Federal Securities Law Blog : Federal Securities Lawyer & Attorney : Porter Wright Law Firm : Securities Exchange Law : Serving Ohio, Washington DC, Florida

Earlier this week, Columbus retailer Big Lots Inc. filed suit in Florida against a stock research company that Big Lots claims obtained nonpublic information about inventory, payroll, and margins.  Big Lots claims that research firm Retail Intelligence Group stole trade secrets and aided employees’ breach of fiduciary duties by inducing 72 Big Lots managers to disclose the confidential information.  Retail Intelligence Group allegedly sold the information to investors in the form of a research report, which correctly predicted decreased performance for the third quarter.

The lawsuit touches on the difficulty of defining what types of behavior should be considered illegal insider trading.  Federal securities laws (and case law) generally prohibit trading securities in breach of a duty to the issuer (or otherwise) while in the possession of material, nonpublic information.  Research firms are known to estimate inventory, converse with suppliers and customers, and engage experts on specific companies or industries, among other things, in order to predict performance.  There is a serious question as to when simply having detailed insight into the health of a corporation morphs into obtaining nonpublic information.  Federal courts have historically interpreted the term “nonpublic” to mean information that companies have not widely disseminated.

Of further concern are the implications for Regulation FD raised by this lawsuit.  Regulation FD prohibits selective disclosure to market professionals and securityholders of material, nonpublic information unless the information is simultaneously disclosed to the public.  Employees certainly cannot tip others with confidential corporate information.  But it is possible to conceive of a situation where one manager’s disclosure of non-material, non-confidential information becomes material, non-public information in the hands of a research firm that has obtained the same type of information from 71 other managers within a single corporation.

The case has garnered further attention because it comes at a time when the U.S. Government is conducting an ongoing criminal investigation of analysts and consultants who provide similar “expert network” services to hedge funds and mutual funds looking for a trading edge.
 

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On Friday the Cleveland Plain Dealer reported that members of the U.S. House Financial Services Committee bought and sold financial stocks last fall, at the same time that the Committee was approving the bailout, and in the same companies that the Committee would later criticize for incompetence and greed. The article points out two potential problems:

1. The potential for conflicts of interest; and
2. The potential for trading on material, non-public information.

Some of the trades resulted in avoiding significant losses; while perhaps more troubling, some trades resulted in increased losses, which may at least be proof there was no impropriety.

In any event, such trades do not appear to violate Congressional ethics rules (although, arguably they could violate broad rules against using one’s office for “improper advantage”); however, the securities rules are more troublesome. If a member of Congress trades in securities based on material, non-public information provided by a corporate insider, the representative faces possible liability under a tipper/tippee theory assuming other elements of the offense are met. But, if the representative trades based on material, non-public information that results from the representative knowing about a new regulation or government program that will affect a company, liability depends on whether the representative has breached a duty to the source of the information, presumably Congress or some other source to which no duty is owed.

Congressional staffers are not so lucky, as they potentially owe a duty to their representative, the source of the information.

This is not a new issue. The Stop Trading on Congressional Knowledge Act aims to close this loophole but has failed to pass despite annual tries since 2006. Also interesting is the fact that two SEC lawyers got in trouble about a month ago for trading in the securities of issuers under investigation, and the Commission quickly enacted rules to stop the practice. Congress has been at least 3 years slower.
 

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The SEC announced yesterday charges against a former Citigroup investment banker who allegedly tipped his friends and family about upcoming mergers involving Citigroup’s healthcare industry clients, resulting in more than $5,000,000 in illegal insider-trading profits.

The case highlights a common insider-trading scenario: an employees uses inside information not to trade stock in his or her employer, but rather to trade stock in the employer’s clients.

In particular, privately-owned companies tend to think of illegal insider trading as a public-company problem, but often private companies and their employees are privy to information about public-company clients that can lead to insider trading concerns.

For example, the healthcare industry has a strong support industry of researchers, policy analysts, consultants, lobbyists, etc., all of whom potentially have access to material non-public information from their public healthcare clients that can be used to engage in illegal insider trading.

This raises a host of issues for private companies that service public companies, including:

• Should we have a company policy regarding employees owning stock in our clients?
• Should we accept stock as payment for services?
• If an employee who knows a lot about the industry makes great stock picks in client stock, will it seem like illegal insider trading even if technically it is not?
• If an employee pieces together a series of seemingly inconsequential non-public information and trades stock based on that information, what are the chances he or she will be accused of illegal insider trading?
• Is there a difference between having a hunch something good will happen to the client’s stock and knowing something good will happen?
• May an employee trade stock based on information that is technically publicly available (or would be provided by the client upon request) but was never actually in a press release?

These issues become more important as the SEC continues to step up enforcement.
 

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The major U.S. securities exchanges and self-regulatory organizations have agreed to consolidate oversight of insider trading in the hands of two regulators: NYSE Regulation and FINRA. The following equity exchanges and FINRA have signed the agreement, which must now be approved by the SEC:

• American Stock Exchange LLC
• Boston Stock Exchange, Inc.
• CBOE Stock Exchange, LLC
• Chicago Stock Exchange, Inc.
• International Securities Exchange, LLC
• NASDAQ Stock Market, LLC
• National Stock Exchange, Inc.
• New York Stock Exchange, LLC
• NYSE Arca Inc.
• Philadelphia Stock Exchange, Inc.
• NYSE Regulation, Inc. (acting under authority delegated to it by NYSE)

Currently, each securities exchange is responsible for investigating insider trading by its market participants, which amounts to 11 separate programs. The consolidation of power into two regulators is expected to make insider trading investigations more efficient by preventing duplicative efforts and failed detection of illegal activity.

The consolidation may result in more convicted insider traders, or it may simply result in more efficient investigation of insider traders who would have been caught anyway. The Wall Street Journal's MarketWatch reports FINRA has already referred 104 insider trading cases to the SEC in 2008, compared to 118 in all of 2007. NYSE Regulation has referred 90 cases as of the end of June, compared to 141 in all of 2007.
 

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