A Brief Review of Insider Trading Law - Rule 10b-5

Insider trading law is highly complex. This is a brief summary of the law.

Rule 10b-5

1. Insider Trading

15 U.S.C. §78j(b) provides that it is unlawful “[t]o use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.” In 1942, the SEC adopted Rule 10b-5, 17 C.F.R. §240.10b-5, which provides:

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.

Although 15 U.S.C. §78j(b) and Rule 10b-5 were originally intended to supplement other antifraud provisions of the federal securities laws, they have become the most important provisions with regard to insider trading.

In the typical insider trading case, an insider who is aware of material information not available to the other party to the transaction or the public purchases or sells a security. In both instances, the cases under Rule 10b-5 focus on the accurate disclosure of material information by one who has such information or the abstention from trading until the information becomes public. For example, in Kardon v. National Gypsum Co., 73 F.Supp. 798 (E.D.Pa. 1947), the court ruled that corporate officers breached their fiduciary duty to selling shareholders and violated Rule 10b-5 when they purchased stock from shareholders without informing the shareholders that the stock was about to be acquired by a third party for a higher amount. Kardon is a classic example of prohibited insider trading.

Rule 10b-5 requires that those who possess inside information either refrain from trading in the security while the information is not public or disclose the information to the public themselves. Speed v. Transamerica Corp., 99 F.Supp. 808, supplemental op., 100 F.Supp. 461, petition denied, 100 F.Supp. 463 (D.Del. 1951). In Speed, 99 F.Supp. at 829, the court commented on the rationale for this duty of disclosure shortly after the enactment of Rule 10b-5:

The duty of disclosure stems from the necessity of preventing a corporate insider from utilizing his position to take unfair advantage of the uninformed minority stockholders. It is an attempt to provide some degree of equalization of bargaining position in order that the minority may exercise an informed judgment in any such transaction.

Nondisclosure or inaccurate disclosure of material information, combined with trading by one with inside information, may result in liability under one of the rule’s three clauses: as a scheme to defraud, as an untrue statement or misleading omission, or as an act or practice that operates as a fraud or deceit on someone in connection with the purchase or sale of a security.

The Seventh Circuit addressed insider trading in the context of the penalty provided in SEC v. Lipson, 278 F.3d 656 (7th Cir. 2002). The court held that the former chairman and chief executive officer of Supercuts, Inc., had properly been found liable for selling his company stock while in possession of material nonpublic information about disappointing revenues and high expenses.

Lipson sold 365,000 shares of Supercuts’ stock shortly before the company announced disappointing earnings. The earnings for the quarter amounted to 7 cents per share, significantly below the analysts’ projection of between 17 and 18 cents per share. Judge Ronald Guzman ordered Lipson to pay $2.8 million, which represented disgorgement of $621,000 in losses avoided by selling Supercuts’ stock, prejudgment interest of $348,000, and $1.8 million as punitive damages, which was three times the amount ordered disgorged.

Lipson contended that the jury improperly was instructed that, if it decided Lipson possessed insider information, it could infer that he used the information in selling his stock, and that accordingly, it improperly shifted the burden of persuasion from the SEC to himself. The Seventh Circuit agreed that such would have been improper but said that the jury was entitled to infer that, if Lipson had inside information, his securities trading was influenced by it. The court stated that common sense indicated that Lipson’s decision to sell when he did and to sell how much he did was influenced by the fact that he had possession of insider information that was unfavorable and likely to affect the market price of the stock.

In United States v. Bhagat, 436 F.3d 1140 (9th Cir. 2006), Atul Bhagat challenged his conviction for insider trading, securities tipping, and obstructing the course of an SEC investigation. Bhagat’s employer, Nvidia Corporation, successfully competed for a large contract to develop a video game console (the X-Box) for Microsoft. Nvidia’s CEO then sent a company-wide e-mail late on a Sunday night announcing the contract award. The next morning, Nvidia sent a number of follow-up e-mails. The first e-mail advised Nvidia employees that the X-Box information should be kept confidential. The other e-mails imposed a trading blackout on the purchase of Nvidia stock for several days and required Nvidia’s employees to cancel any open or outstanding orders for Nvidia stock. Bhagat purchased a large quantity of Nvidia stock — his largest purchase in nearly three years — roughly twenty minutes after the final company-wide e-mail. The government contended that Bhagat read the CEO’s Sunday night e-mail prior to purchasing the Nvidia stock.

There was no direct evidence that Bhagat read any of the e-mails prior to making his purchase. The government asked the jury to infer Bhagat’s knowledge of the contract award by virtue of the fact that he had probably read the original e-mail upon entering the office as a “normal, reasonable person” would. 436 F.3d at 1143. The Ninth Circuit upheld the trial court’s conviction of Bhagat, saying that the evidence presented was significant enough to support the jury’s conclusion that Bhagat was aware of the confidential information before he executed his trades.

In 2000, the SEC adopted Rule 10b5-1 to further define what it means to trade securities “on the basis of” material nonpublic information. Rule 10b5-1 addresses the issue of when insider trading liability arises in connection with a trader’s “use” or “knowing possession” of material nonpublic information. This rule provides that a person trades “on the bases of” material nonpublic information when the person purchases or sells securities while aware of the information. However, the rule also sets forth several affirmative defenses, which have been modified to permit persons to trade in certain circumstances when it is clear that the information was not a factor in the decision to trade. Specifically, there is no violation if the trade was made pursuant to a prearranged plan. For further information, see Allan Horwich, The Origin, Application, Validity, and Potential Misuse of Rule 10b5-1, 62 Bus.Law. 913 (2007).

a. What Information Is Material?

In TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 48 L.Ed.2d 757, 96 S.Ct. 2126, (1976), the Supreme Court concluded in the context of proxy solicitations under Rule 14a-9, 17 C.F.R. §240.14a-9, that a fact is material if there is a “substantial likelihood that, under all the circumstances, the omitted fact would have assumed actual significance in the deliberations of the reasonable shareholder.” In 1988, the Supreme Court held that the materiality test announced in TSC Industries applied to actions brought pursuant 15 U.S.C. §77j(b) and Rule 10b-5, 17 C.F.R. §240.10b-5. See Basic Inc. v. Levinson, 485 U.S. 224, 99 L.Ed.2d 194, 108 S.Ct. 978 (1988).

In Basic, the plaintiffs argued that merger discussions between Basic and another company were “material.” Over a two-year period, Basic’s officers met with representatives of Combustion Engineering, Inc., to discuss a possible merger of the two companies. After heavy trading in Basic’s stock, the company issued press releases to the effect that the company was unaware of any corporate developments that would explain the trading volume. Basic and Combustion agreed to merge in December 1978. Basic shareholders who sold their shares during the period from the first public denial of merger activities up to the trading halt imposed before the merger announcement brought a suit against Basic and certain of its directors, alleging that the public statements were false or misleading in violation of Rule 10b-5 and artificially depressed the stock prices. The district court granted summary judgment for Basic. The Sixth Circuit reversed, holding that, even if the discussions with Combustion Engineering were not “material” when they occurred, they became material when the corporation claimed that it was unaware of any corporate developments that would explain the trading volume. The Supreme Court held that “[m]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information.” 108 S.Ct. at 988.

Smith v. Shell Petroleum, Inc., Fed.Sec.L.Rep. (CCH) ¶95,316 (Del.Ch. 1990), is an example of how courts determine whether an omitted fact is “material.” In Smith, Shell Petroleum initiated a short-form merger with a subsidiary. Shell wanted to obtain exclusive ownership of the subsidiary by purchasing the interests of the minority shareholders. The plaintiffs were minority shareholders of the subsidiary. Shell sent disclosure materials to each plaintiff. Each had the option to accept Shell’s offer for the shares or to seek an appraisal of the shares in court. The plaintiffs sued Shell, alleging that Shell’s disclosure materials understated the value of the oil and gas reserves owned by the company by the sum of $1 billion. Shell admitted that the disclosure materials were inaccurate but argued that the $1 billion understatement was not “material.” The Delaware chancery court disagreed, holding that “there is a likelihood that the misdisclosure would have assumed actual significance in the deliberations of a reasonable shareholder in deciding whether to accept the consideration from the short-form merger or whether to seek an appraisal.” Fed.Sec.L.Rep. (CCH) ¶95,316 at p. 96,506. See also Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995) (“If the court determines that there is a substantial likelihood that disclosure of the information would have been viewed by the reasonable investor to have significantly altered the total mix of information, the statement is material.”); SEC v. Maio, 51 F.3d 623, 637 (7th Cir. 1995) (same standard). See also Allan Horwich, The Neglected Relationship of Materiality and Recklessness in Actions Under Rule 10b-5, 55 Bus.Law. 1023 (2000).

b. To Whom Does the Duty To Disclose Apply?

Rule 10b-5, 17 C.F.R. §240.10b-5, applies to “any person” and to securities of all issuers, whether they be small closely held corporations or publicly owned companies. The duty to disclose under Rule 10b-5 is not limited to officers, directors, or controlling shareholders of the issuer who are ordinarily considered to be “insiders.” There are two theories under which a person who trades a security on the basis of confidential information without disclosing that information will be held to have violated Rule 10b-5: (1) the classical theory and (2) the misappropriation theory.

(1) The classical theory

“Under the classical theory, a person violates [Rule 10b-5, 17 C.F.R. §240.10b-5] when he or she buys or sells securities on the basis of material, non-public information and at the same time is an insider of the corporation whose securities are traded.” SEC v. Maio, 51 F.3d 623, 631 (7th Cir. 1995), quoting SEC v. Cherif, 933 F.2d 403, 408 (7th Cir. 1991). “Classical theory applies to trading by insiders (or their tippees) in the stocks of their own corporations.” [Emphasis in original.] Maio, supra, citing Cherif, supra.

An example of insider trading under the classical theory occurred in In re Cady, Roberts & Co., [1961 – 1964 Transfer Binder] Fed.Sec.L.Rep. (CCH) ¶76,803 at p. 81,013 (Nov. 8, 1961) (1934 Act Release No. 6668). In Cady, an SEC enforcement proceeding, the respondent was a director of a corporation and an employee of a securities brokerage firm. In his capacity as a director, he learned that the corporation intended to reduce the dividend on its common stock. The respondent disclosed that information to the brokerage firm. The brokerage firm sold the common stock for its customers prior to public disclosure of the dividend reduction. The SEC ruled that the broker had a duty either to disclose the reduction in the dividend rate or to refrain from trading until such disclosure occurred. The holding was based on two principles: (a) the existence of a relationship giving access to information intended to be available for a corporate purpose and not for personal benefit and (b) the “inherent unfairness” when a person uses information knowing it is unavailable to others with whom he is dealing. Thus, the respondent had a duty to existing stockholders and to members of the public who purchased stock before the announcement of the dividend reduction.

SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 89 S.Ct. 1454 (1969), is the leading case under the classical theory of insider trading. In Texas Gulf Sulphur, the company discovered a rich ore strike. The company issued a press release stating that it was premature to draw conclusions about the magnitude or quality of the ore strike. At the same time, employees and officers of Texas Gulf purchased substantial amounts of the company’s stock. They made large profits when the value of the strike was fully disclosed. The court held that the company and the officers violated Rule 10b-5. In effect, the court found a duty to the market generally (and not merely to the shareholders of the corporation involved).

Texas Gulf Sulphur is properly viewed as a major expansion of insider trading liability. The court referred to the responsibility of “anyone in possession of material inside information” and an overall duty to shareholders in the marketplace. 401 F.2d at 848, 851 – 852. The court also commented that one who passes information on to another (the tipper) who buys or sells stock is as culpable as one who uses the information for his own benefit (the tippee). 401 F.2d at 852.

(2) The misappropriation theory

Under the misappropriation theory, a person violates Rule 10b-5, by “misappropriating and trading upon material information entrusted to him by virtue of a fiduciary relationship.” SEC v. Maio, 51 F.3d 623, 631 (7th Cir. 1995), quoting SEC v. Cherif, 933 F.2d 403, 410 (7th Cir. 1991). “Misappropriation theory ‘extends the reach of Rule 10b-5 to outsiders [or their tippees] who would not ordinarily be deemed fiduciaries of the corporate entities in whose stock they trade.’ ” [Emphasis in original.] Maio, supra, quoting Cherif, supra. Under the misappropriation theory, the person trading in the stock need not be an insider of the corporation (or a tippee of an insider) whose stock was traded for the conduct to violate Rule 10b-5. As the court explained in Maio, supra, “the misappropriation of material non-public information from its lawful possessor is regarded as a sufficient breach of fiduciary duty ‘in connection with’ the purchase or sale of a security to justify liability under Rule 10b-5.”

The misappropriation theory arose out of the Supreme Court’s holding in Chiarella v. United States, 445 U.S. 222, 100 S.Ct. 1108 (1980). In Chiarella, the defendant, an employee of a financial printing house hired to print certain documents related to a tender offer, was able to deduce the identities of the target companies. He then purchased stock in those companies and sold the stock at a profit after the tender offers were announced. He was convicted of securities fraud. The Supreme Court reversed his conviction for violating Rule 10b-5 and held that “liability is premised upon a duty to disclose arising from a relationship of trust and confidence between parties to a transaction.” 100 S.Ct. at 1115. The Court held that Chiarella had no duty to disclose the information because he did not owe a duty to the target company or its shareholders.

Chief Justice Burger dissented in Chiarella. The Chief Justice quoted with approval a commentator who stated, “Any time information is acquired by an illegal act it would seem that there should be a duty to disclose that information.” [Emphasis in original.] 100 S.Ct. at 1121, quoting W. Page Keeton, Fraud, Concealment and Non-Disclosure, 15 Tex.L.Rev. 1, 25 – 26 (1936). The concept became known as the “misappropriation theory.”

Shortly after Chiarella, the SEC promulgated Rule 14e-3, 17 C.F.R. §240.14e-3, which prohibits insiders and others with material nonpublic information from trading in corporate tender offers. See §1.103 below.

Several courts have followed Chief Justice Burger’s dissent in Chiarella and have applied the misappropriation theory to find violations of Rule 10b-5 when a person who was not in a confidential or fiduciary relationship with the issuer traded based on material nonpublic information.

In United States v. Newman, 664 F.2d 12 (2d Cir. 1981), two employees of investment banking firms misappropriated confidential information about mergers and acquisitions proposed by clients of their firms. The employees gave that information to Newman, who purchased stock in the takeover targets. When the merger plans were announced to the public, Newman sold the shares at a substantial profit. He shared the profits with the employees of the investment banking firms. The court held that Newman could be held criminally liable under Rule 10b-5 because he misappropriated material nonpublic information.

Dirks v. SEC, 463 U.S. 646, 77 L.Ed.2d 911, 103 S.Ct. 3255 (1983), made clear that the tipper must breach a fiduciary duty or the tippee has not breached Rule 10b-5. Dirks was an investment analyst who learned from a former employee of Equity Funding that that company had been fraudulently issuing insurance policies and recording the proceeds as income. Dirks tipped several institutions, which then sold $16 million in common stock before the fraud was exposed. He then contacted the SEC and the Wall Street Journal, and the fraud was eventually exposed. Dirks did not use the information himself and did not receive any direct personal benefit. However, the SEC censured Dirks for tipping his inside information. The Supreme Court reversed the censure. According to the Court, the employee’s purpose in informing Dirks was to expose the fraud, not to profit by using the information, so the tipper breached no duty to Equity Funding.

In SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), cert. denied, 105 S.Ct. 2112 (1985), an employee of a financial printing company learned the identity of certain target companies and purchased their stock before information relating to the tender offers became publicly available. Following Newman, supra, the Second Circuit affirmed. It held that “one who misappropriates nonpublic information in breach of a fiduciary duty and trades on that information to his own advantage violates Section 10(b) and Rule 10b-5.” 745 F.2d at 203.

In United States v. Winans, 612 F.Supp. 827 (S.D.N.Y. 1985), aff’d in part, rev’d in part, 791 F.2d 1024 (2d Cir. 1986), a writer for the Wall Street Journal was convicted of an insider trading scheme. Winans used information about the contents of future columns for his own trading, and he tipped the information to others who also used the information. The Second Circuit affirmed Winans’ conviction. Winans argued that he was not guilty because he was not a corporate insider and did not misappropriate information from insiders. However, the Second Circuit held that the misappropriation of nonpublic information from his employer in connection with a scheme to purchase and sell securities constituted a violation of Rule 10b-5. 791 F.2d at 1031 – 1032. The decision of the Second Circuit was affirmed by an equally divided Supreme Court in Carpenter v. United States, 484 U.S. 19, 98 L.Ed.2d 275, 108 S.Ct. 316 (1987).

In United States v. O’Hagan, 521 U.S. 642, 117 S.Ct. 2199 (1997), the Supreme Court formally recognized the validity of the misappropriation theory. The defendant, O’Hagan, was a partner of a law firm. He learned that one of the firm’s clients was preparing a tender offer of the common stock of Pillsbury Company. O’Hagan purchased Pillsbury stock and options on Pillsbury stock. When the tender offer was announced to the public, O’Hagan sold the securities for a profit of $4.3 million. He was convicted of violating 15 U.S.C. §78j(b). The Supreme Court held that “criminal liability under [15 U.S.C. §78j(b)] may be predicated on the misappropriation theory.” 117 S.Ct. at 2206. Under the misappropriation theory, “a fiduciary’s undisclosed, self-serving use of a principal’s 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.” 117 S.Ct. at 2207.

To establish guilt, the government must show that the tipper breached a fiduciary duty. When there is no breach of a fiduciary duty by the tipper, the tippee cannot be prosecuted under Rule 10b-5. In United States v. Chestman, 947 F.2d 551 (2d Cir. 1991), cert. denied, 112 S.Ct. 1759 (1992), the defendant was a stockbroker. One of his clients informed him that a public company, a majority of which was owned by a member of the client’s family, would soon be acquired. The defendant then purchased 3,000 shares of the company’s stock. After the deal was announced, the stock doubled in value. The defendant was convicted of violating Rule 10b-5. The Second Circuit reversed the conviction because the client (the tippee) did not breach a fiduciary duty to his family members and thus did not commit fraud, so the defendant “could not be derivatively liable as [client’s] tippee or as an aider and abettor.” 947 F.2d at 571.

The most significant case discussing the misappropriation theory in recent years is SEC v. Mark Cuban, 09-10996 (5th Circuit 2010). The SEC sued Mark Cuban, a noted entrepreneur for allegedly violating Section 10(b), Rule 10b-5 and Section 17(a) of the 1933 Act. The SEC alleged that Cuban was a large minority shareholder of Mamma.com, a Canadian company and that he received confidential information from the CEO of Mamma.com and agreed not to disclose that information. According to the SEC, Cuban violated the confidentiality agreement by selling his stock before the company announced an additional stock offering that would dilute his stake in the company. The district court dismissed the complaint but the Fifth Circuit reversed holding that Cuban could be held liable under the misappropriation theory because he assumed a duty of trust and confidence when he agreed to keep the information confidential.

Also significant is SEC v. Dorozhko, 574 F.3d 42 (2d Cir. 2009). The Dorozhko case extends insider trading liability under the misappropriation theory to outsiders who did not have a fiduciary relationship with the company where the outsiders wrongfully obtained the inside information through an affirmative misrepresentation.

c. When Does the Duty To Disclose Arise?

An implicit duty to disclose material information arises when a company or its insiders are trading in the company’s securities while in possession of material information that has not already been disclosed to the public. See, e.g., SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 853 – 854 (2d Cir. 1968) (en banc), cert. denied, 89 S.Ct. 1454 (1969). The Texas Gulf Sulphur court held that “[b]efore insiders may act upon material information, such information must have been effectively disclosed in a manner sufficient to insure its availability to the investing public.” 401 F.2d at 854.

d. Scienter Requirement

In an action for insider trading under the classical theory, the plaintiff must prove scienter. SEC v. Adler, 137 F.3d 1325, 1332 (11th Cir. 1998). In Adler, an insider sold thousands of shares of company stock prior to the company’s public disclosure that a major customer had ordered fewer of the company’s products than it had anticipated and that this shortfall in orders would reduce the company’s revenue and earnings for the next fiscal quarter. The SEC argued that the insider’s possession of material nonpublic information when he made the sale established scienter. The court disagreed. It held that scienter is established when the investor used inside information in making the trade. 137 F.3d at 1337. Under this test, “mere knowing possession — i.e., proof that an insider traded while in possession of material nonpublic information — is not a per se violation.” Id. The court explained that

when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading. The insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade — i.e., that the information was not used. The factfinder would then weigh all of the evidence and make a finding of fact as to whether the inside information was used. Id.

In Elkind v. Liggett & Myers, Inc., 635 F.2d 156 (2d Cir. 1980), the company tipped a financial analyst that its earnings for the second quarter would be lower than expected. A customer of the brokerage firm that employed the analyst sold his shares before the announcement and avoided the loss. The court found that the company had scienter. It held:

One who deliberately tips information which he knows to be material and non-public to an outsider who may reasonably be expected to use it to his advantage has the requisite scienter. 635 F.2d at 167.

A plaintiff must also prove that a tippee had scienter. In United States v. Libera, 989 F.2d 596 (2d Cir. 1993), the defendants obtained information contained in new issues of Business Week prior to the publication of the issues by paying employees of the printer for copies of the proofs of the magazine, and the defendants made significant profits from trading on that information. The defendants were convicted of insider trading because the evidence demonstrated that the tippers breached duties owed to the publisher and the printer and that the tippees (the defendants) were aware that the tippers had breached their duties to the printer and the publisher. 989 F.2d at 600.

In Ernst & Ernst v. Hochfelder, 425 U.S. 185, 47 L.Ed.2d 668, 96 S.Ct. 1375 (1976), the Supreme Court held that scienter, or the intent to deceive, manipulate, or defraud, is an essential element in a private cause of action under Rule 10b-5. Mere negligence does not violate Rule 10b-5. In Ernst & Ernst, the accounting firm was retained by a small brokerage firm to perform periodic audits. In its audits, Ernst & Ernst failed to detect a fraudulent securities scheme being carried out by the president of the brokerage firm, who had been regularly converting funds obtained from clients to his own use. Clients of the brokerage firm filed suit under Rule 10b-5 against Ernst & Ernst for negligently failing to detect and disclose the fraud. The court held that the accounting firm was merely negligent and thus could not be held liable under Rule 10b-5.

In Ernst & Ernst, the Court reserved the question of whether mere recklessness is sufficient to meet the scienter requirement in 15 U.S.C. §78j(b) and Rule 10b-5. 96 S.Ct. at 1381 n.12. Since that time, several circuits have concluded that recklessness will suffice. Several circuits have adhered to a “highly reckless” standard, defined as conduct showing “an extreme departure from the standards of ordinary care . . . to the extent that the danger was either known to the defendant or so obvious that the defendant must have been aware of it.” Rolf v. Blyth, Eastman Dillon & Co., 570 F.2d 38, 47 (2d Cir.), cert. denied, 99 S.Ct. 642 (1978), quoting Sanders v. John Nuveen & Co., 554 F.2d 790, 793 (7th Cir. 1977). In Searls v. Glasser, 64 F.3d 1061, 1066 (7th Cir. 1995), the court formulated the test as follows: “The plaintiff must also demonstrate that the deceit was committed with the intent to mislead or at least with recklessness so severe that it is the functional equivalent of intent.”