Eight (out of 11) members of Toll Brothers board of directors sold significant amounts of the company’s stock between December 2004 and September 2005. Plaintiff sued derivatively on behalf of the corporation, claiming that the defendants had sold “while in possession of material, non-public information about Toll Brothers’ future prospects.” Pfeiffer v. Toll, C.A. No. 4140-VCL, slip op. (Del. Ch. Mar. 3, 2010).
I’ve discussed the state law aspects of the case here.
In the course of its opinion, however, the Delaware Chancery Court (per Laster, VC) touched on a couple of aspects of the federal insider trading prohibition that deserve further attention.
First, the Court opined that:
[The federal insider trading prohibition] depends on the existence of a fiduciary relationship or similar relationship of trust and confidence. Federal law does not give rise to or establish the fiduciary duties of directors or officers. Those matters are governed by state law. Thus the federal insider trading regime as currently structured rests on a foundation of state law fiduciary duties. If Delaware were to hold that the fiduciary duties of directors and officers did not limit their insider trading, the cornerstone of the federal system would be removed. …
… [T]he United States Supreme Court has “consistently held that insider trading liability requires an agency or fiduciary relationship.” [Stephen M. Bainbridge, Securities Law: Insider Trading 92 (1st ed. 1999).] The fiduciary duties owed by directors and officers of a state-chartered corporation are created and governed by state law.
Toll, slip op. at 40-41, 44. I certainly agree that that is what the law ought to be. In Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Washington and Lee Law Review 1189 (1995), I argued precisely that point at considerable length.
On the other hand, there is a plausible reading of the Supreme Court precedents under which there is “a federal duty prohibiting insider trading, which has become part of the overall bundle of fiduciary duties to which insiders are subject.” See generally Stephen M. Bainbridge, Securities Law: Insider Trading 61 (2d ed. 2007), cited in Pfeiffer v. Toll, C.A. No. 4140-VCL, slip op. passim (Del. Ch. Mar. 3, 2010).
This understanding of Dirks was implicitly confirmed by the Supreme Court’s more recent decision in United States v. O’Hagan. The majority reaffirmed the Chiarella/Dirks requirement of a fiduciary relationship, broadly holding that the “relationship of trust and confidence” between insiders and shareholders “gives rise to a duty to disclose” or to abstain. Again, given that many states impose no such duty on corporate officers and directors, one must assume that the duty of which the court spoke is federal in origin.
Id. Knowledgeable readers will recognize that there thus is a potential conflict between the Supreme Court’s insider trading jurisprudence and its holding in in Santa Fe Industries, Inc. v. Green, 430 U.S. 462 (1977), that Rule 10b-5 is concerned with disclosure and fraud, not with fiduciary duties.
The court [so held] in large measure out of a concern that the contrary decision would result in federalizing much of state corporate law and thereby overriding well-established state policies of corporate regulation. While its holding is not squarely on point, the rationale of Santa Fe seems directly applicable to the insider trading prohibition. The court held, for example, that Rule 10b-5 did not reach claims “in which the essence of the complaint is that shareholders were treated unfairly by a fiduciary.” This is of course the very essence of the complaint made in insider trading cases. The court also held that extension of Rule 10b-5 to breaches of fiduciary duty was unjustified in light of the state law remedies available to plaintiffs. As we have seen, insider trading plaintiffs likewise have state law remedies available to them. Granted, those remedies vary from state to state and are likely to prove unavailing in many cases, but the same was true of the state law appraisal remedy at issue in Santa Fe. Finally, the court expressed reluctance “to federalize the substantial portion of the law of corporations that deals with transactions in securities, particularly where established state policies of corporate regulation would be overridden.” In view of the state law standards discussed above, of course, this is precisely what the federal insider trading prohibition did. Given that Santa Fe requires that all other corporate fiduciary duties be left to state law, why should insider trading be singled out for special treatment?
Dirks and Chiarella simply ignored the doctrinal tension between their fiduciary duty-based regime and Santa Fe. In O’Hagan, Justice Ginsburg’s majority opinion at least recognized that Santa Fe presented a problem for the federal insider trading prohibition, but her purported solution is quite unconvincing. Justice Ginsburg correctly described Santa Fe as “underscoring that § 10(b) is not an all-purpose breach of fiduciary duty ban; rather it trains on conduct involving manipulation or deception.” Instead of acknowledging that insider trading is mainly a fiduciary duty issue, however, she treated it as solely a disclosure issue. It is thus the failure to disclose that one is about to inside trade that is the problem, not the trade itself: “A fiduciary who ‘[pretends] loyalty to the principal while secretly converting the principal’s information for personal gain’ . . . ‘dupes’ or defrauds the principal.” As Justice Ginsburg acknowledged, this approach means that full disclosure must preclude liability. If the prospective inside trader informs the persons with whom he or she is about to trade that “he plans to trade on the nonpublic information, there is no ‘deceptive device’ and thus no § 10(b) liability. . . .”
Justice Ginsburg’s approach fails to solve the problem. Granted, insider trading involves deception in the sense that the defendant by definition failed to disclose nonpublic information before trading. Persons subject to the disclose or abstain theory, however, often are also subject to a state law-based fiduciary duty of confidentiality, which precludes them from disclosing the information. As to them, the insider trading prohibition collapses into a requirement to abstain from trading on material nonpublic information. As such, it really is their failure to abstain from trading, rather than their nondisclosure, which is the basis for imposing liability. A former SEC Commissioner more or less admitted as much: “Unlike much securities regulation, the insider trading rules probably do not result in more information coming into the market: The ‘abstain or disclose’ rule for those entrusted with confidential information usually is observed by abstention.” Yet, Santa Fe clearly precludes the creation of such duties.
In any event, Justice Ginsburg’s solution also is essentially circular. Recall that failure to disclose material nonpublic information before trading does not always violate Rule 10b-5. In omission cases, which include all insider trading on impersonal stock exchanges, liability can be imposed only if the defendant had a duty to disclose before trading. If Rule 10b-5 itself creates the requisite duty, however, this requirement is effectively negated. As such, the requisite duty must come from outside the securities laws. Indeed, given Santa Fe, it must come from outside federal law. Yet, as we have seen, the Dirks/O’Hagan framework appears to violate this requirement through circularity—creating a federal disclosure obligation arising out of Rule 10b-5.
Bottom line? The conceptual conflict between the Supreme Court’s current insider trading jurisprudence and its more general Rule 10b-5 precedents remains unresolved. It seems reasonably clear that the principal task is to determine whether a fiduciary relationship exists between the inside trader and the person with whom he or she trades. Whether that determination is made as a matter of state or federal law, unfortunately, is unclear. O’Hagan confirms that the attorney-client relationship is a fiduciary one. Dictum in all three Supreme Court precedents tells us that corporate officers and directors are fiduciaries of their shareholders. Beyond these two categories we must make educated guesses. The sections that follow use the hypotheticals recounted earlier to provide as much guidance on this issue as possible. Until a majority of the Supreme Court has held that a particular relationship is fiduciary in nature, however, we cannot know for sure.
Stephen M. Bainbridge, Securities Law: Insider Trading 65-69 (2d ed. 2007) (footnotes omitted).
In sum, I’m afraid that the relationship between state and federal law in this area is nowhere near as clean cut as the Toll opinion suggests. The federal insider trading prohibition ought to be an empty shell waiting to be filled by state law fiduciary duties, but I’m not all sure that that is what the law is.
Second, notice that the Chancery Court—citing yours truly—opined that “the United States Supreme Court has ‘consistently held that insider trading liability requires an agency or fiduciary relationship.’” Toll, slip op. at 44.
I certainly agree that that is what the Supreme Court decisions say. I also agree that that is what the law ought to be. I’m no longer certain that that is the direction in which the lower courts are moving the law, however. To the contrary, as I explained in Ruling on Hackers as Inside Traders: Right in Theory, Wrong on the Law, Washington Legal Foundation Legal Backgrounder, Vol. 24, No. 32, October 9, 2009, the United States Court of Appeals for the Second Circuit’s decision in SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009) dealt with a question left open in the U.S. Supreme Court U.S. v. O’Hagan decision: the liability of persons who steal inside information but have no fiduciary duty to either the source of the information or the issuer of the securities in which the thief trades.
In Dorozhko, the SEC alleged that a computer hacker broke into a health information company’s computer system and used the stolen information to essentially sell the stock short. The Second Circuit tried to finesse the rules discussed below by treating the case as one involving a misrepresentation rather than insider trading: “we recognize that the SEC’s claim against defendant—a corporate outsider who owed no fiduciary duties to the source of the information—is not based on either of the two generally accepted theories of insider trading.” The problem is that the case makes no sense other than as an insider trading case.
Id. at 1. I went on to explain that “this case was an attempt by the SEC to end run the fiduciary duty requirement applicable to nondisclosure cases. It is an end run around the basics of insider trading law, and the Second Circuit aided and abetted it.” Id. at 2.
In WSJ Law Blog Blows Cuban Case, a July 2009 post to this blog, I explained that the district court decision in the SEC’s case against Mark Cuban went even further by simply gutting the fiduciary duty requirement:
At pages 14-15, for example, the Cuban court's opinion states that the court "rejects Cuban’s contention that liability under the misappropriation theory depends on the existence of a preexisting fiduciary or fiduciary-like relationship." Footnote 5 on page 19 likewise states that:
The court disagrees with Cuban’s assertion that, in O’Hagan, “[t]he Court [drew] a clear distinction between fiduciaries and non-fiduciaries because only a fiduciary would have a duty to make this disclosure and therefore can be said to have engaged in a ‘deception’ if he does not disclose or abstain from trading.” Although O’Hagan is written in terms of fiduciaries and fiduciary relationships, duties, and obligations, it is reasonable to infer that this is because O’Hagan was a criminal case that involved the conduct of a fiduciary. ... The Court may simply have intended that its opinion decide the case without injecting dicta to cover other circumstances in which the misappropriation theory could apply. But regardless of the reason, there is no indication in O’Hagan that such a fiduciary or fiduciary-like relationship is necessary——as opposed to merely sufficient——to impose the requisite duty, or iessential element of the misappropriation theory.
In other words, you can have liability under the misappropriation theory without having a fiduciary duty. Indeed, as the court stated at 20: "The court therefore concludes that a duty sufficient to support liability under the misappropriation theory can arise by agreement absent a preexisting fiduciary or fiduciary-like relationship."
I think these cases are dead wrong, but they are part of a disturbing trend in which the lower federal courts (at the behest of the SEC) are increasingly ignoring the clear teaching of the Supreme Court precedents. As Donna Nagy has explained:
Recent SEC enforcement actions, such as the case filed against Dallas Mavericks' owner Mark Cuban, raise the question whether deception by a fiduciary is essential to the Rule 10b-5 insider trading offense. Under the Supreme Court's classical and misappropriation theories, the answer is clearly yes - each theory has a fiduciary principle at its core. Yet lower courts and the SEC frequently disregard the Court's explicit dictates, and a consensus is emerging that insider trading rests simply on the wrongful use of material nonpublic information, regardless of whether a fiduciary-like duty is breached. …
Donna M. Nagy, Insider Trading and the Gradual Demise of Fiduciary Principles (January 30, 2009). Indiana Legal Studies Research Paper No. 123; Iowa Law Review, Vol. 94, p. 1315, 2009. Available at SSRN: http://ssrn.com/abstract=1335494.
Once again, I’m afraid that the content of federal law in this area is nowhere near as certain as the Toll opinion suggests.
This post ignores the existence of federal statutory law regarding insider trading, see Section 20A of the 1934 Act which provides a private cause of action for insider trading. Some states, e.g. California, also have statutory causes of action directed at insider trading, see Cal. Corporations Code section 25502.5. Federal law provides a cause of action for contemporaneous traders, California law for the company whose shares are traded (like Brophy).
Posted by: Chris | 03/12/2010 at 03:03 PM
I have a few comments about this sentence by VC Laster: "If Delaware were to hold that the fiduciary duties of directors and officers did not limit their insider trading, the cornerstone of the federal system would be removed."
First, it assumes that Delaware is the only state. Admittedly, many (perhaps most) U.S. public companies are organized there.
Second, insider trading under the classical theory (Chiarella) and (the orthodox understanding of) the misappropriation theory (O'Hagan) requires a fiduciary or similar relation of trust and confidence, but it does not follow that federal law of insider trading is based on state law of fiduciary duty. If Delaware (and all other states') courts "were to hold that the fiduciary duties of directors and officers did not limit their insider trading," this would not undermine federal law of insider trading, which is based on a fiduciary or similar relation of trust and confidence that exists wherever one person is another's agent or controls another's property for the other person's benefit. The scope of the duties of agents and fiduciaries is largely a matter of state law, but federal insider trading law also imposes certain duties on agents and fiduciaries.
Third, even if we grant that agency and fiduciary relationships are based on state (common) law, it does not follow that federal law cannot impose duties -- such as insider trading prohibitions -- that apply to agents and fiduciaries, regardless of whether state courts recognize this.
Posted by: Vic | 03/17/2010 at 11:39 AM
Prof. Bainbridge characterizes Dorozhko as "an attempt by the SEC to end run the fiduciary duty requirement applicable to nondisclosure cases." But Dorozhko was not a nondisclosure case. Instead, the Second Circuit remanded the case to the district court to determine if Dorozhko had made an affirmative misrepresentation to Thomson Reuters (e.g., by falsely providing a login ID or password) when he hacked into its computer system to obtain inside information that he traded on. As the Supreme Court recognized in Chiarella, nondisclosure is deceptive only if there is a duty to disclose, based on a fiduciary or similar relation of trust and confidence. If the deception is based on affirmative misrepresentation, however, no fiduciary etc. relation is required.
Moreover, O'Hagan is not entirely clear that a fiduciary relation is required for insider trading liability under the misappropriation theory. The text of O'Hagan also mentions contractual and other duties, in addition to fiduciary duties, whose violation can provide the basis for liability. Also, lower courts (such as in Dorozhko and Cuban) are bound only by O'Hagan's result and those legal principles that are necessary for the result, and they may (at the risk of reversal, of course) ignore as dicta other portions of the opinion for a precedent decision. Although O'Hagan did breach a fiduciary duty that he owed to the source of the material, nonpublic on which he traded, lower courts deciding later cases (such as Dorozhko and Cuban) have construed O'Hagan's holding such that breach of fiduciary duty is non-exclusively sufficient, rather than necessary, for misappropriation theory liability, which may be based alternatively on affirmative misrepresentation (Dorozhko) or breach of contract (Cuban -- except that he did not breach a contract, so in my view his case should be dismissed).
Posted by: Vic | 03/17/2010 at 12:18 PM