Insider Trading under Rule 10b-5
I.
Introduction
A. 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 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.”
B. Rule 10b-5, promulgated under Section 10(b), makes it unlawful for
“any person, directly or indirectly, by the use of any instrumentality
of interstate commerce . . . 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 sale or purchase of any
security.”
C. Nowhere does Section 10(b) or Rule 10b-5 mention insider trading.
II.
The Disclose or Abstain Rule
A. Cady, Roberts
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.
B. SEC v. Texas Gulf Sulphur
In SEC v. Texas Gulf Sulphur Co., 401 F.2d 822 (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.
C. Effect of the Rule
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.
D. Extension of the Rule
The court in Texas Gulf Sulphur was of the view that Rule 10b-5’s
prohibition on insider trading applied to “anyone in possess 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.
III.
Narrowing the Disclose or Abstain Rule
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.
A. Chiarella
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.
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
2
prior to 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.
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.
B. Dirks
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.
Reversing the SEC’s censure of Dirks, the Supreme Court used the
opportunity reiterate its holding in Chiarella that “there can be no
duty to disclose 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 654-55 (citations omitted).
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,
3
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.
IV.
Today’s Prohibitions on Insider Trading
A. Disclose or Abstain Liability after Chiarella and Dirks
After Chiarella and Dirks, disclose or abstain liability under Rule
10b-5 could arise only for persons who owe a 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
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 disclose inside
information before trading or to abstain from trading
altogether.
ii. breach of duty
In Dirks the Court alludes to the inherent unfairness of
insiders trading on information that was intended to be
available only for corporate purposes. This suggests that
the insider breaches a fiduciary duty to refrain from selfdealing when he trades on inside information.
iii. insiders
In addition to officers and directors of a corporation, insiders
include anyone in a relationship with the issuer affording
4