We will now cover two topics from securities law that appear in every corporations course: private securities fraud litigation under the Securities Exchange Act (SEA) rule 10b-5, and insider trading liability under the SEA rules 10b-5 and 14e-3 and SEA §16(b).
Both topics relate to the dissemination of information from within the (listed) firm to the investing public at large, or “the market.” I noted before that US corporations (and, to a lesser extent, investors in US corporations) must disclose a great deal of information under the securities laws (see the securities law primer in chapter 1.3).
But what happens if the corporation does not disclose truthfully? Then, more likely than not, 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. Basic will teach you the basics of such litigation.
Before the full truth is disclosed to the market, corporate insiders have an informational advantage. They could use this information to make profitable trades in their corporation’s securities. For example, a corporation’s fortunes will rise if the corporation discovers a large mineral deposit or makes an engineering break-through. The insiders — the engineers, the CEO, etc. — will know about it first. They might be tempted to buy the corporation’s stock, or call options on such stock, before the news goes out to the world at large. When the news about the discovery or break-through comes out, the corporation’s stock price will go up. The insiders who bought stock or options would pocket a profit — but, if they are found out, they would go to prison. Insider trading is not only illegal but criminal in the US and now in most other jurisdictions around the world.
Formally, the core legal rule for both securities fraud and insider trading is rule 10b-5, discussed below. However, the issues posed in the two sets of cases are quite different. 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.
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. 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.EDIT PLAYLIST INFORMATION DELETE PLAYLIST
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|1||Show/Hide More||Basic Inc. v. Levinson (U.S. 1988)|
Private securities (fraud) litigation is a major industry. Specialized class action law firms drive this litigation. 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. In 2005, the Supreme Court handed down Broudo v. Dura Pharmaceuticals, Inc., which held that “an inflated purchase price will not itself constitute or proximately cause the relevant economic loss.”
Basic defines the standard of materiality for securities fraud. More importantly, Basic endorses the fraud-on-the-market theory, which is the foundation of most securities fraud class actions. 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. How does the fraud-on-the-market theory relate to reliance? Why is this important for class certification?
2. According to the fraud-on-the-market theory, who relies on what? Why do they trade?
3. What social good, if any, do private securities fraud class actions generate? In other words, what is the policy justification, if any, for allowing this costly litigation to proceed?
|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. Firstly, 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. Secondly, materiality is usually self-evident in insider trading cases.
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 weak 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 a hedge fund who compiled the information from public sources. To be sure, the hedge fund might not enter the market if it had to compete against better informed insiders. But it is not obvious why that would be a social loss. If anything, it might be a social gain: it saves the resources (personnel, computing power, etc.) that the hedge fund 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 07, 2017
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