The otherwise laudable efforts of the Securities and Exchange Commission (SEC or Commission) to rein in trading on the basis of material nonpublic information (MNPI) have been accompanied by an administrative overreach when the SEC adopted a rule that seeks to define an essential element of unlawful insider trading. This Article does not argue that the rule should have been drafted differently as a matter of judgment among permissible alternatives, as many who commented on the proposed rule argued. Rather, this Article addresses the heart of the rule, demonstrating fundamental legal shortcomings. The flawed aspects of the rule should not be countenanced—they are not enforceable.
I. Introduction
A. The Law of Insider Trading in Summary
A substantial body of federal common law delineates when it is unlawful to trade securities based on MNPI. This law springs primarily from SEC Rule 10b-5, adopted pursuant to authority granted by section 10(b) of the Exchange Act.
Under the classical, or traditional, theory of insider trading, Rule 10b-5 is “violated when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information” about the company or its securities. This is because “a relationship of trust and confidence” exists “between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.” In open market transactions, Rule 10b-5 imposes a duty upon the insider to make public disclosure of the MNPI before trading or to abstain from trading. Under the classical theory, the duty to abstain or disclose is imposed not only upon a member of the board of directors and a senior officer of the company but upon any employee of the company that issued the securities in which the “insider” traded. This theory also reaches a “temporary insider.”
Under the misappropriation theory of insider trading, a person—whether or not she is an insider of the company in whose securities she trades—violates Rule 10b-5 when she takes confidential information, for securities trading purposes, in breach of a duty owed to the source of the information. There the trader violates Rule 10b-5 by the undisclosed, self-serving use of a another’s information to purchase or sell securities, in breach of a duty of loyalty and confidentiality to the source of the information. There is no requirement that the trader first obtain permission from the source to trade nor, unlike the classical theory, is there a requirement to make public disclosure of the MNPI before trading.
A fact is material if there is a substantial likelihood that a reasonable investor would consider it important in making an investment decision. An omitted fact is material if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the “total mix” of information made available. “[W]ith respect to contingent or speculative information or events . . . materiality ‘will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of the company activity.’” Whether information is nonpublic is usually addressed by determining whether the information is public.
A person who cannot lawfully trade under either theory who conveys MNPI to another may be liable for unlawful tipping. A recipient of the information who trades may be liable as a tippee. The elements of wrongful tipping and tippee trading need not be understood for purposes of this Article.
In any claim brought under section 10(b) and Rule 10b-5 the plaintiff, including the SEC in an enforcement action, must plead and prove that the defendant acted with scienter, “a mental state embracing intent to deceive, manipulate, or defraud.” The SEC has the power to bring a civil action against someone alleged to have engaged in insider trading; the Department of Justice (DOJ) may pursue criminal charges.
B. The Issues Addressed in This Article
This Article critiques the SEC’s rulemaking regarding a fundamental element of insider trading: whether there must be a causal connection between MNPI and the decision to trade, sometimes described as the “possession versus use debate.” The question was—and in the view of the present author to a significant extent remains—whether Rule 10b-5 is violated only when the person who traded consciously used MNPI in deciding to make the trade or whether it is sufficient that he was merely aware of (or possessed) the MNPI when the trade occurred. The Exchange Act does not answer this question. The SEC sought to “clarify” the issue by adopting Rule 10b5-1. That rule provides that to engage in insider trading means to trade “on the basis of MNPI,” which in turn means to be “aware” of MNPI when trading. This Article demonstrates that Rule 10b5-1 is facially invalid in critical respects.
- 1. In adopting Rule 10b5-1, the SEC likely exceeded its rulemaking powers under section 10(b). Any violation of a rule adopted under that section must prohibit using or employing deception—deceptive silence in the case of insider trading because the gravamen is a breach of duty to make disclosure. A prohibition of conduct that does not involve “use” exceeds the Commission’s power. This itself answers the possession versus use question for all cases—unlawful “use” is required by the statute.
- 2. Pre-Rule 10b5-1 caselaw was clear—as the SEC had acknowledged—that proof of use of MNPI is required in all misappropriation cases. Rule 10b5-1 is invalid because it cannot, in effect, reverse that settled law.
- 3. The SEC lacks authority to (re)define in Rule 10b5-1 a term used in caselaw—“on the basis of ”—to mean to be “aware” of MNPI when trading. Because the phrase “on the basis of ” is not a statutory term the SEC cannot, for example, argue it has implicit delegated authority to interpret the phrase.
- 4. The SEC exceeded its authority in adopting affirmative defenses that are designed to be the only defenses available to a charge of insider trading in any civil or criminal case. Moreover, the rule improperly shifts the burden on this issue to a defendant in a criminal case.
II. The Possession Versus Use Debate
The possession versus use debate is more than a matter of scholarly interest; it can have meaningful consequences when the SEC or the DOJ seeks to prove a civil or criminal case. Consider the person who was aware of MNPI but can demonstrate that the reason he traded had nothing to do with that information. For example, he had decided to trade at the market price tomorrow and later learned MNPI. The debate centers on whether that person violated Rule 10b-5 when he traded as planned. The substantive rule affects the government’s path to proving its case. Proving possession or awareness of MNPI is inherently easier than proving that someone made use of MNPI in deciding whether to trade.
This Part II demonstrates that, before Rule 10b5-1 was adopted, courts held that in misappropriation cases there is liability—civil or criminal—only if the trader used MNPI. The Commission itself had recognized that a use test—not the lighter awareness or possession test—applies in all misappropriation cases. In adopting Rule 10b5-1, the agency thus ignored controlling caselaw and its own prior position. If, as shown here, Rule 10b5-1 is invalid insofar as the definition of “on the basis of ” is concerned, the law would revert to the prior split among the Circuits.
A. The Common Law on Possession Versus Use
In a 1997 article, the present author examined the common law of insider trading, concluding that in those jurisdictions that recognized a private damage claim on behalf of a corporation against an insider to recover profits for what is now called insider trading, proof of use of MNPI was required to establish liability. The common law in this respect has not changed.
B. The Federal Law of Possession Versus Use
Apart from “traditional insiders,” such as officers and directors trading in the securities of their own company, the SEC and the courts often predicated insider trading liability under Rule 10b-5 on proof of use of MNPI, though in some cases trading while in possession of MNPI without proof of use of MNPI was explicitly or implicitly found to be sufficient. The lack of a consensus in some respects might provide an opportunity for clarification by the SEC by rule. As shown later, however, the SEC squandered the chance. The most significant federal decisions are discussed in the following subparts.
1. Rulings and Statements by the Commission and Its Staff
Consideration of the position of the Commission is important in deciding whether to credit the Commission’s explanation for adopting an awareness test in Rule 10b5-1, because the validity of the rule may depend on whether its adoption was arbitrary and capricious in the context of the Commission’s stated views.
In the seminal SEC case, the Commission ruled that a broker-dealer firm and one of its brokers engaged in unlawful insider trading in violation of Rule 10b-5. In finding that the trading was unlawful, the opinion referred to “use” of MNPI, although certain passages of the opinion may also be read as suggesting a possession test. When one respondent argued that the sales made were “merely a continuance of his prior schedule of liquidation,” the Commission could have, but did not, reject the non-use argument as a matter of law. Rather, it ruled that the facts did not support the argument. In a later case the Commission described Cady, Roberts as ruling that certain persons are “subject to the fiduciary responsibilities of a traditional corporate ‘insider’ . . . with respect to the investing public and could not make advance use of the information.”
In another case, the Commission ruled that investment advisers, mutual funds, and investment partnerships that received MNPI from a broker-dealer violated Rule 10b-5 when they traded in the stock that was the subject of the MNPI. This time the Commission majority described Cady, Roberts in possession terms. The majority opinion, however, also cited several Commission matters where the focus of the analysis was wrongful “use” of MNPI. Notably, the majority opinion stated that the MNPI must be a “factor” in making the trade. That is manifestly a use element.
Concurring Commissioner Smith stated he would have predicated liability on a finding that respondents had used the MNPI. He explained:
It is important in this type of case to focus on policing insiders and what they do, which I think appropriate, rather than on policing information per se and its possession, which I think impracticable. I believe the emphasis in the law should continue to be upon the conduct of corporate insiders and their privies, as it has been since [1909] and as it was in Cady Roberts [and two court cases] rather than upon a concept—too vague for me to apply with any consistency—of relative informational advantages in the marketplace.
He concluded, stating “that the information must be shown . . . to have substantially contributed to the trading which occurred.” The majority’s requirement that MNPI be a “factor” and Commissioner Smith’s clear preference for a use requirement speak strongly for a use test. Since then, inexplicably, the SEC has largely ignored Investors Management on the possession versus use issue, not even distinguishing it from some other test.
Two years later, the Commission solicited public comments on “the circumstances under which material information of a previously undisclosed nature may be utilized in connection with the purchase or sale of securities.” Among other things, the notice requested comment on “[w]hether guidelines can be established to designate categories of individuals and entities which may be considered to have a sufficient nexus to preclude their use of material, undisclosed information concerning the issuer, in the absence of any general public disclosure of that information.” Nothing public appears to have come of this. Five years later the SEC issued a Section 21(a) report in an insider trading matter which rejected a use test.
In these matters, the Commission’s expression of the elements of the wrong were not consistent, especially viewed in hindsight after possession versus use became an issue. In later years, however, the Commission made unambiguous statements, as a party to litigation or as an amicus curiae, that recognized that a use test applies in misappropriation cases.
During the legislative process leading to the 1984 and 1988 insider trading amendments to the Exchange Act the Commission favored a possession test in the context of express consideration of adopting a statutory definition of insider trading. No definition was enacted.
In 2006, six years after Rule 10b5-1 was adopted, then director of the SEC’s Division of Enforcement effectively acknowledged that a use test is required to prove insider trading—without distinguishing between cases under the two theories:
The challenge [in proving insider trading] is not to establish facts that show suspicious trading—the surveillance records alone are often sufficient to establish that much. The real challenge is to establish that a particular individual was in possession of material non-public information and in fact traded on it in breach of a duty, and to establish those facts based on admissible evidence that can withstand challenge at trial.
. . . It is quite common for insider traders to come up with alternative rationales for their trading—rationales that the staff must refute with inferences drawn from the timing of trades, the movement of funds and other facts and circumstances.
“Alternative rationales”—undoubtedly referring to proof of non-use—would be entirely irrelevant if all that mattered were possession or awareness. The Commission should move to strike any evidence proving non-use, before being put to the task of rebutting it.
The Commission’s position on possession can charitably be characterized as shifting, or at least lacking in rigor.
2. Insider Trading Opinions of the Supreme Court
In the Supreme Court’s four Rule 10b-5 insider trading cases, coming after Cady, Roberts and Investment Management, the possession versus use question was not potentially outcome-determinative. The cases expressed the core legal principles, however, in a manner that suggests a disposition in favor of a use test, until the critical misappropriation case that spoke definitively of a use test.
In Chiarella, the Court’s first case, the Court stated its understanding that Cady, Roberts ruled “that a broker-dealer and his firm violated [section 10(b)] by selling securities on the basis of undisclosed information.” Next, in Dirks, the Court used “on the basis of ” in describing the elements of insider trading.
United States v. O’ Hagan is the most important Supreme Court decision for present purposes. There the Court, using the phrase “on the basis of,” first recognized the misappropriation theory under Rule 10b-5. The Court held that the necessary component of deception under Rule 10b-5 “is satisfied [in a misappropriation case] because the fiduciary’s fraud is consummated . . . when, without disclosure to his principal, he uses the information to purchase or sell securities.” In a later case, the Court described O’Hagan as holding “that the defendant had committed fraud ‘in connection with’ a securities transaction when he used misappropriated confidential information for trading purposes.” At this point the Court had made clear that “on the basis of ” means “to use” and proof of use is necessary to establish a misappropriation violation.
The O’Hagan references to “use” have been described as dicta, because there was no occasion for the Court to distinguish between possession and use and if a more demanding use test had been applied the Court would have found it to have been satisfied. Nevertheless, subsequent decisions, commentary, and government briefs have interpreted O’Hagan to require proof of use in misappropriation cases, leaving no doubt about the weight to be accorded the decision.
3. Salient Rulings in the Lower Courts
In the years preceding the adoption of Rule 10b5-1 in 2000, courts of appeal rendered three important decisions bearing on the possession versus use issue. The first of the cases on which the Commission focused was a Second Circuit misappropriation case often read as supporting a possession test in dictum. In United States v. Teicher, the court stated:
It strains reason to argue that an arbitrageur, who traded while possessing information he knew to be fraudulently obtained, knew to be material, knew to be nonpublic,—and who did not act in good faith in so doing—did not also trade on the basis of that information.
This statement, made in affirming the convictions, was dictum on the possession versus use issue because several of the jury instructions on which the conviction was based described the offense in terms of use of MNPI.
Still more important, the quoted language reflects that “on the basis of ” means “use”—the defendant possessed and he traded “on the basis of.” In any event, Teicher has been superseded by O’Hagan, because, as a misappropriation case, satisfaction of a use test is necessary for a conviction. The Commission overstated the strength of Teicher as a possession case.
In SEC v. Adler, a classical case, a director of the company sold company stock after negative arguably material information was disclosed at a board meeting. That defendant contended that the sales “were part of a preexisting plan to sell [company] stock in order to buy an eighteen wheel truck for his son’s business,” waiting to sell until the expiration of a lock-up period imposed on the director’s stock as part of a registered offering. A second sale occurred after the defendant, no longer affiliated with the company, was allegedly tipped by a director about the discovery of accounting fraud at the company. Defendant contended that his sale in November 1992 “was made pursuant to a preexisting plan to sell 150,000 shares of [the company] after the November 3 presidential election,” though the sale was delayed by a death in the family.
After an extensive review of caselaw and other sources, the court concluded:
[W]e believe that Supreme Court dicta and the lower court precedent suggest that the use test is the appropriate test. The strongest argument that has been articulated in support of the knowing possession test is that a strict use test would pose serious difficulties of proof for the SEC. . . . [W]e believe that the SEC’s problems in this regard are sufficiently alleviated by the inference of use that arises from the fact that an insider traded while in possession of inside information.
The inference of use can then be rebutted. Because issues of fact precluded summary judgment, the case was remanded for a retrial.
In United States v. Smith, the defendant appealed a judgment on a jury verdict that he engaged in insider trading in the stock of the company of which he was a vice president, a classical case. The defendant argued that the jury instructions on the necessary causation issue were confusing. The court held, “[W]e believe that the weight of authority supports a ‘use’ requirement. Perhaps most significantly, the Supreme Court has consistently suggested, albeit in dictum, that Rule 10b-5 requires that the government prove causation in insider trading prosecutions.” The court affirmed the conviction, finding that the instructions sufficiently required proof of a causation element, i.e., use. The court observed that it could not apply the Adler approach of a rebuttable presumption of use arising from possession of MNPI because in a criminal case the court cannot presume an essential element of the crime. Smith thus held that in any criminal insider trading case the government must prove that the trader used MNPI.
In the SEC’s initial amicus curiae brief in Smith, the Commission stated, “The Supreme Court recently indicated in a misappropriation case that it is the misappropriator’s use of the information in his trading that satisfies the § 10(b) requirement that the deception occur ‘in connection with the purchase or sale of [a] security.’” Later in the same case, the SEC took the position that in a misappropriation case, a defendant’s “‘use’ of the information in his trading may be relevant because it is that use that satisfies the Section 10(b) requirement that deception occur ‘in connection with the purchase or sale of a security.’” In its brief, the DOJ as appellee clung to a knowing possession test, following Teicher and noting the relative simplicity of a possession test.
These three cases support some sort of a use test: Teicher stating that trading while in possession inevitably leads to trading on the basis of MNPI, meaning use, Adler adopting a rebuttable presumption of the required element of use arising from proof of possession, and Smith requiring the government to prove use in every criminal insider trading case.
4. Commentary After the Judicial Triad
After these three cases, in his insider trading treatise, Professor Langevoort states that in classical cases, “As a formal legal matter, the possession test seems well grounded.” He recognizes that a use test applies in all misappropriation cases.
Professor Nagy took a more nuanced position. She argued, convincingly to the present author, that when a “traditional insider,” i.e., a director, officer, or controlling shareholder of a company, trades in stock of that company knowing MNPI about that company she must first disclose that information to fulfill her fiduciary duty, that a use requirement has no place in that classical context. Professor Nagy then stated that all other traders
do not owe fiduciary disclosure duties to the corporation’s shareholders by virtue of their status alone, their silence about material nonpublic information cannot be deemed deceptive within the meaning of Rule 10b-5 unless they affirmatively used that information. Thus, although “knowing possession” should be the requisite test in the context of securities trading by traditional insiders, a “use” test should be applied in these other types of insider trading cases.
Thus, Professor Nagy concluded, based on language in O’Hagan, that a use test is required in all misappropriation cases and in all classical cases not involving traditional insiders. She suggested that “[t]he SEC may choose to address this question by rulemaking and, if it does so, the SEC should confine its knowing possession rule to the specific context of securities trading by traditional insiders.” When it adopted Rule 10b5-1, the Commission did not engage with this analysis, nor did it even cite it.
5. Legislation in the 1980s
Amendments to the Exchange Act in the 1980s have been offered as support for an argument that Congress resolved the possession versus use debate. This contention is predicated upon the inclusion of the word “possession” in insider trading penalty provisions added to the Exchange Act in 1984, amended in 1988. This argument is undermined by a careful analysis.
Current section 21A(a)(1)(A) of the Exchange Act, added by ITSA, provides that a penalty may be imposed by a court, upon the application of the SEC, whenever “any person has violated any provision of [the Exchange Act] or the rules or regulations thereunder by purchasing or selling a security . . . while in possession of material, nonpublic information.” First, it is a mystery why the word “possession” was included as a condition to impose a penalty, because under either a possession test or a use test for liability the SEC would have to establish possession on the part of any violator. The SEC proposed the legislation, without any explanation why “possession” was included as an express condition for imposing a penalty. In its supporting memorandum, the SEC stated, “As proposed, H.R. 559 does not define insider trading. It looks to existing law prohibiting trading while in possession of material nonpublic information.”
Professor Langevoort asserts that the inclusion of “possession” in these amendments reflected a legislative resolution. His first support for this is a colloquy about including a “knowing possession” requirement for imposing a penalty. The cited passage includes the following statement by the Director of the Division of Enforcement:
The proposed legislation in my view goes to a remedy. It does not at the present time at all impact the existing case law with regard to insider trading. It is strictly a remedy saying that if a person engages in this insider trading, however defined, that then the amount of disgorgement can be three times the ill-gained profit. And the proposed language that you have before you, presented by the Commission, does not impact the “based on,” “in possession of,” or a “knowing” standard at all.
In the Director’s view, the final legislation, which included the language he addressed, clarified nothing about the elements of insider trading per se. As noted later, statements by others concurred in that point.
Professor Langevoort offers an alternative argument based on ITSFEA. “A familiar canon of statutory construction is that when a statute fails to change the prevailing judicial construction of some prior enacted provision, that failure constitutes an implied endorsement of that judicial interpretation,” subject to several criteria. In fact, some statements in the legislative history do reflect some satisfaction with the state of the law. Professor Langevoort correctly notes, however, the “iron[y]” that there were conflicting lines of judicial authority. One is at left at sea just what it was, at that time, that Congress elected not to tamper with.
The text of the amendments thus shed no light on the substantive law of Rule 10b-5. If Congress did not want to resolve the possession versus use debate but to leave the issue to the courts—as the present author contends—Congress would have chosen the same wording in the statute. If the courts had adopted a pervasive possession test, Congress’s adding it in the penalty section accomplished nothing. Including the word “possession” was irrelevant. That ends the inquiry, unless there should be resort to legislative history. That history shows that, after considerable attention to the possession versus use question, Congress deliberately decided to do nothing regarding a definition of insider trading.
During consideration of what became ITSA, the Commission opposed including a definition of insider trading. The final House report on ITSA stated, “The legislation is not intended to change current law with respect to the level of awareness required of a violator.” The report concluded that “the law with respect to insider trading is sufficiently well-developed at this time to provide adequate guidance” and expressed the concern that “the adoption of a statutory definition could reduce flexibility while “any new definition which might be adopted would be likely to create new ambiguities, thereby increasing rather than limiting uncertainty.”
The definitional issue generated much more attention when, a few years later, ITSFEA was under consideration. S. 1380, introduced in the Senate on June 17, 1987, proposed adding a new section 16A to the Exchange Act. Subsection (b)(1) would have made it unlawful “to use” MNPI “if such person knows or is reckless in not knowing that such information has been obtained wrongfully, or if the purchase or sale of such security would constitute a wrongful use of such information.” Following the approach adopted later in Adler, it would also have provided that “any person who purchases or sells while in possession of [MNPI] shall be presumed to have used that information in connection with such purchase or sale.”
Work in the Senate began behind the scenes when Subcommittee Chair Sen. Riegle had asked two eminent members of the insider trading bar, Harvey Pitt (former General Counsel of the Commission, and later Chairman of the Commission) and John Olson (then chair of the American Bar Association task force on the regulation of insider trading), to develop language to amend the Exchange Act to address an “overhaul of the law.” Two entire hearing sessions were devoted to a statutory definition of insider trading. Though the SEC expressed support for defining insider trading in legislation, it did not support S. 1380 because ambiguities in it “would create problems for the enforcement program.” The Commission opposed “alter[ing] the current relationship between while in possession of inside information and trading on the basis of that information. In the case of individuals, the bill [inappropriately] presumes that the two are indistinguishable, although the presumption can apparently be overcome.” This reflected the Commission’s recognition that “on the basis of ” meant “to use.” Chairman Cox’s written statement elaborated that S. 1380 was “apparently intended to reflect the Commission’s traditional position that trading while in possession of insider information is itself a violation.” He also stated that in SEC enforcement cases “it is very important that trading in possession be the standard” because defendants seek to defend by arguing that they did not use the information.
The Senate hearings continued with a focus on a definition of insider trading. The Commission, reluctantly it seems, submitted a suggested definition at the Committee’s request. The ensuing debate over what became ITSFEA cannot be squared with any argument that, in 1984, ITSA had already added a possession-based definition of the wrong, which should put an end to any argument that adding “possession” then had resolved anything. As explained by Chairman Cox, under the Commission’s grudging proposal, the test would be possession, not trading on the basis of. The legislation would “remove[] any doubt in people’s mind as to whether it’s on the basis of or in possession of.” The Commission thus again expressed definitively that “on the basis of ” is the language of a use test, which the Commission opposed. The Commission’s General Counsel, Daniel Goelzer, cautioned that “defining insider trading in a way contrary to the caselaw would undoubtedly be subject to challenge and we would have to litigate the validity of the rule.” Presciently, Goelzer foresaw the very challenge this Article urges.
As the process proceeded, the Commission, speaking through new Chairman David Ruder, continued to favor a possession test were there to be a statutory definition. Again—if ITSA had already reflected that possession was sufficient to establish liability, why did the Commission argue for a (redundant) definition? The answer is obvious—section 21A did not define the violation.
The House Report supported legislation that did not include any definition and did not change the basic approach of ITSA. The House Committee explained its declination to include a definition for the same reasons as in 1984, concluding that “the Committee does not intend to alter the substantive law with respect to insider trading with this legislation.” When the bill came up for a floor vote, Rep. Markey, speaking in favor of the bill, stated, “The term [insider trading] is not defined in this act. The case law in this area provides clear parameters.” The first was true, the second was not.
Adler correctly rejected the argument that ITSA and ITSFEA provided that possession was a sufficient condition for liability, recognizing that “possession” as used in the penalty provision “only sets a condition” to seeking a penalty. The present author has not identified any case that has relied on section 21A in deciding the appropriate standard for liability.
III. The Adoption and Amendment of Rule 10b5-1
A. The Adoption of Rule 10b5-1
1. The Provisions of Rule 10b5-1
After the decisions in Adler and Smith adverse to the government, the SEC sought to “provide greater clarity and certainty” on the “unsettled” possession versus use question. This effort was the adoption of Rule 10b5-1. Original Rule 10b5-1(a)–(b), adopted in 2000, stated:
(a) General. The “manipulative and deceptive devices” prohibited by Section 10(b) of the Act (15 U.S.C. § 78j) and § 240.10b-5 thereunder include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.
(b) Definition of “on the basis of.” Subject to the affirmative defenses in paragraph (c) of this section, a purchase or sale of a security of an issuer is “on the basis of” material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.
Applying Rule 10b5-1, Rule 10b-5 is violated if a person traded while merely “aware” of MNPI, in addition to the other elements of Rule 10b-5.
2. The Unexplained Disappearance of the Possession Test
The obvious threshold question is why, after several decades of advancing a “possession” test—the Commission’s “traditional position”—the Commission chose not to define the violation in those terms in Rule 10b5-1. There was no explanation in either the 1999 Proposing Release nor in the 2000 Adopting Release. The Commission adopted the awareness test because “in our view, the goals of insider trading prohibitions—protecting investors and the integrity of securities markets—are best accomplished by a standard closer to the ‘knowing possession’ standard than to the ‘use’ standard.” The Commission did not, however, adopt a “knowing possession” standard either.
3. The Uncertain Meaning of “Aware”
To be “aware” of information appears to mean something more than to “possess” it. It must also mean something less than “knowing possession,” because the Commission expressly rejected a “knowing possession” test. In the 2000 Adopting Release, the Commission explained that “aware” is “a commonly used and well-defined English word, meaning ‘having knowledge; conscious; cognizant,’” which is “much clearer” than “‘knowing possession,’ which has not been defined by case law.” The Commission did not, however, cite any judicial application of an “awareness” test to demonstrate the contrast with the undefined concept of knowing possession. If “aware” means “having knowledge,” to be “conscious” of something, how is that “much clearer” than “knowing possession”? If they are not synonyms, what is the difference?
When the Commission amended Rule 10b5-1 in 2022 in other respects, it stated that “[a] person is aware of material nonpublic information if they know, consciously avoid knowing, or are reckless in not knowing that the information is material and nonpublic.” This reconfirmed that the SEC did not adopt a “knowing possession” test. Yet Professor Langevoort reads the awareness test to be “essentially the same as knowing possession” and Loss states that the SEC “adopted a knowing possession test.” Some courts have concluded that the awareness test is equivalent to “knowing possession.” The ultimate result is a lack of clarity, albeit the distinctions among the possible formulations may be difficult to draw in deciding a case.
4. The Weakness of the Inevitably Argument
The Commission also stated that Rule 10b5-1 “reflects the commonsense notion that a trader who is aware of inside information when making a trading decision inevitably makes use of the information.” In fact, it is not at all “inevitable” that MNPI is used if one is aware of MNPI when the trade occurs. Quite the contrary, the Commission itself provided a plausible example of someone who makes a decision to trade and, before the trade is executed, becomes “aware” of MNPI. The Commission indicates that he should not be held liable.
Sometimes a person may reach a decision to make a particular trade without any awareness of material nonpublic information, but then come into possession of such information before the trade actually takes place. A rigid ‘‘knowing possession’’ standard would lead to liability in that case. We believe, however, that for many cases of this type, a reasonable standard would not make such trading automatically illegal.
It is not apparent what “reasonable standard” the Commission was referring to that would result in a finding of no violation. It is certainly not the adopted awareness test. As shown below, Rule 10b5-1 purports to preclude the trader from making a non-use argument, such as the one suggested here.
B. In the End, What Matters Is Use or Non-use, Especially in Misappropriation Cases
When the Commission amended the rule in 2022, tightening the affirmative defenses, the Commission concluded, “Taken as a whole, the revised defense [in the amended rule] is designed to cover situations in which a person can demonstrate that the material nonpublic information was not a factor in the trading decision.” In other words, taking all elements of Rule 10b5-1 into account, the rule is a circuitous route to exonerate a trader if she did not use the information. Thus, in proposing the original rule, the Commission stated:
In O’Hagan, the Supreme Court recognized that under the misappropriation theory of insider trading liability, the fraud is consummated when the defendant, without proper disclosure to the source, ‘‘uses the information to purchase or sell securities.’’ Proposed Rule 10b5-1 is consistent with this view in that it provides for no liability when a trader can meet one of the stated defenses in paragraph (c) demonstrating lack of use.
This apparent candor, implying that “taken as a whole” Rule 10b5-1 is consistent with a use test, should not mask that the Commission went off the rails in several crucial respects. First, Rule 10b5-1 improperly denies the trader any opportunity to prove non-use other than using narrow specified affirmative defenses. Second, the rule shifts the burden to the trader to prove non-use. The Commission did not address this nor did it identify its authority to shift the burden, especially in criminal cases. Third, Rule 10b5-1 makes no distinction (A) between classical cases and misappropriation cases—where, as the Commission elsewhere recognized, that the Supreme Court held that use is an element of the government’s case—or (B) between civil and criminal claims.
C. The 2022 Amendments of Rule 10b5-1
The Commission became increasingly concerned about abuse of 10b5-1 Plans, based in large part on statistical studies of trading by insiders who had adopted these plans. This resulted in an amended rule, in which the Commission added significant conditions to 10b5-1 Plans. The SEC also adopted new public reporting requirements regarding any 10b5-1 Plans established by directors and certain officers of public companies. Several months later the Commission adopted reporting requirements for issuers that use 10b5-1 Plans when repurchasing their stock.
There was no substantive change to definitional Rules 10b5-1(a) and (b). The substance of the original Preliminary Note was moved to new Rule 10b5-1(a). “The final amendments do not alter the ‘awareness’ standard.” Parts V through VII demonstrate fundamental deficiencies in Rule 10b5-1, as adopted and as amended.
IV. Possession Versus Use After Rule 10b5-1
There has been a lack of consistency in decisions that addressed some aspect of the possession versus use issue after Rule 10b5-1 became effective. The rulings are so disparate that they do not suggest a consensus.
A few points, however, are worthy of note. Some criminal cases expressly required the DOJ to prove use. At least one criminal case, however, applied the Rule 10b5-1 “awareness” test. In one criminal case the indictment referred to Rule 10b5-1. Adler was followed in an Eleventh Circuit criminal case. There is no consistency.
Some civil enforcement cases have expressly applied Rule 10b5-1. Some enforcement rulings did not refer to Rule 10b5-1 but applied a test consistent with the rule. One of those cases was a misappropriation case where, confusingly, the court quoted the “use” language in O’Hagan but applied a knowing possession test, stating, “‘[K]nowing possession’ only requires the SEC to show [defendant’s] awareness of (as opposed to use of ) the nonpublic information.” In a civil enforcement case the court did not rely on the rule but instead gave an instruction that defendants would not be held liable if the jury believed “the defendant would have made the exact same trade whether or not he possessed” MNPI as in that event the jury could “infer that the defendant did not trade on the basis of ” MNPI. In responding to defendants’ motion for summary judgment in that case, the SEC argued for a possession test and never cited Rule 10b5-1.
In another case, the court granted the SEC’s motion for summary judgment applying a knowing possession test in what was fundamentally a misappropriation case, with no reference to Rule 10b5-1. In the SEC’s proposed jury instructions, the jury would have been instructed that the SEC must prove “that the defendants deliberately used material, confidential information in order to obtain an unfair advantage.” There were also several references to Rule 10b5-1 in the proposed instructions, one of which included a knowing possession test. In another case, according to the court the SEC expressly declined to rely on Rule 10b5-1. In its brief on appeal from a judgment in its favor, the SEC relied on both a possession test and an awareness test—with no reference to Rule 10b5-1.
In an SEC administrative proceeding the insider trading claim against the respondent was dismissed by the Administrative Law Judge (ALJ), finding that the Division of Enforcement had not proved that respondent had been tipped. On review, the Commissioners were evenly divided on the issues appealed by the Division of Enforcement. Two of the four participating Commissioners filed opinions. Commissioner Stein, writing in opposition to dismissal, referred to an awareness test, albeit without any reference to Rule 10b5-1. Commissioner Pinowar, favoring dismissal, also referred to an awareness test but described one element of tippee liability to be “while in knowing possession of the material non-public information, used the information by trading or by tipping for his own benefit.”
The inconsistency of the SEC’s own application of the rule demonstrates that the rulemaking did not provide clarity to the investing public. The Commission clearly is of two, three, or more minds when it comes to possession (or awareness) versus use even after the adoption of Rule 10b5-1. No wonder the courts are also all over the map. That the rule did not achieve its goal does not mean the rule is invalid. Nevertheless, none of this inconsistency—on the part of the courts or the Commission itself—was even noted in passing when the rule was amended in 2022. The Commission might have chosen to ignore the definitional issue in order to keep the focus on its concerns about abuse of 10b5-1 Plans, to avoid impairing that effort by reopening the can of worms on the definition issue. There is no way to know why, but its inaction surely ill served its constituency, the investing public.
V. The Definitional Provisions in Rule 10b5-1 Exceed the Congressional Grant of Power to the SEC in Section 10(b)
A. The Scope of Section 10(b) and Rules Thereunder
“It is inconsistent with settled methodology in § 10(b) cases to extend liability beyond the scope of conduct prohibited by the statutory text.” In resolving issues under section 10(b) and Rule 10b-5, the starting point is the meaning of the words in the statute. Section 10(b) provides that it is unlawful “[t]o use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of ” rules adopted by the SEC. The terms “use” and “employ” are essentially synonymous. “To “use” or “to employ” means to do something active, more than, for example, doing something when one happens concurrently to be aware of MNPI, whatever “aware” means. To remain within the scope of section 10(b), then, the person must “use” something prohibited by a rule under the section.
Suppose a person is aware that he has the manual for repairing something but in making a repair pays no attention to the contents of the manual or even to the specific instructions for the repair. That is certainly not “using” or “employing” the information in the manual that he arguably was “aware of.” Perhaps “aware” in the context of Rule 10b5-1 was intended to mean not just knowing there is information in hand but also being cognizant of the relevant provisions—yet the Commission expressly rejected a “knowing possession” test. The awareness test in Rule 10b5-1 exceeds the statutory grant to the SEC.
If the proper focus is not on using MNPI per se but instead more broadly on using a “deceptive device” that employs MNPI, the answer is the same. It is not “using” deception, a term of action, to trade while aware of MNPI—unless the trader was aware that the deception involved MNPI. Again, however, the SEC rejected a test of “knowing possession.” Others have questioned the authority of the SEC to adopt the rule.
Making an argument about the validity of Rule 10b-5 itself, in a Rule 10b-5 insider trading case, Justice Scalia, joined by Justice Thomas, observed that “Congress may make it a crime to violate a regulation, but it is quite a different matter for Congress to give agencies—let alone for us to presume that Congress gave agencies—power to resolve ambiguities in criminal legislation.” Moreover, “[o]nly the legislature may define crimes and fix punishments. Congress cannot, through ambiguity, effectively leave that function to the courts—much less to the administrative bureaucracy.” A rule under section 10(b) imposing liability for mere awareness of MNPI is an invalid overreach by the Commission.
B. Application of Principles of Administrative Law
A related argument is grounded on fundamental principles of administrative law. A principal authority for assessing the validity of agency action interpreting a statute has been Chevron, U.S.A. Inc. v. Natural Resources Defense Council, Inc. Chevron adopted a two-step process to determine whether an agency rule is valid.
Here, the first Chevron step is dispositive:
When a court reviews an agency’s construction of the statute which it administers, it is confronted with two questions. First, always, is the question whether Congress has directly spoken to the precise question at issue. If the intent of Congress is clear, that is the end of the matter; for the court, as well as the agency, must give effect to the unambiguously expressed intent of Congress.
That is, once the courts, here the Supreme Court, have spoken definitively, there is no leeway for an agency to decide otherwise. Chevron deference is premised upon implicit delegation of legislative authority from Congress when a statutory phrase is ambiguous. Because the Supreme Court has definitely determined the meaning of “on the basis of,” most certainly in misappropriation cases, there is no room for any residual delegated authority. At the very least, O’Hagan has decreed, that, (1) without exception, use is required in a misappropriation claim, and (2) “on the basis of ” means “to use.” What the SEC feared most in any statutory definition was an “on the basis of ” requirement that meant “to use.” According to Chevron, what the courts have decided cannot be overridden by an SEC rule. Part VI addresses this issue.
