Cite as: Joerg Hartmann, Insider Trading: An Economic and Legal Problem, 1 Gonz. J. Int’l L. (1997-98), available at http://www.gonzagajil.org/.
Insider Trading: An Economic and Legal Problem
How would O'Hagan Come Out Under the New German Securities Trading Act?*
by Joerg Hartmann
Introduction and Description of the Problem
Part 1: Demand For Regulation of the Insider Problem
I. The Impact on a Company and its Operations
1. Insider trading as the most appropriate form of compensation providing incentives for managers
2. Conflict of interests
3. Incentives to undertake overly risky projects
4. Negative effects on the firm in the context of takeovers
5. Benefiting from good and from bad news (perverse incentives)
6. Insider trading as a compensation for controlling shareholders
7. Evaluation and conclusion of the compensation arguments regarding effects of insider trading within the corporation
II. The Impact of Insider Trading on the Capital Market
1. Effects on the marketplace:
2. Increase of the cost of Capital
III. Fairness Arguments
IV. Harm to the Individual Investor
Final Conclusion with Regard to Demand for Regulation
Part 2: The Basic Elements of the U.S. Insider Trading Regulation
I. Background
II. Who is liable as an insider?
1. Traditional and temporary insiders
2. Tippers
3. Tippees
4. Employees of the issuer
5. Issuing corporation itself
6. Shareholders of the corporation
III. The significance of the misappropriation theory
IV. Inside information
V. Scienter
VI. "In connection with the purchase or sale of any security" requirement
Part 3. Insider Trading in Germany
I. The historical background of the Securities Trading Act of 1994 (Wertpapierhandelsgesetz
II. Key elements of the German insider regulation
1. Insider securities
2. Insider Facts (Insidertatsache)
3. Primary and secondary insiders
4. Is the different treatment of primary insiders and secondary insiders under German law justified?
5. Sanctions for Insider Trading
Part 4: Application of Both Laws to a Recent Case in the United States: How would O'Hagan Come Out Under German Law?
Conclusion
i Introduction and Description of the Problem
Insider trading arises in securities transactions when one party possesses nonpublic information. Although insider trading clearly is not a recent phenomenon in the business world, legal as well as economic discussions about it still continue. According to Bergmans,ii the first insider trading case allegedly arose when the Rothschilds benefited from insider trading when they learned of Wellington's victory in Waterloo earlier than the rest of London.iii During the great takeover battles in the 1980s, several insider scandals shocked the corporate world in the United States (U.S.).iv The cases of Ivan Boesky and Dennis Levine, Michael Milken and Martin Siegel provide poignant examples of the significance and dimension of insider trading.v However, insider trading did not end in the 1980s and remains an issue in the 1990s. In 1993, a former Goldman Sachs executive agreed to disgorge $1.1 million that he had received as profits deriving from insider transactions.vi Only recently, in June 1997, the Supreme Court decided the O'Hagan case and approved the validity of the misappropriation theory, giving a clear signal to the capital market.vii The U.S. Supreme Court overturned the Court of Appeals of the Eighth Circuit, which did not hold a lawyer liable who profited from insider transactions.viii Despite the long history of insider trading in the United States and this recent development, many unsolved issues remain.
Both legal and economic scholars still debate whether insider trading should be regulated at all. However, even if this question is answered affirmatively, legal scholars as well as judges in the different circuits discuss the applicable legal theory of liability. The U.S. Supreme Court was given another chance to shed light on the dark side of insider trading. O'Hagan will clearly resolve the chaos regarding insider trading regulations. The Supreme Court's ruling will have tremendous consequences for the treatment of nontraditional insiders, such as directors, managers, and officers, who are outside the corporation in which they possess nonpublic information.ix Thus, insider trading is not merely an issue for legal history. It is still a current legal problem.
An international observation reveals that insider trading regulation has a world-wide dimension in the age of global financial markets.x The European Community also dealt with the problem and forced its member states to implement a mandatory prohibition against insider trading.xi In 1994, even Germany, which had previously refused to consider regulation, enacted a law prohibiting insider trading. xii
This thesis will argue that trading on the basis of nonpublic material information should be regulated, and not left to free market forces. It will then compare insider trading regulation in the United States and Germany. Concerning U.S. law it will mainly describe which persons are liable as insiders when trading in securities on the basis of nonpublic information. Then, the thesis will take a closer look at the insider trading provisions of the recently enacted German Securities Trading Act and presenting the key elements of it. Finally, it will show that there are differences between the two systems regarding liability. The thesis will describe these differences by evaluating the recently decided U.S. insider trading case from a German perspective.
Part 1: Demand For Regulation of the Insider Problem
Purpose of the chapter
It is not clear whether trading in securities on the basis of nonpublic information requires regulation. This discussion still continues between legal and economic scholars. Henry Manne's "provocative little" xiii book Insider Trading and the Stock Market evoked scepticism and controversy about regulation some thirty years ago.xiv He reaches the general conclusion that insider trading is beneficial to the firm, the market and society, and, therefore requires no regulation. Manne's statements started the insider discussion in the United States. More recently, the issue has achieved global proportions.xv However, a consensus between regulators and deregulators is almost impossible.xvi This chapter will present the most relevant arguments. A personal evaluation will follow the different arguments. Before discussing the regulation in detail, the case for it should be made. With the immense volume of literature and variety of approaches proposed since Manne, this thesis requires some focus. Therefore, this paper will focus on:
I. the impact of insider trading on a company and its operations, describing and evaluating compensation and incentives arguments,
II. the marketplace impact regarding informational, allocational and operational efficiency,
III. the issue of fairness, and finally
IV. the issue of harm to individual investors.
I. The Impact on a Company and its Operations
1. Insider trading as the most appropriate form of compensation providing incentives for managers
a) Deregulators' arguments:
(1) Incentives
Deregulators argue that insider trading is an efficient form of compensation, providing incentives for management to act in the firm's best interest. Insider trading, they say, encourages entrepreneurship.xvii According to Manne, the separation of ownership and control in modern corporationsxviii requires the establishment of management incentives.xix While the classic entrepreneur reaps the full benefit of innovation, a corporation's shareholders, not management, enjoy the success of innovation. Therefore, motivating managers towards innovation, requires the creation of incentives. Only insider trading, Manne argues, can overcome the bureaucracy of firms caused by the separation of ownership and control. Furthermore, insider trading supposedly fosters innovative conduct.xx The significance Manne attributes to unregulated insider trading becomes obvious in his conclusion: "A rule allowing insiders to trade freely may be fundamental to the survival of our corporate system. People pressing for the rule barring insider trading may inadvertently be tampering with one of the wellsprings of American prosperity." xxi
(2) Reduction of agency costs
Deregulators claim that unregulated insider trading reduces agency costs.xxii Agency costs arise from the separation of ownership and control because the agent's self-interest and the pursuit of the principal's interest are not congruent.xxiii Agency costs also result from negotiations about the management compensation. Carlton and Fischel believe that, without insider trading, permanent renegotiation about the manager's compensation is required.xxiv These costly renegotiations become unnecessary, because managers design their own compensation packages every time they trade. Therefore, managers seek and develop news on which they can trade and earn profits. Using this argument, deregulators claim that "insider trading may present a solution to this cost-of-renegotiating dilemma."xxv The use of insider information is compared with the use of patents. The benefits of good performance belong to the manager as the innovator receives the benefits in the form of royalties from his innovation.xxvi
Insider trading supposedly not only reduces agency costs by minimizing renegotiations, it also decreases agency costs by minimizing the costs of screening of capable managers, by reducing monitoring costs caused by risk-averse managers, and avoiding opportunity costs caused by suboptimal investment decisions.xxvii Risk aversion arises in managers because of their concern for job security.xxviii Since compensation depends on the creation of valuable information, insider trading rewards superior managers better than inferior ones. Managers who favor risky projects prefer insider trading as a form of compensation, because it favors them more than risk-averse managers. Thus, insider trading is supposedly a more certain reward than other available forms of compensation, and provides more incentives.xxix
(3) The Coase Theorem
Deregulators rely upon the Coase theorem. This theorem states that, in a world without transaction costs and uncertainty, privately negotiated agreements will allocate resources to their most valuable use.xxx It does not matter at what point the law initially allocates a property right since the parties will reallocate it to the user to whom it has the greatest value. Private negotiations will, in the absence of interference by the government, provide the best allocation of private rights. Easterbrook and Fischel argue that "[t]he Coase theorem implies that firms and insiders have strong incentives to allocate the property right in valuable information to the highest valuing user."xxxi Regulators, however, state that the Coase theorem is not applicable in this situation.xxxii Negotiations between managers and shareholders do incur transaction costs. Furthermore, information has the same value for outsiders and insiders.
Regulators also point points out that the negotiated result between the firm and the shareholders could affect other firms and nonshareholders. Consequntly, the application of the Coase theorem seems problematic because it assumes that the affected parties are the negotiating parties.xxxiii Therefore, in my opinion, the Coase theorem does not support arguments against regulation.
b) Regulators' arguments regarding compensation
Generally, regulators question deregulators' fundamental arguments. Regulators claim that there is virtually no empirical evidence indicating insider trading as the most efficient and most accurate form of compensation.xxxiv Regulators argue that the financial ability to purchase stock limits a manager's compensation. Therefore, compensation depends not primarily on the value of the information or on the value of the contribution to the information, but rather on wealth.xxxv Thus, managers' abilities to tailor their own compensation packages is limitedxxxvi Manne’s response that insider trading guarantees a particular form of compensation, but not a particular amount,xxxvii reveals that even he questions the accuracy of insider trading as a form of compensation. This argument put forward by regulators as a direct response to Manne's "provocative" book, is no longer true in today's securities markets. Today, stock option contracts enable investors to profit by investing only a small amount of capital. Option contracts "combine relatively small initial investments with a substantial potential for gain and loss.xxxviii Therefore, it is clear why insiders in the 1980s used call options to gain profits with relatively small capital.xxxix
Additionally, regulators claim that the compensation depends completely on external factors such as the structure of the capital market, the level of the firm-specific risk and the average amount of outsider sales per period.xl Furthermore, it cannot be assured that only the producer of the valuable information will be the one who will exploit the information.xli The manager creating positive news is not the only one who might benefit from it. This leads to a free-rider problem in the case of unregulated insider trading. If a manager wants to exploit information, he must withhold it from colleagues until after his stock transactions. Profitable insider trading requires that the number of insiders with privileged information is small.xlii With an increasing number of insiders within the company, competition might nullify gains from insider trading."xliii In this case, insider trading delays the flow of information.xliv These delays cause significant costs to the firm.xlv When transmission of information within the firm is delayed, the decision making in the firm can potentially be hampered and cause injury to the firm.
Regulators additionally question whether managers would choose insider trading as a form of compensation. They suggest that even managers may prefer more certain compensation over the uncertain nature of insider trading.xlvi
Scottxlvii and Easterbrookxlviii assert that insider trading reduces the wealth of a firm by making performance-based compensation of managers even more difficult. Benefits from insider trading depend on many factors and cannot be anticipated with any certainty. Easterbrook compares insider trading to the purchasing of a lottery ticket.xlix I think this comparison is very illustrative, showing the unpredictable nature of insider trading, and showing that insider trading is not performance-based.
Regulators, however, contribute more to the debate than merely questioning insider trading as an ideal form of compensation. Regulators strongly believe that a compensation scheme based on stock options avoids the disadvantages of insider trading. Options allow managers to participate in the firm's success.l Active participation in the firm through options could affect the manager's efforts more positively than the allowance of insider trading.
2. Conflict of interests
Regulators also argue that insider trading leads to a conflict of interests between a firm and its management.li They believe that insider trading may harm the firm since it motivates insider managers differently than profit-maximizing managers. An insider manager may not work in the firm's best interest.lii While the profit-maximizing-manager constantly maximizes the difference between costs and returns, the insider trading manager is interested only in maximizing the profit in good periods, but may neglect costs in bad periods.liii Two examples can illustrate this conflict of interest more closely: The incentives to undertake overly risky projects and the behavior in context of takeovers.
3. Incentives to undertake overly risky projects
The theory underlying insider trading as compensation asserts that the manager benefits from the change in the stock price since he buys or sells before the trading public has received knowledge. Therefore, insider managers undertake suboptimal risks.liv Insiders may select very risky projects promising an increased volatility in stock prices, thereby giving them greater opportunity to profit from insider trading.lv The insider will not select projects promising the highest return for the firm, but rather projects promising increased volatility in stock prices. The higher the project's risk is, the higher the stock's volatility. Manager's aims and firm's aims are therefore not aligned.
Insider trading is also inappropriate compensation if insiders can purchase options for fraction of the stock's value. While managers will admittedly profit if the stock price increases, they lose almost nothing if the stock price does not increase. Thus, their incentive is not to maximize firm value, but to maximize risk and volatility, producing the highest possible return for options' purchases.
However, Carlton and Fischel lvi believe that colleagues monitor one another and that managers have strong incentives to maximize the value of their services to the firm. The monitoring argument is well founded.lvii The argument about service-value maximization is less persuasive. Actually, tender offers are a practical method of removing incapable management within the market for corporate control. Management, therefore, should have a strong incentive to perform well and maintain the value of the firm if there is an efficient market of corporate control. If management does not perform well and the stock price decreases, shareholders may sell to a bidder who will oust the incumbents. However, currently the market for corporate control is not efficient and the possibility of management defensive tactics, and federal, and state regulation makes it virtually impossible to remove incumbent management without its consent.lviii
Another reason that manager's and firm's aims are incongruent is that the planning horizons of chief executive officers and their firms are different. Most chief executives reach these positions at a mature age. Most are protected by "golden parachutes" in the event that they leave, or become forced out of their offices. As a result, economic incentives are no different when information lowers firm value than when it raises firm value.lix Therefore, there is virtually no reason for the management to abstain from high-risk projects.
4. Negative effects on the firm in the context of takeovers
Insider trading may also harm the corporation in takeovers situations. Insiders may pursue their personal interests rather than those of the firm or shareholders. If managers of the corporation, trying to take over another corporation, use their knowledge to engage in transactions in the stock of the target corporation, the stock price of the target corporation will increase. Thus, insider trading may increase the costs of the transaction to the aggressor.
One not only faces the problem that insider trading increases the costs of a takeover, but also that managers may consider the possible profit from insider trading, rather than the benefits the acquisition may contribute to the firm's wealth.lx A target corporation's manager might use this knowledge to make the takeover more difficult in order to maintain his job. This can be achieved by driving up the stock price of the target corporation. Therefore, insider trading can also have negative effects regarding control and monitoring of the management.lxi
Summary of the "compensation arguments"
According to regulators, profits from insider trading bear no relation to the insider's contribution to the firm's performance. The aims of managers and their firms are not necessarily identical. Therefore, insider trading is not more beneficial to the company than other compensation schemes. With unregulated insider trading as a form of compensation, it is neither possible for the shareholders to determine in advance how much they will actually pay for managerial services, nor to make cost-effective choices on how to run the firm.lxii
Regulators argue that allowing insider trading will likely increase both opportunity costs and agency costs. Agency costs increase because of the described conflict of interests. Opportunity costs will increase, because it is likely that managers will spend most of their time trying to profit from their own insider transactions.lxiii Separation of ownership and control allows managers to behave more opportunistically. Thus, a conflict of interests arises when managers work in their own interests and not in that of shareholders.
5. Benefiting from good and from bad news (perverse incentives)
As discussed already, an unregulated insider trader may delay the transmission of information to gain from his knowledge. Furthermore, it can lead to a problem of "perverse incentives." This problem arises when managers are not compensated for their performance but for their access to material information.lxiv Insider trading enables managers to benefit from good and bad news.lxv While managers obviously profit from good news, further explanation is required on how they may benefit from bad news.
In the case of bad news, insiders can benefit by short selling. An investor engages in short selling by selling stocks he does not actually own. He borrows stock about which he possesses bad news, and promises to pay back the same number of shares at a later date. The investor then sells the borrowed stock at the current market price. As a result of the bad news being made public, the price will decrease. The investor purchases stocks at the lower price to replace the borrowed stocks. The profit is the difference between the price at which he sold the stock and the price at which it is repurchased.lxvi
Insiders can also benefit from purchasing put or call options. Put options are options to sell a certain stock at a fixed price for a limited period of time.lxvii Call options are options to buy a certain stock at a fixed price for a limited period of time.lxviii Therefore, the insider manager can preserve his interest through these financial instruments even in bad times.lxix The manager may be tempted to manipulate corporate events or even produce bad news from which he may also benefit. Consequently, one must face the possibility of overproduction of bad news, because bad news is easier to produce than good news.lxx
6. Insider trading as a compensation for controlling shareholders
Demsetz not only focuses on the managers' compensation, but also states that insider trading may function as a compensation scheme for controlling shareholders.lxxi He argues that insider trading is necessary in the interest of the firm, since it is an efficient form of compensation for controlling shareholders.lxxii According to Demsetz, controlling shareholders must hold a large number of shares to control the corporation. As a result, controlling shareholders do not diversify their assets if they only hold stocks of one particular corporation, and therefore, assume high risks. Thus, Demsetz believes that profits from insider trading should be seen as compensation for the costs and disadvantages these controlling shareholders assume because of the lack of portfolio diversification.lxxiii
Demsetz's theory has not received any attention in the insider trading debate.lxxiv Other authors question the relevance of Demsetz's hypothesis, arguing that a shareholders' influence in controlling a corporation is unclear.lxxv Therefore, the compensation argument regarding controlling shareholders is not a strong argument to deny regulation.
7. Evaluation and conclusion of the compensation arguments regarding effects of insider trading within the corporation
I believe that the deregulators' arguments regarding compensation are unconvincing. It is, without any doubt, correct that managers need incentives to perform optimally. However, benefits from insider trading are not related to a firm's success. A manager can realize gains from insider transactions, whether or not he truly acted in the firm's interest. If one takes into account that managers can also benefit from bad news - which may be easier to create - it becomes apparent that insider trading cannot be an appropriate incentive to do a good job for the firm. Thus, I do not agree with the deregulators' argument that insider trading will induce managers to produce good news.
The problem regarding compensation is that the performance of managers can hardly be evaluated ex ante. The appropriate compensation can only be set if the performance has paid off.lxxvi In my opinion, one should rather follow the suggestions of regulators and choose a compensation based on the manager's contribution to the firm's performance.
The possibility to benefit from good and bad news also encourages managers to manipulate information. Furthermore, it may lead to a conflict of interests, which, indeed, may harm the firm. Therefore, the ideal compensation would correctly align a manager's performance and hard work with the interest of the firm.
A compensation linked directly to the firm's return also provides incentives for managers to maximize the wealth and growth of the firm. A compensation model based on a connection between the stock price and the manager's reward is also a valid alternative to encourage managers. Clearly, compensation plans do exist which provide incentives without exhibiting the negative effects of insider trading.
Furthermore, the deregulators' compensation arguments are not correct in the case of eavesdroppers, such as people who accidentally receive knowledge of inside information, e.g., by overhearing a conversation between two managers in a restaurant. Compensation arguments also do not apply to tippees. These examples illustrate that there is no connection between insiders' benefits and the firms' wealth.
It is noteworthy that most insider trading cases involve market professionals, i.e., people outside the corporation, such as investment bankers, arbitrageurs, and corporate lawyers rather than the corporate insider Manne addressed by his incentive arguments. Clearly, the compensation argument does not apply to market insiders.
Finally, I deny the deregulators’ argument that insider trading reveals the qualification and success of managers. Since insider trading is a form of compensation not tied to good management performance, it does not lead to an effective monitoring mechanism of the management.
While the first subchapter focused on effects of insider trading within the firm, evaluating mainly principal-agent arguments, it did not take into account effects on the capital market. In other words, it was only an isolated observation.lxxvii Therefore, it is premature to reach a clear conclusion at this stage. The next subchapter presents the chief effects of insider trading on the capital market.
II. The Impact of Insider Trading on the Capital Market
The capital market fulfils two functions. First, "it provide[s] companies with capital and investors with shares."lxxviii Second, it channels funds to the most desirable, most profitable uses.lxxix
1.Effects on the marketplace: Informational (a), Allocational (b), and Operational Efficiency (c)
(a) Informational Allocation
Informational efficiency describes "the use of available information to assess securities and securities prices."lxxx An understanding of the effect of insider trading on market efficiency requires a brief look at the basic market theory called the Efficient Capital Market Hypothesis. The Efficient Capital Market Hypothesis states that stock prices reflect the value of the underlying shares based on all public information about the stock.lxxxi There are three different categories of the Efficient Capital Market Hypothesis. These three different categories are the weak form, the strong form and the semistrong form of the Efficient Capital Market Hypothesis:
i. The Weak Form:
The weak form of the Efficient Capital Market Hypothesis assumes that "prices fully reflect all information contained in the historical pattern of market prices."lxxxii Therefore, no investor can predict future prices by looking at the past development of prices. The weak form implies that prices follow a random walk.lxxxiii Consequently, no advantage arises from studying past prices. The weak form of the Efficient Market Theory is irrelevant in the context of insider trading, because insiders base investment decisions on material nonpublic information and not on pricing patterns.lxxxiv
ii. The Strong Form:
The strong form of the Efficient Capital Market Hypothesis states that securities prices reflect both nonpublic and public information.lxxxv While nonpublic information is only available to corporate insiders, public information is all information, which is generally available to investors through disclosures, formal or informal. Assuming the strong form of the Efficient Market Theory applies, an investor derives no advantages from insider trading, since the information is already incorporated in the price of the stock. If it could be shown that securities prices reflect publicly and nonpublicly available information, benefiting from insider trading would not be possible.
"However, the results of strong form tests generally show that corporate insiders and stock exchange specialists benefit because of informational advantages."lxxxvi
iii. The Semistrong Form:
The semistrong form of the Efficient Capital Market Hypothesis holds that security prices reflect only publicly available information.lxxxvii Because publicly available information is already reflected in the prices, an analysis based on public available information cannot lead to above-average returns. Traders receive above-average returns only when they trade on the basis of nonpublic information. The semistrong form implies that investors with nonpublic information aremore capable of estimating the true value of a security. Therefore, they earn excess returns when trading on the basis of nonpublic information. The semistrong form of the Efficient Capital Market Hypothesis is the most widely accepted as applicable to current world markets.lxxxviii In Basic v. Levinson the Supreme Court showed, though not explicitly, its belief in the semistrong form of the Efficient Capital Market Theory.lxxxix
In an efficient capital market, public announcement or disclosure of material information will always influence the stock price immediately. According to the semistrong form of the Efficient Capital Market Hypothesis, stock prices do not incorporate "information that is not publicly available, e.g., inside information about the issuer, or the unexpected possibility that a specific takeover may be made in the future."xc As a consequence, insiders may profit from investing based on their information.xci
- The deregulator’s view on informational allocation
Deregulators argue that prohibiting insider transactions has a negative effect on the creation and the spread of information in the capital market.xcii Fischel describes insider trading as a "mechanism of communicating information."xciii Permitting insider trading would create incentives for insiders to produce positive information in order to be the first to benefit from it. Deregulators argue that insider transactions move stock prices in the right direction, that is, market efficiency increases, because insider trading adjusts stock prices in the right direction.xciv
If this were true, the investor would pay a more accurate and lower price for the security than they would without insider trading, and the free market will produce results which conform with broader social objectives. Deregulators argue that insider trading benefits society. Insider trading smoothes changes in stock prices, and thereby decreases volatility.xcv Therefore, it leads to an increased attractiveness of the securities market, especially for risk-averse investors.
The underlying notion is that insider trading provides the market with information. Those who trade with insiders sell at higher prices in the case of good news or purchase at lower prices in the case of bad news. Since not all information is reflected in a form communicable to the market, insider trading supposedly fulfils a communicative function. An increase in trading volume caused by insider trading could signal to the market that there is undisclosed information which is not being reflected in the price. Deregulators, therefore, think that insiders’ gains are the price society pays for the beneficial effect of market efficiency.xcvi
- The regulator’s position
The direct effect of insider trading on the spread of information seems plausible at first. However, regulators argue that insiders hide their orders, thereby disguising new information. Insiders must place hidden orders to be able to benefit from the information they possess.xcvii Regulators argue that insider trading generates no price signaling effect.xcviii They also question the assumption that unregulated insider trading enhances market efficiency relying on early market studies which show that insider trading did not affect the price significantly in most cases.xcix
According to later studies, the market reacts quickly when insiders buy securities, but price changes are minimal when insiders sell their securities.c Other, more recent studies reveal that transactions by insiders had a strong price effect. However, no transactions were based on nonpublic information.ci
Empirical studies support regulators in their statement that stock prices are not significantly affected, unless investors believe that new information about the issuer is available. According to these studies, the market efficiency argument of the deregulators appears in another light.cii Insider trading does not communicate information as deregulators claim.
Deregulators also claim that insiders sell if they possess adverse inside information. Increased sales volume in the market results in falling prices.ciii However, the supply effect of insider trading does not affect the price significantly, because it "is simply too small."civ
Gilson and Kraakman’s statements raise doubts whether insider trading leads to informational efficiency.cv This conclusion is rooted in the "derivatively informed trading mechanism."cvi This mechanism describes the fact that market prices are influenced in a "two-stage"cvii process. First, insiders begin trading on the basis of nonpublic information, affecting the market price only minimally. Second, outsiders gain knowledge either through tipping, leakage, or market observing. Finally, the market reacts. The crucial issue, however, is that derivatively informed trading is slow and sporadic.cviii Therefore, insider trading does not affect the efficiency of securities markets.cix
There is also evidence that prices are only affected when insider trading is signaled to the market.cx However, it is not clear whether or not insider trading signals the right information to the market. Investors can only observe that new information is available, but not what that information specifically entails.
Additionally, according to regulators unregulated insider trading may not communicate all information to the securities market. Bad information may not be revealed, or only be revealed slowly, whereas insiders are anxious to profit from good news through disclosure.cxi Regulators doubt that insider trading conveys information to the market. They argue that insider trading cannot substitute disclosure because too much "noise" is associated with trading.cxii Investors may use non-accurate financial information and trade for personal or political reasons and not because of nonpublic material information about the value of the issuer's assets or a particular kind of risk. This sends mixed price signals or "noise".cxiii
Consequently, even if one assumes that insider trading communicates new information to the securities market, many questions remain unsolved.
(b) Allocational Efficiency
Allocational efficiency refers to the use of capital resources in the most productive manner.cxiv Information about firms with promising or probable future earnings should cause prices of their securities to rise; the market price of securities of firms with less promising earnings prospects should decline. Society allocates resources to investments promising greater returns and away from those with less promise. Thus, efficient stock prices assure that capital is used in the most efficient way.
Older literature points out the problem that material information is often withheld.cxv Mendelson drew the conclusion that withholding information impairs the allocational efficiency because there is inaccurate pricing.cxvi Insiders might also delay disclosure of material information to benefit from trading before disclosure.cxvii However, delays in disclosure, today, due to insider trading are "infrequent and short-lived and will thus have only little or no effect on the allocation of resources."cxviii
Despite this observation, risks still remain, that corporate insiders have an interest in manipulating the market through the timing of press releases in another way. They may delay a release if it will increase the market volatility.cxix Delay of disclosure, however, adversely affects the market's allocational efficiency because it reduces accurate pricing. Regulators believe that trading cannot avoid the mispricing effect.cxx Only disclosure assures accurate pricing.
(c) Operational efficiency
Insider trading also, arguably, increases transaction costs by increasing the bid-ask spread.cxxi Reaction of market-makers to insider trading purportedly causes this increase. A market-maker benefits from buying at his bid and selling at his ask. According to Schmidt, market-makers are "prime targets of insider trading and always lose to insiders."cxxii Insiders deal with market-makers only if they anticipate that they will realize higher profits than the brokerage fee.cxxiii Market-makers do not know whether they are dealing with insiders.cxxiv When they think that they are trading with insiders, they may increase the bid-ask spread. The increase in the bid-ask-spread will ultimately increase the cost of capital, as marginal, uninformed traders leave the market. Those who stay will change the proportion of investment in debt and equity.cxxv Higher costs of capital curtail investment and thereby weaken the growth of the economy. Therefore, general welfare may decrease.cxxvi
2. Increase of the cost of Capital
Not only market-makers, but also sophisticated investors, protect themselves against insiders. Because insider trading occurs randomly, investors do not know about which firm material information is available, and whether insiders are trading on the basis of nonpublic information. Therefore, investors must "assume that every investment presents the same risk of insider trading as does the market as a whole."cxxvii Accordingly, some investors leave the market while others discount the value of any individual firm by the average agency cost of all firms.cxxviii Discounting protects against the fact that the investor cannot distinguish between firms whose shares are and are not affected by insider trading.
While investors can protect themselves, and are, thereby, not directly harmed, insider trading may harm the issuers of securities.cxxix Their cost of capital increases by the amount that the investors discount the price of their securities.
Akerlof illustrates another detrimental effect by scrutinizing the market for used cars.cxxx Used cars can either be lemons or satisfactory. An individual is more inclined to sell a lemon than a satisfactory vehicle. Realizing this, buyers value all cars at less than their actual value. Therefore, the seller obtains neither the value of a good car, nor the average value of a good and a bad car.cxxxi This study shows how informational asymmetry detrimentally affects the market. This article concludes that markets break down because market participants do not value the good quality highly enough. The same effect can happen to the securities market when information asymmetry leads to withdrawal from the market. The breakdown of the market would lead to an increase of capital costs as well as a decrease the liquidity in of the stock market.cxxxii
Deregulators might respond that insider trading reduces this informational asymmetry. However, insider trading eliminates the informational asymmetry ex post but the market suffers damaging effects if investors perceive the asymmetry ex ante.cxxxiii Therefore, disclosure becomes the only measure which can attack the informational asymmetry.
Evaluation of the capital market arguments
The observation in the preceding subchapter focused on capital market processes. On the one hand, I agree with the statements of regulators describing the possibility that insiders may mask their trading activities. In my opinion, insiders, understandably, want to complete their transactions before the information becomes public. On the other hand, I believe that one should be aware that masking is almost impossible because specialists on the stock exchanges attentively observe the market development. However, this view is only valid within certain limits. The attentive observation of the New York Stock Exchange does not necessarily help if information in California is available. However, I agree with the statements of regulators based on the "derivatively informed trading mechanism" and "noise," which question that insider trading tends to informational efficiency.
Furthermore, the consequence concerning allocational efficiency is not predictable with certainty, due to the fact insiders cannot completely hide their transactions. Therefore, in my opinion, detrimental effects on allocational efficiency are not a particularly strong support for an insider trading regulation.
The argument, based on the assumption that insider trading leads to an increase of the bid-ask spread, also seems unconvincing, since computerization of stock exchanges has generally led to a decrease in the bid-ask spread.
However, it is detrimental to the securities market if sophisticated outsiders react to insider trading and are "unwilling to pay for the full expected value of forthcoming investment returns."cxxxiv Decreased liquidity of the market and increase of the costs of capital may have far-reaching consequences. In this context, regulators can rely on Akerlof's observation of a market breakdown under certain conditions.
Therefore, with regard to market efficiency, insider trading has no desirable advantages over mandatory disclosure. Price changes occur more quickly through public disclosure. Outside investors are better off without insider trading. With insider trading on bad news an outside investor might buy a stock which has a lower value than its purchase price. In the case of insider trading on good news, an outside investor may sell a stock at a price which is below its price following disclosure.cxxxv It is worthwhile pointing out that the current laws do not oppose informational efficiency. Modern insider trading regulations not only prohibit the use of nonpublic material information, but they also enforce the disclosure of nonpublic information by the issuer.cxxxvi
III. Fairness Arguments
Average people often argue that insider trading is unfair.cxxxvii However, also "members of the financial community, regulators, lawyers, and judges seem to be based on the idea that such trading, by giving insiders an unfair advantage, will discourage ordinary investors."cxxxviii This view is either based on intuition or on the effects of insider trading on the distribution of justice.cxxxix Intuition is not necessarily a good basis for condemning insider trading since there are, as shown already, strong arguments in favor of unregulated insider trading which are at least worth considering. Schäfer and Ott state that the argument of distributional justice "assumes naive outsiders." Sophisticated outsiders take into consideration that their expected returns per share is lower than the average return per share, because insiders hold parts of the stock in good periods, whereas outsiders hold all of the stock in bad periods. Sophisticated outsiders will discount this loss and pay a lower price or demand a higher dividend."cxl Therefore, outsiders are not harmed according to Schäfer and Ott.cxli The effect of the investor protection -- the increase of cost of capital -- was already discussed. The Securities and Exchange Commission (SEC) is opposed to unfairness on the capital market. In re Cady, Roberts & Co, the SEC proclaimed that one purpose of the securities laws is to eliminate the "use of inside information for personal advantages."cxlii The Supreme Court also acknowledged that the Securities and Exchange Act of 1934 was drafted "to restore public confidence in financial markets."cxliii It made this position even more clear in O'Hagan applying the misapprorpriation theory. It found that the theory is "well-tuned to an animating purpose of the Exchange Act: to insure honest securities markets and thereby promote investor confidence."cxliv Interestingly, not with a single word the Supreme Court addresses the necessity of regulating insider trading, but rather applies a rigid theory which can promote the investor confidence in the integrity of securities markets. Thus, the Supreme Court realized the importance of investor confidence and the connection between it and the proper functioning of capital markets.cxlv
The intuition of investors and their feeling for justice and fairness should not be underestimated. If investors feel unfairly treated they may lose confidence in the integrity of the securities market. These investors would then withdraw from the market and invest in other opportunities.cxlvi This view clarifies why concern about the confidence of investor in the integrity of the market was a motive for the enactment of the insider trading prohibition.cxlvii Informational disadvantages, however, are not uncommon in our world and they are not illegal per se. The question is, what constitutes a problem with regard to trading on nonpublic material information about an issuer of securities. The problem lies not in the possession of information, but in access to that information. This inequality is unfair because an outside investor cannot independently and lawfully acquire the same information that the corporate insider can. Thus, outsiders can never overcome the insiders’ advantages resulting from the access to material information.cxlviii Put another way, fairness is achieved when insiders and outsiders are in equal positions.cxlix
Deregulators point out that the presence of insiders has not led to a significant decrease of the number of investors participating in the securities market.cl This argument does not carry much weight because the fact that investors have not (yet) changed their preferences for investment is not a reason for the law to abandon them by giving up all attempts to provide equitable securities markets. Cox and Fogarty state that "markets appear to function successfully in nations where official attitudes toward insider trading traditionally have been more benign than in the United States."cli It is interesting that Germany, as a country with an "official[ly] benign attitude towards insider traders" gave up its opposition against the Insider Dealing Directive of the European Union, which it finally implemented as national law. After more than twenty years of discussions, Germany had to recognize that insider trading regulations are seen as a "guaranty seal",clii essential for global competition.cliii The international development of securities law shows that countries increasingly recognize that the regulation of insider trading is a factor which global institutional investors require as a condition of investment. Cox and Fogarty's argument is no longer valid. A closer look at the preamble of the EC-Insider Dealing Directive of 1989 shows that investor confidence was a main base for the regulation of insider trading:
Whereas for that market to be able to play its role effectively, every measure should be taken to ensure that market operates smoothly; whereas the smooth operation of that market depends to a large extent on the confidence it inspires in investors; whereas the factors on which such confidence depends include the assurance afforded to investors that they are placed on an equal footing and that they will be protected against the improper use of inside information; whereas, by benefiting certain investors as compared with others, insider dealing is likely to undermine that confidence that confidence and may therefore prejudice the smooth operation of the market.cliv
In this respect the motivation for the EC-Insider Dealing Directive is not different from the introduction of the Insider Trading and Securities Fraud Enforcement Act of 1988,clv that is, that it stems from fear that the capital market might suffer detrimental effects.
Investors' confidence is fundamental for the proper functioning of securities markets. A well functioning securities market is a precondition of the common wealth. Therefore, legislatures must maintain and restore this confidence. As long as outside investors experience unequal treatment, potential risks for the capital market will remain, even if economic advantages could be derived from insider trading.clvi
Evaluation of fairness arguments
Although deregulators question fairness considerations and arguments, these arguments are closely connected to investors' confidence of in the integrity of the securities market. I think the legislators enacting insider trading regulations were correct when they considered investors' confidence a serious matter for the proper functioning of the market. The growth of mutual funds may be a sign that investors do not trust direct investment in securities. Therefore, the withdrawal of investors from the market is not only a hypothesis.
IV. Harm to the Individual Investor
Major controversy exists about whether insider trading harms the individual investor.clvii "An individual shareholder is said to be harmed because either he would have gotten a better price if the inside information had been disclosed before trading by the insider, or he would not have traded at all."clviii However, the problem is that the shareholder would act anyway, regardless whether insiders trade on the basis of nonpublic information.clix Therefore, deregulators question the notion that anyone is seriously harmed by insider trading.clx Manne advanced the argument that noninsiders are not likely to be harmed by insider trading,clxi a theory called the "victimless hypothesis."clxii Insiders do not directly influence the trading of those who trade in the opposite direction on the basis of an independent decision nor of those who trade in the same direction.clxiii Insiders cause trading only if they induce the other party of the transaction to trade in the opposite direction or insiders preempt trades of the same type.clxiv
However, since insider trading arises on impersonal stock markets, it may be difficult to find a causation between insider activities and investors' harm. A response to this argument is that investors are induced or misled to buy or sell because of the price movements caused by insider trading.clxv This assumption is, however, problematic since the effect of insider trading on price movements is uncertain. In my opinion, one must pursue a consistent view: One cannot question on the one hand the price-moving effects of insider trading, but use the same argument to create a causal relationship between insider trading and economic harm of investor. As a consequence, I believe that this assumption does not answer the causal problem whether insiders induce outsiders to trade in the "opposite direction."clxvi
Supporters of the "victimless crime" theory rely on the fact that the outsider acted voluntarily and would have sold or purchased in any event.clxvii Klock, a legal and economic scholar reveals several shortcomings in Manne's victimless crime assumption.clxviii The first flaw he finds in Manne's own reasoning is that noninsiders are harmed in the case of insider trading on bad information.clxix Klock also points out that Manne relies only on "a single transaction in isolation and holds everything else constant in a nirvana-like fallacy,"clxx a so-called partial equilibrium model.clxxi The difference speaking of securities markets is that prices "impact upon prices of physical capital."clxxii Therefore, a general equilibrium analysis is required.clxxiii Manne is also is also considered incorrect when rejecting the argument that insider trading leads outside sellers to sell for less than if they were in possession of the information.clxxiv Manne compares prices with and without inside information before the information is disclosed. He does not consider that in a world of unregulated insider trading, investors anticipate losses to insiders and adjust their behavior. Klock contends that Manne who "attack[s] his critics for looking at the outsider's position ex post rather than ex ante ... is looking at the situation ex post with respect to the outsider's investment decision."clxxv
A different hypothesis focuses on the investors as a group, rather than on the individual investor.clxxvi Wang identifies economic harm of insider trading according to the "Law of Conservation of Securities."clxxvii He states that "with a purchase of an existing issue of securities, someone ultimately has less of that issue; with a sale of an existing issue, someone ultimately acquires more of that issue."clxxviii Therefore, insiders win at the expense of outsiders.clxxix If the inside trader had not traded, someone else would have. Thus, insider trading preempts others from buying in the case of good news or from selling in the case of bad news.clxxx According to Wang, someone loses in the end if an insider enters the market.clxxxi However, Wang also identifies the shortcomings of this approach: When insider trading takes place on the stock market an identification of victims is impossible.clxxxii Additionally and as already stated, outsiders can act independently, that is, without inducement of insiders.
Evaluation of the arguments with regard to harm
In my opinion, the hypothesis that the individual investor suffers economic harm is not a particularly strong basis for regulation. It is hardly possible to create a causal relationship between insider trading and harm arising on impersonal stock markets. Therefore, the argument that insider trading harms the individual investor is based on too many speculative assumptions.clxxxiii This does not mean, however, that insider trading regulations do not focus on individual investors. Insider trading regulations aim to win investors' confidence by providing fair trading and market integrity more than protecting the individual investor. Protecting against direct economic harm cannot be the primary aim because direct harm is speculative and hard to prove. Clearly, this does not mean that all protection of the individual investor is denied.clxxxiv The role of investors' harm as a justification for regulating insider trading can be seen when looking at the compensation of investors who claim injury from insider trading. The new German Securities Trading Trade Act does not permit the assertion of such a claim against insiders. Furthermore, the German Securities Trading Act is not a law protecting individuals (Schutzgesetz) in the meaning of section 823, paragraph 2 of the German Civil Code, because the Securities Trading Act does not protect individual investors, but rather investors as a group of potential investors.clxxxv Therefore, neither claim is possible. Under the current U.S. law, only persons who traded "contemporaneously" or who had a contract with an insider may claim compensation.clxxxvi
Final Conclusion with Regard to Demand for Regulation
There are no clear and easy answers to the question of regulating insider trading. Insider trading may have benefits for both the company and the capital market under certain conditions. However, the arguments against regulation show a certain vagueness and cannot refute the well-founded doubts of regulators. Even though scholars often argue that fairness considerations do not carry much weight, the personal feelings of the individual investor and his confidence in the integrity of securities markets must be taken into account. Although insider trading can have positive effects for the firm and its wealth, as the arguments of deregulators show, it also bears several severe risks. The costs seem to outweigh the benefits.clxxxvii Therefore, it is correct to prohibit insider trading by a mandatory regulation.
Part 2: The Basic Elements of the U.S. Insider Trading Regulation
I. Background
Before Congress enacted the Securities Exchange Act (SEA) in 1934 in the wake of the stock market crash of 1929, common law dealt with insider trading. Common law applied the standards of material misrepresentation,clxxxviii that is, an insider was only liable when a fiduciary duty or other relationship of trust and confidence existed between the parties.clxxxix
Today, the main tool fighting insider trading in the United States is section 10(b) of the SEAcxc and rule 10b-5 which the Securities and Exchange Commission (SEC) promulgated under section 10(b) in 1942.cxci
Section 10(b) provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange-- ...
(b) To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.
Rule 10b-5 provides:
It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce, or of the mails, or of any facility of any national securities exchange,
(a) To employ any device, scheme, or artifice to defraud,
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading, or
(c) To engage in any act, practice, or course of business which operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security.
Due to the broad language of section 10(b) and Rule 10b-5, courts and the SEC play a significant role in the practical application of these provisions.cxcii Both provisions serve as "catchall" clauses against insider trading.cxciii The term "insider trading" is not defined. Therefore, an understanding of the U.S. approach regarding insider trading requires a brief look at the landmark cases when discussion the following subchapters.
II. Who is liable as an insider?
1. Traditional and temporary insiders
The cases Cady, Roberts & Co.,cxciv Chiarellacxcv and Dirkscxcvi reveal that traditional insiders,cxcvii such as directors and officers, and temporary insiders may be held liable under section 10(b) and rule 10b-5.
Cady, Roberts & Co.
An important step in developing the parameters of Section 10(b) SEA can be found In re Cady, Roberts & Co,cxcviii the first SEC decision to address insider trading on the open market. The Commission recognized that corporate insiders must disclose all material information known to them or refrain from trading. The Commission extended the reach of Rule 10b-5 to "any person" having an affirmative duty to disclose material insider information. According to the Commission this duty derives from the "relationship giving access, directly or indirectly, to information intended to be available only for corporate purpose and not for the personal benefit of anyone, and ... [from] the inherent unfairness involved where a party takes advantage of such information knowing it is unavailable to those with whom he is dealing."cxcix
SEC v. Texas Gulf Sulpur Co.
Although the Second Circuit in SEC v. Texas Gulf Sulphur Co.cc cited Cady, Roberts & Co. with approval, it removed the requirement that there had to be a "relationship" giving access to information and that "inherent unfairness" must be shown in the transaction. The court held that Rule 10b-5 prevents insiders as well as those possessing inside information, who may not be strictly termed an insider, from trading unfairly.cci The doctrinal advantage of the approach in Texas Gulf Sulphur is that it supports a simple rule against exploiting almost all informational disparities that are popularly perceived to give an unfair trading advantage. Consequentially, Rule 10b-5 reaches tippees, financial printers, and officers of an issuing corporation if they violate their obligation to disclose or abstain. They are also liable if the information stems from outside the corporation, since the essence of the wrongdoing lies in exploiting an informational advantage over other traders.ccii
Chiarella v. United States
However, the Supreme Court rejected the equal access theory of Cady, Robert, & Co. and Texas Gulf Sulphur in its first insider trading case, Chiarella v. United States.cciii It overturned the criminal conviction of Mr Chiarella, a financial printer, for trading on knowledge of pending takeover bids. Although the court recognized the duty set forth in Cady, Roberts & Co., it refrained -- unlike the SEC in Cady, Roberts & Co. -- from extending the duty to those other than corporate insiders.cciv The majority opinion Chiarella court introduced the fiduciary duty as a narrower basis for regulating insider trading. Under this theory Rule 10b-5 bars trading on nonpublic information when an insider owes a duty to disclose based on "a relationship between the parties to a transaction."ccv This theory has the effect of conforming the law of insider trading to the requirements of common law fraud which required a duty to disclose only in a fiduciary relationship.ccvi
Dirks v. United States
The Supreme Court reiterated its findings of Chiarella in Dirks.ccvii It also extended liability to "temporary" insider.ccviii Therefore, the liability of section 10(b) and rule 10b-5 also reaches persons who stand outside the corporation, "but rather [...] have entered into a special confidential relationship in the conduct of the business of the enterprise and are given access to information solely for corporate purposes."ccix This liability applies to advisors, lawyers and any other persons who are outsiders, but who also become fiduciaries of the shareholders.ccx
Chiarella and Dirks hold traditional insiders, such as officers and directors, and temporary insiders liable under the federal securities law. "Although Chiarella's conviction and Dirks' censure both were reversed, the Court stated that rule 10b-5 prohibits insider trading on an impersonal stock market if a special relationship exists between the buyer and the seller."ccxi Liability was extended to "temporary" insiders.
2. Tippers
A corporate insider who, for his own benefit, conveys material inside information regarding the corporation to a third party is deemed a tipper. The most important case addressing to tipper's liability is Dirks.ccxii The Supreme Court held that "[t]he tip and trade resemble trading by the insider himself followed by a gift of the profits to the recipient."ccxiii Consequentially, tipping is a primary violation of rule 10b-5 and is not different from the primary violation occurring when the insider trades. However, the tipper must have breached a fiduciary duty to shareholders.ccxiv According to Justice Powell the test for determining whether the tipper breached a fiduciary duty depends upon "whether the insider personally will benefit, directly or indirectly, from his disclosure. Absent some personal gain, there has been no breach of duty stockholders."ccxv
3. Tippees
The Dirks court established the conditions under which tippees can be held liable. The court stated that a tippee assumes a fiduciary duty to the shareholders of a corporation not to trade on material, nonpublic information only under two conditions.ccxvi First, the insider must have breached his fiduciary duty to the shareholders by disclosing the information to the tippee and second, the tippee knows or should know that there has been a breach. Thus, the Supreme Court imposed a derivative fiduciary duty on tippees.
4. Employees of the issuer
If independent contractors can become fiduciaries of the issuing corporationccxvii it follows from a fortiori argument that independent contractors, such as employees are in the required fiduciary relationship to the issuer.ccxviii Wang and Steinberg state that the employee "need not be a high-level employee."ccxix Furthermore, former officers and employees remain under a fiduciary duty.ccxx
5. Issuing corporation itself
If employees are held liable under the federal securities law it follows that a fiduciary duty also exists between the issuing corporation itself and its shareholders.ccxxi Furthermore, they state that the issuer is not allowed to tip for its own benefit.ccxxii When an insider acts not directly, but rather through the corporation the corporation will be held directly liable.ccxxiii
6. Shareholders of the corporation
A person owning a single share of the corporation does not owe a fiduciary duty to the other shareholders.ccxxiv There is only rare case law regarding this questions.ccxxv Loss and Seligman,ccxxvi however, state that controlling shareholders owe a fiduciary duty to other shareholders because "directors are, in effect, representatives of the controlling person and it poses little analytical challenge to relate back to the controlling the director's disclose or abstain duty."ccxxvii Therefore, controlling are liable as insiders.
III. The significance of the misappropriation theory
There is no debate whether corporate insiders may not trade on the basis of nonpublic information without prior disclosure. Regarding outsiders, the described liability in the previous chapter only showed the opinion of the majority in Chiarella. There is a debate whether individuals which have access to material nonpublic information, but do not stand in a relationship of trust and confidence to the shareholders of the corporation must also disclose or abstain.
The majority in Chiarella decided that a duty to disclose arises only from a fiduciary or other similar relationship of trust and confidence between the buyer and the seller.ccxxviii Chief Justice Burger wrote in his dissent that rule 10b-5 should be interpreted to "mean that a person who has misappropriated nonpublic information has an absolute duty to disclose that information or refrain from trading."ccxxix His findings became the source of the misappropriation theory. Under the misappropriation theory, rule 10b-5 is violated when an individual "(1) misappropriates material nonpublic information (2) by breaching a duty arising out of a relationship of trust and confidence and (3) uses that information in a securities transaction, (4) regardless of whether he owed any duties to the shareholders of the traded stock."ccxxx
Thus, by design the misappropriation theory reaches people outside the issuing corporation. Therefore, in Chiarella, Mr Chiarella, who had no relationship with the issuing corporation, was held liable. In Carpenter,ccxxxi the Supreme Court barely affirmed the conviction of a journalist under rule 10b-5 and the misappropriation theory by a 4-to-4-vote. In this case, a journalist allowed a stockbroker to trade on advance information about the content of a column in the Wall Street Journal. However, the court unanimously affirmed the mail fraud conviction. After Carpenter, the Second Circuit immediately applied the misappropriation theory againccxxxii and was supported by the Ninth Circuitccxxxiii and the Seventhccxxxiv Circuit. When the Fourth Circuit rejected the misappropriation theory in Bryan, the whole issue became in a status of chaos.ccxxxv
In O'Hagan, the Eighth Circuit rejected the misappropriation theory as well.ccxxxvi Recently, the Supreme Court approved the validity of the misappropriation theory in O'Hagan giving a clear signal to the securities market. It ruled that "a person who trades in securities for personal profit, using confidential information misappropriated in breach of a fiduciary duty to the source of information, may be held liable for violating Section 10(b) and Rule 10b-5."ccxxxvii Thus the Supreme Court found that the statutory requirements of Section 10(b) are met, that there be a deceptive device "in connection with" a purchase or sale of securities. The decision is important for persons who have no special relationship to the corporation in which securities they trade. If a person misappropriates information nonpublic material information in breach of a fiduciary duty owed to the source of the information and uses the misappropriated information for securities transactions, he is liable. The Supreme Court emphasized that the misappropriation theory is not a new theory, but that the classical theory and the later are rather complementary. Whereas the classical theory addresses a corporate insider's breach of a duty to shareholders with whom the insider transacts, the misappropriation theory is designed to reach outsiders breaching a duty owed to the source of information and not to the trading party.
IV. Inside information
There is no definition of the term "inside information." The duty to disclose or abstain arises only if the information is (a) material and (b) nonpublic.ccxxxviii
(a) Material information
In TSC Industries, Inc. v. Northway,ccxxxix the Supreme Court established a general standard with regard to the "material" requirement in the proxy-soliciting context. According to the Supreme Court "[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote."ccxl In Basic v. Levinson,ccxli the Supreme Court adopted the TSC standard of materiality regarding insider liability of insiders pursuant to rule 10b-5. The Supreme Court refined the TSC standard by stating that materiality "will depend at any given time upon a balancing of both the indicated probability that the event will occur and the anticipated magnitude of the event in light of the totality of company activity."ccxlii The information must affect a reasonable investor's behavior who possesses general professional knowledge. Consequentially, information material only to investors with unique expertise or because of specific research is not considered material.ccxliii
(b) Nonpublic information
Today, there are two different approaches in determining when material information is considered public.ccxliv According to the first view, information is public "when it has been disseminated and absorbed by the investment community. Dissemination consists of releasing the information to the press and having it reported in some widespread medium. Absorption means a reasonable waiting period to allow the investor to make an informed decision."ccxlv This is the democratic view of the SEC.ccxlvi In re Investors Management Co.,ccxlvii the SEC held that material information must be disseminated in a manner calculated to reach the general market through recognized distribution sources. However, dissemination is not sufficient. The Texas Gulf Sulphur Co. court states that insiders may not trade before the information is absorbed by the investing public.ccxlviii Therefore, insiders must wait a certain period for the public to assimilate the information.
The second view follows the Efficient Capital Market Hypothesis.ccxlix
Information is considered public when it is known by the active investment community. If a sufficient number of active investors have knowledge of the information, the price of the security will reflect the information (even though the average investor may not be aware of it). Prior to such information’s absorption into the efficient-market, an insider (or other person subject to the disclose-or-abstain mandate) will be prevented from profiting on the information, thus neutralizing any advantage such person possesses.ccl
The second view requires only a limited amount of dissemination and a shorter waiting period before.ccli
Generally, the question whether information is disseminated properly depends on "the scope of coverage (local or national), specificity, and clarity of media exposure."cclii No defined duration of the waiting period exists. It rather depends on variable factors, "such as how quickly the information is translatable into the investment decision, how wide the dissemination, how active the market in the security, and how widely the security is followed by analysts."ccliii
V. Scienter
Section 10(b) and rule 10b-5 require a showing of scienter as a requirement of liability.ccliv Negligent conduct is certainly insufficient.cclv However, it is difficult to determine which state of mind is required.cclvi In many cases, reckless conduct was held sufficient.cclvii The scienter requirement is easily established with regard to traditional and temporary insiders. They are presumed to possess knowledge of undisclosed information.cclviii The Supreme Court applied the standard to tippees that they know, or "should know that there had been a breach by the insider."cclix
VI. "In connection with the purchase or sale of any security" requirement
An action under section 10(b) requires that the manipulative or deceptive conduct was "in connection with the purchase or sale of any security." Insider cases, in which traditional insiders trade with a victim to whom they owe a fiduciary duty, easily satisfy this requirement.cclx The Supreme Court states that the requirement is satisfied when someone suffers "an injury as a result of deceptive practices touching [his] sale of securities of an investor."cclxi The "in connection with" requirement causes no problems in classical insider trading where the insider defrauds the other party of the securities transaction. However, in O'Hagan that the § 10(b)'s requirement that the conduct involve a "deceptive device or contrivance" used "in connection with" a securities transaction.cclxii The Court's main argument is that the fraud is only consumated when the misappropriator uses the confidential information f | 
