PSST, Want Some Inside Information?

On August 10, 2000 the SEC established Regulation Fair Disclosure (FD) and New Insider Trading Rules. These rules took effect 60 days after publication in the Federal Register.

The new rules relate to three issues:

1. Selective disclosure by issuers of material nonpublic information;
   
2. When insider trading liability arises in connection with a trader's "use" or "knowing possession" of material nonpublic information; and
   
3. When the breach of a duty of trust or confidence in a family or other non-business relationship gives rise to liability under the misappropriation theory of insider trading.

SEC Chairman Arthur Levitt said, "High quality and timely information is the lifeblood of strong, vibrant markets. It is at the very core of investor confidence. Regulation FD will bring all investors, regardless of the size of their holdings, into the information loop -- where they belong."

On December 20, 1999, the SEC proposed new Regulation FD – for "fair disclosure" – to combat selective disclosure. Regulation FD would require that when an issuer intentionally discloses material information, it do so publicly and not selectively. The company may make the required disclosure by filing the information with the SEC, or by another method intended to reach the public on a broad, nonexclusionary basis, such as a press release. When selective disclosure of material information is made unintentionally, the company must publicly disclose the information promptly thereafter.

There was a vast response to the proposal with nearly 6,000 comments received. The responses ranged from those of investors wanting tighter regulations to those of securities industry professionals concerned with the impact of the regulation on the timely dissemination of information.

In response, revisions to the original Regulation FD were made. The principal changes are:

• Narrowed Scope of the Regulation

The regulation will apply only to an issuer's communications with market professionals, and holders of the issuer's securities under circumstances in which it is reasonably foreseeable that the security holders will trade on the basis of the information. The regulation will not apply to issuer communications with the press, rating agencies, and ordinary-course business communications with customers and suppliers.

The regulation will apply only to communications by the issuer's senior management, its investor relations professionals, and others who regularly communicate with market professionals and security holders.

• Rule of Disclosure that Does Not Create Private Liability

The regulation text makes clear that it is a disclosure rule. It does not create liability for fraud. Where the regulation is violated, the SEC could bring an administrative proceeding seeking a cease and desist order, or a civil action seeking an injunction and/or civil penalties.

The regulation has been revised to eliminate the prospect of private liability for companies solely as a result of a selective disclosure violation.

• Requirement of Intentional or Reckless Conduct

The regulation requires public disclosure only where the person making the selective disclosure knows or is reckless in not knowing that the information disclosed was both material and nonpublic.

• No Application to Most Registered Offerings or Foreign Issuers

The regulation now expressly excludes communications made in connection with most registered securities offerings.

The regulation does not apply to foreign issuers.

• No Effect on Eligibility for Short-Form Registration or Resales under Rule 144

A violation of Regulation FD will not disqualify a company from use of short-form registration, or affect investors' ability to resell under Rule 144.

With these changes, Regulation FD establishes a clear rule against selective disclosure and encourages broad public disclosure. At the same time, it does not impede legitimate business communications or expose issuers to liability for selective disclosure arising from arguable but mistaken judgments about the materiality of information.

In a nutshell, the passage of Regulation FD means U.S. companies are required to disseminate material information to the public before or at the same time that they provide that information to selected analysts, investors or other securities industry professionals.

The prohibitions against insider trading play an essential rule in maintaining the fairness, health, and integrity of our markets. Insider trading law has developed on a case-by-case basis under existing provisions of the federal securities laws. From time to time there have been issues on which various courts have disagreed. The SEC has developed new Rules 10b5-1 and 10b5-2 to resolve two such issues.

These two amendments will clarify and enhance existing prohibitions against insider trading. The first addresses the important but unsettled question of whether insider trading liability arises when a person trades while "aware" of material nonpublic information. The second amendment addresses what types of family or other non-business relationships can give rise to liability under the misappropriation theory of insider trading. In all other respects, the law of insider trading remains unchanged.

"Use/Possession" Issue

Courts have split on whether insider trading liability requires trading while in "knowing possession" of material nonpublic information, or proof that the trader "used" the information in trading. New Rule 10b5-1 provides that a trader is in violation if the trader is "aware" of material nonpublic information when making the purchase or sale. The rule also establishes several affirmative defenses or exceptions to liability. These exceptions permit persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as when following a pre-existing plan, contract, or instruction that was made in good faith.

Clarifying Duties of Trust or Confidence in Misappropriation Cases

The misappropriation theory of insider trading provides that a person commits insider trading by misappropriating and trading on inside information in breach of a duty of trust or confidence. The theory's application is most clear in cases involving misappropriation of confidential information in breach of an established business relationship, such as lawyer-client or employer-employee.

The SEC's new Rule 10b5-2 will clarify how the theory applies to certain non-business relationships. Under the new rule, a person receiving confidential information under the following circumstances would owe a duty of trust or confidence, and thus could be liable under the misappropriation theory when:

• The person agreed to keep information confidential
• The persons involved in the communication had a history, pattern, or practice of sharing confidences that resulted in a reasonable expectation of confidentiality
• The person who provided the information was a spouse, parent, child, or sibling of the person who received the information, unless it were shown affirmatively, based on the facts and circumstances of that family relationship, that there was no reasonable expectation of confidentiality.

The ultimate goal of the SEC's actions is to level the playing field for all involved. If you think you have received inside information, do not act on it. Until the information is available to the general public it is useless and any trading actions are in violation of the SEC's Insider Trading rules.