April 24, 2000

United States Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609

E-mail address: rule-comments@sec.gov

Attn: Jonathan G. Katz, Secretary

Comment Letter Re: Proposed Rule 10b5-1
Release No. 33-7787, 34-42259, IC-24209

File No. S7-31-99                                       

Ladies and Gentlemen:

Thank you for this opportunity to comment on the Commission's December 20, 1999 proposal to clarify certain aspects of Exchange Act §10(b) and Rule 10b-5 through the promulgation of a new rule - Rule 10b5-1. As a Professor of Law at the University of Cincinnati College of Law, I both write and teach in the areas of securities regulation and corporate law. The Commission's proposed Rule 10b5-1 holds particular interest for me because the debate that prompted the rule - the so-called "possession vs. use" debate - was the focus of my most recent law review article, The "Possession vs. Use" Debate in the Context of Securities Trading by Traditional Insiders: Why Silence Can Never Be Golden, 67 University of Cincinnati Law Review 1129-1200 (1999), a copy of which is enclosed.

Although my article thoroughly analyzes (and, in the context of traditional insiders, zealously defends) the Commission's long-standing position that "knowing possession" of material nonpublic information is the operative standard for determining Rule 10b-5 liability in insider trading cases, it did not anticipate the Commission's new, surprising willingness to recognize affirmative defenses which allow securities traders with certain "pre-existing plans, contracts, or instructions" to trade with impunity under Rule 10b-5 despite their awareness of inside information. Because the proposed rule's prohibitions and its affirmative defenses are both over-inclusive and under-inclusive, and because the specific language chosen for the proposed rule is confusing and contradictory, I am submitting this comment letter to express my view that proposed Rule 10b5-1 should not be adopted in its present form.

Specifically, this comment identifies and expounds upon three principal concerns:


In view of these concerns, I respectfully offer the recommendation that the Commission reject proposed Rule 10b5-1 in its entirety. Although I applaud the Commission's attempt to resolve the "possession vs. use" controversy through the rulemaking process, it is my opinion that the Commission is attempting to accomplish too much with a single rule that is applicable to all securities traders. Indeed, for the reasons set out more fully below, I would urge the Commission to recognize that creating a single test for Rule 10b-5 liability in insider trading cases is simply not possible because traditional insiders and other securities traders stand in very different positions vis-a-vis the shareholders with whom they are trading. In light of these differences, I would urge the Commission to consider promulgating a narrowly tailored rule that would apply only to securities trading by traditional insiders - a rule that would make clear that traditional insiders (defined as an issuer's officers, directors, controlling shareholders, and the issuer itself) must disclose or abstain from trading the corporation's shares any time when they are in "knowing possession" of material nonpublic information. With respect to other securities traders, Rule 10b-5, against the backdrop of the case law now in existence, is sufficient to govern the conduct of persons who engage in fraud and deception by affirmatively using material nonpublic information in the course of their securities transactions.


I. The "Disclose or Abstain" Rule Set Out in Cady, Roberts and Chiarella Makes Clear That "Pre-Existing" Trading Plans or Arrangements Should Not Operate to Absolve Traditional Insiders From Rule 10b-5 Liability When They Remain Silent About Material Nonpublic Facts in Transactions with the Corporation's Shareholders

For almost forty years, the so-called "disclose or abstain" rule has been an integral part of the insider trading prohibition imposed by the federal securities laws. As first articulated by the Commission in the landmark case of In the Matter of Cady, Roberts & Co., 40 S.E.C. 907 (1961), and later endorsed by the Supreme Court in Chiarella v. United States, 445 U.S. 222 (1980), the rule imposes upon corporate insiders a duty under Rule 10b-5 to "disclose material facts which are known to them by virtue of their position but which are not known to [the shareholders] with whom they deal and which, if known, would affect [the shareholders'] investment judgement.'" Chiarella, 445 U.S. at 227 (quoting Cady, Roberts, 40 S.E.C. at 911). The rule further requires that if "disclosure prior to effecting a purchase or sale would be improper or unrealistic under the circumstances, . . . the alternative is to forego the transaction."2

As the Commission notes in its proposing release, until very recently, there has been little discussion in the case law as to what, precisely, this disclose or abstain rule requires a corporate insider to do (or not to do as the case may be). But in SEC v. Adler, 137 F.3d 1325 (11th Cir. 1996), and United States v. Smith, 155 F.3d 1051 (9th Cir. 1998), two federal courts of appeals squarely confronted the question whether a corporate director or officer is required to disclose or abstain from trading the corporation's stock on all occasions when he is in possession of material nonpublic information or on only those occasions when he is affirmatively using that information in the course of his securities trading. Both circuits rejected the Commission's "knowing possession" position, holding that Rule 10b-5's disclose or abstain obligation only prohibits securities trading on the basis of material nonpublic information.

The Commission's position in both Adler and Smith was entirely correct, and both circuits made a serious doctrinal error when they concluded that traditional insiders who trade while in possession of material nonpublic information - like the director in Adler and the officer in Smith - may trade with impunity if they can prove that their decision to trade "pre-existed" their knowledge of inside information. Regardless of whether material nonpublic information is actually used in a securities transaction, traditional insiders engage in fraud and deception under both the common law and Section 10(b) whenever they remain silent in securities transactions with shareholders whom they know to be unaware of the material facts in their possession.3 A "knowing possession" test applied to traditional insiders, without regard to pre-existing trading plans or arrangements, would also serve more effectively the important normative goals of federal securities regulation.

A. The Doctrinal Basis for the Disclose or Abstain Rule

For decades, insider trading cases have caused federal courts to struggle over a single fundamental question: when can a person's silence about material facts in a securities transaction be considered a "deceptive device" such that the silence can be actionable under Section 10(b)? This question traditionally has posed, and continues to pose, a doctrinal challenge because the common law of fraud and deceit, on which Section 10(b) and Rule 10b-5 were largely predicated, generally imposed liability only for affirmative misstatements. Thus, in business transactions under the common law, the principle of caveat emptor (or caveat vendor) typicallygoverned, and knowledgeable parties were generally free to remain silent about material facts.

The common law did, however, recognize a number of exceptions to this general rule and thus deemed a person's mere silence in a business transaction to be fraudulent under certain circumstances. The particular circumstance that was seized upon by the Supreme Court in its landmark decision in Chiarella v. United States was the exception that recognized a duty to speak when a knowledgeable party stood in a fiduciary relationship with an ignorant one. It is this common law exception for fraudulent nondisclosures, as expanded by the Court in Chiarella, that compels the conclusion that Rule 10b-5 prohibits traditional insiders from trading their corporation's stock anytime they are in knowing possession of material nonpublic information, and without regard to whether their decision to trade may have pre-existed their knowledge of that information.4

1. Chiarella's Holding

The Supreme Court in Chiarella clearly rejected the so-called "parity-of-information" rule that would have applied a broad-based disclose or abstain duty "to all sellers, indeed to the market as a whole." Chiarella v. United States, 445 U.S. 222, 231 (1980). Instead, the Court entrenched the classical theory of insider trading, a theory which premises the Rule 10b-5 violation on the breach of "a duty to disclose arising from a relationship of trust and confidence between parties to a transaction." Id. at 230. More specifically, the Court reasoned that:

[O]ne who fails to disclose material information prior to the consummation of a transaction commits fraud only when he is under a duty to do so. And the duty to disclose arises when one party has information "that the other [party] is entitled to know because of a fiduciary or other similar relation of trust and confidence between them."

Id. at 228. The Court's authority for the latter statement was the Restatement (Second) of Torts, which listed not one, but five, independent exceptions to the general rule at common law that only misstatements were actionable as fraud. See §§ 551(2)(a) - (e) (1976). The Court, however, chose to focus entirely on the exception that rooted disclosure duties in fiduciary relationships. And in so doing, the Court specifically observed "that the relationship between a corporate insider and the stockholders of his corporation gives rise to a disclosure obligation."5

Thus, Adler's and Smith's core holding - that directors and officers selling the corporation's stock may remain silent about material nonpublic facts in transactions with shareholders, provided that they do not use those facts in their trading decisions - cannot withstand close scrutiny. Chiarella's classical theory of insider trading clearly dictates that under Section 10(b) and Rule 10b-5, an issuer's officers, directors, or controlling shareholders, and the issuer itself, engages in fraud and deception whenever they remain silent in securities transaction with shareholders who are ignorant of the material nonpublic information in their possession.6 When a securities trader is a traditional insider, her motive for trading the corporation's securities is simply irrelevant.7

2. Chiarella's Expansion to Contexts Other Than Securities Trading By Traditional Insiders

Much of the uncertainty over the classical theory of insider trading and the scope of itsdisclose or abstain can be attributed to the fact that, from the start, neither the disclose or abstain rule set out in Cady, Roberts, nor its restatement by the Court in Chiarella (as the heart of the classical theory of insider trading) was limited to securities trading by traditional insiders. Rather, the disclose or abstain rule was applied to securities transactions by at least three additional categories of persons: non-officer employees of the corporation whose shares were traded; temporary or constructive insiders of such a corporation (e.g., attorneys, accountants, or other agents); and so-called tippees of traditional insiders, employees, or temporary insiders - an extension that received the Supreme Court's explicit endorsement in Dirks v. SEC, 463 U.S. 646, 660 (1983). Although defendants in each of these three categories lack "independent fiduciary duties" running directly to the corporation's shareholders, id. at 656, they have nonetheless been squeezed into Chiarella's framework of "fraud by a fiduciary's silence" to ensure that persons entrusted with confidential information by a corporation are not free under Rule 10b-5 to exploit (directly or indirectly) that information for personal profit and to the detriment of shareholders. The Court in Dirks was remarkably candid in acknowledging this policy consideration. See id. at 656-59 and n.14.

Compelling policy considerations also prompted the SEC to advance, and courts to accept, the so-called "misappropriation theory," an alternative theory of insider trading liability that predicates a Rule 10b-5 violation on the fraud that is perpetrated on the source of material nonpublic information when a person entrusted by that source misappropriates that information for securities trading purposes. In United States v. O'Hagan, 117 S. Ct. 2199 (1997), the Supreme Court recently resolved a circuit split by endorsing this theory as a "complementary" alternative to the classical theory. In so doing, the Court once again was candid in acknowledging the pragmatic underpinnings of its decision: "[t]he misappropriation theory is designed to protect the integrity of the securities markets against abuses by `outsiders' to a corporation who have access to confidential information that will affect th[e] corporation's security price when revealed, but who owe no fiduciary or other duty to that corporation's shareholders." Id. at 2207-08.

With the erroneous interpretations of Section 10(b) and Rule 10b-5 in Adler and Smith, the law of insider trading has now been brought full circle. The Supreme Court's reasoning in Chiarella had been broadened, supplemented, and complemented so many times to extend Rule 10b-5 liability to a vast array of securities transactions that are perceived as harmful to investors and securities markets, that it was all but forgotten that Chiarella annunciated a legal doctrine initially grounded in the fiduciary relationship between traditional insiders and corporate shareholders - a relationship that accords shareholders a right under Rule 10b-5 to receive disclosure of all material facts known by the traditional insiders with whom they trade. Ironically, it was these laudable efforts by the Commission and courts to take insider trading law beyond Chiarella that left the mistaken impression on the panels in Adler and Smith that Rule 10b-5 is not violated, and that shareholders and the securities markets are not harmed, when traditional insiders purchasing or selling shares in the corporation "merely" remain silent about material facts in their possession at the time of the trade.

Unfortunately, the Commission only compounds that error and exacerbates the confusion when it proposes a one-size-fits-all "on the basis of" test that permits all securities traders to invoke any of four affirmative defenses to the imposition of Rule 10b-5 liability. To be sure, the fact that a traditional insider's trading plan or arrangement to purchase or sell the corporation's securities at a set date and price may have pre-existed his awareness of material nonpublic information plainly demonstrates that the traditional insider did not deceive shareholders by misusing (or misappropriating) the corporation's information to make a personal profit. But that analysis begs the question as to whether that traditional insider engaged in a "deceptive device" within the meaning of Section 10(b) by remaining silent about material facts in transactions with shareholders with whom he stood in a fiduciary relationship. And satisfying proposed Rule 10b5-1's criteria for proving a pre-existing trading plan, contract, or instruction does not render that traditional insider's silence any less deceptive.8

3. The Appropriateness of a "Use" Test in Contexts Other Than Securities Trading By Traditional Insiders

To understand why a securities trader's motivation to use confidential information may be relevant in some contexts but irrelevant in others, it is necessary to reverse course a bit to review why Rule 10b-5 can be read to impose a disclose or abstain obligation on non-officer employees, temporary insiders, and tippees, even though none of these persons can be said to owe fiduciary duties directly to the corporation's shareholders. The short answer is that the Supreme Court has constructed fiduciary-like disclosure duties on the part of these persons for a particular policy reason: namely, to ensure that no corporate agent can benefit, directly or indirectly, from self-dealing in confidential corporate information that belongs only to the corporation and all of its shareholders. Thus, the legal fiction that non-officer employees, temporary insiders, and tippees owe a disclosure duty to shareholders is premised on the fact that they are using the corporation's information for personal profit. This premise was expressly acknowledged in Dirks with respect to both tippee liability and liability on the part of temporary insiders (indeed, the alternative term "constructive insider" is most revealing).

Viewed in this light, it becomes easier to see why affirmative use of material nonpublicinformation is essential to establishing Rule 10b-5 liability in the context of securities trading by non-officer employees, temporary insiders, and tippees: absent use of the corporation's confidential information, these persons simply would not owe a duty of disclosure to the shareholders with whom they were trading. And absent a duty to speak, their mere silence would not be deceptive within the meaning of Section 10(b).9

The appropriateness of a "use" test in cases brought against corporate "outsiders" pursuant to the misappropriation theory is even more evident. Indeed, the Supreme Court emphasized in the recent case of United States v. O'Hagan that it is the defendant's undisclosed use of the source's confidential information in his personal securities trading that satisfies Section 10(b)'s deception requirement. Thus, once again, absent the defendant's use of material nonpublic information, there is no duty to disclose and, and without such a duty, there is no deception in connection with the purchase or sale of a security.10

B. The Normative Basis for the Disclose or Abstain Rule

There is a voluminous amount of law review literature devoted to analyzing the reasons why insider trading should, or should not, be subject to regulation under the federal securities laws. In the interests of brevity, I will simply assert that the principal normative argument for the disclose or abstain rule is to prevent corporate insiders from self-dealing in confidential corporate information.11 To be sure, if preventing such self-dealing were the only normative justification for the disclose or abstain rule, then a single use (or an "on the basis of") test applied to allcategories of securities traders would make a lot of sense: a person must use inside information in order to misuse inside information. Yet there are at least two additional justifications for imposing a duty to disclose or abstain under Rule 10b-5.

The first additional justification can be categorized as a disclosure-based objective: the disclose or abstain rule operates to encourage rapid and complete disclosure by issuers and their corporate officials. Indeed, although both Congress and the Commission have repeatedly emphasized the link between well functioning securities markets and full and accurate disclosures by securities issuers, the federal securities laws do not impose upon issuers a general affirmative duty to disclose material nonpublic information. Rather, securities issuers have substantial discretion under the federal securities laws in determining what and when material news gets released to the public. More particularly, it is an issuer's traditional insiders who generally control the flow of corporate information to the public, and it is therefore traditional insiders that determine the length of time, and the extent to which, the corporation remains silent about both good news and bad news.12 If traditional insiders are prohibited from trading while in knowing possession of material nonpublic information, they will have an extra incentive to disclose to the public more information rather than less, and to make those disclosures sooner rather than later. Put another way, under a strict knowing possession test, traditional insiders would have a greater disincentive to keep material information secret from the public.13

The proposed rule's recognition of four affirmative defenses to Rule 10b-5 liability overlooks the fact that the timing of a corporation's announcement of material news could well be manipulated - postponed a few days or weeks - so that a traditional insider's pre-existing plans or arrangements to trade the corporate shares could yield a greater profit. That is, release of bad news could be delayed so that a pre-existing plan to sell shares could be carried out at the higher pre-announcement price, or release of good news could be delayed so that a pre-existing plan to purchase shares could be executed at the lower pre-announcement price. Of course, such machinations with corporate disclosure could themselves be actionable as a fraud under Rule 10b-5. Yet, as former Commissioner (now Professor) Roberta Karmel has recognized, it is far less complicated to "prove the facts of an insider trading case than to prove that an issuercommitted fraud in the timing of a disclosure item."14 A disclose or abstain rule that applies regardless of a pre-existing trading plan or arrangement takes cognizance of the fact that disclosure decisions can be causally connected to a traditional insider's desire to profit even if the original trading decision was completely independent of the subsequent material developments.15

In addition to these functional disclosure-based reasons, requiring traditional insiders to disclose or abstain from securities while in possession of material nonpublic information, without regard to their ability to prove a pre-existing trading plan or arrangement, can be said to advance other important policies underlying the federal securities laws. These policies can be characterized broadly as a concerns for "investor protection" and the "maintenance of fair and honest securities markets."

In focusing on a traditional insider's use of confidential corporate information in transactions with shareholders, the circuit courts in Adler and Smith were incorrect in assuming that "[t]he persons with whom a hypothetical insider trades are not at a `disadvantage' at all provided that the insider does not `use' the information to which he is privy." United States v. Smith, 155 F.3d 1051, 1068 (9th Cir. 1998). Both circuits, and now the Commission (in proposing these affirmative defenses), seem to be overlooking an alternative way in which shareholders can be said to be disadvantaged by a traditional insider who executes a pre-existing plan and trades the corporation's securities while in possession of material nonpublic information. By knowingly trading securities at a time when the corporation's securities are undervalued (or overvalued) by a securities market unaware of new developments, the traditional insider is preempting a trade by an outside shareholder that, but for the insider's transaction, would have yielded the outside shareholder a profit upon the information's public announcement.16 The traditional insider, then, can be said to be harming outside shareholders by taking an opportunity to profit that rightly belongs to the outside shareholders. Key to this argument, of course, is that the fiduciary relationship between the traditional insider and the corporation's shareholders places him under an obligation to act in their best interest rather than his own.

There is an additional aspect to an argument based on fairness that demonstrates why a traditional insider should not be permitted to trade securities while in possession of material nonpublic information, even if his investment decision is not causally connected to the information. As noted above, traditional insiders control the flow of corporate information to the public and are therefore part of the group of persons who determine whether, and for how long, material developments will remain nonpublic. Accordingly, by intentionally withholding information from the marketplace (albeit often for very good business reasons), traditional insiders create the very condition that results in their opportunity to profit. Because the traditional insider is at least partially answerable for the period of corporate silence that produces this opportunity, fairness dictates that traditional insiders should be prevented from profiting.

Significantly, both of these normative justifications for the disclose and abstain rule are applicable only in the context of securities trading by traditional insiders. That is, neither the disclosure-based justification nor the justification based in fairness would have much relevance to securities trading by non-officer employees, temporary insiders, tippees, and misappropriators because those persons typically lack any control over the timing and breadth of corporate disclosures. Accordingly, these functional and fairness justifications provide additional support for my earlier contention that a search for a single answer to the "possession vs. use" controversy is futile.

II. A Narrowly Tailored "Knowing Possession" Rule Would Provide Traditional Insiders With Clear and Fair Notice That They Will be Held to a Disclose or Abstain Obligation That is Wider in Scope Than the Obligation Imposed on Persons Who Do Not Share Their Status as Fiduciaries to the Corporation's Shareholders

As the foregoing analysis reveals, regardless of whether their decision to trade the corporation's shares may have pre-existed their awareness of material nonpublic information, traditional insiders engage in a "deceptive device" within the meaning of Section 10(b) when they purchase or sell the corporation's while in knowing possession of such information. It is therefore well within the Commission's power to proscribe such conduct pursuant to its rulemaking authority under Section 10(b). But such a rule would have to be narrowly tailored to the context of securities trading by traditional insiders because, as explained above, other securities traders - namely, non-officer employees, temporary insiders, tippees and misappropriators - engage in deception only when they affirmatively use material nonpublic information in the course of their securities transactions. Indeed, although Congress would certainly be free to rewrite the statutory text, unless and until it has done so, the Commission's rulemaking power under Section 10(b) is clearly circumscribed by the deception requirement contained therein.

If the Commission were to propose a rule that was narrowly tailored to the context of securities trading by traditional insiders, its new proposal could take on any number of formats. For example, as it has done with its current proposal, the Commission could promulgate an interpretive rule that defines the "manipulative and deceptive devices" prohibited by Rule 10b-5to include purchases or sales of any issuer's securities by any traditional insider of such issuer when that traditional insider is in knowing possession of material nonpublic information concerning the issuer or its securities. Alternatively, rather than merely interpreting these terms in Rule 10b-5, the SEC could use its specific authority under Section 10(b) to promulgate a separate legislative rule that itself would make it an unlawful act or practice for any traditional insider of any issuer to purchase or sells the issuer's securities while in knowing possession of material nonpublic information concerning the issuer or its securities.17 The Commission could also use a proposing release to clarify that the new rule would obligate traditional insiders to disclose or abstain without regard to their ability to demonstrate that a decision to trade the corporation's securities at a set time and for a set amount pre-existed an awareness of material nonpublic information.

Moreover, regardless of the specific format chosen for the new rule, the Commission would almost certainly have to define the term "traditional insider" more specifically; and here again it would have multiple options. It could, for example, define traditional insider to include any director or officer of, or person controlling or controlled by, the issuer, or the issuer itself. Alternatively, the SEC could link the definition of traditional insider to those persons who already are obligated to detail their purchases or sales of the issuer's securities in Exchange Act Section 16(a) reports, and then add to or subtract from this basis. But whatever option it chooses, the term "traditional insider" should extend only to persons who can fairly be said to owe fiduciary disclosure obligations to the corporation's shareholders.

It is also possible that the SEC could choose to limit liability for violations of a narrowly tailored knowing possession rule to civil penalties under Exchange Act Section 21A and damages to contemporaneous traders under Exchange Act Section 20A. Criminal penalties for violating Rule 10b-5 could be reserved for those defendants who affirmatively use material nonpublic information in the course of their securities trading. This would include trading by traditional insiders, but it would also extend to non-officer employees, temporary insiders, tippees, and outsiders - when any of these persons can be said to have misappropriated the corporation's confidential information (or participated after the fact in such misappropriation).

To be sure, the formulation of a "while in possession of" rule for traditional insiders would require significant time and attention on the part of the Commission and its staff, andwould benefit from additional comments by the regulated community and securities law scholars. But the end result would provide traditional insiders with what they, at present, sorely lack: clear and fair notice that they will be held to a disclose or abstain obligation that is wider in scope than the obligation imposed on persons who do not share their status as fiduciaries to the corporation's shareholders. And the existence of such notice would sound an alert to traditional insiders that pre-existing trading plans and arrangements must be placed "on hold" until such time as the material information in their possession has been released by the issuer to the investing public.


In recognition of the very special position that traditional insiders occupy in the scheme of federal securities regulation, I respectfully encourage the Commission to consider the foregoing categorical approach in its attempt to resolve the "possession vs. use" debate. I would be very pleased to discuss with members of the Commission's staff the comments set out in this letter or the more extensive views reflected in my enclosed article.


Donna M. Nagy
Professor of Law
University of Cincinnati College of Law


he Honorable Arthur Levitt, Chairman
The Honorable Norman Johnson, Commissioner;
The Honorable Isaac Hunt, Jr., Commissioner;
The Honorable Paul Carey, Commissioner;
The Honorable Laura Unger, Commissioner;
David Becker, General Counsel;
Meyer Eisenberg, Deputy General Counsel;
Richard Levine, Assistant General Counsel;
Sharon Zamore, Senior Counsel;
Elizabeth Nowicki, Attorney;
Richard Walker, Director of Enforcement;
Harvey Goldschmid, Special Advisor to the Chairman.

W/ enclosure

1 The four affirmative defenses in the proposed rule preclude Rule 10b-5 liability when a person, before becoming aware of the material nonpublic information: (1) had entered into "a binding contract" to trade securities "in the amount" and "at the price" and on the date at which he or she ultimately traded; (2) had provided instructions to another person to execute such a trade; (3) had adopted and previously adhered to a "written plan" specifying the particular terms and conditions of the trade; or (4) had adopted a written plan for trading the securities that was designed to track a market index, market segment, or group of securities. See Selective Disclosure and Insider Trading, Exchange Act Rel. No. 42259, [Current Transfer Binder], CCH Fed. Sec. L. Rep., ¶ 86,228, p. 82,846 at 82,873-74 [hereinafter, "Proposing Release"].
2 Cady, Roberts, 40 S.E.C. at 911. The Commission drew support for the disclose or abstain rule from a number of early Rule 10b-5 cases, including Kardon v. National Gypsum Co., 73 F. Supp. 798, 800 (E.D. Penn. 1947), and Speed v. Transamerica Corp., 99 F. Supp. 808, 828-29 (D. Del. 1951).
3 When a traditional insider enters into a contract that binds both parties to a securities transaction at some later point in time, the traditional insider would seem to owe a duty of full disclosure only at the time of the formation of the contract rather than at the subsequent time when title to the security actually passes. This conclusion takes account of the Exchange Act's broad definitions of "purchase" and "sale," which include "any contract" to purchase/sell or otherwise acquire/dispose of a security. See Exchange Act § 3(13) and (14). In contrast, when the other party to the traditional insider's contract retains discretion as to the timing of his purchase (or sale), the traditional insider should be held to an obligation of full disclosure because the information in the traditional insider's possession may well serve to change the timing of the other party's investment decision. Cf. Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987) (Rule 10b-5 violated when, without disclosing existence of preliminary merger discussions, employer-issuer purchased stock of employee-shareholder pursuant to pre-existing contract to repurchase upon employee's voluntary retirement), discussed infra at note 8.
4 It is significant that in common law fraud cases granting recovery for insider trading, there was no requirement that the securities transaction and the material nonpublic information be causally connected. Rather, causality - a necessary element in any tort - was viewed from the vantage point of the ignorant shareholder: would the shareholder have consummated the transaction at the agreed upon price had she been made aware of the material facts that were known by her fiduciary? Thus, such common law cases tended to emphasize both the shareholder's "right to know" the material nonpublic information possessed by the corporate insider and the unfairness to the shareholder that resulted from the traditional insider's decision to remain silent about the material facts. See, e.g., Van Schaack Holdings, Ltd. v. Van Schaack, 867 P.2d 892, 897-98 (Colo. 1994) (emphasizing that "directors of a corporation and its controlling shareholders [must] act with an extreme measure of candor, unselfishness, and good faith in relation to remaining shareholder" and concluding that "this duty encompasses the obligation to fully disclose all material facts and circumstances surrounding or affecting a proposed transaction"); Blakesley v. Johnson, 608 P.2d 908, 915 (Kan. 1980) (maintaining that minority shareholder "had a legal right on the facts in this case to rely upon [the majority shareholder] to make a full disclosure"); Hotchkiss v. Fisher, 16 P.2d 531, 535, 534 (Kan. 1932) (maintaining that "a director negotiating with a shareholder for purchase of shares acts in a relation of scrupulous trust and confidence" and concluding that "full and fair disclosure required the furnishing of all information in the director's possession"); Dawson v. National Life Ins. Co., 157 N.W. 929, 938 (Iowa 1916) (recognizing cause of action for fraud in securities trading when corporate officer fails to make "full disclosure of all facts bearing thereon known to such officer and unknown to the shareholder"); Stewart v. Harris, 77 P. 277 (Kan. 1904) (holding that "before any director or managing officer ... can rightfully purchase the stock of one not actively engaged in the management of its affairs, such director or managing officer must inform such stockholder of the true condition of the affairs of the corporation"). See also Elliott J. Weiss, United States v. O'Hagan: Pragmatism Returns to the Law of Insider Trading, 23 J. of Corp. L. 395, 399 (1998) ("A shareholder who sold a corporation's stock to an insider in a face-to-face transaction had a right to expect that the insider, as a fiduciary, would disclose any material nonpublic information that he possessed before effectuating the transaction.").
5 Chiarella, 445 U.S. at 228. Chiarella also made clear that a duty to disclose material nonpublic information under Rule 10b-5 was not limited to a traditional insider's face-to-face transactions (a requirement for fraud under the common law) but would also be imposed in market transactions over anonymous securities exchanges.
6 The Commission's willingness to recognize affirmative defenses in the context of securities trading by traditional insiders runs directly counter to its observation in footnote 83 of the Proposing Release, which explicitly acknowledges that under the classical theory, an insider violates a fiduciary duty to shareholders and thereby commits fraud "regardless of whether he or she `uses' the insider information." See Proposing Release, supra note 1, at 82,860.
7 Of course, as with any Rule 10b-5 action, there would be liability for trading while in possession of material nonpublic information only if the traditional insider acted with scienter. But scienter could be established through proof that the traditional insider knew, or was reckless in not knowing, that the information he possessed was both material and nonpublic to the shareholders with whom he was trading. See SEC v. Falstaff Brewing Corp., 629 F.2d 62, 77 (D.C. Cir.) (where a defendant "[knows] the nature and consequences of his actions, he act[s] with scienter"). See also Restatement (Second) of Torts § 8A (1965) ("If the actor knows that the consequences are certain, or substantially certain, to result from his act, and still goes ahead, he is treated by the law as if he had in fact desired to produce the result.").
8 Had proposed Rule 10b5-1's affirmative defenses been in place, Rule 10b-5 liability would have likely been foreclosed in Jordan v. Duff & Phelps, Inc., 815 F.2d 429 (7th Cir. 1987), cert. dismissed, 485 U.S. 90 (1988). In Jordan, a former shareholder-employee sued the issuer-employer for repurchasing his stock in the corporation without disclosing material nonpublic information relating to the possibility of a merger between the corporation and another firm. See id. at 432-33. The Seventh Circuit held that the issuer-employer violated Rule 10b-5 by remaining silent and repurchasing the employee's shares when it owed the shareholder-employee a fiduciary duty of disclosure. Yet, because the issuer previously had entered into a binding contract to purchase all of the employees shares at a specified price (book value) and at a specified time (the employee's voluntary retirement), the employer-issuer would seem to have an affirmative defense from liability under Rule 10b5-1(c)(A) and would be entitled to remain silent about the possibility of a corporate merger while purchasing the shares from the ignorant seller. It is doubtful that the Commission would approve of this result - a clear change from Jordan and other court decisions holding issuers liable under Rule 10b-5 for violating the disclose or abstain principle, without regard to whether an issuer's determination to repurchase had pre-existed its awareness of material nonpublic information.
9 The Commission may well have had this distinction between traditional insiders and tippees in mind when it concluded in Investors Management Company that, for the defendants to be liable under Rule 10b-5, the material nonpublic information in the tippee's possession must have been "a factor in his decision to effect the transaction." In re Investors Management Company, Exchange Act Release No. 9267, [1970-71 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶ 78,163 at 80,514, 80,519 (July 29, 1971) (emphasis added).
10 Significantly, in the Smith case, the Commission's staff effectively conceded that Rule 10b-5 liability in misappropriation cases requires a causal connection between the misappropriated information and the defendant's securities transactions. See SEC Supplemental Brief at 3, United States v. Smith, 155 F.3d 1051 (9th Cir. 1998) (No. 97-50137) (distinguishing the classical theory from the misappropriation theory, and noting that, in a misappropriation case, a defendant's "`use' of the information in his trading may be relevant because it is that use that satisfies the Section 10(b) requirement that deception occur `in connection with the purchase or sale of a security'").
11 Some securities scholars argue that self-dealing in confidential corporate information should be prevented because of its effects on investors and their confidence in the integrity of the securities markets. See, e.g., Joel Seligman, The Reformulation of Federal Securities Law Concerning Nonpublic Information, 73 Geo. L.J. 1083, 1115 (1985) (contending that the primary policy reason for proscribing insider trading "is to make investors confident that they can trade securities without being subject to informational disadvantages"). Other scholars, however, reject these investor and market-based rationales for the regulation of insider trading, and instead argue that federal prohibition of self-dealing in confidential information can only be justified only as a means of protecting corporate property rights in information. See, e.g., Stephen M. Bainbridge, Incorporating State Law Fiduciary Duties into the Federal Insider Trading Prohibition, 52 Wash. & Lee L. Rev. 1189, 1238-43, 1252-57 (1995).
12 See Roberta S. Karmel, Outsider Trading on Confidential Information - A Breach in Search of a Duty, 20 Cardozo L. Rev. 83, 119-124 (1998); Jill E. Fisch, Start Making Sense: An Analysis and Proposal for Insider Trading Regulation, 26 Ga. L. Rev. 179, 239 (1991).
13 See Victor Brudney, Insiders, Outsiders and Informational Advantages Under The Federal Securities Laws, 93 Harv. L. Rev. 322, 334 (1979) (contending that "to the extent that corporate officers and directors can control the release of corporate information, precluding them from enjoying trading gains on nonpublic corporate information removes an impediment to its prompt release and to the resulting enhancement of market efficiency in pricing"); Theresa A. Gabaldon, The Disclosure of Preliminary Merger Negotiations as an Imperfect Paradigm of Rule 10b-5 Analysis, 62 N.Y.U. L. Rev. 1218, 1257 n. 211 (1987) (noting that "where insiders refrain from disclosing because of their fiduciary duty, issuers might be prompted to make disclosures somewhat earlier than would otherwise be the case in order to permit insiders to trade").
14 See Karmel, supra note 12, at 120.
15 Ironically, in the very same release proposing Rule 10b5-1 and its affirmative defenses, the Commission has proposed Regulation FD, in part out of concern that corporate managers "may delay general public disclosure [of material information] so that they can selectively disclose the information to curry favor or bolster credibility with particular analysts or institutional investors." Proposing Release, supra note 1, at 82,848. As compared with objectives such as "currying favor" or "bolstering credibility," delaying disclosures until after previously planned trades have been executed clearly results in more lucrative and immediate (and therefore more worrisome) benefits to corporate managers.
16 See William K.S. Wang, Trading on Material Nonpublic Information on Impersonal Stock Markets: Who is Harmed, and Who Can Sue Under SEC Rule 10b-5, 54 S. Cal. L. Rev. 1217, 1235 (1981). Professor Wang maintains that all securities transactions by insiders are subject to the "Law of Conservation of Securities," under which the profits gained by the insider must be directly offset by losses sustained by other investors. Id. Professor Wang therefore concludes that if insiders profit, other investors must be harmed. See id. at 1236-37.
17 As a starting place for such a rule, the SEC could look to the insider trading prohibition developed for the ALI's Federal Securities Code, which was proposed to, but never adopted by, Congress. Section 1603(a) of the Code, "Insiders' Duty to Disclose When Trading," provides:
Section 1603. (a) GENERAL - It is unlawful for an insider to sell or buy a security of the issuer, if he knows a material fact with respect to the issuer or the security that is not generally available, unless -

(1) the insider reasonably believes that the fact is generally available; [or]

(2) the identity of the other party to the transaction (or his agent) is known to the insider and (A) the insider reasonably believes that party (or his agent) knows the fact, or (B) that party (or his agent) knows the fact from the insider or otherwise.