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Feb 1993

An accountant's guide to the SEC's new insider trading regulations. (Accountant's Liability)

by Rosen, Robert C.

    Abstract- The SEC's powers in curtailing insider trading and other trading-related violations have been significantly broadened with the passage of three Federal statutes. The Insider Trading Sanctions Act of 1984 (ITSA) gave the SEC the authority to ask the courts to impose penalties on illegal traders and on those who pass on private information to third parties. The Insider Trading and Securities Fraud Enforcement Act of 1988 expanded the coverage of the ITSA to include the punishment of employers who fail to fulfill their obligation as 'controlling persons' to prevent their employees from becoming involved in insider trading. Finally, the Securities Enforcement Remedies and Penny Stock Reform Act of 1990 empowered the SEC to directly impose civil penalties on securities law violators. Accountants should make every effort to understand these insider regulations. Several questions that accountants should ask themselves before buying or selling securities are suggested.

No Ivan Boesky

In the recent insider trading case of SEC v. Katz, et al., Barry N. Katz and Steven Wold, partners in the accounting firm of Vogel, Katz and Wold, Ltd., consented to surrender to the SEC several thousand dollars in alleged illegal profits, interest and penalties, and agreed to a Federal court order permanently enjoining them from future violations of the Federal securities laws. The basis of the SEC complaint against the accountants was that while performing accounting services for Atcor, an Atcor director disclosed to Katz certain confidential information about the impending acquisition of Atcor by Tyco Laboratories, Inc. Katz allegedly told Wold about the possible takeover and on June 30, 1987, both subsequently purchased Atcor stock before the takeover announcement. The two sold their stock nine days later on July 8, 1987, making a joint profit of $4,625 on the increase in the price of Atcor shares after the public announcement of Tyco's tender offer. The SEC investigation and Federal court proceedings against Katz and Wold and their accounting firm are not atypical of the types of cases brought by the SEC against accountants and auditors.

Severe Sanctions for an Uncertain Crime

Despite the recent decline in hostile takeover and merger activity that so characterized the roaring 1980s, illegal insider trading in today's market is still a key focus of SEC enforcement efforts, as well as private damage claims by issuers and shareholders. Unfortunately, as one commentator aptly described it, insider trading law is exceedingly "murky." Nevertheless, violators continue to be subject to Federal, criminal, and civil prosecution, face destruction of their careers, and public disgrace. Since 1984, Federal laws have increased the potential sanctions for trading-related violations by several orders of magnitude.

The SEC's New Powers

Although the restrictions on insider trading have been fashioned largely by the courts, three Federal statutes give judge-made law significantly more deterrent effect. Under The Insider Trading Sanctions Act of 1984 (ITSA) the SEC was empowered for the first time to seek court-imposed penalties of up to three times a trader's profits (or avoided losses). Those who intentionally communicate or tip private market-sensitive information to a third person who then profits by trading securities are subject to the same sanctions.

The breadth and persistence of the 1980s Wall Street abuses, despite ITSA, so outraged Congress that in 1988, it unanimously passed The Insider Trading and Securities Fraud Enforcement Act (ITSFEA). The act extended the reach of penalties to employers who, as "controlling persons," do not take steps to attempt to prevent illegal employee trading. Controlling persons are subject to civil penalties of up to the greater of $1 million or three times the amount of illicit trading profit (or loss avoided).

Washington's latest move to bolster market integrity is the Securities Enforcement Remedies and Penny Stock Reform Act of 1990. While Remedies Act's thrust is directed at areas other than insider trading, the SEC's Director of Enforcement, William McLucas, has noted that the act authorizes the SEC to directly impose civil penalties in administrative proceedings involving "willful" insider trading violations.

In addition to criminal prosecution by the U.S. Justice Department and SEC Federal injunctive enforcement actions, the SEC may suspend or bar professionals practicing before it, such as accountants and attorneys, in Rule 2(e) proceedings. Professionals also face discipline by private and state licensing bodies. And securities law violators are generally subject to state regulatory authorities, and often face exposure in private civil damage actions.

As the Katz case demonstrates, the SEC does not restrict itself to high dollar "celebrity" cases. Proceedings such as SEC v. Jabour, et al. (three employees in computer firm's accounting department separately disgorged $22,000, $3,800, and $1,900) exemplify the SEC's determination to send the message that illegal insider trading will not be tolerated on any scale. Assisting the Commission in this regard are the securities exchanges' and the National Association of Securities Dealers' (NASD) electronic surveillance programs.

The New York Stock Exchange (NYSE) computer system known as Stock Watch monitors daily trading to detect stock price movements and volume activity which exceeds specified parameters. The NYSE also uses its Automated Search and Match System to compare trading data with a database which contains information on 75,000 companies and subsidiaries, and 500,000 executives, bankers, attorneys and accountants. The NASD employs the Real-Time Stockwatch Report to identify unusual trading activity, and the Insider Exception System to track and analyze stock closing prices before significant developments. The exchanges and the NASD coordinate their monitoring programs through use of the Intermarket Surveillance Information System.

Negotiating Insider Trading Regulations

In view of the strength and reach of the SEC's new powers and the ambiguous nature of the law, new approaches to understanding insider regulations should be considered. One method is to utilize the decision- tree concept. By responding to a series of questions it is possible to determine whether it is safe to buy or sell the securities of a particular public company (the "issuer").

A hypothetical example may help, John Smith has learned certain information about Double-Helix. To determine if Smith may trade the public/private nature, and the importance of that information must be analyzed. The analysis then shifts to Smith himself and concerns his relationship to Double-Helix and how he obtained the information. Does Smith's information relate to a corporate takeover? Did Smith receive a "tip" about Double-Helix from a third party.

Is The Information Public?

There are no restrictions on trading in Double-Helix securities based on information about the company which is public. Insider trading restrictions focus on the source of the information about the issuer of the securities being traded. When a person or unpublished document is the source of information about an issuer, it is less likely that such information is accessible to the public generally, i.e., it is less likely that the information is public. Information about Double-Helix is considered public when it has been disseminated in a medium that permits the market to learn of the information and reflect such information in Double-Helix's stock price. Such a medium may be a national business publication, a wire service or an analyst's report, such as the Dow Jones wire service or the Wall Street Journal.

New, hard information about Double-Helix such as an earnings report, may be deemed public within a day or hours after its appearance on the Dow Jones. More subjective information, such as the significance of a new patent application, or information about a company whose stock trades in a lower tier of the over-the-counter market, such as in the "Pink Sheets," is assimilated and becomes public more slowly. In such situations, it may take days or longer for the information to be considered public.

Is The Information Material?

Assuming the information about Double-Helix is non-public, the next question is whether it is "material." In other words, is disclosure of the information likely to result in a significant change in the price of Double-Helix's stock? Or, would a reasonable investor consider the disclosure as substantially changing the total mix of information about Double-Helix which had previously been publicly available? If so, the information is considered material. For example, earnings projections and prospective takeover information are usually considered material. Investors are generally free to trade on the basis of non-material information.

Is There A Fiduciary Relationship?

Traditional Insiders. At this point, Mr. Smith knows (or has recklessly disregarded facts suggesting) that he has non-public material information about Double-Helix, whose securities he wants to trade. Smith's options depend on whether he has a fiduciary duty or relationship of trust with the source of the information. Here, in the parlance of insider trading law, the question is whether Smith is an "insider." If Smith is an officer, director, or employee of Double- Helix, he has a fiduciary duty to the company and is considered to be a "traditional insider." Traditional insiders are deemed to have a relationship of trust and confidence with their employers based on an employment contract, company policies or custom and practice in the employer's industry. Smith must therefore either disclose the information to the marketplace or abstain from trading in Double-Helix's securities and from tipping others who might trade.

Temporary Insiders. Auditors, law firms, brokers, and investment bankers often become "temporary" insiders. For example, if there is an agreement or implicit understanding between Park Johnson & Co., certified public accountants, and Double-Helix that information is furnished in confidence and may be used only for the company's benefit, Park Johnson assumes a fiduciary duty to its client, Double-Helix. As temporary insiders, Park Johnson and its employees may not misappropriate or steal this confidential information from Double-Helix for their own personal benefit. This flat prohibition bars both traditional and temporary insiders from trading (and tipping or informing others who might trade) in the securities of their employers or clients on the basis of material non-public information they have purloined. It also bars insiders from trading in the securities of any company, based on information which the insider secreted from his employer or client. Insiders are similarly forbidden from tipping such information to third parties.

Non-Insiders. A person who has no fiduciary duty to, or trust relationship with, the source of the information is not an insider. For example, such an individual may be free to trade on the basis of an overheard conversation.

Does The Information Relate To A Tender Offer?

SEC Rule 14e-3 prohibits trading by anyone who obtains material information about an unannounced corporate takeover or tender offer, where that person knows or has reason to know that the information came directly or indirectly from the bidder or target. This ban is across- the-board and applies regardless of whether the prospective trader has a fiduciary duty or relationship of trust with anyone. Further, those who have such information about tender offers are generally barred from disclosing it to others who are likely to trade.

Whether a recipient of inside information is permitted to trade depends on whether his source breached a duty to maintain the confidence of such information, and if so, whether the recipient knew of the breach.

Richards, a director of Double-Helix, tells Smith, a securities analyst, about an internal company report, concluding that certain major assets were overvalued. May Smith trade once he has such information? The answer depends on Richards' motive for disclosing the information to Richards. If Richards' intention was to seek a "personal benefit" (e.g., as part of a quid pro quo deal with Smith, or to enhance his reputation in the investment community, or even to make a "gift" of information) then he has breached his fiduciary duty to Double-Helix. If Smith knew or had reason to know of Richards' breach of duty, then Smith, as a recipient of inside information, is barred from trading until the information becomes public.

Employer Prevention Programs

With regard to client confidentiality, Rule 301 of the AICPA's Code of Professional Conduct prohibits members from disclosing confidential client information without the client's specific consent. Besides potential discipline by professional associations for lax controls, accounting firms may be liable as controlling persons for employee misconduct under ITSFEA. Employers who know or are indifferent to circumstances which suggest illegal employee trading are subject to penalties of up to the greater of three times the trader's profits, or $1 million. Controlling persons of individuals who tip inside information are subject to the same sanctions, even when the informer does not trade.

As members of a profession which frequently exposes themselves to sensitive information, it is advisable for accounting and auditing firms to adopt procedures to prevent insider trading. Such a program may considerably reduce the possibility that a firm will be found "reckless" and therefore liable under ITSFEA for not being aware of probable employee violations. The details of a firm's program will depend largely on firm size, and on the nature and level of sophistication of its practice. However, at a minimum an insider trading policy should describe and endorse the legal prohibitions against wrongful trading and tipping. All employees (including clerical personnel) should be provided with a copy of the firm's policy statement and, in turn, should acknowledge in writing their understanding and agreement to abide by it. The firm should periodically remind employees of the policy and revise it as necessary.

Independence requirements forbid accountants from having financial interests in audit clients. However, these restrictions may not apply to many accountants who are actively involved in non-audit, multi-faceted consulting practices. Firms engaging in such activities may wish to adopt more detailed insider trading policies. For example, when an employee has non-public material information about a firm client, all employees may be prohibited from trading in that client's securities. Alternatively, the firm may bar trading in client securities. Alternatively, the firm may bar trading in client securities. Trading in non-client securities about which one or more firm employees has non- public material information may be prohibited. Investment by firm personnel in individual stocks may be barred and equity ownership allowed only through mutual funds, for example. Requiring pre-clearance or reporting securities transactions may also be considered, as may application of a firm's policy to members of employee households. Whatever a firm's trading restrictions, it is imperative that they be consistently monitored and enforced. As has been observed, the failure to do so, whether from inability or unwillingness, may result in more exposure than if the firm had never adopted the restrictions. Therefore, the emphasis should be on restrictions which are realistic and practical in the particular circumstances.

Mr. Rosen is a partner with the Los Angeles law firm of Lewis, D'Amoto, Brisbiois & Bisgaard. Mr. Tevis is in private practice in Los Angeles. The authors have both JD and LLM law degrees.

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