Chapter 15
| Jurisdiction | United States |
What Is Insider Trading?
Many observers have said that insider trading is a clear wrong in search of a viable legal theory that would preclude or prevent it. There is no statute that explicitly prohibits it (except for Section 14(e) and Rule 14(e), which prohibit trading in connection with tender offers, and Section 16(b), which requires certain officers, directors, and 10 percent owners to return profits made or losses avoided on trades in the company's securities within any six-month period). Academics have argued that prohibiting insider trading preserves investor confidence in the integrity of the market, but others, such as Henry Manne, have argued that this is an illusion, since despite insider trading, there is a widespread and growing willingness in the American public to invest. Professor Donald Langevoort has called this "investor confidence" rationale a "useful myth."
Insider trading is a type of securities fraud, and civil and criminal insider trading cases are brought under Section 10(b) and Rule 10b-5. Insider trading has been considered common law fraud but only in those jurisdictions where officers and directors owe fiduciary duties to shareholders. Before the federal securities laws were enacted, some states, such as Massachusetts, required a face-to-face transaction for such a breach.
For there to be insider trading under the federal law, must the stock be sold on a national exchange? Probably not. Any sale that uses any means of interstate commerce or of the mails or of any facility of any national securities exchange would violate Section 10(b) so long as the other elements are met. The hard question is whether the other elements are met.
Under Section 10(b), insider trading occurs when a person or entity trades in any security on the basis of material non-public information about the security or issuer in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively to the issuer of that security or the shareholders of that issuer or to any other person who is the source of the material non-public information.
Cady, Roberts & Co.1
When William Cary became Chair of the SEC, he made it his mission to overturn a Massachusetts state court opinion, Goodwin v. Aggasiz, 186 N.E. 659 (Mass. 1933), that required a face-to-face transaction for insider trading liability. As Professor Langevoort has reminded us, Cary believed that state corporate law was moribund and perhaps even corrupt. His opportunity came in Cady, Roberts & Co., which established a new federal corporation law. This seminal 1961 administrative decision was the first to establish the "abstain or disclose" rule. It also eliminated the previous state "face-to-face" rule.
Robert Gintel bought stock of Curtiss-Wright after being informed by his Cady, Roberts partner, who was on the board of Curtiss-Wright, that the company was going to reduce its dividend. His partner thought the information was public. The SEC brought an administrative action against Gintel. The SEC found that "the common law in some jurisdictions imposes 'on corporate insiders' particularly officers, directors, or controlling stockholders" an "affirmative duty of disclosure." The commission regarded the insider relationship primarily in terms of unequal access to non-public information, not merely one in which there was a common law fiduciary duty. "Abstain or disclose" was the result of the perception of the inherent unfairness of allowing one with access to non-public information to profit from it personally. But there was very little corporate law support for such a duty. As we will see, this theory has not been accepted by the Supreme Court.
"Abstain or disclose" means that the corporate insider must either abstain from personal trading (or tipping others) or ensure that the information he or she has is fully disclosed and disseminated to the market before trading. The SEC decision went beyond corporate employees and covers auditors, outside accountants, brokers, investment bankers, and counsel. They all owe a fiduciary duty to use information that has been entrusted to them only for the benefit of the corporation.
How Did the Prohibition Against Insider Trading Originate?
As noted, it originated as common law fraud first in state courts, then through the antifraud provisions of the state securities laws. Even before the federal securities acts were passed, the Supreme Court held that a corporate director who bought stock knowing that it was going to go up in price committed fraud. Strong v. Repide, 213 U.S. 419 (1909). The first state cases were based on a theory of "fraudulent nondisclosures" (or pure silence). But many states required a face-to-face transaction for liability. See, e.g., Goodwin v. Aggasiz, 186 N.E. 659 (Mass. 1933). Some of the questions raised were whether corporate insiders owed a fiduciary duty to shareholders. As discussed further below, John Siffert, one of the prosecutors in the Chiarella case tells us that duty is the duty of loyalty. Also, some states permitted derivative actions against insiders who used inside information.
"Insider" is not defined by the securities laws but it is construed by courts to be a person or entity that by virtue of a fiduciary relationship with an issuer has knowledge of, or access to, material non-public information. Typically, this would include corporate officers. It also includes "temporary insiders." See Dirks v. SEC, 103 S. Ct. 3261 n.14. But the law goes far beyond corporate officers and covers, for example, any corporate employee.
The "Classic" Theory
This theory is based on a breach of a duty to the shareholder-seller. The theory is that true corporate insiders, such as officers, owe a duty to their shareholders and that when they use non-public, material information belonging to the company for personal gain, they are breaching that duty in a deceptive manner. The duty is similar to the duty of loyalty that is described in Delaware corporate law.2 Thus, in SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1969), the officers breached that duty when they purchased stock just before the announcement of a valuable ore discovery. However, the Texas Gulf Sulphur court did not refer explicitly to a duty of loyalty nor, indeed, did it refer to a breach of any duty. Rather, the court said that under Rule 10b-5, "all investors should have equal access to the rewards of participation in securities transactions" and that "the insiders here were not trading on an equal footing with the outside investors." This led some to believe that Rule 10b-5 was violated whenever there was an imbalance of information between the purchaser and seller. That is not the law.
United States v. Chiarella3
Vincent Chiarella worked for Pandick Press, a financial printer, and learned about upcoming corporate takeovers by reading some of the documents that had been submitted to his company for printing in connection with tender offers. Chiarella deduced the names of the targets from the documents. Without disclosing his knowledge, Chiarella purchased stock in the targets and sold it as soon as the takeovers were announced. He made a profit of more than $30,000 over a fourteen-month period. His was the first criminal prosecution and the first Supreme Court insider trading case under Section 10(b). He was convicted, and his conviction was affirmed by the Second Circuit. However, the Supreme Court reversed his conviction. The Court noted the "abstain or disclose" rule articulated by the SEC, but disagreed with the SEC that mere possession of material non-public information alone triggered the abstain or disclose obligation. The Court held that the possessor is liable only if the trade breached an existing fiduciary duty. Chiarella, the Court ruled, had no duty to disclose his knowledge to a purchaser. He had no special confidential relationship with the parties to the transaction.
Although the Cady, Roberts obligation was not limited to corporate insiders but was flexible and extended to others who have a "special relationship" with a corporation or its insiders, Chiarella didn't have such a relationship with any of the companies whose stock he bought.
Chiarella was the first case to speak of a breach of a duty as a requirement for a successful insider trading prosecution. But what duty? It couldn't be a duty to disclose non-public information to the seller because Chiarella had no such duty. "[O]ne who fails to disclose material information prior to the consummation of a transaction commits fraud only where he is under a duty to do so." Similarly, "no duty could arise from . . . [a] relationship with the sellers . . . for petitioner had no prior dealing with them." Chiarella's conviction was reversed by the Supreme Court because he had no duty to the sellers. "A purchaser of stock who has no duty to a prospective seller because he is neither an insider not a fiduciary has been held to have no obligation to reveal material facts." The author of the majority opinion was Justice Lewis Powell, a corporate lawyer in private practice before his Supreme Court appointment. In a footnote, Justice Powell opined that tippees could inherit a tipper's fiduciary duty by becoming a participant "after the fact" or a "co-venturer." We will see that proposition re-surface in Dirks, which opinion Powell also authored.
The Supreme Court did not consider an alternate argument that Chiarella breached a duty to the acquiring corporation when he acted upon information that he obtained by virtue of his position as an employee of the printer employed by the corporation because that theory had not been submitted to the jury. If it had been submitted to the jury, do you think that the Supreme Court would have upheld a conviction?
If Chiarella had been an insider like the officers in Texas Gulf Sulphur, what would his duty have been? What is the nature of the "duty" or "fiduciary duty" that is violated when...
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