INSIDER TRADING - WHAT BANK DIRECTORS NEED TO KNOW?

Introduction

A bank director learns at a Board of Directors meeting that First National Bank is interested in acquiring his bank. The Board votes to hold a special meeting the following week, with its investment bankers present, to discuss a possible sale or merger. The director purchases the stock of his bank the day following the Board meeting. Two months later, his bank publicly announces that it is being acquired by First National Bank. Upon the announcement, the bank director makes a profit of $175,085 on his stock purchase.

What is wrong with what the director did? He purchased securities of his bank while possessing material nonpublic information concerning the bank. Federal law prohibits that. The law also prohibits insiders from communicating material nonpublic information to others who then buy or sell stock based on such information.

The SEC recently announced that it had charged this bank director with insider trading, and that he had agreed, without admitting or denying the SEC's allegations, to pay $404,925.96 in "disgorgement, prejudgment interest and civil penalties" and to entry of an injunction prohibiting him from future violations.

Although many readers would understand that the director's trading was illegal, these cases come up all too frequently.

Violations of federal securities laws can result in individual and company civil liability of up to $1 million and, for improper insider trading, up to three times the amount of profit gained. There are also substantial criminal penalties.

The remainder of this article will address some specific factual circumstances that help to define what is material nonpublic information, and steps that directors may take to protect themselves and their institutions from securities law violations..

Restrictions on Trading

Directors and other insiders cannot trade in the securities of their bank or company while in possession of material nonpublic information about the bank or company, and may not "tip" material nonpublic information to anyone. Once the information is properly disseminated and digested by the investing public, directors and others in possession of the information may trade.

These restrictions apply regardless of whether the company or bank is subject to SEC reporting requirements. Even directors of banks or companies with a limited number of outside shareholders where infrequent trades occur should be careful to adhere to these restrictions.

If the information is not material, there is no duty to abstain from trading until the information is publicly disseminated.

What is "material"?

What is "material" to a company is normally based on whether there is a substantial likelihood that a reasonable shareholder will consider the information important in deciding whether to buy or sell the stock.

The obligation to sell the company to another company at a substantial premium over the current market value of the stock is clearly material. But where the acquisition is contingent or speculative, it is more difficult to decide whether the information is material.

What if there is no obligation, buy only the receipt of an offer and an intention to consider the offer? That was the situation described in the opening paragraph. The SEC undoubtedly believes that such a situation is material to the company which is the target of the offer, and most would agree.

What if the Board of a bank has a publicly disseminated policy of discussing informally possible acquisitions of the bank with other banks from time to time, but has not decided to sell or agreed to terms, and the discussions have not reached the stage where investment bankers have been retained or counsel utilized to draft a merger agreement? This is a closer call, but there is a legitimate argument that this ongoing process, until it reaches a more serious level of discussion or intentions, is not material to the bank. Nevertheless, those who are aware of these discussions may wish not to trade during the periods in which discussions are conducted, or at least monitor the developments so that if the informal discussions lead to a greater probability that the bank will be sold, they will cease trading at that point.

Probably the most sensitive area of disclosure involves merger prospects, particularly where the institution is the prospective acquiree. But there are many other circumstances involving questions of material nonpublic information. Because companies report financial information quarterly (and nonreporting companies may report no more than annually to shareholders), there are periods during which the directors are aware of information that others are not aware. If that information is material, then directors are prohibited from trading until the information becomes public.

Some examples of material information not relating to acquisitions include a change in top management, a significant increase or decline in the provision for loan losses or non-accrual loans, or a substantial increase or decline in the interest margin. The information can be material whether it is "good" or "bad" news.

What is "Nonpublic"?

Directors and others in possession of material nonpublic information may trade securities in the company once the information is public.

The information is not public until the company has disseminated the information in a manner that will likely inform the investing public. For example, making an announcement at a shareholder meeting or in a letter to shareholders is not sufficient because the investing public includes persons who are not shareholders or who do not attend shareholder meetings.

For the information to be considered public, it is advisable for the company to issue a press release describing the material information accurately and make reasonable efforts to make the press release available as widely as possible, taking into account the nature of the company and its trading market. Directors and other company insiders should then wait to trade at least several days after the press releases are issued to insure that the market has absorbed the information.

Preventative Measures

SEC reporting companies commonly adopt corporate compliance programs to help assure that insiders comply with the securities laws. It is also advisable for nonreporting companies having outside shareholders to adopt compliance programs.

The elements of a compliance program include:

• Guidance on rules affecting reporting and trading by insidersd
• Identification of who has the authority to act as spokesperson for the company and guidance on when and how to disclose material information
• Educating insiders about the prohibition and risks of insider trading
• Implementation of procedures to help prevent and detect abuses
• Limitations within the company on access to confidential information
• Adoption of "blackout periods" during which officers and directors would not be allowed to trade and/or prior notice to a company representative of intended trading to assure that the company is not in possession of material inside information
• Procedures to minimize the risk that insiders tip confidential material information to outsiders
• Prohibitions on selective disclosures of material information

Conclusion

Trading of securities by directors and other insiders when in possession of material nonpublic information is illegal and risky to both the insider and the company. Preventative measures can help to minimize the risk.