May 8, 2000
By Overnight Courier and Electronic Mail
Jonathan G. Katz, Secretary
Securities and Exchange Commission
450 Fifth Street, N.W.
Stop 6-9 - Room 6507
Washington, D.C. 20549
Re: Proposed Rules 10b5-1 and 10b5-2 under the
Securities Exchange Act of 1934 Regarding
Insider Trading; SEC File No. S7-31-99
Dear Mr. Katz:
This letter is submitted in response to a request for comments by the Securities and Exchange Commission ("SEC" or "Commission") on proposed new Rules 10b5-1 and 10b5-2 ("Proposed Rules"). These proposals have been published in Exchange Act Release No. 34-42259 (Dec. 20, 1999), 64 F.R. 72590 (Dec. 28, 1999) ("Proposing Release").
These comments have been prepared by members of the Subcommittee on Civil Litigation and SEC Enforcement Matters of the Federal Regulation of Securities Committee, Section of Business Law, and the SEC Enforcement Subcommittee of the Securities Litigation Committee, Section of Litigation, of the American Bar Association (collectively the "Ad Hoc Task Force"). A draft of this letter was circulated for comment among Chairs and Vice-Chairs of the other subcommittees and task forces of the Federal Regulation of Securities Committee, the officers of that Committee, the members of the Advisory Committee of that Committee and the officers of the Section of Business Law. It also was circulated among the Chair of the Section of Litigation and the Co-Chairs of the Securities Litigation Committee. This letter generally represents the views of those on theaforementioned Committees who have reviewed it but does not represent the official position of the American Bar Association, the Section of Business Law, the Section of Litigation or those Committees.
The Ad Hoc Task Force strongly supports the Commission's efforts to clarify the state of the law relating to insider trading and to delineate with as much precision as possible the conduct by corporate insiders and others that is contrary to law. While the recently Proposed Rules certainly evidence positive steps by the Commission, the Ad Hoc Task Force has suggestions with respect to the Proposed Rules that it believes will foster the Commission's objectives, protect investors and preserve the integrity of the securities markets. In summary, these suggestions address: (i) the Commission's approach to resolving the "use vs. possession" issue in the context of existing case law; (ii) the availability of "affirmative defenses" to liability that are compatible with normal business and marketplace practices; (iii) the clarification of existing law respecting the creation and existence of relationships of trust and confidence where business information is concerned; and (iv) the protection of privacy rights of those in personal and family relationships who become subject to inquiry by the Commission's Staff for possible insider trading. The Ad Hoc Task Force hopes that the Commission will consider the comments that follow, which address specific aspects of the Proposed Rules and respond to certain questions posed by the Commission.1
The task of legislating in this area is not easy, as was recognized by a similar task force in a report in 1985.2 Although there is no one correct approach, whatever approach is taken at this point should be designed to lessen uncertainty and reduce the number of disputes over these issues in the courts.
I. PROPOSED RULE 10b5-1
Proposed Rule 10b5-1 responds to a growing chorus of courts and commentators supporting the concept that before a person may be found liable for insider trading, proof of causation must be adduced; that is, that the trader "used" the information, rather than merely possessed it. See, e.g., SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998) (analyzing extensively Chiarella v. United States, 445 U.S. 222 (1980), Dirks v. SEC, 463 U.S. 646 (1983), and United States v. O'Hagan, 521 U.S. 642, (1997) and concluding that "use" was the mandated test under existing law) and United States v. Smith, 155 F.3d 1051 (9th Cir. 1998) (same); Allan Horwich, Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?, 52 Bus. Law. 1235 (1997). The Proposed Rule apparently responds directly to the suggestion by the United States Court of Appeals for the Eleventh Circuit in SEC v. Adler that the SEC could "promulgate a rule adopting the knowing possession standard as the SEC has done in the context of tender offers" if experience demonstrates that the Court's adoption of a "use" test proves unduly frustrating to the SEC's enforcement efforts. 137 F.3d at 1337 n.33.
It appears, however, that the Proposed Rule does not adhere strictly to the Adler court's analysis of the Commission's burden of proof and broadly shifts most of the evidentiary burden to the defendant faced with charges of insider trading. As noted in the Proposing Release, the subject matter of Proposed Rule 10b5-1 addresses "an important unsettled issue in insider trading law: whether the Commission must show in its insider trading cases that the defendant `used' the inside information in trading, or merely that the defendant traded while in `knowing possession' of the information," Proposing Release at 733 (emphasis supplied). The Proposed Rule, however, does not incorporate a "knowing possession" standard, as described in more detail below. Consequently, the Ad Hoc Task Force is concerned that the Proposed Rule's definition of "on the basis of" could be interpreted as eliminating the "knowing" aspect traditionally viewed as meeting the statute's scienter element, thereby prompting litigation over whether the definition satisfies the statutory elements.3 Furthermore, the Pro posed Rule is not limited to Commission enforce-ment matters - it could be deemed to apply to all actions, including private implied actions and criminal prosecutions arising from insider trading.4
B. Proposed Rule 10b5-1 May Exceed The Statutory Scope Of Section 10(b) Of The Exchange Act
The Commission's efforts to promulgate rules of substantive law should be consistent with, and not beyond the scope of, the enabling section, Section 10(b) of the Exchange Act. The Proposed Rule cannot adopt an interpretation of Section 10(b) and Rule 10b-5 that would proscribe conduct that falls outside the intended scope of the statutory delegation. See, e.g., Central Bank v. First Interstate Bank, 511 U.S. 164, 177 (1994) ("It is inconsistent with settled methodology in § 10(b) cases to extend liability beyond the scope of conduct prohibited by the statutory text.") "[N]ot every instance of financial unfairness constitutes fraudulent activity under Section 10(b)," Chiarella v. United States, 445 U.S. 222, 232 (1980) (citing Santa Fe Industries, Inc. v. Green, 430 U.S. 462, 474-77 (1977)), and while Section 10(b) "is aptly described as a catchall provision . . . what it catches must be fraud." Id. at 234-35. Thus, any definitional regulation must define those "manipulative or deceptive device[s] or contrivance[s]" that fall within the scope of Congressional intent.
The Adler case, drawing on dicta from the Supreme Court opinions in Chiarella, Dirks, and O'Hagan, concluded that one may not be found to have violated Rule 10b-5 by trading while in possession of material nonpublic information unless the trader "used" the information. The Adler court reached this conclusion because Section 10(b) and Rule 10b-5 proscribe fraud, and the court acknowledged that before one commits fraud he or she must take advantage ofanother. The Ad Hoc Task Force submits that "use" is the proper test in light of this persuasive analysis.
That is not to say, however, that the Commission may not promulgate a rule addressing the issue. The Ad Hoc Task Force notes that the "invitation" by the court in Adler was for the SEC, if necessary, to promulgate a Rule dealing with SEC enforcement efforts or a rule of procedure concerning presumptions, not necessarily a rule of general application under Section 10(b) of the Exchange Act.5
C. Proposed Rule 10b5-1 Could Improperly Eliminate The Scienter Requirement Of Section 10(b) Of The Exchange Act
A violation of Section 10(b) and Rule 10b-5 may not be found absent a finding of scienter on the part of the one charged with the violation. In the past, the Commission has proposed meeting the scienter requirement by arguing for a "knowing possession" test. See, e.g., Adler, 137 F.3d at 1332, 1333 n.28, and 1338; Smith, 155 F.3d at 1066 ("[w]hen a corporate insider like Smith has information relating to his company that he knows (or is reckless in not knowing) to be material and nonpublic and he trades in the company's stock, he violates the anti-fraud provisions of the federal securities laws . . ." quoting SEC Brief.) Unlike past proposals,6 Proposed Rule 10b5-1 could be interpreted to allow liability to attach to acts committed without scienter, a result that could put the Proposed Rule at risk of judicial challenge.7
The Commission's statement of the Proposed Rule's general principle that insider trading liability arises when a person trades while "aware" of material nonpublic information could be interpreted to encompass conduct different from, and in addition to, what has traditionally been understood to be "knowing possession." The Commission's discussion of the Proposed Rule does not appear to provide the provenance for the "aware" standard and, while that discussion repeatedly equates "aware" with "knowing possession,"8 the terms do not mean the same thing.
The word "aware" means "marked by realization, perception, or knowledge." Merriam Webster's Collegiate Dictionary 81 (10th ed. 1996). The dictionary further notes that "aware" may indicate either general information, wide knowledge, or vigilant perception. Id. A person may be aware of information when the person makes the purchase or sale of securities without knowing (or being reckless in not knowing) that the information is both material and nonpublic. By dropping the "knowing possession" test and adopting instead the "awareness" test, the Commission appears to have moved to a position that the possessor's knowledge need not encompass both the materiality and the nonpublic nature of the information, as long as the information of which the possessor was aware was, in fact, of that character. Absent knowledge of both these factors as a prerequisite for liability, it could be interpreted that the Proposed Rule would not meet the scienter standard required by law for rules properly promulgated under Section 10(b). Thus, assuming arguendo that a knowing possession rule would pass legal muster as delineating fraudulent conduct, the Ad Hoc Task Force is concerned that the Proposed Rule does not meet even that standard.
D. Proposed Rule 10b5-1 Appears Overbroad And Should Contain An Additional Defense To Liability
The Ad Hoc Task Force agrees with the Commission's statement in the Proposing Release that an absolute standard that necessarily would trigger insider trading liability based upon a person's "awareness" - or even "knowing possession" - of material nonpublic information concerning an issuer prior to a trade in its securities would be "overbroad." Proposing Release at 66. We further agree that, as also recognized by the Commission, in many cases in which a person reaches a decision to make a trade without any awareness of "inside" information, but then comes into possession of such information before making the trade, "a reasonable standard would not make such trading automatically illegal." Id. at 17-18.
Proposed Rule 10b5-1 seeks to address these issues by establishing four affirmative defenses that may be available to certain persons who are able to demonstrate that they made decisions to purchase or sell a security before coming into possession of material nonpublic information about such security or its issuer.9 The Ad Hoc Task Force is concerned, however, as a threshold matter, that by casting these categories as affirmative defenses, the Proposed Rule effectively would shift the burden to defendants and respondents to disprove elements of a charge brought pursuant to Rule 10b-5, e.g., scienter. Accordingly, as set forth below, the Ad Hoc Task Force suggests that, in order to be consistent with existing law, these matters more appropriately should be characterized as "safe harbors." This would leave the burden of proving the primary elements of the violation on the SEC.
Moreover, whether considered safe harbors or affirmative defenses, insofar as these items presently are both exclusive and narrowly circumscribed, the Ad Hoc Task Force is concerned that the scope of the Proposed Rule is overbroad and may not achieve the Commission's goal of creating a reasonable standard.
2. As Drafted, Proposed Rule 10b5-1 Is Overbroad
The Proposed Rule is overbroad for several reasons. First, although it provides affirmative defenses for persons who are able to demonstrate that they are encompassed within one of the four enumerated categories, other persons who similarly made a decision to buy or sell a security before coming into possession of material nonpublic information, and who acted in accordance with that decision, may not have available any express defense. For example, a person who could demonstrate that he or she had a preexisting written plan to purchase or sell a specific amount of a security at the market price, and who subsequently came into possession of inside information and then traded in accordance with the preexisting plan, may be able to take advantage of the affirmative defense within Proposed Rule 10b5-1(c)(1)(i)(C) and, accordingly, would not be liable (assuming, of course, that the plan was entered into in good faith, pursuant to paragraph (c)(ii)). On the other hand, if another person were in the identical factual situation, except had not reduced the preexisting plan to writing, no such affirmative defense may be available and he or she could face liability. The absence of documentary evidence of a plan, although obviously frustrating, cannot disprove the plan and should not preclude the defense.
Thus, the Ad Hoc Task Force is concerned that the Proposed Rule, in its current format, could subject persons who are similarly situated to different results, based not upon their relative levels of culpability or other relevant considerations, but rather based solely upon the nature of the evidence they have in support of the assertion that they had made a decision to trade before coming into possession of material nonpublic information. To the extent that the Proposed Rule would create such distinctions and lead to such differing results, the Ad Hoc Task Force is concerned that it is overbroad and does not create a reasonable standard.10
Second, the Ad Hoc Task Force submits that the Proposed Rule may be unnecessarily broad to the extent that its first three affirmative defenses include the requirement that the "amount," "price" and "date" of such trades must all have been specified prior to the receipt of inside information. In practice, agreements, instructions or plans often do not all contain such specifications for a variety of reasons. Price, for example, cannot always be predicted because of market fluctuations. Specific dates and the total amount of orders are also often omitted in order to permit flexibility depending upon the market and other factors. Thus, the Ad Hoc Task Force believes that these requirements within the Proposed Rule may be overly restrictive and impractical in many normal business transactions. The Ad Hoc Task Force submits that whether or not a person provided all such details before receiving inside information should be considered in determining whether the person had reached a decision to trade before coming into possession of such information, but should not be required for such a determination
Third, the proposed affirmative defenses are unnecessarily restrictive insofar as they could be interpreted to exclude limit orders. Under the Proposed Rule, affirmative defenses would be available for a "contract, plan, or instruction to trade" that utilizes a market order, but not a limit order. Proposing Release at 40, note 88. The Ad Hoc Task Force believes that excluding limit orders from the affirmative defenses would not further the purposes of the Proposed Rule. Indeed, as part of its investor education program, the Commission has encouraged investors to consider using limit orders in order to avoid executions at unanticipated prices in volatile markets. Accordingly, these affirmative defenses should extend explicitly to limit orders.
It appears that the principal theme underlying these affirmative defenses is that, before becoming aware of material nonpublic information, a person provided instructions to another person to execute a trade. Differentiating between marketand limit orders, however, appears to create a distinction without a meaningful difference. Note 88 of the Proposing Release suggests that by using a limit order, the person would not firmly be committed to make a trade because if, on the relevant date, the market price did not reach the limit price, a trade would not be executed. The Ad Hoc Task Force believes that this suggestion incorrectly focuses upon whether a trade is actually executed. The analysis of the affirmative defenses should instead turn on whether the person knowingly possessed material nonpublic information at the time of the "contract, plan, or instruction to trade." Proposing Release at 41. If the person did not knowingly possess material nonpublic information at the time he set the trade in motion, a defense should be available irrespective of the type of order utilized.
This may be demonstrated best by example. Assume that an employee of a public company is given 1,000 shares of her company's stock on March 1, 2000 with the condition that she not sell the shares for one year. Assume further that the employee pays income taxes on the shares based on the March 1, 2000 closing price of $50 per share. If on March 1, 2000 the employee places a limit order to sell 1,000 shares at $50 per share or the market price, whichever is greater, on March 1, 2001, the date the restriction lapses, and she did not possess material nonpublic information at the time the order was placed, the transaction should be covered by the defense. The Ad Hoc Task Force finds it difficult to anticipate circumstances where a market order should be protected while a limit order entered at the same time for the identical number of shares would be considered fraudulent. In short, the Ad Hoc Task Force submits that the person's state of mind at the time the decision is made to place the order should be dispositive, not the type of order utilized.
3. The Affirmative Defenses Should Be Re-Designated Or Should Include An Additional Defense
In order to avoid impermissibly shifting the burden to defendants and respondents to disprove elements of a Rule 10b5-1 charge, the Ad Hoc Task Force submits that the Commission could re-designate the "affirmative defenses" within the Proposed Rule as non-exclusive safe harbors. In the alternative, the Ad Hoc Task Force recommends that the Commission amend Proposed Rule 10b5-1 to provide a catch-all affirmative defense for persons other than those encompassed within paragraphs (c)(1)(i)(A)-(D), who can demonstrate that they reached adecision to make a particular trade without knowledge of material nonpublic information, and subsequently acted in accordance with that decision.11
E. The Commission Should Not Require Written Plans Or Instructions In All Cases
The Commission has requested comments on whether the Proposed Rule should require written plans or instructions in all cases, in order for the affirmative defenses to be available. As discussed in the preceding section, the Ad Hoc Task Force strongly believes that the Commission should not require written plans or instructions in all such cases.
We note that paragraphs (c)(1)(i)(A) (binding contracts) and (c)(1)(i)(B) (instructions for transactions) of the Proposed Rule do not presently require writings, and that paragraphs (c)(1)(i)(C) and (D) do require written plans. As discussed above, if the Proposed Rule were made even more restrictive in all cases, persons who made a decision to make a particular trade without any awareness of material nonpublic information who subsequently came into the possession of such information and then traded in accordance with their original decision, could be subject to liability if they had not originally reduced their decision to writing. Rather than permitting this inequitable result, such persons should be permitted to introduce evidence to demonstrate facts supporting their claim that they decided to make the trade before coming into possession of the nonpublic information, irrespective of whether such evidence is written.
F. The Commission Should Not Require That Contracts, Instructions Or Trading Plans Be Approved By Counsel
The Commission also has requested comments as to whether it should require that contracts, instructions or trading plans be approved by counsel, in order for a person to be able to invoke one of the affirmative defenses to Proposed Rule 10b5-1. The Ad Hoc Task Force believes that it would be inappropriate to impose such a requirement.
As discussed above, consistent with statements of the Commission in the Proposing Release, the Ad Hoc Task Force believes that the appropriate focus of the affirmative defenses should be whether the alleged inside trader is able to demonstrate that he or she made a decision to place a particular trade without any knowledge of material nonpublic information, and then acted in accordance with that decision. Any requirement that counsel approve all contracts, instructions or plans in order for the affirmative defenses under the Proposed Rule to be available would not further the analysis of that issue. At the same time, the cost to investors of compliance with any such requirement would be substantial. If such a rule were adopted investors would have to choose between incurring such significant cost or waiving the availability of an affirmative defense in the event they subsequently received material nonpublic information.
In addition, because in many cases smaller, non-professional investors would be unlikely to be aware of any such requirement or would not be able to afford the cost of compliance with it, they would be unfairly disadvantaged in that the affirmative defenses under the Proposed Rule would not be available to them. Finally, imposition of such a requirement would be likely to lead to unnecessary intrusion into attorney-client relationships and litigation with respect to issues involving applicability of privilege and waiver of privilege. See, e.g., United States v. Bilzerian, 926 F.2d 1285, 1291-94 (2d Cir.), cert. denied, 502 U.S. 813 (1991).
G. The Affirmative Defense For Trading Entities Is Too Restrictive
The Ad Hoc Task Force believes that Proposed Rule 10b5-1(c)(2)(ii), the affirmative defense for entities that trade, is too restrictive for the following reasons: (1) the language of the Proposed Rule concerning written rules and procedures is materially different from the language in Section 15(f) of the Exchange Act and might be interpreted to require a higher standard than Section 15(f), which would be unwarranted and impractical; and (2) there should be two separate defenses for corporate entities: (a) that the person who made the trading decision was unaware of the material nonpublic information when he or she made that decision; or (b) that the entity established, maintained, and enforced written policies and procedures reasonably designed to prevent insider trading.
1. The Standard For Written Policies And Procedures In The Proposed Rule Could Be Interpreted Differently From That In Section 15(f) Of The Exchange Act
Proposed Rule 10b5-1(c)(2)(ii), through language that Congress implicitly rejected, might potentially make compliance with current requirements imposed upon broker-dealers and investment advisers too difficult to meet. Specifically, the use of the term "to ensure" in subparagraph (c)(2)(ii) of the Proposed Rule might be interpreted as imposing a higher standard on written policies and procedures than that which currently exists in Section 15(f) of the Exchange Act, 15 U.S.C. § 78o(f), and Section 204A of the Investment Advisers Act of 1940 ("Advisers Act"), 15 U.S.C. § 80b-4. Indeed, if the term "ensure" is given its common meaning - to make certain or inevitable an outcome - any time that an employee of a broker-dealer or investment adviser is found to have traded on the basis of material nonpublic information, that entity's policies and procedures could be viewed, in hindsight, as having been insufficient to "ensure" that such unlawful trading practices would not take place. Because such a standard is both onerous and impractical, the Ad Hoc Task Force respectfully opposes the adoption of the Proposed Rule as currently drafted.
In 1988, Congress passed the Insider Trading and Securities Fraud Enforcement Act ("ITSFEA"). Section 15(f) of the Exchange Act, which was adopted thereunder, requires that broker-dealers and investment advisers "establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such broker-dealer's business, to prevent the misuse in violation of this title, or the rules or regulations thereunder, of material, nonpublic information by such broker or dealer or any person associated with such broker or dealer." (Emphasis added). Section 204A of the Advisers Act requires the same of investment advisers.
The language of Proposed Rule 10b5-1(c)(2)(ii) is significantly different and could be interpreted to require a firm's written policies and procedures to meet a higher standard than that which Congress approved in Section 15(f) of the Exchange Act and 204A of the Advisers Act. Proposed Rule 10b5-1 provides that for entities that trade, "a purchase or sale of securities is not < on the basis of' material nonpublic information if the person demonstrates that: . . . [t]he person had implemented reasonable policies and procedures, taking into consideration the nature of the person's business, to ensure that individuals making investment decisions would not violate the laws prohibiting trading on the basis of material nonpublic information." (Emphasis added.)
The common understanding of the terms "prevent" and "ensure" is materially different. While the term "[p]revent implies taking advance measures against something possible or probable," (Merriam Webster's Collegiate Dictionary 924 (10th ed.1996)), the term "ensure" indicates "the making certain or inevitable of an outcome." Id. at 386.
The summary of the Proposed Rule states that the affirmative defense for trading entities "is derived from the defense against liability currently provided in Exchange Act Rule 14e-3(b) regarding insider trading in a tender offer situation." Proposing Release at 24. The "ensure" standard imposed by Rule 14e-3(b), however, was implicitly rejected by Congress when it adopted ITSFEA. Had Congress intended to impose such a potentially burdensome standard it could easily have done so. Rule 14e-3(b) was in existence at that time. Instead, Congress used the term "prevent." While Sections 15(f) of the Exchange Act and 204A of the Advisers Act grant the SEC the power to require specific policies and procedures designed to prevent the misuse of nonpublic information (authority to date the Commission has not exercised), it appears that Congress did not grant the SEC the power to change the standard that such policies and procedures must meet in order to be in compliance with the law.
Based upon language in the Proposing Release, the Ad Hoc Task Force believes that the Commission may have intended that subsection (c)(2)(ii) be interpreted consistently with Sections 15(f) of the Exchange Act and 204A of the Advisers Act. Indeed, the SEC's summary of the Proposed Rule provides that to meet the defense, entities that trade must demonstrate that "the entity had implemented reasonable policies and procedures (e.g., informational barriers, restricted lists) to prevent insider trading." Proposing Release at 69 (emphasis added).
The Ad Hoc Task Force believes that it is particularly important that there be no ambiguities with respect to the requirement that broker-dealers create written policies and procedures reasonably designed to prevent insider trading, because the SEC has stated that a firm's failure to meet this requirement is, itself, a violation of the Exchange Act, as the SEC concluded in a recent settled case. See In the Matter of Certain Market Making Activities on NASDAQ, Exchange Act Rel. No. 40910 (Jan. 11, 1999) ("[t]he fact that neither the trader nor J.P. Morgan is charged with insider trading in violation of the antifraud provisions does not affect the Section 15(f) charge. Section 15(f) by its terms requires reasonable policies and procedures, and an underlying insider trading violation is not a predicate to a Section 15(f) charge.")
The Ad Hoc Task Force suggests that Proposed Rule 10b5-1 be modified by making direct reference to the requirements of Sections 15(f) of the Exchange Act and 204A of the Advisers Act in subsection (c)(2)(ii). In the alternative, the Ad Hoc Task Force recommends that the subsection be modified by changing the phrase "ensure . . . would not violate" to the words "prevent from violating."
2. The Two Requirements Of The Affirmative Defense For Entities That Trade Should Be Independent And Separate Defenses
Proposed Rule 10b5-1(c)(2)(ii) is also too restrictive in that the trading entity, to prove that it did not trade on the basis of material nonpublic information, must demonstrate both that the individual who made the investment decision was not aware of the information and that the corporate entity had implemented reasonable policies and procedures to ensure that the individuals making investment decisions would not trade on the basis of material nonpublic information.12 Once an entity has demonstrated that insider trading has not taken place, an inquiry into its policies and procedures is both unnecessary and inappropriate.
The Ad Hoc Task Force believes that if a trading entity develops reasonable policies and procedures designed to prevent individuals from trading on the basis of material nonpublic information and maintains and enforces such protocols, that firm should not be penalized if one of its employees ignores such policies and trades unlawfully. The Ad Hoc Task Force believes that the Proposed Rule, as written, could be read as imposing strict liability on broker-dealers and investment advisers for the acts of their employees, a standard that is contraryto the standard for controlling person liability set forth in Section 21A of the Exchange Act, 15 U.S.C. § 78u-1(a).13
It is clear that Congress did not wish to penalize broker-dealers and investment advisers simply for employing a person who violated the prohibition against insider trading. Section 21A(b)(2) of the Exchange Act explicitly provides that "[n]o person shall be subject to a penalty . . . solely by reason of employing another person who is subject to a penalty" for insider trading. The legislative history makes clear that Congress did not intend to impose strict liability on broker-dealers and investment advisers for the actions of their employees. Congressman Norman Lent, one of the original sponsors of ITSFEA, speaking in favor of the legislation, stated that "[t]he bill requires a causal nexus between the failure of the controlling person's surveillance system and the controlled person's violation, but the bill does not impose absolute liability on controlling persons for violations by their controlled persons." Cong. Rec. H 7470 (Sept. 13, 1988). Congressman Edward Markey, the principal author of ITSFEA, similarly stated that the standard of controlling person liability was "carefully crafted" and "[w]e seek not strict liability . . . ." Cong. Rec. E 3078 (Sept. 23, 1988).
The affirmative defense for trading entities provided in Proposed Rule 10b5-1 could be interpreted to contravene this intent. By stating that the defense for trading entities is not available unless the entity can demonstrate both that the firm had reasonable policies and procedures in place and that the trader did not trade on the basis of nonpublic information, the Proposed Rule could be read to make a trading entity strictly liable for the acts of its employees with respect to insider trading. In light of the Proposed Rule's apparent conflict with Section 21A of the Exchange Act, the Ad Hoc Task Force recommends that the Proposed Rule be modified as described below.
The Ad Hoc Task Force also believes that if a trading entity can demonstrate that the individual who made the investment decision was unaware of the nonpublic information when that person made the trade, the firm should not have to demonstrate that its written policies and procedures were sufficient in order to make use of the affirmative defense and avoid liability for insider trading.
The Ad Hoc Task Force suggests that Proposed Rule 10b5-1 delineate two separate affirmative defenses for trading entities: (1) to demonstrate that the person who made the trading decision was not aware of the material nonpublic information; or (2) that the firm established, maintained, and enforced written policies and procedures pursuant to Sections 15(f) and 204A.14 This modification would promote clarity and certainty in the existing state of the law on insider trading while being equitable and consistent with Congressional intent. Further, the Proposed Rule, as modified, would not alter the current obligation of broker-dealers and investment advisers to establish reasonable written policies and procedures to prevent insider trading.
II. PROPOSED RULE 10b5-2
Proposed Rule 10b5-2 sets forth a non-exclusive definition of three circumstances in which an individual has a duty of trust or confidence for purposes of the misappropriation theory of insider trading liability under Section 10(b) of the Exchange Act. The first two prongs of the Proposed Rule, respectively, define duties of confidentiality whenever an individual agrees to keep information confidential, and where there is a history, pattern or practice of sharing confidences that creates a reasonable expectation of confidentiality. The Ad Hoc Task Force submits that these two prongs should be modified in order to make them (1) consistent with existing case law, (2) capable of more precise application, and (3) protective of privacy rights. The third enumerated duty of confidence arises when an individual receives material nonpublic information from his or her spouse, parent, child or sibling.15 The Ad Hoc Task Force agrees with comments made at the Commission's open meeting when this Proposed Rule was released, cautioning that the Commission should not erode the protections of personal privacy by creating duties of confidentiality that require intrusions into intimate individual and family matters. The Ad Hoc Task Force supports the Commission's effort to clarify the law of insider trading but advocates a measured and deliberate approach, carefully balancing the rights of individuals and families in this new regulatory framework.
B. Proposed Rule 10b5-2(b)(1)
Proposed Rule 10b5-2(b)(1) provides that a duty of trust or confidence shall exist "[w]henever a person agrees to maintain information in confidence." The Ad Hoc Task Force submits that considering the principles set forth in prongs two and three of the Proposed Rule, 10b5-2(b)(1) should be modified to read that a "duty of trust or confidence" shall exist "[w]henever a person expressly (or explicitly) agrees to maintain information in confidence."
In United States v. Chestman, 947 F.2d 551 (2d Cir. 1991), cert denied, 503 U.S. 1004 (1992), the Second Circuit Court of Appeals held that a "fiduciary duty cannot be imposed unilaterally by entrusting a person with confidentialinformation." Id. at 567 (citing Walton v. Morgan Stanley & Co., 623 F.2d 796, 799 (2d Cir. 1980)). The Chestman court explained that absent an explicit acceptance of confidentiality, an acceptance can only be implied from a pre-existing fiduciary-like relationship that included the prior sharing of business confidences. Chestman, 947 F.2d at 571.
The Ad Hoc Task Force notes that there may be some instances where acceptance can be implied in particular pre-existing "fiduciary-like" relationships. However, as drafted, the first prong of the Proposed Rule could be interpreted to extend an implicit acceptance of confidentiality to relationships between causal acquaintances and friends that never discuss business. Although parties to a business relationship will often have a reasonable expectation of confidentiality, the same cannot always be said of individuals in a familial or personal relationship. Non-business relationships are subject to varying expectations that are influenced by subjective views, prior history, frequency of contact, age, etcetera. These factors, among others, in all likelihood will be considered in inquiries under prongs two and three of the Proposed Rule. Accordingly, prong one should be clarified and modified to find a duty of trust or confidence only when a person expressly or explicitly agrees to treat information received as confidential.
C. Proposed Rule 10b5-2(b)(2)
Proposed Rule 10b5-2(b)(2) states that a duty of trust or confidence shall exist:
whenever the person communicating the material non-public information and the person to whom it is communicated have a history, pattern, or practice of sharing confidences, such that the person communicating the material non-public information has a reasonable expectation that the other person would maintain its confidentiality.
As written, the Ad Hoc Task Force believes that this Proposed Rule does not provide a well-defined standard and may cause the erosion of individual privacy rights.
1. The Proposed Rule Contradicts the Misappropriation Theory And Is Subjective
Proposed Rule 10b5-2(b)(2) appears to contradict the basis upon which the misappropriation theory has developed and is inherently subjective. The Proposed Rule would in effect create a duty of trust or confidence based entirely upon the subjective expectations of the person communicating the information. By focusing on the expectations of the person communicating the information, the Proposed Rule disregards the premises upon which the misappropriation theory was formed. In other words, the Proposed Rule appears to focus on the state of mind of the wrong party.
Under the misappropriation theory, a person commits a fraud in violation of Section 10(b) of the Exchange Act and Rule 10b-5 by misappropriating material nonpublic information for securities trading purposes, in breach of a duty of loyalty and confidence. The misappropriation theory is based on the notion that the trading party intentionally committed some sort of "abuse" or "wrong" in using the material nonpublic information. In drafting Proposed Rule 10b5-2, the Commission noted that it was attempting to address situations where "the trader's informational advantage `stems from contrivance, not luck.'" Proposing Release at 84. The ultimate focus of the misappropriation theory has always been based on the intent and actions of the individual who received the information and then traded.
However, it appears that under the Proposed Rule, the legal obligations and duties of the trading party are rooted in the expectations of the communicating party. Pursuant to the Proposed Rule, if the person communicating the material nonpublic information has the expectation that the individual receiving the information will maintain its confidentiality, then the recipient, by definition, will be deemed to have a duty of trust or confidence. The Proposed Rule does not address the expectations of the individual receiving the information. Theoretically, the Proposed Rule may apply equally to legally bind both individuals seeking to abuse a confidential relationship by exacting information for a personal advantage and those who honestly and innocently did not believe that the relationship was a confidential one or that the information was to be kept in confidence. The Ad Hoc Task Force is concerned that the potential for such an outcome is at odds with the underlying premise of the misappropriation theory of insider trading liability, the statute's scienter requirement, and the Commission's basis for the Proposed Rule.
At a minimum, the Ad Hoc Task Force submits that the Commission should revise the Proposed Rule to require that the expectations of confidentiality be mutual. In United States v. Reed, the court stated that "the mere unilateral investment of confidence by one party in the other ordinarily will not suffice to saddle the parties with the obligations and duties of a confidential relationship." 601 F. Supp. at 715. The Reed court reasoned that a confidential relationship exists only when there is evidence to show that "the confidence reposed by the communicating party was actually accepted by the other." Id.
The issue is further complicated by the subjective nature of the term "confidences." There are varying degrees of confidences. What may be deemed confidential information by one person, may not be confidential to another person. Depending on the perspectives of the individuals sharing the information, there may or may not be agreement as to whether the communication constituted a confidence. Even if they agree a confidence was shared, the parties to a communication may not be defining the term "confidence" in the same way as, or consistently with, the SEC's rule. For example, one person may view "confidential" as restricting communications outside of a small circle of people, while another may define the term as restricting communications from everyone. Thus, whether or not two individuals have the same expectation of confidentiality may depend entirely upon their respective understandings.
2. The Language Of The Proposed Rule Is Vague
The language of Proposed Rule 10b5-2(b)(2) is vague because it lacks definitions or minimum standards for several key terms. First, the language of the Proposed Rule is silent as to what may constitute a "history" of sharing confidences for purposes of insider trading liability. The term history can have an expansive reach, spanning many years. In addition, the nature of a particular relationship can change with the passage of time and the personality of the individuals. For example, two people may have been close friends throughout college, sharing secrets and confidences with one another. However, after graduation the friends may have grown apart, with their contact having become sporadic and more distant. Applying the express language of the Proposed Rule, the two individuals would have a history of sharing personal confidences; however, given the lapse in time and the deterioration of their friendship, it may not be reasonable to categorize it as a confidential relationship. Unfortunately, the Proposed Rule does not address either the deterioration of a relationship in which confidences had previously been shared or the significant lapse of time between shared confidences.
The Ad Hoc Task Force suggests that the Commission consider defining precisely what constitutes a "history" for purposes of Proposed Rule 10b5-2(b)(2). At a minimum, the Ad Hoc Task Force suggests that the adjective "recent" be added to modify the term "history." This may limit the amount of time permitted between the shared confidences and ensure that the history of shared confidences be ongoing and current at the time the material nonpublic information is communicated.
Similarly, Proposed Rule 10b5-2(b) does not provide any standards to govern the terms "pattern or practice." Absent from the Proposed Rule is guidance regarding how many, how frequent, and how close in proximity the confidences must be to give rise to a pattern or practice of sharing confidences. The Ad Hoc Task Force recommends that the Commission consider adopting a minimum standard for pattern or practice.
3. The Scope Of The Proposed Rule May Cause The Erosion Of Privacy Rights
Proposed Rule 10b5-2(b)(2) applies to personal as well as business confidences.16 The Ad Hoc Task Force believes that this broad approach would likely result in a further erosion of individual privacy rights. The Proposed Rule may increase the likelihood of the Commission's Staff unnecessarily prying into the personal lives of individuals during investigations, thus opening the floodgates to irrelevant and private information. Indeed, the Commission recognizes that the rule "may require an unduly intrusive examination of the details of the particular . . . relationships." Proposing Release at 85.
Such an intrusion is not only possible, but in fact may be required by the very nature and operation of the Proposed Rule. In order for the Commission's Staff to establish that a duty of trust or confidence existed between individuals it would need to show "a history, pattern or practice of sharing confidences." Therefore, the SEC investigation may focus on gathering information about the extent to which confidences were shared as well as the nature of those confidences. Such confidences could include a myriad of sensitive, personal information, including, among other things: (1) medical information; (2) marital informa tion, such as divorce or infidelity; (3) sexual orientation or practices; (4) familial information, such as adoption; and (5) psychological information, such as therapy or rehabilitation. In addition, it is important to note that all of the personal information that is revealed during the course of the SEC's investigation, whether through testimony or document requests, will likely have little, if anything, to do with the investigation into the alleged insider trading violation, or indeed with whether an expectation of business confidentiality existed. For example, some people may receive confidential personal information with an expectation that the information would be kept private, but would not expect any shared business information to receive the same protections. Therefore, the Ad Hoc Task Force suggests that in light of the unnecessary intrusion into the private lives of individuals which will result from the implementation of the Proposed Rule, the Proposed Rule should be limited in its coverage to reach only those circumstances where there is a history, pattern or practice of shared business confidences.
D. Proposed Rule 10b5-2(b)(3)
The Ad Hoc Task Force believes that the Commission should not regulate family relationships. As drafted, the third enumerated duty under Proposed Rule 10b5-2(b) unfairly generalizes relationships of modern families and may encourage the Commission's Staff, when enforcing the Proposed Rule, to intrude into the privacy of family units. Moreover, the third enumerated duty is unnecessary as it includes relationships already covered by the first and second aspects of the Proposed Rule. In the event that the Commission adopts a family-based duty of confidentiality, the Ad Hoc Task Force recommends that it distinguish between business and personal confidences and only cover individuals living in the same household.
1. The Proposed Rule Fails To Properly Distinguish Between Business And Personal Confidences
As discussed in depth in above, and as the Proposing Release recognizes, United States v. Chestman requires an express agreement of confidentiality or a fiduciary-like relationship that included the prior sharing of business confidences between the parties in a family relationship to establish the necessary duty under the misappropriation theory. In other words, as described above, a pattern or practice creating expectations of a confidential relationship outside of the business context is an insufficient basis under which to create a duty of confidentiality. Many modern families adopt patterns of confidentiality for business issues or other related topics that do not translate to non-business topics. The Ad Hoc TaskForce believes that it is unfair and inappropriate for the Commission's Staff either to probe personal confidences or to presume them.
Furthermore, the Ad Hoc Task Force believes that the Proposed Rule's lack of distinction between business and personal confidences might have the unintended effect of causing an increase in cases brought based upon circumstantial evidence. An illustrative example is a case where one spouse has traded in a security at a time when the other had material nonpublic information about that security by virtue of her employment. The Proposed Rule presumes a fiduciary-like relationship in which that material nonpublic information might be disclosed. Both spouses testify that they protect one another's personal confidences, but do not have a practice of sharing business confidences. With the duty burden satisfied, however, the Staff may be emboldened to bring a circumstantial case, challenging the spouses' credibility and the sufficiency of their testimony to rebut the presumption of a fiduciary-like relationship. The Ad Hoc Task Force believes that the Proposed Rule would therefore also increase reliance upon credibility determinations, leading to the likelihood of unfair enforcement results.
2. The Proposed Rule's Affirmative Defense Improperly Diminishes The Protections Of The Spousal Privilege By Intruding On Family Privacy
A laudable goal of Proposed Rule 10b5-2(b)(3) is to create certainty under the misappropriation theory by imposing a duty of trust and confidence upon parties to core familial relationships. The benefits of this clarity, however, are outweighed by the intrusion the Proposed Rule will impose upon family privacy. In the context of investigations, the Commission's Staff recognizes that confidential communications between spouses are privileged. If adopted, the Proposed Rule's affirmative defense may force innocent persons under inquiry to reveal all of their undisclosed secrets or to explain the reason why they declined to share intimate confidences with a spouse, thereby waiving the marital communications privilege. The Proposed Rule may even lead the Commission's Staff to question whether one spouse has shared a secret with the other, and if so, the nature of that secret.
On the other hand, in situations where spouses choose to protect the intimacy of the family by invoking the confidential marital communicationsprivilege, an adverse inference may be unfairly drawn.17 The Ad Hoc Task Force believes that the Proposed Rule does not, as suggested at the SEC's open meeting, get the Commission away from examining family relationships. Rather, it requires the Commission's Staff to examine family relationships in anticipation of defenses to liability. The Commission, therefore, appears to be drawing a line that forces families to choose between (a) disclosing medical, religious and other private matters to the government in order to avoid prosecution, or (b) protecting intimate family details by invoking the spousal privilege, thereby potentially putting more families at risk for a finding of insider trading liability.
3. The Relationships Described In Proposed Rule 10b5- 2(b)(3) Are Too Broad To Be Equitable Yet Too
Narrow To Cover All Familial Relationships That Involve The Sharing Of Confidences
Implicit in the familial relationships covered by the Proposed Rule is the presumption that modern family units are composed of traditional family members, each of whom regularly shares and preserves private confidences. A sober look at households at the turn of this century, however, reveals the complex composition of modern families, many of which are not covered by the Proposed Rule. Many modern families include relationships, such as domestic partners, stepparents and stepchildren, not addressed by the Proposed Rule. The Ad Hoc Task Force believes that the Proposed Rule does not set forth an adequate basis for explaining why the Commission would presume an expectation of trust between grown siblings living apart, but not between, for example, step-siblings living together. If the Commission adopts Proposed Rule 10b5-2, the Ad Hoc Task Force suggests that it be tailored to address relationships between individuals living in the same household.
The Ad Hoc Task Force appreciates the opportunity to comment on the Proposed Rules. The Ad Hoc Task Force hopes the Commission will consider the views expressed in this Comment Letter in determining whether to approve the Proposed Rules. Members of the Ad Hoc Task Force would be pleased to meet with the SEC to discuss the Proposed Rules and this Comment Letter.
Chair, Federal Regulation of Securities
Committee of the Section of Business Law
Steven W. Hansen
Co-Chair, Securities Litigation Committee
of the Section of Litigation
AMERICAN BAR ASSOCIATION SECTIONS, COMMITTEES, AND
SUBCOMMITTEES REPRESENTED ON THE AD HOC TASK FORCE
OF THE SECTIONS OF BUSINESS LAW AND LITIGATION
|Section of Business Law||Section of Litigation|
|Chair, Michael E. Flowers||Chair, H. Thomas Wells, Jr.|
|Federal Regulation of Securities Committee
of the Section of Business Law
|Securities Litigation Committee of the Section of Litigation|
Chair, Stanley Keller
|Co-Chair, Wendy A. Grossman
Co-Chair, Steven W. Hansen
Co-Chair, Alan Schulman
|Civil Litigation and SEC Enforcement Matters Subcommittee of the Federal Regulation of Securities Committee of the Section of Business Law||SEC Enforcement Subcommittee of the Securities Litigation Committee of the Section of Litigation|
|Co-Chair, W. Hardy Callcott
Chair, Colleen P. Mahoney
|Co-Chair, Andrew W. Sidman
Co-Chair, Harry J. Weiss
|AD HOC TASK FORCE MEMBERS|
|W. Reece Bader||George B. Parizek|
|Gerald E. Boltz||Marvin G. Pickholz|
|W. Hardy Callcott||Anthony Ragozino|
|Todd D. Brody||Dan Schnipper|
|Kenneth Fuchs||Lara Schwartz|
|Charlie J. Gambino||Andrew W. Sidman|
|Bruce A. Hiler||Howard S. Sussman|
|Ben A. Indek||Mike Trager|
|Richard L. Jacobson||Harry J. Weiss|
|Dixie L. Johnson||Burton W. Wiand|
|Colleen P. Mahoney||Michael K. Wolensky|
|Keith W. Miller||Jeffrey Zuckerman|
|I. PROPOSED RULE 10b5-1|
|B. Proposed Rule 10b5-1 May Exceed The Statutory Scope Of Section 10(b) Of The Exchange Act|
|C. Proposed Rule 10b5-1 Could Improperly Eliminate The Scienter Requirement Of Section 10(b) Of The Exchange Act|
|D. Proposed Rule 10b5-1 Appears Overbroad And Should Contain An Additional Defense To Liability|
|2. As Drafted, Proposed Rule 10b5-1 Is Overbroad|
|3. The Affirmative Defenses Should Be Re-Designated Or Should Include An Additional Defense||E. The Commission Should Not Require Written Plans Or Instructions In All Cases|
|F. The Commission Should Not Require That Contracts, Instructions Or Trading Plans Be Approved By Counsel|
|G. The Affirmative Defense For Trading Entities Is Too Restrictive|
|1. The Standard For Written Policies And Procedures In The Proposed Rule Could Be Interpreted Differently From That In Section 15(f) Of The Exchange Act|
|2. The Two Requirements Of The Affirmative Defense For Entities That Trade Should Be Independent And Separate Defenses|
|II. PROPOSED RULE 10b5-2|
|B. Proposed Rule 10b5-2(b)(1)|
|C. Proposed Rule 10b5-2(b)(2)|
|1. The Proposed Rule Contradicts the Misappropriation Theory And Is Subjective|
|2. The Language Of the Proposed Rule is Vague|
|3. The Scope Of The Proposed Rule May Cause The Erosion Of Privacy Rights|
|D. Proposed Rule 10b5-2(b)(3)|
|1. The Proposed Rule Fails To Properly Distinguish Between Business And Personal Confidences|
|2. The Proposed Rule's Affirmative Defense Improperly Diminishes The Protections Of The Spousal Privilege By Intruding On Family Privacy|
|3. The Relationships Described In Proposed Rule 10b5-2(b)(3) Are Too Broad To Be Equitable Yet Too Narrow To Cover All Familial Relationships That Involve The Sharing Of Confidences|