Introduction
The Law Offices of Robert Wayne Pearce, P.A. focuses its practice on securities, commodities and other investment disputes in courtroom litigation, arbitration and mediation proceedings. Mr. Pearce has over 25 years experience defending domestic and foreign investors and stock brokers involving the U.S. Securities & Exchange Commission ("SEC"). He began his career as an SEC prosecutor enforcing the federal securities laws that prohibit insider trading. It is important for all investors to understand the basics of insider trading law to help you avoid future disputes.
"Insider trading" is a term that most investors have heard and usually associate with illegal conduct. But the term actually includes both legal and illegal conduct. The legal version is when corporate insiders - officers, directors, and employees - buy and sell stock in their own companies. When corporate insiders trade in their own securities, they must report their trades to the SEC.
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security. Insider trading violations may also include "tipping" such information, securities trading by the person "tipped," and securities trading by those who misappropriate such information.
The Development of Illegal Insider Trading Law
After the United States stock market crash of 1929, Congress enacted the Securities Act of 1933 and the Securities Exchange Act of 1934, aimed at controlling the abuses believed to have contributed to the crash. The 1934 Act addressed insider trading directly through Section 16(b) and indirectly through Section 10(b).
Section 16(b) prohibits short‑swing profits (profits realized in any period less than six months) by corporate insiders in their own corporation's stock, except in very limited circumstance. It applies only to directors or officers of the corporation and those holding greater than 10% of the stock and is designed to prevent insider trading by those most likely to be privy to important corporate information.
Section 10(b) of the Securities and Exchange Act of 1934 makes it unlawful for any person to "use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." To implement Section 10(b), the SEC adopted Rule 10b-5, which provides, in relevant part:
It shall be unlawful for any person, directly or indirectly ...,
(a) to employ any device, scheme, or artifice to defraud,
(b) to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or
(c) to engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of a security.21
These broad anti‑fraud provisions, make it unlawful to engage in fraud or misrepresentation in connection with the purchase or sale of a security.1 While they do not speak expressly to insider trading, here is where the courts have exercised the authority that has led to the most important developments in insider trading law in the United States.
The breadth of the anti‑fraud provisions leaves much room for interpretation and the flexibility to meet new schemes and contrivances head on. Moral imperatives have driven the development of insider trading law in the United States. And the development of insider trading law has not progressed with logical precision as the reach of the anti‑fraud provisions to cover insider trading has expanded and contracted over time.
The anti‑fraud provisions were relatively easy to apply to the corporate insider who secretly traded in his own company's stock while in possession of inside information because such behavior fit within traditional notions of fraud. Far less clear was whether Section 10(b) and Rule 10b‑5 prohibited insider trading by a corporate "outsider." In 1961, in the case of In re Cady Roberts & Co.,2 the Securities and Exchange Commission, applying a broad construction of the provisions, held that they do. The Commission held that the duty or obligations of the corporate insider could attach to those outside the insiders' realm in certain circumstances. The Commission reasoned in language worth quoting:
Analytically, the obligation [not to engage in insider trading] rests on two principal elements: first, 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, and second, the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing. In considering these elements under the broad language of the anti‑fraud provisions we are not to be circumscribed by fine distinctions and rigid classifications. Thus, it is our task here to identify those persons who are in a special relationship with a company and privy to its internal affairs, and thereby suffer correlative duties in trading in its securities. Intimacy demands restraint lest the uninformed be exploited.3
Based on this reasoning, the Commission held that a broker who traded while in possession of nonpublic information he received from a company director violated Rule l0b-5. The Commission adopted the "disclose or abstain rule": insiders, and those who would come to be known as "temporary" or "constructive" insiders, who possess material nonpublic information, must disclose it before trading or abstain from trading until the information is publicly disseminated,
Several years later in the case of SEC v. Texas Gulf Sulphur Co., a federal circuit court supported the Commission's ruling in Cady, stating that anyone in possession of inside information is required either to disclose the information publicly or refrain from trading.4 The court expressed the view that no one should be allowed to trade with the benefit of inside information because it operates as a fraud all other buyers and sellers in the market.5 This was the broadest formulation of prohibited insider trading.
The 1980s were an extraordinary time in this country's economic history, marked by a frenzy of corporate takeovers and mergers involving what then were dazzling amounts of money. Insider trading reached new heights. Ironically, it is during this period that courts narrowed the scope of Section 10(b) and Rule 10b-5 in the insider trading context.
In the 1980 case of Chiarella v. United States, the United States Supreme Court reversed the criminal conviction of a financial printer who gleaned nonpublic information regarding tender offers and a merger from documents he was hired to print and bought stock in the target of the companies that hired him.6 The case was tried on the theory that the printer defrauded the persons who sold stock in the target to him. In reversing the conviction, the Supreme Court held that trading on material
nonpublic information in itself was not enough to trigger liability under the anti‑fraud provisions and because the printer owed target shareholders no duty, he did not defraud them. In what would prove to be a prophetic dissent, Chief Justice Burger opined that he would have upheld the conviction on the grounds that the defendant had "misappropriated" confidential information obtained from his employer and wrongfully used it for personal gain.
In response to the Chiarella decision, the Securities and Exchange Commission promulgated Rule 14e‑3 under Section 14(e) of the Exchange Act, and made it illegal for anyone to trade on the basis of material nonpublic information regarding tender offers if they knew the information emanated from an insider.7 The purpose of the rule was to remove the Chiarella duty requirement in the tender offer context ‑ where insider trading was most attractive and especially disruptive.
In 1981, the Second Circuit adopted the "misappropriation" theory, holding in the case of United States v. Newman8 that a person with no fiduciary relationship to an issuer nonetheless may be liable under Rule 10b-5 for trading in the securities of an issuer while in possession of information obtained in violation of a relationship of trust and confidence. Newman, a securities trader, traded based on material nonpublic information about corporate takeovers that he obtained from two investment bankers, who had misappropriated the information from their employers.
Three years later in Dirks v. SEC,9 the Supreme Court reversed the SEC's censure of a securities analyst who told his clients about the alleged fraud of an issuer he had learned from the inside before he made the facts public. Dirks was significant because it addressed the issue of trading liability of "tippees": those who receive information from the insider tipper. Dirks held that tippees are liable if they knew or had reason to believe that the tipper had breached a fiduciary duty in disclosing the confidential information and the tipper received a direct or indirect personal benefit from the disclosure.
Because the original tipper in Dirks disclosed the information for the purpose of exposing a fraud and not for personal gain, his tippee escaped liability.
A significant aspect of the decision was contained in a footnote to the opinion, which has come to be known as "Dirks footnote 14." There, Justice Powell formulated the concept of the "constructive insiders" ‑ outside lawyers, consultants, investment bankers or others ‑ who legitimately receive confidential information from a corporation in the course of providing services to the corporation. These constructive insiders acquire the fiduciary duties of the true insider, provided the corporation expected the constructive insider to keep the information confidential.
The Second Circuit again addressed the misappropriation theory in the 1986 case of United States v. Carpenter.10 The case centered on a columnist for the Wall Street Journal, whose influential columns often affected the stock prices of companies about which he wrote. The columnist tipped information about his upcoming columns to a broker (among others) and shared in the profits the broker made by trading in advance of publication.11 In upholding the convictions of the columnist and the broker for securities fraud under Rule 10b-5 and mail and wire fraud, the Second Circuit rejected the defendants' argument that the misappropriation theory only applies when the information is misappropriated by corporate or constructive insiders, holding "[T]he misappropriation theory more broadly proscribes the conversion by insiders' or others of material non‑public information in connection with the purchase or sale of securities."12
The case was appealed to the Supreme Court. The Supreme Court unanimously agreed that Carpenter engaged in fraud, but divided evenly on whether he engaged in securities fraud.13 But in unanimously affirming the mail and wire fraud convictions, the Court quoted an earlier New York decision that ruled: "It is well established, as a general proposition, that a person who acquires special knowledge or information by virtue of a confidential or fiduciary relationship with another is not free to exploit that knowledge or information for his own personal benefit but must account to his principle for any profits derived therefrom."14
Over the next nine years, the misappropriation theory gained acceptance in federal courts.15 Then in 1995 and 1996, two federal circuit courts rejected the misappropriation theory16 on the grounds that the theory "requires neither misrepresentation nor nondisclosure" and that "the misappropriation theory is not moored [in] [section] 10(b)'s requirement that the fraud be "in connection with the purchase or sale of any security." "17
In a landmark victory for the SEC, the Supreme Court in 1997 reversed one of these decisions and explicitly adopted the misappropriation theory of insider trading in the case of United States v. O'Hagan.18 O'Hagan was a partner in a law firm retained to represent a corporation, Grand Met, in a potential tender offer for the common stock of the Pillsbury Company. When O'Hagan learned of the potential deal, he began acquiring options in Pillsbury stock, which he sold after the tender offer for a profit of over $4 million. O'Hagan argued, essentially, that because neither he nor his firm owed any fiduciary duty to Pillsbury, he did not commit fraud by purchasing Pillsbury stock on the basis of material, nonpublic information.
The Court rejected O'Hagan's arguments and upheld his conviction. The Court held, significantly, that O'Hagan committed fraud in connection with his purchase of Pillsbury options, thus violating Rule 10b-5, based on the misappropriation theory.19 In the Court's words:
The "misappropriation theory" holds that a person commits fraud "in connection with" a securities transaction, and thereby violates 10(b) and Rule l0b‑5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information. 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 the information. 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 information20
In the course of its opinion, the Court identified two discrete arguments for prohibiting insider trading. First, the Court stressed that prohibiting insider trading is
... well‑tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence. Although informational disparity is inevitable in the securities markets, investors likely would hesitate to venture their capital in a market where trading based on misappropriated nonpublic information is unchecked by law. An investor's informational disadvantage vis‑à‑vis a misappropriator with material, nonpublic information stems from contrivance, not luck; it is a disadvantage that cannot be overcome with research or skill.21
Second, the Court acknowledged the "information as property" rationale underlying insider trading prohibitions:
A company's confidential information ... qualifies as property to which the company has a right of exclusive use. The undisclosed misappropriation of such information in violation of a fiduciary duty ... constitutes fraud akin to embezzlement ‑ the fraudulent appropriation to one's own use of the money or goods entrusted to one's care by another.22
Although the law of insider trading in the United States is continuing to evolve, the decision in O'Hagan is a significant milestone in defining the scope of Rule 10b‑5 insider trading prohibitions.
The SEC has also adopted Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed. Rule 10b5-1 provides that a person trades on the basis of material nonpublic information if a trader is "aware" of the material nonpublic information when making the purchase or sale. The rule also sets forth several affirmative defenses or exceptions to liability. The rule permits persons to trade in certain specified circumstances where it is clear that the information they are aware of is not a factor in the decision to trade, such as pursuant to a pre‑existing plan, contract, or instruction that was made in good faith.
Rule 10b5-2 clarifies how the misappropriation theory applies to certain non‑business relationships. This rule provides that a person receiving confidential information under circumstances specified in the rule would owe a duty of trust or confidence and thus could be liable under the misappropriation theory.
Because insider trading undermines investor confidence in the fairness and integrity of the securities markets, the SEC has treated the detection and prosecution of insider trading violations as one of its enforcement priorities.
Insider Trading Defense
The SEC has brought and will continue to bring insider trading cases against:
- Corporate officers, directors, and employees who traded the corporation's securities after learning of significant, confidential corporate developments;
- Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information;
- Employees of law, banking, brokerage and printing firms who were given such information to provide services to the corporation whose securities they traded;
- Government employees who learned of such information because of their employment by the government; and
- Other persons who misappropriated, and took advantage of, confidential information from their employers.
Mr. Pearce, a former SEC Enforcement Attorney, has litigated SEC actions for over 25 years, including, but not limited to, insider trading, stock market manipulation and other alleged violations of the Federal securities laws. The Law Offices of Robert Wayne Pearce, P.A. are Florida SEC Defense Lawyers providing Insider Trading Defense representation located at 1499 West Palmetto Park Road, Suite 300, Boca Raton, Florida 33486. Contact us at 1-800-SEC-ATTY (800-732-2889) or by e-mail at Pearce@RWPearce.com.
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1 Section 17(a) of the Securities Act of 1933 reaches similar fraud in the initial offering or sale of a security.
2 40 SEC 907 (1961).
3 Id.
4 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).
5 Id. at 851-52.
6 445 U.S. 222 (1980).
7 The Commission's authority to promulgate rules under Section 14(e) of the Exchange Act is confined to the tender offer context. It reads, in relevant part: "It shall be unlawful for any person ... to engage in any fraudulent, deceptive or manipulative acts or practices, in connection with any tender offer ... . The [SEC] shall ... by rule or regulations define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive or manipulative." 15 U.S.C. §78n(e).
8 664 F.2d 12 (2d Cir. 1981), aff'd after remand, 722 F.2d 729 (2d Cir. 1983), cert. denied, 464 U.S. 863 (1983).
9 463 U.S. 646 (1983).
10 791 F.2d 1024 (2d Cir. 1986), aff'd 484 U.S. 19 (1987).
11 Echoing the Carpenter case, German prosecutors reportedly are considering bringing insider trading charges against a German television journalist, known as "Germany's first international stock market guru," for allegedly telling his friends which stock he was going to recommend on his weekly program. German TV Journalist is Accused of Insider Trading, AP Worldstream, August 17, 1998, financial pages.
12 791 F.2d at 1029.
13 484 U.S. 19, 24 (1987).
14 Diamond v. Oreamuno, 248 N.E. 2d 910, 912 (N.Y. 1969).
15 See, e.g., SEC v. Materia, 745 F.2d 197, 201 (2d Cir. 1984); Rothberg v. Rosenbloom, 771 F.2d 818 (3d Cir. 1985); SEC v. Cherif, 933 F.2d 403 (7th Cir. 1990); SEC v. Clark, 915 F.2d 439 (9th Cir. 1990).
16 United States v. Bryan, 58 F.3d 933, 944 (4th Cir. 1995); United States v. O'Hagan, 92 F.3d 612 (8th Cir. 1996).
17 United States v. O'Hagan, 117 S.Ct. 2199, 2211 (1997) (quoting the Eighth Circuit's opinion in O'Hagan, 92 F.3d at 168.
18 117 S.Ct. 2199 (1997).
19 The Court also rejected O'Hagan's argument that the Commission's Rule 14e-3, which prohibits trading in securities based on nonpublic information about a tender offer (see supra note 28 and accompanying text), is invalid because the Commission exceeded its statutory authority in promulgating it.
20 117 S.Ct. at 2207
21 117 S.Ct. at 2210.
22 117 S.Ct. at 2208.
Schedule Your Initial Consultation With a Securities and Commodities Law Attorney
Contact The Law Offices of Robert Wayne Pearce, P.A., in Boca Raton to discuss your fraud or misrepresentation claim. The firm can be reached by phone at 561-338-0037, toll free at 800-732-2889 or via e-mail.
