At the same time it adopted Regulation FD, the controversial new ban on selective disclosure of material nonpublic information, the Securities and Exchange Commission approved new rules intended to clarify insider trading law in two areas in which the SEC has been unhappy with the direction of federal circuit court opinions. New Rule 10b5-1 under the Securities Exchange Act of 1934 creates a presumption that a person aware of material nonpublic information has "used" that information in trading, subject to designated affirmative defenses aimed at showing that the information was not a factor in the trading decision. New Rule 10b5-2 defines the type of family or other non-business relationships that give rise to a duty not to "misappropriate" material nonpublic information. Rules 10b5-1 and 10b-2 will become effective in mid-October 2000 (60 days after publication in the Federal Register, which is expected this week). SEC Release No. 33-7881 (August 15, 2000).
New Rules 10b5-1 and 10b5-2 are an ironic departure for the SEC. In the past, the SEC has generally not supported efforts to codify the law of insider trading (including Congressional efforts that failed at least in part due to lack of SEC support at the time of the Insider Trading and Securities Fraud Enforcement Act of 1988), preferring instead to let the law develop by judicial decisions and to use lack of clear delineation to its tactical and strategic advantage in its enforcement programs. Faced with circuit court decisions that it does not like in some areas of developing insider trading jurisprudence, however, the SEC is now interested in promoting greater clarity in these areas.
Rule 10b5-1: "Use" versus "Possession"
In the past, the SEC has maintained in enforcement cases that a trader may be liable under Exchange Act Rule 10b-5 (the principal insider trading prohibition) for trading while in "knowing possession" of material nonpublic information and that it is not necessary for the government also to prove that the trader "used" the information for trading. Although there is dicta in U.S. v. Teicher (2d Cir. 1993) supporting the SEC's position, more recent circuit court decisions have rejected it. In SEC v. Adler (11th Cir. 1998), the Eleventh Circuit held, in a civil enforcement action, that "use" is the ultimate issue, but that proof of possession provides a "strong inference" of use that suffices to make out a prima facie case, subject to rebuttal if the defendant can prove evidence that the information was not part of the trading decision (e.g., evidence that orders for the trades in question were placed before the information came into defendant's possession). In United States v. Smith (9th Cir. 1998), the Ninth Circuit required that the government prove actual "use" in a criminal prosecution. Since the government was able to prove actual use in Smith (with a "smoking gun" voice-mail), the Ninth Circuit did not have to decide whether the Adler possession-equals-use presumption would be constitutionally permissible in a criminal case.
New Rule 10b5-1 provides that a purchase or sale of a security is "on the basis of" material nonpublic information as required for a violation of Rule 10b-5 if the person making the purchase or sale was "aware" of the information at the time of the purchase or sale, subject to designated affirmative defenses aimed at showing that the information was not a factor in the trading decision. Unlike the presumption in the Adler case which was rebuttable by any evidence that the material nonpublic information did not play a role in the investment decision, the affirmative defenses to the SEC's awareness-equals-use presumption in Rule 10b5-1 are exclusive and rather narrow. Under Rule 10b5-1, a defendant found to be "aware" of material nonpublic information at the time of a trade must prove that before becoming aware of the information, he or she had (1) entered into a binding contract to make such trade, (2) instructed another person to make the trade for his or her account, or (3) adopted a written plan for trading pursuant to which such trade was made. Such a contract, instruction or plan must have either: (a) specified the amount to be purchased or sold, the price (which may be a particular dollar price or the market price on a particular date or a limit price) and the date on which the securities were to be purchased or sold (which may be any date during the period a limit order is in effect), (b) included a written formula or algorithm or computer program for determining amount, price and date, or (c) permitted the trading person to exercise no influence over how, when or whether to effect purchases or sales.
The adopting release contains discussion of how an issuer may continue a stock repurchase program designed to fall within the affirmative defenses notwithstanding awareness of material nonpublic information. It also discusses employee reliance on the affirmative defenses to continue purchasing under stock-based compensation plans after becoming aware of material nonpublic information.
Rule 10b5-1 includes an additional affirmative defense available only to trading parties that are entities. Under this provision, an entity will not be liable if it demonstrates that the individual making the investment decision on behalf of the entity was not aware of the information and that the entity had implemented reasonable "Chinese Wall" policies and procedures to prevent insider trading.
The adopting release offers no discussion of the constitutionality of the Rule 10b5-1 awareness-equals-use presumption in the context of a criminal prosecution.
Rule 10b5-2: A Family Affair
In Chiarella v. United States (1980), the U.S. Supreme Court held that trading or tipping of information must constitute the breach of a fiduciary duty in order to be illegal under the insider trading prohibitions of Rule 10b-5. One issue treated by the courts since Chiarella is: what kinds of relationships of trust and confidence give rise to a fiduciary duty sufficient for an insider trading claim under Rule 10b-5? In addition to the relationship between a corporate director or officer and the corporation, courts have found the necessary fiduciary duty to exist in several other types of business relationships, including (among others) employer-employee, attorney-client and the relationship between partners in a partnership. Courts have also found the necessary fiduciary duty to exist in certain non-business relationships based on trust and confidence, such as a psychiatrist-patient relationship.
In United States v. Chestman (2d Cir. 1991), however, the Second Circuit Court of Appeals indicated that a family relationship (in that case, marriage) did not by itself constitute a sufficient relationship of trust or confidence for an insider trading claim and neither did a family relationship plus a unilateral imposition of confidentiality (Wife: "Honey, don't tell anyone about this!"). In so doing, the Second Circuit suggested that the result might be different if family members had a bilateral agreement of confidentiality (Wife: "Do you promise not to tell anyone?" Husband: "I promise.") or there was a prior history or pattern of sharing similar confidences such that one family member had a reasonable expectation that the other would keep those confidences.
In the view of the SEC, the Chestman decision "does not fully recognize the degree to which parties to close family and personal relationships have reasonable and legitimate expectations of confidentiality in their communications [and] does not sufficiently protect investors and the securities markets from the misappropriation and resulting misuse of inside information."
New Rule 10b5-2 enumerates a non-exclusive list of non-business relationships under which a sufficient duty of trust or confidence will exist. These include: (1) whenever a person agrees to maintain information in confidence (a bilateral agreement); (2) whenever the person communicating the information and the person to whom it is communicated have a history, pattern or practice of sharing confidences, such that the person communicating the material nonpublic information has a reasonable expectation that the other person would maintain its confidentiality; or (3) whenever a person receives or obtains the information from the person's spouse, parent, child or sibling. The rule specifies, however, that the sufficiency of this last category may be rebutted if the defendant proves that the person providing the information "had no reasonable expectation that [the defendant] would keep the information confidential, because the parties had neither a history, pattern or practice of sharing confidences, nor an agreement or understanding to maintain the confidentiality of the information." In other words, a husband accused of breaching a duty of confidence to his wife by trading on information she had passed to him could rebut the presumption by proving that his relationship with his wife was so bad that she had no reasonable expectation that he would not betray the confidence by trading.
In the proposing release, the SEC noted that the agreement contemplated by the first category of Rule 10b5-2 need not be written or even express. An unspoken, implicit understanding may suffice. The SEC also noted that the history or pattern of sharing confidences in the second category of proposed Rule 10b-5-2 need not include a history or pattern of sharing business confidences in order to suffice. As to the third category, the SEC noted that it has limited its bright-line enumeration to close family relationships of the type that usually does involve a history or pattern of confidence sharing. In particular, the SEC notes it has not extended its list to cover non-traditional relationships (e.g., domestic partners) or more extended family relationships, although those types of relationships could be covered by either of the first two categories in appropriate circumstances. The adopting release offers no discussion of the constitutionality of the burden of proof shifting in the third category as applied in the context of a criminal prosecution.
August 21, 2000