Insider Trading

August 1, 2007

Copyright 2007 Daniel B. Graves

Introduction*
Think about this Two neighbors own adjoining grazing land. One of them drills a well on his land and strikes oil, but the other one doesn't know it. May the person finding oil quietly buy out his neighbor's land as grazing land? It should be OK, so long as there is no affirmative misrepresentation, no fraud, and no relation of trust or confidence.

Examples thanks to Hamilton & Macy, Corporations (Thompson 8th ed.)

Introduction
What is a relationship of "trust and confidence"? A relationship in which the two parties are not dealing just as strangers at arms length but rather as friends, cooperating individuals with mutual interests, or some other heightened codependence. It may be based on personal friendship or prior transactions in which one party relied on the other to treat him fairly and, in fact, the other party did so.

Introduction
What is an affirmative misrepresentation? Assume that there is no relation of trust and confidence. The adjacent landowner who is selling his land to his neighbor asks the buyer neighbor, Have you done any drilling on your land? The buyer responds, "No. Is that OK?

No, that is fraud.

Introduction
What if, instead, the buyer responded, "Isn't it a nice day today?" or something off-putting like that to avoid answering the question? That hardly seems like a misrepresentation. What if the buyer says, "Look, Im a rancher not an oil speculator. You know that"? That is an offputting comment that probably is a fraudulent misrepresentation, since it implies that he has not drilled for oil when he in fact has.

Introduction
What if the person drilling hides the fact that he is drilling? Suppose that he does it at night, he puts up tall walls, or he otherwise hides the fact that there is drilling equipment on his land. At common law there probably was no liability for this conduct since the standard required an affirmative misrepresentation.

Introduction
And what about half-truths? At common law there is a principle about halftruths that might cover some nondisclosure situations. For example, the neighbor might ask, "Have you found natural gas?", and the buyer might respond, "No," when in fact he has discovered oil. That might be a half-truth. Generally, however, in arms-length transactions, so long as no affirmative misrepresentation is made, all of the true facts need not be disclosed.

Introduction
If we accept these general rules about fraud or misrepresentation in this land sale and other commercial transactions, is there any reason to apply different rules when an insider of a corporation is buying or selling shares of his corporation based on non-public information that he has about the corporation? Insiders almost certainly will know more about the affairs of the corporation than an outside shareholder. It doesnt seem fair to permit him to use this information for his own personal benefit to the detriment of an outside shareholder, who is a part owner of the business.

Introduction
And what about the converse situation? Assume that a director sells shares from his personal portfolio shortly before he releases bad news to a member of the general public who was not previously a shareholder. Should an insider owe a duty to the public in general? The transaction seems equally unfair, but there is no way under the common law of fraud to say that the director owes a duty to disclose bad news to everyone with whom he he plans to trade; the common law simply does not have a principle that covers such situations.

Introduction
And just recently, Joseph Nacchio, the former CEO of Qwest Communications, the third largest regional telecommunications company in the country, was convicted of 19 of 42 counts of insider trading for his sales of Qwest stock at a time when he knew the companys earnings were going to be negative and he did not disclose this fact to the public securities market. The companys other stockholders suffered a drop in the per share price of Qwest from $60 in 2000 to $2 in 2002.

Introduction
The federal judge in the case sentenced Nacchio to six years in prison in what prosecutors called the largest insider-trading case in history. The judge also ordered Nacchio to pay a fine of $19 million and forfeit $52 million he earned from his illegal stock sales in 2001. Nacchio made no affirmative false disclosure about the companys earnings. He simply neglected to reveal the impending negative earnings information and traded stock based on what he knew and failed to disclose. Would the common law result have been different?

Introduction
Given the state, then, of the common law, what was the biggest thing that ever happened in the history of the securities laws?

RULE 10b-5
Employment of Manipulative and Deceptive Devices

Rule 10b-5
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.

Rule 10b-5
Notice the typesetting of the last phrase of the Rule, which is set off to say, in connection with the purchase or sale of any security. This last phrase is in reference to each of the prohibitions set forth in the Rule. This is a securities fraud provisions, not a general fraud provision. In Blue Chip Stamps, the US Supreme Court held that only a person who actually purchased or sold a security could bring a private action under Rule 10b-5. What is a security? This term is defined in section 3 of the 34 Act (as well as section 2 of the Securities Act of 1933).

Rule 10b-5
Notice the typesetting of the last phrase of the Rule, which is set off to say, in connection with the purchase or sale of any security. This last phrase is in reference to each of the prohibitions set forth in the Rule. This is a securities fraud provisions, not a general fraud provision. In Blue Chip Stamps, the US Supreme Court held that only a person who actually purchased or sold a security could bring a private action under Rule 10b-5. There must be a purchase or a sale. A person who refrains from purchasing a security because another person misrepresented facts that cause him to so refrain has no standing to bring a 10b-5 case.

What is a security? 34 Act 3(10)

The term "security" means any note, stock, treasury stock, security future, bond, debenture, certificate of interest or participation in any profitsharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or in general, any instrument commonly known as a "security";

What is a security? 34 Act 3(10)

or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to or purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker's acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited. This should pretty much cover it all. You think?

The Wharf (Holdings) Ltd. v. UIH, Inc. (USSC 2001)

THE WHARF UIH

Hong Kong cable system franchisee

Colorado corporation

6-month oral option for 10% of cable franchise

~$66 million strike price

The Wharf (Holdings) Ltd. v. UIH, Inc. (USSC 2001)

UIH had an oral optiona right to buy10% of the Hong Kong cable franchise from The Wharf. Was this option a security within the meaning of Section 10(b) and Rule 10b-5? Yes. The statute specifically includes any option on any security and any right to purchase stock. An option is a also known as a derivative security in the sense that it is a separate security that derives from another underlying security, in this case being an equity interest of 10% of the future cable system.

The Wharf (Holdings) Ltd. v. UIH, Inc. (USSC 2001)

The option agreement here was an oral agreement that was never reduced to writing. Section 10(b) prohibits fraud in connection with the purchase or sale of a security. The Court noted that the Blue Chip Stamps case held that only actual purchasers and sellers have standing to bring private actions under Section 10(b).

What did the Court say about whether UIH was a purchaser of the option security?
That Blue Chip Stamps did not suggest that oral agreements are outside the scope of the causes of action and that, here, UIH had purchased the option in consideration of its provision of the services contemplated by the oral agreement.

The Wharf (Holdings) Ltd. v. UIH, Inc. (USSC 2001)

The Court held that a sale of an option without an intent to permit the exercise of the option is misleading. A buyer normally presumes good faith on the part of a seller and a promise made without an intention to perform is, therefore, fraudulent. Further, the value of the option was zero given the lack of intention to perform and The Wharfs failure to disclose its lack of intention to permit exercise of the option was fraudulently misleading. The Court noted the elements of a cause of action under Rule 10b-5.

Securities Fraud Cause of Action

ELEMENTS OF SECTION 10(b) AND RULE 10b-5 CAUSE OF ACTION Listed Manipulative or Deceptive Device Use (in interstate commerce) of 1 of the 4 kinds of manipulation or deception listed in Rule 10b-5: Any device, scheme, or artifice to defraud Any untrue statement of a material fact Omission of a material fact necessary in order to make the statements made not misleading Any other act, practice, or course of business that operates as a fraud or deceit

Securities Fraud Cause of Action

Scienter Plaintiff must show that the defendant acted with an intent to deceive, manipulate, or defraud. See Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1986). The Court in Hochfelder left open the question whether recklessness is sufficient.

Negligence does not suffice, but numerous lower court decisions after Hochfelder hold that recklessness does suffice.

Securities Fraud Cause of Action

Scienter What constitutes recklessness is not altogether clear, but it would appear that it must be highly unreasonable conduct, not just simple or inexcusable neglect. Recklessness is some extreme departure from the standards of ordinary care and which presents a danger of misleading buyers or sellers that is known to the defendant or is so obvious that the defendant should have been aware of it. See Sunstrand Corp. noted on Text page 534.

Securities Fraud Cause of Action

Scienter Merriam-Websters Dictionary defines the term scienter. Etymology: Latin, knowingly, from scient- sciens, present participle of scire to know 1 : knowledge of the nature of one's act or omission or of the nature of something in one's possession that is often a necessary element of an offense; also : intent to engage in particular esp. criminal conduct. 2 : a mental state in fraud (as securities fraud) that is characterized by an intent to deceive, manipulate, or defraud.

Securities Fraud Cause of Action

Causation Plaintiff must show that the misstatement caused the damages. If a corporation issued an overly optimistic press release, for example, the plaintiff must show that the release caused the price of the security to rise. The defendant could then try to rebut the claim with evidence that the misstatement nevertheless did not contribute to the plaintiff's loss. There are 2 types of causation: (1) transaction causation and (2) loss causation.

Securities Fraud Cause of Action

Materiality Plaintiff must show that a reasonable investor would likely consider the misstatement important. If a reasonable investor considers a fact or mix of facts important, that will necessarily affect the price that he will pay for the security.

Securities Fraud Cause of Action

Reliance Plaintiff must show that damages were sustained because of reliance on the misrepresentation.

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
Facts TGS was exploring for ore in northern Canada. On November 13, 1963, TGS officers learned that the company might have struck a rich vein of ore. Over the next several months, the officers kept quiet about the discovery, but TGS continued its tests. TGS began buying land in the area, so there was a good business justification for nondisclosure, at least until the land acquisitions had been completed.

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
Facts During the nondisclosure period, various TGS insiders bought TGS stock and options. At the time of the ore strike, these insiders owned about 1,100 shares of stock and no options. By April 1964, they held 8,200 shares and options to buy 12,300 more. Because of various leaks (perhaps resulting from this insider trading, although the case doesnt say) and rumors (it would have been difficult to keep completely secret the substantial activity in Canada), the price of TGS stock rose steadily. In November, the trading price for TGS stock sold $17 per share. By April 13, it had risen to $31; by the end of the day on April 16 it was $36, and by May 15 it was $58.

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))

$70 $60 $50 $40 $30 $20 $10 $0 TGS Market Price 13-Nov 13-Apr 16-Apr 15-May

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
On April 12, the company issued a press release (published on Monday, April 13) designed to quell the rumors. Construed narrowly, perhaps it was not false. Yet it seemed designed to create, and probably did create, the false impression that there was no substantial evidence of a valuable ore discovery. On April 15, TGS finally disclosed the ore strike and the news was made public on April 16. The SEC, seeking an injunction and other remedies, sued TGS for issuing a misleading press release and it sued the officers for insider trading.

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
Important points of the case: 1. TGS could keep the ore vein discovery quiet while it purchased the neighboring land. TGS had no duty to disclose the discovery to the people from whom it bought the land.

2. If a company decides not to discloseso that, for example, it could purchase neighboring land cheaply insiders must not buy stock. If the insiders want to purchase, the company must first disclose the inside information. This is the disclose or abstain rule.

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
Important points of the case: 3. The Court announced a reasonable investor standard for materiality: information is material if a reasonable investor would consider it important. Such an investor will consider information important if it might affect the value of the stock. (Look back and see how this compares with the materiality test we saw in the Rule 14a-9 proxy fraud cases, e.g., TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438 (1976). Is materiality a would have, should have, could have, or might have test or is it something else?)

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
Important points of the case: On this same point, the court said that the materiality of undisclosed facts about a particular event is determined by a balancing test: Indicated probability that the event will occur versus The anticipated magnitude of the event in light of the totality of the company activity I (among others Im sure) call this the TGS probability/magnitude materiality test.

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
Important points of the case: 4. Insiders must not trade until the material information has been disseminated effectively. Thus, the TGS insiders who traded before the April 16th public release violated Rule 10b-5. And even after information has been disclosed, a cooling off period is required to allow the market to incorporate the information. Presumably, one must wait until he has no advantage over potential purchasers. How long is long enough?

SEC v. Texas Gulf Sulphur (2d Cir. 1968)(USSC cert denied (1969))
Important points of the case: 5. One need not be a purchaser or seller to be liable under Rule 10b-5. Rather, one need only act or omit to act in connection with the purchase or sale of a security. The Court held that TGS issued its press release in connection with the purchase or sale of a security. The language of Rule 10b-5 suggests that the drafters intended it to apply to fraud committed by someone who was buying or selling a security, but TGS was doing neither. It didnt matter. A press release is issued in connection with a purchase or sale if a reasonable investor would rely on it in deciding whether to buy or sell.

Basic Inc. v. Levinson (USSC 1988)

This case involved the question of when preliminary corporate merger negotiations become material. Also, the Court determined whether a plaintiff is entitled to a rebuttable presumption that he traded a security, after a materially misleading statement by the securitys issuer, based on the integrity of the stock price as set by the stock market.

Basic Inc. v. Levinson (USSC 1988)

A typical merger negotiation timeline:
Letter of Intent/Agreement in Principle/Standstill Agreement signed Definitive merger agreement executed

Preliminary due diligence

Private discussions or solicitations of interest begin

Detailed due diligence conducted while merger agreement negotiations occur

Merger Consummated

At what time does the fact of the merger negotiations become material and should be disclosed?

Basic Inc. v. Levinson (USSC 1988)

Is the timing of materiality of merger discussions a bright line test?

Whats an example of a bright line test for materiality?

What test did the Court say should apply in the merger context?

What did the Court decide is the general standard of materiality for Section 10(b) and Rule 10b-5 cases?

Basic Inc. v. Levinson (USSC 1988)

In Basic, Combustion Engineering and Basic had meetings and conversations in 1976 regarding a possible merger. In 1977 and 1978, Basic made three public statements denying it was engaged in merger negotiations. On Dec. 19, 1978, Basics board of directors endorsed Combustion Engineerings offer to purchase shares of its common stock for $46. Shareholders brought a class action against the corporation and its directors, alleging Basic had made three false or misleading statements and that the shareholders had been injured when they sold their shares at prices artificially depressed by those statements.

Basic Inc. v. Levinson (USSC 1988)

The Supreme Court characterized the issue of whether merger negotiations may be material in any particular case as a factual determination. The Court held that only if there is 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 should the fact be regarded as material.

Basic Inc. v. Levinson (USSC 1988)

Rather than relying on a bright-line test, the Court held that the determination of materiality requires the balancing of the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the activity. No particular fact or event, taken in isolation, will be necessary or sufficient for the determination of materiality; rather, the fact finder must address the totality of the facts in each instance to determine whether the merger negotiations in question are material.

Basic Inc. v. Levinson (USSC 1988)

The Court noted that the balancing analysis requires the fact finder to focus on the companys degree of interest in the transaction to determine the probability that the merger will occur. Among the indicia of interest that the Court noted, by way of example, are board resolutions, instructions to investment bankers, and actual negotiations. To determine the magnitude of the transaction, the fact finder should consider the size of the entities as well as the potential premiums over market value.

Basic Inc. v. Levinson (USSC 1988)

What is the fraud on the market theory? The plaintiff is entitled to a presumption of reliance on the basis of the fraud on the market theory. This presumption may be rebutted by the defendant. What did Justices White and OConnor mean in their dissent which reflected their disbelief in the integrity of the market price?

Safe Harbor for Forward-Looking Statements

Section 21E of the 34 Act provides a safe harbor for forward-looking statements, which are statements relating to the future such as earnings estimates. A person is insulated from liability for forward-looking statements so long as the conditions of the safe harbor are met. This safe harbor was added as part of the Private Securities Litigation Reform Act of 1995. The bespeaks caution doctrine, which pre-dates Section 21E, protects a person from liability for forwardlooking statementseven though they are misleading if the statement is couched in sufficient cautionary language.

Safe Harbor for Forward-Looking Statements

A typical concise version of a forward-looking statements disclosure:

In accordance with the safe harbor provisions of the Private Securities Litigation Reform Act of 1995, XYZ, Inc., notes that any statements in this press release, and elsewhere, that are not historical facts are "forwardlooking statements" that involve risks and uncertainties that may cause the Company's actual results of operations to differ materially from expected results. For a discussion of such risks and uncertainties, see the Company's Annual Report on Form 10-K for the most recently ended fiscal year as well as its other filings with the U.S. Securities and Exchange Commission.

Aiding and Abetting

The case of Central Bank of Denver is noted on Text page 579. This is an important Supreme Court decision pertaining to the liability of secondary parties to alleged violations of 10-5. These secondary players are lawyers, accountants, investment bankers, and other ancillary persons involved in securities purchases and sales.

Aiding and Abetting

For nearly 30 years prior to Central, the federal judiciary recognized, under section 10(b) of the 1934 Securities and Exchange Act and SEC rule 10b-5(4) promulgated thereunder, an implied private right to sue for aiding and abetting. Despite the absence of an express statutory remedy under section 10(b), civil aiding and abetting liability has been recognized and fully developed in 11 federal circuits. Employing this form of liability, commonly referred to as secondary liability, plaintiffs have targeted the "deep pockets" of accountants, lawyers, bankers, and other securities professionals.

Aiding and Abetting

After twice reserving comment on whether section 10(b) conferred an implied right to sue for aiding and abetting, the Supreme Court in Central decided whether the implied private right exists under section 10(b) and Rule 10b-5. Despite its settled construction, the Central Court held that a private plaintiff could not sue for aiding and abetting under section 10(b). The Court's decision and its broad ramifications generated a flurry of both criticism and credence.

Aiding and Abetting

Justice Kennedys majority observed that section 10(b) only prohibits manipulative or deceptive acts in connection with the purchase or sale of securities. Since aiding and abetting falls short of manipulative or deceptive conduct, he refused to extend the section 10(b) language to prohibit conduct not expressed in the text of the statute. Expansion of the statute, Justice Kennedy reasoned, would "add a gloss to the operative language of the statute quite different from its commonly accepted meaning.

Aiding and Abetting

The majority, therefore, reached the "uncontroversial conclusion, accepted even by those courts recognizing a Section 10(b) aiding and abetting cause of action, that the text of the 1934 Act does not itself reach those who aid or abet a Section 10(b) violation. Unlike the federal courts before it, however, the Supreme Court disposed of the case.

Chiarella v. United States (USSC 1980)

Petitioner Vincent Chiarella worked in the composing room of Pandick Press, a financial printer. An acquiring corporation hired Pandick to produce announcements of corporate takeover bids. Although the identities of the acquiring and target corporations were concealed, Chiarella was able to deduce the names of the target companies. Without disclosing his knowledge, Chiarella purchased stock in the target companies and sold the shares immediately after the takeover bids were made public. Chiarella realized slightly more than $30,000 in profits from his trading activities.

Chiarella v. United States (USSC 1980)

The SEC then investigated Chiarella's trading activities. Chiarella entered into a consent decree with the SEC in which he agreed to return the profits he made to the sellers of the shares. A few months later, Chiarella was indicted on 17 counts of violating Section 10(b) of the rule 10b-5. Remember that Section 10(b) of the 1934 Act prohibits the use "in connection with the purchase or sale of any security" of "any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe." Rule 10b-5 makes it unlawful for any person to "employ any device, scheme, or artifice to defraud... in connection with the purchase or sale of any security." Chiarella was convicted at trial and the Court of Appeals for the Second Circuit affirmed his conviction.

Chiarella v. United States (USSC 1980)

What was the question presented? Did Chiarella violate Section 10(b) of the 1934 Act by failing to disclose the impending takeover before trading in the target company's securities?

Chiarella v. United States (USSC 1980)

No. A duty to disclose information arises if there is a relationship of trust and confidence between parties to the transaction. Chiarella had no such duty. He was not a corporate insider in the acquiring corporation and he did not receive confidential information from the target company. He also had no fiduciary relationship with the shareholders of the target company: he was not their agent; they placed no trust or confidence in him; indeed, they had no prior dealings with him. A duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.

Dirks v. SEC (USSC 1983)

In this case we have a broker-dealer officer who specialized in providing investment advice to institutional investors. He received information from a former officer of a company constituting an allegation that assets of the company were vastly overstated as a result of fraudulent corporate practices. Dirks was a tippee of the information from Secrist, the tipper. Dirks decided to investigate the allegation.

Dirks v. SEC (USSC 1983)

Neither Dirks nor his firm owned or traded the securities of Equity Funding. But during his investigation, he talked openly the information he had received with a number of clients and investors. During a two-week period while Dirks investigated the allegations, the stock price of Equity Funding fell from $26 to less than $15 per share.

Dirks v. SEC (USSC 1983)

The SEC looked into Dirks role in the exposure of the fraud at Equity Funding. It charged that Dirks had aided and abetted violations of the Securities Act and the Exchange Act, including Section 10(b) and rule 10b-5. The SEC censured Dirks. He sought review by the DC Circuit Court, which entered judgment gainst. He appealed to the Supreme Court.

Dirks v. SEC (USSC 1983)

The U.S. Supreme Court ruled that an insider of a public company breaches his duty to shareholders and violates Section 10(b) and rule 10b-5 of the Securities Exchange Act when, for his own personal benefit, he tips material nonpublic information about his company to an outsider who trades the companys securities on the basis of such information. Because the SEC prosecuted Dirks under the classical theory of insider trading, the Supreme Court did not address whether the personal benefit test also applied to prosecutions under the burgeoning misappropriation theory of insider trading.

Dirks v. SEC (USSC 1983)

The Dirks Court set forth the personal benefit test for tippers in classical insider trading cases. It ruled that a corporate insider who tips material nonpublic information to outsiders (resulting in a trade of the corporations securities by the tippee or a remote tippee), breaches a duty to shareholders only if his motivation for providing the tip was pecuniary gain or reputational benefit that will translate into future earnings, or to make a gift of confidential information to a trading relative or friend.

United States v. OHagan (USSC 1997)

In 1997, the U.S. Supreme Court in U.S. v. OHagan fully endorsed the misappropriation theory for the first time. OHagan, a lawyer, was found guilty after trial of insider trading under rule 10b-5, because he purchased shares of the target company of a proposed acquisition based on information he misappropriated from his law firm and its client, the company seeking to acquire the target.

United States v. OHagan (USSC 1997)

The Court upheld a conviction, ruling that, under the misappropriation theory, a fiduciarys undisclosed, self-serving use of a principals information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information.

Misappropriation, use, tipping, etc. of material, nonpublic information

The view that insider trading is wrong per se for market reasons is debatable. The cases from Chiarella to OHagan demonstrate a view that insider trading is, however, unfair. It is unfair for an insider or any other person who is privy to material information that has not been made public or has not been disclosed to a buyer or seller by the person with such knowledge to gain from a transaction on the basis of that information. Following are some examples for analysis and discussion:

Rule 10b5(1)

In October 2000, the SEC adopted Rule 10b5-1 which provides insiders of a company additional flexibility in trading the company's securities. Rule 10b5-1 broadens the scope of Rule 10b-5 by providing that a person will be deemed to have traded on the basis of material, nonpublic information if he or she was aware of the material, non-public information at the time of the trade. However, the rule also provides insiders with an affirmative defense from liability for the purchase or sale of securities even if they are aware of material, non-public information at the time of the purchase or the sale.

Rule 10b5(2)

Rule 10b-5(2) was also adopted in 2000. Rule 10b5-2 extends insider trading penalties to trading on the basis of material nonpublic information if (i) the recipient has expressly agreed to maintain confidentiality, (ii) the recipient knows or reasonably should know that the disclosing person expects the information will remain confidential or (iii) the disclosing person and the recipient have a family relationship, even in the absence of some other duty of confidentiality.

Insider Trading

So, insider trading has not been expressly defined by any statute or rule. Instead, insider trading law has developed on a case-by-case basis under the antifraud provisions of the federal securities laws, primarily Section 10(b) of the Securities Exchange Act and Rules 10b-5, 10b-5(1), and 10b-5(2).

10(b) and 10b-5 Discussion Examples

Example 1 In the OHagan case, Justice Ginsburg's opinion says that no violation of Rule 10b-5 would have occurred if O'Hagan had told Dorsey & Whitney and Grand Met that he proposed to invest in Pillsbury stock and options. If my instructions for your final exam were as follows, what would you think? How is this similar to the OHagan opinion?

10(b) and 10b-5 Discussion Examples*

Example 1 You may use your own outline on this exam. You may also use an outline that has been entrusted to you by someone else, but you must tell the other person that you are using her outline on the exam. You do not need her permission. You may furthermore use outlines that you steal from other persons before or during the exam, so long as those outlines were not entrusted to you by anybody.
*From Hamilton & Macey, Corporations (8th ed.)(quoting Painter/Krawiec/Williams).

10(b) and 10b-5 Discussion Examples

Example 2 A psychiatrist buys or sells shares of BankAmerica Corporation after learning from a patient (the wife of the president of American Express) that her husband is seeking to become the CEO of BankAmerica.

Presumably, the psychiatrist owes a fiduciary duty to his patient and he has violated Rule 10b-5.

10(b) and 10b-5 Discussion Examples

Example 3 Assume the same facts as in Example 2, except that the wife passes the inside information to her hairdresser, who buys or sells shares of BankAmerica. It is difficult to believe that a fiduciary duty exists between hairdresser and customer.

10(b) and 10b-5 Discussion Examples

Example 4 A chief financial officer confesses to a priest that she has manipulated the books to increase earnings. The priest absolves the penitent of her sins and calls his broker to place a sell order.

Presumably the priest has violated a fiduciary duty to the penitent.

10(b) and 10b-5 Discussion Examples

Example 5 The CFO in the previous example tells a fellow parishioner, who offers to pray that the CFO will be given divine forgiveness and then he calls his broker. Presumably there is no fiduciary relationship between parishioner and parishioner, but there may be a question whether the parishioner has a duty under church doctrine not to disclose or use the information.

END OF SLIDES (August 1, 2007)