THE GENESIS OF AN ETHICAL
IMPERATIVE: THE SEC IN TRANSITION
Richard J. Hunter, Jr.* & Philip Frese**
The fairness and integrity of conduct within the securities markets is a
concern of utmost significance for the proper functioning of our securities laws.'
The case of United States v. Winans' marks a policy and historical
watershed in judicial determination in the arena of insider trading. Taking note that the United States Supreme Court has "repeatedly recognized that securities laws combatting fraud should be construed 'not technically and restrictively but flexibly,' "s the Second Circuit, a leader
among the United States Circuit Courts of Appeals in expanding liability
in the area of insider trading, analyzed, interpreted and decided two important cases, SEC v. Materia,4 and United States v. Newman, in light
of two earlier Supreme Court cases, Dirks v. SEC,' and Chiarella v.
United States.7 In so doing, the Second Circuit turned a new page in the
application of the "misappropriation" theory, first enunciated by Chief
Justice Warren Burger and supported by Associate Justice William Brennan in Chiarella v. United States.8
Associate Professor of Legal Studies, Seton Hall University.
Assistant Professor of Accounting, Seton Hall University.
1. United States v. Carpenter, 791 F.2d 1024, 1027 (2d Cir. 1986), afl'd, 108 S. Ct. 316
(1987).
2. 612 F. Supp. 827 (S.D.N.Y 1985), afl'd in part rev'd in part sub nom. United States
v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), af/d, 108 S. Ct. 316 (1987).
3. Herman & MacLean v. Huddleston, 459 U.S. 375, 386-87 (1983).
4. 745 F.2d 197 (2d Cir. 1984), cert. denied, 471 U.S. 1053 (1985).
5. 664 F.2d 12 (2d Cir. 1981), cert. denied, 464 U.S. 863 (1983).
6. 463 U.S. 646 (1983).
7. 445 U.S. 222 (1980).
8. "I would read § 10(b) and rule 10b-5... to mean that a person who has misappropriated nonpublic information has an absolute duty to disclose that information or to refrain from trading." Id. at 240 (Burger, C.J., dissenting). Associate Justice William Brennan
also supported the misappropriation theory. "[A] person violates section 10(b) whenever he
improperly obtains or converts to his own benefit nonpublic information which he then uses
in connection with the purchase or sale of securities." Id. at 239 (Brennan, J., concurring in
judgment).
*
**
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[Vol. 25:9
United States v. Carpenter9 is the culmination of judicial decisionmaking, arguing forcefully for an earlier-enunciated view that "trading on
the basis of improperly obtained information is fundamentally unfair,
and that distinctions premised on the source of the information undermine the prophylactic intent of the securities laws." 1
The case may also be viewed as seminal because of its use of and
reliance upon mail and wire fraud statutes, seen potentially as a major
departure from traditional prosecutorial practice and a major new
"weapon" in securities fraud cases. The statutes were used to sustain the
criminal convictions of participants in a scheme in which a Wall Street
Journal reporter (Winans) who was one of the writers of the "Heard on
the Street" column agreed to provide two stockbrokers with advanced
material. This nonpublic information on the content and timing of future
"Heard on the Street" articles was provided in violation of the established policy of the newspaper to treat such nonpublic information
learned on the job as confidential. Based on the information gleaned from
Winans, the two brokers would buy or sell the subject securities.11
By proscribing in broad policy strokes such " 'deceptive' practices in
connection with the purchase or sale of securities . . . under the Securities Exchange Act of 1934," the Second Circuit recognized that "Congress
left to the courts the difficult task of interpreting legislatively defined but
broadly stated principles insofar as they apply in particular cases."12 Yet,
in the area of insider trading, the Congress, the SEC, and the courts have
assumed and shared critical roles because of indecision and reluctance on
the part of any one of the players to play a leadership role.
This article is a comprehensive study of the genesis of judicial, legislative, and administrative law and rule making in the development of proscriptions in the area of insider trading, a recent and heinous phenomenon of modern securities fraud. The article focuses both on the practical
development of applicable laws and administrative rules and also on the
'ethical imperative' created by the recent controversy. The article analyzes the important case precedents as well as two legislative acts: The
Insider Trading Proscription Act of 198713 which was not adopted by the
9. 791 F.2d 1024 (2d Cir. 1986), af['d, 108 S. Ct. 316 (1987).
10. Carpenter, 791 F.2d at 1029 (citing SEC v. Musella, 578 F. Supp. 425, 438
(S.D.N.Y. 1984)).
11. United States v. Winans, 612 F. Supp. 827, 829-38 (S.D.N.Y. 1985), aff'd in part
rev'd in part sub nom. United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), aff'd, 108 S.
Ct. 316 (1987).
12. Carpenter, 791 F.2d at 1027.
13. S. 1380, 100th Cong., 1st Sess., 133 CONG. REC. 8247-48 (1987) [hereinafter S.
1380].
1989-90]
SEC IN TRANSITION
Congress but which would have provided the first concrete legislative definition of 'insider trading,' and the Insider Trading and Securities Enforcement Act of 1988,14 which significantly increased the penalties for
illegal trading practices and which was signed into law by President Reagan in October of 1988.'"
This article recognizes that Congress' 1934 enactment was intended
as a "comprehensive yet open-ended statutory scheme, capable of ongoing
adaptation and refinement,"' 6 which would guarantee an "'open and honest market' . . . in which superior knowledge in the securities markets
would be achieved honestly, fairly, and without resort to pernicious conduct."' 7 Therefore, this article seeks to investigate the application of a
principle first stated in the 1963 Supreme Court case, SEC v. Capital
Gains Research Bureau:8 that underlying section 10(b) and the major
securities laws generally is the fundamental promotion of the " 'highest
ethical standards' .
in every facet of the securities industry."' 9
INTRODUCTION
In recent years, a rash of insider trading scandals has rocked Wall
Street and sent financial markets reeling into an unprecedented tail-spin.
Financial "giants and gurus" such as Ivan Boesky, Dennis Levine, and
Michael Milken and many of the leading securities firms (Kidder
Peabody, Drexel Bernham, Shearson Lehman) have been implicated in
activities that have brought uncertainty and disarray to both Wall Street
and Main Street.
As a result of recent developments (the conviction of R. Foster Winans, a Wall Street Journal Reporter; the guilty plea entered by Drexel
Bernham in December of 1988; and the Securities Exchange Commission's announcement of a "compromise" proposal on a broadened definition of insider trading, which nonetheless became their policy in November of 1987), several important questions have been raised: What are the
legislative and administrative origins of the prohibitions against insider
trading? Are the rules against insider trading a modern phenomenon or
just the logical extension and development of earlier congressional and
SEC actions undertaken during the 1930's, after an era of unfettered, illegal, and devastating market activity? What are the current laws, adminis14.
Pub. L. No. 100-704, 102 Stat. 4677 (1988).
15. Insider Trading and Securities Fraud Enforcement Act of 1988, Pub. L. No. 100704 (1988) (codified in scattered sections of 15 U.S.C.).
16. SEC v. Materia, 745 F.2d 197, 203 (2d Cir. 1984).
17. Carpenter, 791 F.2d at 1036 (citing Materia, 745 F.2d at 203).
18. 375 U.S. 180 (1963).
19. Id. at 186-87.
GONZAGA LAW REVIEW
[Vol. 25:9
trative rules, and important case holdings which proscribe illegal securities transactions and practices? Finally, what are the limits (both
practical and legal) of the scope of governmental activity designed to
thwart the most egregious cases of insider trading?
In addition to the practical questions raised in a serious discussion of
the issue, several important policy questions with clear ethical dimensions
likewise become apparent.
* * ' To whom should the prohibitions against insider trading extend?
(That is, should proscriptions apply to brokers and securities dealers exclusively; or should the rules likewise apply to such allied-persons as analysts, journalists, trade publication writers, printers, and other parties?)
. . . Is a concrete definition of insider trading necessary to assist
prosecutors and SEC attorneys in their fight against insider trading practices? Who should offer such a definition?
* . * Might not such a definition provide skillful practitioners with
legal "loopholes," which may make the current fight even more difficult?
' * Who should be able to bring an action for damages suffered as a
result of insider trading? (Should "contemporaneous traders" be
protected?)
* . . What long-range damage to the integrity of the securities markets, the confidence of individual and institutional investors, and the entire financial system in the United States is wrought by such odious practices as insider trading?
. . . What can be done to help effect a cure?
This article will address both the important practical and policy
questions raised and will seek to offer some observations and conclusions
concerning practices which, unfortunately, have become all too frequent
in the securities markets of the 1980's.
I.
AN
OVERVIEW
OF FEDERAL SECURITIES LAWS
The most important federal securities regulations enacted during the
period of the "Great Depression" were the Securities Act of 193320 and
the Securities Exchange Act of 1934.21 The Securities and Exchange Commission (SEC), an independent agency created by the Securities Ex20.
21.
Securities Act of 1933, 15 U.S.C. § 77a-77aa (1982).
Securities Exchange Act of 1934, 15 U.S.C. § 78a-78kk (1982).
SEC IN TRANSITION
1989-901
change Act of 1934,22 was established during a period of great economic
turmoil and uncertainty in the aftermath of the Stock Market Crash of
1929. The general objectives of the SEC are to provide full disclosure of
all information pertinent to the securities market; effectively regulate the
established and organized securities exchanges, markets, and dealers; and
oversee any and all aspects dealing with the purchase or sale of securities,
trading regulations, tender offers,"3 and the registration of new
24
securities.
The SEC 5 is charged with the responsibility of administering all federal securities law and has as its main responsibilities:
1) Requiring disclosure of facts concerning offerings of securities26
which are listed on the various national security exchanges and certain
securities which are traded "over-the-counter";
2) regulating the trade in securities on the thirteen existing national
and regional securities exchanges and in the over-the-counter markets;
3)
investigating securities fraud;
4) regulating the activities of securities brokers, dealers, salespersons, investment advisers and counselors, and requiring their registration;
5)
supervising the activities of mutual funds;
22. An independent agency cannot be characterized as an arm of the Executive
Branch. Thus, the President has limited removal power for an individual member. See
Humphrey's Executor v. United States, 295 U.S. 602 (1935).
23. For a thorough discussion of the issues involved in a tender offer, see Hunter &
Eagan, Tender Offers, The Williams Act: Shareholder Rights and Responsibilities, 8 AM.
Bus. L. Ass. REG. PROC. 53 (1984); see also The Williams Act, Pub. L. No. 90-439, 82 Stat.
454 (codified as amended at 15 U.S.C. § 78m(d)-(e), 78n(d)-(f) (1982)).
24. J. DOWNES & J. GOODMAN,
DICTIONARY OF FINANCE AND INVESTMENT TERMS
264 (2d
ed. 1987).
25. The SEC's main office is located in Washington, D.C., with regional offices in New
York, Atlanta, Chicago, Ft. Worth, Denver, San Francisco, and Seattle. The Commission
consists of five members, each appointed by the President for a five-year term. The current
Chief Commissioner is David Rudder, former Dean of the Northwestern University Law
School. See L.
RAPPAPORT,
SEC
ACCOUNTING PRACTICE AND PROCEDURE
1.13 (3d ed. 1972).
26. The Act states (in part): "The term 'security' means any note, stock, treasury
stock, bond, debenture, [or] evidence of indebtedness .... " 15 U.S.C. § 77(b)(1) (1982).
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[Vol. 25:9
6) recommending appropriate administrative sanctions, injunctive
remedies, 7 and possible criminal prosecutions 8 against those who violate
federal securities law.29
The Securities Act of 1933 was enacted to prohibit various forms of
securities fraud by requiring that all essential (material) information concerning the issuing of stocks be made available to the investing public.
Professor Walter Gellhorn noted that "[t]he principle objective of the Securities Act of 1933 is to protect investors by requiring a full and accurate
disclosure of the material facts regarding securities offered for sale in interstate commerce or by the use of the mails."'
It may thus be said that the 1933 Act essentially embodies a disclosure requirement. The Hoover Commission (1949) notes: "[T]he [SEC]
has stated that the basic purpose of the Securities Act is disclosure, and
that the Commission has no interest in the substance of the transaction
provided that disclosure is adequate and accurate."3
A.
Registration
Section 5 of the 1933 Act provides that before any nonexempt security32 may be sold or offered to the public through either the mails or any
facility or instrumentality of interstate commerce, a registration statement must be filed with the SEC. Prospective investors must be provided
with an investment prospectus. 3 The registration statement and prospectus are intended to supply sufficient information to enable an unsophisticated investor to evaluate the financial risks involved in the transaction.
Any registration statement filed with the SEC must contain the following general information:'
27. See, e.g., SEC v. Torr, 22 F. Supp. 602, 612 (S.D.N.Y. 1938).
28. A person who "wilfully violates" the Act, or the Rules and Regulations thereunder,
or "wilfully" makes an untrue or misleading statement in a registration statement may be
prosecuted in a criminal action and, upon conviction, fined not more than $10,000 or imprisoned not more than five years, or both. 15 U.S.C. § 77x (1982).
29. See, e.g., H.R. 910, 100th Cong., 2d Sess. § 7(b)(1), reprinted in 1988 U.S. CODE
CONG. & ADMIN. NEWS 6043. [hereinafter H.R. 910].
30. W. GELLHORN & C. BYSE, ADMINISTRATIVE LAW CASES & COMMENTS 653 (4th ed.
1960).
31. Report of the (Hoover) Commission on Organization of the Executive Branch of
the Government, Independent Regulatory Commissions, Appendix N, 148 (1949), reprinted
in W. GELLHORN & C. BYSE, supra note 30, at 656-57.
32. See infra subsection B.
33. 15 U.S.C. § 77e(b) (1982).
34. Id. § 77aa.
1989-901
SEC IN TRANSITION
1) A disclosure of the important provisions of the securities being
offered for sale, including the relationship between the particular security
and other securities offered by the registrant. The issuing party must also
disclose the intended use of the proceeds of the sale.
2) A disclosure of the registrant's property and business interests.
3) A disclosure of the management of the registrant, its security
holdings, remuneration (including salaries, bonuses, and benefits), and
other non-salary benefits such as pensions, warrants, and stock options.
In addition, any special interests of any director or officer in any "material transactions" with the issuing corporation must be disclosed.
4) A financial statement certified by an independent public accounting firm.
5) A disclosure of any lawsuit pending against the registrant or
those of which the registrant has knowledge.
The statute provides that a registration will become effective automatically after the expiration of a twenty-day period, unless in that interval the Commission issues a stop order proceeding; that is, a formal proceeding to deny effectiveness on the ground that the statement is marked
by either material misstatements or omissions.3 5
However, to avoid the devastating consequences of the "stop order"
("public reflection would have been cast on the securities proposed to be
sold and their successful flotation would become all but impossible"),"
the Commission has developed an informal device termed the deficiency
letter. Specialists from the legal staff of the SEC (Division of Corporation
Finance) will carefully scrutinize the registration statement upon its filing. Should a defect or deficiency be discovered, a letter is immediately
addressed to the prospective registrant advising that party of any difficulty or concern and suggesting what will be necessary if the proposed
statement is to be perfected.37 ("It is anticipated by all concerned that
the registration statement initially filed will be amended one or more
times in response to comments of the Commissioner's staff after its review of the materials presented.") 8
It should be recognized that if a cursory review of the registration
statement reveals that it has been inadequately prepared or that a serious
35. See Escott v. BarChris Constr. Corp., 283 F. Supp. 643 (S.D.N.Y. 1968).
36. W. GELLHORN & C. BYSE, supra note 30, at 653.
37. See, e.g., Study of the Securities and Exchange Commission: Hearings before
Subcomm. of House Comm. on Interstate and Foreign Commerce, 82nd Cong., 2d Sess. 423
(1952). It was noted that in less than four percent of the total was a deficiency letter not
sent.
38. Securities Law, Org. Corp. & Other Bus. Enterprises (MB) § 9.02[2], at 9-24.1
(Nov. 1984).
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[Vol. 25:9
problem exists, no further review will be conducted by the Commissioner's staff, and counsel for the registrant will be so advised in what has
been referred to as a "bed bug letter." Such a finding may therefore lead
for a stop order,
to a proceeding under subsections 8(e) and (d) of the Act
39
20(b).
section
under
injunction
an
for
or a proceeding
Another informal method developed by the Commission is a prefiling
conference in which representatives of registrants and underwriters 0 will
discuss anticipated problems in connection with any proposed filing. In
this connection, however, it must be noted that sections 11 and 12 of the
Securities Act impose civil liability for false or misleading information in
connection with the filing of a registration statement. According to Professor Foster in a seminal work applying the Administrative Procedure
Act to the Securities Act, "[T]o the responsible underwriter or officer of
the issuing corporation, the possibility of putting something over on the
Commission and getting by with less than an adequate registration statement is obviously not worth running the risk of being liable for rescission
or damages." '41
One final area of informal SEC procedure is the authority of the
Commission to accelerate the effective date of any registration statement
upon the application of a registrant; that is, the Commission can declare
that the registration statement is effective before the expiration of the
twenty-day period. Acceleration can be very important to the ultimate
success or failure of any offering, "since the determination of the public
offering will often be based on the current trading price of outstanding
securities of the same issue."" 2
Prior to the filing of the registration statement and prospectus43 with
the SEC, a corporation is permitted to secure the services of a securities
39. 11 Bus. Org. (MB) § 7.05(3), at 7-122 (Oct. 1980).
40. An underwriter may strictly be said to agree to purchase the unsold shares of securities of the corporation.
41. Foster, Application of the Administrative Procedure Act to the Statutes Administered by the Securities and Exchange Commission, in THE FEDERAL ADMINISTRATIVE PROCEDURE ACT AND ADMINISTRATIVE AGENCIES 213, 226 (Warren ed. 1947).
42. Org. Corp. & Other Bus. Enterprises (MB) § 9.02(2), at 9-24.1 to 24.2 (Nov. 1984).
"A request for acceleration should be made to the Commission at least two business days
before the date on which it is desired that the statement becomes effective." Id. at 9-24.2. It
should also be recognized that although 15 U.S.C. § 77i (1982) permits judicial review of an
order by the Commission, there are no provisions for either a formal hearing or a formal
dismissal order and it would be wholly impractical to secure a judicial review of any refusal.
See Crooker v. SEC, 161 F.2d 944, 948-49 (1st Cir. 1947).
43. "Prospectus" is defined in 15 U.S.C. § 77b(10) (1982) as "any prospectus, notice,
circular, advertisement, letter, or communication, written or by radio or television, which
"
offers any security for sale or confirms the sale of any security ....
SEC IN TRANSITION
1989-90]
underwriter, who will oversee the sale and distribution of the new issue.
During the twenty-day waiting period, certain oral offers (except those
made by radio or television)"" concerning the purchase and sale of the
proposed securities
are permitted and very limited written advertising is
5
likewise allowed.4
B. Exemptions
A corporation can avoid both the high cost and complicated procedures involved with the registration process by taking advantage of certain exemptions provided for in the registration statute. Generally, a particular transaction will be exempt from registration if the sale or
purchase of the securities does not involve a public offering. 4 "To determine the distinction between 'public' and 'private' in any particular context, it is essential to examine the circumstances under which the distinction is sought to be established and to consider the purposes sought to be
achieved by such distinction. ' "'
Examples of exempt transactions are:
8
1) Private offerings to a limited number of persons;
2) offerings to an institution that has actual access to the required
information which would otherwise be found in the registration
statement;4
9
3) offerings of an entire issue restricted to residents of the state in
which the issuing company is incorporated and doing business,"0 yet such
offerings will nevertheless be subject to state securities laws; 5
44. Org. Corp. & Other Bus. Enterprises, supra note 38, at 9-15. At this time, the socalled red herring prospectus may be distributed. It received this name from the red legend
printed across it stating that the registration has been filed but has not yet become effective.
After the waiting period, written advertising is allowed in the form of the so-called tombstone ad, so named because the format resembles a tombstone.
45. Id.
46. SEC v. Ralston Purina Co., 346 U.S. 119 (1953).
47. SEC v. Sunbeam Gold Mines Co., 95 F.2d 699, 701 (9th Cir. 1938).
48. Ralston Purina Co., 346 U.S. at 125. Should all the subscribers to the venture be a
few persons who are active participants in the venture with intimate and detailed knowledge
of its affairs, no problem would appear to be presented under the Act. Ayers v.
Wolfinbarger, 491 F.2d 8, 16 (5th Cir. 1974).
49. Securities Act of 1933, 15 U.S.C. § 77d(2) (1982).
50. See Chapman v. Dunn, 414 F.2d 153, 157 (6th Cir. 1969); SEC v. Truckee Showboat, Inc., 157 F. Supp. 824 (S.D. Cal. 1957) ("The issuer must conduct a predominant
amount of his business within the same state.").
51. Securities Act of 1933, 15 U.S.C. § 77c(a)(11) (1982). It is clear from the terms of
section 77c(a)(11) that this exemption only applies if the issuer, the offerees, and the purchasers are residents of the same state or territory. This exemption was characterized in a
GONZAGA LAW REVIEW
[Vol. 25:9
4) certain "small issues" under $1,500,000 (originally $100,000) are
exempted from the major registration requirement and may be registered
under a simplified registration process, known as Regulation A;
5) bank securities sold prior to July 27, 1933;
6) commercial paper, 52 if the maturity date does not exceed a nine
month period;
53
7) securities of charitable organizations;
8) exchange securities where there has been a corporate
reorganization;
9) stock dividends and stock splits;
10) securities issued by a common carrier or by a contract carrier;
11) any insurance, endowment, or annuity contract issued by an insurance company. 4
C. The BarChris Case
Violations of the registration requirements of the 1933 Act are
treated very seriously by both the SEC and the courts. In Escott v. BarChris Construction Corp.,5 5 a lawsuit was brought by purchasers of BarChris (a company which installed bowling lanes) debentures who alleged
that the registration statement filed with the SEC (effective May 16,
1961) contained material false statements and material omissions.5
The defendants fell into three separate categories:
1) Persons who signed the registration statement (including BarChris' nine directors, its controller, attorneys, two investment bankers
who were later named to the Board of Directors of BarChris, and several
other persons who participated in the preparation of the registration
statement);
2) the underwriters (eight investment banking firms);
1937 Letter of the General Counsel of the SEC: "From a practical point of view, the provisions of that section can exempt only issues which in reality represent local financing by
local industries, carried out purely through local purchasing." 1 Fed. Sec. L. Rep. (CCH)
2262 (Oct. 10, 1973).
52. See, e.g., U.C.C. art. III (1989).
53. 15 U.S.C. § 77c(a)(8) (1982). Charitable organizations are those designated in
I.R.C. § 170(b)(1)(a) (1982 & Supp. V 1988).
54. 15 U.S.C. § 77c(a)(8) (1982).
55. Escott v. BarChris Constr. Corp., 283 F. Supp 643 (S.D.N.Y. 1968).
56. Id. A material fact is defined as "[a] fact which if it had been correctly stated or
disclosed would have deterred or tended to deter the average prudent investor from
purchasing the securities in question." Id. at 649.
SEC IN TRANSITION
1989-901
3)
BarChris' auditors5 7 (Peat, Marwick, Mitchell & Co.).
On October 29, 1962, increasing financial difficulties became insurmountable and BarChris filed a petition for an arrangement under the
Bankruptcy Act (Chapter 11)5" and defaulted on the interest due on the
debentures.
The court found that various misstatements and omissions contained
in the prospectus were in fact "material." The misstatements and omissions included the overstatement of both sales and gross profits, the understatement of certain contingent liabilities, an overstatement of orders
on hand and the failure to disclose the true facts with regard to loans to
various corporate officers, customer delinquencies, application of proceeds
of the sale of the bonds and the prospective operation of several of the
alleys.59
The court carefully analyzed section 11(b) of the Act, which provides:
[A]s regards any part of the registration statement not purporting to be
made on authority of an expert . . . he had, after reasonable investigation, reasonable ground to believe and did believe, at the time part of the
registration statement became effective, that the statements therein were
true and that there was no omission to state a material fact required to
be stated therein or necessary to make the statements therein not misleading .... '0
Section 11(b) thus defines the due diligence defense for an expert,
and the court inquired whether BarChris' auditors, after reasonable investigation, had reasonable grounds to believe that the figures presented
by BarChris were true and that no material fact had been omitted from
the registration statement, which should have been included in order to
make the figures not misleading."'
57. See, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976). Professor Rohrlich
notes that in such suits, potential defendants include every person who signed the registration statement, every director or partner of the issuer at the time of the filing of the registration statement, accountants, engineers, appraisers who prepared or certified any part of
the registration statement or certified any report or valuation used in connection with the
registration, and each underwriter or underwriting investment banking firm. Org. Corp. &
Other Bus. Enterprises, supra note 38, at 9-68.
58. The Bankruptcy Act was supplanted by the Bankruptcy Reform Act of 1978,
which became effective on October 1, 1979. A Chapter 11 action (Reorganization) is still
permissible. Bankruptcy Reform Act of 1978, 11 U.S.C. §§ 1101-1146 (1982).
59. 283 F. Supp. at 652.
60. Id. at 682-83 (emphasis added).
61.
Id. at 683.
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Judge McLean then noted that accountants generally should not be
held to a higher standard than that recognized in the profession,6 2 but
that the review conducted by the senior accountant (a young man, thirty
years of age, who was not yet a C.P.A., who had no previous experience
with the bowling industry, and who was taking on his first job as a senior
accountant-who, in substance, "got answers which he considered satisfactory, and he did nothing to verify them") did not meet that standard. 3
Based upon a clear violation of section 11 of the Securities Act of
1933, the court imposed liability on the BarChris corporation itself, all of
the signers of the registration statement, the underwriters, and the corporation's auditors.
II.
THE SECURITIES EXCHANGE ACT OF
1934
The Securities Exchange Act of 19346" (the Act) was adopted following a series of congressional hearings (known as the Pecora Investigation)
that brought to the forefront the widespread abuses and shortcomings in
the securities markets of the 1920's and 1930's, chief of which were:
1) Manipulation of the price of securities;
2) misuse and misappropriation of information known only by directors, officers, and principal stockholders of publicly traded
corporations;
3) the refusal of corporate management to render honest and adequate reports to security holders.6
The Act provided for the regulation and registration of the securities
exchanges, brokers, dealers, and national securities associations. The Act
regulates the markets in which securities are traded by maintaining a rigorous system of disclosure for all corporations with securities listed on the
securities exchanges and for those companies that have assets in excess of
$1,000,000 and 500 or more shareholders. Such corporations may be
termed section 12 corporations since they are required to register their
securities under section 12 of the 1934 Act. 6 The Act regulates proxy
solicitation for voting," and permits the SEC to engage in the important
activity of market surveillance to regulate such practices as fraud, market
62. Id. at 703. The standard will be that of a professional accountant. See DesChamps,
Lawyers' and Accountants' ProfessionalLiability, 22 INS. CouNs. J. 279 (1955).
63. 283 F. Supp. at 702.
64. Securities Exchange Act of 1934, 15 U.S.C. § 78a-78hh-1 (1982).
65. Org. Corp. & Other Bus. Enterprises, supra note 38, § 9.06, at 9-71.
66. Securities Exchange Act of 1934, 15 U.S.C. § 781(g) (1982).
67. Id. § 78n(a).
1989-90]
SEC IN TRANSITION
manipulation, misrepresentation, insider trading, and a little-known practice termed market stabilization. 8
Section 16 of the Act requires directors, officers, and principal stockholders to report their holdings of the issuer's equity securities and to
disgorge profits realized from a purchase and sale within a period of less
than six months of any equity security of the issuer."
The basis for many actions brought by the SEC is found in the Act,
section 10(b) and SEC rule 10b-5, adopted in 1942.70 Section 10(b) of the
Act makes it 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, "any manipulative
or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in
the public interest or for the protection of investors."7
A.
Rule lOb-5
Rule 10b-5 states:
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.72
Although rule 10b-5 (the Rule) was originally adopted by the Commission for administrative purposes, the Rule is frequently involved in
private civil litigation. The first such case was Kardon v. National Gypsum Co.7" In this case, the court ruled that certain corporate officers had
68.
Stabilization is a market manipulating technique whereby securities underwriters
bid for securities to stabilize their price during their issuance. See, e.g., H. PHILLIPS & J.
RITCHIE, INVESTMENT ANALYSIS AND PORTFOLIO SELECTION (1983).
69. See Alloys Unlimited, Inc. v. Gilbert, 319 F. Supp 617 (S.D.N.Y. 1970).
70.
Rule X-10b-5, Employment of Manipulative and Deceptive Devices, Exchange Act
Release No. 3230 (1942) (codified at 17 C.F.R. § 240.10b-5 (1988)).
71.
Org. Corp. & Other Bus. Enterprises (MB), supra note 38, § 9.12[1], at 9-87.
72. 17 C.F.R. § 240.10b-5 (1988).
73.
73 F. Supp. 798 (E.D. Pa. 1947), supplemented by 83 F. Supp. 613 (E.D. Pa. 1947).
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violated rule lob-5 when they effected purchases of corporation stock
from various shareholders without revealing that their shares could be
sold for a greater amount to the acquiring corporation, thus breaching a
"fiduciary duty" to the shareholders.""
Later, the application of the rule was significantly expanded in In re
Cady, Roberts & Co. 76 from the category of traditional insiders (i.e., corporate officers and directors) to "tippees," those who received information from insiders. In Cady, Roberts & Co., a dual director of a corporation and an investment firm disclosed confidential information to certain
customers of the brokerage firm who then traded at a profit prior to the
disclosure of the information. The broker was found guilty of fraud under
rule 10b-5. The SEC based its prosecution on the broker's duty to disclose the material information concerning two important elements: The
existence of a fiduciary relationship and the inherent unfairness of insider
76
trading practices.
Thus, the fiduciary duty of the director could not be avoided merely
because he or she was not personally involved in the trade; the duty to
disclose passed to the tippee.
However, many questions presented by private rights of action under
the Rule are still unresolved and are the frequent subject of intense litigation. Examples of such questions raised are:
1. The Necessity for Proof of Materiality and Reliance
Materiality has been defined (in a proxy case) as a "fact. . .[which]
there is a substantial likelihood that a reasonable shareholder would consider . . . important [in deciding how to vote]. ' 77 The element of reliance
is far more complicated.
In a 1965 case,78 the Court of Appeals for the Second Circuit held
that reliance had to be proven in a civil action for damages under rule
10b-5 and stated that a reliance test should be formulated in terms of
whether the misrepresentation was a substantial factor in determining
the course of conduct resulting in the loss to the plaintiff. 79 Reliance must
also be proven in a case based upon a misstatement or a misrepresenta74. 83 F. Supp. 613 (E.D. Pa. 1947), see Huss & Leete, Insider Trading Regulations: A
Comparison of Judicial and Statutory Sanctions, 25 AM. Bus. L.J. 301 (1987).
75. 40 S.E.C. 907 (1961).
76. Id. at 912.
77. TSC Industries, Inc. v. Northway, Inc., 426 U.S. 438, 449 (1976).
78. List v. Fashion Park, Inc., 340 F.2d 457 (2d Cir. 1965), cert. denied, 382 U.S. 811
(1965).
79. List, 340 F.2d at 462.
SEC IN TRANSITION
1989-90]
tion. 0 However, in a 1975 case, Affiliated Ute Citizens v. United States,8'
the Supreme Court stated that in a case of a defendant's nondisclosure of
a material fact that the defendant was under a positive duty to disclose,
the plaintiff need not prove reliance to establish causation; a plaintiff
must only prove that the nondisclosed fact was material and that the defendant breached his or her duty to disclose it.82
Under the circumstances of this case, involving primarily a failure to
disclose, positive proof of reliance is not a prerequisite to recovery. All
that is necessary is that the facts withheld be material in the sense that a
reasonable investor might have considered them important in the making of this decision (citations omitted). This obligation to disclose and
this withholding of a material fact establish the requisite element of causation in fact.8"
2.
The Requirement of Scienter
Prior to the Supreme Court decision in Ernst & Ernst v.
Hochfelder,84 there was considerable doubt as to the necessity of proving
scienter in cases involving rule 10b-5.
In Hochfelder, the Supreme Court rejected the notion that negligent
conduct could form the basis for a finding of liability in a private cause
of action for damages suffered by customers at the hands of a brokerage
firm. Absent allegations of scienter, the Court found there was no liability, even though the firm's auditors had negligently failed to conduct
proper audits to discover certain internal accounting practices that would
have exposed the president of the company's scheme to defraud
customers.86
The plaintiffs were customers of First Securities, who invested in a
fraudulent scheme perpetrated by Lester B. Nay, president of the firm
and owner of 92% of its stock. The fraud was uncovered in 1968 when
Nay committed suicide, leaving a note that described First Securities as
bankrupt and the customer escrow accounts as spurious. The complaint
80.
Ryan v. J. Walter Thompson Co., 453 F.2d 444 (2d Cir. 1971).
81. 406 U.S. 128 (1972).
82. Id. at 154.
83. Id. at 153-54 (citations omitted) (emphasis added).
84. 425 U.S. 185 (1976); see also Gossman, IMC v. Butler. A Case For Expanded Professional Liability for Negligent Misrepresentation?,26 AM. Bus. L.J. 99 (1988).
85. Negligent conduct may be defined as the omission to do something which a reasonable person (in the person of the defendant), guided by those ordinary considerations which
ordinarily re;ulate human affairs, would do, or the doing of something which a reasonably
prudent person would not do. For a more formal definition, see RESTATEMENT (SECOND) OF
TORTS § 283 (1965).
86. 425 U.S. at 203 n.24.
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charged that the escrow scheme violated section 10(b) and rule 10b-5, and
that Ernst & Ernst had "aided and abetted" Nay's fraudulent conduct by
its failure to conduct proper audits of First Securities. The SEC alleged
Ernst & Ernst had failed to utilize appropriate auditing procedures in its
audits of First Securities, thereby failing to discover internal practices of
the firm which prevented an effective audit. 7
The Supreme Court held that the appropriate standard required was
that of scienter, which the Court defined as a state of mind involving an
"intent to deceive, manipulate or defraud."8 8
Although the extensive legislative history of the 1934 Act is bereft of any
explicit explanation of Congress' intent, we think the relevant portions of
that history support our conclusion that [s]ection 10(b) was addressed to
practices that involve some element of scienter and cannot be read to
impose liability for negligent conduct alone.8
In Hochfelder, the Court declined to address whether "reckless disregard" could form the basis for liability 0 or whether a suit for an injunction likewise required scienter.8
Since Hochfelder, the Seventh and Second Circuit Courts of Appeals
have held that "reckless disregard of the truth" does in fact satisfy the
scienter requirement of Hochfelder92 Several district courts have held
that gross negligence, in and of itself, is not "reckless disregard of the
truth."8 3 The Supreme Court in 1980, however, held that proof of scienter
is required in any SEC injunctive action under rule 10b-5. s4
3. Fraudulent Mismanagement
Since rule 10b-5 speaks mainly in generalities, courts are charged
with the responsibility of fleshing out the rule and defining what type of
87. Id.
88. Id. at 193.
89. Id. at 201.
90. Id. at 193-94 n.12 ("In certain areas of the law recklessness is considered to be a
form of intentional conduct for purposes of imposing liability for some act.").
91. Id. ("Since this case concerns an action for damages we also need not consider
whether scienter is a necessary element in an action for injunctive relief under § 10(b) and
rule 10(b)-5.").
92. See Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1045 (7th Cir. 1977),
cert. denied, 434 U.S. 875 (1977); Rolf v. Blyth, 570 F.2d 38, 44-47 (2d Cir. 1978), cert.
denied, 439 U.S. 1039 (1978).
93. See McLean v. Alexander, 599 F.2d 1190 (3d Cir. 1979); Sanders v. John Nuveen
Co., 554 F.2d 790 (7th Cir. 1977).
94. Aaron v. SEC, 446 U.S. 680 (1980).
1989-90]
SEC IN TRANSITION
conduct or activity violates the rule. Thus, it has been alleged that rule
10b-5 includes fraudulent mismanagement of corporate affairs."
In the Supreme Court case of Superintendent of Insurance v. Bankers Life & Casualty Co., 96 the Court upheld a complaint as stating a
cause of action where it was alleged that the defendants had used the
assets of a corporation as part of a scheme to defraud by financing the
purchase of shares through the misappropriation of the sale of government bonds owned by the corporation. The Court noted that section
10(b) of the Act barred deceptive devices or contrivances "whether conducted in the organized markets or face to face,"' 2 and that "[tihe crux of
the present case is that [the corporation] suffered an injury as a result of
deceptive practices touching its sale of securities as an investor.""
Thus, the sale of corporate assets consisting of securities at an inadequate price, 99 or the purchase of securities at an inflated price, violates
the Rule if shareholders or creditors are defrauded. Other types of corporate mismanagement or breaches of a fiduciary obligation may be within
the reach of the Rule, depending on the existence of such factors as:
1) How closely and directly the securities transaction is connected
with the alleged fraud;
2) how material the securities transaction is that plays a part in the
alleged fraud;
3) whether the defendants are in control of the corporation;
4) whether the subject matter of the transaction is discretionary
with the directors or whether stockholder action is required to effect a
practice or activity. '
However, in 1977 the Supreme Court held in the case of Santa Fe
Industries Inc. v. Green'"' that since section 10(b) of the Act only prohibits the use of a "manipulative or deceptive" device or contrivance in contravention of Commission Rules, rule 10b-5 can only be applied to conduct that is itself manipulative or deceptive within the meaning of the
statute."12
95. Birnbaum v. Newport Steel Corp., 193 F.2d 461 (2d Cir. 1952), cert. denied, 343
U.S. 956 (1952).
96.
97.
98.
99.
100.
101.
102.
404 U.S. 6 (1971).
Id. at 12.
Id. at 12-13.
See Drachman v. Harvey, 453 F.2d 736 (2d Cir. 1972).
See, e.g., Competitive Assoc., Inc. v. Laventhol, 516 F.2d 811 (2d Cir. 1975).
430 U.S. 462 (1977).
Id. at 473-74.
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"Manipulation" is "virtually a term of art when used in connection with
securities markets" (citations omitted). The term refers generally to
practices, such as wash sales, matched orders, or rigged prices, that are
intended to mislead investors by artificially affecting market activity
. . . . No doubt Congress meant to prohibit the full range of ingenious
devices that might be used to manipulate securities prices. But we do not
think it would have chosen this "term of art" if it had meant to bring
within the scope of § 10(b) instances of corporate mismanagement such
as this, in which the essence of the complaint is that shareholders were
treated unfairly by a fiduciary."3
Thus, the Court suggested that private actions under rule 10b-5 are
not appropriate in cases of general corporate mismanagement, unless an
element of deception is also alleged." 4
The Santa Fe opinion has not in fact put an end to rule 10b-5 actions involving corporate mismanagement. Decisions by several circuit
courts of appeals have supported an interpretation of rule 10b-5 that the
fraud must occur in connection with the purchase or sale of a security,'0 5
and not merely as an allegation of corporate mismanagement or a breach
of a corporate fiduciary duty to its shareholders.
III.
A.
INSIDER TRADING
Introduction
With a more sophisticated and industrialized society and economy
inevitably will come more economic activity in such areas as tender offers,
mergers, acquisitions, leveraged buyouts, option contracts, higher profits
and earnings, and an overwhelming growth in the securities markets.
These activities have had a phenomenal impact on the issue of insider
trading. No longer are executives, directors, or corporate officers exclusively getting involved. Today, secretaries, clerks, printers, reporters, and
many other individuals' 6 who have access to highly confidential and critical information cannot resist the temptation to abuse their positions of
power or confidence to reap a personal profit.
The laws, rules, and regulations which deal with the question of insider trading are vague. Initially, this vagueness was at the option of the
103. Id. at 476-77 (citation omitted) (emphasis added).
104. Id. at 476-77.
105. See, e.g., O'Brien v. Continental Ill. Nat'l Bank & Trust Co., 593 F.2d 54 (7th Cir.
1979); Reid v. Hughes, 578 F.2d 634 (5th Cir. 1978).
106. See infra notes 143-65, 200-255 and accompanying text for discussions of
Chiarella and Winans respectively.
1989-90]
SEC IN TRANSITION
SEC, which believed that rules and laws associated with the topic should
be expanded and extended on a case-by-case basis (essentially by the
courts) but announced that it would support a statutory definition that
"preserves its authority . . . and provides guidance." '
In fact, this view is preferred by at least one important congressional
policy maker, Representative John Dingell, the Chairman of the House
Committee on Energy and Commerce, who has repeatedly expressed
strong reservations about fixing a specific definition of insider trading,
fearing it would "simply give savvy lawyers loopholes to exploit."'' 8
The SEC currently polices insider trading through a complicated system of securities "radar" and sophisticated computers. Brokerage houses
and the various Exchanges also have surveillance computers that monitor
trades in terms of price and volume in order to thwart insider trading and
assist the SEC in its investigative functions.'
The epidemic of insider trading has been considered by some to be
the most serious Wall Street scandal since the 1920's, and many critics
blame the SEC for not enforcing the current rules more stringently.' "
However, others feel that the Congress is primarily at fault because of its
silence and inactivity in this field. In most cases, and until recently, Congress has left decision-making up to the courts and the SEC. It has been
noted that without a clear legislative mandate, convictions may become
more difficult in the future.' 1
Recent legislation 1 . expanded the enforcement scope of the SEC in
dealing with insider trading," 3 and "beefed up" the civil and criminal
penalties and remedies for violation of section 10(b) and rule 10b-5 of the
Securities Exchange Act of 1934; however, this legislation failed to define
107. Proposed Legislation to Clarify the Law on Insider Trading: Hearing Before the
Subcomm. on Securities of the Senate Comm. on Banking, Housing and Urban Affairs,
100th Cong., 1st Sess. 9 (1987) (Memorandum of the Securities and Exchange Commission)
[hereinafter Proposed Legislation].
108. Ricks, Wall St. J., Nov. 20, 1987, at 4, col. 3; Weiss, Business Week, Aug. 24, 1987,
at 22.
109. Weiss, Insider Trading: The Limits of Self Policing, Business Week, June 23,
1986, at 46-47.
110. Huber, Are We Hissing the Wrong Guys?, Forbes, July 13, 1987, at 52-53, 56.
111. See To Amend the Securities Exchange Act of 1934 to Prohibit Certain Trading
on Communications By Those Who Possess Material, Nonpublic Information: Hearing
Before the Subcomm. on Securities of the Senate Comm. on Banking, Housing and Urban
Affairs, 100th Cong., 1st Sess. 1 (1987) (opening statement of Sen. Riegle) [hereinafter To
Amend].
112. Insider Trading Sanctions Act of 1984, Pub. L. No. 98-376, 98 Stat. 1264 (1984).
113. See S. ARKIN, TRADING ON INSIDE INFORMATION-PROBLEMS OF DEFINING, DETECTING, PROSECUTING, AND DEFENDING INSIDER TRADING CASES 69 (1984).
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specifically the underlying nature of the substantive violation. Under the
1984 revisions to the Insider Trading Sanctions Act, a person can violate
section 10(b) or rule 10b-5 if that person trades while in possession of
inside information, regardless of whether the trade is based on the inside
information." 4
The Insider Trading Sanctions Act of 1984 granted the SEC the authority to seek imposition of a civil penalty against insider trading violators for up to three times the profit gained or loss avoided as a result of
the unlawful purchase or sale of securities. It increased the maximum fine
for a criminal violation from $10,000 to $100,000 and gave the Commission authority to bring an administrative proceeding against persons who
violated the tender offer requirements under section 14 of the Exchange
15
Act.'
Insider trading has been broadly defined as "[t]he act of purchasing
or selling securities while in possession of material, non-public informa16
tion concerning an issue of securities.'
The regulation of insider trading under section 16(b) of the Act was
prompted by a report of the Senate Banking and Currency Commission,
which stated:
Among the most vicious practices unearthed at the hearings of the subcommittee was the flagrant betrayal of their fiduciary duties by directors
and officers of corporations, who used their positions of trust and confidential information which came to them in such positions, to aid them in
their market activities." 7
Perhaps the most widely-known case involving rule 10b-5 was SEC v.
Texas Gulf Sulpher Co."' In this case, the Court of Appeals for the Second Circuit laid down the foundation of the disclose or abstain rule. "Anyone in possession of material inside information must either disclose it
to the investing public, or, if he is disabled from disclosing it . . ., must
abstain from trading in or recommending the securities concerned while
such insider information remains undisclosed.""'
Traditionally, insiders were those persons intimately involved in the
ownership or management of a corporation-its officers, directors, and
114. See Insider Trading Proscriptions Act of 1987, REs GESTAE 239 (Nov. 1987)
[hereinafter Res Gestael.
115. See 15 U.S.C. § 78n(d) (1982).
116. S. GOLDBERG, SEC TRADING RESTRICTIONS AND REPORTING REQUIREMENTS FOR INSIDERs 2-3 (1973) (emphasis added).
117. S. ARKIN, supra note 113, at 69.
118. 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).
119. 401 F.2d at 848 (emphasis added).
1989-901
SEC IN TRANSITION
those stockholders who own ten percent of the class of equity securities
under section 16(a) of the Exchange Act. Such persons are required to file
reports with the SEC concerning both their ownership position and trading in the corporation's securities. 2 °
Further, section 16(b) of the Exchange Act provides for the recapture
of all profits realized by any insider in any purchase and sale or sale and
purchase of any of a corporation's equity securities within any six-month
period. The term equity security encompasses not only common and preferred stocks (and certain hybrids that are similar to such stocks), but
also debt securities, if they are convertible into stock or carry any warrant
or right to purchase stock, warrants, transferable options, and other
rights to purchase stock. This section applies to any equity security,
whether or not registered, if the issuer has a class of equity securities
registered pursuant to section 12 of the Exchange Act.
In addition, however, as defined in the original rule 16(b), an insider
can also be considered to be:
1) The issuer of the securities;
2) an employee of the issuer or broker;
3) any person who knows a material, nonpublic fact relating to the
security;
4) any person to whom information is transmitted or who is told a
material, nonpublic fact (known as a tippee).'
Rule 16(b) is based on the public policy expectation that all investors
who trade on impersonal exchanges have relatively equal access to material information upon which an investor may make an intelligent, individ122
ualized decision.
The essence of the Rule is that anyone who, trading for his own account
in the securities of a corporation, has "access, directly or indirectly to
information intended to be available only for a corporate purpose and
not for the personal benefit of anyone" may not take "advantage of such
information knowing it is unavailable to those with whom he is dealing,"
23
i.e., the investing public.1
In presaging future development of the Rule and an expansion of the
definition of an insider, the court also noted that "the Rule is also appli120.
121.
U.S. 1005
122.
123.
Securities Exchange Act of 1934, 15 U.S.C. § 78p(a) (1982).
See SEC v. Texas Gulf Sulphur, 446 F.2d 1301 (2d Cir. 1971), cert. denied, 404
(1971).
S. GOLDBERG, supra note 116, at 2-3.
Texas Gulf Sulphur, 401 F.2d at 848.
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cable to one possessing the information who may not strictly be termed
an 'insider.'
"124
Thus, it has been determined that anyone in possession of material
inside information must either disclose it to members of the investing
public, or, if precluded from disclosing such information because of its
sensitive or confidential nature (based on a fiduciary relationship), that
individual must "abstain from trading in or recommending the securities
concerned while such inside information remains undisclosed."' 5
By emphasizing the fact that anyone who holds such inside information is liable on the basis of unpublished information, the court stated
that the duty to abstain or disclose arises from the possession of nonpub126
lic information.
The designation of anyone has led to a series of cases that defined a
new category of individuals who were bound by the disclose or abstain
rule and was extended to outside attorneys' 2 and accountants' 2 8 who
were found to have a duty to disclose or abstain from trading on the basis
of information obtained while working for a corporation.
Professor Fleischer noted that insiders' duty to disclose information
or to abstain from dealing in their company's securities arises in those
circumstances which are essentially extraordinary in nature and which
are reasonably certain to have a substantial effect on the market price of
the securities if the extraordinary situation is disclosed. 9
It should be noted here that the insider trading prohibition does not
preclude insiders from investing in their own corporations because they
may be more familiar with corporate operations or practices or because of
superior financial or business acumen, knowledge, or judgment.
The only regulatory objective is that access to material information be
enjoyed equally, but this objective requires nothing more than the disclosure of basic facts so that outsiders may draw upon their own evaluative expertise in reaching their own investment decisions with knowledge
equal to that of the insiders."10
124. Id. (emphasis added).
125. Id. (emphasis added).
126. Id; see also Huss & Leete, supra note 74, at 304.
127. United States v. Peltz, 433 F.2d 48 (2d Cir. 1970), cert. denied, 401 U.S. 955
(1971).
128. Herzfelt v. Laventhol, 378 F. Supp. 112 (S.D.N.Y. 1974), modified, 540 F.2d 27
(2d Cir. 1976); see also Gossman, supra note 84.
129. Fleischer, Securities Trading and Corporate Information Practices: The Implications of the Texas Gulf Sulphur Proceeding, 51 VA. L. REV. 1271, 1289 (1965).
130. Texas Gulf Sulphur, 401 F.2d at 849.
1989-901
SEC IN TRANSITION
B. Disclose or Abstain: SEC v. Texas Gulf Sulphur
Texas Gulf Sulphur Corporation (TGS) drilled a hole on November
12, 1963, near Timmins, Ontario. The drilling appeared to yield a core
with exceedingly high mineral content. Since TGS did not own the mineral rights in the surrounding regions, TGS maintained strict secrecy
about the results of the core sample. Certain evasive tactics were undertaken to camouflage the drill site, including the drilling of a second hole.
During this period, TGS completed an extensive land acquisition
program and began drilling. However, rumors began to spread, and by
early April, 1964, a tremendous rush on the stock was taking place.
On April 11, 1964, an unauthorized report of the extraordinary mineral find hit the papers. On April 12, TGS announced to the press a strike
of at least 25 million tons of ore. Charles Fogarty, the executive vice-president of TGS, had already purchased 1,700 shares of stock during the
month of November 1963, and an additional 300 shares in December. In
March, 1964, he bought 400 shares, and in April he bought an additional
300 shares. Other TGS officials also purchased stock and several executives accepted stock options on February 20, 1964.13'
In Texas Gulf Sulphur, the Court of Appeals for the Second Circuit
found that certain officers and employees of TGS had violated rule 10b-5
by purchasing stock and calls on the stock,"' and by accepting stock options from the stock option commission while in possession of material
undisclosed information concerning the mineral strike. Certain of the defendants were also charged with passing the inside information along to
"tippees," who then purchased stock on the basis of this inside information. The defendants were required to disgorge not only the profits they
had realized from use of the undisclosed material information, but they
33
were also held accountable for the profits of their "tippees.'
TGS was also the object of numerous civil actions for damages
brought by investors"" who had sold their TGS stock on the basis of the
"deceptively gloomy" press release of April 12, 1964, which stated in part:
Recent drilling on one property near Timmins has led to preliminary
indications that more drilling would be required for proper evaluation of
this project. The drilling done to date has not been conclusive, but the
131. Id. at 833.
132. Id. at 841. A stock call permits a party to purchase a stock at a predetermined
price within a predetermined time in exchange for a premium.
133. Id. at 833.
134. Cannon v. Texas Gulf Sulphur, 55 F.R.D. 306 (S.D.N.Y. 1972) (reporting on the
settlement of 37 various civil actions).
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statements made by many outside quarters are unreliable and include
information and figures that are not available to TGS.
The work done to date has not been sufficient to reach definite conclusions and any statement as to size and grade of ore would be premature and possibly misleading. When we have progressed to the point
where reasonable and logical conclusions can be made, TGS will issue a
definite statement to its stockholders and to the public in order to clarify
the Timmins project. 18
The court noted that it does not appear unfair to impose upon the
management of a corporation a duty to ascertain the truth of any statements that the corporation may release to its shareholders or to the public at large. Accordingly, the court concluded that rule 10b-5 may be violated "whenever assertions are made in a manner reasonably calculated to
influence the investing public (e.g., by means of the financial media), if
such assertions are false or misleading or are so incomplete as to mislead," irrespective of whether the issuance of the release was motivated
by any corporate official's ulterior purposes."' 8
"Tippees" were among the defendants in a 1974 case, Shapiro v.
Merrill Lynch, Pierce, Fenner & Smith, Inc.,' in which the court ruled
that "tippees" could be held liable for trading on the basis of undisclosed
material information concerning the Douglas Aircraft Company, for
which Merrill Lynch was the underwriter of a proposed offering of Douglas debt securities.
While preparing the offering, Merrill Lynch was advised by Douglas
of the existence of certain adverse information regarding Douglas' earnings. It was alleged that Merrill Lynch and certain of its employees disclosed this confidential information to several of its customers who either
sold Douglas stock or who made "short sales" on the New York Stock
Exchange between June 20 and June 23, 1976, to purchasers without disclosing the information. Plaintiffs brought their action on behalf of themselves and all others13 who purchased Douglas common stock during this
June 21-24 period.13 9
The court held that defendants owed a clear duty not only to the
purchasers of the shares sold by the selling defendants but also to "all
persons who during the same period purchased Douglas stock in the open
market without knowledge of the material inside information which was
135. 401 F.2d at 845.
136. Id. at 864.
137. 495 F.2d 228 (2d Cir. 1974).
138. Such cases are properly termed "class actions."
139. Shapiro, 495 F.2d 228.
1989-901
SEC IN TRANSITION
in the possession of the defendants."' 4 Thus, the court found that underwriters of corporate securities were liable to all those who traded to their
disadvantage between
the time of the inside trade and dissemination of
4
the information.' '
In 1980, the Second Circuit held in Elkind v. Liggett & Myers, Inc.
4
that the fiduciary duty was not limited to individuals involved in the actual trade but was extended to others with whom the insider had no
contact.
Several other important cases decided in the last decade merit close
scrutiny and analysis in ascertaining the development of insider trading
rules. In the first case, the defined trend towards a judicial expansion of
the application of rule 10b-5 appeared to come to an abrupt end.
1. Chiarella v. United States'4'
Chiarella was a printer who worked in the composing room of a New
York printing house (Pandick Press). Chiarella handled announcements
of corporate takeover bids. Even though the relevant documents were delivered to the printing office with the identity of the target corporation
seemingly concealed,144 Chiarella was able to deduce the names of such
targets from other information. Chiarella then purchased stock in these
target companies and sold the shares immediately after the takeover attempts were made public. Chiarella realized a gain of more than $30,000
in the course of 14 months. When the SEC began an investigation of
45
Chiarella's trading activities, Chiarella entered into a consent decree
with the SEC in which he agreed to return his profits to the buyers of his
shares. However, in 1978 Chiarella was indicted on seventeen counts of
violating section 10(b) of the Securities Exchange Act of 1934 and SEC
46
rule 10b-5.'
The trial court found Chiarella guilty on all seventeen counts because
he willfully failed to inform sellers that he knew of the forthcoming take140. Id. at 237.
141. Id. at 241. Such traders may be termed "contemporaneous traders."
142. 635 F.2d 156 (2d Cir. 1980).
143. 445 U.S. 222 (1980).
144. The term "target" is used for the corporation which is the object of an impending
takeover bid. Such bid may be either friendly or unfriendly. The target company must address its stockholders regarding its opinion as to their response to the tender offer within 10
business days. See 17 C.F.R. § 240.14e-2 (1988).
145. 445 U.S. at 224. A procedure used whereby a defendant in a criminal case agrees
to accept a judgment in return for a promise of no further action. BLACKS LAW DICTIONARY
370 (5th ed. 1979). (In essence, a contract existed between the plaintiff (SEC) and the defendant (Chiarella).)
146. 445 U.S. at 225.
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[Vol. 25:9
over bid that would certainly make their shares more valuable. ' 7 The
court of appeals affirmed the conviction 4 and the United States Su49
preme Court granted certiorari.'
The Supreme Court stated that the case concerned Chiarella's silence, and that silence in connection with the purchase or sale of securities may operate as fraud. However, such liability must be predicated on
a "duty to disclose arising from a relationship of trust and confidence 5 '
between the parties to the transaction.'
15
'
The Court stated conclusively that "[njo such duty could arise from
[Chiarella's] relationship with the sellers of the stock in the target company because [Chiarella] had no prior dealings with them [and] was not
their agent." In sum, he was a complete stranger who dealt with the sellers only through a series of impersonal market transactions. Thus, no fiduciary relationship existed between Chiarella and the sellers because "he
was not a person in whom they had placed their trust and confidence." '
Because Chiarella had been convicted of violating section 10(b) while
he was not a corporate insider and also had not received confidential information from the target company, Chiarella's use of that information
would not be a fraud under section 10(b) "unless he was subject to an
affirmative duty to disclose it before trading."'' In effect, the trial court
had instructed the jury that Chiarella owed a duty to "everyone; to all
sellers, indeed, to the market as a whole."' 54 The jury had simply been
instructed that Chiarella could be convicted if he used "material, nonpublic information at a time when he knew other people trading in the
securities market did not have access to the same information.' ' 55
The jury instructions demonstrate that petitioner was convicted merely
because of his failure to disclose material, nonpublic information to sellers from whom he bought the stock of target corporations. The jury was
147. United States v. Chiarella, 450 F. Supp. 95 (S.D.N.Y. 1978).
148. United States v. Chiarella, 588 F.2d 1358 (2d Cir. 1978).
149. Certiorariis the process by which a lower federal court case or judgment of the
highest state court reaches the United States Supreme Court. The fact that the Supreme
Court refuses to hear a case does not necessarily preclude review at a later date.
150. Fiduciary duty. The concept of a fiduciary duty became the key element later in
United State v. Winans, 612 F. Supp. 827 (S.D.N.Y. 1985), aff'd in part rev'd in part sub
nom. United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986), aff'd, 108 S.Ct. 316 (1987).
151. 445 U.S. at 230.
152. Id. at 232-33.
153. Id. at 231.
154. Id.
155. Id.
1989-90]
SEC IN TRANSITION
not instructed on the nature or elements of a duty owed by petitioner to
anyone other than the sellers. 156
Chiarella thus stands for the proposition that the mere possession of
nonpublic market information did not, in and of itself, create a duty to
disclose such information under section 10(b), which is necessary to sustain an allegation of fraud. However, the concluding language of Chiarella
would assume critical importance in the further development of both the
Rule and of its SEC interpretation. "Because we cannot affirm a criminal
conviction on the basis of a theory not presented to the jury, we will not
speculate upon whether such a duty exists, whether it has been
breached, or whether such a breach constitutes a violation of section
10(b)."157
Note, however, the dissent of Chief Justice Warren Burger who
stated: "As a general rule, neither party to an arm's-length business
transaction has an obligation to disclose information to the other party
unless the parties stand in some confidential or fiduciary relationship."' 58
However, the Chief Justice continued:
[T]he Rule should give way when an informational advantage is obtained, not by superior experience, foresight, or industry, but by some
unlawful means. . . . I would read § 10(b) and rule 10b-5 . . .to mean
that a person who has misappropriated nonpublic information has an15 absolute duty to disclose that information or to refrain from trading. 1
Thus, the Chief Justice strenuously argued for the application of
what has become known as the misappropriation theory. Under this view,
a person's duty to disclose is not predicated merely on the possession of
superior information, but rather on the process (whether lawful or not) by
which the information is acquired.'
The Chief Justice based his view on the language of rule 10b-5 itself:
By their terms, these provisions reach any person engaged in any fraudulent scheme. This broad language negates the suggestion that congressional concern was limited to trading by "corporate insiders" or to deceptive practices related to "corporate information." Just as surely Congress
cannot have intended one standard of fair dealing for "white collar" insiders and another for the "blue collar" level. The very language of sec-
156.
157.
158.
159.
160.
Id. at 236 (emphasis added).
Id. at 236-37 (citation omitted) (emphasis added).
Id. at 239-40 (Burger, C.J., dissenting).
Id. at 240 (Burger, C.J., dissenting) (emphasis added).
Huss & Leete, supra note 74, at 306.
GONZAGA LAW REVIEW
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tion 10(b) and rule 10b-5 "by repeated use of the word any [was] obviously meant to be inclusive."''
The misappropriation theory described in Burger's dissenting opinion (which was supported by both Justice Blackmun and Justice Marshall)' " is very clear in its statement: Any person who has misappropriated (i.e., stolen) nonpublic information has an absolute duty to disclose
the information or refrain from trading. 63
However, it is evident that Chiarella did not clearly answer the following questions posed by Professors Huss and Leete:
1) "Whether a duty could be owed because Chiarella had obtained
the information by abusing his position with his employer, and
2) assuming that a breach of such a duty may be found by the
Court, whether such a breach would then violate rule 10b-5. "' 4
After Chiarella, the SEC formulated Rule 14e-3' 65 which prohibited
both insiders and outsiders in possession of material nonpublic information from trading in corporate tender offers. In doing so, the SEC indicated its intention to rely upon the dissenting opinion of Chief Justice
Burger in prosecuting outsiders under rule 10b-5.
2.
Dirks v. SEC
A second major case involving insider trading and the necessity of
finding a fiduciary duty as a pre-condition to a section 10(b) violation was
Dirks v. SEC, " decided by the Supreme Court in 1983.
Raymond Dirks, a securities analyst, received information from Ronald Secrist, a former officer of Equity Funding of America. Secrist informed Dirks that Equity had been vastly overstating the value of assets
of the company as a consequence of certain fraudulent corporate practices. As a result of his own research and investigation, Dirks was able to
verify Secrist's claim and sought to disclose the information to the Wall
Street Journal.The Journalrefused to print the story, not believing that
such a massive fraud could go undetected and fearing that an article
would prove to be libelous. During this same period, Dirks openly discussed his findings with clients and investors. As a consequence, a stock
161. 445 U.s. at 240-41 (Burger, C.J., dissenting) (citation omitted) (emphasis added
in original).
162. See id. at 245 (Blackmun, J., dissenting).
163. Id. at 243 n.4 (Blackmun, J., dissenting).
164. Huss and Leete, supra note 74, at 306.
165. 17 C.F.R. § 240.14-e3 (1989).
166. 463 U.S. 646 (1983).
1989-90]
SEC IN TRANSITION
run occurred. The New York Stock Exchange halted trading on the stock
after it dropped from $26 to $15 a share.' Later, California insurance
authorities found evidence of fraud. The SEC brought a complaint
against both Dirks and Equity, charging Dirks with violating rule 10b-5
by tipping potential traders to material, nonpublic information. The SEC
noted: "Where 'tippees'-regardless of their motivation or occupation-come into possession of material 'information that they know is
confidential and know or should know came from a corporate insider,'
they must either publicly disclose that information or refrain from
trading."' 8
The SEC reasoned that since Dirks had received confidential information from Secrist (who was clearly an insider), Secrist's duty would be
imputed to Dirks. On this basis, the SEC censured Dirks, and the Court
of Appeals for the Second Circuit affirmed that decision."0 9
The Supreme Court rejected this tenuous connection and stated:
Imposing a duty to disclose or abstain solely because a person knowingly
receives material nonpublic information from an insider and trades on it
could have an inhibiting influence on the role of market analysts, which
the SEC itself recognizes is necessary to the preservation of a healthy
market. 7 '
The Supreme Court reasoned that the test should be framed as
whether "the insider personally will benefit, directly or indirectly, from
his disclosure. Absent some personal gain, there has been no breach of
duty to stockholders."'' Dirks' only motivation was a desire to expose
fraud. The Court concluded:
It is undisputed that Dirks himself was a stranger to Equity Funding,
with no pre-existing fiduciary duty to its shareholders. He took no action,
directly or indirectly, that induced the shareholders or officers of Equity
Funding to repose trust or confidence in him. There was no expectation
by Dirks' sources that he would keep their information in confidence.
Nor did Dirks misappropriate or illegally obtain the information about
17 2
Equity Funding.
A dissenting opinion filed by Justice Blackmun (who also dissented
in Chiarella) posed an important policy question: If Secrist could not
167.
168.
(quoting
169.
170.
171.
172.
Id. at 650.
Id. at 651 (quoting the opinion of the SEC, 21 S.E.C. Docket 1401, 1407 (1981)
Chiarella, 445 U.S. at 230 n.12 (1980))).
681 F.2d 824 (2d Cir. 1982).
463 U.S. at 658.
Id. at 662 (emphasis added).
Id. at 665.
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himself trade on the basis of the confidential information for his own account, why should Dirks then be permitted to selectively disclose the information to the advantage of certain clients and subsequently for his
own advantage? Justice Blackmun noted that such reasoning permitted
Dirks' clients to "shift the losses that were inevitable due to the Equity
Funding fraud from themselves to uninformed market participants."' 7 3
Justice Blackmun added:
I also recognize that the SEC seemingly has been less than helpful in its
view of the nature of disclosure necessary to satisfy the disclose-or-refrain duty. The Commission tells persons with inside information that
they cannot trade on that information unless they disclose it; it [the
SEC] refuses, however, to tell them how to disclose. " "
C. Application of the MisappropriationTheory
While the abstain or disclose theory may work effectively for persons
who trade on information which clearly arises from sources within a company, such a foundation theory generally has not included those persons
who trade on such information which comes from sources outside of that
company. To address this anomaly, several federal courts began to follow
the misappropriation theory, enunciated in the Burger dissent in
Chiarella,and found generally in SEC rule 14e-3. This theory holds that
a person may commit securities fraud when that person secretly uses information given by an insider and trades on this information for personal
benefit. In this situation, the fraud is committed against any person to
whom the defendant owes a fiduciary duty, the defendant's employer, or
any client of the employer.""
The misappropriation theory, with its genesis in case law and not
legislation, had its judicial origin in a 1980 case filed against Adrian
Antoniu, a former Morgan, Stanley & Co. investment banker.17 Since its
rise to prominence in Chiarella, the misappropriation theory has been
widely used as a basis for prosecution in several recent cases and SEC
actions of importance and note.
173. Id. at 670 (Blackmun, J., dissenting).
174. Id. at 678 (citation omitted).
175. United States v. Newman, 664 F.2d 12 (2d Cir. 1981), cert. denied, 464 U.S. 863
(1983).
176. This case has not received the scrutiny of the Ivan Boesky case. See Stewart &
Wermeil, Wall St. J., Nov. 17, 1987, at 1, col. 6; id. at 16, col. 1; see also Wall St. J., Aug. 12,
1982, at 24.
1989-90]
SEC IN TRANSITION
1. United States v. Newman
In United States v. Newman,'77 the Second Circuit held that an outsider who misappropriated information from someone with whom the
outsider had a relationship of trust and confidence and then traded on
the basis of the misappropriated information, had violated section 10(b).
Employees of two investment banking firms that were involved in the
planning of takeover bids passed confidential information concerning the
identity of the target company. The court concluded that in misappropriating this information, the employees had defrauded their employers (the
investment banking firm) "[b]y sullying, [their] reputation [for
confidentiality].1,178
This theft of confidential information also constituted a fraud against
clients of the investment bankers because the price of a target company
stock will affect any investor's decision to bid on it, 171 artificially inflating
the price that would have to be paid for it. Since the fraud was in connection with Newman's securities transactions, this action violated rule 10b5.180
The fraud charged in Newman was directed towards the source of
the nonpublic information; the employer of the thieves. While the court
in Newman recognized that the majority in Chiarella decided that the
jury was not instructed on a duty that might be owed to anyone other
than the sellers, 81 the court in Newman concluded that the scope of rule
10b-5 clearly includes fraudulent conduct, the sole purpose of which is to
put a person into a position to buy and sell securities.'82
The Newman decision has been the subject of intense scrutiny and
commentary. A proponent of Newman concludes that the language of
rule 10b-5 "evinces a clear intent to broadly deal with fraud connected to
a securities transaction."' 83 Critics argue that such an expansive view "is
not only unprecedented but also doctrinally distorted.'
84
According to
Professor Falconer, "the Newman court distorts the usual concept of
fraud. In all its varieties, legal fraud basically involves a transaction in
177. 664 F.2d 12 (2d Cir. 1981), cert. denied, 464 U.S. 863 (1983).
178. Id. at 17.
179. Id. at 17-18.
180. Id. at 19.
181. Id. at 15.
182. Id. at 19.
183. Robertson, United States v. Newman: Misappropriationof Market Information
by Outsiders, 3 PACE L. REV. 311, 348 (1983).
184. Falconer, An Outsider Who MisappropriatesConfidential Information May Be
Charged With Securities Fraud, United States v. Newman, 31 DEPAUL L. REV. 849, 851
(1982).
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[Vol. 25:9
which one party, through misrepresentation or through deceitful silence,
reaps a pecuniary reward from the other party to the transaction."' 8 5
What was clear, however, was that the Newman court applied the
misappropriation theory delineated by the Chief Justice in Chiarella.
2.
SEC v. Materia
One year later, in 1984, the Second Circuit was confronted by an opportunity to apply and expand the misappropriation theory in the case of
SEC v. Materia.'" The case bears a remarkable similarity to Chiarella.
Materia was an employee of a firm that specialized in the printing of
materials used by corporate clients in connection with proposed tender
offers. Although the printer took positive steps to conceal the identity of
the target corporation, Materia (like Chiarella) would purchase the stock
of the target corporation and sell the shares shortly after the tender-offer
information was made public.'87
Materia was charged with violating section 10(b) and 14(e) of the
1934 Act on the basis that Materia had traded in securities while possessing material, nonpublic information which was misappropriated (stolen)
from his employer and its clients.'8 8 Materia admitted that he had both
misappropriated confidential information and had traded to his advantage. However, relying on the proposition that any fraud must be predicated on a duty to disclose to the seller of the security, Materia argued
that his actions nevertheless could not violate section 10(b) or rule 10b5.189
The court rejected Materia's position. While the court acknowledged
that the argument might be applicable to a private enforcement action
(e.g., brought by shareholders who had sold their shares), such an argument would not be relevant in an enforcement action brought by the
SEC. Thus, the court found that Materia had perpetrated a fraud against
his employer, holding that "one who misappropriates nonpublic information in breach of a fiduciary duty and trades on that information to his'
own advantage, violates section 10(b) and rule 10b-5."' 8 °
Citing the language of rule 10b-5, the court concluded that Materia
misappropriated his employer's property, satisfying the "upon any person" language of the Rule. In addition, the theft of information by
185.
186.
187.
188.
189.
Id. at 861.
745 F.2d 197 (2d Cir. 1984), cert. denied, 471 U.S. 1053 (1985).
Id. at 199.
Id. at 200.
Id. at 201.
190. Id. at 203.
1989-90]
SEC IN TRANSITION
Materia also satisfied the requirement that the fraud must be in connection with the purchase or sale of securities. Clearly, Materia's theft had
no extrinsic value in and of itself except "in connection with" his subsequent purchase and sale of securities.
In both Newman and Materia, the defendants had misappropriated
information that was the confidential property of their employers. Newman concerned information misappropriated from an investment banking
firm; Materia misappropriated information from a financial printing firm.
Both Newman and Materia stand for the proposition that there was a
clear duty to third parties: the employer's clients.
3. Ivan Boesky"'
The case of Ivan Boesky is by far the most celebrated of the recent
rash of insider trading cases brought under the theory of misappropriation. (Other persons, however, are also likely to be immediately affected
by the application of this decision and the later case of Foster Winans.
Three prominent Wall Street officials, Robert Freeman, head of arbitrage
at Goldman, Sachs & Co., and two former Kidder Peabody arbitragers,
Richard Wigton and Timothy Tabor, were indicted in April of 1987 under
a theory of misappropriation but their indictments were dismissed after
government prosecutors stated they needed more time to prepare the individual cases.)" 2 To simplify a rather tangled and complex sequence of
civil and criminal charges, the following brief narrative is offered:
Ivan Boesky, a risk arbitrager,193 identified two major sources of potential insider information: Martin Siegel and Dennis Levine. The Boesky-Siegel connection began in August of 1982.11 Siegel was employed
by Kidder Peabody, and agreed to give Boesky advance information
about Kidder clients, with Siegel receiving a percentage of the profits
made by Boesky from this information. These payments were believed to
equal or be in excess of $700,000. Boesky made at least $33 million from a
series of deals. The first major deal was the September, 1984 acquisition
of Carnation Co. by Nestle. Nestle had been a Kidder client. Boesky
191. See SEC v. Boesky, No. 86 Civ. 8767 (S.D.N.Y. Feb. 13, 1987) for a discussion of
the legal issues raised.
192. Stewart & Wermeil, supra note 176, at 16, col 2.
193. An arbitrager is one of a class of brokers or traders who buys or sells futures or
options in one market and sells in another market for the sake of the profit arising from the
difference in price between the two markets. See SEC v. Boesky, No. 86 Civ. 8767 (S.D.N.Y.
Feb. 13, 1987).
194. For a good general discussion of the Boesky matter, see Russell, The Fall of the
Wall Street Superstar,Time, Nov. 24, 1986, at 71, 74; Pauly, The SEC Bags Ivan Boesky,
Newsweek, Nov. 24, 1986, at 68; see also SEC v. Siegel, No. 87 Civ. 0963 (S.D.N.Y Feb. 13,
1987); SEC v. Boesky, No. 86 Civ. 8767 (S.D.N.Y. Nov. 14, 1986); SEC v. Levine, No. 86 Civ.
3726 (S.D.N.Y. July 3, 1986).
GONZAGA LAW REVIEW
[Vol. 25:9
made an estimated $28.3 million from dealing in 1.7 million shares of
Carnation common stock. The second deal involved another Kidder client, Diamond Shamrock. In May, 1983, Diamond Shamrock was successful in its takeover bid for Natomas Company. Boesky made $14.8 million
as a result of buying and selling 817,000 shares of Natomas. Boesky also
profited from the well-publicized takeover battle between Martin Marietta Corporation, a Kidder client, and the Bendix Corporation. Siegel
gave Boesky early information about Martin Marietta's plan to launch a
counter offer for Bendix. Boesky used this information and made a large
profit.
Boesky's dealings with Dennis Levine, a mergers and acquisitions
specialist with Drexel, Bernham & Lambert, began in April of 1985.
Nabisco Brands had hired Shearson Lehman to advise Nabisco in its
merger talks with R.J. Reynolds. Ira Sokolow, an investment banker with
Shearson Lehman, told Levine about the details of the impending deal.
Boesky went on to buy 337,000 shares of Nabisco. The Houston Natural
Gas Company had consulted with Lazard Freres concerning a possible
takeover bid from InterNorth. Robert Wilkis of Lazard likewise supplied
Levine with this inside information. Levine then informed Boesky and
Boesky purchased 301,800 shares of Houston Natural Gas. Between the
two transactions, Boesky reaped profits of $8.1 million, all in a few weeks.
The chain of illegal activity continued in January of 1986. David Brown,
an investment banker with Goldman Sacks, informed Sokolow about a
planned recapitalization of the FMC Corporation. Sokolow subsequently
informed Levine. In February of 1986, Levine informed Boesky, enabling
Boesky to reap a profit of more than $1 million.
Boesky and Levine had worked together with such regularity that
they had employed a "pay scale" for Levine for all information which
Levine had provided. The terms of the agreement provided that Boesky
would pay Levine 5% of the profits made which were derived from Levine's tips and 1% of the profits on any deals in which Boesky already
had an interest.
On May 12, 1986, based on a tip from a Bahamian branch of the
Swiss-based Bank Leu,1" Levine was charged with trading on inside information in the securities of fifty-four separate companies, the profits of
which totaled $12.6 million. 96 Levine pleaded guilty to four felony
counts, paid the government $12,600,000 he allegedly made in profits during his association with Boesky, and was fined $362,000. He also agreed to
assist SEC investigators in their endeavors. In July of 1986, Sokolow and
195.
196.
Glaherson, Who'll be the Next to Fall?, Bus. Week, Dec. 1, 1986, at 39.
Pauly, supra note 194, at 68.
1989-90]
SEC IN TRANSITION
Wilkis were charged with providing insider information to Levine. Sokolow pleaded guilty, paid a $120,000 fine (representing the profits he had
made), and received a year and a day jail sentence on the felony count.
Wilkis and Brown also paid large fines and agreed to assist the SEC in its
further investigations. 9 '
In November of 1986, Ivan Boesky entered into a settlement agreement with the SEC. Boesky agreed to pay the staggering sum of $100
million in penalties ($50 million represents illegal profits, which will be
placed in escrow for the benefit of "harmed investors" who are expected
to file suit claiming damages; and $50 million in civil penalties, which will
be paid to the United States Treasury). Boesky has been barred for life
from trading in securities in the United States, and has agreed both to
assist the SEC in its ongoing investigations into the securities markets
and to plead guilty to an unspecified criminal charge. Later, in fact, Boesky pleaded guilty to a criminal charge and was sentenced to three years
in prison. However, in a much criticized move, the SEC permitted Boesky
to divest himself of more than $440 million in stock prior to the disclosure of the settlement agreement. 9 8
In essence, the overwhelming case against Boesky was based on a
number of legal theories, yet even the SEC recognized that proving Boesky to be a "tippee" within the meaning of the abstain or disclose rule
would be difficult since Siegel and Levine obtained their information
from sources outside of their employ. However, what is clear is that not
only did Boesky violate the misappropriation theory, but also rule 14e-3,
which prohibits any person who possesses material, non-public information, obtained either directly or indirectly from either a bidder or the target company, from trading in the securities of the target company. Passing this information on is illegal when it can be foreseen that the person
receiving this information will trade based on the tip. The main difference between the abstain or disclose rule and the misappropriation theory
is that no breach of fiduciary duty is strictly required under rule 14e-3.
Since Boesky obviously profited from secret, inside information, even
though his fiduciary duty was at best derivative, Boesky committed fraud
by possession and use, and both Levine and Siegel violated rule 14e-3
because clearly, they could foresee that Boesky would in fact trade based
upon the information.
On February 13, 1987, the Commission filed an injuctive action
against Martin Siegel. Siegel agreed to pay the government more than $9
197. Glaherson, supra note 195, at 39.
198. Id.; see H.R. REP. No. 910, 100th Cong., 2d Sess. 12, reprinted in 1988 U.S.
CONG. & ADMIN. NEWS 6043, 6049.
CODE
GONZAGA LAW REVIEW
[Vol. 25:9
million in a settlement and consented to an order barring him for life
from the securities industries. He also pleaded guilty to two felony
charges. In related proceedings, Kidder Peabody consented to the issuance of a permanent injunction, disgorged more than $13 million in illegal
profits, and also paid a civil penalty under the Insider Trading Sanctions
Act of almost $12 million. Later, in an administrative proceeding, Kidder
was censured and ordered to retain an outside consultant to review its
internal policies. '
4.
United States v. Winans
United States v. Winans0° completes the sequence of important recent decisions in the application of judicial and administrative rules concerning insider trading and answers a question not answered in either
Newman or Materia: "[Wihether the existence of a third party to whom
a duty is owed is necessary to the successful prosecution of an enforcement action."20' The Winans decision answered that question in the
negative.
R. Foster Winans was a reporter for the Wall Street Journal (the
Journal), who was convicted of securities and mail fraud in 1985 in federal district court in New York for participating in a stock trading scheme
with Peter Brant, formerly a stockbroker with the firm of Kidder
Peabody. Winans, who authored the Journal's "Heard on the Street" column, leaked advance information (usually from a public phone) about the
timing and content of future columns to Brant. Brant used the information to trade in the stocks mentioned in the columns. Later, Brant enlisted the assistance of fellow Kidder associate, Kenneth Felis. Both
Brant and Felis agreed to give Winans a stake in the profits, which netted
a total of $690,000, of which $31,000 went directly to Winans. °2
Brant pleaded guilty to two counts of securities fraud and became
the government's main witness against Winans and two co-conspirators,
Felis and David Carpenter, a former Journal news clerk. 03
While Winans was neither a broker nor an insider, the SEC alleged
that Winans had misappropriated or stolen confidential information
found in the columns that potentially could have affected the price of
securities discussed in the various columns. The government argued that
199. See id.; see also SEC v. Kidder Peabody & Co., No. 87 Civ. 3869 (S.D.N.Y. filed
June 4, 1987).
200. United States v. Winans, 612 F. Supp. 827 (S.D.N.Y. 1985), aff'd in part rev'd in
part sub noma.United States v. Carpenter, 791 F.2d 1024, aff'd, 108 S. Ct. 316 (1987).
201. Huss and Leete, supra note 74, at 310.
202. Winans, 612 F. Supp. at 834.
203. Id. at 829 n.1.
1989-90]
SEC IN TRANSITION
this misappropriation constituted fraud, both under securities laws and
applicable mail and wire fraud statutes. This action violated rule 10b-5
because the brokers violated the fiduciary duties which they owed to their
employers by providing information obtained during the course of their
employment that enabled others to gain secret profits.20'
Winans had argued that the application of the misappropriation theory was inappropriate because there was no third party to whom Winans'
employer (the Journal) owed a duty. The trial court rejected this contention and stated that the language of Newman and Materia "strongly supports a reading that the existence of third parties is not an essential element." 5 Further, such a confining and restricted view of the scope of a
duty would be an "implicit return to the view that a securities fraud can
only be perpetrated against a buyer or seller of securities."'0 , Finally, Winans had also violated a core consideration in Dirks, because he had real20 7
ized a clear personal gain.
a.
Mail and wire fraud applications
In order to sustain a conviction under applicable mail and wire fraud
statutes,0 s the government must prove "that some actual harm or injury
was at least contemplated."' 20 9 However, it does not need to be proven or
alleged that the victim was actually defrauded, since the statutes forbid
"a scheme to defraud and not actual fraud. ' 21 0 The mail fraud charges
rest squarely on the theory that the Journal was the victim of the fraud
perpetrated by Winans; breaching a fiduciary duty to the Journal when
he had a clear obligation to disclose both the leaking of information and
his own transactions to his employer. 1
The mailing requirement is a major limitation on the breadth of the
statute: "The federal mail fraud statute does not purport to reach all
frauds, but only those limited instances in which the use of the mails is a
part of the execution of the fraud, leaving all other cases to be dealt with
204. Ricks, supra note 108; see also United States v. Carpenter, 791 F.2d 1024, 1026,
1029 (2d Cir. 1986), afl'd, 108 S. Ct. 316 (1987).
205. 612 F. Supp. 827, 840 (S.D.N.Y. 1985).
206. Id. at 841; see also United States v. Newman, 664 F.2d 12, 17 (2d Cir. 1981), cert.
denied, 464 U.S. 863 (1983).
207. See supra note 171 and accompanying text.
208. 18 U.S.C. §§ 1341, 1343 (1982).
209. United States v. London, 753 F.2d 202, 206 (2d Cir. 1985).
210. Id. at 205.
211. Winans, 612 F. Supp. at 844; see also United States v. Von Barta, 635 F.2d 999,
1007 (2d Cir. 1980), cert. denied, 450 U.S. 998 (1981) for a discussion and amplification of
the obligation of an employee in an employment relationship.
GONZAGA LAW REVIEW
[Vol. 25:9
by appropriate state law."2 '2 The use of the mails must be "incident to an
essential part of the scheme."213 Moreover, it is also well settled that one
causes the mails to be used "where one does an act with knowledge that
the use of the mails will follow in the ordinary course of business or where
such uses can reasonably be foreseen, even though not actually
2 1' 4
intended.
While mailings which are too remote from a fraud scheme will not
support a mail fraud charge, 216 the leading case decided by the Third Circuit did not create a per se rule for routine business mail or communication (i.e., such routine mailings would not automatically be excluded as
the basis for a criminal conviction). 21 6 In Winans, however, both the publication and distribution of the Wall Street Journal were an integral and
important part of the scheme to defraud. "The use of the newspaper's
interstate wire and mail production could serve as a predicate for mail
and wire fraud liability. ' 21 7 "[Wlithout publication and distribution of
the copies of the Journal containing the columns in question, there would
be no point to the scheme. '218 Thus, the district court found defendants
Winans and Felis guilty on the mail and wire fraud counts because Winans had submitted the columns for publication to the Journal after
leaking them to Brant and Felis. Both Winans and Felis had clearly "devised and participated in a scheme and artifice to obtain money and
property of the [Wall Street Journal] by means of false and fraudulent
pretenses and representations"2
by telexing articles for printing and
mailing the Journalto subscribers. The court noted that "[a]s a result of
having a reporter engaged in such unethical conduct, the Wall Street
'220
Journal's reputation for journalistic integrity was sullied.
212.
213.
Kann v. United States, 323 U.S. 88, 95 (1944).
Pereira v. United States, 347 U.S. 1, 8 (1954).
214.
Id. at 8-9.
215. United States v. Brown, 583 F.2d 659, 667 (3d Cir. 1978) (citing United States v.
Tarnopol, 561 F.2d 466, 472 (3d Cir. 1977)), cert. denied, 440 U.S. 909 (1979).
216. United States v. Tarnopol, 561 F.2d 466 (3d Cir. 1977).
217.
United States v. Carpenter, 791 F.2d 1024, 1026 (2d Cir. 1986), afl'd, 108 S. Ct.
316 (1987). For the sake of clarity, the appellate case will be noted as Carpenter; the District Court case as Winans. Because of the importance of sources in the evolution of the law,
and for the sake of clarity, notes 218-47 will carry the case name as well as the cite of the
following cases: Carpenter, Winans, Dirks, Chiarella, Materia, and Newman.
218.
Winans, 612 F. Supp. at 847.
219.
Id. at 850.
220.
Id. at 845.
1989-901
b.
SEC IN TRANSITION
The appellate case"'1
On November 26, 1985, the United States Court of Appeals for the
Second Circuit heard the appeal of the various defendants. The court
framed the issues for review as follows:
This case requires us to decide principally whether a newspaper reporter,
a former newspaper clerk, and a stockbroker, acting in concert, criminally violated or conspired to violate or aided and abetted in the violation of federal securities laws by misappropriating material, nonpublic
information in the form of the timing and content of the Wall Street
Journal's confidential schedule of columns of acknowledged influence in
the securities market, in contravention of the established policy of the
newspaper, for their own profit in connection with the purchase or sale of
securities.'
Judge Pierce noted that the gravamen of the complaint placed the
case "within the purview of the 'misappropriation' theory of section 10(b)
and Rule 10b-5 thereunder.""2
He further stated that contrary to the
views of many publicists who had lamented the demise of the theory,
"[in 1980, the Supreme Court left open the question of the viability of
'
that theory,"""
because of both the concurring (Justices Brennan and
2
Stevens)" and dissenting (Chief Justice Burger) 2 6 opinions in Chiarella,
which stated that had the misappropriation theory been presented to the
jury, Chiarella's conviction might have been affirmed. Since the decision
in Chiarella,Judge Pierce noted that the theory had been applied by the
Second Circuit in Materia and Newman. In both cases, the Supreme
2 27
Court had refused to grant certiorari to review the convictions.
On appeal, the defendants argued that the misappropriation theory
may only be applied where the information is misappropriated by corporate insiders or so-called quasi-insiders,22 8 who owe a fiduciary duty of
abstention or disclosure to a corporation and its shareholders. The appellants further contended that it would not be enough that Winans
breached a duty of confidentiality to his employer in misappropriating
221. Carpenter, 791 F.2d 1024.
222. Id. at 1027.
223. Id.; see also Securities and Exchange Act of 1934 § 10(b), 15 U.S.C. § 78j(b)
(1982); rule 10b-5, 17 C.F.R. § 240.10b-5 (1989).
224. Carpenter, 791 F.2d at 1028 (construing Chiarella v. United States, 445 U.S. 222
(1980)).
225. Chiarella, 445 U.S. at 239 (Brennan, J., concurring); id. at 238 (Stevens, J.,
concurring).
226. Id. at 245 (Burger, C.J., dissenting).
227. SEC v. Materia, 745 F.2d 197 (2d Cir. 1984), cert. denied, 471 U.S. 1053 (1985);
United States v. Newman, 664 F.2d 12 (2d Cir. 1981), cert. denied, 464 U.S. 863 (1983).
228. Carpenter,791 F.2d at 1028; Dirks v. SEC, 463 U.S. 646, 655 n.14 (1983).
GONZAGA LAW REVIEW
[Vol. 25:9
and trading on material, nonpublic information. Winans would have to
have breached a duty to the corporations or shareholders whose stock the
participants purchased or sold on the basis of that information.2 2 The
appellate court squarely rejected these contentions and stated that the
"misappropriation theory more broadly proscribes the conversion by 'insiders' or others of material, nonpublic information in connection with
the purchase or sale of securities. 2 30
In Materia,the court stated that section 10(b) was not "aimed solely
at the eradication of fraudulent trading by corporate insiders."2 1 Later,
in Newman, the court noted that the "language of Rule 10(b)-5
. .
.con-
tains no specific requirement that fraud be perpetrated upon the seller or
buyer of securities, ' 28 2 and cited to the language of the Rule itself: "The
Rule prohibits 'any person,' acting 'directly or indirectly,' from employing
'any device, scheme, or artifice to defraud.' ",233
The Rule also prohibits "any act, practice, or course of business
' 234
which operates or would operate as a fraud or deceit upon any person.
Judge Pierce noted that the repeated use of the word "any" evidences
Congress' intention to draft the Rule broadly and that the Rule was
"designed as a catchall clause to prevent fraudulent practices."2 '
In construing Congressional intent, the circuit court also took note of
statements made accompanying the Insider Trading Sanctions Act of
1984.23" Congress noted that the intent of the 1934 Act was to condemn
all manipulative or deceptive trading "whether the information about a
corporation or its securities originates from inside or outside the corporation," 27 and the abuses sought to be remedied were not limited to actions
of corporate insiders and large shareholders. 238 In sum, Congress sought
to proscribe trading on material, nonpublic information obtained not
through skill or disparities in talent or legitimate knowledge, but through
a variety of deceitful practices and unlawful acts which are termed
239
misappropriation .
229.
230.
231.
232.
233.
234.
235.
236.
Carpenter,791 F.2d at 1029.
Id. at 1029 (citing Materia, 745 F.2d at 203) (emphasis in original).
Materia, 745 F.2d at 201.
Newman, 664 F.2d at 17.
Carpenter,791 F.2d at 1029.
17 C.F.R. § 240.10b-5 (emphasis added).
Carpenter, 791 F.2d at 1030 (quoting Chiarella,445 U.S. at 226).
Pub. L. No. 98-376, 98 Stat. 1264 (1984).
237. H.R. REP. No. 98-355, 98th Cong., 1st Sess. 3, 4, reprinted in 1984 U.S. CODE
CONG. & ADMIN. NEWS 2277.
238. Id.
239. See Aldave, Misappropriation:A General Theory of Liability for Trading on
Nonpublic Information, 13 HOFSTRA L. REV. 101, 106 & n.33 (1984).
1989-901
SEC IN TRANSITION
The court then went on to make the following salient points.
1) The fraud and deceit in Winans did not differ significantly from
that proven in Newman and Materia. "Winans misappropriated-stole,
to put it bluntly-valuable nonpublic information entrusted to him in the
24' 0
utmost of confidence.
2) There is no doubt that the fraud committed by Winans in misappropriating the Journal's own confidential schedule was perpetrated upon
"any person" under section 10(b) and rule 10b-5. It was evident that
the
fraud was committed upon Winan's employer, "sullying [its] reputation"
and thereby defrauding it "as surely as if they took its money. 24 ' Note
the striking similarity with Materia (printing press employee liable for
fraud upon employer)2 42 and Newman (investment banking employees li24 3
able principally for "sullying the reputations" of their employers).
3) The use of the misappropriated information for the financial
benefit of the defendants and to the financial detriment of those with
whom the conspirators traded underscored the conclusion that appellants' fraud was clearly in connection with the purchase or sale of securities under section 10(b) and rule 10b-5. It is clear that the misappropriated information regarding the timing and content of certain Journal
columns had "no value whatsoever except 'in connection with'.
subse24 4
quent purchases of securities.
4) The court noted that the confidential and nonpublic information
misappropriated by Winans constituted the required property under the
mail fraud statute. 24 It was sufficient that appellants knew that the use
of interstate mail and wire services was a "reasonably foreseeable conse2 46
quence of the scheme.
In conclusion, the appellate court, in affirming the conviction of Winans, Felis, and Carpenter, stated unequivocally:
Thus, because of his duty of confidentiality to the Journal, defendant
Winans-and Felis and Carpenter, who knowingly participated with
240.
Carpenter,791 F.2d at 1031 (quoting Chiarelia,445 U.S. at 245).
241.
242.
243.
244.
Id. at 1032 (quoting Newman, 664 F.2d at 17).
745 F.2d at 202.
664 F.2d at 17.
Materia, 745 F.2d at 203.
245. Carpenter, 791 F.2d at 1034; see United States v. Louderman, 576 F.2d 1383,
1387 (9th Cir. 1978), cert. denied, 439 U.S. 896 (1978); United States v. Von Barta, 635 F.2d
999, 1006 (2d Cir. 1980), cert. denied, 450 U.S. 998 (1981); see also McNally v. United
States, 483 U.S. 350 (1987); 3 W. FLETCHER, CYCLOPEDIA OF LAW OF PRIVATE CORPORATIONS §
857.1 (Rev. ed. 1986).
246. Pereira v. United States, 347 U.S. 1, 8-9 (1954).
GONZAGA LAW REVIEW
[Vol. 25:9
him-had a corollary duty, which they breached, under section 10(b) and
rule 10b-5, to abstain from trading in securities on the basis of the misappropriated information or to do so 2only
upon making adequate disclos7
ure to those with whom they traded.
Gary Lynch, the SEC's enforcement chief, assessed the importance of
the guilty verdict, the fraud portion of which was later upheld by a divided 4-4 vote of the United States Supreme Court on November 16,
1987.248 "It is clear that the Court believes misappropriation of information is a fraud. ' ' 24 9 However, the Court unanimously upheld the judgment
of the court of appeals with regard to the mail and wire fraud convictions.
The Wall Street Journal, which had argued that Winans' conduct had
put their reputation at risk, noted that when the Supreme Court did not
overturn the misappropriation theory even when stretched to include a
reporter, it would be "highly unlikely that a court would do so in a more
immediate and direct case involving stockbrokers, arbitragers or other
250
Wall Streeters.
It has also been noted that in affirming Winans' conviction on the
basis of violating mail and wire fraud statutes, the Court was, in effect,
broadening the scope of applicability of such statutes to both tangible
and intangible personal property. The Supreme Court stated:
Here, the object of the scheme was to take the Journal's confidential business information-the publication schedule and contents of the "Heard"
column-and its intangible nature does not make it any less 'property'
protected by the mail and wire fraud statutes. . . . [I]t is sufficient that
the Journal has been deprived of its right to exclusive use of the information, for exclusivity is an important aspect of confidential business infor"
mation and most private property, for that matter.26
'
Thus, in a rather bizarre and unusual case (Justice Scalia said it was
"strange" to suggest that a scheme that merely risks some harm is "sufficient to support a criminal charge),"2' 52 the Supreme Court in Winans
may have handed prosecutors a "powerful new weapon, one that could
easily eclipse misappropriation as the dominant theory of insider trading
practices. ' 2 5 3 Harvey Pitt, a partner in the Washington firm of Fried,
247. Carpenter,791 F.2d at 1034.
248. 484 U.S. 19 (1987). A tie vote in the Supreme Court has the effect of affirming the
lower court decision. A tie vote may have less value as precedent than a majority opinion.
249. Stewart & Wermeil, supra note 176, at 16, col. 3.
250. Id. at 16, col. 2
251. Carpenter,108 S. Ct. at 320-21.
252. Wall St. J., Oct. 8, 1987, at 5, col. 3.
253. Id. Because of the emphasis on the mail and wire fraud aspect of the conviction,
many SEC cases may be prosecuted on this basis.
1989-901
SEC IN TRANSITION
Frank, Harris, Shriver & Jacobsen (who represented Ivan Boesky and
who, in 1975, was named General Counsel of the SEC at age 30) noted:
"Most insider-trading cases can be brought as mail- and wire-fraud cases.
I know of no cases that can't go forward. This will embolden prosecution,
both civilly and criminally.""25
Even with the tie-vote in the Supreme Court, which affirmed the conviction of Foster Winans, the distinction between inside and outside
sources of information as determining potential liability under rule 10b-5
is "certainly disappearing."25 Liability may now be predicated both on
the development of an expanded theory of fiduciary duty and the recognized unfairness of trading on the basis of material information not available to the investing public at large. Thus, under the theories developed
in Newman, Materia,Boesky, and Winans, courts are more apt to look to
the process leading to the acquisition of possession of the non-public information and the behavior (illegal or improper) that led to the possession of the material and critical information.
Because no clear statutory definition of insider trading has existed,
the SEC has routinely used the general anti-fraud provisions of section
10(b) of the Securities Exchange Act to prosecute violations of federal
securities law. As a result, investment bankers and securities analysts
have complained that a case-by-case development of the law gives the
SEC too much power and has left muddled exactly what is legal and what
is not, and who is covered or who may not be covered by the various
prohibitions.
Yet, through the legal morass of rules, interpretations, SEC actions,
and plea-bargain agreements, an opinion has developed that calls for a
switch from judicial interpretation to a well-defined statutory approach.
Under such a statutory approach, the broad, case-by-case analysis of the
fraud provisions of rule 10b-5 would be replaced by a statute containing a
specific definition of insider trading and detailed principles concerning
the possession and use of non-public information.
The open policy question remains: Is this the right course to follow?
IV.
LEGISLATIVE AND ADMINISTRATIVE SOLUTIONS TO THE INSIDER
TRADING PROBLEM
Not surprisingly, while the courts were busy deciding the fate of Foster Winans, both the Congress and the SEC were "stepping into the
breach."
254.
255.
Stewart & Wermeil, supra note 176, at 16, col. 2.
Huss & Leete, supra note 74, at 312.
GONZAGA LAW REVIEW
[Vol. 25:9
On February 24, 1987, during an oversight hearing of the Senate Subcommittee on Securities, Senator Donald Riegle requested Securities lawyer and former SEC Chairman Harvey Pitt to form a committee of securities law practitioners to draft statutory language to define and prohibit
insider trading. The work of this group, known as the Ad Hoc Committee,
resulted in the proposed legislation, S. 1380, the focus of a long and protracted debate during much of 1987 and 1988.256
A.
The United States Senate Acts:
Bill of 1987
The Insider Trading Proscriptions
Introduced by Senators Donald Riegle (D-Mich.) and Alfonse
D'Amato (R-N.Y.), this legislation was proposed on June 17, 1987, as a
result of the "tensions felt by Wall Street and the SEC arising from the
lack of specific delineations of what constituted insider trading behavior. '2' 57 The proposed Act reflected the intricacies of the ongoing debate
over a specific definition of the law; one side was pushing for a precise
definition of insider trading which would enable the SEC to prosecute
such cases without having to rely on contested legal theories, and the
other side was insisting that a precise definition of insider trading would
encourage market professionals and securities practitioners to find ways
2 58
to circumvent the Act.
The proposed legislation would add a new section 16A to the Exchange Act, expressly forbidding conduct known as insider trading. The
legislation would build in concepts of breach of duty and misrepresentation, which are embodied in the extensive case law of insider trading. In a
Memorandum of the SEC in support of the Insider Trading Bill of 1987
(Insider Trading Bill), the Commission noted: "While the Commission
does not believe that a statutory definition is, at present, necessary for
the continued success of its enforcement action, it recognizes the benefits
that can result from an appropriately crafted definition, and appreciates
the efforts of the Subcommittee to develop a statutory definition. '259
Stating the views of the Ad Hoc Committee, Attorneys Pitt, Levine,
and Olson stated:
We believe that a prominent clear statement of Congress' views on this
important issue is necessary to enhance the ability of:
- Judges to interpret and apply the statute;
256.
257.
258.
259.
Proposed Legislation, supra note 107 (Opening Statement of Senator Riegle).
Res Gestae, supra note 114, at 239.
Ricks, supra note 108, at 4, col. 3.
Proposed Legislation, supra note 107, at 10 (Memorandum of the Securities and
Exchange Commission).
1989-90]
SEC IN TRANSITION
" Government agencies to establish and enforce goals and policies;
" Lawyers to counsel clients to avoid running afoul of the prohibitions;
and
- Honest people wishing to comply with the law to comprehend its scope
and application.2 "
The Insider Trading Bill would also codify Commission rule 14e-3.
This rule "prohibits trading by a person other than the tender offerer
who possesses material nonpublic information relating to the tender offer
where that person knows that the information was acquired directly or
'
indirectly from the tender offerer or the target company." 261
The Insider Trading Bill parallels in many significant aspects recent
SEC action. It clarifies many of the principles embodied in the major insider trading cases of the last decade. The Insider Trading Bill would
make it illegal for any person to use material, nonpublic information to
trade in such information if that person knows or has reason to know that
such information has been obtained wrongfully, or if the purchase or sale
of a security would constitute the wrongful use of such information. 6 '
The Insider Trading Bill states that "information is deemed to be
used or obtained wrongfully . . . if it has been obtained by, or its use
would constitute, . . . theft, conversion, misappropriationor breach of a
. . . fiduciary, contractual, employment, personal or other relationship of
26 3
trust and confidence.
Further, the Insider Trading Bill would create a presumption that
persons who trade in securities while in possession of material nonpublic
information have used that information in connection with the transaction, regardless of whether the trade was actually based on that information.2"' An exception is allowed in the Bill for a corporation which can
prove that the corporation's purchase or sale of a security was not influenced by such information26 5 and that the individual effecting the
purchase or sale, or causing others to purchase or sell on behalf of the
2 66
corporation, did not know of the material nonpublic information.
The Insider Trading Bill would specifically provide that in determining whether a corporation has sustained its burden of proof, it is relevant
260. Id. at 37 (joint written statement of Harvey L. Pitt, Theodore A. Levine, and
John F. Olson).
261. Id. at 13 (statement of Commissioner Charles C. Cox).
262. S. 1380, 100th Cong., 1st Sess. § 16A(b)(1) (1987) (emphasis added).
263. Id. (emphasis added).
264. Id. § 16A(b)(2).
265. Id. § 16A(b)(2)(A).
266. Id. § 16A(b)(2)(B); see Res Gestae, supra note 114, at 239.
GONZAGA LAW REVIEW
[Vol. 25:9
to consider whether the corporation has "adopted reasonable policies and
procedures to prevent violations of the Trading Act."' 6
Under the Insider Trading Bill, it would also be illegal to tip material
non-public information to any other person who in turn may use the information to trade securities if the "tipper" knows or has reason to know
that the information would be used for the purchase or sale of a security
in violation of the Act.'
In addition, the Insider Trading Bill speaks to several specialized facets of the securities trading industry. The proposed legislation would
place constraints on the use of nonpublic information concerning any
plan for the acquisition or disposition of an issuer of a material block of
the issuer's securities or assets. The Bill would make illegal the direct or
indirect disclosure of such information to any person for the purpose of
influencing or encouraging the purchase or sale of the securities of the
6 9
issuer if any such persons thereafter purchase or sell the securities."
In one other significant feature, the Insider Trading Bill would also
give the SEC specific rule-making authority to implement the provisions
of the Insider Trading Bill and to exempt persons or classes of securities
27 0
Finally,
or a whole range of transactions from the reaches of the Bill.
'
the Bill would confer an explicit "private right of action "27 upon any
person injured by the violation of the Insider Trading Bill in connection
with the purchase or sale of any security.
The SEC's acting Chair, Charles Cox, testified before the Subcommittee on June 19, 1987, concerning the desirability of a statutory definition of insider trading. In general, he stated that the SEC could support a
statutory definition of insider trading that preserved the Commission's
"authority and flexibility."'' Although the Commission did not believe
that a statutory definition was necessary for the continued success of its
enforcement 1 program,' 7 ' "such a definition would be helpful and
7
desirable.'
267. Id.
268. Id. § 16A(c)(1).
269. Id. § 16A(c)(2). Exempted from the provisions are certain communications with
persons defined in section 13(d)(3) of the Securities Exchange Act of 1934.
270. S. 1380, 100th Cong., 1st Sess. § 16A(e), 133 CONG. REc. 8247-48 (1987).
271. Id. § 16A(f).
272. Proposed Legislation, supra note 107, at 10 (Memorandum of the Securities Exchange Commission).
273. Id. at 36 (joint written statement of Harvey L. Pitt, John F. Olson, and Theodore
A. Levine).
274. Id.
1989-90]
SEC IN TRANSITION
On August 3, 1987, the SEC submitted its own proposal for a definition of insider trading."' The Subcommittee on Securities held hearings
on the SEC proposal on August 7, 1987. Surprisingly, the Commission
draft omitted both the misrepresentation and conversion concepts, a
weakness pointed out in the testimony of Harvey Pitt before the Subcommittee on August 7:
This [omission] is unfortunate, because (i) the term "misappropriation"
has been painstakingly developed by the courts and the Commission in
numerous cases over the past several years; (ii) the omission of that concept would possibly preclude certain cases that should be brought; (iii)
the omission of that concept might require the development of a new
body of law with its concomitant uncertainities [sic]; (iv) this formulation would substitute SEC rulemaking for clearly-defined standards applicable to criminal prosecutions, an untenable state of the law.276
The SEC proposal also differed from the Senate Bill in that the SEC
defined insider trading as "trading while in possession of material nonpublic information." 2"
Recognizing the divergence of opinion at the August 7 hearing, the
Subcommittee requested that the Commission assist in the process of developing a consensus approach for legislation defining insider trading. In
response to this request, members of the Subcommittee's staff met with
representatives of the Ad Hoc Committee to discuss a potential
compromise.
B.
The SEC Intervenes
On November 18, 1987, the Commission submitted to the Subcommittee its revised proposal for compromise legislation, barely two days
after the "inconclusive" Supreme Court decision in the Winans case on
November 16, 1987 (effectively upholding the securities fraud convictions
of Winans and two co-conspirators based on the misappropriation theory). The SEC proposal of November 18 defined insider trading as wrongful trading while in possession of (not on the basis of use of) material
nonpublic information.217 The proposal reflected the earlier view of Chairman Cox: "The definition should make it very clear that it's trading in
possession of material nonpublic information that is prohibited. I think
275. Id. at 52-56 (text of bill proposed by the Securities Exchange Commission).
276. Id. at 40 (joint written statement of Harvey L. Pitt, John F. Olson, and Theodore
A. Levine).
277. Id. at 52 (section 16A(a) of bill proposed by Securities Exchange Commission).
278.
To Amend, supra note 111, at 26.
GONZAGA LAW REVIEW
[Vol. 25:9
from the standpoint
of enforcement it is essential that that be what Con27
gress enacts."
9
One improvement in the November 18 compromise proposal may be
seen in the Commission's willingness to adopt a definition of "insider
trading as the 'wrongful use' of 'material nonpublic information' about a
corporation that affects its stock market price, or trading on the basis of
such information that was 'obtained wrongfully.' "280
The text of the November 18 SEC proposal reads:
It shall be unlawful for any person, directly or indirectly, to purchase,
sell, or cause the purchase or sale of, any security, while in possession of
material, nonpublic information relating thereto, if such person knows or
recklessly disregards that such information has been obtained wrongfully, or that such
purchase or sale would constitute a wrongful use of
2 81
such information.
However, it is in the definition of the term "wrongful" that the SEC
may have made its most important stride in the development of a cohesive and logical policy against insider trading. Wrongful is defined as
"theft, bribery, misrepresentation, espionage,
. . .
conversion, misappro-
priation, or any other breach of fiduciary duty, breach of any personal or
other relationship of trust 282
and
confidence, or breach of any contractual or
'
employment relationship.
This definition clearly encompasses the holdings of the major cases
previously discussed by specific references to both the misappropriation
theory (Chiarella) and the breach of fiduciary duty (Boesky and Winans). However, there are several interesting highlights of the November
18 Commission proposal:
1) It is clear that the language encompassing misappropriation and
breach of duty did not appear in the Commission's original proposal submitted during August of 1987, but was retained at the direct insistence of
the lawyer's group, over the objection of several SEC members.28 3 The
inclusion, however, was vigorously supported by current SEC Chairman
279. Id. at 15 (statement of Commissioner Charles C. Cox).
280. Nash, N.Y. Times, Nov. 20, 1987, at D1, col. 3.
281. To Amend, supra note 111, at 29 (Securities and Exchange Commission proposed
Insider Trading Bill, § 16A(b)(1)).
282. Id.
283. Commissioner Ed Fleishman flatly refused to support the proposed dcfinition and
Commissioner Joseph Grundfest made his support of the proposed definition contingent
upon learning of the contents of a future legislative history, which would accompany the
proposal. Ricks, supra note 108, at 4, col 2.
1989-901
SEC IN TRANSITION
David Rudder (in December of 1987), who endorsed the misappropriation
theory and a precise definition of insider trading, which would clarify the
application of the theory and significantly strengthen the SEC's enforcement ability.
2) "The language of the propos[al] does not require [that] the SEC
prove that such wrongfully obtained information [has] served as the basis
for a [securities] transaction; rather, the proposal requires only that the
trader was in possession of such information" in order to make the activity illegal.28s
3) The Commission agreed to expand the categories of those who
can file a private action against an accused inside trader. In addition to
permitting those who trade contemporaneously in the marketplace to
seek redress, others who could prove injury by the illegal trading scheme
could likewise seek compensation. (This category might include an individual investor or a company who could prove that the purchase price of
the stock in a "target" company was driven higher by insider trading; or
that absent the inside information, a decision to sell certain securities had
285
caused financial injury.)
4) The proposal also would make it a crime to trade based upon a
"tip" from an insider, provided that the person receiving the tip knows,
or has reason to believe, the information is of a confidential nature. In
such a case, both the tipper and tippee (provided the tippee knew the
information was privileged) might find themselves as defendants in suits
brought both by the SEC (criminal violation) and private parties (civil
action for damages). s6
5) Securities analysts would not receive the "blanket exemption"
under Commission proposals which they had been actively seeking; however, providing their dissemination of information did not otherwise
amount to a wrongful action, such security analysts would not be subjected to prosecution. 87
The New York Times noted that "[tihe plan is significant . . . because it ended years of reluctance [on the part of] the SEC to commit
itself to a definition of insider trading."2 8 However, Thomas E. Ricks,
Staff reporter for the Wall Street Journal,added that the "lack of una284. Nash, supra note 280, at D6, col. 3.
285. Id. at D6, col. 4.
286. Id.
287. To Amend, supra note 111, at 28 (Securities and Exchange Commission Proposed
Insider Trading Bill, Nov. 18, 1987).
288. Nash, supra note 280, at D1, col. 3.
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nimity on [the issue of] misappropriation could provide ammunition for
'
opponents of the pending Senate bill."289
Both Senators Donald Riegle and Alfonse D'Amato immediately
noted "that the SEC's endorsement of [the] compromise position [including a stringent definition of insider trading that includes the misappropriation theory] should speed the passage of the proposed law." Senator
Riegle, Chairman of the Senate Securities Subcommittee, stated that the
SEC proposal "gives me confidence that we will enact legislation during
' 290
this Congress.
Senator Riegle noted:
On November 16, in Carpenter v.United States, better known as the
Winans case, the Court split right down the middle with a four-to-four
vote with respect to Winans' conviction under the securities laws.
That to me is a clear indication that even our highest Court in the
land is uncertain about the scope of insider trading under today's securities laws. . . . I fully agree the courts ought not write the law alone in
this area. That's really [Congress'] job and we should step up to it.29'
The future of any bill in the House of Representatives, however,
seemed uncertain, because Representative Dingell remained adamant
about a legislative solution to this difficult problem. Earlier, Representative Dingell had speculated that he would consider the long-range implications of the Foster Winans decision "to see whether any tightening of
the law may be desirable to prevent future violators from escaping
29' 2
through judicial loopholes.
However, on March 9, 1988, Dingell flatly stated that Congress would
not produce a legislative definition of insider trading during the current
session, but would instead move to improve methods of detecting the
crime. Dingell noted that the House of Representatives would draft legislation to "beef up" the way stock exchanges and other self-regulatory organizations monitor transactions for evidence of insider trading. "Firmer
and harsher" treatment of so-called "Chinese Walls," or communication
barriers, which were designed to prevent a trading operation from taking
advantage of inside information possessed by its investment banking side,
would also be drafted.
An administrative assistant to Senator D'Amato noted in an interview on January 10, 1989: "The Bill never became law. Congressman
289.
290.
291.
292.
Ricks, supra note 108, at 4, col. 2.
Id.
To Amend, supra note 111, at 1 (statement of Sen. Donald Riegle).
Ricks, supra note 108, at 4, col. 2.
1989-90]
SEC IN TRANSITION
Dingell remained convinced that a legislative definition of insider trading
was not the way to proceed.""'
C. The Insider Trading and Securities Enforcement Act of 1988
Effective supervision of securities firms and of their employees, and
agents is a foundation of the federal regulatory scheme of investor
protection. 94
The Energy and Commerce Committee of the House of Representatives, under the Chairmanship of Congressman John Dingell, introduced
the Insider Trading and Securities Fraud Enforcement Act [Enforcement
Act] in August of 1988, to serve as a signal to Wall Street and investors.
At the time the legislation was introduced, Representative Dingell
noted: "Suspicious trades at no less than eight major Wall Street firms
are being investigated by the SEC . .
.
.The corruption we are seeing
suggests that the Street's ethical foundation is being seriously eroded
"9295
The legislation, as enacted:
1) Subjects brokerage firms, as "controlling parties," to civil
penalties
296
for failing to take adequate steps to prevent insider trading;
2) initiates a bounty program, giving the SEC discretion to reward
informants who provide valuable information leading to the imposition of
insider trading penalties of up to 10% of the penalty imposed or of any
297
settlement reached;
3) creates a new section, 15(f), of the Exchange Act29 and section
204A of the Investment Advisers Act of 1940299 which would require broker-dealers and investment advisers to establish, maintain, and enforce
written policies "reasonably designed" to prevent misuse of material,
nonpublic information by the firm or any of its employees or associated
persons;
293. Personal interview (Jan. 10, 1989); see also Ricks, supra note 108, at 2, col. 2.
294. H.R. REP. No. 910, 100th Cong., 2d Sess. 17, reprinted in 1988 U.S. CODE CONG. &
ADMIN. NEws 6043, 6054.
295. News release, Committee on Energy and Commerce (Aug. 3, 1988).
296. Pub. L. No. 100-704, § 3(a), 102 Stat. 4677, 4677 (codified at 15 U.S.C.S. § 78u1(a)(3), (b) (Supp. 1989)).
297. Id. (codified at 15 U.S.C.S. § 78u-1(e) (Supp. 1989)).
298. Pub. L. No. 100-704, § 3(b), 102 Stat. 4677, 4679-80 (codified at 15 U.S.C.S. 78o(f)
(Supp. 1989)).
299. Id. (codified at 15 U.S.C.S. 80b-4a (Supp. 1989)).
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4) codifies private rights of action for those injured as a result of insider trading;3 00
5) significantly increases monetary penalties for criminal securities
law violations. The Enforcement Act increases the maximum jail term for
criminal securities law violations from 5 to 10 years. The maximum criminal fine for individuals increases from $10,000 to $1,000,000 and the maximum fine for non-natural persons (securities firms, associations, etc.) increases from $500,000 to $2,500,000;o1
6) grants the Commission greater authority to cooperate with foreign
independent regulatory agencies, such as the Commission des Operations
de Bourse (France), the Canadian Provincial Securities Commissions, and
the British Secretary of State for the Department of Trade and
Industry;30 2
7) expands the coverage of the Insider Trading Sanctions Act, where
violators may be liable for up to three times the profit gained or loss
avoided as a result of trading while in possession of material, nonpublic
information,10 to include those brokers-dealers, investment advisers, and
others who fail to take appropriate steps to prevent such violations.304
The Enforcement Act is clearly intended to broaden controlling person liability in order to increase the economic incentives (and by implication disincentives) for such persons to supervise their employees. The
Commission and the courts will continue to interpret the term "controlling person" on a case-by-case basis according to the facts of each case.
Yet, section 21A(b)(1)(A) imposes liability when a "controlling person"
fails to take appropriate action once that person is aware or is in reckless
disregard 0 5 of circumstances "indicating that a controlled person was engaging in an ongoing insider trading or tipping violation or was about to
engage in such a violation.""
300. Pub. L. No. 100-704, § 5, 102 Stat. 4677, 4680-81 (codified at 15 U.S.C.S. 78t-1
(Supp. 1989)).
301. Pub. L. No. 100-704, § 4, 102 Stat. 4677, 4680 (codified at 15 U.S.C.S. 78ff(a)
(Supp. 1989)).
302. Pub. L. No. 100-704, § 6(b), 102 Stat. 4677, 4681-82 (codified at 15 U.S.C.S.
78u(a)(2) (Supp. 1989)).
303. See SEC v. MacDonald, 699 F.2d 47 (1st Cir. 1983).
304. Pub. L. No. 100-704, § 3(a), 102 Stat. 4677, 4678 (codified at 15 U.S.C.S. 78u1(a)(3) (Supp. 1989)).
305. 15 U.S.C.S. 78u-l(b)(1)(A) (Supp. 1989); see also Kersh v. General Council of
Assemblies of God, 804 F.2d 546 (9th Cir. 1978).
306. H.R. REP. No. 910, 100th Cong., 2d Sess. 17, reprinted in 1988 U.S. CODE CONG. &
ADMIN. NEWs 6043, 6054.
1989-90]
SEC IN TRANSITION
In addition, the Enforcement Act codifies an express right of action
against traders and tippees for those who traded in the same class of securities contemporaneously with and on the opposite side of the market
from the inside trader. This provision is intended to overturn certain
court cases which had denied recovery for plaintiffs where the
defendant's
30 7
violation was premised upon the misappropriation theory.
"In the view of the Committee, where the plaintiff can prove that
[he/she] suffered injury as a result of the defendant's inside trading, the
plaintiff has standing to sue in these circumstances, and the remedial
purposes of the securities laws requires recognition of such an action ....
The plaintiff [will, in essence, be permitted] to recover the full extent of
'' 8
[the] actual damages.
The Committee on Energy and Commerce noted its continued concern over the lack of definition of insider trading. "The securities bar and
the Congress have debated this issue for a number of years, including
during the adoption of the Insider Trading Sanctions Act of 1984. " '0'
Yet, while recognizing the importance of providing clear guidelines
for behavior, the Committee declined to include a statutory definition for
the following reasons:
1) "[Clourt-drawn parameters of insider trading have established
clear guidelines for the vast majority of traditional insider trading cases."
The Committee Report noted that "[tihe legal principles governing in3 10
sider trading cases are well-established and widely known.
2) A statutory definition of insider trading could potentially have a
narrowing effect and in an "unintended manner facilitate schemes to
evade the law." 11
3) The Committee did not believe that the lack of consensus over a
definition of insider trading should impede progress on needed enforce312
ment reform.
307. See, e.g., Moss v. Morgan Stanley, 719 F.2d 5 (2d Cir. 1983), cert. denied, 465
U.S. 1025 (1984).
308. H.R. REP. No. 910, 100th Cong., 2d Sess. 28, reprinted in 1988 U.S. CODE CONG. &
ADMIN. NEWS 6043, 6065; see also Anheuser-Busch Co. v. Thayer, CA3-85-0794 (N.D. Tex.
1986).
309. H.R. REP. No. 910, 100th Cong., 2d Sess. 10, reprinted in 1988 U.S. CODE CONG. &
ADMIN. NEWS 6043, 6047.
310. Id. at 11, reprinted in 1988 U.S. CODE CONG. & ADMIN. NEWS 6043, 6048.
311. Id.
312. Id.
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However, it might be well to reflect that in fact, a strong consensus
had been reached by almost all of the participants: the SEC, the Ad Hoc
Committee, the various lawyers' groups, and the United States Senate.
The consensus was embodied in the November 18, 1987, Commission Insider Trading Bill, which modified the original Riegle-D'Amato legislation. 1 ' This consensus approach has been largely ignored by Congressman Dingell.
CONCLUDING OBSERVATIONS AND COMMENTARY
In this article, we have addressed both practical and policy questions
concerning the nature and scope of insider trading, through a careful
tracing of the legislative origin of the SEC, important securities laws, current legislative proposals, and a synthesis of the cases of major importance decided by the federal judiciary in the past quarter-century. The
Securities Act of 1933 required registration statements which would disclose full, accurate and material facts concerning the sale or purchase of
non-exempt securities offered to the investing public through interstate
commerce or the mails. The Securities Exchange Act of 1934 created the
SEC, an independent agency charged with the awesome responsibility of
regulation and registration of securities exchanges, brokers, dealers, and
national securities associations.
The early 1930's followed a disastrous period in stock market -history.
The Acts of 1933 and 1934 were designed as stop-gap approaches to protect the unsophisticated investor from those sellers who would take advantage of the uninformed, thus creating the first ethical imperative
within the securities market. The case law which followed is as varied
(and contradictory) as is imaginable; at times restrictive (Chiarella and
Dirks), and at times expansive (Materia and Winans). Cases have recently identified a wrongdoer as anyone who profits, either directly or
indirectly, from a transaction which involves information known to one
party which is not publicly available to other potential investors. Although this approach may appear reasonable and perhaps desirable, the
courts must then necessarily rule on a case-by-case basis. This may leave
too much room for manipulation or too much time to find a convenient
path to circumvent the implementation (legal and ethical) of case holdings. To the layman or a member of the non-professional investing public,
no clear pattern emerges which can serve as a defined code of conduct.
Yet, in the midst of confusion and uncertainty, one may argue that
abuses will not be curtailed no matter what course of action may be im313. To Amend, supra note 111, at 28 (Securities and Exchange Commission Proposed
Insider Trading Bill, Nov. 18, 1987).
1989-90]
SEC IN TRANSITION
plemented. Others may urge that there must be a more definite rule in
order to determine when a seller or buyer of securities has crossed the
line of right versus wrong. (Perhaps a good term might be: "Boesky's Rubicon.") While it is recognized that the market can adjust the selling price
of a stock or bond to reflect negative or positive information concerning a
certain security, it is also recognized that essential fairness and equity
demand that such information be generally, thus publicly known. In recent years, the courts have been called on increasingly to provide structure and order to the insider trading debate. In response, courts have
done much to aid in the control of misuse of inside information.
Yet it is also recognized that the SEC, as the responsible administrative body, must make clear distinctions to identify who is an insider, what
is inside information, and when a 'technical outsider' bears legal responsibility for improper trading. Without clear and unified rules (and in the
face of seeming Congressional reluctance to provide stability to the debate), the market will continue to experience the abuses of the past and
will no doubt see movement towards future legislative action.
In the face of such a variety of opinions, it should be recognized that
among both accounting and legal practitioners there is a general uneasiness concerning the current status of the law. Many critics note that
courts have too much latitude in their approaches (often vague and contradictory) to enforcing the current rules, stating that while it should not
be the function of courts to make law, in the face of such a definitional
chasm, the courts must stem the breach and come up with a working definition of questioned terms. Others continue to press the view that it is
not the courts but the SEC which has been charged with providing the
required definitions. At the same time (and in recognition of the truth of
the maxim: nature abhors a vacuum), a frustrated and bewildered Congress has chosen to enter the fray.
Thus, in the Riegle-D'Amato Bill (The Insider Trading Proscriptions
Bill of 1987) a specific finding states:
The fairness, honesty, and integrity of the Nation's securities markets
are impaired when corporate insiders and other persons who obtain material, nonpublic information relating to a particular security or group of
securities ... wrongfully use that information, or wrongfully communicate that information to others who misuse it, in connection with the
purchase or sale of any security.""
In sum, the authors conclude that a "specific statutory delineation"
of what constitutes either the "wrongful use" or "communication" of ma314.
S. 1380, 100th Cong., 1st Sess. § 16A(a)(1) (1987).
64
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terial, nonpublic information is required to provide both certainty and
clarity in the law.
Ethics may properly be defined as a philosophy which deals with
character and conduct that distinguishes between right and wrong and
which moves the actor towards the good. Ethics are largely determined by
society and societal norms. Until the "trading society" has made clear
what is its definition of right and wrong conduct, the courts will continue
to render contradictory decisions on the reaches of the law (i.e., the misappropriation theory created by former Chief Justice Warren Burger), the
SEC will continue to enforce vague and open-ended rules and the Congress will continue to "rush to judgment" to provide a legislative answer
in a piecemeal approach. It is clearly the duty of the "trading society" to
take stock in itself and begin a policy of self-definition and self-enforcement, which is the prerequisite, the foundation ethic, to fairness and equity in the securities markets.