(11) SEC Violations - Insider Trading + 10b-5 Rule

What are the two primary sources of insider trading liability?

Common law and Rule 10b-5.

Who may be considered an insider for common law insider trading purposes?

Directors, officers, and controlling shareholders.

When is an insider liable for common law fraud?

When the insider trades based on affirmative misrepresentations, such as lies or half-truths, made to the trading partner.

What type of statements create common law fraud liability for insiders?

Affirmative misrepresentations, including lies and half-truths.

Did corporate insiders owe shareholders a general duty to disclose material information at common law?

No.

What is the majority rule regarding an insider's duty to disclose at common law?

The Special Facts Doctrine.

What is the Special Facts Doctrine?

A doctrine protecting shareholders when insiders trade on undisclosed special information in direct dealings.

What is the first element of the Special Facts Doctrine?

The shareholder traded with an officer, director, or insider.

What is the second element of the Special Facts Doctrine?

The insider traded on special information or special facts and failed to disclose them.

What is the third element of the Special Facts Doctrine?

Privity existed between the insider and shareholder through a face-to-face transaction or common intermediary.

What is the fourth element of the Special Facts Doctrine?

Under the traditional rule, the injured party was a seller, although modern law extends protection to buyers.

What is the fifth element of the Special Facts Doctrine?

The seller had to be an existing shareholder.

To what transactions does the Special Facts Doctrine apply?

Only direct dealings between the insider and shareholder.

What is the minority common law rule regarding insider disclosure?

The insider has an absolute duty to disclose.

What case allows the corporation to recover an insider's profits when the shareholder does not sue under Rule 10b-5?

Diamond v. Oreamuno.

What did Diamond v. Oreamuno hold?

The corporation may recover profits earned from an insider's misuse of confidential corporate information because the information is a corporate asset.

Why may the corporation recover profits under Diamond v. Oreamuno?

Because the insider's failure to disclose constitutes a breach of fiduciary duty to the corporation.

What is the primary purpose of Rule 10b-5?

To prohibit fraudulent or manipulative conduct in connection with the purchase or sale of securities.

What mnemonic helps remember the Rule 10b-5 elements?

Jeff Once Made Some Spicy Revolting Pork Rice.

What is the jurisdictional element of Rule 10b-5?

The fraud must involve interstate commerce, the mails, or a national stock exchange.

Must a Rule 10b-5 misstatement constitute common law fraud?

No.

What types of statements satisfy the omission or misstatement element under Rule 10b-5?

Material omissions or misstatements.

How is materiality determined under Rule 10b-5?

Using the reasonable investor test.

What case established the reasonable investor test for materiality?

Basic v. Levinson (1988).

According to Basic v. Levinson, when is information material?

When there is a substantial likelihood that a reasonable investor would consider it significant.

Must information already be effectively disclosed to the investing public be disclosed again?

No.

What scienter is required under Rule 10b-5?

Recklessness satisfies scienter; specific intent to violate the law is not required.

What case established the scienter requirement under Rule 10b-5?

Ernst & Ernst v. Hochfelder.

Does Rule 10b-5 require proof of specific intent to violate the securities laws?

No.

Who has standing to sue under Rule 10b-5?

Purchasers, sellers, the SEC, and corporate issuers.

What case broadly defines purchaser and seller standing under Rule 10b-5?

Blue Chip Stamps.

Does a merger qualify as a sale under Rule 10b-5?

Yes.

Does a forced sale qualify as a sale under Rule 10b-5?

Yes.

What are the two primary exceptions to the purchaser-seller standing requirement?

Derivative suits and actions seeking injunctive relief.

When is reliance presumed under Rule 10b-5?

When the omitted information is material.

Must reliance be proven in an omission case?

No.

Must reliance be proven when the case involves an affirmative misrepresentation?

Yes.

What presumption assists plaintiffs in affirmative misrepresentation cases involving stock market transactions?

A rebuttable presumption of reliance.

How may the presumption of reliance be rebutted?

By proving the plaintiff did not believe the misrepresentation or would have traded anyway.

Is privity required under Rule 10b-5?

No.

What remedies are available under Rule 10b-5?

Out-of-pocket damages, restitution, injunctions, criminal sanctions, and civil penalties.

Who may be sued for an affirmative misrepresentation under Rule 10b-5?

Any person.

May a corporation be liable under Rule 10b-5 even if it did not trade securities?

Yes, if it made a material misrepresentation.

When may a defendant be liable for an omission under Rule 10b-5?

Only if the defendant had a duty to disclose.

What is the key requirement for omission liability under Rule 10b-5?

The defendant must owe a duty to disclose.

To whom must the defendant generally owe the duty to disclose?

The corporation whose securities are being traded.

Who qualifies as an insider for Rule 10b-5 purposes?

An agent of the corporation with access to material nonpublic information.

What rule was established in SEC v. Texas Gulf Sulphur?

An insider possessing material nonpublic information must disclose the information publicly or refrain from trading.

What is the "disclose or abstain" rule?

An insider must publicly disclose material nonpublic information before trading or refrain from trading altogether.

Who is a tipper?

An insider who provides material nonpublic information to another person.

What is the key issue in determining tipper liability?

Whether the insider disclosed information for personal gain or another improper purpose.

What benefit should you look for when analyzing tipper liability?

A direct or indirect personal benefit.

Who is a tippee?

A non-insider who receives material nonpublic information from an insider.

When is a tippee liable under Rule 10b-5?

Only if the insider breached a fiduciary duty and the tippee knew of the breach.

What case established the standard for tippee liability?

Dirks v. SEC.

Whose duty does the tippee inherit?

The tipper's duty.

Does mere possession of material nonpublic information automatically create liability?

No.

What case held that mere possession of inside information is insufficient to create liability?

Chiarella v. United States.

Why was the defendant not liable in Chiarella?

Because he owed no fiduciary duty to the corporation whose securities he traded.

Can private plaintiffs sue aiders and abettors under Rule 10b-5?

No.

What case held there is no private aiding-and-abetting action under Rule 10b-5?

Central Bank of Denver v. First Interstate Bank of Denver.

What did Stoneridge Investment Partners v. Scientific-Atlanta hold?

Private investors generally cannot sue third parties who merely assist securities fraud unless they relied on the third party's deceptive conduct.

What theory expands Rule 10b-5 liability beyond traditional insiders?

The Misappropriation Theory.

Why was the Misappropriation Theory developed?

To impose Rule 10b-5 liability on individuals who owe no duty to the corporation whose securities they traded.

Under the Misappropriation Theory, when is the duty requirement satisfied?

When the defendant breaches a duty owed to anyone in obtaining or using confidential information.

What fact pattern commonly triggers the Misappropriation Theory?

Obtaining confidential information through a breach of duty to an employer.

What case first recognized the Misappropriation Theory?

Carpenter v. United States.

What did Carpenter v. United States hold?

Misappropriating confidential information and using it for securities trading violates Rule 10b-5 even without a duty to the corporation whose stock is traded.

What case confirmed the validity of the Misappropriation Theory under Rule 10b-5?

United States v. O'Hagan (1997).

What did United States v. O'Hagan hold?

Rule 10b-5 prohibits deceptive conduct connected with securities transactions even when the deception is directed at someone other than the purchaser or seller.

Under O'Hagan, must the deception be directed at the purchaser or seller of securities?

No.

According to O'Hagan, what connection is required for Rule 10b-5 liability?

The deception must merely be connected to a securities transaction.

What exam approach should you use when analyzing insider trading issues?

Begin with Rule 10b-5, and if a required element is missing, analyze common law liability unless the call of the question directs otherwise.

Testable Issue: What are the two principal sources of insider trading liability?

Common law and Rule 10b-5.

Testable Issue: What is the Special Facts Doctrine?

The majority common law rule imposing liability when an insider fails to disclose special information during direct dealings with a shareholder.

Testable Issue: What are the essential elements of Rule 10b-5?

Jurisdiction, omission or misstatement, materiality, scienter, standing, reliance, no privity requirement, and available remedies.

Testable Issue: What is the "disclose or abstain" rule?

An insider possessing material nonpublic information must disclose it publicly before trading or refrain from trading.

Testable Issue: When is a tippee liable?

When the insider breached a fiduciary duty and the tippee knew of that breach.

Testable Issue: What is the Misappropriation Theory?

A theory imposing Rule 10b-5 liability when confidential information is obtained or used through a breach of duty owed to anyone.

Essay Rule: How do you analyze an insider trading problem?

Begin with Rule 10b-5 by analyzing each required element, including duty, materiality, scienter, reliance, and remedies. If Rule 10b-5 fails because a required element is missing, analyze common law insider trading principles, including the Special Facts Doctrine and Diamond v. Oreamuno, unless the question specifically limits the analysis.

Master Synthesis: What is the framework for analyzing insider trading?

First analyze Rule 10b-5 by determining whether all statutory elements are satisfied, identify the source of the defendant's duty, determine whether the defendant is an insider, tipper, tippee, or misappropriator, evaluate the available remedies, and only then analyze common law liability if Rule 10b-5 does not apply.