In US v. Whitman, 2012 WL 5505080 (SDNY 2012), "a jury convicted defendant Doug Whitman of two counts of conspiracy to commit insider trading and two counts of substantive insider trading in violation of the federal securities laws. Specifically, the counts charged that Mr. Whitman traded or agreed to trade on material inside information that he received from tippees who had, in turn, obtained the information from inside employees at Polycom, Inc., Google, Inc., and Marvell Technology, Inc." Id. at *1.
In the course of developing jury instructions, Judge Jed Rakoff faced the question of "Whether in a criminal prosecution under the federal securities laws, the scope of an employee's duty to keep material non-public information confidential is defined by state or federal law?" Id.
In the course of answering that question, Rakoff made several interesting observations:
If it is simply a contractual duty, it seemingly would not support a fraud prosecution, since a breach of contract does not necessarily involve any misrepresentation. Cf. S.E.C. v. Cuban, 634 F.Supp.2d 713, 724–26 (N.D.Tex.2009) (holding that although contract may in certain circumstances give rise to misappropriation liability, the agreement “must contain more than a promise of confidentiality”), rev'd, 620 F.3d 551 (5th Cir.2010). Rather, the duty must be of the kind that requires the employee, if he breaches the duty, to disclose the breach—the failure to do so thereby constituting the misrepresentation that is an essential element of fraud.
I agree that a mere contractual duty is not enough to support an insider trading violation and, moreover, go further to specifically reject the Cuban court's suggestion that a contract can ever give rise to the requisite duty. See this blog post.
Back to Judge Rakoff:
... the initial question remains: what is the source of this duty? Defendant here argues that fiduciary and quasi-fiduciary duties are normally a matter of state law, and that the relevant state here is California, where the tippers and their employers were located.[FN3] ... But the Court agrees with the Government's alternate position, that the duty in question is imposed and defined by federal law.
To begin with, Dirks, and indeed all the Supreme Court cases dealing with insider trading, have implicitly assumed that the relevant fiduciary duty is a matter of federal common law, for they have described it and defined it without ever referencing state law. See Dirks, 463 U.S. 646, 103 S.Ct. 3255, 77 L.Ed.2d 911;Chiarella, 445 U.S. 222, 100 S.Ct. 1108, 63 L.Ed.2d 348; Carpenter, 484 U.S. 19, 108 S.Ct. 316, 98 L.Ed.2d 275; O'Hagan, 521 U.S. 642, 117 S.Ct. 2199, 138 L.Ed.2d 724; see also A.C. Pritchard, Justice Lewis F. Powell, Jr., and the Counterrevolution in the Federal Securities Laws, 52 Duke L.J. 841, 930–31 & nn. 540–41 (2003) (arguing, based on review of the notes of Justice Powell and interviews with his former clerks, that Justice Powell, the author of Dirks and Chiarella,saw Rule 10b–5 jurisprudence as a species of federal common law). Defendant, indeed, has failed to point to a single case where any federal court has expressly held that the duty was defined by state law. Cf. Cuban, 634 F.Supp.2d at 721 (noting SEC's argument that “no federal court has relied exclusively on state law to determine whether a duty sufficient to support misappropriation theory liability exists”).
FN3. Cf. Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L.Rev. 1189 (1995) (arguing that the prohibition against insider trading is best justified on a theory of protecting property rights in confidentiality, which should be determined with reference to state law). Still another possibility—though not advanced by either side here—is that since, under Dirks, the fiduciary duty is ultimately a duty to the shareholders, the relevant law is the law of the state of incorporation, which for two of the three companies here involved—Google and Polycom—is Delaware, see Google Inc. Annual Report (Form 10–K), at 1 (Jan. 26, 2012); Polycom, Inc. Annual Report (Form 10–K), at 1 (Feb. 2, 2012), and for Marvell Technology, is Bermuda. Marvell Technology Group Ltd. Annual Report (Form 10–K), at 1 (Mar. 27, 2012); see also Bainbridge, 52 Wash. & Lee L.Rev. at 1267 n. 320 (“Long-standing choice-of-law rules direct that questions of breaches of fiduciary duty by corporate officers and directors are governed by the law of the state of incorporation.” (quoting Restatement (Second) of Conflicts of Law § 309 (1969))).
Judge Rakoff is correct that insider trading is a species of federal common law, but nevertheless errs by not relying on state law. In the article to which he cites, I argued 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 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.