I recently ran across an article by John Coffee (2013 Colum. Bus. L. Rev. 281) in which he opined that:
SEC v. Cuban ... accepted in principle that a legal duty can arise by contract, whose breach would violate Rule 10b-5. SEC v. Cuban, 634 F. Supp. 2d 713 (N.D. Tex. 2009). The defendant had claimed that only fiduciary breaches recognized under state law could support a violation of Rule 10b-5.Id. at 726. Conservative law professors have long argued the thesis that only such a state law grounded violation could support a Rule 10b-5 violation. See Stephen A. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1267 n.320 (1995). But Rule 10b5-2 today recognizes that a “duty of trust or confidence” can be grounded on a contract or an agreement “to maintain information in confidence.” See Rule 10b5-2(b)(1), 17 C.F.R. § 240.10b5-2(b)(1) (2013). Decisions to date have largely upheld the rule. See SEC v. Yun, 327 F.3d 1263, 1273 (11th Cir. 2003)(recognizing that “a breach of an agreement to maintain business confidences would also suffice” to support insider trading liability); SEC v. Lyon, 529 F. Supp. 2d 444, 452-53 (S.D.N.Y. 2008). However, in SEC v. Cuban, the court drew a tortured distinction between agreeing to maintain confidentiality and agreeing not to trade. Cuban, 634 F. Supp. 2d at 729-31. In its view, Rule 10b5-2(b)(1) improperly “attempts to predicate misappropriation theory on a mere confidentiality agreement lacking a non-use component.” Id. at 730-31. This distinction between agreeing to maintain confidentiality and agreeing not to trade was, however, viewed skeptically by the Fifth Circuit, which vacated and remanded. See SEC v. Cuban, 620 F.3d 551 (5th Cir. 2010). In United States v. Whitman, the district court went well beyond Cuban and held that Rule 10b-5 is not grounded on state law theories of fiduciary duty, but rather on federal common law. United States v.Whitman, No. 12 Cr. 125 (JSR), 2012 U.S. Dist. LEXIS 163138, at *14-16 (S.D.N.Y. Nov. 14, 2012). To the extent that federal law controls, SEC rules could do much more to generalize or expand the scope of the insider trading prohibition.
There are a couple of things going on here. First, can an agreement to keep information confidential create the requisite relationship of trust and confidence necessary to sustain an insider trading conviction? The SEC claims that it can and incorporated that assertion into Rule 10b5-2. Coffee is correct that the cases have mostly upheld the Rule, which isn't terribly surprising given the deference courts typically give agencies. Along with several other prominent securities law experts, however, I filed an amicus brief in the Cuban case arguing that SEC Rule 10b5-2 got it wrong. I've also blogged about the problem with using an agreement as the basis of an insider trading conviction repeatedly, most notably here and here.
Second, while it is true that the Whitman case treats insider trading as a species of federal common law, Judge Rakoff in that case and Coffee here erred by stopping at that point. (I blogged a response to the Whitman case back when it came out.)
In crafting a rule of decision for federal common-law cases, courts can either create a unique federal standard or incorporate state law into the federal rule. In the latter case, the cause of action remains federal, but the content of federal law is supplied by the incorporated state law principles. The decision to incorporate state law depends upon whether there are important federal interests that would be adversely affected by doing so. If so, the court will create a uniform federal standard, but if not, the court may incorporate state law.
As such, you don't simply announce that a rule is federal common law and call it a day. You have to go on to decide if federal common law should subsume state law.
In order to decide whether state fiduciary duties should be incorporated into the federal insider trading prohibition, we thus must ask two questions: Would incorporation adversely affect prosecution of insider trading under the federal securities laws and, if so, would any identifiable policy goal of those laws be frustrated thereby?
In an article Judge Rakoff cited (Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L.Rev. 1189 (1995)), but seemingly did not read closely, I exhaustively reviewed the rules on creating federal common law and concluded that they strongly support treating the federal prohibition of insider trading as an empty shell that has no force or substance until it has been filled with state law fiduciary duty concepts. This conclusion draws support from three prongs: (1) the rules governing the making of federal common law, (2) the Supreme Court's federalism jurisprudence, especially in the context of the securities laws' intersection with state corporate law, and (3) the public policy rationale for regulating insider trading. The argument stretches across 20-plus pages of a very long article, so I'll ask the interested reader to go to the article rather than extending this post.