Insider Trading and Securities Fraud

• Pages: 379-448
• Author: Stephen M. Bainbridge

379

Chapter 11

INSIDER TRADING AND

SECURITIES FRAUD

§ 11.1 Introduction

The term insider trading is something of a misnomer. It conjures

up images of corporate directors or officers using secret information

to buy stock from (or sell it to) unsuspecting investors. To be sure,

the modern federal insider trading prohibition proscribes a

corporation’s officers and directors from trading on the basis of

material nonpublic information about their firm, but it also casts a

far broader net. Consider the following people who have been

convicted of illegal insider trading over the years:

• A partner in a law firm representing the acquiring

company in a hostile takeover bid who traded in target

company stock.

• A Wall Street Journal columnist who traded prior to

publication of his column in the stock of companies he

wrote about.

• A psychiatrist who traded on the basis of information

learned from a patient.

• A financial printer who traded in the stock of

companies about which he was preparing disclosure

documents.

As you can see, the insider trading laws thus capture a wide range of

individuals who trade in a corporation’s stock on the basis of material

information unknown by the investing public at large.

Insider trading is covered by a number of legal regimes, of which

no less than 5 are important for our purposes:

• The disclose or abstain rule under § 10(b) of the

Securities Exchange Act of 1934 and Securities and

Exchange Commission Rule 10b–5 thereunder, which

is principally concerned with classic insiders such as

corporate officers and directors;

• The misappropriation theory under § 10(b) and Rule

10b–5, which deals mainly with persons outside the

company in whose stock they traded;

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Ch. 11

• SEC Rule 14e–3 under Exchange Act § 14(e), which is

limited to insider trading in connection with a tender

offer;

• Section 16(b) of the Exchange Act, which prohibits

corporate directors, officers, and shareholders owning

more than 10% of the firm’s stock from earning “short

swing profits” by buying and selling stock in a six

month period;

• State corporate law, which principally targets

corporate officers and directors who buy stock from

shareholders of their company in face-to-face

transactions.

All five regulatory schemes are discussed below, but our attention

will focus mainly on the federal prohibition under SEC Rule 10b–5.

At the beginning of the 1900s, state corporate law was the only

legal regime regulating insider trading. At that time, as is still true

in some states, corporate law allowed insider trading. Federal

securities law, especially Rule 10b–5, however, has largely

superseded the state common law of insider trading. To be sure, the

state rules are still on the books and are still used in a few cases that

fall through the cracks of the fe deral regulatory scheme, but federal

law offers regulators and plaintiffs so many procedural and

substantive advantages that it has become the dominant legal

regime in this area. The most important feature of federal law,

however, may be that it put a cop on the beat. State law relied on

firms and shareholders to detect and prosecute insider trading.

Under federal law, the SEC and the Justice De partment can

prosecute inside traders, which has substantially increased the

likelihood it will be detected and successfully prosecuted.

A truly significant distinguishing feature of the federal insider

trading prohibition has been change. Although the prohibition is only

about four decades old, it has seen more shifts in doctrine than most

corporate law rules have seen in the last century. Exploring this rich

history is a useful exercise—in many respects you cannot understand

today’s issues without the historical background—but is also fraught

with danger: you must draw clear distinctions between what was the

law and what is the law.

One point requiring particular attention is the evolution of new

theories on which insider trading liability can be based. We shall see

two very important cases in which the Supreme Court restricted the

scope of the traditional disclose or abstain rule. In response to those

cases, the SEC and the lower courts developed two new theories on

which liability could be imposed. As we move through this material,

§ 11.2

ORIGINS OF THE INSIDER TRADING PROHIBITION

381

pay close attention to which theory is being discussed at any given

moment and consider how that theory differs from the others.

§ 11.2 Origins of the Insider Trading Prohibition

Although we now take it for granted that regulating insider

trading is a job for the SEC under federal law, it was not always so.

Until the 1960s, insider trading was as a matter of state corporate

law. Since then, of course, the federal prohibition has largely eclipsed

state law in this area, but the older state rules are still worth

studying.

A. State Common Law

Our overview of the state common law of insider trading is both

historical and functional. We’ll look first at the three different insider

trading rules states adopted in the early 1900s. It turns out that

these rules were largely limited to face-to-face transactions, however,

so we will then look at how states regulated insider trading in the

context of stock market transactions. Completing those two tasks will

carry us through the 1930s, when Congress adopted the federal

securities laws, but we will defer development of federal law in order

to look at how state corporate law treats insider trading today.

1. Face-to-Face Transactions

Prior to 1900 it was treatise law that “[t]he doctrine that officers

and directors [of corporations] are trustees of the stockholders . . .

does not extend to their private dealings with stockholders or others,

though in such dealings they take advantage of knowledge gained

through their official position.”

1

Under this so-called “majority” or “no

duty” rule, liability was imposed solely for actual fraud, such as

misrepresentation or fraudulent concealment of a material fact. As

one court explained, liability arose only where the defendant said or

did something “to divert or prevent, and which did divert or prevent,

the plaintiff from looking into, or making inquiry, or further

inquiries, as to the affairs or condition of the company and its

prospects for dividends. . . .”

2

The first tentative step towards the modern prohibition came in

Oliver v. Oliver,

3

in which the Georgia Supreme Court announced the

so-called “minority” or “duty to disclose” rule. Under Oliver, directors

who obtained inside information by virtue of their position held the

information in trust for the shareholders. Accordingly, directors had

1

H. L. Wilgus, Purchase of Shares of a Corpor ation by a Director from a

Shareholder, 8 Mich. L. Rev. 267 (1910).

2

Carpenter v. Danforth, 52 Barb. 581, 589 (N.Y.Sup.Ct.1868).

3

45 S.E. 232 (Ga.1903).