr. Moshayedi had STEC enter into a secret side deal with EMC to buy more product than it needed so that STEC could continue to promote grow ing sales to keep the stock price up. When the company later released negative sales information, STEC shares dropped over 30 percent, far more than the discount in the secondary offering.
There is no allegation that Mr. Moshayedi misled STEC management about the deal with EMC, or that he secretly converted corporate information to his personal use. Although the complaint alleges he breached a fiduciary duty to the company, it is unclear how Mr. Moshayedi acted improperly as chief executive. And the S.E.C. did not accuse STEC of making any improper disclosures in its earnings announcement.
Unlike most insider trading cases, in which there is no relationship between the buyer and seller, in this case the real victims would be the purchasers in the secondary offering who would have wanted to know about the potential for slowing sales of STEC's flagship product.
This case looks more like a typical fraudulent disclosure case in which the party on the other s ide is misled about the value of the securities. Indeed, it harks back to the situation that led to the adoption of Rule 10b-5 in 1942.
At that time, the S.E.C. receive information that the president of a company was telling shareholders it was doing badly and then buying their shares, when in fact it was performing quite well. There was no specific prohibition of fraudulent conduct in acquiring stock, so the S.E.C. staff members wrote up a proposal that became Rule 10b-5. In approving it, the only discussion was the statement by one commissioner who said, “Well, we are against fraud, aren't we?â€
This was long before the S.E.C. started pursuing insider trading cases, and the civil charges against Mr. Moshayedi are more like a classic omission case in which a seller is accused of misleading a buyer. While the traditional rule of caveat emptor â€" “let the buyer beware†â€" usually applies in the market place, when the seller is the chief executive of a company then one can expect to receive complete disclosure.
Attaching the label “insider trading†to the case will not make it any more difficult to prove as a violation of Rule 10b-5, but it is misleading to claim that Mr. Moshayedi's conduct is similar to others accused of that transgression. Whether he was required to disclose information about STEC's sales is a different issue from converting corporate information for personal gain.
The S.E.C. did not reach settlements with Mr. Schvacho or Mr. Moshayedi before filing its complaints, so there is a chance the cases will be litigated, which means the courts may explore the contours of insider trading.
Peter J. Henning, who writes White Collar Watch for DealBook, is a professor at Wayne State University Law School.
