SEC Enforcement Director Khuzami Offers A Nugget On the Current Insider Trading Standard

December 2, 2011

On December 1, 2011, Robert Khuzami, Director, Division of Enforcement, U.S. Securities and Exchange Commission, delivered a statement to the United States Senate Committee on Homeland Security and Governmental Affairs.  See, Statement on the Application of Insider Trading Law to Trading by Members of Congress and Their Staffs.

Embedded in Khuzami's remarks is a concise explanation of the current state of interpretation concerning what constitutes "Insider Trading."  As I've often noted in my comments to the media, a lot of folks express opinions as to what they think constitutes insider trading but, in reality, the law is not as clear and precise as some pundits would have the public believe.  For one thing, contrary to popular conception, there is no hardcore statutory definition of insider trading.  The concept of this illegal activity is largely derived from interpretation of broader antifraud provisions, and more than a smattering of inference and wishful thinking.

Given Khuzami's regulatory stature and the concise nature of his observations, I offer this regulator's interpretation as helpful guidance:

Law of Insider Trading

There is no express statutory definition of the offense of insider trading in securities.3 The SEC prosecutes insider trading under the general antifraud provisions of the Federal securities laws, most commonly Section 10(b) of the Securities Exchange Act of 1934 ("Exchange Act") and Rule 10b-5, a broad anti-fraud rule promulgated by the SEC under Section 10(b). Section 10(b) declares it unlawful "[t]o 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."4 Rule 10b-5 broadly prohibits fraud and deception in connection with the purchase and sale of securities. As the Supreme Court has stated, "Section 10(b) and Rule 10b-5 prohibit all fraudulent schemes in connection with the purchase or sale of securities, whether the artifices employed involve a garden type variety of fraud, or present a unique form of deception," because "[n]ovel or atypical methods should not provide immunity from the securities laws."5

There are two principal theories under which the SEC prosecutes insider trading cases under Section 10(b) and Rule 10b-5. The "classical theory" applies to corporate insiders - officers, directors, and employees of a corporation, as well as "temporary" insiders, such as attorneys, accountants, and consultants to the corporation.6 Under the "classical theory" of insider trading liability, a corporate insider violates Section 10(b) and Rule 10b-5 when he or she trades in the securities of the corporation on the basis of material, nonpublic information. Trading on such information qualifies as a "deceptive device" under Section 10(b), because "a relationship of trust and confidence [exists] between the shareholders of a corporation and those insiders who have obtained confidential information by reason of their position with that corporation."7 That relationship "gives rise to a duty to disclose [or to abstain from trading] because of the 'necessity of preventing a corporate insider from . . . tak[ing] unfair advantage of . . . uninformed . . . stockholders.'"8

The Supreme Court has recognized that corporate "outsiders" can also be liable for insider trading under the "misappropriation theory."9 Under this theory, a person commits fraud "in connection with" a securities transaction, and thereby violates Section 10(b) and Rule 10b-5, when he or she misappropriates confidential and material information for securities trading purposes, in breach of a duty owed to the source of the information. This is because "a fiduciary's undisclosed, self-serving use of a principal's information to purchase or sell securities, in breach of a duty of loyalty and confidentiality, defrauds the principal of the exclusive use of that information."10 The misappropriation theory thus "premises liability on a fiduciary-turned-trader's deception of those who entrusted him with access to confidential information."11 Under either the classical or misappropriation theory, a person can also be held liable for "tipping" material, nonpublic information to others who trade, and a "tippee" can be held liable for trading on such information.12

A common law principle is that employees owe a fiduciary duty of loyalty and confidence to their employers. In addition, employees often take on contractual duties of trust or confidence as a condition of their employment or by agreeing to comply with a corporate policy. Accordingly, employees have frequently been held liable under the misappropriation theory for trading or tipping on the basis of material non-public information obtained during the course of their employment.13 This includes prosecution of federal employees who, in breach of a duty to their employer, the federal government, trade or tip on the basis of information they obtained in the course of their employment. For example, the SEC recently brought insider trading charges against a Food and Drug Administration employee alleging that he violated a duty of trust and confidence owed to the federal government under certain governmental rules of conduct when he traded in advance of confidential FDA drug approval announcements.14

In light of existing precedent regarding the liability of employees - including federal employees - for insider trading, any statutory changes in this area should be carefully calibrated to ensure that they do not narrow current law and thereby make it more difficult to bring future insider trading actions against any such persons...

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Footnotes Cited in Abstract Above

3 On several occasions, Congress has considered but ultimately declined to enact an explicit statutory prohibition of insider trading. See, e.g., H.R. Rep. No. 100-910, at 11 (1988), reprinted in 1988 U.S.C.C.A.N. 6043, 6048 (legislative history of the Insider Trading and Securities Fraud Enforcement Act of 1988 notes that although Congress had considered a legislative definition of insider trading, the Committee declined to include a statutory definition in the bill because in its view "the court-drawn parameters of insider trading have established clear guidelines for the vast majority of traditional insider trading cases, and . . . a statutory definition could potentially be narrowing, and in an unintended manner facilitate schemes to evade the law."). Congress has specifically provided the SEC with authority to seek civil money penalties for insider trading, 15 U.S.C. § 78u-1, and provided an express private right of action for certain contemporaneous traders in insider trading cases. 15 U.S.C. § 78t-1.

4 15 U.S.C. § 78j(b).

5 Superintendent of Insurance v. Bankers Life & Cas. Co., 404 U.S. 6, 11 n.7 (1971) (quoting A. T. Brod & Co. v. Perlow, 375 F.2d 393, 397 (2d Cir. 1967)).

6 Dirks v. SEC, 463 U.S. 646, 655 n.14 (1983).

7 Chiarella v. United States, 445 U.S. 222, 228 (1980).

8 Id. at 228-29 (citation omitted).

9 United States v. O'Hagan, 521 U.S. 642, 653 (1997).

10 Id. at 652.

11 Id.

12 Dirks v. SEC, 463 U.S. at 660-62.

13 SEC v. Cherif, 933 F.2d 403, 410 (7th Cir. 1991); SEC v. Clark, 915 F.2d 439, 453 (9th Cir. 1990); Carpenter v. United States, 791 F.2d 1024, 1026 (2d. Cir. 1986), aff'd by an equally divided court, 484 U.S. 19 (1987).

14 See, e.g., SEC v. Cheng Yi Liang, et al., Exchange Act Rel. No. 21097 (March 29, 2011), http://www.sec.gov/litigation/litreleases/2011/lr21907.htm; see also United States v. Royer, 549 F.3d 886 (2d. Cir. 2008) (affirming a conviction of an FBI agent for tipping information about ongoing investigations and information on law enforcement databases); SEC v. John Acree, Litigation Rel. No. 14231, 57 SEC Docket 1579 (Sept. 13, 1994) (announcing a settled action with a former employee of the Office of the Comptroller of the Currency for trading on the basis of material non-public information concerning banks).