The Regulation Of Insider Trading - Securities Regulation

The Regulation of Insider Trading

1. In General

   1. Insider trading occurs when a person or entity trades in a security on the basis of material non-public information which has been obtained in breach of a duty of trust or confidence.

      1. Rule 10b5-1 defines trading "on the basis of" material nonpublic information simply in terms of whether the trader was "aware" of the information at the time of the trade.

         • The Rule provides for an affirmative defense if the trader can show that the rule was executed pursuant to a binding contract, specific instructions, or a written trading plan that was entered into before the trader became aware of the information.

           • A "Rule 10b5-1 Plan" must: (1) specify the amount of the securities to be traded and the price and date of the transaction; (2) include a written formula for determining amount, price, and date; or (3) not permit the insider to exercise any subsequent influence over how, when, or whether to effect the purchase or sales, so long as the broker or other who is granted that discretion is not aware of any material nonpublic information when making those decisions.

   2. "Insider" is not defined by securities laws but is construed by courts to be a person or entity that by virtue of a fiduciary relationship with an issuer has knowledge of, or access to, material nonpublic information.

   3. How is the prohibition against insider trading enforced?

      1. By the SEC under § 10(b) of the '34 Act and Rule 10b-5 or § 14(e) of the '34 Act.

         • § 14(e) proscribed trading after a "substantial step" has been taken towards a tender offer.

           • Scienter is required

      2. By the Department of Justice for "knowing or willful" violation

      3. Private right of action in favor of contemporaneous traders, or against corporation in a derivative action.

   4. The basic premise of early insider trading cases was a finding of fraud based upon the unfairness of allowing insiders to profit from their special access to sensitive information. See Cady, Roberts & Co.; SEC v. Texas Gulf Sulphur Co. (pg. 880)

      1. The court in SEC v. Texas Gulf Sulphur Co. noted that such unfairness frustrates "the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material information." (pg. 880)

   5. Insider Trading is now applicable to members of congress. See The STOCK ACT

2. Duty to Abstain or Disclose - Traditional Theory

   1. "Abstain or disclose" means that the corporate insider must either abstain from personal trading (or "tipping" others) or ensure that the information is fully disclosed to the market before trading.

   2. "[N]ot every instance of financial unfairness constitutes fraudulent activity under § 10(b)." Chiarella v. United States (pg. 881)

   3. "[T]he element required to make silence fraudulent [is] a duty to disclose . . . ." Chiarella v. United States (pg. 882)

   4. "[T]he established doctrine [is] that duty arises from a specific relationship between two parties . . . ." Chiarella v. United States (pg. 882)

   5. "Section 10(b) is aptly described as a catchall provision, but what is catches must be fraud. When an allegation of fraud is based upon nondisclosure, there can be no fraud absent a duty to speak." Chiarella v. United States (pg. 882)

      1. The Court held in Chiarella that "a duty to disclose under § 10(b) does not arise from the mere possession of nonpublic market information." Chiarella v. United States (pg. 882)

      2. The Court in this case did not address the misappropriation theory as it was not properly presented to the jury. See Chiarella v. United States (pg. 883)

   6. Duty to Disclose - What does this mean?

      1. SPLIT

         • Public Access Approach

           • The Commission has indicated that information must be disclosed "in a manner calculated to reach the securities marketplace in general through recognized channels of distribution, and public investors must be afforded a reasonable waiting period to react to the information." Fabergo, Inc. (pg. 885)

         • In contrast, the Second Circuit has suggested that a better approach is simply to ask whether the information has yet been fully impounded in the market price. United States v. Libera (pg. 885)

   7. Chiarella stands for the proposition that a corporate insider in possession of material nonpublic information has a duty to either make sure that the inside information is fully disclosed and disseminated to the market before trading on the basis of such information (or "tipping" others) or to abstain from trading altogether. See Chiarella

   8. TRADITIONAL THEORY

      1. "Under the 'traditional' or 'classical theory' of insider trading liability, §10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a 'deceptive device' under §10(b) . . . because 'a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.'" United States v. O'Hagan (quoting Chiarella v. United States)

         • Thus, if there is a relationship of trust and confidence between a person and a corporation, that person has a duty to either disclose the material nonpublic information before trading on the basis of that information or to abstain from trading of the basis of that information altogether. See id.

   9. Rule 10b5-1 defines trading "on the basis of" material nonpublic information simply in terms of whether the trader was "aware" of the information at the time of the trade.

      1. The Rule provides for an affirmative defense if the trader can show that the rule was executed pursuant to a binding contract, specific instructions, or a written trading plan that was entered into before the trader became aware of the information.

         • A "Rule 10b5-1 Plan" must: (1) specify the amount of the securities to be traded and the price and date of the transaction; (2) include a written formula for determining amount, price, and date; or (3) not permit the insider to exercise any subsequent influence over how, when, or whether to effect the purchase or sales, so long as the broker or other who is granted that discretion is not aware of any material nonpublic information when making those decisions.

3. "Outsider" Trading

   1. "Under certain circumstances, such as where corporate information is revealed legitimately to an underwriter, accountant, lawyer or consultant working for the corporation, these outsiders may become fiduciaries of the shareholders." Dirks v. SEC (pg. 887)

      1. "The basis for recognizing this fiduciary duty is . . . that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to the information solely for corporate purposes." Dirks v. SEC (pg. 887)

4. Misappropriation Theory

   1. "The 'misappropriation theory' holds that a person commits fraud 'in connection with' a securities transaction, and thereby violates Section 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information." United States v. O'Hagan (pg. 890)

      1. "Under this theory, a fiduciary's undisclosed, self serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information." United States v. O'Hagan (pg. 890)

      2. "In lieu of premising liability on a fiduciary relationship between company insider and purchaser or seller of the company's stock, the misappropriation theory premises liability on a fiduciary turned trader's deception of those who entrusted him with access to confidential information." United States v. O'Hagan (pg. 890)

      3. "The misappropriation theory is thus designed to 'protect the integrity of the securities markets against abuses by "outsiders" to a corporation who have access to confidential information that will affect the corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders.'" United States v. O'Hagan (pg. 890)

   2. "[I]f the fiduciary discloses to the source that he plans to trade on the nonpublic material information, there is no 'deceptive device' and thus no Section 10(b) violation - although the fiduciary-turned-trader may remain liable under state law for breach of a duty of loyalty." United States v. O'Hagan (pg. 891)

   3. Rule 10b5-2 (pg. 896)

      1. Rule 10b5-2 states that a duty of trust and confidence exists for the purposes of the misappropriation theory whenever: (1) a person agrees to maintain information in confidence; (2) persons sharing information have a history, pattern, or practice of sharing confidences such that the recipient knows or should know that there is an expectation of confidentiality; or (3) information is shared by a person with his or her parent, spouse, child or sibling, unless the recipient can show that their was no reasonable expectation of confidentiality within the particular family relationship.

   4. SEC v. Dorozhko (Supp. pg. 131)

      1. In this anomalous case, the Second Circuit found a violation of § 10(b) based upon hacking into a corporation's system such that they were able to obtain the earnings report prior to its release, notwithstanding the lack of a fiduciary duty owed to the corporation. The resolve was based upon a "straightforward theory of fraud." (Supp. pg. 131)

         • The court stated the following:

           • "Chiarella, O'Hagan, and Zandford all stand for...