Regulators demand the impossible when they require issuers to design and implement an effective compliance program to guard against insider trading, a crime that neither Congress nor the SEC has defined with any specificity.  This problem is then compounded by the threat of heavy civil and criminal sanctions for noncompliance.  Placed between this rock and hard place, issuers adopt over-broad insider trading compliance programs that come at a heavy price in terms of corporate culture, cost of compensation, share liquidity, and cost of capital.  The irony is that, since all of these costs are passed along to the shareholders, insider trading enforcement under the current regime has precisely the opposite of its intended effect.  This is the paradox of insider trading compliance for issuers, just one more symptom of a dysfunctional insider trading enforcement regime that is need of a dramatic overhaul.

Firms with weak compliance programs stand to incur derivative civil and criminal liability for the insider trading of their employees, and the penalties (both reputational and monetary) are stiff.

The Insider Trading and Securities Fraud Enforcement Act of 1988 (“ITSFEA”)[1] extended the civil penalty of treble damages[2] to all “controlling persons.”[3]  Under ITSFEA, issuers may incur derivative liability if they “knew or recklessly disregarded the fact that [a] controlled person was likely to engage in the act or acts constituting the violation and failed to take appropriate steps to prevent such act or acts before they occurred.”[4] The failure to adopt and implement effective insider trading compliance programs and procedures counts as evidence of “reckless disregard” under § 21A(b)(1)(A).[5]  The legislative history reflects that the intent behind ITSFEA was to “increase economic incentives” for controlling persons to “supervise vigorously their employees.”[6]

In addition to the risk of stiff civil penalties under ITSFEA, the federal sentencing guidelines offer issuers an added incentive to adopt insider trading compliance policies and procedures.[7]  Under the guidelines, issuers can significantly reduce their “culpability score” for insider trading and other offenses by having an effective compliance and ethics program in place.[8]  Moreover, the Justice Department has made it clear that the adoption and implementation of effective compliance programs will impact the decision to prosecute firms for the actions of their employees.[9]

Despite the severe consequences for non-compliance, Congress, the SEC, and the courts have left key elements of the crime of insider trading vague and undefined.  It is generally understood that an issuer’s employee (or the issuer itself) violates the law against insider trading when she trades (or tips) on the basis of material non-public information in violation of some “fiduciary or other similar relation of trust and confidence.”[10]  But, for example, neither Congress nor the SEC has offered consistent or satisfactory definitions of when information is “nonpublic,” when it is “material,” or what it means to trade “on the basis of” such information.

Faced with this ambiguity in the law, issuers are unable to design compliance programs that will effectively identify and preempt only illicit trades.  Instead, the only way for firms to protect against civil and criminal liability has been to adopt overbroad compliance programs.  For example, issuers often impose overly restrictive pre-clearance standards or excessively long blackout periods. But stingy preclearance and lengthy blackout periods come at a heavy price to firms in terms of corporate culture, cost of compensation, share liquidity, and cost of capital:

• Compliance officers must be skeptical of employees’ claims that they are not trading on the basis of material non-public information when making pre-clearance decisions. Such distrust may lead to resentment by employees.  This resentment may undermine the spirit of cooperation and mutual respect that is so important to a strong compliance culture, and to a firm’s profitability.  Of course firms could turn to outside counsel for pre-clearance decision-making, but at great cost.[11]

• Corporate insiders typically receive a large portion of their compensation in firm shares.[12] These shares only hold value for insiders if they can be liquidated without much difficulty.[13]  Thus, any restrictions the company places on its employees’ ability to monetize these shares will devalue them as compensation, requiring the company to offer more shares to achieve the same remunerative effect.[14]  Thus, restrictive pre-clearance standards and lengthy blackout periods will devalue a firm’s shares as a means of compensation.    This costs the company (and therefore its shareholders) by making compensation more expensive.[15]

• Employees often account for a large proportion of an issuer’s outstanding shares.[16] When they are restricted in their trading, this will decrease liquidity in the firm’s shares.  This, in turn, increases the firm’s cost of capital.[17]

This is the paradox of insider trading compliance for issuers: ambiguity in the law combined with the threat of stiff reputational and legal sanctions creates a perverse incentive to adopt compliance programs that are highly inefficient and costly to shareholders.  Thus, ironically, the very insider trading regulations that were implemented to increase value for shareholders appear to be having the opposite effect.

I have argued elsewhere that issuer-licensed insider trading can be morally permissible and economically harmless.[18]  With this in mind, our insider trading enforcement regime should be modified to permit an issuer to license its employees to trade on its material nonpublic information so long as (1) the insider submits a plan to the firm that details the proposed trade, (2) the firm authorizes the plan, (3) the firm discloses ex ante to the investing public that it will permit its employees to trade on the firm’s material nonpublic information when it is in the interest of the firm, and (4) the firm discloses ex post all trading profits resulting from the execution of these plans.[19]  Issuer-proscribed insider trading and misappropriation trading would remain regulated.

Among other benefits, this reform would dissolve the paradox of insider trading compliance for issuers.  It would permit firms to reject only those trade requests there are firm-specific reasons for rejecting.  In other words, a firm’s best interests—rather than fear of regulatory scrutiny—would dictate whether a trade request is approved.  This would be an internal business decision that requires no subtle (and therefore risky) interpretations of the law.  If a trade request is rejected and the employee trades anyway, then the insider would be subject to enforcement action.  The proposed reform would therefore bring the interests of issuers and regulators into alignment.  This is what we all want.

ENDNOTES

[1] PUB. L. NO. 100-704, 102 STAT. 4677 (1988) (Codified in multiple sections of .15 U.S.C. § 78).

[2] Firms are subject to penalties not exceeding “the greater of [$1,525,000], or three times the amount of the profit gained or loss avoided as a result of such controlled person’s violation.”  Securities Exchange Act § 21A(a)(3), 15 U.S.C. § 78U-1.  The original $1,000,000 penalty was last adjusted for inflation in 2009.  See S.E.C. Release No. 33-9387, 34-68994; IA-3557; IC-30408 (2013).

[3] Although ITSFEA does not expressly define “controlling person,” the legislative history makes it clear that its meaning is adopted from Exchange Act Section 20(a). See Howard M. Friedman, The Insider Trading and Securities Fraud Enforcement Act of 1988, 68 N.C. L. REV. 465 (1990).

[4] Securities Exchange Act § 21A(b)(1)(A), 15 U.S.C. § 78u-1.  Issuers were subject to derivative liability for their employees’ insider trading under Exchange Act Section 20(a), but they were not subject to treble damages.

[5] See, e.g., Weinberger, Preventing Insider Trading Violations: A Survey of Corporate Compliance Programs, 18 SEC. REG. L.J. 180, 185 (1990); Prentice, The Future of Corporate Disclosure: The Internet, Securities Fraud, and Rule 10b-5, 47 EMORY L.J. 1, 83 (1998); WILLIAM K.S. WANG and MARC I. STEINBERG, 884-4 INSIDER TRADING (2010).

[6] WILLIAM K.S. WANG and MARC I. STEINBERG, 814-13 INSIDER TRADING (2010) (quoting Insider Trading and Securities Fraud Enforcement Act of 1988, H. Rep. No. 910, 100^th Cong., 2d Sess. 7, 17 (1988), reprinted in 1988 U.S.C.C.A.N. 6043, 6044, 6048-6051)

[7] See U.S. SENTENCING GUIDELINES MANUAL §§ 8B2.1 (2014).

[8] See U.S. SENTENCING GUIDELINES MANUAL §§ 8C2.5(f) (2014); see also Ellen Podgor, Educating Compliance, 46 AM. CRIM. L. REV. 1523, 1528 n. 37 (2009) (“Companies can reduce their culpability score by three points when they have in place an effective compliance and ethics program.”).

[9] See Memorandum from Larry D. Thompson, Deputy Attorney-General, U.S. Department of Justice, to Heads of Department Components, United States Attorneys on “Principles of Federal Prosecution of Business Organizations” (Jan. 20, 2003).  The 2006 memorandum from Deputy Attorney-General Paul McNulty replaced the Thompson Memorandum, but it preserved its policy toward compliance programs.

[10] Chiarella v. United States, 445 U.S. 222, 228 (1980).

[11] See, e.g., Joan MacLeod Heminway, Materiality Guidance in the Context of Insider Trading: A Call for Action, 52 AM. U. L. REV. 1131, 1180-82 (2003).

[12] See, e.g., M. Todd Henderson, Insider Trading and CEO Pay, 64 VAND. L. REV 505, 508 (2011) (Between 1999-2008, “the average public company executive earned more than half her total pay in the form of stock options or restricted stock”).

[13] See, id. at 508; see also, Karl T. Muth, With Avarice Aforethought: Insider Trading and 10b5-1 Plans, 10 U.C. DAVIS BUS. L.J. 65, 67 (2009).

[14] See, e.g., Henderson, supra note 13, at 509-510.

[15] Heminway, supra note 11, at 1174-77.

[16] See Jesse M. Fried, Insider Trading Via the Corporation, 162 U. PENN. L. REV. 801, 804 (2014).

[17] See, e.g., Yakov Amihud and Haim Mendelson, Asset Pricing and the Bid-Ask Spread, 17 J. OF FIN. ECONOMICS 223-49 (1986) (the greater the liquidity of a security, the lower the expected return required by investors, which decreases the firm’s cost of capital).

[18] See John P. Anderson, Greed, Envy, and the Criminalization of Insider Trading, 2014 UTAH L. REV. 1 (2014); see also, John P. Anderson, What’s the Harm in Issuer-Licensed Insider Trading?, 69 U. MIAMI L. REV 795 (2015).

[19] See John P. Anderson, Anticipating a Sea Change for Insider Trading Law: From Trading Plan Crisis to Rational Reform, 2015 UTAH L. REV. 339, 379-389 (2015).

The preceding post comes to us from John P. Anderson, Associate Professor, Mississippi College School of Law.  The post is based on his recent paper, which is entitled “Solving the Paradox of Insider Trading Compliance” and available here.