Securities Fraud and Insider Trading

We will now cover two topics from securities law that appear in every corporations course: private securities fraud litigation under the Securities Exchange Act (SEA) rule 10b-5, and insider trading liability under the SEA rules 10b-5 and 14e-3 and SEA §16(b).Both topics relate to the dissemination of information from within the (listed) firm to the investing public at large, or “the market.” I noted before that US corporations (and, to a lesser extent, investors in US corporations) must disclose a great deal of information under the securities laws (see the securities law primer in chapter 1.3).But what happens if the corporation does not disclose truthfully? Then, more likely than not, a specialized plaintiff law firm will file a “securities fraud” class action against the corporation. If the corporate disclosure was misleadingly positive, then the suit will attempt to recover damages for shareholders who bought at an inflated price — inflated because it was based on erroneously positive information. Inversely, sellers will sue if the disclosure was misleadingly negative and thus the price deflated. Notice that those on the other side of these trades—sellers who sell at an inflated price, or buyers who buy at a deflated price—benefitted from the erroneous corporate disclosure, but they are not party to the litigation. Basic will teach you the basics of such litigation.Before the full truth is disclosed to the market, corporate insiders have an informational advantage. They could use this information to make profitable trades in their corporation’s securities. For example, a corporation’s fortunes will rise if the corporation discovers a large mineral deposit or makes an engineering break-through. The insiders — the engineers, the CEO, etc. — will know about it first. They might be tempted to buy the corporation’s stock, or call options on such stock, before the news goes out to the world at large. When the news about the discovery or break-through comes out, the corporation’s stock price will go up. The insiders who bought stock or options would pocket a profit — but, if they are found out, they would go to prison. Insider trading is not only illegal but criminal in the US and now in most other jurisdictions around the world.Formally, the core legal rule for both securities fraud and insider trading is rule 10b-5, discussed below. However, the issues posed in the two sets of cases are quite different. Usually, securities fraud cases turn on whether the information was misleading and material, whereas insider trading cases turn on whether the defendant had access to the information and, if so, whether the defendant improperly obtained or traded on it. The main policy question in securities fraud is the availability of the class action (Strike suits? Who is deterred if the corporation pays the damages?), whereas the insider trading debate revolves around the definition of inside information and hence the boundaries of legitimate trading. Procedurally, securities fraud is typically litigated in a private class action, while insider trading is typically prosecuted by the S.E.C. or even the U.S. Attorney’s Office. As a result, the legal questions are quite different, even though they formally arise under the same rule 10b-5.Rule 10b-5Rule 10b-5 is only one of many anti-fraud rules in securities law (cf., e.g., SEA §14(e) for statements in connection with tender offers). Rule 10b-5 is just the most general, “catch-all” provision. It implements SEA §10(b), which is not self-executing. §10(b) reads in its most relevant substantive part:“It shall be unlawful for any person . . . [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 such rules and regulations as the Commission may prescribe . . .”Rule 10b-5 was adopted in 1942 without, it appears, much thought or any anticipation of the role it would come to play in the hands of the SEC and the courts later on. SEC staffers wanted to go after an instance of clear common law fraud. To obtain jurisdiction over the case, however, they needed the Commission to adopt a rule under §10(b) first. So the staffers copied §17 of the Securities Act and submitted it to the Commissioners. The Commissioners approved without discussion. See Louis Loss & Joel Seligman, Fundamentals of Securities Regulation 937-8 (4th ed. 2004).The rule reads:It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails or of any facility of any national securities exchange,a. To employ any device, scheme, or artifice to defraud,b. To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, orc. To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person,in connection with the purchase or sale of any security.The rule mentions neither a private right of action nor insider trading. But the courts soon implied a private right of action, and the SEC, with approval of the courts, brought insider trading cases under the rule. Ironically, these judicial creations are now recognized in the statute itself. For example, a later amendment of SEA §10 explicitly references “insider trading” rules adopted by the SEC and by judicial precedent, extending such rules to “security-based swap agreements” (i.e., derivatives).Plaintiffs attempted to bring even more corporate disputes under 10b-5, including cases unrelated to disclosure. In fact, in the early 1970s, most corporate law litigation was brought in the federal district courts under rule 10b-5, rather than in Delaware state courts under state law. Delaware was, at that time, unreceptive to shareholder suits involving fiduciary duty claims. By contrast, the 2nd circuit read rule 10b-5 very expansively. The Supreme Court put an end to this in Santa Fe Industries v. Green (U.S. 1977). In that case, the 2nd circuit had ruled that an unfair cash-out merger could be actionable “fraud” under rule 10b-5 even if defendants had fully disclosed all price-relevant information. The Supreme Court insisted, however, that 10b-5 required “deception, misrepresentation, or nondisclosure.” In general, the Supreme Court has become much more hostile to private securities litigation over time. Thus, you should not expect a judicial expansion beyond what you will read below.