V. The Securities Market, Insider Trading, and Rule 10b-5

A. Rule 10b-5 and Securities FraudSecurities transactions are regulated by federal + state securities law

Securities Exchange Act of 1934  then SEC made rules accordingly
Anti-fraud provisions bars deception/ misrep in securities transactions 10b-5 is a catch-all rule, governs disclosure in all purchase and sales of securitiesSEC Rule 10b-5: Employment of Manipulative and Deceptive Practices
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,
o (a) To employ any device, scheme, or artifice to defraud,
o (b) To make any untrue statement of a material fact [lie] 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.S.10(b) of 1934 Securities Exchange Act: Regulation Of The Use Of
Manipulative And Deceptive Devices
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, or any securities- based swap agreement 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

Elements of cause of action under Rule 10b-5 (see Part III's discussion of Rule 14a-9)

1. Implied right of action (Borak, cited in Virginia Bankshares)
o not stated under Rule 10b-5 and 14a-9

private party can sue, but additional condition for causation and reliance

2. Standing to sue (Blue Chip Stamps, cited in Virginia Bankshares)
o Blue Chip: only actual purchasers and sellers can sue (not those who didn't trade)

3. Materiality Basic Inc. v Levinson

4. Causation Basic Inc. v Levinson

5. Reliance Basic Inc. v Levinson

6. Scienter (intent/knowledge): P needs to show that D acted with the intent to deceive/ knew that a statement made was false (or that D showed reckless disregard for truth) [mere negligence is clearly not enough]

7. Pleading standard: s.21(D)(b)(1),(2) Exchange Act - How will P obtain the requisite info to meet the pleading standard before discovery
Basic Inc. v Levinson (1988) Supreme Court P.2 [Dec 3]
- Latitude of companies to deny rumors about important new developments which the company is not expressly required to disclose under the reporting provisions of the Securities Exchange Act
- Evidence necessary to establish reliance under Rule 10b-5 (c.f. treatment of reliance under Rule 14a-9 in
Virginia Bankshares and Mills)
- Standard of materiality under Rule 10b-5
- Applying

1 V. The Securities Market, Insider Trading, and Rule 10b-5

o oFacts:
o

o

o

o o(1) Rule 10(b) of the Securities Exchange Act of 1934, and
(2) Rule 10b-5 of the Securities and Exchange Commissions, in the context of preliminary corporate merger discussions

Board of Basic In. (previously a public co.) engage in merger negotiations with Combustion (acquirer)
Board of Basic issued 3 public statements denying that it was engaged in merger negotiations
Basic eventually enters into a merger agreement with Combustion, $46/share in Dec 1978
Shares of Basic increased (since there is always a premium in mergers, price usually increase afterwards)
Former Basic shareholders
 who sold stock after Basic's first public statement and before the suspension of trading, at an artificially depressed price, in reliance of D's misleading statement
 brought a class action against Basic and its directors, asserting that Ds issued 3 false and misleading public statements, in violation of s.10(b) of 1934 Act and of SEC Rule 10b-5
 measure of damages - between the price they sold their stocks and what their stock worth now
Huge damages and serious consequences - potential jail time
Basic lied because
 there were called by NYSE, which noticed the trading volume suddenly went up (which indicates rumors are floating around)  Basic could have said nothing, but most companies would answer NYSE's questions
 Basic did not want to create false hope (if the deal didn't go through, Board would be under pressure to increase share price)
 Didn't want to incur another bid + Combustion asked the deal to be kept silent
 [No personal aim - e.g. insiders can buy shares and personally profit from the opportunity to buy]

(1) Materiality of the misstatements

If misstatements not material  no issue

Materiality: reasonable investor would consider important in making investment decisions

DC held misstatements were immaterial  CA reversed: preliminary merger discussions are material once a statement is made denying the existence of any discussions, as it make the statement untrue.
 'Fraud-on-the-market theory' to create a rebuttable presumption that the shareholders relied on the company's material misrep

Supreme Court Approach:
 1934 Act was to protect investors against manipulation of stock prices
 Adopt the standard of materiality in TSC Industries v Northway (in proxy-solicitation context) for SEA s.10(b) and SEC Rule 10b-5 context:
 An omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote
 Substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of info made available
 Since merger negotiations are contingent/ speculative  it's difficult to ascertain whether the reasonable investor would have considered the omitted info significant at the time o

Court rejected Plaintiff's Third (and Seventh) Circuits' Approach: preliminary merger discussions do not become material until price and structure of the transaction has been agreed  info concerning any negotiation before this stage could be withheld/ misrep without violation of Rule 10b-5.
 BUT: none of the rationales explain why draw the line at agreement-in-principle  no valid justification for artificially excluding the definition of materially info for merger discussions:

2 V. The Securities Market, Insider Trading, and Rule 10b-5





(1) [Don't want too much disclosures to confuse investors] Investor not overwhelmed by excessively detailed and trivial info, focuses on substantial risk that preliminary merger discussion may collapse (disclosure of its existence could mislead investors and foster false optimism Greenfield v Heublein)
 Court disagrees: assumes investors are unable to appreciate that mergers are risky propositions up until closing Flamm v Eberstadt. Materiality requirement is to filter out useless info that a reasonable investor would into consider significant in making investment decision. [If determined that the info is important, such important info would not overwhelm investors]
(2) Secrecy - limit scope of disclosure obligation to preserve confidentiality of merger discussion, and to prevent prejudice
 Court disagrees: irrelevant to the assessment whether their existence is significant to the trading decision of a reasonable investor
(3) Bright-line rule for determining when disclosure must be made
 Court disagrees: seems to be directed solely at the comfort of the corporate managers
- it is easier to follow than a standard that requires judgment of all the circumstances
 but no excuse for ignoring the purposes of the securities act and Congress' policy decisions

o

Why should we have a law that forces Basic to disclose info that is harmful to their business
 Court: not the right question to ask  should ask whether Basic is entitled to lie - not forcing
Basic to disclose info - Disclosure rule governs what and when Basic have to disclose, not decide by the court but the SEC (Congress)
 Regardless of what Basic have to disclose  Basic cannot lie - should not have make statements to dispel the rumors [silence is fine, but lying is prohibited]

o

Second Circuit's explanation on the role of the material requirement of Rule 10b-5 for contingent/
speculative info or events
 Maternity depend at any given time upon a balance of both the indicated probability that the event will occur, and the anticipated magnitude of the event in light of the totality of the company activity (SEC v Taxas Gulf Sulphur Co)
 Applied by Second Circuit in context of preliminary merger negotiations
 Whether merger discussion are material depends on the facts - interest in the transaction at the highest corporate level (looking at board resolution, instructions to investment bankers, actual negotiations between principals)

(2) Reliance is an element of Rule 10b-5 cause of action

Reliance is distinct from causation of damages
 Causation: what is value before and after  differences would be damages (expert opinion on the values)
 Reliance: provides the causal connection between D's misrep & P's injury (client to testify its reliance in the misstatements in selling their shares)
 Since it is difficult to differentiate whether the member actually relied  presumption of reliance based on the fraud-on-market presumption

'Fraud-on-market theory'
 Price of a co.'s stock in an open securities market is determined by the available material info regarding the company and its business  misstatements will defraud purchaser of stock,
even if they didn't directly rely on the misstatement
 Presumption: persons who traded Basic shares had done so in reliance on the integrity of the price set by the market  but because of D's material misrep, that price had been fraudulently depressed

3 V. The Securities Market, Insider Trading, and Rule 10b-5

P need not show how he would have acted if the material info had been disclosed/ if the misrep had not been made (or would place unnecessarily unrealistic evidentiary burden on
Rule 10b-5 plaintiff
 An investor who buys/sells stock at the price set by the market does so in reliance on the integrity of that price.
 Since most publicly availed info is reflected in market price, an investor's reliance on any public material misrep may therefore be presumed for the purpose of a Rule 10b-5 action
Rebuttals 1) Misrep did not lead to a distortion of price
 Despite the false statement, the market price reflected the merger negotiation
 Damages would be 0, since there is no difference between the market price and its actual value 2) An individual P traded or would have traded, despite knowing the statement was false
 market price would not have been affected by their misrep  break the causal connection 3) People would have sold it even if they didn't not rely on the market price
 damage they suffered is not generated by the market incorporating the false info 4) The people sold the stocks knew of the false information
J White, J O'Connor dissents:
 Investors act on inevitably incomplete/ inaccurate info  those who have lost have not necessarily been defrauded. Yet court still allow investors to recover who can show little more than that they sold stock at a lower price than what might have been
 No evidence that petitioner's officials made the troublesome misstatement for the purpose of manipulating stock prices  imposing damages liability under Rule 10b-5 makes little sense when D is neither a purchaser nor a seller of securities


o

oWhy hold Basic liable? Who benefits and who is hurt?
o Secondary market securities fraud versus "normal" fraud

Securities fraud: D seller commits the fraud, benefits from the fraud; P is hurt by the fraud
 In this case, P is hurt by the fraud, but the people who commits the fraud did not benefit from the fraud. It is secondary market trading (any selling of shares other than co. initial public offering), co. didn't lie to benefit directly from a higher price.
o Why give a private right of action?
 But when the stock value increase  wealth is not generated for the company
 Even if share price is inaccurately, the value is still there  why is accuracy of stock price important?
 If companies cannot lie, shareholders would have better information
 Market will incorporate publically availably info, including info that are false
 Fraud on market theory - shareholders rely on the integrity of the price set by the market
 Some investors do not research, but rely on the aggregate knowledge of other investors in the market - since stocks are traded in market price
 Reliance on the integrity of the market is a substitute for traditional reliance  good enough
 If market is not efficient, not reasonable to rely on the integrity of the market
 If market is efficient, reasonable to rely on the integrity of the market

4 V. The Securities Market, Insider Trading, and Rule 10b-5--

B. Rule 10b-5 and Insider Trading
Different from securities fraud

traditional securities fraud need to make statement that was false/ lie

no lie in insider trading, but undisclosed info
Lack of clear legal basis on prohibiting insider trading

Rule 10b-5 form the basis for imposing a duty on company insiders to disclose material corporate info or refrain from trading on it  though it doesn't expressly bar insider trading, its wording is flexible to allow court and SEC to rely on it
 "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."
o 1934 Act s.16(b) merely ban short-swing profits from sale and purchase of equity securities within a 6month period by corporate officers, directors, or large shareholders
Case law - unclear on

definition of the duties of 'outsiders' who trade on non-public info (e.g. tippees, investment bankers,
financial printers, and journalists); and

when outsiders breach Rule 10b-5
Case law developed 3 legal theories: (1) equal access; (2) fiduciary duty; and (3) misappropriation

(1) Equal Access Theory
- All traders owe a duty to the market, to disclose/ refrain on non-public corporate information

Basis: inherent unfairness of exploiting an unerodable informational advantage, that is confidential info from which other traders are legally excluded
- [Rejected by the Supreme Court] Equal access theory originates in Matter of Cady, Roberts & Co, the first
SEC decision to address insider trading on the open market - apply Rule 10b-5 where:

1. Existence of a relationship giving access (directly/ indirectly) to info intended to be available only for a corporate purpose (and not for personal benefit of anyone); and

2. Inherent unfairness where a party take advantage of such info, knowing it is unavailable to those whom he is dealing [unfair to other traders]SEC v Texas Fulf Sulphur Co. (1967) Court of Appeal P.10 Disclose or Abstain Rule

Facts: TFS had a major mineral discovery
 company not obligated to say anything  it remained silent, as they want to acquire a lot of land before they inform the public
 but TGS's directors, officers and employees traded/ tipped on the basis of advanced knowledge
 SEC bought civil action against them (insider trading can raise criminal action)
 Court held violation of Rule 10b-5

Rule 10b-5 is based on the expectation that the securities marketplace that all investors trading on impersonal exchanges have relatively equal access to material info
 Essence of Rule 10-5: anyone who, trading for his own accounting the securities of a corporation has access, directly or indirectly to the info intended to be available only for a corporate purpose and not for the personal benefit of anyone, may not take advantage of such info knowing it is unavailable to those with whom he is dealing (the investing public)
o If you have material non-public information + person covered by the rule  you are subject to the disclose or abstain rule: disclose the info before trading; or abstain from trading
 Insiders (directors/ management officers) are precluded from unfairly dealing  anyone in possess of material inside info must either
 (1) disclose it to the investing public; or
 (2) abstain from trading in or recommending the securities concerned while such inside info remains undisclosed

5 V. The Securities Market, Insider Trading, and Rule 10b-5

if the public info was material  its possessors should have kept out of the market until disclosure was accomplished
But an insider is not always foreclosed from investing his own company, only because he may be more familiar with the company operations than outside investors
 Insider need not confer upon outside investors the benefit of his superior financial or other expert analysis by disclosing his educated guesses or predictions
Whether facts are material within Rule 10b-5 depend on
 the indicated probability that the event will occur + anticipated magnitude of the event
 Here, knowledge of possibility was more than marginal  the info might well have affected the price of TFS stock and could have been an important fact to a reasonable, if speculative, investor in deciding whether he should buy, sell, or hold
 importance of the attached to the information by the insiders
Court found info was material, but didn't address who is covered by the rules as insiders o

o

o

oCounterparty is hurt when insiders trade in material non-public information - but not necessarily true:
o Price gets executed within seconds, the person who sold to the insider would have sold to someone else anyway

Stock purchase and sell do not generate any net gains  any profit from insider trading comes in the expense of the trading public (counterparty, or people who would have bought the stock if the insider did not)
o It is easy to buy and sell stock than houses - requires less research, closer to market price  hence stock market is liquid
 Reduce liquidity if a lot of insider trading with non-public info  harm to liquidity of market
- as it would create the problem is asymmetry of information  no one should be permitted to trade in non-public material info

Who are hurt by the insider trading
 Harm to the investment public: investors who trade/ wants to trade
 Harm to the company: geologist buying stocks increase trading volume + investor find that the geologist are buying TFS' shares  notice non-public info  would find out of the nonpublic info (TFS tried to keep non-public to buy land)
o How does the ability/ right to trade info affects incentive to generate and disclose info
 manager would have incentive to do bad for the company  lower the stock price to make money on the informationAcademic Debate - Laura Beny, Insider Trading Laws (2007)
o Agency Theories of Insider Trading
 Insider trading as an efficient compensation mechanism
 Prof Manne: insider trading is economically efficient, as it motivates entrepreneurial innovation (entrepreneur creates valuable new info  she will be the first person to know about it)  entrepreneurs can profit/rewarded by buying the company's shares before the public finds out (and raise value of co.'s stock to reflect it)
 Prof Carlton, Fischel: insider trading enables managers to continually update their compensation in light of info, increase manager's incentives by linking their fortunes more closely to those of the firm + no need to renegotiate costs
 Insider trading as an Agency Cost
 Inefficient private benefit of control that insiders at shareholder's expense, distort managerial wage-setting process, allowing managers to reward themselves excessively  firms would then have to monitor managers' trading, which increase cost (offsetting its presumed cost-saving to the firm)
 In practice difficult to ensure those who produce valuable info are the only one who profit from it  free-rider problem + info hording within the firm (incentive to hold info to maintain a monopoly on insider trading profits)

6 V. The Securities Market, Insider Trading, and Rule 10b-5

Obstructing the free flow of info through the firm  reduce firm's overall organisational efficiency
Insider trading is more profitable when stock price is volatile, managers may be encouraged to engage in excessive risky investment behaviour by undertaking overly risky projects that reduce corporate value for the firm

since manager can profit from insider trading  increase managers'
incentives to under-perform o



oMarket Theories of Insider Trading
 Stock price accuracy
 meaning and economic significant

Improve efficiency of capital allocation:
 Increase in value added will increase firm cash flows level and returns to other factor of production
 by improving (i) the quality of investment projects in the economy and (ii) the operation of existing real assets
 Reduce agency costs within the firm - additional disclosure,
increase share price accuracy
 the law and economics debate

Disclosure is costly to the firm, but the benefit is shared between firm,
public and rival firms + disclosure may be detrimental to firm's own investors by revealing too much too soon

Prof Manne (for): insider trading enables a firm to improve the accuracy of its stock price without incurring the costs of premature disclosure of info
 Prof Carlton & Fischel (for): insider trading is less costly than traditional disclosure

Against:
 insider trading is likely to distort manager's incentives to disclose info on time - the more they control the leakage of info, the more they can gain from insider trading  may reduce stock price accuracy by increasing corporate insiders' incentive to manipulate info disclosure to maximise their trading profits
 difficult for outsider to detect insiders' trade
 insider trading have little advantage over traditional disclosure
 Stock market liquidity
 Stock market liquidity = transaction costs of trading
 Law and economic debates

Insider trading is profitable because of the unequal info between insider and outsider - insider buys at less than the stock's true value and sells it at the true value

For: The fact that uninformed investors trade frequently implies that they are not hindered by the existence of more informed parties

For: some investors will always be more informed than others

For: if insider trading were harmful to liquidity, firms would voluntarily prohibit it because greater liquidity is valuable  but firms do not prohibit
 suggest it doesn't harm liquidity (but also evidence that firms do prohibit insider trading, which results in greater liquidity)

Whether insider trading is harmful/ beneficial, and to whom - who should regulate it: gov or private parties

Prof Carlton & Fischel: private contracting (between firms and insider), as the issue of optimal allocation of property right in corporate info, decision most efficiently made by private parties

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