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February 06, 2017

A Statutory Solution to Insider Trading?

A statute directed at making sure that investors in the stock market cannot rely in any way on nonpublic information may be the way to go

Jed S. Rakoff

Author’s note: This article is adapted from a keynote speech presented at the ABA National Institute on US-Canadian Securities Litigation on May 18, 2016, in Toronto, Canada. The article was drafted prior to the Supreme Court's decision in Salman v. United States on December 6, 2016.

The United States, having pioneered the development of the law against insider trading, has now fallen behind many Western nations in the effective formulation of that prohibition. In particular, the United States, by failing to recognize (unlike many other developed countries) that a simple and straightforward ban on insider trading is best achieved through statute, rather than judge-made law, has created unnecessary uncertainty and difficulty in dealing with this insidious problem. 

Let us review the basics. Although trading on the basis of material nonpublic information is not without its apologists, most people view it as a form of cheating (or worse), in roughly the same way that most people regard an athlete who secretly enhances his performance with banned steroids as taking unfair advantage of his fellow athletes and cheating a public that expects the game to be played according to the rules. In both cases, however, there is a lot of money to be made by such cheating. In particular, a securities investor who has, by one or another form of cheating, obtained material confidential information about a publicly traded company that no investor who played by the rules could properly obtain is frequently in a position to make a killing on the stock market.

Although insider trading in one form or another is centuries old, Congress has never passed a statute that specifically defines it or that bans it per se. Instead, first the U.S. Securities and Exchange Commission (SEC) and subsequently the U.S. Department of Justice (DOJ) have tried to police insider trading by using the broad antifraud provisions of the federal securities laws—especially section 10(b) of the Securities Exchange Act and Rule 10b-5, promulgated thereunder—as well as, in the criminal context, the federal mail fraud and wire fraud statutes. Thus, in 1961, the SEC brought the first administrative action against insider trading, In re Cady, Roberts & Co., 40 S.E.C. 907 (1961), charging a violation of Rule 10b-5; and seven years later, in 1968, the SEC’s approach was validated in the first federal appellate decision dealing with insider trading, SEC v. Texas Gulf Sulphur, 401 F.2d 833 (2d Cir. 1968). Ten years after that, in 1978, the DOJ brought the first criminal case for insider trading, United States v. Chiarella, 45 F. Supp. 95 (S.D.N.Y. 1978), again charging antifraud violations. Although Chiarella’s conviction was ultimately reversed in the Supreme Court, Chiarella v. United States, 455 U.S. 222 (1980), the case set the stage for the many successful criminal prosecutions of insider trading that followed thereafter.

Let me pause here to mention some of the problems with these early cases that may now be seen with the benefit of hindsight. In all these cases, and in all the many U.S. cases that have followed since, insider trading has been treated as a species of fraud. This is because the only statutes ordinarily available to a U.S. regulator or prosecutor who seeks to bring charges for insider trading are, as noted, the antifraud statutes. Although most dictionaries define “fraud” and “cheating” as synonyms, fraud in the Anglo-American legal tradition has classically been held to consist of the use of false statements to obtain money or property. Because insider trading typically involves no express false statements—for having secretly come into possession of the inside information, an inside trader simply calls his or her broker and trades—it usually can be prosecuted only under the anti­fraud statutes if the trader has an affirmative duty, often fiduciary in nature, to disclose the trading to the source of the information and fails to do so, thereby, in effect, rendering his or her silence an implicit and false representation. Thus, as the scope of prosecution of insider trading has expanded—from company executives who used confidential company information to cheat their own shareholders, to friends and relatives of such executives who were tipped off to such information in advance, to employees of third-party recipients of such information who misappropriated it for their own personal purposes, and so on—ever more complicated theories have had to be spun in order to transform what was obvious as cheating into what could pass legal muster as fraud. This in turn has led the courts to develop ever more complicated rules for determining when such theories can or cannot properly be invoked.

For example, in its recent decision in United States v. Newman, 773 F.3d 438, 450 (2d Cir. 2014), the Second Circuit Court of Appeals held that “to sustain an insider trading conviction against a tippee, the Government must prove . . . that

(1) the corporate insider was entrusted with a fiduciary duty; (2) the corporate insider breached his fiduciary duty by (a) disclosing confidential information to a tippee (b) in exchange for a personal benefit; (3) the tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit, and (4) the tippee still used that information to trade in a security or tip another individual for personal benefit.

Because a challenge to this formulation is effectively pending before the Supreme Court in the case of United States v. Salman, 792 F.3d 1087 (9th Cir. 2015), cert. granted, 136 S. Ct. 899 (Jan. 19, 2016), I express no opinion as to whether it is correct or not. My sole point here is to note that this and other formulations of what constitutes insider trading go well beyond the conventional formulations of fraud.

All of this suggests that the better way to proceed is by way of statute. So why hasn’t Congress legislated in this area? From time to time, proposed laws against insider trading have been introduced. Indeed, there are four or more such bills pending in Congress right now. But historically, such bills have been vigorously, and successfully, opposed by the SEC on the ground that they were too narrow or created loopholes through which insider traders could escape.

This is not an idle concern. Some of the pending bills do seem overly complicated; and complexity invites evasion, as the tax laws amply demonstrate. So it may be useful, instead of focusing on these bills, to look at what other nations have enacted as statutory prohibitions against insider trading.

In the European Union (EU), the prohibition against trading on inside information was first codified in a directive known as the Market Abuse Directive of 2003, which has been periodically updated and has been implemented by statutes in various EU countries. The directive begins by defining “inside information” as

information of a precise nature which has not been made public, relating, directly or indirectly, to one or more issuers of financial instruments or to one or more financial instruments, and which, if it were made public, would be likely to have a significant effect on the price of those financial instruments or on the price of related derivative financial instruments.

This is generally similar to, though perhaps a bit narrower than, the U.S. concept of “material non-public information.”

But the prohibition on its use is considerably broader than in the United States. Specifically, the directive provides that any person who possesses such information and who either falls within certain specified groups (such as the management or directors of a company) or simply knows or “ought to know” that the information is nonpublic is prohibited from (1) using the information to trade or otherwise deal in any way in the securities to which the information relates, (2) using the information to induce other persons to trade in such securities or to recommend that they do so, or (3) disclosing such information to any third party unless the disclosure is made in the normal course of employment. In other words, there is no requirement that the violator act in breach of a fiduciary duty or the like. If a person possesses inside information, he or she simply cannot trade on it, or make trading recommendations to others on the basis of it, or disclose it to any third party.

Put another way, the EU directive is concerned, not with fraud, but with ensuring that everyone in the securities markets has equal access to information. Please note, this is not the same as saying that every investor has the same information. Nothing in the EU approach prohibits an analyst, for example, from using his or her time and labor to obtain more public information about a given security than the average investor possesses, and from trading and recommending trades on that basis. But what the analyst cannot do is make use of material information that the analyst knows or ought to know is not available to the general public.

Because the EU approach focuses, not on fraud, but on equality of access, it has few of the difficulties that have plagued U.S. law in this area. For example, a remote tippee need not know that the information on which she or her friends are trading is derived from a breach of fiduciary duty, let alone that the original tipper received a personal benefit from disclosing the information. Rather, it is enough to violate the EU directive if the remote tippee knew or ought to have known that the information was nonpublic. And because of the requirements that the information be precise and market-significant, there will be a great many instances where, from the very nature of the information, the recipient will know or ought to know that it is nonpublic.

Though there are some complexities to the EU law, on the whole it is a much more straightforward approach to insider trading than anything the U.S. courts have developed. If there is a flaw, it is not so much in the EU law itself as in its enforcement, or lack thereof. For the fact is that very few criminal prosecutions have been brought in the European Union for violations of any of the statutes that were passed by the individual countries to implement the directive. While this largely reflects a history in many of these countries of not aggressively prosecuting financial misconduct in general, it may also reflect a reluctance to bring criminal prosecutions under a law that only requires a kind of negligence for a violation to be stated. As to the latter, however, the European Parliament recently directed member states to clarify or implement their legislation so as to make clear that intentional instances of insider trading can be criminally prosecuted.

What about Canada? Under the Canadian approach, prohibition of insider trading is a matter of the law of the respective provinces, rather than federal law. But the provincial approach is largely statutory. For example, subsection (1) of section 76 of the Ontario Securities Act provides that “[n]o person or company in a special relationship with an issuer shall purchase or sell securities of the issuer with the knowledge of a material fact or material change with respect to the issuer that has not been generally disclosed.” Subsection (2) of section 76 provides that no such person “shall inform, other than in the necessary course of business, another person or company of a material fact or material change with respect to the issuer before the material fact or material change has been generally disclosed.” Finally, subsection (5)(e) of section 76 provides that the term “special relationship” will extend not just to insiders and the like but also to “a person or company that learns of a material fact or material change with respect to the issuer from any other person or company [on the list of special relationships] and knows or ought reasonably to have known that the other person or company is a [person or company encompassed by that list].” Some, but not all, provinces also have a statutory provision outlawing recommending or encouraging trading on the basis of inside information.

While disclaiming any expertise in Canadian law, I have the impression that the overall Canadian approach, although closer to the EU approach than to the U.S. approach, is something of a compromise between them. Specifically, it is not a fraud-based approach per se, but in requiring knowledge that the inside information have emanated, directly or indirectly, from someone in the zone of those having a special relationship with the issuer, it suggests something akin to knowledge of a breach of fiduciary duty. Although the EU approach seems to me preferable, the Canadian approach still has the virtue of being statutory, rather than judge-made.

Let me conclude this brief and limited survey by mentioning two other possible models for a statute. In the specific context of tender offers, the SEC has promulgated a rule, Rule 14e-3, that completely bans pre-offer trading in any of the relevant securities by any person of any kind who is in possession of material information relating to the tender offer that the person knows or has reason to know is nonpublic and comes from an insider. This is an application to the tender offer context of the kind of approach taken more broadly by Ontario law.

Finally, I want to harken back to the very first criminal case brought for insider trading, United States v. Chiarella. Although that case eventually gave rise (courtesy of a concurring opinion in the Supreme Court) to what is now called the “misappropriation theory” of insider trading, it was not tried on that theory, which is why the conviction was ultimately reversed in the Supreme Court. But both in the trial court and in the Second Circuit Court of Appeals, the conviction was affirmed on the broader theory on which it was tried; namely, in the words of the court of appeals, that “[a]nyone—corporate insider or not—who regularly receives material nonpublic information may not use that information to trade in securities.” United States v. Chiarella, 588 F.2d 1358, 1365 (2d Cir. 1978), rev’d, 445 U.S. 222 (1980). While this formulation, which for a short time was the law of the Second Circuit, might fairly be criticized as being too broad in some respects and too narrow in others, I mention it for two reasons. First, it has the kind of simplicity that is somewhat lacking in the EU and Canadian statutes previously summarized and totally lacking in the U.S. judge-made approach. And, second, it emphasizes, as does the EU approach, a focus on equality of access to information.

In the end, it may be suggested that a statute directed at making sure that investors in the stock market cannot rely in any way on nonpublic information is the way to go. The primary thrust of U.S. securities laws is to ensure transparency in the securities markets, a goal that is effectively undercut if trading on nonpublic information is permitted, regardless of whether the trader has fraudulent intent. To put it in terms of the sports analogy with which I began, a player in the stock market who trades on nonpublic information has an advantage over all other players in the market that rightly should be viewed as unfair, for otherwise the market will be viewed as rigged. And once a market is viewed as rigged, the public loses confidence in it, and the entire marketplace suffers—to the detriment of all of us.

Keywords: litigation, securities, insider trading, European Union Market Abuse Directive of 2003, Ontario Securities Act