Whitman v. United States: Source of insider trading fiduciary relationship and my first SCOTUS brief

The Supreme Court is currently considering the cert petition in Whitman v. US:

(1) Whether, in a prosecution for insider trading under § 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j(b), the relevant inside information must have been a “significant factor” in the defendant's decision to buy or sell, or whether - as the court below held - mere “knowing possession” of inside information suffices for a criminal conviction; (2) whether, in a prosecution for insider trading under § 10(b) of the Securities Exchange Act, 15 U.S.C. § 78j(b), the “fiduciary duty” element must be proved under well-established principles of state law, or whether - as the court below held - courts may define and impose the applicable fiduciary duty as a matter of federal common law; and (3) whether exculpatory testimony given by a witness during a deposition in a closely related federal enforcement proceeding is admissible under Federal Rule of Evidence 804(b) in a subsequent criminal trial when the witness is unavailable, or whether - as the court below held - such testimony may be excluded merely because it was given in a civil rather than criminal proceeding.

With the aid of a talented team of lawyers from Hunton and Williams, led by Shawn Regan, I filed an amicus brief addressing the second issue, as Hunton & Williams announced:

Hunton & Williams today filed an amicus brief urging the US Supreme Court to grant certiorari in a case involving intersecting issues of federalism and insider trading law. The brief urges the Supreme Court to resolve a circuit split as to definition of the "fiduciary duty" element in a criminal prosecution for insider trading under §10(b) of the Securities Exchange Act. Shawn Patrick Regan is counsel of record, joined on the brief by Patrick Robson,Joseph Saltarelli, Michael Kruse and Joshua Paster. The brief was filed on behalf of Professor Stephen Bainbridge, the William D. Warren Distinguished Professor of Law at UCLA.

“We are pleased to have been called upon to prepare and submit this amicus brief on behalf of Professor Bainbridge, a preeminent scholar of corporate law and governance,” Regan said. “Where, as here, there is a split among the circuit courts implicating core Constitutional principles and making it difficult for analysts to determine in advance the line between lawful competitive research to advise investors and potential criminal charges, the conflict should be resolved.”

It's my first sole amicus brief, as opposed to those in which I was one of a bunch of signatories. As we summarized the argument:

This Petition presents, inter alia, the question of whether the “fiduciary duty” element of securities fraud is to be defined by existing state law or crafted ad hoc as a new area of federal common law. The Second Circuit’s approach—“implicitly assuming” a federal rule shall govern so as to achieve “uniformity”—is squarely contrary to core tenets of federalism and the precedents of this Court, which limit the circumstances in which federal courts may create a common law rule of decision. (See Part I, infra.) The Second Circuit’s approach also conflicts with the law of other circuits, some of which look to state law to define “fiduciary duty” and some of which suggest courts may look to state law to develop federal common law. When, as here, the stakes involve not only livelihoods but also potential loss of liberty turning on unpredictable and inconsistent approaches (and outcomes), the conflict should be resolved. (See Part II, infra.) Finally, because the basis for the federal insider trading prohibition is the protection of property interests in corporate information and because this Court’s precedents have consistently recognized the preeminence of states with respect to corporation law and property rights, absent action by policymaking branches of government, the fiduciary duty element of insider trading should be defined under state law, not by virtue of emergent notions of federal common law. (See Part III, infra.) 

The brief builds on my article Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189 (1995).

The US filed an opposition brief. It's not very good on my issue. If I could file a reply brief, I would argue that: The SG argues (22) that "An insider’s duty not to trade on material non-public information or disclose such information to others for trading purposes is a matter of federal law." But what the SG fails to acknowledge is that, as a former SEC's solicitor once observed, ‘[m]odern development of the law of insider trading is a classic example of common law in the federal courts. No statute defines insider trading; no statute expressly makes it unlawful.’ Gonson & Butler, In Wake of ‘Dirks,’ Courts Debate Definition of ‘Insider,’ Legal Times, Apr. 2, 1984, at 16, col. 1. It remains the case today that no statute defines insider trading: 

Other nations have proposed and, in some cases, enacted laws of general applicability against insider trading, see, e.g., European Commission, Proposal for a Regulation of the European Parliament and of the Council on Insider Dealing and Market Manipulation (Market Abuse), at 13, 30–33 COM (2011) 651 final (Oct. 20, 2011) (clarifying European Union (“EU”) regulations on insider trading and proposing EU directive for all EU countries to add criminal sanctions for insider trading in addition to existing administrative sanctions). Congress, however, has never done so, partly because the SEC has generally opposed such proposals on the ground that that any statutory definition of illegal insider trading would inevitably create “loopholes” that would be eventually utilized in much the same way that the tax code generates tax “dodges” that are frequently successful. However, as this very case demonstrates, the judge-made law of insider trading, however flexible, can create potential gaps in coverage that are the functional equivalent of legislative loopholes.

United States v. Whitman, 904 F. Supp. 2d 363, 367 (S.D.N.Y. 2012), as corrected (Nov. 19, 2012), aff'd, 555 F. App'x 98 (2d Cir. 2014).

 

As a result, we are dealing here with a species of federal common law. See, e.g., Steginsky v. Xcelera Inc., 741 F.3d 365, 367 (2d Cir. 2014) ("We hold that the duty of corporate insiders to either disclose material nonpublic information or abstain from trading is defined by federal common law ....").

 

"Once the problem is seen as one to be solved by application of federal common law, a choice of law question arises. Federal common law often is influenced by, and not infrequently incorporates, state law." Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1207 (1995). So there is nothing per se impermissible about looking to state law here. In fact, contrary to the SG's argument, state law is the correct source of the duty for the reasons I lay out at great length at id. at 1212-45. As I demonstrate therein, "insider trading significantly implicates none of the principal purposes of the federal securities laws and, therefore, it cannot be said that important federal policies would be frustrated if state law were incorporated into the prohibition." Id. at 1245.

 

The SG argues that "Petitioner’s contrary approach, which would make the application of the insider-trading laws wholly dependent on “idiosyncratic differences in state law,” “would thwart the goal of promoting national uniformity in securities markets.” (24-25) But the Supreme Court has long recognized that "So long as each State regulates voting rights only in the corporations it has created, each corporation will be subject to the law of only one State. No principle of corporation law and practice is more firmly established than a State's authority to regulate domestic corporations, including the authority to define the voting rights of shareholders." CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 89, 107 S. Ct. 1637, 1649, 95 L. Ed. 2d 67 (1987). The same would be true of insider trading. 

 

In addition, as the Supreme Court has also recognized, those markets with which the SG is concerned are markets in which shares of entities created by state--not federal law--are bought and sold. 

Large corporations that are listed on national exchanges, or even regional exchanges, will have shareholders in many States and shares that are traded frequently. The markets that facilitate this national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that a corporation—except in the rarest situations—is organized under, and governed by, the law of a single jurisdiction, traditionally the corporate law of the State of its incorporation.

CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 90, 107 S. Ct. 1637, 1650, 95 L. Ed. 2d 67 (1987).

 

The SG further argues that "A federal standard is also the only approach consistent with the insider-trading prohibition’s role in protecting investors on national securities markets." (25) As I have pointed out, however:

 

The purposes of the Securities Exchange Act generally and Section 10(b) in particular are usually said to be the protection of investors and the maintenance of public confidence in the securities markets through the imposition of disclosure requirements and prohibitions of fraud.207 If so, the insider trading prohibition seems quite out of place in the federal securities laws. Neither policy justifies a ban on insider trading, nor can either policy explain the state of the law.

Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1238 (1995). I go on to explain at length why that is the case.

 

The SG further agues that "a rule that made Section 10(b)’s prohibition on insider trading entirely dependent on state law would also run afoul of this Court’s admonition that 'in the absence of a plain indication of an intent to incorporate diverse state laws into a federal criminal statute, the meaning of the federal statute should not be dependent on state law.'" (25) But that's an absurd argument: 

Careful examination of the legislative history demonstrates that regulating insider trading was not one of the original purposes of the Exchange Act.168 Neither Section 10(b) nor Rule 10b-5 explicitly regulates insider trading or prohibits nondisclosure of inside information in insider trades. Instead, Congress addressed insider trading in Section 16(b), which permits the issuer of affected securities to recover insider short-swing profits.169 Section 16(b) imposes quite limited restrictions on insider trading. It does not reach transactions occurring more than six months apart, nor does it apply to persons other than those named in the statute or to transactions in securities not registered under Section 12.170 Given that Congress could have struck at insider trading both more directly and forcefully, and given that Congress chose not to do so,171 there is no statutory authority for the creation of a more sweeping *1230 prohibition under Section 10(b).

 

To be sure, Section 10(b) is often described as a “catchall” intended to capture various types of securities fraud not expressly covered by more specific provisions of the Exchange Act.172 What the SEC catches under Section 10(b), however, must not only be fraud, but also within the scope of the authority delegated to it by Congress.173 Nothing in the legislative history suggests that Congress intended Section 10(b) to create a sweeping prohibition of insider trading.174 To the contrary, Section 10(b) received minimal attention during the hearings on the 1934 Act and was apparently seen simply as a grant of authority to the SEC to prohibit manipulative devices not covered by Section 9.175

 

Indeed, if Congress intended in 1934 that the SEC use Section 10(b) to craft a sweeping prohibition on insider trading, the Commission was quite dilatory in doing so. Section 10(b) is not self-executing. It merely proscribes such fraudulent or manipulative devices as the SEC may prohibit by rule. Rule 10b-5, the foundation on which the modern insider trading prohibition rests, was not promulgated until 1942. Nor did the Commission *1231 begin using Rule 10b-5 to regulate insider trading on stock exchanges until the Cady, Roberts decision in 1961.176 Even in Cady, Roberts's wake there were those who thought it did not presage general application of Rule 10b-5 to insider trading.177 As we now know, that short-lived expectation died with SEC v. Texas Gulf Sulphur Co.178 The point remains, however, that the federal insider trading prohibition is a relatively recent administrative and judicial creation lacking any significant statutory basis: “In regulating insider trading under rule 10b-5 the lower federal courts and the SEC have been operating without benefit of support from the legislative history of the 1934 Act or from the language of section 10(b). In plainer words, they have exceeded their authority.”179

Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1229-31 (1995). This discussion is also relevant to the SG's claim that "a 'significant purpose of the Exchange Act was to eliminate the idea that use of inside information for personal advantage was a normal emolument of corporate office.'"  (26)

 

It is true that I have written that, as the SG points out, "the state-law inquiry that petitioner advocates 'is essentially unheard of in federal insider trading jurisprudence.'" But that's in the context of arguing that courts have been getting it wrong!