SEC Pushes Ahead With New Insider Trading Rules

The government is trying to make it easier to prosecute illegal trading.
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The trading in California biotech company

Molecular Dynamics

looked more than a little suspicious to the

Securities and Exchange Commission

.

Hahn Truong, a software manager at the company, sold his shares. So did two of his brothers and a friend, who also shorted the stock. And Truong loaned one brother $15,000 to short even more of the company's shares. All of this happened just days before Molecular Dynamics (which no longer trades) reported it had failed to meet revenue expectations and its share value fell 38% overnight.

The SEC charged Truong with insider trading securities violations. But in April, a California judge threw out most of the charges as the court ruled the agency hadn't proved Truong possessed, or used, insider information to make the trades.

Now, partly in response to these kinds of court decisions and, more specifically, two appeals court decisions cited in Truong's case, the SEC is close to approving what would be its first-ever written rules explicitly governing insider trading.

The proposal, which SEC officials say could be approved by the end of the summer, would mark the first written rules in history explicitly forbidding insider trading and would give regulators and law enforcement authorities a powerful new tool. The regulations would free them from having to prove a person "used" inside information as a basis for stock trades, and allow them to show only that the individual "possessed" the information and traded to have committed a crime.

Federal Securities Enforcement Cases
The Securities and Exchange Commission says it is concerned the number of insider trading cases hasn't decreased since high-profile prosecutions of the 1980s.

Source: Securities and Exchange Commission.

"Common sense would tell you once someone possesses it, it's hard not to use it," says Stephen M. Cutler, the SEC's deputy director of enforcement. "It's the right standard. People can't draw a line through someone's head."

The SEC also is poised to approve a

new rule that for the first time puts written restrictions on insider trading by family members that would make it illegal to trade on information obtained from a spouse, a sibling or a parent.

The SEC is considering both rules in a package that also includes a new regulation on selective financial disclosure, a matter that has generated an enormous amount of controversy on its own.

The package of draft rules, published last December, have generated more than 5,000 comments to the SEC.

The insider-trading proposals are the SEC's latest attempt to put to rest a long debate over whether insider trading should be prosecuted on the basis of use or possession of material inside information.

Interviews and comments

filed with the SEC, however, show the proposals are facing sharp criticism from a many detractors, including the defense bar and securities firm lobbyists.

Among them is defense lawyer John "Rusty" Wing of the New York law firm

Weil Gotshal & Manges

, who says the SEC is overreaching.

"The primary purpose it serves is sort of giving an additional edge to law enforcement. The essence of the crime is the use of the inside information as opposed to just having it," says Wing, chief of the fraud unit for the Manhattan U.S. Attorney's Office when it prosecuted its first-ever insider trading case in the 1970s.

Other defense lawyers agree.

"Making the mere possession of information a crime would be very, very unfair," said Gerald Rath, of the Boston law firm

Bingham Dana

. "I think that possession vs. use debate is one that the SEC has been losing in the courts, and properly so."

Getting Tougher?

The attention the SEC is paying now to insider trading reflects a dramatic departure from its attitude on the practice just two decades ago, when it never prosecuted anyone for trading on inside information. Beginning with the high-profile insider-trading cases involving former Wall Street financiers Michael Milken, Ivan Boesky and Martin Siegel, in the 1980s, though, the SEC has steadily pursued insider-trading violations.

Without any specific written insider-trading rules, the agency has sued defendants for insider-trading violations under its general fraud statute. That's left interpretation of what constitutes illegal insider trading up to the courts.

And while the SEC has maintained that possession of insider information is sufficient to prove someone used it in actual trades, appeals courts in California and in Georgia essentially decided regulators or law enforcement authorities must prove a defendant used the information to make stock trades.

Other court decisions have viewed the insider-trading standard differently, and one rationale for enacting the new rules is to create one standard, Cutler said.

The SEC has offered

caveats

with its proposed rules. It has provided four so-called affirmative defenses for individuals to prove they didn't violate securities laws by possessing insider information.

Under those exemptions, trading wouldn't be illegal if a person has a contract to sell shares, has instructed someone else to sell shares or has a trading plan that specifies time, volume and price of shares to be sold -- before receiving inside information.

But those proposed exemptions, too, have come under fire.

The

Securities Industry Association

, a trade group that represents Wall Street investment banks, said the rule also should permit trades by someone with insider information, in cases of "compelling personal hardship."

And at least one legal expert, University of Cincinnati Law School professor Donna Nagy, says the exemptions could provide a convenient loophole for law breakers.

"The timing of a corporation's announcement of material news could well be manipulated -- postponed a few days or weeks -- so that a traditional insider's pre-existing plans or arrangements to trade the corporate shares could yield a greater profit," she said in comments filed with the SEC.

But Nagy welcomed the SEC's effort to finally put an insider-trading rule in writing.

"I think it's momentous that the commission is putting forth any rules on insider trading," she said in an interview. "I think this, in itself is very significant. It adds a level of clarity that the law screams out to."