Wednesday, 18 May 2016

A silk purse: how a company can recover profits from insider trading

An officer or employee commits insider trading, gaining a large profit for themselves.  The company discovers the wrongdoing.  What to do?

Usually, this is a referral straight to ASIC.  If preliminary analysis of the facts bears out the allegation, ASIC will conduct a thorough investigation, interviewing the alleged wrongdoer and possibly members of the Board.

If satisfied that the facts of the wrongdoing are made out, the alleged offender will be prosecuted, and may go to prison.  So it goes.  The company will suffer inconvenience and even damage to its reputation.  It gets nothing out of the prosecution, and will need to foot its own legal bills during the ASIC investigation (though such an outlay is usually covered by the company’s insurance policy).  It can of course rid itself of the erring employee.

But here is an interesting fact. In 1969, the Court of Appeal of New York decided that a company could recover profits made by an officer from insider trading in the company’s shares (Diamond v Oreamuno 24 NY 2d 494).

How did it do this?

After all, the company had not suffered any quantifiable damage as a result of the trading.  The loss was suffered by those shareholders who had sold their shares to the officer, before the share price crashed when the inside information became public. (But this line of reasoning is weak – those shareholders were going to buy anyway, and if they had not bought the officer’s shares, they would have bought someone else’s, and still suffered their loss).

The company was able to sue the officer to recover the unauthorised profits from insider trading, by application of fairly orthodox equitable principles.  I break them down below:
  • directors and, sometimes, high level officers owe fiduciary duties to their companies
  • these special duties are summed up in two rules: the ‘no profit’ rule, and the ‘no conflict’ rule
  •  the ‘no profit’ rule says that a person must not make a profit out of a fiduciary position, except with the fully informed consent of the beneficiary
  • by engaging in insider trading, the director/officer makes a profit out of his/her fiduciary position, without the informed consent of the company, and
  • remedies for breach of the ‘no profit’ rule include an account of the profits derived.

In the 1970s, US courts in Florida and Indiana considered Diamond v Oreamuno, and decided not to follow it (Schein v Casen 313 So 2d 739 (1975), Freeman v Decio 584 F 2d 186 (1978)).  Since then few, if any, further cases were run in the USA on the basis of Diamond (at least, that could be found on this author’s quick scan).  The cause of action may have become unfashionable in the USA after 1975.  However it is surprising that no company in Australia has mounted a similar action, to force an officer to disgorge profits made from insider trading.  That may be about to change.

Paperlinx Limited v McConnell [2016] FCA 450 is a skirmish in an ongoing dispute between Mr Andrew Price, and Paperlinx Limited, his former employer.  Paperlinx sought disclosure of documents on the basis that, among other things, they had a potential cause of action for a breach of insider trading provisions.  The application could foreshadow an action against Price to disgorge his alleged insider trading profits. 

It should be noted that the Corporations Act 2001 (Cth) provides statutory remedies which reflect, but do not displace, the equitable principles above.  Section 1317H allows a Court to order a person to compensate a company for damage suffered as a result of a breach of civil penalty provision.  Subsection (2) states that for the purpose of determining ‘damage’, profits derived from the breach should be included.


Senior Associate
+61 7 3233 8530
tritchie@mccullough.com.au

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