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					         Insider trading quiz
             The Wall Street Journal
                   Friday, October 4, 2002



Q&A: The In's and Out's of Insider Trading

“So you get a hot stock tip on the golf course this weekend. Will
      you get in trouble with the feds if you trade on it?”
                “Insider trading”

• Insider trading regulation in the US
  – Classic insider trading:
     • Fraudulent silence under Section 10(b)
     • duty of trust or confidence to “abstain or disclose”
  – Tipping liability:
     • know or should know that
     • tipper has breached duty for improper personal benefit
  – Misappropriation liability:
     • Fraud on source “in connection with” securities trading
     • Maintain integrity of securities markets
                “Insider trading”

• Insider trading regulation in the US
  – Classic insider trading:
     • Fraudulent silence under Section 10(b)
     • duty of trust or confidence to “abstain or disclose”
  – Tipping liability:
     • know or should know that
     • tipper has breached duty for improper personal benefit
  – Misappropriation liability:
     • Fraud on source “in connection with” securities trading
     • Maintain integrity of securities markets
                “Insider trading”

• Insider trading regulation in the US
  – Classic insider trading:
     • Fraudulent silence under Section 10(b)
     • duty of trust or confidence to “abstain or disclose”
  – Tipping liability:
     • know or should know that
     • tipper has breached duty for improper personal benefit
  – Misappropriation liability:
     • Fraud on source “in connection with” securities trading
     • Maintain integrity of securities markets
                “Insider trading”

• Effect of SEC rules
  – Rule 10b5-1: state of mind when trading “on the
    basis” of material, nonpublic information
     • “aware” (“conscious knowledge”)
     • Pre-existing trading plans
  – Rule 10b5-2: duty to source in business/personal
    relations
     • Agree to maintain confidentiality
     • Practice of sharing known confidences
     • Spouse, parent, child, sibling – unless no confidentiality
  – Regulation FD: no special access for analysts
                “Insider trading”

• Effect of SEC rules
  – Rule 10b5-1: state of mind when trading “on the
    basis” of material, nonpublic information
     • “aware” (“conscious knowledge”)
     • Pre-existing trading plans
  – Rule 10b5-2: duty to source in business/personal
    relations
     • Agree to maintain confidentiality
     • Practice of sharing known confidences
     • Spouse, parent, child, sibling – unless no confidentiality
  – Regulation FD: no special access for analysts
                “Insider trading”

• Effect of SEC rules
  – Rule 10b5-1: state of mind when trading “on the
    basis” of material, nonpublic information
     • “aware” (“conscious knowledge”)
     • Pre-existing trading plans
  – Rule 10b5-2: duty to source in business/personal
    relations
     • Agree to maintain confidentiality
     • Practice of sharing known confidences
     • Spouse, parent, child, sibling – unless no confidentiality
  – Regulation FD: no special access for analysts
              Insider trading quiz
1. You work as CFO in Up-      1. Yes. This is classic
N-Rising, a bakery                insider trading.
franchiser, that is opening
high-end bakery shops
throughout the country. The    • Only question is whether
numbers have been good,          drop in pastry sales is
until this month when you        “material”
notice an internal report      • State of mind – use
showing a 25% fall in            versus knowledge –
royalties from pastry sales.     resolved by Rule 10b5-1
                                 (“aware”)
Question: You sell some of
your stock. Insider trading?
              Insider trading quiz
1. You work as CFO in Up-      1. Yes. This is classic
N-Rising, a bakery                insider trading.
franchiser, that is opening
high-end bakery shops
throughout the country. The    • Only question is whether
numbers have been good,          drop in pastry sales is
until this month when you        “material”
notice an internal report      • State of mind – use
showing a 25% fall in            versus knowledge –
royalties from pastry sales.     resolved by Rule 10b5-1
                                 (“aware”)
Question: You sell some of
your stock. Insider trading?
             Insider trading quiz
2. You are outside counsel to 2. Yes. You are a
Up-N-Rising. The CFO at Up-        temporary insider ( see
N-Rising calls you and tells       fn 14 - Dirks case).
you about this quarter’s 25%
fall in pastry sales - resulting  Drop in royalties is
in a 15% drop in earnings .        “material”
She asks whether the
company should disclose this • Duty to source in
in a press release.                business/ personal
                                   relation (Rule 10b5-2)
                                   – Agree to maintain
Question: You sell Up-N-              confidentiality
Rising short. Insider trading?
                                   – Practice of sharing
                                      known confidences
             Insider trading quiz
2. You are outside counsel to 2. Yes. You’re a temporary
Up-N-Rising. The CFO at Up-        insider (fn 14 - Dirks).
N-Rising calls you and tells
you about this quarter’s 25% • Drop in royalties is
fall in pastry sales - resulting   “material”
in a 15% drop in earnings .
She asks whether the             • Duty to source in
company should disclose this       business/ personal
in a press release.                relation (Rule 10b5-2)
                                   – Agree to maintain
                                      confidentiality
Question: You sell Up-N-
Rising short. Insider trading?     – Practice of sharing
                                      known confidences
             Insider trading quiz
3. You are a friend of Ralph,   3. Yes. You received a
who you know is sales              tip (duty to inquire).
manager for Up-N-Rising.
Ralph tells you that            •   If “something” is
“something” is happening at         material, nonpublic
the company and you should      •   Elements of illegal
sell your Up-N-Rising               tipping
holdings, if you have any.
                                    –   Breach of duty by
Ralph says no more.                     tipper (personal
                                        benefit)
Question: You sell your Up-         –   Tippee knows or
                                        reason to know of
N-Rising stock? Insider                 violation
trading?
             Insider trading quiz
3. You are a friend of Ralph,   3. Yes. You received a tip
who you know is sales              (duty to inquire).
manager for Up-N-Rising.
Ralph tells you that            •   If “something” is
“something” is happening at         material, nonpublic
the company and you should      •   Elements of illegal
sell your Up-N-Rising               tipping
holdings, if you have any.
                                    –   Breach of duty by tipper
Ralph says no more.                     (personal benefit)
                                    –   Tippee knows or reason
Question: You sell your Up-             to know of violation
N-Rising stock? Insider
trading?
              Insider trading quiz
4. You are a member of a         4. No. Probably no duty to
golf foursome. One of the           inquire.
foursome says, “I think
something’s happening at         •   What does “something
Up-N-Rising. You’d                   happening” mean?
probably do well to short it.”   •   What are you aware of?
He says no more.
                                 •   What was the source of
                                     information?
Question: You make no
further inquiries and buy Up-
N-Rising put options. Insider
trading?
              Insider trading quiz
4. You are a member of a         4. No. Probably no duty to
golf foursome. One of the           inquire.
foursome says, “I think
something’s happening at         •   What does “something
Up-N-Rising. You’d                   happening” mean?
probably do well to short it.”   •   What are you aware of?
He says no more.
                                 •   What was the source of
                                     information?
Question: You may no
further inquiries and buy Up-
N-Rising put options. Insider
trading?
             Insider trading quiz
Duty to inquire

•   WSJ: “If not from a company insider, you’re probably stupid
    to just listen" and trade on it, says Jeffrey Haas, a professor of
    securities law at New York Law School. “You don't have a
    duty to find out where it came from.“

•   WSJ: Nancy Grunberg, former assistant director of SEC
    enforcement, says, "The SEC would want to know -- unless it
    was on a piece of paper that fell out of the sky -- whether you
    asked about the source of the information before you acted on
    it."
              Insider trading quiz
5. New scenario. You are the     5. Yes – actually
CFO of KK Donuts and have           “outsider trading.”
been cogitating on what to do       You cannot
with all the company’s extra        misappropriate your
cash. You talk with the             company’s info.
company’s CEO and
investment banker, who agree
buying Up-N-Rising would be a    •   “Material”
good move. You begin to form     •   Duty to source
a takeover team.
                                 •   “Awareness”
Question: You buy Up-N-
Rising stock. Insider trading?
              Insider trading quiz
5. New scenario. You are the     5. Yes – actually
CFO of KK Donuts and have           “outsider trading.”
been cogitating on what to do       You cannot
with all the company’s extra        misappropriate your
cash. You talk with the             own company’s
company’s CEO and                   info.
investment banker, who agree
buying Up-N-Rising would be      •   “Material”
a good move. You begin to        •   Duty to source
form a takeover team.
                                 •   “Awareness”
Question: You buy Up-N-
Rising stock. Insider trading?
              Insider trading quiz
6. You are the spouse of the 6.      Yes. You may had duty, or
                                     perhaps received a tip.
CFO of KK Donuts, who tells
you that she will be out of   •      Tipper violated duty –
town for the next few days.          personal benefit
                                     –   WSJ: “Prosecutors have
“We’re looking at buying Up-             found it fairly easy to satisfy
                                         the requirement. Courts
N-Rising.” You know that this            have held sufficient to show
is only going to complicate              that the person's reputation
                                         among colleagues would be
your life. You wish there                enhanced by having it
                                         known that he was a good
were a silver lining.                    tipper.”
                                 •   Recipient had duty to source
                                     –   Rule 10b5-2: “duty”
Question: You buy Up-N-                  presumed in close family
                                         relations, unless no
Rising stock. Insider trading?           expectation of confidentiality
               Insider trading quiz
6. You are the spouse of the 6. Yes. Either duty, or tip.
CFO of KK Donuts, who tells
you that she will be out of    • Tipper violated duty – personal
town for the next few days.      benefit
“We’re looking at buying Up-      – WSJ: “Prosecutors have found
                                    it fairly easy to satisfy the
N-Rising.” You know that this       requirement. Courts have held
is only going to complicate         sufficient to show that the
your life. You wish there were      person's reputation among
                                    colleagues would be enhanced
a silver lining.                    by having it known that he was
                                         a good tipper.”
                                   •   Recipient had duty to source
Question: You buy Up-N-                – Rule 10b5-2: “duty” presumed
Rising stock. Insider trading?           in close family relations, unless
                                         no expectation of confidentiality
              Insider trading quiz
7. You are the head of strategic7.   No (maybe)
planning at KK Donuts. You are
no fool. You figure that when KK•    No duty to outside
Donuts announces it is acquiring     company
Up-N-Rising, the stock prices of•    No duty to source?
competitors of Up-N-Rising will
likely fall. The Up-N-Rising         – Current academic
acquisition is moving apace.           “state of art” issue
                                     – Reach of insider
                                       trading prohibition?
Question: You sell short the
stock of Up-N-Rising’s
competitors. Insider trading?
             Insider trading quiz
7. You are the head of strategic   7. No (maybe)
planning at KK Donuts. You are
no fool. You figure that when KK   • No duty to outside
Donuts announces it is acquiring     company
Up-N-Rising, the stock prices of   • No duty to source?
competitors of Up-N-Rising will
likely fall. The Up-N-Rising          – Current academic
acquisition is moving apace.            “state of art” issue
                                      – Reach of insider
                                        trading prohibition?
Question: You sell short the
stock of Up-N-Rising’s
competitors. Insider trading?
             Insider trading quiz
8. You are an outside “public
relations” consultant to KK        8. Yes (probably)
Donuts. The company's CEO
calls and tells you KK Donuts      Rule 10b5-2
may be buying Up-N-Rising to
expand into the high-end French    • Defines duty to
bakery business. You are asked        source
if this would be good for public   • “Persons … have
relations. You have no                history, pattern or
confidentiality agreement.            practice of sharing
                                      confidential
                                      information … so
Question: You buy Up-N-Rising         recipient had
stock. Insider trading?               reason to know
                                      communicator
                                      expected
                                      confidentiality.”
             Insider trading quiz
8. You are an outside “public      8. Yes (probably)
relations” consultant to KK
Donuts. The company's CEO          Rule 10b5-2
calls and tells you KK Donuts
may be buying Up-N-Rising to       • Defines duty to
expand into the high-end French       source
bakery business. You are asked     • “Persons … have
if this would be good for public      history, pattern or
relations. You have no                practice of sharing
confidentiality agreement.            confidential
                                      information … so
Question: You buy Up-N-Rising         recipient had
stock. Insider trading?               reason to know
                                      communicator
                                      expected
                                      confidentiality.”
             Insider trading quiz
9. You are the founder KK            9. Yes (if done right)
Donuts. You hold about 40% of
the company’s stock and want to      •   Rule 10b5-1
diversify. Problem is if you sell,       (Martha Stewart
during what every knows is an            defense)
expansion period, you will be            –   Pre-existing
                                             trading plan
accused of insider trading. You              negates
tell your broker to sell 1% every            “awareness”
month over the next two years –          –   Must show
reducing your KK position to 16%.            •   Binding contract,
                                                 instruct another,
                                                 written plan –
                                                 when “unaware”
Question: You sell (under the                •   Strategy gives
plan) when you are aware of the                  specifics,
                                                 formula, or
Up-N-Rising deal. Insider trading?               disables
              Insider trading quiz
9. You are the founder KK          9. No (if done right)
Donuts. You hold about 40% of
the company’s stock and want to    • Rule 10b5-1
diversify. Problem is if you sell,
                                   (Martha Stewart defense)
during this volatile expansion
                                       – Pre-existing trading
period, you will be accused of           plan negates
insider trading. You tell your           “awareness”
broker to sell 1% every month          – Must show
over the next two years – reducing        • Binding contract,
your KK position to 16%.                    instruct another,
                                              written plan – when
                                              “unaware”
Question: You sell (under the               • Strategy gives
                                              specifics, formula, or
plan) when you are aware of the               disables
Up-N-Rising deal. Insider trading?
              Insider trading quiz
10. You are best friends with     10. Yes (perhaps)
Karl Konners, founder and
CEO of KK Donuts. You both        • Similar to facts of
use the same broker. This           Martha Stewart –
morning the broker called you       Imclone
and blurted, “Karl is selling.
                                     – Insiders selling -
Karl is really selling.” You           “material”
knew that KK Donuts was                information?
being investigated by the FDA        – Breach of duty by
over its products’ fat content.        KK to “inform”
                                       broker
                                     – Sub-tippee knows or
Question: You sell your KK             should know
Donuts holdings. Insider
trading?
              Insider trading quiz
10. You are best friends with     10. Yes (perhaps)
Karl Konners, founder and
CEO of KK Donuts. You both        • Similar to facts of
use the same broker. This           Martha Stewart –
morning the broker called you       Imclone
and blurted, “Karl is selling.
                                     – Insiders selling -
Karl is really selling.” You           “material”
knew that KK Donuts was                information?
being investigated by the FDA        – Breach of duty by
over its products’ fat content.        KK to “inform”
                                       broker
                                     – Sub-tippee knows or
Question: You sell your KK             should know
Donuts holdings. Insider
trading?
               Martha Stewart

David M. Brodsky, co-head of securities litigation group
    at Latham & Watkins in New York:

    The mere fact that insiders are selling, even
    heavily, isn't necessarily "material," or market-
    moving information (though nonpublic). But if it
    turns out that the sales truly are unique -- that the
    founders had never sold shares before, for
    example -- you may be courting trouble.
              Insider trading quiz
11. You are in a taxi on a rainy     11. No.
night in New York City. The driver
stops to pick up two wet             • No breach of duty
customers. “My gosh,” you think,         when KK talked to
“It’s Karl Konners, the head of KK       associate
Donuts.” Karl talks to his associate
in animated whispers about the       • No duty of
FDA dropping its fat-content             eavesdropper to
investigation. “Great news for KK        source
Donuts,” you tell yourself.             – No misappropriation
                                        –   No tipping

Question: You buy KK Donuts
stock. Insider trading?
              Insider trading quiz
11. You are in a taxi on a rainy     11. No.
night in New York City. The driver
stops to pick up two wet             • No breach of duty
customers. “My gosh,” you think,         when KK talked to
“It’s Karl Konners, the head of KK       associate
Donuts.” Karl talks to his associate
in animated whispers about the       • No duty of
FDA dropping its fat-content             eavesdropper to
investigation. “Great news for KK        source
Donuts,” you tell yourself.             – No misappropriation
                                        –   No tipping

Question: You buy KK Donuts
stock. Insider trading?
              Insider trading quiz
12. You are the head of investor    12. No
relations of KK Donuts. You
have been besieged by inquiries     • Regulation FD (fair
about rumors of an Up-N-Rising        disclosure)
takeover. You talk to senior          – Addresses
management and decide on a               systematic tipping
script: “KK Donuts is in                 to analysts and
preliminary talks with Up-N-             preferred analyst
Rising management.” And so               back-scratching
on. You answer no questions.
                                      – Treated as form
                                         of insider trading
Question: . You call three
leading analysts of KK stock and
read the script. Insider trading?
             Insider trading quiz
12. You are the head of investor   12. Perhaps No
relations of KK Donuts. You
have been besieged by inquiries    • Regulation FD (fair
about rumors of an Up-N-Rising       disclosure)
takeover. You talk to senior         – Addresses
management and decide on a              systematic tipping
script: “KK Donuts is in                to analysts and
preliminary talks with Up-N-            preferred analyst
Rising management.” And so              back-scratching
on. You answer no questions.
                                     – Treated as form
                                        of insider trading
Question: You call three leading
analysts of KK stock and read
the script. Insider trading?
    Regulation FD (fair disclosure)
•    “Advice” to market professionals of material
     nonpublic information
    –   Intentional: simultaneous public disclosure
    –   Unintentional: public disclosure within 24 hours
    –   Applies to senior management, investor relations
•    Exceptions:
    –   Normal course of business
    –   Government officials
    –   Road shows when going public
    –   Disclosure by foreign private issuers
•    Enforcement only by SEC (no private action)
                Insider trading quiz
                     (answers)

1. Yes                    7. No (maybe)
2. Yes                    8. Yes (probably)
3. Yes (inquire)          9. No (if done right)
4. No (not inquire)       10. Yes (perhaps)
5. Yes                    11. No
6. Yes                    12. No

				
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