Permanently reviving the temporary insider.

AuthorPrentice, Robert A.
  1. INTRODUCTION II. A BRIEF HISTORY OF INSIDER TRADING LAW A. Overview B. Tracing the Origins of Insider Trading Law C. Classical Insider Trading Theory D. Appearance of the Temporary Insider E. The Misappropriation Theory F. Temporary Insiders and Misappropriators: Similarities and Distinctions G. Lower Court Applications of the Temporary Insider Theory III. RECENT CASE LAW AND CUBAN A. The Cuban Facts B. The Cuban Ruling C. The Agreement(s) D. Rule 10b5-2 IV. RATIONALE FOR REVIVING THE TEMPORARY INSIDER A. The Dubious Bona Fides of the Fiduciary Duty Requirement B. Abandoning the Fiduciary Duty Requirement C. Working With the Fiduciary Duty Requirement D. Fraudulent Conduct V. Policy Behind Reviving the Temporary Insider A. Fairness B. Property Rights C. Economic Impact 1. Economic Disadvantages of Insider Trading 2. Economic Advantages of Insider Trading Regulation VI. CONCLUSION VII. POST-SCRIPT I. INTRODUCTION

    It is a sensible time to reevaluate insider trading law because big things are happening. In the ongoing Galleon insider trading proceedings, the SEC and the Department of Justice are prosecuting perhaps the biggest insider trading scandal in history. (1) The federal government has also recently brought unprecedented charges involving new instruments (credit default swaps), (2) new theories (18 U.S.C. § 1348), (3) and new defendants (employers). (4) Recent defendants range from famous billionaires, (5) to administrative assistants, (6) to foreign nationals working on Wall Street. (7) Cross-national cooperation among securities enforcers pursuing insider trading cases has never been higher. (8) Government regulators around the world seem to believe unanimously that insider trading must be blunted, and foreign governments are bringing unprecedented insider trading prosecutions. (9)

    Meanwhile, policy prescriptions from U.S. commentators are all over the map, ranging from suggestions that insider trading be completely legalized, (10) to proposals that it be half legalized (the sell half), (11) to claims like the one in this Article that it should be more aggressively punished. (12) To further muddy the waters, U.S. courts are reaching conflicting conclusions in colorful and high profile cases. (13)

    This Article undertakes a reevaluation. Obviously, insider trading law is a work in progress. Because Congress and the SEC have declined to promulgate a specific, thorough definition of insider trading, it has been left to the courts to define it on the fly. Insider trading law should be fleshed out in accordance with a reasonable understanding of relevant policy considerations. Many sensible approaches can be reasonably defended. This Article is immediately motivated by the trial court decision in the Mark Cuban case to argue that the case was wrongly decided on its own terms because Cuban could have been held liable as a misappropriator. More importantly, this Article also claims that U.S. securities markets would be better served by a revival of the "temporary insider" category of insider trading liability, a category that more naturally fits the Cuban case.

    Part II traces a brief historical sketch of the development of insider trading law generally and the temporary insider theory more specifically. Part III focuses upon recent case law developments, primarily the Cuban case, which represents the potential extinction of the temporary insider theory. Part IV provides the theoretical rationale for an expansive revival of the theory. Part V emphasizes the reasonably strong policy reasons to paint insider trading law with broad brush strokes.


    1. Overview

      Because they fear it would be easy for bad guys to circumvent a specific, concrete definition of "insider trading," both Congress and the SEC have refused to promulgate one. (14) Still, it is clear that the core notion of insider trading occurs when corporate insiders trade in their firms' securities on the basis of material, nonpublic information. (15) Such trading constitutes a "deceptive device" under section 10(b) (16) and Rule 10b-5 (17) of the 1934 Securities Exchange Act. The lack of a statutory definition of insider trading has placed the onus upon the courts, with substantial influence from the SEC and occasional direction-pointing by Congress, to shape insider trading law.

      Although Congress has not clearly defined insider trading, it has signaled its strong antipathy for the practice. It condemned short-swing insider trading when it enacted section 16(b) of the 1934 Securities Exchange Act. (18) By enacting both the Insider Trading Sanctions Act of 1984 (ITSA) (19) and the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA), (20) Congress broadly disapproved of unfair insider trading. As the hearings for these statutes were being held in the 1980s, "insider trading had no defenders in Washington." (21) Both political parties agreed "that insider trading was undesirable." (22) In 2000, Congress passed the Commodity Futures Modernization Act, (23) which extended section 10(b) case law on insider trading to securities-based swap agreements. (24) In 2002, Congress shortened the reporting requirements for corporate insiders' trades (25) for the purpose of curtailing insider trading. (26) And in 2010 via the Dodd-Frank Act, Congress both punished insider trading by government officials in possession of information affecting commodity prices, (27) and encouraged whistleblowing to facilitate punishment and deterrence of securities wrongs, including insider trading. (28) Thus, over the course of 80 years, Congress has repeatedly condemned insider trading and attempted to punish its practitioners.

      For its part, the Securities Exchange Commission (SEC) has both anticipated and reinforced Congress's condemnation of insider trading by:

      1. interpreting section 78j(b) and Rule 10b-5 to punish insider trading; (29)

      2. promulgating rules such as:

      3. Rule 14e-3 (30) (which specifically punishes insider trading based on tender offer information); 2. Rule 10b5-1 (31) (which lowered the scienter standard for insider trading liability); 3. Rule 10b5-2 (32) (which clarifies and expands the notion of "misappropriation" liability); 4. Regulation FD (33) (which discourages insider trading by punishing selective disclosure by insiders); and

      4. making insider trading a top enforcement priority. (34)

    2. Tracing the Origins of Insider Trading Law

      Modern insider trading law originated in the SEC's 1961 In re Cady, Roberts & Co. (35) proceeding in which the Commission predicated an obligation to refrain from trading on undisclosed inside information upon two factors: (a) "the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone," (36) and (b) "the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing." (37) In the first major court decision following Cady, Roberts, the Second Circuit in SEC v. Texas Gulf Sulphur (38) based insider trading liability upon Rule 10b-5's "justifiable expectation ... that all investors ... have relatively equal access to material information." (39) This 1968 opinion imposed a duty to "disclose ... or ... abstain from trading" upon "anyone in possession of material inside information." (40)

    3. Classical Insider Trading Theory

      The notion that anyone in possession of material inside information could be liable for insider trading that seemed to undergird Cady, Roberts and Texas Gulf Sulphur was rejected by the United States Supreme Court in its first insider trading case, Chiarella v. United States. (41) Chiarella worked for a financial printer and deduced the names of tender offer targets from the materials of potential tender offerors that hired his firm to print financial documents. (42) Stressing that "not every instance of financial unfairness constitutes fraudulent activity," (43) and that though section 10(b) is a "catchall" provision, "what it catches must be fraud," (44) the Court held that because Chiarella was "not a corporate insider and ... received no confidential information from the target company," (45) he had no duty to disclose because mere possession of confidential information does not give rise to such a duty. (46) Rather, it is the existence of a fiduciary duty that creates the duty to disclose or abstain. (47) Because most inside traders acted in the shadows in silence, and because silence is not fraudulent in the absence of a duty to speak, the Court relied upon the existence of a fiduciary relationship to establish that duty to speak. Much mischief has arguably sprung from the adoption of this fiduciary duty approach.

      The next Supreme Court insider trading case was a "tippee" case, Dirks v. SEC. (48) Dirks, a Wall Street professional, had received a tip from a man that his former employer, Equity Funding, had engaged in a massive fraud. (49) After confirming the tip and making at least a mild attempt to alert authorities, Dirks passed the information on to clients who sold Equity Funding stock. (50) In evaluating the SEC's insider trading claims against Dirks, the Supreme Court repeated Chiarella's rejection of the "possession test," repeating that a duty to disclose or abstain arises from the existence of a fiduciary duty. (51) Whereas corporate insiders, the Court held, owe independent fiduciary duties both to the corporation and its shareholders, tippees like Dirks typically have no such relationship. (52) Therefore, to be liable, they must "inherit" a duty to disclose or abstain from their tipper. (53) According to the Court, "the tippee's duty to disclose or abstain is derivative from that of the insider's duty." (54) The tippee category of liability exists primarily to ensure that corporate insiders cannot do indirectly that which they are forbidden...

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