Federal Securities Law: Insider Trading

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Federal Securities Law: Insider Trading

Summary

Insider trading in securities may occur when a person in possession of material nonpublic

information about a company trades in the company’s securities and makes a profit or avoids a

loss. Certain federal statutes have provisions that have been used to prosecute insider trading

violations. For example, Section 16 of the Securities Exchange Act of 1934 requires the

disgorgement of short-swing profits by named insiders—directors, officers, and 10%

shareholders. The 1934 Act’s general antifraud provision, Section 10(b), is frequently used in the

prosecution of insider traders. Although the statute does not specifically mention insider trading

but, instead, forbids the use of “manipulative or deceptive” means in buying or selling securities,

case law has clarified that insider trading is the type of fraud that is prohibited by Section 10(b).

Securities and Exchange Commission (SEC) rules issued to implement Section 10(b), particularly

Rule 10b-5, have also been frequently invoked in insider trading prosecutions. With the Insider

Trading Sanctions Act of 1984 and the Insider Trading and Securities Fraud Enforcement Act of

1988, Congress enacted legislation that imposed up to treble damages (and in some cases the

greater of $1 million or up to treble damages) on persons found guilty of insider trading. More

recently, the Stop Trading on Congressional Knowledge (STOCK) Act of 2012 (P.L. 112-105)

explicitly stated that there is no exemption from the insider trading prohibitions for Members of

Congress, congressional employees, or any federal officials. As noted above, SEC Rule 10b-5 is

the most frequently used SEC rule in lawsuits that charge violations of insider trading

prohibitions. However, other SEC rules, some of which specifically target insider trading, are also

important.

There are numerous cases in which Section 10(b) and Rule 10b-5 have been used to prosecute

insider trading violations. The most recent case of note is the Supreme Court’s decision in Salman

v. United States. On December 6, 2016, the Court unanimously upheld the conviction of Bassam

Yacoub Salman for insider trading on tips that he had received from his brother-in-law. The Court

agreed with federal prosecutors that a trader can be guilty of violating insider trading prohibitions

even if the insider did not receive a tangible benefit, such as money or property, for passing the

tip so long as the trader and insider are friends or relatives.

No bill concerning insider trading appears to have been introduced in the 115th Congress to date.

However, several bills, including H.R. 1173, H.R. 1625, and S. 702, were introduced in the 114th

Congress before the Supreme Court’s Salman decision. The Salman decision appears not to go as

far as these bills would have in prohibiting the acts of trading in securities with inside information

and disclosing inside information.

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Federal Securities Law: Insider Trading

Contents

Introduction ..................................................................................................................................... 1

Overview of Federal Statutes Related to Insider Trading ................................................................ 1

Securities Act of 1933 ............................................................................................................... 1

Securities Exchange Act of 1934 .............................................................................................. 2

Insider Trading Sanctions Act of 1984 ...................................................................................... 4

Insider Trading and Securities Fraud Enforcement Act of 1988 ............................................... 4

Stop Trading on Congressional Knowledge (STOCK) Act of 2012 ......................................... 5

Examples of Penalties for Insider Trading ................................................................................ 5

Selected Regulations ....................................................................................................................... 5

Selected Decisions Illustrating the Use of Section 10(b) and Rule 10b-5 to Prosecute

Insider Trading Violations ............................................................................................................ 6

Strong v. Repide .................................................................................................................. 7

In the Matter of Cady Roberts & Co. .................................................................................. 7

Securities and Exchange Commission v. Texas Gulf Sulphur ............................................. 8

Chiarella v. United States ................................................................................................... 8

Dirks v. Securities and Exchange Commission ................................................................... 9

Carpenter v. United States ................................................................................................ 10

United States v. O’Hagan................................................................................................... 11

United States v. Newman................................................................................................... 12

Salman v. United States..................................................................................................... 13

Congressional Interest in Insider Trading...................................................................................... 14

Contacts

Author Contact Information .......................................................................................................... 15

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Federal Securities Law: Insider Trading

Introduction

Insider trading in securities may occur when a person in possession of material nonpublic

information about a company trades in the company’s securities and makes a profit or avoids a

loss. Federal statutes have provisions that either specifically forbid insider trading or have been

interpreted by courts to prohibit insider trading. This report discusses some of the key statutes as

well as regulations issued by the Securities and Exchange Commission (SEC or Commission) to

implement the statutes. The report also discusses some of the most pertinent court decisions on

insider trading.

Overview of Federal Statutes Related to Insider

Trading

Securities Act of 1933

The Securities Act of 19331 (1933 Act) makes it illegal to offer or sell securities2 to the public

unless the securities have been registered with the SEC.3 A registration statement becomes

effective 20 days after it is filed with the Commission, unless it is delayed or suspended.4

Registration under the 1933 Act covers only the securities actually being offered and only for the

purposes of the offering in the registration statement. The registration statement consists of two

parts: the prospectus, provided to every purchaser of the securities, and Part II, containing

information and exhibits that do not have to be provided to purchasers but are available for

inspection. Section 7 of the 1933 Act, referring to Schedule A,5 sets forth the information that

must be contained in the registration statement.6 This schedule requires a great deal of

information, such as the underwriters, the specific type of business, significant shareholders, debt

and assets of the company, and opinions as to the legality of the stock issue. Section 10(a) of the

1933 Act specifies the information which the prospectus must contain.7 There are also numerous

regulations issued by the Commission which provide additional details about the registration

process under the 1933 Act.8

15 U.S.C. §§ 77a-77aa.

The term “security” is defined very broadly in 15 U.S.C. § 77b(1) as:

any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of

indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust

certificate, preorganization certificate or subscription, transferable share, investment contract, votingtrust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other

mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group

or index of securities (including any interest therein or based on the value thereof), or any put, call,

straddle, option, or privilege entered into on a national securities exchange relating to foreign currency,

or, in general, any interest or instrument commonly known as a “security”, or any certificate of interest

or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to

subscribe to or purchase, any of the foregoing.

15 U.S.C. § 77e.

Id. § 77h(a).

Id. § 77aa.

Id. § 77g.

Id. § 77j(a).

See, e.g., 17 C.F.R. Parts 230, 231, and 239.

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Certain transactions and securities are exempted from the registration process. The exempted

transactions include private placements, intrastate offerings, and small offerings.9 Among the

exempted securities are government securities, bank securities, and short-term commercial paper;

all securities for which it is believed that other, adequate means of government regulation exist.10

Securities Exchange Act of 1934

The Securities Exchange Act of 193411 (1934 Act) is concerned with several different topics, one

of which is the ongoing process of required disclosure by covered publicly traded companies to

the investing public through the filing of periodic and updated reports with the Commission.12

Any issuer13 that has a class of securities traded on a national securities exchange or, in certain

circumstances, has total assets exceeding $10 million and a class of equity securities held of

record14 by 2,000 shareholders or 500 shareholders who are not accredited investors15 must

must also file periodic and other reports with the SEC.17 Section 12 of the 1934 Act requires the

filing of a detailed statement about the company when the company first registers.18 Section 13, in

turn, requires a registered company to file annual and quarterly reports with the SEC.19 These

reports must contain essentially all material information, financial and otherwise, about the

company—information that the investing public would need in making an informed decision

about whether to invest in the company. Section 14 contains requirements about proxy

solicitation.20 Some exemptions from these reporting requirements are provided.21 The

Commission has issued extensive regulations to specify information that these reports must

provide.22

Failure to disclose material information is actionable. For example, Section 18(a) of the Securities

Exchange Act grants an express private right of action to investors who have been injured by

reliance upon material misstatements or omissions of facts in reports that have been filed with the

SEC.23 Section 10(b) of the 1934 Act,24 the general antifraud provision, and Rule 10b-5,25 issued

15 U.S.C. § 77d.

Id. § 77c.

Id. §§ 78a-oo.

Id. § 78m.

For purposes of this report, an “issuer” is a legal entity that issues publicly traded securities to fund its operations and

is required to file material information through annual and other reports with the SEC.

The phrase “held of record” refers to the entity that a company lists in its records as the registered holder of a

security.

In general, an “accredited investor” is an institutional investor or an individual with significant financial means and

sophisticated investment knowledge. See 17 C.F.R. § 230.501.

15 U.S.C. § 78l. As stated earlier, the 1933 Act requires the registration of a particular offering of securities. The

1934 Act requires the registration of a class of securities.

15 U.S.C. §§ 78l, 78m, and 78n.

Id. § 78l.

Id. § 78m.

Id. § 78n.

Id. § 78l.

See, e.g., 17 C.F.R. Parts 240, 241, and 249.

15 U.S.C. § 78r(a).

Id. § 78j(b).

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by the SEC to carry out the statutory fraud prohibition, provide for a cause of action for injuries

caused by omissions, misrepresentations, or manipulations of material facts in statements filed

with the SEC, as well as in statements other than those filed with the SEC.26

One provision in the 1934 Act27 is specifically designed to discourage insiders in the corporation

from taking advantage of their inside information in the trading of the corporation’s securities.

Section 16 of the 1934 Act28 places sanctions on insiders who use inside information in making

short-swing profits.29 For purposes of this provision, an insider is defined as any “person who is

directly or indirectly the beneficial owner of more than 10 percent of any class of any equity

security . . . which is registered . . . or who is a director or an officer of the issuer . . . .”30 Every

person who qualifies as an insider under this definition must file a report with the SEC at the time

of the security’s registration on a national securities exchange or by the effective date of a filed

registration statement or within 10 days after he becomes a beneficial owner, director, or officer.31

If there has been a change in the ownership of the security or if there has been a purchase or sale

of a security-based swap agreement involving the equity security, the insider must file the report

before the end of the second business day following the day on which the transaction has been

executed.32

To prevent the unfair use of inside information, Section 16(b) permits the company or any

security holder to sue on behalf of the company to recover any profit that the person realizes from

any purchase and sale or sale and purchase of any equity security of the company within a period

of less than six months.33

Section 10(b) and Rule 10b-5 are used in most cases of insider trading violations, as well as in

other kinds of alleged securities fraud. (Some of the major cases are discussed below.) Although

Section 10(b) does not refer to specific types of fraud or specific types of insiders, one of its most

frequent applications over the years has been to insider trading. The statute states, in relevant

part:

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 . . .

(b) 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, or any securities-based

swap agreement 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. . . .34

(...continued)

17 C.F.R. § 240.10b-5.

See, e.g., State Teachers Ret. Bd. v. Fluor Corp., 654 F.2d 843 (2d Cir. 1981);Goldberg v. Meridor, 567 F.2d 209 (2d

Cir. 1977).

15 U.S.C. §§ 78a et seq.

Id. § 78p.

“Short-swing profits” are profits from the purchase and sale of a security within six months.

Id. § 78p(a)(1).

Id. § 78p(a)(2).

Id. § 78p(a)(2)(C).

Id. § 78p(b).

Id. § 78j(b).

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Rule 10b-5, mentioned later along with other SEC regulations that focus more specifically on

insider trading, is the general SEC rule used in many securities fraud cases. The rule 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

as a fraud or deceit upon any person,

in connection with the purchase or sale of any security. 35

Insider Trading Sanctions Act of 1984

According to the House report on the bill, the Insider Trading Sanctions Act of 198436 was

enacted because:

Insider trading threatens . . . markets by undermining the public’s expectations of honest

and fair securities markets where all participants play by the same rules. This legislation

provides increased sanctions against insider trading in order to increase deterrence of

violations.

“Insider trading” is the term used to refer to trading in the securities markets while in

possession of “material” information (generally, information that would be important to

an investor in making a decision to buy or sell a security) that is not available to the

general public.37

The 1984 Act provides that, if the Commission believes that any person has bought or sold a

security while in possession of material, nonpublic information, the Commission may bring an

action in federal district court seeking a civil penalty. The penalty may be up to three times the

profit gained or loss avoided.38

Insider Trading and Securities Fraud Enforcement Act of 1988

After a number of hearings and considerable debate in the 100th Congress, President Reagan

signed the Insider Trading and Securities Fraud Enforcement Act of 1988.39 This act expanded the

scope of civil penalties that may be imposed against officers and directors who fail to take

adequate steps to prevent insider trading.40 Among other things, the 1988 Act also established a

17 C.F.R. § 240.10b-5.

P.L. 98-376, 98 Stat. 1264 (Aug. 10, 1984) (codified, as amended, in 15 U.S.C. §§ 78a et seq.)

H. REPT. 98-355, at 2 (1984).

15 U.S.C. § 78u-1(a)(2).

P.L. 100-704, 102 Stat. 4677 (Nov. 19, 1988) (codified, as amended, in a number of provisions of the federal

securities laws).

15 U.S.C. § 78u-1(a)(3) imposes on a person controlling the violator a penalty of the greater of $1 million or three

times the profit gained or loss avoided. Limitations on the liability of controlling persons may be found at 15 U.S.C.

§ 78u-1(b).

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private right of action against the inside trader for buyers or sellers of securities who traded

contemporaneously with the insider.41

Stop Trading on Congressional Knowledge (STOCK) Act of 2012

The STOCK Act,42 signed into law on April 4, 2012, affirms that insider trading prohibitions

apply to Members of Congress, congressional staff, and other federal officials.43

The STOCK Act also has provisions concerning financial disclosure reporting requirements for

legislative and executive branch officials.44

Examples of Penalties for Insider Trading

There are both civil and criminal penalties45 for insider trading, and the penalties can vary

depending on what statutes a trader is found guilty of violating. The 1934 Act sets out the civil

penalties for engaging in securities transactions while in possession of material nonpublic

information.46 As mentioned above, the penalty can be up to three times the profit gained or loss

avoided. However, willful violations of other provisions, such as Section 10(b), the general

antifraud securities provision, may result in other significant penalties, including fines up to $5

million and/or imprisonment for up to 20 years for individuals and fines up to $25 million for

businesses.47

Selected Regulations

As stated above, SEC Rule 10b-5, which implements Section 10(b) of the Securities Exchange

Act, is apparently the most frequently used SEC rule in lawsuits that charge violations of insider

trading prohibitions. However, other SEC rules, some of which specifically target insider trading,

are also important.

Rule 10b5-1 prohibits trading “on the basis of” material nonpublic information.48 This rule states

that one of the proscribed activities under Section 10(b) and Rule 10b-5 is securities trading “on

the basis of material nonpublic information about that security or issuer, in breach of a duty of

trust or confidence that is owed” to the issuer of the security, shareholders of the issuer, or another

who is the source of the inside information.49 The regulation defines “on the basis of” to have a

kind of knowledge requirement:

15 U.S.C. § 78t-1.

P.L. 112-105, 126 Stat. 291 (Dec. 3, 2012) (codified in provisions and notes of several titles of the U.S. Code,

particularly in Titles 5 and 15).

See 15 U.S.C. § 78u-1(g) for duty of Members and employees of Congress and 15 U.S.C. § 78u-1(h) for duty of

other federal officials.

For more information on the STOCK Act, see CRS Report R42495, The STOCK Act, Insider Trading, and Public

Financial Reporting by Federal Officials, coordinated by (name redacted).

The SEC typically seeks the civil penalties, and the Department of Justice typically seeks the criminal penalties.

See, e.g., 15 U.S.C. § 78u-1.

Id. § 78ff.

17 C.F.R. § 240.10b5-1.

Id. § 240.10b5-1(a).

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[A] purchase or sale of a security of an issuer is “on the basis of” material nonpublic

information about that security or issuer if the person making the purchase or sale was

aware of the material nonpublic information when the person made the purchase or sale. 50

Various affirmative defenses are allowed under the rule, such as the alleged violator’s

demonstrating that he had entered into a binding contract to buy or sell the security, had

instructed another person to buy or sell the security for his account, or had adopted a written plan

for trading securities before becoming aware of the material nonpublic information.51

Rule 10b5-2 sets out duties of trust or confidence in insider trading cases based on the

misappropriation of inside information.52 The misappropriation theory of insider trading is a fairly

recent development in securities law. Under the classical theory of insider trading, a corporate

insider is prohibited from trading that corporation’s securities if the trade is based on inside

information and the trader has a fiduciary duty to the corporation’s shareholders. In contrast to

classical insider trading, the misappropriation theory may hold liable a person who is not actually

a corporate insider but has instead been provided inside information in confidence and who

breaches a fiduciary duty to the source of the information in order to gain profit or avoid loss in

the securities market. Rule 10b5-2 sets out examples of what is meant by “duties of trust or

confidence.” Such duties include a person’s agreement to maintain the disclosed information in

confidence; a person’s history with the discloser of the inside information indicating an

expectation that the recipient of the information will keep the information in confidence; and a

person’s receiving information from a spouse or close relative, unless the recipient can show that

he neither knew nor should have reasonably known or agreed that he would keep the information

confidential.53

Regulation FD is another SEC rule that could prohibit insider trading.54 Regulation FD addresses

selective disclosure. It provides that, when an issuer or any person acting on behalf of an issuer

discloses material nonpublic information to certain enumerated persons (typically, securities

market professionals and holders of the securities), that issuer or person acting on behalf of the

issuer must disclose the information to the public. This disclosure must be made simultaneously

with the intentional disclosure to the enumerated persons or as promptly as possible after the

disclosure, in the case of a non-intentional disclosure to the enumerated persons.55

Selected Decisions Illustrating the Use of Section

10(b) and Rule 10b-5 to Prosecute Insider Trading

Violations

There are numerous cases and administrative proceedings in which Section 10(b) and Rule 10b-5

have been used to prosecute insider trading violations. The following is a brief discussion of some

of the most notable of these cases and proceedings.

Id. § 240.10b5-1(b).

Id. § 240.10b5-1(c).

Id. § 240.10b5-2.

Id. § 240.10b5-2(b).

Id. §§ 243.100-243.103.

Id. § 243.100(a).

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Strong v. Repide

Although it was decided 25 years before the enactment of the Securities Exchange Act, Strong v.

Repide56 illustrates that the common law rule of fiduciary duty, which is arguably the idea driving

the case law imposing penalties for insider trading, prohibits a company insider from profiting

from knowledge that he alone has about the company. According to the Court, a corporate

director may not generally have an obligation of a fiduciary nature to disclose to a shareholder the

director’s knowledge affecting the value of the shares.57 However, the Court believed that such a

duty can exist in special cases and did, in fact, exist in this case because the fraudulent

concealment of the identity of a stock purchaser would have affected the value of the stock in

question. To wit, the Court stated: “Concealing his identity when procuring the purchase of the

stock, by his agent, was in itself strong evidence of fraud on the part of the defendant.”58 The

Court went on to state: “The case before us seems a plain one for holding that, under the

circumstances detailed, there was a legal obligation on the part of the defendant to make these

disclosures.”59

In the Matter of Cady Roberts & Co.

In an administrative disciplinary proceeding, In the Matter of Cady Roberts & Co.,60 the SEC

held that Section 10(b) and Rule 10b-5 prohibited insider trading by a person, in this case a

broker-dealer, who may not be within the corporation whose stock has been traded, but who has

received privileged information about the corporation from someone within the corporation.

The case concerned a partner in a brokerage firm who, after receiving a message from a director

of the Curtiss-Wright corporation stating that the board of directors had voted to cut the dividend,

placed orders to sell some Curtiss-Wright stock before news of the dividend cut was disseminated

to the public.61 The broker was not a corporate insider (i.e., he was not an officer, director, or

significant shareholder). However, the SEC held that the broker’s conduct violated at least clause

(3) of the above-quoted SEC Rule 10b-5 in that the conduct operated as a fraud or deceit on the

purchasers and, thus, there was no need to decide the scope of clauses (1) and (2).62 In

determining that there was a violation of clause (3), the SEC appears to have found fraud

committed on both the company and on persons on the other side of the market, noting:

Analytically, the obligation [not to trade on inside information] rests on two principal

elements: first, the existence of a relationship giving access, directly or indirectly, to

information intended to be available only for a corporate purpose and not for the personal

benefit of anyone, and second, the inherent unfairness involved where a party takes

advantage of such information knowing it is unavailable to those with whom he is

dealing. In considering these elements under the broad language of the anti-fraud

provisions we are not to be circumscribed by fine distinctions and rigid classifications.

Thus, it is our task here to identify those persons who are in a special relationship with a

213 U.S. 419 (1909).

Id. at 431.

Id. at 432-33.

Id. at 434.

40 SEC 907 (1961).

Id. at 908-09.

Id. at 913.

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company and privy to its internal affairs, and thereby suffer correlative duties in trading

in its securities. Intimacy demands restraint lest the uninformed be exploited.63

The SEC rejected the broker’s argument that the obligation to disclose material information exists

only in situations involving face-to-face dealings on the grounds that:

[i]t would be anomalous indeed if the protection afforded by the anti-fraud provisions

were withdrawn from transactions effected on exchanges, primary markets for securities

transactions. If purchasers on an exchange had available material information known by a

selling insider, we may assume that their investment judgment would be affected and

their decision whether to buy might accordingly be modified. Consequently, any sales by

the insider must await disclosure of the information.64

Thus, it appears that this case established that Section 10(b) and Rule 10b-5 extend beyond

officers, directors, and major stockholders to others (in this case, a broker-dealer) who receive

information from a corporate source. Later cases, discussed below, appear to support this view.

Securities and Exchange Commission v. Texas Gulf Sulphur

Securities and Exchange Commission v. Texas Gulf Sulphur,65 a 1968 decision by the U.S. Court

of Appeals for the Second Circuit (Second Circuit), effectively supported the SEC’s ruling in

Cady Roberts by suggesting that anyone in possession of inside information must either publicly

disclose the information or not trade the particular stock until the information becomes public.

According to the Second Circuit:

[A]nyone in possession of material inside information must either disclose it to the

investing public, or, if he is disabled from disclosing it in order to protect a corporate

confidence, or if he chooses not to do so, must abstain from trading in or recommending

the securities concerned while such inside information remains undisclosed.66

Chiarella v. United States

The U.S. Supreme Court appears, however, in 1980 to have somewhat modified the rule of Texas

Gulf Sulphur by indicating that, for a fraud to be actionable under Rule 10b-5, there must be a

duty to disclose arising from a relationship of trust and confidence between parties to the

transaction.67 Chiarella v. United States involved an alleged violation of Rule 10b-5 by an

employee of a financial printer.68 The employee, who was involved in printing materials related to

corporate takeover bids, deduced the names of the target companies from information contained

in documents delivered to the printer by the acquiring companies.69 Without disclosing his

knowledge, the employee purchased stock in the target companies and sold the shares

immediately after the information was made public, realizing a profit of $30,000.70 The Second

Circuit held that a violation of Rule 10b-5 had occurred and convicted the employee for willfully

Id. at 912.

Id. at 914.

401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).

Id. at 848.

445 U.S. 222 (1980).

Id.

Id. at 224.

Id.

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failing to inform the sellers of the target company securities that he knew of an imminent

takeover bid that would increase the value of their stock.71

The Supreme Court reversed.72 According to the Court, an employee in this situation did not have

a duty to disclose the information.73 He was not a corporate insider, and he received no

confidential information.74 In addition, no duty arose from the relationship between the printing

company employee and the sellers of the target companies’ securities.75 The Court held that a

duty to disclose under Section 10(b) and Rule 10b-5 does not arise from the mere possession of

nonpublic market information.76

Dirks v. Securities and Exchange Commission

Dirks v. Securities and Exchange Commission77 could be seen to have gone a little further than

Chiarella by indicating that persons not within a corporation who possess inside information are

not always liable when trading on this information. The case involved an officer of a brokerdealer who specialized in providing investment analysis of insurance company securities to

institutional investors.78 He received information that the assets of an insurance company were

greatly overstated because of fraudulent corporate practices and that regulatory agencies had not

acted on charges made by company employees.79 Although the officer of the broker-dealer did not

himself trade the stock, some of his customers did, based on information they received from

him.80 The price of the stock fell, and the SEC began investigations, eventually finding that the

officer had violated Rule 10b-5 by repeating the allegations of fraud to investors who later sold

their stock in the insurance company.81 However, because of his role in uncovering the fraud, he

received only a censure from the SEC.82

See United States v. Chiarella, 588 F.2d 1358 (2d Cir. 1978).

445 U.S. 222 (1980).

Id. at 235.

Id. at 236.

Id.

Id. at 235-37. Concurring and dissenting opinions in Chiarella suggest that, if the misappropriation theory of

securities fraud had been presented, the employee might have been found guilty under it. Chief Justice Burger opined

that the employee’s conviction should have been affirmed because the “evidence shows beyond all doubt that Chiarella,

working literally in the shadows of the warning signs [stating the employer’s confidentiality policy] in the printshop

misappropriated—stole, to put it bluntly—nonpublic information entrusted to him in the utmost confidence.” Id. at 245

(Burger, C.J., dissenting). Although Justice Brennan disagreed with the Chief Justice’s view of the evidence, he agreed

that 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). Justice Blackmun, with whom Justice Marshall joined, wrote that, even without resting Chiarella’s

conviction on a misappropriation theory, he should have been convicted because he had “purloined” information. Id. at

246-52 (Blackmun, J., dissenting). Justice Stevens, who concurred in the opinion of the Court, wrote separately,

emphasizing the “fact that we have not necessarily placed any stamp of approval on what this petitioner did, nor have

we held that similar actions must be considered lawful in the future.” Id. at 238 (Stevens, J., concurring).

463 U.S. 646 (1983).

Id. at 648.

Id. at 649.

Id. at 650.

Id. at 651.

Id. at 652.

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On appeal, the Supreme Court held that no violation of Section 10(b) had occurred in this case.83

In order to find a violation of Section 10(b) by a corporate insider, two elements are necessary,

according to the Court: (1) the existence of a relationship affording access to inside information

intended to be available only for a corporate purpose, and (2) the unfairness of allowing a

corporate insider to take advantage of that information by trading without disclosure.84 However,

the duty arises from a fiduciary relationship, in the Court’s view.85 In addition, there must be

manipulation or deception to bring about a breach of the fiduciary duty.86 Here, according to the

Court, the insider did not trade on the inside information, nor did he make secret profits.87 For the

officer of the broker-dealer to have a duty to disclose inside information or abstain from trading,

the officer must have a fiduciary duty and must have breached that fiduciary duty.88 The officer in

this case had no duty to abstain from using inside information because he had no pre-existing

fiduciary duty to the insurance company’s shareholders.89 Therefore, he did not violate Section

10(b) or Rule 10b-5.90

Carpenter v. United States

Seven years after Dirks, the Supreme Court decided another landmark securities case, Carpenter

v. United States.91 In this case, although the Court did not find the defendants guilty under the

misappropriation theory of securities fraud, it did discuss the issue.92 The case arose when R.

Foster Winans, a former writer for the Wall Street Journal’s “Heard on the Street” column, and

others were charged with violations of Section 10(b) and Rule 10b-5.93 They were also charged

with violating the federal mail and wire fraud statutes94 and conspiracy.95 In researching

information to be used in his column, Winans interviewed corporate executives, but none of the

information he obtained was said to have involved corporate inside information.96 Because of its

perceived quality and integrity, the column had the potential for affecting the prices of the stocks

that it discussed.97

The Wall Street Journal’s official policy was that, before publication, the contents of the column

were its confidential information.98 However, despite being familiar with this rule, Winans agreed

to give Peter Brant and Kenneth Felis, both employees of Kidder Peabody, advance information

about the columns.99 Brant, Felis, and another person, David Clark, bought and sold stocks based

Id. at 667.

Id. at 660.

Id. at 664.

Id. at 663.

Id. at 665.

Id. at 666.

Id.

484 U.S. 19 (1987).

Id. at 23-24.

Id. at 93.

18 U.S.C. §§ 1341. 1343.

Id. § 371.

484 U.S. at 19, 22-23.

Id. at 22.

Id. at 23.

Id.

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on the probable effects of the information that would later appear in Winans’s columns.100 The

profits from these trades over a four-month period amounted to $690,000.101 Kidder Peabody’s

compliance department eventually noticed correlations between the Winans columns and the

Clark and Felis accounts.102 The SEC began an investigation; Winans and his roommate, David

Carpenter, revealed the scheme, and indictments followed.103

The Second Circuit held that Winans had knowingly breached a duty of confidentiality by

misappropriating prepublication information.104 It found that this misappropriation had violated

Section 10(b) and Rule 10b-5 because Winans’s deliberate breach of his duty of confidentiality

was a fraud and deceit on the newspaper.105 The Second Circuit also held that Winans had

fraudulently misappropriated property within the meaning of the mail and wire fraud statutes.106

In reviewing the Second Circuit’s decision, the Supreme Court was evenly divided concerning

these convictions under the securities laws and therefore affirmed, by a vote of four to four, the

Second Circuit’s opinion.107 The Court did not elaborate on whether Winans’s activities violated

the securities laws. It also affirmed the Second Circuit’s judgment with respect to the mail and

wire fraud convictions without elaboration.108

United States v. O’Hagan

Ten years later, in United States v. O’Hagan, the Supreme Court legitimated the misappropriation

theory of securities fraud by finding James O’Hagan guilty of violating Section 10(b) and Rule

10b-5.109 O’Hagan was a partner in a Minneapolis law firm that represented Grand Metropolitan

PLC (Grand Met), a company based in London. Grand Met was interested in acquiring Pillsbury

Company (Pillsbury).110 O’Hagan purchased call options for and stock in Pillsbury after he

learned of Grand Met’s interest.111 After the tender offer was publicly announced, Pillsbury stock

immediately rose.112 O’Hagan exercised his options and liquidated his stock, realizing a profit of

over $4 million.113

The SEC indicted O’Hagan on 57 counts, including securities fraud under Section 10(b) and Rule

10b-5.114 A jury convicted him on all of the counts,115 but the U.S. Court of Appeals for the Eighth

Circuit (Eighth Circuit) reversed, holding, among other things, that the misappropriation theory is

100

Id.

102

Id.

103

Id. at 22-24.

104

United States v. Carpenter, 791 F.2d 1024 (2d Cir. 1986).

105

Id. at 1031.

106

Id. at 1034-35.

107

Because of Justice Powell’s retirement, there were only eight Justices on the Court at the time of the decision.

108

484 U.S. at 25-26.

109

521 U.S. 642 (1997).

110

Id. at 647.

111

Id. at 647-48.

112

Id. at 647.

113

Id. at 648.

114

Id. at 648-49.

115

Id. at 649.

101

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inconsistent with Section 10(b).116 The Supreme Court subsequently reversed the Eighth

Circuit.117

In its decision with respect to the misappropriation theory, the Court found that O’Hagan’s

fiduciary status and his willful intent to violate that status were sufficient to find him guilty of

misappropriating confidential information:

[T]he fiduciary’s fraud is consummated, not when the fiduciary gains the confidential

information, but when, without disclosure to his principal, he uses the information to

purchase or sell securities. The securities transaction and the breach of duty thus

coincide. This is so even though the person or entity defrauded is not the other party to

the trade, but is, instead, the source of the nonpublic information . . . . A misappropriator

who trades on the basis of material, nonpublic information, in short, gains his

advantageous market position through deception; he deceives the source of the

information and simultaneously harms members of the investing public.118

United States v. Newman

A decision late in 2014 by the Second Circuit recently brought increased attention to the issue of

insider trading. In this decision, United States v. Newman, the Second Circuit overturned two

high-profile convictions for insider trading.119 The Second Circuit held that the evidence against

Todd Newman and Anthony Chiasson, who were analysts for hedge funds and investment funds,

could not sustain a guilty verdict.120 According to the Second Circuit, the government had not

adequately shown that the alleged insiders, who were employees of publicly traded technology

companies, received personal benefits for providing information to Newman and Chiasson.121 In

addition, according to the court, the government had not presented evidence that the defendants

knew that they were trading on inside information obtained from insiders who were violating

their fiduciary duties.122 According to some commenters, this decision “upended the

government’s campaign” against insider trading because it held that the government must show

that the insiders, who in this case allegedly passed on inside information, received personal

benefits, presumably of a tangible nature, in order to obtain conviction.123 Although the federal

government sought review of the Second Circuit’s decision in Newman from the Supreme

Court,124 the High Court declined to hear the case.125

116

92 F.3d 612 (8th Cir. 1996).

521 U.S. 642 (1997).

118

Id. at 656.

119

773 F.3d 438 (2d Cir. 2014).

120

Id. at 442.

121

Id. at 449-52.

122

Id. at 451-53.

123

Ben Protess & Matthew Goldstein, Appeals Court Deals Setback to Crackdown on Insider Trading, DEALBOOK

(Dec. 10, 2014), https://dealbook.nytimes.com/2014/12/10/appeals-court-overturns-2-insider-trading-convictions.

124

Alexandra Stevenson & Matthew Goldstein, U.S. Asks Supreme Court to Review Insider Trade Ruling, N.Y. TIMES

(July 30, 2015), https://www.nytimes.com/2015/07/31/business/dealbook/us-asks-supreme-court-to-review-insidertrading-ruling.html?_r=1.

125

136 S. Ct. 242 (2015).

117

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Salman v. United States

As mentioned above, the Second Circuit’s Newman decision required proof of a tangible benefit.

However, in its 2015 decision in United States v. Salman, the Ninth Circuit found that it is enough

to show that the insider and the tippee (the one who receives inside information) share a close

family relationship.126 The Ninth Circuit took specific note of the Supreme Court’s statement in

Dirks v. Securities and Exchange Commission, discussed above, that “[t]he elements of fiduciary

duty and exploitation of nonpublic information also exist when an insider makes a gift of

confidential information to a trading relative or friend.”127 Salman appealed the Ninth Circuit’s

decision to the Supreme Court, which granted review.

On December 6, 2016, the U.S. Supreme Court in Salman v. United States sided with the Ninth

Circuit, unanimously upholding the conviction of Bassam Yacoub Salman for insider trading on

tips that he had received from his brother-in-law.128 The Court agreed with federal prosecutors

that a trader can be guilty of violating insider trading prohibitions even if the insider did not

receive a tangible benefit, such as money or property, for passing the tip so long as the trader and

insider are friends or relatives. In so doing, the Court resolved a difference of opinion between the

U.S. Courts of Appeals for the Second and Ninth Circuits concerning what the government must

prove in prosecuting insider trading cases.

In its Salman decision, the Supreme Court held that the Ninth Circuit had properly applied Dirks

in affirming Salman’s conviction.129 The Court first looked to the trial court evidence that had

established there were close family and friendship relationships among Salman and others

involved in the case.130 With these close relationships in mind, the Court found that Dirks easily

resolved the issue at hand, reiterating the Dirks Court’s statement that “a jury can infer a personal

benefit—and thus a breach of the tipper’s duty—where the tipper receives something of value in

exchange for the tip or ‘makes a gift of confidential information to a trading relative or

friend.’”131

According to the Court in Salman, when an individual disclosed confidential information to his

brother with the expectation that his brother would trade on it, that individual breached his

fiduciary duty to his employer, Citigroup, and its clients.132 Then, when Salman, as a tippee,

traded on this information, knowing that it had been improperly disclosed, he too breached a duty

of trust and confidence to Citigroup and its clients.133 According to the Court, it is not necessary

that the tipper receive something of a tangible nature; rather, the breach of the fiduciary duty to a

trading relative or friend suffices to meet the standard laid out in Dirks.134

126

792 F.3d 1087 (9th Cir. 2015).

127

Id. at 1093 (quoting Dirks v. SEC, 463 U.S. 646, 664 (1983) (emphasis added)).

128

—U.S.—, 137 S. Ct. 420 (2016).

129

Id.

130

Id. at 423-25.

131

Id. at 428.

132

Id. at 428-29.

133

Id. at 429.

134

Id. at 428-29.

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Congressional Interest in Insider Trading

No bills concerning insider trading appear to have been introduced, to date, in the 115th Congress.

However, before the Supreme Court’s Salman decision, at least three bills were introduced in the

114th Congress in an attempt to prevent the type of securities trading that would appear to have

been allowed under the Newman decision.

Two of the bills would have amended Section 10, the general antifraud provision of the Securities

Exchange Act, and one of the bills would have added a new provision, Section 16A, to the

Securities Exchange Act.

H.R. 1173, 114th Congress, referred to the House Committee on Financial Services, would have

added a new subsection (d) to Section 10. This new subsection would have held a person liable

for violating the insider trading prohibition laid out in Section 2(a) of the bill if the person

intentionally disclosed “without a legitimate business purpose” information he knew or should

have known is material information and inside information. The bill would have defined “should

know” to include various factors, such as the person’s financial sophistication, knowledge of and

experience in financial matters, position in the company, and assets under management.

H.R. 1625, 114th Congress, also referred to the House Committee on Financial Services, would

have added a new Section 16A to the Securities Exchange Act. This section would have

prohibited the trading of securities if a person had material nonpublic information about the

securities or knew or recklessly disregarded that the information was wrongfully obtained or that

the securities transaction would involve a wrongful use of the information. The section would

also have prohibited a person from communicating material nonpublic information about

securities to others if: (1) others engaged in securities transactions based on the communication

and (2) the securities transactions were reasonably foreseeable. The standard for the wrongfulness

of a communication is based on information that has been obtained by activities such as theft,

breach of a fiduciary duty, or violation of a federal law protecting computer data. Specific

knowledge of how the information was obtained is not necessary for a violation so long as the

person trading was aware or recklessly disregarded that the information was wrongfully obtained

or communicated. The bill would also have authorized the SEC to provide exemptions from these

prohibitions by rule if the exemptions were not inconsistent with the purposes of the section.

S. 702, 114th Congress, referred to the Senate Committee on Banking, Housing, and Urban

Affairs, would have added a new subsection (d) to Section 10 of the Securities Exchange Act.

This new subsection would have prohibited securities transactions on the basis of material

information that a person knew or had reason to know was not publicly available. It also would

have prohibited knowingly or recklessly communicating information that was not publicly

available if it was reasonably foreseeable that the communication was likely to result in a

securities transaction. “Not publicly available” would have been defined in such a way that it

would not have included information that a person had independently developed from publicly

available sources. The SEC would also have been authorized to provide for exemptions by

regulations if it determined that such regulations were necessary or appropriate in the public

interest and consistent with the protection of investors.

The Supreme Court’s decision in Salman may accomplish at least part of the goals of the

legislation proposed in the 114th Congress. However, the Salman decision does not appear to go

as far as the bills in prohibiting the act of trading in securities with inside information and

disclosing inside information. Salman addressed the issue of whether it is necessary for a tipper to

receive something of a tangible nature when providing inside information to a trading relative or

friend. However, the bills are not limited to relatives and friends; instead, they appear to prohibit

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in a broad way the trading of securities by any person who knows or should know that he

possesses inside information.

Author Contact Information

(name redacted)

Legislative Attorney

[redacted]@crs.loc.gov , 7-....

Congressional Research Service

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