«Abstract Insider trading is one of the most controversial aspects of securities regulation, even among the law and economics community. One set of ...»
Stephen M. Bainbridge
Professor, UCLA School of Law
© Copyright 1999 Stephen M. Bainbridge
Insider trading is one of the most controversial aspects of securities regulation,
even among the law and economics community. One set of scholars favors
deregulation of insider trading, allowing corporations to set their own insider
trading policies by contract. Another set of law and economics scholars, in contrast, contends that the property right to inside information should be assigned to the corporation and not subject to contractual reassignment.
Deregulatory arguments are typically premised on the claims that insider trading promotes market efficiency or that assigning the property right to inside information to managers is an efficient compensation scheme. Public choice analysis is also a staple of the deregulatory literature, arguing that the insider trading prohibition benefits market professionals and managers rather than investors. The argument in favor of regulating insider trading traditionally was based on fairness, which predictably has had little traction in the law and economics community. Instead, the economic argument in favor of mandatory insider trading prohibitions has typically rested on some variant of the economics of property rights in information.
JEL classification: K22, G30, G38 Keywords: Property Rights, Securities Regulation, Insider Trading, Securities Fraud
1. Introduction The law of insider trading is one way society allocates the property rights to information produced by a firm. In the United States, early common law permitted insiders to trade in a firm’s stock without disclosure of inside information. Over the last three decades, however, a complex federal prohibition of insider trading emerged as a central feature of modern US securities regulation. Other countries have gradually followed the US trend, although enforcement levels continue to vary substantially from country to country.
Prohibiting insider trading is usually justified on fairness or equity grounds.
Predictably, these arguments have had little traction in the law and economics community. At the same time, however, that community has not coalesced 5650 Insider Trading 773 around a single view of the prohibition; instead, competing economic arguments produced an extensive debate that is still active. Those law and economics scholars who favor deregulation of insider trading typically argue that efficiency is the sole basis for analyzing a legal regime, and that the prohibition lacks any rational economic basis. Those who favor regulating insider trading typically respond either by rejecting the claim that efficiency is the controlling criterion or by attempting to show that the prohibition is justifiable on efficiency grounds. Most observers of the literature likely would conclude that neither side has carried the field, but that the argument in favor of regulation probably is winning at the moment.
Because the vast bulk of law and economics scholarship on insider trading refers to United States law, a brief overview of the current state of that law seems appropriate. Insider trading, generally speaking, is trading in securities while in possession of material nonpublic information. Under current United States law, there are three basic theories under which trading on inside information becomes unlawful. The disclose or abstain rule and the misappropriation theory were created by the courts under Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder. Pursuant to its rule-making authority under Exchange Act Section 14(e), the Securities and Exchange Commission (SEC) adopted Rule 14e-3 to proscribe insider trading involving information relating to tender offers. (Insider trading may also violate other statutes, such as the mail and wire fraud laws, which are beyond the scope of this chapter.)
2. The Disclose or Abstain Rule
The modern federal insider prohibition began taking form in SEC v. Texas Gulf Sulphur Co. TGS, as it is commonly known, rested on a policy of equality of access to information. Accordingly, under TGS and its progeny, virtually anyone who possessed material nonpublic information was required either to disclose it before trading or abstain from trading in the affected company’s securities. If the would-be trader’s fiduciary duties precluded him from disclosing the information prior to trading, abstention was the only option.
In Chiarella v. United States and Dirks v. SEC, the United States Supreme Court rejected the equal access policy. Instead, the Court made clear that liability could be imposed only if the defendant was subject to a duty to disclose prior to trading. Inside traders thus were no longer liable merely because they 774 Insider Trading 5650 had more information than other investors in the market place. Instead, a duty to disclose only arose where the inside traders breached a pre-existing fiduciary duty owed to the person with whom they traded. (Chiarella; Dirks, pp.
Creation of this fiduciary duty element substantially narrowed the scope of the disclose or abstain rule. But the rule remains quite expansive in a number of respects. In particular, it is not limited to true insiders, such as officers, directors and controlling shareholders, but picks up corporate outsiders in two important ways. Even in these situations, however, liability for insider trading under the disclose or abstain rule can only be found where the trader - insider or outsider - violates a fiduciary duty owed to the issuer or the person on the other side of the transaction.
First, the rule can pick up a wide variety of nominal outsiders whose relationship with the issuer is sufficiently close to the issuer of the affected securities to justify treating them as ‘constructive insiders’, but only in rather narrow circumstances. The outsider must obtain material nonpublic information from the issuer. The issuer must expect the outsider to keep the disclosed information confidential. Finally, the relationship must at least imply such a duty. If these conditions are met, the putative outsider will be deemed a ‘constructive insider’ and subjected to the disclose or abstain rule in full measure (see Dirks, p. 655 n.14). If they are not met, however, the disclose or abstain rule simply does not apply. The critical issue thus remains the nature of the relationship between the parties.
Second, the rule also picks up outsiders who receive inside information from either true insiders or constructive insiders. There are a number of restrictions on tippee liability, however. Most important for present purposes, the tippee’s liability is derivative of the tipper’s, ‘arising from his role as a participant after the fact in the insider’s breach of a fiduciary duty’ (ibid. p. 659). As a result, the mere fact of a tip is not sufficient to result in liability. What is proscribed is not merely a breach of confidentiality by the insider, but rather a breach of the duty of loyalty imposed on all fiduciaries to avoid personally profiting from information entrusted to them (see ibid. pp. 662-664). Thus, looking at objective criteria, a court must determine whether the insider personally will benefit, directly or indirectly, from his disclosure. So once again, a breach of fiduciary duty is essential for liability to be imposed: a tippee can be held liable only when the tipper has breached a fiduciary duty by disclosing information to the tippee, and the tippee knows or has reason to know of the breach of duty.
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3. The Gap-Fillers
Chiarella created a variety of significant gaps in the insider trading prohibition’s coverage. Consider this standard law-school hypothetical: Law Firm is hired by Raider Corp. to represent it in connection with a planned takeover bid for Target Co. Alex Associate is one of the lawyers assigned to the project. Before Raider Corp. publicly discloses its intentions, Associate purchases a substantial block of Target stock. Under the disclose or abstain rule, he has not violated the insider trading prohibition. Whatever the scope of the duties he owed Raider Corp., he owed no duty to the shareholders of Target Co. Accordingly, the requisite breach of fiduciary duty is not present in his transaction. Rule 14e-3 and the misappropriation theory were created to fill this gap.
4. Rule 14e-3
Rule 14e-3 was the SEC’s immediate response to Chiarella. The rule prohibits insiders of the bidder and target from divulging confidential information about a tender offer to persons who are likely to violate the rule by trading on the basis of that information. The rule also, with certain narrow and well-defined exceptions, prohibits any person who possesses material information relating to a tender offer by another person from trading in target company securities if the bidder has commenced or has taken substantial steps towards commencement of the bid.
Note that the rule’s scope is very limited. One prong of the rule (the prohibition on trading while in possession of material nonpublic information) is not triggered until the offeror has taken substantial steps towards making the offer. More important, both prongs of the rule are limited to information relating to a tender offer. As a result, most types of inside information remain subject to the duty-based analysis of Chiarella and its progeny.
The misappropriation theory grew out of then-Chief Justice Burger’s dissent in Chiarella. As an employee of a financial printer, Chiarella had access to tender offer documents being prepared for takeover bidders. Although Chiarella owed no duties to the investors with whom he traded, he did owe a duty of confidentiality to his employer and thereby to the bidders. Chief Justice Burger argued that Chiarella’s misappropriation of material nonpublic information that 776 Insider Trading 5650 had been entrusted to his employer was a sufficient breach of duty to justify imposing Rule 10b-5 liability (Chiarella v. U.S., 240-243, (Burger, C.J., dissenting)). Although Justices Blackmun, Brennan and Marshall supported the Chief Justice’s argument, the majority declined to reach the misappropriation question because that theory of liability had not been presented to the jury. The Second Circuit nevertheless adopted the misappropriation theory as a basis for inside trading liability in U.S. v. Newman, 664 F.2d 12 (2nd Cir. 1981), and followed it in a number of subsequent decisions; see, for example, U.S. v.
Chestman, U.S. v. Carpenter SEC v. Materia.
Like the traditional disclose or abstain rule, the misappropriation theory requires a breach of fiduciary duty before trading on inside information becomes unlawful. It is not unlawful, for example, for an outsider to trade on the basis of inadvertently overheard information (SEC v. Switzer). The fiduciary relationship in question, however, is a quite different one. Under the misappropriation theory, the defendant need not owe a fiduciary duty to the investor with whom he trades. Nor does he have to owe a fiduciary duty to the issuer of the securities that were traded. Instead, the misappropriation theory applies when the inside trader violates a fiduciary duty owed to the source of the information. Had the misappropriation theory been available against Chiarella, for example, his conviction could have been upheld even though he owed no duties to those with whom he traded. Instead, the breach of the duty he owed to Pandick Press would have sufficed.
After two Circuit Courts of Appeals rejected the misappropriation theory, the United States Supreme Court took a case raising the theory’s validity (see U.S. v. O’Hagan, also concluding that the SEC lacked authority to adopt Rule 14e-3; U.S. v. Bryan). James O’Hagan was a partner in the Minneapolis law firm of Dorsey & Whitney. In July 1988, Grand Metropolitan PLC (Grand Met), retained Dorsey & Whitney in connection with its planned takeover of Pillsbury Company. Although O’Hagan was not one of the lawyers on the Grand Met project, he learned of their intentions and began buying Pillsbury stock and call options on Pillsbury stock. When Grand Met announced its tender offer in October, the price of Pillsbury stock rose to nearly $60 per share.
O’Hagan then sold his Pillsbury call options and common stock, making a profit of more than $ 4.3 million. Following a SEC investigation, O’Hagan was