Chapter 21 Regulation of Securities Trading

New Outline

(last updated 28 Nov 06)

Chapter 21 Regulation of Securities Trading

A.  Securities Trading: Markets and Theory

1.  Information and securities markets

2.  Economic theory: insider trading and corporate disclosure

B.  Overview of the Chapter

C.  Insider Trading: State Corporate Law

1.  Duty to shareholder and investors

o  Goodwin v. Agassiz

2.  Duty to the corporation

o  Diamond v. Oreamuno

D.  Insider Trading: Rule 10b-5

1.  Early history

o  In The Matter of Cady, Roberts & Co.

2.  Materiality

3.  Duty to “disclose or abstain”

o  Chiarella v. United States

4.  Tipper-Tippee liability

o  Dirks v. Securities and Exchange Commission

5.  Misappropriation theory

o  United States v. O’Hagan

E.  Disclosure Duties of Corporations

F.  Disgorgement Liability: Section 16

G.  International Regulation of Insider Trading

Class Notes

C.  Insider Trading: State Corporate Law

AN INTRODUCTION TO INSIDER TRADING
Agassiz is president of Cliff Mining Co. He likes to play the stock market, particularly his own company's stock. We live in an information world where knowledge is power and power is money. How can he exploit his informational advantages? / HYPOTHETICAL - TRADING ON GOOD NEWS
Cliff Mining engineers strikes a rich copper field on land the company has rights to. Agassiz is flabbergasted by the highly confidential assay reports from the field. Make some money for Agassiz!
HYPOTHETICAL - TRADING ON BAD NEWS
Cliff Mining has been searching for copper in the Upper Peninsula of Michigan. The company's exploration efforts have been well-publicized. The company's board, disappointed by confidential reports of poor results, instructs Agassiz to end the exploration. Make some money for Agassiz!
HYPOTHETICAL - TRADING AS AN OUTSIDER
Cliff Mining has been searching for a way into Chile. The Chilean government grants exploration rights to another company, Anaconda. Cliff Mining proposes to buy Anaconda in a merger. Make some money for Agassiz!
Goodwin v. Agassiz
(Sup Ct Mass 1933)
Agassiz and McNaughton are directors of Cliff Mining. Agassiz is president; McNaughton is general manager. They bought Cliff Mining stock on the Boston Stock Exchange. What did they know? Goodwin, a shareholder who sold at about the time that Agassiz and McNaughton were buying, sues in his personal capacity. He wants his shares back. What is Goodwin's theory? According to Goodwin, what should the defendants have done? What about the geologist's theory? Why is Massachusetts law the early cradle of US corporate law? / Supreme Judicial Court of Massachusetts:
"The contention that directors also occupy a position of trustee toward individual stockholders in the corporation is plainly contrary to repeated decisions of this court ..."
"Purchase and sales of stock dealt in on the stock exchange are commonly impersonal affairs. An honest director would be in a difficult situation if he could neither buy nor sell on the stock exchange shares of stock in his corporation ..."
*************
Supreme Judicial Court of Massachusetts:
"Whether that theory was sound or fallacious, no one knew, and so far as appears has never been demonstrated."
HYPOTHETICAL
Suppose the facts of the case were that the geologist's theory had actually been proved. That is, Cliff Mining had struck a rich ore field, and Agassiz and McNaughton had bought stock without telling selling shareholders of the strike. Aren't Agassiz and McNaughton fiduciaries? Haven't they violated their duties? / Supreme Judicial Court of Massachusetts:
"Fiduciary obligations of directors ought not to be made so onerous that men of experience and ability will be deterred from accepting such office. Law in its sanctions is not coextensive with morality."
HYPOTHETICAL
Agassiz and McNaughton circulated a false press release that stated the company had abandoned exploration in Michigan and the company expected to sell and withdraw its operations from the area. Agassiz and McNaughton then buy on the stock market; Goodwin sells at about the same time. Does Goodwin have a claim? What about privity?
HYPOTHETICAL
The geologist's theory was right! Cliff Mining will make a fortune. Analyst Ana has been following the portentous copper market. She traipsed around the upper peninsula in Michigan and watched through high-powered binoculars as Cliff Mining engineers gesticulated wildly as they reviewed core samples. Ana and her clients bought heavily. Goodwin (and other contemporaneous sellers) sue her. Do they have a claim?
HYPOTHETICAL
The geologist's theory was right! Cliff Mining will make a fortune. Agassiz and McNaughton want to buy up as much stock as they can. But there are agonizingly few offers to sell on the stock exchange. Their broker learns that Widow Goodwin is willing to sell her large block of Cliff Mining stock. The broker sends a messenger to the Widow's agent, who does not know the messenger is acting for the insiders. The messenger offers to buy. The Widow sells. Does Widow Goodwin have a claim? / *************
Massachusetts Supreme Court:
"Mere silence does not usually amount to a breach of duty, but parties may stand in such relation to each other when an equitable responsibility arises to communicate facts.
THEORY FOR INSIDER TRADING RULES
Consider the following two investment options:
COMPANY A - We encourage our executives to own company stock. They can buy and sell as they deem fit. We have no qualms about trading on confidential information.
COMPANY B - We accept that our executives own company stock. But we do not permit trading on confidential information. We will vigorously enforce the company's rights.
Which company is a better investment? / Pros - COMPANY A
· get info to mkt / soft info like geologist theory
· reward execs / incentive to strike copper
· avoid uncertainty about liability
· protect proprietary info other ways
Cons - COMPANY B
· insider trading is evil
· undeserved easy money / fiduciaries already paid
· fiduciaries duty to shareholders
· undermines company reputation
· incentive to manipulate prices
Diamond v. Oreamuno
(NY 1969)
Insiders Oreamuno and Gonzalez learn that corporate earnings are going to fall 75% for the quarter. THEY SELL!! Diamond brings a derivative suit on behalf of the corporation. What is the harm to the corporation?
What is the effect of corporate recovery? Who will benefit from the corporate recovery? New shareholders who bought from the insiders? To what extent? Long-time shareholders who continued to hold through the 75% drop in earnings? To what extent?
/ New York Court of Appeals:
Agent “must account to his principal for any profits derived" from his confidential or fiduciary relationship. Derivative suit is meant "to prevent .... agents and trustees [from] dealing for their own benefit ..."
The corporation "has a great interest in maintaining a reputation of integrity, and image of probity, for its management and in insuring the continued public acceptance and marketability of its stock."
D. Insider Trading: Rule 10b-5
Chiarella v. United States
(US 1980)
Chiarella v. United States
Chiarella, while working at Pendick Press,
Saw visions of fortune, financial success;
As he stacked reams of paper and collated pages
He dreamed of doubling his journeyman's wages.
Of sleeping on silk sheets, arising at noon
And smoking cigars like a Wall Street tycoon.
He dreamed of a private bank vault unlocking,
And kept an ear perked for opportunity knocking.
One night, while marking up galleys as usual
A prospectus attracted unusual perusal:
Laid out like a map to a buccaneer's treasure
Were the plans of a corporate takeover measure,
Which, though it omitted some terms and conditions,
Could be read by a printer of lavish ambitions.
For Chiarella, of course, this posed no moral crisis--
He knew what merger bids meant to stock market prices,
And the potential for building a nice little stash
When knowledge is power and power is cash.
So he called up his broker and put in a buy
And made thirty grand in the blink of an eye.
Well, if not in a blink, at least fairly soon,
And Chiarella felt like a grasshopper in June.
His gains were envied by brokers and speculators --
And soon were examined by federal investigators,
Who thought that his rise from printer to prince
Would not have occurred without inside hints.
If the printer had help in picking the ringers,
He could expect to be printing the tips of his fingers
(For one couldn't quite hope a consent decree
Would curb the fury of a scorned SEC).
And soon a marshall arrived to announce
Securities fraud, in seventeen counts.
Thus Chiarella, whose future once looked resplendent,
Became, to his family and friends, "the defendant." / At trial, the defendant took rather a beating,
Which the court of appeals was content in repeating.
But the Supreme Court was sad to see someone so hurt,
And snapped up the case on petition for cert.
They fashioned with skill a reversal opinion
Which pruned the perimeter of 10(b)'s dominion.
Like Cardozo when faced with the Palsgraff confusion,
"No Duty!" was Powell's majority conclusion --
No need to part with nonpublic information
In the absence of some fiduciary relation.
It mattered but little, said Chiarella's lawyer,
If he'd breached trust of his employer's employer;
Since the issue eluded the jury at trial,
It could not at present be worth the Court's while.
So Chiarella absconded, despite unrelenting
Protests from Blackmun and Burger, dissenting.
Absconded, however, without true success,
For he lost both his profits and his job at the press,
Lost money to lawyers, and months in the court,
And lost any interest in market reports.
No one quite know what's become of him since --
Not a prisoner, not hardly a prince --
But if, as you pass down some cold New York street,
An ink-stained fellow asks for money to eat,
Remember Chiarella, who dreamt of wealth of beauty,
And remember the lesson from law school: NO DUTY!
by Dan Sharp
A FEDERAL SEARCH FOR DUTY
ACT I - THE SCENE
Chiarella, while working at Pendick Press,
Saw visions of fortune, financial success;
As he stacked reams of paper and collated pages
He dreamed of doubling his journeyman's wages.
Of sleeping on silk sheets, arising at noon
And smoking cigars like a Wall Street tycoon.
He dreamed of a private bank vault unlocking,
And kept an ear perked for opportunity knocking. / A QUERY
How did Chiarella to company secrets become privy,
And then in an instant make a stock killing so spiffy?
ACT II - EUREKA!
One night, while marking up galleys as usual
A prospectus attracted unusual perusal:
Laid out like a map to a buccaneer's treasure
Were the plans of a corporate takeover measure,
Which, though it omitted some terms and conditions,
Could be read by a printer of lavish ambitions.
For Chiarella, of course, this posed no moral crisis--
He knew what merger bids meant to stock market prices,
And the potential for building a nice little stash
When knowledge is power and power is cash.
So he called up his broker and put in a buy
And made thirty grand in the blink of an eye. / PAUSE TO REFLECT
What, you might ask, can be so wrong with trading
On a scoop that a target's simply ripe for a raiding?
Or, for that matter as well, how might we deride
That an investor seeking gains trades from the inside?
ACT III - THE PLOT THICKENS
Well, if not in a blink, at least fairly soon,
And Chiarella felt like a grasshopper in June.
His gains were envied by brokers and speculators --
And soon were examined by federal investigators,
Who thought that his rise from printer to prince
Would not have occurred without insider hints.
If the printer had help in picking the ringers,
He could expect to be printing the tips of his fingers
(For one couldn't quite hope a consent decree
Would curb the fury of a scorned SEC.)
And soon a marshall arrived to announce
Securities fraud, in seventeen counts.
Thus Chiarella, whose future once looked resplendent,
Became, to his family and friends, "the defendant." / WHAT THEORY?
So the feds got indictments using 10b-5 grammar,
Had they a theory to put Chiarella in the slammer?
Jury Instructions:
"Defendant violates the statute if he knew other people trading in the securities market did not have access to the same information."
Justice Blackmun (in dissent):
"... persons having access to confidential material information that is not legally available to others generally are prohibited ... from engaging in schemes to exploit their structural informational advantage through trading ..."
Second Circuit (pre-eminent federal securities court)
"Anyone -- corporate insider or not -- who regularly receives material nonpublic information may not use that information to trade in securities without incurring an affirmative duty to disclose ...
"[The securities laws] create a system providing equal access to information necessary for reasoned and intelligent investment decisions."
Justice Burger:
"As a general rule, neither party to an arm's length business transaction has an obligation to disclose information to the other unless they stand in some confidential or fiduciary relation.
"... the rule should give way when an information advantage is obtained, not by superior experience, foresight or industry, but by some unlawful means [such as stealing information ] ...
ACT IV, Scene 1 - SOMETHING AMISS
At trial, the defendant took rather a beating,
Which the court of appeals was content in repeating.
But the Sup. Ct. was sad to see someone so hurt,
And snapped up the case on petition for cert.
They fashioned with skill a reversal opinion
Which pruned the perimeter of 10(b)'s dominion. / Securities Exchange Act of 1934 Act
§ 10 - It shall be unlawful for any person ...
(b) To 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 ...
ACT IV, Scene 2 - SUPREME'S THEORY
Like Cardozo when faced with Palsgraff confusion,
"No Duty!" was Powell's majority conclusion --
No need to part with nonpublic information
In the absence of some fiduciary relation. / SOURCE OF DUTY?
Justice Powell:
In its Cady Roberts decision, the Commission recognized a relationship of trust and confidence between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation.