April 24, 2000
United States Securities and Exchange Commission
450 5th Street, N.W.
Washington, D.C. 20549-0609
E-mail address: firstname.lastname@example.org
Attn: Jonathan G. Katz, SecretaryComment Letter Re: Proposed Rule 10b5-1
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:
Pre-existing trading plans and arrangements, even ones that are formed in "good faith" and fall within the narrow confines of the four affirmative defenses set out in the proposed rule, should not operate to absolve traditional insiders of their responsibility to "disclose or abstain" from trading shares in the corporation at a time when they are aware that the material information in their possession has not been released to the public.1 Yet, for those traditional insiders who are able to satisfy the specified criteria (i.e, who are able to prove that they purchased or sold the securities as part of a "pre-existing plan, contract or instruction"), the proposed rule effectively creates a safe-harbor that will insulate acts constituting fraud and deception, as those terms traditionally have been defined under both the common law and the case law interpreting Section 10(b) and Rule 10b-5. Moreover, with respect to its application to traditional insiders, the proposed rule substantially undermines two primary objectives of federal securities regulation: (1) the promotion of full, fair, and rapid disclosure of material information by securities issuers to the investing public; and (2) ensuring the fair treatment of investors in the securities marketplace.
General rule. The "manipulative and deceptive devices" prohibited by Section 10(b) of the Act [and Rule 10b-5] thereunder are defined to include, among other things, the purchase or sale of a security of any issuer, on the basis of material nonpublic information about that security or issuer, in breach of a duty of trust or confidence that is owed directly, indirectly, or derivatively, to the issuer of that security or the shareholders of that issuer, or to any other person who is the source of the material nonpublic information.
The prohibition in Rule 10b5-1(a) is confusing because an "on the basis of" test for insider trading liability typically has been used interchangeably with the very same "use" test that was endorsed by the Eleventh and Ninth Circuits (and strongly favored by the securities defense bar), though vigorously opposed by the Commission. Yet, the Commission appears comfortable with this general rule only because paragraph (b) of the proposed rule defines "on the basis of" in a manner that completely belies the phrase's plain meaning and implicit causal component:
Definition of "on the basis of." Subject to the affirmative defenses in paragraph (c) of this section, a purchase or sale of a security of an issuer is "on the basis of" material nonpublic information about that security or issuer if the person making the purchase or sale was aware of the material nonpublic information when the person made the purchase or sale.
Thus, as presently written, the proposed rule would mandate liability in a case where a securities trader, while unable to prove one of the four affirmative defenses, could nonetheless convince a fact-finder that her decision to trade completely lacked any causal connection to the material nonpublic information of which she was later aware at the actual time of her trade. A clearer approach might specify a rebuttable presumption that would enable a fact-finder to infer a defendant's use of information from her possession (or awareness) of that information, withoutdefining "on the basis of" in a manner that so blatantly obfuscates its plain meaning.
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."
|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.
|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 -