Former SEC General Counsel says Rule 10b5-2 is invalid

05/17/2011

Former SEC General Counsel says Rule 10b5-2 is invalid

In an article "inspired" by former SEC General Counsel Ralph C. Ferrara (and written by a couple of his associates), Ferrara takes on an issue with which this blog has often dealt; namely, the validity of SEC Rule 10b5-2. I've explained before that this rule provides "a nonexclusive list of three situations in which a person has a duty of trust or confidence for purposes of the 'misappropriation' theory...." Crucially, the Rule purports that such a duty exists whenever someone agrees to maintain information in confidence. And I have argued that:

Rule 10b5-2's imposition of liability whenever someone agrees to maintain information in confidence is inconsistent with the emphasis in Chiarella and its progeny on the need for a duty of disclosure that arises out of a relationship of trust and confidence. Whether the SEC has authority to create a rule imposing misappropriation liability on the basis of an arms-length contractual duty of confidentiality--as opposed to a fiduciary duty-based duty of confidentiality--has not been tested. In light of the case law discussed above, however, I think the SEC lacked authority to adopt the rule.

Former SEC General Counsel Ferrara agrees (sub. req'd):

Despite the prior, repeated insistence by the Supreme Court that a relationship of trust and confidence must exist upon which to predicate Section 10(b) liability, Rule 10b5-2(b)(1) instead posits that the existence of a confidentiality agreement alone can establish the requisite duty upon which to base Section 10(b) liability. Yet a mere confidentiality agreement does not create a duty of trust and confidence; it is simply a contract not to share information with others – not a prohibition against acting upon such information.

Notably, while the Chiarella, Dirks, and O'Hagan decisions reference the need to establish a fiduciary or similar duty of trust and confidence, Rule 10b5-2(b) speaks of a duty of “trust or confidence.” The use of “or” instead of “and” thus creates new law. District courts prior to the adoption of the Rule had similarly misconstrued the duty requirement. For example, in United States v. Reed, the court misquoted Chiarella as requiring a relationship of “trust or confidence.” ¹⁷ Similarly, the district court in SEC v. Lenfest misquoted the Ninth Circuit, making the same “and” to “or” mutation. ¹⁸ Likewise, the district court in SEC v. Mayhew misquoted the Second Circuit. ¹⁹

¹⁷ Compare United States v. Reed, 601 F. Supp. 685, 704 n.30 (S.D.N.Y. 1985) rev'd on other grounds, 773 F.2d 477 (2d Cir. 1985) with Chiarella, 445 U.S. at 228, 230, 232. Xaphes v. Shearson, Hayden, Stone, Inc., 508 F. Supp. 882, 886 (S.D. Fla. 1981) made the same mistake.

¹⁸ Compare SEC v. Lenfest, 949 F. Supp. 341, 343-344 (E.D. Pa. 1996) with SEC v. Clark, 915 F.2d 439, 443, 447, 452 (9th Cir. 1990).

¹⁹ Compare SEC v. Mayhew, 916 F. Supp. 123, 129 (D. Conn. 1995) with United States v. Chestman, 947 F.2d 551, 564, 565, 566, 567, 568, 569, 570 (2d Cir. 1991), cert. denied, 503 U.S. 1004 (1992).

Moreover, it is evident from the rulemaking process that the SEC intended for the Rule to apply exclusively to personal or familial relationships. The SEC created Rule 10b5-2 to resolve “an unsettled issue in insider trading law” – namely, “under what circumstances certain non-business relationships, such as family and personal relationships, may provide the duty of trust or confidence required under the misappropriation theory.” ²⁰ The SEC described its proposed rule as “determining when family or personal reasons create ’duties of trust or confidence’ under the misappropriation theory.” ²¹ The SEC made no mention of its intent to apply the rule to business relationships. Against this background, it is clear that the SEC exceeded its statutory grant of authority in enacting the Rule.

²⁰ Selective Disclosure and Insider Trading, 65 Fed. Reg. 51716, 51729 (final rule, Aug. 24, 2000) (emphasis added); see also Selective Disclosure and Insider Trading, 64 Fed. Reg. 72590, 72591 (proposed rule, Dec. 28, 1999).

²¹ 64 Fed. Reg. at 72603.

He concludes:

Sooner or later, courts must come to grips with the tension between the “and” of O'Hagan and the “or” of Rule 10b5-2. Until that time, the SEC will continue to pursue traders for conduct that it is either unable or unwilling to define, and will continue to waste its limited resources by exceeding what it may lawfully regulate. Such unchecked agency action may cause undue uncertainty in the financial markets, creating a chilling effect on business and investment. These repercussions, in the current climate of economic instability, should not be taken lightly.

Posted at 11:39 AM in Insider Trading | Permalink

Comments

Rule 10b5-2's imposition of liability whenever someone agrees to maintain information in confidence is inconsistent with the emphasis in Chiarella and its progeny on the need for a duty of disclosure that arises out of a relationship of trust and confidence. Whether the SEC has authority to create a rule imposing misappropriation liability on the basis of an arms-length contractual duty of confidentiality--as opposed to a fiduciary duty-based duty of confidentiality--has not been tested. In light of the case law discussed above, however, I think the SEC lacked authority to adopt the rule.

Former SEC General Counsel Ferrara agrees (sub. req'd):

Despite the prior, repeated insistence by the Supreme Court that a relationship of trust and confidence must exist upon which to predicate Section 10(b) liability, Rule 10b5-2(b)(1) instead posits that the existence of a confidentiality agreement alone can establish the requisite duty upon which to base Section 10(b) liability. Yet a mere confidentiality agreement does not create a duty of trust and confidence; it is simply a contract not to share information with others – not a prohibition against acting upon such information.

Notably, while the Chiarella, Dirks, and O'Hagan decisions reference the need to establish a fiduciary or similar duty of trust and confidence, Rule 10b5-2(b) speaks of a duty of “trust or confidence.” The use of “or” instead of “and” thus creates new law. District courts prior to the adoption of the Rule had similarly misconstrued the duty requirement. For example, in United States v. Reed, the court misquoted Chiarella as requiring a relationship of “trust or confidence.” ¹⁷ Similarly, the district court in SEC v. Lenfest misquoted the Ninth Circuit, making the same “and” to “or” mutation. ¹⁸ Likewise, the district court in SEC v. Mayhew misquoted the Second Circuit. ¹⁹

¹⁷ Compare United States v. Reed, 601 F. Supp. 685, 704 n.30 (S.D.N.Y. 1985) rev'd on other grounds, 773 F.2d 477 (2d Cir. 1985) with Chiarella, 445 U.S. at 228, 230, 232. Xaphes v. Shearson, Hayden, Stone, Inc., 508 F. Supp. 882, 886 (S.D. Fla. 1981) made the same mistake.

¹⁸ Compare SEC v. Lenfest, 949 F. Supp. 341, 343-344 (E.D. Pa. 1996) with SEC v. Clark, 915 F.2d 439, 443, 447, 452 (9th Cir. 1990).

¹⁹ Compare SEC v. Mayhew, 916 F. Supp. 123, 129 (D. Conn. 1995) with United States v. Chestman, 947 F.2d 551, 564, 565, 566, 567, 568, 569, 570 (2d Cir. 1991), cert. denied, 503 U.S. 1004 (1992).

Moreover, it is evident from the rulemaking process that the SEC intended for the Rule to apply exclusively to personal or familial relationships. The SEC created Rule 10b5-2 to resolve “an unsettled issue in insider trading law” – namely, “under what circumstances certain non-business relationships, such as family and personal relationships, may provide the duty of trust or confidence required under the misappropriation theory.” ²⁰ The SEC described its proposed rule as “determining when family or personal reasons create ’duties of trust or confidence’ under the misappropriation theory.” ²¹ The SEC made no mention of its intent to apply the rule to business relationships. Against this background, it is clear that the SEC exceeded its statutory grant of authority in enacting the Rule.

²⁰ Selective Disclosure and Insider Trading, 65 Fed. Reg. 51716, 51729 (final rule, Aug. 24, 2000) (emphasis added); see also Selective Disclosure and Insider Trading, 64 Fed. Reg. 72590, 72591 (proposed rule, Dec. 28, 1999).

²¹ 64 Fed. Reg. at 72603.

He concludes:

Sooner or later, courts must come to grips with the tension between the “and” of O'Hagan and the “or” of Rule 10b5-2. Until that time, the SEC will continue to pursue traders for conduct that it is either unable or unwilling to define, and will continue to waste its limited resources by exceeding what it may lawfully regulate. Such unchecked agency action may cause undue uncertainty in the financial markets, creating a chilling effect on business and investment. These repercussions, in the current climate of economic instability, should not be taken lightly.