The WSJ Law Blog reports that:
Doug Whitman, a former hedge-fund manager, doesn’t deny that he probed public companies for nonpublic information.
But when he goes on trial next week on charges of securities fraud and conspiracy, his lawyers plan to argue that his motives were pure, and that his conduct squared with the 1983 Supreme Court decision Dirks v. SEC, which protects certain trading on inside information, so long as there is no payoff, the WSJ’s Reed Albergotti reports in today’s paper. ...
During Wednesday’s hearing, U.S. District Judge Jed Rakoff, who is presiding over the case, was ... receptive to arguments challenging the law used to prosecute Mr. Whitman.
The government must prove that Mr. Whitman knew that the original sources of the inside stock tips were violating duties they owed to company shareholders to keep the information secret.
But Mr. Whitman’s attorneys argued in a motion to the court that the federal law that deals with the issue is vague, and that because all of the alleged conduct occurred in California, the court should consider the state laws there, where only high-level employees owe fiduciary duties.
Judge Rakoff said he was “impressed” Mr. Whitman’s lawyers raised the issue, adding that the question of which laws should apply has “been ducked” by courts for 25 years.
Might I repectfully encourage Judge Rakoff and the counsel to check out my article Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Washington and Lee Law Review 1189 (1995)? You can download the full text of the paper here: Download INCORPORATING STATE LAW FIDUCIARY DUTIES INTO THE FEDERAL INSIDER TRADING PROHIBITION.pdf (568.4K).
The introduction follows:
Someone violates the federal insider trading prohibition only if his trading activity breached a fiduciary duty owed either to the investor with whom he trades or to the source of the information. [FN1] From a securities law perspective, the federal prohibition thus is an empty shell. It has no force or substance until it has been filled with fiduciary duty concepts.
Despite the centrality of the fiduciary duty element to the federal prohibition, the fiduciary element has received relatively little attention from courts or commentators. On close examination, however, requiring a breach of fiduciary duty as a prerequisite for insider trading liability raises two interesting questions: What is the precise fiduciary duty at issue? Is the source of that duty federal or state law? Despite over a decade of experience *1191 with the fiduciary duty requirement, neither of these questions has a clear and convincing answer.
The failure to resolve these issues has robbed the federal insider trading prohibition of coherence and predictability. [FN2] Perhaps this lack of coherence was acceptable when insider trading was a low priority item for federal prosecutors, and the major penalty was disgorgement of profits. Today, however, insider trading is a major Securities and Exchange Commission (SEC or Commission) enforcement target and carries penalties that can only be described as draconian. [FN3] Due process and simple fairness thus require that the fiduciary duty element be taken more seriously than it has been to date.
Perhaps the fiduciary duty requirement's substantive content is ignored because courts and commentators assume that there is a single fiduciary duty, applicable to all relevant market players, that proscribes the use of confidential information for personal gain. If so, this assumption's inherent invalidity was exposed by the SEC's enforcement effort directed at insider trading in corporate debt securities. [FN4] Under state law, corporate officers and directors generally owe no fiduciary duties to debt securityholders. As a result, assuming state law provides the requisite fiduciary duty, one can plausibly argue that insider trading in debt securities is not unlawful. As this Article will demonstrate, similar state law arguments can be made in a variety of contexts, including the very core of the federal prohibition -- its application to corporate officers and directors. This possibility has generated some critical commentary in the debt security context, [FN5] but its full implications remain largely unexplored. This Article seeks to fill that gap.
Part II of this Article briefly traces the evolution of the current insider trading regime, with particular emphasis on the fiduciary duty element. Part III then explores the content of the fiduciary duty element. Part III argues *1192 that liability is premised not on the mere existence of a fiduciary relationship, but rather on the breach of a specific fiduciary duty -- namely, the duty to refrain from self-dealing in confidential information owned by another party.
The inquiry then shifts to identifying the source of the requisite duty. As a preliminary matter, Part IV argues that the insider trading prohibition is a species of federal common law. Specifically, it is an example of interstitial lawmaking in which the courts are using common-law adjudicatory methods to flesh out Rule 10b-5's bare bones. Once this view of the prohibition is accepted, a choice of law question arises. 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.
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? Part V addresses the former concern, examining the implications of adopting state law fiduciary duty concepts as the rule of decision. It demonstrates that use of state law principles will at least complicate insider trading prosecutions and probably will substantially limit the prohibition's scope.
In light of that finding, Part VI then turns to the latter concern. Because a unique federal set of fiduciary duties applicable to insider trading is most easily justified if application of state law would frustrate an identifiable federal policy goal, Part VI examines the purported federal interests underlying the insider trading prohibition. As Part VI demonstrates, none of the commonly asserted federal policies requires creation of a unique set of federal fiduciary duties. Rather, the insider trading prohibition is justified solely by the need to protect property rights in valuable information.
Based on this analysis, Part VI argues that it is creation of a unique federal rule -- not incorporation of state law principles -- that would frustrate the policies of the securities laws. The Supreme Court has repeatedly made clear that the federal securities laws do not displace the much broader body of state corporate law. To the contrary, the Court has *1193 specifically indicated that questions of fiduciary duty are governed by state law. If the fiduciary duty necessary for insider trading liability is supplied by federal law, a substantial tension thus would develop between the insider trading prohibition and the federalism policies of the securities laws. Incorporating state law fiduciary duties into the prohibition would resolve that tension. Moreover, state law fiduciary duties are generally consistent with the property rights rationale for regulating insider trading. Accordingly, incorporating state law fiduciary duties would advance the federalism policies of the federal securities laws, without frustrating any of the other policies thereof.
[FN1]. This is true insofar as the core federal prohibition under Securities and Exchange Commission (SEC) Rule 10b-5, 17 C.F.R. § 240.10b-5 (1993), is concerned. Breach of fiduciary duty is not required for liability to arise under the narrower provisions of SEC Rule 14e-3, 17 C.F.R. § 240.14e-3 (1993). See generally infra part II.
[FN2]. See generally Robert D. Rosenbaum & Stephen M. Bainbridge, The Corporate Takeover Game and Recent Legislative Attempts to Define Insider Trading, 26 AM. CRIM. L. REV. 229 (1988).
[FN3]. See generally Stephen M. Bainbridge, Note, A Critique of the Insider Trading Sanctions Act of 1984, 71 VA. L. REV. 455 (1985).
[FN4]. For discussion of the SEC's enforcement efforts with respect to debt securities, see Barbara A. Mallon & Dexter B. Johnson, Insider Trading in Non-Equity Securities, 26 REV. SEC. COMM. REG. 147 (1993); Harvey L. Pitt & Karl A. Groskaufmanis, Insider Trading and Junk Bonds, N.Y.L.J., May 16, 1991, at 1.
[FN5]. See, e.g., Harvey L. Pitt & Karl A. Groskaufmanis, A Tale of Two Instruments: Insider Trading in Non-Equity Securities, 49 BUS. LAW. 187 (1993); R. Rene Pengra, Note, Insider Trading, Debt Securities, and Rule 10b-5: Evaluating the Fiduciary Relationship, 67 N.Y.U.L. REV. 1354 (1992).
