THE ASSOCIATION OF THE BAR
OF THE CITY OF NEW YORK
42 WEST 44TH STREET
NEW YORK, NY 10036-6689
COMMITTEE ON SECURITIES REGULATION
|STEPHEN J. SCHULTE, ESQ.
900 THIRD AVENUE
NEW YORK, NY 10022
FAX# (212) 593-5955
|ANDRE WEISS, ESQ.
900 THIRD AVENUE
NEW YORK, NY 10022
FAX# (212) 705-1956
June 19, 2000
Jonathan G. Katz
Securities and Exchange Commission
450 Fifth Street, N.W.
Washington, D.C. 20549-0609
Re: Proposed Rules 10b5-1 and 10b5-2, File No. S7-31-99
Dear Mr. Katz:
The Committee on Securities Regulation (the "Committee") of The Association of The Bar of The City of New York (the "Association") submits this letter in response to the invitation by the Securities and Exchange Commission for comments on the Commission's proposal to adopt new Rules 10b5-1 and 10b5-2 under the Securities Exchange Act of 1934, Release 34-42259 (December 22, 1999) (the "Proposing Release"). Our Committee is composed of lawyers with diverse perspectives on securities issues, including members of law firms, counsel to investment advisers, investment companies and their independent directors, academics and members of the judiciary. A list of our Committee members is attached.
This letter contains our Committee's comments on the proposed regulations concerning so-called "insider trading." Our committee's comments on the Commission's proposals concerning "selective disclosure" are set forth in a separate letter dated April 28, 2000.1
We first summarize our comments below and then discuss them in greater detail in the main part of this letter.
1. We share the Commission's objective of clarifying the law applicable to "insider trading"- the trading of securities on the basis of material, non-public information concerning the issuer of such securities or the securities themselves.2
2. We also applaud the Commission's recognition that not every transaction in securities effected by a person who may be, or may be deemed to be, in "knowing possession"3 of inside information is necessarily wrongful or constitutes a violation of the federal securities laws.
3. We believe, however, that proposed Rule 10b5-1 is unnecessarily and impracticably over-broad in proposing to make liability attach when a trader is merely "aware of" material non-public information, regardless of whether the information is used or availed of in some manner, and in specifying only four4 limited and incomplete affirmative defenses to the proposed general rule. In particular, we are concerned that the introduction of a new standard of "awareness," rather than "knowing possession" or "use," as under the current case law, will create as much, if not more, confusion and litigation as the Commission is seeking to avoid by the proposed adoption of Rule 10b5-1. We also believe that the proposed "affirmative defenses," in addition to being too narrowly drafted, in some cases evidence unwarranted hostility to normal, and undeniably innocent, business practices. Finally, we believe that, at least in criminal cases, it is inappropriate, and may well be unconstitutional, for the Commission, by rule-making, to attempt to shift the burden of proving certain elements of the offense of "insider trading" to the accused by defining these factors as elements of an affirmative defense, rather than as elements of the offense itself.
4. We also believe that the Commission has not, in the Proposing Release, made a persuasive case that the rule it proposes is the most desirable of the possible alternatives - including the alternatives adopted by the most recent Court of Appeals decisions on this point. In particular, we believe the Commission has failed to explain why its proposed rule of "awareness-plus-four-affirmative-defenses" is superior to the test adopted by the Adler court, i.e., "`use' with a strong inference of use from `possession,'"5 which the Commission implicitly rejects. We believe that the Commission would be better advised either to adopt the Adler formulation or to let the case law develop further in this area before attempting to codify the law by rule-making, especially where the Commission's authority to do so may be regarded as questionable6 and where the significance of the benefit sought to be attained by the rule - clarifying an "unsettled issue in [the law of] insider trading" - is itself uncertain.
5. We also oppose the adoption of Rule 10b5-2, at least in the form proposed, both because it is non-exclusive, and thus would allow the Commission to continue to seek to impose insider trading liability on non-fiduciaries of the issuer on an ad hoc basis, without adequate notice or warning to the parties involved of their obligations under the law, and because the rule would impose civil and potentially criminal liability for securities fraud on the basis of presumptions about business and family relationships that the Commission has not established and which, we strongly suspect, will be incorrect as often as they are true. We also note that there is no compelling rationale for the Commission to adopt a rule in this area. Unlike the "use vs. possession" debate, which the Commission seeks to resolve by adopting Rule 10b5-1, the Commission lost both the Chestman and Reed cases, which it now proposes to overturn by adopting Rule 10b5-2, and there appears to be no significant disagreement among the Circuits on this issue.
6. Clarifying the law of insider trading is a worthy objective.
As the Commission recognizes, no statute or rule expressly defines the offense of "insider trading."7 Rather, the prohibition has been derived from the general anti-fraud language of Section 10(b) of the Securities Exchange Act of 1934, and the Commission's Rule 10b-5 thereunder, which itself has at best only a "sketchy legislative history."8 While traditionally, the rule was applied to corporate officers, directors and controlling stockholders who, at common law, had a fiduciary duty not to gain a personal advantage by using corporate information (so-called "classic insiders"), over time the same prohibition was extended to a variety of de facto insiders, like underwriters; and now, with the adoption of the misappropriation theory by the Supreme Court in the O'Hagan case,9 the prohibition clearly may extend to a wide variety of persons who are not "insiders" of an issuer of securities in any recognizable sense. These include such persons as journalists, arbitrageurs, lawyers for potential takeover bidders, financial printers and even medical professionals, who obtain information in the course of their otherwise lawful employment or profession which, if utilized in connection with trading in the public markets, may give them a significant informational advantage over uninformed security holders with whom they have no legal or other relationship and to whom they owe no specific legal or contractual duty. At the same time, in the 1980's, Congress substantially increased the potential penalties, both civil and criminal, that can be imposed for insider trading violations and expanded the scope of the private right of action for contemporaneous traders in the marketplace who never dealt with the person or persons having the inside information.
As a result of these developments, persons participating in the securities marketplace currently "confront a significant degree of uncertainty"10 when trying to determine the lawfulness of their activities, and face severe and potentially catastrophic penalties for guessing or being advised incorrectly. In these circumstances, additional clarity in the form of an appropriately-crafted SEC regulation would be welcomed by market participants and their professional advisors, who today must struggle to define the contours of "an amorphous offense that is dependent upon case-by-case definitions. . .".11 If the scope of the insider trading prohibition could be clarified by Commission action without imposing undue burdens on market participants in the conduct of their lawful business activities and without creating a presumption that every investment decision made on the basis of superior knowledge or insight is unlawful, we could support the adoption of rules by the Commission.
7. We welcome the Commission's implicit abandonment of the "knowing possession" test
As noted in the Proposing Release, since the mid-1970s the Commission has taken the position in a series of enforcement actions that the scienter and "in connection with" (causation) elements of the offense of insider trading may be satisfied merely by showing that the defendant was "in possession of" or (as stated by the Second Circuit in dictum in the Teicher case) had "knowing possession" of material nonpublic information concerning an issuer or its securities at the time of a transaction. Under this approach, the Commission has argued that it need not show that the information involved was the "sole" or "primary" or even "a" factor in the alleged offender's decision to trade, or that he or she "used" the information in effecting the transaction.12
The "knowing possession" facilitates the Commission's enforcement efforts because it is easier to prove that a defendant possessed some information than to show that she used it in connection with a securities transaction or that it was a significant or the primary factor motivating the transaction. Ease of enforcement and administration are important values, and we recognize the many burdens shouldered by the Commission in its efforts to enforce the securities laws, as did the Adler court.13 However, we agree with the two Courts of Appeals that have considered the Commission's position since the O'Hagan decision that the "knowing possession" standard is too sweeping, and that some variation of the "use" test "best comports with the language of § 10(b) and Rule 10b-5, and with the relevant Supreme Court precedent."14 We believe the Commission is correct to now acknowledge, as it does in the Proposing Release, that "an absolute standard based on knowing possession, or awareness, could be overbroad in some respects" because "[s]ometimes a person may reach a decision to make a particular trade without any awareness of material nonpublic information, but then come into possession of such information before the trade actually takes place . . . for many cases of this type, a reasonable standard would not make such trading automatically illegal."15 Although we disagree with certain aspects of the rule now proposed by the Commission, we commend the Commission for its willingness to acknowledge that its continued assertion of the "knowing possession" test is unreasonable and for its effort, in light of the apparent rejection of this standard by the courts, to formulate a concrete alternative.
8. The proposed new Rule 10b5-1 is overbroad and would prohibit transactions where there is no intentional or willful conduct designed to deceive or defraud investors
Section 10(b) and Rule 10b-5 do not prohibit all or certain unspecified acts in connection with the purchase or sale of securities; rather, they prohibit the employment of "manipulative" and "deceptive" trading practices in connection with these transactions.16 Thus, courts have determined that a particular state of mind called scienter - "a mental state embracing intent to deceive, manipulate or defraud"17 - must be shown to exist for a violation of Rule 10b-5 to be found. As the Supreme Court stated in the Dirks case:18
"[i]t is not enough that an insider's conduct results in harm to investors; rather, a violation [of Rule 10b-5] may be found only where there is `intentional or willful conduct designed to deceive or defraud investors.'"
Most recently, in O'Hagan, the Supreme Court emphasized that, in a case of "classical" insider trading, § 10(b) and Rule 10b-5 are violated "when a corporate insider trades in the securities of his corporation on the basis of material, nonpublic information."19 Each of these statements accords with the common understanding - now acknowledged by the Commission - that Rule 10b-5 is not a rule of strict liability ("trading while in possession of material nonpublic information") but a rule requiring an element of fraud, deceit or manipulation.
In light of this understanding, we are disappointed that the Commission proposes to adopt a rule that - exceptions aside for the moment - would bar, even possibly criminalize, trading based on whether or not an insider20 or person wrongly in possession of material, nonpublic information "was aware of the . . . information when the person made the purchase or sale."21
We think this is inappropriate and inadvisable for a variety of reasons. First, we think the reasoning offered by the Commission to support the proposed test is inadequate and in conflict with the only two Court of Appeals decisions on point.
Second, neither the rule nor the release explain or interpret the concept of "awareness." Without such clarification, it is not clear whether "awareness" should be construed to mean something more than, less than or, conceivably, even the same as "knowing possession." We anticipate this lack of a definition will undermine, to some extent, the intended benefits of clarity and certainty the Commission seeks to attain.
Third, the Proposing Release does not distinguish the proposed "awareness" standard from the Adler use-with-a-presumption test, or to explain why it is superior, beyond saying the proposal will provide "greater clarity and certainty" than a presumption or "strong inference" approach. Even granting this to be so (which is by no means obvious), the Commission fails to weigh the advantages of clarity against the disadvantages of adopting a broad rule with narrow exceptions, which include deterring lawful as well as unlawful behavior and requiring written trading instructions where previously this was neither necessary or customary.
Fourth, the proposed affirmative defenses in almost every case are too narrowly drawn, resulting in potential "traps for the unwary" and potentially endowing the Commission with excessive leverage over defendants once the single element of "awareness" has been satisfied.
Finally, a number of elements of the proposed defenses should properly be considered elements of the offense, at least in criminal cases, i.e. the burden of proof should be on the government rather than the defendant. We discuss these points in detail in the subsequent portion of this section.
(a) The Commission's rationale for the "awareness" test is unpersuasive
In light of the importance of resolving the "possession vs. use" debate under existing Rule 10b-5, and the serious potential adverse consequences to those who may be found to be on the wrong side of whatever line is eventually drawn in this area, we find the Commission's stated reasons for proposing "awareness" as the relevant state of mind to be thin. This is especially the case when two Courts of Appeals have recently concluded, in well-reasoned opinions, that some type of "use" of the information involved is required to establish liability under Rule 10b-5 - i.e., that "the weight of authority supports a `use' requirement" (Smith, 155 F.3d at 1067) and "the use test best comports with precedent and Congressional intent. . . ." (Adler, 137 F.3d at 1337).
In the face of these holdings, the Commission asserts essentially three arguments: first, that whenever a person buys or sells a security while aware of material nonpublic information that has been improperly obtained, that person has "the type of unfair informational advantage over the other participants in the market that `insider trading law' is designed to prevent"; second, that as a practical matter, it is "highly doubtful" that a person who "knows" relevant inside information can disregard it when making a decision to purchase or sell a security; and, third, that even if the trader does have other reasons for acting, "other traders in the marketplace would clearly perceive him or her to possess an unfair advantage."22
Giving due respect to the Commission's expertise, none of these three explanations is persuasive. As earlier noted, Rule 10b-5 is addressed to fraudulent, manipulative and deceptive practices; it does not prohibit all "informational advantage[s],"23 and the weight of authority is that merely possessing material, non-public information is, in itself, not unfair or unlawful.24 Both the first and the second propositions ignore the fact that there are many circumstances in which the decision to trade can be and is made before, or without any knowledge that, material information is available, but the information is first received or perceived, or its significance is first apprehended, before the transaction is accomplished, so that the "trade" is effected after the relevant actor becomes "aware" of the information. As one of our Committee members has recently written:
"[The SEC's] argument ignores that there are many situations beyond the narrow exceptions incorporated into Rule 10b5-1 in which the decision to trade is independent of the nonpublic information known to the trader, including where the nonpublic information is received inadvertently, over objection, or without knowledge that the information was nonpublic or material."25
The third stated reason is both speculative and, we think, incorrect. We do not know what "other traders" in the market would clearly perceive, nor has the Commission adduced any support for its statement. More to the point, if the insider or other person possessing material nonpublic information does not actually use the information in connection with the relevant transaction, it is not apparent why counterparties, trading anonymously in the market, should "perceive him or her to possess an unfair advantage." Indeed, the court in Smith held to the contrary.26 The mere possibility that someone may perceive that another has an unfair advantage, if in fact the other has not taken unfair advantage, seems an insufficient policy basis for the Commission to attempt to overrule by rulemaking the decisions of the only two Courts of Appeals to have fully considered the question of whether "use" of material nonpublic information is an essential element of the insider trading offense.
(b) "Awareness" should be defined
The Proposed Rule is notable, in our view, for proposing that the offense of insider trading ought to be defined, at least in part, based on whether the person trading was "aware" of material nonpublic information at a specified time. So far as we ourselves are "aware", the use of the term "aware" in this context is a novel proposal, i.e., implies that a new and different standard be applied to such cases in lieu of either the test of "knowing possession" suggested by the Teicher case or "use" required by Adler and Smith. Certainly the idea that "awareness" embodies a different standard is suggested by the Commission's referring to it in the Proposing Release as "closer to [i.e., not the same as] the `knowing possession' standard . . . ." Unfortunately, however, in our view, neither the rule nor the Proposing Release provides any guidance as to what meaning should be given to this term.
Merely using a new word cannot lead to greater clarity or consistency unless there is some common understanding of what the rule is trying to proscribe, and as to this intended meaning the Proposing Release is noticeably unhelpful. Most of us suspect that "awareness" is intended to imply or require a greater degree of cognition or recognition of the significance of the relevant information than mere "knowing possession,"27 and this suspicion seems consistent with the Commission's implied abandonment of the "knowing possession" test in the face of its rejection in Adler and Smith. At least some members of our Committee, however, are concerned that "awareness" can be, or is even intended to be, read to require something less than the "knowledge" contemplated by the Teicher court. (For example, in a colloquial sense, one may be "aware" of something only in a dim way, without actually "knowing" it.) This lack of a definition of a critical term will likely lead to uncertainty in the business and legal communities if the rule is adopted as proposed, and to a new round of litigation over the intended meaning of the term. Especially in view of the narrowness of the specified affirmative defenses and the serious potential penalties for violation of the insider trading rule, we urge that the Commission attempt to specify what it means by "awareness" or, at a minimum, to clarify that "awareness" requires something more than mere "knowing possession" of the relevant information.
(c) The Commission does not explain why its proposed standard is superior to the Adler test
Although as noted in subsection (a) above, the Commission attempts to justify proposed Rule 10b5-1 as "closer" to the knowing possession standard, the Commission does not explain clearly why it is not satisfied with the "use" test, coupled with an inference of use arising from possession, adopted by the Adler court. Nor does the Commission discuss why its own formulation is superior to that offered by the Court of Appeals for the Eleventh Circuit. We consider these to be significant and unfortunate omissions in the Commission's presentation which it should remedy before a final rule is adopted.
As is well known, in the Adler case the Eleventh Circuit held that the district court correctly determined that the SEC was required to show that a director used inside information in his trading in order to prove an insider trading violation. In response, however, to the Commission's arguments in that case for a "knowing possession" standard - including the argument "that a strict use test would pose serious difficulties of proof" for the SEC - the Court held that the SEC's difficulties would be "sufficiently alleviated" by recognizing that "a strong inference" arises that "when an insider trades while in possession of material nonpublic information, . . . such information was used by the insider in trading."28 In light of this history, it seems to us appropriate for the Commission, in proposing a new definition of insider trading, to explain to market participants and the securities bar why the resolution adopted by the Adler court is unsatisfactory or incorrect.
If the Commission will always benefit from a "strong presumption" of use whenever an insider trades while in "possession" of material nonpublic information, the burden in any controversy will always be on defendants to prove, by sufficient evidence to overcome the presumption, that their trading was innocuous because it did not involve an unfair use of insider information. If the Commission is concerned that the Adler formulation as stated applies only to classical insiders, it could, we think, adopt the strong inference test by rule and broaden it to include those who fall within the "misappropriation" or "de facto insider" doctrines. But it seems unreasonable for the Commission to reject, in effect, a judge-made rule in favor of a novel proposal of its own without analyzing the judicial rule and explaining its inadequacies. As we attempt to show below, the inclusion of the four proposed affirmative defenses is by no means sufficient to exclude all the blameless cases that would be swept up by the proposed "awareness" test. Before the Commission legislates so broadly, therefore, we urge it to explain more specifically its basis for rejecting the Adler jurisprudence, and why the benefits of the proposed rule would outweigh the burdens imposed on market participants.
(d) The proposed affirmative defenses generally are too narrowly crafted
Whether or not the Commission is willing to clarify its proposed "awareness" test, we believe the "affirmative defenses" proposed to be contained in paragraph (c) of the rule should be broadened to reflect both customary market practice and the fact that a transaction is frequently effected at a time subsequent to the time the relevant investment decision is made. As proposed, the affirmative defenses, which would provide exceptions from the general rule of liability for trading while "aware" of material nonpublic information, are too narrow to encompass many readily foreseeable circumstances and thus would tend to entrap the innocent but unwary insider. In addition, the likelihood that innocent but not carefully-preplanned transactions would run afoul of a condition of one of the affirmative defenses also would give the SEC staff unwarranted leverage in negotiating settlement agreements with errant insiders.
(i) Proposed Affirmative Defense (A) - binding contract
Paragraph (A) of Proposed Rule 10b5-1(c)(1)(I) would provide an affirmative defense (subject to the "good faith" requirement of subparagraph (ii)) if, before becoming aware of the material information, the person had entered into a "binding contract" to purchase or sell the security "in the amount, at the price, and on the date which the person purchased or sold the security." As drafted, this defense, while unexceptionable, seems so narrow as to add little if anything to existing law. The Committee believes that the law today is that the relevant time for determining a possible violation of Rule 10b-5 is no later than the time a "binding contract" is entered into, regardless of the time of subsequent closing, payment, delivery, registration of title or other ministerial acts.29 Certainly this should be the case if the contract specifies the actual amount, price and date of sale, as proposed by the Commission, and was entered into before the person charged was "aware" of any material information. At one level, therefore, the Committee has no objection to proposed Affirmative Defense (A); even if it is largely redundant of existing law, it is correct as far as it goes.
Our objection, however, is that it does not go far enough. For example, it is not clear why the defense requires that the contract of sale be "binding." "Binding" to a commercial lawyer means enforceable as a matter of law, meaning, in the typical case, state law. This introduces an element of state contract law which could allow the Commission to defeat an otherwise valid defense on the basis that the contract involved contained some defect which made it non-binding as a matter of the applicable state law, even though it actually was performed in accordance with the parties' intentions. State laws are numerous and various and may operate to make contracts unenforceable for unforeseen and irrelevant reasons. To take just one example, some state laws require agreements to arbitrate, or to submit to the jurisdiction of a particular court, to be in all capital letters, or in bold face type. If such a rule is not observed, is the contract "binding" for purposes of Affirmative Defense (A)? The answer is not clear. It ought to be sufficient for purposes of this defense that the purchaser or seller thought he was bound and actually acted in accordance with the contract, whether or not he could have been required to do so in a breach of contract action in the relevant state court. Therefore, the "binding" concept should be deleted or broadened as suggested in the preceding sentence.
Second, as drafted, the exception would not seem to apply to the sale of a conventional, American-style put or call option (i.e., one that may be exercised by the counterparty at any time during the term), even when the option was sold prior to the seller becoming "aware" of the information. This results from the fact that proposed Affirmative Defense (A) requires the contract to specify not only the price, but also the date, on which the person sold the security. Under a typical option contract, however, the holder may exercise at any time, or during a specified exercise period, and not only on a single date. Even exchange-traded options theoretically may be assigned and exercised prior to their expiration date. Thus, under the proposed rule, if an insider were to sell a three-month call option on some of his employer's stock on day one, become aware of material (unfavorable) nonpublic information on day two and the option were exercised, and the stock sold, on day three, Affirmative Defense (A) would not be available. This is not appropriate, since the seller became irrevocably bound on day one when he or she sold the option while knowing nothing improper, and only later became aware of the nonpublic information.
By logical extension, also, Affirmative Defense (A) ought to be broadened to cover so-called "good till canceled" orders, i.e., those which require a broker to purchase or sell a security when it reaches a specified price, unless the order is canceled prior to execution. GTC orders specify the price but not the date on which the transaction is to occur, and are binding on the customer unless canceled in accordance with agreed procedures. They, too, would not fit into Affirmative Defense (A) as drafted. As a result, an insider could not place a GTC order (e.g., sell 500 shares if the price reaches $50) for herself or members of her family in reliance on this defense, since the possibility would always exist that before the sale was "made", she would become aware of material nonpublic information. This result also seems unnecessarily restrictive.
(ii) Proposed Affirmative Defense (B) - Instructions
The second proposed affirmative defense would allow a person to avoid liability for a transaction when he was "aware" of material nonpublic information if, before becoming so aware, he had "provided instructions to another person to execute a purchase or sale of the security for the instructing person's account, in the amount, at the price, and on the date which that purchase or sale was executed." A related definition of "at the price" indicates that this phrase includes a market order, i.e., one specifying purchase or sale "at the market price" for a particular date, and not only an order at a fixed price. Once again, the exception is correct as far as it goes, but problematic because it does not go far enough.
For example, in addition to the good-till-canceled orders already discussed, Affirmative Defense (B) would seem not to be available for "stop-loss" orders entered prior to an insider becoming aware of material nonpublic information. A "stop-loss" order is an order to a broker to sell a quantity of securities if the market price declines to a specified price or by a specified amount or percentage of its value. Investors typically place such orders when a stock has increased substantially in value, to protect their profit, or is subject to unusually large fluctuations, in order to limit their potential loss - in other words, for ordinary and legitimate investment reasons. Under proposed Affirmative Defense (B), however, insiders, would, in effect, be precluded from placing such orders because the defense requires that orders specify the date they are actually executed. By its nature, a stop loss order cannot be so specific. This could unnecessarily impede insiders from utilizing such risk-reduction strategies. Even if an order was reentered daily, there would still be the unquantifiable risk that the insider might subsequently become "aware" of material nonpublic information but be unable to withdraw the order before it was executed. Insiders would be unable to place "stop-loss" orders before going on vacation, for example, lest they become aware of something material while checking their messages or voicemail and be unable to reach their broker before a trade was executed (a particular risk in a fast-moving market). It is not clear to us that any purpose is served by limiting the defense in this manner.
In addition, as drafted, Affirmative Defense (B) requires that the instructions be given only for a sale for "the instructing person's account." We do not see the point of limiting the defense to the "instructing person's" own account - a limitation that is not proposed to be included in Affirmative Defense (A), for example. Insiders ought equally to be protected in giving orders for accounts of spouses, children, trusts, persons for whom they hold powers of attorney and accounts of entities in which they have a beneficial interest, provided they satisfy all the other conditions of the rule. Otherwise, liability might attach to some accounts but not all in connection with what is essentially a single or contemporaneous transaction.
(iii) Affirmative Defense (C) - Pre-existing Written Plan
The third proposed affirmative defense requires the potential defendant to have "adopted, and previously adhered to, a written plan specifying purchases or sales of the security in the amounts, and at the prices, and on the dates at which the person purchased or sold the security. . . ." While admirable in intent, the restrictions are so numerous as to make the defense virtually useless in practice. For example, the rule requires that an investor have "previously adhered" to a written plan. As a result, it will not be available for the first transaction in a proposed series, for example, a proposed sale of a significant block over a period of days or weeks. Nor is it clear how many transactions must be effected for the test of "previously adhered to" to be satisfied. This ambiguity will create uncertainty and make it difficult to advise clients reliably. Further, the requirement of "prior adherence" makes no allowance for variations from a plan to reflect changes in circumstances - for example, a suspension of sales due to market disruption, significant corporate events, price declines, or the like.
The requirement that the plan be "written" also creates a variety of interpretive issues. Will e-mail be sufficient? Voicemail? Must variations from the original plan also be written? Can transactions be effected based on an oral "plan" if it is subsequently reduced to writing (assuming the "prior adherence" test is satisfied or inapplicable)? These questions, we think, suggest that the Commission should attempt to define "written plan" for purposes of this defense.
The requirement that the plan specify the price at which transactions are actually effected also seems unduly restrictive. As defined, this would require either sales at a specified fixed price or at "the market price for a particular date." But it appears that this defense would not protect purchases or sales made at a formula price determined in accordance with rules specified in the written plan - for example, purchases made at an average cost in an employee stock purchase plan under Internal Revenue Code Section 423 or purchases resulting from an insider's participation in his company's dividend reinvestment plan. Even if such plans are in writing, as typically would be the case, they may not specify that purchases be made "at the market price" as specified in the proposed rules for a particular date. To cure this problem, the Commission should either revise the definition of "market price" or broaden the condition to include transactions effected at prices determined "by reference to" market prices on a date or dates or during a period or periods in accordance with rules specified in the plan.
(e) The structure of the proposed rule would place an undue burden of proof on defendants in a criminal case
Although the proposed rule does not so state, we think it likely that federal prosecutors will seek to apply the rule in criminal prosecutions for insider trading violations because it purports to define when a transaction is effected "on the basis of material non-public information" for purposes of Section 10(b) of the Exchange Act and Rule 10b-5 thereunder. This could result in defendants inappropriately being required to prove that they did not use material non-public information, rather than prosecutors proving, beyond a reasonable doubt, that the defendant did so use the information. We infer, moreover, this result was intended by the Commission, since it has structured the proposed rule to characterize the various exceptions to liability in paragraph (c) as "affirmative defenses" - implying, although not stating explicitly, that the burden of proof of any such defense should and would fall on the defendant, once the required "awareness" of the information in issue was established.
We think this is inappropriate and unfair to defendants, at least in the context of a criminal prosecution. As the Supreme Court stated in the O'Hagan case:
[T]he fiduciary's fraud is consummated, not when the fiduciary gains the confidential information, but when, without disclosure to his principal, he uses the information to purchase or sell securities30 (emphasis added)
If "use" in some form is a necessary element of the violation, then the government should be required to prove such use as part of its case, and should not be able to shift the burden of proving this element of the offense to the defendant.
Indeed, in a criminal prosecution, there would appear to be a constitutional issue as to the government's power to adopt such a presumption that does not require at a minimum a showing that the defendant "used" the relevant information. Although the members of our Committee do not purport to be expert in issues of constitutional law, we note that the Court of Appeals for the Ninth Circuit in the Smith case suggested that even the "knowing-possession standard would . . . go a long way toward making insider trading a strict liability crime" by "de facto eliminat[ing] the mens rea requirement," and therefore should be disfavored.31 In view of the close cooperation that exists between the Commission and the prosecutorial authorities, we believe the Commission should carefully address the implications of the proposed rule for criminal cases before adopting it in its current form.
9. The Commission has not demonstrated that the proposed rule is required to clarify the law or achieve its enforcement objectives
The Proposing Release states that the proposed rule would be an improvement over the Adler test - i.e., a "use" test with a strong inference of use from "possession" - because it will provide "greater clarity and certainty" than a presumption or "strong inference" approach. We have noted above that, while we believe that clarity and certainty are desirable objectives, the proposed rule as drafted would introduce new issues of interpretation that would continue to lead to uncertainty on the part of corporate insiders and others who come into possession of material nonpublic information.
Certainly if adopted as proposed, and possibly if adopted with some or most of the changes we have suggested, the rule would prevent or inhibit innocuous and lawful practices on the part of corporate insiders that are customary today, such as standing instructions to sell stock for purposes of portfolio diversification (unless part of a qualifying written plan), to pay tuition bills when received from the university, to effect Rule 144 sales upon receipt of certificates from a transfer agent, and possibly others. In such cases, the "clarification" that would follow from adoption of the proposed rule is that a transaction, today considered lawful - although perhaps lacking in controlling legal authority - would henceforth be prohibited.
Unless the rule is substantially revised along the lines we have suggested, we believe the benefits of this clarification, on balance, would outweigh the burdens placed on corporate officers, directors and controlling stockholders and others to whom the rule would apply, and thus adoption of the rule would be undesirable. Nor does the Commission demonstrate to the contrary, since its "cost-benefit analysis" in the Proposing Release does not attach any weight to the costs of compliance or the deterrence of lawful activities.
In addition to clarifying the law of insider trading, however, it appears that the Commission also believes that a benefit of the Proposed Rule is that it would make the law stricter in this area, presumably by allowing the Commission to avoid the "use" requirement of the Adler and Smith cases. Thus, the Commission states that the Proposed Rule:
should increase investor confidence in the integrity and fairness of the market because it clarifies and strengthens existing insider trading law.32
In other words, it would make the rules both clearer and tougher.
Our Committee expresses no view as to whether this would be a worthy objective. We think, however, that before adopting Rule 10b5-1 the Commission should state more clearly why the law today needs to be further toughened in this area and attempt to demonstrate why such a charge is required despite the fact that Congress has repeatedly acted to strengthen the Commission's enforcement powers. In recent years, for example, Congress increased the statutory penalties for insider trading, gave the Commission cease-and-desist powers and authorized treble damages for contemporaneous traders in the market. More recently still, the Commission has succeeded in establishing the misappropriation doctrine in the Supreme Court despite its lack of a clear statutory basis. We are not aware of any evidence that the Commission lacks adequate tools to do the job assigned to it by the governing statutes or that the results in the Adler and Smith cases have diminished its authority or blunted its effectiveness. In these circumstances, we believe it is too soon for the Commission to take up the suggestion of the Adler court that the Commission by rule adopt the knowing possession standard, or even something "close[ ] to" it. The idea of SEC rule-making was suggested by the Eleventh Circuit "if experience shows that this approach [i.e., use with an inference of use from possession] unduly frustrates the SEC's enforcement efforts"33 The Commission has made no such showing - indeed, its enforcement efforts are widely admired - and we suspect that too little time (two years) has passed since the Adler decision for the Commission to have an adequate basis for so concluding.
10. Proposed Rule 10b5-2 is based on inappropriate assumptions about family relationships and is not required to achieve the Commission's enforcement goals
Proposed rule 10b5-2 would provide certain non-exclusive definitions of the circumstances in which a person other than a classic insider would be deemed to have a duty of trust or confidence which, if violated, would provide the basis for a finding that the person "misappropriated" material nonpublic information. It would thus provide a partial basis for finding an insider trading violation under O'Hagan, assuming the other elements of the offense were proven. Two provisions of the proposed rule would effectively reverse decisions of the Second Circuit Court of Appeals and the Southern District of New York in the Chestman 34 and Reed 35 cases, respectively, by providing (in paragraphs (b)(3)) that certain family relationships (such as husband and wife) are normally sufficient to create a duty of trust or confidence, without any explicit or implied agreement between the parties, and (in paragraph (b)(2)) that a history, pattern or practice of sharing confidences may also suffice if the person doing the "sharing" has a reasonable expectation of confidentiality.
The Commission and certain commentators have been critical of the results reached in the Reed and Chestman cases because they seem to allow certain family members (a son-in-law and his broker in Chestman and a son in Reed) to benefit by trading on the basis of material non-public information learned from a relative who was a classic insider. Unlike cases where the insider confides the information to a relative intending for one or the other to benefit financially - which is unlawful under the classical tipper-tippee theory - in these cases the insider, for whatever reason, expected the recipient to treat the information as confidential but did not obtain an explicit agreement to that effect or had no business relationship with the recipient that would suffice to establish a fiduciary-like relationship. The Commission believes these results are anomalous and harm investor confidence in the fairness and integrity of the securities markets.
Paragraph (b)(2) of the rule thus would specify that a "duty of trust or confidence" would exist
"Whenever the [persons sharing the information] have a history, pattern, or practice of sharing confidences, such that the person communicating the material nonpublic information has a reasonable expectation that the other person would maintain its confidentiality".
This test is broader than that suggested in the Chestman case by not requiring a showing that the confidences shared related to nonpublic information about public companies or the issuer involved, or even to business matters generally.
Paragraph (b)(3) of the proposed rule would adopt a per se rule that a duty of trust or confidence would be deemed to exist whenever a person obtains material nonpublic information from a spouse, parent, child or sibling, unless the recipient of the information could establish that the relative who was the source of the information had no reasonable expectation that the recipient would keep the information confidential because: (i) the parties did not have a history, pattern or practice of sharing confidences, and (ii) the parties did not have an agreement or understanding to maintain the confidentiality of the information. Under paragraph (b)(2), therefore, the Commission would have the burden of proving the relevant history, pattern and practice and the expectation of the communicating party, whereas under paragraph (b)(3) a family member in one of the specified categories would have the burden of establishing both the absence of a history, pattern or practice of sharing confidences and of an agreement or understanding of confidentiality with respect to the information involved. Without such proof in the later case, misappropriation would, in effect, be inferred from the existence of one of the specified family relationships.
The Commission supports these proposals by arguing that (i) a past pattern of conduct between two unrelated persons, even if not involving business confidences, may be relevant to determining the reasonableness of an expectation of confidentiality with regard to disclosed nonpublic information; (ii) the specified family relationships are those "in which family members most commonly share information with a legitimate expectation of trust or confidentiality"; and (iii) existing law (Reed and Chestman) leads to anomalous results because family members who trade after receiving a "tip," or in breach of an express promise of confidentiality, may be found to violate the insider trading rule, but those who trade without such a promise but in breach of an insider's "reasonable and legitimate expectation of confidentiality" may not be guilty of anything.
We oppose adoption of these proposed prescriptions because we do not agree that the current state of the law is "anomalous," even though we may not agree with the outcome of individual cases; because we do not agree that every relationship in which people may share confidences - even those of a personal or family nature - implies, or should imply, in law that one party has a reasonable expectation that the other will keep business and financial information about public companies confidential and will not trade on such information; and because the Commission's presumptions about the nature of family relationships are unsupported and in many instances unwarranted.
In the first place, we do not share the Commission's conclusion that the current state of the law is anomalous. The Commission may always prove, if the facts support it, that trading by a relative of an insider was unlawful under the traditional quid-pro-quo or de facto insider theories. If the relative's trading does not explicitly benefit the insider-source of the information, the Commission may also establish a "misappropriation" violation if there was an agreement not to trade or the relative assumed an obligation to keep the information confidential that was breached. But anyone who receives information, even from an insider, that is freely imparted and who is not bound by a confidentiality agreement or a relationship that imposes such an obligation cannot be said to "misappropriate" that information if the word is to have any meaning. The insider may have breached his duty to his employer or someone else, but that does not require that his relative also be found liable for disgorgement of trading profits or for monetary damages to unrelated third parties.
It is clear that the adoption of the proposed rule would ease the Commission's and the government's burden in proving some cases of alleged insider trading, and would commensurately increase the burden of associates and family members, who may have traded in an insider's company stock, to establish that they did not misappropriate material nonpublic information in violation of the existing case law and of the presumption embodied in proposed paragraph (b)(3). The difficulty of proving a negative conclusion about another party's state of mind (i.e., that the source of the information "had no reasonable expectation") will, in and of itself, we suspect, increase the prosecutorial leverage enjoyed by the Commission in settlement negotiations with the specified family members (and, perhaps, with suspected primary offenders as well, because the Commission will be able to utilize the potential liability of family members as a bargaining chip).
All of these results might be considered a desirable development if the Commission's enforcement responsibilities were seriously threatened by the current state of the law or if the public's confidence in the fairness and integrity of the nation's financial markets were seriously undermined by a widespread perception that family members in whom trust and confidence were not explicitly reposed by corporate insiders were often abusing their family ties to the detriment of ordinary traders. This, however, the Commission does not demonstrate. One might equally hypothesize that the new presumptions will ensnare unwitting family members who are too naive or unsophisticated to recognize that information imparted to them by relatives is material or confidential, or to know that the law restricts their behavior as well as that of their parents and siblings. In the absence of compelling justification, we would be inclined to leave well enough alone, especially since the decision in the Reed case seems to allow the Commission to pursue troublesome cases based on the specific facts and circumstances.
Our principal objection to the proposed presumptions, however, is that they assume a degree of uniformity in personal and family relationships that the Commission would impose on all associates and close relatives of public company insiders without any rational basis for such rule-making. Consider, for example, the closest proposed relationship, that of insider and his or her spouse. Despite the Commission's assertion that the specified relationships are those in which family members "most commonly share information" with a legitimate expectation of confidentiality, who can possibly doubt that every marriage is different? One husband may share with his wife all the details of his business affairs; another, with equal love and affection, may shield her from all such information. One spouse may enjoy his other half's complete confidence, another couple may be legally married but in fact estranged. One insider may be more likely to confide in his golfing partner or college buddy than to share confidences with his spouse; another may gossip with his spouse about personal matters but keep all details of his business close to his vest. And one may have a spouse who is a sophisticated investment banker who appreciates both the significance of material nonpublic information and the need to keep public company information confidential, while the other has a spouse who has a no such background. The examples could be multiplied. The point is that the proposed rule would treat all spouses and all parents, children and siblings identically, regardless of the facts, and would in effect presume guilt on the part of a spouse who trades, solely because of the fact of the marital relationship and without regard to the actual facts of the transaction in question.
In addition, the proposed presumption in paragraph (b)(2) is inappropriate because it is not limited to business matters generally or the affairs of the public company whose securities are involved in the transaction. Thus, the fact that an insider trusts a colleague or spouse to keep personal matters confidential may be used to validate the presumption that the other party should have kept information about the public company confidential as well. This will lead to irrelevant inquiries into the personal relationships involved and to perverse attempts to prove that relationships are not what they would otherwise seem to be.36 In practice, the requirements of Rule 10b5-2 would place a significant burden on defendants in private party lawsuits. Asserting the affirmative defense could require that a husband/wife, parent/child or other party in one of the specified relationships disclose deeply personal and sensitive information. This could entail the release of medical records, personal diaries, intimate correspondence or other private documents. Traders in securities should not need to give up their privacy rights to this extent simply because they become the target of a 10b-5 action. Apprehension about the need to disclose such information might cause parties to settle, rather than defend, dubious lawsuits. The existence of the presumption could even encourage the filing of frivolous claims that are intended primarily to harass or serve as "fishing expeditions."
The Commission's attempt to create a presumption of misappropriation based on specified family relationships is, we think, doomed to failure based on the variety of human relationships, as compared to the relatively specific legal relationships of employer-employee, client-attorney and law firm-partner in which the misappropriation doctrine was established. These relationships have specified rights and duties attached to them; personal and family relationships do not.37 We therefore urge the Commission to decline to adopt proposed Rule 10b5-2.
* * *
We trust our comments will be helpful to the Commission and its staff, and appreciate the opportunity to participate in the rule-making process.
Committee on Securities Regulation,
The Association of the Bar of the City of
Steven J. Schulte
Mitchell S. Fishman
Chair, Task Force on Proposed
Insider Trading Regulations
Members of the Committee on Securities Regulation
Stephen J. Schulte, Chair
André Weiss, Secretary
Craig S. Barrack
Mark H. Barth
Anthony J. Bosco
Jonathan H. Churchill
Peter C. Clapman
Sarah E. Cogan
Richard A. Drucker
Mitchell S. Fishman
Alan R. Friedman
David B. Harms
Clifford E. Kirsch
Paul L. Lee
Peter J. Loughran
Thomas M. Madden
James B. McHugh
Abby S. Meiselman
Charles M. Nathan
Ernest T. Patrikis
David W. Pollak
Janine L. Pollack
Neila B. Radin
Walter G. Ricciardi
Richard H. Rowe
Faiza J. Saeed
Kathryn E. Schneider
James Q. Walker
Lawrence J. Zweifach
|1||One member of our Committee, A.J. Bosco, is employed by the Securities and Exchange Commission in its New York Regional Office and abstains from the views stated herein.|
|2||In keeping with industry and popular practice, we sometimes refer to such information as "inside information," a term that is found nowhere in the federal securities laws.|
|3||See United States v. Teicher, 987 F.2d 111 (2d Cir.), cert. denied, 510 U.S. 976 (1993).|
|4||As noted below, the Committee believes that the first proposed affirmative defense in Rule 10b5-1(c)(1)(I)(A) is actually redundant of the law as it exists today in this area, and thus is not properly regarded as a separate defense.|
|5||Proposing Release, Section III.A.1, last paragraph.|
|6||It is correct, as noted by the Proposing Release at note 82, that the Eleventh Circuit in the Adler case noted (in a footnote) that "the SEC could promulgate a rule adopting the knowing possession standard, as the SEC has done in the context of tender offers . . . or a rule adopting a presumption approach ...," Securities and Exchange Commission v. Adler 137 F.3d 1325 (11th Cir. 1998), 1337 n.33 (citation omitted). However, the Court did so only in passing, while essentially adopting the "use" test, and only with the preface (not quoted in the Proposing Release) that the SEC could adopt such a "knowing possession" rule "if experience shows that this approach [i.e., the "use" test] unduly frustrates the SEC's enforcement efforts" (emphasis added). As discussed below, we do not think the SEC has made the showing contemplated in Adler. Moreover, the SEC's authority to regulate tender offers under Section 14(e) of the Exchange Act has been held to be broader than its authority to make rules under Section 10(b), as indicated by the Supreme Court in the O'Hagan case ("Under Section 14(e), the Commission may prohibit acts, not themselves fraudulent under the common law or § 10(b), if the prohibition is `reasonably designed to prevent . . . acts and practices [that] are fraudulent'").|
|7||Proposing Release, Part III.A; See David M. Brodsky and Daniel J. Kramer, "A Critique of the Misappropriation Theory of Insider Trading," 20 Cardozo L. Rev. 41 (September 1998) (hereafter "Brodsky and Kramer").|
|8||Brodsky and Kramer at 44.|
|9||United States v. O'Hagan, 521 U.S. 642 (1997).|
|10||Brodsky and Kramer at 44.|
|12||Proposing Release at Part III.A.1.|
|13||137 F.3d at 1336 ("The strongest argument that has been articulated in support of the knowing possession test is that a strict use test would pose serious difficulties of proof for the SEC").|
|14||Adler, 137 F.3rd at 1337-1338; see also United States v. Smith, 155 F.3rd 1051 (9th Cir. 1998) at 1066-68.|
|15||Proposing Release, Section III.A.1.|
|16||Section 10(b); U.S. v. Smith, 155 F.3d 1051, 1068 (9th Cir. 1998).|
|17||Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).|
|18||Dirks v. SEC, 463 U.S. 646, 663 n.23 (1983) (quoting Ernst & Ernst, 425 U.S. at 199).|
|19||O'Hagan, 521 U.S. 642, 651-652 (1997) (emphasis added).|
|20|| Based on footnote 83 to the Proposing Release, if appears that the Commission may be planning to take the position that the "awareness" standard of Proposed Rule 10b5-1, if adopted, and its four affirmative defenses, would apply only to persons who misappropriate material nonpublic information from third parties, and not to classical insiders, who would continue to be subject to a stricter "possession" standard. Thus, the release states:
Although the Proposing Release states that paragraph (a) of Proposed Rule 10b5-1 "incorporates all theories of insider trading liability under the case law - classical insider trading, temporary insider theory, tippee liability, and trading by someone who misappropriated the inside information . . .," the language of note 83 suggests that mere "possession", and not "awareness", of material nonpublic information, could suffice for liability in the case of "classical" insiders. We do not think the Commission should introduce such a distinction in the law - for example, classical insiders are among the persons most likely to execute pre-planned transactions for estate-planning, diversification or college-tuition-payment purposes, and subsequently to come into the unexpected possession of material nonpublic information. Subjecting them to an absolute "possession" rule would vitiate much of the benefit intended to be attained by the adoption of the four affirmative defenses. At a minimum, if the Commission does intend to legislate such a distinction, it should be made apparent on the face of the rule and not introduced by means of a footnote to the Proposing Release.
|21||Proposed Rule 10b5-1(b).|
|22||Proposing Release, Part III.A.1.|
|23||Chiarella v. United States, 445 U.S. 222 (1980).|
|24||See Dirks v. SEC, 463 U.S. 646, 657-663 (1983); cf. In re Investors Management Co., 44 S.E.C. 633, 644 (1971).|
|25||James Q. Walker, "Insider Trading Rule Approaches Strict Liability," New York Law Journal, April 26, 2000, p. 39.|
|26||U.S. v. Smith, 155 F.3d 1051, 1068 ("The persons with whom a hypothetical insider trades are not at a `disadvantage' at all provided the insider does not `use' the information to which he is privy. That is to say, if the insider merely possesses and does not use, the two parties are trading on a level playing field. . . .").|
|27||For example, "awareness" seems to require actual knowledge of the contents of documents, whereas "knowing possession" conceivably could be satisfied without having opened or read them.|
|28||137 F.3d 1325, 1337.|
|29||See, e.g., Radiation Dynamics, Inc., v. Goldmuntz, 464 F.2d 876 (2d Cir. 1972).|
|30||O'Hagan, 521 U.S. 642, 656 (emphasis added).|
|31||Smith, 155 F.3d at 1068 n.25 (citing United States v. United States Gypsum Co., 438 U.S. 422, 436-38 (1978) and Morissette v. United States, 342 U.S. 246 (1952).|
|32||Proposing Release, Section VI.B, first paragraph (emphasis added).|
|33||137 F.3d 1325, 1337 n. 33 (emphasis added).|
|34||United States v. Chestman, 947 F.2d 551 (2d Cir. 1991).|
|35||United States v. Reed, 601 F. Supp. 685 (S.D.N.Y.), rev'd on other grounds, 773 F.2d 477 (2d Cir. 1985).|
|36||Suppose, for example, that an innocent spouse purchases some stock in his wife's company because he is proud that she has been promoted to a position of corporate responsibility. Why should such naiveté, assuming the insider-spouse had some undisclosed information at the time, lead to insider trading liability for the outsider-spouse, unless the insider can prove, in effect, that her relationship with her husband is so poor that she would not expect him to keep her confidences? Or suppose Mrs. Weill had confided her husband's business to her hairdresser instead of her psychiatrist (so that no issue of fiduciary relationship was present); should Mrs. Weill then be presumed guilty of insider trading unless she can show, in effect, that her husband really doesn't trust her? And should the hairdresser's liability depend on whether or not Mrs. Weill normally trusted him with other irrelevant confidential information?|
|37||For the same reasons, the questions the Commission asks about its proposal - for example, should lovers and roommates be treated in the same way as spouses - are equally troublesome. If cohabitation is to create a presumption of insider trading, then should couples be allowed to rebut on the grounds that they weren't involved with each other emotionally? or sexually? or at least not recently? We do not believe it is desirable for the Commission to fashion a rule which requires or encourages its staff to investigate such personal matters.|