Insider Trading Laws and SEC Rule 10b-5

Video File

Purpose

Learn how a corporate officer and a broker violated insider trading laws and SEC Rule 10b-5 by exploiting confidential, non-public information.

Situation:

In May 2001, senior executives of a publicly traded company on Nasdaq met to discuss the implications of negative news and its potential impact on the company’s stock price. The VP of investor relations had insider information that ordinary investors did not know. He used that inside information to make trades in the stock. He then passed the information to his brother, a registered broker, who also made trades for a sizable profit. Regulators at the SEC learned of the brothers’ suspicious trading activities, and began to investigate.

All the information in this case study comes from government press releases and articles referenced below.

State of the Industry:

Congress created SEC Rule 10b-5 and other anti-fraud provisions in the Securities Exchange Act of 1934. Legislators enacted the laws in response to the stock market crash of the 1920s. The law mandates that publicly traded companies must treat shareholders fairly, paying special attention to keep them informed regarding corporate developments that may influence the value of their holdings. Failure to abide by these laws can lead to charges for white-collar crime. If an insider relies information to trade on a stock, and that information is both material and not available to the general public, that insider could face severe consequences—as in this case.

Prosecutors frequently target Wall Street traders that violate laws. Those prosecutions can bring headlines that advance careers for government investigators and prosecutors. Insider trading, in particular, presents a hot button topic for regulators.

Authorities may demonize people that use unfair advantages to trade stocks. Regulatory agencies view the practice of benefiting from confidential information as a representation of everything wrong with capitalism. The growing social justice movement capitalizes on this sentiment to push for even more white-collar prosecutions.

Background and Analysis:

George Matus, Senior V.P. of Investor Relations at Carreker Corporation, learned from company accountants that Carreker’s quarterly earnings would be well short of analysts’ estimates. Following discussions regarding a press release, Matus learned that the negative earnings announcement was scheduled for release after the close of trading several days later.

George Matus acted on that confidential information, placing several calls and transferring funds to Peter Matus, his brother, a licensed stockbroker. George wanted Peter to trade in Carreker Corporation’s securities. Authorities alleged that George intended to capitalize on the confidential insider information he learned during confidential corporate meetings.

Peter Matus purchased 750 put options with respect to Carreker Corp., in his own personal account, approximately four hours before the close of trading on May 22, 2001, creating an opportunity to profit from the decline of the underlying Carreker stock price.

Carreker’s stock price declined after issuance of the press release, just as the Matus brothers anticipated. The stock price fell 43% over the next four days (from $18.67 to $10.62), yielding a profit of approximately $210,000 for the benefit of both George and Peter Matus. The unique, perfectly timed trade and the resulting sizable profit attracted the attention of the SEC.

During informal interviews with SEC investigators, both brothers gave conflicting explanations about their suspicious trading activities Their conflicting statements led the Commission to formally request that both brothers testify under oath regarding the trades. Both brothers invoked their Fifth Amendment rights and refused to testify.

Their refusal to testify led the SEC to formally enjoin each of the defendants from further violations of Sec. 10(b) of the Exchange Act and Rule 10b-5. The SEC also requested an order for disgorgement of their ill-gotten gains plus interest; as well as requiring both defendants to pay civil penalties of three times the profit realized as a result of their unlawful acts.

As Senior Vice President of Investor Relations, George Matus served in a fiduciarily position at Carreker Corporation. His inclusion in meetings regarding the negative quarterly earnings and participation in formulating a notice to shareholders gave him special inside knowledge. Management discussions regarding the specific timing of the press release confirmed the need to keep such information confidential and “non-public” until its appropriate release.

George Matus reacted inappropriately and unlawfully in trading for his personal benefit based on his knowledge of this negative news. In fact, part of his job description specifically mandated keeping such information private until it was appropriate to share with shareholders. Notifying and funding his brother Peter’s account in order to trade on the inside information confirmed his fraudulent intent.

Peter Matus, a registered broker-dealer, also knew or should have known better. Receiving and trading on information he received from his brother, a senior executive and fiduciary of Carreker, constituted an illegal use of confidential information. Peter’s experience as a registered broker-dealer suggested that he understood his behavior may be construed as both illegal and unethical, as a related party. His actions—both before, during and after the release of the negative information—confirmed his willful participation in the fraud.

The Matus brothers “gamed the system” for extra profits as they sought to earn a higher rate of return on the fixed amount of money they invested. They engaged in illegal trading using sophisticated means and sought to conceal their activity in an effort to avoid discovery.

Invoking their Fifth Amendment rights placed both brothers in an unfavorable position, because investigators likely interpreted that silence as an indication of guilt. Although the brothers had every right not to incriminate themselves, their inability to defend their actions enabled the SEC to obtain a punishing judgment against them.

Recommendations:

Corporate executives of companies with publicly traded securities must operate in an environment in which all senior executives, employees and related parties strictly guard their fiduciary responsibilities. George Matus should have treated non-public information as sacrosanct, given his position as Senior Vice President of Investor Relations. Yet, he felt comfortable enough to not only share that information with his brother but to trade on it as well. Compliance must serve a critical function in all organizations, but materially more so for those privileged to trade shares on the public markets.

Executives at publicly traded companies must know, understand, and operate within the trading restrictions applicable to all employees. Such restrictions should be clearly defined in a Compliance Manual overseen by both the legal department and human resources. The Compliance Manual should compel disclosure of all employee stock holdings. The legal department should undertake periodic surveillance checks and provide reminders to employees regarding corporate policy. Management should also provide Continuing Education programs and mandate participation by all employees.

Businesspeople should stay aware of both public sentiments, government priorities, and changing political climates. In the political climate of 2021, we can expect more investigations and criminal prosecutions triggered by business decisions. By providing employees with clear guidance as to appropriate and inappropriate behavior, companies better guard against fraud and protect the company from investigation and prosecution.

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Sources

[1]Put options give holders of the option the right, but not the obligation, to sell a specified amount of an underlying security at a predetermined price, within a specified timeframe. Put options are available on a wide range of assets, including stocks, indexes, commodities and currencies. The changes in the price of a security influence put options. If a stock price goes down, the value of the Put option goes up.

[2] Rule 10b-5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.

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