From The Corporate Counsel:
While Congressional efforts at financial regulatory reform may end up languishing this year, this McGuire Woods blog speculates that 2017 may be the year that finally sees Congress act to sort out the mess that is the law of insider trading:
House Judiciary Committee Chairman Bob Goodlatte announced the committee’s agenda for the 115th Congress. Rep. Goodlatte observed that he and Ranking Member John Conyers were “committed to passing bipartisan criminal justice reform.” Rep. Goodlatte considered it “imperative [to] continually examine federal criminal laws” in conjunction with this effort.
Although past Congressional efforts to codify insider trading laws have failed, these remarks suggest that there may be an opportunity to try again. And some observers are optimistic that a reform bill could pass this year.
What might a statute addressing insider trading look like? The blog points to recent comments from Judge Jed Rakoff as providing a possible model:
Judge Rakoff spoke approvingly of the EU’s approach that focuses on equal access to market information rather than U.S. law’s focus on the insider’s fiduciary duty. Specifically, the EU prohibits anyone from trading on information “that person knows, or ought to have known, [is] insider information.” Thus, the focus is on the information itself, rather than the source.
Such an approach would eliminate disputes over the “personal benefit” test. It would also reverse Newman’s requirement that the tippee know of the tipper’s benefit. While the question of whether a trader “should have known” a tip to be insider information might be problematic, the insider trading statute – like other federal statutes – could define knowledge to include deliberate indifference or reckless disregard.
A clear and uniform federal insider trading standard would benefit everyone – prosecutors, traders & the markets.
Update: Keith Bishop notes that California has enacted an insider trading statute that, in contrast to federal law, actually defines what constitutes unlawful insider trading. Check out Keith’s blog on the statute.
In Chiarella and Dirks, the Supreme Court rejected equal access for very good reasons, which I detailed in my paper Regulating Insider Trading in the Post-Fiduciary Duty Era: Equal Access or Property Rights? (May 8, 2012). UCLA School of Law, Law-Econ Research Paper No. 12-08. Available at SSRN: https://ssrn.com/abstract=2054814:
Because neither the text nor the legislative history of Exchange Act § 10(b) or Rule 10b-5 defines insider trading—or even expressly proscribes it—it was left to the courts to develop not just the relevant legal rules but also the very justification for prohibiting insider trading. In SEC v. Texas Gulf Sulphur Co,[1] the Second Circuit held that an insider in possession of material nonpublic information must either disclose such information before trading or abstain from trading until the information becomes public. Texas Gulf Sulphur thus brought insider trading into the domain of securities law and, accordingly, within the SEC’s regulatory jurisdiction.
There was, however, nothing inevitable about that outcome. State corporate law had regulated insider trading for decades before Texas Gulf Sulphur was decided. Well-established state precedents treated the problem as one implicating not concepts of deceit or manipulation, but rather the fiduciary duties of corporate officers and directors.[2] Accordingly, the Second Circuit could have held that insider trading simply was not within Rule 10b-5’s regulatory purview.
In order to link insider trading to the goals of the federal securities laws, the Second Circuit claimed Congress intended those laws to ensure that “all investors trading on impersonal exchanges have relatively equal access to material information”[3] and “be subject to identical market risks.”[4] As a rationale for regulating insider trading, equality of access has some appeal. Disclosure, after all, is a basic principle of securities regulation. Equal access also addresses the purported unfairness inherent when insiders trade with less well-informed outsiders.
The TGS court cited no legislative history or statutory text supporting the equal access principle, however, relying instead on one SEC administrative proceeding. As Michael Dooley argued, moreover, “insider trading in no way resembles deceit. No representation is made, nor is there any reliance, change of position, or causal connection between the defendant's act and the plaintiff's losses.”[5] Equal access thus was not an inherent feature of the securities laws scheme as contemplated by Congress but rather simply the product of judicial fiat.
Equal access also implied a prohibition that swept far too broadly. In Chiarella, for example, Justice Powell noted that a broad equal access rule might “prohibit a tender offeror's purchases of target corporation stock before public announcement of the offer,” a step Congress clearly had declined to take when it adopted the Williams Act to regulate tender offers.[6] In Dirks, Justice Powell further explained that such a broadly policy basis for regulating insider trading implied a ban that “could have an inhibiting influence on the role of market analysts, which the SEC itself recognizes is necessary to the preservation of a healthy market.”[7]
It is commonplace for analysts to “ferret out and analyze information,” and this often is done by meeting with and questioning corporate officers and others who are insiders. And information that the analysts obtain normally may be the basis for judgments as to the market worth of a corporation's securities. The analyst's judgment in this respect is made available in market letters or otherwise to clients of the firm. It is the nature of this type of information, and indeed of the markets themselves, that such information cannot be made simultaneously available to all of the corporation's stockholders or the public generally.[8]
It was in order to avoid chilling such legitimate activity that Powell sought out a policy rationale that would sweep far less broadly. He found it in the principle that the duty to disclose or abstain “arises from a specific relationship between two parties.”[9] Accordingly, “there can be no duty to disclose where the person who has traded on inside information ‘was not [the corporation's] agent, ... was not a fiduciary, [or] was not a person in whom the sellers [of the securities] had placed their trust and confidence.’”[10]
Consider, for example, a hypothetical based on the facts of Texas Gulf Sulphur, drawn from my book :Insider Trading Law and Policy
Suppose a representative of Texas Gulf Sulphur had approached a landowner in the Timmons area to negotiate purchasing the mineral rights to the land. Texas Gulf Sulphur’s agent does not disclose the ore strike, but the landowner turns out to be pretty smart. She knows Texas Gulf Sulphur has been drilling in the area and has heard rumors that it has been buying up a lot of mineral rights. She puts two and two together, reaches the obvious conclusion, and buys some Texas Gulf Sulphur stock. Under a literal reading of Texas Gulf Sulphur, has our landowner committed illegal insider trading?
The surprising answer is “probably.” The Texas Gulf Sulphur court stated that the insider trading prohibition applies to “anyone in possession of material inside information,” because Congress intended § 10(b) to assure that “all investors trading on impersonal exchanges have relatively equal access to material information.”[1] The court further stated that the prohibition applies to anyone who has “access, directly or indirectly” to confidential information (here is the sticking point) if he or she knows that the information is unavailable to the investing public. The only issue thus perhaps would be a factual one turning on the landowner’s state of mind; namely, did she know she was dealing with confidential information. If so, the equal access policy would seem to justify imposing a duty on her. Indeed, as the Second Circuit explained in a later case, Texas Gulf Sulphur established the proposition that “[a]nyone … who regularly receives material nonpublic information may not use that information to trade in securities without incurring an affirmative duty to disclose,” whether he or she is a “corporate insider or not.”[2] Only the qualifier “regularly” would exempt our farmer.
In effect, Texas Gulf Sulphur thus created “a general duty between all participants in market transactions to forgo actions based on material non-public information.”[3]
And so would the bill proposed by Judge Rakoff. And that's just stupid.
[1] 401 F.2d 833 (2d Cir.), cert. denied, 394 U.S. 976 (1968).
[2] Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1218-27 (1995).
[3] Texas Gulf Sulphur, 401 F.2d at 847.
[4] Id. at 852.
[5] Michael P. Dooley, Enforcement of Insider Trading Restrictions, 66 Va. L. Rev. 1, 59 (1980).
[6] Chiarella, 445 U.S. at 233.
[7] Dirks, 463 U.S. at 658.
[8] Id. at 658-59 (citations and foonotes omitted).
[9] Chiarella, 445 U.S. at 233.
[10] Dirks, 463 U.S. at 654 (quoting Chiarella, 445 U.S. at 232).
[1] SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 847 (2d Cir.), cert. denied, 394 U.S. 976 (1968). To be sure, the farmer in the hypothetical is relying on market information rather than inside information, but we have seen that one can be penalized for trading on the basis of the former just as one can for trading on the latter, see Chapter 1.C.2. In addition, the farmer might argue that she is not “obligated to confer upon outside investors the benefit of [her] superior financial or other expert analysis by disclosing [her] educated guesses or predictions.” Texas Gulf Sulphur, 401 F.2d at 848. On the other hand, if the information is material, she may be obliged to disclose the “basic facts so that outsiders may draw upon their own evaluative expertise in reaching their own investment decisions with knowledge equal to that of the insiders.” Id. at 849.
[2] U.S. v. Chiarella, 588 F.2d 1358, 1365 (2d Cir. 1978), rev’d, 445 U.S. 222 (1980).
[3] Chiarella v. U.S., 445 U.S. 222, 233 (1980).
