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Securities law and the case law on insider trading

The 1934 Act addressed insider trading directly through Section 16(b) and indirectly through Section 10(b).

• Section 16(b) prohibits short-swing profits (profits realized in any period less than six months) by corporate insiders in their own corporation's stock, except in very limited circumstance. It applies only to directors or officers of the corporation and those holding greater than 10% of the stock and is designed to prevent insider trading by those most likely to be privy to important corporate information.
• Section 10(b) of the Securities and Exchange Act of 1934 makes it unlawful for any person "to use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the [SEC] may prescribe."

 To implement Section 10(b), the SEC adopted Rule 10b-5, which provides, in relevant part:

It shall be unlawful for any person, directly or indirectly . . .,

(a) to employ any device, scheme, or artifice to defraud,

(b) to make any untrue statement of a material fact or omit to state a material fact necessary in order to make the statements made, in 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 a security.²¹

These broad anti-fraud provisions, make it unlawful to engage in fraud or misrepresentation in connection with the purchase or sale of a security. WIt is on the basis of those provisions that the courts have exercised their  authority  to make the most important developments in insider trading law in the United States.

 Congress on two separate occasions enacted  legislation dealing with appropriate penalties and other aspects of the violation. Insider Trading Sanctions Act of 1984, Public Law 98-376 [H.R.559], August 10, 1984; Insider Trading and Securities Enforcement Act of 1988, Public Law 100-704 [H.R.5133] November 19, 1988. The substantive law of insider trading is judge-made case law which on several occasions has reached the United States Supreme Court.

Taking into account that the very purpose of professionals in the financial activities is to base its trades on knowledgeable information the basis issue is to determine the border line of permissible trades which makes  it illegal for someone with special knowledge about an issuer of securities, to trade in the securities of that issuer without telling the person with whom the trade is made.

The main principles are set out in three leading cases decided by the Supreme Court:

• The Supreme Court in Chiarella v. United States, 445 U.S. 222 (1980) relied on the  existence of a  fiduciary duty which would  create itself a duty  to disclose, the breach of which would give rise to a violation of law.

•  In Dirks v. SEC, 463 U.S. 646 (1983), the Supreme Court  decided that the insider  breaches that  fiduciary duty if he acts not  in the corporate interest . As to  the recipient of the information he has  an obligation to refrain from trading only if he  knows the guilty circumstances under which the information was passed along to him.

• In United States v. O'Hagan, 521 U.S. 642 (1997), the Supreme Court made clear that the breach of duty by which the information is obtained and its illegal use, could involve a duty of trust and confidence other than between a corporate insider and the shareholders of the corporation whose securities are traded.

            http://stocks.about.com/gi/dynamic/offsite.htm?site=http%3A%2F%2Fwww.usatoday.com%2Fnews%2Fcourt%2Fnscot638.htm

The SEC has issued  three new rules  relating to

•  the practice of selective disclosure of information by issuers to analysts and institutional investors, a practice not considered to be illegal under the Dirks analysis;

• the burden on proof as to the actual use of the inside information, as distinguished from  the simple proof of  a trade while the defendant possessed the information;

• the kinds of non-business relationships  which give rise to a duty of confidentiality.

Selective Disclosure and Insider Trading, SEC, 17 CFR Parts 240, 243, and 249

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