The "possession vs. use" debate in the context of securities trading by traditional insiders: Why silence can never be golden

University of Cincinnati Law Review

Volumn 67, Issue 4, 1999, Pages 1129-1199

  Nagy, Donna M ^a  

^a NONE

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EID: 0347243174     PISSN: 00096881     EISSN: None     Source Type: Journal    
DOI: None     Document Type: Article

References (354)

1. 40 S.E.C. 907 (1961).
2. 445 U.S. 222 (1980).
3. 17 C.F.R. § 240. 10b-5 (1998). Rule 10b-5 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. Id. Rule 10b-5 was promulgated by the Securities and Exchange Commission (the "SEC" or the "Commission") under Section 10(b) of the Securities Exchange Act of 1934 (the "Exchange Act") which makes it unlawful for any person, directly or indirectly: To 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. 15 U.S.C. § 78j(b) (1994).
4. Chiarella, 445 U.S. at 227 (quoting Cady, Roberts, 40 S.E.C. at 911).
5. Chiarella, 445 U.S. at 227 (quoting Cady, Roberts, 40 S.E.C. at 911).
6. Cady, Roberts, 40 S.E.C. at 911. The SEC drew support for the disclose or abstain rule from a number of early Rule 10b-5 cases, including Kardon v. National Gypsum Co., 73 F. Supp. 798, 800 (E.D. Pa. 1947), and Speed v. Transamerica Corp., 99 F. Supp. 808, 828-29 (D. Del. 1951).
7. See United States v. O'Hagan, 117 S. Ct. 2199, 2207 (1997) (citing Chiarella as the source of the "classical" or "traditional" theory of insider trading liability).
8. See United States v. Smith, 155 F.3d 1051, 1066 (9th Cir. 1998) (referring to the "use-possession" debate). See also Dennis J. Block & Jonathan M. Hoff, Insider Trading Liability: "Use v. Possession," N.Y.L.J., Oct. 29, 1998, at 5; Allan Horwich, Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?, 52 BUS. LAW. 1235 (1997); Roberta S. Karmel, The Controversy of Possession Versus Use, N.Y.L.J., Dec. 17, 1998, at 3; Harvey L. Pitt & Karl A. Groskaufmanis, Actual Use of Insider Information at Issue, NAT'L L.J., June 21, 1993, at 20; John H. Sturc & Catharine W. Cummer, Possession vs. Use for Insider Trading Liability, 12 No. 6 INSIGHTS 3 (1998).
9. See United States v. Smith, 155 F.3d 1051, 1066 (9th Cir. 1998) (referring to the "use-possession" debate). See also Dennis J. Block & Jonathan M. Hoff, Insider Trading Liability: "Use v. Possession," N.Y.L.J., Oct. 29, 1998, at 5; Allan Horwich, Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?, 52 BUS. LAW. 1235 (1997); Roberta S. Karmel, The Controversy of Possession Versus Use, N.Y.L.J., Dec. 17, 1998, at 3; Harvey L. Pitt & Karl A. Groskaufmanis, Actual Use of Insider Information at Issue, NAT'L L.J., June 21, 1993, at 20; John H. Sturc & Catharine W. Cummer, Possession vs. Use for Insider Trading Liability, 12 No. 6 INSIGHTS 3 (1998).
10. See United States v. Smith, 155 F.3d 1051, 1066 (9th Cir. 1998) (referring to the "use-possession" debate). See also Dennis J. Block & Jonathan M. Hoff, Insider Trading Liability: "Use v. Possession," N.Y.L.J., Oct. 29, 1998, at 5; Allan Horwich, Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?, 52 BUS. LAW. 1235 (1997); Roberta S. Karmel, The Controversy of Possession Versus Use, N.Y.L.J., Dec. 17, 1998, at 3; Harvey L. Pitt & Karl A. Groskaufmanis, Actual Use of Insider Information at Issue, NAT'L L.J., June 21, 1993, at 20; John H. Sturc & Catharine W. Cummer, Possession vs. Use for Insider Trading Liability, 12 No. 6 INSIGHTS 3 (1998).
11. See United States v. Smith, 155 F.3d 1051, 1066 (9th Cir. 1998) (referring to the "use-possession" debate). See also Dennis J. Block & Jonathan M. Hoff, Insider Trading Liability: "Use v. Possession," N.Y.L.J., Oct. 29, 1998, at 5; Allan Horwich, Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?, 52 BUS. LAW. 1235 (1997); Roberta S. Karmel, The Controversy of Possession Versus Use, N.Y.L.J., Dec. 17, 1998, at 3; Harvey L. Pitt & Karl A. Groskaufmanis, Actual Use of Insider Information at Issue, NAT'L L.J., June 21, 1993, at 20; John H. Sturc & Catharine W. Cummer, Possession vs. Use for Insider Trading Liability, 12 No. 6 INSIGHTS 3 (1998).
12. Section 21A of the Exchange Act authorizes the SEC to seek civil monetary penalties whenever any person has violated the Exchange Act or a rule or regulation thereunder "by purchasing or selling a security while in possession of material, nonpublic information." 15 U.S.C. § 78u-1(a)(1) (1994). The SEC may seek a penalty of up to "three times the profit gained or loss avoided as a result of such unlawful purchase, sale or communication." § 78u-1(a)(2).
13. Insider trading may be criminally prosecuted by the Justice Department under Section 32(a) of the Exchange Act which provides for fines of not more than $1,000,000, or imprisonment of not more than 10 years, or both, for any willful violation of any provision of the Exchange Act or any rule or regulation thereunder. See 15 U.S.C. § 78ff(a) (1994).
14. See John C. Coffee, Jr., Outsider Trading After O'Hagan, 12 No. 7 CORP. COUNS. 6 (Dec. 1997) (referring to the "long-dormant debate between defense practitioners (who argue that, for liability to arise, the information must be 'used' in the sense of causing the trade) and the SEC (which argues that a defendant only must trade while in possession of such information")).
15. 137 F.3d 1325 (11th Cir. 1998).
16. See id at 1328.
17. See id.
18. 155 F.3d 1051 (9th Cir. 1998).
19. Corrected Brief of the Securities and Exchange Commission at 18, SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998) (No. 96-6084). See also Brief of the Securities and Exchange Commission at 5-6, United States v. Smith, 155 F.3d 1051 (9th Cir. 1998) (No. 97-50137) ("[W]hen a corporate insider like Smith has information relating to his company that he knows (or is reckless in not knowing) to be material and nonpublic and he trades in the company's stock, he violates the antifraud provisions of the federal securities laws, whether or not the information is a factor in his decision to trade.").
20. See Adler, 137 F.3d at 1337; Smith, 155 F.3d at 1067.
21. See Adler, 137 F.3d at 1337; Smith, 155 F.3d at 1067.
22. This Article uses the term "traditional insiders" to refer solely to directors, officers, and controlling shareholders of a corporation. Although other commentators may regard the corporation itself as a traditional insider, see, e.g.,7 LOUIS LOSS & JOEL SELIGMAN, SECURITIES REGULATION 3505 (3d ed. 1991), issuer liability under the disclose or abstain rule is treated herein as a separate, though clearly analogous, issue. See infra text accompanying notes 239-45. Moreover, in discussing securities trading by traditional insiders, the Article places an emphasis on officers and directors, because controlling shareholders who are individuals typically serve as directors of the corporations they control. See LOSS & SELIGMAN, supra at 3587.
23. Chiarella, 445 U.S. at 228 (quoting RESTATEMENT (SECOND) OF TORTS § 551(2)(a) (1976)).
24. Id. at 227.
25. 463 U.S. 646, 660 (1983).
26. See id. at 656-59 & n.14.
27. 117 S. Ct. 2199 (1997).
28. Id. at 2207-08 (internal quotes omitted).
29. See infra text accompanying notes 180-82.
30. See infra notes 51 and 116 and accompanying text.
31. See infra text accompanying notes 71-82 (discussing a 1993 decision by the United States Court of Appeals for the Second Circuit that indicated in dicta that the government need prove only knowing possession for liability to attach under Rule 10b-5).
32. See Sturc & Cummer, supra note 7, at 3.
33. Relying on the rulemaking authorization in Section 14(e) of the Exchange Act, 15 U.S.C. § 78n(e) (1994), the SEC promulgated Rule 14e-3(a) in 1980. See 17 C.F.R. § 14e-3(a) (1998). The rule provides that: If any person has taken a substantial step or steps to commence, or has commenced, a tender offer (the "offering person"), it shall constitute a fraudulent, deceptive or manipulative act or practice within the meaning of section 14(e) of the [Exchange] Act for any other person who is in possession of material nonpublic information relating to such tender offer which information he knows or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly from: (1) The offering person, (2) The issuer of the securities sought or to be sought by such tender offer, (3) Any officer, director, partner or employee or any other person acting on behalf of the offering person or such issuer, to purchase or sell or cause to be purchased or sold any of such securities . . . unless within a reasonable time prior to any purchase or sale such information and its source are publicly disclosed by press release or otherwise. Id. (emphasis added). Unlike Rule 10b-5, which requires the breach of a pre-existing disclosure duty for silence to be deemed unlawful, see infra text accompanying notes 178-93, Rule 14e-3(a) "creates a duty in those traders who fall within its ambit to abstain or disclose, without regard to whether the trader owes a pre-existing fiduciary duty to respect the confidentiality of the information." United States v. Chestman, 947 F.2d 551, 557 (2d Cir. 1991) (en banc). Arguably, the existence of a pre-existing duty is not essential to a finding of liability under Rule 14e-3(a) because the SEC's rulemaking authorization in Section 14(e) is broader than its authorization in Section 10(b). See infra note 313.
34. See infra note 316 and accompanying text.
35. 987 F.2d 112 (2d Cir. 1993).
36. Much of this analysis elaborates on my previous discussion of these cases in RALPH C. FERRARA, DONNA M. NAGY, & HERBERT THOMAS, FERRARA ON INSIDER TRADING AND THE WALL § 2.01[5] (1998) [hereinafter FERRARA ET AL.].
37. 137 F.3d 1325, 1327 (11th Cir. 1998).
38. See id. at 1328-29.
39. See id. at 1328 (noting Pegram's sales of Comptronix between September 19, 1989 and September 26, 1989). Comptronix announced publicly the decline in orders via a press release on October 6, 1989, and the price of Comptronix stock dropped from $3.63 to $2.63 over the next two trading days. See id. According to the SEC, by selling the stock prior to the press release, Pegram avoided $17,625 in losses. See id.
40. See id. at 1328. Although there were both factual and legal issues in dispute (such as what precisely was revealed at the board meeting or whether that information was material), the United States Court of Appeals for the Eleventh Circuit assumed, for purposes of review, that Pegram possessed information that was both material and nonpublic. See id. at 1339.
41. See Corrected Brief of the Securities and Exchange Commission at 18, SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998) (No. 96-6084) (maintaining that, [w]hen a corporate insider like Pegram has information relating to his company's stock that he knows (or is reckless in not knowing) to be non-public and material and he trades in the company's stock, he deceives the persons on the other side of his trades by not disclosing to them the information, whether or not he 'uses' the information in his trading).
42. Adler, 137 F.3d at 1328.
43. See id.
44. See id. at 1328-29.
45. See id. at 1329. The fact that Pegram secured prior approval to sell his Comptronix stock from the corporation's general counsel provides at least some evidence that the information disclosed in the September 14, 1989 board meeting may not have been material nonpublic information. Indeed, the district court specifically noted that it was "questionable" whether the information was material. Id. (quoting unpublished order by the district court). Significantly, when asked why he did not object to Pegram's sale and whether he believed Pegram had possessed material nonpublic information at the time, Comptronix's general counsel stated that he "really did not think of it in those terms." Id. at 1329 n.7.
46. See id. at 1329. Notably, the SEC also alleged that Pegram had violated Rule 10b-5 by selling Comptronix stock pursuant to a tip illegally communicated to him in November 1992 at a time when he no longer served as a director of the company. See id. In addition to Pegram, two other defendants were alleged to have violated Rule 10b-5 by selling Comptronix stock in this 1992 time period, and a fourth defendant, Robert Adler, was alleged to have violated Rule 10b-5 by tipping material nonpublic information to Pegram (who, in turn, was alleged to have tipped the other two defendants). See id. at 1329-30. The court's analysis of these 1992 trading and tipping allegations contributes little to the possession vs. use debate because Pegram and the other two trading defendants denied that they possessed any confidential information at the time of their securities transactions and Adler denied conveying any such information to Pegram. See id. at 1329-31.
47. Id. at 1337.
48. Id.
49. Id. at 1338. To support its position that a knowing possession standard would not "always and inevitably be limited to situations involving fraud," the court referenced the United States Supreme Court's statement in United States v. O'Hagan that Rule 14e-3(a)'s knowing possession standard "may prohibit actions that are not themselves fraudulent." Id. (quoting United States v. O'Hagan, 117 S. Ct. 2199, 2217 (1997)). As discussed later, Adler's repeated references to Rule 14e-3(a) as support for its interpretation of Rule 10b-5 overlooks the significant differences between the rulemaking authorization in Section 14(e) of the Exchange Act and the narrower rulemaking authorization in Section 10(b). See infra note 313 and accompanying text.
50. Alder, 137 F.3d at 1337.
51. Id. at 1334. The Supreme Court language on which Adler relied is discussed extensively below. See infra notes 196-208 and accompanying text and infra note 213. The Adler court also maintained that a use requirement was supported by cases where "courts have allowed insiders to introduce evidence of preexisting plans or other 'innocuous' reasons for sales in order to rebut an inference of scienter." Alder, 137 F.3d at 1335 (citing In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1427-28 (9th Cir. 1994); Dura-Bilt Corp. v. Chase Manhattan Corp., 89 F.R.D. 87, 94-95 (S.D.N.Y. 1981)). Adler, however, failed to recognize that in Worlds of Wonder, the shareholder-plaintiffs had not alleged with the necessary specificity that the insider trading defendants actually knew the undisclosed information at issue. See DONALD C. LANGEVOORT, INSIDER TRADING: REGULATION, ENFORCEMENT, AND PREVENTION 3-23 n.5 (1998) (contending that, "[i]n this sense, [Worlds of Wonder] is simply about what must be shown at the pleadings stage - not what state of mind must be shown in order to impose liability as such"). Adler also overlooked other insider trading cases which suggest that scienter may be established even in the face of "innocuous" reasons for an insider's trading. See, e.g., SEC v. Farrell, [1996-1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,365, at 96,297 (W.D.N.Y. 1996) (concluding that the director-defendant's claim that his purchase of the corporation's stock was motivated by a newspaper article discussing the corporation's attractiveness as a take-over was "irrelevant" because scienter was established through the defendant's admissions that he knowingly possessed material nonpublic information and that "he knew that it would be a breach of his fiduciary duty as a director to trade [in] the company's securities while in possession of such information"). For additional discussion of the scienter element in the possession vs. use debate, see infra notes 55-58 and 234-37 and accompanying text.
52. Id. at 1334. The Supreme Court language on which Adler relied is discussed extensively below. See infra notes 196-208 and accompanying text and infra note 213. The Adler court also maintained that a use requirement was supported by cases where "courts have allowed insiders to introduce evidence of preexisting plans or other 'innocuous' reasons for sales in order to rebut an inference of scienter." Alder, 137 F.3d at 1335 (citing In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1427-28 (9th Cir. 1994); Dura-Bilt Corp. v. Chase Manhattan Corp., 89 F.R.D. 87, 94-95 (S.D.N.Y. 1981)). Adler, however, failed to recognize that in Worlds of Wonder, the shareholder-plaintiffs had not alleged with the necessary specificity that the insider trading defendants actually knew the undisclosed information at issue. See DONALD C. LANGEVOORT, INSIDER TRADING: REGULATION, ENFORCEMENT, AND PREVENTION 3-23 n.5 (1998) (contending that, "[i]n this sense, [Worlds of Wonder] is simply about what must be shown at the pleadings stage - not what state of mind must be shown in order to impose liability as such"). Adler also overlooked other insider trading cases which suggest that scienter may be established even in the face of "innocuous" reasons for an insider's trading. See, e.g., SEC v. Farrell, [1996-1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,365, at 96,297 (W.D.N.Y. 1996) (concluding that the director-defendant's claim that his purchase of the corporation's stock was motivated by a newspaper article discussing the corporation's attractiveness as a take-over was "irrelevant" because scienter was established through the defendant's admissions that he knowingly possessed material nonpublic information and that "he knew that it would be a breach of his fiduciary duty as a director to trade [in] the company's securities while in possession of such information"). For additional discussion of the scienter element in the possession vs. use debate, see infra notes 55-58 and 234-37 and accompanying text.
53. Id. at 1337.
54. Id.
55. Geanne Rosenberg, Possession is 9/10ths of Law for SEC, Circuit Infers the Use of Inside Info From Knowledge, NAT'L L.J., Apr. 13, 1998, at B1.
56. Sturc & Cummer, supra note 7, at 5.
57. See Suzanne Manning & Phyllis Diamond, SEC Enforcement: Internet, Munis, Microcap Fraud Head List of New Chief Richard Walker, 30 SEC. REG. & L. REP. (BNA) 942, 944 (June 19, 1998) (quoting SEC Enforcement Division Director Richard Walker).
58. 155 F.3d 1051, 1069 (9th Cir. 1998) (concluding that "Rule 10b-5 requires that the government (or the SEC as the case may be) demonstrate that the suspected inside trader actually used material nonpublic information in consummating his transaction").
59. See id. at 1067, 1068 (noting that the Eleventh Circuit in Adler was "the only court of appeals [that] squarely . . . consider[ed] the causation issue" and expressing agreement with Adler's conclusion that "a 'use' requirement [was] more consistent with the language of § 10(b) and Rule 10b-5"). See also id. at 1068 (stating that, "[l]ike our colleagues on the Eleventh Circuit, we are concerned that the SEC's 'knowing possession' standard would not be - indeed, could not be - strictly limited to those situations actually involving intentional fraud" (footnote omitted)).
60. See id. at 1068-69.
61. See Karmel, supra note 7, at 3.
62. Smith, 155 F.3d at 1068 (second emphasis added).
63. Id. (emphasis added).
64. Id. at n.25.
65. Id. at 1069 ("'A presumption which, although not conclusive, had the effect of shifting the burden of persuasion to the defendant, would have suffered from [constitutional] infirmities'" (quoting Sandstrom v. Montana, 442 U.S. 510, 524 (1979))).
66. Id. at 1069 n.27.
67. Id. at 1066 (citing Chiarella v. United States, 445 U.S. 222, 227 (1980)).
68. Id. at 1069.
69. Id. at 1068-69.
70. Id. at 1066. Addressing this aspect of the district court's opinion, die United States Court of Appeals for the Ninth Circuit emphasized that the district court "instructed the jury that 'the government must prove that the defendant sold or sold short [the company's] stock because of material nonpublic information that he knowingly possessed' and cautioned that '[i]t is not sufficient that the government proves that the defendant sold or sold short [the company's] stock while knowingly in possession of the material nonpublic information.'" Id. at 1070.
71. Id. The Ninth Circuit concluded that the instructions were in fact very clear that the government bore the burden of proving that Smith had sold his corporation's stock "because of material, nonpublic information that he knowingly possessed." Id.
72. See Phyllis Diamond, Insider Trading: CA 9 Adopts "Use" Test for Rule 10B-5 Insider Liability, 30 SEC. REG. & L. REP. (BNA) 1277, 1277 (Aug. 28, 1998) (quoting SEC Enforcement Director Richard Walker's observation that the Ninth Circuit's statements in Smith were "really in the form of dicta").
73. See Smith, 155 F.3d at 1062.
74. Id. (emphasis added).
75. See Diamond, supra note 66, at 1277 (quoting SEC Enforcement Director Richard Walker's statement that the Ninth Circuit's decision in Smith "invites defenses that are . . . spun out of whole cloth"). See also Phyllis Diamond, McLucas Hails O'Hagan Ruling, But Says Issues Over Reach of Theory Remain, 29 SEC. REG. & L. REP. (BNA) 1097, 1098 (Aug. 8, 1997) (quoting former SEC Enforcement Director William McLucas's statement that if use is the test "there's not a defendant that comes in the door that won't have a separate, independent, superseding tort law factor for his buying or selling activity . . .[such as] a tax payment due or a college tuition [obligation]").
76. But see infra note 88 and accompanying text (discussing the SEC's likely concession that a use test may be appropriate in misappropriation cases).
77. 987 F.2d 112 (2d Cir. 1993).
78. See id. at 115-17.
79. See id. at 118.
80. Id. at 119 (quoting the unpublished jury instructions of the district court).
81. Id. (quoting the unpublished jury instructions of the district court).
82. See id. at 120.
83. See id.
84. Id.
85. See id. (citing United States v. Newman, 664 F.2d 12, 18 (2d Cir. 1981) (citations omitted)).
86. Id.
87. Id. The Second Circuit further maintained that, "[i]n our increasingly sophisticated securities markets, where subtle shifts in strategy can produce dramatic results, it would be a mistake to think of such decisions as merely binary choices - to buy or to sell." Id. at 120-21. The court therefore concluded "[a]s a matter of policy . . . a requirement of a causal connection between the information and the trade could frustrate attempts to distinguish between legitimate trades and those conducted in connection with inside information." Id. at 121.
88. Id. The Teicher court concluded that: [i]t strains reason to argue that an arbitrageur, who traded while possessing information he knew to be fraudulently obtained, knew to be material, knew to be nonpublic, - and who did not act in good faith in so doing - did not also trade on the basis of that information. We find that on the facts of this case, no reasonable jury could have made such a distinction. Id. at 121 (citations omitted).
89. See SEC v. Falbo, 14 F. Supp. 2d 508, 524 (S.D.N.Y. 1998) (citing Teicher and stating that, to prevail on summary judgment, "the SEC must demonstrate that . . . [the defendant] knowingly possessed material misappropriated information at [the] time" of his securities trading); SEC v. Farrell, [1996-1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 99,365, at 96,297, 96,302 (W.D.N.Y. 1996) (citing Teicher and concluding that the director's defense that he did not purchase his corporation's securities "on the basis of" material nonpublic information "was immaterial" in light of the fact that the director admitted that he possessed such information at the time of his securities trading).
90. See, e.g., United States v. O'Hagan, 139 F.3d 641, 653 & n.7 (8th Cir. 1998) ("[a]ssuming, without deciding, that for [the defendant] to be convicted of securities fraud he must have traded 'on the basis of' material, nonpublic information," but citing Teicher for the proposition "that 'knowing possession' of material nonpublic information obtained from a breach of duty should be sufficient for a criminal violation of Rule 10b-5").
91. 117 S. Ct. 2199 (1997).
92. Unlike the classical theory of insider trading liability, which predicates the Rule 10b-5 violation on the fraud and deceit that is practiced on the shareholders with whom a defendant trades, under the misappropriation theory, it is the source of the material nonpublic information that stands as the "victim" of a defendant's Rule 10b-5 violation. See O'Hagan, 117 S.Ct. at 2207. See also Donna M. Nagy, Reframing the Misappropriation Theory of Insider Trading Liability, A Post-O'Hagan Suggestion, 59 OHIO ST. L.J. 1223, 1226 (1998) (maintaining that O'Hagan resolved confusion among lower courts by clearly identifying the source of the information as the party who is deceived and defrauded by a misappropriator's securities transactions).
93. Unlike the classical theory of insider trading liability, which predicates the Rule 10b-5 violation on the fraud and deceit that is practiced on the shareholders with whom a defendant trades, under the misappropriation theory, it is the source of the material nonpublic information that stands as the "victim" of a defendant's Rule 10b-5 violation. See O'Hagan, 117 S.Ct. at 2207. See also Donna M. Nagy, Reframing the Misappropriation Theory of Insider Trading Liability, A Post-O'Hagan Suggestion, 59 OHIO ST. L.J. 1223, 1226 (1998) (maintaining that O'Hagan resolved confusion among lower courts by clearly identifying the source of the information as the party who is deceived and defrauded by a misappropriator's securities transactions).
94. See O'Hagan, 117 S. Ct. at 2207 (holding that Rule 10b-5 is violated in misappropriation cases because "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"); id. (stating that "'[t]he misappropriation theory' holds that a person commits fraud 'in connection with' a securities transaction, and thereby violates § 10(b) and Rule 10b-5, when he misappropriates confidential information for securities trading purposes, in breach of a duty owed to the source of the information"); id. at 2208 (maintaining that, under the misappropriation theory, "a fiduciary who '[pretends] loyalty to the principal while secretly converting the principal's information for personal gain' . . . 'dupes' or defrauds the principal.") (quoting Petitioner's Brief at 17, United States v. O'Hagan, 117 S. Ct. 2199 (1997) (No. 96-842)).
95. See Supplemental Brief of the Securities and Exchange Commission at 3, United States v. Smith, 155 F.3d 1051 (9th Cir. 1998) (No. 97-50137) (emphasizing that "[c]lassical insider trading is to be distinguished from the 'misappropriation' theory of insider trading, under which it may be relevant whether a defendant made use of the information" and stating that, in a misappropriation case, a defendant's "'use' of the information in his trading may be relevant because it is that use that satisfies the Section 10(b) requirement that deception occur 'in connection with the purchase or sale of a security'"). See also Diamond, supra note 69, at 1098 (quoting then SEC Enforcement Division Director William McLucas's observation that O'Hagan's focus on a misappropriator's use of information to make a profit "fairly can be said to mean that certainly in a misappropriation case, one can assume that 'use' is synonymous with 'on the basis of").
96. See supra notes 85-87 and accompanying text.
97. See supra note 15.
98. See H.R. REP. NO. 98-355, at 31 (1983), reprinted in 1984 U.S.C.C.A.N. at 2274, 2304 (stating that existing law "prohibit[s] trading while in possession of material nonpublic information" (letter from SEC Chairman John S.R. Shad to Timothy E. Wirth, Chairman of the Subcomm. on Telecomms., Consumer Protection and Fin., House Comm. on Energy and Commerce)). See also Insider Trading Sanctions and SEC Enforcement Legislation: Hearings on H. R. 559 Before the Subcomm. on Telecomms., Consumer Protection, and Fin. of the House Comm. on Energy and Commerce, 98th Cong. 99 (1983) ("[T]he Commission's . . . consistent position has been that possession of material inside information is the test." (comments of Daniel Goelzer, then general counsel for the SEC)).
99. See H.R. REP. NO. 98-355, at 31 (1983), reprinted in 1984 U.S.C.C.A.N. at 2274, 2304 (stating that existing law "prohibit[s] trading while in possession of material nonpublic information" (letter from SEC Chairman John S.R. Shad to Timothy E. Wirth, Chairman of the Subcomm. on Telecomms., Consumer Protection and Fin., House Comm. on Energy and Commerce)). See also Insider Trading Sanctions and SEC Enforcement Legislation: Hearings on H. R. 559 Before the Subcomm. on Telecomms., Consumer Protection, and Fin. of the House Comm. on Energy and Commerce, 98th Cong. 99 (1983) ("[T]he Commission's . . . consistent position has been that possession of material inside information is the test." (comments of Daniel Goelzer, then general counsel for the SEC)).
100. For example, then SEC Enforcement Division Director William McLucas stated: The Commission has always taken the position that once a person learns of, or "comes into possession of," material information, that person must either disclose the information or abstain from trading. Any purchase or sale of a security thereafter would be in breach of the duty to disclose or abstain from trading. A prior intention to buy or sell, while arguably relevant to the issue of scienter, cannot be held to negate a breach of fiduciary duty or duty of trust and confidence, without gutting the express purpose of the insider trading proscriptions. It is the subsequent breach of duty by trading that violates § 10(b), and not whether or not a trader had a prior intention to sell before he breached a duty. William R. McLucas & Alma M. Angotti, Insider Trading: Is It Back or Did It Ever Really Go Away?, 9 No. 10 INSIGHTS 1, 4 (Oct. 1995).
101. Exchange Act Release No. 14675, [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 81,570, at 80,295 (Apr. 18, 1978).
102. See id. at 80,298.
103. Id.
104. Id.
105. See infra text accompanying notes 283-96.
106. But see infra note 310 and accompanying text (criticizing the SEC's choice to articulate its possession test only in informal formats).
107. See Report of Investigation in the Matter of Sterling Drug, Inc., Exchange Act Release No. 14675, [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 81,570, at 80,295, 80,298 (Apr. 18, 1978). Two directors testified that they sold their stock because they retired from their positions with the corporation and wished to diversify their investments. See id. Moreover, both directors maintained that the sales were necessary to satisfy tax and other financial obligations. See id. As to the other director, documentary evidence revealed that he had an intention to sell his stock in the corporation prior to his knowledge of the alleged material nonpublic information. See id.
108. Exchange Act Release No. 9267, [1970-71 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 78,163, at 80,514 (July 29, 1971).
109. See SEC v. Adler, 137 F.3d 1325, 1339 (11th Cir. 1998) (declining to accord "much deference" to the SEC's position, in part because "the SEC position has not been consistent"); see also id. at 1336 (citing Investors Management and Sterling Dmg and concluding that the SEC's position "has undergone some fluctuation over time"); United States v. Smith, 155 F.3d 1051, 1067 (9th Cir. 1998) (contending that the "SEC's position with respect to the causation issue has flip-flopped").
110. See In re Investors Management Co., Exchange Act Release No. 9267, [1970-71 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 178,163 at 80,514, 80,515-16 (July 29, 1971). Though many analysts expected the earnings per share of Douglas Aircraft Co. Inc. to range from $4 to $4.50 in 1966 and from $8 to $12 in 1967, the defendants in Investors Management learned that the corporation's earnings per share were expected to be only 49 cents in 1966 and approximately 85 to $6 in 1967. See id. at 80,515.
111. See id. at 80,515-16.
112. See id. at 80,516.
113. Id. at 80,515.
114. Id. at 80,519 (emphasis added).
115. Id. at 80,522 (emphasis added).
116. The SEC hearing examiner did, however, dismiss proceedings against one investment adviser upon proof that the adviser traded for independent reasons. See id. at 80,515 & n.2. The SEC did not disturb this finding on review. See id.
117. See id. at 80,515 ("[S]ince we felt that the legal issues raised respecting the obligations of persons other than corporate insiders who receive non-public corporate information (sometimes referred to as 'tippees') had significant implications for the securities industry and investing public, we deemed it appropriate to consider those issues and express our views on them." (footnote omitted)).
118. See infra note 230 and accompanying text (discussing reasons for drawing distinctions between tippees and traditional insiders for purposes of the possession vs. use debate).
119. See infra text accompanying notes 161-64 (contending that it is the traditional insider's status as a fiduciary that poses special burdens on his right to remain silent in a securities transaction with corporate shareholders).
120. Adler's and Smith's conclusion that this causality requirement extended beyond tippees is evidenced in part by their insertion of the bracketed term "insider" in quoting the pertinent statements from Investors Management. See, e.g., SEC v. Adler, 137 F.3d 1325, 1336 (11th Cir. 1998) (stating that, in Investors Management, "the SEC concluded that one of the elements of an insider trading violation under § 10(b) and Rule 10b-5 is that the material nonpublic information 'be a factor in [the insider's] decision to effect the transaction'"); United States v. Smith, 155 F.3d 1051, 1067 (9th Cir. 1998) (stating that "in the not-too-distant past, the SEC concluded that an essential element of an insider trading violation was that the inside information 'be a factor in [the insider's] decision to effect the transaction'" (quoting In re Investors Management, Exchange Act Release No. 9267, [1970-71 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 78,163 at 80,514, 80,515-16 (July 29,1971))).
121. Adler, 137 F.3d at 1336.
122. As the Supreme Court has noted, "[a]n administrative agency is not disqualified from changing its mind; and when it does, the courts . . . should not approach the statutory construction issue de novo and without regard to the administrative understanding of the statutes." NLRB v. Local Union No. 103, 434 U.S. 335, 351 (1978).
123. See Horwich, supra note 7, at 1264 (pointing out that the SEC has not "explicitly addressed the shift in position from its opinion in Investors Management"). See also Block & Hoff, supra note 7, at 5 (noting that, without citing or distinguishing Investors Management, "the SEC abruptly altered its position with respect to the 'use v. possession' standard").
124. As noted earlier, the SEC would be unlikely to advocate a knowing possession test in an insider trading case brought pursuant to the misappropriation theory. See supra note 88 and accompanying text. SEC officials have, however, specifically commented that O'Hagan's focus on "use" is not relevant in classical theory cases. In fact, shortly after O'Hagan, the then SEC Director of the Enforcement Division observed that "certainly with respect to traditional insiders and certainly in the conventional analysis of tippee liability, we would argue that the standard remains . . . 'in possession of.'" Diamond, supra note 69, at 1098 (quoting William McLucas).
125. See SEC v. Baker, Lit. Release No. 13,850, 55 S.E.C. Docket 823, 823 (Oct. 27, 1993) (stating that "[t]he Commission alleges that, although [the respondent] planned for at least six months to sell the stock, he acquired certain confidential information that made his sales violative of the antifraud provisions"); SEC v. Hallwood Group, Lit. Release No. 14986, 62 S.E.C. Docket 1172 (July 22, 1996) (alleging that a corporate director and the institution he controlled violated Rule 10b-5 when the director allowed the institution to carry out a pre-existing plan to sell the stock of the corporation while the director was in possession of material nonpublic information regarding the corporation's deteriorating earnings).
126. Agency principles generally attribute to an institution the knowledge possessed by the employees of that institution. See RESTATEMENT (SECOND) OF AGENCY § 272 (1958). This attribution principle, coupled with a possession test for Rule 10b-5 liability, would effectively bar institutional trading in a company where any employee has privileged knowledge of material nonpublic information concerning that company, even if the individual trading employee is completely ignorant of that information. The concept of a Chinese Wall is invoked to avoid the harshness of this result That is, multi-service financial institutions that have policies to ensure that information possessed in confidence by certain sectors of the institution (e.g., the investment banking department) is properly segregated - "walled off" - from the trading department are able to trade without fear that knowledge of the segregated information will be attributed to the persons who are actually doing the trading. For additional discussion of Chinese Walls, see FERRARA ET AL., supra note 31, at 9-1 to 9-12. See also Broker-Dealer Policies and Procedures Designed to Segment the Flow and Prevent the Misuse of Material, Nonpublic Information, [1989-1990 Transfer Binder] Fed. Sec. L. Rep.(CCH) ¶ 84,520, at 80,617 (March 1990).
127. See, e.g., LOSS & SELIGMAN, supra note 17, at 3505 (noting, among other arguments, that the "very difficulty of establishing actual use of inside information points to possession as the test"). The insider trading prohibition in the proposed (but never adopted) FEDERAL SECURITIES CODE required only a showing that an insider "knows a material fact with respect to the issuer or the security that is not generally available." FED. SEC. CODE § 1603(a) (Supp. II 1981). Professor Loss was the reporter for the American Law Institute's project, and the commentary to § 1603 reveals that the provision was intended to codify "Rule 10b-5 as applicable to insider trading." FED. SEC. CODE § 1603 cmt. (l) (1980). See also Horwich, supra note 7, at 1259 (noting that "section 1603(a) purported to be descriptive, not prescriptive, and [that it] thus reflected the view that, under the case law as of that time, there was no causation element either as a matter of the plaintiff's burden of proof or as a defense").
128. See, e.g., Horwich, supra note 7, at 1268 (concluding that the "rationale underlying the prohibition on insider trading and the number of cases which recognize a causation element (at least as a defense) strongly suggest that the better rule is one which incorporates an 'on the basis of element into any cause of action for unlawful insider trading"); Pitt & Groskaufmanis, supra note 7, at 20 (contending that the Supreme Court's decisions in Dirks and Chiarella suggest that a "use" test is the appropriate standard for Rule 10b-5 liability); 5C ARNOLD S. JACOBS, LITIGATION AND PRACTICE UNDER RULE 10B-5, § 66.02[c], at 3-725 (1992) (concluding that one of the "exceptions" to the "general" disclose or abstain rule is that an "insider's . . . decision to buy or sell must be based on his inside information").
129. See infra text accompanying notes 209-37.
130. Pub. L. No. 98-376, 98 Stat. 1264 (1984) (codified as amended subsections of 15 U.S.C. § 78 (1994)).
131. Pub. L. No. 100-704, 102 Stat 4677 (codified as amended subsections of 15 U.S.C. § 78 (1994)).
132. See 15 U.S.C. § 78u-1 (1994).
133. See 15 U.S.C. § 78t-1.
134. 15 U.S.C. § 78u-1(a)() (emphasis added); id. § 78t-1(a) (emphasis added). In ITSA, Congress also added Section 20(d) to the Exchange Act which uses "while in possession" language to regulate insider trading in options. See id. § 78t(d): Wherever communicating, or purchasing or selling a security while in possession of, material nonpublic information would violate . . . any provision of this chapter, or any rule or regulation thereunder, such conduct in connection with a purchase or sale of a put, call, straddle, option or privilege with respect to such security . . . shall also violate . . . such provision, rule, or regulation. Id. (emphasis added).
135. LANGEVOORT, supra note 46, at 3-25.
136. See LOSS & SELIGMAN, supra note 17, at 3535 (noting that Congress, both in the Insider Trading Sanctions Act of 1984 (ITSA) and the Insider Trading and Securities Fraud Enforcement Act of 1988 (ITSFEA), "opted specifically for the 'possession' test").
137. 2 ALAN R. BROMBERG & LEWIS D. LOWENFELS, SECURITIES FRAUD & COMMODITIES FRAUD § 7.4(610), at 7:160.4 (1984).
138. WILLIAM K.S. WANG & MARC I. STEINBERG, INSIDER TRADING § 4.4.5, at 183 (1996).
139. Id. at 184.
140. 15 U.S.C. § 78u-1(a)(1) (1994) (emphasis added); id. § 78t-1(a).
141. See 17 C.F.R. § 14e-3(a) (1998); supra note 28.
142. Cf. Jackson Nat'l Life Ins. Co. v. Merrill Lynch & Co., 32 F.3d 697, 703 (2d Cir. 1994) ("[T]he language of the statute thus is quite plain that to state a claim under § 20A, a plaintiff must plead a predicate violation of the '34 Act or its rules or regulations."); In re Verifone, 784 F. Supp. 1471, 1488 (N.D. Cal. 1992) ("[O]ne who trades while in the possession of material, nonpublic information - is liable [under Section 20A] only where an independent violation of another provision of the securities laws has occurred."); T. Rowe Price New Horizons Fund, Inc. v. Preletz, 749 F. Supp. 705, 709 (D. Md. 1990) (Section 20A "is applicable only if there has been an insider trading violation of another provision of the securities laws.").
143. See SEC v. Adler, 137 F.3d 1325, 1336-37 (11th Cir. 1998) (stating that "the 'in possession' language of ISTA (sic) does not resolve whether possession or use is the proper standard for an insider trading violation" of Rule 10b-5).
144. See, e.g., LANGEVOORT, supra note 46, at 3-23 to 3-24 n.7 (stating that "one might well conclude that the [classical] theory presents a much stronger case for the possession test than the misappropriation theory"); see also supra note 88 and accompanying test (pointing out the SEC's apparent concession that use may be the appropriate test in cases brought pursuant to the misappropriation theory).
145. See infra notes 230-32 and accompanying text.
146. See infra notes 230-32 and accompanying text.
147. Chiarella v. United States, 445 U.S. 222, 227 (1980).
148. See infra note 213 and accompanying text.
149. See supra note 3.
150. See, e.g., Dirks v. SEC, 463 U.S. 646, 659 (1983) (contending that "[t]he need for a ban on some tippee trading is clear"); United States v. O'Hagan, 117 S. Ct. 2199, 2207 (1997) (stating that "[t]he misappropriation theory is . . . designed to 'protec[t] the integrity of the securities markets against abuses by "outsiders" to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed . . . .'") (quoting Petitioner's Brief at 14, O'Hagan, 117 S. Ct. 2199 (No. 96-842); see also Elliott J. Weiss, United States v. O'Hagan: Pragmatism Returns to the Law of Insider Trading, 23 J. CORP. L. 395, 398 (1998) (contending that the O'Hagan Court "explicitly relied on considerations of public policy to explain its support for the misappropriation theory").
151. See infra note 209.
152. SEC v. Adler, 137 F.3d 1325, 1338 (11th Cir. 1998). See United States v. Smith, 155 F.3d 1051, 1068 (9th Cir. 1998) (noting that "[t]he persons with whom a hypothetical insider trades are not at a 'disadvantage' at all provided the insider does not 'use' the information to which he is privy").
153. See, e.g., Chiarella v. United States, 445 U.S. 222, 226 (1980) (emphasizing that "[t]his case concerns the legal effect of the petitioner's silence" and maintaining that "[i]n order to decide whether silence in such circumstances violates § 10(b), it is necessary to review the language and legislative history of that statute as well as its interpretation by the Commission and the federal courts"). See also Roberta S. Karmel, Outsider Trading on Confidential Information - A Breach in Search of a Duty, 20 CARDOZO L. REV. 83, 86 (1998) (noting that "[t]he typical insider trading case involves silence").
154. See infra notes 159 and 193.
155. See RESTATEMENT (SECOND) OF TORTS § 525 (1976) (to be liable for fraud under tort law, the plaintiff must prove that the defendant "fraudulently [made] a misrepresentation of fact, opinion, intention or law for the purpose of inducing [the plaintiff] to act . . . upon it . . . [causing] pecuniary loss . . . by his justifiable reliance upon the misrepresentation"); W. PAGE KEETON ET AL., PROSSER AND KEETON ON THE LAW OF TORTS § 106, at 736-37 (5th ed. 1984) (discussing actions for fraud and deceit at common law).
156. See RESTATEMENT (SECOND) OF TORTS § 551(1) (1976); accord Peek v. Gurney, L.R. 6 H.L. 377, 403 (1873) ("Mere non-disclosure of material facts, however morally censurable . . . would in my opinion form no ground for an action in the nature of an action for misrepresentation."); see also Paula J. Dalley, From Horse Trading to Insider Trading: The Historical Antecedents of the Insider Trading Debate, 39 WM. & MARY L. REV. 1289, 1296-97 (1998); Deborah A. DeMott, Do You Have the Right to Remain Silent? Duties of Disclosure in Business Transactions, 19 DEL. J. CORP. L. 65 (1994).
157. See RESTATEMENT (SECOND) OF TORTS § 551(1) (1976); accord Peek v. Gurney, L.R. 6 H.L. 377, 403 (1873) ("Mere non-disclosure of material facts, however morally censurable . . . would in my opinion form no ground for an action in the nature of an action for misrepresentation."); see also Paula J. Dalley, From Horse Trading to Insider Trading: The Historical Antecedents of the Insider Trading Debate, 39 WM. & MARY L. REV. 1289, 1296-97 (1998); Deborah A. DeMott, Do You Have the Right to Remain Silent? Duties of Disclosure in Business Transactions, 19 DEL. J. CORP. L. 65 (1994).
158. See infra text accompanying note 181.
159. See infra text accompanying note 180.
160. See Horwich, supra note 7, at 1243.
161. See Weiss, supra note 142, at 398 (emphasizing that "[c]ommon law courts disapproved of insider trading on two quite different bases"); see also Douglas M. Branson, Choosing the Appropriate Default Rule - Insider Trading Under State Law, 45 ALA. L. REV. 753, 754 (1994) (enumerating several specific foundations under the common law upon which state judges have based liability for insider trading).
162. See, e.g., Dawson v. National Life Insur. Co., 157 N.W. 929, 938 (Iowa 1916) (recognizing cause of action for fraud in securities trading when corporate officer fails to make "full disclosure of all facts bearing thereon known to such officer and unknown to the shareholder"); Stewart v. Harris, 77 P. 277 (Kan. 1904) (holding that "before any director or managing officer . . . can rightfully purchase the stock of one not actively engaged in the management of its affairs, such director or managing officer must inform such stockholder of the true condition of the affairs of the corporation"). See also infra note 164.
163. See, e.g., Brophy v. Cities Serv. Co., 70 A.2d 5, 8 (Del. Ch. 1949) (recognizing liability to the corporation for an insider's trading profits because "[p]ublic policy will not permit an employee occupying a position of trust and confidence toward his employer to abuse that relation to his own profit, regardless of whether his employer suffers a loss"); Diamond v. Oreamuno, 248 N.E.2d 910, 912 (N.Y. 1969) (holding that "a corporate fiduciary, who is entrusted with potentially valuable information, may not appropriate that asset for his own use even though, in so doing, he causes no injury to the corporation").
164. See supra note 87 and accompanying text.
165. See Dalley, supra note 148, at 1317 n. 157 (noting that "the secret profit rule has a separate doctrinal and theoretical basis from Rule 10b-5 liability"); see also Dirks v. SEC, 463 U.S. 646, 653 n. 10 (1983) (recognizing dial "[t]he duty that insiders owe to the corporation's shareholders not to trade on inside information differs from die common-law duty that officers and directors also have to the corporation itself not to mismanage corporate assets, of which confidential information is one").
166. Recently, in the context of a detailed analysis of the possession vs. use debate, one securities commentator concluded that "under die common law of insider trading, actual use of die nonpublic information, as distinguished from merely trading while knowing the information, is the crux of the wrong." Horwich, supra note 7, at 1245. This conclusion, however, was drawn from an analysis of common law cases that viewed insider trading not as a fraud perpetrated on the trading shareholder, but as a violation of agency principles - specifically, the violation of an agent's duty not to personally profit from the use of an asset (i.e., confidential information) belonging to his principal. See id. at 1242-45 (discussing in the text: Brophy v. Cities Serv. Co., 70 A.2d 5 (Del. Ch. 1949) (derivative action for recovery of profits); Polin v. Conduction Corp., 411 F. Supp. 698 (E.D. Mo. 1976) (derivative count under Delaware law); Tuckman v. Aerosonic Corp., CIV.A. No. 4094, 1982 WL 17810, at *1 (Del. Ch. May 20, 1982) (derivative action seeking imposition of constructive trust); Stepak v. Ross, CIV.A. No. 7047, 1985 WL 21137 (Del Ch. Sept. 5, 1985) (approving proposed settlement of derivative claim for recovery of profits); Lewis v. Hirsch, [1994-95 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 98,382, at 90,614 (Del. Ch. June 1, 1994) (rejecting proposed settlement of derivative claim because there was evidence that insiders may have personally profited from use of the corporation's information); and Freeman v. Decio, 585 F.2d 186 (7th Cir. 1978) (applying Indiana law and rejecting derivative claim for recovery of profits because the corporation could not prove that it was damaged by the insider's misuse of information)). An analysis focusing on the common law cases that viewed insider trading as a fraud practiced on shareholders, see supra note 153 and infra note 164, supports a different conclusion.
167. See Herman & MacLean v. Huddleston, 459 U.S. 375, 388-89 (1983).
168. See A.C. Pritchard, United States v. O'Hagan: Agency Law and Justice Powell's Legacy for the Law of Insider Trading, 78 B.U. L. REV. 13, 15 (1998) (maintaining that in Chiarella and Dirks, "[Justice] Powell sought to . . . anchor[] insider trading law to his interpretation of the common law of deceit"); see also Basic, Inc. v. Levinson, 485 U.S. 224, 253 (1988) (White, J., concurring in part & dissenting in part) (emphasizing that, "[i]n general, the case law developed in this Court widi respect to § 10(b) and Rule 10b-5 has been based on doctrines which we, as judges, are familiar: common-law doctrines of fraud and deceit"); Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723, 744 (1975) (stating that "it is not inappropriate to advert briefly to die tort of misrepresentation and deceit, to which a claim under Rule 10b-5 certainly has some relationship").
169. See LOSS & SELIGMAN, supra note 17, at 3466-76 (contrasting the so-called "majority rule" (which permitted traditional insiders to remain silent about material facts in transactions with shareholders on the theory that fiduciary duties were owed only to the corporation but not to the individual shareholder) with the so-called "special circumstances" doctrine (which recognized a duty to disclose when one party to a transaction had access to highly significant facts that were unknown to the other party) and the so-called "minority rule" (which recognized a fiduciary relationship between traditional insiders and the corporation's shareholders and imposed disclosure duties on traditional insiders by virtue of their status)).
170. See Dalley, supra note 148, at 1297 (noting that the "fiduciary trading rule developed significance in the second half of the nineteenth century when stockholders tried to use it to support a claim for insider trading against corporate officers and directors" and that a "minority rule allowing such suits to go forward [soon] developed"); Branson, supra note 152, at 756 (noting that, at common law, "[a] few courts condemned all insider trading, that is, silence by a fiduciary when in possession of material nonpublic investment information and when trading with owners of those shares"). It is often speculated that, without the evolution of Rule 10b-5, the common law would have eventually embraced minority rule as the overwhelming norm in securities transactions involving traditional insiders. See LOSS & SELIGMAN, supra note 17, at 3476; see also Donald C. Langevoort, Insider Trading and the Fiduciary Principle: A Post-Chiarella Restatement, 70 CAL. L. REV. 1, 5 (1982) (noting that the pre-Rule 10b-5 fiduciary trading cases "clearly indicated a trend . . . toward treating the insider as a fiduciary for the shareholders as well as for the company").
171. Dawson v. National Life Ins. Co., 157 N.W. 929, 334 (Iowa 1916); see also Stewart v. Harris, 77 P. 277, 279 (Kan. 1904) ("The managing officers of a corporation are not only trustees in relation to the corporate entity and the corporate property, but they are also to some extent and in many respects trustees of the corporate shareholders"). As will be seen, the Court in Chiarella accepted this view of the insider-shareholder relationship, and recognized the disclosure duty reflected in Section 551(2)(a) of the Restatement (Second) of Torts. See infra note 180 and accompanying text.
172. See GEORGE T. BOGERT, TRUSTS § 96, at 348 (6th ed. 1987): If a trustee enters into a transaction with a beneficiary relating to the interest of the beneficiary under the trust, the trustee owes the beneficiary a duty to display the utmost fairness, which ordinarily involves disclosure to the beneficiary of all relevant facts which are unknown to the beneficiary. . . . [This] doctrine applies to all fiduciaries and also to persons in a confidential relationship. Id.; see also RESTATEMENT (SECOND) OF TRUSTS § 170 ("The trustee in dealing with the beneficiary on the trustee's own account is under a duty to the beneficiary to deal fairly with him and to communicate to him all material facts in connection with the transaction which the trustee knows or should know"). Some securities law scholars have offered a transaction cost minimizing rationale for the common law's imposition of the duty of full disclosure in face-to-face transactions between traditional insiders and the corporation's shareholders. See, e.g., Lawrence A. Hamermesh, Calling Off the Lynch Mob: The Corporate Director's Fiduciary Duty to Disclose, 49 VAND. L. REV. 1087, 1553 (1996) (contending that the imposition of "a fiduciary duty of disclosure provides a convenient, ready-made substitute for what selling stockholders would want in any event - presentation of the material facts - and what directors, by virtue of their role as centralized repositories of corporate information, are well suited to provide efficiently"). But it is also important to recognize that the fiduciary duty of disclosure encompasses a strong moral component as well. See Tamar Frankel, Fiduciary Law, 71 CAL. L. REV. 795, 830 (1983) (contending that "once a person becomes a fiduciary,
173. See GEORGE T. BOGERT, TRUSTS § 96, at 348 (6th ed. 1987): If a trustee enters into a transaction with a beneficiary relating to the interest of the beneficiary under the trust, the trustee owes the beneficiary a duty to display the utmost fairness, which ordinarily involves disclosure to the beneficiary of all relevant facts which are unknown to the beneficiary. . . . [This] doctrine applies to all fiduciaries and also to persons in a confidential relationship. Id.; see also RESTATEMENT (SECOND) OF TRUSTS § 170 ("The trustee in dealing with the beneficiary on the trustee's own account is under a duty to the beneficiary to deal fairly with him and to communicate to him all material facts in connection with the transaction which the trustee knows or should know"). Some securities law scholars have offered a transaction cost minimizing rationale for the common law's imposition of the duty of full disclosure in face-to-face transactions between traditional insiders and the corporation's shareholders. See, e.g., Lawrence A. Hamermesh, Calling Off the Lynch Mob: The Corporate Director's Fiduciary Duty to Disclose, 49 VAND. L. REV. 1087, 1553 (1996) (contending that the imposition of "a fiduciary duty of disclosure provides a convenient, ready-made substitute for what selling stockholders would want in any event - presentation of the material facts - and what directors, by virtue of their role as centralized repositories of corporate information, are well suited to provide efficiently"). But it is also important to recognize that the fiduciary duty of disclosure encompasses a strong moral component as well. See Tamar Frankel, Fiduciary Law, 71 CAL. L. REV. 795, 830 (1983) (contending that "once a person becomes a fiduciary, the law places him in the role of a moral person and pressures him to behave in a selfless fashion, to think and act for others"); Marleen A. O'Connor, How Should We Talk about Fiduciary Duty? Directors' Conflict-of-Interest Transactions and the ALI's Principles of Corporate Governance, 61 GEO. WASH. L. REV. 954, 965 (1993) (noting that "[t]he word 'fiduciary' is derived from the Latin term 'fiducia' meaning 'trust'" and that "it is [thus] not surprising that we use words such as 'faithfulness,' 'honesty' and 'fidelity' to characterize the fiduciary obligation"); see also Victor Brudney, Contract and Fiduciary Duty in Corporate Law, 38 B.C. L. REV. 595, 611 (1997) (contending that "management's duty of loyalty requires the same self- denying behavior on its part, whether its duty is owed to the corporation or to the common stockholders"). A fairness/morality based rationale for the possession test for traditional insiders is discussed infra text accompanying notes 280-303.
174. See GEORGE T. BOGERT, TRUSTS § 96, at 348 (6th ed. 1987): If a trustee enters into a transaction with a beneficiary relating to the interest of the beneficiary under the trust, the trustee owes the beneficiary a duty to display the utmost fairness, which ordinarily involves disclosure to the beneficiary of all relevant facts which are unknown to the beneficiary. . . . [This] doctrine applies to all fiduciaries and also to persons in a confidential relationship. Id.; see also RESTATEMENT (SECOND) OF TRUSTS § 170 ("The trustee in dealing with the beneficiary on the trustee's own account is under a duty to the beneficiary to deal fairly with him and to communicate to him all material facts in connection with the transaction which the trustee knows or should know"). Some securities law scholars have offered a transaction cost minimizing rationale for the common law's imposition of the duty of full disclosure in face-to-face transactions between traditional insiders and the corporation's shareholders. See, e.g., Lawrence A. Hamermesh, Calling Off the Lynch Mob: The Corporate Director's Fiduciary Duty to Disclose, 49 VAND. L. REV. 1087, 1553 (1996) (contending that the imposition of "a fiduciary duty of disclosure provides a convenient, ready-made substitute for what selling stockholders would want in any event - presentation of the material facts - and what directors, by virtue of their role as centralized repositories of corporate information, are well suited to provide efficiently"). But it is also important to recognize that the fiduciary duty of disclosure encompasses a strong moral component as well. See Tamar Frankel, Fiduciary Law, 71 CAL. L. REV. 795, 830 (1983) (contending that "once a person becomes a fiduciary, the law places him in the role of a moral person and pressures him to behave in a selfless fashion, to think and act for others"); Marleen A. O'Connor, How Should We Talk about Fiduciary Duty? Directors' Conflict-of-Interest Transactions and the ALI's Principles of Corporate Governance, 61 GEO. WASH. L. REV. 954, 965 (1993) (noting that "[t]he word 'fiduciary' is derived from the Latin term 'fiducia' meaning 'trust'" and that "it is [thus] not surprising that we use words such as 'faithfulness,' 'honesty' and 'fidelity' to characterize the fiduciary obligation"); see also Victor Brudney, Contract and Fiduciary Duty in Corporate Law, 38 B.C. L. REV. 595, 611 (1997) (contending that "management's duty of loyalty requires the same self- denying behavior on its part, whether its duty is owed to the corporation or to the common stockholders"). A fairness/morality based rationale for the possession test for traditional insiders is discussed infra text accompanying notes 280-303.
175. See GEORGE T. BOGERT, TRUSTS § 96, at 348 (6th ed. 1987): If a trustee enters into a transaction with a beneficiary relating to the interest of the beneficiary under the trust, the trustee owes the beneficiary a duty to display the utmost fairness, which ordinarily involves disclosure to the beneficiary of all relevant facts which are unknown to the beneficiary. . . . [This] doctrine applies to all fiduciaries and also to persons in a confidential relationship. Id.; see also RESTATEMENT (SECOND) OF TRUSTS § 170 ("The trustee in dealing with the beneficiary on the trustee's own account is under a duty to the beneficiary to deal fairly with him and to communicate to him all material facts in connection with the transaction which the trustee knows or should know"). Some securities law scholars have offered a transaction cost minimizing rationale for the common law's imposition of the duty of full disclosure in face-to-face transactions between traditional insiders and the corporation's shareholders. See, e.g., Lawrence A. Hamermesh, Calling Off the Lynch Mob: The Corporate Director's Fiduciary Duty to Disclose, 49 VAND. L. REV. 1087, 1553 (1996) (contending that the imposition of "a fiduciary duty of disclosure provides a convenient, ready-made substitute for what selling stockholders would want in any event - presentation of the material facts - and what directors, by virtue of their role as centralized repositories of corporate information, are well suited to provide efficiently"). But it is also important to recognize that the fiduciary duty of disclosure encompasses a strong moral component as well. See Tamar Frankel, Fiduciary Law, 71 CAL. L. REV. 795, 830 (1983) (contending that "once a person becomes a fiduciary, the law places him in the role of a moral person and pressures him to behave in a selfless fashion, to think and act for others"); Marleen A. O'Connor, How Should We Talk about Fiduciary Duty? Directors' Conflict-of-Interest Transactions and the ALI's Principles of Corporate Governance, 61 GEO. WASH. L. REV. 954, 965 (1993) (noting that "[t]he word 'fiduciary' is derived from the Latin term 'fiducia' meaning 'trust'" and that "it is [thus] not surprising that we use words such as 'faithfulness,' 'honesty' and 'fidelity' to characterize the fiduciary obligation"); see also Victor Brudney, Contract and Fiduciary Duty in Corporate Law, 38 B.C. L. REV. 595, 611 (1997) (contending that "management's duty of loyalty requires the same self-denying behavior on its part, whether its duty is owed to the corporation or to the common stockholders"). A fairness/morality based rationale for the possession test for traditional insiders is discussed infra text accompanying notes 280-303.
176. See, e.g., cases cited supra note 153; Van Schaack Holdings, Ltd. v. Van Schaack, 867 P.2d 892, 897-98 (Co. 1994) (emphasizing that "directors of a corporation and its controlling shareholders [must] act with an extreme measure of candor, unselfishness, and good faith in relation to remaining shareholder" and concluding that "this duty encompasses the obligation to fully disclose all material facts and circumstances surrounding or affecting a proposed transaction"); Blakesley v. Johnson, 608 P.2d 908,915 (Kan. 1980) (maintaining that minority shareholder "had a legal right on the facts in this case to rely upon [the majority shareholder] to make a full disclosure"); Hotchkiss v. Fisher, 16 P.2d 531, 535, 534 (Ka. 1932) (maintaining that "a director negotiating with a shareholder for purchase of shares acts in a relation of scrupulous trust and confidence" and concluding that "full and fair disclosure required the furnishing of all information in the director's possession"). See also Weiss, supra note 142, at 399 ("A shareholder who sold a corporation's stock to an insider in a face-to-face transaction had a right to expect that the insider, as a fiduciary, would disclose any material, nonpublic information that he possessed before effectuating the transaction"). In addition to a shareholder's right to know the facts possessed by a traditional insider, a few of the jurisdictions that regarded insider trading as a fraud on shareholders also emphasized that the information used by the traditional insider in his securities transaction was a quasi-asset of the corporation. See, e.g., Oliver v. Oliver, 45 S.E. 232, 234 (Ga. 1903) (stating that "the shareholder is as much entitled to the advantage of that sort of an asset as to any other regularly entered on the list of the company's holdings"). Yet rather than a necessary element in establishing the fraud perpetrated on a shareholder, a traditional insider's use of a corporate asset was generally regarded as an additional reason for the recognition of a disclosure duty. See id. at 233-34.
177. A causation requirement in the context of securities trading by traditional insiders would be inconsistent with other exceptions noted in the Restatement (Second) of Torts for when a party's mere silence in a business transaction may be deemed fraudulent. For example, § 551 (2)(c) of the Restatement requires a party to disclose "subsequently acquired information that he knows will make untrue or misleading a previous representation that when made was true or believed to be so." RESTATEMENT (SECOND) OF TORTS § 551 (2)(c) (1976). Like the Restatements fiduciary trading exception, this "subsequently acquired information" exception clearly focuses on the ignorant party's right to know the material information rather than the knowledgeable party's initial reasons for entering into the transaction.
178. See Goodwin v. Agassiz, 186 N.E. 659, 660 (1933) (refusing to recognize the breach of a disclosure duty when the traditional insider's securities transactions were carried out over an anonymous stock exchange); see also Hamermesh, supra note 163, at 1153 n.295 (stating that "[r]esearch has not disclosed any case in which a stockholder selling in the market has successfully invoked a fiduciary disclosure duty, as opposed to Rule 10b-5, to recover compensatory damages from a director who concurrently bought stock"); Todd A. Bauman, Comment, Insider Trading at Common Law, 51 U. CHI. L. REV. 838, 853 (1984) (emphasizing that "the traditional common law rule allowed insider trading in anonymous markets, while regulating such activity in face-to-face transactions in shares of closely held corporations").
179. See Pritchard, supra note 159, at 26 (noting that "the fiduciary obligation of corporate officers and directors . . . does not extend to prospective shareholders who may purchase their shares for the first time when an insider sells").
180. 40 S.E.C. 907 (1961).
181. Id. at 911.
182. Id. at 912.
183. See id.
184. 401 F.2d 833 (2d Cir. 1968).
185. Id. at 848.
186. Id.
187. See id. at 847-48 (emphasizing that, in enacting the Exchange Act, "Congress purposed to prevent inequitable and unfair practices and to insure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on exchanges"); see also Jonathan R. Macey, From Fairness to Contract: The New Direction of the Rules Against Insider Trading, 13 HOFSTRA L. REV. 9, 17 (1984) (noting that Texas Gulf Sulphur "fully embraced the fairness concept as the proper theoretical basis for assigning liability under Rule 10b-5"); Lawrence E. Mitchell, The Jurisprudence of the Misappropriation Theory and the New Insider Trading Legislation: From Fairness to Efficiency and Back, 52 ALB. L. REV. 775, 808 (1988) (noting that, once the court in Texas Gulf Sulphur established the defendant's access to material nonpublic information, "the relevance of relationship fell away and the focus was upon the effect on the market of advantaged trading").
188. See id. at 847-48 (emphasizing that, in enacting the Exchange Act, "Congress purposed to prevent inequitable and unfair practices and to insure fairness in securities transactions generally, whether conducted face-to-face, over the counter, or on exchanges"); see also Jonathan R. Macey, From Fairness to Contract: The New Direction of the Rules Against Insider Trading, 13 HOFSTRA L. REV. 9, 17 (1984) (noting that Texas Gulf Sulphur "fully embraced the fairness concept as the proper theoretical basis for assigning liability under Rule 10b-5"); Lawrence E. Mitchell, The Jurisprudence of the Misappropriation Theory and the New Insider Trading Legislation: From Fairness to Efficiency and Back, 52 ALB. L. REV. 775, 808 (1988) (noting that, once the court in Texas Gulf Sulphur established the defendant's access to material nonpublic information, "the relevance of relationship fell away and the focus was upon the effect on the market of advantaged trading").
189. Texas Gulf Sulphur, 401 F.2d at 848 (quoting In re Cady, Roberts & Co., 40 SEC 907, 912 (1961)).
190. Admittedly, this interpretation conflicts with the conventional wisdom, which generally has viewed the possession test as a direct offshoot of the parity of information approach. See, e.g., BROMBERG & LOWENFELS, supra note 129, at 7:160.2 (noting that the "[p]ossession theory derives from the policy of equal access to information which underlay the [Texas Gulf Sulphur] decision").
191. Chiarella v. United States, 445 U.S. 222, 231 (1980).
192. Id. at 230. Justice Powell's majority opinion in Chiarella cited Cady, Roberts in support of its "fraud by a fiduciary's silence" approach to Rule 10b-5 liability. See id. at 226-27. But, as Justice Blackmun correctly recognized in his dissent, Cady, Roberts's "duty to abstain or disclose arose, not merely as an incident of fiduciary responsibility, but as a result of the inherent unfairness of turning secret information to account for personal profit." Id. at 249 (J., Blackmun, dissenting).
193. Id. at 228 (quoting RESTATEMENT (SECOND) OF TORTS § 551(a)(2) (1976) (emphasis added)).
194. See RESTATEMENT (SECOND) OF TORTS § 551(2)(a)-(e) (1976).
195. Chiarella, 445 U.S. at 228.
196. For a more extensive discussion of Chiarella's classical theory as well as the misappropriation theories of insider trading liability that were considered by the concurring and dissenting Justices, see Nagy, supra note 86, at 1229-33, 1234-36, and sources cited at n.18.
197. Chiarella, 445 U.S. at 232-33.
198. Chiarella, 445 U.S. at 232.
199. Id.
200. See Victor Brudney, O'Hagan's Problems, 1997 SUP. CT. REV. 249, 254-55 n.15 (1997) (noting that "[i]t is not without a certain irony that the Supreme Court, in its efforts to narrow the scope of the disclosure requirements of Section 10(b), assumed, and in some sense may have furthered, broad local law fiduciary disclosure obligations of management and controllers").
201. See supra note 166 and accompanying text.
202. See Chiarella, 445 U.S. at 228 n.9 (citing Strong v. Repide, 213 U.S. 419, 431-434 (1909) (face-to-face transaction involving director and shareholder)); id. at 228-29 (citing Speed v. Transamerica Corp., 99 F. Supp. 808, 829 (D.Del. 1951) (face-to-face transaction involving majority shareholder and minority shareholder)); and id. at 229-30 (citing Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 146 (1972) (face-to-face transaction involving fiduciary bank employees who purchased stock from their beneficiaries)). The Court in Chiarella neither acknowledged nor justified this departure from the common law. Quite possibly, the Court accepted the reasoning articulated by the SEC in Cady, Roberts: We reject this suggestion [that disclosure duties apply only in face-to-face transactions]. It would be anomalous indeed if the protection afforded by the antifraud provisions were withdrawn from transactions effected on exchanges, primary markets for securities transactions. If purchasers on an exchange had available material information known by a selling insider, we may assume that their investment judgment would be affected and their decision whether to buy might accordingly be modified. Consequently, any sales by the insider must await disclosure of the information. In re Cady, Roberts & Co., 40 S.E.C. 907, 914 (1961).
203. See Chiarella, 445 U.S. at 227 n.8 (quoting Judge Learned Hand's statement in Gratz v. Claughton, 187 F.2d 46, 49 (2d Cir. 1951)).
204. See Chiarella, 445 U.S. at 227. Here again, the SEC in Cady, Roberts offered a more extensive justification for this departure from the common law: There is no valid reason why persons who purchase stock from an officer, director or other person having the responsibilities of an "insider" should not have the same protection afforded by disclosure of special information as persons who sell stock to them. Whatever distinctions may have existed at common law based on the view that an officer or director may stand in a fiduciary relationship to existing stockholders from whom he purchases but not to members of the public to whom he sells, it is clearly not appropriate to introduce these into the broader anti-fraud concepts embodied in the securities acts. Cady, Roberts, 40 S.E.C. at 913.
205. See, e.g., Pritchard, supra note 159, at 22-27.
206. See Basic, Inc. v. Levinson, 485 U.S. 224, 244, n.22 (1988) (stating that "[a]ctions under Rule 10b-5 . . . are in part designed to add to the protections provided investors by the common law" (citations omitted)); Herman & MacLean v. Huddleston, 459 U.S. 375, 389 (1983) (stating that "an important purpose of the federal securities statutes was to rectify perceived deficiencies in the available common-law protections by establishing higher standards of conduct in the securities industry"). Cf. Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 310 (1985) (stating that the Court has "eschewed rigid common-law barriers in construing the securities laws").
207. See supra note 139 and accompanying text.
208. Chiarella, 445 U.S. at 228 (quoting RESTATEMENT (SECOND) OF TORTS § 551(2)(a) (1976)).
209. Id. at 227 (citing Cady, Roberts, 40 S.E.C. at 912 & n.15).
210. Id. at 228-29 (quoting Speed v. Transamerica Corp., 99 F. Supp. 808, 829 (D.Del. 1951)).
211. Id. at 230.
212. Dirks v. SEC, 463 U.S. 646, 653 (1983).
213. See id. at 653-54 (quoting Chiarella, 445 U.S. at 227).
214. Id. at 654 (quoting Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 472 (1977)).
215. Id. (quoting Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 472 (1977)).
216. Id. (quoting In re Merrill Lynch, Pierce, Fenner & Smith, Inc. 43 S.E.C. 933, 936 (1968)).
217. Id. (quoting In re Cady, Roberts & Co., 40 S.E.C. 907, 916 n.31 (1961)).
218. See id. at 662. More specifically, the Court stated that whether a traditional insider's disclosure of confidential information to a third party is a breach of duty depends "in large part on the purpose of the disclosure." Id. at 662. This determination involves an inquiry into "whether the insider will personally benefit, directly or indirectly, from his disclosure." Id. According to the Court, "[a]bsent some personal gain, there has been no breach of duty to the stockholders." Id.
219. See id. at 661-62 (stating that "[a]ll disclosures of confidential corporate information are not inconsistent with the duty insiders owe to shareholders").
220. See id. at 662. Rather than focusing on whether the insider was motivated by a desire to personally profit from his disclosure to a third party, Dirks's dissenters - Justices Blackmun, Brennan, and Marshall - would have found the necessary breach of fiduciary duty from evidence that the insider knew that the third party was likely to use the information to trade the corporation's shares (or to tip others who would then trade). See id. at 671-76 (Blackmun, J., dissenting). The majority, however, contended that the dissenters' theory would have imposed on the third party tippee "a general duty to forgo market transactions 'based on material nonpublic information'" - a standard of liability explicitly rejected by the Court in Chiarella. Id. at 665 n.27. The majority also was concerned that a broader test for tippee liability "could have an inhibiting influence on the role of market analysts which . . . is necessary to the preservation of a healthy market." Id. at 658.
221. This contextual interpretation of Dirks's personal benefit requirement is bolstered by the Court's observation that "'[i]t is important in this type of case to focus on policing insiders and what they do . . . rather than on policing information per se and its possession . . . .'" Id. at 663 (quoting Investors Management Co., 44 S.E.C. 633, 648 (1971) (Smith, J., concurring in result)). As discussed above, both Dirks and Investors Management involved securities trading by third parties who themselves owed no independent fiduciary duties to the shareholders with whom they were trading. See supra notes 102-108 and accompanying text.
222. See, e.g., JACOBS, supra note 120, at 3-664 (arguing that "a person would not breach 10b-5 if he decides he will trade on a future date he fixes in his own mind, does nothing outwardly to manifest that decision, receives inside information, and then trades in keeping with his original plan"); Horwich, supra note 7, at 1268-69 (citing Chiarella and Dirks and contending that "the essence" of the insider trading prohibition "is 'taking advantage' of information not known to those with whom one is trading" and emphasizing that "[o]ne does not 'take advantage' of something which first comes to his attention after he has made his investment decision"); Pitt & Groskaufmanis, supra note 7, at 20 (contending that Chiarella and Dirks support a use test); see also Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 WASH. & LEE L. REV. 1189, 1201 (1995) (emphasizing Dirks's "secret profit" statements and concluding that "a duty to disclose before trading arises only if trading would violate a duty to refrain from self-dealing in confidential information owed by the trader to the owner of that information").
223. See SEC v. Adler, 137 F.3d 1325, 1333-34(11th Cir. 1998) (citing statements in Chiarella, Dirks, and O'Hagan); United States v. Smith, 155 F.3d 1051, 1067 (9th Cir. 1998) (same).
224. LOSS & SELIGMAN, supra note 17, at 3504-05.
225. See, e.g., WANG AND STEiNBERG, supra note 130, at 63 (Supp. 1999) (noting that, although "this treatise uses the phrase 'trading on' material nonpublic information throughout . . ., [the treatise] certainly does not use that phrase to endorse one side of the 'while in possession of versus 'on the basis of' debate").
226. The majority opinion in United States v. O'Hagan, 117 S. Ct. 2199 (1997) provides a useful illustration of a court's - in this case the Supreme Court's - tendency to use the terms "while in possession of and "on the basis of interchangeably. In describing the classical theory of insider trading, the Court stated: Under the "traditional" or "classical theory" of insider trading liability, §10(b) and Rule 10b-5 are violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information. Trading on such information qualifies as a "deceptive device" under §10(b), we have affirmed, because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation." Id. at 2207 (quoting Chiarella v. United States, 445 U.S. 222, 228 (1980)). What evidence is there that the Court in O'Hagan may have been less than precise when choosing its words to describe the classical theory of insider trading? The most powerful evidence is that the O'Hagan Court consistently used the phrases "on the basis of or "trading on" material nonpublic information throughout its opinion, regardless of whether it was referring to insider trading under the classical theory, the misappropriation theory, or SEC Rule 14e-3(a) - a rule whose text, see supra note 28, specifically regulates trading "while in possession of material nonpublic information concerning a tender offer. See O'Hagan, 117 S. Ct. at 2205, 2207, 2209, 2210, 2212, 2215, 2217, 2219. The Court's imprecise description of Rule 14e-3(a) suggests that it may have been similarly imprecise when it articulated a description of the classical theory of insider trading liability under Section 10(b) and Rule 10b-5, See WANG AND STEINBERG, supra note 130, at 63 (Supp. 1999) (stating that "[t]his indiscriminate use of the phrase 'trading on' suggests that the Court may not have intended to take any position on the question of 'while in possession of' versus 'on the basis of'"); but see supra notes 85-88 and accompanying text (discussing "use" as an essential factor in establishing Rule 10b-5 liability under the misappropriation theory).
227. See supra text accompanying notes 168-71.
228. See Weiss, supra note 142, at 400 (noting that Cady, Robert's explanation for why insiders are subject to a disclose or abstain obligation reflected concerns about fairness and unjust enrichment and "did not mention deception or manipulation, the conduct that section 10(b) prohibits").
229. See supra notes 153, 161-64 and accompanying text (discussing the common law of fraud and deceit) and text accompanying notes 179-86 (discussing Chiarella).
230. See infra notes 270-303 and accompanying text.
231. See LOSS & SELIGMAN, supra note 17, at 3505.
232. SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968).
233. Id. at 862 (emphasis added); see also SEC v. International Chem. Dev. Corp., 469 F.2d 20, 27 n.3 (10th Cir. 1972) (stating that "[c]orporate officers and agents are liable for injecting such false and deceptive publications into the marketplace, even if they are not simultaneously buying and selling for their personal accounts").
234. 485 U.S. 224, 241-49 & 239 n.17 (1988) (recognizing that material misstatements intentionally made by corporate officials may have operated as a "fraud on the market" and allowing lawsuit to go forward even though corporation and its officials were not trading in the corporation's securities and may have had "business reasons" for falsely denying marketplace rumors).
235. See In Re Time Warner Inc. Sec. Dug., 9 F.3d 259, 268 (2d Cir. 1993) (plaintiff's allegations of fraudulent omissions state a claim under Rule 10b-5 because "[a] duty to disclose arises whenever secret information renders prior public statements materially misleading"); Weiner v. Quaker Oats Co., 129 F.3d 310, 316 (3d Cir. 1997) (plaintiffs may proceed with their fraudulent omissions claim under Rule 10b-5 because "[t]here can be no doubt that a duty exists to correct prior statements, if the prior statements were true when made but misleading if left unrevised" (quoting In re Phillips Petroleum Sec. Litig., 881 F.2d 1236, 1245 (3d Cir. 1989))).
236. See Basic, 485 U.S. at 240 n. 17 (stating that "we think that creating an exception to a regulatory scheme founded on a prodisclosure legislative philosophy, because complying with the regulation might be 'bad for business,' is a role for Congress, not this Court").
237. See supra notes 153, 161-65 and accompanying text.
238. See cases cited in supra note 193.
239. Louis Loss, The Fiduciary Concept as Applied to Trading By Corporate "Insiders" in the United States, 33 MOD. L. REV. 34, 47 (1970).
240. See supra note 112 and accompanying text.
241. As agents of the corporation, non-officer employees and temporary insiders clearly owe fiduciary duties to the corporation that employs or retains them. See RESTATEMENT (SECOND) OF AGENCY § 13 (1958) (stating that the principal-agent relationship is a fiduciary one with respect to matters within the scope of the agency relationship). Yet, unlike traditional insiders, non-officer employers and temporary insiders generally are not regarded as trustees of the corporation's shareholder. See supra notes 163-64 and accompanying text (discussing authority supporting the view that traditional insiders owe shareholders a duty to display the utmost fairness and are obligated to place the shareholders' welfare above their own). It is this moral dimension of "selflessness" that is generally not present in the relationship between non-officer employees or temporary insiders of the corporation and the shareholders of the corporation. And without this moral dimension, it is unlikely that a court would impose a duty of full disclosure based solely on a non-officer employee's or temporary insider's mere possession of material nonpublic information. See infra notes 231-32 (discussing Dirks's focus on the misuse of the corporation's confidential information).
242. See Bainbridge, supra note 209, at 1203 (contending that "the disclose or abstain theory of liability is more accurately described as a duty to refrain from self-dealing in confidential information belonging to another than as a duty of confidentiality or disclosure"). I agree with Professor Bainbridge's contention insofar as it describes the duty owed to shareholders by persons other than traditional insiders. We part company, however, on the issue of traditional insiders because I ascribe significantly more weight to Chiarella's recognition that traditional insiders stand as fiduciaries to the corporation's shareholders, see Chiarella, 445 U.S. at 227, and to Chiarella's statement that "a duty to disclose arises when one party has information 'that the other party is entitled to know because of a fiduciary or other similar relation of trust and confidence between them.'" Id. at 228 (quoting RESTATEMENT (SECOND) OF TORTS § 551(2)(a) (1976)).
243. The Court in Dirks candidly acknowledged that Chiarella's fiduciary principle "created analytical difficulties for the SEC and courts in policing tippees who trade on inside information" because "the typical tippee has no such relationship[]" with the corporation's shareholders. See Dirks v. SEC, 463 U.S. 646, 655 (1983). The Court, however, was able to hurdle this obstacle by viewing "the tippee's duty to disclose or abstain [as] derivative from that of the insider's duty." Id. at 659. That is, certain tippees could be said to assume an insider's disclosure duty to the corporation's shareholder not because they possessed material nonpublic information, but because they may be regarded "'as a participant after the fact in the insider's breach of a fiduciary duty.'" Id. (quoting Chiarella, 445 U.S. at 230 n.12) (emphasis added). Clearly, this somewhat dubious theory of a tippee's disclose or abstain obligation is predicated on the tippee's subsequent use of the material nonpublic information. Without such use of the corporation's information, a tippee could not be regarded as a participant after the fact in the insider's wrongdoing.
244. The concept of a "temporary insider" initially took form through an important footnote in the Dirks opinion. See Dirks, 463 U.S. at 655 n.14. There, the Court recognized that underwriters, accountants, lawyers, and other persons under contract with the corporation are often privy to confidential information. See id. The Court opined that, under certain circumstances, "these outsiders may become fiduciaries of the shareholders." Id. The Court, however, was rather specific in describing these circumstances from which this purported fiduciary duty could be constructed: "The basis for recognizing this fiduciary duty is not simply that such persons acquired nonpublic corporate information, but rather that they have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes." Id. (emphasis added). The Court further clarified the scope of this duty by noting that, for such a duty to be imposed, "the corporation must expect the outsider to keep the disclosed nonpublic information confidential, and the relationship at least must imply such a duty." Id. Thus, as with tippees, Dirk's reasoning demonstrates that a temporary insider's duty to disclose or abstain is predicated on the use of confidential information.
245. See LOSS & SELIGMAN, supra note 17, at 3594 (stating that "[s]ince Dirk's footnote 14 blurred the distinction between traditional corporate fiduciaries and outsiders in a confidential relationship by referring to the latter category also as fiduciaries, we denominate these outsiders as 'constructive insiders' for the sake of analytic precision"). Although the Supreme Court has not addressed explicitly the rationale for imposing a disclose or abstain duty on non-officer employees, lower courts have constructed such a duty for reasons similar to those articulated in Dirk's footnote regarding temporary insiders. See, e.g., SEC v. Texas Gulf Sulphur Co., 401 F.2d 833, 848 (2d. Cir. 1968) (holding an employee-geologist liable for purchasing the company's stock on the basis of confidential information that the employer's land contained highly rich ore); cf. Brophy v. Cities Servs. Co., 70 A.2d 5, 7 (1949) (noting that if "an employee in the course of his employment acquires secret information relating to his employer's business, he occupies a position of trust and confidence toward it, analogous in most respects to that of a fiduciary, and must govern his actions accordingly").
246. Because insider trading cases against non-officer employees, temporary insiders, and tippees should not be brought unless the defendant actually used the corporation's material nonpublic information, the SEC could bypass entirely the legal fiction that these persons owe fiduciary disclosure duties to shareholders by prosecuting such cases under the misappropriation theory. See Barbara Bader Aldave, Misappropriation: A General Theory of Liability for Trading on Nonpublic Information, 13 HOFSTRA L. REV. 101, 121 (1984) (arguing that "[o]ne of the virtues of the misappropriation theory is that it eliminates many of the fictions and anomalies that are associated with the Chiarella-Dirks reasoning"). A practice of pursuing non-officer employees, temporary insiders, and tippees under O'Hagan's "fraud on the source" misappropriation theory would effectively reserve the classical theory for Rule 10b-5 cases involving traditional insiders, and would thus reserve the possession test for classical theory cases. I would favor, however, pursuing such persons under a reframed misappropriation theory that holds, as Chief Justice Burger urged in Chiarella, that any person trading securities on the basis of misappropriated information owes a disclosure duty to the persons with whom he is trading. See Nagy, supra note 86, at 1287-1310 (discussing common law authority for the proposition that use of misappropriated information triggers a disclosure duty in business transactions (even in the absence of a fiduciary relationship with the information's source), and concluding that the text of Section 10(b) and Rule 10b-5 would support a broader misappropriation theory that focuses on the misappropriator's fraud on investors).
247. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193-194 n.12 (1976) (holding that acts of negligence fail to satisfy the scienter requirement in Section 10(b), which is generally defined as "a mental state embracing intent to deceive, manipulate or defraud").
248. Although the Supreme Court has never specifically addressed the question, it has acknowledged circuit courts' views that reckless conduct satisfies Section 10(b)'s requirement of scienter. See Herman & MacLean v. Huddleston, 459 U.S. 375, 378 n.4 (1983).
249. SEC v. Falstaff Brewing Corp., 629 F.2d 62, 77 (D.C. Cir. 1980). See also RESTATEMENT (SECOND) OF TORTS § 8A (1965) ("If the actor knows that the consequences are certain, or substantially certain, to result from his act, and still goes ahead, he is treated by the law as if he had in fact desired to produce the result."). These authorities were cited in the briefs filed by the SEC in Adler and Smith. See Corrected Brief of the Securities and Exchange Commission at 18, SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998) (No. 96-6084); Brief of the Securities and Exchange Commission at 10, United States v. Smith, 16 F.3d 1051 (9th Cir. 1998) (No. 97-50137).
250. Ultimately, even under a knowing possession standard, the SEC may not have been able to prove in Adler that the director-defendant violated Rule 10b-5 when he sold his Comptronix stock while in possession of the information that he learned at the Comptronix Board meeting. Scienter may well have been the stumbling block because, as noted earlier, the fact that the director pre-cleared his trades with the general counsel provides at least some evidence that neither person viewed the information as material. See supra note 40.
251. Chiarella v. United States, 445 U.S. 222, 230 (1980).
252. See, e.g., LANGEVOORT, supra note 46, at 3-6 (stating that "[i]ssuers themselves may buy or sell their own securities, and have long been held to an obligation of full disclosure under Rule 10b-5"); Theresa A. Gabaldon, The Disclosure of Preliminary Merger Negotiations as an Imperfect Paradigm of Rule 10b-5 Analysis, 62 N.Y.U. L. REV. 1218, 1255 (1987) (noting that the duty to disclose or refrain from trading applies to issuers); Daniel J. Winnike, Rule 10b-5's Effect on Employer Stock Repurchases and Option Cancellations on Termination of Employment, 19 SEC. REG. L.J. 227, 237-38 (1991) (emphasizing that "there is little doubt that the relationship between a corporation and its shareholders engenders the type of trust and confidence" necessary to trigger the duty to disclose or abstain); but see Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 DUKE L.J. 879, 916-21 (1988) (contending that issuers do not owe fiduciary duties to their shareholders, though recognizing that the traditional insiders who control the issuer do owe such duties and that the corporation therefore may be vicariously liable for any breaches).
253. See, e.g., LANGEVOORT, supra note 46, at 3-6 (stating that "[i]ssuers themselves may buy or sell their own securities, and have long been held to an obligation of full disclosure under Rule 10b-5"); Theresa A. Gabaldon, The Disclosure of Preliminary Merger Negotiations as an Imperfect Paradigm of Rule 10b-5 Analysis, 62 N.Y.U. L. REV. 1218, 1255 (1987) (noting that the duty to disclose or refrain from trading applies to issuers); Daniel J. Winnike, Rule 10b-5's Effect on Employer Stock Repurchases and Option Cancellations on Termination of Employment, 19 SEC. REG. L.J. 227, 237-38 (1991) (emphasizing that "there is little doubt that the relationship between a corporation and its shareholders engenders the type of trust and confidence" necessary to trigger the duty to disclose or abstain); but see Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 DUKE L.J. 879, 916-21 (1988) (contending that issuers do not owe fiduciary duties to their shareholders, though recognizing that the traditional insiders who control the issuer do owe such duties and that the corporation therefore may be vicariously liable for any breaches).
254. See, e.g., LANGEVOORT, supra note 46, at 3-6 (stating that "[i]ssuers themselves may buy or sell their own securities, and have long been held to an obligation of full disclosure under Rule 10b-5"); Theresa A. Gabaldon, The Disclosure of Preliminary Merger Negotiations as an Imperfect Paradigm of Rule 10b-5 Analysis, 62 N.Y.U. L. REV. 1218, 1255 (1987) (noting that the duty to disclose or refrain from trading applies to issuers); Daniel J. Winnike, Rule 10b-5's Effect on Employer Stock Repurchases and Option Cancellations on Termination of Employment, 19 SEC. REG. L.J. 227, 237-38 (1991) (emphasizing that "there is little doubt that the relationship between a corporation and its shareholders engenders the type of trust and confidence" necessary to trigger the duty to disclose or abstain); but see Deborah A. DeMott, Beyond Metaphor: An Analysis of Fiduciary Obligation, 1988 DUKE L.J. 879, 916-21 (1988) (contending that issuers do not owe fiduciary duties to their shareholders, though recognizing that the traditional insiders who control the issuer do owe such duties and that the corporation therefore may be vicariously liable for any breaches).
255. Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1204 (1st Cir. 1996). The Shaw court supported this proposition with cites to a number of cases, including some of the following: McCormick v. Fund Am. Cos., Inc., 26 F.3d 869, 876 (9th Cir. 1994) ("[T]he corporate issuer in possession of material nonpublic information, must, like other insiders in the same situation, disclose that information to its shareholders or refrain from trading with them."); Jordan v. Duff & Phelps, Inc., 815 F.2d 429, 435-39 (7th Cir.1987) (finding a duty to disclose merger negotiations to an employee who departs voluntarily and cashes in his shares as a condition of termination); Kohler v. Kohler Co., 319 F.2d 634, 638 (7th Cir.1963) ("[U]nderlying principles [mandating disclosure of material nonpublic information] apply not only to majority stockholders of corporations and corporate insiders, but equally to corporations themselves . . . ."); Green v. Hamilton Int'l Corp., 437 F. Supp. 723, 728 (S.D.N.Y. 1977) ("[T]here can be no doubt that the prohibition against 'insider' trading extends to a corporation.").
256. See In re Ward La France Truck Corp., 13 S.E.C. 373 (1943); see also Timely Disclosure of Material Corp. Devs., Exchange Act Release No. 8995, [1970-1971 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 77,915, at 80,036 (Oct. 15, 1970) (emphasizing that "unless adequate and accurate information is available, a company may not be able to purchase its own securities or make acquisitions using its securities, and its insiders may not be able to trade its securities without running a serious risk of violating Section 10(b) . . . and Rule 10b-5").
257. The most well known case involving such facts is Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987). In Jordan, a former shareholder-employee sued an issuer-employer for repurchasing his stock in the corporation without disclosing material information relating to the possibility of a merger between the corporation and another firm. See id. at 432-33. The United States Court of Appeals for the Seventh Circuit held that the issuer-employer violated Rule 10b-5 by remaining silent and repurchasing the employee's shares when it was under a duty to disclose the merger negotiations. The court provided the following reasoning: The "duty" in question is the fiduciary duty of corporate law. Close corporations buying their own stock, like knowledgeable insiders of closely held firms buying from outsiders, have a fiduciary duty to disclose material facts. . . . The "special facts" doctrine developed by several courts at the turn of the century is based on the principle that insiders in closely held firms may not buy stock from outsiders in person-to-person transactions without informing them of new events that substantially affect the value of the stock. Id. at 435. See also Smith v. Duff & Phelps, 891 F.2d 1567, 1574-75 (11th Cir. 1990) (assuming that a corporation was obligated under Rule 10b-5 to disclose material information in its possession before repurchasing retiring employee's stock). Although both cases involved stock repurchases by close corporations, as one commentator has argued "[i]t is difficult to see that a close corporation owes any greater or lesser fiduciary responsibility to its shareholders than a publicly held company." Winnike, supra note 239, at 238.
258. For example, in the Duff & Phelps cases, the issuer had agreed by contract to repurchase the retiring employees shares, and the employees' decisions to retire was a volitional act on their part alone. See Jordon, 815 F.2d at 432; Smith, 891 F.2d at 1568. Accordingly, the corporation could not be said to have purchased the employees' shares on the basis of the material nonpublic information that was in its possession. See Jordan, 815 F.2d at 435; Smith 891 F.2d at 1572-74.
259. For example, in the Duff & Phelps cases, the issuer had agreed by contract to repurchase the retiring employees shares, and the employees' decisions to retire was a volitional act on their part alone. See Jordon, 815 F.2d at 432; Smith, 891 F.2d at 1568. Accordingly, the corporation could not be said to have purchased the employees' shares on the basis of the material nonpublic information that was in its possession. See Jordan, 815 F.2d at 435; Smith 891 F.2d at 1572-74.
260. For example, in the Duff & Phelps cases, the issuer had agreed by contract to repurchase the retiring employees shares, and the employees' decisions to retire was a volitional act on their part alone. See Jordon, 815 F.2d at 432; Smith, 891 F.2d at 1568. Accordingly, the corporation could not be said to have purchased the employees' shares on the basis of the material nonpublic information that was in its possession. See Jordan, 815 F.2d at 435; Smith 891 F.2d at 1572-74.
261. For example, in the Duff & Phelps cases, the issuer had agreed by contract to repurchase the retiring employees shares, and the employees' decisions to retire was a volitional act on their part alone. See Jordon, 815 F.2d at 432; Smith, 891 F.2d at 1568. Accordingly, the corporation could not be said to have purchased the employees' shares on the basis of the material nonpublic information that was in its possession. See Jordan, 815 F.2d at 435; Smith 891 F.2d at 1572-74.
262. See Winnicke, supra note 239, at 238. The difficulties faced by corporations seeking to repurchase shares while engaged in confidential merger negotiations were summarized by one court in the following manner: [What] is a company to do in circumstances such as these when delicate preliminary but serious negotiations are being conducted at a time when it is desirable to try to buy out a disaffected stockholder? The options seem to us to be: (1) to refuse to disclose and refrain from buying during negotiations; (2) to disclose and attempt to buy during negotiations; and (3) if it clearly appears that the selling stockholder is in no way relying on nondisclosure, to take a chance on litigation . . . . If these options seem inadequate, the basic answer is that the law has deliberately tried to equalize bargaining power between the individual and the corporation. The fact that during critical negotiations the scales may be weighted in favor of the departing stockholder is part of the price paid. Rogen v. Ilikon Corp., 361 F.2d 260, 268 (1st Cir. 1966). Today, options number one and two would seem to be the only viable ones available to the issuer because the third option has been effectively eliminated by the Supreme Court's holding in Affiliated Ute Citizens of Utah v. United States, 406 U.S. 128, 152-54 (1972) (holding that, in Rule 10b-5 actions for omissions, a plaintiff's reliance may be presumed where the omitted facts are "material").
263. LOSS & SELIGMAN, supra note 17, at 3505.
264. See SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180, 201 (1963).
265. 15 U.S.C. § 80b-6 (1994). Section 206(2) prohibits investment advisers from "engag[ing] in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client." Id.
266. Capital Gains, 375 U.S. at 200. Specifically, the investment advisers had argued, and the lower courts had found, that liability for fraud and deceit could not be imposed absent proof that "any misstatements or false figures were contained in any of the bulletins"; or that "the investment advice was unsound"; or that "defendants were being bribed or paid to tout a stock contrary to their own beliefs"; or that "these bulletins were a scheme to get rid of worthless stock"; or that the recommendations were made "for the purpose of endeavoring artificially to raise the market so that [respondents] might unload [their] holdings at a profit." Id. at 185 (quoting SEC v. Capital Gains Research Bureau, Inc., 306 F.2d 606, 608-09 (2d Cir. 1962) (en banc)).
267. See id. at 191 (emphasizing that the Investment Advisers Act of 1940 "reflects a congressional recognition 'of the delicate fiduciary nature of an investment advisory relationship'" (quoting 2 LOUIS Loss, SECURITIES REGULATION 1412 (2d ed. 1961))).
268. Id. at 200 (quoting Peterson v. Greenville, 373 U.S 244, 248 (1963); Mosser v. Darrow, 341 U.S. 267, 271 (1951)). The Court concluded, however, that "[i]t [was] clear that the respondents' failure to disclose the practice here in issue was purposeful, and that they intended that action be taken in reliance on the claimed disinterestedness of the service and its exclusive concern for the clients' interests." Id. at 192 n.39.
269. 406 U.S. 128 (1972).
270. Significantly, the Court in Chiarella cited Affiliated Ute as authority for its classical theory of insider trading. See Chiarella v. United States, 445 U.S. 222, 229 (1980) (noting that "[t]his Court followed the same approach in Affiliated Ute").
271. See, e.g., Chasins v. Smith, Barney & Co., 438 F.2d 1167 (2d Cir. 1971).
272. See id. at 1172 (concluding that "failure to inform the customer fully of its possible conflict of interest, in that it was a market maker in the securities which it strongly recommended for purchase by him, was an omission of material fact in violation of Rule 10b-5").
273. See id. at 1171 (maintaining that "[t]he question here is not whether Smith, Barney sold to Chasins at a fair price but whether disclosure of Smith Barney's being a market maker in [the securities] might have influenced Chasins' decision to buy the stock"); id. at 1172 (stating that "[a]n investor who is at least informed of the possibility of such adverse interests, due to his broker's market making in the securities recommended, can question the reasons for the recommendations").
274. See supra text accompanying notes 42-44 and 52-53.
275. See, e.g., ROBERT CHARLES CLARK, CORPORATE LAW 271 (1986) (emphasizing that "many people, including judges and legislators, feel no need to say anything [other than] . . . . [i]t is simply . . . unfair for some investors (insiders and their tip[p]ees) to have preferential access to information").
276. See Arthur Levitt, A Question of Integrity: Promoting Investor Confidence By Fighting Insider Trading, in VITAL SPEECHES OF THE DAY, VOL. LXIV, 354, 355 (Apr. 1, 1998).
277. Despite a number of serious attempts, Congress has not passed any legislation setting the parameters of insider trading liability in general or under Section 10(b) specifically (other than Section 16(b) of the Exchange Act, 15 U.S.C. §78p(b) (1994), which effectively prohibits so-called "short swing" trading profits by a corporation's officers, directors, and 10% shareholders). For a comprehensive description of Congress's attempts to define insider trading, see FERRARA ET AL., supra note 31, ch. IV.
278. See, e.g., H.R. REP. NO. 98-355, at 5 (1983) (emphasizing that "[t]he abuse of informational advantages that other investors cannot hope to overcome through their own efforts is unfair and inconsistent with the investing public's legitimate expectation of honest and fair securities markets where all participants play by the same rules"); H.R. REP. NO. 100-910, at 8 (1988) (stating that "[i]nsider trading damages the legitimacy of the capital market and diminishes the public's faith . . . . [T]he small investor will be - and has been - reluctant to invest in the market if he feels it is rigged against him").
279. For example, Section 16(b) of the Exchange Act states specifically that its regulation of "short-swing" profits was enacted "[f]or the purpose of preventing the unfair use of information which may have been obtained by . . . [a statutory insider] by reason of his relationship to the issuer." 15 U.S.C. § 78p(b) (1994).
280. Of course, not all securities law scholars argue that insider trading should be illegal. See, e.g., HENRY MANNE, INSIDER TRADING AND THE STOCK MARKET (1966); Dennis W. Carlton & Daniel R. Fischel, The Regulation of Insider Trading, 35 STAN. L. REV. 857 (1983). These scholars argue that insider trading is an effective and appropriate method of compensating insiders and entrepreneurs, see MANNE, supra at vii-viii, and that insider trading can benefit securities markets by increasing their allocative efficiency through the swift incorporation of new information in the marketplace, see Carlton & Fischel, supra at 861- 72.
281. Of course, not all securities law scholars argue that insider trading should be illegal. See, e.g., HENRY MANNE, INSIDER TRADING AND THE STOCK MARKET (1966); Dennis W. Carlton & Daniel R. Fischel, The Regulation of Insider Trading, 35 STAN. L. REV. 857 (1983). These scholars argue that insider trading is an effective and appropriate method of compensating insiders and entrepreneurs, see MANNE, supra at vii-viii, and that insider trading can benefit securities markets by increasing their allocative efficiency through the swift incorporation of new information in the marketplace, see Carlton & Fischel, supra at 861-72.
282. See, e.g., Joel Seligman, The Reformulation of Federal Securities Law Concerning Nonpublic Information, 73 GEO. L.J. 1083, 1115 (1985) (contending that the primary policy reason for proscribing insider trading "is to make investors confident that they can trade securities without being subject to informational disadvantages"); see also Victor Brudney, Insiders, Outsiders and Informational Advantages Under the Federal Securities Laws, 93 HARV. L. REV. 322, 356 (1979) (stating that "[i]f the market is thought to be systematically populated with . . . transactors [trading on the basis of misappropriated information] some investors will refrain from dealing altogether").
283. See, e.g., Joel Seligman, The Reformulation of Federal Securities Law Concerning Nonpublic Information, 73 GEO. L.J. 1083, 1115 (1985) (contending that the primary policy reason for proscribing insider trading "is to make investors confident that they can trade securities without being subject to informational disadvantages"); see also Victor Brudney, Insiders, Outsiders and Informational Advantages Under the Federal Securities Laws, 93 HARV. L. REV. 322, 356 (1979) (stating that "[i]f the market is thought to be systematically populated with . . . transactors [trading on the basis of misappropriated information] some investors will refrain from dealing altogether").
284. See, e.g., John C. Coffee, Jr., Is Selective Disclosure Now Lawful?, N.Y.L.J., July 31, 1997, at 5 (arguing that "the victims of insider trading are not simply those who traded with the party possessing inside information,
285. See Robert H. Haft, The Effect of Insider Trading Rules on the Internal Efficiency of the Large Corporation, 80 MICH. L. REV. 1051, 1053 (1982) (contending that the prohibition of "insider trading may enhance business decision-making in large corporations").
286. See, e.g., Bainbridge, supra note 209, at 1238-43, 1252-57; see also Macey, supra note 175, at 30-37 (discussing the economic function of property rights in information).
287. Chiarella v. United States, 445 U.S. 222, 227 (1980).
288. See LANGEVOORT, supra note 46, at 3-23 (stating that "[i]f the law is premised on the notion of unjust enrichment - taking unfair advantage of access to information vis-à-vis the beneficiaries of a fiduciary relationship - then the prohibition should attach only where in fact there has been advantage taken").
289. See Bainbridge, supra note 209, at 1191-92 (contending that Rule 10b-5 is violated when a person breaches "a specific fiduciary duty - namely, the duty to refrain from self-dealing in confidential information owned by another party").
290. See H.R. REF. No. 73-1383, at 11 (1934): The idea of a free and open public market is built on the theory that competing judgments of buyers and sellers as to the fair price of a security brings about a situation where the market price reflects as nearly as possible a just price. Just as artificial manipulation tends to upset the true function of an open market, so the hiding and secreting of important information obstructs the operation of the markets as indices of real value. Id.
291. See Timely Disclosure of Material Corp. Devs., Exchange Act Release No. 8995, [1970-1971 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 77,915, at 80,035-36 (Oct. 15, 1970) (expressing a preference for disclosure even where no affirmative duty exists); see also In Re Faberge, Inc., 45 S.E.C. 249, 254 (1973): The concept of a free and open market for securities necessarily implies that the buyer and seller are acting in the exercise of enlightened judgment as to what constitutes a fair price . . . . [With] incomplete information regarding the corporation, the market price fails to reflect the normal operation of supply and demand. Id. (quoting S. REP. NO. 73-1455, at 68 (1934)).
292. See In Re Burlington Coat Factory Sec. Litig., 114 F.3d 1410, 1432 (3d Cir. 1997) (emphasizing that "[e]xcept for specific periodic reporting requirements (primarily the requirements to file quarterly and annual reports), there is no general duty on the part of a company to provide the public with all material information"); In re Time Warner Inc. Sec. Litig., 9 F.3d 259, 267 (2d Cir. 1993) (stating that "a corporation is not required to disclose a fact merely because a reasonable investor would very much like to know that fact").
293. Issuers whose securities are publicly traded are obligated to file annual and quarterly reports with the SEC. See Exchange Act §§ 12-13, 15 U.S.C. § 78l-78m (1994). Publicly traded companies include companies whose securities are registered under § 12(b) of the Exchange Act, 15 U.S.C. § 78l(b) (i.e., issuers listed on a national securities exchange); companies whose securities are registered under § 12(g) of the Exchange Act, 15 U.S.C. § 78l(g) (i.e., issuers trading in the over-the-counter market when securities are held of record by at least 500 persons and the issuer has total assets exceeding $10 million); and companies who have filed a Securities Act registration statement that has become effective, 15 U.S.C. § 78o(d). The Exchange Act also mandates disclosure through SEC filings when publicly held companies solicit proxies, see Exchange Act § 14(a), 15 U.S.C. § 78n(a), and when securities issuers intend to engage in certain "control" transactions, including tender offers, see Exchange Act §§ 13(d), 13(e), 14(e), 14(1), 15 U.S.C. §§ 78m(d), 78m(e), 78n(e), 78n(f).
294. See Karmel, supra note 145, at 114 (noting that, "[a]lthough the Exchange Act's regime for corporate disclosure is frequently referred to as a continuous disclosure system, it does not, in fact, require corporations to make continuous disclosure of material information").
295. See id. at 120 (contending that, "[t]he disclose or abstain doctrine was, and still is, ancillary to the SEC's primary mandate"); see also Insider Trading: Some Questions and Some Answers, 1 SEC. REG. L.J. 328, 333 (1974) (reprinting Comment Letter from the American Bar Association (ABA) Subcommittee on Rule 10b-5 and the ABA Subcommittee on Broker-Dealer Matters (Oct. 15, 1973) (stating that Cady, Roberts's disclose or abstain rule had "two inter-related socially desirable consequences: promotion of disclosure by corporations and corporate officials, and contribution to public confidence in the securities markets through fulfillment of investors' anticipations regarding the fairness of their treatment in the marketplace" (emphasis added)); Dennis S. Karjala, Statutory Regulation of Insider Trading in Impersonal Markets, 1982 DUKE L.J. 627, 630 (stating that, in addition to compensating injured parties, deterring conduct injurious to market integrity and investor confidence, and punishing wrongdoers, "inducing rapid public disclosure of material information is a fourth possible goal of any system that regulates insider trading").
296. See id. at 120 (contending that, "[t]he disclose or abstain doctrine was, and still is, ancillary to the SEC's primary mandate"); see also Insider Trading: Some Questions and Some Answers, 1 SEC. REG. L.J. 328, 333 (1974) (reprinting Comment Letter from the American Bar Association (ABA) Subcommittee on Rule 10b-5 and the ABA Subcommittee on Broker-Dealer Matters (Oct. 15, 1973) (stating that Cady, Roberts's disclose or abstain rule had "two inter-related socially desirable consequences: promotion of disclosure by corporations and corporate officials, and contribution to public confidence in the securities markets through fulfillment of investors' anticipations regarding the fairness of their treatment in the marketplace" (emphasis added)); Dennis S. Karjala, Statutory Regulation of Insider Trading in Impersonal Markets, 1982 DUKE L.J. 627, 630 (stating that, in addition to compensating injured parties, deterring conduct injurious to market integrity and investor confidence, and punishing wrongdoers, "inducing rapid public disclosure of material information is a fourth possible goal of any system that regulates insider trading").
297. See Gabaldon, supra note 239, at 1257 n. 211 (noting that "where insiders refrain from disclosing because of their fiduciary duty, issuers might be prompted to make disclosure somewhat earlier than would otherwise be the case in order to permit insiders to trade"); see also Jeffrey D. Bauman, Rule 10b-5 and the Corporation's Affirmative Duty to Disclose, 67 GEO. L. J. 935, 988 (1979) (recognizing that "[e]xisting restrictions on insider trading provide some incentive for disclosure of material information" but advocating an affirmative disclosure duty that would apply irrespective of securities trading by issuers or their insiders).
298. See Brudney, supra note 263, at 334 n.43 (contending that "[t]o the extent that corporate officers and directors can control the release of corporate information, precluding them from enjoying trading gains on nonpublic corporate information removes an impediment to its prompt release and to the resulting enhancement of market efficiency in pricing"); Karmel, supra note 145, at 120 (contending that "[t]he need to police the disclosure of such a vast array of public companies made it necessary to develop an enforcement remedy to compel such disclosure"); see also Donald C. Langevoort, Organized Illusions: A Behavioral Theory of Why Corporations Mislead Stock Market Investors (and Cause Other Social Harms), 146 U. PA. L. REV. 101, 112 (1997) (acknowledging "difficult coordination problems," but recognizing that "[t]here is an immediate and potentially immense pecuniary gain for managers if they can buy or sell in advance of a market movement, tempting them to delay their truth-telling in order to fully exploit the informational advantage").
299. See Financial Indus. Fund v. McDonnell Douglas Corp., 474 F.2d 514, 521-22 (10th Cir. 1973) (suggesting that a plaintiff who sells shares during period of nondisclosure may have a private cause of action against a nontrading corporation for bad faith delays in releasing material nonpublic information).
300. See Karmel, supra note 145, at 120.
301. These concerns were specifically codified in the Exchange Act's preamble, see Securities Exchange Act, Pub. L. No. 73-291, 48 Stat. 881 (1934) (stating that it is an "Act to provide for the regulation of securities exchanges and of over-the-counter markets . . . to prevent inequitable and unfair practices on such exchange and markets") and in Section 2, see id. § 78b (1994), (referencing the need to regulate "to insure the maintenance of fair and honest markets").
302. See supra text accompanying notes 257-69.
303. Report of Investigation in the Matter of Sterling Drug, Inc., Exchange Act Release No. 14675, [1978 Transfer Binder] Fed. Sec. L. Reg. (CCH) ¶ 81,570, at 80,295, 80298 (Apr. 18, 1978) (emphasis added).
304. See United States v. Smith, 155 F.3d 1051, 1068 (9th Cir. 1998) (noting that the SEC's position "rests upon a faulty premise" because "[t]he persons with whom a hypothetical insider trades are not at a 'disadvantage' at all provided the insider does not 'use' the information to which he is privy").
305. See supra text accompanying notes 195, 224-26.
306. See William K.S. Wang, Trading on Material Nonpublic Information an Impersonal Stock Markets: Who is Harmed, and Who Can Sue Under SEC Rule 10b-5, 54 S. CAL. L. REV. 1217, 1234-35 (1981).
307. See supra text accompanying notes 180-86.
308. See Wang, supra note 285, at 1235. Professor Wang maintains that all securities transactions by insiders are subject to the "Law of Conservation of Securities," under which any profits gained by the insider must be directly offset by losses sustained by other investors. See id. Professor Wang therefore concludes that if insiders profit, other investors must be harmed. See id. at 1236-37 (noting that "[i]n practice, however, it is virtually impossible to recreate the universe that would have existed had there been no inside trade").
309. See supra notes 162-64 and accompanying text. See also Dixmoor Golf Club v. Evans, 156 N.E. 785, 787 (Ill. 1927) ("It is a breach of duty for . . . directors to place themselves in a position where their personal interests would prevent them from acting for the best interests of those they represent.").
310. See Smith v. Duff & Phelps, Inc., 891 F.2d 1567, 1574 (11th Cir. 1990) (stating that the corporation's failure to disclose potential merger plans to a retiring employee "is a prime example of officers or majority shareholders in exclusive possession of possibly material information acting to further their own financial gain at the expense of other stockholders" and remarking that "[s]uch corporate opportunism flies in the face of the [fiduciary principle]").
311. See Brudney, supra note 263, at 347 ("If fiduciary characterization of duties is required, it is available from the premise that all shareholders are entitled to equal access to information from the corporation when it deals with them. The premise of homogeneity precludes differential treatment of the shareholders of the same class."); Gabaldon, supra note 239, at 1261 (citing Brudney, supra, and contending that, "[b]y trading in its own securities without disclosing material information, the issuer has violated the 'premise of homogeneity'").
312. Chiarella v. United States, 445 U.S. 222, 230 (1980). Although the Court referenced this obligation in the specific context of "guarantee[ing] that corporate insiders . . . will not benefit personally through fraudulent use of material, nonpublic information," id., the obligation itself bears no such limitation. See supra note 163.
313. See Adolf A. Berle, Jr., Publicity of Accounts and Directors' Purchases of Stock, 25 MICH. L. REV. 827, 830-31 (1927) (contending that a corporate management which, as individuals, chooses to enter the open market and which at the same time exercises control over the release of information concerning corporate affairs, can deal with the current value of its securities, if not at pleasure, at least with tremendous effect; and the liquid value of the corporate securities held by the stockholder becomes a matter which the corporate management itself can determine).
314. Cf. Bainbridge, supra note 209, at 1239 ("Unless immediate disclosure of material information is to be required, a step the law has been unwilling to take, there will always be winners and losers . . . .").
315. Construing Rule 10b-5 to prohibit traditional insiders from trading while in possession of material nonpublic information is also consistent with the common law principle that prevented parties to a business transaction from profiting from their silence when they were the cause of the other party's ignorance. See Dalley, supra note 148, at 1344 (stating that "[t]he common law also imposes a duty to disclose information on a party who is responsible for her trading opposite's incorrect information").
316. Saul Levmore, Securities and Secrets: InsiderTrading and the Law of Contracts, 68 VA. L. REV. 117, 123 (1982).
317. Cf. Marcel Kahan, Securities Laws and the Social Costs of "Inaccurate" Stock Prices, 41 DUKE L.J. 977, 1021 (1992) (noting that, "[i]f stock prices are inaccurate because they do not reflect some non-public information, but no person who possesses that information trades, uninformed investors would have no reason to anticipate a loss by trading" (footnote omitted)).
318. Horwich, supra note 7, at 1271.
319. See 15 U.S.C. § 78e (1994). In view of these restrictions, the SEC has promulgated Rule 144, which provides a safe harbor for persons to sell in ordinary trading transactions limited amounts of securities owned by persons controlling, controlled by, or under common control with the issuer. See 17 C.F.R. 230.144 (1998).
320. See 15 U.S.C. § 78p (1994).
321. See id. § 77k(a) (conferring a private right of action against a number of specific categories of persons, including "every person who signed the registration statements" and "every person who was a director of (or person performing similar functions) or partner in, the issuer at the time of the filing of the registration statement with respect to which his liability is asserted").
322. See S. REP. NO. 73-47, at 5 (1933) (stating that [i]f one of two presumably innocent persons must bear a loss, it is familiar legal principle that he should bear it who has the opportunity to learn the truth and has allowed untruths to be published and relied upon. Moreover, he should suffer the loss who occupies a position of trust in the issuing corporation toward stockholders, rather than the buyer of stock who must rely on what he is told.). H.R. REP. NO. 73-85, at 5 (1933) (emphasizing that, "for those whose moral responsibility to the public is particularly heavy, there is a correspondingly heavier legal responsibility").
323. For example, although the New York Stock Exchange (NYSE) encourages stock ownership by directors and officers of listed companies, it specifically advises that "prior to making a purchase or sale a director or officer [should] contact[] the chief executive officer of the company to be sure there are no important developments pending which need to be made public before an insider could properly participate in the market." NEW YORK STOCK EXCHANGE LISTED COMPANY MANUAL § 309.00(1998). The NYSE views even the perception of insider trading to be "extremely embarrassing and damaging to both the company and the Exchange." Id. at § 202.01. The American Stock Exchange (AMEX) and the National Association of Securities Dealers Automated Quotation System ("NASDAQ.") have adopted similar restrictions for the same reasons. See generally FERRARA ET AL., supra note 31, at §§ 7.02[1], 7.03.
324. See FERRARA, et al., supra note 31 at § 7.01 (advising that, "[i]n drafting and implementing a compliance program, securities issuers should take special care to ensure that their officers, directors, and employees do not trade in the corporation's securities when such persons are in possession of material, nonpublic information"); see also Robert A. Barron, Model Memoranda, 17 Sec. Reg. L. J. 195, 196-201 (1989) (outlining a model insider trading memorandum for officers and directors of a hypothetical corporation (XRAY Corp.)). In addition to requiring officers and directors to confer with the Corporate Secretary before purchasing or selling any securities that have been issued by XRAY Corp., the memorandum made clear that it was a violation of both company policy and the federal securities laws to trade such securities while in possession of material nonpublic information. Id. at 196, 200. The memorandum also advised that: To prevent the appearance of impropriety, it is XRAY's policy that no officer or director may purchase or sell XRAY common stock (or options on such stock) during the period beginning three weeks before a public announcement of earnings and ending forty-eight hours after such an announcement has been made. It is to be stressed that trading outside this "blackout" period is not permitted if the purchaser or seller is in possession of material inside information. Id. at 200.
325. Calls for a definition have tended to be particularly strong in the period of time following a decision by the Supreme Court in the area of insider trading. See, e.g., Homer Kripke, A Note on Insider Trading An Example of How Not to Make Late, 39 ALA. L. REV. 349, 349 (1988) (concluding that "legislation is now needed to straighten out the mess we call insider trading law"); Richard W. Painter et al., Don't Ask, Just Tell: Insider Trading After United States v. O'Hagan, 84 VA. L. REV. 153 (1998) (concluding that the "Supreme Court's analysis, or perhaps lack of analysis, of Section 10(b) . . . makes a compelling case that the United States should abandon its common law approach to trading on material, nonpublic information and follow Europe by incorporating a more specific prohibition into either the Commission's rules or the statute itself").
326. Calls for a definition have tended to be particularly strong in the period of time following a decision by the Supreme Court in the area of insider trading. See, e.g., Homer Kripke, A Note on Insider Trading An Example of How Not to Make Late, 39 ALA. L. REV. 349, 349 (1988) (concluding that "legislation is now needed to straighten out the mess we call insider trading law"); Richard W. Painter et al., Don't Ask, Just Tell: Insider Trading After United States v. O'Hagan, 84 VA. L. REV. 153 (1998) (concluding that the "Supreme Court's analysis, or perhaps lack of analysis, of Section 10(b) . . . makes a compelling case that the United States should abandon its common law approach to trading on material, nonpublic information and follow Europe by incorporating a more specific prohibition into either the Commission's rules or the statute itself").
327. See supra note 28.
328. See supra 270-71, 280 and accompanying text.
329. Upton v. SEC, 75 F.3d 92, 98 (2d Cir. 1996) (quoting Grayned v. City of Rockford, 408 U.S 104, 108 (1972)).
330. For a general discussion of nonacquiescence and the SEC, see Peter J. Rooney, Comment, Nonacquiescence by the Securities and Exchange Commission: Its Relevance to the Nonacquiescence Debate, 140 U. PA. L. REV. 1111 (1992) (reviewing several instances of SEC nonacquiescence); see also Douglas M. Branson, SEC Nonacquiescence in Judicial Decisionmaking: Target Company Disclosure of Acquisition Negotiations, 46 MD. L. REV. 1001 (1987).
331. For a general discussion of nonacquiescence and the SEC, see Peter J. Rooney, Comment, Nonacquiescence by the Securities and Exchange Commission: Its Relevance to the Nonacquiescence Debate, 140 U. PA. L. REV. 1111 (1992) (reviewing several instances of SEC nonacquiescence); see also Douglas M. Branson, SEC Nonacquiescence in Judicial Decisionmaking: Target Company Disclosure of Acquisition Negotiations, 46 MD. L. REV. 1001 (1987).
332. See, e.g., Upton, 75 F.3d at 98 ("Although the [SEC's] construction of its own regulations is entitled to substantial deference . . . we cannot defer to the [SEC's] interpretation of its rules if doing so would penalize an individual who has not received fair notice of a regulatory violation." (internal quote marks and citations omitted)); Checkosky v. SEC, 139 F. 3d 221, 222 (D.C. Cir. 1998) (dismissing an SEC disciplinary proceedings against two accountants, in part because the SEC offered a "multiplicity of inconsistent interpretations" for determining "improper professional conduct" under Rule 102(e)(1)); see also John F.X. Peloso, The SEC's Failure to Provide Adequate Notice, N.Y.L.J., June 18, 1998, at 3 (noting that "several circuits have dismissed proceedings in which the SEC either had not previously promulgated a governing rule or had failed to interpret an existing rule in an intelligible fashion").
333. See, e.g., Upton, 75 F.3d at 98 ("Although the [SEC's] construction of its own regulations is entitled to substantial deference . . . we cannot defer to the [SEC's] interpretation of its rules if doing so would penalize an individual who has not received fair notice of a regulatory violation." (internal quote marks and citations omitted)); Checkosky v. SEC, 139 F. 3d 221, 222 (D.C. Cir. 1998) (dismissing an SEC disciplinary proceedings against two accountants, in part because the SEC offered a "multiplicity of inconsistent interpretations" for determining "improper professional conduct" under Rule 102(e)(1)); see also John F.X. Peloso, The SEC's Failure to Provide Adequate Notice, N.Y.L.J., June 18, 1998, at 3 (noting that "several circuits have dismissed proceedings in which the SEC either had not previously promulgated a governing rule or had failed to interpret an existing rule in an intelligible fashion").
334. As noted earlier, the court in Adler refused to defer to the SEC's knowing possession test in part because of what it characterized as the SEC's inconsistent positions in Sterling Drug and Investors Management. See supra note 101 and accompanying text. Adler also declined to give much deference to the SEC's views because the "SEC has had ample opportunity to adopt a rule or amend Rule 10b-5 so as to provide that a trade with knowing possession of material nonpublic information triggers insider trading liability." SEC v. Adler, 137 F.3d 1325, 1339 (11th Cir. 1998). The court was particularly critical of the SEC's decision to articulate its views "only in the context of a 'report of investigation,' which provided no reasoning and was not even binding on the parties to that matter." Id. For a general criticism of the SEC's tendency to advance regulatory positions in informal formats, see Donna M. Nagy, Judicial Reliance on Regulatory Interpretations in SEC No-Action Letters: Current Problems and a Proposed Framework, 83 CORNELL L. REV. 921, 957-66 (1998). The SEC's preference for developing new regulatory interpretations through litigated proceedings instead of rulemaking has also been subjected to sharp criticism. See ROBERTA S. KARMEL, REGULATION BY PROSECUTION: THE SECURITIES AND EXCHANGE COMNOSSION vs. CORPORATE AMERICA 96 (1982) (strongly disfavoring prosecutorial strategies for developing law, in part because "[o]ther regulated persons who will become subject to that regulatory policy do not have the opportunity to object or to comment upon the new interpretation or rule, as they would have in a rulemaking proceeding").
335. Adler, 137 F.3d at 1337 n.33.
336. See Ernst & Ernst v. Hochfelder, 425 U.S. 185, 212-14 (1976) (holding that the SEC's authority to proscribe certain fraudulent acts in Rule 10b-5 is limited by the scope of the terms of the enabling provision in Section 10(b)); see also Santa Fe Indus., Inc. v. Green, 430 U.S. 462, 476 (1977) (holding that Section 10(b) and Rule 10b-5 are not violated absent a showing that the defendant engaged in deception or manipulation).
337. See Sturc & Cummer, supra note 7, at 6. The court in Adler appeared to be operating under the misimpression that, because the SEC made knowing possession the operative standard in the text of Rule 14e-3(a), it could do so freely in the context of rulemaking under Section 10(b). See 137 F.3d 1337 n.33 (observing that the SEC used knowing possession language "in the context of tender offers"). However, Rule 14e-3(a)'s ban on trading while in possession of material nonpublic information concerning a tender offer is promulgated under Section 14(e) of the Exchange Act, a statutory provision that authorizes the SEC to "define, and prescribe means reasonably designed to prevent, such acts and practices as are fraudulent, deceptive, or manipulative." 15 U.S.C. § 78n(e) (1994) (emphasis added). Accordingly, as the Supreme Court recently held in O'Hagan, Section 14(e)'s language authorizes "prophylactic measure[s]" that could "encompass[] more than the core activity prohibited" under the statute. United States v. O'Hagan, 117 S. Ct. 2199, 2217 (1997). It is this broader rulemaking authority under Section 14(e) that at least arguably allows the SEC to impose a disclose or abstain obligation under Rule 14e-3 without regard to whether the trader owes a pre-existing duty to keep the tender offer information confidential. See supra note 28. Because Section 10(b) does not give the SEC the same authority to make rules "reasonably designed to prevent" any acts and practices that might violate the statute, the SEC's rulemaking authority under Section 10(b) is necessarily limited to proscribing only activity that is deceptive or manipulative.
338. See supra text accompanying notes 195, 224-26.
339. See supra 228-32 and accompanying text.
340. See Rachel Witmer, Insider Trading: Panelists Discuss Suggestion for Rule on More Possession of Inside Information, 30 SEC. REG. & L. REP. (BNA) 625, 625 (Apr. 24, 1998) (quoting SEC Solicitor Paul Gonson's reference to Adler's "important" footnote suggesting an SEC rule); Phyllis Diamond, Insider Trading: Goldschmid Says SEC Considering Rulemaking in Insider Trading Area, 31 SEC. REG. & L. REP. (BNA) 201, 201 (Feb. 12, 1999) (quoting SEC General Counsel Harvey Goldschmid's statement that the SEC was considering rulemaking on the "second [or] third level issue[]" of possession vs. use); see also Harvey Goldschmid, Insider Trading: A New Cycle, Nov. 1998, available in Westlaw, PLI-CORP library (discussing Adler and Smith and stating that "[f]or me, an important questions is: Should the Commission accept the 11th Circuit's rulemaking suggestion?").
341. See Rachel Witmer, Insider Trading: Panelists Discuss Suggestion for Rule on More Possession of Inside Information, 30 SEC. REG. & L. REP. (BNA) 625, 625 (Apr. 24, 1998) (quoting SEC Solicitor Paul Gonson's reference to Adler's "important" footnote suggesting an SEC rule); Phyllis Diamond, Insider Trading: Goldschmid Says SEC Considering Rulemaking in Insider Trading Area, 31 SEC. REG. & L. REP. (BNA) 201, 201 (Feb. 12, 1999) (quoting SEC General Counsel Harvey Goldschmid's statement that the SEC was considering rulemaking on the "second [or] third level issue[]" of possession vs. use); see also Harvey Goldschmid, Insider Trading: A New Cycle, Nov. 1998, available in Westlaw, PLI-CORP library (discussing Adler and Smith and stating that "[f]or me, an important questions is: Should the Commission accept the 11th Circuit's rulemaking suggestion?").
342. See Rachel Witmer, Insider Trading: Panelists Discuss Suggestion for Rule on More Possession of Inside Information, 30 SEC. REG. & L. REP. (BNA) 625, 625 (Apr. 24, 1998) (quoting SEC Solicitor Paul Gonson's reference to Adler's "important" footnote suggesting an SEC rule); Phyllis Diamond, Insider Trading: Goldschmid Says SEC Considering Rulemaking in Insider Trading Area, 31 SEC. REG. & L. REP. (BNA) 201, 201 (Feb. 12, 1999) (quoting SEC General Counsel Harvey Goldschmid's statement that the SEC was considering rulemaking on the "second [or] third level issue[]" of possession vs. use); see also Harvey Goldschmid, Insider Trading: A New Cycle, Nov. 1998, available in Westlaw, PLI-CORP library (discussing Adler and Smith and stating that "[f]or me, an important questions is: Should the Commission accept the 11th Circuit's rulemaking suggestion?").
343. On this point, the court in Adler was in fact correct. See 137 F.3d 1325, 1338 (11th Cir. 1998) (stating that "we do not believe that the SEC's knowing possession test would always and inevitably be limited to situations involving fraud").
344. As a starting place for such a rule, the SEC could look to the insider trading prohibition developed for the All's Federal Securities Code. See supra note 119. Section 1603 of the Code, "Insiders' Duty to Disclose When Trading," provides: Section 1603. (a) GENERAL - It is unlawful for an insider to sell or buy a security of the issuer, if he knows a material fact with respect to the issuer or the security that is not generally available, unless-(1) the insider reasonably believes that the fact is generally available; [or] (2) the identity of the other party to the transaction (or his agent) is known to the insider and (A) the insider reasonably believes that that party (or his agent) knows the fact, or (B) that party (or his agent) knows the fact from the insider or otherwise. FED. SEC. CODE § 1603(a) (Supp. II 1981).
345. The Administrative Procedure Act, 5 U.S.C. §§ 551-559, 701-706 (1994), affords interested parties the right to participate in an agency's rulemaking process. For rulemaking to be valid, the agency must (1) publish general notice of the proposed rule in the Federal Register, 5 U.S.C. § 553(b) (1994), and (2) give interested persons "an opportunity to participate in the rule making through submission of written data, views, or arguments," id. § 553(c). Although rules that merely interpret the terms of a statute are generally exempt from the these "notice and comment" requirements, see id. § 553(d), the SEC's practice is to provide for notice and comment on any substantive rules that are to be codified in the Code of Federal Regulations ("CFR"). The benefits of public participation in SEC rulemaking have been pointed out by a number of commentators. See, e.g., KARMEL, supra note 310, at 96 (advocating rulemaking in place of regulation by prosecution); Nagy, supra note 310, at 958-60 (contending that notice and comment "furthers democratic values by including all SEC constituencies in the policy formation process" and produces qualitatively better rules that reflect the insight and expertise of those most informed on the subject matter).
346. See supra text accompanying notes 239-45 (discussing judicial holdings that issuers purchasing or selling their own shares have a duty under Rule 10b-5 to disclose or abstain when they are in possession of material nonpublic information). The ALTs proposed Federal Securities Code defined the term "insider" to include the securities issuer. See FED. SEC. CODE § 1603(b) (1980).
347. See supra notes 312-13 and accompanying text (emphasizing that, although Congress is free to create new prohibitions for insider trading, the SEC is limited to rulemaking within the scope of Section 10(b)).
348. Securities law scholars disagree as to whether the classical theory of insider trading would extend liability under Section 10(b) and Rule 10b-5 to a traditional insider who purchases publicly traded debt, as opposed to equity, securities in the corporation. The point of contention involves the fact that, traditionally, corporate executives have not owed fiduciary obligations to holders of the company's debt. Compare LANGEVOORT, supra note 46, at 3-21 (stating that "[t]he approach more consistent with Chiarella is that no abstain or disclose obligation arises in connection with trading in debt securities, leaving liability in such a case to rest on the availability of the misappropriation theory") with R. René Pengra, Insider Trading, Debt Securities, and Rale 10b-5: Evaluating the Fiduciary Relationship, 67 N.Y.U. L. REV. 1354, 1401 (1992) (interpreting Chiarella and Dirks to allow federal courts to "consider individually in each case whether the relationship between the issuers and holders of debt instruments possesses the essential characteristics of a fiduciary relationship").
349. See supra note 235 (discussing the view now accepted by virtually all federal circuits that reckless conduct establishes scienter for purposes of Section 10(b)). The SEC used "knows or has reason to know" language in Rule 14e-3(a), see supra note 28, but this, once again, is arguably acceptable because of the SEC's broader rulemaking authorization in Section 14(e). See supra note 313.
350. A person subject to Rule 14e-3(a) is obligated to disclose or abstain "unless within a reasonable time prior to any purchase or sale such information and its source are publicly disclosed by press release or otherwise." See supra note 28.
351. See 15 U.S.C. § 78u-1 (1994).
352. See id. § 78t-1.
353. For a discussion of the SEC's powers to define the scope of Rule 10b-5's prohibitions, see Joseph A. Grundfest, Disimplying Private Rights of Action Under the Federal Securities Laws: The Commission's Authority, 107 HARV. L. REV. 963 (1994); see also 15 U.S.C.A. § 78mm (West 1998 Supp.) (authorizing the SEC to exempt any class of persons from any provision of the Exchange Act or rule thereunder "to the extent that such exemption is necessary or appropriate in the public interest and is consistent with the protection of investors").
354. See supra notes 86-87 and accompanying text.