EUROPEAN

BUSINESS

LAW REVIEW

Law & Business

AUSTIN BOSTON CHICAGO NEW YORK THE NETHERLANDS

Editorial Board

Guido Alpa General Editor, Professor, La Sapienza, Rome, President of the Italian Bar.

Mads Andenas General Editor, Professor, University of Oslo, Director of the Centre of Corporate and Financial Law, Institute of Advanced Legal Studies, University of London.

Giuseppe Conte Professor of Law, University of Florence. Francesco Capriglione Professor, Luiss University, Rome.

Jan Dalhuisen Professor, King’s College, London, and University of Utrecht.

Duncan Fairgrieve Sciences-Po, Paris and the British Institute of International and Comparative Law, London.

Laurence W Gormley Barrister, Professor of European Law, University of Groningen. Stefan Grundmann Professor, Humboldt University, Berlin.

Renato Nazzini Reader, University of Southampton.

Barry A K Rider Director of the Institute of Advanced Legal Studies and Professor of Law, University of London; Tutor and Fellow, Jesus College, Cambridge; Barrister, England and Wales.

Jukka Snell Professor, School of Law, University of Swansea. Jan Wouters Professor, University of Leuven.

through controversial case law.3 However, inside information can never be com- pletely defined because all information is, to varying degrees, non public. Most information is unknown and even, at times, unknowable. For example, most people do not know generally accepted accounting principles (GAAP). Yet, the GAAP are internationally well established and necessary to a solid fundamental analysis of any stock. Is GAAP inside information? Are accountants “insiders”? Do they have an “unfair” trading advantage? Their knowledge of fundamental analysis of stock values (ratios) does in fact give them a trading advantage as Warren Buffet exem- plifies. We rightly do not punish accountants for their expertise even though their expertise is based on a thorough knowledge of exactly the type of information that is regarded as “inside”!

The untenability of the “inside” information distinction becomes clear if we look at insider trading from the perspective of information theory. Information, like any product, has a life cycle. All information starts its life cycle as “unknown”. Informa- tion at first is known by no one. Information is somehow discovered or invented. Then it is “known only by a few”. We might call these persons “insiders” and the law sometimes does. This “inside” information over time is disseminated at a rate cor- responding to its value. When does the information stop being “inside” and start being “public”? I think that question is unanswerable. In any event, once information becomes widely disseminated it has little value. The value of “inside” information exists because it is rare. Like any product, “rare” information has greater value than “common” information. The value of a piece of information encourages its dissemi- nation. Outlawing use of “inside” information is a very good way to slow down its publication. In no other market do we punish those who would profit from their knowledge. In fact, in a few markets – patents, trademarks and copyrights – the law actually makes information monopolies. The value of “insider” information determines how rapidly and to whom the information flows. When the law imposes restrictions on the use of insider information it is distorting market processes, restricting informa- tion flow leading to inefficiency.

The inability to conjure a defensible justification of the prohibition of insider trad- ing is a damning condemnation of the law as it stands. Were insider trading something other than an inevitable and good part of the market it would be easy to find a rationale to justify it and ways to prohibit it.

3“Since there is no explicit statutory definition of insider trading, it has been established through controversial case law. One important issue is the definition of inside information. Inside information initially meant information concerning a company’s assets or earning power that affected the stock price. Thus, traditional insider trading usually involved trading by directors, officers, and employees of the corporation. This definition has expanded over time to include “market information,” which is any information that affects the market for a company’s security, not just information affecting the company’s assets or earning power. This more expansive definition of inside information has led to individuals besides traditional insiders being found guilty of insider trading. Today, courts do not make the distinction between these two types of information. Therefore, trading based on traditional inside information as well as outside information is considered insider trading in violation of Rule 10b-5.” Christopher M Gorman, ‘Are Chinese Walls the Best Solution to the Problems of Insider Trading and Conflicts of Interest in Broker-Dealers?’ (2004) 9 Fordham J. Corp. & Fin. L. 475, 478.

The best justification for considering some information “inside” is, unsurprisingly, based on theories of ownership. The “inside” information is (supposedly) the property of the corporation. However, that analysis is erroneous. “Inside” information is no trade secret. And if it were a trade secret then the corporation would have an action for deceit or fraud – and then the inside trading law would be superfluous. Informa- tion, ordinarily, is not property.4 The law recognizes only a few limited instances where information is property, namely: Trade secrets, trademarks, patents, and copy- rights. If the corporation wishes to protect its information it can do so merely by observing the legal requirements of trade secret law. Or it can contractually bind its officers, directors and employees from disclosing or trading on the information acquired during their employ or tenure.

A related defense of the prohibition of “inside” trading is that the inside trade injures the corporation’s shareholders. However, some shareholders in fact clearly benefit from insider trading. Further, the supposed detriments of insider trading are speculative and ambiguous. Finally, the rapid and complete flow of information ben- efits shareholders – and allowing insider trading encourages rapid information flow. It may seem paradoxal that rapid, complete information flow results from allowing trades on asymmetric information. However, greed is a great motivator. When people know that the informed trader may know something they don’t – which is always the case! – they will be more careful in their trading and more inquisitive as to the cause of the insider’s trade. Prohibiting insider trading creates a false sense of security among “outsiders” and hinders market signals.

If the corporation wishes to defend its shareholders from the officers, employees and/or directors it can with ordinary contract law.5 This raises an interesting question: Would a defense that the corporation explicitly contracted away its confidentiality in some piece of information be a defense to a claim of inside trading? If we take the fiduciary duty argument seriously in some cases the answer would be yes. In fact, the general principle of freedom of contract shows why, absent a compelling state inter- est, the corporation should be able to contract away the right to trade on information. In all events, the corporation could contractually protect confidentiality and thereby prohibit trading on the information.

Supposedly, the courts want to protect shareholders. Since when have persons with wealth needed or even wanted protections of the state? The general principle of law

4“As a general matter, when you are creating property rights in information, you are doing a very difficult thing, and something that is traditionally limited to narrow exceptions. The default rule remains the freedom of information.” Joel Reidenberg, Jennifer Barrett, Evan Hendricks, Solveig Singleton, David Sobel, ‘The Conflict between Commercial Speech and Legislation Governing the Commercializa- tion of Private Sector Data’(2000) 11 Fordham Intell. Prop. Media & Ent. L.J. 59, 78; “Property rights in copyright law are treated as exceptions from the general rule that information lawfully obtained is available to everyone”, Raymond T Nimmer, Patricia Ann Krauthaus, ‘Copyright on the Information Superhighway: Requiem for a Middleweight’ (1994) 6 Stan. L. & Pol’y Rev. 25, 30.

5Kimberly D Krawiec also argues that insider trading should be regulated by contract law. “Property rights in copyright law are treated as exceptions from the general rule that information lawfully obtained is available to everyone” Kimberly D Krawiec, ‘Privatizing “Outsider Trading”’ (2001) 41 Va. J. Int’l L. 693, 693.

in a liberal democracy is that the freedom of contract governs private transactions.6 Since the supposed wrongs of insider trading can be better remedied by the corpora- tion why should the law take on a paternalistic role? Why should the law protect the imprudent from the natural consequences of their problems? Protecting folly encour- ages it.

Were insider trading somehow fundamentally wrong it would be possible to pro- hibit it simply with the ordinary tort of deceit. But it is not possible to paint all conduct currently held culpable as “insider trading” as a form of fraudulent misrepresentation. This should make us suspect whether anything wrongful is happening here at all.

2. Information is Inevitably Imperfect because it is Asymmetric

It is utopian to expect information in a market to be symmetrically distributed among buyer and seller.7 Inside information is one of many examples of the infor- mation asymmetry that is the very reason that market transactions occur.8 Were information symmetric no trading would ever occur since perfect equilibrium would be instantly attained (perfect information and no transaction costs, remember?) and maintained. Were information in fact perfect there would be no trading because all persons would have maxed out their utility functions for all time.9 Perfect informa- tion would result in frozen transactions because no person would be able to improve their position by trading in a universe with perfect information. Yet, trade is exactly the means by which information flows approach perfection.

Information flow is like an asymptote – it is a limit. As more transactions occur information flow approaches perfection. Yet, paradoxically, as information flow increases, reasons for trade decrease: The result of perfect information flow would be no trading, yet trade is no more or less than the flow of information! This explains exactly why information flow will never be perfect. Though information flow is imperfect, information at any time is in some equilibrium of supply and demand. Information which is not widely disseminated may appear to be out of equilibrium, however the very rarity of that information makes it valuable and thus provides an incentive for its dissemination. In other words, apparent information asymmetries

6Henry N Butler, Economic Analysis For Lawyers (1998) at 785 (“Most corporation laws are enabling statutes in the sense that they reflect the philosophy of freedom of contract which has guided corporation law since the first truly modern general incorporation laws were passed in the late nine- teenth century.”)

7James D Cox, ‘Insider Trading and Contracting: A Critical Response to the “Chicago School”’ (1986) Duke L.J. 628, 631.

8Macey, 273.

9Krawiec notes that if information were perfect and there were no transaction costs that it would be impossible to sell information. Kimberly D Krawiec, ‘Privatizing “Outsider Trading”’ (2001) 41 Va. J. Int’l L. 693, 699. She is right but does not follow this though to the logical conclusion. However I take Hayek, who notes that all trading is in fact an exchange of information and then go one step further than Krawiec. No trading would occur at all if information were perfect and there were no transaction costs! But even if we don’t follow through, Krawiec leads us to the logical consequence that if information were perfect then no one would produce information – and thus for this reason too perfect information is impossible. Too much information kills information.

automatically result in equilibrium due to the law of supply and demand. Thus, legal intervention does not help markets reach equilibrium. Instead, it distorts the market. There is no real difference between wage and price controls and prohibitions on insider trading. Wage and price controls look sensible and good, but in reality destroy market signals resulting in inflation and disequilibria of supply and demand (gluts and shortages). Prohibiting insider trading likewise results in an information shortage leading to a greater disequilibrium than would have resulted had the market been allowed to perform its function of correcting information asymmetries through pric- ing.

An analogy to physics may, with qualifications, be helpful: You will never reach the speed of light but can approach it. If all objects are matter/energy and the speed of light is constant then you can never exceed the speed of light precisely because it is the very measure of existence and motion. As the number of market transactions increase information flow increases. Yet, paradoxically, as information flow increases, reasons for trading decrease. Thus, like the speed of light, you can never reach perfect information flow because information asymmetries are the very force that drives market transactions that increase flow of information. Were perfect information reached there would be no market transactions just as were we to reach the speed of light time would simply stop. While it is possible that time might be reversible, it is not in Einstein’s model. This analogy is of course only that. I am not saying informa- tion flow reflects the energy/matter continuum. I am only saying this is a similar paradox occurs. As transactions increase information flow approaches perfection but as information approaches perfection reasons for transactions decrease. Thus perfect information will never be attained.

3. Because Information is Asymmetric Trade is Inevitable and Desirable

Information is inevitably asymmetric and this explains why trade is inevitable and good. The author happens to speak French and German. Would the author’s trading of stocks based on information discovered in French or German be “unfair”? Of course not, for that would be the result of the author’s diligent search. Is it wrong when the author profits by his work as a translator? No, just the opposite, transla- tions improve information flow and are driven by information flow. This asym- metry is inevitable so long as the world has more than one language. Trading on “inside” information is also one of many market asymmetries that inevitably arise in daily life. This asymmetry is only and best corrected through the invisible hand of the free market.

Because information is inevitably imperfect and asymmetric and because informa- tion is free and not property until proven otherwise the concept “inside information” is untenable. All information is, to some extent, non-public.

B. Who is an Insider?

1. The Common Law

Who is an insider? This is a very good question! Unfortunately, federal law has no clear answer to the question of who is an insider.10 Are corporate directors officers, employees, their relatives, their friends, the friends of their friends, their acquain- tances, their business partners, etc. insiders? Where does the chain of “being inside” stop? And more importantly: What effect does creating this chain have on informa- tion flows? Creating this chain distorts information flow and the result is market distortion. The indeterminacy of this chain explains why I think the term is indefin- able.

The U.S. federal courts could have taken the common law bright line approach and defined “insiders” as officers and executives. A bright line approach seems reflected in the courts distinction between “insiders” and “tippees”. Tippees at least are fairly well defined in U.S. law: A tippee is a person who acquires material non- public information from a source who is in a fiduciary relationship to the company to which the information refers.11 So long as the tipper does not directly or indirectly benefit from tipping there is no liability to the tipper or tippee12 (even though the tip- per may have breached a fiduciary duty!). Where an insider breaches their fiduciary duty to the corporation and the tippee knew or should have known that the informa- tion was wrongfully obtained then a fiduciary duty is imputed to the tippee.13 In that case the tippee must then disclose the information prior to trading on it or abstain from trading. However, defining who is owed a fiduciary duty raises more ambigui- ties.

Unfortunately the U.S. courts do not follow through on the black letter/bright line method to define insider. We can however look at the facts of individual cases. While we can say that a printer who derived confidential information from their work14 or a trader who tried to inform people of systematic fraud are not liable for insider trading15 on the facts of those cases does that mean they were not tippees? Or does that mean that their conduct was not wrongful? Your guess may be better than mine. At least it is clear that there must be a specific duty that arises by the relationship between the two trading parties.16 In other words, “no duty” is a valid defense to an accusation of insider trading. Again, the tort origins of any prohibition on insider show through.

10“The term ‘insider’ is not defined by statute in the context of the U.S. prohibitions against insider trading.” Michael D Mann and Lise A Lustgarten, ‘Internationalization of Insider Trading Enforcement: A Guide to Regulation and Cooperation’ (1993) Practising Law Institute PLI Order No. B4-7024 Janu- ary 14, 14–15.

11 Black’s Law Dictionary at 718 (West, 7th ed. 1999). 12 Dirks v. SEC, 463 U.S. at 662 (1983).

13 Dirks v. SEC, 463 U.S. 646, 660 (1983).

14 Chiarella.

15 Dirks.

16 Chiarella, at 233.

But if insider trading law is just one special subset of torts, why define the tort of insider trading as distinct from fraud or deceit?

The courts, though making overtures, do not embrace a bright line test to determine whether a person is an insider, though they do at least clearly define tippees. If the courts do not take a bright line approach that may imply that they perhaps instead took up a multifactor interest balancing test approach. That would be logical, and might give us some guidance. A multifactor balancing test would look at the relation- ships of the parties to the trade to each other17 and to the securities being traded. It would also look at the information, how it was obtained, who obtained it, from whom it was obtained. But, although the courts could work these factors out to determine who is an insider or a tippee, they have not yet done so. The best we seem to be able to do in U.S. law to determine who is an insider or a tippee is to examine the actual facts of litigated cases and make analogies from the case at bar to the facts of litigated cases. This is an unsatisfying approach but is at least somewhere to start.

In any case, the court does look to whether the “insider” owed a fiduciary duty to the corporation. As to “tippees” they are defined as those to whom a fiduciary duty can be imputed based on their relationship to an insider and/or the character of the information they received.18 Note however that this definition of tippee is broader and more flexible than the bright line definition provided above. I would not be surprised were the court to adopt a more flexible (ambiguous) balancing approach because jurisprudencesincethelegalrealistsrejectbalancingtestsas“inflexible”“manipulable” or “arbitrary” and also because “insider” is not defined clearly using a bright line test.

The U.S. federal law of insider trading is terribly ambiguous. Let us look then at the common law on insider trading where we see some bright-line clarity as to the definition of “insiders”. In the common law, just as in § 16 of the SEA, the definition of insiders is restrictive. At common law, the courts took one of three positions. Insid- ers (officers and directors) had no obligation to disclose trading information so long as the result of the trade did not harm the corporation.19 That is, their duty, rightly, was to the corporation as a whole and not any particular shareholder or shareholders, let alone the market as a whole. A slightly more extensive view extended the fiduciary duty to existing shareholders when purchasing the shares of those shareholders.20

17“The relationship of a person, and the corresponding duty that person owed to: (a) the corporation that issued the securities traded (the issuer); (b) the issuer’s shareholders; and (c) other entities from which the person acquired material non-public information concerning the issuer.” Michael D Mann & Lise A Lustgarten, ‘Internationalization of Insider Trading and Enforcement-A Guide to Regula- tion and Cooperation’ (1993) ACI Int’l. Sec. Law Develop. at 7 (PLI Corporate Law Practice Course Handbook Series No. 798).

18 Chiarella, at 230, especially note 12. However, though the court seems to recognize it determines an insider based on two factors: Relationship as a fiduciary either to the corporation or to the corpora- tions shareholders (as opposed to the trading party!) and relationship to the information the court has in no way clarified the exact contours of the definition of an insider.

19Kim Lane Scheppele, ‘“Insider Trading’s Just Not Right”: The Ethics of Insider Trading’ (Sum- mer, 1993) 56-SUM Law & Contemp. Probs. 123, 126–127 (internal citations omitted).

20 Ibid.

Again, the remedy was to disclose the information to the shareholder. Still another intermediate view imposed a duty to disclose only if there was on the basis of actual facts a fiduciary relationship between the parties prior to the sale of the securities.21 Because the common law, like § 16 SEA, defines insiders restrictively, essentially considering only corporate officers or executives insiders, insiders for 10b and 13e should also be a limited class of people (officers and directors) trading with a definite class of persons (those to whom a fiduciary duty exists at the time of the trade). “Con- structive insiders” such as “tippees” are so attenuated that they should be free to trade,

at least on their own accounts or those of their clients without sanction.

2. The Tort of Deceit

The common law of the U.S. federated states essentially limited inside trading to cases involving officers or directors trading with those whom they owe a fiduciary duty. Thus, at common law, any more expansive view of insider trading would have to fall under common law tort of deceit.

Fraud and deceit may be slightly different actions at least in so far as deceit may refer to cases where there is no contract whereas fraud refers to cases where a contract existed.22 The issue is complicated by the fact that state anti-fraud statutes may com- pliment or displace the common law. However, an aggressive plaintiff’s lawyer would argue that fraud and deceit are separate causes of action and plead them in the alter- native.

Fraud is less strictly defined than deceit and is of more modern vintage – it is gen- erally codified in statute law. There are just two elements, a material misstatement or omission which the plaintiff relies on. Causation is shown merely by the fact of reli- ance which however must be directly proven (actual reliance).23 In stock trading, the materiality of a misrepresentation is based on a “reasonable investor” standard: “[a] n omitted fact is material if there is a substantial likelihood that a reasonable share- holder would consider it important in deciding how to vote.”24

There’s just one problem with this approach. Different investors have different opinions. Some investors are risk averse and base investment decision on dividends. Other investors are risk friendly and will regard not dividends but growth in sales as more important factors in their investment decision. While we might describe inves- tors as “bears” and “bulls”, some seek seeking “blue chips” others “growth stocks”

21 Ibid.

22See, e.g., See Dewey v. Lutz, 462 N.W.2d 435 (N.D. 1990); Hellman v. Thiele, 413 N.W.2d 321 (N.D. 1987).

23Carol R Goforth, ‘The Efficient Capital Market Hypothesis – An Inadequate Justification’ 27 Wake Forest L. Rev. 895, 911 citing W Page Keeton Et Al., Prosser And Keeton On The Law Of Torts (5th ed. 1984) § 108. Goforth points out that “It is clear that a plaintiff in a common law securities fraud case must prove direct reliance. A fraud-on-the-market theory is not available.” Gruber v. Price Waterhouse, 117 F.R.D. 75, 81 (E.D.Pa.1987).

24 TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 96 S.Ct. 2126, 48 L.Ed.2d 757 (1976) (proxy solicitation).

the fact is there is no one reasonable investor but rather a spectrum of reasonable investment strategies depending on the investors age and income. An investment strategy for a retiree must be cautious whereas a person in their prime can accept greater risk in order to obtain greater reward to build their retirement funds. Further some investors trade based on fundamental analysis others on the basis of technical analysis and still others based on some combination.

The common law tort of deceit in contrast is a much tougher tort to prove than fraud but it is also more widely recognized and not tied to any statute. The elements of a deceit are clear:

1)An affirmative misrepresentation of a material fact (mere silence will not sup- port a claim for the tort of deceit) 25

2)Made with knowledge of falsehood.

3)Where the misrepresentation is intended to induce reliance

4)And where the misrepresentation in fact induces reliance.26

Though individual cases for fraud can be maintained at the state level a class action at the state level for securities fraud is no longer possible due to the Securities Litigation Uniform Standards Act of 1998 (Uniform Standards Act)27 which pre- empts class actions for securities fraud at the state level.

Obviously, any action which undermines the free will of the party to a trade is wrongful because it prevents parties to trades from securing their best possible posi- tion given their trading profile. Yet, where does insider trading undermine the will of the trading party who is not privy to the supposedly secret information? Nowhere. There is no duress, force majeure or fraudulent act in insider trading. Simply put, most insider trading will not be covered by common law fraud or deceit. Why should it, it is not harmful.

C. What is Inside Trading?

Just as U.S. federal law does not define who is covered by its prohibitions it also does not define prohibited conduct clearly. That of course opens the law up to an attack on vagueness grounds. The short swing profits provi- sions are relatively clear. But SEA 10 b is notoriously ambiguous.28 However, attacks on the basis that the law is too ambiguous are unlikely to succeed: In

25 Bradford Third Equitable Benefit Building Society v Borders [1941] 2 All ER 205 at 211A explained the tort of deceit.

26See, e.g., Alpine v. Friend Bros., Inc., 244 Mass. 164, 138 N.E. 553. Robichaud v. Owens – Illi- nois Glass Co., 313 Mass. 583, 585, 48 N.E.2d 672. McCarthy v. Brockton National Bank, 314 Mass. 318, 326, 50 N.E.2d 196.

27Pub. L. No. 105–353, 112 Stat. 3227.

28Judith G Greenberg, ‘Insider Trading and Family Values’ (Spring, 1998) 4 Wm. & Mary J Women & L. 303, 303.

United States v. Chestman29 an attempt to attack SEC 14e-330 was rejected.

29947 F.2d 551, Fed. Sec. L. Rep. P 96,259, 60 USLW 2245 (U.S.Ct.App. 2d. Cir., 1991).

3017 C.F.R. § 240.14e-3 (1999) Transactions in securities on the basis of material, nonpublic infor- mation in the context of tender offers.

(a)If any person has taken a substantial step or steps to commence, or has commenced, a tender offer (the “offering person”), it shall constitute a fraudulent, deceptive or manipulative act or practice within the meaning of section 14(e) of the Act for any other person who is in possession of material informa- tion relating to such tender offer which information he knows or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly from:

(1) The offering person,

(2) The issuer of the securities sought or to be sought by such tender offer, or

(3) Any officer, director, partner or employee or any other person acting on behalf of the offering per- son or such issuer, to purchase or sell or cause to be purchased or sold any of such securities or any securities convertible into or exchangeable for any such securities or any option or right to obtain or to dispose of any of the foregoing securities, unless within a reasonable time prior to any purchase or sale such information and its source are publicly disclosed by press release or otherwise.

(b)A person other than a natural person shall not violate paragraph (a) of this section if such person shows that:

(1) The individual(s) making the investment decision on behalf of such person to purchase or sell any security described in paragraph (a) of this section or to cause any such security to be purchased or sold by or on behalf of others did not know the material, nonpublic information; and

(2) Such person had implemented one or a combination of policies and procedures, reasonable under the circumstances, taking into consideration the nature of the person’s business, to ensure that individual(s) making investment decision(s) would not violate paragraph (a) of this section, which policies and pro- cedures may include, but are not limited to, (i) those which restrict any purchase, sale and causing any purchase and sale of any such security or (ii) those which prevent such individual(s) from knowing such information.

(c)Notwithstanding anything in paragraph (a) of this section to contrary, the following transactions shall not be violations of paragraph (a) of this section:

(1) Purchase(s) of any security described in paragraph (a) of this section by a broker or by another agent on behalf of an offering person; or

(2) Sale(s) by any person of any security described in paragraph (a) of this section to the offering person. (d)(1) As a means reasonably designed to prevent fraudulent, deceptive or manipulative acts or prac- tices within the meaning of section 14(e) of the Act, it shall be unlawful for any person described in paragraph (d)(2) of this section to communicate material, nonpublic information relating to a tender offer to any other person under circumstances in which it is reasonably foreseeable that such commu- nication is likely to result in a violation of this section except that this paragraph shall not apply to a communication made in good faith,

(i)To the officers, directors, partners or employees of the offering person, to its advisors or to other persons, involved in the planning, financing, preparation or execution of such tender offer;

(ii)To the issuer whose securities are sought or to be sought by such tender offer, to its officers, direc- tors, partners, employees or advisors or to other persons, involved in the planning, financing, preparation or execution of the activities of the issuer with respect to such tender offer; or

(iii)To any person pursuant to a requirement of any statute or rule or regulation promulgated thereunder.

(2) The persons referred to in paragraph (d)(1) of this section are:

(i)The offering person or its officers, directors, partners, employees or advisors;

(ii)The issuer of the securities sought or to be sought by such tender offer or its officers, directors, partners, employees or advisors;

(iii)Anyone acting on behalf of the persons in paragraph (d)(2)(i) of this section or the issuer or persons in paragraph (d)(2)(ii) of this section; and

14e-331 was held to be a valid exercise of rulemaking authority,32 and provided adequate notice of the prohibited behavior33 and was no violation of the due process clause of the U.S. Constitution.34 So, global challenges to the SEA or SEC rules are likely to fail. Still, they might be plead. Therefore we now examine the substan- tive content of these vague laws to see where they might be challenged or how to fight them within their own terms.

1. Section 16 b SEA 1934 Short Swing Trades35

§16 is the most coherent piece of legislation dealing with insider trading. However

§16 does not use the term insider. § 16 governs transactions by those who: “directly

(iv) Any person in possession of material information relating to a tender offer which information he knows or has reason to know is nonpublic and which he knows or has reason to know has been acquired directly or indirectly from any of the above.

31“Rule 14e-3(a) forbids any person to trade on the basis of material, nonpublic information that concerns a tender offer and that the person knows or should know has been acquired from an insider of the offeror or issuer, or someone working on their behalf, unless within a reasonable time before any purchase or sale such information and its source are publicly disclosed. Rule 14e 3(a) imposes a duty to disclose or abstain from trading whether or not the trader owes a fiduciary duty to respect the confidentiality of the information.” O’Hagan, Syllabus.

32Chestman at 556.

33Chestman at 564.

34Chestman at 565.

3515 U.S.C. § 78p (1994) Section 16(a) provides as follows:

Every person who is directly or indirectly the beneficial owner of more than 10 percentum of any class of any equity security (other than an exempted security) which is registered pursuant to § 78l of this title, or who is a director or an officer of the issuer of such security, shall file, at the time of the registration of such security on a national securities exchange or by the effective date of a registration statement filed pursuant to § 78l(g) of this title, or within ten days after he becomes such beneficial owner, director, or officer, a statement with the Commission (and, if such security is registered on a national securities exchange, also with the exchange) of the amount of all equity securities of such issuer of which he is the beneficial owner, and within ten days after the close of each calendar month there- after, if there has been a change in such ownership during such month, shall file with the Commission and if such security is registered on a national securities exchange, shall also file with the exchange), a statement indicating his ownership at the close of the calendar month and such changes in his owner- ship as have occurred during such calendar month.

15 U.S.C. § 78p(a) Section 16(b) provides as follows:

For the purpose of preventing the unfair use of information which may have been obtained by such beneficial owner, director, or officer by reason of his relationship to the issuer, any profit realized by him from any purchase and sale, or any sale and purchase, of any equity security of such issuer (other than an exempted security) within any period of less than six months, unless such security was acquired in good faith in connection with a debt previously contracted, shall inure to and be recoverable by the issuer, irrespective of any intention on the part of such beneficial owner, director, or officer in enter- ing into such transaction of holding the security purchase or of not repurchasing the security sold for a period exceeding six months. Suit to recover such profit may be instituted at law or in equity in any court of competent jurisdiction by the issuer, or by the owner of any security of the issuer in the name and in behalf of the issuer if the issuer shall fail or refuse to bring such suit within sixty days after request to shall fail diligently to prosecute the same thereafter, but no such suit shall be brought more than two years after the date such profit was realized. This subsection shall not be construed to cover any transaction where such beneficial owner was not such both at the time of the purchase and sale, or

or indirectly the beneficial owner of more than 10 percentum of any class of any equity security (other than an exempted security) which is registered pursuant to

§78l of this title, or who is a director or an officer of the issuer of such security” (§ 16 a). Likewise, § 16 b covers the “beneficial owner, director, or officer by reason of his relationship to the issuer”. Thus, one could argue that any inside trad- ing legislation could only concern these people for they are the only ones expressly named – as we know, expresio unius exclusio alterius. However, as the legal real- ists predict, the court simply ignores such a basic maxim of statutory construction to reach the result it prefers.36 A systemic interpretation, wherein we look at a law not in isolation but in comparison with flanking provisions to understand the extent of that law, also leads to the same result: Congress legislated insider trading in § 16 a and § 16 b at the same time as § 10 b. § 16 deals with insider trading. Thus, § 10 deals with something else. However, the courts do not accept this argument.

What types of trading does § 16 cover? “Short swing” trades: That is, profits of a purchase and sale by a person of the company’s stock within six months must be disgorged to the company. Trades covered by § 16 are subject to a 2 year statute of limitations from time of sale. (§ 16 b). § 16 imposes liability without fault: All short swing trades are covered. No wrongful conduct need be shown to be liable under

§16.37

In practice § 16 is rarely invoked. However the real role of § 16 is to tell us what types of persons might be covered by any inside trading inferred from §10b.

A good argument can be made that the short swing trading provision is the exclu- sive remedy of inside trading: Expressio unius, exclusio alterius. Statutes, such as § 10b will ordinarily be interpreted in accord with their plain meaning, and the term “insider trading” is not found in § 10b. However, though the legislation clearly addresses insider trading only in § 16, the courts do not accept this argument and permit § 10 to cover transactions that should be covered instead by Sec. 16.38 The court reasons that: “Congress’ failure to impose criminal sanctions for non-fraudulent conduct under section 16(b) does not mean that it intended to immunize insider trad- ing that is fraudulent under section 10b and Rule 10b-5.”39 That is true – but it is also irrelevant. The issue is not whether conduct is immune but whether conduct is wrong- ful at all!

the sale and purchase, of the security involved, or any transaction or transactions which the Commis- sion by rules and regulations may exempt as not comprehended within the purpose of this subsection.

15 U.S.C.S. § 78p(b).

36 Herman & MacLean v. Huddleston, 459 U.S. 375, 387 n.23 (1983) (rejected expressio unius as supposedly contrary to purpose of the 1933 Securities Act). A court ought only to examine legislative intent where the text of the statute is unclear. When the expressio unius maxim resolves ambiguity the court ought to follow it in the interests of legal certainty.

37 Kern County Land Co. v. Occidental Petroleum Corp., 411 U.S. 582, 595 (1973).

38J. Dormer Stephen III, ‘United States v. O’Hagan: The Misappropriation Theory under Section 10(b) and Rule 10b-5 – Can the Judicial Oak Grow Any Higher’ (1998) 102 Dick. L. Rev. 277, 314.

39 U.S. v. Lang 766 F.Supp. 389, 402 (D.Md.,1991) (Finding criminal penalty under 10b applies despite § 16).

CAPITAL MARKETS IN U.S. AND E.U. LAW [2010] EBLR477

2.SEA § 10b40 and Rule 10b-541

§ 10b is an enabling act to catch all types of fraud involving purchase or sale of a security (sale is broadly interpreted) “but what it catches must be fraud” (Chi- arella). Pursuant to § 10b, §10b-5 essentially codifies common law actions for deceit.42 However §10b-5 does not preempt state remedies – the state and federal laws have concurrent not exclusive jurisdiction43 over stock fraud. One could argue that it creates the risk of double jeopardy.44 However, court created doctrines

40SEA 1934 15 U.S.C. § 78j (1994) Manipulative and deceptive devices:

“It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumen- tality of interstate commerce or of the mails, or of any facility of any national securities exchange –

(a)(1) To effect a short sale, or to use or employ any stop-loss order in connection with the purchase or sale, of any security registered on a national securities exchange, 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.

(2) Paragraph (1) of this subsection shall not apply to security futures products.

(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appro- priate in the public interest or for the protection of investors.

Rules promulgated under subsection (b) of this section that prohibit fraud, manipulation, orinsider trading (but not rules imposing or specifying reporting or recordkeeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation, orinsider trading), and judicial prec- edents decided under subsection (b) of this section and rules promulgated thereunder that prohibit fraud, manipulation, orinsider trading, shall apply to security-based swap agreements (as defined in section 206B of the Gramm-Leach-Bliley Act) to the same extent as they apply to securities. Judicial prec- edents decided under section 77q(a) of this title and sections 78i, 78o, 78p, 78t, and 78u-1 of this title, and judicial precedents decided under applicable rules promulgated under such sections, shall apply to security-based swap agreements (as defined in section 206B of the Gramm-Leach-Bliley Act) to the same extent as they apply to securities.”

4117 C.F.R. § 240.10b-5 (1999) Employment of manipulative and deceptive devices.

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, or

(c)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.

42Comment, ‘Securities Regulation: The Fraud on the Market Theory and its Effect on the Reliance

Requirement for a Private Action Under 10b-5’ (1983–4) 13 Stetson L.Rev. 343, 344. 4379A C.J.S. Securities Regulation § 255.

44But I doubt that the SEC or courts would accept that argument. U.S. v. Marcus Schloss & Co., Inc. 724 F.Supp. 1123, 1127 (S.D.N.Y.,1989); Comment, ‘Implications of the 1984 Insider Trading Sanction Act: Collateral Estoppel and Double Jeopardy’ (1985) 64 N.C.L.Rev. 117 (asserting that a successful criminal prosecution and an ITSA action awarding treble damages would subject an insider to two essentially criminal actions, thus violating the double jeopardy clause). But see: Silver, ‘Penal- izing Insider Trading: A Critical Assessment of the Insider Trading Sanctions Act of 1984’ (1985) Duke L.J. 960, 1012–17 (ITSA sanctions are civil not criminal and thus cannot be the subject of double

jeopardy prohibition).

regarding liability under § 10b have extended § 10b to cover: not only executives and directors but also employees and tippees and liability may be based either under a classic theory or a theory of misappropriation/breach of fiduciary duty.

3. The Classic Theory of 10b Liability

The classic view of 10b and 10b-5 is that liability shall be imposed for “trad[ing] in the securities of his corporation on the basis of material, non-public information.”45

– though none of these magic words appear anywhere in the statute or rule. The theory is that the insider is breaching a trust owed to the corporations sharehold- er’s.46 Direct benefit to the tipper is a precondition for the liability of the tipper who does not trade on the information they (wrongly?) divulge.47 Likewise, the tippee will not be liable under Rule 10b-5 unless the plaintiff shows benefit to the tipper.48 However benefits can be intangible,49 and gift transactions can be a basis of liability.50 These view on tipper and tippee liability under the classical theory were affirmed in S.E.C. v. Sargent.51

4. Misappropriation Theory

The misappropriation theory is based on the idea that the inside information is somehow (how?) proprietary to the corporation. But, if the theory is that corporate information was wrongly appropriated then any wrong committed by inside trading could be immunized by a contract or provision in the corporate charter.

The misappropriation theory was developed in the case of United States v. O’Hagen. The court in O’Hagan held that: “a person commits fraud ‘in connection with’ a securities transaction, and thereby violates [section] 10(b) [of the Securities Exchange Act of 1934] and Rule 10b-5, when he misappropriates confidential infor- mation for securities trading purposes, in breach of a duty owed to the source of the information.”52 Thus, the elements of a 10b-5 breach are:

1)Misappropriation

2)of confidential information

3)for securities trading purposes

4)in breach of a duty owed to the source of the information.

45 United States v. O’Hagan, 521 U.S. 642, 651 (1997). 46 United States v. O’Hagan, 521 U.S. 642, 651 (1997).

47 Dirks v. SEC, 463 U.S. 646, 662, 103 S.Ct. 3255, 77 L.Ed.2d 911 (1983). 48 SEC v. Warde, 151 F.3d 42, 48–49. (2d Cir.1998).

49 SEC v. Warde, 151 F.3d 42, 47 (2d Cir.1998). 50 SEC v. Warde, 151 F.3d 42, 47 (2d Cir.1998). 51229 F.3d 68, 77 (C.A.1 (Mass.),2000).

52 United States v. ‘O’Hagan, 521 U.S. at 652.

Disclosure to the source of the information will immunize the trader from an accu- sation of insider trading under the misappropriation theory.53 The victim is not the party traded with but the source of the information.54

When does a fiduciary duty exist? “the existence of a fiduciary relationship turns on whether the source of the misappropriated information granted the misappropria- tor access to confidential information in reliance on a promise by the misappropriator that the information would be safeguarded.55 The theory is that the fiduciary has wrongly used confidential information:56 “‘[T]he misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.’” Based on this language one should argue that a deception must be shown for the breach of fiduciary duty to occur under the misap- propriation theory.57 However in O’Hagan the court seemed willing to accept mere non-disclosure as deception, i.e. deception may well be only implied from conduct. However the misappropriation theory is based not just on a fiduciary relationship but also on entrusting property to the fiduciary. “‘[T]he misappropriation theory premises liability on a fiduciary-turned-trader’s deception of those who entrusted him with access to confidential information.’” Thus I would argue that both a fiduciary duty and a misuse of property must be shown – and information is generally not considered property! This argument is likelier to succeed.

Because the misappropriation theory is based on the existence of a fiduciary duty if there is no duty owed to the corporation or if no duty to the corporation was violated there can be no insider trading under the misappropriation theory:58 If no fiduciary duty exists then “disclose or abstain” rule developed in SEC v. Texas Gulf Sulphur Co.59 Thus, “a duty to disclose under S10(b) does not arise from the mere possession of nonpublic market information.”60

As seen, the competing concepts of fiduciary relationship and property in informa- tion that is in fact not proprietarian underlie the misappropriation theory. Because of these conflicts “a theory of insider trading based solely on fiduciary duties, as cur- rently used by the U.S. Supreme Court, is inadequate to regulate insider trading.”61 If a director or officer owes fiduciary duties not just to the corporation (which is unques- tioned) but also to all shareholders then the officer, or director will be subject to multiple conflicting fiduciary duties. “the best interests of the corporation, ... may not coincide with the best interests of an individual shareholder transacting business with

53“If the fiduciary discloses to the source that he plans to trade on the information, there is no “deceptive device” and thus no §10(b) violation.” O’Hagan.

54The transaction and the breach of duty coincide, even though the person or entity defrauded is not the other party to the trade, but is, instead, the source of the nonpublic information.” O’Hagan.

55 O’Hagan, 521 U.S. at 652, 117 S.Ct. 2199.

56 United States v. Chestman, 947 F.2d 551, 569 (2d Cir.1991) (en banc). 57“deceptive nondisclosure is essential to §10(b) liability under the theory”, O’Hagan.

58 Chiarella.

59401 F.2d 833 (2d Cir. 1968) (en banc)

60 Chiarella v. United States, 445 U.S. 222, 235 (1980).

61Kim Lane Scheppele, ‘“Insider Trading’s Just Not Right”: The Ethics of Insider Trading’ (Sum- mer, 1993) 56-SUM Law & Contemp. Probs. 123.

the corporation.”62 The interest of one shareholder may be directly opposing the inter- est of another one and both may have interests different from the corporation. Misap- propriation theory is unsound because the supposedly proprietary information is generally not in fact property and if property were the basis of the wrong then the corporation could simply contract away the problem. I suspect that would be unac- ceptable to the SEC and the courts.

The misappropriation theory raises the specter of multiple conflicting duties between the directors and officers of a corporation as to the various shareholders of the corporation and the corporation itself. This conflict shows the incoherence of misappropriation theory. It also raises a related puzzling problem: Can a corporation be liable for trading its own shares on “inside” information?63 I don’t try to answer this question because the SEC and court theories are simply incoherent: They would find the corporation could be liable64 in keeping with the desire to punish those who rise by their intelligence and thereby invoke the ire of others. The fact that such illogical problems arise under existing insider trading law is, in my opinion, the con- sequence of flawed assumptions about the nature of insider trading.

5.ECMH Revisited – Basic Inc. v. Levinson

Just as duty must be shown65 to prove a 10b case so also must causation be shown. The causal link must be made between the false statements or omissions and the resulting injury. Thus, reliance on fraudulent statements must be shown as one element of a 10 b 5 action when using the misappropriation theory because reliance demonstrates the causal link between the plaintiff’s act and the defendant’s injury.66 This view was reaffirmed in Basic Inc. v. Levinson.67 However, at least in class actions, one can show reliance by showing that the inside trading worked a fraud on the market.

Here is where the erroneous ECMH theory comes most clearly into the picture. The argument that reliance can be inferred due to supposed fraud on the market is an attenuated68 and unrealistic argument based on faulty premises. The result of this

62Mark J Loewenstein, William KS Wang, ‘The Corporation as Insider Trader’ (2005) 30 Del. J. Corp. L. 45.

63For a detailed treatment of the logical problems that inevitably arise if a corporation could be an inside trader on its own shares see: Ibid.

64“There can be no doubt that the prohibition against ‘insider’ trading extends to a corporation”, Green v. Hamilton Internat’l Corp., 437 F.Supp. 723, 728 (S.D.N.Y.1977).

65 United States v. O’Hagan, 521 U.S. at 652.

66485 U.S. 224, 243 (1988).

67485 U.S. 224 (1988).

68“The fraud on the market theory allows a plaintiff to allege a more attenuated version of reli- ance” C Edward Fletcher, III, ‘Sophisticated Investors Under The Federal Securities Laws’ (1988) Duke L.J. 1081, 1114. “The fraud on the market theory has also attenuated the privity element by creating a rebuttable presumption that all contemporaneous traders have relied on a misrepresentation, because that misrepresentation defrauds the entire market mechanism. See, Basic Inc. v. Levinson, 485 U.S. 224 (1988). The fraud on the market theory has been criticized for imposing excessive costs on investors. See Paul G Mahoney, ‘Precaution Costs and the Law of Fraud in Impersonal Markets’ (1992) 78 Va. L.

attenuation of linkages between cause and effect is to create open ended liability.69 Moreover, proving reliance (really, presuming it) because of a supposed fraud on the market is in fact a tautological argument.70 Wrong presumptions generally (but not inevitably!) lead to wrong conclusions, the case here.

The first faulty premise of the reliance based on a FOTM is the ECMH itself. As demonstrated, ECMH does not accurately describe reality. The second faulty premise of the FOTM theory is that inside trading is somehow unfair, either to investors, the market, or society and thus defrauds the market as a whole. In fact, inside trading has exactly the opposite result: It makes capital markets more efficient.

The fraud on the market theory, like ECMH71, is tautological. If we were to assume that inside trading somehow (how?) distorts market signals (which is not at all the case) then any inside trade would always work a fraud on the market – and thus reli- ance would always be found.72 The fraud on the market theory is thus illogical.73 Its illogic provoked a spirited dissent in Basic inc. v. Levinson decision (only six justices weighed in on the case, decided 4–2).

D. Why is Insider Trading Treated as a Wrong?

The unclarity in the substantive law is a reflection of unclarity in the rationales justifying the law. If you ask five people who think insider trading is wrong why you are likely to get five different answers: “even among those who intuit that insider trading is unfair, there is no clear consensus as to what is unfair about it”.74 Congress has given no justification for outlawing inside trading.75 Why should the Congress have done so? The statutes invoked (10b5, 16a) do not even use the terms “inside trading”! Thus, unsurprisingly, they do not define either an insider or an inside trade. If you think that is unsettling for democracy I am in your company.

Rev. 623. Steven R Salbu, ‘Tipper Credibility, Noninformational Tippee Trading, and Abstention from Trading: An Analysis of Gaps in the Insider Trading Laws’ (1993) 68 Wash. L. Rev. 307, 314 n. 44.

69“Although other courts have used a similar standard, the Second Circuit extended the presump- tion to cover a more attenuated chain of causation, thereby creating the possibility of unlimited liability under the fraud-on-the-market theory of recovery.” ‘Panzirer V Wolf, ‘Causation in Fraud-on-the-Market Actions – Investors’ Insurance in the Second Circuit?’ (1983) 49 Brook. L. Rev. 1291 1302–1303.

70“Combining the ECMH with the CAPM produces a prediction of fundamental value efficiency through a different and more troubling analytical path – by tautology.” Lynn A Stout, ‘The Mechanisms of Market Inefficiency: An Introduction to the New Finance’(2003) 28 J. Corp. L. 635, 641.

71“The ECMH assertion that prices reflect all relevant information is essentially tautological.” John F Barry III, ‘The Economics of Outside Information and Rule 10B-5’ (1981) 129 U. Pa. L. Rev. 1307, 1340 n. 129.

72Prozan and Fatale, 703.

73 Basic Inc. v. Levinson 485 U.S. 224, 259–260 108 S.Ct. 978 U.S.,1988 (Justice White’s dissent, joined by jj. Blackmund and O’Connor).

74Jeanne L Schroeder, ‘Envy And Outsider Trading: The Case Of Martha Stewart’ (2005) 26 Car- dozo L. Rev. 2023, 2050.

75Jonathan R Macey, ‘Securities Trading: A Contractual Perspective’, (1999) 50 Case W. Res. L. Rev. 269.

Before the background of this silent legislative abdication it is noteworthy that most objections to insider trading are based ultimately not on economic arguments but on moral arguments.76 Mann thinks that moral criticisms of insider trading are a “refuge for the intellectually bankrupt”.77 If one takes the view that moral choice is a subjective matter and that no objective moral standards exist or can be found he is right. That is, most of what presents itself as moral theory unscientific because moral theories generally are not based on an empirical analysis of facts. However I disagree with Mann in that I think an objective moral science based in materialism is possible. But even if I am right on this point the courts just don’t have or apply such a standard, at least not in cases of “inside trading”.

Supposedly, insider trading is somehow unfair. But, when we ask for details, for facts, we get tautologies or even ad hominem. When authors try to define fairness in contemporary terms they founder on the fact that “fairness” is a term of many mean- ings, it is polysemic.78 Likewise, authors who try to define fairness run aground on the subjectivism of late modern and post-modern discourse theory.79 If fairness is defined subjectively either due to its multiple meanings or due to the (supposed) intersubjectivity of moral claims then it is impossible to use fairness as an objective legal standard. This is why Mann says talk about morals is for intellectual bankrupts. Moral claims might be possible, but not on a subjective or even intersubjective basis.

A principled argument for outlawing inside trading would be that it somehow distorts market signals. However this is simply not the case. “For exchange-listed stocks ... 88.3 percent of the private information that informed traders have at the beginning of each trading day is absorbed in one day for the average stock ... . For over-the-counter stocks, an average of 85.1 percent of private information is absorbed in one day.”80 In other words, the “cat gets out of the bag” very quickly. This is because inside information is a powerful market signal: “insider trading is associated with immediate price movements and quick price discovery ... the stock market

76See Henry G Manne, Insider Trading and the Stock Market (1966) at 4.

77Henry G Manne, ‘Insider Trading and the Law Professors’ (1970) 23 Vand. L. Rev. 547, 549. 78“Fairness could mean many things. Ian B Lee, ‘Fairness And Insider Trading’( 2002) Colum.

Bus. L. Rev. 119, 141.

79“From where does the normative force of fairness come? The answer may well depend on one’s philosophy. Some may view it as a corollary of a deontological obligation to treat others as equals. Utilitarians and other consequentialists, on the other hand, may view the rules of fairness as being a condition for the possibility of welfare-improving cooperative action, the solution to a chronic Prison- ers’ Dilemma in which members of society have an incentive to exploit each other’s situational vulner- abilities even though all of them would be much better off in a society where such exploitation did not occur. It is also possible that a weak form of consequentialism can be reconciled with deontology, for example, if cooperation is not merely an instrumental means of achieving some overall and independ- ently specified good, but rather adds a vector of value to the idea of being better off. Perhaps there is a kind of good that we can only hope to achieve through cooperation and the logic of such coopera- tion includes rules we describe as rules of fairness.” Ian B Lee, ‘Fairness And Insider Trading’(2002) Colum. Bus. L. Rev. 119, 141–142.

80Ji-Chai Lin & Michael S Rozeff, ‘The Speed of Adjustment of Prices to Private Information: Empirical Tests’ (1995) 18 J. Fin. Res. 143, 144.

detects informed trading and impounds a large proportion of the information ... before it becomes public.”81 And this is part of why insider trading is good for the econ- omy.

Not only does “inside” trading not distort markets, it is in fact a vector for rapid transmission of important information. By seeking to control the market the courts create the very evil they seek to correct – which is is usually the result of intervention in the free market.

E. What Are We to Make of the Ambiguity Both as to the Object and Subjects of “Insider Trading”?

The legal ambiguity of insider trading could be attacked as constitutionally vague82 or as an undue delegation of congressional legislative power83 or for failure to provide adequate notice of prohibited conduct.84 To date, such attacks have not been succesful. However, when a law is unclear both as to its object (what constitutes insider trading) and as to its subject (who is an insider) that tells us that the law as defined is bad. This bad law is not the result of bad legislative drafting. Rather it is inevitable. When information in its life cycle passes from “inside” to “public” is inherently unknowable and cannot be generally defined. Further, who might be considered an “insider” is so fact dependant that no answer could be reached that would be satisfactory. If a “bright line” test were taken, the state common law approach, such that all officers and directors are insiders – that would leave lots of

81Lisa K Meulbroek, ‘An Empirical Analysis of Illegal Insider Trading’ (1992) 47 J. Fin. 1661, 1663.

82See Daniel J Barastow, Comment, ‘Due Process and Criminal Penalties Under Rule 10b-5: The Unconstitutionality and Inefficiency of Criminal Prosecutions for Insider Trading’ (1982) 73 J. Crim. L. 96; Oliver Perry Colvin, ‘A Constitutional Challenge To Rule 10b-5’, Insights May, 1992. In a 14e-3 context a constitutional challenge for vagueness was specifically rejected by the court. U.S. v. Chestman 947 F.2d 551 C.A.2 (N.Y.) (1991).

83“Antifraud rules have been upheld consistently and in diverse contexts when challenged, for example on grounds of vagueness or excessive delegation of legislative authority. See, e.g., Charles Hughes & Co. v. Securities and Exchange Commission, 139 F.2d 434, 436, (C.C.A. 2d Cir. 1943) ( Rule 15c1-2 valid; sufficiently definite; no unconstitutional delegation; broker-dealer revocation affirmed); Speed v. Transamerica Corp., 99 F. Supp. 808, 831–32 (D. Del. 1951) ( 10b-5 valid; not unconstitu- tionally vague; no improper delegation; civil liability imposed); U.S. v. Persky, 520 F.2d 283, 286–88, Fed. Sec. L. Rep. (CCH) § 95209 (2d Cir. 1975) ( 10b-5 valid; despite expansive interpretation in civil cases, it provided fair warning that defendant’s conduct was unlawful; conviction affirmed); U.S. v. Chiarella, 588 F.2d 1358, 1369, Fed. Sec. L. Rep. (CCH) § 96608, 3 Fed. R. Evid. Serv. 1347 (2d Cir. 1978) (10b-5 sufficiently clear to satisfy due process and affirm conviction of financial printer for trading without disclosure of nonpublic information of forthcoming tender offers).” Source: Bromberg & Lowenfels on Securities Fraud and Commodities Fraud (2005) § 2:3 (2d ed.).

84See, e.g., United States v. Lang, 766 F.Supp. 389, 402 (D.Md. 1991); United States v. Willis, 737 F.Supp. 269 (S.D.N.Y. 1990).

similar trades uncovered (spouses,85 relatives,86 friends and acquaintances of the bright-line class). If a “flexible” standard is taken up (which federal law tries to do) the result is uncertainty as to what conduct by what people is prohibited or permitted. And legal uncertainty is a very large transaction cost. Of course, uncer- tainty can be reduced with insurance, but insurance is not cost free so it is only a partial solution. But all these considerations are irrelevant since they are predicated on an erroneous assumption. Insider trading is good for the economy.

II. The Insider Trading Directive in the E.U.

U.S. law on insider trading has been shown to be badly thought out. Legislative imprecision and unstated and erroneous presumptions, lead to legislation which can be understood only – if at all – by looking at dozens of cases. The result is uncer- tainty and unpredictability leading to over-regulation or under-regulation and a lack of respect for the law.

Happily the situation is clearer in Europe. There, the courts took up U.S. rules but rendered them more precise in legislation. The same erroneous assumptions about trade are at the root of the E.U. legislation, but at least the resulting rules are more clearly formulated. While conduct which isn’t wrongful is prohibited in Europe, as in the U.S., because the E.U. took up the U.S. norms on insider trading, at least one can predict which conduct is or is not wrongful.

Just as the U.S. influenced E.U. law the E.U. law in turn shaped the laws of the Member States. Prior to the Insider Trading Directive, insider trading was treated differently in each Member State, being a criminal offense in a few states, yet per- fectly legal in most others.87 Here, the EC has acted to create a Community standard. Today insider trading is regarded as wrongful throughout the EU and subject to a uniform continental standard. There is less legal uncertainty as a result. This is a clear example of global norm convergence. As such it is to be expected that E.U. and U.S. capital markets can fairly examine each other’s laws for persuasive evidence of the content of their own law – a form of de facto global unification is occurring here, as elsewhere, in the law. One can even speak of a unitary Atlantic securities market.

Transatlantic securities harmonization occurred rapidly but not instantly. The first community prohibition of insider trading was the 1989 Directive. 15488 This Directive

85But : “marriage does not, without more, create a fiduciary relationship. ‘[M]ere kinship does not of itself establish a confidential relation. … Rather, the existence of a confidential relationship must be determined independently of a preexisting family relationship.’ Reed, 601 F.Supp. at 706 (quoting GG Bogert, The Law of Trusts and Trustees § 482, at 300–11 (Rev. 2d ed. 1978))” U.S. v. Chestman 947 F.2d 551, 568 (C.A.2 (N.Y.), 1991).

86“more than the gratuitous reposal of a secret to another who happens to be a family member is required to establish a fiduciary or similar relationship of trust and confidence.” Ibid.

87Insider trading was legal in Germany until 1994. See, e.g., Anupama J Naidu, ‘Was its Bite Worse than its Bark? The Costs Sarbanes-Oxley Imposes on German Issuers may Translate into Costs to the United States’ (2004)18 Emory Int’l L. Rev. 271, 299.

88Council Directive Coordinating Regulations on Insider Trading, 1989 O.J. (C 277) 13 [1 Com- mon Mkt. Rep. (CCH)] P 95,028.

has since been replaced by a more comprehensive Directive 15589 which covers shares and a variety of option contracts as well as prohibiting market manipulation. Market manipulation is defined as trading or disseminating information in order to give false or misleading signals as to price movements. 15690 Again, the directive is more spe- cific about defining market manipulation than Securities Exchange Act (SEA) Section 10b, which prohibits “any manipulative or deceptive device or contrivance”.91 This might be because the SEA was enacted in the wake of the greatest stock market crash in history, whereas the directives were not. The 2003 Directive covers shares, unit trusts, money markets instruments, futures, swaps, options, derivatives and any other instrument trading on a regulated market or for which a request to trade has been made. 15892 Once again the terms are more specific than the 1933 and 1934 acts, which defines security very broadly 15993 – so broadly in fact that even investments in a common ponzi scheme have been held to be a security.94 The basic premises of the 1989 Directive are retained within the 2003 Directive and the 1989 Directive may be persuasive evidence of the meaning of the 2003 Directive.

A. What is Inside Information

The 1989 Directive and its 2003 successor clearly define “inside information”.95 This is not the case in U.S. law. As we saw “insider” is not clearly defined in U.S. law and “inside information” is undefined in the relevant SEC legislation and

89Council Directive 2003/6,2003 O.J. (L 96) 16–26 (EC). 90Ibid. at 20.

91Securities Exchange Act of 1934, 10, 15 U.S.C. 78j (1994) (discussing manipulative and decep- tive devices).

92Council Directive 2003/6, Art. 1(3), 2003 O.J. (L 96) 21 (EC).

93The Securities Act of 1933 defines “security” as: “Any note, stock, treasury stock, bond, deben- ture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral trust certificate, preorganization certificate or subscription, transferable share, investment con- tract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, or, in general, any interest or instrument commonly known as a ‘security’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.” 15 U.S.C. 77b(1).

The Securities Exchange Act of 1934 defines “security” as:

Any note, stock, treasury stock, bond, debenture, certificate of interest or participation in any profit- sharing agreement or in any oil, gas, or other mineral royalty or lease, any collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certifi- cate, certificate of deposit, for a security, or in general, any instrument commonly known as a ‘secu- rity’ or any certificate of interest or participation in, temporary or interim certificate for, receipt for, or warrant or right to subscribe to any purchase, any of the foregoing; but shall not include currency or any note, draft, bill of exchange, or banker’s acceptance which has a maturity at the time of issuance of not exceeding nine months, exclusive of days of grace, or any renewal thereof the maturity of which is likewise limited.

15 U.S.C. 78c(a)(10).

94 Sec. & Exch. Comm’n, v. Glenn W Turner Enter., Inc., 474 F.2d 476; (9th Cir. 1973).

95Council Directive 2003/6, Art. 1(1), 2003 O.J. (L 96) 16, 20 (EC).

regulations.96 In U.S. law the concepts, presumptions and rationales for the prohibi- tion of insider trading are amorphous at best, conflicting at worst. The state of play in Europe is better than in the U.S. because the basic terms of the law are clearer.

Inside information in E.U. law is reasonably well defined and U.S. jurists could and in my opinion should grapple with E.U. law for that reason, to find arguments about the content of U.S. law from the E.U. laws which were clearly inspired by and even modeled after the U.S. laws but which also reformed and improved them. What is inside information in E.U. law?

The 1989 Directive defined inside information as “information which is unknown to the public of a specific nature and relating to one or more issuers of transferable securities, or to one or more transferable securities, which, if it were published, would be likely to have a material effect on the price of the transferable security or transfer- able securities in question.”97 The 2003 Directive similarly provides that: “‘Inside information’ shall mean 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 prices of those financial instruments or on the price of related derivative financial instruments.”98

The European Directive’s definition of insider trading is clearer than the U.S. definition. The same elements arise in both legal systems: Materiality and Publicity (“material non-public information”).99 However, “Unlike the U.S. insider trading laws, determination of illegal trading is based not on breach of a fiduciary duty, but rather, on possession of non-public information.”100 That is, both the rationale and definition of prohibited conduct are clearer in the EU than in the U.S.

B. Who is an Insider

The 1989 predecessor Directive clearly defined the term “insider”, unlike U.S. law, where the term is not statutorily defined. An insider is one who, due to his relation- ship to the company as manager, director, employee or major shareholder, pos- sesses inside information (material non-public facts) and knowingly uses such inside information to acquire or dispose of securities to which the information relates for his own account or another.101 The 2003 Directive not only directs the prohibition to persons who acquired inside information due to their position as a

96“In fact, section 10(b) and Rule 10b-5 (or any of the federal statutes, rules, or regulations) do not define ‘insider trading’ or ‘inside information’ (or ‘misappropriation,’ for that matter).” Micah A Acoba, ‘Insider Trading Jurisprudence after United States v. O’Hagan: A Restatement (Second) of Torts 551(2) Perspective’ (1999) 84 Cornell L. Rev. 1356, 1362.

97Warren, supra, at 220.

98Council Directive 2003/6, Art. 1(1), 2003 O.J. (L 96) 16, 20 (EC). 99See U.S. v. Svoboda, 347 F.3d 471, 475 n. 3 (2d Cir. 2003). 100Karmel, supra, at 23.

101Council Directive 89/592, Art. 2, 1989 O.J. (L 334) 30–32 (EEC).

director, manager, employee or majority shareholder but includes those who acquired the information illegally.102

The 1989 Directive prohibited insiders from “tipping” others about inside informa- tion except in the course of ordinary business.103 The prohibition of “tipping”104 and the exception for trades in the ordinary course of business are also found in Directive 2003/6.105 “Tipping” is more clearly defined in E.U. law than in U.S. law106 as are the instances where “tipping” is permitted. The “safe harbor” provisions allowing disclo- sure of inside information in the ordinary course of employment (“tipping”) are, as an exception to a general rule, to be interpreted strictly.107 Thus, disclosure of inside information in the course of employment is also prohibited unless “there is a close link between the disclosure and the exercise of his employment, profession or duties, and that disclosure is strictly necessary for the exercise of that employment, profes- sion or duties.”108 That is, disclosure of inside information in the course of employ- ment will be seen as rightful “only if it is strictly necessary for the exercise of an employment,professionordutiesandcomplieswiththeprincipleofproportionality.”109 The court will examine the quality of the disclosed information to determine whether the disclosure was, given the actual facts of the case, necessary.110 One could thus predict a correlation between the impact of information on prices inversely to the probability that the information rightfully disclosed. In all events, the judicial inter- pretations of the meaning of the earlier Directive very likely apply to the successor Directive.

102Council Directive 2003/6, Art. 2(1)(a-d), 2003 O.J. (L 96) 16, 21 (EC) (defining insiders as mem- bers of boards of Directives, key management, large shareholders and even employees of the company).

103Ibid. Case C-384/02, Criminal Proceedings against Knud Groengaard and Allan Bang, 2005 (C 384) par. 26 (ECR) (stating that under Article 3(a) of Directive 89/592, the prohibition of disclosing inside information does not apply to its disclosure by a person in the normal course of the exercise of his employment, profession or duties).

104Council Directive 2003/6, Art. 3(a), 2003 O.J. (L 96) 16, 21 (EC). 105Ibid.

106Tippees are defined as those to whom fiduciary duty can be imputed based on their relationship to an insider and/or the character of the information they received. See U.S. v. Chiarella 588 F.2d 1358, 1365–67; (2d. Cir. 1978) rev’d, U.S. v. Chiarella, 445 U.S. 222 (1980). That definition is ambiguous.

107 Groengaard, 2005 E.C.R. II-0000. “Even if that rule, having regard to the terms used, is capable of covering very different situations, it must, as an exception to a general prohibition and in the light of the objective pursued by Directive 89/592, be interpreted strictly.” Ibid.

108Ibid.

109Ibid.

110See Ibid. (stating that “in order to determine whether a disclosure is justified in a particular case, it is appropriate to take account also of the sensitivity of the inside information in question. Particular care is required when the disclosure is of inside information manifestly capable of affecting signifi- cantly the price of the transferable securities in question. In that context, it is appropriate to observe that inside information relating to a merger between two companies quoted on the stock exchange is in general particularly sensitive.”)

C. What is Insider Trading?

1. Prohibition of Insider Trading

The text of the 1989 Directive and the 2003 Directive are similar so we can expect that interpretations of the 1989 text would be likely to apply to the 2003 text. The 1989 Directive orders Member States to forbid:

... any person who ... has access to such information by virtue of the exercise of his employment, profession or duties, possesses inside information from taking advantage of that information ... by acquiring or disposing of for his own account or for the account of a third party, either directly or indirectly, transferable secu- rities of the issue or issuers to which that information relates.111

And its successor version in 2003 says:

Member States shall prohibit any person referred to in the second subparagraph who possesses inside information from using that information by acquiring or disposing of, or by trying to acquire or dispose of, for his own account or for the account of a third party, either directly or indirectly, financial instruments to which that information relates. 186112

Thus, rather than seeing the 2003 Directive as displacing case law and legislation developed under the 1989 Directive we should expect to see the courts interpreting the 2003 Directive in light of the 1989 Directive and its attendant case law.

2. Prohibition of Market Manipulation

Unlike the 1989 Directive, the 2003 Directive prohibits market manipulation. Mar- ket manipulation is clearly defined as transactions which give false or misleading signals to the market as to supply and demand or which fix the price of a given issue at an abnormal or artificial level.113 Art. 2(b) of the Market Abuse Directive uses language quite similar to SEA Section 10, including in market manipulation: “transactions or orders to trade which employ fictitious devices or any other form of deception or contrivance;”114 that language of course is straight out of U.S. law. Subsection 2(c) goes on to list some possible manipulative devices, such as internet rumor mongering. That list is of course not exhaustive.

111Council Directive 89/592, 1989 O.J. (L 334) 30, (EEC). 112Council Directive 2003/6, Art. 2(1), 2003 O.J. (L 96) 16, 26 (EC). 113Ibid.

114Ibid.

3. Sanctions for Market Abuse

Both the 1989 and 2003 inside trading Directives require Member States to enact sanctions for insider trading but do not define what they may be.115 Thus a Member State could punish insider trading as a crime or a tort or both. This shows that Directives permit a flexible and nuanced response to the problems posed by the construction of the single market, all the more so when we remember that Direc- tives generally establish minimum standards which Member States can exceed.116

D. Why is Insider Trading Treated as a Wrong?

The E.U. takes the position that insider trading undermines investor confidence,117 which leads to sub-optimal clearing of securities markets.118 These rationales of the 1989 Directive are also found in the 2003 Directive.119 They are essentially the same rationales for the prohibition of insider trading that one sees in U.S. law.120 But, unlike the U.S., at the time of the adoption of the Insider Trading Directive, insider trading was by no means a criminal offence in all or even a majority of Member States. The Directive seeks to improve protection against abuse throughout the community.

The Directive essentially shifted the focus on insider trading from “pure company law” which juxtaposed the company’s interest against the insiders based on a rationale that insider trading is a breach of fiduciary duty to a multilateral approach. Under the modern multilateral approach, stockholders, employees, managers, and the general public are seen as having competing interests to be balanced and the rationale for the prohibition of insider trading is to maintain market efficiency.121 The basis of the

115Warren, supra at 220.

116See, e.g., Council Directive 2003/6, Art. 6(2), 2003 O.J. (L 96) 16, 21 (EC).

117See, e.g., Case C-384/02, Criminal Proceedings against Knud Groengaard and Allan Bang, 2005 (C 384) par. 22 (ECR). “Directive 89/592 prohibits insider dealing with the aim of protecting investor confidence in the secondary market for transferable securities and, consequently, of ensuring the proper functioning of that market.” Ibid.

118‘Adoption of Insider Trading Rules Creates Wide Ban on Use of Information’, 2 Int’l Sec. Reg. Rep. (BNA) No. 14, at 1 (21 June 1989). See also Case C-384/02, Criminal Proceedings against Knud Groengaard and Allan Bang, 2005 (C 384) par. 22 (ECR). “Directive 89/592 prohibits insider dealing with the aim of protecting investor confidence in the secondary market for transferable securities and, consequently, of ensuring the proper functioning of that market.” Ibid.

119Council Directive 2003/6, preamble, 2003 O.J. (L 96) 16,17 (EC).

120The Securities and Exchange Act of 1933 defines itself as “An [Act] to provide full and fair disclosure of the character of securities sold in interstate and foreign commerce and through the mails, and to prevent frauds in the sale thereof, and for other purposes.” Securities Act of 1933, Pub. L. No. 22, 48 Stat. 74 (1933). The Securities Exchange Act of 1934 states that its purposes are “... to protect interstate commerce, the national credit, the Federal taxing power, to protect and make more effective the national banking system and Federal Reserve System, and to insure the maintenance of fair and honest markets in such transactions.” Securities Exchange Act of 1934, 15 U.S.C.A. 78(b) (2006).

121Stephen J Leacock, ‘In Search Of A Giant Leap: Curtailing Insider Trading In International Securities Markets By The Reform Of Insider Trading Laws Under European Union Council Directive 89/592’ (1995) 3 Tulsa J. Comp. & Int’l L. 51, 58.