Is Exercising Employee Stock Options Illegal Insider Trading? Maybe

, New York Law Journal


Daniel Nathan
Daniel Nathan

Amidst the flurry of Securities and Exchange Commission (SEC) cases involving improper employee stock option backdating several years ago, many commentators opined on the potential insider trading implications of companies' issuance of stock options to officers and directors. As a result, we all now know that "spring loading" and "bullet dodging" raise securities law questions, not simply a dizzying array of mechanical mayhem. Yet the literature is surprisingly scant concerning the potential insider trading implications of an insider exercising her stock options. The time is ripe for this discussion, particularly since the SEC and Department of Justice have ambitiously prioritized insider trading enforcement of late.

Picture this: As a valued contributor to a public company, you received stock option grants over several years. You and your company have done well, and the stock price is now higher than the grant price. A bit of immediate profit sure looks attractive, particularly with your daughter bound for that pricey private university. Yet when you spoke with the company's general counsel, he confidentially informed you that the company will soon announce a massive restatement of its financial statements, likely causing the stock price to precipitously decline. The GC told you that he instituted a blackout period prohibiting transactions in the company's stock. Can you nevertheless exercise your options and sell the resulting shares?

Overview of Law

Under established law, dire consequences—including monetary sanctions, restrictions on future employment opportunities, and possible criminal prosecution—await insiders who misstep while selling their company's stock. While navigating this precipice, therefore, a review of governing principles provides a helpful tether to safety.

Insider trading is not defined by statute or regulation. Rather, case law interpreting the antifraud provisions of the Securities Act of 1933, the Securities Exchange Act of 1934, and rules adopted thereunder, establishes the basis for liability. Generally, unlawful insider trading occurs when a person:

• transacts in a security,

• while knowingly in possession of material nonpublic information,

• in breach of a duty of trust and confidence.

Courts use the breach of a duty analysis as a proxy for establishing deception, which is required by the antifraud provisions of the securities laws. See, e.g., United States v. O'Hagan, 521 U.S. 642, 652-53 (1997).

Insider trading is charged under one of two theories: "classical" and "misappropriation." Under the "classical" theory, a corporate insider (such as an employee, director, or a temporary insider like an investment banker) owes a duty to his company's shareholders to refrain from trading the company's stock on the basis of the company's material non-public information. Any transactions in the company's stock based on material non-public information will benefit the company insider at the expense of other shareholders. The "misappropriation" theory applies to someone who converts material non-public information to his own use by trading ahead of an announcement in violation of a duty of trust and confidence (such as a fiduciary duty) owed to someone other than the company's shareholders.

Methods of Exercising

To understand when and how a company insider may exercise her stock options, the critical inquiry is whether an options exercise involves a purchase or sale of securities in breach of a duty.1 As a general matter, an employee stock option is a contract between a company and an agent (an employee or director) that allows the holder, once vested, to buy a specified number of shares of the company's stock at a given price before the expiration date. There are several common ways in which an agent can pay for the exercise of stock options, and company policy might limit agents to use only certain methods:

• Cash Exercise: The option holder pays the option price per share in cash to the company in exchange for the appropriate quantity of shares. The employee then can decide to hold the shares in her portfolio, or make a separate decision to sell some or all of the shares into the market.

• Net Settled Exercise: The holder pays for the options exercise by giving enough shares back to the company (or the company retains those shares at the time of exercise) sufficient to compensate the company for the exercise price at the shares' current market value. The company may then choose to sell or retire the held-back shares.

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