Rounding the peg to fit the hole: a proposed regulatory reform of the misappropriation theory.

• Author: Beeson, Jonn R.

Introduction

Ritz Travel is a travel agency catering to celebrities, important diplomats, and executives in key positions at several Fortune 500 companies.(1) To provide a level of service that will attract such clientele, the travel agency has implemented several policies and procedures governing its employees' conduct. Included in these procedures is a strict rule of confidentiality that prohibits any employee from discussing the travel plans of a client with anyone outside the agency. Due to its policies, Ritz Travel has been remarkably successful for a number of years.

While watching the news at home one day, Matt Pilfer, an employee at Ritz, learned that Flight 97, a transcontinental flight from Armond, New York to Los Angeles, had just crashed and that there were no survivors. Pilfer immediately recalled that he had ticketed Lou Gerstner, Chairman and CEO of IBM, on that flight. Pilfer happened to own thirty shares of IBM. Realizing that IBM's stock would probably drop in response to the death of Gerstner, Pilfer rushed to the phone to contact his broker before the flight's passenger list was publicly announced. Pilfer placed an order to sell all thirty shares of IBM. After the public announcement that Lou Gerstner had died, IBM stock dropped $10 per share.

Adam Skinner, a portfolio manager, happened to be at the airport the day Lou Gerstner boarded Flight 97. Skinner immediately recognized Gerstner and wondered why he would be traveling to Los Angeles. Always alert to potential market developments, Skinner noted Gerstner's flight number and destination. Upon learning that Flight 97 had crashed, and speculating that the price of IBM stock would fall, Skinner immediately placed orders for his own account and the accounts of several customers to sell IBM short.(2) Skinner made profits and commissions in excess of $100,000 on the sale.

Under the matrix of current securities regulation, have Pilfer and Skinner violated any securities laws? The answer, perhaps surprisingly, is that although both traded on the same information, Pilfer, the travel agent, has engaged in insider trading while Skinner, the securities analyst, has not.

During the 1980s, insider trading violations(3) became more numerous and more public. The highly publicized prosecutions of such notable figures as Ivan Boesky, Dennis Levine, and Ilan Reich made "insider trading" a household term.(4) In 1988, the General Accounting Office reported that the number of opportunities for insider trading had sharply increased.(5) Although Congress,(6) the Securities and Exchange Commission ("SEC" or "Commission"),(7) and the Stock Exchanges(8) have addressed the problem numerous times, insider trading continues to be pervasive.

In 1993, Robert Freeman, a former Goldman Sachs executive, agreed to disgorge $1.1 million in profits obtained in transactions involving the leveraged buyout of Beatrice Companies.(9) His transactions were allegedly based on material nonpublic information.(10) The SEC also successfully litigated an action against Martin Sloate, a stockbroker who purchased securities on the basis of tips he received from a psychiatrist who was treating the wife of Sanford Weill, then CEO of Shearson Loeb Rhodes.(11) In the widely publicized case against "Crazy Eddie" Antar,(12) the SEC recovered more than $8 million that Antar had held illegally outside the United States.(13) The SEC also recovered additional funds that Antar had tried to shelter in the names of his wife and children.(14) The SEC, in testimony before Congress, alleged that in one case an individual was able to realize a $430,000 profit in forty-eight hours by purchasing approximately $3000 in call options of a corporation that would later be the subject of a takeover proposal.(15)

These examples illustrate the heavy sanctions levied against inside traders and the continuing practice of engaging in insider trading notwithstanding its illegality. According to the results of one study, a certain number of inside transactions accompany all material corporate events, dramatically affecting the price of companies' stock.(16) Even given the tremendous potential for personal liability, however, "the law concerning the trading of securities on the basis of [inside] information is unsettled because the applicable statutes and cases have failed to define clearly who is prohibited from trading."(17) Admittedly, insider trading is difficult to define comprehensively, but the term is probably best described as 'the purchase or sale of securities on the basis of material, nonpublic information."(18) While the traditional vision of insider trading involves an insider to a corporation(19) trading on information that is not available to the public, noninsiders(20) are also inclined to attempt to profit by trading on the basis of material(21) nonpublic information.(22)

Rule 10b-5, promulgated by the SEC in 1942 as an exercise of the rulemaking power granted by section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act"),(23) is the basic federal antifraud provision used to regulate the securities markets.(24) Through judicial interpretation, the courts have expanded the scope of Rule 10b-5(25) to the point that it is now referred to as the "catchal(26) provision for fraud. The courts and the SEC have broadened application of the rule even further, however, to regulate not only fraudulent practices in securities transactions, but also all trading on the basis of material nonpublic information where no fraud has occurred.(27) As Rule 10-5 does not itself define insider trading or even specifically outlaw it, the courts and the Commission have felt free to find liability in situations that offend notions of fair play, where no other theory on which to base a remedy is available.(28)

The basis for liability under Rule 10b-5 was founded upon common law notions of fraud.(29) At common law, silence regarding facts that were not available to another party was not considered fraud unless the first party had a duty to speak that arose out of a special relationship or unless other special facts were present.(30) Accordingly, courts traditionally required a breach of a fiduciary duty or similar relationship before liability for trading on the basis of material nonpublic information would attach.(31) Strict adherence to such a requirement, however, would allow outsiders who have no fiduciary duty or relationship of trust that extends to the corporation to trade in the market on material nonpublic information.

To address this problem, federal prosecutors and the courts developed the misappropriation theory, asserting that investor confidence in the integrity of the securities markets can be maintained only if Rule 10b-5 is broadly interpreted.(32) The misappropriation theory does not require that the purchaser or seller of securities be defrauded. Instead, the theory states that "a person violates[sections] 10(b) whenever he improperly obtains or converts to his own benefit nonpublic information which he then uses in connection with the purchase or sale of securities."(33) It is under this theory that Matt Pilfer in the opening hypothetical was indicted for insider trading. Pilfer breached a duty to his employer, Ritz Travel, by using confidential information, properly obtained in the course of his employment, improperly as a basis for his trades and thereby violated Rule 10b-5.

Part I of this Comment discusses the operation of the securities markets and the theoretical effects of insider trading on those markets. Using this background, Part I explores the principles that have driven the development and application of laws regulating the securities markets. Part II analyzes the legislative, regulatory, and judicial development of traditional insider trading laws. It then discusses the divergence between traditional insider trading laws as implemented and the rationales that they purport to satisfy. Part II also examines how courts have attempted to align the principles behind the regulation of the securities markets with the laws as implemented by applying a new theory of liability - the misappropriation theory. The use of the misappropriation theory and why it is ineffectual as a weapon in the SEC's and Justice Department's arsenals in their attack on insider trading is then explained. Part III proposes that the SEC adopt a new regulatory rule that will abolish application of the misappropriation theory. The new rule will instead structure the regulation of the securities markets in a way that addresses the harms of insider trading and yet seeks to ensure that capital markets remain efficient. Such a rule would not focus on the source of the information, as courts do when they apply the misappropriation theory, but would instead clearly define those people who are prohibited from trading on the basis of material nonpublic information, eliminating the confusion of the current system.

1. The Functions and Mechanisms of the Securities Markets

   and the Corresponding Effects of Insider Trading

   1. Efficient Capital Markets?

      An analysis of basic market theory is necessary to understand the perceived harms of insider trading. This understanding is important because the courts and the Commission have provided remedies based upon these perceived harms to shield investors from those who trade illegally on the basis of nonpublic information. The Efficient Capital Market Hypothesis ("ECMH") is a theory that provides a foundation for many of the arguments that insider trading is in fact a harmful activity. The ECMH provides that 'in an open and developed securities market, the price of a company's stock is determined by the available material information regarding the company and its business."(34) For example, if a share of Pepsi Co. is trading for $36, that price is the true value of Pepsi Co. given all information known about Pepsi Co.'s business prospects and growth opportunities. As long as there...