Insider Trading: Examining Primary Theories of Liability
Insider trading continues to be a high priority area for the U.S. Securities and Exchange Commission's enforcement program. The SEC brought 57 insider trading enforcement actions in 2011 and, in 2012, brought 58 insider trading enforcement actions against 131 individuals and entities. Yet despite the SEC's intense and persistent attention to insider trading enforcement and the headline grabbing nature of the SEC's enforcement actions, many in the financial and business community remain unfamiliar with the origins and legal basis for the prohibition against insider trading in the United States and the exact conduct that is proscribed. This article will focus on the primary theories of insider trading liability.
Prohibited "insider trading" is, in a nutshell, the purchase or sale of securities on the basis of material, non-public information in breach of a duty arising out of a fiduciary relationship or other relationship of trust and confidence. The statutory basis for this prohibition against insider trading is Section 10(b) of the U.S. Securities Exchange Act of 1934, as amended, and Rule 10b-5 promulgated thereunder. Section 10(b) and Rule 10b-5 are general anti-fraud provisions that make it unlawful for any person to engage in any act, practice or course of business that would operate as a fraud or deceit upon any other person in connection with the purchase or sale of a security. It is from this general anti-fraud provision as well as common law principles of fiduciary duty that the prohibition against insider trading and the two primary theories of insider trading liability (which are known as the "classical" theory and the "misappropriation" theory) evolved.
While the question of what constitutes material non-public information is deserving of its own article of equal length to this one, it is worth briefly summarizing the key points here. The dividing line between what is "non-public" and "public" and "material" and not "material" are not exact. In general, information is public if it has been disclosed in a manner sufficient to insure availability to the investing public, for example, through a major news wire service, and sufficient time has passed since its dissemination for investors to have absorbed the information.
For information to be material there must be a substantial likelihood that a reasonable investor would consider it important in deciding whether or not to purchase or sell a security. In other words, there must be a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available. In addition, Section 10(b) and Rule 10b-5 make no distinction between so called "corporate information," confidential information originating from within a company, and so called "market information," information that originates from outside of the company but is price sensitive with respect to a company's securities. Both "corporate information" and "market information" can be material, non-public information for purposes of the prohibition against insider trading.
The so-called classical theory of insider trading pertains to corporate insiders (which include both permanent insiders, such as officers, directors and employees, and so-called "temporary insiders," such as an issuer's attorneys, accountants and other service providers). Under the classical theory of insider trading Section 10(b) and Rule 10b-5 are violated when a corporate insider trades securities of the issuer on the basis of material, non-public information. The modern classical theory of insider trading is largely credited to a 1980 Supreme Court case, United States v. Chiarella.
In Chiarella, the Supreme Court found that a corporate insider has a duty to disclose or abstain from trading which arises from the relationship of trust and confidence that exists between the shareholders of an issuer and those insiders who have obtained confidential information by reason of their position with that issuer. Trading in breach of this duty constitutes a fraud or deceit on the shareholders of the issuer under Section 10(b) and Rule 10b-5. In practice, the classical theory has meant that insiders may not trade whenever they are in possession of material, non-public information. The classical theory of insider trading also applies to issuers themselves and prohibits an issuer from selling or repurchasing its own securities while in possession of material, nonpublic information.
At the time it was decided, the Supreme Court's decision in Chiarella significantly narrowed the prohibition against insider trading by finding that there is no fraud absent a breach of a fiduciary duty as discussed above. Prior to Chiarella a leading case on insider trading was a U.S. Court of Appeals for the Second Circuit case, SEC v. Texas Gulf Sulfur. This case laid down what can fairly be described as a rule of parity of information.
In Texas Gulf Sulfur the Second Circuit Court of Appeals found that "anyone in possession of material inside information must either disclose it to the investing public, or…must abstain from trading or recommending the securities concerned while such inside information remains undisclosed." Thus under Texas Gulf Sulfur the duty to disclose material, non-public information or abstain from trading extended not only to corporate insiders, but to anyone. Chiarella rejected this rule of parity of information.
The "misappropriation theory" of insider trading complements the classical theory of insider trading and applies to situations in which the trader may not be a corporate insider, but owes a duty of trust and confidence to someone other than the issuer and its shareholders. Under this theory a person, including a non-insider, commits fraud in connection with a securities transaction when he misappropriates confidential information for securities trading purposes, in breach of a duty of trust or confidence owed to the source of the information. A fiduciary's undisclosed use of a principal's information to purchase or sell securities, in breach of a duty of trust or confidentiality, defrauds the source of the information of the exclusive use of that information and thereby violates Section 10(b) and Rule 10b-5. The misappropriation theory was endorsed by the Supreme Court in 1997 in its decision in United States v. O'Hagan.
Open questions on the scope of the misappropriation theory remain. For example, the existence of a duty of trust and confidence between non-insiders and the relationships that give rise to such a duty may not be obvious. A leading case decided by the Second Circuit, United States v. Chestman, enumerated several inherently fiduciary relationships that gave rise to a duty of trust and confidence, such as "attorney and client, executor and heir, guardian and ward, principal and agent, trustee and trust beneficiary, and senior corporate official and shareholder."
Once one moves beyond these obvious examples of fiduciary relations, the Chestman court found that a "fiduciary relationship involves discretionary authority and dependency: One person depends on anotherthe fiduciaryto serve his interests. In relying on a fiduciary to act for his benefit, the beneficiary of the relation may entrust the fiduciary with custody over property of one sort or another. Because the fiduciary obtains access to this property to serve the ends of the fiduciary relationship, he becomes duty-bound not to appropriate the property for his own use."
In addition, the SEC adopted Rule 10b5-2 in 2000, which provides a non-exclusive definition of circumstances in which a person has a duty of trust or confidence for purposes of the misappropriation theory. These circumstances include (1) whenever a person agrees to maintain information in confidence, (2) when people have a history, pattern, or practice of sharing confidences, and (3) whenever a person receives or obtains material nonpublic information from his or her spouse, parent, child, or sibling. The first item in the previous list, an agreement to keep information confidential, is particularly pertinent in the world of finance where non-disclosure agreements between parties to a potential or actual transaction may be a matter of daily routine. Investment professionals should be aware that whenever they agree to keep information confidential, they may be restricting themselves from trading in securities of one or more issuers.
Recently, the sufficiency of a confidentiality agreement to establish liability under the misappropriation theory has been called into question. In the 2009 case of SEC v. Mark Cuban, the U.S. District Court for the Northern District of Texas dismissed civil insider trading charges that the SEC brought against Mark Cuban on the grounds that an agreement to keep information confidential (absent an explicit agreement to refrain from using the information) does not establish a duty of trust and confidence or fiduciary duty and, therefore, could not form the basis for liability under the misappropriation theory of insider trading. In the same case, the District Court ruled that Rule 10b5-2(b)(1), which provides that a duty of trust and confidence for purposes of the misappropriation theory exists whenever a person agrees to keep information confidential, exceeded the SEC's rulemaking authority under Section 10(b) of the Exchange Act to proscribe conduct that is deceptive and, accordingly, the SEC could not rely on Rule 10b5-2(b)(1) to establish liability for insider trading under Section 10(b).
The SEC appealed the District Court's rulings to the U.S. Court of Appeals for the Fifth Circuit, which ultimately reversed the dismissal of the charges against Cuban on the basis that the SEC's complaint could be read to allege that Cuban had agreed not to trade. However, the Fifth Circuit did not address any of the legal issues concerning the sufficiency of confidentiality agreements to establish a duty of trust and confidence or the validity of Rule 10b5-2(b)(1) in its opinion. Accordingly, the questions raised by the District Court on these points remain unresolved. Given the uncertainty around these questions, many market participants continue to act as if a confidentiality agreement is sufficient to establish a duty of trust and confidence for purposes of insider trading liability. In addition, it is worth noting that most non-disclosure agreements contain express covenants that the recipient will only use the information for a specific permitted purpose.
Context of Tender Offers
Rule 14e-3 governs insider trading in the context of tender offers. In short, Rule 14e-3 provides that if a bidder has taken a substantial step to commence a tender offer, no other person who possesses material, non-public information relating to the tender offer, which such person knows or has reason to know is non-public and was acquired, directly or indirectly, from the bidder, the target company, or any insider of the bidder or the target company, can buy or sell the target company's securities, unless the material, non-public information and its source are publicly disclosed.
Rule 14e-3 also prohibits "tipping" of material, non-public information regarding a tender offer to third parties. Unlike insider trading liability under Section 10(b) of the Exchange Act and Rule 10b5-1, liability under Rule 14e-3 is not predicated on the breach of a fiduciary duty or duty of trust and confidence. No such duty need exist to establish liability for insider trading under Rule 14e-3.
It is also important to understand the differences between the regulation of insider trading in the United States and foreign jurisdictions. In Canada, Europe, Australia, Japan and other foreign jurisdictions, laws prohibiting insider trading differ substantially from insider trading laws in the United States and may be broader than U.S. laws. For example, Section 118 of the United Kingdom's Financial Services and Markets Act prohibits an "insider" from buying or selling securities on the basis of inside information. At first blush, it may not sound that different from U.S. law, but the definition of an insider for purposes of Section 118 is quite broad and includes any person who has inside information "as a result of having access to the information through the exercise of his employment, profession or duties" or "which he has obtained by other means and which he knows, or could reasonably be expected to know, is inside information." Thus, for purposes of Section 118, almost anyone in possession of inside information is an "insider" and simply receiving inside information could mean that a trader is restricted. Accordingly, when trading in overseas markets, traders are cautioned to be familiar with local law.
Tipper and Tippee Liability
Under both the classical and misappropriation theories of insider trading, tippers and tippees of material, non-public information may face liability for insider trading under Section 10(b) and Rule 10b-5.
In general, under the classical theory of insider trading a corporate insider will be subject to tipper liability when he discloses material, non-public information to a tippee and receives a personal benefit as a result of disclosing the material, non-public information to the tippee thus breaching his fiduciary duty to shareholders of the issuer to not use corporate information for his own personal gain. The tippee's liability is derivative of the tipper's liability. Under the classical theory, the tippee is liable for trading on the basis of a tip if the tipper has disclosed the material, non-public information in breach of his fiduciary duty and the tippee knew or should have known that the disclosure was a breach of such duty.
The standards for tipper and tippee liability under the misappropriation theory generally overlap with the standards under the classical theory. Tipper liability requires that (1) the tipper had a duty to keep material non-public information confidential; (2) the tipper breached that duty by intentionally or recklessly relaying the information to a tippee who could use the information in connection with securities trading; and (3) the tipper received a personal benefit from the tip.
Tippee liability requires that (1) the tipper breached a duty by tipping confidential information; (2) the tippee knew or had reason to know that the tipper improperly obtained the information (i.e., that the information was obtained through the tipper's breach of duty); and (3) the tippee used the information by trading or by tipping for his own benefit.
By all indications, 2013 promises to deliver more blockbuster insider trading enforcement actions and prosecutions. Much attention will be focused on SAC Capital and the SEC's indication that it may hold that firm responsible as a "controlling person" for actions of former portfolio manager Matthew Martoma. To the extent that the SEC increases the number of enforcement actions that it brings against the employers of individual perpetrators, investment managers, other financial institutions and public companies could find themselves exposed to civil penalties and other liability for actions of employees engaged in illegal insider trading. Given that insider trading has been, and will most likely continue to be, a top enforcement priority for the SEC, general counsels and compliance officers should keep up to date on developments in insider trading law and regularly review their insider trading compliance policies and procedures and employee training programs.
Greg Kramer is a partner in the corporate and securities practice areas of Kleinberg, Kaplan, Wolff & Cohen.