The Misappropriation Theory of Insider Trading: Its Past, Present, and Future

• Publication year: 1994

UNIVERSITY OF PUGET SOUND LAW REVIEWVolume 18, No. 2WINTER 1995

The Misappropriation Theory of Insider Trading: Its Past, Present, and Future

Troy Cichos(fn*)

I. Introduction

It happens all the time, without a second thought. People on the golf course, at the weekly card game, or at a backyard barbecue, pass on hot stock tips to friends and relatives. If asked about the possibility of violating insider trading laws, the following responses would be typical: "It could never happen to me," and "it's only a problem for large, powerful investors." These responses, while typical, are wrong. Just ask Carl Reiter.

One day on the golf course, one of Reiter's oldest friends advised him to buy stock in Revco Drug Stores; the friend knew "the guy doing the deal."(fn1) Reiter, a real estate developer, invested a few thousand dollars in the stock, made a profit of $2,625 in two months, and thought the investment was over. It was not. Two years later, one of Reiter's golfing partners got a phone call from a person claiming to be an investigator for the Securities and Exchange Commission (SEC). The friend's response was "yeah, right, and I'm Ivan Boesky." The person was an investigator, and Reiter and the other golfers who acted on the stock tip were charged with violating insider trading laws.(fn2) Reiter eventually disgorged his profits resulting from the tip and paid a fine of the same amount.(fn3) Reiter was shocked that the powerful SEC was concerned about his small investment and that insider trading laws applied to such conduct.(fn4) The actions of the SEC in this case, however, are not unusual. The scope and application of insider trading have expanded the concept to a point that it is no longer limited to actual insiders and can affect any person who trades in securities.(fn5)

"Insider trading" is neither defined nor expressly prohibited by federal securities laws.(fn6) Rather, the Securities and Exchange Act of 1934 (Act) broadly proscribes "deceptive" practices in connection with the purchase or sale of securities.(fn7) Section 10(b) of the Act gives the SEC authority to promulgate rules and regulations to achieve those aims.(fn8) Pursuant to this authority, the SEC adopted Rule 10b-5, which prohibits fraudulent and deceptive practices in the trading of securities.(fn9) These two legislative and administrative enactments are the vehicles through which insider trading is prohibited and enforced.(fn10)

Because the prohibition against deceptive practices is broad, and because insider trading has not been specifically denned by Congress, the SEC and the judiciary have denned insider trading.(fn11) Unfortunately, this process has led to conflicting views of insider trading and to decisions based primarily on the facts of each case, rather than upon a bright line rule.(fn12) Moreover, the courts and the SEC do not always agree as to how wide the insider trading net should be cast.(fn13) Three conclusions are certain. First, the vast majority of law in this area is created and advanced by courts within the Second Circuit.(fn14) Second, the SEC and the Second Circuit courts generally attempt to interpret insider trading law as broadly as possible, leaving it to higher courts to scale back the law if interpreted too broadly.(fn15) Third, insider trading can be divided into the following two categories: classic insider trading and the misappropriation theory of insider trading.(fn16) These two categories extend the prohibitions of Section 10(b) to two different groups of individuals.

Classic insider trading is premised on the duty that a corporate employee owes to shareholders of the corporation: to place the shareholders' interests ahead of the employee's personal interests.(fn17) The misappropriation theory, however, is premised upon the presence of any fiduciary or fiduciary-type relationship between two people or entities. Under the misappropriation theory, a party with no ties to a corporation or any of its employees may still violate insider trading laws by trading in the corporation's securities.(fn18)

Section 10(b) was first used to regulate insider trading in the early 1960's. The type of conduct regulated was closely tied to the express provisions of Rule 10b-5 that prohibit fraudulent and deceptive practices.(fn19) However, in 1978 the Second Circuit used a much broader interpretation of Section 10(b) and Rule 10b-5 to combat insider trading in Chiarella v. United States.(fn20) Although the Supreme Court reversed the Second Circuit's broad interpretation in Chiarella,(fn21) three years later the Court accepted an almost equally broad interpretation in Dirks v. SEC.(fn22) These two cases represent the core of classic insider trading regulation.

While the Supreme Court's reversal of Chiarella reduced the scope of Section 10(b) and Rule 10b-5, Chief Justice Burger's dissenting opinion in the case represents the germination of the misappropriation theory. In United States v. Carpenter,(fn23) the Second Circuit relied on Chief Justice Burger's discussion of misappropriation theory to advocate a very broad and wide reaching interpretation of Section 10(b) and Rule 10b-5-one that affects any person who makes a trade in any securities market.(fn24) This interpretation brings people who have no association with a corporate insider within the sphere of liability for insider trading and epitomizes the misappropriation theory of insider trading.(fn25) Although the Supreme Court has never explicitly affirmed the misappropriation theory,(fn26) the Court has expanded the scope of insider trading to such an extent that the activities being restrained are not those that Congress originally intended to restrain under Section 10(b).

In this Comment, I discuss the evolution and current application of the misappropriation theory of insider trading and argue that it simply strays too far from the fraud tenets of Section 10(b) and Rule 10b-5.

A thorough understanding of the misappropriation theory is possible only if one understands how it diverges from the classic theory of insider trading. Therefore, in Section II, I discuss the evolution and present doctrine of classic insider trading. The discussion in this Section focuses on major cases in the development of this theory. Section III presents the misappropriation theory of insider trading. Section III focuses upon (1) the broad scope of the misappropriation theory as initially adopted by the Second Circuit in United States v. Carpenter,(fn27) (2) the Circuit's later attempt to limit the scope of the theory in United States v. Chestman,(fn28) and (3) the effect that Chestman has had on limiting the scope of the theory. Section III ultimately shows that the misappropriation theory strays far from the fraud prohibitions of Section 10(b) and has no identifiable limits, thereby proscribing conduct that is not properly regulated by Section 10(b) and Rule 10b-5. Finally, Section IV presents alternative ways to achieve the valuable public policy of the misappropriation theory.(fn29) Section III concludes that new rules prohibiting the use of material, nonpublic information for an improper purpose should be promulgated under the authority granted to the SEC by Section 10(b).

II. Classic Insider Trading

The regulation of insider trading is based on the assumption that the use of material, nonpublic information in a securities transaction undermines investor expectations of fairness and equal opportunity in the securities markets.(fn30) Individuals who are privy to material,(fn31) nonpublic(fn32) information should not be allowed to profit from knowledge of this information unless the knowledge is gained through investigation and skill, not through a position of trust and confidence.(fn33)

A person working for a corporation or an investment house has access to material, nonpublic information based on her position inside the confidential sphere of the entity. With that position comes the corresponding duty to refrain from using the information for personal gain. Use of confidential information within the securities market without disclosure to the rest of the market violates the duty owed to shareholders and is fraud prohibited by Section 10(b) and Rule 10b-5. This is what is meant by the term "insider trading." The scope of the classic theory of insider trading is set out below.

A. In re Cady, Roberts, Inc.

The first major development in the application of Section 10(b) to insider trading activities occurred in the 1961 SEC hearing In re Cady, Roberts, Inc.(fn34) This case involved a registered broker-dealer who, while in possession of information concerning a planned dividend cut by a company, directed his clients to liquidate their holdings in that company.(fn35) The broker acquired this information from a corporate insider who owed a fiduciary duty to the shareholders of the corporation.(fn36) The SEC determined that the broker's actions "violated [Rule 10b-5(3)] as a practice which operated ... as a fraud or deceit upon the purchasers."(fn37) The SEC reasoned that because a corporate insider owes a fiduciary duty to both the shareholders and the corporation itself, using confidential information for personal benefit constitutes fraud. This reasoning has been termed the "disclose or abstain" rule.(fn38)

Two factors led the SEC to adopt the disclose or abstain rule. First, the relationship between an insider...