A Brief History of Insider Trading Law Carl H. Loewenson, Jr. and Andreea Vasiliu

• Pages: 23-38

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CHAPTER 3

A Brief History of Insider

Trading Law

Carl H. Loewenson, Jr. and Andreea Vasiliu

In the absence of a general prohibition against insider trading, liability is

governed primarily by a complex and sometimes contradictory body of

case law interpreting Section 10(b) of the Securities Exchange Act of 1934,

which states in broad language: “It shall be unlawful for any person . . . [t]o

use or employ, in connection with the purchase or sale of any security...

any manipulative or deceptive device or contrivance in contravention of

[Securities and Exchange Commission (SEC) rules and regulations].”1

SEC Rule 10b-5 similarly and broadly provides: “It shall be unlawful for

any person... [t]o employ any device, scheme, or artifice to defraud . ..

in connection with the purchase or sale of any security.”2 This chapter

summarizes the principal developments in insider trading case law over the

past century and the most important theories that have shaped its evolution.

1. The Early Case Law

Before the passage of the Securities Exchange Act in 1934, common law

jurisdictions varied widely on whether they viewed insider trading as fraud.3

1 15 U.S.C. § 78j(b).

2 17 C.F.R. § 240.10b-5.

3 Ralph C. Ferrara etal., Ferrara on Insider Trading and the Wall at 2-36.24 (Rel. 38, L

J P 2015) (1995); see also Paula J. Dalley, From Horse Trading to Insider Trading:

The Historical Antecedents of the Insider Trading Debate, 39 W.  M . R. 1289 (1998).

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24 CHAPTER  A Brief History of Insider Trading Law

Fraud was generally defined as occurring when a person intentionally mis-

represented a material fact that was justifiably relied on by another to his

or her detriment. Under the “majority rule,” a traditional corporate insider

owed fiduciary duties to the corporation but not to shareholders.

4

Insiders

could thus use their informational advantage and withhold material facts

in transactions with the corporation’s shareholders.5 Under the “minority

rule,” a traditional insider was a fiduciary of both the corporation and its

shareholders. As a fiduciary, the insider had to disclose all material facts in

his or her possession prior to consummating a “face-to-face transaction”

with a shareholder (as distinct from an impersonal transaction between

anonymous parties on an exchange).6 A third rule, the “special facts” doc-

trine, imposed disclosure obligations when one party to a transaction had

access to highly significant facts that were unknown to the other party.7

There were two limiting principles under the common law: (1) traditional

insiders owed shareholders a disclosure duty only in face-to-face transactions

(i.e., the minority rule left insider trading in impersonal markets unfet-

tered), and (2) traditional insiders were regarded as fiduciaries only vis-

à-vis investors with preexisting relationships with the corporation, with

nothing preventing such insiders from selling their stock to investors who

did not already own stock in the corporation.8 In some jurisdictions (e.g.,

New York and Delaware), shareholders could bring derivative actions

against traditional insiders who had used the corporation’s confidential

information to procure “secret profits” in stock exchange transactions or

in over-the-counter market transactions.9

A private right of action under Section 10(b) and Rule 10b-5 was first

recognized in Kardon v. National Gypsum Co.,10 a case in which the plain-

tiffs had sold their stock directly to insiders (defendants) who possessed

material non-public information about the company. The court held that

“these provisions apply to directors and officers who, in purchasing the

4 Ferrara etal., Ferrara on Insider Trading and the Wall at 2-36.24.

5 See, e.g., Bawden v. Taylor, 98 N.E. 941, 942 (Ill. 1912); Barth v. Fidelity & Columbia Trust

Co., 224 S.W. 351, 356–57 (Ky. Ct. App. 1920).

6 See, e.g., Stewart v. Harris, 77 P. 277, 281 (Kan. 1904); Dawson v. Nat’l Life Ins. Co., 157

N.W. 929, 937–38 (Iowa 1916).

7 See, e.g., Strong v. Repide, 213 U.S. 419 (1909).

8 Ferrara etal., Ferrara on Insider Trading and the Wall at 2-36.25–2-36.26.

9 Id. at 2-36.26.

10 73 F. Supp. 798 (E.D. Pa. 1947).

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