“Fine Distinctions” in the Contemporary Law of Insider Trading

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William Cary’s opinion for the SEC in In re Cady, Roberts & Co. built the foundation on which the modern law of insider trading rests.  Today, we have a stable framework of three distinct legal theories—the classical theory, the misappropriation theory, and Rule 14e-3—each of which is well understood as to its basic elements. Most insider trading cases handed down in any given year say nothing particularly new about the state of the law, but rather simply apply familiar principles to sometimes challenging facts. But every so often we do discover something new about the core conception(s) of insider trading. My paper, “Fine Distinctions” in the Contemporary Law of Insider Trading, a contribution to Columbia Law School’s recent celebration of Cary’s Cady Roberts opinion, explores some of these—particularly the emergence of a doctrine of “reckless” insider trading.

Historically, the crucial question is this: how or why did the insider trading prohibition survive the retrenchment that happened to so many other elements of Rule 10b-5?  The Supreme Court’s decision in Chiarella v. United States in 1980 written by Justice Lewis Powell cut back on the law’s scope, but still sustained the useful fiction developed by Cary of insider trading as actionable deception. The core of insider trading regulation was left standing. We might call this a fictional “Cary-Powell compromise,” because Justice Powell was the moving intellectual force on the Court in reconceptualizing insider trading and cited Cady Roberts repeatedly and with apparent favor in both Chiarella and its follow-on, Dirks v. SEC, even as he was otherwise doing so much pruning.  Powell’s two opinions joined with Cary’s in promoting the fiduciary’s duty of affirmative disclosure as the crucial explanation for how insider trading can be thought to be deceptive, without mention of the lingering irony of depending so much on purely constructive fraud. The later-developing misappropriation theory, a significant modification to the compromise that the Court finally ratified in United States v. O’Hagan in 1997, long after Justice Powell had retired, was even more accommodating in accepting fiduciary faithlessness as deception, pushing the law back more in Cary’s direction.  This strange and intellectually ungainly judicial commitment to assertive insider trading regulation, even by some fairly conservative judges, shows how powerful a totemic symbol the prohibition of insider trading has become in “branding” the American securities markets as supposedly open and fair, and American securities regulation as the investors’ champion. Insider trading regulation had already taken on an expressive value far beyond its economic importance, which judges were reluctant to undercut.

My argument is that the Supreme Court embraced the continuing existence of the “abstain or disclose” rule, and tolerated constructive fraud notwithstanding its new-found commitment to federalism, because it accepted the central premise on which the expressive function of insider trading regulation is based: manifestations of greed and lack of self-restraint among the privileged, especially fiduciaries or those closely related to fiduciaries, threaten to undermine the official identity of the public markets as open and fair.  The law effectively grants an entitlement to public traders that the marketplace will not be polluted by those kinds of insiders.  But enough time may have passed that we may have lost sight of the compromise associated with this fiction and started acting as if insider trading really is the worst kind of deceit. The result is pressure on doctrine to expand, using anything plausible in the 10b-5 toolkit.

My aim in the paper is to tie this concern more clearly to the uneasy deceptiveness of insider trading, first using somewhat familiar examples such as the debate over whether possession or use is required for liability and the supposed overreach of Rule 10b5-2.  Each of these settings brings us back to the centrality of intent, reminding us that the Cary-Powell compromise has in mind a form of purposefulness that is closely tied to greed and opportunism, making insider trading a sui generis form of securities fraud. That takes us to the most jarring recent development in insider trading law, the emergence (particularly in SEC v. Obus) of recklessness as an alternative basis for liability.  I finish with a brief consideration of insider trading without a fiduciary breach.

The full text of the article is available here.  Any feedback would be greatly appreciated.

2 Comments

  1. Mark Rosen

    This is an excellent piece that cogently addresses many if not all of the key issues in insider trading jurisprudence. I would posit that, in Obus, the Second Circuit made an even larger departure from established principles of scienter than you suggest. The court construed Dirks’ “should know” language as allowing for a negligence standard with respect to tippee scienter (regarding the tippee’s awareness of the tipper’s breach of a fiduciary-like duty). However, negligence has never been sufficient to sustain a securities fraud claim, and courts have consistently held that “should have known” means recklessness, not negligence. See, e.g., Novak v. Kasaks, 216 F.3d 300, 308 (2d Cir. 2000) (“securities fraud claims typically have sufficed to state a claim based on recklessness when they have specifically alleged defendants’ knowledge of facts or access to information contradicting their public statements. Under such circumstances, defendants knew or, more importantly, should have known that they were misrepresenting material facts related to the corporation”). In the insider trading context, Warde’s progeny (Franco, Sekhri, Alexander) confirm that the tippee must at least be reckless in not knowing that the information was conveyed in breach of a fiduciary-like duty. And of course, as you point out, Falcone and Chestman apply an even higher standard of actual knowledge, albeit in the criminal setting.

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