Insider Trading

Insider Trading 

The Common Law Background:  

The common law background regarding insider trading centered on the obligations of directors and officers when trading in their corporation's stock using material nonpublic information. 

I. The Traditional Majority Rule 

The majority rule at common law was permissive regarding insider trading: a director or officer of a corporation could trade in its stock without disclosing material nonpublic information (inside information) acquired through their position. A leading case illustrating this approach was Goodwin v. Agassiz. 

II. The "Special Facts" Exception 

The dominant exception to this majority rule was the "special facts" doctrine, established in the Supreme Court case of Strong v. Repide in 1909 and later adopted by many other courts. 

• Strong v. Repide Context: The case involved Repide, a director and administrator general of Philippine Sugar, who was also the owner of nearly three-fourths of the company's shares. The value of Philippine Sugar was entirely dependent on making an advantageous sale of its properties to the United States government, and Repide was in charge of these negotiations. 

• The Transaction: While negotiations were pending, Repide, knowing the sale was probable, used an intermediary to purchase shares from a minority shareholder (Strong) through a broker. Neither the shareholder nor the broker was informed about the state of the negotiations. The price Repide paid was about one-tenth of what the shares became worth less than three months later when the government sale was completed. 

• The Ruling: The Supreme Court affirmed an award of damages to the minority shareholder, holding that even where a director has no general duty to disclose before purchasing shares, a duty exists "by reason of the special facts". 

• Critique: Commentators noted that there was often "no meaningful way to differentiate" cases involving special facts from those that did not. This made the rule difficult to administer consistently, leading the exception, in effect, either to undermine the majority rule or render it unworkable. 

III. Atrophy and Evolution 

The common law rule governing disclosure in the sale of securities largely atrophied after the 1940s. This occurred due to the rise and development of SEC Rule 10b-5 under the Securities Exchange Act, which came to dominate the field of insider trading regulation. 

While generally not part of the core historical common law rule concerning trading disclosure, the general fiduciary obligations owed by corporate managers provided an alternative basis for later state-level recovery, such as in New York in the 1960s. These later developments reflected a judicial effort to hold fiduciaries accountable: 

• Fiduciary Duty of Agents: A person who acquires special knowledge or information through a confidential or fiduciary relationship is typically not free to exploit that knowledge for personal gain but must account to the principal for any derived profits. 

• Corporate Asset Theory: In New York, the fiduciary concept was extended to hold that officers and directors must account to the corporation for profits realized from using inside information to trade in the company’s stock, even without specific damage to the corporation. The rationale was that confidential, potentially valuable information is a corporate asset that fiduciaries cannot appropriate for their own use. Such personal exploitation casts a cloud on the corporation's reputation and integrity. 

This remedy of disgorgement provided an effective method for dealing with insider abuses in cases not covered by federal law (like Section 16(b)), preventing the "unjust enrichment realized by the defendants from their allegedly wrongful act". 

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The Federal Disclose or Abstain Requirement 

The Case: In the Matter of Cady, Roberts & Co. (1961) 

This was a landmark ruling by the Securities and Exchange Commission (SEC) that helped define what is illegal insider trading under Section 10(b) and Rule 10b-5 of the Securities Exchange Act. 

1. What Happened? (Facts) 

• The case involved a broker who was also a director of a company. 

• He received confidential, material information that the company was about to reduce its dividend. 

• Before this information was made public, the broker used that inside knowledge to sell publicly traded shares for his clients. 

• In simpler terms: The broker knew bad news before anyone else and secretly traded on that knowledge before the public could react. 

2. What Was the Big Legal Question? (Issue) 

Did this trading violate the anti-fraud rules of the Securities Exchange Act (Rule 10b-5), even though the person trading was not a typical "insider" like an officer or director trading in his own account?. 

3. What Did the SEC Decide? (Holding) 

Yes, the broker violated the rules. The SEC established the "disclose or abstain" rule: 

• If you have access to material nonpublic information, you must either disclose that information before trading, or abstain from trading altogether. 

• Since public disclosure of corporate confidences might be "improper or unrealistic" under the circumstances, the alternative requirement is to forgo the transaction. 

4. Why Does the Rule Apply? (Reasoning/The Two Key Elements) 

The SEC set forth two principal elements that determine when this obligation applies to any person: 

The duty arises from the need to prevent a corporate insider from taking unfair advantage of uninformed shareholders. This concept is based on a relationship of trust and confidence, requiring those with a duty to place the shareholder's welfare before their own. 

5. Who is an "Insider"? (Scope) 

The traditional duty applied primarily to obvious corporate "insiders," such as officers, directors, or controlling stockholders. 

However, the SEC emphasized that these groups do not exhaust the classes of persons who have this obligation. The duty applies to anyone who has access to and possession of material inside information ("any person") and assumes a duty due to their special relationship with the company. These can include temporary fiduciaries such as attorneys, accountants, consultants, or underwriters who acquire confidential corporate information. 

In summary, Cady, Roberts established the foundational principle that if you have special access to confidential corporate information, you cannot use it to trade unless you first make it public. This rule is designed to ensure a fair marketplace by focusing on the unfair advantage gained through access to nonpublic corporate assets. 

Chiarella v. United States 

United States v. O’Hagen 

Note on Who’s a Misappropriator? 

Here are notes on the concept of who qualifies as a "misappropriator" in the context of federal insider trading law, primarily under Section 10(b) and Rule 10b-5. 

The Misappropriation Theory, which was officially adopted by the Supreme Court in United States v. O'Hagan, provides the legal framework for identifying a misappropriator. 

I. Definition and Basis of Misappropriation 

The Misappropriation Theory holds that a person commits fraud "in connection with" a securities transaction when they misappropriate confidential information for securities trading purposes, in breach of a duty owed to the source of that information. 

A misappropriator is considered a corporate "outsider" because the duty they breach is owed not to the shareholders with whom they trade, but to the source of the information (their principal). 

The deception required for liability lies in the fiduciary (the misappropriator) feigning fidelity to the source while secretly converting the principal's confidential information for personal trading gain. The confidential information qualifies as property to which the source has a right of exclusive use. 

II. The Nature of the Required Relationship 

Misappropriation liability is premised on a relationship of trust and confidence that gives rise to a duty not to exploit confidential information for personal use. 

Traditional Fiduciary Relationships: The requisite fiduciary duty upon which the misappropriation theory rests must be a fiduciary or similar relationship. Hornbook fiduciary relationships that satisfy this requirement include those between: 

• Attorney and client 

• Trustee and trust beneficiary 

• Principal and agent 

• Executor and heir 

• Guardian and ward 

• Senior corporate official and shareholder 

Characteristics of Fiduciary Relationships: The relationship is characterized by discretionary authority and dependency. The fiduciary obtains access to property (information) to serve the ends of the relationship, becoming duty-bound not to appropriate that property for their own use. An agent, for example, has a duty to the principal not to use or communicate information confidentially given to them or acquired during the course of their agency. 

Examples of Misappropriators in Case Law: 

• United States v. O'Hagan: O'Hagan, a partner at a law firm representing a bidder (Grand Met) in a tender offer, bought stock in the target company (Pillsbury). He was deemed a misappropriator because he breached a duty of trust and confidence owed to his law firm and its client, Grand Met, the source of the nonpublic information. 

• A journalist who tipped others on advance knowledge of market-moving columns was found to violate the mail and wire fraud statutes as a wrongful misappropriation of confidential information from his employer. 

Absence of Duty: In the foundational case defining the need for this duty, Chiarella v. United States, the defendant was not a misappropriator under this theory because he was a printer who owed a duty to his employer (the printing company) but was found to be a "complete stranger" to the sellers of the stock he traded. He lacked the necessary fiduciary relationship with the parties on the other side of the transaction. 

III. The SEC’s Expansion (Rule 10b5-2) 

The SEC adopted Rule 10b5-2 to clarify when non-business relationships (like family and personal ties) create the necessary duty of trust or confidence required under the Misappropriation Theory, seeking to resolve anomalous results in case law like United States v. Chestman. This rule sets forth a non-exclusive list of situations where a duty of trust or confidence is presumed to exist: 

1. Agreement to Maintain Confidence: A person explicitly agrees to maintain information in confidence. 

2. History or Pattern of Sharing: Two people have a history, pattern, or practice of sharing confidences such that the recipient reasonably knows the communicator expects confidentiality. This is a "facts and circumstances" test based on the mutual expectation of the parties. 

3. Close Family Relationships (Bright-Line Rule): A person receives material nonpublic information from certain close family members—spouses, parents, children, and siblings. A duty of trust or confidence is presumed to exist, though an affirmative defense allows the recipient to demonstrate that, under the circumstances, no duty existed. 

IV. Distinction from Classical Theory and Other Concepts 

• Classical Theory: Requires a fiduciary relationship between the corporate insider and the shareholders of their own corporation (e.g., an officer trading their company's stock). 

• Misappropriation Theory: Requires a fiduciary relationship between the "outsider" (misappropriator) and the source of the information. 

• Defense: Liability under the Misappropriation Theory is foreclosed if the fiduciary makes full disclosure of the trading plan to the source of the information (the principal). However, this disclosure does not absolve the fiduciary from potential state law liability for breach of a duty of loyalty. 

• Not Theft/Embezzlement of Money: The theory does not apply where a person merely defrauds a bank for a loan or embezzles cash and then uses the proceeds to buy securities, because the fraud (the theft of the money) would be complete regardless of the subsequent securities transaction. The information misappropriated must be valuable because of its use in a securities transaction.