Section 10(b) of the Securities Exchange Act of 1934 prohibits any person from using the mails or facilities of interstate commerce “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 as necessary or appropriate in the public interest or for the protection of investors.” In 1942, the SEC learned of a company president who misrepresented the company’s financial condition in order to buy shares at a low price from current stockholders. So the commission adopted a rule under the authority of Section 10(b). Rule 10b-5, as it was dubbed, has remained unchanged for more than forty years and has spawned thousands of lawsuits and SEC proceedings. It reads as follows:
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,
- to employ any device, scheme, or artifice to defraud,
- 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 circumstances under which they were made, not misleading, or
- 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.
Rule 10b-5 applies to any person who purchases or sells any security. It is not limited to securities registered under the 1934 Securities Exchange Act. It is not limited to publicly held companies. It applies to any security issued by any company, including the smallest closely held company. In substance, it is an antifraud rule, enforcement of which seems, on its face, to be limited to action by the SEC. But over the years, the courts have permitted people injured by those who violate the statute to file private damage suits. This sweeping rule has at times been referred to as the “federal law of corporations” or the “catch everybody” rule.
Insider trading ran headlong into Rule 10b-5 beginning in 1964 in a series of cases involving Texas Gulf Sulphur Company (TGS). On November 12, 1963, the company discovered a rich deposit of copper and zinc while drilling for oil near Timmins, Ontario. Keeping the discovery quiet, it proceeded to acquire mineral rights in adjacent lands. By April 1964, word began to circulate about TGS’s find.
Newspapers printed rumors, and the Toronto Stock Exchange experienced a wild speculative spree. On April 12, an executive vice president of TGS issued a press release downplaying the discovery, asserting that the rumors greatly exaggerated the find and stating that more drilling would be necessary before coming to any conclusions. Four days later, on April 16, TGS publicly announced that it had uncovered a strike of 25 million tons of ore. In the months following this announcement, TGS stock doubled in value.
The SEC charged several TGS officers and directors with having purchased or told their friends, so-called tippees, to purchase TGS stock from November 12, 1963, through April 16, 1964, on the basis of material inside information. The SEC also alleged that the April 12, 1964, press release was deceptive. The US Court of Appeals, in SEC v. Texas Gulf Sulphur Co., 1 decided that the defendants who purchased the stock before the public announcement had violated Rule 10b-5. According to the court, “anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing to protect a corporate confidence, or he chooses not to do so, must abstain from trading in or recommending the securities concerned while such inside information remains undisclosed.”
On remand, the district court ordered certain defendants to pay $148,000 into an escrow account to be used to compensate parties injured by the insider trading.
The court of appeals also concluded that the press release violated Rule 10b-5 if “misleading to the reasonable investor.” On remand, the district court held that TGS failed to exercise “due diligence” in issuing the release. Sixty-nine private damage actions were subsequently filed against TGS by shareholders who claimed they sold their stock in reliance on the release. The company settled most of these suits in late 1971 for $2.7 million.
Following the TGS episode, the Supreme Court refined Rule 10b-5 on several fronts. First, in Ernst & Ernst v. Hochfelder, 2 the Court decided that proof ofscienter—defined as “mental state embracing intent to deceive, manipulate, or defraud”—is required in private damage actions under Rule 10b-5. In other words, negligence alone will not result in Rule 10b-5 liability. The Court also held that scienter, which is an intentional act, must be established in SEC injunctive actions. 3
The Supreme Court has placed limitations on the liability of tippees under Rule 10b-5. In 1980, the Court reversed the conviction of an employee of a company that printed tender offer and merger prospectuses. Using information obtained at work, the employee had purchased stock in target companies and later sold it for a profit when takeover attempts were publicly announced. In Chiarella v. United States, the Court held that the employee was not an insider or a fiduciary and that “a duty to disclose under Section 10(b) does not arise from the mere possession of nonpublic market information.” 4Following Chiarella, the Court ruled in Dirks v. Securities and Exchange Commission (see Tippee Liability , that tippees are liable if they had reason to believe that the tipper breached a fiduciary duty in disclosing confidential information and the tipper received a personal benefit from the disclosure.
The Supreme Court has also refined Rule 10b-5 as it relates to the duty of a company to disclose material information, as discussed in Basic, Inc. v. Levinson (see Duty to Disclose Material Information ). This case is also important in its discussion of the degree of reliance investors must prove to support a Rule 10b-5 action.
In 2000, the SEC enacted Rule 10b5-1, which defines trading “on the basis of” inside information as any time a person trades while aware of material nonpublic information. Therefore,
a defendant is not saved by arguing that the trade was made independent of knowledge of the nonpublic information. However, the rule also creates an affirmative defense for trades that were
planned prior to the person’s receiving inside information.
In addition to its decisions relating to intent (Ernst & Ernst), tippees (Dirks), materiality (Basic), and awareness of nonpublic information (10b5-1), the Supreme Court has considered the misappropriation theory, under which a person who misappropriates information from an employer faces insider trading liability. In a leading misappropriation theory case, the Second Circuit Court of Appeals reinstated an indictment against employees who traded on the basis of inside information obtained through their work at investment banking firms. The court concluded that the employees’ violation of their fiduciary duty to the firms violated securities law. 5 The US Supreme Court upheld the misappropriation theory in United States v. O’Hagan, 6 and the SEC adopted the theory as new Rule 10b5-2. Under this new rule, the duty of trust or co work at investment banking firms. The court concluded that the employees’ violation of their fiduciary duty to the firms violated securities law. nfidence exists when (1) a person agrees to maintain information in confidence; (2) the recipient knows or should have known through history, pattern, or practice of sharing confidences that the person communicating the information expects confidentiality; and (3) a person received material nonpublic information from his or her spouse, parent, child, or sibling.
In 1987, in Carpenter v. United States, 7 the Supreme Court affirmed the conviction of a Wall Street Journal reporter who leaked advanced information about the contents of his “Heard on the Street” column. The reporter, who was sentenced to eighteen months in prison, had been convicted on both mail and wire fraud and securities law charges for misappropriating information. The Court upheld the mail and wire fraud conviction by an 8–0 vote and the securities law conviction by a 4–4 vote. (In effect, the tie vote affirmed the conviction.) 8
Beyond these judge-made theories of liability, Congress had been concerned about insider trading, and in 1984 and 1988, it substantially increased the penalties. A person convicted of insider trading now faces a maximum criminal fine of $1 million and a possible ten-year prison term. A civil penalty of up to three times the profit made (or loss avoided) by insider trading can also be imposed. This penalty is in addition to liability for profits made through insider trading. For example, financier Ivan Boesky, who was sentenced in 1987 to a three-year prison term for insider trading, was required to disgorge $50 million of profits and was liable for another $50 million as a civil penalty. In 2003, Martha Stewart was indicted on charges of insider trading but was convicted for obstruction of justice, serving only five months. More recently, in 2009, billionaire founder of the Galleon Group, Raj Rajaratnam, was arrested for insider trading; he was convicted in May 2011 of all 14 counts of insider trading. For the SEC release on the Martha Stewart case, see http://www.sec.gov/news/press/2003-69.htm.
Companies that knowingly and recklessly fail to prevent insider trading by their employees are subject to a civil penalty of up to three times the profit gained or loss avoided by insider trading or $1 million, whichever is greater. Corporations are also subject to a criminal fine of up to $2.5 million.
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