If this SEC explainer propaganda piece were an essay exam, it'd get a C- (and that's taking into account rampant grade inflation). It's replete with errors.
Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.
Looks straightforward right? But it carefully obfuscates the distinction between debt and equity securities. Granted, one court has held that insider trading in convertible debentures violates Rule 10b–5,[1] but this case is distinguishable from those involving nonconvertible debt securities. Because they are convertible into common stock at the option of the holder, both the market price and interest rate paid on such instruments are affected by the market price of the underlying common stock. Federal securities law recognizes the close relationship of convertibles to common stock by defining the former as equity securities.[2] As such, the status of insider trading in nonconvertible debt remains unresolved. A strong argument can be made, however, that the prohibition should not extend to trading in nonconvertible debt.
The problem is what even the SEC admits is the necessary breach of fiduciary duty. In most states, neither the corporation nor its officers and directors have fiduciary duties to debtholders. Instead, debtholders’ rights are limited to the express terms of the contract and an implied covenant of good faith.[3] Cases in a few jurisdictions purport to recognize fiduciary duties running to holders of debt securities, but the duties imposed in these cases are more accurately characterized as the same implied covenant of good faith found in most other jurisdictions.[4]
The distinction between this implied covenant and a fiduciary duty is an important one for our purposes. An implied covenant of good faith arises from the express terms of a contract and is used to fulfill the parties’ mutual intent. In contrast, a fiduciary duty has little to do with the parties’ intent. Instead, courts use fiduciary duties to protect the interests of the duty’s beneficiary. Accordingly, a fiduciary duty requires the party subject to the duty to put the interests of the beneficiary of the duty ahead of his own, while an implied duty of good faith merely requires both parties to respect their bargain.
A two-step move thus will be required if courts are to impose liability under the disclose or abstain rule on those who inside trade in debt securities. First, the clear holdings of Chiarella and Dirks must be set aside so that the requisite relationship can be expanded to include purely contractual arrangements and the requisite duty expanded to include mere contractual covenants. Second, the implied covenant of good faith must be interpreted as barring self-dealing in nonpublic information by corporate agents. In that regard, consider the leading Met Life decision, which indicates that a covenant of good faith will be implied only when necessary to ensure that neither side deprives the other side of the fruits of the agreement.[5] The fruits of the agreement are limited to regular payment of interest and ultimate repayment of principal. Because insider trading rarely affects either of these fruits, it does not violate the covenant of good faith.
Insofar as public policy is concerned, the argument for creating fiduciary duties—federal or state—running to bondholders is extremely weak. Bond issuances are repeat transactions. Where parties expect to have repeated transactions, the risk of self-dealing by one party is constrained by the threat that the other party will punish the cheating party in future transactions. The issuer’s management has a strong self-interest in the corporation’s cost of capital (i.e., avoiding takeovers, maximizing personal wealth, avoiding firm failure). Management therefore will be slow to do anything that unnecessarily increases their cost of capital. But if they abuse their current bondholders, that will come back to haunt them the next time they want to use the bond market to raise capital. If investors care about protection from insider trading, management therefore will provide it by contract.
In addition, negotiations between the issuer and the underwriters that market the debt securities will produce efficient levels of protection. Because the bond market is dominated by a small number of institutional investors, the relationship between underwriters and bondholders is another example of the repeat transaction phenomenon. Underwriters will not sully their reputations with bondholders for the sake of one issuer. Moreover, in a firm commitment underwriting, the underwriters buy the securities from the issuer. If the indenture does not provide adequate levels of protection, the underwriters will be unable to sell the bonds. Again, if debtholders care about insider trading, the contract will prohibit it.
The disclose or abstain theory thus should not prohibit insiders from trading in debt securities on the basis of material nonpublic information. Having said that, however, various alternative theories of liability may come into play in this context. In particular, the misappropriation theory might apply. Suppose a corporate officer traded in the firm’s debt securities using material nonpublic information belonging to the corporation. As the argument would go, even though the officer owes no fiduciary duties to the bondholders, he owes fiduciary duties to the corporation. The violation of those duties might suffice for liability under the misappropriation theory. The misappropriation theory clearly would not reach trading by an issuer in its own debt securities.[6]
[1] In re Worlds of Wonder Sec. Litig., 1990 WL 260675 (N.D.Cal. 1990).
[2] 17 C.F.R. § 230.405 (“The term equity security means any stock or similar security . . . or any security convertible, with or without consideration into such a security. . . .”).
[3] See, e.g., Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504 (S.D.N.Y.1989); Katz v. Oak Indus., 508 A.2d 873 (Del.Ch.1986).
[4] See, e.g., Broad v. Rockwell Int’l Corp., 642 F.2d 929 (5th Cir.), cert. denied, 454 U.S. 965 (1981); Gardner & Florence Call Cowles Found. v. Empire, Inc., 589 F. Supp. 669 (S.D.N.Y.1984), vacated, 754 F.2d 478 (2d Cir.1985); Fox v. MGM Grand Hotels, Inc., 187 Cal.Rptr. 141 (Cal.Ct.App.1982).
[5] Metropolitan Life Ins. Co. v. RJR Nabisco, Inc., 716 F. Supp. 1504, 1517 (S.D.N.Y.1989).
[6] See Salovaara v. Jackson Nat’l Life Ins., 66 F. Supp. 2d 593, 601 (D.N.J. 1999) (declining to “to extend O’Hagan to a civil case involving a transaction [by an issuer] for high yield debt securities”), aff’d on other grounds, 246 F. 3d 289 (3d Cir. 2001).
Back to the SEC explainer:
Examples of insider trading cases that have been brought by the SEC are cases against: ... Friends, business associates, family members, and other "tippees" of such officers, directors, and employees, who traded the securities after receiving such information ....
What the SEC fails to explain is that the issue of when friends can be held liable in tipping cases is right now before the US Supreme Court. The Supreme Court has granted cert in Salman v. United States, posing the following question for argument:
Whether the personal benefit to the insider that is necessary to establish insider trading under Dirks v. SEC requires proof of “an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or similarly valuable nature,” as the Second Circuit held in United States v. Newman, or whether it is enough that the insider and the tippee shared a close family relationship, as the Ninth Circuit held in this case.
The WSJ reports:
In the New York case, U.S. v. Newman, an appeals panel said prosecutors had to prove the insider disclosed the information for a personal benefit that included something valuable being exchanged. The decision upended multiple convictions and top prosecutors complained that the ruling could make it legal for traders to obtain and use confidential information from friends.
Mr. Salman, citing Newman, argued that evidence of a family relationship between the tipper and the tip recipient wasn’t enough to demonstrate that the insider received a personal benefit.
The San Francisco-based Ninth U.S. Circuit Court of Appeals rejected that argument in a ruling last July. The Supreme Court will review the decision and could hear oral arguments as soon as April. Mr. Salman has been serving his prison sentence since August 2014.
There are excellent doctrinal and policy reasons to think that the SEC's consistent pattern of overreaching in these cases will get slapped down by the court. See my earlier posts:
US v Newman: A big win for coherence and fairness in insider
Alison Frankel on our brief in the US v. Newman insider ...
Evaluating the Government's cert petition in US v. Newman ...
Back to the SEC explainer:
... insider trading undermines investor confidence in the fairness and integrity of the securities market ....
Piffle. Insider trading is said to harm investors in two principal ways. Some contend that the investor’s trades are made at the “wrong price.” A more sophisticated theory posits that the investor is induced to make a bad purchase or sale. Neither argument proves convincing on close examination.
An investor who trades in a security contemporaneously with insiders having access to material nonpublic information likely will allege injury in that he sold at the wrong price; i.e., a price that does not reflect the undisclosed information. If a firm’s stock currently sells at $10 per share, but after disclosure of the new information will sell at $15, a shareholder who sells at the current price thus will claim a $5 loss.
The investor’s claim, however, is fundamentally flawed. It is purely fortuitous that an insider was on the other side of the transaction. The gain corresponding to the shareholder’s loss is reaped not just by inside traders, but by all contemporaneous purchasers whether they had access to the undisclosed information or not.
To be sure, the investor might not have sold if he had had the same information as the insider, but even so the rules governing insider trading are not the source of his problem. On an impersonal trading market, neither party knows the identity of the person with whom he is trading. Thus, the seller has made an independent decision to sell without knowing that the insider is buying; if the insider were not buying, the seller would still sell. It is thus the nondisclosure that causes the harm, rather than the mere fact of trading.
The information asymmetry between insiders and public investors arises out of the mandatory disclosure rules allowing firms to keep some information confidential even if it is material to investor decision-making. Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers in this situation. Irrespective of whether insiders are permitted to inside trade or not, the investor will not have the same access to information as the insider. It makes little sense to claim that the shareholder is injured when his shares are bought by an insider, but not when they are bought by an outsider without access to information. To the extent the selling shareholder is injured, his injury thus is correctly attributed to the rules allowing corporate nondisclosure of material information, not to insider trading.
Arguably, for example, the TGS shareholders who sold from November through April were not made any worse off by the insider trading that occurred during that period. Most, if not all, of these people sold for a series of random reasons unrelated to the trading activities of insiders. The only seller we should worry about is the one that consciously thought, “I’m going to sell because this worthless company never finds any ore.” Even if such an investor existed, however, we have no feasible way of identifying him. Ex post, of course, all the sellers will pretend this was why they sold. If we believe Manne’s argument that insider trading is an efficient means of transmitting information to the market, moreover, selling TGS shareholders actually were better off by virtue of the insider trading. They sold at a price higher than their shares would have commanded but for the insider trading activity that led to higher prices. In short, insider trading has no “victims.” What to do about the “offenders” is a distinct question analytically.
A more sophisticated argument is that the price effects of insider trading induce shareholders to make poorly advised transactions. It is doubtful whether insider trading produces the sort of price effects necessary to induce shareholders to trade, however. While derivatively informed trading can affect price, it functions slowly and sporadically. Given the inefficiency of derivatively informed trading, price or volume changes resulting from insider trading will only rarely be of sufficient magnitude to induce investors to trade.
Assuming for the sake of argument that insider trading produces noticeable price effects, however, and further assuming that some investors are misled by those effects, the inducement argument is further flawed because many transactions would have taken place regardless of the price changes resulting from insider trading. Investors who would have traded irrespective of the presence of insiders in the market benefit from insider trading because they transacted at a price closer to the correct price; i.e., the price that would prevail if the information were disclosed. In any case, it is hard to tell how the inducement argument plays out when investors are examined as a class. For any given number who decide to sell because of a price rise, for example, another group of investors may decide to defer a planned sale in anticipation of further increases.
An argument closely related to the investor injury issue is the claim that insider trading undermines investor confidence in the securities market. In the absence of a credible investor injury story, it is difficult to see why insider trading should undermine investor confidence in the integrity of the securities markets.
There is no denying that many investors are angered by insider trading. A Business Week poll, for example, found that 52% of respondents wanted insider trading to remain unlawful. In order to determine whether investor anger over insider trading undermines their confidence in the markets, however, one must first identify the source of that anger. A Harris poll found that 55% of the respondents said they would inside trade if given the opportunity. Of those who said they would not trade, 34% said they would not do so only because they would be afraid the tip was incorrect. Only 35% said they would refrain from trading because insider trading is wrong. Here lies one of the paradoxes of insider trading. Most people want insider trading to remain illegal, but most people (apparently including at least some of the former) are willing to participate if given the chance to do so on the basis of accurate information. This paradox is central to evaluating arguments based on confidence in the market. Investors that are willing to inside trade if given the opportunity obviously have no confidence in the integrity of the market in the first instance. Any anger they feel over insider trading therefore has nothing to do with a loss of confidence in the integrity of the market, but instead arises principally from envy of the insider’s greater access to information.
Back to the explainer:
The SEC adopted new Rules 10b5-1 and 10b5-2 to resolve two insider trading issues where the courts have disagreed.
What the SEC should have said was "where the courts have disagreed with" the SEC's position and so we got all snippy and decided to adopt bad rules to try to overturn those cases.
The SEC long has argued that trading while in knowing possession of material nonpublic information satisfies Rule 10b–5’s scienter requirement.[1] (Indeed, it does so yet again in the very first excerpt from the explainer quoted above.) To evaluate that argument, let’s explore a hypothetical based on the facts of Diamond v. Oreamuno.[2] Insiders of MAI sold their holdings of firm stock while in possession of bad news that was both material and nonpublic. As such, they avoided significant losses that would have resulted from the drop in MAI’s stock price that occurred when the bad news was made public. Suppose one of the defendants claimed the bad news had not caused his sale; instead, he argues that he would have sold his MAI stock regardless of whether he thought the stock would be going up or down in the future. Perhaps he needed money to pay catastrophic medical bills, for example. Alternatively, perhaps he had a pattern of disposing of MAI stock at regular intervals. Many senior corporate executives receive a substantial portion of their compensation in the form of stock grants or options, which they periodically liquidate to realize their cash value. In either case, our hypothetical defendant would have traded while in possession of material nonpublic information, but not on the basis of such information. Can he be held liable?
In U.S. v. Teicher,[3] the Second Circuit answered that question affirmatively, albeit in a passage that appears to be dictum. An attorney tipped stock market speculators about transactions involving clients of his firm. On appeal, defendants objected to a jury instruction pursuant to which they could be found guilty of securities fraud based upon the mere possession of fraudulently obtained material nonpublic information without regard to whether that information was the actual cause of their transactions. The Second Circuit held that any error in the instruction was harmless, but went on to opine in favor of a knowing possession test. The court interpreted Chiarella as comporting with “the oft-quoted maxim that one with a fiduciary or similar duty to hold material nonpublic information in confidence must either ‘disclose or abstain’ with regard to trading.”[4] The court also favored the possession standard because it “recognizes that one who trades while knowingly possessing material inside information has an informational advantage over other traders.”[5]
In S.E.C. v. Adler,[6] the Eleventh Circuit rejected Teicher in favor of a use standard. Under Adler, “when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade—i.e., that the information was not used.”[7] Although defendant Pegram apparently possessed material nonpublic information at the time he traded, he introduced strong evidence that he had a plan to sell company stock and that that plan predated his acquisition of the information in question. If proven at trial, evidence of such a pre-existing plan would rebut the inference of use and justify an acquittal on grounds that he lacked the requisite scienter. Similarly, the court opined, evidence that the allegedly illegal trades were consistent with trading also would rebut the inference of use.
The choice between Adler and Teicher is difficult. On the one hand, in adopting the Insider Trading Sanctions Act of 1984, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information. In addition, a use standard significantly complicates the government’s burden in insider trading cases, because motivation is always harder to establish than possession, although the inference of use permitted by Adler substantially alleviates this concern.
On the other hand, a number of decisions have acknowledged that a pre-existing plan and/or prior trading pattern can be introduced as an affirmative defense in insider trading cases, as such evidence tends to disprove that defendant acted with the requisite scienter. In contrast, Teicher’s mere possession test is inconsistent with Rule 10b–5’s scienter requirement, which requires fraudulent intent (or, at least, recklessness). In addition, dictum in each of the Supreme Court’s insider trading opinions also appears to endorse the use standard. Indeed, contrary to the Teicher court’s claim, Chiarella simply did not address the distinction between a knowing possession and a use standard. Finally, the Teicher court’s reliance on the trader’s informational advantage is inconsistent with Chiarella’s rejection of the equal access test.
In 2000, the SEC tried to resolve this issue by adopting Rule 10b5–1, which states that Rule 10b–5’s prohibition of insider trading is violated whenever someone trades “on the basis of” material nonpublic information.[8] Because one is deemed, subject to certain affirmative defenses, to have traded “on the basis of” material nonpublic information if one was aware of such information at the time of the trade, Rule 10b5–1 formally rejects the Adler position.[9] In practice, however, the difference between Adler and Rule 10b5–1 may prove insignificant. On the one hand, Adler created a presumption of use when the insider was aware of material nonpublic information. Conversely, as noted, Rule 10b5–1 provides affirmative defenses for insiders who trade pursuant to a pre-existing plan, contract, or instructions. As a result, the two approaches should lead to comparable outcomes in many cases.
Even though Rule10b5–1 thus can be squared with Adler, the SEC clearly intended the Rule to resurrect the mere possession test to the fullest extent possible. Did the SEC have authority to do so in the face of contrary judicial holdings? There is some evidence that supports the SEC’s position. In adopting the Insider Trading Sanctions Act of 1984, for example, Congress imposed treble money civil fines on those who illegally trade “while in possession” of material nonpublic information.
The bulk of the evidence, however, raises serious doubts as to the validity of Rule 10b5–1. The SEC cannot adopt rules that go beyond the scope of the statutes authorizing them.[10] The Supreme Court has consistently held that Section 10(b) of the Exchange Act, which provides the authority under which Rule 10b–5 was adopted, prohibits only fraud and manipulation.[11] In turn, as we have seen, fraud requires proof that the defendant intended to deceive (i.e., scienter). Indeed, the Supreme Court explained in Dirks that “[i]t is not enough that an insider’s conduct results in harm to investors; rather a violation [of Rule 10b–5] may be found only where there is ‘intentional or willful conduct designed to deceive or defraud investors.’ ”[12] Yet, as the Ninth Circuit pointed out in Smith, “a knowing-possession standard would . . . go a long way toward making insider trading a strict liability crime.”[13] Second, as the Ninth Circuit also noted, “the Supreme Court has consistently suggested, albeit in dictum, that Rule 10b–5 requires that the government prove causation in insider trading prosecutions.”[14] In other words, the government must prove that the defendant used the inside information in making the relevant trading decisions. Rule 10b5–1’s failure to impose such a requirement on the government thus leaves it vulnerable to challenge.
[1] See SEC v. MacDonald, 699 F.2d 47, 50 (1st Cir. 1983) (holding that the scienter “requirement is satisfied if at the time defendant purchased stock he had actual knowledge of undisclosed material information; knew it was undisclosed, and knew it was material, i.e., that a reasonable investor would consider the information important in making an investment decision”).
[2] 248 N.E.2d 910 (N.Y. 1969).
[3] 987 F.2d 112 (2d Cir.1993).
[5] Id.
[6] 137 F.3d 1325 (11th Cir. 1998). The Ninth Circuit subsequently agreed with Adler that proof of use, not mere possession, is required. The Ninth Circuit further held that in criminal cases no presumption of use should be drawn from the fact of possession—the government must affirmatively proof use of nonpublic information. U.S. v. Smith, 155 F.3d 1051 (9th Cir. 1998).
[8] Exchange Act Rel. No. 43,154 (Aug. 15, 2000).
[9] 17 C.F.R. § 240.10b5–1(a).
[10] See Business Roundtable v. SEC, 905 F.2d 406, 408 (D.C. Cir. 1990).
[11] See, e.g., Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 473 (1977) (“The language of § 10(b) gives no indication that Congress meant to prohibit any conduct not involving manipulation or deception.”).
[12] Dirks v. SEC, 463 U.S. at 646, 663 n. 23 (1983).
[13] U.S. v. Smith, 155 F.3d 1051, 1068 n.25 (9th Cir.1998).
Returning to the explainer one last time, the SEC's discussion of Rule10b5-2 is even more egregious as it fails to acknowledge the very considerable arguments that the Rule is hopelessly invalid.
Rule 10b5–2 provides “a nonexclusive list of three situations in which a person has a duty of trust or confidence for purposes of the ‘misappropriation’ theory. . . .” First, such a duty exists whenever someone agrees to maintain information in confidence. Second, such a duty exists between two people who have a pattern or practice of sharing confidences such that the recipient of the information knows or reasonably should know that the speaker expects the recipient to maintain the information’s confidentiality. Third, such a duty exists when someone receives or obtains material nonpublic information from a spouse, parent, child, or sibling. On the facts of the famous Chestman case,[1] accordingly, Rule 10b5–2 would result in the imposition of liability because Keith received the information from his spouse who, in turn, had received it from her parent.
There is, however, considerable doubt as to the validity of the Rule. First, while it is true that the court in Chestman court observed that the requisite relationship could be satisfied either by a fiduciary relationship or a “similar relationship of trust and confidence,” the court recognized that so expanding the class of relationships giving rise to liability could lead to results-oriented applications.[2] If a court wishes to impose liability, it need simply conclude that the relationship in question involves trust and confidence, even though the relationship bears no resemblance to those in which fiduciary-like duties are normally imposed. Accordingly, courts should be loath to use this phraseology as a mechanism for expanding the scope of liability. The Chestman court was sensitive to this possibility, holding that a relationship of trust and confidence must be “the functional equivalent of a fiduciary relationship” before liability can be imposed.[3] Chestman also held that, at least as to criminal cases, it would not expand the class of relationships from which liability might arise to encompass those outside the traditional core of fiduciary obligation.[4] Rule 10b5–2, however, goes far beyond relationships that are the functional equivalent of fiduciary relationships by capturing, for example, purely contractual arrangements. Nevertheless, at least one court has upheld the Rule as a valid exercise of the SEC’s rulemaking authority.[5] In my view, however, it did so erroneously.
[1] US v. Chestman, 947 F.2d 551 (2d Cir.1991), cert. denied 503 U.S. 1004 (1992). Ira Waldbaum was the president and controlling shareholder of Waldbaum, Inc., a publicly-traded supermarket chain. Ira decided to sell Waldbaum to A & P at $50 per share, a 100% premium over the prevailing market price. Ira informed his sister Shirley of the forthcoming transaction. Shirley told her daughter Susan Loeb, who in turn told her husband Keith Loeb. Each person in the chain told the next to keep the information confidential. Keith passed an edited version of the information to his stockbroker, one Robert Chestman, who then bought Waldbaum stock for his own account and the accounts of other clients. Chestman was accused of violating Rule 10b–5. According to the Government’s theory of the case, Keith Loeb owed fiduciary duties to his wife Susan, which he violated by trading and tipping Chestman.
The Second Circuit held that in the absence of any evidence that Keith regularly participated in confidential business discussions, the familial relationship standing alone did not create a fiduciary relationship between Keith and Susan or any members of her family. See id. at 568 (holding that “marriage does not, without more, create a fiduciary relationship”). Likewise, unilaterally entrusting someone with confidential information does not by itself create a fiduciary relationship, even if the disclosure is accompanied by an admonition such as “don’t tell,” which Susan’s statements to Keith included. See id. at 567 (holding that “a fiduciary duty cannot be imposed unilaterally by entrusting a person with confidential information”). Repeated disclosures of business secrets, however, could substitute for a factual finding of dependence and influence and, accordingly, sustain a finding that a fiduciary relationship existed in the case at bar. Id. at 569. On the facts of the case at bar, however, there was no evidence of such repeated disclosures as between Keith and Susan or her family.
Since Keith had no fiduciary duty, his use of the information for personal gain did not violate Rule 10b–5.
[2] Id. at 568.
[3] Id.
[5] U.S. v. Corbin, 729 F. Supp.2d (S.D.N.Y.2011).
My books on insider trading:
