Mark Cuban recently filed an amicus brief in the Second Circuit, addressing the DOJ petition for rehearing en banc, which provides helpful context amid the flurry of arguments made by the DOJ and SEC about the United States v. Newman panel decision. The Cuban brief dismantles the prosecutors’ notion that the Supreme Court’s decision in Dirks v. SEC made every transfer of material inside information from one “friend” to another a sufficient basis for convicting the recipient for violating section 10(b) of the Securities Act of 1934 if there is a trade made in possession of that information. We previously discussed the flaws in the DOJ and SEC contentions here: DOJ Petition for En Banc Review in Newman Case Comes Up Short, and here: SEC’s Amicus Brief in U.S. v. Newman Fails To Improve on DOJ’s Effort. The Cuban brief is available here: Mark Cuban Amicus Brief in US v. Newman.
One very helpful aspect of the Cuban brief is to put insider trading law into its proper historical context. We began to do this in one of our early posts: The Myth of Insider Trading Enforcement (Part I), That post described how a statute that never barred insider trading was converted by SEC and judicial fiat into one that prohibited trading that the SEC thought was inequitable. Regrettably, that discussion ends just before the critical Supreme Court decision in Chiarella v. United States, which represented the Supreme Court’s first effort to bring high-flying theories of insider trading liability endorsed by the SEC and the Second Circuit back to earth. In particular, the long-standing effort of the SEC to found insider trading fraud on the concept of equal access to information, rather than conduct that constitutes fraud, was — or should have been — halted by the Chiarella decision. The Cuban brief goes into some of this history, explaining how the SEC and DOJ have consistently tried to expand the scope of what is unlawful based on theories of equity among investors, rather than what section 10(b) actually does, which is to prohibit fraud in connection with securities trades.
In many respects, the Cuban brief follows and expands on our “Myth of Insider Trading” analysis (which perhaps explains why we like it):
While Congress was aware of concerns regarding insider trading at the time the Securities Exchange Act of 1934 was enacted, see, e.g., Donald Cook & Myer Feldman, Insider Trading under the Securities Exchange Act, 66 Harv. L. Rev. 385, 386 (Jan. 1953), the Act addresses only a narrow subspecies of insider trading – namely, where a director, beneficial owner, or officer personally achieves shortswing profits by using nonpublic information to make both a purchase and a sale of company stock within six months of each other. Securities Exchange Act of 1934,404, tit. 1, § 16(b) (codified as amended at 15 U.S.C. § 74p(b)). And even in that situation, only the company (or a shareholder acting derivatively on behalf of the company) may sue for disgorgement; there is no criminal liability, and the SEC may not bring an action to enforce the prohibition. Id.
Despite the lack of Congressional proscription (or even intent) regarding insider trading beyond the limited context of section 16(b), the SEC has not hesitated to argue that section 10(b)’s fraud provision and Rule 10b-5 broadly proscribe “insider trading.” Addressing the issue in In the Matter of Cady, Roberts & Co., 40 S.E.C. 907 (1961), the SEC held that a trader committed a fraud – and thus violated Rule 10b-5 – whenever he or she traded while knowing material nonpublic information that the counterparty did not. In effect, the SEC demanded a parity of information between traders: A trader either had to disclose his informational asymmetry or abstain from trading. See Chiarella v. United States, 445 U.S. 222, 227 (1980).
This expansive view of insider trading had little basis in the Exchange Act – indeed, it went well beyond Congress’s narrow proscription in section 16(b) against short-swing trades by a limited group of insiders. The SEC nevertheless managed to convince lower courts – including this one – to adopt its “disclose or abstain” rule, and many successful (but baseless) insider trading actions were brought accordingly. See, e.g., SEC v. Tex. Gulf Sulfur Co., 401 F.2d 833 (2d Cir. 1968).
The SEC pressed its flawed parity-of-information rule for nearly two decades. It jettisoned the rule only when the Supreme Court reversed a decision of this Court to hold that information parity is “inconsistent with the careful plan that Congress has enacted for regulation of the securities markets.” Chiarella, 445 U.S. at 235. The Chiarella Court explained that Congress did not outlaw all forms of insider trading but only those that constitute fraud. Id. Trading on nonpublic information is fraudulent only when the investor has an independent duty under the common law to disclose that information or abstain from trading. Id. By contrast, the SEC’s parity-of-information rule had created a “general duty between all participants in market transactions to forego actions based on material, nonpublic information” and thus “depart[ed] radically” from both the Exchange Act and established fraud doctrine. Id. at 233.
Despite the setback in Chiarella, the SEC continued to press for expanded insider trading proscriptions. Three years after Chiarella, the Supreme Court again took up the issue in Dirks v. SEC, 463 U.S. 646 (1983). There, the SEC had charged an analyst with insider trading after he had received and passed on to traders information from insiders concerning corruption at a financial firm. Id. at 648-49. The SEC’s position was that the analyst automatically inherited the insiders’ common law duty not to trade on confidential information by virtue of having received information from those insiders . Id. at 655-56. In other words, the SEC believed that every tippee is subject to the parity-of-information rule. Id.
Once again, the Supreme Court rejected the SEC’s view of insider trading as overly expansive. After repeating Chiarella’s holding that there can be no liability for insider trading unless there is a fraud, id. at 666 n.27, the Court held that a tippee does not per se acquire a duty to disclose or abstain whenever he acquires insider information, id. at 659. To the contrary, a tippee “assumes a fiduciary duty to the shareholders of a corporation not to trade on material nonpublic information only when the insider has breached his fiduciary duty to the shareholders by disclosing the information to the tippee and the tippee knows or should know that there has been a breach.” Id. at 660 (emphasis added); see also Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 313 (1985) (explaining that Chiarella and Dirks make clear that “a tippee’s use of material nonpublic information does not violate § 10(b) and Rule 10b-5 unless the tippee owes a corresponding duty to disclose the information”).
History thus demonstrates that the SEC and DOJ will relentlessly push to expand the outer limits of what constitutes insider trading until they are reined in. But expanding the reach of the insider trading laws is Congress’s purview. . . . And time and again, Congress has declined to define insider trading.
Cuban Brief at 5-9 (footnotes and some citations omitted).
The Cuban brief also provides some history about the failure of Congress to provide any definition of what falls inside, and outside, of an insider trading prohibition. Despite continuing uncertainty about what is and is not lawful conduct, no clarification of the law has ever occurred, although numerous unsuccessful efforts were made. See the Cuban Brief at 9-12. Of course, the SEC has always had it within its power to use the rulemaking process to create more clear parameters of what is and is not prohibited. It has never done so, in no small part because the SEC has no desire to have a clear standard that would limit the ability of law enforcement authorities to exercise wide discretion effectively to legislate the scope of what is prohibited through enforcement actions. See our post: SEC Insider Trading Cases Continue To Ignore the Boundaries of the Law.
The Cuban brief sums up well where this leaves the state of insider trading law:
[T]he ambitious stance of the Department of Justice (egged on by the SEC in its own cases) [is] to take every opportunity to seek an expansion of the parameters of prohibited insider trading by bringing claims based on novel theories for which there is no precedent. Without definitive guidance as to what is a violation and what is not, well-meaning innocent individuals are left in the untenable position of having to worry that what is (and should be) a lawful transaction today will suddenly be alleged by the Government to violate the federal securities laws tomorrow.
The Government, in its ever-broadening campaign against insider trading, seems to have lost sight that its underlying goal should be to assure that the markets are fair and equitable so that companies and investors are able to participate with confidence, thus encouraging capital formation. Companies need capital to grow, and investors need to know that the companies in which they invest, and the markets in which they transact, will treat them fairly. Pursuing individuals under novel theories does nothing to improve the fairness of the markets.
Cuban Brief at 2-3 (footnote omitted).
Our previous posts on Newman explain that the panel decision did not open the floodgates for insider trading or impose any new great burden on the DOJ or SEC to prove violations of section 10(b). But even if the DOJ’s and SEC’s “sky is falling” prediction in their rehearing filings with the Second Circuit were right, reconsidering the Newman decision is not the solution to that problem. The solution is a studied effort to define what is and is not unlawful and provide certainty in this area of the law that prevents fraud but allows trading markets to function fairly and efficiently.
February 20, 2015
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