Drawing Outside the Lines: Contrasts in Evolving Definitions of “Insider Trading”

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Professor of economics Peter J. Henning wrote July 30th for the New York Times of the ever-changing definition of what classifies as “insider trading” in today’s market. Henning’s approach is at once streamlined and nuanced, walking us through a user-friendly tutorial of how and why fiduciary duties are upheld. Because insider trading holds no set definition within federal law, proving it within legal confines can be a hazy process. Henning illustrates this flexibility by profiling two recent cases filed by the U.S. Securities and Exchange Commission (“SEC”). For a detailed definition of fiduciary duty and its effects on one’s securities, visit the Investors page of our firm’s website.

Likely the most common claim cited within insider trading cases is violation of the SEC’s “Rule 10b-5” – subtitled “Employment of Manipulative and Deceptive Devices” – which bans “any device, scheme, or artifice [used] to defraud” investors. Simply put, insider trading violates an investor’s rights when a financial representative takes confidential information and uses it for their own gains. Rule 10b-5 was created in 1942, after the SEC allegedly got word of a company’s president who lied to shareholders, claiming the company was doing poorly and then buying investors’ shares, when in fact their stock was booming. Henning writes that incredibly, until the inception of Rule 10b-5, such fraud was not explicitly prohibited.

Often insider trading violations amount to “jumping the gun” with regard to the exchange of information leading directly to trades of stock or other securities. Earlier this year, trader Larry Schvacho allegedly made over $500,000 from stock in Atlanta tech firm Comsys IT Partners. Last week the SEC set out to prove through civil action that Schvacho had been given non-public information as to the stock’s value by Larry Enterline, a close friend of Schvacho’s and chief executive at Comsys. Proving insider trading in this instance would likely require not only proof of possession of non-public information, but a determination that Schvacho breached the trust of his longtime confidante.

The Supreme Court has presented legal parameters for fiduciary duty and the ways in which insider trading violates such an agreement. In Chiarella v. United States, the court determined that insider trading “is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.” Typically this information comes to those who hold a job within the financial entity in question, or as some kind of consultant outside of the company.

That Schvacho is said to be a mere friend of Enterline’s with no occupational ties to Comsys makes proving claims of insider trading that much more challenging. In the case of United States v. Chestman, a U.S. Court of Appeals rejected a comparable scenario in which a husband capitalized on knowledge of an upcoming deal accrued from his wife. In the case of Schvacho and Enterline, the SEC aims to set a precedent toward expanding the parameters of fiduciary duty to interpersonal relationships.

The SEC’s case is helped by Schvacho allegedly having violated another of its commands, Rule 14e-3, which prohibits insider trading on information about a tender offer. Rule 14e-3 does not require proven breach of fiduciary duty, merely knowledge that the information capitalized upon was considered confidential.
It has been suggested that the SEC seeks to also prove that insider trading can stem not only from unfairly utilizing knowledge, but also from a failure to disclose vital information to one’s investors. Earlier this year, the Commission sued Manouchehr Moshayedi, chairman of STEC, for supposedly selling over $133 million in company shares due to disconcerting knowledge about the company that was not publicly shared.

The SEC claims that in secretive dealings with STEC’s peers, Moshayedi requested that companies buying STEC products procure more of such products than they actually needed, so that STEC could continue to tout increased sales, thereby raising the value of its stock. But once STEC’s under-the-table negotiations were publicly revealed, STEC shares are alleged to have plummeted by over 30 percent.

Henning believes that the case against Moshayedi is not so much an instance of insider trading, but rather “a typical fraudulent disclosure case in which the party on the other side is misled about the value of the securities… a classic omission case in which a seller is accused of misleading a buyer.” Henning goes on to suggest that Moshayedi’s requirement to disclose information about STEC’s sales is a separate concern from his having inappropriately used concealed corporate information for his own gain.

Having not reached settlements in either of the cases against Schvacho and Moshayedi, the possibility of courts redefining or broadening current definitions of insider training remain a possibility. And while the legal boundaries of what constitutes fraud and insider trading remain debated, the need for investors to inform themselves in the face of lacking transparency remains.