Principles and Exercise Potential insider trading liability depends upon the method of the execution of the transaction, as well as on the timing of the transaction. Under the first two methods (the intra-company exercises), a holder ultimately should not be held liable for insider trading based on the exercise of the stock options, even if the holder exercised while aware of yet-to-be-announced market-moving news, whether positive or negative. Why? Because any material non-public information about the company typically is known by both parties to the option exercise transaction. An intra-company exercise occurs entirely between the holder and the company and does not involve a sale to the market.
As a result, the insider does not violate a duty to the company's shareholders (or, presumably, to anybody else) by capitalizing on an informational advantage when exercising the options; there usually is no such advantage. Notably, this may not be true in all circumstances, so officers and directors should remain cautious. See SEC v. Texas Gulf Sulphur, 401 F.2d 833, 856-57 (2d Cir. 1968) (finding directors violated Rule 10b-5 by accepting a stock option award because they failed to disclose information about drilling results to the board or to the board's stock option committee). Nevertheless, in many cases, the insider who is aware of non-public positive information that will move the market thus is in a position to obtain shares by exercising her stock options before the announcement, as long as she exercises those options by paying cash for them or via net settlement. On the other hand, people in possession of material non-public positive information obtained as insiders or pursuant to a duty of trust or confidence typically cannot purchase shares on the open market prior to the announcement without committing insider trading. For example, in our hypothetical, both the holder and the company are aware of the pending restatement at the time of a cash or net settlement exercise. The holder thus likely did not deceive her counterparty (the company) by withholding information of which the company was unaware. Without deception, there is no insider trading. In a similar circumstance involving mutual fund share redemptions, the U.S. Court of Appeals for the Seventh Circuit recently noted that the classical theory of insider trading is inapplicable when there is information parity among the parties to the transaction. See Insider Trading in Mutual Funds: Do Traditional Theories Apply? Morrison & Foerster Client Alert, http://www.mofo.com/files/Uploads/Images/130808-Insider-TradingMutual-Funds.pdf (discussion of case in which court remanded to determine whether the misappropriation theory should apply to the case). Importantly, a holder's subsequent decision to sell some or all of the new shares constitutes a new trading decision that is independent from the option exercise by which she obtained the shares. Once obtained, she may not sell the shares to the market while in possession of material non-public information. In contrast, a "Broker-Assisted Cashless" exercise necessarily involves a contemporaneous sale to the market. The holder thus could be in a position to take advantage of an informational asymmetry, to the detriment of a buying member of the public. This type of exercise (and attendant sale) before the announcement of adverse market-moving information would leave a buyer with shares that will decline in value once the adverse news is announced. On the other hand, if the material non-public information involved positive news, the sale of stock to the public as part of a "Broker-Assisted Cashless" exercise would not disadvantage or deceive the buyer. To the contrary, that lucky buyer would receive an immediate windfall when the good news is announced. Of course, that timely purchase might subject the buyer to his own regulatory scrutiny. In our hypothetical, for example, the insider should avoid a "Broker-Assisted Cashless" exercise because she could be accused of taking advantage of the higher stock price before the restatement is disclosed. The Justice Department and SEC both have pursued insider trading charges in similar instances. See, e.g., United States v. Nacchio, 573 F.3d 1062, 1068 (10th Cir. 2009) (insider trading charges based on options exercise involving market sales amidst accounting concerns); SEC v. Elles, Rel. No. 2010-252 at http://www.sec.gov/news/press/2010/2010-252.htm (insider trading charges based on options exercises and sales prior to disclosure of accounting concerns); SEC v. Dollar General, Rel. No. 19653 at http://www.sec.gov/litigation/litreleases /2006/lr19653.htm (insider trading charges based on options exercise involving market sale before restatement announcement). To summarize: The safest course for an insider to exercise her stock options and avoid potential insider trading liability is through the "Cash" or "Net Settled" methods, because those transactions are conducted with the company, which likely has the same information as the insider. An exercise of stock options by an insider in a "Broker-Assisted Cashless" exercise before the announcement of unquestionably positive market-moving news may not be improper insider trading, since it would simply result in the sale of underpriced shares on the open market to a buyer, who would incur a windfall. An insider likely would not make that sale, since it would be in effect giving away value; moreover, the unusual nature of the transaction could attract regulatory scrutiny. A "Broker-Assisted Cashless" exercise before an announcement that does or could involve negative market-moving news might well be improper insider trading because it necessarily involves a market sale to buyers who do not yet know the negative news. Finally, however employee stock options are exercised, a decision to sell the resultant shares into the market at some later time constitutes a separate trading decision that likewise is subject to insider trading principles.
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