Insider Trading under SEC Rule 10b-5
By Kevin Haynes

SOURCE OF THE OBLIGATION – SEC Rules 10b-5, 14e-3
o Nowhere does Rule 10b-5 mention insider trading.
o Although there have been several abortive legislative attempts, there is no explicit
definition of what constitutes improper use of material nonpublic information.
o Rule 10b-5(c) 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.”
o In Cady, Roberts & Co., 40 S.E.C. 907 (1961), the Commission held that a
corporate insider must abstain from trading in the shares of his corporation unless he
has first disclosed all material inside information known to him.
o In Chiarella v. United States, 445 U.S. 222 (1980), Justice Powell explained that:
The obligation to disclose or abstain [under Rule 10b-5] derives from
“[a]n affirmative duty to disclose material information[, which] has been
traditionally imposed on corporate ‘insiders,’ particular officers, directors,
or controlling stockholders. We, and the courts have consistently held
that insiders must disclose material facts which are known to them by
virtue of their position but which are not known to persons with whom
they deal and which, if known, would affect their investment judgment”
(quoting Cady, Roberts & Co., 40 S.E.C. 907, 911 (1961)).
The Commission emphasized that the duty arose from (i) the existence of a
relationship affording access to inside information intended to be available
only for a corporate purpose, and (ii) the unfairness of allowing a corporate
insider to take advantage of that information by trading without disclosure
(citing Cady, Roberts, 40 S.E.C. at 912 and n.15). . . . In its Cady, Roberts
decision, the Commission recognized a relationship of trust and confidence
between the shareholders of a corporation and those insiders who have
obtained confidential information by reason of their position with that
corporation. This relationship gives rise to a duty to disclose because of the
“necessity of preventing a corporate insider from . . . tak[ing] unfair
advantage of the uninformed minority stockholders” (quoting Speed v.
Transamerica Corp., 99 F.Supp. 808, 829 (D.Del.1951)).
Chiarella, 445 U.S. at 227, 228.
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o Thus there must be a duty to speak in order for disclose-or-abstain liability under
Rule 10b-5 to obtain. Possession of material nonpublic information without more
does not create the duty to disclose or abstain from trading.
o Under Rule 14e-3, in the tender offer context, mere possession of material nonpublic
information creates the duty to abstain from trading. Rule 14e-3 (with certain narrow
exceptions) prohibits any person in possession of material information relating to a
tender offer by another person from trading in target company securities if the bidder
has commenced or taken substantial steps toward commencing the bid. The SEC
adopted Rule 14e-3 in response to increased insider trading activity during the
mergers and acquisitions boom of the 1980s. The Supreme Court in United States v.
O’Hagen, 521 U.S. 642 (1997), upheld Rule 14e-3 as a valid exercise of the SEC’s
rulemaking authority.

RULE 10b-5
o Scienter
Violations of Rule 10b-5 require a showing that the defendant acted with scienter.

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In the context of insider trading, a pattern of unusual trades by insiders can
establish an inference of scienter. In re Silicon Graphics, Inc. Securities
Litigation, 183 F.3d 970, 986-987 (9th Cir. 1999); In re Peritus Software
Services, Inc. Securities Litigation, 52 F. Supp.2d 211, 224 (D. Mass.
1999).

The plaintiff has the burden of showing the existence of such an
unusual trading pattern.

This requires a showing that the insiders’ transactions were
“dramatically different” from their prior trading patterns.

Insider trading is “suspicious only when it is dramatically out of line
with prior trading practices at times calculated to maximize the
personal benefit from undisclosed inside information.” In re Silicon
Graphics, Inc. Securities Litigation, 183 F.3d 970, 986 (9th Cir.
1999) quoting In re Apple Computer Securities Litigation, 886 F.2d
1109, 1117 (9th Cir. 1989).

When determining whether such a dramatic trading pattern exists,
among other things the courts will look at (1) the magnitude of insider
trading; (2) the timing of the transactions; and (3) whether the
transactions vary from prior practices.
o Materiality
Under Rule 10b-5, only material omissions and misrepresentations are actionable. In
the insider trading context, the nonpublic information on which the insider traders must
be material.

In SEC v. Texas Gulf Sulphur Co., 401 F.2d 833 (2d Cir. 1968), the court
noted that the corporate insiders were purchasing call options and that this
created a strong inference that they were taking advantage of knowledge
concerning the company’s mineral exploration in eastern Canada.

Thus the fact that the insiders trade creates a strong inference of materiality.
o Use versus Possession
In order to establish a successful insider trading claim, must it be shown that the
defendant actually used the information in deciding whether to trade or is it sufficient
to establish that the trade was made while defendant was in possession of material
non public information?

The SEC has maintained that possession of the information is sufficient to
trigger the liability of someone who is subject to the disclose or abstain
obligation.

Two circuit courts have held that it must be shown that the defendant used
the information in question. United States v. Smith, 155 F.3d 1051 (9th Cir.
1998); SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998).

Other courts have pointed out however once it is established that a defendant
traded while in possession of nonpublic material information, it may be
inferred that he or she in fact used the information.

In 1999, the Commission proposed a rule that would have adopted a
possession test but subsequently the Commission modified its approach to
one where the presumption of liability could be rebutted by a showing that the
defendant had (1) a preexisting binding contract to enter into the transaction
in question, (2) executed a prior instruction to a third party to execute the
transaction in question, or (3) had previously adopted a written plan
specifying the transactions in question. See Sec. Exch. Act Rel. No.
34-24259 (SEC Dec. 20, 1999).

As adopted in 2000, SEC Rule 10b-5(1) embodies a use test combined with
a presumption of use based on possession.

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The presumption of use of material nonpublic can be rebutted by
showing that material nonpublic information was not a factor in a
trading decision because a trade was carried out pursuant to a
preexisting contract, instruction or plan. See Rule 10b-5(1)(c)(1).

The presumption of use of material non public information can also be
rebutted by entities which establish that sufficient informational barriers have
been erected.

Rule 10b-5(2) establishes a nonexclusive list of three situations in
which a person has a duty of trust or confidence for purposes of
applying the misappropriation theory. Rule 10b52 provides that a
“duty of trust or confidence” exists where a person:
o obtains material nonpublic information from his or her spouse,
parent, child or sibling;
o has a history, pattern or practice of sharing confidences with
the recipient of the material nonpublic information, such that
the recipient “knows or reasonably should know” that the
person communicating the information to the recipient expects
that the recipient will maintain the information in confidence;
or
o agrees to maintain information in confidence.

EXAMPLES OF TRADING ON MATERIAL NONPUBLIC INFORMATION
o True Insiders
A corporate director learned that his/her company has struck oil, can he/she trade on
that information before it is publicly disclosed?
No, it violates Rule 10b-5.
o Constructive/Temporary Insiders
A printer working on a tender offer disclosure document figured out the identity of the
target corporation and bought the target company stock before that information was
made public. Is this permissible?
Probably not.
In Chiarella, a number of the Justices indicated that a conviction could stand
if based upon a theory that the printer was given that information in a position
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