Insider Trading Rules Need Rationalization

The current scope of the insider trading prohibition is arbitrary and unrationalized.  Both sides in the debate should be able to agree on this, as the current scope is at the same time both underinclusive and overinclusive.  On the one hand, if a thief breaks into your office, opens your files, learns material, nonpublic information, and trades on that information, he has neither breached a fiduciary duty nor “feigned fidelity” to the source and is presumably immune from insider trading liability under current law.  On the other hand, if an employee of an acquiring firm seeks to test out information about a potential target with a friend at a major investor in the target and that investor later acquires more stock in the target based on that conversation, it is possible under SEC v. Obus that the employee will be deemed to have violated Rule 10b-5 on theory that he made a gift of the information, even though no payment or economic benefit is paid to the alleged tipper.  This is considerably grayer behavior than that of the thief.  Thus, drawing lines so that the thief escapes liability, while the inquiring employee does not, seems morally incoherent.  Nor are such lines doctrinally necessary.

The problem lies in how courts are interpreting the basic methodology to insider trading handed down by the Supreme Court in SEC v. Dirks and United States v. O’Hagan.  These cases dictate that (i) a violation of Rule 10b-5 requires conduct that is “deceptive” (the term used in Section 10(b)), and (ii) trading based on an undisclosed breach of a fiduciary or similar duty is deceptive.  This formula illustrates, but does not exhaust, the types of duties whose undisclosed breach might also be deemed deceptive and hence violative of Rule 10b-5.

Yet, in SEC v. Dorozhko, the Second Circuit found that a computer hacker who thereby discovered material nonpublic information would violate Rule 10b-5 when he traded on it—but only if he made a false representation in penetrating computer security.  Although this decision extends the law, its insistence on a false representation seems misguided.  Whatever the technique by which the computer was hacked, this conduct was inherently deceptive.

In an article that will appear this Spring in the Columbia Business Law Review (and which is posted on SSRN here), this author suggests that the SEC needs to better define the boundaries on the insider prohibition by adopting clarifying rules, much as it did in 2000 when it adopted Rules 10b5-1 and 10b5-2.  For example, a rule could define theft or misappropriation of confidential business information, even absent a breach of fiduciary duty, to violate Rule 10b-5 if it involved some element of covert behavior or deception.  Another proposed rule might impose a duty to not trade on material nonpublic information that has not been lawfully released.  This would parallel the common law duty of a “finder” to serve as a bailee with respect to lost personal property.

The premise to this inquiry is twofold:  (1) the original purpose of Section 10(b) of the 1934  Act was to serve as a “catchall” provision to stop the use of other “cunning devices” that the draftsmen of the Act knew would arise from time to time, and (2) the 1934 edition of Webster’s Dictionary (to which the Supreme Court has looked in defining the terms in the 1934 Act) defines the term “deceive” to include “to deal treacherously” with another.  Both sources suggest that behavior not involving a fiduciary breach can violate Rule 10b-5.

It is not, however, the intent of this article that Rule 10b-5 and the insider trading prohibition should be extended to its maximum possible scope.  The costs and benefits of various possible changes must be balanced.  Ultimately, the position is taken that, because deception has little, if any, social value, rules keyed to its prohibition make the greatest sense from both a doctrinal and policy perspective.

The full article is available here.


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