A Unified Theory of Insider Trading Law

Zachary J. Gubler is Professor of Law at the Sandra Day O’Connor College of Law, Arizona State University. This post is based on a forthcoming article by Professor Gubler.

In the United States, insider trading law is premised on an anti-fraud statute—Section 10(b) of the Securities Exchange Act of 1934—and therefore liability turns on theories about why insider trading is fraudulent. For nearly forty years, courts have relied on the “classical theory” to explain the classic case of insider trading, where a corporate insider uses information derived from his corporate position to trade in his own corporation’s stock. Drawing on the common law of fraudulent non-disclosure, the classical theory provides that insider trading is fraudulent when the trader owes fiduciary duties to the party on the other side of the trade. In A Unified Theory of Insider Trading Law, forthcoming in the Georgetown Law Journal, I argue that the classical theory of insider trading has outworn its usefulness because it fails to do what a theory must, which is explain settled law and provide answers to unsettled law that are intuitively appealing. Instead, courts should replace the classical theory with an alternative, the misappropriation theory, which courts currently limit to cases involving insider trading by “outsiders”—non-employees of the corporation whose securities form the basis of the trade. The result would be a single, unified theory of insider trading law that both explains what courts do and yields intuitively compelling results.

The problem with the classical theory is that it only makes sense in the narrowest of cases: where a corporate executive purchases shares in his company’s stock as a result of material non-public information belonging to his corporation. There, the executive has a fiduciary relationship with the stockholder on the other side of the trade, and therefore it is fraudulent for the executive not to disclose the information motivating the trade. However, one can alter almost any aspect of that narrow hypothetical and immediately run into problems under the classical theory. For example, what if the executive is selling his company’s stock to someone who is not yet a stockholder of the corporation? Or what if instead of trading on the information, the executive passes it along to a friend who trades on it? Because the classical theory requires a duty owed to the transactional counterparty, it has a difficult time explaining why there should be insider trading liability for sales of stock or for tips. Now, to be sure, the Supreme Court long ago extended liability to both of these scenarios. However, it is unclear how one reaches that conclusion under the classical theory.

Of course, if the classical theory weren’t expected to continue to drive outcomes in unsettled cases, these types of logical problems might not be that big of a deal. But it is, and they are. Consider for example, the question of insider trading in debt securities. Information affects the value of publicly traded debt in much the same way as equity, and yet executives don’t owe fiduciary duties to debtholders. Consequently, under the classical theory, there is no liability for insider trading in debt, as most courts have held. Or consider the treatment of repurchases under the classical theory. Since the corporate entity itself cannot be said to owe fiduciary duties to shareholders, under the classical theory, the insider trading ban would not extend to a corporation’s repurchases of its own stock. This might seem problematic considering that a repurchase can increase the value of unsold shares, and given that it is the corporation’s management, themselves stockholders, who ultimately make the repurchase decision.

So, what’s the solution? In the article, I argue that we should replace the classical theory with the misappropriation theory of insider trading. The main difference between the two theories has to do with the beneficiary of the fiduciary duty in question—the shareholder-counterparty in the case of the classical theory and the source of the information in the case of the misappropriation theory. So, for example, if a lawyer acquires information from a client about a company with which he has no relationship and then subsequently trades in that company’s stock, there is no liability under the classical theory. However, there is liability under the misappropriation theory because of the lawyer’s relationship of trust and confidence with the source of the information, his own client. The lawyer’s failure to disclose the breach of that trust is deemed fraudulent.

Courts have historically applied the misappropriation theory only to cases of insider trading involving corporate outsiders, but there is no reason why it couldn’t also be applied to the classic case of insider trading. After all, when an insider trades in his own corporation’s stock based on material non-public information, he misappropriates that information in breach of a fiduciary relationship owed to the corporate entity. This unified approach to insider trading law would have two important advantages over the classical theory. First, applying the misappropriation theory to the classic case of insider trading would do a better job explaining what courts actually do in these cases. It would no longer require logical leaps to explain why courts hold insiders liable for insider trading involving sales of securities or for tips. Additionally, with respect to those classic insider trading cases where the law is unsettled, the misappropriation theory would lead to more intuitively appealing results than under the classical theory. Specifically, the misappropriation theory would lead to liability for insider trading in debt securities. In such cases, the insider misappropriates information from his corporation regardless of what type of security he subsequently trades in. Additionally, the misappropriation theory would allow for liability in certain circumstances for corporate repurchases.

Of course, the misappropriation theory isn’t perfect. But I argue that its weaknesses are actually less of a concern in the classic case of insider trading than in outsider trading where it’s already well established. Otherwise, the theory’s weaknesses can be addressed through fairly simple SEC disclosure rules. In short, a unified misappropriation theory of insider trading would go a long way to solve some of the problems at the heart of U.S. insider trading law.

The complete article is available for download here.

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