Why is this Topic Important to Wealth Managers? This blogticle presents discussion on trades made based on inside information. We have all heard about Enron and the fraudulent practices, but liability can actually extend well beyond insiders. It is thus important to realize sensitive information shared with wealth managers could be subject to federal regulation to prevent trading based on manipulative or deceptive devices.

What is the liability imposed by federal law with regards to trading based on inside information?

Generally trading based on inside information is legislated under Section 10(b) of the 1934 Securities Exchange Act, [1] and SEC Rule 10b-5 promulgated thereunder. [2]

As the law is currently stated, it is unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange:

(a) To employ any device, scheme, or artifice to defraud,

(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or

(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

Generally liability can occur for civil and criminal penalties when an insider or temporary insider tips or trades based on material non-public information. Not only are tippors liable though, tippees may be as well. When an individual trades on material non-public information which was given to him by a tippor, he may be held liable if he knew or had reason to know the tippor was breaching a fiduciary duty (owed to the corporation) by tipping.  A breach of fiduciary duty generally occurs if there is a personal financial gain, increase in reputation or quid pro quo.

Moreover, there may be investor and SEC liability for those who are considered “misappropriatiors”. Under the misappropriation theory an individual may be held criminally or civilly liable based on the purchase or sale of securities on the basis of, or the communication of, material non-public information misappropriated in breach of a duty of trust or confidence.

A duty of trust or confidence generally exists when:

(1) Whenever a person agrees to maintain information in confidence;

(2) Whenever the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the recipient of the information knows or reasonably should know that the person communicating the material nonpublic information expects that the recipient will maintain its confidentiality; or

(3) Whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling. Provided, however, that the person receiving or obtaining the information may demonstrate that no duty of trust or confidence existed with respect to the information, by establishing that he or she neither knew nor reasonably should have known that the person who was the source of the information expected that the person would keep the information confidential, because of the parties’ history, pattern, or practice of sharing and maintaining confidences, and because there was no agreement or understanding to maintain the confidentiality of the information. [3]

Tomorrow’s blogticle will continue to discuss issues related to the practice of wealth management.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] 15 U.S.C.A. § 78j(b).

[2] 17 C.F.R. § 240.10b-5.

[3] 17 C.F.R. § 240.10b5-2.

Tags: Business, Enron, Fiduciary, Freedom of information legislation, Insider trading, Legal liability, SEC Rule 10b-5, U.S. Securities and Exchange Commission

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