From horse trading to insider trading: the historical antecendents of the insider trading debate.

• Author: Dalley, Paula J.

INTRODUCTION

Generally speaking, a corporate insider(1) may not buy or sell a corporation's securities while that insider is in possession of material, nonpublic information relating to that corporation's securities. This is the so-called "disclose or abstain" rule, embodied in Rule 10b-5(2) promulgated under Section 10(b)(3) of the Securities Exchange Act of 1934 (the "1934 Act").(4) The law is a great deal more complex than this simple statement implies; nevertheless, the courts have not had significant difficulty applying the basic disclose-or-abstain rule in its simplest form.

The case generally credited with creating the disclose-or-abstain rule is SEC v. Texas Gulf Sulphur Co.,(5) in which executives of Texas Gulf Sulphur, among others, who were aware that the company had made a rich mineral strike, purchased shares of the company's stock.(6) The company had not publicized the strike for a number of reasons, not the least of which was that it had not yet acquired the land surrounding the area where the strike had been made,(7) and it wanted to complete the acquisition before the public--and the owners of the land--learned of the strike. The insiders were found to have committed securities fraud by purchasing stock from sellers who were unaware of the "real" value of the stock.(8) No one thought, however, that the company had entered into a contract fraudulently by purchasing the land from sellers who were unaware of the "real" value of the land.(9) In fact, the common law of fraud seems to be quite clear that the company's purchase of the land was not fraud.(10)

At first glance, there might be a number of reasons for this difference between contract and securities law, the most obvious of which is that the securities market is different from the real property market.(11) Well-functioning capital markets are an essential feature of an advanced economy;(12) thus, the securities acts, for policy reasons, might require disclosure beyond what was required at common law. Furthermore, given that the oft-cited, but not undisputed, philosophy of the securities laws is to mandate full disclosure of corporate information,(13) it makes sense that mandatory disclosure rules exist in securities transactions. There is a popular belief that to be healthy a securities market must be perceived to be "fair"; securities regulators around the world have adopted antifraud provisions modeled on Rule 10b-5 in an effort to attract investors to their exchanges.(14) A credible account of the disclose-or-abstain rule, therefore, is that it is a deliberate alteration of the common law intended to banish the rule of caveat emptor in the stock market, to encourage wider participation, to reduce the cost of capital, and, thus, to increase the competitiveness of American companies.(15) There is, however, a problem with that account.(16) In 1980, the Supreme Court, interpreting Rule 10b-5 in Chiarella v. United States,(17) held that the Rule only prohibited "fraud."(18) Although the definition of fraud under Rule 10b-5 was not limited strictly to common law fraud, the Court was quite clear in its rejection of the argument that Rule 10b-5 required full disclosure in every case.(19) Whatever the securities laws may have done otherwise, they did not abrogate the rule of caveat emptor, if, in fact, such was the common law rule before the securities laws were enacted.

What, then, becomes of the disclose-or-abstain rule? The Court preserved the disclose-or-abstain rule as it applies to corporate insiders because such insiders owe fiduciary duties to their shareholders and, therefore, have a duty to disclose material facts.(20) That holding did not comport with the common law, however, because before 1934, not only were insiders generally permitted to trade stock based on nonpublic information,(21) it was doubtful whether insiders owed any fiduciary duties to their shareholders, as opposed to the corporation as an entity.(22) Since 1980, however, it has been the law that it is fraud, under the 1934 Act, for a corporate insider to trade the stock of her corporation while in possession of material, nonpublic information. Such a transaction, unlike the purchase of land with a mine on it, is fraud because, in theory, the trader owes a fiduciary duty to the opposite party in the transaction--the corporation's current and future stockholders--and the remedy, therefore, should be disgorgement of the insider's profits.(23)

The Chiarella decision spawned what seems to be a new academic discipline. Hardly a month goes by without an article on insider trading appearing in one legal journal or another.(24) Some of the debate has revolved around whether it is even desirable to regulate insider trading at all. Few contemporary commentators advocate permitting all insider trading, but there is a great deal of debate on just what kinds of insider trading to prohibit.(25) Almost everyone agrees, for example, that true corporate insiders should not be permitted to trade with inside information, but that market and company analysts should be allowed to do so. Where the line between those cases should be drawn, however, remains problematic, as does the legal support for the rules drawing such lines.(26)

Meanwhile, since Chiarella, the federal courts have been left to determine what exactly is common law fraud in the securities context. The SEC has tried occasionally to enforce a level playing field by prosecuting anyone with superior, nonpublic information. Defendants have included a corporate psychiatrist of an executive's wife(27) and a popular football coach in an advantageous spot at a track meet.(28) The courts have attempted to produce a theory capable of determining when such trading is fraud. Recently, the Supreme Court approved a version of the "misappropriation theory" developed by several federal courts of appeal as a definition of insider trading.(29) That theory answers some questions but raises others. The scholarly commentators and the courts have thus united in an effort to articulate a standard for insider trading. In so doing, they take their places in the ranks of jurists through the centuries who have wrestled with the question: "When is it unlawful to buy or sell a thing when you know something the other party doesn't?"(30)

This Article is intended to place the insider trading debate in its historical context by examining the arguments made in recent cases and commentary and comparing them to arguments made in analogous contexts in the past two centuries.(31) Remarkably, the arguments made through the decades hardly have changed at all. Virtually every approach proposed in the Rule 10b-5 literature has direct nineteenth century precursors and remains subject to the same objections that rendered it unacceptable in its earlier appearances. Similarly, Rule 10b-5 cases are just as inconsistent, and the reasoning of the cases just as unsatisfactory, as the common law insider trading cases of a century ago or the general fraud cases of 150 years ago. In short, legal minds and the law itself have been unable to solve one of the most basic questions of commercial behavior: "When must I tell my trading partner what I know?" Faced with the inadequacies of legal solutions, courts and commentators have fallen back on nonlegal standards of ethical behavior, perhaps in tacit acknowledgment of the limitations of legal method.

This Article begins with an attempt to summarize the current law and its legal development. Part I addresses the Supreme Court's fiduciary trading rule, including common law precursors to the rule; the Court's decision; the treatment of Chiarella in lower federal courts since 1980; and the recent decision in United States v. O'Hagan.(32) Part II examines the various considerations courts and commentators have used in attempting to define the ideal trading rule and traces the use of those considerations in various contexts over the past two centuries. Finally, Part III considers the extent to which stock market transactions differ from other transactions and what the implications of those differences might be. In conclusion, this Article returns to the implacability of the problems presented and the law's reliance on other standards of behavior.

1. INSIDER TRADING, THE FIDUCIARY TRADING RULE, AND THE MISAPPROPRIATION THEORY

   The general rule at common law was that there was no fraud liability for "mere silence"; in other words, a knowledgeable party could buy from or sell to an ignorant party unless there was a "duty to disclose" the nonpublic fact.(33) The problem with that rule was that no one was quite sure what would give rise to a duty to disclose. Some commentators claimed that any superior information gave rise to a duty to disclose.(34) If this were true, however, the exception would completely swallow the rule.(35) Nevertheless, the common law recognized a duty to disclose based solely on superior knowledge in two situations: When the knowledgeable party was an expert, such as an art dealer, and the ignorant party relied on the other's expertise,(36) and when the nonpublic fact was a latent defect that the ignorant party could not discover for himself.(37) There was also a duty to disclose when the nonpublic "fact" was hidden by a false impression produced by the knowledgeable party.(38) The clearest duty to disclose was that which arose between fiduciary and beneficiary.

   Clearly, it is unlawful for a knowledgeable party to buy from or sell to an ignorant party when the knowledgeable party owes a fiduciary duty to the ignorant party.(39) This rule (the "fiduciary trading rule") can be traced at least to Joseph Story's early nineteenth century treatises and probably earlier.(40) Given that some fiduciaries are prohibited completely from transacting business with their beneficiaries without consent,(41) the prohibition on transactions where information is unequal is not particularly startling. This rule is such a...