To Trade or Not to Trade during the COVID-19 Outbreak?
In a matter of weeks, COVID-19 has completely transformed operations, financial performance, and market predictions for just about every company. Executives must now implement significant changes concerning nearly every aspect of the operations of their companies, monitor market conditions and the effects of the implemented changes, and then repeat as needed. Meanwhile, government officials are monitoring industries and making real-time decisions on how to help individuals and businesses. All of these deliberations and changes are creating mountains of material, non-public information.
The U.S. Securities and Exchange Commission (SEC) in the past few weeks has issued several reminders about prohibitions on insider trading on the basis of material, nonpublic information. Additionally, the SEC is encouraging companies to timely report material effects that COVID-19 has had on a company, including what management expects the future impact will be, how management is responding to evolving events, and how management is planning for COVID-19-related uncertainties, as such information can be material to investment decisions.
Corporate Insider Trading
Under well-established principles of U.S. securities laws, company insiders (for example, the company’s directors, officers, employees, and consultants) who have access to material, nonpublic information about a company or its securities may not trade in the company’s securities on the basis of that information. Insider trading is meant to prevent a certain kind of corporate theft; when corporate insiders trade on material, nonpublic information before it becomes known to the public, they misappropriate confidential information for securities trading purposes for their own benefit. As one court explained, “A firm’s confidential information belongs to the firm itself, and an insider entrusted with it has a fiduciary duty to use it only for firm purposes. The insider who personally benefits—i.e., whose purpose is to help himself—from disclosing confidential information therefore breaches that duty; the insider who discloses for a legitimate corporate purpose does not.” Also, the securities laws do not have a dollar threshold below which insider trading is not a crime. The conduct is still insider trading, for example, even when the insider only invests a couple thousand dollars to make the trade.
For these same reasons, when corporate insiders share material, non-public information with other people outside of the company (“tippees”) in breach of a fiduciary duty to the company, the insiders remain just as liable when the tippees trade on such information as when the insiders conduct the trades themselves. And under many circumstances, the tippees are liable for trading on the insider information, too. The test is whether an insider “personally will benefit, directly or indirectly, from his disclosure.” When the insider’s benefit is based on a gift of confidential information to a relative or friend, the insider must either expect a quid pro quo or must intend to benefit the tippee. And apart from tips being given as gifts, insiders and tippees can be liable under a broad array of circumstances when the tippee gives something of value back to the insider. Examples include a “reputational benefit that will translate into future earning,” an instance when the tippee gave one insider “an iPhone, live lobsters, a gift card, and a jar of honey,” and an instance when the tippee had another insider admitted into an investment club where the insider “had the opportunity to access information that could yield future pecuniary gain” (even though he never realized that opportunity).
Worth noting, the U.S. Department of Justice (DOJ) can bring criminal insider trading actions against insiders and tippees under the criminal securities fraud statute, and this statute actually requires the government to satisfy fewer elements than the civil SEC insider trading rule, Rule 10b-5. Specifically, the criminal securities fraud statute does not require proof of an insider’s fiduciary duty or proof of a personal benefit. Recently, the DOJ’s Acting Chief of the Fraud Section as well as the Assistant Chief of the Fraud Section’s Securities & Financial Fraud Unit wrote an article touting the advantages of prosecuting insider trading under the criminal securities fraud statute. The authors explained that Rule 10b-5 “has been interpreted so extensively that the case law underlying it is, at times, unhelpful to the government.” The criminal securities fraud statute, meanwhile, “offers a simpler approach, without the unwelcome freight which decades of litigation—much of it civil—has piled onto [Rule] 10b-5.”
Government regulators are specifically focused on insider trading now because of the volume of material, nonpublic information being produced in response to the COVID-19 pandemic. On March 23, 2020, Stephanie Avakian and Steven Peikin, Co-Directors of the SEC’s Division of Enforcement, issued a statement, in which they emphasized the importance of maintaining market integrity and stated that the Enforcement Division “is committing substantial resources to ensuring that . . . investors are not victims of fraud or illegal practices.” The SEC is concerned that, during the pandemic, “corporate insiders are regularly learning new material nonpublic information that may hold an even greater value than under normal circumstances.” The SEC also recognizes that, during COVID-19 outbreak, “a greater number of people may have access to material nonpublic information than in less challenging times.” The concern is exacerbated by the fact that, subject to certain conditions, public companies can have a 45-day extension to file with the SEC certain disclosure reports due on or before July 1, 2020.
In its March 25, 2020 guidance regarding disclosure and securities law obligations in connection with the COVID-19 pandemic, the SEC again emphasized that if COVID-19 has had a material effect on a company or if a company is aware of a material risk related to COVID-19, “the company, its directors and officers, and other corporate insiders who are aware of these matters should refrain from trading in the company’s securities until such information is disclosed to the public.”
On April 8, 2020, SEC Chairman Clayton and Director of the SEC Division of Corporation Finance, William Hinman, issued a statement on the importance of disclosure and urged public companies “to provide as much information as is practicable regarding their current operating status and their future operating plans under various COVID-19-related mitigation conditions” in their earnings releases, analyst calls, and in subsequent communications to the marketplace. One of the reasons for such encouragement to disclose information about the company’s current operations and plans is a concern about insider trading. Chairman Clayton and Director Hinman clearly stated that “companies and their investors are well served when the type of information we outlined [in the statement] is held closely until disclosed, and, when disclosed, is broadly disseminated.” (Similarly, the Commodity Futures Trading Commission recently announced that it “will aggressively pursue misconduct in our markets tied to the impact of the coronavirus pandemic.”)
Insider trading is relatively uncomplicated for government regulators to identify and investigate, and teams of enforcement attorneys at the SEC and criminal prosecutors at the DOJ are assigned to investigate this conduct and pursue these cases. Frequently when a company makes an announcement that has a significant impact on stock price, the SEC or independent regulators (such as FINRA and NYSE Regulation) direct the company to report to the regulators: (i) the identity of each person who learned about the insider information prior to the company’s announcement, (ii) when each person learned of the information, and (iii) the corporate division or third-party where each person worked. Separately, the regulators review trading data for the stock and derivatives, and they identify each trader who profited by making trades a short time before and after the public announcement of the insider information. All that’s left then is for the regulator to compare the two lists. When regulators see a profitable trade or series of trades made by a person on the company’s disclosed list of insiders, the regulators frequently initiate an insider trading investigation. And, even when a trader who is not on any list of corporate insiders makes a series of profitable trades straddling a number of announcements, regulators often still will initiate an insider trading investigation to see if that trader was tipped by one or more insiders.
The STOCK Act
The STOCK Act has been in the news recently because of allegations of unlawful trading based on information learned during classified briefings concerning COVID-19. Under the Act, virtually every federal government official and employee “owes a duty arising from a relationship of trust and confidence to the United States Government and the citizens of the United States with respect to material, nonpublic information derived from” each person’s government employment or “gained from the performance of such person’s official responsibilities.” In other words, the STOCK Act underscores fiduciary duties owed by government officials and employees, and because the insider trading securities laws prohibit fiduciaries from trading on material, non-public information, the STOCK Act sweeps government officials and employees under those same laws. Importantly, the STOCK Act impacts more than just government officials and employees and likely also prohibits tippees from trading on confidential government information.
This intersection between government information and corporate insiders presents opportunities for insider trading and will be monitored carefully by government regulators. A recent study shows that insider trading spiked in the aftermath of the financial crisis in 2008 and 2009 as the government released funds under the Troubled Asset Relief Program (TARP) to certain financial institutions. Researchers at the University of Pennsylvania, Stanford University, University of Cambridge, and University of Navarra recently studied trading at 497 financial institutions during 2005 to 2011 (capturing conduct before, during, and after distribution of TARP funds). The researchers found “strong evidence of a relation between political connections and informed trading during the period in which TARP funds were disbursed.” Specifically, they found “a pronounced increase in the trading activity of politically connected insiders 30 days prior to the announcement.” According to the researchers, “[d]uring the period over which TARP funds were disbursed, the difference in one-month-ahead future returns between the purchases and sales of insiders with (without) political connections [was] both economically and statistically significant.” Meanwhile, the researchers found that similar results did not occur “among insiders without political connections: insiders without political connections [did] not appear to time their trades to coincide with TARP infusions.” And they found “no evidence of a relation between political connections and informed trading” either during over the 24 months leading up to the financial crisis or during the crisis period before the creation of TARP”—that is, before October 2008.
This study is highly relevant today and most certainly has come to the attention of regulators at the SEC and DOJ.
What to Do?
Companies and corporate insiders need to be aware that their transactions in the company’s securities, and the trading of anyone whom those insiders might tip, are going to be monitored closely by the SEC, the DOJ, and other regulators throughout the COVID-19 pandemic. Insiders who are involved in the company’s discussions, compilation, and review of material, non-public information about the impact of COVID-19 on the company should not trade on such information and should not share such information with third-parties (without a legitimate business reason to do so) until such information is disclosed to the public. The SEC stated in its March 25, 2020 press release that the SEC “encourages all companies and other related persons to consider their activities in light of their disclosure obligations under the federal securities laws. For example, where a company has become aware of a risk related to the Coronavirus that would be material to its investors, it should refrain from engaging in securities transactions with the public and discourage directors and officers (and other corporate insiders who are aware of these matters) from initiating such transactions until investors have been appropriately informed about the risk.”
Companies should review their insider trading policies and evaluate whether the policies should be amended (i) to strengthen preclearance procedures; (ii) to broaden the group of individuals covered by the policies or the definition of material, non-public information included in the policies; or (iii) to update other terms of the policies to incorporate the impact of COVID-19 pandemic. Companies also should consider refreshing their internal training on their insider trading policies or issuing internal reminders about the policies.
In addition, companies should review the terms of their 10b5-1 plans, as well as any 10b5-1 plans entered into by insiders themselves. Attention should be given to the terms of the plans concerning events that could lead to the suspension or termination of the 10b5-1 plans, either upon the notice of a company or the insider to the investment bank implementing the plan or in the bank’s discretion in case of a force majeure event. Companies and insiders should also be cautious in establishing new 10b5-1 plans or amending existing 10b5-1 plans during the COVID-19 outbreak. A 10b5-1 plan can be established only when the person entering into the plan is not aware of any material, non-public information about the company or its securities, which requires a careful consideration during the COVID‑19 outbreak. A 10b5-1 plan also cannot be amended when the person who has entered into such plan is aware of material, non-public information, and it is not recommended to frequently modify or suspend 10b5-1 plans.
Returning to the title of this article and whether to trade or not to trade during the COVID-19 outbreak, if an insider or tippee is in the possession of material, nonpublic information, the answer is simple—do not trade or engage in any other transaction in the company’s securities on the basis of such information until it is broadly disseminated to the public.
"To Trade or Not to Trade during the COVID-19 Outbreak?" by Paul H. Tzur and Yelena M. Barychev was published in FEI Daily on April 21, 2020.