The Problem with Insider Giving

For a brief moment last month, Kodak Corporation’s stock soared from $2 a share to more than $33 a share on news that it might obtain substantial government financing. At that peak, Kodak director George Karfunkel unloaded shares then worth $116 million. If he had sold them, he might have been at grave legal risk.  As a director, Karfunkel likely had nonpublic information about Kodak’s prospects, and, if so, his fiduciary duties would have forbidden him from trading. But Karfunkel didn’t sell his shares – he gave them to a charity he runs.

Karfunkel is not alone.[1] NYU finance professor David Yermack’s research identified “a pattern of excellent timing of Chairmen and CEOs’ large stock gifts to their own family foundations.”[2]  Gifts of stock are a substitute for sales, because the giver can lock in a large deduction at a price they know will soon drop, but they seemingly circumvent insider trading rules. As Yermack told the Wall Street Journal, “there’s no law against insider giving.”

Yet, there is – and should be.

It is true that Rule 10b-5, the legal basis of most insider trading claims, requires the sale or purchase (rather than just a gift) of a security.[3]  However, the law has long recognized that the defendant need not herself have sold or purchased, so long as her violation is in connection with someone else’s trade.

One such connection exists if the insider controls the charity, as Karfunkel does, and causes it to trade. The SEC has brought successful claims against such insiders.[4] In other cases, the donor may merely hint that the charity would be unwise to hold it for too long.  Tippers of information violate 10b-5 when they share information, expecting that the recipient will trade.[5] Tippers are usually only liable if they sought a personal benefit, but that too may exist in many cases: Many donors are feted and given offices of distinction, and the SEC has obtained favorable settlements asserting that the giver’s lucrative tax write-off suffices as a “personal benefit.” [6]

Nor is it plain that tipper liability is the only theory that might attach to an insider giver. When a director donates stock to maximize his write-off in light of non-public information, he misappropriates it from the source every bit as much as if he had sold it. He defrauds his principal of the exclusive use of the information. While I am not aware of any case considering this application of O’Hagan’s misappropriation theory, it strikes me as plausible.[7]

All that assumes the charity sells the shares at some point. It’s a reasonable assumption: Even if the donor doesn’t tell the charity to trade, charities don’t want to hold undiversified portfolios, and they really won’t want to do so if they learn that waiting to sell usually results in the stock going down. The only case where it is reasonable to expect the charity will retain the shares indefinitely is one in which the donor retains control over the charity’s decisions (as with a pet charity), which may bear on whether there really has been a gift for tax purposes.

More important, other corners of insider trading law operate without requiring any stock to be traded. Federal prosecutors can pursue insiders using mail and wire fraud statutes[8] or the recently added 18 USC §1348,[9] which do not require the sale or purchase of a security. Leaving federal law aside, state law prohibitions on insider trading place no special emphasis on trading: Self-serving breach of the duty of loyalty can lead to liability.[10] Less familiar facts can call for less familiar law, and there is no reason that insider giving must be addressed solely with Rule 10b5.

Should there be a law against insider giving? The case is strong.

Insider trading makes the market a more dangerous place for non-insiders. The insiders’ gains come at the expense of market makers who systematically lose to them and must widen bid-ask spreads accordingly.[11] That effect occurs just as much if an executive sells six million shares as if he donates to a charity that sells the shares. At the same time, insider trading does little to improve price accuracy because the executive’s motivating insight (say, that the company is overvalued because it is unlikely to get the government contract) came to him without much affirmative effort and will be released to the market through securities filings soon enough anyway. In short, the main problem with classical insider trading (it hurts the market without much offsetting benefit) is true of insider giving.

One might argue that prosecutions for insider giving would tend to chill gifts of stock, and thus harm charities, but the risk is low. Any time it is lawful for executives to sell their stock, they could lawfully donate it. The 10b5-1(c) trading plans that allow for periodic sales of stock could allow gifts as well. And leaving insider giving unaddressed could hurt charities, too. If dealers come to assume that nonprofits often receive and sell toxic stock, they will be reluctant to offer prompt and reasonable liquidity to them.

It may well be true that prosecutors should focus less attention on insider giving, because it will tend to be a less tempting crime. A stock has to be grossly overvalued for a gift to net the donor any overall gain. But insiders sometimes know their company to be grossly overvalued. And insider giving becomes more attractive when executives know their sales can depress market prices – say, because the volume is great enough to exhaust current buying interest. It can be better to donate a large amount of stock at the current market price than to sell it at a plummeting declining price. It is unfair for insiders to use their edge to dodge part of the loss by enriching the pet charity of their choice; other investors don’t get such consolation.

Insider giving – its possibility, regulation, and effects – challenges commonplace assumptions about the domain of insider trading law. Like other marginal cases of market abuse, it requires us to recognize how many puzzling questions lurk just outside of the heartland of insider trading law.

ENDNOTES

[1] Interestingly, Karfunkel is not even alone in the domain of photography-company fiduciaries allegedly involving charities in insider trading. Plaintiffs won a jury verdict arguing, inter alia, that Polaroid’s founder had caused a charitable foundation to sell large amounts of Polaroid stock while adverse information about the stock remained non-public (though the verdict was later overturned on other grounds). Backman v. Polaroid Corp., 910 F.2d 10, 17 (1st Cir. 1990).

[2] David Yermack, Deductio Ad Absurdum: CEOs Donating Their Own Stock to Their Own Family Foundations, 94 J. Fin. Econ. 107 (2009). See also, S. Bercu Avci, Cindy A. Schipani, & H. Nejat Seyhun, Manipulative Games of Gifts by Corporate Executives 18 U. Penn. J. Bus. L. 1131, 1133 (2016) (finding evidence that executives “use material, undisclosed inside information about future prospects of their own firms stock to maximize their donation and tax deductions (inside information”)).

[3] Portnoy v. Memorex Corp., 667 F.2d 1281, 1283 (9th Cir. 1982).

[4] Zomax, Inc. et al., Exchange Act Release No. 19262, 2005 WL 1384084 (June 9, 2005)

[5] United States v. Martoma, 869 F.3d 58, 69 (2d Cir. 2017).

[6] Complaint – Demand for Jury Trial, SEC v. Buntrock, No. 02C 2180 (N.D. Ill. Mar. 26, 2002), https://www.sec.gov/litigation/complaints/complr17435.htm [https://perma.cc/GJM3-V7FP]; Buntrock, Litigation Release No. 19351 (Aug. 29, 2005), https://www.sec.gov/litigation/litreleases/lr19351.htm [https://perma.cc/T2GY-PYMX];

[7] Cf. United States v. Martoma, 869 F.3d 58, 70 (2d Cir. 2017) (“Imagine that a corporate insider, instead of giving a cash end-of-year gift to his doorman, gives a tip of inside information with instructions to trade on the information and consider the proceeds of the trade to be his end-of-year gift. In this example, there may not be a ‘meaningfully close personal relationship” between the tipper and tippee, yet this clearly is an illustration of prohibited insider trading, as the insider has given a tip of valuable inside information in lieu of a cash gift and has thus personally benefitted from the disclosure’.”) If sale and gift are like encouraging someone to sell, then giving to someone expected to sell seems like a plausible extension.

[8] William K.S. Wang, Application of the Federal Mail and Wire Fraud Statutes to Criminal Liability For Stock Market Insider Trading and Tipping, 70 U. Miami L. Rev. 220 (2015).

[9] https://clsbluesky.law.columbia.edu/2020/01/03/the-new-insider-trading/; https://clsbluesky.law.columbia.edu/2020/02/26/the-blaszczak-bombshell-are-we-returning-to-a-parity-of-information-theory-of-insider-trading/

[10] State law insider trading actions are often referred to as Brophy actions, named for Brophy v. Cities Service, 70 A.2d 5 (Del. Ch. 1949). But Brophy actions are merely a subset of duty of loyalty suits.

[11] Merritt B. Fox, Lawrence R. Glosten, Gabriel V. Rauterberg, Insider Trading and its Regulation, 43 J. Corp. 817 (2018).

This post comes to us from Professor Andrew Verstein at UCLA Law School.

Leave a Reply

Your email address will not be published. Required fields are marked *