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First, visit the following websites on insider trading: Securities and Exchange Commission (SEC) website regarding insider...

First, visit the following websites on insider trading: Securities and Exchange Commission (SEC) website regarding insider trading. SEC enforcement actions (insider trading cases) These websites will help you become familiar with the general basics of the regulatory rules applying to insider trading. You are not expected to become an expert on this topic. Apply these rules to the facts of this very brief case: Someone you know has knowledge of an impending merger between two companies. The combination of the two firms will certainly change the market dynamics of the industry. Moreover, owners of stock in both companies will greatly benefit once the news of the merger is publicly announced. Project Requirements Your presentation must consist of 6 to 7 slides that are clear, legible and address the following: Discuss the general basics of the regulatory rules applying to insider trading and its implications and address the following: Legal implications Ethical implications Economic-social implications You must include a title slide in addition to the six to seven slides. The title page must include: The title of the project The names of the group members The area where the team member provided initiative (contributed to the project). Each slide will include a bulleted list highlighting important aspects of your research. Details of your research and citations will be presented in the notes section of each slide in the presentation.

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Introduction

Insider trading has long been the subject of intense debate in the United States. Insider trading is considered both as legal and illegal. There are people who argue for prohibition of insider trading and there are people who argue for allowing insider trading. Those arguing that insider trading should be prohibited state that it destroys investor confidence in the stock market and harms those who trade with, or on the other side of the market from, the insider. Their main contention is that the insider trading delays the release of information both to the public and within the corporation, thus harming both market and corporate efficiency and conversely, that it harms corporations by resulting in the premature release, through leakage, of their confidential information. Those who argue that insider trading should not be prohibited (and sometimes even that it should actively be encouraged) state that it provides entrepreneurial compensation and provides an incentive for management to take beneficial risks. They also argue that it does not harm traders and does not decrease confidence in the markets. Indeed, insider trading is an important mechanism of market efficiency.

While the debate will undoubtedly continue, the trend in the United States is not only to continue the prohibition against insider trading, but also to expand its coverage and increase the penalties for violation. The United States of America is the first nation to make the insider regulations and implemented it effectively. The rest of the world has borrowed these regulations and modified as per their needs in their respective nations. The United States of America has successfully dealt with the matters of insider trading over the last decade. The United States of America has been the prime enforcer of insider trading regulations. Trading of securities by company executives based on the basis of unpublished price sensitive information has been illegal in USA from the very beginning of the corporate sector but the enforcement regime has evolved over the years.

More Americans are investing in the stock market than ever before and Americans now have almost double as much money invested in the stock market as in commercial banks. Americans' have trust and confidence in the American stock markets and that trust stems from a belief that the government relentlessly pursues its mandate to maintain the fairness and integrity of the stock markets. It is the trading that takes place when those privileged with confidential information about important events use the special advantage of that knowledge to reap profits or avoid losses on the stock market, to the detriment of the source of the information and to the typical investors who buy or sell their stock without the advantage of "inside" information.

The primary source for the regulation of insider trading in the United States is federal law. The law is enforced by a federal regulatory agency, the Securities Exchange Commission (SEC), by federal prosecutors, and by federal private civil rights of action, both express and implied. State law has played a relatively minor role. Insider trading refers normally that buying or selling a security of a company, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, non-public information about the security. Accordingly, there are two elements to the concept of inside information: confidentiality and materiality. Information is material, under the securities law of the US, if a reasonable investor is likely to consider it significant in making an investment decision or if the information is reasonably certain to have a substantial impact on the market price of a company‘s securities.

In the United States, it is unlawful for a corporate fiduciary to trade in the securities of his or her own company on the basis of material, non-public information. Fiduciaries who may not trade may not "tip" for personal pecuniary benefit. Non-fiduciaries are also prohibited from trading or tipping under certain circumstances. First, "tippees" who know that their "tipper" 119 breached a fiduciary duty in giving them the information may not trade on it or tip others. Second, those who are given confidential information because of their professional or business relationship with the company-so-called "temporary insiders"-may not trade on or tip that information. Third, those who misappropriate information in violation of a duty to an employer (who is not the issuer of the securities traded) commit a crime if they trade or tip. Finally, no one in possession of material, non-public information relating to a tender offer, who acquired that information from the bidder or target, may use it to trade, and insiders of the bidder and target may not disclose information to anyone likely to trade, whether or not they violate a fiduciary duty by doing so.

Non-public information is defined as information that has not been promulgated in a manner making it available to investors generally. No statutory definition of insider trading exists in the United States and the prohibition of such activity has been developed through the implementation of statutes and regulatory rules, as well as common law interpretation. Dissemination can be achieved by disclosing information in reports filed with the Securities Exchange Commission or the Exchanges, and publishing it in the press. Dissemination is completed when the public has assimilated the information in the disclosure. The Securities Exchange Act addresses insider trading directly through Section 16(b) and indirectly through Section 10(b).

• Section 10(b) makes it unlawful for any person to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any securities not so registered, any manipulative or deceptive device or contrivance in contravention of such rules that the SEC may prescribe to implement Section 10(b).

• Section 16(b) prohibits short-swing profits (profits realized in any period less than six months) by corporate insiders in their own corporation's stock, except in very limited circumstances. It applies to directors or officers of the corporation and 10% shareholders. Profits earned in that way belong to the corporation.

These broad anti-fraud provisions make it unlawful to engage in fraud or misrepresentation in connection with the purchase or sale of a security. Although, these sections do not expressly mention ―insider trading,‖ under this provision the courts and the Securities Exchange Commission have developed theories of insider trading liability.

Historical evolution of Insider trading in USA

The concept of Insider Trading has a very hoary origin. It emancipated in the United States way back in 1792 when first Inside Trader Causes the First US Market Crash. It was in the year 1789, upon the establishment of the US Department of the Treasury, William Duer was appointed as Assistant Secretary, under the first Secretary of the Treasury Alexander Hamilton. William Duer had the distinction of being the first individual to use the non-disclosed knowledge gained from his official position to become entangled in speculative trading, in effect, he was the first inside trader. Borrowing heavily to finance his illicit schemes, he went bankrupt when the bubble burst. The New York City economy crashed along with him. It was the first encounter of insider trading faced by USA.

Regulation of insider trading in many other countries with similarly developed capital markets is not much older. Even in relatively recent times could be argued quite convincingly that the only country with relatively functional and enforceable regulations is the United States of America, where the roots of legislations are in the beginning of the 1940's and a wider application by the courts has begun in the early 1960's. The approach of the U.S. regulator, the United States Securities and Exchange Commission (SEC), is sometimes with a little exaggeration deemed to be thus; that people who engage in insider trading should be left naked, homeless, and without wheels‖. This approach has been seen for a long time as extreme when compared with the most other countries, which, with some exceptions, did not punish insider trading at all or existing rules were rarely enforced.

The First Insider Trading Scandal

In 1792, only a few years after America officially became a nation, it produced its first fraud. At this time, American bonds were like developing world issues or junk bonds today they fluctuated in value with every bit of news about the fortunes of the colonies that issued them. The trick of investing in such a volatile market was to be a step ahead of the news that would push a bond's value up or down. Alexander Hamilton, secretary of the Treasury, began to restructure American finance by replacing outstanding bonds from various colonies with bonds from the new central government. Consequently, big bond investors sought out people who had access to the Treasury to find out which bond issues Hamilton was going to replace. William Duer, was a member of President George Washington's inner circle and assistant secretary of the Treasury, who was ideally placed to profit from insider information as Duer was privy to all the Treasury's actions and would tip off his friends and trade in his own portfolio before leaking select info to the public that he knew would drive up prices. After years of this type of manipulation, even raiding Treasury funds to make larger bets, Duer left his post but kept his inside contacts. He continued to invest his own money as well as that of other investors in both debt issues and the stocks of banks popping up all over the country.

With all the European and domestic money chasing bonds, however, there was exploratory surplus as issuers rushed to cash in. Rather than stepping back from the overheating market, Duer was counting on his information edge to keep ahead his and his investor‘s illict gains into the market and also borrowed heavily to further leverage his bond bets.With the unpredictable correction, Duer was left with worthless investments and huge debts. Hamilton had to rescue the market by buying up bonds and acting like a lender of last resort. William Duer ended up in debtor's prison, where he died in 1799. The speculative bond bubble in 1792 and the large amount of bond trading was, interestingly enough, the catalyst for the buttonwood agreement.

Securities and Exchange Commission

The United States has historically been the world leader in Insider Trading law. The Securities Exchange Act of 1934 has constituted the U.S. Securities and Exchange Commission (SEC) which is a federal agency that provides protection for investors and regulates the bulk of the securities industry -- including U.S. stock exchanges, options markets, and other electronic exchanges and securities markets. The Securities Exchange Act of 1934 is a law which governs the secondary trading of securities in the U.S. The commission's division of enforcement investigates possible violations of federal securities related laws and can take civil action with other law enforcement agencies when it comes to criminal cases. The foundation for Insider Trading Law was laid down strongly by the Supreme Court of US in Strong vs Repide where it was made mandatory by the U.S. Supreme Court that a company official is obliged to disclose her identity and nonpublic information when she trades the company stocks and fiduciary duty of the company official towards the shareholders.

Statutory Insider Trading Laws were first passed in the year 1933. Congress passed the Securities Act in the year 1933 and the Securities Exchange Act in the year 1934. Both the Acts were intended to increase transparency for investors while placing the obligation of due diligence on the preparers of documents containing detailed information about the security. The Second Act created the Securities and Exchange Commission (SEC) to regulate the secondary trading of securities. Ultimately the acts bolstered investor confidence and helped to stimulate the economy. In the US Securities Exchange Commission is empowered to impose civil in addition to criminal sanctions under the Insider Trading Sanctions Act, 1984. The prevention of Insider Trading was widely treated as an important function of securities regulation from time immemorial. Later on it spread to several countries across the globe.

The International Securities Enforcement Cooperation Act, 1990 and the Insider Trading and Securities Fraud Enforcement Act, 1988 widened the ambit of international cooperation and assistance in criminal investigations in cases related to insider trading. There were also provisions for reimbursement of expenses incurred by the Commission from the foreign securities authorities for the assistance provided to them. Moreover, to ensure tidy and effective investigative procedures, the Securities Exchange Commission (SEC) has entered into 32 arrangements with its foreign counterparts to ensure assistance in investigative procedures that include information sharing and co-operation in the investigation. The foregoing arrangements include two concepts- Mutual Legal Assistance Treaties and Memoranda of Understanding (Hereinafter referred to as MoU). The US has entered into Mutual Legal Assistance treaties with various countries that aim at providing assistance in locating witnesses, obtaining their testimony, production and authentication of documents and other criminal investigations and these treaties are binding on the parties of the treaty. On the other hand, the MoU‘s are nonbinding statements of intents between the regulators. The US has entered into MoUs with countries that include Japan, Switzerland, UK, Brazil, Italy, Portugal, Germany, Netherlands, France, Mexico, etc. It is appropriate to note here that United States has entered into the abovementioned treaties and Memorandum in order to deal with trans-national violations of Insider Trading Regulations more efficaciously.

The Securities and Exchange Act, 1934, catalogue the provisions relating to the protection of interest of investors against Insider Trading. Subsequently, in the year 1961, US came up with an enforcement prohibiting the practice of Insider Trading, being the first country to do so, while in most of the other countries it was legislated against only in the 80‘s and 90‘s. Moreover, the ‗triple damage remedy‘ which was found in the Racketeer Influenced and Corrupt Organization Provisions, 1970 and Organized Crime Control Act, is being strictly applied in the cases relating to securities, frauds and mainly dealing with Insider Trading. The Securities and Exchange Commission (SEC) has been further empowered to seek ‗triple penalty remedy‘ under the provisions of the Insider Trading Sanctions Act, 1984. The SEC has been empowered by the Act to bring enforcement actions against any violations of the provisions of the securities laws.

Every market is primarily of two type primary market and secondary market. Primary market is the market is the where companies where companies raise money by issuing securities in the market and secondary market is the market where trading of securities between persons often unrelated to the issuer, frequently through brokers or dealers. The U.S Securities Exchange Commission was created by Securities Exchange Act 1934. The Securities Exchange Commission is responsible for regulating secondary market and protecting the investors. The primary market is regulated by the Securities Act of 1933. After the stock market crash of 1929, Congress passed the Securities Act of 1933 and Securities Exchange Act, 1934 to restore the faith of the investors in the market. The Securities Exchange Act, 1934 made it mandatory for the companies to disclose the risk and provide full information about the affairs of the business to the market.

The United States has the two largest stock exchanges (by market capitalization) in the world: New York Stock Exchange and NASDAQ. Thus, the United States ranks first in the world by market capitalization. With such a concentration of securities trading in U.S., insider trading laws are extremely important. The SEC creates the rules that govern the securities market and also enforces them along with the Department of Justice. The SEC is the most active all the world‘s financial regulatory institutions at prosecuting insider trading and the laws.

Sections 10 b and 16 of the Securities Exchange Act of 1934

The regulation of the securities markets in the U.S. was initiated through the Securities Act of 1933, and the Securities Exchange Act of 1934. The Section 10(b) of the Exchange Act is the main provision on which the prohibition of insider trading is based. Section 10(b) of the empowers the SEC to formulate rules to curb insider trading.

Further, Section 10(b), although enabled the SEC to frame rules to prevent fraud and market practices, in the absence of any rules framed by SEC under this section, the U.S., did not have a specific provision for prohibiting insider trading. The U.S. however relied upon Section 16 of the Exchange Act to address the insider trading activities. Section 16 of the Exchange Act provides for a threefold attack against the possible abuses of inside information by corporate insiders, which inter alia include: (i) reporting by certain insiders of their stock holdings and transactions in the company‘s securities (ii) makes it unlawful for the same insiders to engage in short sales of their company's equity securities (iii) permits the company or a security holder to initiate an action on behalf of the corporation to recover the benefits of the short swing profits. However, the section had certain limitations because the short swing profits could be recovered under this section only with respect to transactions that were carried out within a period of six (6) months prior to the date of initiation of the legal action and also, provided the transactions were carried out by the category of ‗high-level insiders‘ covered by Section 16 (b).

Rule 10b-5-anti fraud provision

Notwithstanding the existence of Sections 10 (b) and 16 of the Securities Exchange Commission, the United States faced significant incapacities in effectively curbing the complicated insider trading activities. In this background, the Securities Exchange Commission identified the need for implementing more specific and severe regulations. Accordingly, the Rule 10b-5, the SEC‘s panoramic antifraud provision, was promulgated only in the year 1942.

In the absence of specific statutory provisions, the development of jurisprudence on insider trading in the U.S was based on the various interpretations provided by different courts to the antifraud provisions under Rule 10b-5 of the Exchange Act. Rule 10b- 5 has emerged as the most efficacious enforcement tool against fraud in the U.S. securities market. The scope of this rule was so extensive and it could by interpretation, include any kind of fraudulent activities in securities carried out by a variety of corporate insiders and related parties. Therefore, it can be said that an effective insider-trading prohibition regime originated in the US with the implementation of Rule 10b-5.

Liability fixed on the basis of Fiduciary Duty

A fiduciary relationship is based on actual expectation of fair dealing, which arises from a pre-existing relationship of trust and confidence. In such cases, the principal and the beneficiary will rely on each other‘s good faith. Silence in such cases will be termed as fraudulent or deceptive. However, in large corporations, shareholders and management rarely have this kind of relationship where the former trusts that in security transactions, the latter would not take advantage of their position. Therefore, with the development of the market, and the complex financial relationships, the fiduciary theory also became insufficient.

Continuing on this line of precedent, it became the established rule under Rule 10b-5, that the insiders owe a fiduciary duty of disclosure while engaging in direct transactions with the shareholders. The initial tortuous liability approach has eventually transformed into the liability for breach of fiduciary duty. The courts relied on the blanket rule of compulsory disclosure, derived from the fiduciary status that existed between the management and the shareholders. In cases involving insiders who owe a fiduciary duty, the courts had interpreted that it was fraudulent for a fiduciary to trade without disclosure of the information based on which the trades were entered into, and therefore, such insiders were covered by Rule 10b-5.

Doctrine of Unjust Enrichment

The requirement for a broader principle to address the insider trading issues resulted in the constitution of the doctrine of unjust enrichment. This principle mandated that even where the insider does not solicit the transaction or bargain the price, he must still place the shareholders‘ interests above his own by sharing the corporate information with the shareholders. Under this doctrine, a person who was in a position of responsibility in respect of property or welfare of another, such as a corporate officer or director, was obliged to act in that capacity for the best interest of the beneficiaries. The idea was that the insider officer or director should not benefit beyond the compensation expressly given to them at the beneficiaries‘ expense. Thus, the duty of affirmative disclosure has merged into the theory of constructive fraud.

Fraud on the Market Place

According to the theory of general fraud, the insider, by trading in the market, while in possession of unpublished price sensitive information, commits fraud on the market place. Although, the U.S. courts had recognized the fiduciary duty component in the transactions where the buyer and seller were the insiders and the shareholders respectively, the courts had refused to accept the theory of general fraud on the market place in cases where the insider was a seller. The courts refused to accept that mere possession of the price sensitive information while trading amounts to fraud on the buyers in the securities market. The court‘s view was that when the insiders sold the securities and an investor bought the securities in the market, such buyer would have bought the securities in any event, irrespective of who the seller was. The U.S. courts had then weighed the expectation of a shareholder for fair dealing where the shareholder does not know or bother about the identity of the other party to the trade as compared to the insiders‘ interests. In view of the foregoing, the courts had rejected the theory of an insider‘s affirmative duty of disclosure in a stock exchange transaction.

However, for the first time in the year 1961, with the decision in Cady, Roberts & Co, the Securities Exchange Commission (SEC) declared that insider trading in the impersonal market violates Rule 10b-5. Until this decision, liability for fraud was imposed on the insiders who directly traded based on the material price sensitive information. Until this decision, the courts had applied the common law principles of, deceit or fraud as the basis for liability in insider trading cases. In the case of Cady, Roberts, an important issue arose regarding the liability of a person who is not an insider, but is trading in the shares of a particular company, based on the information obtained from a source within the company whose shares are being traded. The SEC had observed that there is no fiduciary obligation on the part of such class of persons who are not insiders but trade for an insider based on the information received from the insider. Therefore, to fix the liability for such corporate outsider, the SEC looked for a better explanation to bring such class of persons within the ambit of Rule 10b-5. The modern federal insider trading prohibition can be said to have begun with the Securities Exchange Commission‘s enforcement action in the Cady, Roberts Case.

The corporate insiders and others would be able to devise plans to engage in certain prearranged securities transactions without the breach of the prohibition on trading on the basis of the material non-public information about the securities with the rule 10b5-1 in place. The rule was valuable for the executives and other insiders who wished to trade in securities not for obtaining private gain by insider trading, but for other reasons, especially when there is an increase in stock prices, and when they may come into possession of material nonpublic information.

The Rule 10b5-1 provided for certain affirmative defenses. An acquiescent defense applies when the provisions of the defense are satisfied so long as the action taken to establish the defense was ―in good faith and not as part of a plan or a scheme to evade the prohibitions‖ of Section 10(b), under the Rule 10b5-1(c) (1) (ii). The rule presume a purchase or sale to be not ―on the basis of‖ material nonpublic information if before becoming ―aware‖ of material nonpublic information, the person had:

(i) Entered into a binding contract to purchase or sell the security; or

(ii) Instructed another person to purchase or sell security for the instructing person‘s account; or

(iii) Adopted a written plan for trading securities. (Rule 10b5-1 (c) (1) (i) (A).

Changes to Rule 10b 5-1 made in 2009

The Division of Corporation Finance of the Securities and Exchange Commission's on 25 March 2009, issued new and revised interpretations regarding the operation of pre-established trading plans and instructions designed to satisfy Rule 10b5-1(c) under the Exchange Act, which provides an affirmative defense from insider trading liability. In the updated interpretations, the Division modified its interpretation relating to Section 10(b) and Rule 10b-5 liability for plan and trade cancellations and provided new guidance regarding:

(i) The standard for satisfying the material nonpublic information requirement of the defense;

(ii) The availability of the Rule 10b5-1(c) defense when cancelling a trading plans or establishing a replacement trading plan;

(iii) The transferability of a trading plan when a broker responsible for the plan goes out of business; and

(iv) The effect on the availability of the defense of a provision for the automatic reduction in the number of shares repurchased based on other discretionary transactions by the insider.

The new and revised interpretations in general endorse some of what have emerged as the best practices in Rule 10b5-1 plan design, but reflect a somewhat restrictive view on the availability of the Rule's affirmative defense. In a recent decision, a federal district court has rejected the SEC‘s charge in the insider trading case against Dallas Mavericks CEO, Mark Cuban. The District Court concluded that an agreement to keep information confidential does not encompass any agreement not to trade and therefore, the trading in securities even after agreeing to keep the information confidential does not deceive the source of information. The SEC appealed against the district court‘s dismissal of insider trading charges against MC, relating to MC‘s sale of shares of Mamma.com Inc. On 21 September 2010, the United States Court of Appeals for the Fifth Circuit (the ―Court‖) had vacated the district court‘s dismissal.

Investigative Powers in the United States

The specific objectives of the SEC in insider trading investigations are as follows:

(i) To establish materiality;

(ii) To identify suspicious traders;

(iii) Identify insiders and traders;

(iv) Establish possession (connect insiders and traders);

(v) To establish scienter;

(vi) To establish duty (i.e., employment contracts, confidentiality agreements, etc.); and

(vii) To set the stage for disgorgement.

In the U.S., the SEC has broad powers for investigation. Section 21(a) (1) of the Exchange Act provides as follows:

The Commission may, in its discretion, make such investigations as it deems necessary to determine whether any person has violated, is violating, or is about to violate any provision of this title, the rules or regulations there under, the rules of a national securities exchange or registered securities association of which such person is a member or a person associated with a member and may require or permit any person to file with it a statement in writing, under oath or otherwise as the Commission shall determine, as to all the facts and circumstances concerning the matter to be investigated. The Commission is authorized in its discretion, to publish information concerning any such violations, and to investigate any facts, conditions, practices, or matters which it may deem necessary or proper to aid in the enforcement of such provisions, in the prescribing of rules and regulations under this title, or in securing information to serve as a basis for recommending further legislation concerning the matters to which this title relates.‖

Regulation and control of insider trading

At the time of the twentieth century, when judges in several states became willing to remove corporate insiders transactions with uninformed shareholders. Americans have counted largely on their courts to advance the law prohibiting and controlling insider trading. Although, Congress gave Americans the directive to protect investors and keep their markets devoid of fraud, it has been the jurists, albeit at the counseling of the Commission and the United States Department of Justice, who have played the greatest and most important role in stipulating the law of insider trading. One of the earliest and abortive federal attempts to control insider trading arose after the 1912-1913 congressional hearings in front of the Pujo Committee, which said that ―the improper method of officers and directors in speculating upon inside and advanced information.

The Disclose or Abstain theory

The disclose or abstain theory was propounded by the Security Exchange Commission(SEC) in case of Cady Roberts & Co, whereby it has been held that it is the duty of the insider person to disclose the unpublished price sensitive information and abstain from using the same information if the same has not been made public. This theory is also known as classical theory. The Sections 25(b), 15A and 19(a) (3) of the Securities Exchange Act of 1934 were discussed in this case.

The Misappropriation Theory

According to this theory, if a person receives some unpublished price sensitive information (UPSI) and breaches the fiduciary duty by communicating the information to third person and such third person uses the same to trade. The U.S Supreme Court in case of Vincent F Chiarella vs. United States has in detail discussed this theory. The question before the Court was that weather a person who learns from the confidential documents of one corporation that it is planning an attempt to secure control of a second corporation violates Section 10(b) of the Securities Exchange Act of 1934 if he fails to disclose the impending takeover before trading in the target company's securities. The petitioner was a printer by trade and he worked as a "markup man" in the New York composing room of Pandick Press, a financial printer. Among documents that petitioner handled were five announcements of corporate takeover bids. When these documents were delivered to the printer, the identities of the acquiring and target corporations were concealed by blank spaces or false names. The true names were sent to the printer on the night of the final printing. The petitioner, however, was able to deduce the names of the target companies before the final printing from other information contained in the documents. Without disclosing his knowledge, petitioner purchased stock in the target companies and sold the shares immediately after the takeover attempts were made public. The petitioner was convicted by the Court of Appeal but subsequently his conviction was set aside by the Supreme Court on the ground that if petitioner had no duty to disclose the information he cannot be convicted for violating the same.

The US Supreme Court in another case of United States vs. O'Hagan has approved the misappropriation theory and has held that insider trading is committed when a person obtains the unpublished price sensitive information and uses the same in securities transactions in breach of the fiduciary duty. In this case James O'Hagan was a partner at Minneapolis law firm Dorsey & Whitney. In July 1988, the firm was retained by Grand Metropolitan, which was considering an offer to take over the Pillsbury Company, headquartered in Minneapolis. Even though he was not directly involved in the transaction, O'Hagan learned about the possible takeover by overhearing a discussion at lunch. In August 1988, O'Hagan began purchasing stock and options of the Pillsbury Company, at around $39 per share. By the end of September, O'Hagan owned approximately 5,000 shares of Pillsbury and 2,500 options – more than any other individual investor. In October, Grand Met announced the takeover bid and the price of Pillsbury stock rose to $60 per share. O'Hagan subsequently sold his stock at a profit of more than $4.3 million.

The U.S Supreme Court in case of Dirks vs. SEC has held that where a corporate insider (―tipper‖) tips inside information to a party unaffiliated with the corporation (―tippee‖) who trades on the information. The Court held that a tippee is liable for insider trading only when she trades on the information in breach of a fiduciary duty that she assumes by receiving information from a tipper in breach of the tipper‘s fiduciary duty. This case holds significance owing to the fact that the courts are dynamic in judging the culpability of the insider. In this case Dirks disclosed the information in order to expose a fraud, rather than for personal gain, nobody was liable for insider trading violations in this case. The Court defined the concept of constructive insiders and held that when somebody uses the inside information to expose the ongoing malpractice within the company and not uses the same for personal gain cannot be held liable for violating insider trading regulations.

In case of United States vs. Carpenter, the Supreme Court upheld the mail and wire fraud convictions for a defendant who received information from a journalist rather than from the company itself. In this case defendant received the information from a journalist at the wall street journal who passed on the information. In this case journalist along with defendant is also convicted on the ground that he had misappropriated information belonging to his employer. It was held by the Court that "It is well established, as a general proposition that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit, but must account to his principal for any profits derived there from."

In recent worldwide famous case of United States vs. Rajaratnam the Court has unanimously held the validity of phone tapping and upheld the conviction solely based on the information collected via phone tapping. It was the largest hedge fund insider trading case in United States history. Raj Rajaratnam is a Sri Lankan American billionaire founder of the Galleon Group a hedge fund management firm. On October 16th 2009, Raj was arrested by the FBI on allegations of insider trading- a process of trading a public company‘s stock or securities by an individual who has access to private information about a certain company. His actions led to the closure of the Galleon Group. On May 11, 2011 he was found guilty on all 14 counts of securities fraud and conspiracy. Both civil and criminal proceedings were initiated against him and he was sentenced to 11 years of imprisonment and penalty of $92.8 Million imposed against Raj Rajaratnam.

Facts of the case were that Raj Rajaratnam founder of the Galleon Group a hedge fund management firm received the confidential information from Rajat Gupta who was a member of the board of 3 directors of The Goldman Sachs Group, Inc. ("Goldman Sachs" or "Goldman"), the global financial services firm headquartered in New York. He tipped the confidential information to Raj rajaratnam and asked him to buy Goldman Sachs shares. After the information, Raj rajaratnam purchased 1.5 million shares for approximately for $33 million dollars. In the same evening the Warren Buffett's $5 billion investment in Goldman Sachs was announced and share value of the Goldman Sachs rose to a high 13 nearly 7%. Thus, Rajat gupta was also held liable and sentenced to 2 years of imprisonment, to be followed by a one14 year term of supervised release, and was ordered to pay a fine of $5,000,000. The conviction has been upheld by the Court of appeal for the second circuit.

The Securities Acts Amendments of 1975

The Securities Acts Amendments of 1975 created the Municipal Securities Rulemaking Board (MSRB), an organization that writes rules governing broker dealers engaged in municipal securities transactions. MSRB rules are approved by the Securities and Exchange Commission (SEC).This event is often overlooked in the history of the SEC, and has continuing relevance, according to John H. Walsh, partner in Sutherland's Financial Services Group and a member its securities enforcement and litigation team said that "Much of what the SEC does in the area of market structure and oversight of FINRA, the New York Stock Exchange, the options markets, and other SROs, has been determined by the 1975 amendments,"

Sarbanes-Oxley Act of 2002

This law set new standards for all U.S. public company boards, management and public accounting firms, and requires the Securities and Exchange Commission to implement rulings on requirements to comply with the law. Harvey Pitt, the 26th chairman of the SEC, led the SEC to implement dozens of rules to comply with the Sarbanes-Oxley Act.

Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010

This financial regulatory reform legislation was passed as a response to the late-2000s recession and among the new reforms is one that permits the SEC to rule on "proxy access." This means that qualifying shareholders can modify the corporate proxy statement sent to shareholders to include their own director nominees, with the rules set by the SEC.

The United States has the two largest stock exchanges (by market capitalization) in the world: New York Stock Exchange and NASDAQ. Thus, the United States ranks first in the world by market capitalization. With such a concentration of securities trading in U.S., insider trading laws are extremely important. Statutory insider trading laws were first passed in 1933. Congress passed the Securities Act of 1933 and the Securities and Exchange Act of 1934. Both Acts were intended to increase transparency for investors while placing the obligation of due diligence on the preparers of documents containing detailed information about the security. The second Act created the Securities and Exchange Commission (SEC) to regulate the secondary trading of securities. Ultimately, the Acts bolstered investor confidence and helped to stimulate the economy. The SEC creates the rules that govern the securities market and also enforces them along with the Department of Justice. The SEC is the most active all the world‘s financial regulatory institutions at prosecuting insider trading and the laws.

Insider trading continues to attract a considerable amount of attention from economists, legal academics, the media, and government agencies around the world. Although academics still debate the economic desirability of insider trading, the consensus among the American public, Congress, and the SEC is that insider trading is ―unfair‖ and erodes investor confidence in the market. This consensus has given rise to a set of insider trading laws that attempts to preserve investor confidence in the market and level the playing field between insiders and public shareholders.

While the government cannot prevent individual members of the public from making poor investment decisions, it can attempt to ensure that those decisions are as well-informed as possible by prohibiting individuals with superior knowledge from using information that is not yet in the public domain. In the United States, the golden rule concerning the treatment of privileged information is ―to not reveal the information or to abstain from transacting.

Regulation of insider trading in many other countries with similarly developed capital markets is not much older. Even in relatively recent times could be argued quite convincingly that the only country with relatively functional and enforceable regulations is the United States of America, where the roots of legislations are in the beginning of the 1940's and a wider application by the courts has begun in the early 1960's. The approach of the U.S. regulator, the United States Securities and Exchange Commission (SEC), is sometimes with a little exaggeration deemed to be thus; that people who engage in insider trading should be left naked, homeless, and without wheels‖. This approach has been seen for a long time as extreme when compared with the most other countries, which, with some exceptions, did not punish insider trading at all or existing rules were rarely enforced.

Insider trading investigation techniques

The following provisions of federal law have been uncovered as most generally violated by insider trading:

1. Tender offer provisions;

2. Aiding and abetting;

3. Failure to supervise;

4. Perjury/false statements to government;

5. Policies and procedures;

6. Obstruction of justice;

7. Broker dealer‘s books and records;

8. Issuer‘s books and records;

9. Reporting of beneficial ownership;

10. Manipulation; and

11. Antifraud.

Insider trading investigations are usually started after a public announcement which materially affects the price of the issuer‘s securities (e.g. announcements of proposed tender offers and announcements of significant earnings declines frequently warrant investigations of possible insider trading). Defendants come from a wide variety of backgrounds and include corporate employees, investment bankers, physicians, students, attorneys, housewives, account executives, and others. Insider trading cases typically involve the use of circumstantial evidence to prove that the defendant possessed material non-public information. Telephone records frequently provide this circumstantial evidence in ―tipping‖ cases. Whether this type of circumstantial evidence is sufficient often depends upon the credibility of the defendant who denies, under oath, that a tip took place. For this reason, evidence bearing on the credibility of potential defendants is critical. A false exculpatory statement by a defendant in the course of the investigation is frequently the linchpin of a successful investigation strategy.

The main sources of information on breaching the law concerning insider trading are as follows

1. Informants, namely: anonymous calls, market professionals, disgruntled employees, and competitors.

2. Market surveillance, namely: • Self-Regulatory Organizations (SROs) – SROs provide the SEC with reports of suspicious trading, frequently there are detailed reports of their investigations including backup materials, • SEC review of market trading – the staff monitors market trading through online data services and through review of major periodicals. Depending on the evidence, the staff may immediately either open a Matter under Inquiry (MUI) to take a further preliminary look at the situation, or an investigation.

In the course of insider trading investigations, the following steps are especially important:

1. Establishing materiality of the case (generally a price movement of 10% or more) with obtaining price/volume trade data, contacting issuer, and reviewing news releases.

2. Identification of insiders and traders – the Commission staff routinely requests chronologies from issuers, law firms, investment bankers and tender offertory in order to determine what the material non-public information was, when it was created and when various persons had access to it. These chronologies show the locations, dates, times, participants and subject matter of relevant meetings and documents from the inception of the discussion of the material event through its public disclosure. In many investigations the staff creates a master chronology using information from trading records, travel records, day timers, calendars, telephone and other records.

3. Identification of suspicious trades – it is an ongoing process (e.g. trades which may not appear suspicious at the outset can later become suspicious as more evidence is developed, and vice versa). Large trades are routinely classified as suspicious, however small trades can be suspicious if they can be linked to other suspicious trades or to insiders. To identify suspicious trades the Commission and SRO staff routinely analyze trading records among others in computerized format via the automated Blue Sheet system (namely: monthly account statements, account opening documents, order tickets, price volume runs, etc.) 138

4. Establishing ―duty‖ – employees of law firms, brokerage firms, investment banking firms and issuers routinely executes blanket confidentiality agreements with respect to information they receive in the course of their employment. The agreements are obviously most helpful in establishing a duty of trust and confidence with respect to information which may have been used or conveyed in connection with the suspect trading.

5. Establishing connection between insiders and traders – such documents as day timers, address books, calendars, telephone records, bank records and other personnel files are extremely useful in establishing connections between insiders and traders. These files are available from a number of sources, including employers, witnesses, and institutional data bases.

6. Setting stage for disgorgement – last but not least, it is the part of investigation which includes statements on profit summaries and location of assets as well as profit sharing, payoffs concerning usage of nominee accounts. Cases involving significant foreign trading are more complicated. In order to prevent a dissipation of illegal profits when the suspicious trading occurs in a foreign based account, the SEC frequently seeks emergency relief.

The SEC action covers usually several additional steps

1. Connecting a foreign broker dealer (co-ordination with the Office of International Affairs): As above and additionally the SEC warns that a foreign broker dealer could be named as a defendant in immediate legal action if it fails to identify customer or freeze funds. Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934, which became the principal laws applicable to stock markets after the crash of 1929, aimed at controlling abuses and protecting investors. To implement the 1934 Act, the SEC addressed the statutory provision regarding insider trading (Section 10b) by adopting associated antifraud regulations (Rule 10b5). In the United States, the development of insider trading law has not progressed evenly as the reach of the anti-fraud provisions to cover insider trading has expanded and contracted over time. The legal system in the United States is based on the common law tradition of England, which relies on courts to develop the law. Therefore, it is worthwhile to examine the case law and the history of interpretation of the scope of insider trading in the case law. The anti-fraud provisions are relatively easy to apply to a corporate insider who secretly trades in his own company‘s stock 50. Supra note 3. 139 while in possession on inside information because such behavior fits within traditional notion of fraud. Far less clear was whether Section 10(b) of the 1934 Act and Rule 10b-5 prohibited insider trading by a corporate ―outsider.

2. Connecting an U.S broker dealer: SEC requests identity of account holder. If it is not disclosed, the Commission asks that the account holder be contacted and told to contact the SEC, requests information on knowledge of deal and insiders, reasons for trade, voluntary freeze, etc. SEC asks to be informed if the account holder seeks to withdraw/transfer funds or securities. SEC requests monthly account statements, Blue Sheet data, etc.

The Securities Exchange Commission in 1961, in the case of Cady Roberts & Co., applied a broad construction of the provisions, held that the duty or obligation of the corporate insider could attach to those outside the insiders‘ realm in certain circumstances. The Commission reasoned: ―Analytically, the obligation (not to engage in insider trading) rests on two principal elements: first, the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing. In considering these elements under the broad language of the anti-fraud provisions we are not to be circumscribed by fine distinctions and rigid classifications. Thus, it is our task here to identify those persons who are in a special relationship with a company and privy to its internal affairs, and thereby suffer correlative duties in trading in its securities. Intimacy demands restraint lest the uninformed be exploited.‖ Based on this reasoning, the SEC held that a broker who traded while in possession of nonpublic information he received from a company director violated Rule 10b-5. The Commission adopted the ―disclose or abstain rule,‖ that is, that insiders, and those who would come to be known as ―temporary‖ or ―constructive‖ insiders, who possess material nonpublic information, must disclose it before trading or abstain from trading until the information is publicly disseminated.

Several years later in the case of SEC v. Texas Gulf Sulphur Co., a federal circuit court supported the Commission‘s ruling in Cady, stating that anyone in possession of information is required either to disclose the information publicly or to refrain from trading. The court expressed the view that no one should be allowed to trade with the benefit of inside information because it operates as a fraud to all other buyers and sellers in the market. In the 1980s, US courts narrowed the scope of Section 10(b) of the 1934 Act and Rule 10b-5 in the insider trading context. This was the broadest formulation of prohibited insider trading.

In the 1980 case of Chiarella v. United States, the United State Supreme Court reversed the criminal conviction of a financial printer who gleaned nonpublic information regarding tender offers and a merger from documents he was hired to print and bought stock in the target of the companies that hired him. The case was tried on the theory that the printer defrauded the persons who sold stock to him. In reversing the conviction, the Supreme Court held that trading on material nonpublic information in itself was not enough to trigger liability under the antifraud provisions, and because the printer owed target shareholders no duty, he did not defraud them. In response to the Chiarella decision, the SEC promulgated Rule 14e-3 under Section 14(e) of the Exchange Act, and made it illegal for anyone to trade on the basis of material nonpublic information regarding tender offers if they knew the information emanated from an insider. The purpose of the rule was to remove the Chiarella duty requirement in the tender offer context, where insider trading is most attractive and especially disruptive.

The Second Circuit Court in the year 1981, adopted the ―misappropriation‖ theory, holding in the case of United States v. Newman that a person with no fiduciary relationship to an issuer nonetheless may be liable under Rule 10b-5 for trading in the securities of an issuer while in possession of information obtained in violation of a relationship of trust and confidence. Newman, a securities trader, traded on material nonpublic information about corporate takeovers that he obtained from two investment bankers, who had misappropriated the information from their employers.

Three years later in Dirks v. SEC, the Supreme Court reversed the SEC‘s censure of a securities analyst who told his clients about the alleged fraud of an issuer he had learned from the inside before he made the facts public. Dirks was significant because it addressed the issue of trading liability of ―tippees,‖ i.e., those who receive information from the insider tipper. Dirks held that tippees are liable if they knew or had reason to believe that the tipper had breached a fiduciary duty in disclosing the confidential information and the tipper received a direct or indirect personal benefit from the disclosure. Because the original tipper in Dirks disclosed the information for the purpose of exposing a fraud and not for personal gain, his tippee escaped liability. A significant aspect of the decision was contained in a footnote to the opinion, which has come to be known as ―Dirks footnote.‖ There, Justice formulated the concept of the ―constructive insiders‖ – outside consultants, investment bankers, lawyers or others – who legitimately receive confidential information from a corporation in the course of providing services to the corporation. These constructive insiders acquire the fiduciary duties of the true insider, provided the corporation expected the constructive insider to keep the information confidential.

The misappropriation theory was again addressed by the Second Circuit Court in the year 1986 in case of United States v. Carpenter. The case centered on a columnist from the Wall Street Journal, whose influential columns often affected the stock prices of companies about which he wrote. The columnist tipped information about his upcoming columns to a broker (among others) and shared in the profits the broker made by trading in advance of publication. In upholding the convictions of the columnist and the broker for securities fraud under Rule 10b-5 and mail and wire fraud, the Second Circuit rejected the defendants‘ argument that the misappropriation theory only applies when the information is misappropriated by corporate or constructive insiders. The case was appealed to the Supreme Court. The Supreme Court unanimously agreed that the columnist engaged in fraud, but divided evenly on whether he engaged in securities fraud. But in unanimously affirming the mail and wire fraud convictions, the Court quoted an earlier New York Court decision that ruled: ―It is well established, as a general proposition, that a person who acquired special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived there from.

Thereafter, the Supreme Court adopted the misappropriation theory of insider trading in the case of United States v. O’Hagan. O‘Hagan was a partner in a law firm retained to represent a corporation, Grant Met, in potential tender offer for the common stock of the Pillsbury Company. When O‘Hagan learned of the potential deal, he began acquiring options in Pillsbury stock, which he sold after the tender offer for profit of over $4 million. O‘Hagan argued, essentially, that because neither he nor his firm owed any fiduciary duty to Pillsbury, he did not commit fraud by purchasing Pillsbury stock on the basis of material, nonpublic information. The Court rejected O‘Hagan arguments and upheld his conviction. The Court held, significantly, that O‘Hagan committed fraud in connection with his purchase of Pillsbury options, thus violating Rule 10b-5, based on the misappropriation theory.

In the Court‘s words: ―The misappropriation theory holds that a person commits fraud in connection with a securities transaction, and thereby violates the law, 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 the information. In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company‘s stock, the misappropriation theory premises liability on a fiduciary-turned-trader‘s deception of those who entrusted him with access to confidential information.

Two related factors that have recently been changing the nature of insider trading enforcement are technology and globalization. The old assumptions about the logical places to look for connections — neighbors, family, co-workers — may not always bear fruit in a world where you can whisper to someone a half a world away and equally easily trade in a market just as far away.

Limitation of American Insider trading laws

The liability for insider trading under the U.S. law under the anti-fraud rule evolved on the basis of fiduciary duty and relationship of trust and confidence. The legal framework does not clarify the instances or the relationships which may be regarded as the fiduciary relationship or that of trust or confidence. As a result, each case has to be decided based on its specific facts and circumstances. Thus, there is no consistency in the decisions of the different U.S. courts and as such no precedential assistance for interpretation in the prospective and ongoing cases.

A survey of the securities laws of some of the developed markets reveals that several countries have rejected the U.S. approach on the insider trading laws and do not want to rely on the U.S. insider trading laws for framing their own laws. The U.S. approach has been rejected mainly due to the lack of consistency displayed in the decisions of the SEC and the courts in the U.S. while deciding the insider trading cases. Certain loopholes that still exist in the U.S. insider trading laws and the U.S. courts‘ and the SEC‘s decisions are as follows: -At the outset, the scope of the term ―insider‖ is unclear, i.e., who are the persons who can be regarded as insiders, and to whom the liability for fraud and insider trading can be extended. Although in some of the cases, the categories of the classical insiders and the temporary insiders have been specified, due to the lack of clarity in the laws, there are interpretational difficulties in determining whether the trader is an insider and can be held liable under the Rule 10b-5. For instance, whether a close friend can trade legally on the basis of the material non-public information that he inadvertently learns when visiting the insider at his home or office, is a question which can be only be decided on the specific fact situation, and not under any legal provision.

Even though the U.S., the veteran regulator for insider trading and famous for rigorous enforcement of insider trading laws, has a regulatory framework on insider trading with emphasis on ‗knowing possession‘ of material nonpublic information, most countries have opted for framing insider trading laws based on the ‗access‘ doctrine. A definition based on ‗access‘ doctrine, other countries expect that it would cover both categories of insiders, the traditional insiders and others those who have access to information by virtue of their profession, i.e., accountants, lawyers, etc.

Impact of Insider Tradign and Change in M


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