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THE EVOLVING CONTROVERSY OVER INSIDER TRADING
JOHN W. BAGBY
The restriction of insider trading is widely accepted as a principal en-forcement goal under various provisions of the federal securities laws. These provisions deny certain trading opportunities to persons with knowledge of material, nonpublic, confidential information about an issuer, its business prospects, or external events that may affect the market for the issuer's securities. This trading restriction is often termed the "disclose or abstain" rule, since the "insider" usually has a choice either to trade after disclosing the confidential information or to refrain from trading altogether until the information becomes public.
The insider trading restriction originated in state common law.' The first congressional restriction of insider trading was imposed by section 16(b) of the Securities Exchange Act of 1934 (1934 Act).' This provision gives the issuer a right of action for all profits made by officers, direc
Assistant Professor of Business Law. The Pennsylvania State University. ' See, e.g., Strong v. Repide, 213 U.S. 419 (1909); Diamond v. Oreamuno, 24 N.Y.2d 498,
248 N.E.2d 910 (Ct. App. 19691. ' 15 U.S.C. S 78p (1982). Section 16 has two major provisions. First, S 16 (a) requires
all officers, directors or persons who beneficially hold more than 10% of any class of equity securities in an issuer registered under S 12 of the 1934 Act to file Form 3 with the Securities and Exchange Commission (SEC) disclosing the ownership within 10 days after attaining that status. Another statement of ownership of equity seeurities must also be filed within 10 days after any month in which changes in ownership occur. Seoond, S 16 (b) prohibits these "statutory insiders" from making short-swing profits in the issuer's equity securities. Any purchase and sale occurring within any six -month period triggers a right of action in the issuer fer disgorgement of the trading profit. Although S 16(b) does not prohibit all insider trading, it restricts short-swing profits by officers, directors and 10% shareholders apart from the trading restrictions impnsed under SEC regulations implementing other provisions ofthe 1934 Act.Seeal$o17 C.F.R. SS 240.16a-1 - 240.1&10 (1985Hstock owner ship reporting requirements for directors, officers, and principal shareholders).
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tors, and ten percent shareholders of the issuer in a purchase and sale of the issuer's equity securities within any six-month period. However, a considerable insider trading jurisprudence has also developed around the separate anti-fraud provisions in section lO(b) of the 1934 Act' and Rule lOb-5 of the Securities and Exchange Commission (SEC).' These anti-fraud provisions have precipitated more litigation and uncertainty than any other part of the securities laws. The SEC has reinforced the insider trading restrictions with promulgation of Rule 14e-3 of the SEC,' an independent provision prohibiting insider trading in connection with tender offers.' Congress has further reinforced these trading restrictions by providing the SEC with the power to seek a treble penalty under the Insider Trading Sanctions Act of 1984 (ITSA).' This legislation empowers the SEC to base enforcement actions on any recognized theory of insider trading restriction.' In addition, tbe courts are aggressively applying the civil treble damage remedy found in the Racketeer Influenced and Cor rupt Organizations (RICO) provisions of the 1970 Organized Crime Con-trol Act' to cases of securities fraud, including insider trading.
This article traces the development of the public policy debate sur-rounding these insider trading provisions.10 To facilitate an evaluation
' 15 u.s.c. 78j (1982). ' 17 C.F.R. 240.10b-5 (1985). ' 17 C.F.R. 240.14e-3 (1985). ' See infra notes 110 and 135 and accompanying text. ' Pub. L. No. 98-376,98 Stat. 1264 (1964), 15 U.S.C. 78a note, 78c, 78c note, 78o, 78t,
78u(d)(2), 78ff, (Supp. 1984). ' See irifra notes 73-146 and accompanying text . 18 u.s.c. 1961-68 (1982). " No scarcity of printer's Ink has been spilled on the topic. H. MANNE. INSIDER TRADING
AND THE STOCK MARKET (1966); Brudney, Insiders, Outsiders and Iriformational Advantages under the Federal Se~mrities Laws, 93 HARV. L. REv. 322 (1979); Easterbrook, Insider Trading, Se
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of the restrictions, it relates this philosophical evolution to prevailing economic theory. After a brief introduction summarizing the case law history of Rule lOb-5 and insider trading, the theoretical and economic arguments are explored. Next the article analyzes recent legislation and the emergence of the expansive misappropriation theory, and makes some observations about the ironies created by the disjunction between the theory and the practice of the trading provisions. Finally, the article of-fers some new perspectives on insider trading analysis that a void the pitfalls of past analysis and of the contemporary approach, and provides insight into the costs and benefits of the trading restrictions. RULE lOb-5 AND COMMON LAW FRAUD
A fundamental problem for the courts confronting insider trading cases has been the relationship between Rule lOb-5 and the common law of fraud. Proof of the elements of securities fraud is somewhat less stringent than proof of common law fraud. This is consistent with the view that the federal regulatory scheme supplements the state cause of action to better protect the securities market's integrity. Most of the 10b-51itiga-tion has refined the elements of duty, scienter, reliance, and remedies. The courts' treatment of the scienter question displays the greatest con-sistency between lOb-5 and the common law. In private rights of action, scienter was required in Ernst & Ernst v. Hochfelder," and in SEC ad-ministrative prosecutions the scienter element was adopted in Aaron v. SEC." This reaffirmation of the strict common Ia w exclusion of ordinary negligence suits is the most fundamental similarity between the two ac-tions. However, liberalization of the other elements makes the federal cause of action more preventive than remedial, as under the common law.13
At common law, a defrauded plaintiff is required to prove a form of causation by showing that the defrauder's misstatement or omission led to justifiable reliance that induced the plaintiffs action or inaction."
tion of Insid.e Inf01'1nation: Some Empirical E'V'i.deme. 58 J. Bus. 69 (1985); Keown & Pinker ton, Merger Announcements and Insider Trading Activity: An Empirical Investigation, 36 J. FIN. 855 (1981); Jaffe, The Effect of Re!lUlation Clutnges em Insider Trading, 5 BELL J. ECON, & MGMT. Set 93 (1974); Jaffe, Special biformaticm and Insider Trading, 47 J. Bus. 410 (1974); Penflll!n, Insider Trading and the Dissemination of Firm's Forecast Informa tion, 55 J. Bus. 479 (1982).
" 425 u.s. 185 (1976) . .. 446 u.s. 680 (1980). " See H.R. REP. No, 83, 73d Cong .. 2d Sess. 1934); S. REP, No, 792, 73d Cong., 2d Sess.
(1934). By reducing the plaintiffs burden of proof under Rule 10b-5, the courts have furthered the congressional intent that the securities laws should prevent fraud and the attendant loss of confidence in the capital markets (securities market's integrity). This provides incentive to abstain from fraudulent activity and avert liability.
" RESTATEMENT (SECOND) OF TORTS 537, 546 (1977).
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an issuer who planned to sell most of the corporate assets purchased minority shares at prices well below the proportionate value to be real-ized from the asset sale. In another case with similar facts, a majority shareholder was held liable for nondisclosure of the undervaluation of inventory after purchasing minority shareholdings." After consumma tion of an undisclosed merger, the majority shareholder would have real-ized the gains.
The concept of tippee liability and the fiduciary requirement finally arose in the SEC administrative action of In re Cady, Roberts & Co. 25 There, a director of the Curtiss-Wright Corporation learned of an impending dividend reduction and disclosed this fact to a colleague at the brokerage house where they were both employed. The tippee liquidated the Curtiss-Wright shareholdings of several clients before the public announcement precipitated a market price decline. SEC Chairman Cary outlined the nature of the insider trading restriction:
Analytically, the obligation rests on two principal elements; first, the existence of a relationship giving access, directly or indirectly, to infor-mation intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage ol such information knowing it is unavailable to those with whom he is dealing."
Despite the insider/director's abstention from trading, his access to con-fidential information "tainted" the subsequent use of it, creating the con-cept of tippee liability.
The apparent precision and careful construction of the trading restric-tion were abandoned in later decisions. An era of expansive interpreta-tion of Rule lOb-5 followed, creating liability for perceived abuses without careful analysis of the consequences on the efficient functioning of the securities markets. This led to a period of uncertainty during which securities regulations i