Insider Trading
06/15/2008

Article originally appeared in Gaming Management on 6/15/08

For U.S.-based public gaming enterprises, the threat of an illegal insider trading scandal may jeopardize a gaming license, or even the survival of the business. The alleged use of nonpublic information for unwarranted personal gain quickly destroys the trust of shareholders and regulators in the company and its executive team. To address this risk, companies employ policies and procedures, and sign executive compliance statements and oversight by compliance officers, among other things. However, many do not adequately bridge the gap between these techniques and the practices, policies and procedures that govern gaming activities.

Many publicly held gaming companies have failed to include provisions for insider trading in their gaming compliance policies and procedures, and likewise have ignored the need to train officers, directors and rank-and-file employees on this serious matter. Interlacing existing insider trading policies and procedures with a gaming compliance program, and then instructing personnel on how to understand and use the materials, provides an extra safeguard to ensure compliance. It is also advisable to take advantage of the expertise of the gaming compliance officer when developing training programs and implementing the plan across all facets of the business. These types of activities help maintain the integrity and reputation of the company, especially with gaming regulators.

Insider Trading Defined

Insider trading has many definitions and connotations that encompass both legal and prohibited activities.The legal version of insider trading occurs when company insiders—officers, directors or employees—buy or sell stock or other securities in their own companies within the confines of company policy and the governing security regulations.The public can track insider trades by virtue of publicly filed reports required by securities regulations.The illegal version of insider trading, on the other hand, refers to the prohibited practice under federal and state statutes of buying or selling a public company’s stock or securities in breach of a fiduciary duty or other relationship of trust and confidence while in possession of material, non-public information.This type of insider trading achieved widespread notoriety in the 1980s with the large number of notable executive indictments by the Securities and Exchange Commission (SEC) and the United States Department of Justice. It seems this also inspired Hollywood’s imagination with the production and release of the movie Wall Street. The theory behind the prohibition on insider trading is that it undermines investor confidence in the fairness and integrity of the securities markets. Trades made by insiders, based on “material,” non-public information, are considered to be fraudulent because the insiders are violating the trust or fiduciary duty that they owe to the shareholders and the public at large. A major Federal Appellate Court decision (List v. Fashion Park Inc., 340 F.2d 457, 462 (1965)) noted that “the basic test for materiality ... is whether a reasonable man would attach importance ... in determining his choice of action in the transaction in question.” In other words, if an investor would likely consider the information important regarding the purchase or sale of stock and securities, then it is deemed material.

Federal Regulation

Following the United States’ stock market crash of 1929, Congress enacted the Securities Act of 1933 and Securities Exchange Act of 1934 (SEA of 1934), in part to keep the public securities markets free from fraud and to control the abuses believed to have contributed to the crash. Two specific statutes govern insider trading: Section 16(b) and Section 10(b) of the SEA of 1934. In summary, Section 16(b) of the SEA of 1934 prohibits shortswing profits by corporate insiders in their own company’s stock. According to Section 16(b) “corporate insiders” are the company officers (e.g., president, vice president, chief financial officer), directors and any other beneficial owners of more than 10 percent of the company’s equity securities. Section 16(b) is applied mechanically, and generally requires that any prohibited profits realized on a buy-and-sell (or sell-and-buy) of a security within a six-month period by an officer, director or 10 percentshareholder are recoverable by the corporation. Any buy and/or sell transaction of securities within a six-month period is typically actionable, and there is no requirement to show that the insider actually traded while possessing material, non-public information. Any shareholder can bring an action under this section of the SEA of 1934. “Insiders,” however, can go beyond officers, directors and 10 percent shareholders. Section 10(b) of the SEA of 1934, as implemented by Rule 10b-5 of the SEC, makes it unlawful for an individual to engage in fraud or misrepresentation in connection with the purchase or sale of a security. Under these provisions, the courts have expanded the scope of insider trading by, in part, considering trades by certain “corporate insiders” to be fraudulent. This would apply to individuals whose “relationship of trust” is much more remote in nature than that of a fiduciary like an officer or director. For example, in 1997 the Supreme Court embraced a “misappropriation” theory of omissions, holding that misappropriating confidential information for securities trading purposes, in breach of a duty owed to the source of that information, gives rise to a duty to disclose that information or abstain from trading activities. Although the law on insider trading in the United States is continuing to evolve, existing law basically requires that any insider having material information with regards to a corporation is prohibited from trading, based on that knowledge, until the information is available to the general public. Rule 10b5-2 now clarifies how the misappropriation theory applies to certain non-business relationships by stating, among other things, that a person receiving confidential information would generally owe a duty of trust or confidence and may be liable under the misappropriation theory. Simply put, these persons must either disclose that information or abstain from trading public securities.

Violations of Insider Trading

This situation has encouraged governmental regulators, enforcement agencies and several stock exchanges to actively monitor, investigate and prosecute illegal securities trading activities among a wide group of investors. These entities search for suspicious or unusual trades and trading activity levels. Unexplained transactions trigger inquiries and, potentially, fullblown investigations. Allegations of illegal insider trading may result in enforcement action by federal and state agencies. For example, the SEA of 1934 permits the federal government to bring suit against insiders alleged to have engaged in illegal securities trades to seek injunctions, recover any illegal gains (or losses avoided) and/or impose civil penalties, the amount of which may be up to three times the profit gained (or loss avoided). In addition, public trading can be halted on the company’s securities. U.S. governmental agencies prosecute more than 50 such cases each year. The effect of broadened powers has also led to U.S. and state governmental agents prosecuting a variety of persons for insider trading beyond corporate officers, directors, employees and significant shareholders. Indicted individuals have included friends, business associates and family members of insiders. Prosecution has also implicated other “tippees,” such as attorneys, bankers, brokers, employees of printing firms, and government employees. In most cases, these parties obtained material, nonpublic information by virtue of their relationships with the company or persons within the company.

Gaming Company Solutions

Gaming companies can leverage their gaming compliance plans to avoid insider trading problems in significant ways. Reinforcing policies designed to ensure the confidentiality of certain company information until its general release to the public using training, monitoring activities and effective whistleblower programs is one way. All gaming enterprise officers, directors and employees should be educated about insider trading policies and procedures, linked specifically to gaming compliance activities, and be encouraged to annually confirm this understanding in writing. They should also be taught how to recognize suspicious activity and how to report these events promptly to appropriate supervisory level personnel or use whistleblower systems. Key vendors and other parties should also receive communication about the policy requirements, together with instructions to report suspected violations. Efforts like these will help manage material financial information, both positive and negative, so that it is appropriately safeguarded until its release by officers and directors, and then only released consistently and disseminated broadly to the public at large. Another way is to recognize that not all potentially illegal insiderinformation is in the form of material financial information. It may include plans, expectations and negotiations. Consider the possible importance of information such as the imminent issuance of a casino license, the results of a pending bid to build a casino, labor disputes, joint ventures or mergers with third parties, impending financial problems, results of trials or significant litigation exposure due to actual or threatened litigation, changes in senior management, or the announcement of new construction projects. As you can tell from this listing, the possibilities are limitless. To address this matter, gaming companies once again must train all insiders about potential improper disclosures and trading activities, and the protocols to report and handle them. Well-crafted guidelines can also help gaming enterprises prevent incidences that could result in civil or criminal actions, shareholder suits, or regulatory issues related to allegations of insider trading. Guidelines presented in simple, understandable language about the day-to-day usage of compliance policies are easy to use and apply. Such guidelines might prohibit activities like sharing confidential and proprietary non-public information, or might encourage personnel to refrain from commenting on analyst projections or any releases of forward-looking information. Requiring employees to obtain approvals before making any public presentations of company information, a common occurrence at any of the many gaming tradeshows or conferences, also may be important. Formally, a publicly traded gaming company’s directives may specifically prohibit officers, directors or certain employees from conducting any trades for a set period after the company has made a public announcement of material information, including earnings releases. It should also give guidance or “windows” as to when trades are permittable, and it must require that any officer, director or employee possessing material, non-public information is prohibited from trading on that information even during an open “window,” unless required disclosures have been appropriately made. In addition, it is recommended that policies govern certain types of trades, such as puts, calls and short sales. A simple method for bringing insider trading activity to the attention of management and directors is to have personnel report all securities transactions to the compliance officer or another designated official. In particular, major securities holders, officers and directors may be required to report holdings and activity to the compliance officer. In this way, relevant transactions are noticed and can be tracked and periodically reported to other company officials and governmental agencies as necessary. Transactions also can be subjected to pre-clearance procedures to protect the company. In problematic situations, personnel can be encouraged to report suspicious activity related to insiders to the compliance officer. However, as mentioned above, whistleblower programs also may be an effective way to learn about these events.

Conclusions

Public gaming companies face significant business risks from the failure to recognize and report insider trading activity. In the past, federal and state regulators have aggressively prosecuted suspected violations of insider trading rules, placing company officials and the enterprise in the direct line of harm. To address this issue, gaming companies should consider linking insider trading directives with gaming compliance policies and procedures. Once integrated, insiders—including officers, directors, major shareholders and employees—can be trained to recognize and report suspected improper trading activities to appropriate company officials. In concert, everyone who is considered the recipient of insider information can then work effectively together to manage the risk of illegal trading and its effect on gaming compliance.

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