The question of whether the Securities and Exchange Commission must establish a causal connection between the receipt of material non-public information and trading by an insider to prevail on a claim of insider trading has engendered considerable debate. At issue is whether the SEC must prove that the insider who trades merely possesses such information or must show that the insider actually used the information. 1
The debate has been highlighted by an apparent disagreement between two federal appellate courts that recently have considered the issue in United States v. Smith and SEC v. Adler 2, and prior appellate decisions. 3 Notwithstanding the differing standards that have been suggested, a review of the recent cases in which courts found liability reveals a causal link between the possession of the material non-public information and the trading in each case.
Courts long have held it unlawful to buy or sell publicly-traded securities on the basis of material non-public information -- conduct generally referred to as "insider trading." 4 Such claims may be brought under ££ 10(b) and 14(e) of the Securities Exchange Act of 1934. 5
Under the traditional theory of insider trading, liability may arise where a corporate insider trades in the securities of his own corporation on the basis of material, non-public information. 6 Liability for insider trading also may be based on the "misappropriation theory," under which £ 10(b) is violated when an individual (even if not a corporate insider) obtains possession of material, non-public information that has been gained in violation of a fiduciary duty to its source, and then trades in those securities. 7
In connection with prosecutions for insider trading under £ 10(b), the SEC has urged the adoption of the "knowing possession" standard. Pursuant to this standard, liability arises where the insider knowingly possesses material non-public information, and trades in the company's stock while in possession of such information, without regard for whether the inside information caused or influenced the decision to trade. The Second Circuit endorsed application of this standard in United States v. Teicher. 8
Others have argued that the appropriate standard should be a "use" standard, which would require a causal connection between the material non-public information and the insider's trading. Recently, the Ninth and Eleventh circuits have opined that the use (or causation) standard should be applied in insider trading cases.9
In United States v. Teicher, the Second Circuit, in dictum, stated that a violation of £ 10(b) occurs when a trade is conducted by one in "knowing possession" of material, non-public information.10 First, the court noted that the "in connection with the purchase or sale of a security" requirement of£ 10(b) must be, and had been, construed flexibly in order to include deceptive practices "touching" on the purchase or sale of the security.11 Thus, " 'the predicate act of fraud may be perpetrated on the source of the non-public information, even though the source may be unaffiliated with the buyer or seller of securities.'" 12In the view of the Second Circuit, adoption of the "knowing possession" standard would be consistent with this language.
Next, the Second Circuit pointed out that a "knowing possession" standard was consistent 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." 13
The final factor considered by the Second Circuit was the simplicity in applying such a standard. The court noted that "unlike a loaded weapon which may stand ready but unused, material information can not lay idle in the human brain."14 However, although it favorably discussed the "knowing possession" standard, the Second Circuit expressly found that in the case before it, it was "unnecessary to determine whether proof of securities fraud requires a causal connection" in light of the evidence presented.15
The 'Use' Standard
In contrast, the Eleventh Circuit adopted the "use" standard in SEC v. Adler. 16 The Eleventh Circuit first considered the language of ££ 10(b) and 17(a) of the Exchange Act 17: it rejected the Second Circuit's conclusion that the dispositive language in £ 10(b) was the "in connection with" language and instead concluded that the language of £ 10(b) "suggests a focus on fraud, deception, and manipulation."18 According to the Eleventh Circuit, the use standard "best comports" with this language. 19
The Eleventh Circuit then reviewed language from several Supreme Court decisions that it considered relevant to its discussion. 20 It first cited to and focused on the language in Chiarella v. United States, stating "that an insider's duty arises from 'the unfairness of allowing a corporate insider to take advantage of [inside] information by trading without disclosure' . . . and that 'the federal courts have found violations of £ 10(b) where corporate insiders used undisclosed information for their own benefit.'" 21
The Eleventh Circuit then focused on the statement in Dirks v. SEC, 463 U.S. 646 (1983), that not only are insiders forbidden by their fiduciary relationship from personally using undisclosed corporate information to their advantage, but they also may not give such information to an outsider for the same improper purpose of exploiting the information for their personal gain. 22
The Eleventh Circuit explained that "this language . . . suggests that knowing possession of material nonpublic information at the time of trading may not be enough to establish liability for insider trading." 23 Finally, the Eleventh Circuit cited the Supreme Court's recent decision in United States v. O'Hagan for the proposition that "trading on such information qualifies as a deceptive device under £ 10(b)." 24
Based on the foregoing, the Eleventh Circuit concluded that the "use" standard was more consistent with the Supreme Court's statements implying that liability arises out of trading actually influenced by the material non-public information.
The Eleventh Circuit, however, tempered the potential impact of its adoption of the "use" standard by also holding that "when an insider trades while in possession of material nonpublic information, a strong inference arises that such information was used by the insider in trading." 25 In the view of the Eleventh Circuit, the strongest argument in support of the knowing possession test is that "it often would be difficult for the SEC to prove that an alleged violator actually used the material nonpublic information."26
The court alleviated this problem by creating the rebuttable evidentiary presumption. 27
Ninth Circuit Ruling
In United States v. Smith, the Ninth Circuit was asked to consider whether a conviction for insider trading requires proof of actual use of the inside information. 28 The court compared and contrasted the Second Circuit's decision in Teicher and the decision of the Eleventh Circuit in Adler, and concluded that "we believe that the weight of authority supports a "use" requirement."29
The Ninth Circuit viewed the Supreme Court's consistent suggestions that £ 10(b) requires proof of causation in insider trading prosecutions as the most significant factor in favor of adoption of the use standard. 30 The Ninth Circuit also agreed with the Eleventh Circuit that a "use" requirement is more consistent with the language of £ 10(b), which emphasizes manipulation, deception and fraud. 31 The court reasoned that if the insider merely possesses and does not use [the information], the two parties are trading on a level playing field; . . . both individuals are "making their decisions on the basis of incomplete information." It is the insider's use, not his possession, that gives rise to an informational advantage and the requisite intent to defraud. 32
The Ninth Circuit also rejected the Second Circuit's reliance on the "disclose or abstain" maxim because of the court's belief "that the latter half of the maxim 'disclose or abstain' enjoins not all trading, but trading on the basis of material non-public information."33
However, the apparent split in the circuits regarding the applicable standard in the context of an insider trading action may not be as wide as it initially appears. As recognized by the Eleventh Circuit in Adler, the Second Circuit's favorable discussion of the "knowing possession" standard in Teicher was dicta; and "by considering the defendants' alleged motivations for trading, the Teicher court applied a use/causal connection-type standard for insider trading liability." 34
The Second Circuit's most recent decision to address this issue -- SEC v. Warde -- upheld a judgment finding the defendant liable in a civil enforcement action, in part because the defendant had received inside information and had "traded upon it."35 Once again, the Second Circuit recited the standard for liability as the possession standard -- that is, the defendant traded in securities while in possession of material non-public information 36 --however, the decision in Warde did not cite Teicher, nor did it address the "use" versus "possession" distinction.
The Second Circuit in Warde concluded that the pattern of trading there established by the SEC "supports the inference that [the tipper] communicated inside information to [the defendant], who in turn traded upon it." 37 The court also held that the evidence presented by the SEC was sufficient to establish that the defendant "relied on inside information." 38Thus, this decision, though restating the "knowing possession" standard, seems to be consistent with the use standard adopted by the Ninth and Eleventh Circuits.
1 See, e.g., 7 Louis Loss & Joel Seligman, Securities Regulation, 3504-05 (3d ed. 1991); 2 Alan R. Bromberg & Lewis D. Lowenfels, Securities Fraud & Commodities Fraud,£ 7.4(600), at 7:159, 7:160.14 (1996); Allan Horwich, "Possession Versus Use: Is There a Causation Element in the Prohibition on Insider Trading?," 52 Bus. Law. 1235 (1997).
2 United States v. Smith, No. 97-50137, 1998 U.S. App. LEXIS 20750 (9th Cir. Aug. 25, 1998); SEC v. Adler, 137 F.3d 1325 (11th Cir. 1998).
3 See United States v. Teicher, 987 F.2d 112 (2d Cir.), cert. denied, 510 U.S. 976 (1993); see also SEC v. Warde, 151 F.3d 42 (2d Cir. 1998).
4 See United States v. O'Hagan, 117 S. Ct. 2199, 2213-14 (1997).
5 See 15 U.S.C. £ 78j(b) (providing that it shall be unlawful for any person to use any manipulative or deceptive device in connection with the purchase or sale of any security); 15 U.S.C.£ 78n(e) (providing that it shall be unlawful for any person "to engage in any fraudulent, deceptive, or manipulative acts or practices, in connection with any tender offer").
6 See, e.g., SEC v. Texas Gulf Sulphur, 401 F.2d 833, 848 (2d Cir. 1968), cert. denied, 394 U.S. 976 (1969).
7 See O'Hagan, 117 S. Ct. at 2213-14 (attorney held criminally liable under £ 10(b) pursuant to misappropriation theory).
8 987 F.2d 112, 120 (2d Cir. 1993).
9 See United States v. Smith, 1998 U.S. App. LEXIS 20750; SEC v. Adler, 137 F.3d 1325.
10 987 F.2d at 120.
11 Id. (citing United States v. Newman, 664 F.2d 12, 18 (2d Cir. 1981), cert. denied, 464 U.S. 863 (1983)).
12 987 F.2d at 120 (quotingUnited States v. Chestman, 947 F.2d 551, 566 (2d Cir. 1991) (en banc), cert. denied, 503 U.S. 1004 (1992)).
13 987 F.2d at 120 (citingChiarella v. United States, 445 U.S. 222, 227 (1980)).
14 987 F.2d at 120-121.
15 Id. at 121.
16 137 F.3d at 1337.
17 15 U.S.C. £ 77q(a).
18 137 F.3d at 1333.
19 Id. at 1338.
20 Id. at 1334.
21 Id. at 1333 (quotingChiarella, 445 U.S. at 226-228, 229-30).
22 137 F.3d at 1333-34.
23 Id. at 1334.
25 Id. at 1337.
27 Id. at 1338.
28 1998 U.S. App. LEXIS 20750at *1.
29 Id. at *50.
30 Id. at *50 -51 (citing O'Hagan, 117 S. Ct. at 2207; Dirks v. SEC, 463 U.S. 646, 662 (1983) (reversing conviction of an analyst and holding that tipping liability requires a breach of fiduciary duty owed to shareholders by a corporate insider who "personally will benefit, directly or indirectly, from his disclosure");Chiarella, 445 U.S. at 225-37 (reversing conviction of employee of a financial printer who had traded on the basis of non-public information because the duty to disclose or abstain from trading "arises from a specific relationship between two parties" and the printer had no agency or other fiduciary relationship with the Company)).
31 1998 U.S. App. LEXIS 20750at *54.
32 Id. at *56 (citations omitted).
33 Id. at *57 -58.
34 137 F.3d at 1335 n.25.
35 151 F.3d at 48 (emphasis added); see also Dura-Bilt Corp. v. Chase Manhattan Corp., 89 F.R.D. 87, 95 (S.D.N.Y. 1981) (in connection with motion for class certification, court stated that "defendants' reliance on inside information . . . may be inferred from a showing of defendants' possession of the information"; however, "defendants may introduce evidence to rebut this inference").
36 151 F.3d at 48.
37 Id. (emphasis added).
38 Id. at 91,038.
Reprinted with permission from the October 21, 1998 edition of the New York Law Journal © 1998 ALM Properties, Inc. All Rights Reserved. Further duplication without permission is prohibited.