Under the present judicial interpretation of federal securities law, an individual is prohibited from trading on non-public information that has been misappropriated in contravention of a fiduciary duty. Trades made using non-public information that has not been misappropriated are not prohibited by Rule 10b-5, promulgated under the Securities and Exchange Act of 1934. The current requirement of misappropriation to trigger Rule 10b-5 liability creates a gap that permits transactions that are both ethically and economically undesirable. Judicial or legislative reforms are recommended to close the gap and help ensure the fairness and efficiency of securities markets.
1 Rule 10b-5, Employment of Manipulative and Deceptive Devices, Exchange Act Release No. 3230, 7 Fed. Reg. 3804 (1942).
2 Securities Exchange Act of 1934, ch. 404,48 Stat. 881 (codified as amended at 15 U.S.C. Sections 78a-7811 (1988 & Supp. I 1989)) [hereafter the 1934 Act].
3 213U.S 419 (1909).
4 Restatement (Second) of Torts Section 525.
5 See, e.g., Steinberg v. Chicago Medical School, 371 N.E. 2d 634 (1977), wherein statements in a medical school catalogue to the effect that admission was based on academic merits of applicants was held to be an express statement of fraud when the shool in fact admitted many applicants on the basis of financial pledges.
6 Strong v. Repide created the common law nexus between a special relationship and the inference of misrepresentation from silent trading. In essence, the trade itself can be considered a fraudulent transaction if a duty to disclose is inferable from the “special facts” of the case.
7 The purpose of the act can be found in its legislative history; see S. Rep. No. 792, 73d Cong., 2nd Session 3 (1934), reprinted in 5 Legislative History of the Securities Act of 1933 and the Securities Exchange Act of 1934 Item 17 (J. Ellenberger & E. Mahar comp. 1973).
8 Rule 10b-5 states, “It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange, (1) to employ any device, scheme, or artifice to defraud; (2) to make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statement made, in light of the circumstances under which they were made, not misleading, or (3) 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 any security.”
9 The Securities and Exchange Commission construed Rule 10b-5 broadly in the case In re Cady, Roberts & Co., 40 S.E.C. 907 (1961). They stated that the Rule broadly restricts the trading practices of “any person,” and declined to require insider status as a prerequisite to the rules application, asserting that the rule was meant to ameliorate the inherent unfairness which exists when information not available to the public is used by one party to a market transaction.
10 See, e.g., SEC v. Texas Gulf Sulphur Co., 401 F. 2d 833 (2d Cir. 1968), cert, denied, 394 U.S. 976 (1969). This decision stated that anyone who possesses inside information must either disclose the information to the public or refrain from trading the securities involved. It rendered tippees of information liable regardless of the source of the information. The case contains the broadest interpretation of the intent and scope of Rule 10b-5 to date. The philosophy of the opinion is essentially that non-public information, regardless of its derivation and the status of its holder, renders an unfair advantage when the holder trades on the information. This advantage was considered sufficient in itself to qualify any trading thereunder as fraudulent. See also Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F. 2d 228 (2d Cir. 1974).
11 445 U.S. 222(1980).
12 See also United States v. Newman, 664 F. 2d 197 (2d Cir. 1981).
13 463 U.S. 646 (1983).
14 The Insider Trading and Securities Fraud Enforcement Act of 1988 (H.R. 5133) addresses the issue of tipper and tippee liability. The Purpose and Summary Section indicates that while the 1988 Act does not overrule the basic substantive principle regarding tippers and tippees as stated in Dirks, “the Committee intends that a person who ‘controls’ a tipper and otherwise meets the standards for imposition of a penalty should be liable for profits made by indirect tippees in a situation in which the tipper may communicate to one person, who does not trade and therefore receives no direct profits, but who acts as a conduit and passes on the information to others who do trade.” (pp. 20-21)
15 719F.2d5 (2d Cir. 1983).
16 A plaintiff trades contemporaneously with the alleged inside trader if the transactions occurred at the same time, regardless of whether the shares traded by each can be identified as part of the same transaction. Thus some plaintiffs who trade contemporaneously with defendants do not engage in any purchase or sale that can be traced directly to those defendants, and are not technically injured by them. Under a literal reading of fraud requirements, such defendants cannot be held to have caused the injuries of the plaintiffs. A more forgiving approach allows recovery by contemporaneous traders, under the implicit reasoning that the defendant hurt someone, and that the plaintiff was a member of the group hurt. Since it is difficult to trace transactional causality in impersonal markets, justice can be served only by allowing all contemporaneous traders to recover from the defendant who traded illegally using inside information.
17 745 F. 2d 197 (2d Cir. 1984).
18 Pub. L. No. 100-704, 102 Stat. 4677 (codified in scattered subsections of 15 U.S.C. Section 78 and in 15 U.S.C. Section 80b-4a (1988)) [hereafter ITSFEA].
19 Report of the House Committee on Energy and Commerce (No. 100-910, p. 7). 20719F.2d5 (2d Cir. 1983).
21 Sec. 20A (a) of the Act states, “Any person who violates any provision of this title or the rules or regulations thereunder by purchasing or selling a security while in possession of material, non-public information shall be liable in an action in any court of competent jurisdiction to any person who, contemporaneously with the purchase or sale of securities that is the subject of such violation, has purchased (where such violation is based on a sale of securities) or sold (where such violation is based on a purchase of securities) securities of the same class.”
22 Report of the House Committee on Energy and Commerce (No. 100-910, pp. 26-27).
23 United States v. Winans, 612 F. Supp. 822 (S.D.N.Y., 1986).
24 779 F. 2d 1024 (2d Cir. 1986), affirming United States v. Winans, 612 F. Supp. 822 (S.D.N.Y., 1986).
25 108 S.Ct. 316 (1987).
26 Scholars have suggested conflicting interpretations of the 4-4 decision in Carpenter. Bromberg has suggested that the even split left misappropriation theory considerably weakened. Donovan, “Supreme Court Upholds Conviction of Former Business Writer Winans,” Investor's Daily, Nov. 17, 1987, at 1 col. 4 (quoting Alan Bromberg, Professor of Securities Regulation at Southern Methodist University). Sontag has cited SEC Commissioner Grundfest as stating that the decision in Carpenter has left misappropriation theory “alive and well.” Sontag, “Misappropriation Theory in Limbo: An SEC Victory—or Not?”, Nat'l L.J., Dec. 7, 1987, at 10, col. 2.
27 This contention is discussed in some detail in Salbu, “A Legal and Economic Analysis of Insider Trading” 8 Bus and Prof. Ethics J. 2, 3-21 (1990), which asserts that misappropriation theory was invented as an ineffective expedient to force a fit between the goals of market protection and the anti-fraud gravamen of the language in Rule 10b-5.
28 These two varying approaches to reading Rule 10b-5 are characterized as “effect” versus “conduct” in Mitchell, “The Jurisprudence of the Misappropriation Theory and the New Insider Trading Legislation: From Fairness to Efficiency and Back,” 52 Albany L. Rev. 775 (1988).
29 The Second Circuit built on its far-reaching decision of SEC v. Texas Gulf Sulphur Co., in which that court indicated that its crucial concern was protection of the market mechanism, stating, “Whether predicated on traditional fiduciary concepts, or on the “ special facts’ doctrine, the Rule is based in policy on the justifiable expectation of the securities marketplace that all investors trading on impersonal exchanges have relatively equal acess to material information.” 401 F.2d at 848 (citing “Insider Trading in Stocks,” 21 Bus. Law. 1009, 1010 (1966) (remarks of panelist William L. Cary)).
30 In Ernst and Ernst v. Hochfelder, 425 U.S. 185 (1976), the Supreme Court required proof of scienter in private claims. The decision suggests that Section 10(b) of the 1934 Act was intended to remedy culpable conduct rather than repair market failures or imperfections. The Court's emphasis on manipulation and deception created the foundation for its holding in Chiarella, beginning to limit the application of the Act and its rules to infractions against individuals rather than the market.
31 See supra note 5 for the legislative history of the 1934 Act.
32 Efficient capital market theory is the received model for analysis of this question. The theory suggests that pricing of securities will most closely approach equilibrium when information is allowed to flow freely and when buyers and sellers are encouraged by their confidence in the marketplace to participate therein. Note, “The Efficient Capital Market Hypothesis, Economic Theory and the Regulation of the Securities Industry,” 29 Stan. L Rev. 1031 (1977). On the basis of efficient capital market theory, some scholars have suggested that prohibition of insider trading is bad policy because, inter alia, any mandate to refrain from trading on the basis of true information impedes the assimilation of such information into the market pricing mechanism. Others have responded that perceptions of unfairness in the market discourage participation and thereby hinder efficiency. For a discussion of this issue, see Manne, H., Insider Trading and the Stock Market (1966); Bainbridge, “The Insider Trading Prohibition: A Legal and Economic Enigma,” 38 U. Fla. L. Rev. 35 (1986); Brudney, “Insiders, Outsiders, and Informational Advantages Under the Federal Securities Laws,” 93 Harv. L Rev. 322 (1979); Carlton & Fischel, “The Regulation of Insider Trading,” 35 Stan. L Rev. 857 (1983); Dooley, “Enforcement of Insider Trading Restrictions,” 66 Va. L Rev. 1 (1980); Easterbrook, “Inside Trading, Secret Agents, Evidentiary Privileges, and the Production of Information,” 1981 Sup. Ct. Rev. 309.
33 For a detailed discussion of the effects of market structure, see Cooter, R. & Ulen, T., Law and Economics (1988), pp. 37–41.
34 These characteristics were discussed by Adam Smith in describing the kind of atomistic competition in which the invisible hand operates to regulate the market precisely because no single player has the ability to overwhelm its dynamics through the use of unusual or extraordinary market power. Although he disfavored the interference of government in the marketplace via mercantilist policy, he recognized the necessity for regulation of monopoly power and the relevance of market structure to the validity of his ideas. Smith, A., The Wealth of Nations (1776). Changes in market structure and their impact on efficient market doctrines are addressed in Galbraith, J. K., The New Industrial State (1967), observing in particular that planning by large and powerful businesses has an effect on the supply of capital. The potential for “market coordination” within the framework of monopolistic or oligopolistic contexts is discussed in detail in Chandler, A., The Visible Hand: The Managerial Revolution in American Business (1977).
35 McGee and Block suggest that insider trading should be legalized because, inter alia, the problem of misappropriation is already addressed through adequate remedies of common law. The logic of this argument is sound only under the assumption that Rule 10b-5 addresses solely micro-level transactions and has no macroeconomic function. If the Rule in fact concerns market integrity as well as individual sales, both common law remedies for misappropriation and the misappropriation approach to insider trading are insufficient remedies.
36 Information asymmetry exists when buyer and seller have unequal information regarding the stocks being purchased.
37 See Kronman, “Mistake, Disclosure, Information and the Law of Contracts,” 7 J. Legal Stud. 1 (1978); Scheppele, “Efficiency and Equality in the Common Law: An Analysis of Nondisclosure as Fraud” (unpublished mimeo, Nov. 1985).
38 The relationship between economic theory and the assumptions regarding information are discussed in Becker, L., Property Rights: Philosophical Foundations (1977);Ackerman, B., ed., The Economic Foundations of Property Law (1976);Manne, H., ed., The Economics of Legal Relations: Reading in the Theory of Property Rights (1975).
39 Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228 (2d Circuit 1974); Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976); Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977).
40 See Note, “Limiting the Plaintiff Class: Rule 10b-5 and the Federal Securities Code,” 72 Mich. L. Rev 1398 (1974).
41 495 F.2d 228, 238 (2d Cir. 1974).
42 Fridrich v. Bradford, 542 F.2d 307 (6th Cir. 1976), cert, denied, 429 U.S. 1053 (1977).
43 One need only imagine analogous situations in other areas of law to see the inappropri-ateness of such surrogate liability within our legal system. If X injures Y in an automobile crash and Y wanders from the scene under the spell of amnesia, never to surface again, then we have a similar situation wherein the victim of the injury is untraceable. If Z has been injured in a similar accident wherein the tortfeasor has left the scene and cannot be located, should Z have cause of action against X as a “stand-in”? Such a policy would require an extreme departure from the basic common law tenets of causality in cases of injury claims.
44 542 F.2d 307, 326 n. 11 (Celebrezze, J., concurring.) (6th Cir. 1976).
45 719 2d5 (2d Cir. 1983).
46 Examples of such alternatives can be found in Section C, infra.
47 See supra note 15.
48 See supra note 18.
50 This doctrine dates back at least to Laidlaw v. Organ, 2 Wheat. (15 U.S.) 178, 4 L.Ed 214 (1817), wherein a defendant purchased tobacco from plaintiff at a very low price under conditions of export blockade during the War of 1812. Defendant knew that the Treaty of Ghent had been signed and made the purchase without disclosing this information, which was not yet generally dispersed in New Orleans, to the plaintiff seller. When the plaintiff sought to void the sale, the Court denied the remedy, holding that the buyer was not bound by duty to communicate to the seller its intelligence of the extrinsic circumstances.
51 Calamari & Perillo, The Law of Contracts, 2d ed., 1977, p. 287. Among the statutes the authors discuss in this regard are the Securities Act, the Truth-in-Lending Act, the Interstate Land Sales Full Disclosure Act and the Truth in Negotiation Act.
52 401 F.2d 833 (2d Cir. 1968), cert, denied, 394 U.S. 976 (1969).
53 Davis v. Reisinger, 120 App. Div. 766, 105 N.YS. 603 (1st Dep't 1907).
54 108 S. Ct. 978 (1988).
* This article is a condensed version of an article entitled “The Misappropriation Theory of Insider Trading: A Legal, Economic and Ethical Analysis,“ which appeared in Volume 15, Issue 1 of the Harvard Journal of Law and Public Policy (1992).
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