ALTHOUGH there is no statute expressly proscribing "insider trading," Sec.10(b) of the Securities Exchange Act of 1934 1 and Rule 10b-5 2 thereunder have been interpreted to prohibit securities trading on the basis of material nonpublic information.3 It has been a subject of debate whether the use of such information in connection with a trade, as distinguished from the mere possession of the information, is necessary to establish liability. Although the Securities and Exchange Commission has advocated the possession theory, the courts have not clearly articulated a uniform standard. Recently, in United States v. Smith, 4 the U.S. Court of Appeals for the Ninth Circuit rejected the SEC's possession approach, thereby requiring a causal relationship between the possession of the information and the trading to establish an insider trading violation.
Origins of the Debate
Section 10(b) and Rule 10b-5 generally prohibit (a) any misstatement of a material fact or (b) any manipulation or other act of fraud or deceit in connection with the purchase or sale of a security. A Sec.10(b) violation also requires that the defendant act with scienter.5 The debate with respect to "use v. possession" as an element of a Sec.10(b) violation can be traced to the SEC's seminal insider trading opinion in In re Cady, Roberts & Co.6 In Cady, the SEC held that an insider who becomes aware of certain material nonpublic information regarding an issuer must either disclose that information or abstain from trading in the issuer's securities. In a footnote, the SEC noted that "[a] significant purpose of the Exchange Act was to eliminate the idea that the use of inside information for personal advantage was a normal emolument of corporate office."7
Notwithstanding the reference to the "use of information," Cady has been cited in support of the proposition that mere possession of inside information is sufficient to establish a violation, as it is the possession of that information that supposedly gives the insider an unfair advantage over other market participants. So, for example, in SEC v. Texas Gulf Sulphur Co.,8 the U.S. Court of Appeals for the Second Circuit, citing Cady, observed that "anyone in possession of material inside information must either disclose it to the investing public, or, if he is disabled from disclosing it . . . , must abstain from trading in . . . the securities concerned while such inside information remains undisclosed."
The SEC's own application of Cady has been ambiguous. For example, in In re Investors Management Co.,9 the SEC, explaining Cady, held that "[w]hen a recipient of such corporate information, knowing or having reason to know that the corporate information is nonpublic, nevertheless uses it to effect a transaction in the corporation's securities for his own benefit, we think his conduct cannot be viewed as free of culpability under any sound interpretation or application of the antifraud provisions." The SEC then turned its analysis to whether the information was a "factor in the [defendant's] investment decision," a prerequisite, according to the opinion, to a finding of insider trading liability. In that regard, the SEC stated that it was "of the opinion that where a transaction of the kind indicated by the information (e.g., a sale or short sale upon adverse information) is effected by the recipient prior to its public dissemination, an inference arises that the information was such a factor." Significantly, the SEC continued, "The recipient of course may seek to overcome such inference by countervailing evidence."10
Notwithstanding Cady and Investors Management, the SEC abruptly altered its position with respect to the "use v. possession" standard. Without citing any authority, including any reference to Investors Management, the SEC declared, in In re Sterling Drug Inc., "Report of Investigation" 11: "Rule 10b-5 does not require a showing that an insider sold his securities for the purpose of taking advantage of material non-public information . . . If an insider sells his securities while in possession of material adverse non-public information, such an insider is taking advantage of his position to the detriment of the public."12
Supreme Court Guidance
Several Supreme Court decisions appear to interpret Cady's "disclose or abstain" doctrine to support the higher-threshold "use" test for finding insider trading liability. In Chiarella v. United States,13 for example, the Court held that there can be no Sec.10(b) violation absent a duty to disclose. In so holding, the Court rejected the argument that a person violates Sec.10(b) simply because he has trades in a security with respect to which he has an informational advantage: "We hold that a duty to disclose under Sec.10(b) does not arise from the mere possession of nonpublic market information." Similarly, in Dirks v. SEC,14 the Court held that a securities analyst did not violate Sec.10(b) because he did not have a duty to the shareholders who purchased the stock from the analysts' clients to whom the analyst had provided the nonpublic information. Relying upon Cady, the Court noted that, "an insider will be liable under Rule 10b-5 for inside trading only where he fails to disclose material nonpublic information before trading on it."
The Supreme Court's most recent discussion of the issue can be found in United States v. O'Hagan.15 In O'Hagan, the Court confirmed the viability of the SEC's "misappropriation theory" for establishing insider trading liability. The Court reasoned that "the 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 securities. . . . The [misappropriation] theory does not catch all conceivable forms of fraud involving confidential information; rather, it catches fraudulent means of capitalizing on such information." Significantly, several commentators have suggested that O'Hagan substantially undermines the SEC's "possession" theory for insider trading liability.16
Although appellate and district courts generally have not expressly addressed the "use v. possession" issue, some courts appear to have done so indirectly or implicitly. In that regard, the issue has been addressed in the context of whether the court will permit a defendant to offer explanations for his trading notwithstanding his access to material nonpublic information. Typically, courts allowing such evidence do so in respect of the scienter element of an insider trading claim.
For example, In re American Business Computers Corp. Securities Litigation,17 involved a class action where plaintiffs alleged that certain defendants engaged in insider trading. The court denied defendants' motion for summary judgment, noting that the defendants' argument that their trades "were consistent with an established pattern and practice unrelated to the allegedly undisclosed information" presented an issue of fact requiring trial.
By entertaining defendants' argument that they "traded on random and unconnected dates and had honest reasons for the trades they made," the court arguably implied that a defense could be based on a showing of alternative justifications for trades made by those possessing inside information.
Indeed, the Seventh Circuit, in Freeman v. Decio,18 expressly held that such a showing can nullify any inference of scienter drawn from the defendant's possession of inside information. Similarly, in Worlds of Wonder Securities Litigation,19 the Ninth Circuit noted that a defendant's actual trading activity could rebut any inference that the trading activity was based on inside information.20
Quoting from its earlier decision in In re Apple Computer Securities Litigation, the court stated that "unrebutted [credible and innocent] explanations [for the stock sales] are sufficient to defeat any inference of bad faith."
In contrast, decisions such as in In re Atlantic Financial Management, Inc. Securities Litigation,21 can be cited for the implicit validation of the "possession" theory. In that case, the court denied defendants' motion for summary judgment on an insider trading claim in part because of evidence that the defendants traded while in possession of material nonpublic information. According to the court, scienter may be established where "defendants traded while in possession of undisclosed information which they knew to be both undisclosed and material."
The debate over the "use v. possession" standard began to sharpen following the Second Circuit's opinion in United States v. Teicher.22 Referred to as the "leading case" in support of the "possession" theory,23 Teicher rejected the "use" requirement and expressly agreed, although in admitted dictum, 24 with the SEC's position as set forth in Sterling Drug. In Teicher, the Second Circuit affirmed the convictions of tippee-arbitrageurs who traded while in possession of information that was misappropriated by their tipper. The court articulated several factors in support of a "knowing possession" standard (which the court noted, incorrectly, to have been "consistently endorsed by the SEC").
First, the court stated, both Sec.10(b) and Rule 10b-5 require only that a deceptive practice be performed "in connection with" the sale or purchase of a security. The court then noted that the phrase "in connection with" has been "flexibly" construed, leaving the reader to surmise that such a malleable interpretation supports the easier-to-prosecute "knowing possession" standard.
Second, citing to Chiarella but without elaboration, the court observed that the "possession" test "comports with the oft-quoted maxim that one with a fiduciary or similar duty to hold material nonpublic information in confidence must either 'disclose or abstain' with regard to trading."
Third, the court concluded, "a 'knowing possession' standard has the attribute of simplicity." Apparently the court believed that it would be too burdensome to examine a defendant's state of mind, to determine the insider's intent and to decide, for example, whether the trader would have engaged in the transaction regardless of his knowledge of the inside information.
A blanket "knowing possession" test, in other words, presumably would minimize the legal burdens, or, as the court stated, "a requirement of a causal connection between the information and the trade could frustrate attempts to distinguish between legitimate trades and those conducted in connection with inside information."25
The first court to directly confront the issue of "use v. possession" was the Eleventh Circuit in SEC v. Adler,26 where the court adopted the "use" standard in conjunction with a "strong presumption" that the possession of inside information leads to the use of that information.
Conceding that the "use v. possession" debate was a "difficult and close question," the court based its decision on the language of Sec.10(b) and Rule 10b-5, and concluded that the statutory emphasis on "fraud and deception" best comported with the "use" standard.
Turning to the various dicta in Chiarella, Dirks and O'Hagan, the Eleventh Circuit concluded that the Supreme Court's language repeatedly established fraud as the gravamen of a Sec.10(b) violation that is not necessarily captured by a "possession" test: "we do not believe that the SEC's knowing possession test would always and inevitably be limited to situations involving fraud."
Nevertheless, the Eleventh Circuit was troubled by the concern that the adoption of the "use" test would create an unduly high burden of proof. As the court stated, "[t]he 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."
To address that concern, the court held that a "strong inference of use" arises from proof that an insider traded while in possession of inside information. According to the court, "the insider can attempt to rebut the inference by adducing evidence that there was no causal connection between the information and the trade - i.e., that the information was not used." Interestingly, in rejecting the SEC's possession theory, the court noted that the SEC has had ample opportunity to adopt a rule to implement that standard, but has declined to do so.
In United States v. Smith27, the Ninth Circuit affirmed, on other grounds, a defendant's conviction, but nevertheless held that the federal securities laws require that the government "demonstrate that the suspected insider trader actually used material nonpublic information in consummating his transaction."
In Smith, an officer of a publicly traded software company was convicted on 11 counts of insider trading, following a jury determination that he had sold his entire position in his company's stock and also sold short another 35,000 shares, while he possessed certain nonpublic information concerning the company's forecasts of negative future sales and revenue.28
Referring to the Second Circuit's "thoughtful analysis" in Teicher, the Ninth Circuit nonetheless disagreed with that opinion and adopted the "use" standard. Addressing the Second Circuit's arguments point by point, the Ninth Circuit first noted the inconsistent position of the SEC. Although acknowledging that an administrative agency is entitled to change its position, the court cited to Investors Management to show that in the "not-too-distant-past, the SEC concluded that an essential element of an insider trading violation was that the inside information 'be a factor in [the insider's] decision to effect the transaction.'
The Ninth Circuit further dissented from the primary rationale underlying the analysis in Teicher, concluding that the Second Circuit had "lost sight of the law's main thrust" when it concentrated on the "flexible" meaning of Sec.10(b)'s "in connection with" language. In the view of the Smith court, the relevant securities laws do more than just enjoin certain "unspecified" conduct "in connection with" the purchase or sale of securities.
Rather, Sec.10(b) and Rule 10b-5 "prohibit the employment of 'manipulative' and 'deceptive' trading practices in connection with those transactions." Thus, the Ninth Circuit reasoned that the fraudulent trading component of the securities laws was more in line with the "use" standard of liability.
The Smith court also articulated the view that the scienter requirement of an insider trading violation also supported the "use" test.
Joining its Adler "colleagues on the Eleventh Circuit," the court expressed concern that a "possession" standard would be incapable of being limited to only those situations where the defendant committed an intentional fraud, the hallmark of scienter.
The court was particularly troubled by the hypothetical (but realistic) case by which a defendant carried out a preexisting plan to trade, without any intent to deceive. The court criticized the SEC's position that, in such a situation, a "requisite intent to defraud is inherent in the act of trading while in possession of inside information."
According to the Ninth Circuit, if the insider possesses but does not use information, the insider is not trading to the disadvantage of other parties because the insider and other parties would be operating on an equal level. "It is the insider's use, not his possession, that gives rise to an informational advantage and the requisite intent to defraud."
The Ninth Circuit then addressed the Second Circuit's argument that the "oft-quoted maxim" of "disclose or abstain" supported the "possession" standard. Noting that the trouble with oft-quoted maxims is that they "rarely, if ever, capture the complexity of the idea that they are supposed to represent," the court noted that in the cases from which the maxim emerged - Chiarella and Cady - the defendants had actually used the inside information in implementing the trades.
Thus, the Ninth Circuit understood a second prong to the maxim: that "disclose or abstain" did not prohibit all trading, but rather prohibited "trading on the basis of material nonpublic information."
Lastly, the court turned to the argument that a "possession" test would be easier to enforce. The court acknowledged that a "use" standard would make criminal prosecutions, as in the Smith case, more difficult for the government to prove. However, the court adhered to the "use" test, observing that those difficulties "are by no means insuperable."
The court noted that the presumption established in Adler, although not applicable to the criminal case before it (and therefore the court expressed no view with respect to the Adler "inference of use"), might address any burden of proof problems emanating from a "use" standard.
Interestingly, both parties in Smith asserted in supplemental briefing that Adler should not be adopted. Arguing that the Ninth Circuit should follow the holding in Teicher, the government claimed that Adler was unsupported by the federal securities laws and in conflict with the SEC's position. And Smith claimed that Adler should not be followed because its presumption of use was inappropriate in a criminal proceeding.
The Second Circuit's opinion in Teicher notwithstanding, Supreme Court guidance and judicial trends in the appellate and district courts suggest that proof that inside information was used in connection with trading will prevail as the operative standard for insider trading cases.
Indeed, the SEC's apparent rationale for its position is based on public policy principles more than on statutory construction. In that regard, courts may expressly, as reflected in Adler, or implicitly, as reflected in numerous decisions since Cady, implement a pragmatic application of the use test by allowing a defendant to submit evidence of alternative justifications for his trading where it is shown that he was in fact in possession of material nonpublic information.29
The source of the analytical controversy, however, is based on the lack of a statutory definition of insider trading, something that the SEC has long resisted. Accordingly, the courts have been constrained to articulate insider trading principles under Sec.10(b) and Rule 10b-5, both of which require proof of manipulation or deceit as well as scienter.
In that context, it would appear that although a "possession" standard may arguably vindicate certain public policy objectives, a "use" standard would be more consistent with the Sec.10(b) construct.
- 15 U.S.C. Sec. 78j(b).
- 17 C.F.R. Sec. 240.10b-5.
- The SEC, by rule, has also proscribed trading on the basis of material nonpublic information in connection with tender offers. See 17 C.F.R. Sec. 240.14e-3.
- No. 97-50137, 1998 WL 527066, at 14 (9th Cr. Aug. 25, 1998).
- Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976).
- 40 S.E.C. 907 (Nov. 8, 1961).
- Id. at 912 n.15 (emphasis added).
- 401 F.2d 833 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).
- 44 S.E.C. 633 (1971).
- See also Dura-Bilt Corp. v. Chase Manhattan Corp. 89 F.R.D. 87, 95 (S.D.N.Y. 1981), citing Investors Management Co. for the proposition that although the use of inside information could be inferred from the possession of such information, "defendants may introduce evidence to rebut this inference of use."
- [1978 Transfer Binder] Fed. Sec. L. Rep. (CCH) 6 81,570 at 80,298 (Apr. 18, 1978).
- In re Sterling Drug Inc., No. 14675, 1978 SEC LEXIS 1759, at 13-14 (Apr. 18, 1978).
- 445 U.S. 222, 227 (1980).
- 463 U.S. 646 (1983).
- 117 S.Ct. 2199 (1997).
- See Ferrara, Thomas & Nagy, Ferrara On Insider Trading And The Wall Sec.2.01 (1998); Pitt and Groskaufmanis, "The Supreme Court Has Upheld the Misappropriation Theory, But How Far the SEC Will Take the Ruling is Anything But Clear," National Law Journal, (Aug. 4, 1997).
- [1993-1994 Transfer Binder] Fed. Sec. L. Rep. (CCH) 698,103 at 98,803 (S.D.N.Y. Nov. 16, 1993). See also Lilly v. State Teachers Retirement System, 608 F.2d 55 (2d Cir. 1979); SEC v. Shapiro, 494 F.2d 1301 (2d Cir. 1974).
- 584 F.2d 186, 197 n.44 (7th Cir. 1978).
- 35 F.3d 1407 (9th Cir. 1994).
- See also Dura-Bilt Corp. v. Chase Manhattan Corp., 89 F.R.D. 87 (S.D.N.Y. 1981).
- [1989 Transfer Binder] Fed. Sec. L. Rep. (CCH) 694,444 at 92,852 (D. Mass. Dec. 6, 1988).
- 987 F.2d 112 (2d Cir. 1993).
- See Horwich, "Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading," 52 Business Lawyer 1235, 1250 (1997).
- The Second Circuit's explicit articulation of the "knowing possession" standard, although detailed, was dictum because the court decided that it was "unnecessary to determine whether proof of securities fraud requires a causal connection," since it affirmed the convictions based on harmless error. 987 F.2d at 121.
- Id. at 121. The court further wondered whether the possession of inside information could ever be "mere," that is, without influence. Applying the following curious analogy, the court observed that, "[u]nlike a loaded weapon which may stand ready but unused, material information can not lay idle in the human brain." Id. at 120.
- 137 F.3d 1325 (11th Cir. 1998).
- 1998 WL 527066 (9th Cir. Aug. 25, 1998).
- It should be noted that the bulk of the opinion does not deal with the "use v. possession" debate. Rather, much of the case concerned the evidentiary issue whether the illegal interception of Smith's voicemail, which was suppressed at trial, should have led to further suppressions under a derivative, fruit of the poisonous tree doctrine.
- Interestingly, the Second Circuit recently upheld a judgment in favor of the SEC without reference to the "use v. possession" controversy or even to Teicher. SEC v. Warde, 151 F.3d 42 (2d Cir. 1998), involved an action brought against a tippee accused of purchasing stock and warrants of a company which was the subject of a yet undisclosed tender offer. The court noted that the SEC was required to prove, among other things, that the defendant tippee traded "while in possession" of nonpublic information. In its analysis, however, the court concluded that the defendant "traded upon" the information. Warde, however, may not be helpful in clarifying the Second Circuit's approach in that the defendant was not only charged with violations of Sec.10(b), but also Sec.14(e) - and, in particular, the SEC's Rule 14e-3 which expressly prohibits trading "while in possession" of information pertaining to substantial steps taken toward the commencement of a tender offer. In that respect, Rule 14e-3 differs from the higher standard inherent in Section 10(b) and Rule 10b-5. Although the Supreme Court held in O'Hagan that the SEC did not exceed its rulemaking authority in adopting Rule 14e-3 without requiring a breach of a duty to establish a violation, as in the case of Sec.10(b). See 117 S. Ct. at 2214-19.
Dennis J. Block and Jonathan M. Hoff are members of Cadwalader, Wickersham & Taft. Associate Philip Markowitz, participated in the preparation of this article.
This article is reprinted with permission from the October 29th issue of the New York Law Journal © 1998 NLP IP Company.