Insider Trading and the Gradual Demise of Fiduciary Principles

AuthorDonna M. Nagy
PositionC. Ben Dutton Professor of Law, Indiana University Maurer School of Law- Bloomington

C. Ben Dutton Professor of Law, Indiana University Maurer School of Law- Bloomington. This Article has benefited from insights and comments by Professors Kelli Alces, Hannah Buxbaum, Jill Fisch, Kimberly Krawiec, Donald Langevoort, Richard Painter, Margaret Sachs, Hillary Sale, and William Wang, and from presentations made at Boston College Law School, The University of Iowa College of Law, University of Notre Dame Law School, Seattle University School of Law, University of British Columbia National Centre for Business Law, and the 2008 Meeting of the Law and Society Association. I am grateful for the excellent research assistance provided by Matthew Lees.

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I Introduction

Just over a decade ago, the U.S. Supreme Court established that there are two complementary theories of insider trading liability, each with a fiduciary principle at its core. 1 under the "classical" theory developed in Chiarella v. United States2 and reaffirmed three years later in Dirks v. SEC,3corporate insiders violate Section 10(b) of the Securities Exchange Act of 19344 and Rule 10b-5 thereunder5 when they trade their corporation's securities while aware of material nonpublic information.6 An insider's silence about material facts pertaining to the transaction constitutes deception because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation."7Insiders (namely, officers, directors, and employees) who are aware of material nonpublic information are therefore obliged to "disclose or abstain" from trading the securities of their corporation.8 The obligation to disclose or abstain also extends to temporary agents of the corporations and to persons (so-called tippees) who trade securities based on information shared with them by an insider. 9

Under the alternative "misappropriation" theory endorsed by the court in United States v. O'Hagan,110 persons "outside" the issuing corporation can likewise violate Section 10(b) and Rule 10b-5.n Such a violation occurs when a fiduciary personally profits from a securities transaction through Page 1318 undisclosed use of a principal's material nonpublic information.12 Thus, as the Court explained, whereas the classical theory "premis[es] liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information."13 The O'Hagan Court emphasized that the misappropriation theory serves the important policy goals of promoting market integrity and investor confidence because "investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law."14 The Court was clear, however, that the circle of outsiders liable under the misappropriation theory was "limited to those who breach[ed] a recognized duty" owed to the information's source.15 Page 1319

Despite the Supreme Court's explicit dictate that fiduciary principles underlie the offense of insider trading, there have been recent repeated instances in which lower federal courts and the Securities and Exchange Commission ("SEC") have disregarded these principles. On some occasions, judicial adherence to fiduciary principles would have dictated rulings in favor of defendants charged with insider trading, but courts essentially ignored those principles.16 SEC settlements in insider trading cases also reflect this disregard.17 On other occasions, courts have ignored fiduciary principles where adherence to them would have established the defendant's liability.18 These litigated cases and settled proceedings have a common theme: the offense of insider trading involves the wrongful use of material nonpublic information, regardless of whether a fiduciary-like duty is breached. 19

The SEC has also circumvented fiduciary principles with respect to rules adopted in the wake of O'Hagan. This circumvention occurred in connection with Rule 10b5-1's affirmative defenses, which allow insiders who trade securities while aware of material nonpublic information to avoid liability by demonstrating that they traded pursuant to a written plan that pre-existed their awareness of such information.20 These affirmative defenses clash with the underlying premise of the classical theory: insiders, by virtue of their status as fiduciaries, owe disclosure duties to shareholders when engaging in securities transactions. The SEC likewise ignored fiduciary principles in Rule 10b5-2(b)(1).21 That rule extends liability under the misappropriation theory to securities transactions based on information subject to a confidentiality agreement, regardless of the nature of the Page 1320 relationship between the trader and the information's source.22 Both SEC rules, however, are consistent with the view that insider trading involves the wrongful use of material nonpublic information regardless of the presence of a fiduciary-like duty.

The decade since O'Hagan has thus taught us much. First, as I argued shortly after the decision, O'Hagan's paradigm of "deception by a fiduciary" was not broad enough to encompass cases involving more novel forms of trading on misappropriated information. 23 Yet more novel forms of outsider trading-such as trading on confidential information stolen by a stranger to the source-have the same deleterious effects on securities markets as secret trading by a fiduciary. The Court in O'Hagan failed to provide a convincing rationale as to why the misappropriation theory is limited to outsiders with a fiduciary-like nexus to the information's source. Accordingly, lower courts, encouraged by the SEC, have been willing to allow O'Hagan's policy justifications for the federal insider trading proscription to trump the fiduciary-based doctrine actually endorsed by the Court. But a coherent and consistent theory of insider trading liability has yet to emerge as an alternative to the Court's classical and misappropriation approaches.

Relatedly, the last ten years reflect a host of outcomes that return insider trading law almost full circle to the years preceding Chiarella. Prior to Chiarella, lower courts and the SEC maintained that unequal access to material nonpublic information triggered a disclosure obligation under Rule 10b-5.24 Chiarella and Dirks rejected this broad-based disclosure duty and predicated the disclosure obligation on a fiduciary relationship between the parties to the securities transaction. O'Hagan then expanded the disclosure obligation to include one that was predicated on a fiduciary relationship between the trader-tipper and the source of the information as well as on a fiduciary relationship between the trading parties. Today, however, insider trading cases do not turn necessarily on the breach of a disclosure obligation flowing from a fiduciary-like relationship. Rather, numerous lower courts and the SEC have in effect concluded that the wrongful use of information constitutes the crux of the insider trading offense and that fiduciary principles are only relevant insofar as they establish such wrongful use.

Most importantly, the last decade has demonstrated the urgent need for redirection. Rather than allowing lower courts and the SEC to continue on a Page 1321 course of revisionism and results-oriented decisionmaking, it would be far better to replace the classical and misappropriation theories with a federal statute that defines and directly prohibits the offense of insider trading. Alternatively, in the absence of legislation by Congress, courts should supplement the classical and misappropriation theories, or replace them entirely, with other fraud-based theories of Rule 10b-5 liability.

The Article proceeds as follows. Part II chronicles the development of fiduciary principles in Chiarella, Dirks, and O'Hagan. The analysis reveals that the Court's affinity for fiduciary principles in insider trading cases originated as a means of confining the scope of liability under Rule 10b-5 to insiders who exploit the corporation's information for their own personal profit. But after O'Hagan expanded the scope of Rule 10b-5 liability to include outsiders with no relationship to the corporation that had issued the securities, the Court's slavish devotion to fiduciary principles no longer made much sense.

Part III charts the gradual demise of fiduciary principles in insider trading decisions by lower federal courts, settled enforcement proceedings, and rules adopted by the SEC. It argues that this demise was inevitable given the shaky foundation on which the Supreme Court built its insider trading jurisprudence and the developing consensus that insider trading involves the wrongful...

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