The stock and other securities of large corporations tend to be traded on securities markets. In particular, listed securities such as Apple or IBM stock trade on securities exchanges like the New York Stock Exchange. (These days, exchanges are essentially computer systems matching buy and sell orders received through brokers.) Such trading between investors is also referred to as the secondary market. The primary market denotes sales by the corporation of its own securities to investors—in other words, the primary market is the market where the corporation actually raises capital. By contrast, secondary market trades between investors do not directly impact the finances of the corporation.
Nevertheless, the secondary market is very important for the issuing corporation, and indirectly affects its primary market. Most importantly, the secondary market provides liquidity to its investors, i.e., the ability to turn their investment into cash when desired (by selling to another investor). Investors pay more in the primary market for securities that have a liquid secondary market. In fact, once the secondary market is up and running, the corporation can anonymously sell additional stock directly into the secondary market, or buy it back for that matter (provided it has publicly announced its intention to do this in special SEC filings). Similarly, the liquidity afforded by the secondary market facilitates the acceptance of the corporation’s securities as a means of payment. In particular, public corporations tend to pay their executives mostly in (restricted) stock, and often pay for acquisitions with stock as well (“stock deals”). Illiquid securities without a secondary market are sometimes accepted as payment as well, but less often and only at a discount. Finally, a liquid secondary market supports the accumulation of large minority blocks by activist shareholders without much of a price impact. As a blockholder, the activist will reap a sizeable reward from share price appreciation if the activist’s intervention (engagement with the board, proxy fight, etc.) increases the value of the corporation (see price efficiency below), making the activist’s intervention worthwhile. In this way, liquidity helps overcome the shareholder collective action problem.
Information asymmetry reduces liquidity. The higher the chance that your (anonymous) trading counterparty knows more than you do and trades only because you are getting a bad deal, the less willing you are to trade. To reduce information asymmetry, and to facilitate the exercise of voting and other rights covered in this course, the Exchange Act requires extensive periodic and ad hoc disclosures from issuers of publicly traded securities (see the Securities Law Primer in the introductory part of the course).1
Even with ample disclosure, you might worry that you will lose out against a savvy trader who is quicker at collecting or better at processing the information. Fortunately, savvy traders compete with one another for good deals, pushing the security’s price close to the savvy traders’ best estimate of the security’s value. In fact, the efficient capital market hypothesis (ECMH) holds that, in a liquid market, the price will always be exactly equal to the best estimate of the security’s fundamental value given publicly available information. There are two problems with the ECMH, which had its heyday in the 1970s and early 1980s and features prominently in Basic below. First, the ECMH cannot be completely true: if the price were always equal to the best estimate of fundamental value, then nobody could gain from informed trading, and hence nobody would have an incentive to learn and analyze the information required to bring prices in line in the first place. Second, in a world of uncertainty, “fundamental value” is in the eye of the beholder, and savvy traders may just try to predict the misperceptions of others with whom they hope to trade the security tomorrow.2 Much empirical work has shown that the truth is somewhere between that cynical view and the ECMH, and mostly closer to the ECMH: security prices are not completely efficient (i.e., equal to fundamental value), but they are usually a very good approximation. (In either case, most people who think they can outguess everyone else are fools.)
If security prices are a good approximation of fundamental value, it means they summarize information that can be used to evaluate performance. This is the idea behind stock and options as performance pay for executives: the value of their stock and options will track the price of the stock, which is an indicator, albeit a noisy one, of the executives’ performance. By the same logic, price efficiency ensures that an activist shareholder will increase the stock price and hence gain from an intervention only if the activist’s intervention actually improves the corporation. In the case of the executives (but not of the activist!), an important caveat is that even a fully efficient price only reflects public information.3 Top executives can use their discretion under the accounting and disclosure rules to manage the information flow and hence the stock price to increase the value of their performance pay, or simply to avoid being fired. Similarly, corporate insiders (executives, engineers, etc.) can profitably—but not legally, see below—trade their corporation's securities even in fully efficient markets because they frequently possess “material nonpublic information” (mineral discoveries, engineering breakthroughs, regulatory matters, etc.).
Securities trading and securities regulation are thus inextricably intertwined with corporate governance and corporate law. In this course, we cannot cover the details of the disclosure and trading rules under the securities acts. We must, however, spend at least a little time discussing the enforcement of the disclosure rules that we have encountered in this class (e.g., 8-Ks, 10-Ks, 13-Ds, proxy statements, etc.), and more generally of truthfulness of the corporation’s communications to its shareholders. Much of the enforcement burden falls on the SEC, which again belongs in a specialized course. But some of the enforcement is through private securities litigation, often brought by the same law firms that prosecute shareholder actions in Delaware courts. Indeed, these plaintiff law firms used to substitute federal securities lawsuits for Delaware litigation when Delaware courts were less receptive to shareholder lawsuits, and may try to do so again after Trulia. Specifically, we will study private securities fraud litigation under the Securities Exchange Act (SEA) rule 10b-5, which is the most general and hence most important and most controversial basis for such litigation.
The other aspect of securities law we will study is the prohibition and prevention of insider trading. The reason to do so is twofold. First, it is another area that might have fallen under state corporate law if doctrine had developed differently, and to a limited extent still does. Second, insider trading turns out to involve an important corporate governance issue: If insider trading were legal, executives might manage the corporation to maximize trading opportunities rather than corporate value. Besides, insider trading is a crime that most young lawyers will have opportunity and temptation to commit, so it is in your self-interest to learn what not to do. We will study insider trading liability under the SEA rules 10b-5 and 14e-3 and SEA §16(b).
1 Actually, the utility of information by itself does not quite explain why disclosure needs to be mandated by statute, rather than provided voluntarily or, more to the point, under an obligation self-imposed in the corporate charter. We get to these questions in the last part of the course.
2 In the memorable words of John Maynard Keynes’s General Theory of Employment, Interest, and Money (1935):
“professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one's judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”
3 Technically, this is known as the semi-strong form of market efficiency. The strong form holds that the price includes all information, even private information. The strong form is quite clearly false, even though some private information does seep into the stock price, in part through legal and illegal insider trading (covered below).
Before delving into the details, let us take a look at rule 10b-5, which is the formal basis of most securities litigation and most insider trading enforcement.
Rule 10b-5 is only one of many anti-fraud rules in securities law (cf., e.g., SEA §14(e) for statements in connection with tender offers). Rule 10b-5 is just the most general, “catch-all” provision—among other things, it applies to any security, not just registered securities. It implements SEA §10(b), which is not self-executing. §10(b) reads in its most relevant substantive part:
“It shall be unlawful for any person . . . [t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe . . .”
Rule 10b-5 was adopted in 1942 without, it appears, much thought or any anticipation of the role it would come to play in the hands of the SEC and the courts later on. SEC staffers wanted to go after an instance of clear common law fraud. To obtain jurisdiction over the case, however, they needed the Commission to adopt a rule under §10(b) first. So the staffers copied §17 of the Securities Act and submitted it to the Commissioners. The Commissioners approved without discussion. See Louis Loss & Joel Seligman, Fundamentals of Securities Regulation 937-8 (4th ed. 2004).
The rule reads:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,
a. To employ any device, scheme, or artifice to defraud,
b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
c. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,
in connection with the purchase or sale of any security.
The rule mentions neither a private right of action nor insider trading. But the courts soon implied a private right of action, and the SEC, with approval of the courts, brought insider trading cases under the rule. Ironically, these judicial creations are now recognized in the statute itself. For example, a later amendment of SEA §10 explicitly references “insider trading” rules adopted by the SEC and by judicial precedent, extending such rules to “security-based swap agreements” (i.e., derivatives).
Plaintiffs attempted to bring even more corporate disputes under 10b-5, including cases unrelated to disclosure. In fact, in the early 1970s, most corporate law litigation was brought in the federal district courts under rule 10b-5, rather than in Delaware state courts under state law. Delaware was, at that time, unreceptive to shareholder suits involving fiduciary duty claims. By contrast, the 2nd circuit read rule 10b-5 very expansively. The Supreme Court put an end to this in Santa Fe Industries v. Green (U.S. 1977). In that case, the 2nd circuit had ruled that an unfair cash-out merger could be actionable “fraud” under rule 10b-5 even if defendants had fully disclosed all price-relevant information. The Supreme Court insisted, however, that 10b-5 required “deception, misrepresentation, or nondisclosure.” In general, the Supreme Court has become much more hostile to private securities litigation over time. Thus, you should not expect a judicial expansion beyond what you will read below.
To avoid confusion, it is important to understand that insider trading cases and securities fraud actions involve and emphasize very different aspects of rule 10b-5. Usually, securities fraud cases turn on whether the information was misleading and material, whereas insider trading cases turn on whether the defendant had access to the information and, if so, whether the defendant improperly obtained or traded on it. The main policy question in securities fraud is the availability of the class action (strike suits? Who is deterred if the corporation pays the damages?), whereas the insider trading debate revolves around the definition of inside information and hence the boundaries of legitimate trading. Procedurally, securities fraud is typically litigated in a private class action, while insider trading is typically prosecuted by the S.E.C. or even the U.S. Attorney’s Office. As a result, the legal questions are quite different, even though they formally arise under the same rule 10b-5.EDIT PLAYLIST INFORMATION DELETE PLAYLIST
Edit playlist item notes below to have a mix of public & private notes, or:MAKE ALL NOTES PUBLIC (2/2 playlist item notes are public) MAKE ALL NOTES PRIVATE (0/2 playlist item notes are private)
|1||Show/Hide More||Securities Litigation|
You know that listed corporations have extensive affirmative disclosure obligations under the securities acts (see the Securities Law Primer in the introductory part of the course). But what happens if the corporation does not disclose truthfully? One possibility is that the SEC will bring an enforcement action. Another possibility that we will look at here is that a specialized plaintiff law firm will file a “securities fraud” class action against the corporation (!). If the corporate disclosure was misleadingly positive, then the suit will attempt to recover damages for shareholders who bought at an inflated price — inflated because it was based on erroneously positive information. Inversely, sellers will sue if the disclosure was misleadingly negative and thus the price deflated. Notice that those on the other side of these trades—sellers who sell at an inflated price, or buyers who buy at a deflated price—benefitted from the erroneous corporate disclosure, but they are not party to the litigation.
Most of the time, any individual trader’s losses from the fraud are too small to make an individual lawsuit worthwhile. The big question in securities litigation is therefore the availability of the class action. That is the main question addressed in Basic, besides defining the standard of materiality for securities fraud. By endorsing the fraud-on-the-market theory, Basic paved the way for an entire industry of specialized class action law firms. Congress and recently the Supreme Court have tried to reign in some of this litigation, which remains controversial. In 1995, Congress passed the Private Securities Litigation Reform Act, which, among other things, introduced very strict pleading requirements via SEA §21D.
Doctrinally, the fraud-on-the-market theory is an interpretation of the reliance element of the private right of action under rule 10b-5. Notwithstanding the convoluted text of the rule, the elements of a 10b-5 claim appear to be exactly the same as those of common law fraud: (1) a false or misleading statement (2) of a material fact (3) made with scienter that (4) the plaintiff reasonably relied on, (5) causing injury to the plaintiff. As the Basic decision shows, however, these similarities are deceptive. These elements have a special meaning in the context of 10b-5.
|1.1||Show/Hide More||Basic Inc. v. Levinson (U.S. 1988)|
|2||Show/Hide More||Insider Trading|
We now turn to insider trading. As mentioned above, the main rule is again 10b-5, but the questions are rather different than those in standard securities fraud cases. Doctrinally, the main question is how to fit the idea of insider trading (use of inside information) under an anti-fraud rule (answer: by inventing a duty to disclose, such that insiders commit fraud by omission if they don’t disclose). The main policy question is how far insider trading liability should reach. There must be some informed trading if prices are supposed to be “efficient,” i.e., correct. The three cases we will read are about that.
Practically speaking, the biggest issue of insider trading law is enforcement. In the words of Judge Rakoff at the sentencing of Rajat Gupta (the retired chief executive of McKinsey and board member of Goldman Sachs who passed confidential information from Goldman’s board meeting to a hedge fund as soon as he left the meeting):
Insider trading is an easy crime to commit but a difficult crime to catch. Others similarly situated to the defendant must therefore be made to understand that when you get caught, you will go to jail.
These enforcement difficulties are one reason why insider trading is policed primarily through criminal and administrative enforcement, not private litigation. Many insider trading cases come to light only through criminal law enforcement tools such as wire-tapping. The exchanges also have monitoring systems and report unusual trading activity to the SEC.
Another reason why private litigation plays a minor role is the lack of incentives for plaintiff law firms. The courts and SEA §20A(b)(1), adopted in 1988, have capped insider trading damages at the gain derived by the defendant. In any event, the individual defendants are usually judgment proof beyond some comparatively small amount of personal wealth (compared, that is, to the hundreds of millions the plaintiff law firms can win from corporations).
Perhaps in recognition of these enforcement difficulties, §16 of the Exchange Act provides two rules that do not directly target insider trading but may catch or expose most of it.
Subsection (a) provides that corporate directors, officers, and principal stockholders must within two business days disclose each and every transaction in the corporation’s equity securities, including derivatives written on those securities. The Act defines principal stockholders as those who own at least 10% of the corporation’s stock. The SEC provides further definitions of the subsection’s terms in rules 16a-1 and 16a-2. Rule 16a-3(a) stipulates that filings are to be made on the so-called “form 4.”
Naturally, not all trades by corporate insiders disclosed on form 4 are illegal. If the insider does not possess any material non-public information at the time of trade, the trade is permissible. But once disclosed on form 4, the insiders’ trades can be scrutinized by private and public investigators.
Subsection (b) of §16 grants the corporation a right of action to recover any so-called short swing trading profits from its officers, directors, and principal stockholders. (The provision explicitly contemplates a shareholder derivative action if the corporation does not bring suit within 60 days of a request.) The provision is explicitly targeting insider trading in a prophylactic manner. It reads, in its core part:
“For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer . . . within any period of less than six months . . . shall inure to and be recoverable by the issuer.”
Clearly, not all trades occurring within six months of one another use insider information. Nor are all trades that do use insider information unwound within six months. The provision is thus both over- and under-inclusive as a weapon against insider trading. It is, however, very easy to administer, especially given the information provided on forms 4.
The main rule that directly targets the impermissible use of insider information is 10b-5.
As already mentioned, the issues arising under 10b-5 in insider trading cases are quite different from the main issues in standard securities fraud litigation. Many of the issues occupying private securities fraud litigators are simply irrelevant in criminal insider trading cases. Criminal liability requires only a misrepresentation of a material fact committed with scienter. The other, victim-centric elements of private fraud claims, namely reliance, injury, and loss causation, are irrelevant. Moreover, prosecutors tend to shy away from cases where materiality is not self-evident.
The main doctrinal question in insider trading cases is whether there was a misrepresentation. To cast the mere use of inside information in impersonal security markets as a misrepresentation towards an anonymous counterparty required considerable doctrinal work by the courts. Before rule 10b-5, most courts had refused to subsume insider trading under common law fraud. The SEC, the federal courts, and ultimately the Supreme Court brought insider trading under the 10b-5 anti-fraud rule by stipulating a “duty to abstain [from trading] or disclose.” In reading the cases, you might wonder where exactly that duty comes from. In any event, Congress explicitly endorsed this jurisprudence post hoc.
In comparative perspective, the Supreme Court’s wrestling with the notion of a “duty to disclose or abstain” is an anomaly. Other jurisdictions, such as the UK, have insider trading rules distinct from general anti-fraud rules. The doctrinal issue of a “duty to disclose” does not arise there. Of course, all jurisdictions have to grapple with the legal and policy question of what exactly does and should constitute illegal insider trading.
There are other, more specialized insider trading rules. In particular, after losing Chiarella below, the SEC adopted rule 14e-3 against insider trading in the context of tender offers. As discussed in O’Hagan below, this rule is not directly based on the fraud concept and therefore broader.
Many other SEC rules deal with details of insider trading, in particular under rule 10b-5. Again, the irony is that the SEC never passed an explicit rule against insider trading under SEA §10, even though it did pass rules interpreting the court decisions interpreting rule 10b-5 with respect to insider trading.
For example, the SEC adopted a safe harbor provision for “trading plans” under which executives pre-commit to buy or sell their corporation’s securities at certain future points in time (rule 10b5-1). This rule is important because a large part of executive compensation is stock or options. Executives could hardly ever monetize these awards before retirement if they did not have this safe harbor.
Rule 10b5-2 purports to define the “duty of trust” whose breach can give rise to insider trading liability under the misappropriation theory (see O’Hagan below). Of note, paragraph (b)(3) of the rule presumes such a duty between family members.
Insider trading may also raise a claim under state law. The Delaware Supreme Court recently reaffirmed this rule in Kahn v. Kolberg Kravis Roberts (2011). Relying on Guth, the Court held that such a “Brophy” claim (after a 1949 decision) is not limited to damages sustained by the corporation or even to the loss of a corporate opportunity (to trade). Instead, the Court predicated insider-trading liability on “unjust enrichment based on the misuse of confidential corporate information.” Again, however, such private claims are rarely brought, presumably because of the enforcement difficulties outlined above.
While insider trading is criminal today, it used to be considered a normal executive perk in the not too distant past. Moreover, serious policy analysts have argued that insider trading ought to be permissible. Their main argument is that insider trades reveal information to the market. To wit, if insiders buy, the market can infer good news, and the stock price will go up. Inversely, if insiders sell, the market can infer bad news, and the stock price will go down. In either case, the insider trades move the prices closer to the “fundamental value” of the stock. Insider trading thus makes the price more “informationally efficient,” i.e., correct.
The standard objection is that like any trading gain, the inside trader’s gain is another trader’s loss. Insider trading thus systematically shifts value from outside investors and speculators to insiders. As a result, such outside investment and speculation may be deterred.
The standard objection is seriously incomplete because losing against a better informed trader is a normal part of trading. For an uninformed trader, it is irrelevant if he or she loses to an insider or to hedge funds who compiled the information from public sources. A more subtle objection is that hedge funds might not enter the market if they had to compete against better informed insiders. The net effect of insider trading could thus be less information in stock prices. As long as the information content is at least not less, however, having the insiders do the trading is actually preferable: it saves the resources (personnel, computing power, spy satellites, etc.) that the hedge funds would have directed at figuring out information that the insiders already possess.
There is a much bigger problem with the contrarian view favoring insider trading. It assumes that all other insider behavior would be unchanged if insider trading were allowed. Realistically, insiders would probably be much more reluctant to disclose information if keeping it secret increased their trading profits. Thus, allowing insider trading might reduce, rather than increase, the information available to the public and ultimately the informational efficiency of stock prices. Worse, insiders might intentionally increase the riskiness of the corporation’s business if they could use inside information about risk realizations for profitable trading. That is, the ability to trade would divert insiders’ attention and warp their incentives in choosing projects. They could attempt to profit from, and expend resources on, trading (a social zero-sum game), rather than focusing on producing good products, etc. (a social welfare improvement). Prohibiting insider trading thus helps align insiders’ incentives with social welfare.
|2.1||Show/Hide More||Chiarella v. United States (U.S. 1980)|
This decision rejects the so-called “equal access theory” of insider trading, according to which anyone trading while in possession of material nonpublic information violates rule 10b-5.
1. According to the majority, why is the equal access theory inconsistent with rule 10b-5? In other words, what else is required for a 10b-5 violation, besides trading while in possession of material nonpublic information?
2. As Burger’s dissent points out, Chiarella did not simply trade while in possession of material nonpublic information: Chiarella misappropriated that information from his employer. Why is such misappropriation not sufficient to subject his trades to 10b-5 liability? Or is it? Cf. part IV of the majority opinion and O’Hagan, infra.
3. Do you think the equal access theory would be good policy? What interests would it protect, if any? What desirable activities might it hamper?
|2.2||Show/Hide More||Dirks v. SEC (US 1983)|
Dirks is the leading case on “tippee” liability under rule 10b-5. A “tippee” is a corporate outsider who trades after receiving material nonpublic information from an insider or another tippee.
1. According to the majority, when are tippees liable under rule 10b-5?
2. Why did the majority exonerate Dirks?
|2.3||Show/Hide More||U.S. v. O'Hagan (U.S. 1997)|
In O’Hagan, the Supreme Court endorsed the so-called “misappropriation theory” of insider trading liability under rule 10b-5, and upheld rule 14e-3.
1. The misappropriation theory rests 10b-5 liability on deceiving the source of the information. What exactly is the deception, and does it occur “in connection with the purchase or sale of any security” (see SEA §10(b) and rule 10b-5)?
2. Does rule 14e-3 expand liability beyond rule 10b-5? If so, what is the statutory basis for the expansion?
3. Did O’Hagan overrule Chiarella and Dirks?a. Could the defendant in Chiarella have been convicted under O’Hagan’s theory of rule 10b-5? If so, why wasn’t he? Hint: re-read part IV of Chiarella.
b. Could the defendant in Chiarella have been convicted under rule 14e-3? If so, why wasn’t he?
c. Does O’Hagan’s misappropriation theory of 10b-5 insider trading liability replace the “classical theory” as endorsed and applied by Chiarella and Dirks—liability premised on a duty to the shareholders of the corporation whose shares are being traded? Or are the two theories complementary? What behavior would violate rule 10b-5 under the classical theory but not under the misappropriation theory?
December 12, 2017
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