BusOrg (Fall 2013)

Insider Trading Hypos

Relevant law:

·  Section 10(b), Securities Exchange Act of 1934

·  Rule 10b-5

·  Rule 10b5-1

·  Rule 10b5-2

Corporations: E&E (chapter 23)

  1. You work as CFO in Up-N-Rising, a bakery chain that’s opening high-end bakery shops throughout the country. The numbers have been good, until this month when you notice an internal report showing a 25% fall in pastry sales. What might be the problem if you sell some of your company stock?

A.  Self-dealing

B.  Usurpation of corporate opportunity

C.  Misappropriation – outsider trading

D.  Classic insider trading

  1. Pastry sales are a tiny portion of overall Up-N-Rising sales. In fact, there is little reason to believe that if the 25% drop in pastry sales were known that there would be any effect on the company’s stock price. You sell your company stock. Any problems?

A.  Yes. You cannot trade in your company stock since you are an insider.

B.  Yes. Your selling when you are aware of company information is illegal insider trading.

C.  No. Your selling is not insider trading, unless you are aware of material information (defined as information likely to affect stock prices).

D.  No. Your selling is not insider trading since you are selling to non-shareholders.

  1. Actually, the drop in pastry sales is likely to significantly affect earnings and, once disclosed, will cause Up-N-Rising’s stock price to fall a good deal. As CFO of Up-N-Rising, you have received regular stock grants as part of your compensation package. Sweet! In fact, you have about 200,000 shares of Up-N-Rising in your stock portfolio. Not bad! The company has set up “trading windows” after quarterly and annual reports are released. You sell during one of these trading windows. Any problems?

A.  Yes. Your selling is illegal insider trading; you cannot trade in your company’s stock – since you are an insider.

B.  Yes. Your selling is illegal insider trading; you traded while you were aware of material, nonpublic information you received in your company position.

C.  No. Your selling is not illegal, assuming you had planned to sell your stock during the trading window whether or not you had inside information.

D.  No. Your selling is not illegal, assuming that you are not one of the top five highest paid executives of the company.

  1. You change roles. You are now outside counsel to Up-N-Rising. The CFO at Up-N-Rising calls you and tells you about this quarter’s 25% fall in pastry sales – likely to result in a 15% drop in earnings (new facts!). She asks whether the company should disclose this in a press release. You sell Up-N-Rising short. Any problems?

A.  Yes. You are a temporary insider and assume a duty to “disclose or abstain” similar to other company insiders

B.  Yes. You have a duty to the source under Rule 10b5-2, whether or not you have a confidentiality agreement or have had a practice to maintain confidences.

C.  No. Selling short means borrowing shares, so you’re really not a current shareholder.

D.  No. You had no agreement to maintain confidentiality, and thus you can use the information as you please.

  1. You are still outside counsel to Up-N-Rising. After learning about the likely 15% drop in earnings, you figure, “I can’t sell short, but my brother-in-law can.” You call him and say, “Bob, remember how you asked me to tell you if I’m working on anything interesting.” You tell Bob what you know, and he buys a boatload of put options on Up-N-Rising. Any problems?

A.  Yes. Bob is a temporary insider and assumes a duty to “disclose or abstain.”

B.  Yes. Bob is a tippee, who assumes your duties not to trade. You breached a duty by telling Bob, and he should have known you did something wrong.

C.  No. Bob is not dealing with shareholders of Up-N-Rising. Insider-trading duties run only to actual shareholders, not participants in derivatives markets.

D.  No. Bob is in the clear, assuming he did not give you anything of financial value for your tip. (No Christmas present from Bob!)

  1. Your brother-in-law Bob is a member of an “investment club.” He and his buddies get together and talk about investments. They have some beers and believe they can beat the stock market. They write a book about their investing prowess and appear on a national talk show to strut their stuff. But in fact their spreadsheet is flawed. They would have done better investing in low-cost index funds. But the club still gets together, and Bob tells his buddies about your tip. They sell Up-N-Rising short. Any problems?

A.  Yes. Bob is a sub-tipper, and his buddies are sub-tippees by virtue of selling on the basis of information not known to the market.

B.  Yes. Bob is a sub-tipper, and his friends are sub-tippees who should have inquired about where Bob got the tip – probably from an insider who breached a duty.

C.  No. Bob is not a company insider and thus breaches no duty to the company when he tips his friends, even though they buy him a beer for being a “great guy.”

D.  No. Bob’s friends are simply acting on a market rumor, like so many on Wall Street who buy and sell stocks based on the flimsiest of information.

  1. Shift gears. You are no longer outside counsel. Instead, you’re just a regular person whose friend Ralph is sales manager for Up-N-Rising. Ralph tells you that “something” is happening at the company and you should sell your Up-N-Rising holdings, if you have any. Ralph says no more. You sell your Up-N-Rising stock. Any problems?

A.  Yes. Any information from an insider constitutes a “tip” and requires you to “disclose or abstain.”

B.  Yes. If you trade on the information that means you deem it to be “material,” which is enough to establish liability.

C.  Probably. When you receive a tip you have a duty to inquire about the source of the tip and whether there was a fiduciary breach.

D.  No. For this to be an illegal tip, Ralph must receive some financial gain in return. If you do not pay him, there is nothing illegal about this tip.

  1. New scenario. You are the CFO of KK Donuts and have been cogitating on what to do with all the company’s extra cash. You talk with the company’s CEO and investment banker, who agree buying Up-N-Rising would be a good move. You begin to form a takeover team. You buy Up-N-Rising stock. Any problems?

A.  Yes. You have engaged in insider trading by using information that was not yours.

B.  Yes. You traded when aware of misappropriated information from your company, which is material given its price-sensitivity.

C.  No. You have no relationship with Up-N-Rising and can trade in its stock without any problems.

D.  No. There was no material information that you used or were aware of, since the takeover has not been announced.

  1. You are the spouse of the CFO of KK Donuts, who tells you that she will be out of town for the next few days. “We’re looking at buying Up-N-Rising.” You know that this is only going to complicate your life. You wish there were a silver lining. You go shopping and buy some Up-N-Rising stock. Any problems?

A.  Yes. You have duties of confidentiality whenever you receive information from family members.

B.  Yes. You have a duty under Rule 10b5-2 not to trade on information from a family member, if the family has expectations of confidentiality.

C.  No. Information exchanged among family members cannot be a tip since there is no “personal benefit”

D.  No. This is not an illegal tip because you have not paid for the information.

  1. You are the head of strategic planning at KK Donuts. You are no fool. You figure that when KK Donuts announces it is acquiring Up-N-Rising, the stock prices of competitors of Up-N-Rising will likely fall. The Up-N-Rising acquisition is moving apace. You sell short the stock of Up-N-Rising’s competitors. Any problems?

A.  No. You are not an insider as to these competitors.

B.  No. You are not trading in the stock of either your company or the potential target of the acquisition.

C.  Yes. If KK Donuts has a policy against your using company information to make stock trades, you are liable for misappropriation – a kind of insider information.

D.  Yes. If you have an informational advantage that others in the market do not, you cannot trade.

  1. You are an outside “public relations” consultant to KK Donuts. The company's CEO calls and tells you KK Donuts may be buying Up-N-Rising to expand into the high-end pastry business. Given the current health consciousness movement, you are asked if this would be good for public relations. You have no confidentiality agreement with KK Donuts. You buy Up-N-Rising stock, which rises when the takeover plan is announced. Any problems?

A.  Yes. The information about the takeover was not available on the stock market.

B.  Yes. You have a duty to the source of the information (KK Donuts) under Rule 10b5-2, since you were doing work for the company.

C.  Yes. You are liable for being a tippee, since the CEO received a personal benefit when he gave you the information.

D.  No. You have no duty to the source under Rule 10b5-2, assuming that there is no prior practice of sharing confidential information.

  1. You are the founder KK Donuts. You hold about 40% of the company’s stock and want to diversify. Problem is if you sell, during this volatile expansion period, you will be accused of insider trading. You tell your broker to sell 1% every month over the next two years – reducing your KK position to 16%. Later you sell (under the plan) at a time when you are aware of the Up-N-Rising deal. Any problems?

A.  Yes. Your sales happened when you were aware of material inside information.

B.  Yes. As a controlling shareholder, you can only sell in a public offering.

C.  No. Rule 10b5-1 allows your sales pursuant to the plan, assuming you were unaware of material, non-public information when you set it up and it is binding and written.

D.  No. By selling only 1% per month, you are not engaged in insider trading.

  1. You are best friends with Karl Konners, founder and CEO of KK Donuts. You both use the same broker. This morning the broker called you and blurted out, “Karl is selling. Karl is really selling.” You know that KK Donuts is being investigated by the FDA over its products’ fat content. You sell your KK Donuts stock. Any problems?

A.  Yes. You traded on material inside information, namely the information that the company’s CEO was selling.

B.  Yes. You traded on material insider information, namely the likelihood the FDA was going to take action against the company.

C.  Yes. You traded on an improper tip, namely the CEO’s sales order to the broker, which you should have known was a breach of duty.

D.  No. You are allowed to figure things out.

  1. You are in a taxi on a rainy night in New York City. The driver stops to pick up two wet customers. “My gosh,” you think, “It’s Karl Konners, the head of KK Donuts.” Karl talks to his associate in animated whispers about the FDA dropping its fat-content investigation. “Great news for KK Donuts,” you tell yourself. You buy KK Donuts stock. Any problems?

A.  Yes. You have information not available to others.

B.  Yes. Taxi drivers have duties of trust and confidence to their customers.

C.  No. You are a stranger, with no duties to Konners or KK Donuts. You are allowed to figure things out.

D.  No. You suspect that Karl wanted you to overhear the conversation, so that he would seem like a big shot – thus, he derived a personal benefit.

  1. You are the head of investor relations of KK Donuts. You have been besieged by inquiries about rumors of an Up-N-Rising takeover. You talk to senior management and decide on a script: “KK Donuts is in preliminary talks with Up-N-Rising management.” And so on. You call three of your favorite stock analysts and read the script. Any problems?

A.  Yes. This is an improper tip, since you expect them to say good things about KK Donuts, thus increasing the value of your stock options.

B.  Yes. This is information nobody else knows, so you can’t disseminate it.

C.  Yes. Regulation FD (Fair Disclosure) requires that any disclosures by public companies to some investors be made to all investors at the same time – a web simulcast!

D.  No. This is the way companies trickle information into the markets.

  1. Final question. You are the CEO of KK Donuts. Congrats! You are convinced you and your company are about the greatest things since sliced bread – typical executive hubris. On January 1 you spend your annual bonus to buy 100,000 shares of KK Donuts stock on the stock market. The stock price goes up, no doubt because of your management acumen, and you sell the 100,000 shares on April 1 and realize a profit of $500,000. “I worked hard, I deserve it,” you tell yourself. Both trades are disclosed to the SEC as required. Any problems?

A.  Yes. You cannot trade in your company’s stock – there is a presumption you had inside information when you sell your company stock within 6 months of having bought it.

B.  Yes. You cannot realize a profit on trades in your company’s stock made within a six-month window – and if you do the company can force you to disgorge the profits.

C.  No. You did not trade on specific material, non-public information – you bought and sold (and made some trading profits) like any other investor.

D.  No. You did not make any disclosures to the market or do anything that “manipulated” the stock price, so your short-term profits are not subject to disgorgement.