In a new article, I respond to an article by Professor Andrew Verstein concerning the awareness/use problem in insider-trading law. As many readers know, this problem arises because, although Rule 10b-5 prohibits persons bound by a duty of confidentiality from trading securities on the basis of material, non-public information (“MNPI”), it is unclear just what it means to trade on the basis of such information. Do you violate the rule if you trade merely while you are aware of MNPI, even though that MNPI played no causal role in your decision to trade (i.e., the awareness rule)? Or does a violation require that your awareness of MNPI figure in some significant way in your decision to trade (i.e., the use rule)?
In the 1990s, there was a circuit split on this issue, with the Second Circuit adopting the awareness rule, the Ninth Circuit adopting the use rule, and some other circuits adopting variations of one rule or the other. In 2000, the Securities and Exchange Commission moved to settle the issue by promulgating Rule 10b5-1, which adopted the awareness rule, subject to a few limited affirmative defenses. Nevertheless, Rule 10b5-1 has not quite ended the awareness/use debate. For one thing, some observers think that the affirmative defenses allowed by rule undermine the awareness standard that the rule otherwise embodies. For another, courts have simply not enforced Rule 10b5-1 consistently. Some district courts have applied the awareness standard of Rule 10b5-1 in accordance with its terms, but other district courts, even some in circuits that had earlier adopted the awareness standard, apply a use rule, especially in criminal cases. Albeit in a modified form, the awareness/use debate thus persists.
Professor Verstein approaches the debate in terms of mixed motives and would prohibit trades only if the trader’s primary reason for trading involves proscribed MNPI. In response, I argue that market norms clearly demonstrate that sophisticated parties strongly prefer the awareness rule to the use rule and that they appear to have very strong reasons for doing so. If, as I think, the corporate and securities laws should lower transaction costs so that sophisticated parties may more easily obtain the results they seek, then the insider trading laws should be interpreted as embodying the awareness rule, not the use rule.
The key fact is that, although nothing in the federal securities laws requires public companies to adopt insider trading policies, most public companies (and certainly virtually all large and well-advised public companies), as well as most financial institutions, law firms, and accounting firms, have such policies, and, critically, such policies virtually always prohibit employees from trading securities when they are in possession of MNPI, not merely from using MNPI to trade. In other words, such policies employ the awareness rule, and, indeed, leading treatises expressly advise using that rule. Furthermore, insider-trading policies virtually always go much further than even the awareness rule requires by imposing so-called blackout periods during which certain senior employees (the ones most likely to have MNPI) are absolutely forbidden to trade the company’s securities, regardless of whether they are aware of any MNPI. Such blackout periods include quarterly blackout periods, which usually begin about two weeks before the end of the fiscal quarter and end two business days after the company discloses its financial results for the quarter in a Form 10-Q or 10-K, and special blackout periods, which the company declares in the period leading up to a public disclosure about significant events like mergers or acquisitions, cybersecurity incidents, or new product developments. The rationale underlying blackout periods is twofold: They prevent insider trading, and they help avoid even the appearance of impropriety. In addition, even when blackout periods are not in effect (i.e., during so-called trading windows), insider trading policies commonly require the most senior employees to pre-clear all their trades with a particular company officer, usually the chief compliance officer. To help enforce these rules, many companies require at least their most senior employees to disclose to the company all their brokerage or securities accounts and provide information about all trades they undertake through such accounts.
Nor is there any mystery about why companies adopt such strict insider trading policies. The company has strong interests, including legal and reputational interests, in ensuring that its employees neither violate the insider trading laws nor even appear to do so. Of course, strict insider trading policies prohibit employees from making some trades that would be legal, even under interpretations of Rule 10b-5 employing the awareness rule. They thus reduce employees’ potential income. Employees tolerate this for the same reason that they agree to all kinds of other employer restrictions on their behavior: They are compensated to do so. Scholars have long recognized that insider trading can be viewed as a form of employee compensation, and in a competitive market, employees who receive less of one form of compensation will receive more of another form.
This point bears some elaboration. The market in which insider trading policies typically apply, the employment market for business and financial executives, is highly competitive, which means that the terms of employment agreements, including insider trading policies, will tend to be efficient. That is, they will maximize the joint surplus created by the transaction. In particular, contractual provisions that create substantial value for one party at a small cost to the other party will very likely be included in the agreement, perhaps with a minor adjustment to the price term to compensate the party who is bearing the small cost.
Now, strict insider trading policies – an awareness standard, blackout periods, pre-clearance rules – create substantial value for the company at little cost to the employee. They create substantial value for the company because, as noted above, the company has strong interests not only in its employees not using its MNPI, but also in its employees not even appearing to profit in this way. Of course, it is possible for an employee in possession of MNPI to trade without using that MNPI, or to trade while using the MNPI just a little bit, having some other reason as the primary reason for the trade. But it is also obvious that, when an employee in possession of MNPI trades, the employee is in fact almost always using the MNPI to trade, and, moreover, the employee will always appear to the market to be doing so. Companies thus have a strong interest in prohibiting employees from trading while in possession of MNPI – a strong incentive, that is, to impose an awareness rule.
Now, sometimes employees in possession of MNPI want to trade for purposes unrelated to any MNPI they may have, as when they want to sell shares of the company’s stock to diversify their investments or increase cashflow. This common situation can be, and nearly universally is, handled through Rule 10b5-1 trading plans, which, subject to certain conditions, allow employees to agree in a binding way, at a time when they possess no MNPI, that they will sell securities at pre-determined times and in pre-determined amounts at certain future dates. Insider trading policies virtually always allow for Rule 10b5-1 trading plans, though they also frequently impose conditions on them beyond those required by law. To the extent that Rule 10b5-1 plans do not fully address the problem of employees wanting to sell shares for reasons unrelated to MNPI, most insider trading policies also allow an employee, subject to certain conditions, to request that the chief compliance officer exempt a particular trade from the insider trading policy. Naturally, one of the conditions of obtaining such an exemption is that, at the time the exemption is granted and at the time of the trade, the employee is not in possession of any MNPI.
The upshot is that strict insider trading policies confer substantial benefits on the company by protecting its legal and reputational interests and impose only modest costs on employees bound by such policies, for such costs are mitigated by Rule 10b5-1 trading plans and by case-by-case exemptions in extraordinary circumstances. To the extent that there are any residual costs to the employees from abiding by these policies, those costs are much less than the benefits captured by the company, and so the company can easily afford to compensate the employees (e.g., with increased salary) for the costs they bear and still be far better off. Strict insider trading policies thus solve a problem in which the company’s interests and the employee’s interest to some degree conflict, and, as economic theory would suggest, the solution embodied in those policies is efficient.
The problem of mixed motives in the law is Professor Verstein’s forte, and he has done impressive work on mixed motives in relation to equal protection and employment discrimination. The insider trading laws, however, are part and parcel of the corporate and securities laws, and in my view, with limited exceptions, such laws should be, and in fact mostly are, aimed at sophisticated commercial parties, who prize efficiency, predictability, ease of administration, and low transaction costs. It is hard for me to see how any rule that requires a court to determine which motives or reasons caused a person to act (let along which of these was primary in a given case) could satisfy the reasonable needs of such parties. As is clear from all manner of commercial agreements, sophisticated parties go to great lengths to avoid inquiries into a party’s state of mind. The universal reliance of insider trading policies on the awareness standard and the even more objective standards involved in blackout periods and pre-clearance rules are examples of this, but there are innumerable others. It thus makes sense to interpret the insider trading laws the way sophisticated parties affected by them would agree to interpret them, not in terms of a mixed-motives analysis.
This post comes to us from Professor Robert T. Miller, the F. Arnold Daum Chair in Corporate Finance and Law at the University of Iowa College of Law. It is based on his recent article, “Market Practices and the Awareness/Use Problem in Insider Trading Law: A Response to Professor Verstein’s Mixed Motives Insider Trading,” in the Iowa Law Review Online and available here.