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|It has been clear for at least 60 years that as a general matter it is unlawful in the US for a person to purchase or sell securities of a company when in possession of material nonpublic information about the company. But courts have struggled to come up with the rationale for why this is the case, which has sometimes led to surprising results when the government has tried to punish insider trading. The House of Representatives has recently passed a bill that purports to clarify the law regarding insider trading. However, that legislation is likely to create as many problems as it would solve. What is needed is clear, simple legislation that puts in place the broad prohibition that most people think already exists.|
It has been clear, at least since a Securities and Exchange Commission (SEC) administrative decision in 1960, that as a general matter it is unlawful in the US for a person to purchase or sell securities of a corporation when in possession of material nonpublic information about the corporation. Trading by an insider, or by a tippee, can violate Section 10(b) of the Securities Exchange Act of 1934, and in particular the anti-fraud provisions of SEC Rule 10b-5. A number of former corporate insiders are in jail for ignoring the insider trading prohibition.
What is not clear is what causes insider trading to violate Section 10(b) and Rule 10b-5. This lack of clarity has led to more than 50 years of litigation.
There are two theories for why trading by insiders when they are aware of material nonpublic information is unlawful. One is that the insider is committing a fraud on the person from or to whom the insider purchases or sells securities, because the insider is aware of important information that is not available to the other person. The second is that an insider's fiduciary relationship with the shareholders of the corporation requires the insider to be sure that the shareholders with whom the insider deals have all relevant information of which the insider is aware. Neither of these rationales is entirely satisfactory.
The first theory would apply to persons who have no relationship to a company to the same extent it would apply to corporate insiders or people who obtain nonpublic information from corporate insiders. That clearly is not intended to be the case. There is general agreement, for example, that if someone on the street saw a building collapse, it would not be unlawful for that person to immediately call his or her broker and place an order to sell stock of the corporation that owned the building.
Also, fraud customarily requires harm to the defrauded person. With regard to securities traded on exchanges, if an insider does not sell stock because he or she is aware of material nonpublic information, the person who would have bought the stock from the insider at the prevailing market price will simply purchase the stock from somebody else at that prevailing market price (or the person who would have sold stock to the insider will sell it to somebody else for the prevailing market price). Unless the insider purchases or sells stock in market-moving volumes, the person who would have sold stock to, or purchased stock from, the insider will probably not be affected at all by whether the insider refrains from trading.
The second theory also does not always work. While an insider who buys stock is always dealing with a stockholder of the corporation, there is no reason to think that when an insider sells stock, the person who buys it will be an existing stockholder. Therefore, there is no reason to think an insider who sells stock will have a pre-existing fiduciary relationship with the person who buys it.
The securities fraud statute applies only if there is a false or fraudulent statement, which is not the case in most instances of insider trading
Beginning in 1980, the US Supreme Court began to address what makes it unlawful for a person to purchase or sell securities when in possession of material nonpublic information. Three decisions were particularly important in addressing this question.
The first decision, rendered in 1980, related to Vincent Chiarella, an employee of a financial printer who sometimes worked on documents relating to tender offers. Tender offers almost always involve purchases at substantial premiums above the pre-tender offer market prices of the target company stock. Chiarella used his advance knowledge of five tender offers to purchase stock of the target companies before the tender offers were announced and profited from the price increases resulting from them.
Chiarella was convicted of violating federal securities laws. But the Supreme Court reversed the conviction, stating that the trial court had incorrectly charged the jury that Chiarella could be convicted for trading on the basis of nonpublic information without also telling the jury that in order to convict, it had to find that Chiarella had had a duty to disclose the information. The Supreme Court did not address whether Chiarella had had such a duty.
The second decision, rendered in 1983, related to Raymond Dirks, an officer of a brokerage firm, who had been told by a former officer of a large insurance company that the insurance company's assets were hugely overstated as a result of fraud, but that regulatory agencies had failed to act on charges made by company employees. Dirks tried to encourage the Wall Street Journal to expose the fraud, but it wouldn't publish the story. Meanwhile, Dirks told customers of his firm what he had learned, and some of them sold stock of the insurance company. Eventually, the fraud was uncovered, and the insurance company went into receivership.
The SEC ruled that Dirks had violated Section 10(b) by telling customers about the fraud, stating that when tippees come into possession of material information they know or should know which came from a corporate insider, they must either publicly disclose the information or refrain from trading.
The Supreme Court disagreed with the SEC. It acknowledged that if a person who is tipped about material information knows the information was disclosed in breach of the tipper's duty, the tippee acquires the tipper's duty to disclose the information or refrain from trading. However, the Supreme Court said that an insider is not liable for disclosing nonpublic information to a person who trades on it unless "the insider receives a direct or indirect personal benefit from the disclosure, such as a pecuniary gain or a reputational benefit that will translate into future earnings" or the insider "makes a gift of confidential information to a trading relative or friend". The Supreme Court said that because the former insider who told Dirks about the fraud had not received a personal benefit from making the disclosure, the former insider had not violated the securities laws, and therefore people who traded on the basis of what the former insider had disclosed did not violate the securities laws.
Since the Dirks decision, there has been frequent litigation regarding what constitutes personal benefit to an insider, including another decision of the Supreme Court, and the question is still not fully resolved.
The third important US Supreme Court decision involved James O'Hagan, a lawyer who learned that a client of his firm was going to make a tender offer for stock of a company that was not a client of the law firm, and purchased stock of the target company before the tender offer was announced. O'Hagan was convicted of violating Section 10(b), but an appellate court reversed the decision, because there was no fiduciary or other relationship that created a duty for O'Hagan to disclose the likelihood of a tender offer to the persons from whom he purchased stock.
The Supreme Court reinstated O'Hagan's conviction, finding that O'Hagan had violated Section 10(b) by misappropriating information about the tender offer from his law firm and its client. In other words, O'Hagan was convicted of breaching an obligation to the source of the information, even though he had no obligations to the people from whom he purchased stock. The Supreme Court did not discuss what would have happened if the law firm's client had told O'Hagan he could purchase the stock.
In addition to being convicted of violating Section 10(b) and Rule 10b-5, O'Hagan had been convicted of violating Section 14(e) of the Securities Exchange Act and Rule 14e-3(a) under it. Section 14(e) prohibits fraudulent or deceptive acts in connection with a tender offer, and directed the SEC, for purposes of that subsection, to "prescribe means reasonably designed to prevent, such acts that are fraudulent, deceptive, or manipulative". Rule 14e-3(a) makes it unlawful for a person who knows that someone is taking steps to commence a tender offer because of information obtained from the offering person or the issuer of the securities being sought, to purchase or sell the securities being sought before the information is publicly disclosed. It totally prohibits a person from purchasing or selling securities when in possession of nonpublic information that someone is going to commence a tender offer, even if there is no fiduciary or other duty to disclose.
The appellate court that reversed O'Hagan's conviction for violating Rule 10b-5 also reversed his conviction for violating Rule 14e-3(a), stating that the SEC had exceeded its powers in adopting a rule that was not limited to instances in which there was a duty to disclose. The Supreme Court reinstated the conviction, stating that the SEC had authority under Section 14(e) to create an absolute "disclose or abstain from trading" rule. It expressly did not address whether the SEC's rulemaking authority under Section 14(e) was broader than its authority under Section 10(b).
The adoption of Rule 14e-3 in 1980 was the first, but not the last, time the SEC used its rule-making power to address trading when in possession of inside information. In 2000, the SEC adopted Regulation FD, which, with some exceptions, prohibits an issuer of securities from disclosing material nonpublic information regarding that issuer or its securities to an investment professional or to "a holder of the issuer's securities, under circumstances in which it is reasonably foreseeable that the person will purchase or sell the issuer's securities on the basis of the information". Regulation FD was directed primarily at the practice of companies giving securities analysts information that was not available to the investing public generally. It was not viewed as a general prohibition against trading on the basis of material nonpublic information.
The efforts of the courts to find a rationale for why insider trading is unlawful have probably done more to confuse the issue than to clarify it
Nine years later, the SEC adopted two more rules directed at insider trading, Rules 10b5-1 and 10b5-2. Rule 10b5-1 prohibits the purchase or sale of a security by a person who is aware of material nonpublic information about the security or its issuer "in breach of a duty of trust or confidence owed to the issuer of the security, to shareholders of the issuer or to any other person who is the source of the material nonpublic information". Rule 10b5-2 defines a duty of trust or confidence to exist when (a) a person agrees to maintain information in confidence, (b) the person communicating the material nonpublic information and the person to whom it is communicated have a history, pattern or practice of sharing confidences, or (c) a person receives material nonpublic information from his or her spouse, parent or child. Therefore, the prohibition in Rule 10b5-1 applies to only a very limited number of situations.
Despite the unwillingness of both the courts and the SEC to enunciate an outright prohibition against trading in securities when in possession of material nonpublic information, there is a widespread belief that such a prohibition exists. Financial institutions maintain detailed compliance programmes aimed at ensuring that nobody trades when in possession of material nonpublic information. Companies create blackout periods beginning two to four weeks before the end of each fiscal quarter when nobody with access to financial information is permitted to trade in the companies' securities. Syndicated loan agreements often enable lenders that have securities trading operations to elect not to receive nonpublic information that is given to the lending group.
The law regarding insider trading remains fluid, as demonstrated by two court decisions in 2019. One is a December 30 2019 decision of a federal appellate court upholding a conviction under a criminal statute relating to securities and commodities fraud for unauthorised disclosure of a pending governmental rule change. The court analogised the unauthorised disclosure to embezzlement and ruled that the conviction could stand even if the person who disclosed the information received no personal benefit from the disclosure. But the securities fraud statute applies only if there is a false or fraudulent statement, which is not the case in most instances of insider trading. Also, the criminal statute is available to the Department of Justice, but not to the SEC.
The other occurrence was the passage by the House of Representatives in December 2019 of a proposed Insider Trading Prohibition Act, that specifically addresses when trading while in possession of material nonpublic information is unlawful. Under the Insider Trading Prohibition Act, if it were enacted into law:
- It would be unlawful for any person to purchase or sell a security while aware of material, non-public information relating to the security, or material nonpublic information, from whatever source, that would reasonably be expected to have a material effect on the market price of the security, if the person knows, or recklessly disregards, that the information was obtained wrongfully, or that the purchase or sale would constitute a wrongful use of the information.
- It would be unlawful for a person whose own purchase or sale of a security would violate the Act, wrongfully to communicate material nonpublic information to a person if (1) the person to whom the information is communicated (a) purchases or sells any security to which the communication relates, or (b) communicates the information to another person who makes such a purchase or sale, and (2) the purchase or sale was reasonably foreseeable.
- Trading while aware of material nonpublic information, or communicating material nonpublic information, would be wrongful only if the information was obtained by, or its communication would constitute,
- theft, bribery, misrepresentation or espionage;
- violation of a federal law protecting computer data or the intellectual property or privacy of computer users;
- conversion, misappropriation, or other unauthorised and deceptive taking of the information; or
- breach of a fiduciary duty, a confidentiality agreement, a contract, a code of conduct or ethics policy, or a personal or other relationship of trust and confidence for a direct or indirect personal benefit (including pecuniary gain, reputational benefit, or gift of confidential information to a trading relative or friend).
- It would not be necessary that a person trading while aware of information or communicating information know the specific means by which the information was obtained or whether any personal benefit was paid or promised to any person in the chain of communication, so long as the person trading while aware of the information or communicating the information is aware (or consciously avoids becoming aware) that the information was wrongfully obtained, used or communicated.
The principal change in the law that would be made by the Insider Trading Act is that it would eliminate the need for the person who communicates nonpublic information to receive personal benefit, and substitute a requirement that the person who trades on the basis of nonpublic information know (or consciously avoid learning) that the information was "wrongfully obtained, improperly used or wrongfully communicated". It seems likely that would lead to frequent litigation about whether something was or was not wrongful. And it seems to make it lawful for insiders to trade on the basis of nonpublic information that a company authorises them to use.
It is unfortunate that the proposed legislation does not simply prohibit trading when in possession of material nonpublic information obtained as a result of being an insider or obtained directly or indirectly from a person known to be an insider. The vast majority of US investors, including sophisticated investment professionals, avoid trading when they have anything that might be viewed as material nonpublic information about a publicly traded company. With rare exceptions, the court decisions defining boundaries of the prohibition against insider trading have involved people who knowingly ignored the prohibition, and whose lawyers tried to come up with technical arguments why they should not be punished for doing so.
The efforts of the courts to find a rationale for why insider trading is unlawful have probably done more to confuse the issue than to clarify it. Use of the criminal prohibition against commodities and securities fraud may avoid many of the complications of using the securities laws to prohibit insider trading, but that prohibition only applies to situations involving false or fraudulent statements. It would be far preferable if the Insider Trading Prohibition Act were modified simply to prohibit trading when in possession of material nonpublic information obtained directly or indirectly from a company or a person known to be an insider. That would make the law clear and simple, and put in place the prohibition that most people think already exists.
Goodwin Procter, New York
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