The Proscription Against Insider Trading: Once Again Unsettled Among Federal Circuits

• Publication year: 1997
• Pages: 41
• Citation: Vol. 26 No. 2 Pg. 41

26 Colo.Law. 41 Colorado Lawyer 1997.

1997, February, Pg. 41. The Proscription Against Insider Trading: Once Again Unsettled Among Federal Circuits

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Vol. 26, No. 2, Pg. 41

The Colorado Lawyer
February 1997
Vol. 26, No. 2 [Page 41]

Specialty Law Columns
Business Law Newsletter
The Proscription Against Insider Trading: Once Again Unsettled Among Federal Circuits
by Bradford J. Lam

Column Ed.: David P. Steigerwald of Sparks Dix, P.C Colorado Springs - (719) 475-0097

This newsletter is prepared by the Business Law Section of the CBA to apprise members of the Bar of current information concerning substantive law. This month's article was written by Bradford J. Lam, Denver, a shareholder of Cairns Dworkin & Chambers, P.C., (303) 584-0990

In October 1996, the Second Circuit Court of Appeals upheld the insider trading conviction of a former toy company executive who pleaded guilty to trading stock based on inside information about AT&T Corporation's takeover plans.1 He was one of five people tipped off by a former vice president for labor relations at AT&T.

In August 1996, the Eighth Circuit Court of Appeals reversed the criminal insider trading conviction of a Minneapolis lawyer whose firm had been retained by Grand Metropolitan PLC in connection with its 1988 takeover of Pillsbury Corporation.2 Like the toy company executive, the lawyer used inside information to earn a $4.3 million profit by trading in target company stock. However, unlike the Second Circuit, the Eighth Circuit refused to hold the lawyer liable for insider trading because the defendant did not owe a fiduciary duty to the traded company's stockholders.3

These two decisions highlight a dilemma facing today's securities practitioner in the insider trading area. Until 1995, securities counsel could, in nearly all the circuits, anticipate insider trading liability for both corporate insiders and outsiders. However, recent decisions in the Eighth and Fourth Circuits demonstrate a reluctance to apply the so-called "misappropriation theory" to reach individuals who lack any fiduciary duty to the traded stock's shareholders. Outsiders who trade on inside information may now be outside the reach of insider trading liability in these two circuits. Nevertheless, three other circuits, the Second,4 Seventh,5 and Ninth,6 continue to recognize the viability of the misappropriation theory. The Third and Tenth Circuits also have cited the misappropriation theory in a manner that was at least neutral, if not favorable.7

Section 10(b): Deception Prohibited

"Insider trading" may be prosecuted under two theories, commonly called the "classical theory"8 and the "misappropriation theory."9 Before detailing these theories, however, it is instructive to review the language from which the theories spring - § 10(b) of the Securities Exchange Act of 1934 and its SEC-created counterpart, Rule 10b-5.10 Section 10(b) of the Exchange Act prohibits deception in connection with the offer or sale of any security:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of Interstate Commerce or the mails, or of any facility of any national securities exchange -

. . .

(b) To use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [Securities and Exchange] Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

The touchstones of § 10(b) liability are "manipulation" and "deception" "in connection with the purchase or sale of any security." In analyzing insider trading, the primary focus is on the deception element of § 10(b).11

Acting pursuant to the authority granted to it under § 10(b), the SEC promulgated Rule 10b-5, which further provides:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of Interstate Commerce or of the mails or of any facility of any national securities exchange (a) [t]o employ any device, scheme or artifice to defraud, [or]

. . .

(c) [t]o engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.

The SEC enacted Rule 10b-5 to establish a prohibition on "fraud" as a means of defining the scope of conduct proscribed as "deception" under § 10(b).

As stated by the Eighth Circuit in O'Hagan, fraud under Rule 10b-5 cannot be construed more broadly than its statutory enabler, deception.12 In other words, Rule 10b-5 fraud cannot include conduct that does not amount to § 10(b) deception. Thus, although §...