This case study examines Insider Trading rules (SEC rule 10b-5) and how corporate officers must treat their responsibilities with respect to confidential non-public information that could impact the trading of their securities in the capital markets.
Senior executives of a publicly-traded company on Nasdaq, upon learning of the probability of a negative quarterly earnings event, met to discuss and prepare a formal press release informing shareholders of the negative news and its potential impact on the price and trading of its securities on both Nasdaq and the Options marketplaces. The subsequent actions of two brokers resulted in an unfair opportunity to profit from the decline of the underlying stock price based on insider information, a violation of SEC rule 10b-5.
After completing this course, readers will be able to:
- Identify what constitutes Confidential Information.
- Understand the core concepts and concerns of regulators with respect to “Non-Public” Confidential Information in the trading of corporate securities.
- Explain the ever-growing application of Insider Trading rules to “Non-Corporate Individuals,” such as related parties and close family members.
- Describe how the Insider Trading rule applies to “Options.”
SEC Rule 10b-5, Inside Information, Corporate Insiders, Related Parties, Tipper, Options, Confidential Information
Industry Current State
One of the most egregious and continuing problems for corporations, their senior management and employees, is the responsibility to treat shareholders fairly in keeping them equally informed with regards to corporate activities and actions that may impact the value of their holdings. The appropriate and timely release of such information and its resultant consequences was the genesis of SEC Rule 10b-5 and its anti-fraud objectives as set out in the 1934 Securities Exchange Act.
On or about May 4, 2001, Geoge Matus, a Carreker Corp Senior V.P. of Investor Relations, learned from company accountants that the quarterly earnings would be well short of analysts’ consensus estimates. On or about May 16, after having participated in discussions regarding drafting a press release, he learned that the presumably negative announcement would occur after the close of trading on May 22, 2001.
Soon after, George Matus placed several calls and made two attempts to transfer funds to Peter Matus, his brother, and a licensed stockbroker, so that Peter Matus could trade in Carreker Corporation’s securities on the basis of George Matus’ confidential insider information. George Matus, successfully completed the transfer of $50,000 to his brother’s brokerage account to facilitate Peter Matus’ trading activities, to purchase 750 Put Options approximately four hours before the close of trading on May 22, 2001. Thus, they created an opportunity to profit from the decline of the underlying Carreker stock price as a result of the inversely increased value of their Put Options.
The subsequent decline of Carreker Corp’s equity securities, of approximately 43% over the next four days (from $18.67 to $10.62), and the eventual sale of its related Put Options by Peter Matus on May 29, 2001, yielded a profit of approximately $210,000 for the benefit of both George and Peter Matus.
When questioned informally about their suspicious trading activity, the brothers gave conflicting explanations to the SEC. This led to the Commission’s formal request for both brothers to testify under oath regarding the Put Option trades. Both brothers invoked their Fifth Amendment rights and refused to testify.
This, in turn, 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. They 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 the result of their unlawful acts.
As Senior Vice President of Investor Relations, George Matus’ clearly served in a fiduciarily position at Carreker Corporation. His knowledge of the negative quarterly earnings and participation in formulating a timely and appropriate notice to shareholders gave him special knowledge pertaining to confidential inside information. Management discussions regarding the specific timing of the press release to take place following the close of trading on May 22, 2001, ratified the need for all senior executives, employees, and related parties with knowledge of the earnings, such as George Matus, to keep such information confidential and “Non-Public” until its appropriate release.
George Matus understood that it was inappropriate, unlawful, and fraudulent for him to personally trade or benefit in any way, from his knowledge of this negative news–either directly or indirectly. In fact, part of his job description entailed keeping such information private until it became appropriate to share it with shareholders. His efforts to notify and fund his brother Peter Matus’ trading activities confirmed his fraudulent intent. George placed multiple phone calls, made several attempts to transfer funds. More importantly, George gave written instructions to expedite the movement of funds to accounts that might not prompt immediate awareness of the brothers’ fraudulent intent and activities.
Peter Matus, a registered broker-dealer, also knew or should have known better. The information he received from his brother, a senior executive and fiduciary of Carreker Corp., and the intended activities contemplated by his brother, constituted the illegal use of confidential, non-public information. Even more importantly, Peter’s experience as a registered broker-dealer ensured that he too clearly understood his own personal illegal behavior as a close family member and related party. His actions, both before, during, and after the release of the “public” negative information, only confirmed his willful participation in fraudulent activities.
The decision to use “Put Options” for their activities also implicates their knowledge and awareness that they were illegally participating in insider trading. By using a related security, such as Put Options, their activity was less obvious, decreasing the likelihood of discovery. The use of options, a typically less costly trade than shorting the common shares themselves, also afforded greater leverage and profit potential relative to the amount invested.
The specific choice of Put Options, instruments predicated on the expectation that the price of the underlying security would decline within a defined period of time, confirmed their belief that the news would reflect negatively in the public markets. This enabled the brothers to profit more substantially from their fraudulent acts.
The subsequent invoking of their Fifth Amendment rights by both brothers, was the final nail in their coffins, leaving no doubt as to their knowledge and awareness that their activities might be subject to criminal violations and sanctions.
Corporate executives of companies with publicly traded securities need to create an environment in which all senior executives, employees, and related parties strictly guard their fiduciary responsibilities. George Matus, in his role as Senior Vice President of Investor Relations, had a duty to treat material non-public information as sacrosanct. Yet, he felt comfortable enough to not only share that information with his brother but to trade on it himself as well. Compliance must serve a critical function in all organizations, but materially more so for those privileged to trade its shares on the public markets.
At a minimum, executives must be made aware of the trading restrictions that all employees, including themselves, are subject to. It must be clearly spelled out in a Compliance Manual overseen by both legal and human resources departments, providing appropriate guidance and accountability to all, demonstrating a clear expression of corporate compliance efforts.
Management must provide for and insist on internal Continuing Education programs and efforts, applicable to all corporate employees as well as senior executives, management, and other related parties. They should also compel mandatory disclosure requirements pursuant to which employees disclose their personal securities brokerage accounts and activities, supervised by the corporation’s legal department. Companies must also engage in periodic surveillance checks for these matters and inform employees that close family members and other related parties deemed under their joint control and benefit, must abide by the same restrictions.
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. Put options are impacted by changes in the price of the underlying security. If a stock price goes down, the value of the Put Option goes up.
 Rule 10b-5 prohibits any act or omission resulting in fraud or deceit in connection with the purchase or sale of any security.
Industry Future State
Wall Street is a favorite target for prosecutors seeking to build a reputation, and insider trading presents a hot button topic for regulators. Society desires equal footing for all in the capital markets, demonstrating disdain for the wealthy and privileged who take advantage of their position. The practice of benefiting from confidential information represents everything wrong with capitalism, which is increasingly out of favor in and emblematic of everything wrong from the growing social justice perspective. As a result, we can expect increased investigation and enforcement going forward.