Imagine the following scenario. Your company is publicly traded. As such, senior management is keenly aware of the potential for executives and employees trading in the company’s securities on the basis of material nonpublic information in violation of Section 10(b) of the Exchange Act and the infamous Rule 10b-5 promulgated thereunder. To prevent improper trading, the company has instituted an insider trading policy which, among other things, requires certain high-level executives to pre-clear trades internally, prohibits directors and officers from trading during “blackout periods” (i.e., the period immediately prior to fiscal quarter and year ends), and requires periodic training for all employees on the scope of insider trading laws. As model corporate citizens, all of the company’s directors, officers, and employees follow the company’s policies precisely. No one would dare to take the risk of attempting to gain illicit profits by trading the company’s stock while in possession of material nonpublic information.

One day, just before the end of a quarter (and therefore during a blackout period), analysts covering your company reduce their estimates for the company’s quarterly results which in turn, causes the company’s share price to decline. The company’s officers know that the analysts’ revised estimates are accurate and that the company will report sub-par earnings results the following week but none of those officers initiated any trades to improperly take advantage of this material nonpublic information. However, as a result of the decline in share price alone, one of the company’s executive officers unknowingly violated Section 10(b) and Rule 10b-5 and both he and the company are now potentially on the hook for insider trading liability. 

How can this be if none of the officers executed any trades you ask? The problem arises from the fact that company policy does not prohibit margining company securities. When the share price declined, the value of the securities in the executive’s margin account dropped sufficiently to trigger a margin call requiring the executive to deposit additional collateral to make up the shortfall or risk having the broker sell a portion of the pledged securities (this is similar to what happened to the founder and chairman of Green Mountain Coffee Roasters, Inc. earlier this year). Regardless of which route is taken, the executive is in a problematic situation. 

If the executive does nothing and allows the broker to sell company stock, he’d be violating company policy by trading during the blackout period and would likely be trading while in possession of material nonpublic information in violation of state and federal securities laws. If he deposits additional collateral to the margin account, he is still technically making an investment decision regarding company stock that could potentially be violative of insider trading laws. For example, if the executive believed the market had overreacted to the analyst’s forecast, he might elect to deposit additional cash or securities to the margin account to avoid the pledged company stock from being sold at too low of a price. In this particular case, by depositing additional collateral, he’d be partially avoiding some of the loss on his company stock if the share price rebounded the following week. In the eyes of U.S. securities laws and regulations, trades which seek illicit gains and trades which avoid losses are effectively the same since either would provide a benefit to the person trading on material nonpublic information. 

Therefore, even by not selling and making the investment decision to deposit additional collateral in his margin account, the executive could still be in trouble if, as a result, he avoids a loss that he would have otherwise incurred. Additionally, individuals subject to Section 16 of the Exchange Act could also incur unintended short-swing profits due to a margin call which would need to be disgorged to the company. 

The executive is not the only one with potential problems under these facts. Section 20(a) of the Exchange Act authorizes the SEC to bring actions against persons who control securities law violators. While the term “control” is not expressly defined under the federal securities laws and regulations, some courts have found a control relationship where evidence shows that the controlling person has the power to influence the conduct forming the basis for liability.  Other courts have required an additional showing that the controlling person exercised control generally over the violator although evidence need not go as far to show that the controlling person actually participated in the proscribed activity. 

Persons that could be potentially liable as a “control person” could include not only the company but also: 

  • employees with supervisory authority;
  • officers and directors of the company;
  • controlling shareholders; and
  • parent corporations.

The existence of control by itself, however, does not necessarily result in liability. The controlling person may avoid liability under Section 20(a) by showing that he or she acted in good faith and did not directly or indirectly induce the violation. 

In light of the foregoing, I recommend that public companies review their insider trading policies and procedures on a regular basis and to be proactive in curbing potential insider trading law violations. Moreover, companies should ensure they are enforcing the insider trading policies they have in place to avoid potential liability under the good faith exception for control person liability under the Section 20(a). Additionally, although it is not prohibited, I also recommend that public companies adopt policies that prohibit employees from margining company stock. In smaller public companies, there may be push back on such a prohibition because it is not uncommon for early-stage founders to hold much of their assets in the form of company stock. 

If, despite the potential risks, a public company elects to allow its directors, officers and employees to margin company stock, the company should consider alternatives to mitigate risks associated with an untimely margin call. One possible way is to take the investment decision at the time of a margin call out of the hands of the individual by directing the broker (and providing irrevocable authority to the broker) to always sell the pledged securities without permitting the deposit of additional collateral. There are other alternative approaches that could be implemented as well. However, I believe the best approach is to eliminate the risk altogether by installing a strong comprehensive insider trading policy which prohibits pledging of company securities.


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