Insider Trading As Fraud

U.S. Insider trading law is strange. Because Congress has never adopted a comprehensive statute on the subject, insider trading law is largely a species of federal common law. That’s not to say that the Supreme Court has nothing to go on — since 1980, it has developed its insider trading jurisprudence around Section 10(b) of the Securities Exchange Act of 1934 and the SEC’s Rule 10b-5. But in some ways, this fact makes things even stranger because Rule 10b-5 simply creates liability for securities fraud. And yet, what does insider trading have to do with fraud?

A lot, or so I argue in a recent article. Specifically, I suggest that Rule 10b-5 should be understood as altering the common law rule that prevents contracting parties from effectively deterring certain hard-to-detect breaches, of which insider trading is but one example. I refer to this as the “contractual fraud theory” of insider trading law. The gist of the argument can be illustrated with a simple example highlighting the limitations contract law historically faces in helping people protect valuable information: If a company hires a consultant to provide strategic advice regarding a potential merger, the company might try to protect its merger-related information by means of a contractual confidentiality or non-use provision. But this only works if the company is able to detect the breach of those contractual duties, and some breaches, like the use of information, are difficult to detect. To that end, the company might include an additional contractual provision requiring the consultant to disclose a breach of the underlying confidentiality or non-use provision itself. The problem is that at common law courts are extremely reluctant to award extra-compensatory damages, and therefore the breach of this “disclosure covenant” would not result in liability that is any different from the breach of the underlying confidentiality or non-use agreement. In other words, the breaching party has no incentive to disclose the underlying breach because it doesn’t avoid any additional damages by doing so. This result has not escaped the critical eye of contract scholars.[1]

Under the contractual fraud theory, insider trading law fixes this common law problem, at least insofar as it pertains to the protection of information from insider trading. It fixes it by imposing extra-compensatory (potentially treble) damages on insider trading in situations where we think that the parties are likely to have bargained for such a result, if they were able to, at common law. Such a hypothetical bargain is likely to be found where it is difficult to protect one’s information in other ways — for example, by controlling the flow of information to a counterparty — because doing so would fundamentally undermine the nature of the relationship in the first place. Controlling information flow, for example, might not be feasible in a fiduciary relationship with a lawyer or an employee, because of the open-ended, multi-faceted nature of those relationships. But it might be feasible in an arm’s length contract involving a supplier. Consequently, under the contractual fraud theory, it is reasonable to assume that parties have implicitly opted for the extra-compensatory damages made possible by the insider trading law regime in the fiduciary relationship but not the arm’s length one. Additionally, there might be other non-fiduciary relationships, for example certain strategic alliances, where alternatives to the insider trading law regime for protecting one’s information are similarly problematic and where insider trading liability should therefore apply.

Thus, the contractual fraud theory explains why there should be insider trading liability in fiduciary relationships and not in arm’s length ones. But it also answers one of the other enduring questions of insider trading law: To what non-fiduciary relationships (if any) should insider trading liability attach? Under the contractual fraud theory, the answer is straightforward: Those situations where, because of the nature of the relationship, alternative ways of protecting information are simply not feasible.

The contractual fraud theory also explains other puzzling features of modern insider trading law. For example, under settled law, there is no insider trading liability where a thief, with no relationship to a particular company, steals that company’s material non-public information and trades on it. Other theories of insider trading law have a difficult time explaining why this is so. But not the contractual fraud theory. Under that theory, insider trading law is principally about solving a contracting problem: how to contractually protect against hard-to-detect breaches. Yet, in the case of our unaffiliated thief, there is no contractual relationship, and therefore under this theory, the law is correct not to impose insider trading liability.

Yet the case of the unaffiliated thief isn’t even the most puzzling feature of insider trading law. That questionable honor would have to go to what many consider to be the truly wrongheaded result illustrated by the “brazen fiduciary.”[2] It should not be surprising that there is liability if a company’s lawyer trades on his client’s information in breach of his fiduciary duty of loyalty and confidentiality. That is the case under settled law, and it is also the case under the contractual fraud theory. But the law also holds that the lawyer can escape liability for insider trading simply by informing his client of his intent to trade ahead of time. This result is almost uniformly criticized, in some cases mercilessly so, and yet under the contractual fraud theory, it makes some sense: Insider trading law is about solving the problem of hard-to-detect-breaches. A breach isn’t hard to detect if the breaching party affirmatively discloses it, and therefore under the contractual fraud theory, the law is correct to find no liability there.

Finally, the contractual fraud theory of insider trading law implies that the SEC should be allowed to take a different view of Rule 10b-5 than the Supreme Court does.  The question at the heart of the contractual fraud theory is whether, in a given contractual relationship, the court should find an implicit agreement to disclose the breach of a fiduciary or contractual duty not to engage in insider trading. That inquiry turns on the private costs and benefits of such a provision; that is to say, the information owner’s cost of protecting the information through means other than the insider trading law regime and the benefit of having the contracting party disclose the breach, which is a function of how costly the breach is to detect. But there are also public costs and benefits associated with insider trading, for example, the costs to the economy if insider trading undermines the integrity of markets and the efficiency benefits that some commentators argue might arise from more insider trading. While the courts aren’t particularly well equipped to weigh such considerations, the SEC certainly is, hence the reason why under the contractual fraud theory the SEC might take a broader view of insider trading law than the Supreme Court.

Such a conclusion has important implications, not least of which have to do with the validity of Rule 10b5-2, the SEC rule that purports to extend the Supreme Court’s insider trading jurisprudence to any contractual relationship containing a duty of trust or confidence. Under the contractual fraud theory, Rule 10b5-2 isn’t necessarily invalid just because, as some commentators argue and some courts have held, it casts a wider liability net than the one created by the Supreme Court.

True, the contractual fraud theory might not be the theory that one would use to construct the ideal body of insider trading law from scratch. But it is the theory that, in my view, best explains the shape of the law we have ended up with, and for that reason, it is the best theory for predicting how the doctrine will develop in the future.

ENDNOTES

[1] See Gregory Klass, Contracting for Cooperation in Recovery, 117 Yale L.J. 2 (2007).

[2] This is Donna Nagy’s term. See Donna M. Nagy, Reframing the Misappropriation Theory of Insider Trading Liability: A Post-O’Hagan Suggestion, 59 Ohio St. L.J. 1223, 1257 (1998).

This post comes to us from Professor Zachary Gubler at Arizona State University’s Sandra Day O’Connor College of Law. It is based on his recent article, “Insider Trading As Fraud,” available here.