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THE EVOLVING CONTROVERSY OVER INSIDER TRADING

•JOHN W. BAGBY

The restriction of insider trading is widely accepted as a principal enforcement goal under various provisions of the federal securities laws. These provisions deny certain trading opportunities to persons with knowledge of material, nonpublic, confidential information about an issuer, its business prospects, or external events that may affect the market for the issuer's securities. This trading restriction is often termed the "disclose or abstain" rule, since the "insider" usually has a choice either to trade after disclosing the confidential information or to refrain from trading altogether until the information becomes public.

The insider trading restriction originated in state common law.' The first congressional restriction of insider trading was imposed by section 16(b) of the Securities Exchange Act of 1934 (1934 Act).' This provision gives the issuer a right of action for all profits made by officers, direc·

• Assistant Professor of Business Law. The Pennsylvania State University. ' See, e.g., Strong v. Repide, 213 U.S. 419 (1909); Diamond v. Oreamuno, 24 N.Y.2d 498,

248 N.E.2d 910 (Ct. App. 19691. ' 15 U.S.C. S 78p (1982). Section 16 has two major provisions. First, S 16 (a) requires

all officers, directors or persons who beneficially hold more than 10% of any class of equity securities in an issuer registered under S 12 of the 1934 Act to file Form 3 with the Securities and Exchange Commission (SEC) disclosing the ownership within 10 days after attaining that status. Another statement of ownership of equity seeurities must also be filed within 10 days after any month in which changes in ownership occur. Seoond, S 16 (b) prohibits these "statutory insiders" from making short-swing profits in the issuer's equity securities. Any purchase and sale occurring within any six -month period triggers a right of action in the issuer fer disgorgement of the trading profit. Although S 16(b) does not prohibit all insider trading, it restricts short-swing profits by officers, directors and 10% shareholders apart from the trading restrictions impnsed under SEC regulations implementing other provisions ofthe 1934 Act.Seeal$o17 C.F.R. SS 240.16a-1 - 240.1&·10 (1985Hstock owner· ship reporting requirements for directors, officers, and principal shareholders).

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tors, and ten percent shareholders of the issuer in a purchase and sale of the issuer's equity securities within any six-month period. However, a considerable insider trading jurisprudence has also developed around the separate anti-fraud provisions in section lO(b) of the 1934 Act' and Rule lOb-5 of the Securities and Exchange Commission (SEC).' These anti-fraud provisions have precipitated more litigation and uncertainty than any other part of the securities laws. The SEC has reinforced the insider trading restrictions with promulgation of Rule 14e-3 of the SEC,' an independent provision prohibiting insider trading in connection with tender offers.' Congress has further reinforced these trading restrictions by providing the SEC with the power to seek a treble penalty under the Insider Trading Sanctions Act of 1984 (ITSA).' This legislation empowers the SEC to base enforcement actions on any recognized theory of insider trading restriction.' In addition, tbe courts are aggressively applying the civil treble damage remedy found in the Racketeer Influenced and Cor· rupt Organizations (RICO) provisions of the 1970 Organized Crime Control Act' to cases of securities fraud, including insider trading.

This article traces the development of the public policy debate surrounding these insider trading provisions.10 To facilitate an evaluation

' 15 u.s.c. § 78j (1982). ' 17 C.F.R. § 240.10b-5 (1985). ' 17 C.F.R. § 240.14e-3 (1985). ' See infra notes 110 and 135 and accompanying text. ' Pub. L. No. 98-376,98 Stat. 1264 (1964), 15 U.S.C. §§ 78a note, 78c, 78c note, 78o, 78t,

78u(d)(2), 78ff, (Supp. 1984). ' See irifra notes 73-146 and accompanying text . • 18 u.s.c. §§ 1961-68 (1982). " No scarcity of printer's Ink has been spilled on the topic. H. MANNE. INSIDER TRADING

AND THE STOCK MARKET (1966); Brudney, Insiders, Outsiders and Iriformational Advantages under the Federal Se~mrities Laws, 93 HARV. L. REv. 322 (1979); Easterbrook, Insider Trading, Se<Jret Agents, Evidentiary Priviwges, and the ProdtWtian of Information. 1981 SuP. CT. REV. 809; Carlton & Fischel, The Regulation of Insider Trading, 35 STAN. L. REV. 857 (1983); Farley, A Cum:mt Look at the Law of /nsilkr Trading, 39 Bus. LAw. 1771 (19841; Haft, The Effect of Insilkr Trading Ruks on the Internal Efficiency of the Large Corp<rration, 80 MICH. L. REv.1051 (1982); Langevoort, The lmi<Wr TradingActof1984 and itsEf feet on Existing Law, 37 VAND. L. REv. 1273 (1984); Langevoort, Insider Trading and the Fiduciary Principw: A Post-Chiarella Restatement, 70 CALIF. L. REV. 1 (1982); Lorie & Niederhoffer, Predictive and Statistical Properties of Insider Trading, J. L. & EcoN. 35 (1968); Scott, Insider Trading: Ruw JOb-5, Disclosure and Corporate Privacy, 9 J. LEGAL STUD. 801 (1980); Wu, An Economist Looks at Sectim 16 of the Se~mrities Exchange Act of 1994;68 CoLUM. L. REV. 260 (1968); and Note, Insider Trading at Common Law, 51 U. CHI. L. REv. 838 (1984). Commentators in the economics and financial economics literature have sought to reconcile the efficient market theory with insider trading restrictions, given the goal of efficient capital raising, by adopting certain empirical measures (e.g., cumulative average residuals). See Baesel & Stein, The Value ofiriformation: Infertmcesfrom the Profitability of Insilkr Trading, 14 J. FIN. & QUANT. ANAL. 553 (1979); Finnerty ,Insiders and Market Ejjicieney, J. FIN. 1141 (1976); Givoly & Palmon, Insider Trading and the Exploita-

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of the restrictions, it relates this philosophical evolution to prevailing economic theory. After a brief introduction summarizing the case law history of Rule lOb-5 and insider trading, the theoretical and economic arguments are explored. Next the article analyzes recent legislation and the emergence of the expansive misappropriation theory, and makes some observations about the ironies created by the disjunction between the theory and the practice of the trading provisions. Finally, the article offers some new perspectives on insider trading analysis that a void the pitfalls of past analysis and of the contemporary approach, and provides insight into the costs and benefits of the trading restrictions.

RULE lOb-5 AND COMMON LAW FRAUD

A fundamental problem for the courts confronting insider trading cases has been the relationship between Rule lOb-5 and the common law of fraud. Proof of the elements of securities fraud is somewhat less stringent than proof of common law fraud. This is consistent with the view that the federal regulatory scheme supplements the state cause of action to better protect the securities market's integrity. Most of the 10b-51itigation has refined the elements of duty, scienter, reliance, and remedies. The courts' treatment of the scienter question displays the greatest consistency between lOb-5 and the common law. In private rights of action, scienter was required in Ernst & Ernst v. Hochfelder," and in SEC administrative prosecutions the scienter element was adopted in Aaron v. SEC." This reaffirmation of the strict common Ia w exclusion of ordinary negligence suits is the most fundamental similarity between the two actions. However, liberalization of the other elements makes the federal cause of action more preventive than remedial, as under the common law.13

At common law, a defrauded plaintiff is required to prove a form of causation by showing that the defrauder's misstatement or omission led to justifiable reliance that induced the plaintiffs action or inaction."

tion of Insid.e Inf01'1nation: Some Empirical E'V'i.deme. 58 J. Bus. 69 (1985); Keown & Pinker· ton, Merger Announcements and Insider Trading Activity: An Empirical Investigation, 36 J. FIN. 855 (1981); Jaffe, The Effect of Re!lUlation Clutnges em Insider Trading, 5 BELL J. ECON, & MGMT. Set 93 (1974); Jaffe, Special biformaticm and Insider Trading, 47 J. Bus. 410 (1974); Penflll!n, Insider Trading and the Dissemination of Firm's Forecast Informa· tion, 55 J. Bus. 479 (1982).

" 425 u.s. 185 (1976) . .. 446 u.s. 680 (1980). " See H.R. REP. No, 83, 73d Cong .. 2d Sess. 1934); S. REP, No, 792, 73d Cong., 2d Sess.

(1934). By reducing the plaintiffs burden of proof under Rule § 10b-5, the courts have furthered the congressional intent that the securities laws should prevent fraud and the attendant loss of confidence in the capital markets (securities market's integrity). This provides incentive to abstain from fraudulent activity and avert liability.

" RESTATEMENT (SECOND) OF TORTS § 537, § 546 (1977).

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However, since the impersonal nature of the public securities markets effectively precludes such proof in securities litigation, an alternate form of proof of causation has become acceptable. The securities fraud victim must demonstrate that misstatements or omissions were made "in connection with"" a "purchase or sale" of securities." The victim's reliance is inferred if transactions are executed at prevailing market prices, since prices set by the efficient market incorporate misinformation, resulting in deception and a general "fraud on the market."" In enforcement actions brought by the SEC or the Department of Justice, the burden of proving causation is even lighter.1

' Questions of the proof of injury and the availability of remedies are often mixed with the issue of standing." Some of these concerns have been modified in SEC enforcement actions under the ITSA.20 However, the predominant focus in recent years has been on the scope of responsibility for the trading restriction.

EVOLUTION OF THE INSIDER TRADING RESTRICTION

The central inquiries in an analysis of the duty discussed here are the identification of the "insiders" constrained by the trading restriction and the type of information whose use is restricted. The Supreme Court has reaffirmed'1 the SEC's original formulation of the "disclose or abstain" duty" by predicating it on a fiduciary or confidential relationship. However, a review of early interpretations of the trading restriction reveals that the requisite fiduciary relationship and its connection to the plaintiffs injury were not always rigorously analyzed.

In the early cases, the courts were most concerned with nondisclosures. The seminal case of Kardon v. Nati(YYI,(J,l Gypsum Co. 23 implied a private right of action for insider trading. In Kardon, the directors of

" 5 U.S.C. § 78j(b) (1982) and 17 C.F.R. § 240.10b-5 (1985); Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).

" 5 U.S.C. § 78j(b) (1982) and 17 C.F.R. § 240.10b-5 (1985). " See, e.g., Blackie v. Barrack, 524 F.2d 891 (9th Cir. 1975), cert. denied, 429 U.S. 816

(1976); In re LTV Sec. Litig., 88 F.R.D. 134. 144 (N.D. Tex. 1980). But see Shores v. Sklar, 647 F.2d 462 (5th Cir. 1981) (en bane). Fridrich v. Bradford, 542 F.2d 307 (6th Cir.), cert. denied, 429 U .S.1053 (1977). See gcncraUy Fischel, Use ofMode:m Finance TheiR'!! inSeeurities 1-'raud Ca.seslnvolving Actively Tralkd Securities, 38 Bus. LAw. 1 (1982~ Comment, Fraud on the Market Thoory, 95 HARV. L. REv. 1143 (1982).

" The question of standing is mixed with causation. See infra notes 183-216 and accom· panying text.

" Id. " Pub. L. No. 98-376,98 Stat. 1264 (1984), 15 U.S.C. §§ 78a note. 78c, 78c note, 78o, 78t.

78u(dK21 78ff (Supp. 1984). See infra notes 73-146 and accompanying text. " Chiarella v. United States, 445 U.S. 222 (1980). " ln re Cady Roberts & Co .. 40 S.E.C. 907 (1961). " 73 F. Supp. 798 (E.D. Pa. 1947).

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an issuer who planned to sell most of the corporate assets purchased minority shares at prices well below the proportionate value to be realized from the asset sale. In another case with similar facts, a majority shareholder was held liable for nondisclosure of the undervaluation of inventory after purchasing minority shareholdings." After consumma· tion of an undisclosed merger, the majority shareholder would have realized the gains.

The concept of tippee liability and the fiduciary requirement finally arose in the SEC administrative action of In re Cady, Roberts & Co. 25 There, a director of the Curtiss-Wright Corporation learned of an impending dividend reduction and disclosed this fact to a colleague at the brokerage house where they were both employed. The tippee liquidated the CurtissWright shareholdings of several clients before the public announcement precipitated a market price decline. SEC Chairman Cary outlined the nature of the insider trading restriction:

Analytically, the obligation rests on two principal elements; first, the existence of a relationship giving access, directly or indirectly, to information intended to be available only for a corporate purpose and not for the personal benefit of anyone, and second, the inherent unfairness involved where a party takes advantage ol such information knowing it is unavailable to those with whom he is dealing."

Despite the insider/director's abstention from trading, his access to confidential information "tainted" the subsequent use of it, creating the concept of tippee liability.

The apparent precision and careful construction of the trading restriction were abandoned in later decisions. An era of expansive interpretation of Rule lOb-5 followed, creating liability for perceived abuses without careful analysis of the consequences on the efficient functioning of the securities markets. This led to a period of uncertainty during which securities regulations intruded more directly into matters of corporate governance traditionally left to state Jaw. The period began with the Second Circuit's extension of the Cady Roberts unfairness concept in the often-quoted case of SEC v. Texas Gulf Sulphur Co. 21 In that case, information concerning a highly favorable mineral discovery was withheld from the public. Several insiders purchased stoek and options during the period preceding public disclosure of the discovery. In addition, the corporation issued a press release denying the discovery. In the Second Circuit's wellknown opinion, unfairness became the primary focus of analysis, and the

" Speed v. Transamerica Corp .. 99 F. Supp. 808 (D. Del. 1951). " 40 S.E.C. 907 (1961). " I d. at 911. " 401 F.2d 833 (2d Cir. 1968), cert. denied, 404 U.S. 1005 (1969).


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fiduciary roots of the insider trading restriction apparently were ignored. Indeed, an egalitarian notion that "all investors trading on impersonal exchanges [should] have relatively equal access to material information" emerged." This was interpreted to mean that no trader should possess any informational advantage over any other; moreover, if any person had reason to know that information was nonpublic, the trading restriction automatically attached. This interpretation gave rise to the "parity of information" rule or "possession" theory. It was expanded to include a broker and several of its customers in In re Investors Management Co., 29

where the broker learned of a client's reduced earnings in negotiations as a potential underwriter."' In a companion case arising from the same facts, Shapiro v. Merrill Lynch, Pierce, Fenner & Smith Inc.,31 the Second Circuit broadened its interpretation to include a "duty to the entire marketplace."

Contemporaneously, another line of cases whittled away at the traditional concept of fraud. Instances of corporate mismanagement were found to violate lOb-5 under a "new fraud" theory. For example, the Second Circuit granted standing to a corporation to prevent its board of directors from perpetuating its control by defrauding the corporation." The elements of this "new fraud" later emerged in a shareholder's derivative action, Schoenhaum v. Firstbrook,33 where a grossly inadequate consideration allegedly was paid for shares in a merger. An inadequate price, when coupled with a controlling influence over the issuer, appeared to signal a new form of fraud despite the absence of allegations of any failure to disclose."

The demise ofthese expansions of the anti-fraud rules was inevitable, given the potential for extraordinary and unpredictable liability. Such interpretations provided damaging disincentives to the conduct of financial analysis and clearly interfered with the development of state corporate law." By the late 1970's, the pendulum began to swing back to

" !d. at 848. " 44 S.E.C. 633 (1971). " See infra notes 176-80 and accompanying text. " 495 F.2d 228 (2d Cir. 1974). " Ruckle v. Roto Am. Corp., 339 F.2d 24 (2d Cir. 1964). One director alleged that the

other directors withheld financial statements, approved a large stock issuance to perpetuate their control. and approved transactions without disclosing material facts to the entire board.

"' 405 F.2d 215 (2d CirJ, cert. denied sub nom. Manley v. Schoenbaum, 395 U.S. 906 (1968). " See, e.g., Note, The Controlling Influence Standard in Rule IOb-5 CM'fJO'YYlte Mism.arw.ge

ment Cases, 86 HARV. L. REV. 1007 (1973). " Superintendent of Ins. of the State of New York v. Bankers Life & Casualty Co .. 404

U.S. 6, 12 (1971). Federalism considerations dictate that Congress did not intend to create a federal cause of action if the matter is "one traditionally relegated to state law." Cort v. Ash, 422 U.S. 66, 78 (1975).



the traditional anti-fraud roots of Rule lOb-5." For example, the "new fraud" concept came to apply only to situations involving misrepresentations or omissions connected to a purchase or sale of securities. Thus, a breach of fiduciary duty alone is insufficient to trigger 10b-51iability." Similarly, the more traditional formulation of the fiduciary concept came to underlie any inquiry into the insider trading restriction.

Two recent Supreme Court decisions firmly reject the egalitarian parity-of-information rule in favor of the more traditional analysis. Alth9ugh it w!>uld appear that any material misstatement overtly committed by anyone could form the basis of an anti-fraud action, the trading restriction stands on a different footing. The Supreme Court rejected the "duty to the whole marketplace" formulation in Chiarella v. United States.38 There, Chiarella, a financial printing firm employee, deduced the identity of tender offer targets from documents submitted to his employer, Pandick Press. But Chiarella's insider trading conviction was reversed because he was held to !>We no fiduciary duty to the shareholders of the takeover target. Indeed, Chiarella was "a complete stranger who dealt with sellers only through the impersonal markets.""

Additional focus on the fiduciary roots of the duty concept is necessary for an analysis of tippee liability. In Dirks v. SEC," a securities analyst named Dirks made significant contributions to the discovery of the Equity Funding scandal. Before publicizing his discovery, however, Dirks discussed his findings with colleagues and clients, many of whom liquidated large blocks of Equity Funding stock prior to the public announcement. The Supreme Court reversed the SEC's censure of Dirks on the ground that tippee liability arises only when a tippee has reason to know

" See Transamerica Mortgage Advisors Inc. v. Lewis, 444 U.S. 11 (19791; Touche Ross & Co. v. Redington, 442 U.S. 560 (19791; Piper v. Chris-Craft Indus .. 430 U.S. I (19771.

" Sante Fe Indus. v. Green, 430 U.S. 462, 470 (19771 . .. 445 u.s. 222 (19801. " /d. at 232. However, the SEC views the practice of trading in target securities on

the basis of any non public information as harmful. As a result of Chiarella the new Rule 14e-3 was promulgal<ld, 17 C.F.R. S 240.14e-3 (19841. Under it, the disclose or abstain obligation attaches if the trader, insider or not, has reason to know that the tender offer information is nonpublic and originated from an inside source. It need not be proved that the tippee knew the insider breached a fiduciary duty or that the tip was made for an improper purpose (e.g .. personal benefit to tipper). See infra Dirks v. S.E.C., 463 U.S. 646 (1983). See also S.E.C. Securities Act Release No. 6,239 (Sept. 4, 1980) and In re Curtiss Noll Corp .. FED. SEC. L. REP. (CCHI 1 82,657 (SEC 19801 (Rule 14e-3 prosecution). Knowledge of merger negotiations is material and Rule 1-le-3 applies even if merger negotiations are terminated because unusual trading activity can be reasonably connected to such inside information. S.E.C. v. Gaspar, (1984-1985 Transfer Binder] FED. SEC. L. REP. (CCHI , 92,004 at 90,977, 90,979, 90,980 (S.D.N.Y. 1985) .

.. 463 u.s. 646 11983).

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the the tipper is breaching a fiduciary duty in transferring the confidential information. Secrist, the insider, was a former Equity Funding officer who sought Dirk's assistance in verifying a massive asset overstatement. Secrist's communication with Dirks was not a fiduciary breach since the cover- up of a fraud is not part of an officer's fiduciary duties." As a result of the Dirks analysis, tippee liability must be based on the following criteria: (1) the tip is made improperly (that is, the tipper will personally benefit directly or indirectly from the disclosure)," (2) the tipper breaches ajidmiary relationship in transmitting the information, and (3) the tippee kncrws or should kncrw of the fiduciary breach."

The Dirks case states that another category of insider should be con- • strained by the "disclose or abstain" duty. The trading restriction also attaches to "temporary insiders" who have a special relationship of trust and confidence with the corporation "in the conduct of the business of the enterprise" and who "are given access to information solely for cor-porate purposes."" These individuals are more properly classified as tip-pers rather than tippees. They would include, among others, lawyers, accountants, underwriters, and other consultants of the issuer." At least two district courts have had the opportunity to apply the temporary in· sider rule." In one of them, information concerning a potential joint ven-ture received from the president of a corporation by the purchaser of stock resulted in temporary insider status for one purchaser."

It seems clear that Dirks and Chiarella stand for the rejection of the information-parity theory. However, when taken in connection with the emerging misappropriation theory" there is no reason to assume that

" "The need for a ban on some tippee trading is clear .... Thus. some tippees must assume an insider's duty to the shareholders not because they receive inside information, but rather because it has been made available to them improperly." ld. In re Investors Mgmt .. 44 S.E.C. 633, 641 (1971). Therefore. Secrist's disclosure to Dirks to unearth a fraud did not trigger Dirk's liability.

" In S.E.C. v. Switzer, the University of Oklahoma football coach Barry Switzer traded on information overheard at a track meet. No improper purpose was found in the insider communicating it to his wife. even though it might appear unreasonable if overheard at a public place. 590 F. Supp. 756 (W.D. Okla. 1984). See also State Teachers Retirement Bd. v. Fluor Corp. 654 F.2d 843 (2d Cir. 1984): In re Wentz, (1984 Transft!r Binder] FED. SEC. L. REr. (CCH) 83,629 (SEC 1984): and S.E.C. v. Gasper, [1984·1985 Transfer Binder) FED. SEc. L. REP. (CCH) 192,004 at 90,979 (S.D.N.Y. 1985) (improper purpose found in the personal benefit derived from enhaneement of reputation).

" Dirks, 463 U.S. at 659-61. " Dirks. 463 U.S. at 655 nl4. 45 /d. " S.E.C. v. Gaspar, [1984-1985 Transfer Binder] FED. SEC. L. REP. (CCH), 92,004 at

90,978 (S.D.N.Y. 1985) and S.E.C. v. Lund, 570 F. Supp. 1397 IC.D. Cal. 1983). " S.E.C. v. Lund. 570 F. Supp. 1397. " See infra notes 147-320 and accompanying text.

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the "disclose or abstain" rule has been gutted. The evolution of these legal theories will become more widely accepted as general public policy if they are integrated into the prevailing wisdom. Therefore, a review of economic theory and public policy seems appropriate to clarify the insider trading restriction.

The Insider Trading Theoretical Controversy

There is considerable debate among economists, lawyers, and securities professionals over the efficacy of restricting insider trading. Those opposing the restriction argue that the incentives and results from certain insider trading are beneficial. .. The theorists who support the restriction allege that the practice is unfair, contravenes basic fiduciary standards, and undermines investor confidence in the capital markets."' The recent trading restriction legislation and early court opinions argue principally that insider trading is unfair."' Indeed, Congress's original trading restriction in section 16(b)62 was designed to prevent "the most vicious practices ... [in] the flagrant betrayal of their fiduciary duties by officers and directors."" Although investors expect fairness in the markets, proponents of this view contend, insiders' informational advantages cannot be overcome through competition." As the public perceives unfairness in the capital markets, investors will retreat and invest in alternatives to securities, thereby impeding the formation of capital. 55 Confidence in the capital markets is fragile, so the trading restriction is necessary to maintain investors' confidence and ultimately, the integrity of the securities markets.'"'

" See infra notes 57-61 and 63-66. " Haft, The Effect of 11UI'ider Trading Rules on the Imernal Ef.fi,cierwy of the Large Cor

poration. 80 MICH. L. REV. 1051 (1982), Sthotland, Unsafe at Any Price: A Reply to Manne, "Insider Trading and the Stock Market." 53 VA. L. REV. 1425 (1967).

" See, e.g., RR. REP. No. 355, 98th Cong., 1st Sess. (1983), reprinted in 1984 U.S. CODE CoNG. & Ao. NEWS 2274; Dirks v .. S.E.C .• 463 U.S. 646,653 (1983); In re Cady Roberts & Co., 40 S.E.C. 907 (1961) .

.. 15 u.s.c. § 78p(b) (1982). " STOCK EXCHANGE PRACTICES, REPOIIT OF THE COMM. ON BANKING & CURRENCY. 8. REP.

No. 1455, 73d Cong., 2d Sess. 55 (1934). See infra notes 169-83 and atcompanying text. M Brudney,/nsiders, Ou.tsidursandlnfarm.a.tioo.alAdva~undertheFedera.lSoouritU!s

Laws, 93 HARV. L. REV. 322 (1979). " See generally Scott, Insider Trading: Rule tOb-5, Disclosure and Corporate Privacy,

9 J. LEGAL STUD. 801 (1980); comments of Arthur Levitt, Jr., Chairman of the American Stock Exchange, quoted in Business Week, Apr. 29, 1985, at 79 ("If the investor thinks he's not getting a £air share, he's not going to invest and that is going to hurt capital formation in the long run"),

~ Evidence 1>f the link between confidence and market integrity include the market crash of 1929 and runs on banks or aavings institutions.

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Opponents of trading restrictions view insider trading as a victimless crime and relltricting it as a waste of enforcement resources." It has been argued that investors trade on "fundamental" considerations or for personal financial needs independent of short-term inside information. The opponents' argument notwithstanding, however, disclosure of the inside information would probably induce the transaction at some other price reflecting inside information. Rational traders would not simply "take" the market price if the inside information reflected a better assessment of intrinsic value. Disclosure of adverse information would result in lower prices and disclosure of favorable information would result in higher prices. Losses attending nondisclosure is one type of injury the trading restriction is intended to prevent ...

Opponents of the trading restriction also argue that any loss in confidence affects only the issuer whose shares are traded, not the markets generally." As a result, insider trading has no negative affect on the securities markets."' Therefore, insider trading restriction should be left to private contracting by shareholders who can respond by simply prohibiting Insider trading, perhaps through corporate charter amendments or by passage of a shareholder resolution." However, this argument fails to recognize that a general disenchantment with the securities markets could arise if insider trading is perceived as widespread. Firms in volatile industries are more susceptible to insider trading than are firms with stable markets. Moreover; it is unlikely that shareholders could detect, monitor, or effectively remedy insider trading. Indeed, prior to therecent wave of prosecutions, the SEC had great difficulty discovering insider trades."

In addition, a few commentators have argued that insider trading is beneficial to the issuer. First, since the issuer's management produces the confidential information, management has a greater claim to it than do outside traders." However, this argument ignores the claim that cor-

" H. MANNE. SltJYI'a note 10; see also Hetherington, Insider Trading and the Logic of the Law, 1967 WIS. L. REV. 720; and Note, The Effieient Capital Market Hypothesis, Economic Theory and the FlegulatUm. of the Securities Industry, 29 STAN. L. REv. 1031 (1977).

" See 15 U.S.C. § 78(uMdlC (Supp. 1984). ~ Carlton & Fischel, supra note 10, at 880; Scott, supra note 10, at 809. " Note, supra note 10, at 849. " It is argued that the absence of shareholder imposed trading restrictions reinforces

the argument that the market perceives no harm in insider trading. Carlton & Fischel. supra note 10, at 859.

" SeeThe Epidemic ofln.siderTrading, Business Week, Apr. 29,1985, at 78-92: See also Carlton & Fischel, supra note 10, at 859 & n.12; Keown, Pinkerton, Young & Hansen, Rece-nt SEC Prosecution and Jn.sider Trading on Forthcoming Merger Ann.Ouncements,13 J. Bus. REs. 329, 336 (Aug. 1985).

" Note, supra note 10, at 848; Easterbrook, supra note 10.



porate confidences belong only to the corporation and its shareholders. Management has no secondary right in the information it produces; there is no authority for the suggestion that a hierarchy of claims over inside information exists after the corporation's rights, unless a contract creates one.'' Second, the emolument theory suggests that "profits from 'sure thing' speculation in the stocks of their corporations were more or less generally accepted by the financial community as part of the emolument for serving as a corporate officer or director •... "" One version of this theory actually encourages the use of inside information by those "entrepreneurs" who fail to receive compensation for their talents in direct relation to the successes they produce.'" If entrepreneurs who are the insiders responsible for new developments fail to perceive a connection between their creativity and the sufficiency of their rewards, the incentive to produce creative developments ill diminished. Therefore, insider trading should be permitted to link the entrepreneur's creativity to his rewards when the market produces price fluctuations commensurate with the issuer's gains from the creative projects. Trading thus allegedly benefits the issuer as well, since the insider's official compensation may be reduced, providing corresponding benefit to shareholders.

The emolument theory fails to recognize several difficulties." First, there are incentive reward systems that can approximate the positive motivation·qf entrepreneurial insider trading." Second, insiders will have an incentive to manipulate the timing and accuracy of the information disseminated. Third, unproductive insiders will have many of the same opportunities to trade as do creative insiders. Fourth, insider trading opportunities also exist in adverse situations and would reward poor performance, an outcome at odds with the entrepreneurial theory. Fifth, the emolument theory allows for trading by insiders unassociated with the creative ventures. Sixth, there will be incentives to select higher-risk investments producing wider stock price fluctuations that provide more opportunities for trading profits. These shortcomings illustrate that emolument theory insider trading has significant flaws.

" See infra note 160 and accompanying text. " 10 S.E.C. Ann. Rep. 50 (19441. " Manne. In Defense of Insider Trading, 44 HARV. Bus. REV. 113 (1006). See alBo Wu,

supra note 10. " See generally Schotland, Unsafe at Any Price: A Reply to Manne, "'lnBider Trading

and the Stock Market," 53 VA. L. REv. 1425, 1438-9 (19671 ahd Longstreth, Halting Insider Tmding, N.Y. Times. Apr.12, 1984. at A27, col. 3: "The arguments in favor of insider trading are. in short, rubbish."

" For example, stock options. bonuses, promotions, fringe benefits and special project evaluations can provide a more direct reward link than insider trading without the associated loss of market confidence or the damaging trading by "non-entrepreneurial" insiders and tippees.

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Finally, opponents of the trading restriction argue that efficiency is enhanced with unrestricted trading." When insiders trade, the amount of available information increases, enabling the market to infer fundamental information about the firm's prospects. Consequently, insider trading "signals" the market to move in the correct direction more quickly.'" Several studies of insider trading based on SEC filings by statutory insiders under section 16(a) tend to support the "signalling" theory. The evidence indicates that insiders consistently outperform the market by correctly predicting the direction of their issuer's future stock price movements." In contrast, proponents of restrictions on insider trading claim that the market will become more efficient if trading is restricted. Information will flow to the market as it is produced rather than as it is manipulated by inside traders. Indeed, internal corporate efficiency is enhanced because decision-making is more accurate and timely if insiders do not manipulate the flow of information within the firm to enhance their personal trading opportunities. 72 This theoretical controversy has been important for courts and the SEC because the unfairness and market integrity arguments underlie the misappropriation theory. Additionally, congressional intent supporting the Insider Trading Sanctions Act illustrates the predominance of the unfairness and market integrity arguments in the continuing development of insider trading jurisprudence.

INSIDER TRADING SANCTIONS ACT

The passage of the Insider Trading Sanctions Act of 1984 (ITSA) is a significant event in the development of the trading restriction and in

" See Carlton & Fischel, supra note 10, at 838; Note, The Efficient Capital Market Hypothelris, Economic Theory and the Regulati<m of the Securities Industry, 29 STAN. L. REv. 1031, 1073 (1977).

" Givoly & Palmon, supra note 10 (price movements due more to signaling than to the ultimate public release of the information). However, insiders who trade for personal reasons, such as sales due to personal financial needs, may send inaccurate signals.

11 Givoly & Palmon, supra note lOi Penman. supra note 10; Keown & Pinkerton, supra note 10; Baesel & Stein, supra note 10; Finnerty, supra note 10; Jaffe, The Effect of Regulation Changes on/wider Trading, 5 BELL J. ECON. & MGMT. SCI. 93 (1974); Jaffe, supra note 10; and Lorie & Niederhoffer, supra note 10. However, statutory insiders required to file Form 3 under S 16(a) are limited to officers, directors and 10% shareholders. Most insider trading litigation involves Rule 10b-5 and has been brought against lower-level employees, outsiders, tippees, and other insiders who do not file Form 3. The results of broader research might be similar, however, there is reason to question generalizing from this small sample because it is biased toward upper-level executives. Statutory insiders arc aware of the public visibility of tbeir trading reports. Inside information from lower levels or outsiders might be more unreliable or lead to inaccurate trading signals.

" Haft, supra note 10.

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the expansion of securities regulation remedies generally." Congress's only prior definitive articulation of a trading restriction was section 16(b) of the 1934 Act." The SEC and the courts have developed Rule lOb-575

into the predominant and more general trading restriction. Therefore, congressional recognition of the developing case law in the ITSA legitimates some forty years of administrative and judicial expansion of the trading restrictions originating in the 1934 Act."' The following section examines the remedial, procedural, and public policy ramifications of the ITSA on the insider trading restriction derived from section lO(b) and Rule lOb-5.

The ITSA provides for a triple penalty-not found in prior law-in civil enforcement actions brought by the SEC. This harsher penalty arose from a general disenchantment caused by the public perception that there was little deterrent effect from existing law." For example, few criminal prosecutions had been brough~ by the Justice Department. Additionally, any deterrent threat from multiple recoveries in class actions negated, both in compromises over the remedial provisions of the Federal Securities Code" and by the Second Circuit's decision in Elkind v. Liggett & Myers, Inc." As a result, the SEC prepared a draft treble penalty proposal in 1982,80 resulting ini H.R. 559, which passed the House easily." The Senate version, S. 910,82 added several provisions which were later accepted by the House without a joint conference committee. On August 10, 1984, the ITSA was signed into law by President Reagan.83

The remedies used under prior law survive the addition of the treble penalty provision." For example, the SEC has developed its injunctive

" Pub. L. No. 98-376,98 Stat.1264 (1984),15 U.S.C. §§ 78a note, 78c, 78c note, 78o, 78t, 78u(dK2), 78ff, (Supp. 1984).

" 15 u.s.c. § 78p(b) (1982). " 17 C.F.R. § 240.10b-5 (1985). " Congressional endorsement of developing judicial interpretations is usually infer

red to the extent that Congress is aware of the developments and omits to modify them. See generally Agusti, The Effect of Prior Judicial and Administrative Constructions on Codijication of Pre-Existing Federal Statutes: The Case of the Federal Securities Code, 15 HARV. J. ON LEGIS. 367 (1978).

" H.R. REP. No. 355. 98th Cong., 1st Sess. (1983) reprinted in 1984 U.S. CODE CoNG. & Ao. NEWS 227 4, 2279 [hereinafter cited as House Report).

" Compare A.L.I. FED. SEc. CODE §§ 1603, 1708(bK2KB) (1980) with A.L.I. FED. SEc. CoDE § 1708(bK4) (Supp. 1981).

" 635 F.2d 156, 168 (2d Cir. 1980). ~ House Report, supra note 77, at 2292-2306 Oetter from John Shad to Congressman

Tip O'Neil with an accompanying memorandum). " 15 SEC. REG. & L. REP. (BNA) 1773 (Sept. 23, 1983). "' 16 SEC. REG. & L. REP. (BNA) 1135 (July 6, 1984). M 16 SEC. REG. & L. Rll>P. (BNA) 1383 (Aug. 17, 1984). M House Report, I!Upra note 77, at 2281.

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power under section 21(d) of the 1934 Act" into its primary enforcement device. To enforce their decisions, federal judges have access to a variety of equitable remedies ineluding disgorgment, curative disclosures, and changes in corporate governance and organization." Administrative proceedings may be instituted against broker-dealers under section 15(b)(4)." The SEC may direct future disclosure or order the correction of past nondisclosures under section 15(c)(4)." Moral suasion may be exercised via section 21(a), under which the SEC publicly reports on its investigations but declines to bring administrative or court action." Finally, the Justice Department has authority to seek criminal penalties under section 32," including imprisonment and fines previously limited to $10,000. However, as Congress found little deterrent effect in these remedies, it enacted the treble penalty provision and increases in criminal fines up to $100,000."

The Treble Penalty Provision

The ITSA amends section 21 of the 1934 Act"' to provide the SEC with discretion to bring enforcement actions against violators of any provision of the securities laws (e.g., Rules lOb-5 and 14e-3) who purchase or sell any security "while in possession of'" material nonpublic information. The court may, within its discretion, assess up to three times the trading profit as a penalty payable to the federal treasury. The only guideline for assessment of the penalty is that the court should consider the defendant's conduct "in light of the facts and circumstances." .. However, the defendant may be required to pay as much as four times the "profit gained or loss avoided," since the disgorgement remedy under Rule lOb-5 inures to the benefit of affected traders" and is separate and apart from the treble damage penalty ...

" 15 U.S.C. § 78u(d) (1982). '"' See infra notes 188-203 and accompanying text. " 15 U.S.C. § 78o(b)(4) (1982). " 15 U.S.C. § 7&J(cX4) (1982). However, this remedy was not available previously in proxy

contests. " 15 U.S.C. § 78u(a) (1982). " 15 u.s.c. § 78ff (1982). " ITSA § 2; House Report, supra note 77, at 2281. " 15 U.S.C. § 78u(dK2l (1981). " This creates a type of strict liability whether or not the insider is motivated by posses·

sion of the inside information. However, this strict liability is triggered by possession of confidential information and not by mere insider status, as under § 16(b).

" ITSA § 2. The factors which could be considered might include the defendant's intent, investment sophistication, and financial condition.

" S.E.C. v. Certain Unknown Purchasers, [1983 Transfer Binder] FED. SEc. L. REP. (CCH) 1 99,424 (S.D.N.Y. 1983).

" !TSA section 2 and House Report at 2281. There is an open question concerning in-

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The ITSA measure of the "profit gained or loss avoided" differs somewhat from damage measures employed under Rule lOb-5. Since there is little deterrent in a disgorgement limited to the trading profit, several courts have adopted Rule lOb-5 formulas that maximize the damage amount." Consider the example of an insider who purchases shares on confidential information and resells them many months after the public announcement of that information. A court applying a Rule IOb-5 formula might assess damages as of the time of sale. Clearly, a porticm of the trading profit would be attributable to the inside informa· tion. However, another portion could reflect general market conditions or other elements of the stock's performance unrelated to the inside in· formation, since financial theory suggests that the market incorporates new information into stock prices very quickly, perhaps in a matter of hours or days."' A court's ability to assess a multiple penalty under ITSA reduces the need to create a deterrent through an excessive measure of trading profit." Instead, the penalty is measured by profit gained or loss avoided computed as "the difference between the purchase or sale price ... and the value ... measured by the trading price ... a reasonable period after public dissemination of the nonpublic information."'00 The liquidity of the market for the issuer's shares and the nature of the infor· mation could affect any adjustment of the "reasonable" period. The reasonable period after public dissemination could be adjusted by fac· tors that would slow or speed up the assimilation of the nonpu blic information. For example, the liquidity of the market for the issuer's shares, the nature of the information, or the extent of publicity of the information could affect any adjustment of the "reasonable" period.

Several types of trading activity are exempt from the treble penalty. First, actions may be brought only by the SEC: no new private right of action or right in the punitive damage-like penalty is created."' Second, only trades executed through a national exchange or trades executed from or through a broker or dealer are covered. Face-to- face transactions do

sider trading by officers, directors, and 10% shareholders under the separate insider trading restriction found in S 16(b). Since the issuer is entitled to all the short-swing profits of these insiders independently of the treble damage penalty under the ITSA or the disgorgemont remedy under§ 10(b), the damages paid in an insider trading ease could conceivably reach five times the trading profit.

" See, e.g., S.E.C. v. MacDonald, 699 F.2d 47 (1st Cir. 1983) (damages measured a reasonable time after dissemination of information).

" See supra note 45 and Patell & Wolfson, The Interday Speed of Adjw;tmrnt of Stock Prices to Earnings and Dividend Announcements, 37 J. FIN. EcoN. 223 (1984).

" House Report, supra note 77, at 2285. ''" 15 U .S.C. § 78u(dK2KCI (Supp. 19841. '"' 15 U.S.C. S 78u(dK2KA) (Supp. 19841.



not present the same compelling reasons for the treble penalty."' Third, except for standardized options, public offerings of securities by issuers are also exempt."' Fourth, the SEC may by rule or regulation exempt certain classes of persons or transactions.'"' Fifth, three classes of possible secondary liability are exempt: (1) controlling person liability"' for damages assessed against agents,'00 (2) respondeat superior liability.'" and (3) liability for aiding and abetting other than by communicating confidential information.'08 These secondary liability exemptions are intended to protect only innocent business associates.109 Principals, controlling persons, and aiders and abetters who have knowledge of the confidential nature of the information and approve the transactions could be htlld liable.""

ITSA Impact on Prior Law

In passing the ITSA, Congress did not intend to disturb the judicial development of the insider trading restriction except to strengthen remedies and close some loopholes.111 Indeed, a significant proposal to change prior law was never adopted, despite a thorough battle.'" Some witnesses at the House hearings noted the lack of clarity in the judicial boundaries identifying insiders,"' but fairness dictates precision in assessing liability, given the potential for the punitive penalty. This contro-

'" House Report, IIUpra note 77, at 2298. "" 15 U.S.C. § 78u(dU2)(A) (Supp. 1984). "' 15 U.S.C. § 78u(dU2UAl (Supp. 1984). '" 15 U.S.C. § 78t(a) (1982). "' 15 U.S.C. 5 78u(dK2KBl (Supp.1984). This provision insulates brokerage firms and in

vestment bankers from liability for merely employing a violator. House Report,IIUpra note 77, at 2282.

"' 15 U.S.C. § 78u(dK2KB) (Supp. 1984). 101 id. "' For example, a broker which executed a transaction for an insider would not be liable

solely because of the trade. Proof of scienter would be necessary to bring the broker within the treble-damage penalty provision.

"" The SEC requested, and Congress apparently intended that the SEC exercise its exemptive authority to release multi-service firms which take adequate precautions to construct a "Chinese Wall" preventing the transfer of wnfidential information between the trading and consulting units of the firm. See 17 C.F.R. § 240.14e-3(bl (1985) (Chinese Wall requirement) and 130 Cor<o. REI::. 88913 (daily ed. June 29, 1884) (congressional intent to exempt adequate Cllinese WaU procedures).

"' House Report, s·u,-p•ro note 77, at 2282. "' !d. at 2286. But Hee, Report oftfu! Ta.•k Force rrnRegulatirm. oflnsuter Trading, 41 Bus.

LAw. 223, 253-64 (1985). Two alternative legislative proposals are offered to break with the anti· fraud roots of § lO(b) and the restriotive interpretation imposed by Di1'ir.8 and Chia~ella. Alternative A is a complex prohibition &f enumerated activities. By contrast, alternative B would essentially codify the misappropriatil>n theory.

"' House Report, supra note 77, at 2286.

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versy prevented a consensus on an insider definition, and the courts were left with discretion to refine the definition.114 To avoid creating any new ambiguities, the Committee declined to depart from the current judicial interpretation of "insider," which is "well-developed" and "widely known.""'

The impad of the trading restriction is further reinforced by the House Report's recognition of the usefulness of two significant cases'" and three recent interpretations.117 First, this implicit congressional imprimatur accepts the fiduciary roots of the "disclose or abstain" duty."' Second, the temporary insider concept suggested in Dirks"• and applied in SEC v. Lund"" is acceptable to broaden the duty perimeter.'" Third, the condition$ for a tippee's inheritance of the trading restrietion enumerated in Dirks are atceptabJe."" Fourth, Congress apparently considers the tender-offer-insider-trading restriction under Rule 14e-3"' to be a valid exercise of the SEC's rulemaking power under the Williams Act."' Fifth, the major loophole of insider option trading has been closed."' Sixth, the emerging misappropriatioa theory creating the so-ealled "outsider liability""• has been approved.127

Several House members voiced misgivings that an overbroad reading of Dirks might compromise the SEC's efforts to pursue insider trading

'" !d. A rigid definition would not be desirable since "unscrupulous traders would skirt around any definition constructed." I d. (testimony of Arnold S. Jacobs).

t\5 /d. "' S.E.C. v. Texas Gull Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S.

976 (1969): In re Cady Roberts & Co .. 40 S.E.C. 907 (1961). "' United Stales v. Newman, 722 F .2d 729 (2d Cir.l983), cert. denied,l04 S. Ct.193 (1983);

Dirks v. S.E.C., 463 U.S. 646, (1983); S.E.C. v. Lund, 570 F. Supp. 1397 (C.D. Cal. 1982). '" House Report, supra note 77, at 2287. "' Dirks 463 U.S. at 655 n.14 (1983). '"' 570 F. Supp.1397 (C.D. Ca1.1983l.See also S.E.C. v. Gaspar, [1984-1985 Transfer Binder]

FED. SEC. L. REP. (CCHl 192,004 at 90,978 (S.D.N .Y.l985). See •"Upra note 41 and accompanying text.

'" House Report, su'(JI'a note 77, at 2286 n.20. "" House Report, supra note 77, at 2287-88. See tmpra text accompanying notes 37 & 38. "' 17 CF.R. § 240.14e-3 (1985). '" House Report. 811:/1'1'0- note 77. at 2286 n.llO. •~. IT&A U. A new seetMaiO(<Il provides that if ITSA liability "'""It! ucompany a 'ure......, or sale !II a seetll'ity, theft also tlre·put'Cilalte "'sale uf"a·put; Ctlll. straddle, epLioR,

or.~p wiah resp<!Ct So S<H!It seeucitf or wl ... l"espee\ to i<\tl'llfi!HII' ladex of securities iR~Iudil!C SU<Oft security, skall also v;.late iUid resYlt ia oomparallle liability .... " Expan· !lion of Uatrnillgrestridioo to the new index futures aild Olptkms ekl.., a loophole w~ich lo t~pUlng "f' ••· aew Investment& in Industry it!IMxes an prolife!'ating.

'" See irifra •••tioo"" tit<! e"""1fing mlsappf011riatl"" thHry R<Jtes 141·330 ani! aecompaaying text.

'" House Report, supra note 77, at 2286 n.OO.

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cases.'" As a result, the Committee cautioned that Dirks should be narrowly construed and limited to its facts.'"' Additionally, the Committee instructed the SEC to monitor the effects of Dirks for two years and report back to Congress by 1986, presumably to avert any narrowing of the tippee definition.'"

At least three prosecutions under the IT SA have been initiated by the SEC. In SEC v. Ablan,'" the SEC alleged that two agents of an outside director of Monchik-Weber Corporation received confidential information from the issuer's president that McGraw-Hill, Inc., was contemplating an acquisition of Monchik- Weber. The complaint further alleged that the defendants, personally and through Macrofin, Int. S.A., made large purchases of Monchik ·Weber stock prior to a public announcement. that caused the price to rise. The SEC seeks disgorgement, the treble damage penalty, and a temporary restraining order to freeze the defendant's assets. In SEC v. Gaffney,"' the defendants. without admitting or denying the allegations in the complaint, consented to the entry of judgment for a permanent injunction, disgorgement, and payment of civil penalties under the ITSA. The SEC's complaint alleged that Gaffney, in his capacity as an officer, received confidential information from Clop lay Cement Company concerning the progress of merger negotiations with Louisville Cement Company. Gaffney transferred this confidential information to two friends who purchased stock in Louisville Cement prior to the public announcement of the merger. The two defendants disgorged $57,253.87 and $81,510.81 of illegal profits respectively and agreed to pay $35,000 and $38,755.30 in penalties under the ITSA. 133 Finally, the First Boston Corporation has consented to disgorge $132,138 of insider trading profits and $234,276 in penalties without admitting or denying the SEC's charges of insider trading.'" Allegedly, First Boston tra:ded in stock and options of Cigna Corporation, an investment banking client, while in possession of nonpublic information concerning a $1.2 billion

'" House Report, supra note 77, at 2287. 1211 /d. "" I d. The Committee expressed the need for a firm and continued disapproval of in

sider trading. A review of 34 cases brought by the SEC since Dirks revealed that only one case might be affected by Dirks. A report back to the Committee in 1986 should include: "(1) the number of insider trading cases brought, settled, and tried; (2) the propositions for which counsel cites Dirks in representation of clients accused of insider trading: and (3) a summary and analysis oflower court decisions citing and interpreting Dirks." !d.

'" [1984 Transfer Binder] FED. SEC. L. REP. (CCH) 191,847 (S.D.N.Y. Nov.?:/, 1984) (litigation release).

"' [1984-1985 Transfer Binder] FED. SEc. L. REP. (CCH), 92.002 (S.D.N.Y. Apr.18,1985) (litigation release).

'"" !d. at 90,962. '~ S.E.C. v. First Boston Corp. 18 SEC. REG. & L. REP. (BNA) 672 (S.D.N.Y. 1986).

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write-off. First Boston agreed to review its "Chinese wall" procedures, which should prevent leaks of confidences from its investment banking division to its trading department. These prosecutions reveal that the SEC is continuing to press the misappropriation theory, that the SEC considers tender offers and mergers to provide numerous insider trading opportunities, and that the precise multiple of treble damages sought is flexible, depending on the circumstances.

The ITSA 's Impact on Oth&r Matters

In passing the ITSA, Congress took advantage of the opportunity to comment on some aspects of securities litigation and to change other aspects. First, the burden of proof in ITSA actions should remain at the lower standard of a "preponderance of the evidence."'" Although some commentators had suggested the higher "clear and convincing" test, the conspicuous absence of any standard in the ITSA is intended"' to rein· force the Supreme Court's selection of a "preponderance" test applicable to both judicial'" and administrative"' actions. Second, despite the suggestions of some Committee witnesses that a jury trial provision should be added to the ITSA penalties, Congress specifically declined to do so.'"' The Supreme Court had previously reserved the question of a seventh amendment requirement of jury trials in civil penalty actions.' .. Considering the additional judicial burdens the constitutional questions presented, Congress declined to adopt the jury trial proposal. At this time, no right to a jury determination of a governmental civil penalty exists.'"

The ITSA specifically addressed three more general securities litigation concerns. First, the limit on fines in criminal actions brought by the Justice Department has stood at $10,000 since passage ofthe1934 Act.'" The deterrent effect of such actions is reinforced by raising the maximum fine to $100,000.'43 Second, a special statute of limitations, applicable only to SEC actions based on the ITSA, is set at five years.'" The period begins to run on the date of the purchase or sale that constitutes the violation. Third, section 15(c)(4)'" has been amended to apply to the correction of

·~ House Report, supra note 77, at 2289. "' Id. "' S.E.C. v. C.M. Joiner Leasing Corp., 320 U.S. 344, 355 (1934). "' Steadman v. SE.C., 450 U.S. 91, 95 (1981). '" House Report, supra note 77, at 2289. "" Atlas Roofing Co. v. Occupational Safety Comm'n, 430 U.S. 442. 449 n.6 (1977). "' See United States v. Reader's Digest Ass'n., 662 F .2d 955, 967 (3d Cir. 1981), cert.

denied, 445 U.S. 908 (1982); accord United States v. Duffy, 550 F.2d 533,534 (9th Cir. 19771. "' 15 u.s.c. § 78ff (1982). "' House Report, rrupra note 77, at 2285. "' 15 U.S.C. § 78u(dK2KCl (Supp. 1984). "' 15 U.S.C. 5 78o(cK41 (1982).


590 I Vol. 24 I A 1l'!IJ1"ican Business Law Journal

public filings required under section 14.148 As a result, misstatements in the proxy and tender offer filings required under section 14 may be remedied administratively under the SEC enforcement powers in section 15(c)(4). As the impact of these procedural and remedial changes becomes more widely known, the ITSA may prove to be the most significant deterrent in all of insider trading jurisprudence.

THE EMERGING MISAPPROPRIATION THEORY

It is commonly believed that insider trading is illegal only when an insider of the issuer or certain tippees trade in the issuer's securities. Some recent commentaries have interpreted the Chiarella and Dirks decisions consistently with this restrictive view.'" However, Dirks and Chiarella have reaffirmed rather than narrowed the original scope of the trading restriction.'" These decisions simply reverse the over-expansive trend of Rule 10b-5 jurisprudence discussed earlier."' The Cady Roberts principles have reemerged as a misappropriation theory prohibiting personal use of information secured in a fiduciary relationship when the use is coupled with unfairness and potential injury to the financial markets. Apparently, some observers have assumed that the original "source" of the nonpublic information must also be the issuing "source" of the securities traded. However, there is no legislative authority for limiting the trading restriction to transactions in the securities of the information source. Several recent authorities break this apparent connection through application of the misappropriation theory, thereby broadening the sources of potentially confidential information.

In the Chiarella trial indictment, the government failed to charge the financial printer with a fiduciary breach of loyalty, trust, and confidence to his employer, Pandick Press. On appeal to the Supreme Court, the Justice Department added allegations amounting to the misappropriation theory, but only as an afterthought. However, reversal of the Chiarella jury verdict had been predicated on instructions that a general fiduciary duty is owed to the market. Therefore, the Supreme Court was unable to affirm a criminal conviction "on the basis of a theory not presented to the jury .... "100 Although a strong dissent urged application of the misappropriation theory,151 the majority declined to do so.'52

"' 15 U.S.C. § 78n (1982); See In re Magna Corp., S.E.C. Securities Exchange Act Release No. 22, 166 (June 24, 1985) (applying S 15(cX4l amendments to S 14(a) proxy violation).

'" See, e.g., N.Y. L.J., Vol. 190 at 1, col. 1 (Sept. 28, 1983). "' See In re Cady Roberts & Co., 40 S.E.C. 907. 911 (1961). 149 See l·:upra text accompanying notes 27-31. '" Chiarella v. United States, 445 U.S. 222, 236 (1980), citing Rewis v. United States,

401 u.s. 808, 814 (1971). '" Chiarella, 445 U.S. at 245 (Burger, C.J., dissenting). '" Chiarella, 445 U.S. at 237.



The SEC and private plaintiffs have tried unsuccessfully to expand the reach of 10b-51iability through the parity of information duty'" and the "new fraud" theories.' .. However, the more recent expansionist efforts have successfully pressed the misappropriation theory originating in the 1969 SEC administrative action of In re Blyth & Co. 155 There, a broker-dealer traded in government securities after receiving nonpublic Treasury Department information from a Federal Reserve Bank employee. The fact that the government was the source of the information did not alter the wrongfulness of the trading activity. The Cady Roberts rationale was thereby expanded to the tippee of a government insider.'"'

The Misappropriation Rule

The misappropriation theory imposes civil, criminal, and regulatory liability for "insider" trades by both traditional insiders and some "outsiders." The trading restriction may attach even if the outsider is not privy to nonpublic information from sources inside the issuer whose shares are traded. Outsiders lack any direct fiduciary relationship with the issuer or its shareholders. Therefore, traditional insider analysis fails to reach a broad range of conduct that arguably undermines the integrity of the markets in a manner similar to traditional insider trading. Rather than focusing on an obligation owed to the misappropriator's trading partner (the theory rejected in Chiarella), outsider trading liability is premised on a duty owed to the source of the information. "An agent is subject to a duty to the principal not to use or communicate information confidentially given to him by the principal or acquired by him during the course of or on account of his agency .... ""'This "fraud on the source" theory'" has its origins in the law of restitution.'"' Thereunder, a person who misappropriates confidences for personal benefit holds the proceeds for the

"' See supra notes 27-31 and accompanying text. '" See supra notes 32-37 and accompanying text. "' 43 S.E.C.1037 (1969). See also United States v. Peltz, 433 F.2d 48 (2d Cir.), cert. denied.

401 U.S. 955 (1971) (illegal conspiracy to trade on nonpublic information about impending SEC litigation with issuer which shares were traded).

·~ Blyth & Co., 43 S.E.C. at 1040. This approach has received support in the Federal Securities Code. A new class of"quasi-insiders," including, e.g .. judges' clerks, are restricted from trading on nonpublic information if it is converted out of a fiduciary relationship and is not obtained through legitimate economic activity. See A.L.I. FED. SEc. ConE§ 1603, comment 3(d). pp. 538-39 (Proposed Official Draft 1978). The Code has gained widespread acceptance approximating that of a Restatement, particularly in fraud and civil liability matters. See, e.g., Dirks, 463 U.S. at 657 n.l5, Chiarella, 445 U.S. at 228 n.9.

'" RESTATEMENT (SECOND) OF AGENCY § 359 (1958). IM See Langevoort, mpra note 10. '" United States v. Reed, FED. SEc. L. REP. (CCHI, 91,927 at 90,603 (S.D.N.Y. 1985).

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benefit of the entrusting party ."• Applied to the context oft he securities laws, this theory makes it irrelevant whether the securities issued by the information source are traded. A breach of the duty of loyalty triggers the lOb-5 "disclose or abstain" obligation irrespective of any duty running to the issuer whose shares are traded.'"

The proof of misappropriation is an indicator of 10b-5liability. Under misappropriation theory, the trading restriction is triggered by a breach of confidence. Previously, it was assumed that the fiduciary duty must run directly to the victim to permit suit. However, the appropriation of confidential information from the beneficiary of a fiduciary duty is sufficient conduct to trigger the trading restriction irrespective of a duty running to the trading partner. As a result of the insider's fiduciary duty to the issuer, to its shareholders, or to some outside entity, a separate duty to the investing public arises to "disclose or abstain" from trading.'"' This rule does not reestablish the egalitarian "parity of information" rule rejected in Chiarella.' .. Instead, the rule restricts use of non public information only if the information is misappropriated. Misappropriation is not a new variety of securities fraud: rather, the misappropriation theory is based on the original Cady Roberts formula, but as applied to securities trading, "misappropriation" is more generalized than the conventional understanding of the term "insider trading." Where the misappropriator converts confidential information from sources either inside or outside the issuer, a breach of the "disclose or abstain" duty arises. The Cady Roberts standards apply since "the existence of a relationship affording access to inside information intended to be available only for a corporate purpose" is present.'"' The common fixation on the adjective "inside" as relating only to the issuer of the securities traded ignores a whole range of activity that poses the same threat to. securities market integrity as does the more traditional insider trading."'

"' RESTATEMENT OF RESTITUTION § 200 (1937), '" See, e.g., United States v. Newman, 664 F.2d 12 (2d Cir. 1981), ajJ'd after remand, 722

F.2d 729 (2d Cir.), cert. deniM., 104 S.Ct. 193 (1988); S.E.C. v. Materia, FED. SEC. L. REP. (CCH), 91,681 (2d Cir. 1984), cert. denied, (Apr. 22.1985, No. 84·1036); Moss v. Morgan Stanley, Inc., FED. SEC. L. REP. (CCHI, 99,045 (S.D.N.Y. 1988), ajJ'd, 719 F.2d 5 (2d Cir. 1983), cert. denied sub nom. Moss v. Newman, 104 S. Ct.l280 (1984): S.E.C. v. Musella, 578 F. Supp. 425 (SD.N .Y .1984); O'Connor & Assoc. v. Dean Witter Reynolds, Inc .. 529 F. Supp. 1179 (S.D.N.Y. 19811; United States v. Reed,, 91,927 FED. SEC. L. REP. (CCHI !S.D.N.Y. 1985).

"' O'Connor & Assoc. v. Dean Witter Reynolds, Inc., 529 F. Supp.1179, 1187 (S.D.N.Y. 1981). Cited with approval in S.E.C. v. Musella, 578 F. Supp. 425,439 n.12 (S.D.N.Y. 1984),

"' Chiarella, 445 U.S. at 228. '" Cady Roberts. 40 S.E.C. at 911. ,., Newman, 664 F.2d at 17.


1986 I ContriYI!ersy Over Insider Trading I 593

By endorsing the alternative "misappropriation" theory of rule lOb-5 liability ... the Second Circuit gave legal effect to the commonsensical view that trading on the basis of improperly obtained information is fundamentally unfair, and thl!t distinctions premised on the source of the information undermine the prophylactic intent of the securities laws'"' [emphasis added).

This "double duty" principle imposes restrictions on those trading on material non public information if it is tainted by the breach of a fiduciary duty. It is immaterial whether the fiduciary duty runs directly to the sellers (or buyers) of the securities.167 If nonpublic information is misappropriated from the beneficiary of any fiduciary duty, the tradirtg restriction applies to the misappropriator' s trading activity .'68

The Confidential Relationship

The most fundamental difference between the traditional insider trading and misappropriation is the existence in the latter of a relation· ship affording access to confidential information. The confidential relation that triggers the trading restriction is somewhat broader than the common law fiduciary concept. At common law, a fiduciary relationship arises where there are two parties;•• and one places confidence in the other with a resulting superiority and influence on the other side."' The broader concept of a confidential relationship applicable to misappropriation includes both the traditional common law fiduciary relations"' and less formal relationships where one person trusts and relies on another.'72

•u Musella, 578 F. Supp. at 438. JH7 [d,

lfi~ However, standing must be established for a private right of action to exist. See 1'n

jra notes 183-216 and accompanying text. '" Moss v. Morgan Stanley, Inc., 719 F.2d 5,16 (2d Cir. 1983), cert. ckniedsub nom. Moss

v. Newman, 104 S. Ct. 1280 (1984). "" Francois v. Francois, 599 F.2d 1286, 1292 (3d Cir. 1979), cert. cknwd, 444 U.S. 1021

(1980); Yohe v. Yohe. 466 Pa. 405, 853 A.2d 417, 421 (1976). "' Strict fiduciary relationships attach to agents, executors, administrators, guardians,

trustees, attorneys, and senior corporate officials. See Scott, The Fiduciary Principle, 37 CALIF. L. REV. 539, 541 (1949).

"' Many other relationships imply confidentiality despite a lack of formal labels suggesting an inherently fiduciary-like relationship. It is difficult to define the concept with precision and the term "confidential" suggests a large miscellaneous list of relationships where the parties expect intimacy apart from the fixed character of certain institutions. See Comment, The Confickntial Relationship Theory of Constructive Trw;ts: An Exception to the Statute ofF'rauds ("The Gmjide:ntial Relationship Theory"), 29 FORDHAM L. REV. 561 11961). In United States v. Margiotta, 688 F.2d 108,122 (2d Cir.1982), cert. cknied, 461 U.S. 913, (1983), a litmus paper test for fiduciary duty was specifically rejected. However, two "time-tested" aspects of the relationship emerge: (1) a reliance test under which one may be a fiduciary when others rely on him because of a special relationship, and (2) a de facto


594/ Vol. 24/ American Business L1.1,w Journal

This more expansive category of relationships implying trust and confidence includes the individual traders in all the misappropriation cases decided thus far.113 For example, although family ties do not automatically involve confidentiality,'" it may be established independently among family members.'"

Although some fiduciary relationships arise from contractual negotiations, the trading restriction will not arise from an arms-length negotiation. In Walton v. Morgan Stanley & Co.,"" the Second Circuit refused to imply a confidential relationship between an investment banking firm and a takeover target. Morgan Stanley had represented Kennecott Copper Company in acquisition negotiations with Olinkraft, the takeover target. Olinkraft furnished Morgan Stanley with confidential information for evaluation of the potential tender effer. Morgan Stanley purchased Olinkraft shares after the merger negotiations were terminated. No fiduciary relationship arose from the "arm's length" negotiation between those involved in the bargaining."' However, the decision turned on the characterization of Morgan Stanley as a tippee of confidential information from Kennecott. Admittedly, no confidential relationship existed between Kennecott· and Olinkraft.'" Under tbe contemporary misappropriation analysis, however, Morgan Stanley could more properly be characterized as a fiduciary of Kennecott, and the confidential information as misappropriated from that relationship. Indeed, several recent cases illustrate that similar defects in pleading'" and in the characterization ofrelationships'80 prevented suits that could have been based on the misappropriation theory rather than the broader theory of a duty to the whole market rejected in Chiarella.

control test where one who makes actual decisions may be designated a fiduciary (political official involved in kickback scheme, but who held no public office, held to be a fiduciary of local government).

"' See infra text accompanying notes 219-75. "' Francois v. Francois, 599 F.2d 1286,1292 (3d Cir.1979), cert. denied, 444 U.S. 1021 (1980). "' United States v. Reed, 1 91,927 FED. SEc. L. REP. (CCHI at 90,608 (S.D.N.Y. 1985). "' 623 F.2d 796 (2d Cir. 1980). "' I d. at 799. "' See also Dirks v. S.E.C., 463 U.S. 646, 662 n.22 (1983)and Frigitemp Corp. v. Finaneial

Dynamics Fund, Inc., 524 F.2d 275,278-79 (2d Cir.197ii) (no duty owed to the corporation seltingolebenlures where investment compe,nies trad<:d on confidential information obtained m negetiatioas for a private placemootl.

'" E.g., Clliarella v. United States, 445 U.S. 222, 236 (1980) . . •• Under Ule misappropriation theory it may he uanecessary 1.9 characterize a trader

as a tippee or 811 insider with the atl.9ndant tliffieulties el proel. Instead, the trading restriction attaches ifthe trader aequired the oonpublie infermation from a oonfldential relationship. Since the issuer need not be the source of tlte confidential infMmation, it is unnecessary to expand the group of potential fiduciary beneficiaries as attempted in Dirks or Chiarella.

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The only apparent sensitive issue in applying Rule lOb-5 to outsider misappropriation cases is the requirement that the fraud be made "in connection with" a purchase or sale of securities. Proof of a breach of confidence is not required to establish a direct causal path of damages between the trader and the confidential beneficiary. Rather, the Supreme Court has interpreted the "in connection with" requirement so that the fraud need only "touch" the sa.Ie of securities tenuously181 to invoke the jurisdiction of the securities laws. Liberal interpretation of the "in connection with" element reinforces the view that the broadly remedial purposes of the securities Jaws should be construed to protect the securities markets' integrity.'" But the broad "in connection with" requirement does limit private rights of action to prevent indeterminate liability to an indeterminate class of plaintiffs.'88 Although this duty path must be established in private rights of action, however, the misappropriation cases modify the common understanding of the relationship between "in connection with" and enforcement actions brought by the SEC or the Justice Department. The "in connection with" requirement does not focus on implication of the trading restriction (duty to "disclose or abstain"); instead, it limits only the standing of certain private plaintiffs.

Standing

The misappropriation theory raises questions of private plaintiff standing similar to those arising in other securities law contexts.'" Criminal violations of Rule lOb-5 under the misappropriation theory may be prosecuted by the Department of Justice"' without any allegation that specific damages were suffered by a particular purchaser or seller .186 The threat of criminal prosecution for misappropriation serves to deter future fraudulent conduct and to implement the congressional and public policy of preserving market integrity.187

'" Superintendent of Ins. v. Banker's Life & Casualty Co., 404 U.S. 6 (19711. See also Cooper v. North Jersey Trust Co., 226 F. Supp. 972 (S.D.N.Y. 1964) and A.T. Brod & Co. v. Perlow, 375 F.2d 393 (2d Cir. 1967).

'" See, e.g .• United States v, Na!taliri, 441 U.S. 768 (1979); S.E.C. v. Capital Gains Bureau, 375 u.s. 180 (1963). '

·~ Blue Chip Stamps v. Manor Dr~gStores, 41z'lf.iS. 723,'149 U975)i Birnbaum v. Newport Steel Corp., 193 F .2d 461, 463 (2d Cir.), bert. drmied, 343 u:s. 956 d9521.

•~ J.I. Case v. Borak, 377 U.S. 426,431 (1961') (proxy context), but see Ash v. G.t\F Corp., 723 F.2d 1090, 1094 (3d Cir. 19831 (tui stal)ding for sharehOlder who did not exercise proxy); Summers v. Lukash, 562 F. Supp. 737,741 (E.D. Pa.1983); Crane Co. v. American-Standard Inc., 603 F.2d 244 (2d Cir. 1979) (standing for bidder in tender offer denied under§ 14(e) and Rule !Ob-5 applying Piper v. Chris-Craft lndWl., 430 U.S. l (1977)).

"' 15 u.s.c. § 78ff (1982). '"' Ne:wman, 664 F .2d at 16; Reed, FED. SEc. L. REP. , 91,927 (CCHI at 90,604. '"Newman, 664 F.2d at 16-17; S.E.C. v. Materia, FED. SEc. L. REP. ICCHI 1 99,526


596 I Vol. 24 I American Busi'M88 Law Journal

In SEC injunctive actions, a similar market protection policy allows the Commission standing without reference to specific or provable damages or to the identification of particular victims.108 Ancillary questions such as standing are not germane in SEC enforcement actions. "It is sufficient that the defendant's conduct 'operat(ed) •.. as a fraud or deceit upon any person, in connection with the purchase or sale of any secur· ity.' .. , .. The SEC, as the principal governmental body charged with protection of the financial markets, is authorized to seek temporary or permanent injunctive relief against existing or potential violators, 190 On a showing that a reasonable likelihood of future violations exists.'" the trial judge is vested with equitable authority.'"

Congress must have recognized that considerable trial court discretion exists to fashion appropriate equitable relief, since the historic powers of equity have been quite broad/93 The SEC may seek any form of ancillary relief necessary and appropriate to effect the purposes of the Securities Acts.'94 For example, illegal insider trading profits may be placed in escrow,"' disgorged.',. or paid over to a private plaintiff.'" Additionally, the appointment of a receiver,'98 impoundment of assets,'99 or the installation of SEC approved directors""' may be appropriate under certain circumstances ... ' Similarly, a private plaintiff need not be a defrauded purchaser or seller in order to sue for injunctive relief from fraudulent activities under Rule lOb-5.'"' That Rule lOb-5 does not re-

(S.D.N.Y. 11183)atll7,028, FED. SEc. L. REP. (CCH) 191,681 (2d Cir. 1984), cert. dewied,(Apr. 22,1985, No. 84-1036), 58 U.S.L.W. 3757.

'" Id. ·~ Reed. FED. SEC. L. REP. (CCH) 191.927 at 90,604. See alsoNwman, 664 F.2d at 18-19;

Gaspar, FED. SEC. L. REP. iCCH) 1 92,004 at 90.978. •~ 15 U.S.C. § 78u(d) (1982). '" S.E.C. v. Manor Nursing Centers. Inc .• 458 F.2d 1082, 1102 (2d Cir. 1972). '" Chris-Craft Indus. v. Piper Aircraft Corp., 480 F.2d 341, 390 (2d Cir.), cert. denied,

414 u.s. 910 (1973). ·~ MitcheU v. Robert DeMario Jewelry, Inc .. 361 U.S. 288. 291-92 (1900). '" See S.E.C. v. Texas Gulf Sulphur Co., 446 F .2d 1301, 1307, cert. dlmied. 404 U.S. 1005

(1971) and Materia, FED. S&e. L. REP. (CCHl 1 91,681 at 99,449. "' S.E.C. v, Reed, 97 F.R.D. 746 (S.D.N.Y. 1983) (consent decree to disgorge profits from

insider trades in options: funds placed in escrow). ·~ S.E.C. v. Manor Nursing CenteM!. Inc., 458 F .2d 1082 (2d Cir. 1972). '" Texas Gulf Sulphur Co .• 446 F.2d at 1307. '" S.E.C. v. Manor Nursing Centers, Inc., 458 F .2d 1082.(2d Cir. 1972). "' International Controls Corp. v. Vesco, 490 F.2d 1334 (2d CirJ, cert. denied, 417 U.S.

932 (1974) . .. ld. "" See Farrand, Ancillary Remedies in SEC Civil Eriforcement Actions, 89 HARV. L. REv.

1799 (1976). "" Crane Co. v. Westinghouse Air Brake Co., 419 F.2d 787.798 (2d Cir. 1969); Mutual

Shares Corp. v. Genesco, 384 F.2d 540, 546 (2d Cir. 1967); Kahan v. Rosensteil, 424 F.2d


1986 I Controversy 01Jer Insider Trading I 597

quire that the fraud be perpetrated on the seller or buyer of securities in injunctive cases203 is further evidence that standing in enforcement cases is interpreted broadly.

Standing becomes a pivotal issue"" only when a private plaintiff seeks damages in the judicially implied private right of action.'" The private plaintiff must prove two elements to establish standing: (1) that a duty to "abstain or disclose" runs to the plaintiff.'"' and (2) that direct injury results from the alleged fraudulent practices.'" As suggested in Moss v. Morgan Stanley, Inc.,20

' standing cannot be based on a circuitous linking of liability. For example, government enforcement action may be based on a fiduciary duty owed to the fiduciary's employer. However, a private plaintiff suing for damages cannot "piggyback" a claim on this duty.'"' "There is no 'duty in the air' to which any plaintiff can attach his claim,""' The Newman decision was specifically limited so that an employee's duty to abstain or disclose would not be stretched to encompass an employee's duty of disclosure to the general public.'" However, this restriction on standing was distinguished in O'Connor & Associates v. Dean Witter Reynolds, Inc . .'" where an options trading firm sought to restrict the distribution of profits derived from trading on misappropriated confiden· tial information. If the original "source" of the confidential information is a traditional insider, then it is unnecessary for a private plaintiff to ''piggyback" on an outside fiduciary duty. Instead, more traditional theories of tippee liability provide the appropriate link for private standing where an insider of the issuer is the original source of information.'"

Standing has been broadened in private damage actions brought by tip pees against their tipper. In one case, the Supreme Court affirmed the Ninth Circuit's reversal of a trial court's dismissal of a damage ac-

161, 173 (3d Cir.l. cert. denied, 398 U.S. 950 (19701: Britt v. Cyril Bath Co, 417 F.2d 433, 436 (6th Cir. 1969).

~· 17 C.F.R. S 240.10b-5 (19851. ~· Newman, 664 F.2d at 17. "' Blue Chip Stamps, 412 U.S. at 737, 749. "" Ch.irlrella, 445 U.S. at 229; Frigitemp Corp. v. Financial Dynamics Fund, Inc .. 524 F.2d

275, 282 (2d Cir. 19751. ~' O'Connor, 529 F. Supp. at 1186. See also Blue Chip Stamps, 412 U.S. at 737; Elkind

v. Liggett & Myers,lnc., 635 F.2d 156,165 (2d Cir. 1960); Shapiro v. Merrill Lynch, Pierce, Fenner & Smith, lne., 495 F.2d 228 (2d Cir. 19741.

"' 719 F .2d at 13. ""Id. "" I d. citing lower court Moss v. Morgan Stanley, Inc., 553 F. Supp.1347,1353 (S.D.N.Y.

1983). "' Newman, 664 F.2d at 15 n.l. "' O'Connor, FEn. SEc. L. REP. (CCH), 91,911 at 90,510. '" ld. at 90,511.

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tion brought by ten investors against their broker, Bateman Eichler, Hill Richards, Inc.21

' The equitable defense of in pari delicto is often applied to insulate a wrongdoer from liability if the victim is partially at fault. However, private damage actions by tippees against tippers are dismissable under this equitable doctrine only where the victim is at least equally at fault, creating a form of comparative in pari delicto: "[T]he public interest will most frequently be advanced if defrauded tippees are permitted to bring suit and to expose illegal practices by corporate insiders and broker-dealers to full public view for appropriate sanctions .... "'15

In this case, the investors purchased shares in T.O.N.M. Oil & Gas Exploration Corporation and alleged a conspiracy between the broker and issuer to manipulate stock prices. Despite the investors' knowledge that the information relayed by the brokerage was allegedly confidential, a cause of action existed for damages against insiders and broker-dealers who made intentional tips of confidential information. The SEC amicus brief supported the availability of private damage actions, since they enhance the SEC's enforcement efforts. ' 1

'

The Misappropriation Cases

The Justice Department began testing the misappropriation theory as an alternative to the "duty to the whole market" notion even before the Supreme Court decided Chiarella. Two cases that arise out of the same facts, United States v. Newman211 and Moss v. MorganSta.nley.' 1

' set the bounds for enforcement and private damage actions under the misap· propriation theory. Between 1972 and 1975, E. Jacques Courtois and Adrian Antoniu were employed in the mergers and acquisitions department of the investment banking firm of Morgan Stanley & Company. In 1975, Antoniu left Morgan Stanley to work for Kuhn Loeb & Company219

yet maintained contacts with Courtois. Between 1973 and 1978, Courtois and Antoniu misappropriated from their employers nonpublic information entrusted by clients in confidence. For example, 1976 tender offer discussions between Warner-Lambert Company and Deseret Pharmaceutical Company were revealed to Morgan Stanley. Courtois learned of the merger plans and urged Antoniu to purchase stock in Deseret and several other firms before the public announcement. This information

"' Bateman Eichler, Hill Richards Inc .. v. Berner. !05 S. Ct. 2622 (1985). '" /d. at 2633. "" "Justices Permit Insider-Trading Investor Suits," Wall St. J .. June 12, 1985. at 2,

col. 2. "' 722 F.2d 729 (2d CirJ. cert. denwd, 104 S. Ct. 193 (1983). "' 719 F.2d 5. "" Morgan Stanley & Co. and Kuhn Loeb & Co. have since consolidated into Lehman

Brothers Kuhn Loeb Inc .. NfJWmfln, 664 F.2d at 15.

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was then communicated to James M. Newman, who managed the overthe-counter department at a New York brokerage firm. Newman purchased 11,700 shares of Deseret at approximately $28 for his own and his clients' accounts and advised clients to purchase Deseret. Newman then passed along the information of this and other prospective mergers to foreigners who traded through secret foreign accounts and spread their purchases among several brokers to avoid detection. The trading group made substantial profits in the stock of several takeover targets. Newman and the trading group tendered their shares after the public announcement was made.

The United States District Court for the Southern District of New York dismissed an indictment charging Newman with securities fraud,220 mail fraud,221 and conspiracy to commit securities and mail fraud.222 The Second Circuit reversed the dismissal'" and later affirmed his subsequent conviction224 for violating Rule IOb-5 of the SEC.22

' Although the Supreme Court had once deferred "resolution of this [misappropriation theory) issue for another day,""" Newman presented the opportunity to extend the common law misappropriation theorym to situations involving trust and confidence arising in a "relationship affording access to inside information intended to be available only for a corporate purpose."'" The Second Circuit adopted the theory in Chief Justice Burger's Chiarella dissent that Newman "misappropriated -stole to put it bluntly- valuable nonpublic information entrusted to him in the utmost confidence.""'

The misappropriation theory recognizes that the reputation of an in· sider's employer may be sullied "as safe repositories of client confidences (and therefore] appellee and his cohorts defrauded those employers as surely as if they took their money.""' However, proof of specific harm to a particular party is not critical to the maintenance of either a criminal prosecution or a SEC enforcement action based on misappropriation.'"

"" 15 U.S.C. § 78j(b) (1982) and 17 C.F.R. § 240.10b-5 (1985). '" 18 u.s.c. § 1341 (1982). ''" 18 u.s.c. § 371 (1982). "' Newman, 664 F.2d at 20. "' Newman, 722 F.2d at 729. '" The SEC has since specifically prohibited trading in target corporation securities

by individuals associated with a tender offeror, 17 C.F.R. § 240.14c-3 (1985). "' Chiarella v. United States, 445 U.S. 222, 236 (1980). '"' See generally Keeton, Fraud-Ccmcealment and Nan-Disclo.<ure, 15 TEx. L. REV. I.

(1930). "" Cady Robert.<, 40 S.E.C. at 911. "' Chiarella, 445 U.S. at 245. "' Newman, 664 F.2d at 17.See also Texas Gulf Sulphur Co., 446 F.2d at 1308: Diamond

v. Oreamuno, 24 N.Y.2d 494,499 (1969) (applying state corporate fiduciary law to insider trading).

'" Materia, No. 84-6043, slip op. at 36-41.

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As the Newrru:m court declared "Appellee and his cohorts also wronged Morgan Stanley's and Kuhn Loeb's clients, whose takeover plans were keyed to target company stock prices fixed by market forces, not artificially inflated through purchases by purloiners of confidential information.""" Of course, private rights of action are strictly construed"" judicial creations requiring specific proof of standing'" and injury."'

In Materia v. SEC,""' the misappropriation theory was applied to a situation substantially similar to Chiarella. The Supreme Court denied certiorari, letting stand the Second Circuit's affirmance of an injunction against future violations and disgorgement of $99,862.50 in trading profits. Like Chiarella, Materia worked for a financial printing firm, Bowne of New York City, Inc. (Bowne), between1969 and 1982.Asa copyholder, Materia would read aloud a client's draft documents to a proofreader to check the accuracy of page proofs against the original copy. Although Bowne made extensive efforts to maintain anonymity of tender offer targets.'" Materia, a self-proclaimed "stock-aholic,"',. deduced the identity of at least five target firms."' The disguised early drafts contained

"" Newrnan, 664 F.2d at 17. The court cited FOX & Fox, BUSINESS ORGANIZATIONS, COR !'ORATE ACQUISITIONS AND MERGERS,§ 27.05(4] 1981:

In a tender-offer situation, the effect of increased activity in purchases of the target company's shares is, similarly, to drive up the price of the target company's shares; but this effect is damaging to the offering company because the tender offer will appear commensurately less attractive and the activity may cause it to abort.

See also Mandelker, Risk and Return: The Case of Merging Firms, 1 J. FIN. EcoN. 303 (197 4)

on the economics of tender offers, and R. POSNER & K. SCOTT, ECONOMICS OF CORPORATION LAW AND SECURITIF.S REGULATION (1980) on the behavior of the stock price of acquiring and acquired firms. For a discussion of the preannouneement perf<>rmanee <>f the target issuers traded in Newman, see Keown, Pinkert<>n, Young & Hansen, Recent SEC Prosecutions and Insider Trading on Forthcmning Merger Annou,.,..,ts, 13 J. Bus. REs. 329 (1985).

"" See Transamerica Mortgage Advisors, Inc. v. Lewis. 444 U.S. 11 (1979); Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976); Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975).

'" Moss, 719 F.2d at 13. "' Transamerica Mortgage Advisors. Inc. v. Lewis, 444 U.S.U (1979);But see Affiliated

Ute Citizens of Utah v. United States,406 U.S.128 (1972~ Shapito v. Merrill Lynch, Pierce, Fenner & Smith, Inc., 495 F.2d 228, 241 (2d Cir. 1974); Myzel v. Fields, 386 F.2d 718, 748 (8th Cir. 1967), rert. rknied, 389 U.S. 951.

"" 745 F.2d 197 (2d Cir.), cert. denied, 105 S. Ct. 211 (1985). "" See infra notes 276-97 and accompanying text. '" Materia. FED. SEC. L. REP. (CCH) 1 99,583 at 99,448. "' The SEC alleged that tender offer documents were submitted to Bowne for printing

by these clients: Ampco Pittsburgh Corp., HP, Inc., a wholly-owned subsidiary ofHumana, Inc., National Medical Enterprises, Inc .. P.C. Enterprises, Inc., and Easco Corp. Materia invested in the following target companies as a result of his access to the proofed documents and his sleuthing efforts: Buffalo Forge, Brookwood, Cenco, Criton, and Evans Aristocrat. Materia, FED. SEC. L. REP. (CCH), 99,526, at 97,026 and 1 99,583.


1986 I Controversy Over Insider Trading /601

sufficient data for an astute investigator to deduce the targets' identities .... Within hours of.each discovery, Materia and his nominees made substantial purchases of the targets' shares. These holdings were sold profitably within a few days following public announcement of the tender offers.'"

SEC v. Musella"' presents another example of an employee of a "temporary insider""' misappropriating confidential information from the employer. Alan Robert Ihne managed the office services department of Sullivan & Cromwell, a New York City law firm. In at least four instances, Ihne came into contact with documents submitted to Sullivan & Cromwell by clients. lhne then communicated the confidential information to two groups, also named as defendants. Daniel and James Covello, who were experienced bond traders, and the "Musella" group, consisting of eight i!!dividuals,~« received tips from Ihne.•••

In 1981, Sullivan & Cromwell was retained by Merrill, Lynch, Pierce, Fenner, and Smith, Mobil Oil's dealer/manager, for legal advice in the takeover of Marathon Oil. In February, 1982, Sullivan & Cromwell was retained to provide legal services to Morgan Stanley & Co., which was acting as financial advisor to a special advisory committee of Tesoro's board of directors in connection with a proposed reorganization of Tesoro. Later, Sullivan & Cromwell also reviewed the plans for a leveraged buyout of Tesoro that was never i:ompleted. Klockner, Humboldt & Deutz, A.G., retained Sullivan & Cromwell in July,1982 to render legal services in connection with a proposed acquisition of Steiger Tractor. Similarly, Peter Kiewit Sons, Inc., retained Sullivan & Cromwell to assist in the filing of Form 13D preceding the acquisition of the securiti.es of MAPCO, Inc."' In each ease, the Covellos and the Musella group made substantial purchases of the stock and call options ( whose total exceeded $1.8 million) in these issuers before the information was made public.'" The Musella group also traded in securities of several other Sullivan & Cromwell

"" The target's state ol incorporation, the number o! outstanding shues. the dates and amounts of recent dividends were some of the clues ineluded in early drafts of the documents. Materia. FED. SEc. L. REP. (CCHI 1 91,681 at 99,448.

t4L /d. '" 578 F. Supp. 425 (S.D.N.Y. 1984): "' I d. at 436. See Dirks 463 U.S . .at 655 n.l4. u~ One defendant, Richard Roseneranz, consented to a permanent injunction prior to

trial, the others consented to preliminary injunctions against further violations of the securities laws, Musella. 578 F. Supp. at 431 n.l & 2.

"' All defendants either admitted or stipulated to their trading activities. MW!Illla, 578 F. Supp. at 431.

~• 17 CF.R. S 240.13d-1 (1985)6ndicates ownership of 5% or more or acquisition of more than 2% of equity securities in a potential takeover target).

"' Musella. 578 F. Supp. at 431-2.

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clients during 1981 and 1982. In addition to the court-ordered disgorgement, defendant Ihne received a three and one-half year sentence in a companion Justice Department criminal prosecution.'"

In SEC v. Gaspar,"' negotiations between members of the Clark family and representatives for the private investment firm of DysonKissner- Moran (DKMJ were conducted in anticipation of an acquisition of the Clark family's forty-one percent holdings in Clark Oil Corporation. George Gaspar participated in the negotiations on behalf of Robert W. Baird & Company, an investment banking firm and broker-dealer representing DKM. Although the acquisition negotiations were terminated without purchase, Gaspar tipped Joseph Schreck, a registered representative of the broker-dealer firm of Smith Barney, Harris, Upham & Co., Inc. Other representatives of Smith Barney actively advised clients to purchase Clark shares during the acquisition negotiations in January, 1980. Gaspar and 'the Smith Barney representatives were aware of their employers' codes of ethics prohibiting such communications or trading. The court enjoined Gaspar from further violations since he and Baird were "temporary insiders" as the concept is defined in Dirks.250 Additionally, his "tips to Schreck amounted to a misappropriation or theft of confidential corporate information and operated as a 'fraud and deceit' upon Baird and DMK.'''" Other Smith· Barney brokers inherited the "disclose or abstain" duty as specified in Dirks.''' The Gaspar court combined features of Dirks, Rule 14e-3, and the misappropriation theoryt() prohibit all use of the misappropriated information.

Another series of misappropriation cases arose' out of an attempt by Standard Oil of California (Socall to take over Amax, l!lc."'' Socal held

'" Wall St. J., June 17,1985 at23, col. 2. James Stivaletti, a former stockbroker, served as a middleman to transfer the inside information. Stivaletti pled guilty to seven felony counts, was fined $10,000, and was sentenced to two and a half years in prison for his part in the scheme, Wall St. J., July 12, 1985, at 14, col. 5.

'" [1984-1985 Transfer Binder] FED. SEc. L. REP. 1 92,004 (SD.N,Y. 19851. · "' !d. at 90,975. '" !d. at 90,978-79. 252 ld. "' O'Connor & Assoc. v. Dean Witter Reynolds, Inc., 529 F •. S"upp'; :1179 IS.!:>,N.Y.19!!J)

!motion to dismiss denied), O'Connor & Assoc. v. DeanWi~r Reynolds,Irie., "FEb. SEc. L._ REP. ICGHI , JM1,1~ ldass .action cer~ificationl. O'Ooniior -&•.At!soe. v. Dean Witter Reyn!'l<ls.lnc._, FED. $Ec, L. REP.lCCHI 1 99,1132 !elan eertifreatlon ltn\lndment granted), O'Connor & Assoc. v. Dean Witter Reynolds, Inc,, FED. ·SEc. LiREP. (CCH), 91,527 (motion for leave to .amended complaint with alleged racketeering violation gruted), O'Connor & Assoc. v. Dean Witter Reynolds, Inc., FED. SEC. L. REP. (CCHl, 91,911 (defendant's motion for judgment on t]w pleadings denied), Additional!y;'oriminal and administrative enforcement actions arising from these facts include, United States v. Reed, FED. SEC. L. REP. ICCHJ, 91,927 (S.D.N.Y. 1985) (criminal prosecution, motion to dismiss misappropria-

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•

.. , susan van vacLor LgJ v.,.,; v ... v


approximately twenty percent of A max from 1975 until the two companies commenced secret merger negotiations in 1980. Gordon Reed, a member of Amax's board of directors, discussed the Socal negotiations several times with his son, Thomas Reed, a former national security advisor for the United States. The Reeds apparently exchanged confidential business information regularly. Gordon expected that Thomas would treat the Socal negotiations confidentially. Immediately after receiving informa· tion that Socal had proposed a $78.50 tender offer to the Amax board, Thomas purchased Amax call options that produced at least $431,000 in profit. Subsequently, the Amax board declined to support the tender offer. Nevertheless, the market value of Amax stock rose from about $38 to $57 after public disclosure.

O'Connor & Associates is an options trading firm that trades for its own account. During the period in which Reed and others traded on the nonpublic information concerning the Socai-Amax negotiations, O'Connor sold call options. O'Connor was granted a restraining order against the brokerage firms of Dean Witter Reynolds, Inc., and A.G. Becker, Inc., preventing the distribution of any profits realized from the option trades made for Reed and his nominees. The district court for the Southern District of New York held that Rule lOb-5 applied to options trading despite the absence of any direct fiduciary duty from the tippee to the option seller. It reasoned that Thomas Reed breached a fiduciary duty "to his father" in converting the confidential nonpu blic information about the Socai-Amax negotiations to his own use."' As a traditional insider, Reed's father was the source of inside information from the issuer. Therefore, the options trading firm could predicate its standing on this relationship without any circuitous piggyback or bootstrap theories that might have required expansion of the duty perimeter.'"

The SEC and the Justice Department have actively pursued insider trading actions with some novel twists on the misappropriation theory.'56

In SEC v. Thayer,''" the SEC alleged that in tipping a close personal friend, former deputy defense secretary Paul Thayer obtained sufficient "personal gain" for the tip to constitute an improper means under the Dirks tippee rule.'" Despite Thayer's failure to trade or profit on the informa· tion, the SEC alleged a violation of Rule lOb-5. Thayer and others set-

tion counts denied) and S.E.C. v. Reed, 97 F.R.D. 746 (S.D.N.Y. 1963) (cllflsent decree to disgorge profits from insider trades in options funds placed in escrow).

•~ O'Connor & Assoc., 529 F. Supp. at 1185. "' See supra text accompanying notes 208-13. "'See, e.g., S.E.C. v. Gaffney, FED. SEC. L. REP. (CCHl, 92.002 (S.D.N.Y. 1985). '" FED. SEC. L. REP. (CCHl, 99,718 (S.D.N.Y. 1984) (venue changed to Northern District

of Texas). "' Dirks, 463 U.S. at 662.



tied the SEC charges, receiving criminal fines and sentences in a companion Justice Department action.""

In a widely publicized case involving the financial press, a newspaper columnist was convicted of leaking advance notice of the substance of his "Heard on the Street" column. The resulting SEC enforcement action"" and the criminal prosecution''" were based on the misappropriation theory. Under this theory, the fiduciary duty runs in favor of the newspaper irrespective of any connection to a wrong directed toward the employer's (newspaper's) clients (readers).262 Another SEC investigation involved trading by CBS employees in put options of the G. D. Searle Corporation. 283 Searle is the sole manufacturer of N utrasweet, and CBS employees bought the put options prior to the public airing of a negative news report alleging health hazards with the product. In another incident, the New York Stock Exchange and the Chicago Board Options Exchange censured and fined Paine Webber, a broker-dealer, for "front running.''"' Prior to the issuance of a favorable report changing the investment recommendation made by Paine Webber's analyst for the automobile industry, the firm purchased General Motors stock and call options."' The censure ruling is a controversial extension of the misappropriation theory since it involves trading by the firm itself rather than by its employees or fiduciaries. This interpretation by a private regulator (the NYSE) reinforces the Supreme Court's recent broadening and firming of discipline on broker-dealers in the registration of investment advisory newsletters"" and liability to tippees for tipping inside information.'" A

"' Wall St. J., May 9, 1985. at 2. col. 2. "' S.E.C. v. Brant, [1984 Transfer Binderj FED. SEc. L. REP. (CCHI 1 91,571 (S.D.N.Y.

1984). "'' United States v. Winans, 612 F. Supp. 827 (S.D.N.Y. 19851. affd in part, rev'd in part,

FED. SEC. L. REP. (CCHI 1 92,742 (2d Cir. 1986). '" I d. at 840. "' Wall St. J., Feb. 24. 1984. at 14, col. 8 & Wall St. J., May 3. 1984, at 5. col. 1. "' Wall St. J., June 12. 1985, at 2. ~ol. 3. Paine Webber consented to the imposition of

the fines and the censure without admitting or denying the allegations. Under the settlement Paine Webber is to pay $15.000 to each exchange and institute written supervisory procedures to prevent such trading in the future. See infra text accompanying notes 304-22 for a discussion of the impact of corporate codes of conduct.

"' Paine Webber purchased 100,000 shares of General Motors on May 10, 1982 and 470 call options on May 11, 1982. Additionally, the firm sold approximately 470 put options on May 11, 1982. Each option contract entitled the holder to buy '••Ill or sell (put) 100 shares of the underlying GM stock. As a result, Paine Webber controlled 147,000 shares of GM which appreciated $1.25 per share on the day after the report was released. Call options primarily generate commission fees, Id.

"' Lowe v. S.E.C., 105 S. Ct. 2557 (1985). '" See supra text accompanying notes 214-15.



fine line between first amendment protections and government control of free speech is drawn by these recent eases.

The imposition of trading restrictions on market analysts and financial publishers is based on their visibility, impact, and status in the market. A writer's duty to readers arises when, "with knowledge of the stock market and an intent to gain personally, he encourage[s) purchases of the securities in the market.""' The restriction is applied "flexibly" whenever a relationship provides greater access to information which benrifits a trader who is aware that others will rely on recommendations initiated by the trader .... The appearance of an honest market, including the credibility of those who recommend it and create demand for certain securities, is enhanced by the existence of a duty to readers.'"'" Clearly, there is misappropriation of information, even if it is produced by the financial writer or analyst, since the benefits are intended for the employer (newspaper). The misappropriation theory applies when the misappropriator's trading arguably causes harm to the employer. However, there is no requirement that the employer's clients must also suffer harm.'" Indeed, the client is not a necessary figure in the misappropriation theory since the abuse of an employer's confidences is sufficient wrongdoing to trigger the trading restriction.27

'

The misappropriation theory also applies to cases arising under other federal anti-fraud statutes.273 Tl)e experience under the mail and wire fraud statute"" illustrates that criminal culpability is triggered by a breach of fiduciary duty to the principal arising from the fiduciary's misuse of position."' The reach of these general statutes is sufficiently broad to

"' Zweig v. Hearst Corp .. 594 F.2d 1261, 1268 {9th Cir. 1979) (merger partner sought damages from finanelal columnist who published a favorable artide concerning the other merger partner, columnist's article inflated the market price and columnist sold personal holdings during the market rise).

"' White v, Abrams, 495 F.2d 72!1, V35 (9th Cir; 19741, Crocker-Citizen's Nat'l Bank v. Control Metals Corp., 1166 F .2d 631, 633 n.2 (9th Cir. 1977).

'" Zweig, 594 F .2d at 1269. Zweig ean be distinguished from Winan.; since the latter in· volved no specific recommendations for security transactions. However, general news stories and specific recommendations in the finaMialj)ress may have similar impact on the market for securities so the distinction--may be irrelevant in many situations.

"' Winans, 612 F. Supp. at 1340. 'l.'he Justice Department originally argued that there was also a breach of duty to the readers of the Wall Street Journal. However, this addi· tiona! theory is unnecessary to trigger the trading restriction. ld. at n.7.

'" ld. at 841-44. '" E.g .. United States v. Girard, 601 F .2d 69 (2d CirJ, cert. denied, 444 U.S. 871 (1979);

United States v. Kent, 608 F.2d li42 (5th Cir. 1979). '" 18 u.s.c. §§ 1341-43 (1982). "' E.g., United States v. Von Barta, 635 F.2d 999,1003 (2d Cir. 1980); United States v.

Weiss, 752 F.2d 777 (2d Cir.1985); United States v. Siegel, 717 F.2d 9 (2d Cir.1983l; United States v. Margiotta, 68S F.2d 108 (2d Cir. 1982), cert. denied, 461 U.S. 913 (1983); United

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cover misappropriation in the securities trading context'!16 and in actions against government officials. 277 "There is abundant authority that a scheme to use a private fiduciary position to obtain pecuniary gain is within the mail fraud statute."'"

Circumstantial Evidence of Misappropriation

The single most perplexing problem with the enforcement of the insider trading restriction is detection and proof. The task of separating legitimate from illegal trading in the enormous volume of trading activity in options and the underlying securities presents an almost impossible task for the SEC and the Justice Department.'" New regulatory priorities and the shrinking real value of enforcement budgets have forced a major shift in the allocation of the SEC's enforcement effort toward insider trading at the expense of other matters.,.. Detection and substantiation of tippee trading activity is even more difficult without direct evidence or admissions. However, it appears that inferences derived from circumstantial evidence provide sufficient proof, particularly in injunctive cases."'

Absent an admission, five major issues arise in the proof of trading violations. First, the alleged misappropriator must have access to the nonpublic source of confidential information."" The demonstration of a confidential or fiduciary relationship often precedes and underlies the question of access.""' Second, the defendant must have acted with scienter,'84

although most cases allow liberal inferences from circumstantial evidence

States v. Bronston, 658 F.2d 920 (2d Cir. 1981), cert denied, 456 U.S. 915 (1982). But see United States v. Dixon, 536 F .2d 1388, 1399 (2d Cir. 1976); United States v. George, 477 F.2d 508,512 (7th Cir.l973) (mere breach of corporate fiduciary duty is not automatically within mail and wire fraud statute). See al$o United States v. Snyder, 668 F.2d 686, 691 (2d Cir.1982) (criminal conviction should not rest merely on breach of civil fiduciary duty): "[t]he additional element which frequently transforms a mere fiduciary breach into a criminal offense is a violation of the employee's duty to disclose material information to his employer."

"' Von Barta, 685 F.2d at 1006. United States v. Buckner, 108 F.2d 921 (2d Cir.l, eert. denied, 309 u.s. 669 (1940).

"' United States v. Mandel, 591 F.2d 1357, 1359 (4th Cir. 1979). "' United States v. Dixon, 536 F.2d 1388, 1399 (2d Cir. 1976). "' See, The Epidemic of Insider Trading, Business Week, Apr. 29, 1985 at 80-81. "' Statement of Gary Lynch, SEC enforcement director. Wall St. J .. Nov. 7, 1985, at

17, col.1; Statement of John M. Fedders, SEC enforcement director, Wall St. J .. Mar. 23, 1982. at 18, col. 3; Business Week, Feb. 11, 1985, at 61, col. 3.

'" University of Texas v. Camenisch, 451 U.S. 390,395 (1980); and Musella, 578 F. Supp. at 440.

"' Materia, FED. SEc. L. REP. (CCH) 1 99,583 at 97 ,274-97,283; and Musella, 578 F. Supp. at 440-41.

"' See infra text accompanying notes 305-20 (corporate codes of conduct restrict use of confidential information).

"' Ernst & Ernst v. Hoehfelder, 425 U.S.I85 (1976); Aaron v. S.E.C.,446 U.S. 680 (1980).


1986 I ContriYVersy Over Insider Trading I 607

to satisfy the scienter question. 285 A separate scienter consideration arises when tippee liability is at issue. The tippee must either have known or had reason to know that the tipper was breaching a fiduciary relationship in communicating the information .... Third, the issues of reliance and causation must be proved. However, these elements typically converge in an inquiry into the actual use of the confidential information. For example, if prior to trading the trader has access to information he knows is confidential, causation is presumed.'" Fourth, there must be a purchase or sale of the security.""' Typically, brokerage records provide documentation for the trading question.289 In tipping eases, a fifth element requires proof that the tipper has an improperr purpose in transferring the information. Usually the receipt of personal gain (i.e., a direct or indirect benefit) from making the tip would be considered improper.""" An examination of the evidence accepted in misappropriation cases suggests a liberal use of inference and presumptions, since the problem of proof-making is "like [fitting] pieces to a puzzle."'"

Three recent misappropriation cases illustrate the relatively thin proof deemed sufficient for insider trading cases. In Musella, ... access to client confidences by the office services manager of a large New York securities law firm was inferred from several organizational and operational

. routines. For example, the firm's attorneys used code names to conceal the identity of takeover targets. However, the office services group had access to information such as the annual reports of potential targets, photoc(lpies of documents with coded target names before the coding took place, SEC filings, and the names and inter-office correspondence of the attorneys involved in tender offer work (the takeover group). Access to confidential information may be inferred from circumstances in which the misappropriator has limited access to pieces of the puzzle if they can be reasonably related to reveal definitive confidential information.

'" Herman & MacLean v. Huddleston, 459 U.S. 375, 103 S. Ct. 683, 692 n.30 (1983): The proof of scienter required in fraud cases is often a matter of inference from circumstantial evidence. If anything, the difficulty of proving the defendant's state of mind supports a lower standard of proof Power than a preponderance of the evidence]. In any event, we have noted elsewhere that circumstantial evidence can be more than sufficient.

'" Dirks, 463 U.S. at 660, 661. '" Musella, 578 F. Supp. at 441; Gaspar, FED. SEc. L. REP. (CCH) at 90,975. "' See supra notes 181-83 and accompanying text. "' The parties often stipulate to trading or fail to dispute evidence of trading from

brokerage records, phone conversations, and other communications or transactions, Gaspar, FED. SEc. L. REP. (CCH) at 90,970-73.

"' Dirks, 463 U.S. at 662. "' Musella, 578 F. Supp. at 441. "' Jd. at 440.



In Materia, ... access to confidential information concerning takeover targets was presumed due to the consistent parallels in behavior between the clients of Bowne (a financial printerj and Materia's trading activity. That Materia's estranged wife had access to this information was presumed since the two spouses communicated readily with a stepson who also traded in the target's securities. Inferences about the flow of information ("a demonstrable link"j were reinforced by records of foreign telephone calls, ... friendships between insiders and tippees, ... and the timing of all trading activity involving only the securities of targets."' Although few evidentiary sources can usually be adduced, it appears that strong inferences have also been drawn froni circumstances such as "substantial amounts of money invested ... on the rare occasions when they entered the market; ... intimate relationships; ... the ... sudden burst of intense trading in [the target's] ... securities: and the remarkable overlap and seeming orchestration of the ... trades."'"' However, charges of illegal tippee trading brought against Materia's estranged wife, Concetta, were dismissed because proof of Materia's improper purpose and Concetta's scienter was unconvincing. The general community of financial interest that the estranged couple had due to their filing of joint tax returns and Materia's payment of child support was not sufficient to constitute a personal benefit to Materia from the alleged tipping.'"' Similarly insufficient was the evidence that Concetta recklessly disregarded the likelihood that her parallel trading with her husband was based on confidential information.'"' Apparently, she may have thought Materia's "stock-aholic" level of interest in the market was sufficient reason for her to invest. Coneetta's Jack of market sophistication justified the con· elusion that she did not know that the source of the information was confidential despite the fortunate coincidence in profitable tender -offer investments.""'

•• Materia, FED. SEc. L. REP. (CCH) 1 99,583 at 97,281. "' Stinletti spoke to both Ihne (insider) knd Musella (tippee) from Hong Kong ]ust prior

to the commencement of trading activity. MIUlella, 578 F. Supp. at 441. "' Id. Ihne was a "drinking partner" of Stivaletti. "' !d. " ... ]there are] inferences as to actual disclosure and scienter that naturally and

compellingly flow therefrom:· Materia, FED. SEc. L. REP. (CCHl 1 99.583 at 97,281. '" Musella, 578 F. Supp. at 441. · "' Materia, FED. SEc. L. REP. ICCHl 199.583 at 97,282. "' I d. at 97,283. *" I d. However, ln Musella a similar relationship suggested a conscious tipping link where

the tippee was a more sophisticated investor: "Even assuming he was initially in the dark, certainly the announcement of the Mobil-Marathon tender offer immediately after his purchase of Marathon call options should have led him to question the "fortuity" of his timing before taking advantage of further brotherly stock tips."" Musella,578 F. Supp. at 442.

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The defendant in Gaspar•" failed to dispute evidence of access ae· eomplished through telephone calls and brokerage records. Calls between Gaspar, the potential aequirer's negotiator, and brokers at Smith Barney established the likely flow of misappropriated information. Trading records for Smith Barney customers coincided with datesC)f the negotia· tions and established the illegal trading. The court then inferred the eon· nection between misapproprQ!ted information and illega1 trading by Smith Barney subtippees, despite co11tentio.nsthat no fiduciary duty was owed to particular purchasers and that Smith Barney utilized "technical analysis""'" to recommend trades.

The hearsay rule is inapplicable to the testimony and records used to establish the demonstrable link of confidential information flow. Thus, testimony by brokerage customers concerning statements made to them by tl\eir brokerage representatives are not excluded on this basis.'"' These statements are not offered to prove the truth of what is said (e.g., that the Clark/DKM negotiations were pending). Instead, customer testimony provides circumstantial evidence of the passage of information from the misappropriator through various tippees to subtippees.''"

Corporate Codes ofConduct

The trading restriction and the "disclose or abstain" obligation depend on the existence of a fiduciary relationship."'' In traditional "insider" trading analysis, the requisite fiduciary relationship arises whenever of· ficers, directors, employees, or temporary insiders800 possess confiden· tial information concerning the issuer. However, the generalized misap· propriatlon theory bases the trading restriction on the existence of a fiduciary relationship with any entity "inside" or "outside" the issuer whose shares are traded. Thereafter, it becomes n~essary to demonstrate the co11fidential nature of the fiduciary's relationship to the employer, the existence of which is reinforced by any firm-imposed trading restric· tion. An increasing number of United States corporations impose insider trading restrictions on all employees who have regular access to confiden· tial informatlon.30

' It is important to determine the exil!tence, purpose, and scope of these corporate ethics statements because they may trig-

"'' Gaspar, FED. SEc. L. REP. (CCH) at 90,968. "" Technical analysis involves tho prediction of st.ock price movements based on the

behavior of past price movements and trading volume. This fnrm of analysis does not in· vnlve a fundamental analysis of corporate financial performance or expectation.

"" Gaspar, FED. SEc. L. REP. (CCHl at 90,97$ n.2. "' I d. See Scholle v. Cuban-Venezuelan Oil Voting Trust, 285 F.2d 318,321 (2d Cir.l960). "' See supra notes 169,83 and accompanying text. "' Dirks, 463 U.S. at 6·55 n.l4. "' Chatov, What Corporate Ethics Statements Say, 22 CAt.IF. MGMT. REV. 20 (19801.

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ger the trading restriction in both "insider" and "outsider" trading cases, apart from any analysis of inherent fiduciary duties.

Corporate ethical codes may explicitly mention a trading restriction, or it may be inferable from other ethical principles. First, the ethics statement might specifically prohibit trading in the issuer's own securities if it is based on inside information. Second, the restriction may attach to the securities of the firm's clients. Third, a general restriction may extend to confidential information about any firm irrespective of whether it is a client. Non-clients could include a tender-offer target, another firm investigated by the firm for journalistic purposes, or a firm being researched for financial recommendation purposes. Fourth, the restriction might be inferred from a general prohibition against personal exploitation of information collected for a corporate purpose. Fifth, some combination of these prohibitions could conceivably be constructed in response to particular abuses or pressures. In addition to the classification of the restricted information, the code could restrict individual employee trading, firm trading, or both. Questions about the legal effect of these corporate ethical restrictions arise whenever a misappropriation case is predicated on internal policies and procedures.

It has been argued that if firms perceived any economic benefit in restricting insider trading, they would restrict it."" Several commentators argue that apart from recent reaction to insider trading prosecutions, few firms restrict insider trading.'" Indeed, some firms might seek to reward employees by permitting trading on confidential information. However, recent empirical research casts doubt on these accounts and indicates that insider trading is the fifth most frequently prohibited activity among the growing number of firms imposing codes of ethics, with restrictions against conflicts of interest ranking second.'" The existence of an explicit corporate trading restriction facilitates a finding that the requisite fiduciary duty exists, thereby triggering the application of the misappropriation theory. ·

In response to the Dirks decision, the Financial Analysts Federation Code of Ethics and Standards of Professional Conduct was amended to restrict trading on material nonpublic information."' Such professional

"' Note, lrurirkr Trading at CIW!mon Law, 51 U. CHI. L. REV. 838, 857 (1984). "" Carlton & Fischel. supra Dote lO,at 858; DooJ;ay, En/CII'OO'ff!IJ1It oflmtider 'I'rading Restric

tions, 66 VA. L. REv. 1, 44-45 (1980); Easterbreok, supm note 10. at 333; Wang. Trading on Material Non public I nformati<m on Impersonal Stock Markets: Who is Ha'l'mlid, and Who Cnn Sue Whom Under SEC Rule JOb-5?, 54 S. CAL. L. REv. 1217 (1981).

"' Chatov, What Corporate Ethics Statements Say, 22 CALIF. MGMT. REV. 20 (1980). "' Prohibition .. , The financial analyst shall comply with all laws and regulations

relating to the use of material non-public information. (1) If the analyst acquires such information as a result of a special or confidential relationship with the issuer, he shall not communicate the information (other than within the rela-


1986 I Controversy Over Insider Trading /611

association codes of conduct may validly be used in situations involving internal disciplinary actions. Additionally, corporate ethical codes often receive considerable weight in legal actions."' Indeed, criminal liability may be premised on corporate internal policies."' Recent misappropria· tion cases have reaffirmed the applicability of ethical codes in outsider trading cases. For example, in Musella'" the court took judicial notice of a law firm's policy against public discussion of sensitive client infor· mation despite the SEC's failure to prove the existence of the policy. The financial printer in Materia"' posted its trading restrictions for all employees to see. Gaspar was aware of the professional Code of Ethics and Standards of Professional Conduct adopted by his employer."' Com· munication of the ethical policy is sufficient to trigger the fiduciary duty and concomitant legal trading restricti(!n.'" The SEC probably will in· sist on the imposition of trading restrictions and the associated cloak of confidentiality in its negotiation of consent decrees.

Absent specific codes of conduct, the behavior of firms, as revealed by their internal control and work procedures, may also form the basis for an implied trading restriction. For example, the efforts to maintain client·confidences by the financial printer in Materia and the law firm in Musella would permit the inference of an internal trading restriction. The obvious use of code names in internal memoranda was "certainly an indicia of confidlmtiality.""' The blanking out of firm names in documents••• and the stamping of the word "confidential" on identifying documents illustrate that the confidentiality requirement is well known to employees."" It appears that courts have no trouble interpreting policies, codes of conduct, and work procedures so as to presume that

tionship), or take inve•tment adion on the basis of such information, if it violates that relationship. (2) If the analyst is not in a special or confidential relationship with the issuer, he shall. not communicate or act on material non-public information if he knows or should have known that such information was disclosed to him in breach of a duty. If such a breach exists, the analyst shall make reasonable efforts to achieve public dissemination of such information.

THE FINANCIAL ANALYSTS FEDERATION CODE OF ETHICS AND STANDARDS OF CONDUCT, as amended Apr, 29. 1984.

"' See generally Snapper, Whether Profestrional AssociatiO'M May Enforce Professional Corks, 3 Bus. & PIIOF. Ethics J. 43 (1984).

"' Winans, 612 F. Supp. at 843. See also Von Barta. 635 F.2d at 1007. ~• Musella, 578 F. Supp, at 439. "' Materia, FED. SEC, L. REP. (CCH) 199,526 to 97,026. '" Gaspar, FED. SEC, L. REP. (CCH) , 92,004 at 90,975. "" Materia, FED. SEC. L. REP. (CCH) , 99,526 at 97,026. "' Musella, 578 F. Supp, at 439. 3!9 /d. "' Materia, FED, SEC. L. REP. (CCH) 1 99,583 at 97,275.

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612 I Vol. 24 I American Busin«~B Law Journal

employees are aware of general trading restrictions. Indeed, the SEC's insistence on the addition of such code provisions in consent decrees assures even greater applicability of the trading restriction.

DISCUSSION AND IMPLJCATfONS

Recent developments in insider tl'ading restrictions have continued to narrow the focus of the issue!llitigated,ll!&ding to a refinement of the applicable duty. But the emergence of the misappl'opriatiQn theory has presented a most striking paradox .. The conventional wisdom assumes that the original source of information triggering the trading restriction must reside within the issuer.•" However, this restrictive interpretation is flatly rejected by the misappropriation cases,M and implicitly rejected by Congress'"' and the Supreme Court .... Emergence oft he misappropriation theory necessitates a reappraisal of the parameters of trading information, including its source, its publication, and certain expectations concerning its use.

Classifications of Information

The most obvious informational classification is the public/nonpubli<: distinction. Public availability of information can be assumed if the issuer distributes a press release or bas filed required disclosure statements with a government ageney, or if the information is generally available.325

The suffieiency of efforts to make information public is CTueial to securities fraud and related disclosure problell\$. However, the sole use of this distinctiop to trigger the trading restriction suggests adoption of the in. formation parity rule rejected as inefficient in ChiareUa. Therefore, another indicator of the sensitivity of information must be developed.

A second informational dichotomy that distinguishes between "inside" and "outside" information has been offered .... " 'Inside' information

"generallY concerns the internal business affairs of the issuer- assets and

"' See United States v. Reed, ($.D.N.Y .1985), 91.927 FED. S11:c. L. REP. (CCHI at 90,603. See gerwrally Poser, Miou$e ofCcmfidetl.tiall'/iformation C.mrerning a Tender Offer as a Securities Fraud, 49 BROOKLYN L. REV. 1265, 1270 (1983), Brudney, SUJR"l note 10, at 331.

·'" See supra notes 147-320 and accompanying text. '" See supra note 127. "' Dirks, 463 U.S. at 61!5. "' The "public" naturel>f i11formation is addressed in the Federal Securities Code which

defines generally available as a "fact ... [being] ... generally available one week (or any other period prescribed by Commission rule) after it is disclosed by m11ans of a filing or press release or in any other manner reJ~sonably desigood to briqg it to tm, attention of the investing publi~. Otherwise the burden of proving that a fact is 'generally available' is on the person who so asserts." A.L.I. FED. SEC. CODE S 265 (1978).

"" Mo.<.<, 719 F 2d at 10 n.9.

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1986 I ContrfYIIersy Over Insider Trading 1 613

earning power."1127 Outside information is generated from outside the issuer. Outsiders who may process confidential nonpublic material information that could affect the price or the markflt for an issuer's securities include: institutional investors; tender offerors: investment bankers; government officials; judges; judicial clerkS; columnists; law firms: accounting firms; investment bankers; investmentan:alysts; stock exchange professionals (e.g., market makers, floor traders, specialists, block positioners, and odd-lot dealers); and other ecinsultants representing an issuer, tender offeror, or potential merger partner.Outsideinformation is created by sources outside the issuer who are not insiders in the traditional sense and often are not tippees. Outside information may Include interpretive comment by professional analysts relating to the issuer's credit; supply prospects, sales .prospects, or expected cash flows, or to market activity in the issuer's securities. Additionally, it may relate to the outsider's intentions to make new contracts with the issuer for purchases or sales of the issuer's products or securities. For example, .a supplier might award a lucrative contract to the issuer, resulting in a favorable impact on the issuer's securities. Alternatively, a customer placing a large order with the issuer could cause the use of idle capacity, favorably affecting the issuer's securities. In either case, the outsider possesses nonpu blic information that eould enhance trading opportunities.

Imposition of the trading restriction on outsiders becomes more problematic where influential analysts' statements are given great weight by the market. For example, Henry Kaufman, chief economist at Soloman Brothers, often comments on market conditions, and this apparently causes pronounced market movements. A former SEd enforcement chief has indicated that Soloman Brothers is free to trade on the basis of these comments,!l!ll However, the SEC considers it inappropriate for the publishers of.financialllewsletters to trade in ad vane\!! of the publication of an analytical article with potefitiaJ market imj;llict;m While at first it appears that there is 'little difference between trading by analysts and trading by their employers, a closer examination reveals the crucial fiduciary link. Financial advisors like Winans, the author of the "Heard on the Street" column in .the Wa,llStreetJournal, have personal and confidential relationships with their employers. Thel!e relationships trigger the trading restriction. Under an expansive version of the misappropriation theory, both the employer and the employee have an additional fiduciary duty to readers and other clients not to trade in advance of a

"' !d. m See Statement of Fedders. Wall St. J .. Feb. 26, 1985, at 6. '" See, e.g., Wall St. J., Dec. 20, 1984. at 6.

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market-moving publication.""' However, so long as an analyst's comments are not published primarily for the benefit of clients or readers but are simply announced publicly, no fiduciary duty to the market would arise.'"

Although the inside versus outside information dichotomy is the traditional classification, it is imprecise. Instead, the crucial factor is the general public's access to the information. Where this is absent, information concerning market or financial performance has a confidential character that gives advantages to its possessors. Such situations pro· perly trigger the trading restriction. Therefore, it is not especially useful to separate inside information from outside information, since these qualifiers refer only to the original source of the information and not to its availability or confidentiality.

Without the incentive to profit from information generated by outsiders, there would be a great loss. of the mechanisms leading to market equilibrium and efficiency. It is important to retain the benefits of the analytical activities of independent market participants because they con· tribute to efficiency. Private use of confidential information belonging to an issuer, a temporary insider, or an employer must be distinguished from the "perceptive analysis of generally known facts" that may validly be exploited by an investor.""' Therefore, the inside/outside information dichotomy fails to provide a sufficiently discriminating test for trigger· ing the tradil)g restriction. Over-reliance on this distinction could remove important incentives to undertake security analysis and entrepreneurial market research.'"

Another view of outside information compares it to "'market' information (that] is related solely to the market for securities rather than their intrinsic value.""" By contrast, inside information is analogous to "corporate" information concerning the issuer's performance and operations, and may include such things as research discoveries, level of business activities, or internal financial and operational decisions. A narrow interpretation of market information•% encompasses the trading ac-

~ See also Searle (Nutrasweet) option investigation, Wall St. J .• Feb. 27, 1984, at 24 and Zweig. 594 F.2d at 1270.

'" However. a personal fiduciary duty to the analyst's employer would still prohibit personal trading by the analyst.

"' Cady Roberts, 40 S.E.C. at 915. :~'1.1 "Nor is an insider obligated to confer upon outside investors the benefit of his superior

financial or other expert analysis by discl<>sing his educated guesses or predictions." Texas Gulf Sulphur Co .. 401 F.2d at 848. Indeed, no such obligation exists at common law without proof of fraudulent concealment, Goodwin v. Agassiz, 283 Mass. 358, 363, 186 N .E. 659, 661 (1933).

"' Moss, 719 F.2d at 10 n.9. "' See generally, Brudney. supra note 10, at 333.



tivities of the capital markets, but only in relation to the issuer. It includes, for example, large block trades,338 investment advisory recommendations,337 specialists' assessments of trading activity, and potential tender offers. The narrower market activity classification represents technical trading, timing, and volume data with a recognized value in aiding the prediction of stock price movements. A more general type of outside or market information affecting the issuer relates to factors such as the macro conditions of the economy, competitive pressures, foreign affairs, and regulation. In general, market information relates to the market for an issuer's securities, as distinct from information about its assets and earning power. 33

'

A third informational dichotomy focuses on the intent and efforts of the issuer, temporary insider, or takeover bidder to maintain the privacy of the information. The "confidentiality" of information refers to both the "right" and the "efforts" made to prevent others from learning it. Some confidential matters relate to the issuer's operational performance and have a direct and immediate exploitable value to competitors. These include, for example, trade secrets, patents, research findings, and management and operational techniques. Other confidential matters, transmitted solely for corporate purposes, are broader than trade secret information because they may include financial and tender-offer information.

Although the classifications just mentioned are convenient, they overlap and are too simple to be useful in modern insider- trading analysis. For example, publicizing information does not assure its wide a vailability because the prominence given or importance attached to it may depend on a host of factors independent of the issuer. Although it may be intuitively appealing at first, the public/non public dichotomy requires proof that an official or overt effort is made to disseminate the information. The possibility of leaks and the difficulty of their proof makes the "public" designation unworkable. The inside/outside distinction fails to capture the fiduciary roots of the misappropriation cases. Without general agreement that the boundaries separating inside from outside information may exist apart from the issuer, the distinction fails adequately to describe the confidentiality thrust of the misappropriation theory.

'" See, e.g., Regen v. Ilikon Corp.,361 F .2d 260,264 (1stCir.1966);Reed v.Riddle Airlines, Inc., 266 F .2d 314,315,319 (5th Cir.1959); Brascan Ltd. v. Edper·Equities Ltd.,[1979 Transfer Binder] FED. SEc. L. REP. (CCH) 196,882 (S.D.N.Y. 1979).

"' Zweig v. Hearst Corp .• 594 F.2d 1261 (9th Cir. 1979). "" For an empirical review of the trading advantages and profit opportunities possessed

by specialists due to their first-hand access to trading activity, see Niederhoffer & Osborne, Market Making atul Rewrsal <m tiiiJ Stook Exchange, 61 J. AM. STATISTICAL ASS'N, 879 (1959).

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The presence or absence of confidentiality also presents an imperfect distinction since it subsumes two distinct elements. First, confidentiality implies that intentional worts are undertaken to maintain secrecy. Second, the right to maintain confidentiality may arise independently of the efforts undertaken. The right to confidentiality arises from the general privacy right, statutory privacy rights (e.g., patents), the common law of trade secrets,33

' fiduciary obligations, or efforts to keep trade secrets confidential. However, no right of confidentiality exists if a regulatory provision requires disclosure. These imperfections require a new analysis of informational parameters and the trading restrictions implied by confidentiality.

A New Analysis for "Insider Trading"

The basic factors to be considered in insider trading cases should center on: (1) identification of the original source of the information, (2) the presence of a right to maintain confidentiality, (3) the intent to maintain confidentiality, and (4) efforts to do so.34' This analysis fits neatly into the misappropriation theory since under that theory: (1) a fiduciary source, (2) requires or implies the right to confidentiality, (3) as long as the beneficiary intends to maintain confidentiality,'" and (4) makes an effort to do so. Thus, use .of information for personal gain, secured through a confidential relationship and intended only for a corporate purpose,'" trig· gers 10b-51iability.34' "Unexploitable" and "unerodable" information advantages may lead to an "unintended" ... use of the information through trading.lf other investors may not lawfully obtain the confidential information, then an illegal trading advantage arises.34' The presence of these

"' "One who discloses or uses another's trade seeret, without a privilege to do so, is liable to the other if .. ·"- be discovered the seeret by.improper means, or b. his disclosure or use constitutes a breach of confidence reposed in him by the other in disclosing the secret to him." REsTATEMENT OF ToRi'S S 257 (1939).

'"' "[Means of trade secret access] which are improper are theft, trespass, bribing, or otherwise inducing employees or others to reveal the information in breach of duty, fraudulent misrepresentations, threats of harm by unlawful eonduet, wiretapping, procuring one's own employees or agents to become employees of the other for purposes of espionage. and so forth." RESTATEMENT oF ToRTS § 259, Comment c, (1939). "In general [Improper means of discoveryl ... "are means which fall below the general accepted standards of commercial morality and reasonable conduct_" RESTATEMENT OF TORTS§ 257 comment f (1939).

"' Barry, The Erxrnmnics oJOutside/nf(fl"WJ.(;ion on Rule IOb-5, 129 U. PA. L. REV. 1307, 1355·59 (1981).

'" See supra text accompanying notes 169-83, 228-32, and 299-317. "' Cady Roberts, 40 S.E.C. at 9ll. "' Barry, TheEI)Onomics ofOut•idelnformatitm anLlRule JOb-5.129 U. PA. L. REv.I307,

1360·65, 1389 (1981). "' Brudney, supra note 10.

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1986 I Contrrrversy Over Insider Trading I 617

elements triggers a more precise and reliable basis for restricted trading than do the other insider definitions used in the past.

When used to indicate the existence of confidentiality and trigger the trading restriction, the elements of source, right, intent, and efforts apply neatly to the misappropriation cases decided thus far. For example, in Newman"" and Moss"~ the source of the merger information used by Courtois and Antoniu originated from within their employer, Morgan Stanley. The investment banker bad only a limited right to use the information for consulting purposes since it was provided in C\)nfidence by clients only for purposes of tender-offer analysis ... , However, neither Courtois or A!)toniu had a right to use the information, because it was received and produced !!Olely for the corporate purpose of serving the Morgan Stanley clients. Finally, the intent and efforts of Morgan Stanley to maintain confidentiality of the private r.evelations of clients can be inferred from the nature of the fiduciary duty owed to Morgan Stanley."' The specific intention to maintain confidentiality is presumed because of the sensitivity of tender-offer plans and the nature of the consulting relationship.,.. The Musella}•• case is susceptible to the same analysis even though the temporary insider was a law firm engaged in consulting for acquisition and reorgani~ation matters. Clients were the source of private information provided in confidence to Sullivan and Cromwell only for the business purpose of obtaining legal advice. Thereafter, the law firm made extensive intentional efforts to maintain secrecy, thus satisfying the four criteria. 352

Similar results arise by applying the source/rights/intent/efforts elements to the financial printers in CkiareUa"" andMateria.854 Both Pandick and Bowne received information from clients about impending acquisitions. The clients had an exclusive right to this information because it was intended only for corporate purposes, and was transferred only to facilitate financial printing services necessary for the tender offers.

"" Newman. 664 F.2d at 14. "' Moss, 719 F.2d at 13. "' Since Morgan Stanley received the information as a temporary insider under the

theory annnunced in Dirks, 463 U.S. at 655 n.14, Morgan Stanley would have no right to trade for its own corporate account. There is no evidence ofan "arnls-length" bargaining positi<>n between Morgan Stanley and the tender offer targets which has been held to legitimize trading by a potential takeover negotiator which previously negotiated with the target, see supra notes 176-80 and accompanying text.

"'Newman, 664 F.2d at 17. "' See supra notes 276-317 and accompanying text. '" Musella. 578 F. Supp. at 436. See Dirks v. S.E.C .• 463 U.S. 646, 655 n.14. "' See supra note 287 and aeeompanying text. "' 445 u.s. 222 (1980). "' Materia, 745 F.2d 197.

1



The prints hop employees deciphered the information despite significant intentional efforts by their employers to maintain secrecy .355

This analysis is particularly useful when we consider the more novel applications of the misappropriation theory to the financial press in Brant:"' and Winans,"' or the recognition of a fiduciary duty owed to a relative or close confidant in Reed.358 The author ofthe Wall Street Journal "Heard on the Street" column produced information only for the newspaper's use. Therefore, the newspaper is the source of the information. Until publication, the right to use the information rests only with the newspaper. Confidentiality is expected of all reporters, as is evidenced hy the Journal's internal policy. Similarly, Thomas Reed regularly received confidential information from his father, a traditional insider, under the expectation of confidentiality. These new theories do not expand the insider trading restriction beyond its fiduciary roots when the source/right/intent/efforts elements are considered.'"

Defining the trading restriction by the sourcelrightlintentlefforts criteria may prove to be superior to other definitions for four reasons. First, there will likely be greater public acceptance of an insider trading definition derived from misappropriation, conduct widely considered reprehensible. Although the "insider" label is likely to stick, there is growing recognition that the term does not necessarily relate to the issuer whose shares are traded, but instead relates to unerodable informational advantages. Second, any broader definition of "insider" raises nearly insurmountable enforcement problems. Misappropriation often leaves its own trail and the beneficiary has an incentive to reduce the negative impact. Third, misappropriation will not reduce analysts' incentives to produce useful information, because legitimate efforts to undertake security analysis are preserved. Finally, misappropriation is consistent with the longstanding fiduciary duties of confidentiality derived from the common law. Theories emphasizing "insider" status fail to squarely recognize the universality of the fiduciary roots underlying the trading restriction.

:15

·1 See supra text accompanying nQtes 314-17.

'~ S.E.C. v. Brant. (1984 Transfer Binder) FED. SEc. L. REP. (CCHl, 91,571 (S.D.N.Y. 1984): See supra text accompanying note 263 (Nutrasweet investigation of trading by CBS employees) and text accompanying notes 264 & 265 ("front running" recommendatiOJIS by investment advisor Paine W.:bber).

'" United Statesv. Winans, 612 F. Supp. 827 (S.D.N.¥.1985), aff'd in part, rev'd in part. FED. SEC. L. REP., 92,742 (2d Cir. 1986).

"' See supra notes 253-54 and accompanying text. '" As a result, this approach may be superior to that proposed by the ABA Task Force

Report since it does not require legislation, preserves existing case law, maintains the anti -fraud and fiduciary roots of the trading restriction, and tolerates gTeater participa· tion by private plaintiffs in RICO actions and in private injunctive actions.

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CONCLUSION

Developments in the economic theory, judicial attitudes, and legislative intent behind regulation of insider trading require a reappraisal of several disturbing paradoxes presented by the trading restriction. 'rhe evolving conceptual framework, public policy considerations, and definitions exhibit dissonance and contradictions demanding further efforts at reconciliation. However, some conceptual ironies noted in the past have been resolved by the emerging misappropriation theory. For example, the fiduciary roots of the trading restriction are inconsistent with the SEC's egalitarian "parity of information" rule.""" But the abandonment of that prinCiple in Chiarella' .. resolves one of the most disturbing p;~radoxes in anti-fraud securities regulation. Thus, incentives for market makers, specialists, and analysts to produce information are preserved, with attendant benefits for the whol~ market. Another irony has been the apparent emphasis on and perceived importance of insider trading enforcement. However, the disgorgement penalty has provided Iittledisincentive to insider trading. With passage of the ITS A, its imposition of a treble penalty, and increases in criminal prosecutions, the disharmony between enforcement efforts and insufficient penalties is also resolved. However, there are still several apparent contradictions between the misappropriation theory and existing case Ia w.

In Sante Fe Industries v. Green;•• the Supreme Court required that lOb-5 plaintiffs must prove deception by the defendant in private antifraud suits, a requirement not specifically addressed in misappropriation cases. There are three pOssible ways to resolve this apparent conflict. First, the tacit congressional approval ofthe miSacppropriation theory could actually overrule the Sante Fe dece}ltion requirement. However, it is unlikely that Congress intended such a result since the Sante Fe district court expanded lOb-5 beyond its federal applicability into traditional areas of state corporate law. Second, Sante Fe may be read to require proof of deception oitly in private actions for corporatE\ mismanage-

"' The SEC advocated the adoption of a precise definition for insider information which strongly suggests a per se rule i>f information possession. However, this is equivalent to the information parity approach which may be damaging to the incentives to produce beneficial information. Some commentators accept this broad rule as definitive: "the act of purchasing or selling securities while in possession of material, non public information about an issuer or the trading market for an issuer's securities," H.R. REP. No. 355, 98th Con g., lstSess. 2 n.3 (1983) '>'e'p'l"inted in 198.4 U.S. CODE CoNG. & AD. NEWS 2274,2293 n.33. See generally. Comment, Insi<k In/ormation nnd fh!tside TradJJrs: Corporate Recovery of the Outsi<kr's Unfair Gain, 73 CALIF. L. REV. 482, 496 (198~).

'" ChiareUa, 445 U.S. at 229. "' 430 u.s. 462, 473-74 (1977).

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620 I Vol. 24 I American Business Law Journa;l

ment, where standing is examined more closely .... Implied rights of action are construed strictly and the deception requirement assures that unfounded suits are limited. Third, the breach of confidentiality inherent in misappropriation cases may be equivalent to deception. Under this last argument, the misappropriation of information for personal use involves a deceptive breach of trust. Some judicial language suggests that this linkage is inferred from fraudulent behavior directed at anyone.'"' Therefore, deception arises from fraudulent conduct without necessity of proof that the deception causes damage to flow from the misappropriator to persons trading with the misappropriator."' The inclusion of option transactions within the trading restriction reinforce!! the irrelevance of the damage path .... Misappropriation merely triggers the trading restriction since the primary objective of the securities laws is to maintain the integrity of the securities markets. The compensation of victims is secondary and should not pose conceptual hurdles to antifraud enforcement. However, the conceptual conflict between the Sante Fe deception requirement and the misappropriation theory must be addressed in future cases to maintain the legitimacy of both.

It might appear that developments in the misappropriation theory and passage of the ITSA signal a clean break with the insider trading jurisprudence of the past. However, several insider trading themes have emerged to reinforce the "disclose or abstain" rule as originally envisioned. The fiduciary duty serves to trigger the trading restriction without requiring analysis of damages to the Issuer. Indeed, the prin· cipal justification for the trading restriction continues to be the protection of the capital markets. Yet, it is necessary to enforce meaningful disincentives to insider trading. A more commonsensical interpretation of "inside" information emerges when it is replaced by the label "con· fidential," thereby permitting the trading restriction to retain its public acceptance and internal consistency. Confidentiality is a more precise Indicator of liability and is consistent with the spirit of the original legislation. It also may be appropriate to rethink the unfairness element from Cady Roberts, 0117 which is better equated with the unerodability of information advantages or the unintended use of private information. Further legitimacy can be brought to the development of the insider trading restriction only by returning to its fiduciary roots and abandoning the SEC's information-parity approach.

"' See supra notes 183-216 and accompanying text. "' See supra notes 157-182 & 189 and accompanying text. ~• See ,,upra note 167 and accompanying text. "' See 15 U.S.C. § 78cc(a) (1982). ~' Cady Roberts. 40 S.E.C. at 911.

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