The SEC must prove it - use of nonpublic information in the decision to sell or buy

A new rule established in a federal court could make it easier for corporate insiders to avoid insider-trading charges.

According to the "use test" established in April by the 11th U.S. Circuit Court of Appeals in Montgomery, Ala., the SEC must prove an individual not only knew material, nonpublic information before making a trade, but also used that information directly in making a sell/buy decision.

Although the unanimous decision is a first, lawyers warn that it does not give insiders carte blanche for reckless trading. "No practitioner is going to tell clients it's now OK to make trades prior to the release of nonpublic information," says Stuart Cable, a partner with the Boston law firm Goodwin, Procter & Hoar LLP.

The use test emerged from charges against three executives of Comptronix Corp. who had been accused of selling stock prior to the release of bad corporate news. In remanding the case to district court, where the new test will be applied in the Comptronix case, the appeals judges said the SEC had to prove that the insider information led directly to the trades. However, if the individuals could prove the trades were part of an established financial plan or pattern of trading, they should be found not guilty.

Cable suggests that the court was sending a message meant to chasten zealous SEC enforcers. The SEC wants "to keep things vague," he argues, "so they can go after someone who crosses the line, although no one knows exactly where the line is. If you want to read between the lines [of the ruling], what the 11th Circuit is really saying is that it's unhappy with the SEC."

Chris Mixter, chief litigation counsel for the SEC's division of enforcement, counters that the appeals court ruling still allows the SEC to infer whether insiders used nonpublic information. "Once the brain knows information, once it gets in your head and it is important information, how can you say you didn't use it?" Mixter wonders. "It's enough at least to get the case before a jury."

The use test applies only in the 11th Circuit, but Cable expects the issue to eventually reach the U.S. Supreme Court. In the meantime, the judges' ruling also invited the SEC to spell out more clearly when and how insiders can trade. Mixter says that no such effort is under way.

COPYRIGHT 1998 CFO Publishing Corp.
COPYRIGHT 2000 Gale Group