Addressing a question that has long been a subject of debate among legal commentators,(1) the Ninth and Eleventh Circuits recently held that "knowing possession" is not sufficient to impose insider trading liability under section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder.(2) At issue in this debate is whether section 10(b) and Rule 10b-5 require a causal connection between the material, nonpublic information and the insider's trading--that is, a showing that the insider actually used the information--or whether knowing possession of such information at the time of the trade is sufficient for liability to attach.
Few courts have addressed this issue directly.(3) Indeed, in many cases it has not been necessary for the courts to address the issue: often it is clear that the insider used the information.(4) As Allan Horwich has noted, however, "[t]he scarcity of pertinent cases does not ... mean that the question is merely of abstract interest.... [T]he issue frequently arises in counseling [corporate executives] who may obtain inside information pending completion of a transaction or in the midst of a pre-established trading program."(5)
This Comment will examine the "possession versus use" debate, assessing the arguments that have been made in support of the two sides and concluding that "knowing possession" is the more appropriate standard. Because one cannot develop a sensible rule without first understanding the rule's purpose, Part I will begin with an overview of insider trading, including the rationale underlying its prohibition. Part II will then present the "possession versus use" debate, exploring the origins of the debate, as well as the recent cases addressing the issue. Next, Part III will examine more closely the arguments advanced in support of the "use" standard. Advocates of the "use" standard have based their arguments largely on Supreme Court precedent. As discussed in Part III, however, this reliance on prior case law is misplaced because the question of "possession versus use" was not at issue in the cases relied upon. Rather than relying on prior case law, this Comment suggests that one should instead consider the reasons underlying the insider trading prohibition, as well as the difficulty of proof associated with prosecution, to determine the appropriate standard. These considerations form the basis for the arguments in support of the "knowing possession" standard. Part IV will discuss these arguments, concluding that "possession" is the more appropriate test for insider trading liability.
OVERVIEW OF INSIDER TRADING
"`Insider trading' is a term of art that refers to unlawful trading in securities by persons who possess material nonpublic information about the company whose shares are traded or the market for its shares."(6) Although the federal securities laws do not expressly proscribe insider trading, section 10(b) of the Securities Exchange Act of 1934(7) and Rule 10b-5(8) promulgated thereunder by the Securities and Exchange Commission ("SEC") have been interpreted as prohibiting insider trading.(9) In interpreting these provisions, the SEC and the federal courts have developed two distinct theories of liability: the "traditional" or "classical" theory, and the "misappropriation" theory of insider trading.
Theories of Liability: The Classical Theory and the Misappropriation Theory
Under the classical theory of insider trading, a corporate insider may not trade in the securities of his corporation while in possession of material, nonpublic information.(10) Such trading violates section 10(b) and Rule 10b-5 because of the relationship of trust and confidence that exists between the shareholders of a corporation and corporate insiders; because of this relationship, "insiders who have obtained confidential information by reason of their position with that corporation" may not take "unfair advantage of ... uninformed ... stockholders."(11) The term "insider" refers to a broader class of persons than those traditionally considered corporate insiders and includes "temporary insiders" such as attorneys, investment bankers, consultants, and accountants.(12)
Liability, however, is not limited to those who actually trade; nor is it limited to insiders. An insider who "tips" material, nonpublic information violates section 10(b) and Rule 10b-5 if the tip breaches a fiduciary duty and the tippee (the recipient of such a tip) trades, even if the insider does not trade.(13) The tippee may also be liable for trading if the tipper breached his fiduciary duty by conveying the information.(14)
Liability under the classical theory requires a breach of an insider's duty owed to the shareholders of the corporation in whose securities the insider (or a tippee) traded.(15) The classical theory thus does not impose liability where an "individual `outside' a corporation purchase[s] the corporation's securities while in possession of material, nonpublic information that was obtained in a manner that did not involve an insider's breach of duty."(16) Such trading has been described as "outsider trading," since the traders are outsiders of the corporation in whose securities they traded.(17)
Recognizing this limitation of the classical theory, the SEC and the courts developed the misappropriation theory. The misappropriation theory imposes liability where an individual "misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information."(18) Rather than predicating liability on a fiduciary relationship between the insider and the corporation's shareholders, "the misappropriation theory premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information."(19) As in the case of the classical theory, both tippers and tippees may be liable for insider trading under the misappropriation theory.(20)
Reasons for the Insider Trading Prohibition
The traditional basis for the insider trading prohibition is the belief that insider trading violates our notion of "fair play" and threatens the integrity of the capital markets.(21) As the American Bar Association Task Force on Regulation of Insider Trading observed:
In our society, we traditionally abhor those who refuse to play by the rules, that is, the cheaters and the sneaks. A spitball pitcher, or a card shark with an ace up his sleeve, may win the game but not our respect. And if we know such a person is in the game, chances are we won't play. These commonsense [sic] observations suggest that two of the traditional bases for prohibitions against insider trading, are still sound: the `fair play' and `integrity of the markets' arguments.(22) Underlying the development of the insider trading prohibition is the view that insider trading is fundamentally unfair.(23) As Donald Langevoort has observed, "most people who oppose insider trading seem to believe that quite apart from any harm caused to specific investors, insider trading is simply an unfair exploitation of information that properly belongs to someone else."(24) The unfairness stems not from the insider-trader's possession of superior information, but from the trader's possession of an informational advantage that other investors cannot overcome: other investors cannot acquire the inside information.(25) Clearly, informational advantages exist; some investors will necessarily have superior information as a result of superior intelligence, diligence, or power.(26) And not all such informational disparities should be eliminated.(27) When other investors are unable to obtain information, however, no matter how great their resources or diligence, such informational advantages are unfair,(28) and it is those informational advantages that the insider trading prohibition seeks to prevent.(29)
In addition to--or perhaps because of--this fundamental unfairness, insider trading threatens the capital markets. The strength and stability of the capital markets depend on investor confidence in those markets.(30) Insider trading, however, undermines investors' expectations of honest and fair securities markets.(31) If investors believe that other market participants have an unerodable informational advantage--that the markets are not fair--they will be reluctant to participate in the securities markets:
A rational buyer (or seller) in a market, who knows that the person with whom he is dealing has material information about the value of the product being exchanged which he could not lawfully acquire, will either refrain from dealing with that transactor or demand a risk premium. If the market is thought to be systematically populated with such transactors some investors will refrain from dealing altogether, and others will incur costs to avoid dealing with such transactors or corruptly to overcome their unerodable informational advantages.(32) It is this recognition that underlies the insider trading prohibitions.(33) Indeed, as SEC Enforcement Director William R. McLucas asserted, "one of the purposes of bringing an insider trading case, in addition to addressing specific instances of fraud, is to ensure the integrity of the market."(34)
THE "POSSESSION VERSUS USE" DEBATE
Although Congress has condemned insider trading and expressed strong support for the prohibition of such conduct.(35) Congress has resisted attempts to expressly define insider trading.(36) Instead, the prohibition against insider trading has developed solely from judicial (and administrative) interpretation of the anti-fraud provisions of section 10(b) and Rule 10b-5. The lack of a statutory definition of the insider trading offense has led to some ambiguity regarding the type of conduct that is prohibited.(37) One such area of ambiguity is whether the insider's motivation for trading is relevant to a determination of insider-trading liability under Rule 10b-5...