Insider Trading Under Rule 10b-5
Kevin Haynes
A. Introduction
1. Section 10(b) of the Securities Exchange Act of 1934 (the “Exchange Act”) provides that “[i]t 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 “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,…any manipulative or
deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate in the public
interest or for the protection of investors.” 15 U.S.C. §78j(b).
2. Rule 10b-5, promulgated under Section 10(b), makes it unlawful for “any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce...[t]o 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 sale or purchase of any security.” 17 C.F.R. §24010(b)-5.
3. Nowhere does Section 10(b) or Rule 10b-5 mention insider trading.
Kevin Haynes is a professor at University of North Carolina School of Law in Chapel Hill,
North Carolina.
A complete set of the course materials from which this outline was drawn may be purchased from ALI-ABA by calling 1-800-CLE-NEWS and asking for customer service. (Have the
order code CK003 handy). Or order online at www.ali-aba.org/aliaba/CK003.htm.
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B. The Disclose Or Abstain Rule
1. Cady, Roberts
a. In Cady, Roberts & Co., 40 S.E.C. 907 (1961), the SEC held that trading in the
open market by corporate insiders on the basis of material, nonpublic
information is a “deceptive” device in violation of Section 10(b) and Rule
10b-5. In so holding, the SEC also set forth what came to be known as the
“disclose or abstain” rule: a corporate insider must disclose all material
nonpublic information known to him before trading, or if disclosure is
improper or impracticable, abstain from trading.
2. SEC v. Texas Gulf Sulphur
a. In SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), cert. denied, 394
U.S. 976 (1969), the Second Circuit held that a corporate insider in possession of material nonpublic information must either disclose such information before trading or abstain from trading until the information has been
disclosed.
3. Effect Of The Rule
a. In most cases under the disclose or abstain rule, disclosure is not an option.
Typically material nonpublic information of a corporation is nonpublic
because the corporation has legitimate reasons for maintaining secrecy,
and fiduciary duties preclude an insider in possession of that material
nonpublic information from disclosing it for personal gain. Thus complete
abstention is most often what the rule requires.
4. Extension Of The Rule
a. The court in Texas Gulf Sulphur was of the view that Rule 10b-5’s prohibition on insider trading applied to “anyone in possession of material inside
information” because the Rule was meant to assure that “all investors
trading on impersonal exchanges have relatively equal access to material
information.” Thus the Rule’s prohibition, according the court, extends to
anyone with direct or indirect access to material information not generally
available to the public—to corporate insiders as well as outsiders.
C. Narrowing The Disclose Or Abstain Rule
1. In the 1980s, the Supreme Court’s rulings in Chiarella v. United States, 445 U.S.
222 (1980), and Dirks v. SEC, 463 U.S. 646 (1983), significantly narrowed the
scope of the disclose or abstain rule of Texas Gulf Sulphur.
Insider Trading Under Rule 10b-5 7
2. Chiarella
a. Vincent Chiarella was an employee of a financial printer that prepared tender offer disclosure documents. Although the printer used codes to conceal the identities of tender offerors and their targets, Chiarella was able to
break the codes and with that information, purchase shares in target companies before the tender offers were made public.
b. Chiarella was convicted of violating Rule 10b-5 by trading on the basis of
inside information. The Second Circuit upheld the conviction on the basis
of its holding in Texas Gulf Sulphur that Rule 10b-5 imposes a general duty
on anyone in possession of material, nonpublic information either to disclose that information before trading on it or to abstain from trading altogether. Under the court’s Rule 10b-5 “equal access to material information” rationale, Chiarella was in violation of the Rule even though he was
not an insider or agent of any of the companies in whose stock he traded.
c. The Supreme Court reversed Chiarella’s conviction, and in so doing,
rejected the Second Circuit’s equal-access rationale for Rule 10b-5. The
Court held that there can be no violation of Rule 10b-5 for failure to disclose “absent a duty to speak,” and that duty does not arise from mere
possession of nonpublic information. The duty to disclose or abstain
under Rule 10b-5 can only arise from a relationship of trust and confidence between the inside trader and the party on the other side of the
transaction.
3. Dirks
a. Raymond Dirks, a securities analyst, began investigating Equity Funding
of America after receiving allegations of fraud at the company from
Ronald Secrist, a former officer of the company. Dirks’s investigation uncovered massive fraud at the company. Dirks turned the results of his
investigation over to the SEC and the Wall Street Journal, while also discussing his findings with various clients, many of whom sold their Equity
Funding stock before the fraud became public. After the fraud at Equity
Funding was exposed, the SEC started an investigation of Dirks’s role in
uncovering it, and eventually censured him for violating securities laws
prohibiting insider trading by discussing his findings of fraud at Equity
Funding with his clients.
b. Reversing the SEC’s censure of Dirks, the Supreme Court used the opportunity to reiterate its holding in Chiarella that “there can be no duty to dis-
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close where the person who has traded on inside information ‘was not [the
corporation’s] agent,...was not a fiduciary, [or] was not a person in whom
the sellers [of the securities] had placed their trust and confidence.’ Not to
require such a fiduciary relationship...would amount to ‘recognizing a
general duty between all participants in market transactions to forgo
actions based on material, nonpublic information.’” Dirks, 463 U.S. at 65455 (citations omitted).
c. Dirks involved trading by persons receiving information from an insider’s
tippee (Secrist was the insider; Dirks, his tippee). In tipping cases, the
Court held in Dirks, someone who receives information from an insider (or
anyone else holding information in trust) is not liable under Rule 10b-5 for
trading on the information unless the insider, by disclosing the information to the tippee, breached a fiduciary duty of loyalty to refrain from profiting on information entrusted to him, and the tippee knows or has reason
to know of the breach of duty. There was no such breach of duty in Dirks:
Secrist tipped off Dirks to expose the fraud at Equity Funding, and not for
any personal gain.
D. Today’s Prohibitions On Insider Trading
1. Disclose Or Abstain Liability After Chiarella And Dirks
a. After Chiarella and Dirks, disclose or abstain liability under Rule 10b-5
could arise only for persons who owe fiduciary duties to those with whom
they trade. In tipping cases the requisite relationship was between the tipper and the source of the information, and for liability to obtain, tipping
the information had to breach the tipper’s fiduciary duty to the information’s source not to profit on the information entrusted to him. These holdings significantly narrowed the class of persons potentially liable for insider trading under Rule 10b-5, but left unclear what kind of fiduciary relationship was required and what duty, if any, had to be breached for liability to be imposed.
i.
The Requisite Fiduciary Relationship
(1) In United States v. O’Hagan, 521 U.S. 642 (1997), the Supreme
Court implicitly confirmed its holding in Dirks and Chiarella that the
requisite fiduciary relationship is one of trust and confidence between
insiders and shareholders that places on insiders the duty either to